Financial Update (Third Quarter 2007)

Gov. Warsh: Marketplace Best Discipline for Hedge Funds

Governor WarshHedge funds bring significant benefits to financial markets but also present formidable challenges to risk management, Federal Reserve Gov. Kevin Warsh said in prepared remarks during July 11 testimony before the U.S. House Committee on Financial Services.

Markets enforce funds' discipline
Warsh said the Federal Reserve Board views market discipline as the most effective means of limiting risks to the financial system from hedge funds. The most important providers of such market discipline, Warsh continued, are the large, global financial institutions that are hedge funds' main creditors and transaction counterparts. Institutions that invest in hedge funds—including big foundations, endowments, and pension funds—constitute another source of market discipline, he added.

While the free market should be the primary force limiting hedge fund risk, regulators also have a role to play. "As the umbrella supervisor of U.S. bank holding companies, the Federal Reserve continues to pay keen attention to hedge fund exposures and is working to ensure stronger risk-management practices," Warsh testified.

Gov. Warsh's testimonyoff-site image

Fed's oversight bolsters other agencies' efforts
In particular, he added, the Fed will continue to work with other regulatory agencies to ensure that global financial institutions prudently manage their exposures to hedge funds. Warsh explained that the Fed has focused on five key supervisory initiatives related to hedge funds:

  • reviews of "stress tests," the methods financial institutions use to gauge the potential effects of a variety of adverse scenarios;
  • a supervisory assessment, in conjunction with other agencies, of the leading global banks' practices for managing their exposures to hedge funds;
  • a review of the risks associated with the rapid growth in lending to relatively higher-risk corporate borrowers, often to finance acquisitions or leveraged buyouts;
  • a new evaluation of practices designed to manage liquidity risk; and
  • continued efforts to reduce risks associated with weaknesses in the clearing and settlement of credit derivatives and other over-the-counter derivatives.

A hedge fund generally is an investment pool that is privately organized, administered by a professional manager, and not widely available to the public. The hedge fund business has grown rapidly in recent years. By the end of 2006, more than 9,000 such funds managed more than $1.5 trillion in assets, Warsh told the congressional committee.

July 18, 2007