Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Banking and Financial Services, U.S. House of Representatives, March 24, 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 overreliance 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 the market discipline entailed in banks' assessment and surveillance of the risks taken by their counterparties. The recent guidance on sound risk-management practices issued by the Basle Committee on Bank Supervision, the Federal Reserve, and the Office of the Comptroller of the Currency (OCC) represents significant steps toward achieving the goal of enhancing market discipline. I commend the subcommittee's efforts to advance public awareness of these efforts by holding today's hearings on this recent supervisory guidance.
Of course, public sector work on promoting more effective market discipline on hedge funds and other entities that might employ leverage is by no means complete. The guidance and other supervisory efforts we are discussing here today target primarily commercial banking institutions. Work under way by the International Organization of Securities Commissions (IOSCO) to issue similar guidance regarding securities firms' relationships with hedge funds is another important step. Although not directly focused on the issue of hedge funds, international efforts to enhance public disclosure of financial institution risk profiles may also provide meaningful input. In this context, the recent consultative paper "Recommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Firms," issued jointly last month by the Basle Committee on Bank Supervision and IOSCO, makes an important contribution to the discussion of possible public policy responses. In the United States, the President's Working Group on Financial Markets is considering a number of issues and policy responses regarding leveraged institutions and their relationships with their counterparties. …