Hedge funds may play an even more prominent role in transmitting shocks to the rest of the financial market and amplifying systemic risk than previously thought, according to a study published by the U.S. Federal Reserve Bank of San Francisco.
Until recently, hedge funds were believed to have played only a small part in the 2007 financial crisis during which commercial banks, hedge funds and investment banks suffered huge losses from investments in housing-linked assets in the United States.
However, Reint Gropp, professor of finance at Goethe University in Frankfurt, Germany, argued in the latest San Francisco Fed Economic Letter that linkages and spillover effects between those institutions during a crisis are continuously underestimated.
He found that standard approaches may overstate spillovers in normal times and understate spillovers in volatile times.
If these effects are properly accounted for, “hedge funds may be the most important transmitters of shocks during crises, more important than commercial banks or investment banks,” he writes.
“During calm times the risks emanating from hedge funds are as small as those from other financial institutions,” including banks, investment banks and insurance companies, Gropp noted.
But during volatile market conditions, for example at the onset of the 2007–09 financial crisis, some of the effects dramatically increase in importance.
This also applies to spillovers between commercial banks and investment banks.
The study found that during a crisis, shocks from hedge funds have substantial effects on insurance companies, commercial banks and investments banks.
Insurance companies in turn, even if they are affected by a crisis, are not as systemically important in the sense that they cause distress elsewhere.
During crises, the spillovers become very large, making hedge funds more important transmitters of shocks than commercial banks or investment banks, the study said.
The impact is not only direct, through counterparty or creditor relationships, but also affects asset prices in general.
The study ascribes the effects to the opaqueness of hedge funds and the additional debt they take on to boost returns, arguing that if highly leveraged hedge funds are forced to liquidate assets at fire-sale prices, these asset classes may sustain heavy losses.
A potential scenario would be the loss and margin spiral, where hedge funds are forced to liquidate assets to raise cash to meet margin calls. The sale of the assets increases the supply in the market, which drives prices lower. This in turn leads to further defaults and threatens systemically important institutions.
Another example, cited by the study, relates to investment banks that hedge their corporate bond holdings using credit default swaps. Credit default swaps pay out in case the bond issuer defaults on payments to investors.
If hedge funds take on this risk in return for a fee in a swap transaction and fund the investment by borrowing from the same bank, the spillover risk from the hedge fund to the bank increases.
The study said that in contrast to the existing literature on the topic, the model it uses can differentiate between common shocks that affect all institutions and spillover effects from one type of institution to another.
However, in order to measure the economic spillover effects, rather than just the statistical ones, it would be necessary to obtain more detailed information on the risk exposure, assets and liabilities of different financial institutions – data generally not available for hedge funds.
In this sense, the study supports the reporting of leverage, liquidity, counterparties and asset holdings information, in the way it is required to do by the Alternative Investment Managers Directive in Europe.