The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citigroup, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.
From the book “Restoring Financial Stability: How to Repair a Failed System”. Section V: The Role of the Fed
Background Systemic risk is the risk that the failure and distress of a significant part of the financial sector reduces the availability of credit which in turn may adversely affect the real economy. Not all economic downturns involve systemic risk, but the occurrence of systemic risk has almost invariably transformed economic downturns into deep recessions or even depressions. Such systemic risk has been ubiquitous in the current crisis. It has manifested itself in the moral hazard encouraged by “too-big-to-fail” guarantees, in the externalities created by deleveraging, fire-sales, hidden counter-party risk and liquidity shortages, and in the aggregate decline in home prices.
From the book “Restoring Financial Stability: How to Repair a Failed System”. Section II: Financial Institutions
The available data show a remarkable diversity of management styles under the “hedge fund” banner. Hedge funds are major participants in the so-called shadow banking system, which runs parallel to the more standard banking system. Hedge funds have the ability to short sell assets, which allows them to use leverage, and leverage means that their equity value, absent limited liability, can go negative. Hedge funds add value to the financial system in a number of ways: (i) by providing liquidity to the market; (ii) by correcting fundamental mispricing in the market; (iii) through their trading, by increasing price discovery; and (iv) by providing investors access to leverage and to investment strategies that perform well.