Hedge Funds, Financial Intermediation, and Systemic Risk

18 Pages Posted: 7 Sep 2007 Last revised: 14 Dec 2007

See all articles by John Kambhu

John Kambhu

Federal Reserve Bank of New York

Til Schuermann

Oliver Wyman

Kevin J. Stiroh

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Abstract

Hedge funds, with assets under management approaching an estimated $1.5 trillion in 2006, have become important players in the U.S. and global capital markets. These largely unregulated funds differ from other market participants in their use of a variety of complex trading strategies and instruments, in their liberal use of leverage, in their opacity to outsiders, and in their convex compensation structure. These differences can exacerbate potential market failures stemming from agency problems, externalities, and moral hazard. Counterparty credit risk management (CCRM) practices, used by financial institutions to assess credit risk and limit counterparty exposure, are the first line of defense against market disruptions with potential systemic consequences. This article examines how the unique nature of hedge funds may generate market failures that make counterparty credit risk for exposures to the funds intrinsically more difficult to manage, both for regulated institutions and for policymakers concerned with systemic risk. The authors acknowledge that various market failures, such as the events surrounding the 1998 collapse of hedge fund Long-Term Capital Management, may make CCRM imperfect. However, CCRM has improved significantly since then, and it remains the appropriate starting point for limiting the potential for hedge funds to generate systemic disruptions.

Keywords: banks, counterparty credit risk management, liquidity

JEL Classification: G12, G21

Suggested Citation

Kambhu, John and Schuermann, Til and Stiroh, Kevin J., Hedge Funds, Financial Intermediation, and Systemic Risk. Economic Policy Review, Vol. 13, No. 3, December 2007. Available at SSRN: https://ssrn.com/abstract=1012348

John Kambhu (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Til Schuermann

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

Kevin J. Stiroh

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
(212) 720-6633 (Phone)
(212) 720-8363 (Fax)

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