Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
ThinkAdvisor

Portfolio > Alternative Investments > Hedge Funds

What shakes the system most during a financial crises?

X
Your article was successfully shared with the contacts you provided.

Hedge funds may play an even bigger role than banks in transmitting financial shocks to the rest of the market, and thus may intensify systemic risk more than previously thought, according to new research.

An economic letter issued last week by the Federal Reserve Bank of San Francisco reported a new risk measurement that suggests that financial crises intensify spillover effects among certain types of financial institutions.

It shows that hedge funds may be the most important transmitters of shocks during crises.

See also: Investors eager to make more hedge fund plays

Reint Gropp, a visiting scholar at the San Francisco Fed from Goethe University in Frankfurt, developed a new way to measure spillover effects, and estimated the effects for investment banks, commercial banks, insurance companies and hedge funds.

How big and how long risk spillovers among financial institutions last depend on whether markets are in normal times or in crisis, Gropp reported. They can be much larger during crisis times.

He found that insurance companies — the case of AIG during the recent financial crisis notwithstanding — are not systemically important in causing distress elsewhere. They tend to be relatively safe in crises, as their returns are negatively correlated to those of other institutions.

In contrast, spillovers from hedge funds during crises become huge, and make the funds more important shock transmitters than either commercial or investment banks.

The reason is that hedge funds are opaque and highly leveraged, Gropp said. If forced to liquidate under duress, they may sustain big losses, possibly leading to further defaults or threatening systemically important entities both directly as counterparties or creditors and indirectly through asset price adjustments.

See also: Investors pour $18.3B into hedge funds in March

How big are the spillover effects from hedge funds? Gropp said that during normal market conditions a 1 percentage-point increase in hedge fund riskiness raises risk of investment banks by an estimated 0.09 percentage point.

During crises, the same shock increases the risk of investment banks by 0.71 percentage point.

By comparison, a 1 percentage-point increase in risk of commercial banks leads to a 0.01 percentage-point increase in risk of investment banks during normal times, and a 0.05 percentage point increase during crises.

Hedge fund spillover effects are largest after 10 to 15 days, and subside after about three months, according to Gropp.

He said more research is needed to explain the mechanisms that underlie the estimated spillover effects.


NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.