Fitch: Private Funds Pose Most Systemic Asset Management Risk

NEW YORK--(BUSINESS WIRE)-- Private funds, i.e. hedge funds, pose the greatest systemic risk for the investment management sector based on key risk indicators identified by the Financial Stability Board's (FSB) latest consultation paper, according to Fitch Ratings.

The paper on non-bank, non-insurance financial institutions that may pose systemic risk takes a dual approach for investment management, focusing on investment funds and asset managers, was published earlier this month. The latest FSB consultation paper identifies size (with and without regard to leverage), substitutability, interconnectedness, complexity and cross-jurisdictional activities as potential drivers of systemic risk in the investment management space. These factors are considered in the context of private less-regulated funds, regulated funds and asset managers.

In our view, the two key drivers of systemic risk are the use of excessive leverage (and associated counterparty relationships) and "substitutability," or a fund's gross (leveraged) size relative to its investment sector. If one or more large, heavily leveraged funds come to represent "the market," this could introduce illiquidity in times of stress. 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.

From this perspective, larger, leveraged private funds pose the most systemic risk in the investment management sector. Private funds are lightly regulated, and leverage constraints are far looser, reflecting counterparty risk limits rather than regulatory limits. Regulated investment funds are restricted from taking on excessive leverage. Leverage for regulated U.S. funds, measured as assets-to-net asset value, is restricted to 1.5x for senior debt, below the 3.0x or greater proposed by the FSB. In Europe, UCITs funds leverage is limited to 2.0x. This makes the transmission of systemic risk due to a forced deleveraging low in our view for regulated funds.

Regulatory treatment of certain off-balance sheet derivative transactions represents one potential caveat. Certain derivatives are used by regulated funds in the U.S., where the regulatory treatment may not fully capture the true "economic leverage" that is incurred. For this reason, we "gross up" the balance sheets of rated funds that use derivatives to fully capture the underlying risks (see Fitch Research on "Closed-End Funds: Derivatives Under Review," dated Nov. 16, 2011, for more information).

In the case of asset managers, we note that they operate primarily on an agency basis, acting on behalf of investors in their funds. 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. It is the funds themselves that take on leverage, to the degree allowed, utilize derivatives and have counterparty exposures.

Concentrating on unregulated private funds, with an emphasis on excessive leverage and fund-level market footprint, i.e. substitutability, may result in a more focused, nuanced approach. A deeper understanding of off-balance sheet activities at private funds and larger regulated funds also may help prudential regulators and the market identify less transparent sources of leverage and risk.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

Applicable Criteria and Related Research:

Closed-End Funds: Derivatives Under Review (Increased Use and Limited Transparency Are Key Considerations)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=656591

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Fitch Ratings
Roger Merritt
Managing Director
Fund and Asset Managers
+1 212-908-0636
33 Whitehall Street
New York, NY
or
Yuriy Layvand
Director
Fund and Asset Managers
+1 212-908-9191
or
Kellie Geressy-Nilsen
Senior Director
Fitch Wire
+1 212-908-9123
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
[email protected]
Elizabeth Fogerty, +1 212-908-0526
[email protected]

Source: Fitch Ratings

---

Serious News for Serious Traders! Try StreetInsider.com Premium Free!

---

You May Also Be Interested In

• It Is Your Story to Tell Celebrates Three Years of Transforming Lives and One Year as an Official 501(c)(3) Nonprofit
• Royal Office of Morocco Releases Statement on President Trump's Reaffirmation of U.S. Recognition of Moroccan Sovereignty Over Western Sahara
• The Cannabis Industry Built on Schedule III. Federal Courts Are About to Decide Whether That Foundation Holds