Given the rapid growth of the hedge fund industry, a natural focal point is the nature of the relationship between record industry inflows, diminishing returns and the potential use of excessive leverage. Again, the basic argument is a simple one: Elevated hedge fund investment returns in the past have tended to attract a large number of new entrants into the hedge fund industry. Increasingly, these new entrants and their activities tend to eliminate market inefficiencies which had, to a large extent, accounted for the past high returns. With diminished returns, hedge funds are finding it difficult to justify their elevated fee structure. In an attempt to preserve returns commensurate with their fees, hedge fund managers might be driven to resort to increasingly elevated levels of leverage. The data on flows and returns suggest that at least some components of such a dynamic are currently at work. Record inflows to the hedge fund industry during the first quarter of 2004 have indeed been followed by unsatisfactory performances throughout most of the hedge fund industry during the second quarter of 2004. Leverage figures are much harder to assemble and to interpret than flow and performance data. The Bank of England recently concluded that overall leverage in the hedge fund industry had not markedly increased and remained moderate compared with the 1997-1998 period. On balance, however, it is not particularly useful to put too much stock in such cursory assessments of industry leverage. First, the data aggregation problem is significant.

These problems notwithstanding, the question of leverage in the hedge fund industry deserves further study. The primary focus should continue to be directed at the risk management operations and processes of the world’s major investment banks. They are the primary trading partners of the hedge fund industry. They are also the most important providers of leverage to the industry. Since the LTCM crisis, the global investment banks have clearly strengthened their risk management operations. On the other hand, the hedge fund business has become a significant source of profit for the big banks. Competition in providing lending and brokerage services to the hedge fund industry is fierce. Some erosion of lending standards is a likely consequence of such an intensely competitive environment. In light of the previously discussed difficulties in measuring leverage, senior bank executives, risk managers and bank supervisors should be particularly vigilant in ensuring disciplined lending frameworks, fierce competition notwithstanding. If the leading global investment banks maintain adequate counterparty risk and liquidity risk management systems and operations, leverage in the hedge fund industry should represent but a marginal risk to the stability of the global financial system. Fortunately, the global investment banking community is a small and concentrated one. Moreover, adequate bank supervisory structures exist and are currently being modernized. This should facilitate further study of the nexus between the risk taking of individual hedge funds and the risk management systems and processes within the world’s most important financial institutions.