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Up to 1,000 hedge funds could close in aftermath of market turmoil, says Tabb report

In the future, investment banking will be more tightly regulated and dominated by risk-averse commercial banks, while new firms that are structured as partnerships but are much smaller will take on many of the industry's more risky (but well remunerated) activities, according to industry analyst Larry Tabb.

'The sub-prime crisis needs to be put into a more immediate perspective so banks, brokers, industry executives and the entire financial services ecosystem can begin adjusting their business models, support systems and strategies to react to the massive changes affecting the financial markets,' says Tabb, founder and chief executive of research firm Tabb Group.

In a new report, The Future of Investment Banking: Subprime and Its Impact on the Industry, Tabb cautions that regulators and legislators must also put these issues into perspective lest they implement changes that may inadvertently do more harm that good.

Arguing that the sub-prime crisis was built on greed, not corruption, Tabb analyses the role played by government initiatives, historically low interest rates, misaligned incentives, poor corporate governance structures, incorrect pricing of risk, incomplete understanding of risk management, conflicts of interest and faulty securitisation theories, compounded by a faltering US economy.

Pressure to make quarterly earnings forecasts put pressure on banks to keep these structures flowing, with risk managers unable to stop the runaway train, he says: 'Who was going to tell the CEO to stop the goose from laying the golden eggs?'

With the independent investment-banking model temporarily on the shelf, Tabb argues that once markets stabilise, commercial banks, including Morgan Stanley and Goldman Sachs, now drawing on deposits and savings accounts as cheap money funding sources, will be forced by regulators, legislators and boards to become more conservative.

Risk and compensation levels will drop and the more highly compensated and risk-tolerant people will leave, setting up or joining the investment banks of the future which, he says, will be structured as partnerships, be more adroit and nimble and take on much of the risky aspects of the traditional investment banks of the past.

'The major difference is they will be much smaller and less capable of instigating financial Armageddon,' Tabb says, 'and because they will be set up as partnerships, more cognisant of risk levels, they will be hesitant to take risks to jeopardise their well-being.'

Devastated by the still unravelling securitisation debacle, the push toward investing in transparently-priced and valued products in conjunction with banks' desires to get risk off their balance sheets will force investors to restructure the way products are issued, underwritten, distributed traded and cleared.

Moving from an over-the-counter to an exchange-traded, centrally cleared structure will enable banks to reduce risk, lower their balance sheets and provide more commission income. Four major initiatives are currently underway, Tabb notes. As more products move on-exchange, the marketplace will need to apply advanced trading technologies, increasing demand for connectivity and order management, execution management and high-speed, low-latency market data solutions.

Unfortunately, Tabb says 'the nature of the new regulatory structures place hedge funds at a distinct disadvantage.' As a result, Tabb Group believes that the second half of 2008 will see as many as 1,000 funds close. However, Tabb argues that if market conditions continue to deteriorate and short-selling bans are reinstated, some of these shuttered funds will become self-capitalised market makers or broker-dealers. 'From adversity and change comes opportunity,' he says.

Once the turmoil subsides, he believes, new regulations will 'come from all directions and toward all players,' including loan originators (prohibiting non-doc and possibly zero principal loans), credit ratings agencies and commercial banks (leverage restrictions), plus new Glass-Steagall-type legislation.

Founded in 2003 with offices in New York and London, Tabb Group uses an interview-based research methodology developed by Larry Tabb to analyse and quantify the investing value chain linking fiduciaries, investment managers, brokers, exchanges and custodians.

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