million of equity investments in ltcm made by three u. s. banking organizations in september of 1998. as of the third quarter of 1998, only five u. s. commercial banks had material otc derivative exposures to hedge fund counterparties. credit exposures arising from these relationships consisted of the current mark - to - market value of the derivative transactions as well as the potential exposure that might arise from future changes in these market values ( the potential future exposure or pfe ). all of the banking institutions mark their derivative positions to market on a daily basis and require any net current market value owed to them to be fully collateralized, generally with high quality securities, such as u. s. treasuries or sovereign debt from g - 10 countries. for those hedge funds judged to be of lower credit quality, banks generally require the posting of collateral or margin above current market values to protect against the potential future exposure of derivative contracts with these counterparties. with regard to ltcm, the review found that the fund was atypical among hedge fund counterparties in both the size of its positions and the amount of leverage it employed. while several hedge funds had larger net asset values ( capital ) than ltcm and a few funds may have employed the same or comparable book leverage, ltcm ’ s combination of size and leverage was singular. investigations of the management of the ltcm account at several institutions found that an over - reliance on the collateralization of the current market value of derivatives positions and the stature of ltcm ’ s managers led to compromises in several key elements of the credit risk management process. in some cases, assessments of ltcm ’ s creditworthiness was found to be less than adequate as a result of limited information on the fund ’ s true risk profile and risk management capabilities. in particular, exposure measures and scenario analyses that could have identified potential losses under stress situations were found to be less than adequate. importantly, while ltcm was found to be atypical among hedge fund counterparties, shortcomings in the risk management of hedge fund counterparty exposures appeared to extend beyond this one fund. in several cases, the review team found inadequate counterparty risk management policies and procedures. in others, while formal policies and procedures may have existed, gaps between policy and practices were identified. specifically, the review team found that the due diligence and ongoing risk assessments of hedge funds were largely qualitative and lacked quantitative rigor. the review also found compromise

mr meyer ’ s testimony on the federal reserve ’ s policy guidance to banks regarding hedge funds testimony of mr laurence h meyer, a member of the board of governors of the us federal reserve system, on hedge funds before the subcommittee on financial institutions and consumer credit of the committee on banking and financial services, us house of representatives, on 24 march 1999. i welcome this opportunity to discuss the federal reserve ’ s supervisory actions in the aftermath of the near - collapse of long - term capital management ( ltcm ). today ’ s hearings cover an important topic. the ltcm incident merits study to ensure that the lessons it provides are sufficiently understood and that constructive action is taken to effectively reduce the potential for similar events in the future, without compromising the efficiency of global capital markets. the primary issues raised by the ltcm incident appear to revolve around the broad theme of how to control the leverage and risk - taking of unregulated financial institutions – in particular, hedge funds – so that they do not become a source of systemic risk or jeopardize taxpayer funds via the federal safety net. in our market - based economy, the discipline provided by creditors and counterparties is the primary mechanism for “ regulating ” this risk - taking. in the case of ltcm, this discipline appears to have been compromised. weaknesses in several key elements of the risk management processes at some creditors and counterparties were magnified by competitive pressures, resulting in risk exposures that may not have been fully understood or adequately managed. less - than - robust risk management systems, evidenced by an over - reliance on collateral, compromised both the assessment of counterparty creditworthiness and the measurement and control of risk exposures at several financial institutions. to be sure, the lessons stemming from this episode have not gone unlearned, and there is no lack of effort to identify and implement appropriate public policy and private sector responses to the potential risks posed by hedge funds. these efforts range from private industry and supervisory initiatives aimed at strengthening the credit risk management infrastructures at financial institutions, to consideration of enhanced disclosure by global financial institutions, to those evaluating the costs and benefits of direct regulation of hedge funds. efforts to promote market discipline by strengthening the risk management systems of creditors and counterparties offer the most immediate and efficient way to accomplish the desired objective of minimizing the potential for systemic risk arising from the activities of hedge funds. supervisory oversight of bank risk management practices, including the issuance of guidance on sound practices, reinforces