Leveraged Finance, Banks and Transparency. Concluding Remarks

Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB
9th ECB-CFS Research Network Conference on
“Asset Management, Private Equity Firms and International Capital Flows”
Dublin, 9 October 2007

Ladies and gentlemen,

Would it have made a difference if this conference had been organised a year ago, and not today? Probably yes. Although research cannot predict how financial markets are going to move, research is essential as it provides the basis for a better understanding of developments and trends in the financial sector. Today regulatory issues have come much more to the forefront which a key difference compared to one year ago.

The purpose of this conference and the research activities of the ECB-CFS Network in this field is to better understand the role of new players – their incentives, their strategies and the impact of their regulatory environment. We want to understand the micro-foundations of the macro trends.

George Bernard Shaw said that “ if all economists were laid end to end, they would not reach a conclusion.” I think that, on the contrary, after these two days we have reached a conclusion and gained a better understanding of some of the key players of financial markets.

I would like to stress in these concluding remarks that – despite all the financial innovations and developments of recent years – banks remain at the core of the financial system.

Banks are the key prime brokers of hedge funds and are the key lenders for the leveraged buy-out operations carried out by private equity firms. Mutual funds – especially in Europe – are generally associated with banks. Moreover, conduits or SPVs that manage CDOs and credit derivatives written on bank loans are also created by banks. Banks therefore play a crucial role in these key new markets. Let me say a bit provocatively that banks are still the core of the 21st century’s financial system. However, regulation – especially transparency – has to go hand in hand with these new developments.

In these concluding remarks, I will refer to a number of new intermediaries which are, in general, highly leveraged such as hedge funds, private equity firms, conduits or SPVs. [1] All of these intermediaries are closely connected with banks. I will first talk about the benefits of these new intermediaries, then I will discuss the crucial role that banks still play before touching very briefly on a few of the risks associated with these new intermediaries and, finally, concluding with some thoughts on policy.

New instruments’ contribution to financial development and integration

Hedge funds, private equity firms and credit risk transfer markets (CRT) have the potential (if the appropiate risk management setting is in place) to improve the distribution of risk in the economy, increase the liquidity in the financial system and, in general, improve firms’ performance thereby enhancing financial integration and stability.

With respect to hedge funds, let me say that in general hedge funds have brought significant benefits to financial markets. Hedge funds have the potential to reduce systemic risk by dispersing risks more broadly and by serving as a large pool of capital that can stabilise financial markets in the event of disturbances.

With respect to private equity, let me only touch on leveraged buyouts (LBOs). As we can see from the paper presented yesterday by Ulf Axelson, activity in the LBO segment of the private equity market has increased tremendously over the last few years. [2] LBOs may discipline firms thereby enhancing their economic performance. Tough higher indebtedness of firms can, however, add a burden and thus may turn into a risk factor.

With respect to CRT markets, there is growing consensus that the flexibility provided by credit derivatives, whereby risks can be traded separately, has the potential to facilitate risk-sharing, enhance the efficiency of risk management and promote market completeness.

The key role of banks

The key creditors and counterparties of hedge funds are a set of global commercial and investment banks. These global banks provide credit to hedge funds through securities repurchase agreements and act as counterparties to the funds' OTC and exchange-traded derivatives. The terms on which these global banks transact with hedge funds act as a constraint on hedge fund leverage.

Large banks’ involvement in LBO operations is crucial for these operations. Indeed, banks have played a central role in supporting the rapid pace of growth of EU private equity markets: debt financing, syndication, as well as deal origination and the creation of innovative debt structures have made banks necessary intermediaries in the EU LBO market.

Banks are also the key players in the credit risk transfer market. Banks set up conduits or SPVs in which bank loans are pooled, tranched and sold to investors with different appetites for risk.

What are the risks and, in particular, what are the risks for banks?

Banks are the prime lenders to hedge funds and private equity firms, therefore these intermediaries’ problems directly affect banks. However, the exposure of banks in these markets is not great, compared with the banks’ capital buffers, and risk management has improved substantially.

As we have seen in the very recent evolution of credit markets, problems in some of the banks’ off-balance-sheet operations – for example, in some conduits or in some funds associated with banks – may come back to and impact banks. In addition, assymetry of information has substantially increased in financial markets. Not to know where the risks are implies a lower level of liquidity in financial markets – especially in interbank markets – thereby worsening funding problems for banks.

What does all of this mean for policy?

For operations with hedge funds and private equity firms, it is important that banks properly apply adequate and sound risk management techniques, and this despite rising competitive pressures in the market. Since these operations are often transnational in nature and therefore subject to supervision from different national authorities, more coordination at international level is needed between competent authorites. In that context, I would like to stress the importance of timely and prudent implementation of the recommendations of the Financial Stability Forum concerning risks relating to hedge funds which were issued in 2000 and updated in 2007. [3] These recommendations include the strengthening of risk management by banks; more timely and systematic exchange of information among supervisors on core institutions’ counterpary exposures to hedge funds; strengthening market discipline exerted by counterparties and investors on hedge funds; and enhancing, where relevant, existing sound practice benchmarks for hedge funds.

Stephen Brown, in a very interesting paper, discussed this morning the SEC’s attempt to directly increase hedge fund disclosure. [4] Since banks are the key creditors and counterparties of hedge funds, an indirect way to increase hedge fund disclosure would be through more transparency from the hedge funds’ sources of funds. Securities and banking regulators oversee the relationships of hedge funds with the commercial banks and broker-dealers that lend to and transact with hedge funds. Banks must regularly assess the creditworthiness of their hedge fund borrowers and counterparties. These financial institutions can help further reduce systemic risk by sharing information about their counterparty exposures to hedge funds. This is in fact one of the conclusions of the Geneva Report prepared by a team led by Roger Ferguson and summarised by Philipp Hartmann last evening over dinner. [5]

More complicated may be the case of conduits or SPVs and funds associated with banks. Because of legal or reputational reasons, banks are associated with or may be liable for risks that apparently are outside their books. Therefore, greater transparency is needed in these markets (not only to better price risk and to have deeper and more liquid financial and interbank markets) but also to better assess banks’ risk exposure in their off-balance-sheet operations. However, even with more transparency, if – because of explicit or more implicit links – off-balance-sheet risks affect banks, then sufficient capital and liquidity buffers ought to be held against such “outside” risks. The Basel II framework offers an opportunity for enhanced risk management and prudent treatment of complex products and activities, such as the ones mentioned above. However, it is important that the competent authorities consider the most appropriate treatment in light of the experience and lessons drawn as a result of the current market evolution. A potential place to start this review could be banks’ off-balance-sheet operations and liquidity issues more generally.

Research – by providing the basis for a better understanding of the financial sector – can help us to prepare reviews and develop new policies. I look forward to reading your new research papers and also to participating in the Symposium in mid-February next year that will conclude the Second Phase of the ECB-CFS Research Network, and also the first conference of the Third Phase that will be hosted by Česká národní banka in autumn 2008.

Let me conclude with one final point. When preparing my closing remarks, I had a brief look at the history of the Central Bank and Financial Services Authority of Ireland which has been such a wonderful host of this conference. I discovered that on 8 October 1947 – almost sixty years ago to the day – the first Governor of the Irish Central Bank, Joseph Brennan, gave a paper at the centenary session of the renowned Statistical and Social Inquiry Society of Ireland whose President he had been in the 1930s. [6]

In the seminal paper, which was entitled “Some Aspects of Cheap Money”, Brennan warned against the “expansion of the volume of money” as “one of the essential factors in inflation” and based his policy advice on a lucid analysis of the Irish banking sector.

While it is not my intention to discuss current monetary policy here today, I would, however, like to emphasise that your research on new developments and instruments in the financial sector is paramount not only from a financial integration and stability perspective but also for monetary policy. A good understanding of the financial sector and its increasing complexity is a key ingredient for good monetary policy.

It is a comforting thought that in sixty years central bankers might look back at some of the papers presented here at the conference and discover a similar degree of farsightedness, as we saw in Governor Brennan’s paper.

Thank you very much for your attention.

[1] Leverage refers to the possibility of amplifying returns by investing with borrowed funds. Leveraged investments have gained prominence recently through the growth of hedge funds and private equity firms. Not all hedge funds use leverage, but some use it extensively (see " International Financial Stability," Geneva Reports on the World Economy, by Roger Ferguson (Swiss Re), Philipp Hartmann (European Central Bank and CEPR), Fabio Panetta (Banca d’Italia) and Richard Portes (London Business School and CEPR), 2007).

[2] Ulf Axelson (Swedish Institute for Financial Research): “ The Financing of Large Buyouts: An Empirical Analysis” with Tim Jenkinson (Saïd Business School, Oxford University and CEPR), Per Strömberg (Swedish Institute for Financial Research, CEPR and NBER) and Michael S. Weisbach (University of Illinois at Urbana-Champaign and NBER).

[3] Financial Stability Forum (2007): Update of the FSF Report on Highly Leveraged Institutions from 2000.

[4] Stephen Brown (New York University Stern School of Business): “Optimal Disclosure and Operational Risk: Evidence from Hedge Fund Registration” with William Goetzmann (Yale School of Management), Bing Liang (Isenberg School of Management, University of Massachusetts) and Christopher Schwarz (University of Massachusetts).

[5] " International Financial Stability," Geneva Reports on the World Economy, by Roger Ferguson (Swiss Re), Philipp Hartmann (European Central Bank and CEPR), Fabio Panetta (Banca d’Italia) and Richard Portes (London Business School and CEPR).

[6] Joseph Brennan (1947): “Some Aspects of Cheap Money”, Statistical and Social Inquiry Society of Ireland, Centenary Session 6-9 October 1947, Proceedings.

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