Mr Meyer's testimony on the Federal Reserve's policy guidance to banks regarding hedge funds  (Central Bank Articles and Speeches, 24 Mar 1999)
Central bank: fed | Type: speech | Date: 1999-03-24

## Mr

Meyer's testimony on the Federal Reserve's policy guidance to banks regarding hedge fundsTestimony of Mr Laurence H Meyer, a member of the board of Governors of the US Fede Reserve System, on hedge funds before the Subcommittee on Financial Institutions Consumer Credit of the Committee on Banking and Financial Services, US House Representatives, on 24 March 1999.I welcome this opportunity to discuss the Federal Reserve's supervisory actions aftermath of the near-collapse of Long-Term Capital Management (LTCM).

Today's heari cover an important topic.

The LTCM incident merits study to ensure that the les provides are sufficiently understood and that constructive action is taken to effect the potential for similar events in the future, without compromising the efficienc capital markets.The primary issues raised by the LTCM incident appear to revolve around the broad th how to control the leverage and risk-taking of unregulated financial institutions - i hedge funds - so that they do not become a source of systemic risk or jeopardize funds via the federal safety net.

In our market-based economy, the discipline pro creditors and counterparties is the primary mechanism for 'regulating' this risk-tak case of LTCM, this discipline appears to have been compromised.

Weaknesses in severa elements of the risk management processes at some creditors and counterparties magnified by competitive pressures, resulting in risk exposures that may not have b understood or adequately managed.

Less-than-robust risk management systems, evidence an over-reliance on collateral, compromised both the assessment of counte creditworthiness and the measurement and control of risk exposures at several f institutions.To be sure, the lessons stemming from this episode have not gone unlearned, and the lack of effort to identify and implement appropriate public policy and private secto to the potential risks posed by hedge funds.

These efforts range from private ind supervisory initiatives aimed at strengthening the credit risk management infrastr financial institutions, to consideration of enhanced disclosure by global financial to those evaluating the costs and benefits of direct regulation of hedge funds.Efforts to promote market discipline by strengthening the risk management syste creditors and counterparties offer the most immediate and efficient way to accomp desired objective of minimizing the potential for systemic risk arising from the a hedge funds.

Supervisory oversight of bank risk management practices, including the of guidance on sound practices, reinforces the market discipline entailed in banks' and surveillance of the risks taken by their counterparties.

The recent guidance on management practices issued by the Basle Committee on Banking Supervision, the Fed Reserve, and the Office of the Comptroller of the Currency (OCC) represent significa toward achieving the goal of enhancing market discipline.

I commend the Subcommit efforts to advance public awareness of these efforts by holding today's hearings on supervisory guidance.Of course, public sector work on promoting more effective market discipline on hedg and other entities that might employ leverage is by no means complete.

The guidan other supervisory efforts we are discussing here today target primarily commercial institutions.

Work underway by the International Organization of Securities Commi (IOSCO) to issue similar guidance regarding securities firms' relationships with heis another important step.

Although not directly focused on the issue of hedge fu international efforts to enhance public disclosure of financial institution risk profiles provide meaningful input.

In this context, the recent consultative paper 'Recommendatio for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Fir issued jointly last month by the Basle Committee on Banking Supervision and IOSCO, makes an important contribution to the discussion of possible public policy responses.

In the States, the President's Working Group on Financial Markets is considering a number of iss and policy responses regarding leveraged institutions and their relationships with counterparties.

Its report is expected in the near future.Despite these various public sector initiatives, the real key to effective market discip in the players themselves - the private sector.

The market has clearly learned from the L incident and our supervisory staff has seen significant tightening of credit standards o funds as well as improvements in the risk management processes at major banking institutions.

Here, too, much work remains.

Accordingly, we look forward to th recommendations of the Counterparty Risk Management Policy Group (CRMPG) regarding private sector initiatives for enhancing the credit risk management practices of credit their leveraged counterparties.

Subcommittees of this private industry group, comprise major international banks, securities firms, and hedge funds, are investigating avenue improving measures of derivative exposures and the exchange of information between counterparties.

The findings of the group will reinforce the efforts to promote enhanceme risk management systems at banking institutions and are expected to advance sound practi in key areas such as the type of information that can be exchanged between hedge funds their counterparties without compromising hedge funds' proprietary information.

## Supervisory Efforts by the Federal Reserve in the Aftermath of LTCMIn

its role as a bank supervisor, the Federal Reserve's primary contribution to adva market discipline lies in its responsibility to ensure that the risk management proce individual banking organizations are commensurate with the size and complexity of the portfolios.

We promote the adoption of sound risk management practices through on-sit reviews and targeted examinations of banking organizations and by regularly issuin supervisory guidance to both banks and our supervisory staff.

This morning I will bri summarize recent Federal Reserve efforts in both of these areas and will explain how Fed Reserve supervisory guidance provides direction to banking institutions and examiners t supports, and is consistent with, that issued by the Basle Committee on Banking Supervis and the Office of the Comptroller of the Currency.

President McDonough's testimony answer the Subcommittee's questions regarding the recent guidance on highly leveraged instituti (HLIs) issued by the Basle Committee on Banking Supervision and the regulation of hedge funds in other developed countries.Immediately following the LTCM episode, the Federal Reserve detailed staff from the Boar of Governors and the Federal Reserve Bank of New York to conduct special reviews at thos state member banks with significant hedge fund relationships to identify:- the nature and magnitude of bank credit exposures to hedge funds;- the comprehensiveness of banks' due diligence processes regarding hedge funds;- the quantitative controls used in managing exposures to hedge funds;- the adequacy of management information systems and internal controls with rega hedge fund counterparties; and- the extent to which the LTCM relationship was an exception to banks' normal h fund relationships.Our review found that U.S.

commercial banking exposures to hedge funds are prim counterparty exposures arising from OTC derivatives contracts.

Overall, direct u loans to hedge funds have traditionally been a small portion of bank lending, even at global institutions.

As of the third quarter of 1998, direct, unsecured loans disb U.S. commercial banks to hedge funds were estimated at $1.7 billion, or approximat percent of Tier 1 capital of those banking institutions with exposures to hedge f amount represents only direct lending arrangements and includes $170 million in dispersed by U.S. banks to LTCM under a $900 million shared national credit facility which was contributed by foreign banking organizations).

It does not include the $90 of equity investments in LTCM made by three U.S. banking organizations in Septembe 1998.As of the third quarter of 1998, only five U.S. commercial banks had material OTC de exposures to hedge fund counterparties.

Credit exposures arising from these rela consisted of the current mark-to-market value of the derivative transactions as w potential exposure that might arise from future changes in these market values (the future exposure or PFE).

All of the banking institutions mark their derivative po market on a daily basis and require any net current market value owed to them to collateralized, generally with high quality securities, such as U.S. Treasuries or so from G-10 countries.

For those hedge funds judged to be of lower credit quality generally require the posting of collateral or margin above current market values against the potential future exposure of derivative contracts with these counterpartiWith regard to LTCM, the review found that the fund was atypical among hedge f counterparties in both the size of its positions and the amount of leverage it empl several hedge funds had larger net asset values (capital) than LTCM and a few fun have employed the same or comparable book leverage, LTCM's combination of size a leverage was singular.Investigations of the management of the LTCM account at several institutions found over-reliance on the collateralization of the current market value of derivatives p the stature of LTCM's managers led to compromises in several key elements of the cre management process.

In some cases, assessments of LTCM's creditworthiness was found be less than adequate as a result of limited information on the fund's true risk pro management capabilities.

In particular, exposure measures and scenario analyses th have identified potential losses under stress situations were found to be less thanImportantly, while LTCM was found to be atypical among hedge fund counterparti shortcomings in the risk management of hedge fund counterparty exposures appeare extend beyond this one fund.

In several cases, the review team found inadequate coun risk management policies and procedures.

In others, while formal policies and procedu have existed, gaps between policy and practices were identified.

Specifically, the r found that the due diligence and ongoing risk assessments of hedge funds were qualitative and lacked quantitative rigor.

The review also found compromises in t systems and credit exposure measurement methodologies employed, including limited ucounterparty exposure stress testing.

In particular, measures of the potential future ex arising from derivative positions with hedge fund counterparties were found in need significant enhancements at some banks.

In general, banks placed undue reliance on t collateralization of current mark-to-market exposures and underestimated the potent exposure that could arise under difficult market conditions.The findings of this special review served as a primary source for the Basle Committe recent report, 'Sound Practices for Banks' Interactions with Highly Leveraged Instituti Federal Reserve staff played a major role in shaping the scope of the Basle documents, dr significant portions of early versions of the Basle Committee's main paper, and provi significant input into its sound practices paper.

President McDonough's testimony discus at length, the content of the Basle documents, including the sound practices they identifThe Board of Governors fully endorses both Basle documents.

The Basle guidance has been incorporated in Federal Reserve guidance by direct reference in our recent Supervision Regulation Letter, 'Supervisory Guidance Regarding Counterparty Credit Risk Management' (S.R. 99-3).

They have been transmitted by the appropriate Federal Reserve Banks to all member banks and holding companies with significant hedge fund exposures and to all Federal Reserve staff supervising those institutions.

Moreover, the March 1999 update to Federal Reserve's Trading and Capital Markets Activities Manual will incorporate the spec sound practices identified in the Basle documents in a special hedge fund subsection o existing Counterparty Credit Risk Management section.The results of the targeted reviews conducted in the third and fourth quarter of 1998 been shared with each institution reviewed, and supervisory plans tailored to each instit particular circumstances have been developed.

Supervisory staff is monitoring each ban management of hedge fund counterparty exposures as well as the bank's efforts to address identified risk management shortcomings.

I understand that other G-10 bank supervisors ha translated the Basle documents into the appropriate foreign language and transmitted the industry associations and/or institutions with hedge fund relationships.

In some c supervisors have taken steps to monitor bank hedge fund exposures and bank initiatives enhance internal counterparty credit risk management systems.Private Sector Response in the Aftermath of LTCM[is this a heading?

If so, bold and follo by new para.] As would be expected coming out of the LTCM event and other market difficulties in 1998, banking institutions, in their own self-interest, appear to underway in making enhancements to their credit risk management systems.

With regard to the due diligence process, banks are requesting and receiving more information from th hedge fund counterparties, such as value-at-risk calculations, position concentrat aggregate off-balance sheet positions, and the results of stress tests.

Banks have also i the rigor of the due diligence processes applied to hedge fund counterparties, including of their own quantitative risk management specialists to conduct on-site reviews of h fund risk management systems.

Increasingly, hedge funds recognize that they need to provi their counterparties with more information.

All parties are looking for remedies sho having funds disclose specific position information that they feel might compromise integrity of their proprietary investment strategies.

It is expected that a major contri this area will be made by the Counterparty Risk Management Policy Group.Banks are also moving to develop more realistic counterparty credit risk exposure measu including the development of various types of stress testing of their credit risk exposmajor counterparties.

Some banks are reviewing their policies regarding how, when, a what type of counterparties they will require collateralization of potential future eIn general, all of the banks reviewed last year have conducted their own internal a of lessons learned and, in their own self-interest, are reassessing their busine regarding hedge funds and moving forward to make necessary enhancements to their management processes.

## Federal Reserve Board Guidance on Counterparty Credit Risk ManagementFederal Reserve supervisory guidance that is particularly pertinent to issues surrou relationships with hedge funds was first issued in the Federal Reserve's Trading Manual

(TAM), published in 1994.

This manual discusses general sound practices managing the market, credit, legal, liquidity and operating risks involved in bank derivatives activities.

The manual also provides guidance in other areas such as a capital requirements, financial performance measurement, ethics and regulatory repor compliance.

It also provides over 35 individual instrument profiles that describe th supervisory issues involved in each product.

Over the years, this manual has come to a definitive industry resource on sound risk management practices as they relate to t derivative activities.

Revision of the guidance in this manual is an ongoing pro manual was substantively revised in 1998 and is updated each March and September.In 1994, the Federal Reserve also issued specific guidance focusing on hedge funds. specific guidance and our manual emphasize the importance of sound financial anal counterparties that can quickly adjust their risk profiles.In reviewing the 1998 financial performance of large banking institutions, a number o lessons on how, where, and why breakdowns in risk management processes can occur h been re-emphasized to both banks and bank supervisors.

As has been the case in instances of bank losses, competition, the pursuit of earnings, and the general business often result in the introduction of risk exposures for which existing risk infrastructures may not be sufficient.

Moreover, breakdowns in risk management most arise in product, customer, and business lines that experience significant growth normal initial profitability.In an effort to emphasize the importance of some of the general lessons highlighted over the past two years and to advance the application of these lessons in the i avoiding future difficulties in other areas, the Federal Reserve issued its supervis counterparty credit risk management on February 1 of this year to provide general g The guidance is aimed at providing supervisors and bank management insights on elements of counterparty credit risk management systems at large complex ban organizations that may need special review and enhancement in light of the rapid taking place in banking and financial markets.

The guidance is targeted at relation all types of bank counterparties, including hedge funds.

It reiterates and exp fundamental principles of counterparty credit risk management that are covered in supervisory materials of the Federal Reserve and other regulators, and in establishe standards.

It emphasizes areas that, while generally understood for several years, ha increasingly important given the global linkages of financial markets.

In parti important inter-relationships between market and credit risks and their effec magnitude of derivative counterparty exposures, especially in times of stress increasingly important area that merits the attention of all banks engaged in activities.

Accordingly, this issue is discussed at length in our recent guidance.From a broad perspective, the guidance advises banking institutions to focus suffic resources on ensuring the adequacy of all elements of their counterparty credit management systems, especially for activities, business lines and products experienc significant growth, above normal profitability or risk profiles, and large potential exposures.

Recognizing that strong internal controls and internal audit functions are th line of defense in avoiding problems, the guidance also advises institutions to ensur internal audit and independent risk management functions focus on growth, profitability risk criteria in targeting their reviews.

Institutions are also advised to calibrate thei management policies and procedures to the risk profiles of specific types of counterparti instruments.

Too often, general policies and procedures developed to cover all types counterparty exposures can lead to important gaps in the assessment of risks to specific of counterparties.The guidance specifically addresses four basic elements of counterparty credit r management systems: the assessment of counterparty creditworthiness; credit risk exposu measurement; the use of credit enhancements and contractual covenants; and credit ri exposure limit-setting and monitoring systems.

With regard to the assessment of counterp creditworthiness, the guidance points out the need for policies and procedures that are t to the risk profiles of counterparties and for internal controls that ensure actual conform with these policies.

In complying with this guidance in the context of their h fund relationships, banks are expected to have specific policies for assessing the uniq profiles of hedge funds, including the scope of due diligence analysis and ongoing monito to be conducted, the type of information required from hedge fund counterparties, and nature of stress testing used in assessing credit exposures to hedge funds.

As menti above, the Federal Reserve has adopted the Basle Committee's recent guidance on sound practices governing bank relationships with hedge funds and expects that banks' inter policies regarding their hedge fund relationships will be brought into compliance with sound practices.In the area of exposure measurement, the Federal Reserve's guidance also points out t potential future exposure measures are becoming more important in managing the credi exposures of derivatives positions.

Accordingly, institutions must ensure that potential exposures for both secured and unsecured positions are measured realistically and are b incorporated into measurement and limit systems.

It also advises institutions to ste existing programs to enhance credit risk exposure measures by incorporating netting a portfolio effects.

The need for better stress testing and scenario analysis of credit e that incorporates the interaction of credit and market risks is also identified.

In ess guidance points to the need for a better balance between the qualitative and quantit elements of exposure assessment and management for all types of counterparties.

## Conformance of Federal Reserve Supervisory Guidance with Other SupervisorsThe development of supervisory guidance on sound risk management, like industry practices is an evolutionary process enhanced by experience.

It could be argued that, to a large the fundamental principles of assessing counterparty credit risks, the measuring and s testing of the potential future exposures of derivative positions, and the dangers of reliance on collateral have been well documented in supervisory guidance for several ye However, given advances in technology and the increasing pace of financial innovation a market interdependency, the techniques and means used to implement these principles ar under constant development and refinement.

Accordingly, supervisors must endeavor to ensure that their guidance is as up-to-date as possible.As mentioned above, our most recent guidance both re-emphasizes and supplements exi Federal Reserve Board principles and guidelines.

Although different supervisors st different bases of existing guidance, we believe the current body of Federal Reserve on the risk management of trading, derivatives, and other capital markets activities consistent with that issued over the years by the Basle Committee on Banking Supervis by other U.S. bank regulators.The recent guidance released by the Basle Committee, 'Sound Practices for Ba Interactions with Highly Leveraged Institutions', covers the same material and prov same direction to supervised institutions for a specific type of counterparty as tha all types of counterparties contained in existing Federal Reserve guidance.

Moreove mentioned above, the specific Basle guidance has been fully incorporated in the soo released updates to our Trading and Capital Markets Activities Manual.In addition, existing Federal Reserve guidance is also consistent with that issued b In its most recent supplemental guidance to Banking Circular 277 and the Comptro Handbook for National Bank Examiners, the Comptroller identifies 13 lessons learned events over the past two years.

Although Federal Reserve guidance on trading and de activities may use different formats, it conveys the same direction and sound pr supervised institutions embodied in each of these 13 lessons.

For example, the Comp recent guidance discusses the need for senior management and the board of direc understand the limits of their price risk measurement systems and goes on to empha need for stress testing such exposures.

Supervisory guidance of the Federal Reserve advised of the importance of stress testing market risks and the conveyance of these senior management and the board of directors so that they can fully understa institution's risk exposure and adjust risk tolerances accordingly.

Our most recent g the measurement of potential future exposures and stress testing supplements th guidance.Perhaps the most importance guidance emphasized by the Federal Reserve and the OCC that which advises banks and examiners to ensure that sufficient risk management is at new, growing, and highly profitable activities.

As mentioned above, such areas h the source of most bank losses.In summary, the Federal Reserve believes that its existing supervisory guidance on tr derivatives activities at state member banks and bank holding companies is entirely with, and complementary to, that of the Basle Committee on Banking Supervision an OCC.

Together, this supervisory guidance offers a clear set of sound practices th implemented appropriately, serves to enhance and support market discipline by streng the risk management processes of major creditors and counterparties.Supervisory Lessons Learned[heading?

If so, bold and followed by new para.] Even developing and developed financial markets and the various types of losses posted by institutions over the past two years, including recent events surrounding bank he relationships, have also provided supervisors and examiners with important lessons. perspective, we would like to think that effective supervision contributed to the ab institutions to weather the financial storms of the past two years.

Our reviews in the financial results illustrate that, while the LTCM incident and other episodes o two years may have significantly impacted earnings, they did not threaten the solven U.S. commercial banking institution.Still, our review of our own performance suggests room for enhancements on our part.

With the context of the Federal Reserve's risk-focused approach to supervision, major counterp exposures are generally reviewed during both regular and targeted reviews of bank derivatives and counterparty credit risk systems.

Our internal reviews found several where examiners, like banking institutions, may have placed too much emphasis on the fu collateralization of current exposures.

In the past, examiners have generally foc supervisory resources on assessing the risks entailed in unsecured credit exposures.

Mo forward, our guidance instructs examiners to incorporate measures of potential fut exposure in stratifying samples and selecting counterparties and transactions upon whic base targeted testing of practices and internal controls, regardless of the collaterali current market value exposures.

Examiners are also instructed to review the results adequacy of an institution's stress testing and scenario analyses in assessing bot magnitude and management of credit exposure.The need to emphasize in-depth transaction testing is another important supervisory le learned (or relearned) in the LTCM case, and this is emphasized in our supervisory guida The increasing complexity of financial markets and banking activities places a premium focusing supervisory resources at high-risk areas and conducting sufficient transaction t to identify variances between policy and practice.

Increasingly this involves conduc transaction testing with highly qualified specialists.

Targeting resources at retaining, and developing such specialists as well as providing them with automated tools to enha their efficiency and effectiveness is a top supervisory priority at the Federal Reserve.

## ClosingIn

closing, I would like to emphasize the significant amount of attention that the L incident, in particular, and bank relationships with hedge funds, in general, have receiv continue to receive, from both public and private venues.

Although market discipline may have worked in preventing the LTCM event in the first place, the marketplace has reac appropriately and we have learned much to carry us forward.

Banks and securities firms, their own self-interest, have tightened their risk management processes as they relate to funds.

Hedge funds now face a new reality of tougher counterparty oversight.

Supervisors also enhancing their oversight of banks' hedge fund exposures.

The supervisory guidan issued by the Basle Committee, the OCC, and the Federal Reserve represents an effectiv quick, and needed response to an important issue.

This guidance effectively reinforces pr sector initiatives to enhance counterparty credit risk management processes.

As I mention the outset, even more work needs to be done to ensure that the lessons we have learned the past two years become engrained in standard practice and to ensure that effective m discipline is brought to bear on the risk-taking of hedge funds and other entities that m of significant financial leverage.

In particular, we look forward to the report recommendations of the Counterparty Risk Management Policy Group that will provide additional practical tools for implementing both industry and supervisory sound practic counterparty credit risk management.