Hedge funds and other types of private funds pose the greatest systemic risk for the investment management sector, Fitch Ratings said.
The firm published its views in a statement on its website Monday in reference to the latest consultation paper on non-bank, non-insurance financial institutions that might pose systemic risk to the rest of the financial markets. The paper was published by the Financial Stability Board and the International Organization of Securities Commissions earlier this month.
“In our view, the two key drivers of systemic risk are the use of excessive leverage (and associated counterparty relationships) and ‘substitutability,’ or a fund’s gross (leveraged) size relative to its investment sector,” the statement said. “If one or more large, heavily leveraged funds come to represent ‘the market,’ this could introduce illiquidity in times of stress.”
These two factors combined are “most likely to create systemic risk in times of stress,” Fitch Ratings said.
Fitch Ratings said private funds are “lightly regulated,” and leverage constraints are looser than elsewhere in the financial markets, “reflecting counterparty risk limits rather than regulatory limits.”
The ratings agency also referred to the proposed designation of money managers as systemically important. It said these firms operate primarily on an agency basis — acting on behalf of investors. Therefore, money management is generally not a balance sheet-intensive business and does not involve large amounts of leverage.
“Concentrating on unregulated private funds, with an emphasis on excessive leverage and fund-level market footprint … may result in a more focused, nuanced approach,” Fitch Ratings said in the statement. “A deeper understanding of off-balance sheet activities at private funds and larger regulated funds also may help prudential regulators and the market identify less transparent sources of leverage and risk.”
