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Hedge Funds and financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks Michael R. King ∗, Philipp Maier

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Hedge Funds and financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks Michael R. King ∗, Philipp Maier
Journal of Financial Stability 5 (2009) 283–297

Contents lists available at ScienceDirect

Journal of Financial Stability journal homepage: www.elsevier.com/locate/jfstabil

Hedge funds and financial stability: Regulating prime brokers will mitigate systemic risks
Michael R. King a,∗, Philipp Maier b,1 a b

Monetary and Economic Department, Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basel, Switzerland International Studies Division, Bank of Canada, 234 Wellington, Ottawa, Ontario, Canada K1A 0G9

a r t i c l e

i n f o

a b s t r a c t
We review key characteristics of the hedge fund industry, and identify conditions under which this sector can pose a threat to financial stability. Direct regulation of hedge funds that increases transparency does not appear feasible, may create a moral-hazard problem, and may reduce market liquidity. Indirect regulation by prime brokers and market discipline by creditors, counterparties, and investors have been effective in limiting the risks from the hedge fund sector. To reduce systemic risks, more regulation of prime brokers is warranted to avoid competitive dynamics from undermining counterparty risk management practices. © 2009 Elsevier B.V. All rights reserved.

Article history: Received 20 November 2007 Received in revised form 27 October 2008 Accepted 20 February 2009 Available online 10 March 2009 JEL classification: G2 G18 Keywords: Hedge funds Regulation Systemic crisis Counterparty risk LCFIs

1. Introduction The credit crisis that has embroiled US and global financial markets since the summer of 2007 has created a number of casualties, most notably three of the top five US investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch). In hindsight their highly leveraged business model was

The views expressed in this paper are those of the authors and should not be attributed to either the Bank for International Settlements or the Bank of Canada. We thank Christine Tse for


References: Adrien, T., Shin, H.S., 2008. Liquidity, Monetary Policy, and Financial Cycles. Federal Reserve Bank of New York Current Issues in Economics and Finance 14 (1). Allen, W.A., Wood, G., 2006. Defining and achieving financial stability. Journal of Financial Stability 2, 152–172. Bank of England, 2005–2007. Financial Stability Report, various issues. Basel Committee on Banking Supervision, January 1999. Banks’ Interactions with Highly Leveraged Institutions. Mimeo. Bernanke, B.S., 2006. Hedge funds and systemic risk. In: Remarks by Chairman Ben S. Bernanke at the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, May 16 2006. Chan, N., Getmansky, M., Haas, S.M., Lo, A.W., March 2005. Systemic risk and hedge funds. NBER Working Paper 11200. Cole, R.T., Feldberg, G., Lynch, D., 2007. Hedge funds, credit risk transfer and financial stability. Banque de France. Financial Stability Review (April), 7–17. CRMPG, June 1999. Improving Counterparty Risk Management Practices, Mimeo. CRMPG, July 2005. Toward Greater Financial Stability: A Private Sector Perspective, Mimeo. Corrigan, E.G., March 2007. Statement before the Committee on Financial Services. US House of Representatives. Danielsson, J., Taylor, A., Zigrand, J.-P., 2005. Highwaymen or heroes: should hedge funds be regulated? Journal of Financial Stability 1, 522–543. Edwards, F.R., 1999. Hedge funds and the collapse of long-term capital management. Journal of Economic Perspectives 13 (2), 189–210. Financial Stability Forum, April 2000. Report of the Working Group on Highly Leveraged Institutions, Mimeo. GAO, January 2008. Hedge Funds. United States Government Accountability Office Report to Congressional Requesters No. GAO-08-200. Garbaravicius, T., Dierick, F., August 2005. Hedge funds and their implications for financial stability. European Central Bank Occasional Paper No. 34. Geithner, T.F., 2008. Actions by the New York fed in response to liquidity pressures in financial markets. In: Testimony before the US Senate Committee on Banking, Housing and Urban Affairs, April 3, 2008. Gieve J. Sir, 2006. Hedge funds and financial stability. Speech by Sir John Gieve, Deputy Governor of Bank of England, October 17, 2006. Hott, C., 2009. Herding behavior in asset markets. Journal of Financial Stability 5, 35–56. ISFL, July 2008. Hedge Funds 2008. International Financial Services, London. McGuire, P., Tsatsaronis, K., September 2008. Estimated hedge fund leverage. BIS Working Paper No. 260. President’s Working Group, 1999. Hedge funds, leverage, and the lessons of long-term capital management. Report of the President’s Working Group on Financial Markets, April 15, 1999.
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