The European Central Bank (ECB) is warning banks in the EU about hedge fund exposure risk after a survey spotlighted potential weaknesses in risk management practices.
The survey, carried out by the Banking Supervision Committee (BSC) of the European System of Central Banks (ESCB), found that exposures of large EU banks varied across countries and generally were not large in relation to either banks' balance sheets or total income. However this is partially due to the fact that the global prime brokerage market is dominated by US firms.
But there were some indications that large EU banks' exposures were growing rapidly.
The ECB warns that the relative size of exposures to hedge funds will increase further in line with the continuing expansion of the hedge fund industry, and in particular its European segment.
While hedge fund risk exposure was described as "stringent" at most banks, the ECB highlighted scope for improvements in counterparty discipline, which was found to be under pressure due to highly competitive market conditions. The research also found that most stress tests applied by banks included historical scenarios which often applied to individual hedge funds only. Stress testing of collateral was less common.
Firm-wide aggregation of multiple exposures to individual or groups of hedge funds using similar strategies was also seen as problematic, while information flows from hedge funds to banks were sometimes inadequate.
Banks' descriptions of their risk management practices also raised questions about whether they were sufficiently taking into account or had enough timely information on the risk profile of a fund as a whole, particularly on the larger ones with financing and trading relationships with several counterparties.
Download the report (pdf)