By Olivia Oran and Dan Wilchins
NEW YORK (Reuters) - Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) are winning back the trading business of hedge fund clients that they lost to European rivals during the financial crisis, as new capital rules spur banks like Deutsche Bank (XETRA:DBKGn) to scale down their businesses. The two U.S. banks together now have about 37 percent of the market for trading with hedge funds and financing positions, known as "prime brokerage," up about 6 percentage points from the end of last year, according to research firm Preqin.
The market share gains are fueling stock trading profits at JPMorgan Chase & Co (NYSE:JPM). as well as at Goldman and Morgan Stanley, and could be a bright spot when the companies post results later this month.
Prime brokerage is one of the few areas on Wall Street where revenue and prices are rising, even though competition is receding, executives in the business and analysts told Reuters.
"With the foreign banks backing away, it's become a greener pasture for some of the U.S. prime businesses," said Larry Tabb, founder of financial markets advisory firm Tabb Group.
It's a business which the U.S. banks are marketing aggressively. Steve Boyd, founder of hedge fund Armistice Capital, originally used just Zurich-based UBS AG as a prime broker when he started the fund in 2012. Last year, a Morgan Stanley representative told him the bank wanted his business.
"We weren't even looking for a second prime yet," Boyd said. "They told us they were interested in investing in a relationship with us, and didn't just want to work with us when it was highly profitable for them." Armistice ended up giving some of its business to Morgan Stanley.
European banks are falling behind because of new global rules, known as Basel III, designed to make banks safer. Those rules limit the amount of debt that banks can take on to fund their assets, and specify the minimum amount of equity, or capital, that banks must use.
Prime brokerage for stocks, bonds, and related derivatives demands high amounts of capital, by one measure, forcing Europeans banks that are close to the lower limits of capital to scale down their businesses. Preqin data show that since 2013, Deutsche Bank's market share has fallen by a percentage point to 7 percent, with the losses happening mainly in 2014.
Credit Suisse's new chief executive, Tidjane Thiam, is planning to slash its prime brokerage business, according to a Swiss newspaper report in September.
In April, Credit Suisse's co-head of investment banking, Tim O'Hara, had said the bank is fully committed to the business.
Both Credit Suisse (SIX:CSGN) and Deutsche Bank are in the middle of global strategic reviews, spokeswomen for the banks separately said.
The gains at the U.S. banks underscore how being faster to comply with new rules can result in greater revenue gains. Analysts said that even if the prime brokerage business itself is often low margin, it can be a crucial source of stock trading revenue.
Coalition estimates that prime brokerage accounted for 35 percent of all equities revenue in 2014, up from 31 percent the year before and 25 percent in 2009. Morgan Stanley, for example, posted an 28 percent increase in stock trading revenue in the second quarter thanks in part to equity prime brokerage.
For Goldman Sachs, stock trading revenue rose 63 percent in the second quarter from the same period a year earlier, also helped by prime brokerage. Goldman chief financial officer Harvey Schwartz said that the bank has been benefiting from higher pricing, though it was not the primary driver of performance.
For the ten biggest global investment and universal banks, prime brokerage revenue in 2014 grew to about $14.2 billion, according to research firm Coalition, up 11 percent from the year before.
A REVERSAL
U.S. banks have been able to boost revenue in part by raising prices. One prime brokerage executive at a European bank estimated that financing a stock trade could be as much as five times more expensive than it had been. Many executives across Wall Street stressed that without charging more, the business cannot be profitable for them anymore, because prime brokerage demands so much capital.
Prices for services can vary widely even from one customer to another at the same bank, depending on such things as how big the fund is and how much business it does with the bank.
Many banks are pressing customers to either do more trading with them or find a new prime broker. For hedge funds, that is translating to more of them working with fewer prime brokers: in 2012, 54.6 percent of newly launched hedge funds worked with one prime broker. In 2015, that figure had risen to 71.2 percent, according to industry data tracker Eurekahedge.
A rebound in the hedge fund industry has also helped to boost prime brokerage revenue for the banking industry. Total global hedge fund capital rose for the 11th consecutive quarter during the second quarter to $2.97 trillion.
In 2008 during the crisis, hedge fund capital fell to as low as $1.4 trillion.
Those were dark times for banks globally, particularly in the United States. After JPMorgan rescued Bear Stearns, and Lehman Brothers started wobbling and ultimately failed, hedge funds began pulling money out of U.S. banks.
Preqin's data does not go back to before the financial crisis, but Global Custodian magazine said 44 percent of hedge funds reduced balances with Goldman Sachs and 70 percent pulled back from Morgan Stanley.
Some customers turned to banks perceived as having the explicit backing of their home governments, such as Deutsche Bank and Credit Suisse, and those viewed as having strong credit like JPMorgan.
European banks are suffering because of Basel III capital rules known as "leverage rules" that don't give banks a break for having less risky assets. In prime brokerage businesses, banks finance customers' trades, which tend to be relatively low-risk loans. But the size of the positions can be relatively large, forcing banks to use high amounts of capital to fund the assets.
The Basel III global leverage rules are expected to be finalized next year. The current preliminary Basel minimum is 3 percent, a figure that is expected to be higher for the final rules that become mandatory in the beginning of 2018.
The U.S. set its own rules last year that are more severe than the expected global minimum requirements. U.S. banks have built capital to meet those rules, and now have more than enough, allowing them to take more risk, executives said.
Goldman and Morgan Stanley, which both must have a 5 percent minimum leverage ratio for their holding companies under U.S. rules, have a 9.6 percent and 7.9 percent ratio, respectively, according to regulatory filings as of June 30. Other jurisdictions are requiring levels above the Basel minimums too—Swiss banks are required to have at least a 6 percent leverage ratio.
Individual nations' may calculate leverage differently from one another and from the Basel Committee of global banking supervisors, which sets the Basel capital rules. Under those rules, Credit Suisse has a 3.7 percent ratio, but under Swiss rules, it has a 4.3 ratio, meaning it will have to build capital. Deutsche Bank's leverage ratio is 3.6 percent under Basel rules.