Indirect supervision of hedge funds.

Abstract

Many risks associated with hedge funds can be addressed through indirect measures aimed at the hedge funds’ counterparties and creditors, nearly all of which are regulated banks and securities fi rms. Hence, we consider here how indirect supervision has been made more effective over time and how we should be continuing to make it more effective in practice. The theoretical usefulness of hedge funds in making markets more effi cient and more stable is undisputed but does not always materialize in practice. In order to preserve market effi ciency and fi nancial stability, we need therefore to increase incentives for an effective and long lasting market discipline. Not to do anything is simply not an option given the growth of the hedge fund industry and the fact that hedge funds often act no differently from other financial institutions, whose history has shown worth a look by fi nancial watchdogs. Risk management needs to continuously keep pace with fi nancial innovation. This is a challenge for the indirect supervision of hedge funds but also a support to the pragmatism of this approach. In order to be able to press banks to put enough emphasis on sound risk management, international cooperation is required. Without an international level playing field, short term competitive pressure between banks would indeed most likely derail our efforts. This is a strong and welcome incentive for regulators to be efficient. In addition, the cooperation between banking and securities supervisors should continue to allow indirect supervision to be strengthened and updated as characteristics of the hedge fund business evolve over time. The first mitigant against the risks associated, for any single institution, with hedge funds is robust internal risk management systems. Hence, specific attention is warranted as regards access by banks to more comprehensive information on their Highly Leveraged Institutions (HLI) counterparties, better incorporation of counterparties’ transparency and credit quality into collateral policies, effective improvements of complex products exposures’ measurement (due account being taken of model risks), enhancements to stress testing (in particular liquidity stress testing). In addition, indirect supervision needs to be leveraged by an improvement in hedge funds broad transparency to the market. Stress tests, indeed, should enable banks to capture their full exposure to a suffi ciently broad range of adverse conditions, including not only their direct exposure to a particular hedge fund but also their overall exposure to market dislocations that might be associated with the failure of one or several hedge funds (second round effects). A second mitigant is an efficient oversight, in particular by banking supervisors, of the trading relations that hedge funds have with their counterparties. In this respect, the Pillar 2 of Basel II (namely the supervisory review process which will deal with all banking risks beyond those covered by Pillar 1 regulatory capital charges) will incorporate some of the risks specifically concentrated in hedge fund exposures, i.e. liquidity risk, concentration risk, tail risk, model risk... It seems also now critical to check that banks’ internal information systems are capable of capturing the full range of exposures to hedge funds. Finally, banks are required by supervisors to hold regulatory capital as a buffer in relation to the risks they take. This capital adequacy requirement forms the third line of defence against the risks that a financial institution assumes today when dealing with hedge funds. Last but not least, micro and macro prudential targets converge when banking supervisors press each individual institution for more comprehensive stress tests and the related risk management actions, including against second round effects, i.e. against systemic instability.