Study: Hedge Funds Pose Major Systemic Risk

Apr 15 2014 | 3:32pm ET

Hedge funds may indeed be too big to fail, a new study argues, and may have contributed significantly to the economic crisis that began in 2007.

The hedge fund industry has spent much of the last seven years arguing that its members do not pose a systemic risk to the global financial system. The campaign has been widely successful; most of the blame for the crisis has fallen on banks and other large financial institutions, and hedge funds have been spared the tougher regulations imposed on other sectors of the financial industry.

This may be a mistake, according to a German economics professor.

Reint Gropp, in the latest issue of the San Francisco Fed Economic Letter, argues that hedge funds fueled the 2007-2009 crisis and are today an even bigger threat than banks.

"During calm times, the risks emanating from hedge funds are as small as those from other financial institutions," Gropp wrote. "During crisis times, shocks from hedge funds have substantial effects on all three other types of financial institutions we study."

"We find that hedge funds may play an even more prominent role in transmitting shocks to the rest of the financial market, and thus may amplify systemic risk more than previously thought."

Hedge funds amplify risks by attempting to amplify their returns through leverage, Gropp wrote. During a crisis, that leverage can destabilize the economy in the form of both defaults and forced asset sales, driving down valuations.

The risks posed by banks have become more broadly understood due to new regulations and reporting requirements that hedge funds are, for the most part, exempt from.

"Hedge funds are opaque and highly leveraged," Gropp, a professor at Germany's Goethe University, wrote. "This can lead to further defaults or threaten systematically important institutions not only directly as counterparties or creditors, but also indirectly though asset price adjustments."

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