This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

Many of the comments around potential future hedge fund regulation are discussing how systemic risks can be addressed and have looked toward potentially greater regulation of the banks and other counterparties to hedge funds.  One of the items likely to be addressed by legislation is the amount of leverage any one hedge fund can take.  Additionally, bank’s risk management practices with regard to hedge funds and other counterparties is likely to be addressed.

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Bank Regulators Have Conducted Some Examinations Relating to Hedge Fund Business at Banks:

Bank regulators (the Federal Reserve, OCC, and FDIC) monitor the risk management practices of their regulated institutions’ interactions with hedge funds as creditors and counterparties. They are responsible for ensuring that the organizations under their jurisdiction are complying with supervisory guidance and industry sound practices regarding prudent risk management throughout their business, including the guidance and practices applicable to their activities with hedge funds. The 1999 PWG report recommended that bank regulators encourage improvements in the risk management systems of the regulated entities and promote the development of a more risk-based approach to capital adequacy.

In overseeing banks’ hedge fund-related activities, the bank regulators examine the extent to which banks are following sound practices as part of their reviews of banks’ capital market activities. Bank regulators conduct routine supervisory examinations of risk management practices relating to hedge funds and other highly leveraged counterparties to ensure that the supervised entities (1) perform appropriate due diligence in assessing the business, risk exposures, and credit standing of their counterparties; (2) establish, monitor, and enforce appropriate quantitative risk exposure limits for each of their counterparties; (3) use appropriate systems to identify, measure, and manage counterparty credit risk; and (4) deploy appropriate internal controls to ensure the integrity of their processes for managing counterparty credit risk.

The Federal Reserve’s supervision of banks’ hedge fund-related activities is part of a broader, more comprehensive set of supervisory initiatives to assess whether banks’ risk management practices and financial market infrastructures are sufficiently robust to cope with stresses that could accompany deteriorating market conditions. Specifically, the Federal Reserve has been focusing on five key supervisory initiatives: (1) comprehensive reviews of firms’ corporate- level stress testing practices, (2) a multilateral supervisory assessment of the leading global banks’ current practices for managing their exposures to hedge funds, (3) a review of the risks associated with the rapid growth of leveraged lending, (4) a new assessment of practices to manage liquidity risk, and (5) continued efforts to reduce risks associated with weaknesses in the clearing and settlement of credit derivatives and other OTC derivatives.

The bank regulators also have performed targeted examinations of the credit risk management practices of regulated entities that are major hedge fund creditors or counterparties. From 2004 through 2007, FRBNY conducted various reviews that addressed aspects of certain banks’ counterparty credit risk management practices that involved hedge fund activities. These reviews were motivated by the rapid growth of the hedge fund industry and also done to gauge progress made in improving risk management practices pursuant to supervisory guidance and industry recommendations. Examiners conducted meetings with management and reviewed policies and procedures primarily by performing transactional testing, relying on internal audits, and studying other functional regulators’ reviews.

According to a Federal Reserve official, while global banks have significantly strengthened their risk management practices and procedures for managing risk exposures to hedge funds, further progress is needed. For example, in a 2006 firmwide examination of stress- testing practices at certain U.S. banks, FRBNY indicated a need for the banks “to enhance their capacity to aggregate credit exposures at the firm wide level, including across counterparties; to assess the potential for counterparty credit losses to be compounded by losses on the banks’ proprietary trading positions; and to assess the potential effects of a rapid and possibly a protracted decline in asset market liquidity.”[1] According to this official, the Federal Reserve has begun a review of liquidity risk management practices at the largest U.S. bank holding companies, focusing on the firms’ efforts to ensure adequate funding in more adverse market conditions.[2]

Federal Reserve examiners made a variety of other recommendations as a result of the various reviews. Many of their recommendations were developed as ways that banks could continue to enhance their risk management processes associated with hedge fund counterparties. The examiners found a range of practices for counterparty stress testing for hedge funds and noted that there was room for improvement even at the banks with the most advanced practices. Where examiners identified deficiencies, specific recommendations were made. Although credit officers often adjusted credit terms for degree of transparency, examiners recommended that banks’ policies explicitly link transparency to credit terms and that banks monitor evolving credit terms for hedge fund counterparties. Moreover, examiners found that the banks that were part of the reviews needed to enhance their policies to more specifically address due diligence requirements or standards to provide clearer standards and guidance for reviewing hedge fund valuation processes.

In 2005 and 2006, OCC conducted an examination of hedge fund-related activities–mainly counterparty credit risk management practices (such as due diligence of their hedge fund customer’s business), and margining and collateral monitoring processes–at the three large U.S. banks. OCC generally found the overall risk management practices of these banks to be satisfactory. However, examiners identified concerns in the lack of transparency in the banks’ hedge fund review processes and issued recommendations accordingly. For example, examiners found in certain banks a lack of adequate credit review policies that clearly outline risk assessment criteria for levels of leverage, risk strategies and concentrations, and other key parameters and documentation to support accuracy of a bank’s credit analysis and risk rating system. Examiners also found that financial information provided by some hedge fund borrowers has been incomplete and that banks should document the lack of such information in their credit review process. OCC noted that the banks have taken satisfactory steps in response to examination issues raised.

In addition, in 2005 and 2006, FDIC conducted an examination of hedge fund lending at one of its banks. FDIC noted that the bank was not in compliance with the bank’s lending policy to diversify its hedge fund loans and that certain policies should be updated, but generally found the risk management practices of the bank’s hedge fund lending program to be satisfactory.

Bank regulators largely rely on their oversight of hedge fund-related activities at those regulated entities that transact with hedge funds in their efforts to mitigate the potential for hedge funds to contribute to systemic risk. Since 2004, regulators have increased their attention to these activities. In particular, bank regulators are reviewing the entities’ ability to identify and manage their counterparty credit risk exposures, including those that involve hedge funds. Regulated entities have the responsibility to practice prudent risk management standards, but prudent standards do not guarantee prudent practices. As such, it will be important for regulators to show continued vigilance in overseeing banks’ hedge fund-related activities.

[1] Testimony of Kevin Warsh, Governor, Board of Governors of the Federal Reserve Board System, before the House Committee on Financial Services, 110th Congress, 1st Sess., July 11, 2007.

[2] Liquidity risk is the potential that a firm will be unable to meet its obligations as they come due because of an inability to liquidate assets or obtain adequate funding or that it cannot easily unwind or offset specific exposures without significantly lowering market prices because of inadequate market depth or market disruptions.

Please contact us if you would like more information on items discussed in this article.  Other related HFLB articles include:

• GAO Report Provides Insight into Future Hedge Fund Regulation
• Hedge Fund Prime Brokerage
• Hedge Fund Attorney