Banks need to do more to manage hedge fund risks, Fed’s Barr warns

Bloomberg News

WASHINGTON — Banks should improve how they account for counterparty risks as the hedge fund industry grows and becomes more intertwined with banking, Federal Reserve Vice Chair for Supervision Michael Barr said. 

Barr, speaking at the New York Fed’s Conference on Counterparty Credit Risk Management, cited the bailout and unwinding of Long-Term Capital Management — a highly leveraged hedge fund — in 1998, and the scramble that ensued among regulators to stabilize the financial system as an illustration of the consequences of not managing counterparty risks proactively. 

“That event prompted deep reflection on both the risks presented by nonbanks such as hedge funds and the state of counterparty credit risk management practices by banks that finance their activities,” Barr said. 

More recently, the failure of Archegos Capital management led to more than $10 billion in losses across the banking system, “and revealed many of the same gaps in how banks manage their exposure to investment funds, which are far larger today than at the time of LTCM’s collapse,” he said. 

“Managing these exposures has become more challenging as the financial system has become more complex, diverse, and interconnected,” Barr said. “For example, the sudden rise in commodities prices in March 2022 rippled around the global financial system in part because of the sudden rise in margin requirements on commodities derivatives as the stress hit.”

Biden administration regulators have been keeping a closer eye on the risks that hedge funds and nonbanks pose to the financial system. The Financial Stability Oversight Council has reinstated its ability to designate nonbanks as systemically risky, and just last week in a private session said that it supported work on existing priorities such as “nonbank financial remediation.” 

Federal Deposit Insurance Corp. Chairman Martin Gruenberg in September also highlighted his views on nonbanks — including hedge funds — and financial stability. 

In the future, Barr said, the Fed plans to use its own tools to help manage the risk across the banking system, including publishing the aggregate results of explanatory analysis related to the simultaneous default risk of banks’ five largest hedge fund counterparties.

“We expect the information yielded from that analysis will deepen our supervisory understanding of counterparty credit risk at the banks,” Barr said. “As we noted, the exploratory analysis will not affect bank capital requirements.” 

Barr asked that banks consider managing their counterparty risk through increased due diligence, improved ability to measure and identify counterparty credit risk and ensuring that bank management responds appropriately when risk managers raise concerns. 

“In the case of both LTCM and Archegos, the lack of appreciation for their overall size, leverage, and concentration was a significant factor in explaining the deficiencies in how banks risk-managed their exposures to those funds,” he said. “This lack of transparency contributed to remarkable growth of the funds’ positions and exacerbated the risk to counterparty banks from their collapse.” 

Banks should also maintain appropriate margin to account for this problem, Barr said. 

“Based on their assessment of the risk, it is important that banks maintain appropriate levels of margin to insulate them from loss,” Barr said. “Risk-based margining and associated terms and conditions are an important and often necessary part of the counterparty credit risk management toolkit.” 

He said that margining practices should be “conservative and appropriately risk-sensitive” as financial markets can be volatile. 

“Waiting to increase margins until markets become volatile and the risks apparent can, ironically, create additional risk,” Barr said.