Financial reforms could restrict lending to hedge funds and increase systemic risk

The Dodd-Frank financial reforms could introduce greater systemic risk into the financial system if they force hedge funds to seek leverage from less tightly regulated banks in Europe, according Sylvan Chackman at Bank of America Merrill Lynch.

Regulatory changes in the US could significantly restrict the ability of banks to provide leverage to hedge funds and drive up the cost of financing, according to Sylvan Chackman, co-head of global market financing and futures at Bank of America Merrill Lynch.

“When you look at the details of the regulations, what you have is higher margins and an inability to net across assets. The cost of leverage is rising and this is going to trickle down to hedge funds,” Chackman said in a panel discussion at the SkyBridge Alternatives conference in Las Vegas.

Federal Reserve chairman Ben Bernanke is expected to outline stricter rules for systemically significant US financial institutions at a Senate banking committee hearing on 12 May.

The proposals are likely to include “enhanced” capital requirements, leverage standards and annual stress tests for institutions deemed to pose a risk to the financial system.

Regulators are also pushing forward with reforms to the derivatives market that would require swap dealers to post margin and clear standardised derivatives through a central counterparty.

Banks are also being forced to set aside more capital by the Basel committee on banking supervision.

Chackman said his main concern is the Dodd-Frank rules could force US hedge funds offshore in search of leverage.

“It would be fine if everyone was playing by the same rules but Dodd-Frank only applies to US financial institutions and their affiliates. What you will see is a fierce push by European banks to capture the hedge fund fee base,” said Chackman.

Hedge funds are estimated to generate around $60bn (€42.4bn) in fees annually for the sell-side. European banks are eager to capture a larger of this business and may be prepared to offer higher leverage at lower rates than US banks to attract hedge fund clients.

“Hedge funds may go outside the US to more loosely regulated entities for that leverage. We could see a concentration of hedge fund activity in a handful of European banks and a concentration of systemic risk,” said Chackman.

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