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For release on delivery
10:00 a.m. EDT
July 11, 2007

Statement of
Kevin Warsh
Board of Governors of the Federal Reserve System
before the
Committee on Financial Services
U.S. House of Representatives

July 11,2007

Chairman Frank, Ranking Member Bachus, and other members of the Committee, I
appreciate the opportunity to appear today on behalf of the Board of Governors of the Federal
Reserve System to discuss the systemic risk implications of the growth of hedge funds.
The Board believes that the increased scale and scope of hedge funds has brought
significant net benefits to financial markets. Indeed, hedge funds have the potential to reduce
systemic risk by dispersing risks more broadly and by serving as a large pool of opportunistic
capital that can stabilize financial markets in the event of disturbances. At the same time, the
recent growth of hedge funds presents some formidable challenges to the achievement of public
policy objectives, including significant risk-management challenges to market participants. If
market participants prove unwilling or unable to meet these challenges, losses in the hedge fund
sector could pose significant risks to financial stability.
The Board believes that the "Principles and Guidelines Regarding Private Pools of
Capital" issued by the President's Working Group on Financial Markets (PWG) in February
provides a sound framework for addressing these challenges associated with hedge funds,
including the potential for systemic risk.1 The Board shares the considered judgment of the
PWG: the most effective mechanism for limiting systemic risks from hedge funds is market
discipline; and, the most important providers of market discipline are the large, global
commercial and investment banks that are their principal creditors and counterparties.
The emphasis on market discipline neither endorses the status quo nor implies a passive
role for government. In recent years, the global banks have significantly strengthened their
practices and procedures for managing risk exposures to hedge funds. But, further progress on
this front is needed—in no small part because of the increasing complexity of structured credit

- 2 -

products such as collateralized debt obligations.2 The Board believes that even those banks with
the most sophisticated risk-management practices must further strengthen their enterprise-wide
systems to put the PWG Principles fully into practice.
As the PWG Principles rightly emphasize, supervisors of global banks are responsible for
promoting market discipline by monitoring and evaluating banks' management of their
exposures to hedge funds. As the umbrella supervisor of U.S. bank holding companies, the
Federal Reserve continues to pay keen attention to hedge fund exposures and is working to
ensure stronger risk-management practices. In addition, through the Federal Reserve Bank of
New York, the Federal Reserve is actively facilitating collaboration and coordination among
domestic and international supervisors of the global banks that are key counterparties and
creditors of hedge funds. This area of significant focus-targeting management of exposures to
hedge funds—is part of a broader, comprehensive set of supervisory initiatives that seeks to
ensure that banks' risk-management practices and market infrastructures are sufficiently robust
to cope with stresses that may accompany a deterioration of market conditions.
To that end, the Federal Reserve has been focusing on five key supervisory initiatives:
(1) comprehensive reviews of firms' stress-testing practices; (2) a multilateral supervisory
assessment of the leading global banks' current practices for managing their exposures to hedge
funds; (3) a review of the risks associated with the rapid growth of "leveraged lending"; (4) a
new assessment of practices to manage liquidity risk; and (5) continued efforts to reduce risks
associated with weaknesses in the clearing and settlement of credit derivatives and other overthe-counter (OTC) derivatives.

A collateralized debt obligation (CDO) is a security that entitles the purchaser to some portion of the cash flows
from a portfolio of assets, which may include bonds, loans, mortgage-backed securities, or other CDOs. For a given
pool, CDOs designated as senior debt, mezzanine debt, subordinated debt, and equity often are issued.

-3Indeed, this Committee should be assured that the Federal Reserve has taken on these
initiatives with great purpose and resolve. These initiatives are fully consistent with the
founding purpose assigned to the Federal Reserve by Congress: to help mitigate the risks to the
financial system and the broader economy caused by periodic bouts of instability and financial
Hedge Funds
Although there is no precise legal definition, the term "hedge fund" generally refers to a
pooled investment vehicle that is privately organized, administered by a professional investment
manager, and not widely available to the public. The assets, investment strategies, and risk
profiles of funds that meet this broad definition are quite diverse. In no sense are hedge funds an
"asset class," like stocks, bonds, commodities, or real estate. While some hedge funds pursue
investment strategies similar to those pursued by private equity funds, the strategies of the sector
as a whole are quite varied. Some hedge funds are highly leveraged, while many use little or no
The hedge fund sector has grown very rapidly in recent years. By the end of 2006, more
than 9,000 funds managed more than $1-1/2 trillion of assets.3 Assets managed in the United
States are estimated to account for about 60 percent of the total. The hedge fund industry
remains small relative to the U.S. mutual fund industry, which included more than 8,000 funds
with about $10-1/2 trillion of assets under management at the end of 2006.4 Hedge funds,
however, can make greater use of leverage than mutual funds. Their market impact is further
magnified by the active trading of some funds. The aggregate trading volumes of hedge funds
4 19May07.pdf
See Investment Company Institute (2007), 2007 Investment Company Fact Book (Washington, D.C.: ICI, May).

-4reportedly account for significant shares of total trading volumes in some segments of the
financial markets.5
Possible Implications of Hedge Fund Growth for Financial Stability and Systemic Risk
In important respects, the activities of hedge funds tend to foster financial stability. They
are significant providers of liquidity across the financial markets. Many hedge funds are devoted
to exploiting arbitrage opportunities that emerge when financial asset prices become misaligned.
For example, when interest rates spiked in the summer of 2003, demands by hedgers of mortgage
prepayment risks strained the liquidity of interest rate options markets, sending option prices
soaring. Some hedge funds saw profit opportunities in selling interest rate options, and their
actions helped restore liquidity to the markets and reduced the cost of hedging.
The growth of hedge funds has also contributed to a broader dispersion of risks in the
financial system, which thus far seems to have made the financial system somewhat less volatile.
For example, in 2001 and 2002, significant losses caused by corporate bond defaults were
absorbed without causing any discernible stress in the financial system. This experience
contrasted with earlier periods when financial risks were concentrated at banks and other insured
depositories. In those earlier periods, declines in asset prices created considerable financial and
economic stress-the losses produced failures of many depositories and severely impaired the
capital and lending capacity of others.
At the same time, the growth of hedge funds clearly presents risk-management challenges
to participants in financial markets. If those risk-management challenges are not addressed
successfully, problems in the hedge fund sector could pose risks to the broader financial system.

Greenwich Associates (2004), "Hedge Funds: The End of the Beginning?", December; Greenwich Associates
(2006), "For Hedge Funds, Fixed-Income Trading Volumes Soar, While Costs Take on New Importance,"

-5For example, when the hedge fund Long-Term Capital Management (LTCM) nearly failed in
September 1998, market participants were concerned that LTCM's losses would force
liquidation of its very large positions in a wide range of financial markets, which could amplify
price movements and erode market liquidity. Indeed, the primary factor that induced LTCM's
counterparties and creditors to recapitalize the institution was their fear that liquidation of
LTCM's positions would adversely affect the value of their own trading positions and their
exposures to other counterparties.
In recent months, many market participants have expressed concern that a widening of
credit spreads from relatively narrow levels could lead to hedge fund losses that would make
funds unwilling or unable to maintain their existing positions, thus potentially eroding market
liquidity. Such circumstances could pose significant challenges to hedge funds' counterparties
and creditors and perhaps to other market participants. Thus far, however, the repricing of credit
risk does not appear to have imposed significant strains on the financial system.
Limiting Potential Systemic Risks from Hedge Funds
Since the LTCM episode, policymakers have continued to discuss the best approach to
limiting potential systemic risks from the activities of hedge funds. In the immediate aftermath
of the episode, the PWG studied the implications for financial stability and published its
conclusions in April 1999 in a report entitled "Hedge Funds, Leverage, and the Lessons of LongTerm Capital Management."6 The report concluded that the episode had posed a threat to
financial stability as a result of a breakdown in market discipline by its creditors and
counterparties, which allowed LTCM to become leveraged excessively. The report concluded
that the most effective means of limiting systemic risk from hedge funds was to reinvigorate

- 6 -

market discipline. To that end, the PWG made various recommendations, which were directed
primarily at enhancing credit risk management by hedge funds' creditors and counterparties.
Late last year, the PWG reassessed how best to address the challenges posed by the
continued growth of the hedge fund sector. The results of that reassessment were reflected in the
PWG's release on February 22 of this year of an "Agreement Among PWG and U.S. Agency
Principals on Principles and Guidelines Regarding Private Pools of Capital." The term "private
pools of capital" was intended broadly to describe pooled investment vehicles that are privately
organized, administered by a professional manager, and not generally available to the public.
Thus, the definition includes hedge funds, private equity funds, and venture capital funds. The
PWG highlighted certain overarching principles, followed by principles that specifically
addressed investor protection and systemic risk.
The balance of my testimony will focus on the application of the systemic risk principles
to hedge funds. As I have noted, the overarching principle is that the most effective mechanism
for limiting systemic risk from hedge funds is market discipline. In this regard, the 2007 PWG
Principles are consistent with the 1999 PWG report. Four specific systemic risk principles set
out by the PWG furnish guidance to four sets of parties that have important roles in imparting
market discipline: creditors and counterparties, investors, hedge fund managers, and supervisors
of creditors and counterparties.
The key creditors and counterparties of hedge funds are a relatively small group of global
commercial and investment banks. These global banks provide credit to hedge funds through
securities repurchase agreements (repos) and act as counterparties to the funds' OTC and
exchange-traded derivatives. The terms at which these global banks transact with hedge funds
can act as an important constraint on hedge fund leverage. Furthermore, losses to these global

-7banks from their credit exposures to hedge funds or from market disruptions that could
accompany liquidation of hedge funds' positions are the most plausible channel through which
excessive leverage by hedge funds could threaten the broader financial system or the real
economy. Thus, the management by these banks of their exposures to hedge funds is extremely
The PWG Principles call upon the key counterparties to commit resources and maintain
policies and procedures consistent with best practices for counterparty risk management. These
policies and procedures relate to due diligence; exposure measurement, including stress testing;
and margin requirements and other credit terms. There should be a strong correlation between
the information held by a counterparty about a hedge fund's risk profile and the terms on which
credit is extended. The principles indicate that counterparties should seek quantitative and
qualitative indicators of a fund's exposures to market and credit risk and its vulnerabilities to
liquidity pressures from counterparties and investors. When sufficient information is not
forthcoming from a fund, a counterparty should correspondingly tighten its margin requirements
and other credit terms.
Since 1999, foundations, endowments, public and private pension funds, and other
institutions have become an increasingly significant source of capital to the hedge fund sector.
These institutions, many of which are quite sophisticated, are another source of market discipline
on risk-taking by hedge funds. Accordingly, the PWG Principles call upon investors to carefully
evaluate the strategies and risk-management capabilities of hedge funds and to ensure that a
fund's risk profile is compatible with the investor's appetite for risk. The Board supports the
PWG's formation of an "investors group" to develop detailed guidelines for best practices for

- 8 -

investors in hedge funds, including practices relating to due diligence and ongoing assessments
of a fund's risk profile.
Managers of hedge funds also can contribute to limiting the systemic risks from their
activities. In particular, their management of funding liquidity risk is a crucial determinant of
whether losses suffered by a fund in adverse market conditions spill over to their counterparties.
Since 1999, the Managed Funds Association, the International Organization of Securities
Commissions (IOSCO), and other organizations have issued and updated guidance on sound
practices regarding valuation, risk management, and disclosure. The PWG Principles call for
fund managers to meet those industry sound practices. Furthermore, the hedge fund industry
should periodically review guidance on sound practices, and when necessary, enhance it. The
Board supports the PWG's formation of a hedge fund "managers group" to review and enhance
existing guidance on sound practices in light of the PWG Principles.
Finally, because all the key counterparties of hedge funds are subject to prudential
regulation, their supervisors have a vital role to play in limiting systemic risks, including those
that may emanate from hedge funds. The PWG Principles call for supervisors to communicate
clearly to counterparties their expectations regarding prudent management of the counterparties'
credit exposures to hedge funds and to other leveraged counterparties. The principles also
emphasize the need for international policy coordination among the supervisors of the key
counterparties, which are organized in the United States and several European countries.
The Federal Reserve's Responsibilities as a Banking Supervisor
The Federal Reserve continues to work with other domestic and international prudential
supervisors to communicate supervisory expectations with respect to prudent management of
credit exposures to hedge funds and other leveraged counterparties. After the LTCM episode,

-9the Federal Reserve contributed substantively to a report by the Basel Committee on Banking
Supervision (BCBS) that identified sound practices for managing such exposures. These
practices covered the overall strategy for credit risk management, the processes for information
gathering and due diligence, the measurement and control of credit exposures, the limit-setting
process, the use of collateral and other mechanisms for limiting losses, and the ongoing
monitoring of positions and exposures. IOSCO issued similar supervisory guidance around the
same time.
As the umbrella supervisor of U.S. bank holding companies, the Federal Reserve began
issuing supervisory guidance on the management of counterparty credit risks in the early 1990s.
The BCBS sound practices were incorporated in this guidance to reflect the lessons learned from
the LTCM episode. Adherence to the guidance is assessed as part of examinations of the global
banks that are among the principal hedge fund counterparties.
The Federal Reserve's supervision of counterparty risk management practices is part of a
broader, more comprehensive set of supervisory initiatives. The goal of these initiatives is to
assess whether global banks' risk-management practices and financial market infrastructures are
sufficiently robust to cope with stresses that could accompany a deterioration of market
conditions, including a deterioration that might result from the rapid liquidation of hedge funds'
positions. As I will discuss in greater detail, those supervisory initiatives include
(1) comprehensive reviews of firms' stress-testing practices; (2) a multilateral supervisory
assessment of the leading global banks' current practices for managing their exposures to hedge
funds; (3) a review of the risks associated with the rapid growth of "leveraged lending"; (4) a
new assessment of practices to manage liquidity risk; and (5) continued efforts to reduce risks


associated with weaknesses in the clearing and settlement of credit derivatives and other OTC
1. Stress-testing. Global banks perform stress tests to assess the potential effects of a
variety of adverse scenarios, including the effects of greater market volatility or reduced liquidity
on their market risks and counterparty credit risks. They also consider scenarios in which their
access to funding could be reduced, and develop contingency funding plans accordingly. A
review of selected global banks' stress-testing practices that the Federal Reserve conducted in
2006 indicated a need for the banks to enhance their capacity to aggregate credit exposures at the
firmwide level, including across counterparties; to assess the potential for counterparty credit
losses to be compounded by losses on the banks' proprietary trading positions; and to assess the
potential effects of a rapid and possibly protracted decline in asset market liquidity.
2. Management of Exposures to Hedge Funds. In the fall of 2006, the Federal Reserve
Bank of New York initiated a multilateral supervisory review of the leading global banks'
current practices for managing their exposures to hedge funds. The U.S. Securities and
Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), and
prudential supervisors in Germany, Switzerland, and the United Kingdom are participating in
this review. The first phase of the review was completed last December. The reviewers found
that banks' current and potential future credit exposures to hedge funds were small relative to the
banks' capital, largely because of the pervasive use of collateral agreements. It was not clear,
however, how well the banks' measurement of potential exposures captures the possible size of
those exposures under more adverse market scenarios. The multilateral review is ongoing.
3. Leveraged Lending. The Federal Reserve is focusing on the risks to U.S. bank holding
companies from leveraged lending activities—that is, from lending to relatively higher risk

-11 -

corporate borrowers, often to finance acquisitions or leveraged buyouts. The largest U.S. banks
typically distribute a large share of the loans that they originate to other banks and institutional
investors. Nonetheless, the banks can be exposed to significant risks, and the review is intended
to assess the scale of these risks and the effectiveness of the banks' associated risk-management
practices. The Federal Reserve's efforts in this area are being coordinated with the OCC and the
4. Liquidity Risk Management. The financial system's capacity to cope with stress
depends critically on the management of funding liquidity pressures that may arise, especially
pressures on the large global banks that play a central role in financial markets. The Federal
Reserve is beginning a review of liquidity risk-management practices at the largest U.S. bank
holding companies, focusing on the firms' efforts to ensure adequate funding in more adverse
market scenarios.
5. Weaknesses in Clearing and Settlement of OTC Derivatives. The Federal Reserve first
brought together the group of supervisors participating in the multilateral review of management
of hedge fund exposures in September 2005 to oversee derivatives dealers' efforts to address
weaknesses in settlement practices in the credit derivatives markets. Our intent has been to
ensure that the clearing and settlement practices for all OTC derivatives are sufficiently robust
that they would not be a source of increased risk during a period of significantly greater price
volatility or trading volumes. Of greatest concern in September 2005 was the widespread failure
of derivatives dealers to enforce a contractual requirement that a counterparty receive the
dealer's prior written consent before assigning a credit derivative to another dealer. The failure
to enforce this requirement fundamentally compromised counterparty risk management by
creating confusion about the identity of counterparties. It also contributed to growing backlogs


of unconfirmed credit derivatives trades. The assignment problem was quickly resolved by
widespread adoption of an industry protocol that created strong incentives to obtain prompt
written consent to assignments. The broader problem of confirmation backlogs for credit
derivatives is being addressed through more widespread use of an electronic confirmation
platform. Building on the success of that initiative, the supervisors are now overseeing dealers'
efforts to address confirmation backlogs in the over-the-counter markets for equity derivatives.
The PWG Principles provide a sound framework for addressing the public policy issues
raised by the growth of hedge funds, including the potential systemic risk consequences. These
principles are not an endorsement of the status quo. To the contrary, hedge funds, their creditors
and counterparties, and their investors, need to take action to put these principles fully into
practice. The Federal Reserve has worked, and will continue to work, with the PWG and others
to promote practices consistent with the PWG's Principles for Private Pools of Capital. In
particular, the Federal Reserve will continue to work with other supervisors to ensure that global
banks manage their exposures to hedge funds prudently. More generally, the Federal Reserve
will continue to pursue a comprehensive set of initiatives that seek to ensure that banks' riskmanagement practices and market infrastructures are sufficiently robust to cope with any stresses
that may result from a deterioration of the benign financial conditions experienced in recent