FSOC Misunderstands Leverage, Threatens Risk Management

The Financial Stability Oversight Council recently released its “Update on Review of Asset Management Products and Activities,” in which it questions “how certain asset management products and activities could pose potential risks to U.S. financial stability.”

One aspect of the report focuses on hedge funds’ use of leverage, and the purported increase in risk associated with an increase in leverage:

The relationship between a hedge fund’s level of leverage and risk, and whether that risk may have financial stability implications, is highly complex. Leverage is not a perfect proxy for risk, but there is ample evidence that the use of leverage, in combination with other factors, can contribute to risks to financial stability. These risks are likely to be greater if an elevated level of leverage is employed…

While the report strikes an appropriately cautious tone about using leverage as a proxy for risk, and lists the shortcomings of such an approach, it also cautiously endorses this method of measuring risk, which was written into a proposed rule change by the SEC last December that would limit the amount of leverage 1940 Act funds may obtain through derivatives.

The above passage quoted from the report refers to hedge funds, though the same logic drove the SEC’s proposed rule change that would affect other much more heavily regulated funds, including mutual funds and exchange traded funds. It is important to examine how this simplistic approach may potentially harm average investors if it is used to impose limits on the amount of borrowing by 1940 Act funds.

Leverage (borrowing) is not always speculative. Or, to the extent that the purchase of any asset with the expectation that it will rise in value is speculative, then it isn’t unduly speculative. In fact, leverage is often a means of managing risk. Leverage qua leverage is neither good nor bad, it is simply a tool. Leverage allows for investors to dial in much more precisely how much risk they would like to take on in any particular asset class. The ability to use leverage allows investors to equally distribute risk across different asset classes—an important advantage when attempting to create an optimally diversified portfolio.

Treasury Secretary Jacob Lew, upon the release of the report, remarked that “greater leverage does not necessarily imply greater risk or systemic risk”. Investors should hope that the financial regulatory establishment heeds his caution.