McDonough: Hedge Funds

Testimony by President William J. McDonough before the Subcommittee on Financial Institutions and Consumer Credit, US House Committee on Banking and Financial ServicesGood morning Chairman Roukema and members of the Subcommittee. I appreciate the continued attention that you and your colleagues on the Subcommittee and on the Banking Committee as a whole have brought to bear on the complex and important issues under discussion today.

The near-failure of Long-Term Capital Management last fall raised a number of issues regarding the activities of highly leveraged institutions. Since then, banking supervisors have been hard at work to assess where banks have been deficient in their dealings with hedge funds and other highly leveraged institutions, which I will refer to as "HLIs". This work has resulted in the issuance of supervisory guidance, both internationally and in the United States, with the aim of improving banks' policies and practices regarding HLIs.

I am happy to be appearing before you with my colleague Governor Meyer - who I understand will concentrate on discussing the Federal Reserve's policy guidance to banks regarding hedge funds - and Deputy Comptroller of the Currency Brosnan. I will focus my remarks on the work done at the international level by the Basle Committee on Banking Supervision, which issued a report and sound practice recommendations on January 28 with regard to banks' dealings with HLIs.

Before I get too far into the details, let me share with you my overall approach to the issues we will be discussing this morning. My views have been shaped not only by my positions as Chairman of the Basle Committee on Banking Supervision and President of the Federal Reserve Bank of New York, but also by my 22 years of experience as a commercial banker. Both my private- and public-sector experience have led me to conclude that the LTCM episode, and the proper supervisory response to it, are fundamentally about two things: leverage and good judgment.

Leverage is an important part of our financial system. Most of the time leverage plays a positive role, resulting in greater market liquidity, greater credit availability, and a more efficient allocation of resources in our economy. But problems can arise when financial institutions go too far in extending credit to their customers and counterparties. That's where good judgment comes in.

In my view, the most important decisions a banker can make are whom to do business with and how far that business relationship should be pursued. Those judgments are not easy: one of our fundamental aims as supervisors should be to see that banks are using the right tools to make those decisions. Because banks play a pivotal role in the world economy, the importance of these decisions cannot be overestimated.

Basle Report Findings and Guidance

Introduction

Let me turn to the Basle Committee on Banking Supervision, which is comprised of bank supervisors from the G-10 countries who develop supervisory policy for internationally active banks. While the Committee does not have formal enforcement powers, its conclusions and recommendations are widely implemented, both in G-10 countries and many other nations. The Committee's report focuses on the relationship between banks and HLIs. Our goal was to provide a framework for identifying the broader issues raised by the LTCM episode, the policy responses of supervisors, and some key risk management challenges for the banking industry going forward.

Because the Basle Committee's focus is on banking supervision and regulation, its primary emphasis has been on ensuring that major banks prudently manage their risk exposures to HLIs. The best way to achieve this is through the adoption of sound practices by the industry. It is primarily the responsibility of each banking organization to manage its risks. But given the special role that banks play in our economy and the systemic risks that can occur when they do not function properly, banks' risk management activities are a legitimate public policy concern. Our sound practice standards give banks and their supervisors the tools to measure industry progress toward the goal of effective risk management.

The Committee's report revealed a number of deficiencies in banks' practices. In particular, the Committee observed an imbalance among the key elements of the credit risk management process, with too strong a reliance upon collateral to protect against credit losses. This undue emphasis, in turn, caused many banks to neglect other critical elements of effective credit risk management, including in-depth credit analyses of counterparties, effective exposure measurement and management techniques, and the use of stress testing.

The Credit Approval Process

For a bank to make sound lending decisions, it needs to obtain sufficient information about the borrower. Supervisors routinely emphasize the need for banks to have an effective credit approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. I should note that banks' credit exposure to LTCM was in two forms: the exposure arising from the trading of financial products with LTCM, and the exposure stemming from loans made to LTCM. Banks' primary exposure to LTCM was through their trading activities. Loans were not a large factor in the events that transpired last fall.

Regardless of whether a bank is a trading counterparty with, or a direct lender to, an HLI, it must obtain comprehensive and timely financial information about that HLI's risk profile and credit quality, and it must perform ongoing credit analysis of that HLI. In addition, a bank must have a clear understanding of an HLI's operations and risk management capabilities. The Committee observed weaknesses in each of these areas. Let me give a few examples.

For one, the Committee found that banks did not obtain sufficient financial information to allow for a full assessment of how much and what types of risk had been assumed by large HLIs. In particular, banks did not obtain the information needed to assess leverage sufficiently. They did not have sufficient information to understand HLIs' concentrations in particular markets and risk categories, or their exposure to broad trading strategies.

Also, banks did not sufficiently understand the ability of HLIs to manage their risks. Because risk profiles can change from one day to the next, or even from moment to moment, it is necessary for an HLI's counterparties to ensure that the HLI can effectively manage its business operations and risks on an ongoing basis.

Exposure Measurement

The Committee also concluded that banks should develop better measures of the credit exposure resulting from different types of trading activities. In particular, banks must develop more effective measures of what is called "potential future exposure." Potential future exposure measures the credit exposure between a counterparty and a bank, and how this exposure could change in the future as market prices fluctuate.

The ability of banks to measure potential future exposure is crucial when dealing with HLIs. Unfortunately, methods for calculating potential future exposure had not kept pace with the growth and complexity of HLIs. As we have seen, under volatile market conditions, a bank's exposure to HLIs can grow substantially.

In many instances, banks request HLIs to post collateral covering their exposures. However, a bank that does not use a realistic measurement of potential future exposure to decide how much collateral to require can later find its collateral holdings to be grossly insufficient. We expect the industry to develop more effective ways to measure and manage potential future exposure, and supervisors will closely monitor progress to ensure that this occurs.

Stress Testing

The Committee's report also shows that banks must develop measures that better account for credit risk under extreme market conditions. This can be achieved through what we call "stress tests", where a bank conducts "what if" analyses of how credit exposures to a single counterparty could grow under these market conditions. These might include a large rise or fall in interest rates or a major change in an exchange rate.

More rigorous stress testing could have given banks at least some warning of the types of exposures they faced last fall. The critical importance of stress testing is noted very explicitly in our new supervisory guidance.

Sound Practice Recommendations in the Basle Committee Report

The Basle report is accompanied by a sound practices document that sets forth an important set of standards that will guide both banks and their supervisors. Among other things, these sound practices call upon banks to:

• establish clear policies governing their involvement with HLIs;

• adopt credit standards addressing the specific risks associated with HLIs;

• establish meaningful measures of potential future exposure;

• establish meaningful credit limits, incorporating the results of stress testing; and

• monitor exposure on a frequent basis.