Biggest Hedge Funds Pose Worst Systemic Risks, Says Fitch

International regulators must focus on the largest hedge funds in their “too big to fail” tests, according to Fitch Ratings.

“The combination of excessive leverage and a large market footprint are most likely to create systemic risk in times of stress.” —Fitch RatingsThe agency was responding to a consultation published earlier this month by the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO), which proposed several methods of determining systemically important asset management entities.

The factors put forward in the consultation paper included leverage, a fund’s dominance of a particular market, total assets on both a fund and a company level, complexity, and cross-border activities.

However, Fitch said the regulators should focus on the first two of these factors, meaning the biggest hedge funds were the most important entities to scrutinize.

“If one or more large, heavily leveraged funds come to represent ‘the market,’ this could introduce illiquidity in times of stress,” the agency said in a statement. “We believe the combination of these two factors, excessive leverage and a large market footprint, are most likely to create systemic risk in times of stress.”

The FSB and IOSCO have led the international response to the financial crisis by recommending strict rules for financial entities seen as systemically important to the global financial system. Investment banks were the initial focus, and insurance companies have also come under the scope of the regulators’ investigations. Asset management groups have so far avoided such scrutiny.

Fitch’s response to the asset management consultation argued that a company’s combined assets were not a good determiner of systemic importance as fund managers “operate primarily on an agency basis” on behalf of investors, with the assets themselves being held typically by custodian banks.

“As a result, asset management generally it is not a balance sheet intensive business and does not involve large amounts of leverage, maturity transformation or financial complexity,” Fitch said.

The agency concluded that “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 urged regulators to forge “a deeper understanding of off-balance sheet activities at private funds and larger regulated funds” to identify other sources of risk.

Related Content: Why a $100B Fund Is Too Big to Fail