Shadow Banking & Hedge Funds

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1 AIMA Presentation Shadow Banking & Hedge Funds PRMIA 3 rd April 2012 Andrew Baker (CEO, AIMA) Enhancing Understanding, Sound Practices and Industry Growth

AIMA -Global Reach Over 1,300 member firms worldwide Over 6,000 individual member contacts Members in over 40 countries Over 1,200 contacts among

2 AIMA -Global Reach Over 1,300 member firms worldwide Over 6,000 individual member contacts Members in over 40 countries Over 1,200 contacts among regulators and policymakers Over 600 institutional investor contacts Over 900 media contacts Enhancing Understanding, Sound Practices and Industry Growth 2

3 AIMA - Members by region Enhancing Understanding, Sound Practices and Industry Growth 3

4 Member Breakdown by Type of Firm Hedge Fund Managers 3% 7% 5% 10% 10% 16% 48% FoHFs Lawyers Fund Administrators Accountants / Auditors Prime Brokers Consultants / Others Enhancing Understanding, Sound Practices and Industry Growth 4

5 Shadow Banking Enhancing Understanding, Sound Practices and Industry Growth 5

6 Instability - modern financial system Secured lending, mark to market accounting and resulting procyclicality. Long complex intermediation chains: non-transparent maturity transformation. Funding liquidity driving market liquidity in traded markets. Increased demand for safe liquid assets. Unstable and myopic risk assessment Source: Adair Turner, Shadow Banking and Financial Instability Speech to Cass Business School, March 2012 Enhancing Understanding, Sound Practices and Industry Growth 6

7 Background what is shadow Banking? G20 Seoul Summit leaders instructed the FSB to develop recommendations to strengthen the oversight and regulation of the shadow banking system. Broadly defined shadow banking can be described as credit intermediation involving entities and activities outside the regular banking system. Authorities to cast net wide looking at all non-bank intermediation, monitor all activities within shadow banking system. Focus on activities of: maturity /liquidity transformation/imperfect credit risk transfer leverage regulatory arbitrage Enhancing Understanding, Sound Practices and Industry Growth 7

FRB NY Shadow Banking Schematic http://www.ny.frb.

8 FRB NY Shadow Banking Schematic Enhancing Understanding, Sound Practices and Industry Growth 8

9 Regulatory concerns Primary concerns: Systemic risk (maturity/liquidity transformation, flawed credit risk transfer). Regulatory arbitrage (undermining stricter bank regulation). Build up of additional leverage and risks in the system Procyclicality. ENHANCED SUPERVISION & REGULATION OF SHADOW BANKING SYSTEM! Enhancing Understanding, Sound Practices and Industry Growth 9

10 Actions Strengthen the regulation and oversight of the shadow banking system. Effective monitoring of the sector will consist of: high level principles a stylised 3 step process Oversight of national/regional implementation of regulatory initiatives with regard to: data reporting and transparency underwriting standards credit rating agencies A single regulatory approach is unlikely to be desirable. Enhancing Understanding, Sound Practices and Industry Growth 10

11 Shadow Banking & Hedge Funds Initial shadow banking definition so broad as to catch large portions of the asset management sector including hedge funds. Credit hedge funds look past the name, hedge fund index classification instead focus on the actual activities performed. Credit Hedge Fund Universe can be split into 4 investment types: Relative value credit Long short credit Macro credit Fundamental credit Estimates as to the size of this universe vary from ¼ to 1/3 of the global hedge fund industry ($500bn). Shadow Banking Total Estimate: $60 trillion (FSB, 2011). Enhancing Understanding, Sound Practices and Industry Growth 11

12 Size of the hedge fund sector Hedge Funds still only account for a small percentage versus other investors of the global asset management industry, making up less than 2% of the estimated total. Source: AIMA research, December 2010 Enhancing Understanding, Sound Practices and Industry Growth 12

13 Size of credit hedge fund universe Enhancing Understanding, Sound Practices and Industry Growth 13

Credit Intermediation Since 2008 the degree to which credit hedge funds have employed direct lending as an investment strategy has diminished considerably.

14 Credit Intermediation Since 2008 the degree to which credit hedge funds have employed direct lending as an investment strategy has diminished considerably. Volume of US direct lending to middle market companies. Source: Standard and Poor s (Leveraged Commentary and Data) Enhancing Understanding, Sound Practices and Industry Growth 14

Credit Intermediation The collateralised loan market remains largely shutdown; overall leveraged loan market is flat in the US and shrinking in Europe with high yield

15 Credit Intermediation The collateralised loan market remains largely shutdown; overall leveraged loan market is flat in the US and shrinking in Europe with high yield bonds preferred. CLO Capacity by year ( ) Source: Standard and Poor's Leveraged Commentary and Data Enhancing Understanding, Sound Practices and Industry Growth 15

16 Credit Intermediation Securitisations (which would have contributed to growth in credit markets) have also fallen sharply. Source : RBS Global Banking and Markets Enhancing Understanding, Sound Practices and Industry Growth 16

17 Maturity/Liquidity Transformation Hedge fund liability is opposite to that of a bank, funding maturity is longer than the liquidity of the risk portfolio. Source: FSA, 2011 Enhancing Understanding, Sound Practices and Industry Growth 17

18 Maturity/Liquidity Transformation What liquidity do you require? Historical Source: Deutsche Bank Alternative Investment Survey (2011) Enhancing Understanding, Sound Practices and Industry Growth 18

19 Maturity/Liquidity Transformation What is the longest lock-up that you will accept on new hedge fund investments? No lock up is acceptable 10.1% Less than 6 months 6.0% Less than 1 year 7.0% 1 years soft lock up 15.9% 1 years hard lock up 18.8% 2 years soft lock up 13.7% 2 years hard lock up 9.6% 3 years soft lock up 4.0% 3 years hard lock up 3.6% 3 or more years 5.1% NA/Prefer not to answer 6.3% Source: Deutsche Bank Alternative Investment Survey (2011) Enhancing Understanding, Sound Practices and Industry Growth 19

20 Leverage Modest levels of leverage employed - Employ far lower levels than banks (2008 peak being 2.6 times vs 41 times recorded by investment banks). Industry leverage declined in the last 12 months from 1.27 times to 1.1 times investment capital. Source: HFR, Inc 2011 Hedge Fund Leverage Report Enhancing Understanding, Sound Practices and Industry Growth 20

21 Not Systemically relevant During the recent crisis, hedge funds frequently closed and liquidated in an orderly manner, with little or no impact on the system and no burden placed on taxpayer. Source: HFR (2011) Enhancing Understanding, Sound Practices and Industry Growth 21

22 Not Systemically relevant With over 9,000 funds estimated globally, dispersion of assets reduces risk of failure of one hedge fund leading to run in the industry. Source: HFR (2011) Equity Hedge Energy 1.53% Equity Hedge Market Neutral 1.81% Equity Hedge Fundamental Growth 3.72% Equity Hedge Fundamental Value 15.99% Equity Hedge Quantitative Directional 0.72% Equity Hedge Short Bias 0.17% Equity Hedge Technology/Healthcare 2.23% Event Driven - Special Situations 13.13% Event Driven - Distressed/Restructuring 5.91% Event Driven - Merger Arbitrage 0.88% Event Driven - Private Issue/Reg D 0.32% Event Driven - Activist 2.32% Event Driven - Credit Arbitrage 0.28% Macro -Discretionary 6.72% Macro - Systematic Diversified 8.95% Macro - Commodity 1.24% Macro - Currency Discretionary 0.50% Macro- Currency Systematic 0.91% Macro - Multi Strategy 2.28% Relative Value -Fixed Income Asset Backed 1.96% Relative Value - Fixed Income Convertible Arb 1.95% Relative Value - Fixed Income Corporate 4.27% Relative Value - Multi Strategy 15.0% Relative Value - Fixed Income Sovereign 0.66% Relative Value - Volatility 0.47% Relative Value - Yield Alternatives 0.42% Emerging Markets 5.66% Enhancing Understanding, Sound Practices and Industry Growth 22

23 Adequate Regulation No more regulation needed! Industry is already subject to strict regulation in all major jurisdictions around the world (Dodd Frank, AIFM etc..). All major jurisdictions are introducing a detailed and mandatory systemic risk reporting regime (via IOSCO). Level of regulation and oversight should ensure that if there was to be a build up of systemic risk within the hedge fund sector, competent authorities should have all the necessary tools to intervene. Definition of shadow banking should be narrowed further to capture activity with likely highest systemic risk, main focus being on: Regulatory arbitrage (off balance sheet vehicles etc.) Non bank deposit-like taking institutions most susceptible to market panic Enhancing Understanding, Sound Practices and Industry Growth 23

24 Not Shadow Banks! Hedge Funds and their managers are : An integral part of the asset management community which exist to serve among other investors, pension funds, endowments, foundations Adequately regulated/subject to strict and extensive reporting Small in relation to the financial system Operate with modest levels of leverage Uniquely capable of managing their liquidity profiles so as to mitigate not accentuate pro-cyclicality Safe to fail, do not need government support Stabilising element of the financial system In this sense, hedge funds should not be classified as shadow banks! Enhancing Understanding, Sound Practices and Industry Growth 24

25 Possible regulation proposed timelines Source: FSB Enhancing Understanding, Sound Practices and Industry Growth 25

26 Further reading AIMA Research (2012), The role of credit hedge funds in the financial system - asset managers, not shadow banks. Financial Stability Board (2011), Shadow Banking: Strengthening Oversight and Regulation. Pozsar, Adrian, Ashcraft and Boesky (2010), Shadow Banking, Federal Reserve Bank of New York Staff Reports, No Adrian and Shin (2009), The Shadow Banking System: Implications for Financial Regulation, Federal Reserve Bank of New York Staff Reports, No.382. Enhancing Understanding, Sound Practices and Industry Growth 26

27 Contact Alternative Investment Management Association Tel: +44 (0) Fax: +44 (0) Web: Enhancing Understanding, Sound Practices and Industry Growth 27

The LIAJ s Comments on the FSB's Consultative Document Strengthening Oversight and Regulation of Shadow Banking

The LIAJ s Comments on the FSB's Consultative Document Strengthening Oversight and Regulation of Shadow Banking A Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos 11