House Banking, Committee leaders warned Wednesday that Congress may regulate hedge funds if banks are unable to better manage the risk of lending to these highly leveraged firms.

"If indirect regulation does not work, I am willing to look at the direct regulation of hedge funds," said Marge Roukema, R-N.J., the chairwoman of House Banking's financial institutions subcommittee.

Committee Chairman Jim Leach questioned whether relying on banks to limit their exposure to hedge funds is adequate.

"Stress testing alone is insufficient," the Iowa Republican said. "I'm still left with the strong feeling that there is a (hedge fund) industry out there ... with incentives to take great risks for short-term profits."

Regulators, however, urged lawmakers to give market-based supervision a chance.

"Direct regulation of hedge funds would require a high level of coordination involving the political, legislative, and judicial bodies of many countries," said William J. McDonough, the president of the Federal Reserve Bank of New York. "That is clearly beyond the jurisdiction of most banking supervisors."

Direct regulation also would force most hedge funds to move offshore, which means they would be beyond the reach of U.S. bank regulators, he said.

The comments came at a hearing on the near-collapse of Long-Term Capital Management, the highly leveraged hedge fund the New York Fed corralled its creditors into rescuing last September.

Federal Reserve Board Governor Laurence H. Meyer said banks extended significant credit to Long-Term Capital because they believed their loans were fully collateralized.

Lenders failed to demand information on the hedge fund's business strategies or other data that could have alerted them to impending problems, he said.

They also failed to stress test the loans to discover whether the collateral would be sufficient in the event of a major market disruption, he said.

Because of Long-Term Capital's downfall, banks have increased their oversight of hedge fund loans, he said.

Michael Brosnan, deputy comptroller for risk evaluation, said eight national banks had extended $1.3 billion of credit to hedge funds as of Feb. 28. That is down $500 million from Sept. 30, 1998.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.