Report
Hedge Funds and Systemic Risk
Sep 19, 2012
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A RAND study revealed that hedge funds did not play a pivotal role in the financial crisis of 2007–2008 but that they have the potential to contribute to systemic risk in the future. The research identified related risk factors, assessed whether recent regulations address them, and highlighted remaining vulnerabilities: (1) the possibility of highly leveraged investments in markets with unreliable liquidity, a volatile combination; (2) the risk that large numbers of modest-sized hedge funds will pursue similar strategies; and (3) the absence of coordinated regulations across national jurisdictions.
Hedge funds, which are investment pools open to high-asset individuals and institutions, have been exempt from many of the reporting and regulatory requirements that govern investment pools open to other investors. Hedge fund firms have been free to pursue any investment strategy they choose, including investing in complex financial instruments, such as derivatives and mortgage-backed securities. They have also faced few restrictions on short selling, leverage, or concentrated positions. As a result, they are able to move nimbly to take advantage of profit-making opportunities as these arise.
Because of their rapid growth over the past 15 years — from $200 billion worth of managed assets in 1998 to $2.4 trillion in 2010 — their active role in many markets, and investments in financial instruments at the heart of the 2007–2008 financial crisis, hedge funds have come under increasing scrutiny. However, without more information on their operations, it is difficult for policymakers and regulators to assess the potential risk hedge funds pose to the stability of the U.S. financial system.
Despite the difficulty, RAND researchers have tackled this issue: They examined whether hedge funds contributed to the global financial crisis and whether their operations could destabilize the U.S. financial system in the future. To help overcome the scarcity of data, the researchers conducted interviews with 45 hedge fund managers and lawyers, investors, regulators, staff of industry associations, congressional staff, researchers, and policy analysts. They also synthesized the research on this issue and consulted available data, provided largely by a leading firm that compiles self-reported statistics on hedge fund operations and performance.
They found that hedge funds did not play a pivotal role in the financial crisis but have the potential to contribute to systemic risk in several ways. Recent regulations effectively address some, but not all, of these risks.
The researchers found that, although hedge funds worsened the financial crisis in certain ways, they did not play a pivotal role compared with other agents, such as credit-rating agencies, mortgage lenders, and issuers of credit default swaps:
However, the behavior of hedge funds destabilized financial markets in one important way: They withdrew tens of billions of dollars from prime brokers — divisions of banks that provide services and extend credit to hedge funds — and their parent investment banks out of fear that their assets could be frozen if the banks declared bankruptcy (an event that occurred in September 2008 with Lehman Brothers Holdings). Even though there were valid reasons for these withdrawals, they were essentially a run on the bank, like the actions of individual depositors during the Great Depression.
Although hedge funds did not play a major role in the financial crisis, the researchers concluded that they can pose systemic risk to the financial system — that is, they can cause the initial failure of one or more financial firms or a segment of the financial system, disrupting a core function of the financial system — for several reasons:
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111-203, 2010) and other reforms address many of these concerns — particularly the first three. First, they aggressively address gaps in the information available to regulators on hedge fund operations, including the requirement to provide a great deal more information about the derivatives market. Second, they overhaul the derivatives market, giving regulators the authority to impose margin and other requirements that will cover the risk of default. Unless major categories of derivatives are exempted from the rulemaking process, these reforms should help prevent the buildup of highly leveraged positions that can lead to the rapid failure of a large fund.
Third, by segregating hedge fund assets from other bank operations, regulations help reduce the risk of runs on the banks. However, the hedge funds will still have the option to deposit funds in nonsegregated accounts at foreign subsidiaries of U.S. banks. The potential remains that hedge fund runs at these subsidiaries will weaken the parent organization.
Recent reforms also make considerable progress in addressing the next two areas of concern — short selling and compromised risk-management incentives — but some questions remain about the effectiveness and comprehensiveness of the approach:
It is not clear, however, whether the reforms will do much to change the potential for hedge funds to build highly leveraged portfolios that turn out to be illiquid in periods of financial turmoil. Given the size cutoffs of recently adopted regulations, few, if any, hedge funds will be subject to direct regulations. This means that control of leverage and portfolio liquidity will fall largely to "market discipline" and indirect regulation — that is, the authority of federal regulators to oversee the risks banks face when they lend to hedge funds and other parties.
Although recent reforms have addressed many of the concerns outlined in this brief, the authors describe several gaps in the current regulatory system that should be considered in future reforms:
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