Systemic Risk And The Long-Term Capital Management Rescue

Systemic Risk And The Long-Term Capital Management Rescue Sandra L. Edwards User Support Specialist September 9, 2019 Congressional Research Service 7-.... www.crs.gov RL30232 Systemic Risk And The Long-Term Capital Management Rescue ABSTRACT Systemic risk is generally defined as the possibility that a financial problem in one firm or market may spread by “contagion” to others, and that, if panic spreads far enough, general confidence in financial institutions may be impaired, the flow of funds from lenders and investors to borrowers may be disrupted, and the real economy may suffer a loss of jobs and productive investment. Economists are divided on the nature, and even the existence of systemic risk, but in the wake of the recent global financial turmoil, congressional interest has increased. Several committees and subcommittees have held hearings, and legislation affecting hedge funds may be considered by the 106th Congress. This report will be updated as needed to reflect legislative, regulatory, and marketplace developments. Systemic Risk And The Long-Term Capital Management Rescue Summary In September 1998, the Federal Reserve Bank of New York coordinated a rescue of Long-Term Capital Management (LTCM), a hedge fund that was on the brink of failure. The survival of a hedge fund, a private investment partnership available only to wealthy individuals and institutions, is normally not a matter of public concern. This case was different: LTCM had used such extensive leverage —it had augmented the size of its investments by borrowing and through use of derivative financial instruments — that its failure seemed to carry a “systemic” risk to financial markets in general and to the economy. Systemic risk is generally defined as the possibility that a financial problem in one firm or market may spread by “contagion” to others, and that, if panic spreads far enough, general confidence in financial institutions may be impaired, the flow of funds from lenders and investors to borrowers may be disrupted, and the real economy may suffer a loss of jobs and productive investment. Economists are divided on the nature, and even the existence of systemic risk, but in the wake of the recent global financial turmoil — of which the LTCM incident is a part — congressional interest has increased. Several committees and subcommittees have held hearings, and legislation affecting hedge funds may be considered by the 106th Congress. In April 1999, the President’s Working Group on Financial Markets (an interagency group of financial regulators) issued a report on the implications of the LTCM case. The report focused on the systemic risk posed by highly-leveraged financial institutions, which include not only hedge funds, but many large banks and securities firms. The failure of one of these institutions could be contagious to others, because they trade heavily with one another. The challenge to policy is to constrain excessive leverage. The Working Group report concludes that the best defense against excessive risk taking is market discipline, but notes that history shows that from time to time market participants become complacent and fail to monitor the risks posed by their creditors and trading partners. Firms themselves may often underestimate the risks of their own financial positions and trading activities: measurement of risks involved in complex, global investment strategies is difficult. What was thought to be a safe position may be revealed as highly risky in a market crisis. The Working Group puts forward a number of specific recommendations, some requiring legislative action, including more disclosure by hedge funds and the firms that trade with them, improvement in risk measurement techniques by regulators and private firms, enhanced authority to monitor affiliates of regulated institutions, and the imposition of international standards on offshore financial centers. This report will be updated as needed to reflect legislative, regulatory, and marketplace developments. 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