SPEAKERS CONTENTS INSERTS
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BANK LENDING TO AND OTHER TRANSACTIONS WITH HEDGE FUNDS
WEDNESDAY, MARCH 24, 1999
U.S. House of Representatives,
Subcommittee on Financial Institutions and Consumer Credit,
Committee on Banking and Financial Services,
The subcommittee met, pursuant to notice, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Marge Roukema, [chairwoman of the subcommittee], presiding.
Present: Chairwoman Roukema; Representatives Leach, Castle, Kelly, Ryun, LaFalce, Vento, C. Maloney of New York, Bentsen, Sherman, Sandlin, Mascara, Inslee, Moore, and Gonzalez.
Chairwoman ROUKEMA. Good morning. I am going to call this hearing of the Financial Institutions and Consumer Credit Subcommittee to order. I am surprised that there are not more Members here. There were many inquiries made on this subject. It generated a lot of interest over the phone, in any case, so hopefully we will have other Members attending.
We know that this is an extremely important hearing and we want to get this testimony on the record for future consideration and future deliberations. It is obvious that we will be looking at bank interactions with these so-called highly leveraged institutions, which we call hedge funds.
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We will be discussing the recent report of the Basle Committee on Bank Supervision, as well as discussing the new guidance from the OCC and the Fed in this area. We are particularly appreciative of those who are testifying here today.
While the title and the description of this hearing may appear to be somewhat elusive or some would say dryI would not say that; I find it very interestingwe must make no mistake about it; the hearing is vital and it is focused on safety and soundness of our financial institutions. Frankly, I believe there will be some lessons that we can learn as a subcommittee in the context of financial modernization. That story is yet to be told.
But the near failure and private rescue of the hedge fund Long-Term Capital Management in September of last year raised a number of questions. The fact that a consortium of fourteen major securities firms and commercial banks needed to inject $3.65 billionas in ''b''into LTCM in order to avert a potential systemic crisis was, of course, very disturbing to the financial community. The Federal Reserve played a role in the private rescue and one which I will address later and one that I believe was necessary and commendable.
But at the bottom, the issue is safety and soundness and systemic risk that we talk about almost incessantly when we talk about financial modernization. Were commercial banks and securities firms in this situation lending to and engaging in other transactions, such as derivatives, with LTCM in a prudent manner? The hearing that the full committee held in October of last year suggested that some banks were not.
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As we know, LTCM was considered to be the Cadillac of hedge funds and it was supposed to have had some star quality. That is frightening, isn't it? If that had star quality, what might be out there? But that is an aside.
What other hedge funds could boast the John Merriweather of Salomon Brothers, two Nobel Prize-winners in economics and David Mullen, a former Vice Chairman of the Federal Reserve? Reportedly, LTCM had gains of over 25 percent annually for the previous three years and it was turning away investors. Normal banks and securities firms were competing to lend to LTCM and normal due diligence and underwriting practices apparently were not followed. That is the question we have to ask: Why weren't normal practices followed? That is one of our questions.
But this hearing will address the total regulatory response to the LTCM problem. Hopefully the regulators can tell us what the major problems were and how they are addressing the problem and what new guidance they have issuedand this is very important for all of us because we are not just talking about the past; we want to look to the futurewhat new guidance has been issued and how that guidance should help avert new problems. We would also like to know what other initiatives you, the regulators, are working on in this area.
They will also tell us how bank regulators in other countries are addressing this issue, to the extent that we understand or have full knowledge of it, and what material differences there are between us and the other countries. We will also hear about how other countries approach the regulation of hedge funds.
I won't go into a full questioning on what are hedge funds. They are similar to mutual funds, as we know, and they are private investment companies whose investors are primarily corporations, trusts and wealthy individuals.
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The biggest difference between hedge funds and mutual funds is that they are not subject to registration or regulation by the SEC, although I would note that LTCM was subject to registration and regulation by the Commodities Futures Trading Commission. The CFTC knew the leveraging, 30-to-1, that LTCM had, based on its 1997 financial statements, but that leverage of 30-to-1 was not brought to the attention of the other Federal regulators. And it is not clear why there was no warning. I have other questions on that particular subject which I hope we will go over in the questioning period.
But the hedge fund industry is quite large and diverse, as we in this room know. It is estimated that there are close to 5,000 hedge funds and approximately 3,000 in the U.S. The vast majority of the hedge funds are quite small, but the industry is estimated to have over $250 billion in capital under management.
As noted above, there are several different types of investments. I will not go into all the details of the breakdown of the size of those hedge funds, but the hedge funds and the OTC derivatives we know, regardless of whatever size they are, are not subject to direct Government registration and regulation.
Apparently LTCM had derivatives contracts with a value of approximately $1.25 trillion. Most, if not all of the OTC derivative contracts, were with the large commercial banks and large securities firms. Six large U.S. commercial banks account for approximately 94 percent of the OTC derivatives market, and this kind of concentration should come to our attention and should be more thoroughly understood.
Page 5 PREV PAGE TOP OF DOC Here I will just make not a side comment; it is a direct comment, but the flap over the CFTC's concept release last year, which suggested that OTC derivatives may be futures under the Commodity Exchange Act and, as you know, Congress voted to prohibit any action by the CFTC in this area and that is on-going under investigation with the Agriculture Committee in their jurisdiction.
A major issue addressed by the Basle Committee Report, as well as the OCC and Fed guidance, addresses how banks should approach OTC derivative contracts' counterparty risk issue. I won't or maybe I can't go into great detail in this area because we are going to hear from our experts on this subject later on. But needless to say, I will observe that banks should know with whom they are contracting and whether that party will be able to perform. That is what due diligence and underwriting standards are all about, but that is a question I hope our panel is going to address.
These issues of hedge funds and derivatives are also being looked at by the President's Working Group on Financial Markets and their hedge fund report should be released in about six weeks and their derivatives report by summer. And I would hope and I certainly intend to look at that report and follow up, as appropriate, with perhaps hearings on that.
Quite frankly, I think indirect regulation through regulation of the banks and securities firms, as most authorities have said, are out there, but I am going to reserve judgment on that because I am somewhat worried that regulation will lead to hedge funds going offshore, as has been stated on numerous occasions. Nevertheless, I want to make it clear that if indirect regulation does not work, I think we have to give more attention to looking at what might qualify as direct regulation.
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With respect to over-the-counter derivatives, the Agriculture CommitteeI already referenced thatthe Agriculture Committee and the Banking Committee will be looking at this on a mutual basis and a cooperative basis. The banking and securities regulators actually regulate this area indirectly through banks and securities firms which they oversee. While I understand some of the CFTC's concerns in this area, the fact that the Fed, Treasury and SEC believe otherwise would seem to offset those concerns, and perhaps you can enlighten us on that subject.
I expect to, as I indicated, I do expect to hold another hearing once the Working Group reports are issued. But I want to take a moment now to talk about the role the Federal Reserve played in the LTCM situation. I certainly support the actions of the Federal Reserve at that time and it is my opinion that that action was necessary to avert a systemic problem. The Fed did its job of facilitating a private rescue, considering the global market turmoil that was present.
This hearing, however, is all about what steps have to be taken to avoid another LTCM-type problem. We want to hear from the regulators on how they have eliminated or at leastwell, probably not eliminated, but at least cut down the likelihood of another type problem.
And here I know I have gone on for a while, but I do have a couple of questions that I hope will be specifically addressed by the panel. Will the new guidance issued by the agencies prevent a repeat of this kind of LTCM problem? Put another way, if guidance had been issued, would the LTCM situation have been avoided? Are there regulatory changes necessary? What about tightening risk-based capital requirements, enhanced market transparency through additional disclosure requirements and setting statutory limits on transactions with hedge funds? Now, that gets into a highly controversial question, statutory limits, but I think it is one that we have to address directly.
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From an international perspective, and here I reference the question of what other countries are doing and we should know more about that and how they can integrate with our own system. And how do bank risk management systems factor in the risk of dealing with the counterparties who are based in different countries all over the world? This is very difficult, but you experts should be able to enlighten us and give us more insights on that subject. And, of course, as we all remember, the LTCM situation was precipitated by Russia defaulting on government debt and it resulted in emerging market turmoil and volatility and I do not have to remind anyone that there was, and continues to be, considerable market volatility overseas in several of the Asian markets.
I sincerely hope that we hear if not all the answers to these questions, at least enlightened viewpoints on how we directly address the problem here. And with that, I would defer to my good friend, the Ranking Member, Mr. Vento, whom I am sure has an opening statement.
Mr. VENTO. Yes, thank you, Madam Chairwoman, for holding the hearing and for the efforts on the part of our witnesses in terms of their endeavors.
Obviously we are all students in a sense with regard to these instruments. At least certainly I feel as though I am and I am very interested to learn how you are integrating or employing the work done by the Basle Committee in terms of your guidance with regard to U.S. financial institutions and other entities that are willing to take your advice, either directly or indirectly.
Page 8 PREV PAGE TOP OF DOC Twenty/twenty hindsight, of course, always makes things more clear; at least it should. We have had several months since the demise and subsequent phoenix rising from the ashes of the Long-Term Capital Management episode. And while questions persist with regard to regulators' role during the evolution of the Long-Term Capital Management problem, the regulators today have gone on to shape new guidance on the international and national levels.
I, for one, incidentally, being an advocate of a mixed economy, do believe in not going to economic ground zero in these instances, so I am not as much disturbed by it as some others may be. I just think we ought to be aboveboard and on the table in terms of playing that role and not be so modest about it as some would tend to be.
In any case, lawmakers, however, are left to wonder whether the house of cards is going to stand the next crisis. I hope to learn through this hearing whether we have solid building blocks as the foundation for adequate monitoring, regulation, or at least the appropriate level of regulation and measurement of risk, that will improve the odds for whatever cards are dealt in the future economic cycles to withstand the variable changes that hedges, incidentally, themselves are supposed to be designed to absorb. I mean this cognitive construct is an interesting analysis and I think we have to bear that in mind.
The last time we heard from some of the witnesses there had been scarcely enough time to report the events, much less evaluate the situation with regard to the Long-Term Capital Management issue. Today, however, it may be easier to make an informed judgment as to whether something was amiss with regard to, for example, credit analysis. Now is the time to understand and learn from such events. What evaluations can be made regarding a derivative's portfolio or a hedge fund's portfolio in normal market conditions, not to mention the volatile market circumstances? Was there enough stress testing and were the instruments of measurement valid and reliable?
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Most importantly, I hope the answers to these questions have been reflected in the Basle Report and analysis or the OCC and the Federal Reserve Board guidance to the national and State member banks.
Madam Chairwoman, from my perspective, it is only useful to dwell on Long-Term Capital Management to the degree that we learn from it, and we find out how the regulators have learned from it. The quick erosion of capital and apparent inability of our able regulators and the even prize-winning financial minds in the business to foresee the possible downsides of their hedges did not lend itself to enhancing and safeguarding the transactions. That is the end result.
Risk supervision by regulators, really the supervision of risk management methodology appropriate for a financial institution may not be as appropriate as it is fundamental to the overall safety and soundness of our financial system today. Whether it is up to speed regarding entities such as Long-Term Capital Management I think is another question.
Questions persist regarding the adequacy of supervision on such basis. In fact, the events here may well come home to roost regarding insured institutions as they provide credit to entities that invest in the Long-Term Capital Management portfolio types. Should the risks be marked-to-market every day, as an example, every week, every quarter? What due diligence is really done by the bank regarding counterparty risk? Should there be more transparency, obviously more reporting, more capital requirements? Or are we just going to be faced with an avalanche of paper that is meaningless in this particular process, especially given the volatility and the dynamic nature of these instruments? And I know that these are the questions that the learned regulators at the table are facing.
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I hope that by the time the President's Working Group on Financial Markets comes up with their own studies and recommendations, that we will have enough answers to these questions and the turf conflicts will be resolved regarding hedge funds in that instance.
Certainly the appropriate framework for regulation and supervision of hedge funds remains an open question. As these instruments play an increasingly important role in our global economy, the interactions with insured institutions and other financial institutions must be built upon a sound foundation and the dynamic behavior of hedge funds, derivatives, plotted to avert disruptive reactions to the swings in the economy and performance of these entities in the marketplace.
Certainly the Basle Report regards the possible registries for hedge funds, transparencies, measurement and magnitude of risk all point to a more predictable, stable reaction to the changesthe invariable changesthat may visit the marketplace.
The reaction of the regulators and policymakers should endeavor to lift the cloud of mystery and properly convey the true character of risk that is necessary if such investment instruments, in good economic times, as the swings in the free market and, of course, in times that are more volatile. And it ought to understand that to take these very instruments designed to absorb shocks, it should reflect the ability to take these very instruments designed to absorb shocks down a bumpy road for a rough ride.
So I look forward to the testimony today and the continued evolution of the policy and trying to at least get a clear picture of what is happening, because if there is understanding with regard to these, we avert the major problem in terms of someone pushing the panic button in the marketplace. And I think that was one of the factors, because there was not a clear understanding throughout the marketplace as to the default or the failure of Long-Term Capital Management, and that indeed we had an intervention that did occur. And once that happens and we absorb a few losses, there has to be understanding so it does not serve as a catalyst to cause serious disruption in our economy, Madam Chairwoman. And I look forward to the witnesses. Thank you, Madam Chairwoman.
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Chairwoman ROUKEMA. Thank you, Mr. Vento.
I would like to acknowledge the attendance here today of our full committee Chairman, Mr. Leach, and the Ranking Member, Mr. LaFalce. Does either Mr. Leach or Mr. LaFalce have a statement to make?
Mr. LEACH. I have no opening statement, Madam Chairwoman.
Chairwoman ROUKEMA. We welcome you here today.
And the Ranking Member, John LaFalce.
Mr. LAFALCE. Thank you, Madam Chairwoman. I have no opening statement, but I do want to commend you for holding this hearing. It is extremely important. I know this is not the end of it. I know that you will have additional hearings and I think that is important, too, because I do think that it is imperative that we hear the voice and perspective of other members of the Financial Working Group, such as the CFTC and the SEC.
Miss Brooksley Born is an outstanding individual, attorney, quite knowledgeable about this, and whether she is the one who should have raised the questions that she did, nevertheless she did raise questions that are important questions, large questions, and we should be considering them. I think a number of the questions we raise today she may have raised initially.
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Second, I would also like to hear from the SEC at some point in time in the future on a great many issues. But during the committee mark-up of H.R. 10, one issue that was discussed, and I think is still unresolved, is the extent to which certain trading activities should or should not be within the bank or should be pushed out of the bank. And it might depend upon the particular products involved because what has been done historically is not necessarily everything that is happening today or what is going to be happening in the future. The market that exists for that type of activity historically and today might be different than the market that exists in the future, so we do need to be considering those issues and those two agencies at some point in time, I am sure, will be heard from by your subcommittee.
Chairwoman ROUKEMA. I thank you, Mr. LaFalce.
Are there other opening statements on this side?
Yes, Mrs. Kelly.
Mrs. KELLY. I would like to thank you, Chairwoman Roukema and Ranking Member Vento, for agreeing to hold the hearing on the risks that banks take when lending to hedge funds. Obviously hindsight is 20/20 and if we knew last year what we know now, welllife would not be as interesting.
My focus for this issue is simple. Are the banks properly considering the risks that are present when loaning money to a hedge fund? Are they getting all of the proper information necessary to properly evaluate the risks? Are they aware of how highly leveraged the hedge fund is when they evaluate the loan? These are the questions that I am turning over in my mind.
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I want to be clear that I am not advocating any additional regulation of the loan activities at this time. I just want to ensure that we learn as much as possible from the past so that we will not repeat mistakes, especially mistakes that could have had devastating consequences for our banking system, our economy and our markets.
I also want to thank the three witnesses for taking the time to join us here today to discuss their views so we can better consider bank hedge fund issues.
I look forward to the hearing and to discussing this further. Thank you very much. I yield back my time.
Chairwoman ROUKEMA. Thank you, Mrs. Kelly.
Are there other opening statements?
Chairwoman ROUKEMA. Fine. Thank you. We will move on with this hearing.
I have just a couple of administrative announcements. It is normal procedure at subcommittee hearings first of all to tell our witnesses that your written testimony will be included in the record. We would hope that you might be able to abbreviate your remarks. The full text of your testimony will be in the record.
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Members are also permitted, under the rules, to present written questions to the witnesses if they so desire. This is normally done if we either run out of time or it is more appropriate in the Member's own opinion to submit written questions.
And then third, the hearing record will remain open for the usual period of time for submission of additional information. I have already received a copy and ask unanimous consent to include a copy of the recent report on this subject by the New York State Banking Department. Without objection that will be included in the hearing record.
Also, the written submission that we are anticipating receiving from the Federal Deposit Insurance Corporation.
Chairwoman ROUKEMA. In addition, and I would ask unanimous consent on this. The Managed Funds Association, which represents a part of the hedge fund industry, has requested the opportunity to submit in writing a statement for the record. Without objection, so ruled.
Chairwoman ROUKEMA. And now let me introduce our witnesses in the order in which we will be hearing from them.
William J. McDonough, the President of the Federal Reserve Bank of New York. We welcome you, President McDonough.
President McDonough has an exceptional background. He took office in July of 1993 and has served as Vice Chairman of the Federal Open Markets Committee since 1996. He is currently Chairman of the Basle Committee on Bank Supervision, which authored the report that we are focusing on today. We are going to delve into this report and examine it in depth today. Mr. McDonough had a distinguished 22-year career with First Chicago Corporation prior to coming to the Federal Reserve.
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Mr. McDonough, you have testified before the Banking Committee before. You know the rules. You know what to expect and we welcome you here today.
The second witness, and again this is in the order in which your testimony will be taken, is Governor Laurence Meyer from the Board of Governors of the Federal Reserve System. Governor Meyer is a graduate of Yale, has a distinguished background in economics, both academic and practical. Governor Meyer has been a Governor of the Federal Reserve Board since 1996.
Governor Meyer has been an academic, but he has also headed the firm of Laurence H. Meyer and Associates prior to becoming a member of the Board.
Our third witness on the panel is Michael J. Brosnan of the Office of the Comptroller of the Currency. Mr. Brosnan is Deputy Comptroller for Risk Evaluation, which is what we are focusing on today, isn't it? Deputy Comptroller Brosnan is the OCC's representative on the President's Working Group on Financial Markets. He has also participated on behalf of the OCC in the Basle Committee's Working Group on Highly Leveraged Institutions and assisted in the production of their reports.
So you can see we have people of authority here, both by educational and financial background, as well as their own experience in dealing with these matters as they relate to the Basle Committee Report that we are going to be evaluating today.
I welcome all three of you and would begin then with President McDonough.
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STATEMENT OF HON. WILLIAM J. McDONOUGH, PRESIDENT, FEDERAL RESERVE BANK OF NEW YORK
Mr. MCDONOUGH. Thank you. Good morning, Chairwoman 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 very happy to be here this morning with distinguished representatives of the Federal Reserve Board of Governors and of the Comptroller of the Currency. Since they will talk about their implementation of efforts in recent times, 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 position as Chairman of the Basle Committee or as President of the Federal Reserve Bank of New York, but also by 22 years in the trenches 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.
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Leverage is an important part of our financial system. Most of the time leverage plays a positive role, resulting in greater market liquidity, great 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 to their counterparties. That is 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 underestimated.
Let me turn to the Basle Committee on Banking Supervision. It is comprised of bank supervisors from the G10 countries who develop supervisory policy for internationally active banks. The committee itself does not have formal enforcement powers, but its conclusions and recommendations are widely implemented, both in G10 countries and many other nations. And the Basle Committee Report in this case has been brought forward in all of the major trading countries of the world; that is, financial market trading countries, not just in the United States.
The committee's report focuses on the relationship between banks and HLIs. Our goal is to provide a framework for identifying the broader issues raised by the episode, the policy responses of supervisors, and some key risk management challenges for the banking industry.
Page 18 PREV PAGE TOP OF DOC 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 exposure 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.
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 the company. Banks' primary exposure to LTCM was through the trading activities. Loans were not a large factor.
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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 the 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 all of those 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, in particular 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 a constant basis.
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 that exposure can change in the future as market prices fluctuate.
Page 20 PREV PAGE TOP OF DOC The ability of banks to measure potential future exposure is crucial when dealing with HLIs. Unfortunately, methods for calculating potential future exposure have not kept pace with the growth and complexity of HLIs. We have seen, under volatile market conditions, that a bank's exposure 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.
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 can grow under stressed 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 that they faced last fall. The critical importance of stress testing is noted very explicitly in our new supervisory guidance.
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, establish meaningful measures of potential future exposure, establish meaningful credit limits, incorporating the results of stress testing, and monitor exposure on a frequent basis.
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Banks generally tightened the credit risk standards for their HLI exposures after the near-collapse of LTCM. However, it is important that supervisors ensure that progress continues. Memories tend to be short. If there is anything my 22 years in banking told me, it is that. And we want to make sure that as markets calm down, as they have in the past months, banks do not return to the old ways of doing business.
As you know, the Basle Capital Accord is one of the great successes of the Basle Committee. Well before the events of last fall, the committee was developing fundamental revisions to the accord to better reflect the many changes in financial markets and in risk management practices since we created the accord in 1988. Among the G10 supervisors, there is broad agreement that the future accord should make greater distinctions among a bank's credit risks. Those discussions are continuing.
The strong link between sound risk management practice and the Capital Accord provides another reason for rapid adoption of the Basle Committee's sound practices. The HLI report raises several important technical issues of relevance to the accord. For example, the committee's call for better measures of potential future exposure may apply to the way such exposures are measured for capital purposes.
Now one of the Basle Committee's hopes is that its sound practice recommendations will be widely implemented by supervisors both here and overseas. Governor Meyer and Deputy Comptroller Brosnan will be discussing in detail the guidance issued by the Fed and the OCC. I should also note that the New York State Banking Department recently released a report on banks' hedge fund activities that supports the observations and supervisory practices set forth in the Basle Committee Report. The New York State Banking Department and the New York Fed worked very closely together. In addition, international supervisory bodies and supervisors from countries outside the United States are in the process of acting on many of the proposals that we are discussing with you today.
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In February, IOSCO, the International Organization of Securities Commissions, with which the SEC and the CFTC are affiliated, decided that they would focus on securities firms dealing with hedge funds and the ways in which risk management and market transparency can be improved. That would complement the Basle Committee's work concerning banks. Because banks and securities firms are the primary counterparties of HLIs, it is crucial that there be coordinated supervisory response at the international level among securities and bank supervisors.
At their meeting last month, the G7 countries issued a statement endorsing both the Basle Committee and the IOSCO efforts. The G7 intends to continue to review the topic of HLIs, which will be of assistance as we urge countries to implement sound practices.
I would not want to characterize or opine upon the efforts of any one jurisdiction. Many countries' efforts, like ours, are under way only recently and need time to develop and take hold. There probably will be differences in the degree to which supervisors in different countries address the questions, if only because the intensity of HLI activities varies among countries. But on the whole, I believe that supervisors in major countries will follow up, and are following up on the recommendations issued by the Basle Committee.
Madam Chairwoman, many governments have considered or will consider the advantages and disadvantages of imposing direct regulations on the HLI industry. The Basle Committee Report discussed that issue and concluded that concentrating on the behavior of banks and other counterparties doing business with HLIs would yield effective and more immediate results. In short, we know what we could do quickly and effectively rather than wait for the great difficulties which would be involved in direct control.
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A common element of many HLIs is that they are structured in ways that minimize their exposure to supervisory oversights and costs. Thus, many have chosen to organize themselves legally in jurisdictions that offer modest supervision and very low taxes.
Am I pleased that so many HLIs are organized legally in what many would characterize as tax havens? Definitely not. But I do not think that problems involving unwise exposure to HLIs can fairly be blamed on the fact that many of these entities are chartered offshore. To be sure, the due diligence review that banks make for every customer should encompass the customer's place of incorporation and its ramification. Basically I think that if you don't know enough about a counterparty, the obvious credit judgment is no, don't do business with them.
Currently I know of no comprehensive direct regulation of hedge funds in any of the G7 countries. There are, however, aspects of hedge fund activities, such as commodities and futures trading, that are subject to regulatory oversight, as has been mentioned in the opening remarks.
I do not believe that it would be easy to develop a workable approach to the direct oversight of hedge funds. The reality is that imposing direct regulation on hedge fund entities that are chartered in the major industrialized countries would likely result in the movement of all operations offshore. Direct regulation of hedge funds would require a high level of coordination involving the political, legislative, and judicial bodies of many countries, and that is clearly beyond the jurisdiction of most banking supervisors.
As bank supervisors, we have opted for a strategy that will, I believe, bring substantial near-term results. Our approach to improving the financial system's interactions with HLIs is to focus quickly and aggressively on the decisions by banks that could create excessive leverage or imprudent credit exposure. Perhaps our strategy can be termed indirect, but I am reasonably confident that it will succeed.
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Madam Chairwoman, I thank you and your colleagues for the opportunity to explain more about the international efforts that address financial institutions dealing with hedge funds. I promised quick and decisive action on the events that were so fresh in our minds when I testified before you and the other Members of the House Banking Committee last fall. I hope you agree that we have made real progress at the Basle Committee level and in the supervisory developments you will hear about from my colleagues on the panel this morning. Thank you.
Chairwoman ROUKEMA. I thank you.
Now Governor Meyer, please.
STATEMENT OF HON. LAURENCE H. MEYER, GOVERNOR, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. MEYER. Good morning, Madam Chairwoman and Members of the subcommittee. I welcome this opportunity to discuss the Federal Reserve's supervisory actions in the aftermath of the near-collapse of Long-Term Capital Management. The LTCM incident merits study to ensure that the lessons it provides lead to constructive public and private sector actions to mitigate risks going forward.
While there are a number of efforts underway to address the risks posed by hedge funds, those that promote market discipline by strengthening the risk management systems of creditors and counterparties offer the most effective way of minimizing the potential for future LTCMs.
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The recent guidance issued by the Basle Committee on Bank Supervision, the Federal Reserve and the OCC are important and significant steps toward achieving that goal. I commend the subcommittee for advancing public awareness of this guidance by holding today's hearings.
We have already seen the market tighten credit standards on hedge funds, and major banks are moving to improve their risk management processes. These private sector efforts will be further advanced by the work of the Counterparty Risk Management Policy Group to develop industry standards for credit risk management practices of creditors and their leveraged counterparties.
The Federal Reserve supervision of banks reinforces market discipline through on-site reviews and the issuance of guidance on sound practices. My prepared testimony discusses recent Federal Reserve efforts as they relate to bank hedge fund relationships. It also discusses how Federal Reserve guidance supports and is consistent with that issued by the Basle Committee and the OCC.
The Basle guidance draws heavily from the findings of special reviews of bank hedge fund relationships conducted by the Federal Reserve staff, and the Board fully endorses the Basle Committee's findings.
Both documents have been transmitted to all State member banks and holding companies with significant hedge fund exposures and to all Federal Reserve staff supervising those institutions. This guidance has also been incorporated into the March 1999 update to the Federal Reserve's Trading and Capital Markets Activities Manual.
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On February 1, the Federal Reserve issued general supervisory guidance regarding counterparty credit risk management in an effort to build upon the Basle guidance and the lessons we have learned from other recent market events. From a broad perspective, the guidance advises banking institutions to focus efficient resources on ensuring the adequacy of all elements in their counterparty credit risk management systems, especially in areas with significant growth above normal profitability and large potential future exposures.
Institutions are also advised to calibrate their policies and procedures to the risk profiles of specific types of counterparties and instruments. The guidance addresses the assessment of counterparty creditworthiness, credit risk measurement, the use of credit enhancements and contractual covenants and credit risk limit-setting and monitoring systems. The guidance both reemphasizes and supplements existing Federal Reserve principles and guidelines.
Although supervisors start from different bases of existing guidance, we believe that the Federal Reserve Guidance on Trading and Derivative Activities is entirely consistent with that issued over the years by the Basle Committee and the OCC.
Events over the past two years, including those surrounding hedge funds, have also provided supervisors with important lessons. From one perspective, we would like to think that effective supervision contributed to the ability of U.S. institutions to weather the financial storms of the past two years. While the LTCM incident and other market events may have significantly impacted earnings, they did not threaten the solvency of any U.S. commercial banking institution.
Page 27 PREV PAGE TOP OF DOC Still, our review of our own performance suggests room for improvement and our recent guidance identifies several areas for focusing supervisory resources in the future.
In the aftermath of the LTCM episode, hedge funds face a new reality of tougher counterparty oversight. Banks and securities firms have tightened their risk management processes and supervisors are enhancing their guidance and the oversight of banks' hedge fund exposures. The guidance issued by the Basle Supervisors Committee, the OCC and the Federal Reserve represent an effective and quick response to an important issue.
However, more work needs to be done to ensure the lessons learned become ingrained in standard practice so that effective market discipline controls the risk-taking of hedge funds. We therefore look forward to the report of the Counterparty Risk Management Policy Group, as well as to the report of the President's Working Group and other groups on additional recommendations for mitigating risk posed by hedge funds.
This concludes my prepared remarks and I would be happy to answer your questions.
Chairwoman ROUKEMA. Thank you.
Mr. Brosnan, please.
STATEMENT OF HON. MICHAEL L. BROSNAN, DEPUTY COMPTROLLER FOR RISK EVALUATION, OFFICE OF THE COMPTROLLER OF THE CURRENCY, DEPARTMENT OF THE TREASURY
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Mr. BROSNAN. Chairwoman Roukema and Members of the subcommittee, thank you for the opportunity to comment on issues raised by recent Basle Committee Reports on banks and highly leveraged institutions, including hedge funds.
My name is Michael Brosnan and I am the Deputy Comptroller for Risk Evaluation at the Office of the Comptroller of the Currency. In that position I am responsible for both capital markets activities and system-wide risk evaluation.
Let me begin by saying that in the past, hedge funds have not been a significant source of credit risk for the handful of national banks involved. That is because their aggregate exposures were small and largely collateralized with marketable securities.
However, in the favorable economic times before the summer of 1997, some banks became complacent, allowing their credit standards to slip. In volatile world financial markets, complacency, in turn, led to losses related to lending, trading activities and investing at some large banks. Though these setbacks did not materially affect their reported capital, the stock price of some banks declined significantly, apparently because the market doubted their ability to manage exposures during uncertain times.
In response, the OCC reviewed its examination procedures related to hedge fund risk. We supplemented our guidance on financial derivatives, trading activities and counterparty risk as recently as January 25 with the release of OCC Bulletin 992. Derivatives are the prime focus of our efforts because they are a staple of major hedge funds.
Page 29 PREV PAGE TOP OF DOC In addition, we have worked with other regulators on the Basle Committee Reports on bank interactions with highly leveraged institutions that I mentioned earlier. Maintaining effective supervisory guidance is an ongoing process.
I think it is also important to note that the OCC maintains experienced examination staff on-site in the largest national banks, including those involved with hedge funds. Our examiners have found that those banks have taken active steps to control and manage their hedge fund exposures. These efforts have paid off. Exposures which were relatively small even last September have declined still further.
On September 30, 1998 our on-site examiners reported that eight national banks had significant exposures totaling about $1.8 billion net of Treasury or cash collateral from firms that are generally regarded as hedge funds. This figure is now $1.3 billion, a 27 percent decline according to the most recent figures. No national bank now has an exposure of more than 3 percent of its equity capital.
In conclusion, I want to emphasize three points. First, relatively few national banks have hedge fund exposures and those exposures have declined rather sharply in recent months. But those banks are among the largest and most visible in the marketplace, so it is critical that they manage this line of business with care.
Second, no supervisor can prevent a bank from suffering losses in all lines of business. What we must do, however, is focus on areas of vulnerability. My statement today outlines our progress on those fronts.
Page 30 PREV PAGE TOP OF DOC And third, there is no substitute for on-site examiners who are able to monitor changes in banks' exposures and meet directly with bank staff to discuss and test the way they are managing those risks. Thank you.
Chairwoman ROUKEMA. Thank you.
Your testimony is very informative, but it is a lot to absorb, so please forgive me if some of my questions repeat what you have already said. It will be put in the context in which the questions came to mind.
Mr. Brosnan, you just referenced the question of on-site examiners. One of the questions I was going to askI do not know why we do not have precise information on thisbut, does the Federal Reserve have resident examiners on-site at the large State member banks or not? Mr. Brosnan pointed out that that was one of the procedures that was definitely used by the OCC in their own large national bank situation.
Mr. MEYER. In general, we do not have supervisors in residence. There are specific cases, but that is not a general practice.
Chairwoman ROUKEMA. In light of LTCM, have you been reviewing your policy on on-site examiners or not?
Mr. MEYER. I do not think that is the necessary lesson here. We do continuous off-site monitoring. We do careful on-site examinations and we do not feel that it is necessary to have our staff in residence to get the job done.
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Chairwoman ROUKEMA. Well, we will hold off on on-site examiners in deference to some of the more basic, fundamental questions. But I do think that is an open issue that bears more exploration, discussion and examination.
Let me see. I think there was a reference to stress testing. Are there other regulatory changes necessary? Someone, I think two of you referenced more stress testing and I question, by whom? I do not think you were clear as to who would perform that stress testing.
But related to that is my question: what about tightening the risk-based capital requirements? And what about having more requirements for transparency and additional disclosure requirements? I think both of you referenced that, but I did not hear any concrete, detailed recommendations.
Could both you, Mr. McDonough, and you, Governor Meyer, address that? Should there be stiffer requirements here?
Mr. MEYER. Well, as you know, the international capital requirements for banks is set by international consensus with the Basle process. And right now we have a reform effort under way looking to see if refinements are needed in that process. And I think it is widely
Chairwoman ROUKEMA. Are you saying explicitly that there should be no unilateral action at all?
Page 32 PREV PAGE TOP OF DOC Mr. MEYER. Well, we participate and we believe that it is important to get a level playing field among countries and to get equality in treatment, that we handle these capital standards as part of an international agreement and we are participating in the Basle process, trying to reform that process.
One of the things that is widely agreed is that one area where reform is needed is that the capital treatment with respect to loans is not adequate. With respect to nonmortgage loans it is a single capital charge, an 8 percent capital charge, irrespective of whether it is a AAA-rated corporation or a junk-rated corporation.
So that would be one area that the Basle Committee, and President McDonough could expand upon, is exploring the possibility of having additional risk rates in the loan portfolio and that is a very promising direction, one which we think needs to be pursued.
Chairwoman ROUKEMA. And the disclosure requirements, transparency?
Mr. MEYER. There is a great deal of work going on. As you know, the Basle Committee also does a survey every year, the last one came out in November, and we can track really significant improvements in the disclosure of banks, particularly of their derivative positions. This is the particular disclosure I am talking about. And we have seen improvements over time in bank disclosures of their risk positions.
But this is another area which is evolving and we need to see further improvements because that increases the market discipline on banks when we have better disclosure of their risk positions. And one of the things in a recent Basle Report out, joint with IOSCO, it is recommending for enhanced disclosures by banks, more qualitative information and more quantitative information about their risk positions. And I think these are constructive recommendations.
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Chairwoman ROUKEMA. Yes.
Mr. MCDONOUGH. Madam Chairwoman, the main thing that we are doing in the Basle Committee is shifting the approach to capital from one that has been basically just 8 percent of a risk-adjusted portfolio to one that has a basic capital requirement, but a much heavier emphasis on supervision and on market discipline.
Let us take them in reverse order. Market discipline means that if you are a bank and I am your counterparty, that you have to tell me enough about what is going on, what is your risk appetite, what is your approach to it, how good are your internal controls, so I can make a judgment about whether I want to do business with you in a rational manner. That is market discipline. You cannot have it without transparency. That is why we push it hard. I am sure
Chairwoman ROUKEMA. You have anticipated one of the other questions I had about market discipline. Yes, continue.
Mr. MCDONOUGH. Now backing up to the capital requirement itself, one of the things that you will recall that we talked about is what is called potential future exposure. So you have a counterparty relationship with the bank, with a highly leveraged institution, and not only do you say what is the mark-to-market that that institution would owe me today, but given the possibility that if the market behaves about the way that it did in the last couple of years, how big could that credit exposure grow? And you had sure better be covered for that.
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It is very likely that what we will decide to do is to apply the capital requirement not to the mark-to-market today, but to the potential future exposure. That would give you a lot more capital required.
Then you get into the business of stress testinghow bad can it get? We are picking up the supervisory level, as you asked, on who does the stress testing? Well, the institution itself would do it. We may give them a certain amount of guidance as to how radical they should consider the stress events that would be likely to take place, as guidance to them, but basically our view is that it is best done by the individual institution, with the supervisor looking over the institution's shoulder and saying, ''That is reasonable'' or ''We've got lots of experience because we look at twenty institutions, and the best practices of other institutions are that they do it a different way; we suggest it to you.''
So at the end of this process, we are going to have the banks managing themselves better and the supervisors looking over their shoulders with our public interest responsibility, to make sure that they manage themselves better.
Chairwoman ROUKEMA. I am not quite sure that that has been precise enough to address my concerns. It just seems to me that there have to be some fundamental basic standards there, that you cannot put them all on their honor, so to speak.
Mr. MCDONOUGH. I do not envision that we would put them on their honor, but if you have a set of guidelines that say this is how you should manage your affairs, it limits how well a bank manages itself to the skills of the supervisors in telling them how to run their business.
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I think our experience with the mixed economy is, as Mr. Vento described it, that what you want is good, effective supervision, but you also want a very high feeling of need on the part of the individual institution to manage itself properly. I think there you get one-plus-one equals more than two. That is really what we have in mind.
Chairwoman ROUKEMA. All right, thank you. There is more to be digested on this subject.
Mr. Brosnan, did you want to address any part of that?
Mr. BROSNAN. I would not have anything to add on that capital discussion, but on the issue of stress testing I would say that that was one of the key lessons that was learned by both bankers and us during exams in 1997 as well as 1998.
The guidance that the OCC issued was extremely specific and pointed on the issue of stress testing. We laid out that banks should, in the normal course of business, consider certain unlikely, but realistic, scenarios in the stress testing, such as the equity market move in 1987, the currency movements in 1992, interest rate movements in 1994, issues in 1997, as well as most recently in 1998, in their normal stress testing process. Those numbers, although they are unlikely, should be reported upward to senior management so they can make fully informed and conscientious decisions as to whether or not the bank could take additional risk or to cut it off.
There is no guarantee that just because they run stress tests that the numbers that come out will actually be used in the decisionmaking process, but there is huge value for the bankers, as well as the supervisors and then the board of directors, for that matter, in knowing what could happen in very unlikely, but possible scenarios.
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Banks have not been as vigilant in this area, at least not across the system, as they should have been, and they know that. However, the lesson learned with the 2-by-4 that came and hit people over the head several times now suggests that this is going to be something that is going to be raised up. And also the technology that is out there is so much better this year than it was two years ago, and certainly four or five years ago, that it is much easier and less expensive to do this sort of thing.
I can assure you that during exams of national banks, OCC examiners will expect banks to raise the bar on the price risk or the trading stress testing. Banks are also in the very early stages of credit risk stress testing, which is much more difficult, but we are going to make this happen, as well. Much more important than us pushing it, bankers see this as something in their own best interest to do and to do well, for the obvious reasons.
Chairwoman ROUKEMA. Thank you.
Mr. VENTO. Thanks, Madam Chairwoman. Good questions and I appreciate the work done by staff on some of our questions and background material.
On the stress test issue, clearly one of the objectives here and the reason that hedge funds or derivatives have come into vogue is because they offer supposedly a greater degree of security and certainty so that you will not lose money whether you are a securitization or whether you are insurance or whether you are in banking. Banks, it seems to me, get into it in terms of lending and we have, of course, the banks under our grip, so to speak, as regulators and as policymakers and with the insurance angle and some of the other concerns that we have, but it is a question of we can probably put some rules in place for banks, which would sort of atrophy the roles of banks.
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It sounds to me like a little bit of that is happening right now. I mean, I do not know that hedge funds are going into atrophy, but it sounds like the banks are doing a little less of it simply on the basis of this shot across the bow last year. That is sort of my impression. That is not necessarily a question, but I think it probably is accurate.
The issue with stress tests, of course, becomes very important, as was instructed here, is to think about if we are, for instance, loaning money in Indonesia and you have a hedge that you are dealing with in terms of that as your security, you are dealing with it. Then you have this devaluation of their currency. I mean, it is a question of withoutI mean the hedge is obviouslythe reason for the hedge, incidentally, I assume is because we get a better money multiplier with it, that we can actually extend more credit, that you can somehow take the dollars that a bank or a security firm is putting out and you can multiply it into more. In other words, you can get more miles per gallon out of that particular loan or that security.
So this brings up the issue of a stress test. If you take that analysis, I do not know howI mean it is like trying to come up with the magic formula, some sort of equation that is going to be appropriate. We know it is going to be imperfect.
Mr. MCDONOUGH. Could I comment on that?
Mr. VENTO. Yes.
Mr. MCDONOUGH. The problem with all testing or hedging is that we base our view of the future on our view of the past. So the various things, for example, that Mr. Brosnan mentioned that banks are supposed to do, look at what happened in the 1987 stock market crash, as a technical matter, that ought to come under your potential future exposure.
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A stress test is to try to figure out what is very unlikely to happen, but could happen. I will give you an example of hedges that went wrong.
When institutions throughout the Western world were lending money to Russia, they thought that the thing that they should guard themselves against was a devaluation of the ruble and so they took out a hedge against a devaluation of the ruble.
The only problem is, with the brilliance of hindsight, the only institutions that would give you a hedge against the devaluation of the ruble were located in Russia. So the imperfection of the hedge, by hindsight, was pretty obvious. You were dealing with institutions such that, if Russia really went kafloozy, which it did, they would too; so the hedge went away because your counterparty went away. That would be a stress test. In fact, the unlikelihood of that happening was really what triggered the LTCM episode.
So stress testing is a combination of a fair amount of science, because to some degree you are saying that if this awful thing happened, based on what our experience of the past was, how bad could it get? But I think what we have to realize, which makes stress testing so very important, is that you are really dealing with the unlikely, and therefore it takes a very broad-gauged view of the likelihood of stress coming at you.
Mr. VENTO. Yes, we have written stress tests for various types of entities that are regulated and, of course, we could have passed the ball to OFHEO or to somebody else to come up with the stress test, so I am certainly familiar because obviously we are dealing in a commodity that is domestic and like real estate or some other elements, it is a little easier. But the range of different exposures that come under here is much greater.
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But it does have the extentI mean the reason that these hedges and derivatives end up being utilized or employed is because they obviously multiply money, because they obviously give the effect of being able to convey or close a transaction that otherwise would not be conveyed.
Now the whole issue of regulation, of course, is very interesting. I was looking at this registry, this credit register that would be established byI tried to turn it into an Italian word, ''basil,'' but it is ''Basle.'' It is a tendency that the Chairwoman and I have.
Chairwoman ROUKEMA. I said ''Basle.''
Mr. VENTO. OK, so I am talking about my problem.
In any case, the registry issue, couldn't that be interpreted that if you are on the register, that that gives legitimacy, in fact? I understand that your concern is that there be certain precepts with regard to transparency and not necessarily legitimacy, I think.
Mr. MCDONOUGH. We included in the Basle Report the possibility of using credit registers because some European countries use credit registers as an important part of their supervisory activity.
Page 40 PREV PAGE TOP OF DOC There is a difficulty in credit registers being extremely useful, as a matter of fact, because when you are dealing with a highly leveraged institution, the credit register will tell you where it was at whatever the date of the last report in the credit register was, which is interesting, but not very important.
What is really important is how well does the counterparty with which you are dealing run its business? If it runs its business very well, it has very effective risk management capabilities and you know what their whole exposure is. That, in my view, is how you should base your credit judgment.
I think the experience of countries that use credit registersand France is one that uses them quite activelyis that they are very useful. I doubt very much that other countries which do not have the experience with credit registers are likely to use them and my own personal view is that this market is so extraordinarily dynamic that the registers give interesting and good information, but if I were a market participant, I would not base my credit judgment on them. And as a supervisor, I would prefer that the credit judgment be based, if partially on a credit register, then also on lots of other things.
Mr. VENTO. It is like driving forward by looking through the rear-view mirror.
Mr. MEYER. In addition to it maybe not being timely enough to be useful to the counterparties, it might also give a false sense of security, and I think that is another issue. We have to be careful with some of these reporting and disclosures who it gets reported to, whether it is just filed away and gives a false sense of security, an impression that there is oversight when there really is not any, and that can lead to moral hazard concerns and not advance the situation.
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Mr. VENTO. Madam Chairwoman, if I can pursue this, I think even the whole issue of disclosure may be enough. Personally, of course, I sort of do not like being threatened when you are reviewing something and looking at options about what we could do, because it seems to me that if some of these hedges are fully disclosed it is going to affectwe hope it will affectthe behavior of institutions and investors. I guess that is the reason for having disclosure. We think that it is necessary and good information and that the buyer does not have the ability to do that today to the extent they would if we provided for or required a certain amount of disclosure.
So that may itself push folks away. I personally think that if hedges are going to continue to play the role in derivatives, that they have to have a tie to the largest economy in the world and some of the credit-making and other activities. I think just the discussion of this has, of course, caused some atrophy of this, at least as it affects banking, and I don't know.
I mean what do you all see as the role of these hedges and derivatives down the road? Maybe that is just a general question. Obviously we are going to put a lot of effort into this. Anyone want toshort answers here?
Mr. MEYER. First of all, hedge funds are a vehicle for widely varying investment strategies and give options to individuals and corporations to invest, manage their risk and take risks as they see fit.
So the important issue, it seems, is to guard against excessive risk-taking here and in that judgment, the best way to do that is to discipline the hedge funds through the counterparty surveillance of the regulated institutions that help them achieve their leverage. I think that is the best direction to go.
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But they play a useful role and the important thing is, as with leverage, leverage plays an important role in our economy and we have to achieve a certain balance. We have to mitigate the risk, but still allow that leverage to achieve the ends of meeting the financial needs and investment needs of the economy.
Mr. MCDONOUGH. They serve a useful purpose. I think the best example for a person from Minnesotamy native State is Illinoisis the role of locals in the Chicago Commodities Exchanges. As you know, the locals are absolutely essential because they are the people who are willing to take the other side of the deal when the farmer wants to lay off his risk in the harvest.
They are speculators. Hedge funds essentially are speculators. Speculators, if they are kept controlled in the way that we are trying to do in this indirect manner, actually play quite a useful purpose in the same way the locals do on the commodities exchanges. But just as the locals can create problems on the commodities exchanges if they get in over their heads, so, too, can hedge funds or other users of these risk mitigation products. Risk mitigation, gone awry, gets dangerous, and that is essentially the sort of thing we are dealing with here.
Mr. VENTO. Thank you.
Mr. BROSNAN. Can I add a couple more points?
Chairwoman ROUKEMA. Yes, go right ahead.
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Mr. BROSNAN. There are over 5,000 hedge funds, depending on how you define them, and there is a reason for that, from the investment community on up to the people who run them.
Banks are engaging in business with hedge funds, fund managers more generally, for three reasons. One is they get tremendous information flow from these funds, particularly the largest ones. They get an idea of which way currencies, interest rates, and so forth, are moving, and the bank is able to use that information as it provides services to its much broader client base.
They also get transaction flow. Transactions come through the bank and it helps them stay active and justify their position in the marketplace. They are able to buy and sell and they are more prominent because of that.
And also hedge funds buy things. They don't just engage in derivatives. They also buy cash instruments. They will buy residuals of mortgage-backed securities, for example, that banks originate, so that enables the bank to provide credit more widely in terms of dollars and also lower pricing to their retail client base. Those are just some simple examples.
I think that hedge funds are not going to go away as a customer base of banks. The issue comes back to how does the bank manage its risk with hedge funds?
Now thinking of the credit register, it is an excellent concept where somebody somehow finds out how much debt one of these funds has, or any other entity has, for that matter. Why limit it to hedge funds?
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But as I look at a bank, I think the bank has a complete responsibility to know how much debt and how many other obligations that people who borrow money from the bank have, and banks can, through the normal course of their lending, through loan covenants, get that information. The question is are they going to do it? And they were complacent in some instances in the past. Today we are seeing significantly ratcheted-up efforts where they are finding out this information.
But I think that provides just a little extra context on a prior question.
Mr. VENTO. Thanks.
Thanks, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you.
Mr. LEACH. Thank you, Madam Chairwoman.
I would like to just enter the stress testing issue from a little different perspective. Part of it relates to the role of legislators versus the role of Executive branch, particularly the regulators. Clearly we have a responsibility for ensuring that the concerns of the public interest are laid on the table. On the other hand, sophistication in stress testing, and so forth, is really more the command of the Executive branch.
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In this regard, however, it has been my experience over the last decade or so that there is an irony in the emphasis on stress testing. That nothing is more important than stress testing; on the other hand, use of stress testing as the preeminent vehicle of regulation has sometimes been tied up with capacities of institutions to overleverage rather than put constraints on activities. And I think that sometimes the big picture is missed.
Ten-, twenty-, thirty-years ago the emphasis in regulation was capital ratios, words like margin requirements and certain types of securities transactions were the order of the day. Today stress testing is, but I don't think one can avoid the former concern as one puts emphasis on the latter.
By that I mean as this committee has looked at Long-Term Capital Management, we have learned that this institution had about 30-to-1 leveraging. Governor Meyer very appropriately said that one way you put a constraint on leveraging is to look at the lender, and I think that is very appropriate.
But in theory, we not only have a model of an institution that has collapsed, but in the collapse of this institution I think there has been lack of attention to the fact that basically it collapsed in positive economic times. And I stress this because we all know we have had an Asian crisis, we have had a Russian crisis, but real GNP growth in the totality of the world is still positive. In other words, not everything has hit the worst circumstance.
So things have occurred in a bad, but not extraordinarily bad circumstance, and one has to look at extraordinarily bad as well as bad.
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Now having said this, as we look at Long-Term Capital Management, which was 30-to-1 leveraging, we are told, and now, in essence, it has to be looked at as if it is a bank because it is owned by banks. So in theory you have a bank, the major money center banks with about 5 percent core capital; they now own, in effect, Long-Term Capital Management, which is 30-to-1 leveraging, so you have 500-to-1 leveraging.
Stress testing does not indicate sufficiently how extraordinary that is in the history of finance. 500-to-1 leveraging of capital. That is something that I think regulators have to be very concerned about.
Now one of my concerns, as you all know, is the conflict of interest that now exists with the major institutions owning the world's largest hedge fund. But putting it another way from a regulatory perspective, you have what I believe is a collusive agreement to keep capital in; that is, to keep Long-Term Capital going, these groups which now own the institution have agreed to keep capital in.
So the obvious question to the regulators, it seems to me, is very straightforward and it is not simply the question of stress testing. That is, what do you think is the appropriate leveraging ratio that should exist? And is it 500-to-1? Or have you ordered another leveraging ratio?
So my question to both Mr. McDonough and Mr. Meyer is, you come before us as regulators having determined, as the United States Federal Reserve Board, that a failure of Long-Term Capital posed extraordinary systemic risk to the world financial system based upon 500-to-1 leveraging, based upon bad, but not extraordinarily bad times. Can you defend 500-to-1 today or are you suggesting it ought to be brought down to 50-to-1, 20-to-1? What is the leveraging ratio that you think is appropriate for this hedge fund, which, after all, is basically operating as an affiliate structure of a series of banks?
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Mr. MEYER. First let me address the issue of did the LTCM near-collapse occur in an environment that was unusually favorable, rather than one that was stressed. I would take issue with that.
Mr. LEACH. Well, I am going to have to stop you. I do not mean to intervene, but I do not allow you to put up a straw horse. So let me say the horse that is on the table.
I said the situation was bad, but not extraordinarily bad, because real GNP growth was positive. I did not say it was a good environment. And I want you to be fair in responding.
Mr. MEYER. My point was that the environment in the U.S., certainly in terms of growth, employment, was exceptional, very good, but the environment in global financial markets was highly distressed at the time.
Mr. LEACH. What I am suggesting, and I want to come back, I want you to be fair; I said the situation was bad, that there were enormous difficulties in Asia and Russia, but the total GNP circumstance worldwide was still positive and that things could have been worse.
So again I want a response based on that premise, not on a straw premise.
Mr. MEYER. Except I would argue that in the financial markets that were relevant to the success of the positions that LTCM had, that these were some of the most distressed situations in financial markets we had seen in decades.
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And indeed one of the things that LTCM was betting on was that relationships between assets came back to more normal relationships and what happened was in these distressed situations, all of them moved further and further away from normality, and that is what got them into problems.
Mr. LEACH. I concur in that, but I want to just use your verb again. You use the word ''bet,'' which I think is a very impressive verb to use, that this is a betting institution with 500-to-1 leveraging.
Second, all I can say is what would have happened if, in addition, you had had an implosion in the United States economy and that things could have been worse. That is the only thing I am laying on the table, that what we have is a circumstance in which we had a bad international environment, but it could have been worse. Yet in the same token, we have the United States Government determining that for systemic reasons, this institution had to be saved.
So I want to come back. In that setting, do you still support 500-to-1 leveraging or do you have a different leveraging feeling?
Mr. MEYER. One also has to appreciate that LTCM was virtually unique in terms of the amount of leverage.
Mr. LEACH. Excuse me. We have had testimony in prior hearings that the hedge fund industry is divided about into thirds, one-third with virtually no leveraging, about one-third with modest leveraging, but one-third of the industry with 25- to 35-to-1. Maybe that is too high but
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Mr. MEYER. That is much too high.
Mr. LEACH. Could be, in that one-third, but if you are saying LTCM was unique, then can you tell us that now that, in effect, the two of you supervise institutions that own LTCM, as well as lend to LTCM, which is a category of differentiation that did not exist; are you standing by allowing 30-to-1 leveraging or what leverage ratio are you suggesting?
Mr. MEYER. I think the purpose of this consortium is to unwind and reduce the leverage, and some of that leverage has been reduced already.
Mr. LEACH. What is the leveraging today?
Mr. MEYER. The last report I had was down to about 20-to-1 in the last report that I saw, from close to 30-to-1.
Mr. LEACH. What is your goal?
Mr. MEYER. Well, the goal is that the ownership position of the U.S. banks in the consortium is going to be wound down and sold off, so this is not going to be a permanent condition. This is part of the gradual unwinding and resolution of the problem, rather than an activity that is a permanent
Mr. LEACH. Is this the commitment of the owners of LTCM? I will tell you, Governor Meyer, that you have different people asserting different things. There is LTCM management saying we are on-going and this is going to be a new era. You have others that say the goal is to unwind.
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Are you reflecting the view of what the Fed wants, what the parties have agreed to?
Mr. MEYER. Well, this is what we understand the strategy is of U.S. banks with regard to their ownership interests and we will be overseeing how it evolves and is reduced and how the risk management of the banks is enhanced to deal with the risk that they have. And that will be monitored very, very closely and is being monitored very closely.
Mr. LEACH. Can I come back to the 20-to-1? Are you seeking 10-to-1? Are you seeking total dissolution of the fund?
Mr. MEYER. Well, first of all, part of this issue is if LTCM is unwound and sold and out of the banking system, then we don't set any particular targets for the leverage of LTCM and we leave it to the counterparties. Again
Mr. LEACH. But you have asserted that you think that these kinds of funds ought to be looked at from the perspective of the lenders to them. You must have some sort of goal on what banks should appropriately lend.
Mr. MEYER. I think again that leverage is too crude a ratio to say that there is a specific amount of leverage because leverage is not the same thing as risk. You have to look at leverage, but you also have to look at the risk and you can come up with too simplistic a cutoff for leverage.
Page 51 PREV PAGE TOP OF DOC Mr. LEACH. Would you agree that 30-to-1 is too high?
Mr. MEYER. I would definitely agree with that.
Mr. LEACH. Is 20-to-1 too high?
Mr. MEYER. Again I do not want to give a specific cutoff and it depends upon what the underlying risks of the institution are and how well those risks are being managed. And the question is, is it too high for a hedge fund? Is it too high for a bank to be involved with that hedge fund? That is another issue, too.
Mr. LEACH. Well, the only reason I raise this, we are in a public policy situation where it has been affirmed to this subcommittee that we had possible systemic risks which would have had ramifications for the American economy as a whole from this circumstance. So as a subcommittee of the Congress, we are obligated to assess whether regulators are looking at a circumstance to ensure that it does not arise again.
So all I am asserting to you is that I am a big believer in risk stress testing, but I am also a very big believer that the stress testing models that have been played with have from time to time pulled the wool over the eyes of public policymakers into moving in the direction of allowing greater leveraging than might appropriately be the case.
We also have a circumstance that sometimes in the competitive environment, stress testing reliance allows competitive advantages over other institutions. For example, the gentleman from Minnesota mentioned OFHEO and the GSEs and if you allow total reliance on stress testing and low capital ratios you give a competitive advantage over institutions that are required to keep capital higher, and my view is that capital is something that cannot be completely overlooked.
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So all I am suggesting to each of you is that the stress testing alone is insufficient and I think some of the words of President McDonough are very thoughtful on the subject of how you have to look at other things, as well.
Mr. MEYER. I just might point out that one of the issues that comes up in the LTCM incident is the lack of balance across the whole range of credit risk management tools. Stress testing is one of them, but it is not the end-all. The initial due diligence is very important. The kind of information that you get on a continuing basis from the counterparty, the on-going monitoring, the limits that you setall of these are important, as well.
So stress testing has its role, but it has to be kept in balance with other elements in the credit risk management process.
Mr. LEACH. I would just conclude by saying I am still left with the strong feeling that there is an industry that obviously never wants to go under, no part of it, but that there are incentives to take risks to get greater short-term profits that if great mistakes are made, the public is more exposed than the managers of the institutions.
And for that reason I have a view that governmental oversight, at least from the perspective of bank lending to this kind of institution, is very important and that stress testing is so sophisticated and the ingredients change so rapidly that no institution of governance or of private sector activity can ever be fully on top of it.
Page 53 PREV PAGE TOP OF DOC Therefore other factors have to be looked at, and the most important other factor is capital. And LTCM is a great warning of the overleveraging of capital.
I also do not know where the exact number should be, but I would be surprised it should be as highly leveraged as either LTCM was or apparently currently is.
Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you, Mr. Chairman.
Mr. Inslee has been waiting here for some time and then we will have Mr. Bentsen next. Mr. Inslee, please.
Mr. INSLEE. Thank you, Madam Chairwoman.
I am a new Member of this subcommittee and maybe the least versed in the subtleties of all this than anybody else in the room, but I want to tell you that this incident that occurred was greatly disturbing to me and I am just going to tell you my lay review of it, if you will.
It appeared to me that we, meaning collectively, the Congress, the regulators, whomever else may bear responsibility, allowed ourselves to get in a very highly leveraged situation which created a systemic risk to federally-insured depository institutions that apparently required emergency response that was neither predicted, planned for or was probably particularly healthy and that this was not, from my knowledge, an absolutely isolated incident. It involved highly leveraged lending, if you will, to organizations that the word ''betting'' came up and it may be pejorative, but it certainly did not involve investment in the sense of producing physical structure, intellectual capability, but rather involved betting on the market, in a sense. And that is very disturbing to me that this occurred.
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And I guess a lay kind of question. I would just ask each of you to tell me, have we, meaning the regulators or the Congress or whomever, taken steps to give us a high level of confidence? Today can you say that we have a high level of confidence that similar incidents will not occur? If I could just ask that general question of you.
Mr. MCDONOUGH. Let me start the answer. When you say that you are very concerned about what happened, my answer is you should be very concerned about it. Long-Term Capital got much too big, much too highly leveraged and, as we have discussed, the financial institutions, banks, securities firmsU.S. and foreignwere not doing their homework adequately in providing the amount of credit that they did, which allowed the company to get as leveraged as it did.
So what we have done so far is to try to see where the mistakes were made in the credit process, because whatever one thinks about the wisdom or lack thereof of the people running Long-Term Capital Management, they could not have gotten that big if financial institutions had not allowed them to get that big, and we do supervise financial institutions, which is, of course, why we are actively concerned.
The improvements that I believe we have made in dealing with banks, both in the U.S. and abroad, and that the securities regulators are about to make, we believe, in dealing with the securities firms, makes a repetition of this kind of thing very, very, very much less likely, but it does not make it impossible.
We can never guarantee to you that in a basically free market economyeven though there are very good public policy reasons for no market to be absolutely, 100 percent free, because we are supposed to protect the citizenspeople will never make mistakes again.
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One of the things that worries me, having been a banker for 22 years, is that one notices that banks have periodic repetitions of making bad loans to the real estate industry. And the reason is that the people who make the bad loans get chastised, their hands get burned, and about four or five years later all those people are gone and a new group of people make the same mistake again.
What supervisors can do is to have a longer memory and to try to make them less likely to make the same mistake again, and we are very much dedicated to that. We are very much dedicated to the notion that we will make such a thing very much less likely, but it would be overassuring you to say that it is absolutely impossible. It is not.
Mr. INSLEE. I appreciate that.
Let me ask just one question of each of you. If you had to pick one thing which you believe has not been done that ought to at least be considered to get us to a higher level of confidence, could you tell what it would be? Would it be addressing the leverage issue that Chairman Leach addressed? I would like to know your personal belief as to what could be giving us a higher level of confidence in this regard that has not been done to date.
Mr. MEYER. I think the most important steps are to reinforce the credit risk management of the banks and the guidance of the supervisors.
I think secondarily if I had to pick one other, above and beyond, that goes beyond that, it would be looking into disclosure, transparency of particularly the bank relationships with the hedge funds and the reporting thereof. And I think we are seeing this evolve over time. I think we are seeing improvements there, but that would be in the area of disclosure that I think would be other steps that might be worthwhile, at least to be considered in a variety of President's working groups and other Basle committees.
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Mr. MCDONOUGH. I think we are all saying that the thing that needs to be done is that the securities regulators come out with a guidance, and I am very anxious that they, in fact, do so.
Mr. BROSNAN. I would think the one thing that we have to do is remain committed to making sure we have very current, evolving policy, reacting very quickly here. We have to keep doing that. We have to keep sharp, top-notch examiners on the beat.
And in addition, the public message that is coming out from the heads of the various agencies, Comptroller Hawke and others, is don't be complacent; don't let this happen again. We are in relatively good times generally speaking and we just can't let too many ugly loans, if you will, continue to develop in the system.
Mr. INSLEE. Thank you.
Chairwoman ROUKEMA. Thank you. I am going to use my prerogative as the Chairwoman and I am not going to ask for the answer now, but it is a follow-up to Mr. Inslee's question. I would ask if you would all perhaps be a little more precise in answer to my question in writing, if you will. It really relates to what Mr. Inslee just asked. Both Governor Meyer and Governor McDonough referenced it.
I was going to refer to a recent article in the Wall Street Journal that quoted Alan Greenspan. I did not think that anyone had been precise enough in either answering my first questions about whether or not we should be tightening risk-based capital requirements or the additional disclosure, transparency through disclosure.
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But related to that, and related to what Chairman Leach just said, and the statement of Alan Greenspan was that it would be far better to provide incentives for banks to enhance their risk modeling procedures. I think all of you have referenced that, but there has been no specificity. I have heard no specificity from Mr. Greenspan in the speech that was referenced in this article as to enhancing risk modeling. My question is, what types of improvements can be made? What are we talking about here and what is that relationship to stress testing?
I would like to have some specific recommendations from you as to not only what those enhanced risk procedures should be, but how we implement them and be sure that the oversight of the regulators is there.
I guess he also referenced it a bit later in the article, where Greenspan suggested that regulators should consider telling banks to change the way they assess risk in order to incorporate a broader range of market scenarios. I don't know what market scenarios are being referenced there.
But the question is how do we do that? I mean it is a general statement, but I want to know with specificity what the regulators are prepared to do or if there needs to be a statutory requirement in this regard.
And excuse me; you understand I am asking for a written response for the record. Thank you.
Page 58 PREV PAGE TOP OF DOC Thank you very much.
Mr. BENTSEN. Thank you, Madam Chairwoman. Actually I think your question is one that I was going to ask, is how would you develop a risk analysis or a stress test or could you develop one that would model what happened to LTCM, the whole world collapsing or whatever, things falling apart.
Let me ask a couple of other questions. I am glad the Chairwoman asked that and let me ask a couple of other questions.
First of all, the Chairman of the full committee asked questions about leverage ratios. Outside bank lending, and I agree there should be better disclosure, but outside bank lending, should we care what the leverage ratios are of a Long-Term Capital Management, if they are doing it with private investments and shareholder money? Other than the fact that it properly disclosed, should we care, if it does not affect the banking system?
Mr. MEYER. It affects the banking system if the banks have relationships with the hedge funds and therefore the banks have to understand what the leverage is, be able to translate that leverage into risk and decide whether or not that risk is managed well enough to justify bank relationships with the hedge funds. That is what is important.
Mr. BENTSEN. By that relationship, meaning credit exposure on the part of the banks.
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Mr. MEYER. Exactly.
Mr. BENTSEN. But outside credit exposure on the part of the banks
Mr. MEYER. No.
Mr. BENTSEN. And from your testimony, Governor Meyer, you state the exposure to the banking system, at least to the U.S. banking system, is still quite limited. The credit exposure.
Mr. MEYER. You mean direct loans?
Mr. BENTSEN. Right.
Mr. MEYER. Yes, hedge funds, quite limited, yes.
Mr. BENTSEN. Would the other exposure be indirect in investment of excess capital on the part of banks?
Mr. MEYER. Well, most of the exposure of banks is through their derivative dealings with the hedge funds, as opposed to direct lending to the hedge funds.
Mr. BENTSEN. So in that regard the risk is counterparty risk, not credit risk.
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Mr. MEYER. Well, that is the problem, I think. What we have seen in this incident is the tight connection between market risk and credit risk. So if there is a market event that takes place and bank exposures increase, and they usually mark that to market and have daily collateralizing of it, but if the counterparty cannot meet its margin requirement, then that turns into credit risk.
In addition, they have additional credit risk if there is a default of a hedge fund, for example. Between the time that they liquidate the position they could suffer further exposures and losses.
So there is a tight connection. This is perhaps the single most important lesson of this episode. There is a tight connection between market and credit risks.
Mr. BENTSEN. Does the Fed supervisory letter take into consideration just credit risk or does it also look at the market risk associated with counterparty agreements?
Mr. MEYER. It really focuses tightly on this connection between market and credit risk. I mean the problem is that in many cases, as President McDonough noted, there was an overreliance on the collateralization of these current mark-to-market positions so that banks and maybe examiners gave too little attention to the credit risk that was implicit in these relationships and we've focused attention back to those credit risks.
Mr. BENTSEN. The credit risk implicit in the market risk, counterparty agreement risk?
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Mr. MEYER. Implicit because while the current position is collateralized, you have to worry about what will happen if there are changes in those exposures, whether or not the counterparty will be able to meet the margins and come up with the collateral if its exposure increases. That is where credit risk comes in.
Mr. BENTSEN. With respect to the supervisory letter, those are recommendations on practices that should be followed on the part of banks under the jurisdiction of the Fed. That letter came out in February, I guess, of this year.
Does that carry the force of a rule or is it just a recommendation? And to what extent do you feel the banks are following that?
Mr. MEYER. First of all, banks were moving in many of these directions even before that supervisory guidance was out. They have in their own interest an incentive to tighten up on their risk management.
The supervisory guidance is guidance, but when examiners go in, they are looking to see whether or not the banks are following sound practices and best practice standards and they are prepared to criticize management and rate the bank lower if the banks are not managing their credit risk appropriately. So it carries significant weight.
Mr. BENTSEN. And just to follow up with Mr. McDonough, in your opinion, and I know you testified last fall on this issue, but the systemic risk that came from the Long-Term Capital, was that related more to the market risk, that banks would be left with a much-deflated-in-value counterparty agreement for which there would be no market to unravel it, at least in the short term? Or was it the credit risk associated with the credit exposure, the traditional credit exposure?
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Mr. MCDONOUGH. It is really a combination of two things. Essentially, do you enter into a relationship with your counterparty in a swap agreement, an interest rate swap, a foreign exchange swap or something more exotic than that? If the market moves and I am the stronger institutionlet us change itif you are the stronger institution and I am the weaker institution. The market moves in such a way that I owe you money and I cannot pay. You have another side to that transaction, which you probably have with Chairwoman Roukema. If I cannot pay you what I owe you because I have just gone broke, you are not going to get the flow of funds from me that you are going to owe to the Chairwoman. Therefore the market risk becomes a credit risk, like that.
Now, what we were concerned about in the case of Long-Term Capital and why we decided there was systemic risk involved was not even that of market risk becoming credit risk that I described. You may recall that we estimated at the time that the loss to the seventeen major counterparties of Long-Term Capital would be in the range of $35 billion, which would be unfortunate for their shareholders, but fully tolerable, in my view.
The reason that we thought it was appropriate to arrange this private sector solution to a private sector problem is that we believed that, with the tremendous tumult in international financial markets, if the very large, overly large, positions of Long-Term Capital got dumped on the marketsbecause in my example all the counterparties were trying to offset the positions that they now hadthe international financial system could have stopped functioning well. Remember that you had 50 basis-point spreads between on-the-run Treasuries and the most recent off-the-run issues, something never seen before.
Page 63 PREV PAGE TOP OF DOC So it was the possible damage to the real economy that really caused us to play the role that we did.
Mr. BENTSEN. Thank you.
Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. Thank you. I appreciate that.
Mr. CASTLE. Thank you, Madam Chairwoman. I have had to go to the floor and do things, so I missed a good deal of this. And frankly, I could probably read a question here and try to impress you with my knowledge, but my knowledge is limited in this area. And I am not even sure to whom questions should be addressed in terms of what we are doing.
But if some of the changes, and I understand from looking at your statements and what you have stated here in the Basle Report and various other guidelines that have been adopted that things are different now, at least than they were when Long-Term Capital Management ran into its problems.
Are these changes sufficient? Would that have been avoided? Will we avoid something similar to that now, as a result of these changes? Or is that just something that cannot be answered because of the uncertainty of dealing with the subject matter?
Page 64 PREV PAGE TOP OF DOC Mr. MCDONOUGH. In my view, had the counterparties of Long-Term Capital Management followed the credit practices that are recommended in the Basle Committee's Report and in the instructions that the Fed and the Comptroller's office have given to the banks under their jurisdiction, and assuming the securities regulators were doing the same thing, the amount of leverage that Long-Term Capital was arriving at in the course of June-July 1998 would have led the banks and securities firms to the conclusion that they were dealing with a counterparty that was of questionable creditworthiness. And I believe that they would have insisted, in dealing with the firm, that the firm reduce its overall leverage in order to reduce its risk.
Now would that have been sufficient? It is hard to tell because the incident of the Russian debacle on the 17th of August was so extraordinary that Long-Term Capital's basic viewwhich is that it had this risk here and this risk there and they sort of offset each other because they will not become positively correlatedall came apart, so that things that were not supposed to be positively correlated all became perfectly positively correlated and everything went wrong for them at the same time.
Whether even the advice we are giving now would have achieved something for a firm as large as Long-Term Capital, I am not sure. Would it have made the carnage considerably less and the risk therefore considerably less? Therefore might one have arrived at the view that even though things were tough, it was a better public policy result to have let Long-Term Capital go down unless all of its counterparties decided themselves, without benefit of being convened in my boardroom, that they were going to recapitalize it?
Mr. CASTLE. Is it your conclusion, in retrospect obviously because we have now had a chance to really look at this and understand it better, that what Long-Term Capital in particular was doing or hedge funds in general, and I do not begin to understand swaps of derivatives or whatever, but what they were doing in general is perfectly acceptable as a business practice that should be able to be carried out? In other words, there is nothing inherently wrong with it, that what was wrong there were poor credit practices and various other things that they did?
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Or did you reach a conclusion that some of their actual practices, some of the practices perhaps of hedge funds in general, are questionable and need to be reined in in some way or another?
Mr. MCDONOUGH. My view is that, sticking to the specific case of Long-Term Capital, they had allowed their leverage to get much too big.
Now, the people who run the firm do not agree with that and I believe that they came and testified to that effectthey did not testify, but talked to all of you and made that point very clearly. I think they are wrong. And I think as a public policy matter they were wrong and that was the problem.
Now I think that what we have to say is that supervised institutionsbanks and securities firmsallowed them to get that big by permitting too much leverage to take place. But it isn't as if these were innocent souls who had all these counterparties insisting on lending the money. They were running their own firm.
Now as I mentioned on October 1 when I first testified before the committee, they were also extraordinarily unlucky, but had they been smaller, they could have been extraordinarily unlucky and it would not have created the danger of systemic risk.
Mr. CASTLE. If I may, Madam Chairwoman, just one final brief question?
Page 66 PREV PAGE TOP OF DOC Chairwoman ROUKEMA. Go ahead.
Mr. CASTLE. I know that the Fed and the OCC have put in new regulations and other things have been followed. My question is, I have always worried about the offshore aspects of all of this. If anyone like Long-Term Capital Management decides hey, we do not like these new requirements or whatever, can they avoid them with the use of computers, with the use of offshore, or do they have to deal with enough American banks or under regulatory authority that they cannot avoid it?
I know that is a complex, broad question, but if you could put it in plain English so a lowly Member of Congress can understand, I would appreciate it.
Mr. MCDONOUGH. I think, Congressman Castle, the direct answer is that they can avoid direct control over them, because I think it is so very hard to achieve. If you all decided you would like to directly control these institutions, it would be a tremendous task.
In the meantime, what we do know how to do is not allow them to get so big that they are a systemic risk by trying to make sure that their counterparties in the U.S., which we do supervise, and their counterparties in the other major industrial countries of the world that we supervise by an indirect method, reduce very, very substantially the risk that it could happen again.
Mr. CASTLE. Thank you very much and I yield back.
Page 67 PREV PAGE TOP OF DOC Chairwoman ROUKEMA. Thank you, Congressman Castle.
Now Congresswoman Maloney.
Mrs. MALONEY. Thank you.
Unless the banks have correct information about hedge fund risk exposures, a bank itself cannot assess its risk unless the strength of the hedge fund is exposed to them. I mean they may have very strong policies within the bank on their hedge fund policies, but if the information they are getting on leverage and exposure is incorrect or they are not getting it at all, you have a big problem, and that is what many of the bankers said, that they just had no idea that there was this much leverage, yet they continued to loan to them.
Do you believe that the banks currently have the information necessary to ensure that excessive risk is not assumed?
Mr. MCDONOUGH. My view, Congresswoman Maloney, is that if the bank is not sure that it has the information needed, it has a very simple credit decision to make: that it will not do business with the company. The banking business is a very tough business. If you do not have enough knowledge to make a credit judgment, the answer is easy.
Mrs. MALONEY. Excuse me, sir; that is not the question that I am asking. I am asking do they now have the information given to them, through the regulations, that is necessary for them to make the credit risk assessments? Is that part of the regulations, that by law, the hedge funds must give them the risk exposure, and so forth, and so forth?
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Mr. MCDONOUGH. The law does not apply to the highly leveraged institution or hedge fund. The regulated entity is the bank in our case that is lending money or serving as a counterparty. That is where the law applies. And we provide supervisory guidance.
When our supervisors go in and see if the bank is following the supervisory guidance, which is what they are supposed to be doing, that is fine. If they are not, we certainly have quite a lot of power within our supervisory responsibilities to rap them on the knuckles or go to their board of directors.
Mrs. MALONEY. I would like to ask the other two gentlementhe question that I am asking, I know that we have good regulation of banks and we have good supervision of banks. My question is do we have it of the hedge funds? They were the ones that caused the problem. They were the ones that created a stunning event where the central bank, for the first time, came in and worked with the private sector, having them assume big losses and exposure. Basically you say it is not a bail-out, but when you talk to the partners in these firms, they say it was a bail-out.
But back to my point. If you are a bank, your risk assessment is only going to be as good as the information that comes to you. And what I think is that at the very least, we should work for transparency so that the information to make risk analysis is appropriate.
And I think that it is perfectly appropriate to have some type of guidelines or requirements for hedge funds, not telling them what to do, but at least let the public or the banks that are making these decisions or even the trustees or the people who are investing in the banks know the risks that the bank is taking.
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You understand what I am saying? Because I think that what we are hearing is that once these events happened, ''Oh, my goodness gracious.'' Who knew that they were leveraged to such an extent? They could have brought down major sectors of the American economy, brought themselves big profits, but their mistakes, many other people had to pay for.
So I am saying don't regulate them, but how can we require that the information they give the lenders is accurate? I talked to some lenders saying they could not get any information, yet they were making so much money, they felt a pressure to be part of the system or they would lose money in comparison to the other banks. It was sort of like a downward spiral.
So my question is, how can we make sure that the information that goes to the well-run, regulated institution, meaning the banks making these loans, can make a proper decision?
Mr. MEYER. That is exactly what the guidance of the supervisors and the regulators is intended to do. I think there are two issues here that I want to focus on. First is what information did they have? In fact, banks had information on LTCM's balance sheets. Indeed, they knew the leverage. The question is what did they do with the information?
So it is not only what information you have; it is what you do with it, how it is filtered into the credit risk management process.
One of the problems here was that despite the fact that banks knew that this was a highly leveraged institution, they treated it as if it was a very low risk institution, in part because they relied too much on its past performance and its excellent past performance and they relied too much on the reputation of the principals involved.
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So they had some information. They did not have enough information, and that is what the guidance really is about. They did not have enough information to translate leverage into the riskiness of that relationship. And the kinds of information that the guidance tells banks they need to have from their hedge fund relationships is they need to know about the concentrations in their positions. That is one thing that adds to the riskiness of it. They need to have better quantitative measures of the risk of the hedge fund portfolios, what we call value-at-risk measures, results from stress tests.
So we want more detail, more quantitative information that the banks should have about their hedge funds before they enter into a relationship.
And the next thing is we want them to link
Mrs. MALONEY. Did they have that information last summer when these decisions were made?
Mr. MEYER. They did not have the sufficient information on concentrations. They did not have quantitative information on value-at-risk and results of stress tests. That is the kind of information they did not have and that they should have in their hedge fund relationships.
The other thing, too, is that to the extent that a particular hedge fund relationship does not end up providing the information to the bank, they have to take that into account in the limits they set with how much business they are going to do with that hedge fund and whether they do business at all. There has to be a linking between each part of the credit risk management process. Less information means less business or business on different termsmore collateralization, other ways that banks can protect themselves against the risks from the hedge fund relationship.
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Mrs. MALONEY. Did the shareholders know they were taking these huge risks?
Mr. MEYER. The shareholders of the banks?
Mrs. MALONEY. Yes.
Mr. MEYER. Well, banks do provide some information, for example, on their derivative positions in their annual reports, and that is increasing over time, but that is a good example. We need both better information from hedge funds to banks and better disclosure of banks to market of the risks they are taking. I think those both are very important.
Mrs. MALONEY. My time is up. Thank you.
Chairwoman ROUKEMA. Thank you.
Now Ranking Member Congressman Vento has requested time for a second question.
Mr. VENTO. I will be brief. I understand that I was absent for a short while, but it sounds like there have been some very good questions asked.
Chairwoman ROUKEMA. Yes, excellent.
Page 72 PREV PAGE TOP OF DOC Mr. VENTO. You know, the issue with regard to the derivatives and the role that they are playing, just recently the OCC apparently released its over-the-counter derivative figures. Can you give us any insights into the magnitude of those and the qualitative measure of them, if you have made such a valuation?
Mr. BROSNAN. As you probably know, every quarter we do a formal analysis of derivative activities of all U.S. commercial banks and we put out our assessment. We started doing this internally for our own benefit, to make sure we knew what was going on and to efficiently direct our supervisory resources. It became more efficient for us to release it publicly on a website so we could be part of the demystification process, if you will.
Our report should officially go out tomorrow, but you might already have it through excellent sources. What the bottom line will be is that derivative activities by commercial banks continue to grow, albeit at a smaller rate than we have seen in the last several quarters. Derivative contracts remain important risk management tools for banks and their clients and it is because of that that we see the growth. We are not seeing the growth because banks are using these instruments to bet, if you will; the vast, vast majority of transactions are for customers.
The other big conclusion that will come out of this is that the revenues that were made by banks from their trading activities, of which derivatives are a significant component, have returned to a much more normal level in the fourth quarter compared to what we saw certainly in the third quarter of 1998, as well as the fourth quarter of 1997. Those are the two big bottom lines.
Page 73 PREV PAGE TOP OF DOC Mr. VENTO. One other question, Madam Chairwoman. I think it would be helpful to me.
First of all, when someone buys into a hedge fund they are buying into Long-Term Capital Management. We have picked on them, I guess, most here today because of the dramatic events last fall or summer.
But the issue is that beyond just the purchase into the fund, the banks need toor whoever is doing that, securities firms, as wellneed due diligence on almost a constant basis. Obviously if they have an investment, a loan in Russia and they are hedging it against rubles, the point is that you would have to continue to do due diligence.
And the questions that I have are even once you have invested in the fund, you really have transferred it. They could go back into the marketplace in Russia and reframe that loan, reframe that particular investment or that particular hedge on a monthly basis, as needed. It is almost like you have boughtI can think in biological termsa retrovirus. You know, you buy something that keeps changing.
So the question is whether or not the financial institutions or whoever are buying these, you know, the disclosure has to constantly change and you do not really have the option, once you have bought into the fund, you really have bought a position of trust with these Nobel Prize-winners in this particular case.
But I mean in many other hedge funds you are transferring that particular responsibility, that management role in the hedge. In the derivatives it is a little different, but as you said, it translates almost immediately in terms of counterparty to be the same type of credit risk. So it may be a difference without much of a distinction.
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Do you want to comment on that observation, Mr. McDonough?
Mr. MCDONOUGH. I think, Congressman Vento, that you have two aspects. One is the investor in the fund. Most hedge funds require that the investors be high net worth individuals, which when I was a kid we called rich people, and they have to be sufficiently wealthy that they can presumably afford the loss. That is really, I think, not of great interest, certainly not of great interest to us as bank supervisors, and I would suggest not of great public policy interest. People are wealthy enough to do that kind of thing and lose some money.
Mr. VENTO. Yes, I have not run into anyone who is so wealthy that they like to lose it.
Mr. MCDONOUGH. Well, they do not like to, but
Mr. VENTO. Suitability does not seem to
Mr. MCDONOUGH. I do not think we have put the public purse behind them.
Mr. VENTO. They all like free enterprise. They like the part about making money.
Mr. MCDONOUGH. But a far different issue is when you have an insured institution or an uninsured major financial institution doing business
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Mr. VENTO. The securities firms we are talking about.
Mr. MCDONOUGH. Doing business with these institutions as a provider of credit, whether it is direct credit or through trading relationships, which become credit very quickly.
As you have suggested, I think that the only way you deal with such institutions is that you have to know them very intimately so you really know how they run the place, because exactly what their financial performance looked like at the end of last month is interesting, but it does not tell you a whole lot about what their risk is now.
So to go back to what you need to know about the institution with which you are dealing as a counterparty, I think not only do you have to know what their present risk position is; you also have to be able to continue to monitor it for just the reasons that you cite.
And what you really have to know is how good are they at running a risk business? And if their appetite for risk is higher than it should be for you to be dealing with as a counterparty, then you should not deal with them.
Mr. VENTO. The problem is you get into this incrementally, as you have noted. A lot of us can see this particular succession of events happening in the former Soviet Union countries or in the Pacific Rim and I think you incrementally get into it and, of course, whether you should reframe the hedgein the case of a hedge at least you are transferring that authority. In the case of a derivative, you are keeping it within the institution itself and you are actually making those decisions. And neither one of them, I don't think that financial institutions were necessarilythey can do the diligence, but I think that the cost and overhead in terms of doing that might exceed the profitability of the particular activity.
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So there are some real problems inherent. I think there are some real questions here with regard to monetary policy and economic growth and the future use. You know, we always tend to look at what we are comfortable with, the history of it. And I think we need to really extrapolate ahead as to where and what role these fill and how we are going to deal with it.
I thank you, Madam Chairwoman, for the extra time. Thank you.
Chairwoman ROUKEMA. I am sorry. Congresswoman Maloney, did you want another minute or so?
Mrs. MALONEY. Yes, I did.
Chairwoman ROUKEMA. Please be brief. Our panelists have been very patient here. They have been here for a long time and I think a number of us have additional meetings to attend to.
Mrs. MALONEY. Just very briefly, I may have missed it. I had another meeting I had to be at. But I read where the Administration had set up an advisory panel that is looking at this, a cross-agency advisory panel that is working on the Long-Term Capital issue and was going to issue a report. Could you bring us up to date? I assume the Federal Reserve is participating in that and where does that stand and when will that report be coming forward?
Chairwoman ROUKEMA. Yes, indeed, we had talked about that earlier and I indicated that we would keep it open for possible follow-up hearings on the basis of the President's Working Group.
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Governor Meyer, would you like to add to that?
Mr. MEYER. There's a President's Working Group on Financial Markets that is studying a wide range of policy options, including bank supervision of the hedge fund counterparties, but going beyond that, looking into disclosure issues and looking at the costs and benefits of direct regulation of hedge funds. They are expected to put out a report both on hedge funds and on derivatives more generally in the next several months.
Mrs. MALONEY. Thank you.
Chairwoman ROUKEMA. I thought it was sooner than that, than the next several months. At least I was hoping so. But in any case, they are working on it and it will be forthcoming and we certainly want to review that.
Mr. VENTO. One brief question.
Chairwoman ROUKEMA. Yes.
Mr. VENTO. I was going to say what aboutyou know, last year, the last two years we had some controversy over the Federal Accounting Standards Board issue in addressing derivatives, which of course was universally thumbs down, I think pretty much, from financial institutions. But that, I expect, is that actuallyobviously that rule has now, as I understand it, gone into effect. Will that be addressed in the working group? Has that been discussed or aren't you free to comment about that, Mr. Meyer or Mr. McDonough?
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Mr. MEYER. I do not actually know whether that is one of the issues that is under consideration at this time. I am really not sure.
Mr. VENTO. Well, my guess with the working group and the SEC's interest and the Federal Accounting Standards Board is that it wouldor couldand we may have some different thinking with regard to those rules today than we have had in the past, I would expect.
Thank you, Madam Chairwoman.
Chairwoman ROUKEMA. And now I am going to bother everyone by just submitting one last question, and I apologize for this. However, can any of you give me assurances that whatever we are doing will protect us against an even greater need for a bail-out in the future with some other hedge fund that might affect the taxpayers because of deposit insurance violations? No? Yes?
Mr. MCDONOUGH. My view is that we have made it very considerably less likely.
Chairwoman ROUKEMA. You have made it considerably less likely but not impossible?
Mr. MCDONOUGH. Very considerably less likely, but I think any of us would be unwise to say that it is impossible.
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Chairwoman ROUKEMA. That is of great concern to me.
Yes, Governor Meyer.
Mr. MEYER. We have significantly mitigated risks, but one has to be careful about promising above and beyond that. That there is no possible event in the global economy that could create a problem with systemic risk, I think that is above and beyond what we ought to be able to promise.
Chairwoman ROUKEMA. That is not what I wanted to hear, but I knew that was going to be the honest answer, to tell you the truth.
Yes, Mr. Brosnan.
Mr. BROSNAN. If we effectively implement the guidance that we have written during bank examinations, and banks follow that guidance, vulnerability to events like we have recently experienced will be lessened. But, there is no way to assure that it will not happen again.
Chairwoman ROUKEMA. Thank you very much. You have been extraordinarily helpful and informative and in a very academic and professional way. I greatly appreciate the help you have given us. We look forward to working with you in the future. Thank you so much.
Page 80 PREV PAGE TOP OF DOC [Whereupon, at 12:21 p.m., the hearing was adjourned.]