15 December 2008

ECB Financial Stability Review warns against risks resulting from hedge funds performance

If hedge funds increasingly fail to retain their investors, the possibility of further sizeable position unwinds by the sector may pose a challenge to financial markets, the December Financial Stability Review states.

An important source of risk for euro area financial markets in the period ahead is connected with the return performance of hedge funds, the ECB writes noting that the vulnerability of funds to the risk of investor redemptions appears to have grown.

 

“Looking ahead, if hedge funds increasingly fail to retain their investors, the possibility of further sizeable position unwinds by the sector may pose a challenge to financial markets”, the December Financial Stability Review states.

 

The ECB also warns against rising risks of the global CDS markets which have not yet been tested by a scenario of simultaneous multiple defaults in the corporate sector”. “This risk is likely to rise with a deterioration of the corporate credit cycle”, the ECB notes. Volumes have surged over the past decade and the euro area LCBGs have taken large positions to hedge their credit risk exposures, the ECB states. However, there are also signs of a 'gradual recovery' as Lucas Papademos notes in his opening remarks.  

 

Banks will need to be especially vigilant in ensuring that they have adequate capital and liquidity buffers to cushion the risks that lie ahead, the ECB underlines and calls on financial institutions to play their part in order to revive the process of efficient financial intermediation.

 

Also, the outlook for the euro area insurance sector has deteriorated since June. “In particular, the financial market turbulence and spill-overs to the real economy have posed further challenges”, the report states. However, the shock-absorption capacity of Euro area insurers in terms of their solvency positions has not been significantly affected, Papademos notes.

 

Looking ahead the ECB outlines a number of risks and vulnerabilities remain which the financial system may have to cope with, notably:

Ø       a further deterioration in the US and the euro area housing markets and the impact this may have on banks’ loan quality and the value of securities backed by mortgage-related assets;

Ø       a deeper and more prolonged slowdown in both the global and the euro area economy than currently expected that could cause a sharper and broader deterioration in borrowers’ ability to service their debt;

Ø       a more pronounced deleveraging by banks, due to persistently high funding costs and concerns about the adequacy of capital buffers, which could negatively affect the flow of credit extended to the broader economy; and

Ø       a surge in financial market volatility caused by a further unwinding of positions by hedge funds.

 

 

The report also contains five Special Features, namely:

 

Recent policy initiatives to strengthen the resilience of the financial system:

Ensuring the consistency of the policy responses and identifying possible interactions between the various measures are of primary importance. Due consideration has to be given to systemic concerns, as well as to the possible impact of regulatory and supervisory measures on the overall economy when assessing options for policy responses. Looking further ahead, the reassessment of the scope of financial regulation is considered to be a priority by policy-makers.

 

Risk management lessons of the financial turmoil:

This special feature summarises what has worked well in risk management and what the first lessons are that can be learnt from the experience gained over the past year and a half. Senior managers are the ultimate guarantors for an adequate risk culture to permeate into all parts of the institution. They should be directly involved in risk management decision-making so as to ensure that the institution’s agreed risk tolerance is respected and maintained.

 

Deleveraging and resilience among large and complex banking groups in the Euro area

This special feature attempts to evaluate the resilience of large euro area banking groups in the current environment of financial turmoil. The analysis suggests that euro area banks are likely to enhance their efforts to deleverage, which would be expected, in turn, to lead to more moderate credit growth over the coming quarters. At the same time, the analysis underlines the potential positive effects of the ongoing efforts to replenish banks’ capital buffers.

 

Liquidity risk premia in money market spreads

Spreads of unsecured interbank term money market rates have revealed significant liquidity risk premia. The liquidity risk premium in inter-bank money market rates can be interpreted as an indicator of the risk that individual banks with a lack of high-quality collateral will be hit by a significant liquidity shock.

 

Securitisation in the Euro area

• The lack of sufficient statistical data on credit risk transfers has emerged as an important issue for both central banks and the financial industry.
• In the CDO market, only multi-national issuance remains unaffected; the UK and Ireland appear to have suffered the steepest declines, which may be related to their status as the largest issuers.
• Investor preference has shifted towards securities with longer maturities. This may have further exposed investors to price volatility risk, which should be managed adequately.
• The ongoing tensions in credit markets and the potential continuation of the downward trend in house prices in the euro area may adversely affect the performance of mortgages further, which could negatively impact ratings in the period ahead.

 

Press release

Opening remarks Papademos

Financial Stability Review - December

 

© ECB - European Central Bank