Hedge Funds May Pose Systemic Risk in Crisis, U.S. Report Says

Hedge funds and insurers might threaten U.S. economic stability in a time of crisis, according to a report aimed at helping regulators decide which non-bank financial companies warrant Federal Reserve supervision.

An exodus of hedge-fund investors could “cause activity in some markets to freeze,” said the Feb. 3 report by staff of the Financial Stability Oversight Council. The report, obtained by Bloomberg News, also said the failure of a large insurance company could “result in dramatic and destabilizing actions being taken by investors.”

The 80-page report is a preliminary draft that, without making recommendations, offers a glimpse of issues regulators, including Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy F. Geithner, will consider when deciding which firms should be designated “systemically important” and warrant central bank scrutiny. The council, created by last year’s Dodd-Frank financial overhaul law to prevent another financial crisis, may begin making those rulings by midyear.

Companies including Blackrock Inc., the world’s largest money manager, and lobbyists for the hedge-fund and mutual-fund industries have made the case to regulators they aren’t important enough to the financial system to merit the designation. Financial executives have said the costs of more regulation would put them at a disadvantage to their competitors.

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