SAN FRANCISCO Hedge funds, not banks, may be the most important transmitters of shocks during financial crises, according a study published Monday by the Federal Reserve Bank of San Francisco.
The finding suggests that hedge funds may be a bigger conduit for systemic risk to financial markets than previously thought, and may have been central in generating risk during the 2007-2009 crisis, Goethe University professor Reint Gropp wrote in the latest edition of the regional bank's Economic Letter.
Hedge funds often borrow heavily to boost returns, making them particularly vulnerable to steep losses during a sudden market downturn, Gropp wrote.
Those losses can spread to other financial firms in two ways: either directly, if the fund defaults to its creditors; or indirectly, if for instance the hedge fund tries to meet its obligations to creditors by selling assets at fire-sale prices, driving down valuations broadly and forcing other financial firms to engage in their own fire sales to raise cash.
"During calm times the risks emanating from hedge funds are as small as those from other financial institutions," including banks, investment banks and insurance companies, Gropp wrote. "During crisis times, shocks from hedge funds have substantial effects on all three other types of financial institutions we study."
The biggest impact, the study found, is on investment banks.
Hedge funds have come under increased scrutiny since the crisis and are now subject to stricter reporting requirements than they had been.
Still, much of what hedge funds do -- how much risk they take, what assets they hold -- remains under wraps.
(Reporting by Ann Saphir; Editing by Leslie Adler)