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News that investment banks in New York are divided over whether or not they want to continue having access to special liquidity provided by the Federal Reserve may at first sight seem a bit of gamesmanship, with the relatively strong seeking to embarrass their weaker competitors. In fact, it goes much deeper. The core question is whether the investment bank business model will still work in the post-credit-crunch world.
The issue is quite simple. Just after the Bear Stearns rescue, it emerged that the bank was 42 times geared, meaning that for every dollar of equity capital, it had $42 of borrowings. Its entire business was supported on just over 2% capital, the kind of hairy ratio that puts it way beyond what would be tolerated in most hedge funds.
This, of course, explains why it only took a relatively small move against it in the markets to wipe out its capital and put it in need of rescue. It also made it obvious that it was a lot riskier than most hedge funds.
What we now know, however, is that Bear was just the most extreme example, and most investment banks run on leverage of 32 times, meaning their equity capital covers just 3% of what they do. This gives them a significant competitive edge over commercial banks, the worst of which, like RBS, have about 5% with others closer to 7%.
The American regulators, clearly worried by their brush with disaster, have put out a proposal that investment banks in future should be restricted to 22 times, which some might think is hardly a model of prudence, given what some of them have been up to. It would in effect mean they would have to increase their core capital from about 3% to 5% - more in line with what main-street banks have to carry.
Hedge funds are already rubbing their hands because they see the requirement for a higher capital ratio as the trigger for a fire sale of assets that are currently on the investment banks' balance sheets but will be unprofitable going forward.
But even if this doesn't happen, increased capital requirements will clip the bankers' wings and make their businesses less profitable. Indeed, Morgan Stanley's Huw van Steenis estimates it will typically cut a bank's return on equity from around 20% to 15% - the kind of return one expected from broker-dealers in the early 1990s.
The worry among the stronger investment banks in New York is that the longer they depend on the Fed for funds, the more likely it is that they will be hit by new, tougher capital requirements. They seem to think that if they can cut loose now, they may escape tougher regulation altogether. That's surely stretching a point, but one can see why they would want to believe it.
The alternative, that they basically put their businesses back 15 years to where they were in the early 1990s is clearly something they would rather not think about. But it has huge implications for the sector and how banks will operate in the future.
Catastrophe is the way forward
When the insurance industry needed to be recapitalised in 2001 after the losses from the destruction of the World Trade Center, it was done for the most part by creating new companies in Bermuda into which investors could pour capital, safe in the knowledge it would not be diverted into a pot to pay for losses already incurred elsewhere.
When, five years on, the world insurance industry again needed to be recapitalised, in this case after the destruction of New Orleans by Hurricane Katrina, most of the capital came from new players like hedge funds, who invested in many cases through sidecars. These were pools of capital attached to existing insurance but again insulated from any legacy issues, and temporary in their commitment. The capital was there only for a finite period and to take advantage of the good rates.
Capital was also raised by the issuance of catastrophe bonds, securities which paid a rate of interest but where the capital would be lost in the event of a specified disaster.
This is seen as the shape of things to come. Next time the industry needs recapitalising, as it surely will in the next few years, many believe catastrophe bonds will provide the capital. Investment banks are gearing up to take advantage of the opportunity and the insurance industry is positioning itself.
Amlin set the pace last month with the creation of a fund which will invest in Cat bonds and build up group expertise in the area. This week it was Benfield's turn to do something markedly similar with an investment in a company called Juniperus Capital. This is fast becoming a trend.
