Hedge funds and other investors might threaten U.S. economic stability in a time of crisis, according to a report aimed at helping regulators decide which non-bank financial companies warrant Federal Reserve supervision.
An exodus of hedge fund investors could “cause activity in some markets to freeze,” said the Feb. 3 report by staff of the Financial Stability Oversight Council. The report, obtained by Bloomberg News, also said the failure of a large insurance company could “result in dramatic and destabilizing actions being taken by investors.”
Private equity firms could be a source of risk because of the “highly leveraged nature of their portfolio companies and their use of bridge loans,” according to the staff report. It noted that out of the industry’s roughly 2,000 managers, about 250 oversee more than $1 billion in assets each.
The report also discussed retirement plans sponsored by non-profit organizations and state and local governments. “Many retirement plans are very large,” the document said. “Therefore, they could pose potential systemic risk.”
In the case of insurers, a big company’s failure could “reduce overall investor sentiment,” the report said. It noted relationships between the life insurance and corporate bond sector, and between municipal bond markets and property/casualty insurers.
The 80-page report is a preliminary draft that, without making recommendations, offers a glimpse of issues regulators — including Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy F. Geithner — will consider when deciding which firms should be designated “systemically important” and warrant central bank scrutiny. The council, created by last year’s Dodd-Frank financial overhaul law to prevent another financial crisis, may begin making those rulings by midyear.
The report also details possible criteria, marked “confidential,” that regulators could use to monitor risks related to firms’ market share and portfolio holdings. Some of the information is already available through public filings. In other cases, the companies would have to document financial information never before released to regulators.
For example, regulators could require hedge funds to provide information on value-at-risk, a measure of risk relative to investor capital.
The oversight council has authority to make companies under its jurisdiction raise capital, increase liquidity and sell assets deemed too concentrated in one segment of the economy. The staff report’s considerations “are meant to provide context and an initial filter” for regulators as they consider individual firms, the document said.
Companies including BlackRock and lobbyists for the hedge fund and mutual fund industries have made the case to regulators they aren’t important enough to the financial system to merit the designation. Executives have said the costs of more regulation would put them at a disadvantage to their competitors.
The Managed Funds Association, a Washington-based lobbying group whose members include D.E. Shaw, Citadel and SAC Capital Advisors, argued in a November letter to Mr. Geithner that hedge funds are too small to be systemically important, noting that the mutual fund and banking sectors are much bigger.
Steven Adamske, a spokesman for Mr. Geithner, declined to comment on the document.
