An examination of the Financial Stability Board’s (FSB) latest methodology for assessing the systemic riskiness of investment industry firms finds that hedge funds would likely be considered as posing the greatest systemic risk under the FSB’s approach.

A new report from Fitch Ratings finds that private funds, such as hedge funds, pose the greatest systemic risk based on key risk indicators set out by the FSB in a paper on identifying financial entities, other than banks or insurers, that may be considered systemically important.

Fitch says that the FSB paper identifies size, substitutability, interconnectedness, complexity and cross-jurisdictional activities as potential drivers of systemic risk in the investment management space. “In our view, the two key drivers of systemic risk are the use of excessive leverage (and associated counterparty relationships) and ‘substitutability’, or a fund’s gross (leveraged) size relative to its investment sector,” says Fitch.

“If one or more large, heavily leveraged funds come to represent ‘the market’, this could introduce illiquidity in times of stress. We believe the combination of these two factors, excessive leverage and a large market footprint, are most likely to create systemic risk in times of stress,” it adds.

The rating agency concludes that in that context larger, leveraged private funds pose the most systemic risk in the investment management sector. “Private funds are lightly regulated, and leverage constraints are far looser, reflecting counterparty risk limits rather than regulatory limits,” it says.

By contrast, regulated investment funds are restricted from taking on excessive leverage, it says, which “makes the transmission of systemic risk due to a forced deleveraging low in our view for regulated funds.” Although one potential caveat to this, Fitch says, is that “certain derivatives are used by regulated funds in the U.S., where the regulatory treatment may not fully capture the true ‘economic leverage’ that is incurred.”

As for asset managers, Fitch says that this is generally not a balance sheet intensive business, and does not involve large amounts of leverage, maturity transformation, or financial complexity for the firms. “It is the funds themselves that take on leverage, to the degree allowed, utilize derivatives and have counterparty exposures,” it says.