Money & Investing

Basel Panel Recommends Limits
On Dealings With High-Risk Firms

By MATT MURRAY
Staff Reporter of THE WALL STREET JOURNAL

NEW YORK -- After their failure to monitor adequately the risks associated
with Long-Term Capital Management LP, banks and securities firms should
adopt a host of restrictions on dealings with high-risk institutions, a group of
bank supervisors said.

Among the measures banks should take are improving their risk measurement
and stress-testing, demanding more financial disclosure from highly leveraged
institutions, and tightening credit limits to those institutions, said a report issued
by the Basel Committee on Banking Supervision, a group of senior regulators
and central bankers from the leading industrialized nations from Western
Europe, as well as the U.S., Japan and Canada.

The committee began studying banks' relationships with hedge funds and other
highly leveraged institutions in the fall following the near collapse of Long-Term
Capital. After the hedge fund piled up losses during the market tumult of the
summer, 14 banks and securities firms, including virtually all of the major Wall
Street institutions, were forced to cobble together a bailout.

The Basel report, unveiled at the Federal Reserve Bank of New York,
concludes banks "generally did not appear to possess effective policies and
guidelines for managing exposures to some highly leveraged institutions in a
manner consistent with their overall credit standards."

Among the most glaring defects: lack of information and the willingness to
demand it, imprudent loosening of some financial terms, poor credit controls,
insufficiently frequent reviews of their dealings, and inadequate measurement of
banks' secondary-market exposure.

The last shortcoming became the subject of debate in the days immediately
after the bailout, when a number of banks disclosed their direct counter-party
exposure to the hedge fund, much of which was collateralized by such
investments as U.S. Treasury bills, yet refused to disclose their off-balance
sheet exposures, which in most cases weren't collateralized.

"What we want to make sure of is that the very expensive lesson of LTCM is
not lost," said William J. McDonough, chairman of the Basel committee and
president of the New York Fed, who helped to orchestrate the bankers'
meetings that led to the bailout. He noted some banks simply didn't ask too
many questions of the secretive firm in hopes of learning some "LTCM magic"
for themselves. "There was a feeling that 'Babe Ruth never strikes out four times
in a row,' " Mr. McDonough said. "Well, he did."

The Basel committee, which has wide influence but no legal authority, made no
recommendations on the question of further regulatory control over hedge
funds. The suggestions in its report depend solely on banks' willingness to adopt
them.

Regulatory overhaul is up to individual nations, but because such reform would
mean little unless adopted across the board, it is considered difficult in the case
of slippery hedge funds, which often register in offshore locations to avoid
scrutiny as it is. Early next week, the Board of Governors of the Federal
Reserve in Washington is expected to release guidelines for bank examiners for
assessing banks' involvement with hedge funds.

Mr. McDonough said the committee wanted to focus on beefing up existing
regulations given the likely political difficulties in establishing new ones. "It is
reasonably clear that direct control would be extremely difficult to carry off and
would take a very long time," he said.

Mr. McDonough also defended the New York Fed's role in the Long-Term
Capital bailout, saying it averted serious damage to the U.S. and world
economies. Asked if, with hindsight, he thought the New York Fed should have
done anything differently, he simply answered, "No."