Bankers may declare everything is under control but risky strategies involving hedge funds are increasingly a cause for concern.
If banks did not take risks, there would be no profits. Smart banking is about understanding and managing risk better than the competitors. That is why banks are continually reviewing and upgrading their risk management systems.
But, no matter how clever a bank’s risk managers are, or how state-of-the-art its technology may be, there is always a danger that unforeseen risks catch an institution by surprise.
For the past few months, The Banker has been exploring the various risks associated with the rise in hedge funds (see cover story page 16). It is the ubiquitous nature of hedge funds, and the way they are appearing across departments, that persuaded us this was a topic worthy of investigation.
This view was underscored by Tim Geithner, the president of the New York Federal Reserve, last month. He said some Wall Street banks were relaxing the financial controls on hedge fund clients to win business and that risk management was, in some banks, falling behind best practice.
Hedge funds are important clients for banks’ prime brokerage operations and their sales and trading arms. They appear again as counterparties in proprietary trading strategies and, on top of this, banks are often invested directly in the funds. There is no doubt that a major dislocation in the hedge fund sector could cause some serious stress.
The key banks involved are the leading investment banks – Goldman Sachs, Morgan Stanley, Deutsche et al – that have embraced hedge funds as a source of revenue while the underwriting and advisory markets have underperformed.
But the first law of banking is that higher returns involve higher risks. Studies by the Bank of England and Fitch Ratings have raised concerns about hedge-fund related strategies. There are worries about concentration, liquidity, leverage – all the usual dangers – but especially the way in which the true hedge fund picture may be obscured from view. There is also a considerable overlap with the leading banks appearing as the key traders, liquidity providers and counterparties in several markets.
The Banker’s research shows that tried and tested risk models such as Value at Risk, as well as newer methods such as dynamic hedging, may not be totally robust in the face of the risks posed by hedge funds. Is this the source of the next financial crisis?
When asked about risks in their institutions, bankers will naturally declare everything is under control. But crises, by their very nature, unfold unexpectedly. Models attuned to the last crisis cannot, by definition, be totally geared to the next one.
The Banker hopes that the worst fears about the role of hedge funds in the banking sector prove unfounded. However, we would be falling down on the grounds of editorial integrity if, having seen evidence to the contrary, we did not investigate.
