The European Central Bank (ECB) is today publishing a report on large EU banks’ exposures to hedge funds. The report was prepared by the Banking Supervision Committee (BSC) of the European System of Central Banks (ESCB). This Committee brings together representatives from the ECB, the national central banks of the ESCB and EU banking supervisory authorities.
The report represents part of the BSC’s continued efforts to gain a better understanding of the implications of the recent rapid expansion of hedge fund activities for the European financial system. It is largely based on the findings of a survey that was conducted together with the member institutions of the BSC during the second quarter of 2005. The report examines the significance of the financial links that have developed between large EU banks and hedge funds. Because of the important role that hedge funds play as participants in financial markets and as counterparties to financial institutions, especially banks, it has become increasingly relevant to monitor their activities and assess any implications for financial stability.
The survey showed that exposures of large EU banks varied across countries and generally were not large in relation to either banks’ balance sheets or total income. This is due, at least partially, to the fact that the global prime brokerage market is largely dominated by US firms. However, there were some indications that large EU banks’ exposures were growing rapidly, although in most EU countries exposures were found to be negligible and/or mainly in the form of investments. It seems probable that the absolute and relative size of exposures to hedge funds will increase further in line with the continuing expansion of the hedge fund industry, and in particular its European segment.
The banks surveyed generally had stringent requirements for exposures to hedge funds, with a strong emphasis on collateralisation. Most of the banks surveyed also reported the use of stress tests for evaluating the potential effects of volatile or illiquid markets on their exposures. However, the survey also highlighted scope for further improvements in the following areas:
Counterparty discipline, as applied by banks, was found to be under pressure owing to highly competitive market conditions.
Most stress tests applied by banks, particularly the regular ones, included historical scenarios and were often applied to individual hedge funds only. Stress testing of collateral was less common and offers further scope for improvement.
Firm-wide aggregation of multiple exposures to individual hedge funds or groups of hedge funds using similar strategies was sometimes seen as problematic.
Information flows from hedge funds to banks, despite some progress, did not always seem to be adequate.
Banks’ descriptions of their risk management practices raised questions about whether banks were sufficiently taking into account and/or had enough timely information on the risk profile of a fund as a whole, particularly on the larger ones with financing and trading relationships with several counterparties.
As regards policy conclusions, the survey indicated that recent developments in the hedge fund sector may not necessarily pose a direct threat to financial stability in the EU through banks’ direct exposures to hedge funds. However, most of the risk management recommendations that were raised after the near-default of Long Term Capital Management (LTCM) in 1998 remain relevant. In this respect, both the risk management guidance developed by supervisors and the capital adequacy regime provide an appropriate framework for dealing with risks resulting from EU banks’ interactions with hedge funds.
The report can be downloaded from the “Publications” section of the ECB’s website (http://www.ecb.europa.eu). Printed copies are also available free of charge from the ECB’s Press and Information Division (firstname.lastname@example.org, fax: +49 69 1344 7404).
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