Hedge funds intensify financial crises

Risk transfer between financial market participants increases significantly during times of crisis /
“Standard measures need to be adjusted to adequately reflect spillover effects"

Hedge funds amplify risks within the financial system during times of crisis. Thus, they significantly increase systemic risk which is held responsible for the spread and intensity of the recent financial crisis. With new methods of statistical measurement a research group around Reint Gropp, Professor of Sustainable Banking and Finance at the House of Finance of Goethe University Frankfurt and at the research center SAFE, was able to estimate spillover effects between different financial market participants during normal and crisis times. While spillover effects between commercial banks, investment banks, hedge funds and insurance companies are only modest during normal times, a financial crisis significantly amplifies these spillover effects – both in scope and duration. In particular, the risk transfer between hedge funds and the other market participants increases.



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The researchers are also able to express the spread of risks in concrete figures: During normal market conditions, a 1 percentage point increase in the risk of hedge funds is estimated to increase the risk of investment banks by 0.09 percentage point. During times of financial distress, however, the same shock increases the risk of the investment banking industry by 0.71 percentage point. The risk transfers are usually largest after 10 to 15 days.

“An important lesson learnt from the crisis is that common risk measures like ‘value at risk’ significantly underestimate systemic risk,” Reint Gropp says. “The current standard measures need to be adjusted to adequately reflect spillover effects among different parts of the financial system.”

A reason for the high risk of hedge funds is, according to the researchers, that they are opaque and highly leveraged. Highly leveraged hedge funds are often forced to liquidate assets at fire-sale prices during times of crisis which can incur heavy losses in these asset classes. This leads to further defaults or threaten systemically important institutions not only directly as counterparties or creditors of hedge funds, but also indirectly through asset price adjustments. In this way, hedge funds spread systemic risk more quickly and to a greater extent compared to other financial market participants and thus intensify financial crises.

Link to the policy paper "How Important are Hedge Funds in a Crisis?"