Managing Risk in Alternative Investment Strategies: Successful Investing in Hedge Funds and Managed Futures
ISBN-10: 0-273-65698-8; ISBN-13: 978-0-273-65698-2; Published: Jul 15, 2002; Copyright 2002; Dimensions S; Pages: 320; Edition: 1st.
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Hedge funds have been around for 50 years, but they’re not well understood. Satyajit Das removes some of the murk from this corner of the financial universe, clarifying what you need to know about the history and the reality of hedge funds (and hedge fund managers).
Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives
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Hedge fund returns are hot. Based on the fee structure, you paid for a Ferrari—not some anemic, environmentally correct hybrid!
Some hedge funds have shown high returns. There are wide divergences between the best- and worst-performing funds. Long-run returns are clouded by the “survivorship bias”—that is, many hedge funds have perished along the way. High returns require that you select the better-performing funds.
You need to consider the sustainability of returns. Macro funds were beneficiaries of the confluence of specific factors: the integration of emerging economies into global markets, the end of communism in Eastern Europe, the growth of world trade, and deregulation of financial markets such as currencies and interest rates. These epochal events were once-in-a-lifetime occurrences that created trading opportunities. For example, Soros’ triumph in breaking the pound was predicated on the collapse of a highly flawed system of currencies. In 1997-98, hedge funds made substantial returns when similarly pegged currencies fell apart. This can be seen in the varied fortunes of macro funds in recent years. Some have prospered, but many funds, included the fabled Quantum and Tiger Funds, have restructured or disappeared.
Relative-value hedge funds were beneficiaries of similar events. LTCM’s early success was linked to opportunities related to the creation of a single European currency and tax arbitrage opportunities. Relative-value funds benefited in the 1990s from the introduction of new and innovative products that few understood and fewer had the skills and systems to value. The shrinkage of opportunities has forced relative-value funds to migrate into new areas—credit being the major one.
Hedge funds may offer investors 15–20% p.a. returns with minimal risk—but such funds are far riskier than the risk statistics reveal. The systems used don’t actually capture the real risks. Investors use Sharpe or information ratios to measure performance. Assume that Treasury bills yield 5% p.a. Further assume that hedge fund A has an annualized return of 20% with a volatility of 10%, and hedge fund B has a return of 15% with a volatility of 5%. The Sharpe ratios, are, respectively:
Hedge fund B, despite its lower absolute performance, provides the investor with greater returns relative to risk than hedge fund A.
Sharpe ratios are flawed. They are ex post (based on actual risk) rather than ex ante (expected risk). Actual risk return achieved should be compared to the risk that was known to be taken at the time the position was taken. This generally shows higher risk and lower risk-adjusted returns.
There are alternative risk models. The Sortino ratio, a variation of the Sharpe ratio, focuses only on adverse price changes, using deviation below a specified level. A personal favorite is “drawdowns”—a euphemism for actual losses incurred and the cash that must be found to cover a peak-to-trough change in the fund’s position.
The real risks of hedge funds are correlation risk, liquidity risk, and complexity or model risk. Unsurprisingly, traditional systems are poor at capturing these risks. Traders, whether in hedge funds or otherwise, are extremely skilled in arbitrage—internal arbitrage. Traders arb the internal risk metrics to inflate risk-adjusted returns on which their bonuses are based. Nature abhors a vacuum.
Many hedge fund trades seek to buy or sell “mispriced” securities. The position is hedged by an offsetting trade using similar securities. The idea is that the values will converge. The market prices may correct, allowing the trader to unwind his trades at a profit. If the market prices don’t correct, the trader must hold the position through to maturity to realize the profit. The holding period can be long, very long—on the order of 30 years. Hedge funds have short risk horizons—no longer than 6–12 months. Changes in mark-to-market values, the resulting margin calls, and the investor’s right to redeem capital periodically make it difficult to manage this risk. Leverage, liquidity risk, and complexity are lethal companions.
LTCM liked to arbitrage small value differences between similar securities. The returns were small, so LTCM typically leveraged the trades to increase returns. After the Asian crisis, credit spreads (the margin above government bonds for additional risk) blew out well above what was needed to cover the actual risk of people not paying up. LTCM wanted to lock this in and leverage the position.
LTCM entered into interest-rate swaps where they received fixed rates, getting government bond rates plus a margin (credit spread). Then they went short government bonds on the other side, paying the government rate. LTCM effectively locked in the credit spread. They leveraged the position massively. The game depended on the spread getting smaller (convergence) or holding the position to maturity (10 years). Unfortunately, the spread kept getting wider. Interest rate swaps rose, and government rates fell. LTCM now had losses on both legs of the trade. They had to find cash to cover their losses, and they ran out of money. The LTCM principals witnessed firsthand the truth of John Maynard Keynes’ observation: “There is nothing so disastrous as a rational investment policy in an irrational world.”
In 2006, emerging markets took a hit. Market-neutral hedge funds losses mirrored the fall in the market. A short memory and a rising market generally passes for investment genius. One hedge fund manager explained: “Everything in the market was a compelling buy. We could find nothing to short.”
Over 50% of the hedge funds that fund-of-funds managers invest in have been in existence for less than 2 years. The majority of hedge funds are small—less than 10 staff. The operational risk and key personnel dependency is high.
In 2006, Amaranth, a multi-strategy hedge fund with around $9 billion under management, lost $6 billion in natural gas trading. [4] In 2005, Brian Hunter, a 32-year-old Canadian, made a bet that natural gas futures would rise. Surging gas prices following Hurricane Katrina made large trading gains for the fund, and Hunter was named head of Amaranth’s energy trading operations.
He placed a similar bet in 2006, but natural gas prices fell sharply, triggering losses. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Amaranth ultimately discontinued operations. A spokesman for the hedge fund made the following observation regarding the losses: “We did not expect that the market would move so aggressively against our positions!”
In his book Hedge Funds: The Courtesans of Capitalism, [5] Peter Temple compares hedge funds to courtesans—high-class prostitutes whose clients are drawn from the wealthy or upper classes. If hedge funds are the prostitutes (the girls), then the banks are clearly the pimps and bordello keepers.
Creating hedge funds to house trading activities “off balance sheet” solves many problems for banks. The introduction of capital controls on trading in 1994 made it punishable for banks to hold trading positions on balance sheet. Hedge funds also alleviate the problem of attracting and remunerating “gun” traders. Bank shareholders, regulators, the public at large, and bank CEOs react negatively to large payments to traders, especially when it exceeds their own salaries. The hedge funds are also able to leverage more than the banks themselves.
Banks help set them up hedge funds, invest in them, and trade with them. A whole new service, “prime brokerage,” combines settling and clearing hedge fund trades, execution services, and financing hedge funds. Investment banks have set up “incubators” to help budding traders create hedge funds. The services include training in etiquette and investor relations to communicate properly with investors.
Banks also design products around hedge funds, such as capital-guaranteed hedge fund investments for risk-averse investors—you can’t lose your principal, although you may end up earning nothing on your investment for 10 years. This type of investment helps explain why, in the words of Groucho Marx, many investors in hedge funds “work [themselves] up from nothing to a state of extreme poverty.”
Dealers love hedge funds. Dealers earn from hedge funds at around 30–40% plus of their total earnings. The bulk of earning is from lending money to hedge funds. No bank, at least I think, would lend to hedge funds. Lending is made possible through repurchase agreements (repos) and derivative trades.
In a repo, the bank lends money against the value securities held or sold short by the hedge fund. The value of the security (collateral) secures repayment. Derivatives don’t require initial investment, just a promise to perform in the future. The promise is secured by the hedge fund’s lodging cash or securities. The collateral is increased or reduced as market prices change to ensure adequate coverage. This is no-risk lending—regulators don’t require banks to hold capital against these transactions.
If a position moves adversely, the bank will require the hedge fund to lodge more collateral—a margin call. What happens if they can’t come up with it? In order to reduce risk, banks use a “haircut”—over-collateralization to ensure that it has a buffer if the hedge fund cannot meet a margin call. Banks are under competitive pressure to reduce the haircut. LTCM didn’t require any haircut at all; it was “special.” Writing in the Wall Street Journal, Holman Jenkins observed, “Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?” [6]
The setting of the haircut is flawed. To cover their risk, banks must estimate the worst-case daily change in value of the positions. This is art, not science. Hedge fund strategies have “event” risk when the value of the position could change a lot.
The relationship between dealers and hedge funds is littered with moral hazards. Senior executives at many banks were personal investors in LTCM. Some were involved in negotiating the bailout. It’s all part of the “special” relationship.” [7]
Banks love dealing with successful hedge funds so they can copy from the “best and brightest.” Banks have internal hedge funds that work closely with special sales desks that service hedge funds. Some had been created specifically to serve LTCM. They worked out LTCM’s trading strategies and then did the trades for their own account. When risk limits were full, they marketed the same strategies to other banks and hedge funds.
When the storm hit in mid-1998, all the traders found that they had put on the same trades. LTCM were perhaps the only ones who were not aware of this. Louis Bacon, the principal of Moore Capital, once remarked, “There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game.” [8] In the end, LTCM was the game.
Under stress conditions, prices are affected by illiquidity. Sometimes, prices are unavailable. The valuation of positions are often very conservative, triggering larger mark-to-market losses, necessitating more collateral. Mark Twain observed, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” To this day, LTCM swears that the banks manipulated the prices to force them out of business.
Even if the hedge fund goes under, banks can make money by buying the positions at an “undisclosed” (read: “distressed”) price. They make money from unwinding the position. Banks provide a true cradle-to-grave service for hedge funds.
8. More Money Than You Know What Do With?
Hedge fund managers are the new elite. Brian Hunter, responsible for energy trading at Amaranth before it imploded, earned $75–$100 million in 2005. This, by the by, only ranked him a middling 29th-highest paid in his profession, according to Trader Monthly. [9] One hedge fund manager earned $1 billion in 2005! [10] Apparently money isn’t important; it’s just a scorecard of success.
Having more money than you can possibly spend creates new challenges for the Masters of the Universe. Billionaire hedge fund managers bid up the price of luxury apartments and modern art. Michael Steinhardt owns a large estate containing exotic wildlife. He was seeking to collect every duck and swan variety in the world.
Hedge funds managers are often generous donors to charities—tax deductible, of course. There is the paradox of charity—how enrichment by a variety of means paves the way for conspicuous generosity. George Soros supports free markets and democratic initiatives in Eastern Europe. Detractors question whether it has anything do with the fact that hedge funds are beneficiaries of the opening up of these economies. Some “donations” are also “involuntary,” to settle antitrust and securities charges.
Hedge fund managers are generally secretive. Paradoxically, some hedge fund managers brazenly seek acceptance as “thought leaders.” George Soros has written many books—The Alchemy of Finance: Reading the Mind of the Market, Staying Ahead of the Curve, The Crisis of Global Capitalism: Open Society Endangered. He thinks of himself as a “financial and philosophical speculator,” says Peter Temple. [11]
The centerpiece of Soros’ musings is “reflexivity.” Markets don’t tend toward equilibrium; markets feed on their own misconceptions to produce exaggerated price changes until they reach an “inflexion point” when it changes. Soros suggests following the trend and selling as it reaches the peak. This advice takes about 400 pages. In the December 1998 issue of The Economist, the following review of The Crisis of Global Capitalism appeared. [12]
Because of who he is there will always be buyers for his books, publishers for his books, and cash-strapped academics to say flattering things about his books. None of this alters the fact that his books are no good…. A remarkable thing happens to money when it passes through Mr. Soros; it emerges multiplied, but otherwise unchanged. With other inputs the results are more disappointing—to be blunt, more in line with biology. Mr. Soros gorged on chopped philosophy, mashed economics, and fact and figures swimming in grease. It was too much. Before he knew what was happening out rushed this book.
Woodstock for Hedge Funds
The hedge fund industry’s search for acceptance has reached new realms. In 2006, the industry staged “Hedgestock.” [13] The title paid homage to Woodstock—the historic three days of peace, love, promiscuity, music, drugs, and shockingly bad dancing. Hedgestock was to be two days (nobody could afford three days in this time-challenged age) of networking and finance. Adam Smith understood networking: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices.” [14]
The hippies had celebrated their counterculture movement at Woodstock. Hedge fund managers are keen to advertise that they were the vanguards of the “alternative” movement—”alternative investments,” that is! It was the dawning of the age of hedge funds, not the age of Aquarius.
The Fall of Hedge Funds?
Hedge funds have underperformed more traditional asset classes such as equities in recent years. Investors always chase yesterday’s returns. Adjusted properly for risk and the absence of liquidity, hedge funds return at best no more than—and frequently less than—traditional assets.
A recent study found that hedge fund performance doesn’t appear to deliver alpha consistently. [15] There are exceptions, but they’re few and far between. Many of the really good hedge funds are closed to investors. Even where you can invest, the flow of funds into better-performing funds rapidly erodes returns. Too much money is chasing too few opportunities. Clever people can make money if there are only a few clever people and lots of opportunities. This is scalability—what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. [16] There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.
Ultimately, if you make money from inefficiency, someone—other investors—must supply the inefficiency. We cannot all exploit inefficiencies, as nobody would be supplying the market inefficiency in the first place. To be “alternative,” there has to be a majority; the alternative cannot be the majority.
Hedge funds with certain areas of expertise began to trade in other markets as opportunities became limited, creating “style drift.” LTCM had drifted from their métier—relative-value trading in fixed income—into volatility trading, credit-spread trading, and merger arbitrage. Lack of disclosure meant that you didn’t know how far the ship was off course until it was on the rocks. Cases of fraud and other common crimes had also begun to surface.
Smart investors know that there’s no money to be made from investing in hedge funds. In investing, the majority is always wrong. The focus is now “incubators”—venture capital for hedge funds. They identify traders, seed startups, and allow them to establish a track record. Once established, the hedge fund seeks third-party funding, allowing the original investors to exit. They retain the real money—a free carry or shareholding in the general partner or fund manager. Incubators are only open to the really rich and connected.
The hedge fund universe is overheated. At the suggestion of a “bubble,” one hedge manager bristled that hedge funds weren’t an “asset class,” and therefore there was no “bubble” to burst—only asset classes experienced bubbles. Another hedge fund apologist argued that all funds managers in the future would be hedge funds. The semantics aren’t reassuring.
Hedge funds are also under attack from clones. Hedge fund performance doesn’t depend significantly on skill, nor is it as distinctive as the Masters of the Universe claim. In fact, hedge fund returns can be replicated using readily available instruments such as equity index futures and corporate bonds. [17] Banks are starting to clone hedge funds using precisely these instruments. [18] The advantage for investors is lower fees, with the risk of blowups like Amaranth or LTCM. The clones are not the real thing—they’re cheap reproductions. Some analysts argue that the replication models are flawed, though they have their own version that works.
Who’s in Charge?
As John Kenneth Galbraith observed, “In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less.” Regulators see hedge funds as providing essential liquidity and distributing risk more efficiently, reducing risks of a major financial shock. There is also a ideological element. In the aftermath of the Asian crisis, economist Robert Wade wrote, “[Greenspan] and other U.S. officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians and that free capital markets are seen as key to world economic recovery and advance; the idea that international capital markets are themselves the source of speculative disequilibria and retrogression must not be allowed to take root.” [20] Bailouts of troubled banks in developed countries are naturally not contrary to free market principles.
In theory, hedge funds remove risk from regulated banks. But banks are deeply embedded in the hedge fund industry. The only significant control is on lending to or entering into derivative trades with hedge funds using collateralization to manage risk. Writing in the Motley Fool Internet Bulletin Board, Lou Corrigan noted, “Alan Greenspan was mistaken in believing that the largely unregulated hedge fund industry can be effectively controlled by regulating creditors. […]Creditors can be just as prone to greed as the latest wizard of Wall Street, but they are often the last to understand the risks that would ordinarily help fear counterbalance greed.” [21]
Benign neglect is giving way to concern. Timothy Geithner, president of the Federal Reserve Bank of New York, has warned that the changes in markets may make financial crises less common but more severe. Australia’s Reserve Bank governor Glenn Stevens has speculated that, in crises, hedge funds are users rather than providers of liquidity. The UK’s Financial Services Authority has identified conflicts of interest as well as operational risks in the relationship between banks and hedge funds.
Hedge Funds Ate My Lunch?
There is a temptation to dismiss the Masters of the Universe, their culture of risk, the hedge funds, and the extreme money games as peripheral to “real life.” After all, fast and foolish money will always find a way to play extreme sports. Isn’t it just a case of a few rich investors playing around with their courtesans and getting more excitement than they bargained for?
Not really. Hedge funds affect all of us—directly and indirectly. Your money—your savings, your retirement funds, the money you invest in banks—increasingly finds it way into the hands of hedge funds. Corporate or government pensions and defined-benefit schemes are a thing of the past. The investment performance of hedge funds—preservation of capital and returns—will shape your senior years and the ability of your company pension funds to meet their liabilities.
Hedge funds also affect us indirectly. In 1997, attacks on the overvalued currencies of Asian countries helped bring about deep recessions, resulting in the collapse of companies, massive unemployment, and social unrest. Malaysia’s prime minister Mahathir blamed hedge funds. “It was greed; a kind of greed that cares nothing for the destruction caused for the collapse of perfectly healthy and prosperous economies, greed that thrives on the misery of others.” [22]
Mahathir did not refer to the poor government, crony capitalism, and corruption that created the conditions for the problems. But the activities of hedge funds undoubtedly exacerbated the severity of these problems. Hedge funds may have colluded in manipulating markets to maximize their returns. In the event of a major shock, hedge funds will sharply increase volatility and the severity of any adjustment.
Any major problems in the hedge fund industry will ultimately affect the stability of the banks and the financial system itself. Hedge funds trade with banks. Banks provide the leverage that hedge funds use. Hedge funds don’t really disperse risks. They increase and concentrate them.
In recent years, there have been warnings: the turmoil in the credit market in 2005 when General Motors and Ford were downgraded; the emerging market correction in mid 2006; the collapse of Amaranth in 2006. Commentators have seized these situations to illustrate the robustness of the system. Banks and financial systems emerged seemingly unaffected.
But banks and hedge funds sustained significant losses in each episode, which were absorbed by profits or gains in other activities. Low cost of money allowed the problems to be handled without a meltdown. The markets also recovered, helped by traders’ increasing positions, assuming the correction was a “buying” opportunity at “better price levels.” Banks sometimes merely bought the portfolio from the distressed hedge fund to avoid potential losses from a forced liquidation of the position. The bank was getting the positions at attractive price levels and hoped they could trade their way out of it.
The greatest concern is concentration of risk. Shortage of trading opportunities means that traders—both in hedge funds and banks—focus on “events”—the emergence of the BRIC economies; commodity prices; corporate actions (mergers, leveraged buyouts, and bankruptcy). There are innovations—volatility swaps (bets on the level of volatility), correlation swaps (bets on correlation), and gamma/dispersion swaps (bets on both volatility and correlation). Hedge funds use them to further leverage up their bets on the “big” stories. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration.
Matthew Lynn, writing in UK’s Sunday Business, warned, “[T]he risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it—in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary.” [23]
Courtesans have played pivotal roles in the rise and fall of empires. Hedge funds may yet play such a role. If a major event occurs, the effect on the Masters of the Universe and the extreme money games may seriously damage financial systems and economies, and taxpayers will bear the losses. Australian economist Ian Macfarlane commented, “Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities.” [24] Yet the popular investment consensus is that hedge funds, alternative investments, should be a part—indeed, a growing part—of your investment strategy.
Huge structural imbalances in the world, an excess of investment capital chasing returns, and the gradual withdrawal by central banks of the liquidity that has fed recent growth are capable of triggering the problem. How far off is that event? Economists only exist to make climatologists look good. I’ll tell you after the event.
In any major global city today, you can find homeless people sleeping rough. They are the dark underbelly of capitalism. If you look into their eyes, you see resignation, hopelessness, despair, and occasionally defiance. Why are they there? Substance abuse, mental illness, just sheer bad luck. But I fear a future when many us will be on the streets. Etched into the tattered piece of cardboard will be our story: “Please help. Hedge funds ate my money!”
References
[1] Martin Baker, A Fool and His Money: How to Understand the Money Markets and Those Who Work in Them (Orion Publishing, 1995).
[2] Tom Wolfe, The Bonfire of the Vanities (Bantam, 1987).
[3] Alan Kohler, “Hedging Your Bets for a Life Less Ordinary,” Weekend Edition Sydney Morning Herald, 5–6 August 2006.
[4] See “Flare-up,” The Economist, 21 September 2006.
[5] Peter Temple, Hedge Funds: The Courtesans of Capitalism (John Wiley & Sons, 2001).
[6] Holman W. Jenkins, “How a Cat Becomes a Dog,” Wall Street Journal, 5 April 2000.
[7] Merrill Lynch, Bear Stearns, and Paine Webber senior executives are understood to have invested in LTCM. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random House, 2001).
[8] Quoted in [5].
[9] See [4].
[10] The manager is reputed to be Jim Simons of Renaissance Technologies; see [3].
[11] See [5].
[12] Quoted in [5].
[13] See Stephen Schurr, “Hedge Funds Jump on Hippie Bandwagon,” Financial Times, 3–4 June 2006; Penny Wark, “Selling Themselves Short,” The Times, 9 June 2006; The Economist, “Tune On, Tune In, Meet Clients,” 10 June 2006.
[14] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Methuen and Co., Ltd., 1776).
[15] William Fung, et al., “Hedge Funds: Performance, Risk, and Capital Formation,” 19 July 2006.
[16] Hilary Till, “On the Role of Hedge Funds in Institutional Portfolios,” Journal of Alternative Investments, Spring 2004.
[17] See Jasmina Hasanhodzic and Andrew W. Lo, “Can Hedge-Fund Returns Be Replicated? The Linear Case,” 16 August 2006.
[18] See H. Kat and H. Palaro, “Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication,” “Replication and Evaluation of Fund of Hedge Fund Returns,” “Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds,” “Tell Me What You Want, What You Really, Really Want! An Exercise In Tailor-Made Synthetic Fund Creation Alternative,” all working papers of the Investment Research Centre, Cass Business School, City University, London.
[20] Robert Wade, “The Asian Economic Crisis and the Global Economy,” quoted in [5].
[21] Quoted in [5].
[22] Quoted in [5].
[23] Matthew Lynn, “Financiers Play with Fire Again,” Sunday Business, 9 April 2000.
[24] Quoted in [5].
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liquidity, market, credit and operational risks for. hedge funds trading commodities. 1. Controlling liquidity risk. Particularly since the dramatic fall of …
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Hedge Fund Survey Overview
By Richard HorwitzCapital Market Risk Advisors, a financial advisory firm specializing in risk management, released the results of a recent survey on hedge funds as risk management. Hedge Fund Types Surveyed Participants include: Fund of Funds, Managed Futures, Risk Arbitrage, Long/ Short and Macro.
Approaches to risk management varied by hedge fund types.
Most respondents manage less than $500 million in onshore as well as offshore funds. No respondents manage more than $1 billion in offshore funds.
The majority of respondents hold equity assets, with 70% holding international equity and 61% holding domestic assets.
Approximately 43% hold domestic fixed income assets and 33% hold international debt assets. Convertibles and distressed debt are held by approximately 15% of respondents.
Approximately 60% of respondents reported holding FX overlays.
Approximately 75% of respondents have a risk manager, though those that do not are not planning on adding a risk manager.
All respondents by the end of this year will have formalized their “risk appetite”.
An overwhelming majority of respondents have implemented a set of risk limits.
The majority of respondents measure risk-adjusted performance on an absolute basis. Those who do not measure risk adjusted performance generally do not plan to change.
Less than 50% of respondents measure risk-adjusted performance on a relative basis.
Sharpe and Sortino Ratios are the most widely used tools for measuring risk-adjusted performance.
Approximately 70% of respondents will calculate VaR on an absolute basis by the end of this year.
However, only 13% of respondents calculated VaR on a relative basis.
The Variance/Covariance and Historical (Delta/Gamma) methods are the most widely used methods for calculating VaR.
Respondents applied differing holding periods to calculate VaR. Daily and monthly were the two most frequently selected.
Scenario Analysis (actual scenarios such as the Russia/LTCM crisis and the Tequilla crisis) and Volatility Shifts are the two most widely used stress testing techniques.
Respondents are split on the frequency of stress-testing, though the majority stress test at least weekly.
More than 80% of respondents measure liquidity — split relatively evenly among those that do it formally, those that do it informally and those that employ a hybrid of formal and informal means.
Informal measurement of liquidity risk is practiced at slightly higher levels than explicit measurement.
Whereas over 60% measure liquidity risk in terms of reduced volume on an informal basis, less than 40% do so on an explicit basis.
The majority of respondents will be aware of the dealers’ haircut methodologies by the end of the year.
Most respondents do not use and do not plan to use liquidity insurance.
Risk ratios are the most commonly reported risk statistic to investors, followed by leverage. VaR is currently only reported by 26% of respondents.
The majority of respondents have not increased their risk reporting since the LTCM crisis. The biggest increase has been in VaR and Risk Adjusted Performance.
Approximately 30% of respondents said that investors were asking for increased reporting on concentration measures.
Approximately 20% to 30% of respondents said that investors were requesting increased reporting on liquidity.
More than a third of respondents stated that investors have increased their demand for position-level information.
Richard Horwitz is a Vice President at Capital Market Risk Advisors, Inc., a consulting firm headquartered in New York that specializes in risk management, valuation, strategy, and independent risk oversight. Horwitz received his undergraduate degree in Electrical Engineering from MIT and his MBA from the Sloan School of Management at MIT.
http://www.federalreserve.gov/boarddocs/speeches/2006/200605162/default.htm
Remarks by Chairman Ben S. Bernanke
At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia
May 16, 2006
Hedge Funds and Systemic Risk
Thank you for inviting me to speak today. In keeping with the theme of this conference, I will offer some thoughts on the systemic risk implications of the rapid growth of the hedge fund industry and on ways that policymakers might respond to those risks.
The collapse of Long-Term Capital Management (LTCM) in 1998 precipitated the first in-depth assessment by policymakers of the potential systemic risks posed by the burgeoning hedge fund industry. The President’s Working Group on Financial Markets, which includes the Federal Reserve, considered the policy issues raised by that event and, in 1999, issued its report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. The years since then have offered an opportunity to consider whether the Working Group’s recommendations for addressing those issues have been effective and whether new concerns have arisen that warrant an alternative approach.
LTCM and the Working Group’s Recommendations
As the title of the report indicated, the Working Group focused on the potential for leverage to create systemic risk in financial markets. The concern arises because, all else being equal, highly leveraged investors are more vulnerable to market shocks. If leveraged investors default while holding positions that are large relative to the markets in which they have invested, the forced liquidation of those positions, possibly at fire-sale prices, could cause heavy losses to counterparties. These direct losses are of concern, of course, particularly if they lead to further defaults or threaten systemically important institutions; but, in addition, market participants that were not creditors or counterparties of the defaulting firm might be affected indirectly through asset price adjustments, liquidity strains, and increased market uncertainty.
The primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors. In the LTCM episode, unfortunately, market discipline broke down. LTCM received generous terms from the banks and broker-dealers that provided credit and served as counterparties, even though LTCM took exceptional risks. Investors, perhaps awed by the reputations of LTCM’s principals, did not ask sufficiently tough questions about the risks that were being taken to generate the high returns. Together with the admittedly extraordinary market conditions of August 1998, these risk-management lapses were an important source of the LTCM crisis.
The Working Group’s central policy recommendation was that regulators and supervisors should foster an environment in which market discipline–in particular, counterparty risk management–constrains excessive leverage and risk-taking. Effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients’ risk profiles and that they have systems to monitor and limit exposures to levels commensurate with each client’s riskiness and creditworthiness. Placing the onus on market participants to provide discipline makes good economic sense; private agents generally have strong incentives to monitor counterparties as well as the best access to the information needed to do so effectively.
For various reasons, however, creditors may not fully internalize the costs of systemic financial problems; and time and competition may dull memory and undermine risk-management discipline. The Working Group concluded, accordingly, that supervisors and regulators should ensure that banks and broker-dealers implement the systems and policies necessary to strengthen and maintain market discipline, making several specific recommendations to that effect. The Working Group’s recommendations on this point have largely been followed. Domestically, regulatory authorities issued guidance on risk-management practices, and bank supervisors now actively monitor and conduct targeted reviews of banks’ dealings with hedge funds. The Securities and Exchange Commission (SEC) intensified its risk-management inspections of the larger broker-dealers after LTCM. Internationally, both the Basel Committee on Banking Supervision and the International Organization of Securities Commissions produced papers on sound practices in dealings with highly leveraged institutions, and the Basel Committee conducted a series of follow-up studies.
An alternative policy response that the Working Group considered, but did not recommend, was direct regulation of hedge funds. Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds’ risk-taking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds’ ability to provide market liquidity.
In focusing on counterparty risk management in its recommendations, the Working Group did not intend to prevent failures in the hedge fund industry. Hedge funds offer their investors high prospective returns but also high levels of risk. Experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy. The Working Group’s recommendations were aimed, instead, at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.
Effectiveness of the Working Group’s Approach
Has the approach proposed by the President’s Working Group worked? Any answer must be provisional, but, to date, it apparently has been effective. Since the LTCM crisis, ongoing improvements in counterparty risk management and the resultant strengthening of market discipline appear to have limited hedge fund leverage and improved the ability of banks and broker-dealers to monitor risk, despite the rapidly increasing size, diversity, and complexity of the hedge fund industry. Many hedge funds have been liquidated, and investors have suffered losses, but creditors and counterparties have, for the most part, not taken losses. The general perception among market participants is that hedge funds are less highly leveraged today than in 1998 though, to be sure, meaningful and consistent measurements of leverage are not easy to come by and many newer financial products embed significant leverage in relatively nontransparent ways.
According to bank supervisors and most market participants, counterparty risk management has improved significantly since 1998. Some of this progress is due to industry-led efforts, such as two reports by the Counterparty Risk Management Policy Group (CRMPG) that lay out principles that institutions should use in measuring, monitoring, and managing risk. Reviews conducted by bank supervisors in 2004 and 2005 indicated that banks have become more diligent in their dealings with hedge funds. In most cases, substantial resources have been devoted to expanding and improving the staffing of the risk-management functions related to hedge fund counterparties. Dealers universally require hedge funds to post collateral to cover current credit exposures and, with some exceptions, require additional collateral, or initial margin, to cover potential exposures that could arise if markets moved sharply. Now, risk managers can more accurately measure their current and projected exposures to hedge fund counterparties, and more firms use stress-testing methodologies to assess the sensitivity of their exposures to individual counterparties if the market moves substantially.
Despite this progress, some concerns about counterparty risk management remain and may have become even more pronounced given the increasing complexity of financial products. I will note four of these concerns. First, hedge funds are profitable customers for dealers, and our supervisors are concerned that competition for hedge fund business has eroded initial margin levels. Second, given the increasing volume of complex transactions with hedge funds, we are also concerned whether counterparty exposures in such complex transactions are being measured accurately. Supervisors are monitoring banks with these issues in mind. Third, our supervisors are concerned that more extensive stress-testing should be done. Although stress-testing of exposures at the level of the individual hedge fund counterparty is becoming more common, still-wider application of this technique would be useful. Similarly, aggregate stress tests–by which a dealer evaluates its exposure to the hedge-fund sector in the event of a large market move–merit wider use. Aggregate stress tests are a desirable complement to stress tests of individual hedge fund counterparties because funds sometimes imitate each others’ strategies or choose strategies that are affected by common market factors. Supervisors are encouraging the expanded use of stress-testing when it is appropriate. Fourth, supervisors are concerned that the assessment of counterparty risks should be better tied to the amount of transparency offered by hedge funds. In particular, good risk management should link the availability and the terms of credit granted to a hedge fund to the fund’s willingness to provide information on its strategies and risk profile. Our supervisors are pushing banks to clearly link transparency with credit terms and conditions.
Since the Working Group report was issued, hedge funds have greatly expanded their activities and strategies, and their interactions with counterparties and creditors have accordingly become more complex. The continuing challenge for supervisors, counterparties, and hedge funds is to ensure that rigorous and appropriate methods of risk management are brought to bear even as institutions, instruments, and markets change. Two recent challenges of note are the spread of prime brokerage services and the emergence of operational issues in the settling of trades in newer types of over-the-counter (OTC) derivatives, particularly credit derivatives.
Hedge funds have long used arrangements that allow them to execute trades with several dealers but then to consolidate the clearing and settlement of their trades at a single firm, the “prime broker.” The prime broker typically provides financing and back-office accounting services to the hedge fund as well as settlement services. In the past couple of years, prime brokerage has expanded beyond cash trades for securities to include foreign exchange and OTC derivative trades, and more firms are offering prime brokerage services.
Prime brokerage poses some unique challenges for the management of counterparty credit and operational risk. Prime brokers must ensure that they have adequate information and controls to protect against counterparty credit risk arising both from the client and from the executing dealer. They also must implement internal controls to monitor and track transactions executed as part of the prime brokerage agreement and to ensure that the transactions meet the terms of the agreement. Supervisors of firms that offer prime brokerage services, particularly supervisors of new entrants, must ensure that the firms are fully aware of the risks involved and effectively manage them.
The proliferation of new financial products also poses risk-management challenges, including challenges on the operational side. For example, trading in credit derivatives has grown dramatically in recent years, and firms have had difficulties in processing and settling these and other OTC derivative trades in a timely way. These problems are not limited to hedge funds but affect all participants in the OTC derivatives market and all dealers in credit derivatives. Recently, supervisors in several jurisdictions, working with the Federal Reserve Bank of New York, have pushed firms to improve their processes for confirming and assigning trades. So far, good progress has been made, with private-sector participants meeting most of their objectives for reducing backlogs. Commitments are in place to effect still further improvement.
A noteworthy feature of these efforts is the cooperation among authorities. The Federal Reserve has devoted more effort in recent years to maintaining a dialogue with international supervisors, such as the U.K. Financial Services Authority, and we will continue to do so. Domestically, the Federal Reserve is coordinating with the SEC, which is the primary regulator of several large firms that deal in OTC derivatives or engage in prime brokerage activities.
Proposals for Creating a Database of Hedge Fund Positions
Following the LTCM crisis and the publication of the Working Group’s recommendations, the debate about hedge funds and the broader effects of their activities on financial markets abated for a time. That debate, however, has now resumed with vigor–spurred, no doubt, by the creation of many new funds, large reported inflows to funds, and a broadening investor base. Renewed discussion of hedge funds and of their benefits and risks has in turn led to calls for authorities to implement new policies, many of which will be topics of this conference. I will briefly discuss one of these proposals: the development of a database that would contain information on hedge-fund positions and portfolios.
It is commonly observed that hedge funds are “opaque”–that is, information about their portfolios is typically limited and infrequently provided. It would be more accurate to say that the opacity of hedge funds is in the eye of the beholder; the information a fund provides may vary considerably depending on whether the recipient of the information is an investor, a counterparty, a regulatory authority, or a general market participant. From a policy perspective, transparency to investors is largely an issue of investor protection. The need for counterparties to have adequate information is a risk-management issue, as I have already discussed. Much of the recent debate, however, has focused on the opacity of hedge funds to regulatory authorities and to the markets generally, which is viewed by some as an important source of liquidity risk. Liquidity in a particular market segment might well decline sharply and unexpectedly if hedge funds chose or were forced to reduce a large exposure in that segment.
Concerns about hedge fund opacity and possible liquidity risk have motivated a range of proposals for regulatory authorities to create and maintain a database of hedge fund positions. Such a database, it is argued, would allow authorities to monitor this possible source of systemic risk and to address the buildup of risk as it occurs. Various alternatives that have been discussed include a database maintained by regulators on a confidential basis, a system in which hedge funds submit position information to an authority that aggregates that information and reveals it to the market, and a public database with nonconfidential information on hedge funds.
I understand the concerns that motivate these proposals but, at this point, remain skeptical about their utility in practice. To measure liquidity risks accurately, the authorities would need data from all major financial market participants, not just hedge funds. As a practical matter, could the authorities collect such an enormous quantity of highly sensitive information in sufficient detail and with sufficient frequency (daily, at least) to be effectively informed about liquidity risk in particular market segments? How would the authorities use the information? Would they have the authority to direct hedge funds or other large financial institutions to reduce positions? If several funds had similar positions, how would authorities avoid giving a competitive advantage to one fund over another in using the information from the database? Perhaps most important, would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds’ risk-taking? A risk of any prescriptive regulatory regime is that, by creating moral hazard in the marketplace, it leaves the system less rather than more stable.
A system in which hedge funds and other highly leveraged market participants submit position information to an authority that aggregates that information and reveals it to the market would probably not be able to address the concern about liquidity risk. Protection of proprietary information would require so much aggregation that the value of the information to market participants would be substantially reduced. Timeliness of the data would also be an issue.
A public database of nonproprietary information could provide the public with a general picture of hedge-fund activity without creating the false impression that the authorities were engaged in prudential oversight of hedge funds. Such a public database might demystify hedge funds, but it would not address the central policy concern that opacity creates liquidity risk.
I expect discussion and analysis of the potential costs and benefits of increased disclosures will continue, as well as suggestions about how such disclosures might be structured and disseminated. The important challenge is to structure any disclosures in a way that does not generate moral hazard or weaken market discipline.
Conclusion
In the final analysis, authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again. Private market participants, too, have their role to play in ensuring that such lapses do not recur. The principles articulated in the CRMPG’s reports are a good starting place for firms, and senior management should rigorously assess their operations against those principles and commit the resources to address deficiencies. Authorities’ primary task is to guard against a return of the weak market discipline that left major market participants overly vulnerable to market shocks. Continued focus on counterparty risk management is likely the best course for addressing systemic concerns related to hedge funds. This public policy approach does not entail the moral hazard concerns created by authorities’ monitoring of positions using a private database. Rather, a focus on counterparty risk management places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so.
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http://www.fenews.com/fen46/front-sr/jorion/jorion.html
The first hedge fund was started by A.W. Jones in 1949. Unlike the typical equitymutual fund, the fund took both long and short positions in equities. Since then, the hedge fund industry has undergone exponential growth. Today, there are more than 8,000 hedge fund managers with close to $1 trillion in investor equity.
This growth has led to concerns about the industry. In particular, investors should be concerned about risk management practices, liquidity and transparency of their hedge funds. This short article discusses whether these concerns are warranted and what steps hedge funds could take to be accepted as mainstream investment vehicles.
Hedge funds are private investment vehicles that are generally leveraged. As an industry, however, they are very heterogeneous. Hedge fund strategies include long/short equity, global macros, equity market neutral, fixed-income arbitrage, convertible arbitrage, event driven and managed futures. Some hedge fund categories, such as those that invest in futures contracts, have little liquidity risk and are amenable to traditional risk measurement methods. Others, however, are exposed to liquidity risk, which needs special attention.
Liquidity Risk
Liquidity risk arises on the assets side, when the positions cannot be liquidated quickly without incurring transaction costs. It also arises on the liabilities side, either from the leverage (debt), or from potential investor redemptions (equity). Typically, funds with greater asset liquidity risk impose longer lockup periods for investors in order to balance liquidity risk on both sides of their balance sheet.
On the asset side, liquidity risk is a function of the size of the positions as well as of the price impact of a given size trade for the instrument. Some categories of hedge funds have intrinsic liquidity risk because the instruments they use are thinly traded, implying a large price impact for most trades. This is the case with convertible bonds or distressed securities. In this case, liquidity risk arises even for small funds. Liquidity risk, however, is also an issue when the fund positions grow very large, even in liquid markets.
Liquidity risk is difficult to factor into the usual value-at-risk (VAR) models. Usually, VAR models loosely account for liquidity risk by extending the horizon for less liquid assets. This is a totally ad hoc approach, however. Accounting for potential losses due to asset liquidation requires a price impact function, which is difficult to estimate. Optimal liquidation strategies should balance the direct cost of fast liquidation against the risk of keeping open positions.
Liquidity and Valuation
Instrument liquidity risk creates another problem which is that of stale prices. Say that the reporting period for net asset values (NAV) is the end of each month. If transaction prices are not observed at the end of the month, the valuation may be using a price from a trade that occurred in the middle of the month, creating measurement errors in the reported NAVs. This is a minor nuisance, but does not necessarily create a systematic bias in the NAVs. Investors, however, should make sure the hedge fund manager is not manipulating asset values to overstate the fund’s performance.
Liquidity and Risk Measures
Unfortunately, stale prices do bias risk measures in a number of subtle ways. First, the reported monthly volatility will be less than the true volatility. This is because prices are based on trades during the month, which is similar to an averaging process. Averages are less volatile than end-of-period values.
The second effect is that monthly changes will display positive autocorrelation. A movement in one direction will only be partially captured using prices measured during the month. The following month, part of the same movement will show up in the return. This positive autocorrelation substantially increases the risk over longer horizons and invalidates the usual square root of time rule, which is widely used to extrapolate risk to longer horizons.
A third, related effect is that measures of systematic risk will be systematically biased downward. If the market goes up during a month, only a fraction of this increase will be reflected in the NAV, leading to beta measures that are too low. Thus the diversification benefits of the hedge fund may be overstated.
Transparency
Because hedge funds follow proprietary trading strategies, they are generally reluctant to reveal information about their trading ideas or positions. This lack of transparency has serious disadvantages for investors.
Disclosure allows risk monitoring of the hedge fund, which is especially useful with active trading. This can help to avoid situations where the hedge fund manager unexpectedly increases leverage or changes style. Closer monitoring of the fund can also decrease the probability of fraud.
Disclosure is also important for risk aggregation. The investor should know how the hedge fund interacts with other assets in the investor’s total portfolio. Whether the hedge fund has a positive or negative correlation with the rest of the portfolio will have an effect on the total risk.
Greater disclosure is often resisted on the grounds that it would disclose proprietary information, leading to the possibility of a third party trading against the hedge fund. Another argument sometimes advanced is the lack of investor sophistication. In other words, disclosing positions would dump too much information on investors who might not able to use it. Indeed, a simple listing of the positions would provide limited information in the absence of a rationale for the trading strategy.
These two arguments can be addressed with external risk measurement providers. These firms have access to the individual positions of hedge funds, with the proper confidentiality agreements, and provide aggregate risk measures to investors. They only release exposures to major risk factors, such as net duration, net systematic risk and so on. This solution neatly solves the problems of risk aggregation and managers’ widespread reluctance to disclose detailed information about their positions.
Another solution is the fund-of-fund structure. These are diversified portfolios of hedge funds, which try to achieve diversification by careful selection of styles and managers. Funds of funds can also take views on strategies, increasing allocation to strategies that are expected to perform better. Many of these funds of funds have developed advanced methods to measure their total portfolio risk based on the complete positions of the hedge funds to which they allocate assets.
Conclusions
Continued growth of the hedge fund industry is only sustainable if these issues of liquidity and transparency are addressed in one way or another. Investors should be aware that liquidity risk may be important for some categories of hedge funds and may lead to biases in risk measures. Several methods can be used to correct for these biases. Finally, the development of risk measurement providers and funds of funds demonstrates the importance of transparency for hedge funds.
Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information
WOLFGANG BÜHLER
University of Mannheim - Department of Business Administration and Finance
TIM O.H. THABE
University of Mannheim October 2006EFA 2006 Zurich Meetings Paper
Mannheim Finance Working Paper No. 2006-13
Abstract:
In a structural model for credit risk we endogenize inability to pay as a second independent reason for default besides overindebtedness. Inability to pay is triggered by rational behavior of incompletely informed outsiders. The firm needs to raise additional cash via secondary equity offerings in order to service it’s coupon payments. Underpricing of secondary equity offerings is explained as necessary for these offerings to be successful. In addition to Duffie/Lando (2001) we find that the liquidity risk has a strong impact on the current firm value and the optimal leverage. Credit spreads of debt in the primary market depend on the degree of liquidity risk. They can be lower or higher than in case without liquidity risk.Our results have a number of additional, interesting consequences. Contrary to Duffie/Lando (2001) incomplete information of outside investors has an impact on the default probability of the firm and therefore on the optimal capital structure which is determined in the primary market. The debt-equity ratio is typically lower than in the Duffie/Lando (2001) model that operates under complete information in the primary market and can result in lower credit spreads.
Keywords: Bond Default, Credit Spread Modelling, Incomplete Accounting Information, Optimal Capital Structure, Seasoned Issue Underpricing
JEL Classifications: D82, D92, G12, G13
Working Paper Series
Bühler, Wolfgang and Thabe, Tim O.H., “Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information” (October 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://ssrn.com/abstract=906988
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906988
Friday, 8 October 2004
Speech by Paul Sharma
The subject of my speech is liquidity risk. The Department which I head at the Financial Services Authority covers all prudential risks – market risk, credit risk, operational risk, insurance risk etc as well as of course liquidity risk – across the three sectors of banking, insurance and securities. My Department has of course therefore been heavily engaged in negotiating and implementing the reforms to the regulation of credit, market and operational risk in Basel 2 and the reforms to the regulation of insurance risk in our new realistic solvency regime. These reforms have been based on years of detailed work, extensive consultation and intensive negotiation and are now the subject of major implementation projects at the both the FSA and regulated firms. The reforms have succeeded in focusing attention on credit, market, insurance and operational risk. A vast literature, both regulatory and academic, exists on these risks. In sharp contrast almost no attention has been given to liquidity risk.
However this too is now changing and in my speech I will focus on two recent initiatives. Firstly there are the reforms set out in the FSA’s Consultation Paper 128 and in the feedback statement to that consultation paper. These reforms set out new rules and guidance on the non-quantitative aspects of liquidity risk management. The rules and guidance are due to come into force at the end of this year1. Secondly there is the work of the Joint Forum of the Basel Committee and its international regulatory counterparts, IOSCO and the IAIS, in the securities and insurance fields. The Joint Forum is the senior international body, at present under the chairmanship of the FSA’s Gay Huey Evans, that looks at key regulatory issues that are of common interest across the three sectors. It has set up a sub-group under the joint chairmanship of Richard Mead (New York Federal Reserve) and myself to report on liquidity risk. Joint Forum does not itself legislate regulatory standards but in the past its finding and recommendations have lead to others carrying out significant regulatory reforms. For example the initiative which lead to the EU directive on conglomerates was based initially on a Joint Forum report.
Prior to these recent initiatives we have grown so accustomed to extensive regulatory and academic discussion of credit risk, market and even operational risk that the comparative absence until recently of liquidity risk from the regulatory debate no longer seems surprising. Actually it should surprise us a great deal. Historically in the 1930s and again in the 1970s liquidity runs have been the causes of multiple banking failures within the UK leading to systemic instability and there are of course much more recent examples if one looks outside the UK. Also analytically if one looks at the basic business model it is obvious that liquidity is one of the fundamental risks that arises in banking.
Within their banking books, banks borrow short and lend long. This gives rise to three obvious risks – credit risk on the lending and long-term interest rate risk and liquidity risk from the mismatch between the term structure of the assets and liabilities. Basel 2 sets out regulatory standards for the first two risks but is almost silent on the liquidity. Within their trading books, banks and investment banks hold trading assets backed by regulatory capital calculated on a VaR basis that assumes that the market risk from those assets could be mitigated within a short period of time. This in turn assumes that those assets are liquid although there is increasing evidence that in recent years banks and investment banks have started including significant volumes of illiquid assets in their trading books.
I shall speak about the latest trends in the regulatory responses to these risks in a moment but before doing so I shall first set out what I mean by liquidity risk. A conventional analysis of liquidity risk distinguishes between funding liquidity risk and market liquidity risk.
The first is more important in the context of the maturity transformation that occurs in the banking book. The second is more important in the context of tradable assets in the trading book.
However rather than define liquidity risk in this rather conventional way I would prefer to describe it using some of the concepts being developed in the Joint Forum work. This sees liquidity risk in terms of adverse liquidity outcomes that arise from a combination of an external or non-liquidity trigger event and an internal vulnerability.
In risk management terms preventing trigger events, reducing vulnerabilities and, when they occur, mitigating adverse outcomes are all important strategies. In comparison conventional regulatory responses appear somewhat one-dimensional focusing nearly exclusively on a few narrow methods of reducing one particular aspect of vulnerabilities. The next stages of the FSA’s reform of its regulatory approach to liquidity risk have, and will have, a broader, but also more flexible, regulatory focus. I shall now turn to this.
In discussing the regulatory approach to liquidity risk it is important to distinguish between quantitative (pillar 1), qualitative (pillar 2) and disclosure (pillar 3) requirements. Turning first to pillar 1 we have at the UK level at present a patchwork of different regimes as set out in the various interim prudential sourcebooks. At the EU and international levels there is as yet no harmonisation of quantitative liquidity rules. Following Basel 2 and the draft EU Capital Requirements Directive this remains by the far the most important aspect of banking regulation on which there are no internationally or EU agreed standards.
As part of the FSA’s programme to introduce an Integrated Prudential Sourcebook that treats like risks in a like manner regardless of the sector in which they occur, the FSA set out in Discussion Paper 24 in October 2003 some ideas of how a single quantitative regime across the banking, building society and investment banking sectors might be created.
In principle there are three broad approaches that a firm might use in the quantitative control of its liquidity risk.
The existing IPRU regimes for banks and building societies follow a stock approach for large banks and cash flow matching and mixed approaches for smaller banks and for building societies. However the detail of these various different existing approaches as expressed in the Interim Prudential Sourcebook is open to criticism as needing to be update for modern market developments and also to create a level playing field across the sectors on the basis, as already explained, of “like risk like treatment”. For example the stock liquidity approach that is at present used for large banks suffers from the defects that it only applies to sterling, it only accepts a narrow range of assets as stock liquidity assets and it is not the main way large banks actually manage their liquidity risk for internal risk management purposes. The existing regime for investment firms uses an approach based on illiquid asset deductions which in effect fuses and conflates capital rules and liquidity rules.
Discussion Paper 24 set out ideas for a new integrated approach to Pillar 1 requirements for liquidity risk. It basically followed the ‘mixed approach’ described above. The responses to the discussion paper received from the industry and others supported the idea that there was a need for reform but also, as we expected, pointed out that significant further work was needed. The ideas in the discussion paper were not yet fit to be taken forward to a consultation paper stage. In particular four important points were made by industry commentators with which we agree. First, the outline new approach set out in the discussion paper was far too prescriptive and detailed. Second, it would create new divergences between the way in which liquidity risk was regulated and ways in which it was managed by firms for their own internal purposes, especially for the investment banking sector which typically uses an approach closer to the stock approach. Third it placed too much weight on a Pillar 1 approach of the regulator setting hard quantitative limits as opposed to relying upon and developing further the FSA’s own Pillar 2 ideas that rest on the concept of the senior management of a firm forming its own view – subject to supervisory review – as to their firm’s liquidity needs. Fourth it risked creating a Pillar 1 regime for liquidity in the UK that was significantly out of step with the emerging international regulatory trends and was not sufficiently cross-sectoral in its approach especially for mixed banking-insurance conglomerates. The FSA will not therefore be taking forward the Discussion Paper 24 approach to Pillar 1 liquidity standards to the consultation stage. Instead the next steps in our work on the reform of liquidity risk will be to implement our existing Pillar 2 proposals and to participate further in the international work on Liquidity. That is in particular the Joint Forum sub-group which I co-chair. Further domestic reform will await the outcome of this international work and will be reassessed in the light of that outcome.
The FSA set out its Pillar 2 requirements in its feedback statement to Consultation Paper 128. This sets out rules and guidance that are due to come into force at the end of this year that require a firm:
These rules and guidance anticipate and amplify the requirement set out in the draft EU Capital Requirement Directive that firms have in place “policies and processes for the measurement and management of their net funding on an on-going and forward-looking basis”. The directive adds that “Alternative scenarios shall be considered and the assumptions underpinning the net funding position shall be regularly reviewed” and that “Contingency plans to deal with liquidity crises shall be in place”.
Turning now to Pillar 3 (disclosure requirements), this is the aspect of the regulation of liquidity risk that has received the least attention of all at either the UK or international level. However the Joint Forum sub-group is now looking at this and the FSA will await its findings.
Drawing my remarks to a conclusion I would repeat the thought with which I started. Liquidity risk has perhaps for too long been overlooked as a focus of attention for regulatory reform. That is now changing both at the UK and International levels.
by Paul Sharma - Head of Prudential & Accounting Standards, FSA.
1See the FSA’s letter of 15 September to trade associations on the PSB Implementation page (under the Integrated Prudential Sourcebook heading) on the FSA’s website for a precise statement of which aspect of the CP128 rules and guidance are to be brought into force.
http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2004/SP201.shtml
