Research out of the Federal Reserve Bank of San Francisco (FRBSF) points to hedge funds as being major sources of instability during a crisis in a report that confirms what many critics already believed – that hedge funds played a big role in the financial crisis by acting as leveraged counterparties to investment banks and others (h/t Zero Hedge).

“Designating which financial institutions are deemed systemically important could depend on identifying to what degree distress in one institution spills over to other parts of the financial system,” writes FRBSF visiting scholar Reint Gropp in an April 14 letter.

Hedge funds transmit more risk during a crisis than other institutions

Spillover effects are hard to measure because it’s difficult to separate when one institution transmits risk to another versus when two institutions simply have the same exposures. When the housing market failed, for example, it’s hard to untangle which losses were caused by direct exposure to the market and which were caused either by direct exposure to other financial institutions or by the indirect effect of falling asset prices as other actors sold into an illiquid bear market.

To get around this problem, Gropp developed a statistical model that he says is able to filter out common causes of risk and to determine the direction of risk transmission. As the economy goes from stability to crisis, it’s not surprising that the transmission of risk also goes up, but hedge funds are unique because the transmission scales so quickly.

When things are stable, every additional 1% of risk that hedge funds take on results in an additional 0.09% risk for investment banks. During a crisis, Gropp estimates that the same 1% increase in risk among hedge funds instead turns into 0.71% extra risk for investment banks.

By contrast, a 1% increase in risk among commercial banks creates an additional 0.01% risk for investment banks when the economy is stable and 0.05% during a crisis. Assuming the investment banks also have their own exposure to systemic risk (a pretty easy assumption) hedge funds amplify shocks to the system in a way that other institutions really don’t.

2014-11-1

2014-11-2

Hedge funds are ‘systemically important’: Gropp

Gropp doesn’t try to understand how risk is transmitted from one institution to another, his goal is first to establish that his statistical model works and second to show that hedge funds are systemically important, with all the regulatory consequences that would imply.

“There is a growing recognition that hedge funds are systemically important,” writes Gropp. “Concerns over the systemic importance of hedge funds also underlie the tighter reporting requirements for large institutions in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Our findings support these initiatives as a way to improve the measurement of overall risk in the financial system.”