Stress Testing Is Key in New Era of Complex Derivatives and Hedge Funds

By James Hamilton, J.D., LL.M.

As the financial system moves from being essentially bank-centered to market-centered with complex derivatives and global counterparties, the challenges of maintaining financial stability and fostering effective risk management have increased, noted Federal Reserve Board Vice Chair Donald Kohn in recent remarks at the Exchequer Club. But he assured that the historic mission of the Board remains fostering financial stability and managing financial crises. He also urged increased use of stress testing as a key to effective risk management.

This important speech by the Fed senior official highlights the fact that we are a long way from even the world of Long Term Capital Management. It also comports with similar comments by Fed Chair Ben Bernanke urging the stress testing of exposures at the level of individual hedge fund counterparties. In addition, New York Federal Reserve Bank CEO Timothy F. Geithner has noted that the proliferation of new forms of derivatives and structured products has dramatically changed the nature of leverage in the financial system and made potential risk harder to assess.

Speaking of Mr. Geithner, the vice chair praised the work being done by the NY Federal Reserve Bank in working with other domestic and international regulators to develop a stronger clearing and settlement infrastructure for the OTC derivatives markets.

At the urging of regulators, market participants set goals and implemented policies for reducing the huge backlogs of unconfirmed trades in credit derivatives. As a result, confirmation backlogs were reduced 94 percent between September 2005 and November 2006. Importantly, market participants also terminated the practice of assigning trades without the prior consent of the counterparty. While these efforts initially focused on credit derivatives, market participants have now agreed to turn their attention to equity derivatives, noted Mr. Kohn, for which large backlogs still exist. They are also providing regulators with data on backlogs of all types of OTC derivatives, which will allow them to monitor the industry's progress across the board.

The evolution of financial markets and instruments have made risk managers acutely aware of the need to ensure that financial firms' risk management systems are taking sufficient account of stresses that might not have been threatening ten or twenty years ago. Identifying risk and encouraging management responses are at the heart of the Fed’s efforts to encourage enterprise wide risk-management practices at financial firms, emphasized the central banker, and essential to those practices is the stress testing of portfolios for extreme events.

A recent Wall Street Journal piece identified Mr. Geithner as the Fed’s go-to guy for preserving financial market stability as many less-regulated players, such as hedge funds, have become increasingly more important. He has begun to do some heavy lifting in this regard, such as with credit derivatives, and can be expected to do more.