CRS Describes Key Policy Concerns Related to Hedge Fund Activity
Commentary by Steven Lofchie
In an In Focus Report, the Congressional Research Service ("CRS") described regulatory policy and financial stability concerns regarding hedge fund activities.
These concerns include:
- "risk diagnosis and systemic risk monitoring" due to a lack of data and disclosures on hedge fund activities;
- threats to financial stability as a result of hedge funds' (i) use of leverage and (ii) interconnectedness with other financial markets (CRS noted that concentrated trades and rapid exits during market distress can cause shockwaves); and
- high fee structures (including asset management fees and performance fees), which may motivate fund managers to take greater risks while causing the investor to bear the downside risk.
CRS reviewed several market events involving hedge funds that caused harm to financial stability. CRS said that the collapse of Long-Term Capital Management ("LTCM") in 1998 created one trillion dollars' worth of exposure for other financial institutions and prompted a $3.6 billion investment led by the Federal Reserve Board of New York to acquire 90 percent of LTCM's ownership. CRS said that the "[l]essons learned" from LTCM's failure were the risk of excessive leverage and importance of disclosures.
CRS also mentioned the "flash crash" in 2010 in U.S. capital markets, which CRS said led to policy debates regarding regulators' lack of understanding regarding modern financial markets.
Commentary
This year there have been three major bank failures resulting in massive draws on the FDIC deposit insurance fund and there very likely would have been other bank failures had the U.S. government not effectively given assurances that it stood behind all depositors at every FDIC-insured bank. Legislators might want to focus their immediate attention on regulated bank risk rather than on hedge funds.