Capital Markets

Fed: Hedge Funds Get Too Much Credit

In a sign of growing concern, the president of the New York Federal Reserve calls on banks to tighten up their lending to hedge funds.
Tim Reason and Ronald FinkMay 16, 2006

Banks should impose stricter lending standards on hedge funds, the president of the Federal Reserve Bank of New York said Tuesday. That is the strongest suggestion yet that bank regulators remain concerned about often incestuous relationships that allow banks to lay off risk to hedge funds, even as those funds borrow from banks to fund their activities.

Speaking at the Third Credit Risk conference at the NYU Stern School of Business, New York Fed president Timothy Geithner echoed former Federal Reserve Chairman Alan Greenspan in nothing “The transfer of credit risk from banks to non banks “probably improves the overall efficiency and resiliency of the system.” Unlike Greenspan, however, Geithner stressed the word “probably.”

Geithner went on to note that bank regulators have “some concern and unease” based in part on uncertainty. “There’s a lot we do not know” about non-bank market participants, he said, referring to largely unregulated hedge funds. He then offered several suggestions, noting that his overall objective was to encourage “greater caution and conservativism” on the part of the banks.

Bank relationships with hedge funds have been the subject of recent industry efforts at self-regulation, notably the 273-page report of the Counterparty Risk Management Policy Group II. Produced by Gerald Corrigan, a former Federal Reserve official who conducted a bank-sponsored postmortem on Long Term Capital Management, the report painted a rosy picture of improvements in the financial world’s handle on market and credit risk, but warned that operational risks resulting from the rapid rise in the use of credit derivatives and other financial innovations could, under the wrong circumstances, spiral out of control.

That’s a reference to the fact that banks and hedge funds frequently trade credit default swaps, but poor systems for recording those trades have created a backlog. In the case of a massive credit meltdown, that could make it difficult to find the ultimate owner of the swaps. Despite improvements, said Geithner, the operational infrastructure and that backlog of unconfirmed trades is an ongoing source of concern.

Geithner saved his strongest comments, however, for bank lending practices, noting that the Fed wants to see more conservative behavior on the part of banks. He said the Fed is concerned about the “very favorable credit conditions for hedge funds,” citing “erosion in loan covenants” and “higher levels of transaction leverage.” Banks, he said, should tighten their margin requirements, for hedge funds.

Geithner also seemed to cast doubt on the Corrigan report’s confident assertions about the banking industry’s use of stress testing and scenario analysis. The Fed, he noted, was encouraged by improvements in these areas, but stressed that banks ought to be wary of relying too heavily on such tools. “[Bank] management needs to understand the limitations and uncertainty of the tools they use for scenario analysis and stress testing,” said Geithner.

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