Statements to the Congress - Patrick M. Parkinson, Laurence H. Meyer, and Alan Greenspan appear before the House Committee on Banking and Financial Services

Federal Reserve Bulletin, July, 1999

Statement by Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, May 6, 1999

I am pleased to appear before this committee to discuss the President's Working Group on Financial Markets' Report on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. Under Secretary Gensler has made a comprehensive presentation of the report's conclusions and recommendations. Chairman Greenspan participated actively in the Working Group's discussions and supports the contents of the report. My remarks this morning will be limited to highlighting a few key conclusions and recommendations.

LEVERAGE AND MARKET DISCIPLINE

As the title of its report indicates, the Working Group has concluded that the central public policy issue raised by the Long-Term Capital Management (LTCM) episode is excessive leverage. Leverage plays a positive role in our financial system, resulting in greater market liquidity, lower credit costs, and a more efficient allocation of resources in our economy. But leverage poses risks to firms and their creditors, and the LTCM episode demonstrated that a single firm could become both so large and so highly leveraged that failure of its business strategies could pose risks to the financial system as well.

While LTCM is a hedge fund, excessive leverage is neither characteristic of, nor necessarily limited to, hedge funds. Available data indicate that no other hedge fund was or is as large as LTCM, and no other large hedge fund was or is so highly leveraged. Indeed, a large majority of hedge funds are not significantly leveraged, having balance sheet leverage ratios of less than 2 to 1. Many financial institutions, including some banks and securities firms, are far larger than LTCM and are significantly leveraged. Whether any of these larger financial institutions was or is as highly leveraged as LTCM cannot be established definitively. Leverage is best defined as the ratio of economic risk relative to capital, but defined this way, it is very difficult to measure. The fact that no other large U.S. financial institution saw its capital significantly impaired indicates that none was so vulnerable as LTCM to the extraordinary market conditions that emerged last August.

In our market-based economy, the discipline provided by creditors and counterparties is the primary mechanism that regulates firms' leverage. If a firm seeks to achieve greater leverage, its creditors and counterparties will ordinarily respond by increasing the cost or reducing the availability of credit to the firm. The rising cost or reduced availability of funds provides a powerful economic incentive for firms to restrain their risk-taking. In our system, government oversight of leverage is the exception, not the rule. Even when government oversight has been deemed appropriate, as is the case of banks and brokerdealers, it is intended to supplement and reinforce market discipline, not to replace it.

However, in the case of LTCM, market discipline seems largely to have broken down. LTCM received very generous credit terms, even though it took an exceptional degree of risk. Furthermore, this breakdown in market discipline reflected weaknesses in risk-management practices by LTCM's counterparties that were also evident, albeit to a lesser degree, in their dealings with other highly leveraged firms.

If market discipline is to be effective, counterparties of a firm must obtain sufficient information to make reliable assessments of its risk profile, both at the inception of the credit relationship and throughout its duration. Furthermore, they must have in place mechanisms that place limits on the credit risk exposures that become more stringent as the firm's riskiness increases and its creditworthiness declines. In the case of LTCM, however, few, if any, of its counterparties really seem to have understood its risk profile, especially its very large positions in certain illiquid markets. And many of its counterparties did not effectively limit their risk exposures to LTCM. In part, they simply did not anticipate the extraordinary market conditions last August. But a combination of the aggressive pursuit of earnings in a highly competitive environment and excessive confidence in LTCM's management appears to have led some counterparties to suspend or ignore fundamental riskmanagement principles.

The Working Group's recommendations are intended to make market discipline more effective by (1) improving risk-management practices, and (2) increasing the availability of information on the risk profiles of hedge funds and their creditors. The Working Group has not recommended steps, such as direct government regulation of hedge funds, that would risk significantly weakening market discipline by creating or exacerbating moral hazard.

ENHANCING RISK MANAGEMENT

Primary responsibility for addressing the weaknesses in risk-management practices that were evident in the LTCM episode rests with the private financial institutions--a relatively small number of U.S. and foreign banks and broker-dealers, most of which were LTCM's counterparties--whose credit and clearing services are critical to the establishment of leveraged trading positions. Addressing the weaknesses is in their self-interest, as their experience with LTCM demonstrated. And as the world leaders in risk management, these firms have the capabilities as well as the incentives to address the weaknesses. Nonetheless, prudential supervisors and regulators have a responsibility to help to ensure that the processes that banks and securities firms utilize to manage risk are commensurate with the size and complexity of their portfolios and responsive to changes in financial market conditions.