How Important Are Hedge Funds In A Crisis?

by Reint Gropp – FRBSF Economic Letter, Federal Reserve Bank of San Francisco

Before the 2007–09 crisis, standard risk measurement methods substantially underestimated the threat to the financial system. One reason was that these methods didn’t account for how closely commercial banks, investment banks, hedge funds, and insurance companies were linked. As financial conditions worsened in one type of institution, the effects spread to others. A new method that more accurately accounts for these spillover effects suggests that hedge funds may have been central in generating systemic risk during the crisis.

 

“Continued focus on counter-party risk management is likely the best course for addressing systemic concerns related to hedge funds.” —Ben S. Bernanke (2006)

During the 2007–09 financial crisis, commercial banks, hedge funds, and investment banks suffered huge losses from investments that were exposed to housing markets. In fact, in 2008 the International Monetary Fund estimated that these types of institutions, along with insurance companies, had lost a combined $1.1 trillion.

One of the important lessons from the crisis is that systemic risk due to linkages between different types of institutions are significantly underestimated in most widely used risk measures, such as value at risk. Standard measures need to be adjusted to adequately reflect spillover effects among different parts of the financial system. Further, designating which financial institutions are deemed systemically important could depend on identifying to what degree distress in one institution spills over to other parts of the financial system.

However, measuring spillovers effects in practice is difficult for three main reasons. First, spillovers among financial institutions may be quite small in times of financial stability, but large when the system is under stress. Second, it is difficult to distinguish whether a shock affects all financial institutions at the same time or affects only one institution before it is transmitted to other institutions; this is particularly problematic if a common shock affects financial institutions with different intensity and not exactly at the same time. Third, spillovers are typically measured as correlations among the returns of different assets. These calculations suffer from a major disadvantage: Correlations do not identify the direction risk travels between assets. This means that, based on correlations, one cannot judge whether an adverse shock started in institution A and spread to institution B, or the reverse.

This Economic Letter reports on a method developed in Adams, Füss, and Gropp (2013) that addresses these concerns. This new risk measurement suggests that, compared with normal times, financial crises amplify the spillover effects among certain types of financial institutions. A surprising finding from this study is that hedge funds may be the most important transmitters of shocks during crises, more important than commercial banks or investment banks.

Measuring spillover effects

To incorporate spillover effects into a measurement of risk, we first must find a way to measure them. To do this, we develop a statistical model that links the risk in commercial banks, investment banks, hedge funds, and insurance companies. We use the model to estimate the risk in each type of financial institution. We then eliminate the common components that affect all sets of institutions simultaneously in order to focus on stress that flows from one set to another. The model distinguishes which direction these spillover effects flow between pairs of financial institutions. Finally, we estimate the links during both tranquil periods and crisis times.