Academic journal article Federal Reserve Bulletin

Statements to the Congress

Academic journal article Federal Reserve Bulletin

Statements to the Congress

Article excerpt

Statement by Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, May 6, 1999

I am pleased to appear before this committee to discuss the President's Working Group on Financial Markets' Report on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. Under Secretary Gensler has made a comprehensive presentation of the report's conclusions and recommendations. Chairman Greenspan participated actively in the Working Group's discussions and supports the contents of the report. My remarks this morning will be limited to highlighting a few key conclusions and recommendations.

LEVERAGE AND MARKET DISCIPLINE

As the title of its report indicates, the Working Group has concluded that the central public policy issue raised by the Long-Term Capital Management (LTCM) episode is excessive leverage. Leverage plays a positive role in our financial system, resulting in greater market liquidity, lower credit costs, and a more efficient allocation of resources in our economy. But leverage poses risks to firms and their creditors, and the LTCM episode demonstrated that a single firm could become both so large and so highly leveraged that failure of its business strategies could pose risks to the financial system as well.

While LTCM is a hedge fund, excessive leverage is neither characteristic of, nor necessarily limited to, hedge funds. Available data indicate that no other hedge fund was or is as large as LTCM, and no other large hedge fund was or is so highly leveraged. Indeed, a large majority of hedge funds are not significantly leveraged, having balance sheet leverage ratios of less than 2 to 1. Many financial institutions, including some banks and securities firms, are far larger than LTCM and are significantly leveraged. Whether any of these larger financial institutions was or is as highly leveraged as LTCM cannot be established definitively. Leverage is best defined as the ratio of economic risk relative to capital, but defined this way, it is very difficult to measure. The fact that no other large U.S. financial institution saw its capital significantly impaired indicates that none was so vulnerable as LTCM to the extraordinary market conditions that emerged last August.

In our market-based economy, the discipline provided by creditors and counterparties is the primary mechanism that regulates firms' leverage. If a firm seeks to achieve greater leverage, its creditors and counterparties will ordinarily respond by increasing the cost or reducing the availability of credit to the firm. The rising cost or reduced availability of funds provides a powerful economic incentive for firms to restrain their risk-taking. In our system, government oversight of leverage is the exception, not the rule. Even when government oversight has been deemed appropriate, as is the case of banks and brokerdealers, it is intended to supplement and reinforce market discipline, not to replace it.

However, in the case of LTCM, market discipline seems largely to have broken down. LTCM received very generous credit terms, even though it took an exceptional degree of risk. Furthermore, this breakdown in market discipline reflected weaknesses in risk-management practices by LTCM's counterparties that were also evident, albeit to a lesser degree, in their dealings with other highly leveraged firms.

If market discipline is to be effective, counterparties of a firm must obtain sufficient information to make reliable assessments of its risk profile, both at the inception of the credit relationship and throughout its duration. Furthermore, they must have in place mechanisms that place limits on the credit risk exposures that become more stringent as the firm's riskiness increases and its creditworthiness declines. In the case of LTCM, however, few, if any, of its counterparties really seem to have understood its risk profile, especially its very large positions in certain illiquid markets. …

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