Hedge Funds and Systemic Risk

1. Hedge Funds and Systemic Risk P.V. Viswanath For a First Course in Investments Tsinghua University

2. What are hedge funds? • Hedge funds are a heterogeneous class of institutions. • Hedge funds have been defined as a risky investment pool that seeks very high returns by taking very high risks. • Hedge funds are generally open only to a limited number of accredited, wealthy investors. • Because of this, they are not subject to as much regulatory oversight and reporting requirements as other investment funds. • They tend to provide strong incentives to managers to obtain high returns. • Many hedge funds use investment and risk management skills to seek positive returns regardless of market direction. This is probably why the name “hedge” funds has been applied to them.

3. Hedge Funds and Active Management • Funds that have reporting requirements are less likely to engage in active management strategies because the disclosure reduces the potential return from superior skills and information. Hedge funds, not being subject to onerous disclosure requirements tend to engage in active management. • The CAPM says that E(Ri) – Rf = bi[E(R) – Rf]. More generally, we can say that E(Ri) is the return for taking market-wide or systematic risks. • Alpha is often defined as ai = E(Ri) – Rf –bi[E(R) – Rf], or more generally, the return for taking asset specific risks. • Managers can make money either by taking on • systematic risk, viz. beta, for which the market rewards you with a risk premium. • specific risks and expecting to be rewarded by alpha. This is possible if the manager can locate mispriced assets or if s/he takes on liquidity and other risks in specific financial assets. Sometimes assets seem to be priced too low, but it may be that this is due to specific liquidity risks that the manager does not realize.

4. Hedge Funds and Active Management • Even if the manager can locate mispriced assets, the mispricing is unlikely to remain for long. Hence hedge fund managers have to engage in dynamic, active strategies. • Hedge funds rely on incentive structures to motivate managers – hence they provide a lot of flexibility and freedom to the manager. Consequently, hedge funds can act more nimbly; they can collect information faster, they benefit from cheaper access to markets, they can afford to hire the best analysts and they enjoy superior trade execution and portfolio structuring.

5. Hedge Fund Tools • Hedge funds combine long and short positions. • They concentrate rather than diversify (alpha focus). • They borrow and leverage their portfolios. • They invest in illiquid assets. • They trade derivatives and hold unlisted securities. • If market returns are not judged to be good, managers can move into cash, hedge against market declines or implement short strategies. • This in contrast to mutual funds, which tend to have more narrowly defined charters. • A flexible investment policy allows the manager to adapt to market conditions, but it also subjects the fund to greater manager risk.

6. Hedge funds offer limited liquidity • Because providing liquidity can be costly, hedge funds restrict their investors’ liquidity. • They specify at which dates investors can enter a hedge fund. • An initial lock-up period is mandatory. Investors cannot their funds back immediately. A lock-up period of a year is normal. • At the end of the lock-up period, investors can, normally, withdraw funds at the end of each quarter. Some funds have longer redemption periods and may charge penalty fees to dissuade early redemption. • Investors are required to give advance notice of their wish to redeem – typically 30 to 90 days before redemption. • While these provisions reduce the ability of investors to demand their money back, they also allow hedge funds to invest in illiquid securities, which increases downside risk in the event of a negative event.

7. Hedge Fund Fees • Hedge fund managers impose a management fee, as well as an incentive fee. • Management fees are a percentage of assets under management and range from 1% to 3% p.a; they are intended to meet operating expenses. • Incentive fees range from 15% to 25% of the annual realized performance and enable hedge funds to attract talented investors. These fees are intended to encourage managers to achieve maximum returns. • Many funds include a hurdle rate and/or a high-water mark. • The hurdle rate indicates the minimum economic performance that the fund adviser must achieve in order to be allowed to charge an incentive fee. • The high-water mark states that any previous losses must be recouped by new profits before the incentive fee is to be paid. • This incentive structure explains why hedge fund managers pursue an absolute return target, i.e. their goal is to be profitable regardless of what the market is doing. • Further, these compensation structures are convex – increase strongly with good performance, but fall only mildly with poor performance. This convexity creates strong incentives to take on risks, and with lower transparency, it is easier to hide those risks from both investors and counterparties. • In addition, many risks are tail risks – that is, risks that have a small probability of generating severe adverse consequences and, in exchange, offer generous compensation the rest of the time.

8. Hedge Funds and Transparency • Hedge funds provide limited transparency. There are two reasons for this: • First, the legal structure of hedge funds sometimes preclude them from publicly disclosing performance information, because this could be considered by regulators as a public marketing activity, which is prohibited. • Second, revealing specific positions about individual holdings or strategies could affect fund returns. • For example, a fund desiring to achieve a strategic position in a company would not want to disclose this until it had already finished accumulating its position. Else the market price would tend to go up and raise the cost of achieving that position. • A fund that is short in an illiquid market would not want to disclose its holding, fearing a short squeeze.

9. Systemic Risk and Banks • “Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions that occur over a short period of time, often caused by a single major event.” Chan, Getmansky, Haas and Lo (2005) • Historically, this has occurred in banks. The reason is that a large proportion of bank liabilities are demand deposits, while their assets are in much more illiquid loans, mortgages etc. • As long as investors believe that their money is safe, they will keep their money in the bank because of the advantages of easy access, check-writing privileges etc. • However, once investors lose confidence, then they will attempt to withdraw their money. Of course, banks are not going to be able to honor a large percentage of deposit withdrawal requests because they do not have a lot of (unprofitable) cash sitting in the bank.

10. Systemic Risk and Banks • Withdrawals can be honored only if the bank sells off its assets. The bank’s attempt to sell assets in large volumes causes prices in those asset markets to drop because other investors do not have ready cash to pay for the assets that the bank is seeking to sell. • However, if the bank’s portfolio is diversified, then the increased supply of assets for sale will not cause prices to drop as much. • Banks, though, have a comparative advantage in investing in specific markets, such as loans to companies in a few sectors (in which they have expertise) and, typically, residential and commercial real estate. • To the extent that other banks are also invested in similar assets, this will reduce the market value of their own assets and thereby engender a lack of confidence in those banks and cause more bank runs. • Hence bank runs are caused by two facts: a) a requirement for the banks to satisfy demand for payment; b) decreased confidence in the profitability of the bank and c) the bank’s asset portfolio is concentrated in a few asset markets.

11. Systemic Risk and Hedge Funds • As mentioned above, hedge funds also have concentrated portfolios. Hence, if they need to sell assets in a hurry, the value of their portfolios can drop dramatically in a short time. • Hedge fund managers also have incentives to take excessive risk. Hence, if the market moves against a particular fund, confidence in the fund can drop rapidly. • As mentioned above, hedge funds often take leveraged positions. Along with their tendency to take risky positions, this means that they can easily find themselves in situations where they have to make payments on their borrowings when their cash inflows are low. • Also, as discussed above, hedge funds sell short and take positions in derivatives. This means that if the market moves sharply against them, they will need to either make large margin payments or close out positions at huge losses.

12. The optimal level of systemic risk is not zero • Systemic Risk, as we have noted, comes from three facts: • a) a requirement for the financial institution to satisfy demand for payment; • b) decreased confidence in the profitability of the financial institution and • c) the financial institution’s asset portfolio is concentrated in a few asset markets. • Banks provide checking facilities, i.e. settlement facilities and hence their exposure to systemic risk can be justified. Federal Deposit Insurance has been successfully used to reduce the probability of bank runs. • What about hedge funds? • Hedge fund exposure to systemic risk is due to fund manager incentives that lead them to take on a lot of risk. If so, then the matter could, potentially, be solved by forcing hedge funds (and banks) to have less aggressive incentive schemes or by putting restrictions on their asset portfolios. But would this be best for the economy? • The answer is, in general, no. And the reason is that hedge funds and banks provide a valuable service through their activities. Furthermore, a lot of their activities involve the gathering of information. Since the regulator would not have this information, regulating them would require blanket restrictions on their activities, which are likely to be costly.

13. Why are hedge funds important for the economy? • Hedge funds are active traders and contribute to increased market efficiency and liquidity through their frequent trading and ability to exploit arbitrage opportunities (through investigating and generating new information). • This activity is generally stabilizing and provides considerable benefits in terms of • a) greater market liquidity, • b) lower volatility, and • c) more stable relationships in the relative prices of financial assets. • This promotes efficient allocation of capital and improves real outcomes. • But hedge funds, and even more so, banks, intervene directly in the real economy in a productive way.

14. Hedge funds, banks and real activity • Information asymmetry between investors and borrowers (firms and entrepreneurs) leads to moral hazard problems or to adverse selection problems, which in turn causes credit rationing. Credit is not directed to deserving borrowers (i.e. borrowers who have projects with NPV > 0). • In order to know whether a business is worth investing in, or not, investors need to expend resources in the production of information. It is inefficient for each saver to do this individually; banks have unique skills that allow them to effectively screen lending opportunities, ex ante, before investing, and then to monitor borrowers ex post. They become “delegated monitors” that produce the critical information to facilitate the efficient allocation of credit. They do this by establishing long-standing relationships with the firms they lend to, and then monitor. • Hedge funds, on the other hand, tend not to establish long-term relationships. They are short-term investors. But by taking positions in distressed securities, in merger arbitrage and in sector plays, they make these markets more liquid and facilitate the operation of relatively long-term players such as banks, private equity funds and venture capital.

15. Why care about a systemic risk event? • Why should a central bank care about a systemic event? • An essential feature of systemic risk is the potential of financial shocks to lead to substantial, adverse effects on the real economy, for example, by causing a reduction in productive investment by reducing credit provision or destabilizing economic activity. • It is the transmission of financial events to the real economy that is the defining feature of a systemic crisis, and what distinguishes it from a purely financial event.

16. Financial Sector to Real Sector Transmission • In a systemic crisis, which is likely to originate in a financial sector, there might be impacts on credit and interest markets, if the affected parties are intermediaries for credit. This could lead to increases in the cost of capital in the short run and maybe also in the medium run. • If a financial intermediary is in a bind and a creditor, such as a hedge fund, sells its collateral, the rapid sale of these assets might itself cause the asset prices to drop dramatically, thus reducing the value of the remaining collateral. This is particularly the case if the assets are not very liquid. Then, if other assets have been used as collateral for margined loans, the reduced value of the collateral may invite further sales. Continuing sales into a falling market can cause major problems, both for the borrower and for the lender. Furthermore, the reduced value of the collateral might impair the ability of the hedge fund to borrow to continue its normal operations. • Hedge fund difficulties reduce liquidity in the financial markets and thus hamper the broader provision of credit. Such disruption fundamentally reflects the loss of confidence of investors and a reduced ability or willingness of investors to bear risk through the provision of credit.

17. Financial Sector to Real Sector Transmission • Banks and broker-dealers act as counter-parties for hedge funds and provide collateral (in their role as prime brokers), as well as sometimes providing equity financing. A hedge-fund induced shock to a commercial bank might therefore cause that bank to reduce their intermediation to the hedge fund sector in general. • Banks with direct exposure to hedge funds would have their capital impaired – either that their liabilities are greater than their assets or that they are in great danger of being insolvent. This would prevent the bank from continuing its intermediation activities, which would affect real activity. Of course, if many banks have such exposure, then the effect on real activity could be widespread and serious. Furthermore, if banks have exposure to each other, then difficulties at one bank could be compounded. • If banks go bankrupt, then their networks are destroyed, as well. If bank lending activity becomes disrupted due to insolvency or capital shocks, socially productive relationships are severed and critical information gets destroyed. As mentioned above, banks monitor through the establishment of long-term relationships. • After a systemic risk event, these relationships are destroyed and information is destroyed. As a result, some viable investment projects go unfunded and economic activity is reduced.

18. Do we need regulation? • Why would counterparty credit risk management (CCRM) not suffice to limit risk-taking by hedge funds band constrain systemic risk to socially efficient levels? The answer has to do with various kinds of externalities. • An externality is a cost or benefit that is not transmitted through pricesand is incurred by a party who did not agree to the action causing the cost or benefit. • Sometimes, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may neither bear all of the costs nor reap all of the benefits of the activity, and too much or too little of the good will be produced or consumed in terms of overall costs and benefits to society. • For example, manufacturing that causes air pollution imposes costs on the whole society, while fire-proofing a home improves the fire safety of neighbors. • If there is a given economic activity that involves positive externalities, it may be necessary to impose costs on all who benefit from that activity in order to ensure that there is enough of it. Financial stability may be such a good.

19. Financial Market Stability is a public good • Financial Market Stability is also a public good, i.e. it is nonrival (use by one person does not preclude use by others) and non-excludable (available to all). The non-excludability of public goods means that it is difficult to get all benefiting parties to bear the cost. As a result, it has positive externalities and tends to be underproduced in a competitive market. • Suppose there is a hedge fund that has exposures with many banks. Any bank that reduces its exposure (and its fees) to that hedge fund will benefit other the banks, since its riskiness will reduce. • This works in reverse, also; i.e., each bank has an incentive to free-ride by reducing its counter-party credit risk management (CCRM) and enjoying the benefits of the CCRM of the other banks. • This kind of a situation exists with ordinary lending to non-financial corporations as well; however, in those situations, there’s usually much more information available about the indebtedness of the company. In other words, competitive equilibrium will not impose enough collective discipline. Competition for new hedge fund business erodes CCRM.

20. Agency Problems • An agency problem exists when participants have different incentives, and information problems prevent one party (the principal) from perfectly observing and controlling the actions of the second (the agent). In this case, the agent might act in a way that is detrimental to the principal. • Sometimes agency problems can be resolved through appropriately written contracts, but sometimes a third party may be able to help reduce agency costs. • Agency problems might exist within a dealer/bank (e.g. a trader might have incentives to take on excessive risk – more than the risk officer might be comfortable with), a hedge fund (the hedge fund investor might take on more risk than his investors might want) or in the credit relationship between the bank and the hedge fund (the hedge fund might take on more risk than the bank might feel comfortable with). • A trader or salesperson at a large dealer/bank may have less risk aversion and shorter horizons than the firms’ management as his participation in the short-run upside exceeds participation in the downside.

21. Costs of Hedge Fund Opacity • The opacity of a hedge fund might make it more difficult for its investors or for the bank to monitor it. Hedge fund strategies are complex and not revealed to outsiders (including investors and bank-lenders, because such information might be based on private information and have competitive value.) • Hence the bank might not be able to determine appropriate counterparty risk ratings that drive credit terms, such as initial margins or limits on the size of business conducted with the fund. These issues are exacerbated by the practice of paying hedge fund managers on the total amount of assets under management; potential losses fall in the future, and investors cannot apply current profits to make up future losses. • Agency problems are caused by information asymmetry. Voluntary disclosure of the information may not help because such disclosure may not be credible. However, if regulators require disclosure, e.g. of hedge fund portfolios, it might be credible. A possibility would be for hedge funds to report their positions to a regulator who would take action if the hedge fund’s portfolio were excessively risky, but would not reveal it to the public. This would protect the hedge fund’s investment in the production of valuable information.

22. Costs of Hedge Fund Opacity • The long-run self-interest of hedge fund managers does not curtail excess risk-taking because it’s difficult to get information on past activities of fund managers – even managers of failed hedge funds are able to raise capital in subsequent funds. • Similarly, traders who lose their jobs over trading losses are often able to obtain new employment as traders. • The reason is that it’s not easy to distinguishing managers/traders with talent from those without talent because there’s a lot of noise. • The high-water-mark contract provisions of hedge fund managers also exacerbate excess risk-taking tendencies. Rosenberg (2006) finds evidence that the volatility of hedge funds’ returns increases as the returns fall below their high-water market. The volatility increase is largest for funds with an incentive fee and high-water-mark provision.

23. Banks and Moral Hazard • There is also a moral hazard problem – the large banks who generate this systemic risk, because of the very fact of that systemic risk are likely to be protected by central banks; as a result, they are likely to take on additional risk. • If there are no downside realizations, the bank shareholders obtain the benefits, while if there are downside events, then the central bank steps in to provide ex-post insurance.

24. What can regulators do? • Possible Regulatory Responses: • Requiring hedge funds to mandatorily provide more information. • Restricting hedge fund activities. • Restricting bank lending to hedge funds.

25. Bibliography • Chan, Nicholas; Mila Getmansky; Shane Haas and Andrew Lo, “Systemic Risk and Hedge Funds,” NBER Working Paper no. 11200, March 2005. • Kambhu, John; TilSchuermann and Kevin J. Stiroh, “Hedge Funds, Financial Intermediation, and Systematic Risk,” FRBNY Economic Policy Review, December 2007. • Lhabitant, Francois-Serge, “Handbook of Hedge Funds,” John Wiley and Sons, 2006. • Various Wikipedia sites.