Understanding the impact of hedge funds on financial crises is, at best, complicated. "Spillover effects" are difficult to measure. But Reint Gropp--Chair of Sustainable Banking and Finance at Goethe University, Frankfurt, and visiting scholar at the Federal Reserve Bank of San Francisco--takes a crack at it in a new Economic Letter:
While most observers tend to agree that hedge funds have some systemic importance, there is little agreement on how large a role they play as transmitters of adverse financial shocks. Figures 1 and 2 summarize the model’s findings regarding the flow of shocks between different types of financial institutions. In the figures, red arrows correspond to spillover effects; the green arrow in Figure 2 shows positive effects from insurance companies, as mentioned earlier. The thickness of the arrows correspond to the strength of the effects: a thin arrow means that a spillover is statistically significant but economically small, while a bold arrow means it is both significant and economically important.
Figure 1 shows that during calm times the risks emanating from hedge funds are as small as those from other financial institutions. However, Figure 2 shows that during crisis times, spillover effects increase overall. In particular, hedge funds have economically large spillovers to the other three types of institutions.
Why are the spillovers from hedge funds during financial crises so much bigger, and why do they seem to increase more than those from other financial institutions? Hedge funds are opaque and highly leveraged. If highly leveraged hedge funds are forced to liquidate assets at fire-sale prices, these asset classes may sustain heavy losses. This can lead to further defaults or threaten systemically important institutions not only directly as counterparties or creditors, but also indirectly through asset price adjustments (Bernanke 2006). One channel for this risk is the so-called loss and margin spiral. In this scenario, a hedge fund is forced to liquidate assets to raise cash to meet margin calls. The sale of those assets increases the supply on the market, which drives prices lower, especially when market liquidity is low. This in turn leads to more margin calls on other financial institutions, creating a downward spiral. Another example is investment banks that hedge their corporate bond holdings using credit default swaps. If hedge funds take the other side of the swap and fund the investment by borrowing from the same bank, the spillover risk from the hedge fund to the bank increases. These types of interconnectedness may underlie some of the spillover effects in our study.
In percentage terms, 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. It is interesting to compare this risk to spillovers from commercial banks to investment banks. During normal conditions, a 1 percentage point increase in the risk of commercial banks leads to a 0.01 percentage point increase in the risk of investment banks. During financial distress, spillovers from commercial banks to investment banks increase relatively modestly to 0.05 percentage point. Although somewhat higher, this increase from normal conditions to crisis times is much smaller than that for hedge funds. Spillovers from investment banks to other financial institutions show similar results, while insurance companies tend to exhibit small spillover effects, even in crisis times.
Read How Important Are Hedge Funds in a Crisis? here.