Financial Conglomerate Affiliated Hedge Funds: Risk Taking Behavior and Liquidity Provision

Financial Conglomerate Affiliated Hedge Funds: Risk Taking Behavior and Liquidity Provision

March 23 2017

A new wave of financial regulation following the global financial crisis aims to curtail proprietary trading by systemically important financial institutions. For instance, in the U.S., the now debated Volcker Rule prohibits “banking entities from engaging  in proprietary trading and from acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or a private equity fund”. The Liikanen Report and the Vickers Report advice similar or even tougher initiatives in the EU and in the UK, respectively. As a consequence, hedge funds that are sponsored by financial conglomerates  could cease to exist, even if they are funded mostly using other investors’ capital.

The rationale of these regulations is limiting risk taking by financial conglomerates that are systemically important and directly or indirectly benefit from public guarantees. Ideally, the regulations would avoid episodes like the Bear Stearns’ collapse, which was partly driven by its exposure to two affiliated hedge funds. These regulations, however, may have unintended consequences on market stability because hedge funds are known to provide liquidity to financial markets

To address these issues, this paper explores how affiliation to financial conglomerates relates to hedge funds’ funding and risk taking. We find that financial-conglomerate-affiliated hedge funds (FCAFHs) have more stable funding than other hedge funds.

As a consequence, FCAHFs are able to take more risk and to purchase less liquid and more volatile stocks than other hedge funds during financial turmoil. In good times, instead, FCAHFs expand their assets less than other funds and are less exposed to systematic risk. Thus, FCAHFs perform a stabilizing function for the financial system, even though they do not generate higher returns for their investors.