Prior to the financial crisis, banking institutions exercised tight discipline over hedge funds. Prime brokers to hedge funds, while certainly interested in attracting hedge fund clients by offering credit on terms better than their competitors, nevertheless were exacting in their lending and other exposures to the funds. As noted by the Government Accountability Office in 2008:
To control their risk exposures, creditors and counterparties to generally large hedge funds told us that, unlike in the late 1990s, they now conduct more extensive due diligence and ongoing monitoring of a hedge fund client....Creditors and counterparties of large hedge funds use their own internal rating and credit or counterparty risk management process and may require additional collateral from hedge funds as a buffer against increased risk exposure....
Creditors and counterparties told us they currently establish credit terms partly based on the scope and depth of information that hedge funds are willing to provide, the willingness of the fund managers to answer questions during on-site visits, and the assessment of the hedge fund’s risk exposure and capacity to manage risk. If approved, the hedge fund receives a credit rating and a line of credit. Several prime brokers told us that losses from hedge fund clients were extremely rare due to the asset-based lending they provided such funds. Also, one prime broker noted that during the course of its monitoring the risk profile of a hedge fund client, it noticed that the hedge fund manager was taking what the broker considered to be excessive risk, and requested additional information on the fund’s activity. The client did not comply with the prime broker’s request for additional information, and the prime broker terminated the relationship with the client.
As a result, hedge fund leverage from prime brokers before the financial crisis was not particularly high; and it is even lower now. Over-the-counter derivatives dealers also kept hedge fund counterparties on a short leash by requiring the funds to post so much collateral that their derivatives exposures were more than fully collateralized.
But now, and since the financial crisis, it is hedge funds that are exercising discipline over banks. FT Alplhaville's Lisa Pollack notes
[t]hat hedge fund clients get itchy feet far easier these days, and that some of them look at the credit default swap spreads of their counterparties when deciding whether to stick with them or get out of dodge.
And from an earlier post with Tracy Alloway:
Bankers at relatively healthy financial institutions describe how clients have been seeking to turn over their prime broker relations to stronger lenders. If they’ve been unable to do so – because they may have a myriad of assets and services linking them to their prime broker – these funds have found other ways to limit their counterparty risk.
But the phenomenon is broader than just hedge funds imposing discipline back on the banks that extend them credit. Financial institutions are also being more stringently monitored by their own short-term creditors, a development that Gillian Tett recently noted was fatal to MF Global:
The chain of events that sparked the broker’s demise appears to have started when it published its last set of quarterly accounts. As financial players perused that statement, using their flashy new monitoring systems, they spotted the brokers’ sovereign exposure – and started to worry about counterparty and liquidity risk.
Market discipline should be a two-way street when risks are reciprocal. Improving counterparty risk has taken on a new urgency since the financial crisis, and it is good to see some of that urgency being translated into practice.