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Hedge funds, banks need risk standards: Fed official

Date: Thursday, April 19, 2007
Author: Reuters

NEW YORK, April 18 (Reuters) - A senior U.S. Federal Reserve official said on Wednesday that hedge funds, their lenders, and investors have "considerable work" to do to adopt consistent standards for managing risk in that class of assets.

The ballooning $1.4 trillion industry still has little in the way of standards for credit terms, risk measurement and transparency, according to Jim Embersit, deputy associate director for the Market and Liquidity Risks Section for the Fed's Division of Banking Supervision.

Embersit's comments, during a panel discussion about hedge funds at New York University's Stern School of Business, come as regulators struggle to weigh threats that such funds pose to the financial system and individual investors.

Growing legions of pension funds are piling into hedge funds, representing growing retail investment in an asset class previously largely confined to wealthy individuals, foundations and endowments.

"This is an area that is crying out for leadership in the investor community," said Embersit. He said investors should demand consistent standards for risk management and internal controls to allow them to assess their exposure to various investment strategies.

"Investors should seek assurances that hedge funds are complying with risk management practices," said Embersit. He also said "more work needs to be done in dealer banks" that lend money to hedge funds for their strategies.

With hedge funds now numbering more than 8,000, banks may be loosening their lending and due diligence standards as they grapple with a flood of new clients in their prime brokerage divisions, he warned.

Embersit's comments come on the heels of a report by the U.S. President's Working Group on Financial Markets, which concluded that current regulations appear sufficient to allay systemic threats and protect hedge fund investors.

However, the panel, headed by the U.S. Treasury Department, urged hedge fund managers to take measures to keep investors in the loop so they can better assess their risks.

Of particular concern are the risks in so-called crowded trades, where multiple funds may exit the same asset at the same time and lead to buy-sell imbalances, panelists said.

Gary Krivo, managing director and co-head of the asset management and hedge fund group for JPMorgan Chase & Co., said many widely used hedge fund trades can have multiple counterparties through investment banks' prime brokerage divisions. Hence, the extent of the aggregate leverage and risk in such trades may not be immediately quantifiable.

"If there are eight to 10 counterparties, do we know the risks?" asked Krivo. "We may not have the whole picture."

He said JPMorgan, however, has systems in place to ensure that it does know the extent of counterparty risk for unusual and highly leveraged trades.

Some panelists said there is no way to quantify systemic risk, since the total amount of leverage is unknown with the ballooning creation and use of financial derivatives, much of it in use to amplify hedge fund trades.

"The real problem is that we don't know the amount of leverage in the system," said Stephen Brown, a Stern School finance professor.