Major Financial Institutions Seeking Counterparty Credit Risk Managers
Hedge funds pose a “systemic risk” to the economy, according to a report just released by the General Accountability Office (GAO). Despite industry efforts to improve management and transparency, Pennsylvania Democrat, Rep. Paul Kanjorski, Head of the House Capital Markets Subcommittee, says, “We need to ensure that we have adequate knowledge of this sector of our capital markets and effective market discipline, especially as the pension assets of more and more Americans are invested in hedge funds.” The report concludes that the $1.8 trillion dollar hedge fund industry requires continued monitoring by regulators and counterparties.
Counterparty credit risk management (CCRM) is the best defense against the systemic risk linked to hedge funds, according to research conducted by the Fed Bank of New York. The practices are used to assess credit risk and limit counterparty exposure. Executive search firm, A.E. Feldman, says that CCRM is becoming very important in alternative investments, and the trend is opening doors for qualified candidates at major financial institutions.
The General Accountability Office says regulators and investors remain concerned that credit risk management at major financial institutions is inadequate to contain the risk hedge funds pose to the financial system. According to the Fed Bank of New York, prime brokerage relationships expose banks to counterparty credit through the extension of credit to the funds. In addition, most hedge funds use multiple prime brokers as service providers, which decentralizes the data needed to accurately assess a hedge fund client’s total leverage.
As a result, the GAO says that banks should continue to strengthen practices for managing risk exposures to hedge funds, calling upon banks to enhance firm-wide risk management systems and practices. In keeping with that recommendation, the Fed Bank of New York contends that banks’ first line of defense against market disruptions with potential systemic consequences is their counterparty credit risk management practices.
The Fed Bank also notes however, that hedge funds complicate CCRM because of their unrestricted trading strategies, liberal use of leverage and opacity to outsiders. Still, the GAO reports that CCRM practices have improved markedly in recent years, citing enhanced risk management techniques by counterparties, improved supervision, more effective disclosure and transparency, strengthened financial infrastructures, and more efficient hedging and risk distribution techniques.
