Recent growth in the hedge fund industry may not pose a systemic risk to large European banks, but there banks could be doing better in their risk management, suggests a report published today by the European Central Bank.

The survey showed that exposures of large EU banks varied across countries and generally were not large in relation to either banks’ balance sheets or total income. “This is due, at least partially, to the fact that the global prime brokerage market is largely dominated by U.S. firms,” it noted. “However, there were some indications that large EU banks’ exposures were growing rapidly, although in most EU countries exposures were found to be negligible and/or mainly in the form of investments.”

“It seems probable that the absolute and relative size of exposures to hedge funds will increase further in line with the continuing expansion of the hedge fund industry, and in particular its European segment,” the ECB said.

It also found that the banks surveyed generally had stringent requirements for exposures to hedge funds, with a strong emphasis on collateralization. Most of the banks surveyed also reported the use of stress tests for evaluating the potential effects of volatile or illiquid markets on their exposures.

However, the survey also found room for improvement in several areas, including disclosure and risk management. Information flows from hedge funds to banks, despite some progress, did not always seem to be adequate, it found.

Also, firm-wide aggregation of multiple exposures to individual hedge funds or groups of hedge funds using similar strategies was sometimes seen as problematic. And, it said that banks’ descriptions of their risk management practices raised questions about whether banks were sufficiently taking into account and/or had enough timely information on the risk profile of a fund as a whole, particularly on the larger ones with financing and trading relationships with several counterparties.

It also said that counterparty discipline was found to be under pressure owing to highly competitive market conditions. Most stress tests applied by banks, particularly the regular ones, included historical scenarios and were often applied to individual hedge funds only. Stress testing of collateral was less common and offers further scope for improvement, it suggested.

The survey indicated that recent developments in the hedge fund sector may not necessarily pose a direct threat to financial stability in the EU through banks’ direct exposures to hedge funds. However, most of the risk management recommendations that were raised after the near-default of Long Term Capital Management in 1998 remain relevant, it added. “In this respect, both the risk management guidance developed by supervisors and the capital adequacy regime provide an appropriate framework for dealing with risks resulting from EU banks’ interactions with hedge funds,” it said.