By Robert Hunter

The fallout from the Long-Term Capital Management disaster continues to rain on the financial world. Last October, just a few weeks after the Federal Reserve-led bailout of LTCM and amid a tumultuous period for other well-known hedge funds, the Bank for International Settlements' Basle Committee on Banking Supervision convened to investigate banks' interactions with highly leveraged institutions (HLI). The goal: to create, in the words of Basle Committee chairman William McDonough, “a full understanding and prudent management of the particular risks generated from banks' interactions with HLIs—risks both to the direct creditors and, under certain market conditions, to the financial system as a whole.” The committee released a report of its findings in January.

	Because most institutions with exposures to hedge funds appear to be tightening their standards, the best practices are designed to ensure that the improvements are locked in over time.

On February 1, the U.S. Federal Reserve issued an equally hard-hitting missive entitled “Supervisory Guidance Regarding Counterparty Credit Risk Management Systems” (see box); meanwhile, the International Organization of Securities Commissions has now set up a task force to examine HLIs, with a report expected by the end of May.

Besides creating yet another acronym for derivatives practitioners to grapple with, the Basle Committee's report analyzes just what went wrong last fall and offers an accompanying set of best practices to prevent such events from happening again. The guidelines, of course, are just that—anything more would require coordination with financial regulators around the world and broad-based political support, a rosy scenario at best. But because “most institutions with exposures to HLIs appear to be tightening their standards following the events of last October,” the Basle report notes, the best practices are designed to ensure that the improvements are locked in over time.

At the onset, the report tries to define what, exactly, an HLI is—with limited success. “It is virtually impossible to provide a precise definition,” the authors concede. They focus attention on large financial institutions that are subject to little or no direct regulatory oversight, that are subject to limited disclosure requirements and that employ “significant leverage.” The lines of demarcation, of course, are blurry, since not all hedge funds share these characteristics, while many “mainstream” financial institutions do.

In terms of the precise nature of banks' relationship with LTCM before last fall, the authors note, “by far the largest exposures were those arising from over-the-counter derivatives and repo positions.” In those transactions, banks usually dealt on a collateralized basis, so “direct exposures to LTCM, measured as the replacement value of instruments net of collateral, did not comprise a large percentage of the overall trading and derivatives activities of individual banks.”

So what was the problem? Banks were poised to rack up huge losses from the liquidation of collateral and the rebalancing of portfolios when the market hit the skids. “These potential secondary exposures were significant,” the report notes, “given the prevalent market volatility and the potential for a major adjustment in prices once the liquidation process commenced.” Moreover, the authors assert, LTCM's guarded secrecy of its positions limited the ability of counterparties to gauge these secondary exposures.

On a more general level, the report notes, systemic risks from HLI exposures can result from the size of the particular HLI, its leverage and the concentration of its portfolio in various markets. When positions are abandoned quickly and haphazardly, the result can be higher volatility, illiquidity in related markets and subsequent damage to the portfolios of creditors and third parties. The results of these developments aren't pretty: Counterparties tend to recoil from risk, and the overall climate of uncertainty can lead to longer-term market distortions.

Echoing the sentiments of Commodity Futures Trading Commission chairperson Brooksley Born, the authors note that banks' risk management procedures were ill-equipped to handle the magnitude of counterparty risk that LTCM and other hedge funds presented—largely because of hedge funds' vague reporting and the absence of a common measure to calculate leverage and exposure. Moreover, “the vulnerability of banking institutions to HLIs may be magnified by the existence of a strong competitive environment in which creditors are tempted to compromise important elements of the risk management process and to agree to generous credit conditions.” Chief among banks' risk management failures: major deficiencies in due diligence procedures, largely because of poor financial disclosure, and poor monitoring of secondary market exposures.

Prognosis

The Basle Committee offers a three-pronged attack to prevent another LTCM disaster—an indirect set of practices aimed at HLI counterparties, bank supervisory measures to improve the transparency of HLI activities and a suggested framework for HLI regulation. In terms of indirect measures aimed at HLIs and their counterparties, the committee suggests that banks develop a more thorough due diligence process, stress-test their portfolios more, and develop better ways to measure their future and secondary exposures. These activities, the committee says, could reduce the amount of leverage HLIs assume in the future. Supervisors have a number of tools at their disposal as well, including imposing more stringent capital requirements and changing supervisory rules for individual banks based on the relative riskiness of their various lines of business.

In terms of improving HLI transparency, the committee suggests two possible steps: launching a general review of the public disclosure practices of all global dealers, and creating a credit register for bank loans to HLIs.

As for direct regulation, the committee suggests several possible courses of action, including licensing requirements, “fit and proper” tests, and minimum capital and risk management standards. The committee acknowledges, however, that these steps can only take place after a precise definition of an HLI is commonly accepted, and after jurisdiction is established for firms' offshore activities. The last prerequisite, of course, would require an unprecedented degree of international and domestic political cooperation. In other words, don't hold your breath.

Meanwhile, in the States…

William McDonough, who serves as chairman of the BIS, clearly had a busy January. While putting the finishing touches on the BIS's hedge fund report, he was working on a similar report associated with his day job as chairman of the New York Federal Reserve. The Federal Reserve Board's report serves as a guideline to help supervisors and examiners improve on their ability to do the following: Devote sufficient resources and adequate attention to the management of the risks involved in growing, highly profitable or potentially high-risk activities and product lines. Have internal audit and independent risk management functions that adequately focus on growth, profitability and risk criteria in targeting their reviews. Achieve an appropriate balance among all elements of credit risk management, including both qualitative and quantitative assessments of counterparty creditworthiness; measurement and evaluation of both on- and off-balance-sheet exposures, including potential future exposure; adequate stress testing; reliance on collateral and other credit enhancements; and the monitoring of exposures against meaningful limits. Employ policies that are sufficiently calibrated to the risk profiles of particular types of counterparties and instruments to ensure adequate credit risk assessment, exposure measurement, limit setting and use of credit enhancements. Ensure that actual business practices conform with stated policies and their intent. Ensure that institutions are moving in a timely fashion to enhance their measurement of counterparty credit risk exposures, including the refinement of potential future exposure measures and the establishment of stress-testing methodologies that better incorporate the interaction of market and credit risks. For copies of the reports, see www.org/publ/index.htm and www.bog.frb.fed.us/boarddocs/SRLETTERS/1999.

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