Constraints on financial industry “smart money” under Basel III will create opportunities in illiquid assets for buy-side investors, says Anurag Mahesh of Deutsche Bank Private Wealth Management.

The firm’s Asia-Pacific head of global investment solutions notes that new regulations restricting the ability of banks and hedge funds to take advantage of market inefficiencies will create gaps for the likes of pension funds and private banks to fill.

Just last month, the Basel Committee on Banking Supervision outlined plans for key changes to what banks can count as tier-one capital, raising the likelihood of further rights issues, and moved to restrict the use of leverage and prevent excessive credit growth.

Although these adjustments are scheduled to be introduced incrementally over the next decade, the implications will be considerable, notes Mahesh.

“First and foremost the price of risk will probably never go to the levels we saw in 2007, when buy-side investors were not being compensated enough for the level of risk they were taking,” he says.

“The reason was that there was this massive amount of smart capital, sitting on top of the private investor capital, that was coming in quickly and arbitraging any opportunities in the capital market space. But because smart money will be constrained in what it can do, these opportunities will filter down to private bank lines.”

On the understanding that the new rules will weaken the principal position and transaction power of banks, Mahesh says real-money investors such as pension funds and private banks should be able to deploy capital more fruitfully in future. It is a development that he notes moves towards a broader goal of deepening capital markets and introducing a more diverse set of players.

“Increasingly banks will need to raise tier-one capital,” he explains. “But at a transaction level you also need capital and that is where I think private bank individuals and [buy-side] clients can play a vital role.

“Mark-to-market is a very relevant concept in the banking industry, but that may not be relevant for a client who may be willing to take a view on, say, underlying credit default over a one-year period.

“A private client is going to get a lot more return out of the same risk that a bank simply will no longer be positioned to exploit.”

Mahesh says opportunities to invest are likely to emerge in fixed income, currencies and commodities above equities given the time horizon that these asset classes typically demand.

“Equities can mean very short-term trading as an asset class, so either there aren’t enough market dislocations or the capital you require is not large,” he says. “When it comes to a little bit more illiquid credit opportunities, the capital [requirement] is higher.”

He notes that investors are likely to get a higher return for less liquid investments, something that banks would have been able to hold on their balance sheets prior to Basel III. “If clients are happy to take illiquidity risk, they will get compensated a lot more than they have in the past.”

Mahesh concludes that the financial industry is morphing into two distinct categories, one being a world that goes long on risk, and the second being one that provides balance-sheet-backing.

“I could buy a bond, or I could buy a total-return swap and put in cash, let’s say as margin. The two trades are equivalent in terms of what you achieve,” he says. “But in the second trade, because the cash element is separate, the return that the client should earn is higher because he is committing balance sheet.

“Every asset category increasingly is being defined in these two different ways, and clients are going to get paid for that. And if they’re not, they should and that is a clear theme going forward.”