Central banks and supervisory authorities have recognized the importance of maintaining financial stability in the past few decades. The increased interaction between large institutions has increased the rapid spread of financial problems across institutions and markets. Financial problems, such as sharp reduction of financial resources, may have negative consequences on production, welfare and employment. Since the supervision of registered investment institutions does not protect against investment risks, a large equity base and trading position hedge fund, such as LTCM, may pose a threat to financial stability. In this context, supervisory authorities were worried about the size of trading positions, the potentially high leverage and the lack of disclosure by these institutions. It leads one to ask; was LTCM an isolated incident? Could another firm pose this sort of danger again? In national forums and in an international context, authorities are discussing the improvement of disclosure of financial data by unregulated participants in financial markets. This can be done on a voluntary basis with initiatives towards self-regulation of groups of institutions or by internationally coordinating regulations. Supervisory authorities support this idea, but doubt whether increased disclosure is enough to fix the potential problems large hedge funds, such as LTCM, can create.18
· Lessons Learned
LTCM?s near default has caused banks to become more aware of the risks associated with investing in hedge funds. The difficulty of analyzing and monitoring a hedge fund contributes to the risk. Also, since hedge funds are not limited by regulations, institutions operating hedge funds can assume more leverage. Another factor contributing to risk is a hedge fund’s reliance on properly functioning financial markets and models, making systematic risk very prominent. To avoid another such a number of banks have tightened their lending policy to such institutions.
Advantages of hedge funds include an improvement of market liquidity (under normal circumstances) and an improvement of market efficiency through value-at-risk (VAR) trading. Disadvantages may be periodic increases in volatility, which the LTCM case exemplified, and a concentration of risks in unregulated markets. If banks and securities firms are more careful in their use of hedge funds, the systematic risks associated with the use of hedge funds could be reduced. This is because the size of positions taken by hedge funds increases the systematic risk in those markets.
The LTCM case brought to light a number of important issues. The Committee of G-10 banking supervisors made recommendations to help improve banks’ risk management. A paper on sound practices is geared towards guiding banks and supervisory authorities when considering a credit relationship with hedge funds or other highly levered institutions. The first recommendation is that organizations should only invest in institutions with a sound lending strategy. In other words, the organization must consider the institutions’ desired risk/return ratio, diversification objectives, and risk management framework. The second recommendation is that if a bank does decide to do business with highly leveraged institutions, it should conduct a thorough and frequent analysis of the credit-worthiness of the institution, i.e the risk profile and risk management of the institution. Finally, banks should concentrate on risk measurement of derivative positions, collateral management and the use of attendant covenants.19
Summary
Ultimately, the cause of LTCM?s near default was a combination of its excessive use of leverage, the inefficiency of the Black-Scholes model under extreme market conditions, the drying-up of liquidity in financial assets, social and psychological investment factors, and global systematic risk. The Fed did not underestimate the importance of LTCM to the international financial system, as shown by the FRBNY?s US$3.625 billion intervention. The most frightening aspect of the whole ordeal was how quickly and efficiently one American firm, a hedge fund, was able to position itself as a real potential threat to the global economy. It is difficult to believe that LTCM was actually so special as to be the only firm that could ever accomplish such an obscene feat. The private mutual funds industry may need to be further regulated, or at least controlled, in order to avoid a reoccurrence. Banks and financial institutions learned a valuable lesson from the LTCM fiasco, as these institutions will now be more cautious in doing business with hedge funds.
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