In the emerging sphere of supranational macro-prudential supervision, an important debate is progressing among global policy-makers. Throughout the G20, policy-makers and practitioners are attempting to solve one of the fundamental challenges posed by the recent crisis: how to construct a global system of oversight and supervision that is capable of identifying the build-up of excesses and stresses in the financial system, and how best to address such warning signs in a timely and effective manner. The goal is to mitigate systemic risk and market meltdowns, and the related negative effects on the real economy.
What are the key drivers of systemic risk or financial instability? This is an important starting point and as fundamental as it seems, many policy-makers today do not agree on the drivers or how to define these terms.
Let us assume that financial instability is more than market volatility or individual firm failures but involves such extreme volatility and market disruptions that key markets cease to function, including in particular, the failure of core financial functions such as the provision of liquidity and credit. Such extreme events are often the product of strong procyclical forces, exacerbating market or economic adjustments and the stakes are even higher today, given the increased inter-connectedness of global financial markets and institutions.
Thus, an important policy goal must be to better understand market dynamics and to develop policies that reduce or modify a variety of procyclical forces in markets (eg, fair value accounting, overreliance on risk-based capital and VAR-type models, and increasingly common risk management models and practices within and across sectors), as well as the resulting procyclical behaviour of a broad group of market participants. Policy adjustments can reduce these procyclical drivers and facilitate more diverse market behaviour, and thus improve financial stability by reducing the “crowded response” to market shocks.
It is widely acknowledged today that hedge funds were not a cause or a contributor to the systemic events of 2008. Indeed, hedge funds, as an important contributor to market liquidity and price discovery, typically provide important stabilising and counter-cyclical influences to a variety of markets. The diversity of investment strategies and trading styles evident in the hedge fund industry provide important market stability to the frequent herding behaviour evident in many traditional investment management and banking activities.
For these same reasons, it is quite logical, even necessary, that hedge funds contribute to the supervisory analysis of markets and systemic risk.
A fundamental premise underpinning current policy discussions is a desire to improve transparency both at the market and counter-party level, and with and among supervisors. As a matter of principle, this basic premise and goal should be supported.
The global hedge fund industry, through the Alternative Investment Management Association (AIMA), its global association, in February 2009 (in advance of the G20 Finance Ministers meeting in London), announced its support for a variety of policy initiatives focused on improving transparency, including mandatory manager registration and the periodic reporting by larger managers of systemically-relevant information to supervisors and other macro-prudential authorities.
We understand that this could bring additional challenges, including the risk of creating structures that may foster regulatory overload. As such, it is important that (i) a macro-prudential or financial stability-oriented reporting system be applied consistently on a global basis, (ii) only institutions that can practically contribute to this analysis should be asked to incur the costs of doing so, (iii) supervisory capacity needs to exist to effectively use this information, and (iv) all financial sectors and relevant market participants are required to contribute.
AIMA has been working with major national and supranational authorities to develop such a supervisory framework throughout 2009, and most supervisory authorities appreciate the challenges inherent in devising a reporting system for systemically-relevant information. The data gathered needs to be relevant to the risks we seek to mitigate and it must be understood that neither the public nor the private sector can draw on infinite resources in this regard. Take a practical example: supervisors would gain little from scrutinising every position taken by a hedge fund manager or any other market participant. A reporting system seeking to gather too much information is more likely to conceal the building-up of risks than to uncover them since red flags may remain hidden under a mass of data. Indeed, it is important to observe and understand the larger picture, including market and institutional linkages, in order to evaluate systemic risks.
The primary goal of such reporting is to improve the supervisory understanding of market dynamics, not to interfere in markets or to seek a “zero-failure” regime. However, the crisis has again raised questions over one of the guiding principles of prudential supervision, that of “non-zero failure.” Policy-makers should recognise that they will not be able to prevent all failures nor is that a desirable goal. In an efficient and functioning market, some firms will fail, so the focus should be on creating brakes, buffers or barriers in the system to prevent cascading failures as well as the means to efficiently reallocate capital to more productive uses. As a practical matter, based on a variety of growing fiscal pressures, many governments may also be increasingly unable or unwilling to pursue large bailouts and related stimulus programs.
Previous G7 and Financial Stability Board (FSB) studies did not find unique systemic risks created by hedge funds in general or vis-à-vis their systemically important bank and broker counter-parties. And as concerns herding behaviour, hedge fund managers, by design, look for value and opportunity away from the herd as part and parcel of their efforts to generate investment outperformance. Indeed, on this issue, supervisory efforts may be better spent evaluating the market behaviour of other market participants.
A few statistics may be instructive. The entire hedge fund industry manages assets worth about $1.5 trillion today. It may seem a large number, but the broader asset management industry is vast – around $62 trillion in assets under management by some estimates. By that measure, hedge fund firms manage a little over 2% of all professionally-managed assets. Of course, some banks manage more assets than the entire hedge fund industry and do so with much greater leverage.
Nevertheless, hedge funds should not – and do not – fly under the radar. Improving financial stability means empowering supervisors to take a holistic view of the financial system. While hedge funds – and this is an important distinction – are not systemically “important” institutions based on the risk they pose to the financial system or the core services they provide, as mature market participants, our industry can and should contribute to financial stability analysis by providing public authorities with systemically “relevant” information. It should also be noted that many of the largest hedge fund managers have been voluntarily sharing market and risk management information with national and international authorities for many years.
Which hedge fund managers should be asked to provide such information to supervisors? One criteria (not the only one) should be assets under management, with managers having more than $1 billion in AuM, for example, required to comply with enhanced reporting requirements. This would capture about 325 managers and about 80% of assets managed by the global hedge fund industry, providing both practical and relevant coverage. In this way, supervisors should gain a useful view of market activity via the window of hedge fund managers, including market trends and the possible build-up of various types of risks across the financial system and sectors.
What type of information should be gathered? Supervisors should consider a range of issues and look beyond the popular focus on leverage. It is worth noting that the historic peak of average hedge fund leverage, set in 2006, was $2.90 for every dollar invested (2.9 times assets), according to Credit Suisse – a miniscule level compared to the 30-50 times leverage employed by some of the biggest banks at that time.
During 2007 and 2008, the average leverage employed by hedge funds was much lower. To better understand the market and system risks, supervisors need to evaluate a variety of risk factors, such as (i) portfolio or balance sheet concentrations, (ii) historic and current volatility levels across markets, (iii) very importantly, liquidity conditions on both sides of the balance sheet, and (iv) leverage levels, on and off-balance sheet, across institutions and sectors. Understanding these risk factors, especially liquidity conditions, should be of primary importance and produce a better analysis of systemic risk. This is also the type of risk analysis (in general terms) that major hedge fund managers conduct on a regular basis and possibly why numerous observers have concluded that risk management systems at major hedge funds are typically of the highest standard.
Policy-makers and regulators are not alone in the desire for greater financial stability; it is in the interests of everyone operating in financial markets and the broader economy, including the alternative investment community. The G20, the FSB, the International Organization of Securities Commissions (IOSCO) and national supervisors have made a significant commitment to improve financial stability.
As part of the new regulatory framework, the hedge fund industry and AIMA are working closely with national and international supervisory authorities, and fully support their efforts to create an effective global macro-prudential system and reduce systemic risk. Otherwise, we could all be left in the dark... again.
This article first appeared in AIMA Journal (Pg 15, Q1 2010 issue). For more information, please go to www.aima.org.