Fed_Study_on_Hedge_Fund_Counterparty_Risk

Fed_Study_on_Hedge_Fund_Counterparty_Risk - John Kambhu Til...

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FRBNY Economic Policy Review / December 2007 1 Hedge Funds, Financial Intermediation, and Systemic Risk 1 .In t r odu c t i on inancial economists and policymakers have historically focused on banks as prospective channels of systemic distress through, for instance, bank runs and the concomitant reduction in the supply of credit. This “special” attribute of banks has been behind the classic policy rationale for regulating them. The ongoing move toward financial markets, arm’s- length transactions, and active trading, however, has shifted focus to the potential impact of a hedge-fund-led disruption on financial institutions, markets, and the broader economy. 1 Financial intermediaries, of course, have many ways to reduce their exposure and mitigate the impact of financial market shocks. The first line of defense is the intermediary’s counterparty credit risk management (CCRM) system. Banks establish limits; implement risk reporting infrastructures; and define haircut, margining, and collateral policies—all designed to assess credit risk and limit their counterparty exposure. Effective CCRM is obviously needed for any counterparty, but hedge funds differ in important ways, such as in their use of 1 See, for example, McCarthy (2006), President’s Working Group on Financial Markets (2007), and the papers in the Banque de France (2007) special issue devoted to hedge funds. In addition to concerns about financial system implications, there are concerns about investor protection and market integrity issues, which we do not discuss. John Kambhu is a vice president and Til Schuermann an assistant vice president at the Federal Reserve Bank of New York; Kevin J. Stiroh was a vice president at the Bank at the time this article was written. <[email protected]> <[email protected]> The authors thank Tobias Adrian, Art Angulo, Kevin Coffey, Mark Flannery, Beverly Hirtle, Steve Manzari, Trish Mosser, Mike Nelson, Brian Peters, Asani Sarkar, Phil Strahan, Zhenyu Wang, two anonymous referees, and seminar participants at the Federal Reserve Bank of New York for helpful suggestions, and Sarita Subramanian for excellent research assistance. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. • An important channel through which largely unregulated hedge funds interact with regulated institutions is prime brokerage relationships. • Central to these relationships is the extension of credit to hedge funds, which exposes banks to counterparty credit risk. • Counterparty credit risk management (CCRM) practices, used to assess credit risk and limit counterparty exposure, are banks’ first line of defense against market disruptions with potential systemic consequences.
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This note was uploaded on 04/09/2010 for the course NBA 5450 taught by Professor Richardmarin during the Fall '09 term at Cornell.

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Fed_Study_on_Hedge_Fund_Counterparty_Risk - John Kambhu Til...

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