At a Senate hearing Wednesday, federal regulators pledged to issue guidelines early next year to crack down on bank lending to hedge funds.
One document, being developed by the Federal Reserve Board, will address credit-risk management lessons learned from the Asian financial crisis and the collapse of the Long-Term Capital Management hedge fund, said Patrick Parkinson, the Fed's associate director of research and statistics.
Specifically, the guidelines will address how banks approve loans, impose limits on counterparty risk, stress-test to gauge credit risk, and secure collateral, he said. The other banking agencies are considering similar guidance, he said.
"Improvements in creditors' risk-management capabilities ... should significantly strengthen the effectiveness of market discipline and thereby place more effective constraints on leverage and risk-taking," Mr. Parkinson told lawmakers.
Senate Agriculture Committee Chairman Richard G. Lugar, R-Ind., called the hearing to investigate how Long-Term Capital could operate with only $1 for every $125 of assets when it collapsed in September. Long-Term Capital was so highly leveraged that the Federal Reserve Bank of New York organized a rescue, fearing the fund's default would sink the financial markets.
The crisis caused both banking regulators and the President's Working Group on Financial Markets, which consists of the Treasury Department and banking and securities regulators, to investigate the need for additional regulation of hedge funds.
Mr. Parkinson said the working group is considering imposing capital or margin requirements on hedge funds to limit their leverage. The group also is exploring ways to provide creditors with more data on how much risk hedge funds are taking, he said.
Separately, the Basel Committee for Banking Supervision is expected in January to issue guidance to help regulators oversee highly leveraged institutions, he said.
Earlier at the hearing, Commodity Futures Trading Commission Chairwoman Brooksley Born said international cooperation is crucial to regulating hedge funds and she criticized risk-management practices at many of the lenders to Long-Term Capital.