The nation’s central bank said that financial system vulnerabilities increased over the last six months, pointing to the blow-up of family office Archegos Capital Management and the run-up in “meme stocks” like Gamestop.
“A few recent episodes have highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system,” the Federal Reserve noted in its Financial Stability Report released Thursday.
In January, a r/WallStreetBets-fueled battle over stocks like Gamestop (GME) and AMC Entertainment (AMC) led to billions in losses at Melvin Capital Management, one of the hedge funds that held bets against those companies.
Two months later, Archegos Capital Management triggered multi-billion losses at a number of international banks after it faced a margin call on its stock bets. The private firm, which managed the wealth of Bill Hwang’s family, leaned on total return swap agreements and other derivatives in its positions.
The Fed report noted that both events appeared to have “limited” impacts.
But Fed Governor Lael Brainard said Archegos and the “meme stock” episodes illustrate the possibility that a nonbank financial institution could “generate large losses in the financial system.”
She criticized the current supervisory framework for having a lack of “visibility” into hedge fund exposures. Archegos, for example, was able to skirt disclosures on its size or leverage because of its status as a “family office.”
“The potential for material distress at hedge funds to affect broader financial conditions underscores the importance of more granular, higher-frequency disclosures,” Brainard said Thursday.
The Financial Stability Oversight Council, a panel that includes several financial regulators, recently re-convened a working group that will examine the oversight of hedge funds.
The report suggests that the pressures could build further as the economic re-opening continues to build "elevated" risk appetite among investors.
The Fed noted that asset valuations have broadly risen since the last report in November, adding that vulnerabilities have also risen.
Responding to a question from Yahoo Finance last Wednesday, Fed Chairman Jerome Powell acknowledged that asset prices appeared “frothy” but not at levels that would threaten financial stability.
“You are seeing things in capital markets that are a bit frothy, that's a fact,” Powell said. “I won't say it has nothing to do with monetary policy, but it also has a tremendous amount to do with vaccination and reopening of the economy.”
Brainard similarly noted that record highs on the stock market signal increased risk taking, emphasizing the need to monitor risks as the economy continues to climb back from the COVID pandemic.
The Fed governor called on using the countercyclical capital buffer to boost bank capital requirements, which she and her colleagues voted against using in December last year.
“The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event,” Brainard said Thursday.
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.