Credit Institutions Operating in the Irish Market: Their

Exposures to Hedge Funds, Private Equity and the

Subprime Sector
by Gavin Doheny1

ABSTRACT
From an international perspective, the profitability of traditional banking activities has been in decline in recent years. Accordingly,
international banks are believed to have supplemented their income from sources other than traditional banking activities. In
particular, it appears the growth of the subprime, hedge fund and private equity sectors has been facilitated somewhat by the
increased involvement of international banks. Notwithstanding the fact that numerous Irish banks earn significant levels of non-
interest income, typically the Irish banking sector continues to earn the greater part of its earnings from traditional banking
activities. A combination of exceptionally strong economic growth over the past 15 years and a booming housing market has
placed the Irish banking sector in an unusual position by international standards. To some degree, this combination of
developments has meant that traditional banking activities have remained highly profitable in the Irish market. Therefore, it is not
obvious that credit institutions operating in the Irish market have had the same incentives to engage with non-traditional banking
activities. This article documents a survey of exposures that licensed credit institutions operating in the Irish market hold in relation
to the hedge fund, private equity and subprime sectors. The survey results indicate that credit institutions operating in the Irish
market are not substantially exposed to the subprime or hedge fund sectors. Surveyed institutions do, however, possess more
substantial exposures to the private equity sector, although these exposures still only account for a small percentage of the
respective institutions’ total assets.

Introduction
Internationally, it appears that the profitability of
traditional banking activities has been declining in recent
years, as net interest margins have trended downwards.
International financial markets over the same period
have been characterised by strong growth, increasing
financial globalisation, increasing innovation, enhanced
risk management techniques and an abundance of new
financial products. These developments have facilitated
an environment in which credit institutions can
potentially seek out higher returns on the global financial
markets and compensate somewhat for the declining
profitability of more traditional banking activities. In
particular, the growth of sectors such as subprime, hedge
funds and private equity may to some degree reflect the
increased involvement of international banks in these
sectors.
In general, Irish credit institutions have continued to gain
the greater part of their earnings from traditional banking
activities. The Irish economy has recorded remarkably
strong growth over the last fifteen years or so and more
recently has experienced a housing sector boom. To
some extent, this economic performance has maintained
the profitability of traditional banking activities in the Irish
market. This suggests that credit institutions operating in
1
The author is an economist in the Monetary Policy & Financial Stability Department. The views expressed in this article are the personal responsibility
of the author and are not necessarily those held by the CBFSAI or the ESCB. All remaining errors and omissions are the author’s. The author would
like to thank his colleagues within the CBFSAI for invaluable assistance in completing this paper.
the Irish market might not have had the same incentive
to engage with non-traditional banking activities.
The aim of this paper is to ascertain whether licensed
credit institutions operating in the Irish market have
become substantially involved with the hedge fund,
subprime or private equity sectors. The results of this
article are based on a survey of the activities of 47
licensed credit institutions operating in the Irish market.
The broad findings of this paper are that the surveyed
credit institutions are not substantially exposed to any of
the three sectors examined within this article. The rest of
this article is organised as follows, Section 1 outlines a
brief discussion of each of the three sectors examined
within the survey, Section 2 presents the results
emanating from the survey responses and Section 3
examines the results of the survey and presents an
overall summary. The conclusions of the exercise are
articulated in the final section.
1. Sectoral Overview
This section provides a brief overview of the subprime,
hedge fund and private equity sectors. All three sectors
examined within this article have experienced rapid
growth in recent times. It is therefore advantageous to
show the recent trends and structures of these three

Financial Stability Report 2007 129

sectors. Section 1.1 examines the subprime sector,
Section 1.2 looks at the hedge fund industry and Section
1.3 explores the private equity sector.
1.1 The Subprime Sector
There is no universally accepted definition as to what
constitutes subprime exposures. However, international
literature has established a broadly accepted view that
in general subprime loans refer to lending to those
individuals who have a blemish on their credit history or
a form of non-regular income e.g., self employed. The
appeal of (entering) the subprime market for an
originating institution is primarily the prospect of higher
returns. As prospective subprime customers represent a
higher degree of risk (in terms of probability of default)
credit institutions can charge higher interest rates on
related loans. The subprime sector has garnered
increased attention from supervisory authorities recently
due to the problems experienced in the US subprime
market.
There are three main channels for credit institutions to
become exposed to the subprime sector. First, a credit
institution may directly issue subprime loans; these
primarily take the form of subprime mortgages, but they
can also refer to other loan types e.g., motor loans. Once
an institution has issued subprime loans they can either
retain the risk on their balance sheet or securitise the risk
and sell it on in the form of an asset-backed security
(ABS). This type of securitisation represents the second
type of exposure a credit institution may hold in relation
to the subprime sector. An institution may hold indirect
(investment) exposures, if it has purchased securities that
are ultimately backed by subprime loans. These types of
securities most commonly come in the form of
residential mortgage-backed securities (RMBSs) or a
collateralised debt obligation (CDO) which contains a
subprime component. Through this type of indirect
exposure a credit institution becomes exposed to the risk
of default on the underlying assets. Finally, credit
institutions may become exposed to the subprime sector
by extending lines of credit or liquidity (i.e., contingent
lending facilities) to Special Purpose Vehicles (SPVs) that
hold subprime ABSs or directly issue subprime loans.
This type of exposure has recently become known as
subprime conduits.
Media attention has come to focus upon the US
subprime market recently due to the large volume of
defaults sustained by US subprime lenders. US subprime
lenders sought to take advantage of a combination of
low interest rates and a strong housing market, by
130 Financial Stability Report 2007
loosening lending criteria, with the view that the
borrower would face a low repayment burden and even
in the event of a default the capital appreciation of the
property would protect the issuing institution from any
losses. Typically, these subprime mortgages were sold on
in the form of RMBSs, CDOs and other related securities.
When macroeconomic conditions changed in the US
(i.e., interest rates increasing or house price growth
slowing) these subprime loans experienced high default
frequencies. Issuing institutions or those that had
purchased the related securities (direct and indirect
exposures) experienced quite substantial losses.
A review of the size of the subprime market in Ireland
suggests that there are currently six companies operating
directly in the market, four of which commenced since
early-2007:
● GE Money (50/50 joint venture with the IFG
Group);
● Start Mortgages (64 per cent owned by UK-based
Kensington Group);
● Finance Ireland and Investec (Nua Homeloans
Joint Venture);
● Fresh Mortgages Ltd. (funding line from Credit
Suisse);
● Irish Life & Permanent and Merrill Lynch
(Springboard Joint Venture); and
● IIB and Lehman Brothers (Stepstone Joint Venture).
At present, the subprime market in Ireland is estimated
to be worth approximately \1 billion in new business per
annum. As per the Irish Banking Federations’s data series
on new mortgage lending, this represented 2.3 per cent
of the value of new mortgage issued by mainstream
credit institutions in 2006.
1.2 Hedge Funds
Although there is no internationally accepted definition
of a hedge fund, they can typically be viewed as a
collective pool of capital, which undertakes a diverse
range of investment strategies with the ultimate aim of
achieving superior absolute returns. Internationally, the
hedge fund industry is characterised by issues such as:
offshore domicile financial centres and a light regulatory
framework (structured so as to be largely exempt from
registration, reporting and disclosure requirements).
Hedge funds generally achieve their superior returns
through active trading strategies, leverage, derivatives
and short selling. As of end-2006, assets under
management by hedge funds stood at $1.4 trillion
outstanding, representing a significant expansion in
recent years.
The survey distinguished between three different types
of hedge fund structures that credit institutions may
engage with. Fund-of-hedge-funds (FOHFs), as one might
imagine, differ from single hedge funds in that their
portfolio consists of other hedge funds. Typically, the
purpose of these funds is to gain greater diversification.
Hedge funds make use of a vast array of investment
strategies. Single hedge funds might concentrate their
strategy on one or more investment approaches, FOHFs
combine a number of hedge funds in their portfolio to
further diversify the risks faced by investors. Hedge fund
structures may also be derived from seed capital, which
occurs when an institution provides seed capital to
create a hedge fund structure (typically credit institutions
provide seed capital to their own-managed hedge fund
structures). One of the principal incentives for credit
institutions to engage with hedge fund structures is to
avail of the potentially higher diversified returns.
From a financial stability perspective, there are both
positive and negative factors associated with the rapid
growth of the hedge fund industry. Positively, hedge
funds can boost market liquidity, aid the price discovery
process via arbitrage and provide investors with a means
of diversifying their portfolio. However, there are a
number of hedge fund characteristics that may have
negative repercussions for financial stability, including:
● large banks exposed to hedge funds, though either
creditor or trading counterparty links, face direct
losses in the event of the poor performance or
failure of a hedge fund (counterparty risk); and
● market disturbance risks may also be linked to the
growth of the hedge fund industry. A
concentration of risk can occur when similar
investment strategies by a number of hedge funds
results in a concentration of trades. This
concentration of trades can result in market
disturbances and reduced liquidity when the
positions are unwound or come to maturity.
Hedge funds’ active investment strategies mean
that they become important providers of liquidity
in some markets; however, if this is withdrawn
market disturbances could cause sharp price
changes.
● the characteristics of certain hedge funds can give
rise to general financial stability concerns. The
opacity of hedge funds means that counterparties
might not fully appreciate the risks posed by the
funds strategy. The complexity of some funds leads
to valuation difficulties, which can raise the
possibility that risks are mismanaged or
misunderstood. Also the leverage involved in some
hedge funds can make them more sensitive to
market movements. These inherent characteristics
raise the overall risk profile of the hedge fund
industry.
Hedge funds have attracted increasing levels of attention
internationally, as policy makers have become
increasingly concerned about their possible impact upon
financial stability. The survey distinguished between the
four primary types of direct exposures that credit
institutions may hold in relation to hedge fund structures.
First, investment exposures occur when an institution
makes an investment in hedge fund structures. Secondly,
financing exposures occur when credit facilities are
provided to hedge fund structures. Thirdly, direct
exposures can arise through either the supply of
administration services or prime brokerage services to
hedge fund structures. Each type of exposure is explored
further within the survey responses section of this paper
(Section 2.2.1).
The rapid expansion of the hedge fund industry has
given rise to calls from many commentators for
increased regulation of, and disclosure from the sector.
International literature is divided on the issue. On one
side some commentators argue that increased regulation
of the industry would prove to be counterproductive and
that increased transparency is a more realistic option to
address the potential risks posed by hedge funds.
Opposing increased regulation for the hedge fund
industry, Danielsson and Zigrand (2007) assert that most
of the calls for increased regulation are based upon a
misperception of the effectiveness of financial
regulations and a misunderstanding of the positive
contribution of hedge funds to the financial system. They
believe that regulation is best implemented on the
demand side i.e., regulation of a pension fund instead of
the hedge fund in which the pension fund invests.
McCarthy (2007) is strongly opposed to a general
requirement for hedge funds to disclose positions, either
to regulators or the general public. Part of the reason for
this opposition to regulation is the difficulty in regulating
hedge funds; active trading strategies mean the positions
of hedge funds in a given market can change quite
rapidly. Imposing reporting requirements would, on this
Financial Stability Report 2007 131
argument, burden hedge fund structures considerably,
and also provide an impetus to hedge fund managers
to move the operation to a region with a more relaxed
regulatory regime. The majority of commentators
opposing increased regulation/disclosure of hedge fund
structures nevertheless recognise the value of imposing
greater transparency and best practice guidelines upon
hedge fund structures.
In favour of increased regulation and disclosure from
hedge fund structures, Nouy (2007) believes that risk
management must keep pace with financial innovation,
and that not to do anything is simply not an option, given
the growth of the hedge fund industry. Weber (2007) is
of the opinion that, as the financial system becomes
more complex and less transparent, it is a growing
challenge for central banks to make an adequate
assessment of the potential risks to financial stability. He
asserts that the most important line of defence in
containing potential risks to stability is adequate market
discipline, which in turn requires greater transparency.
Weber feels that it would be of benefit to the hedge fund
industry to define more demanding sound practices of
disclosure to investors.
In general, there is a common consensus that there is at
the very least an appetite for increased transparency
from the hedge fund industry. Many commentators have
also highlighted the benefits of establishing self-imposed
best practice guidelines/restrictions on hedge fund
structures in order to mitigate some of the risks
emanating from the industry.
1.3 Private Equity
Typically, private equity firms can be regarded as
investment firms that accumulate funds from interested
investors and transfer them to other firms in the form of
risk capital. The ECB (2007) defined the private equity
market as providing ‘‘medium or long-term equity or
equity-linked finance for privately-held firms at various
stages of their lifecycle’’. The private equity industry is
typically subdivided into two main categories, namely,
the venture capital segment and the buyout segment.
The venture capital segment is predominately concerned
with providing finance for early-stage/start-up firms while
the buyout segment is more focused on the acquisition
and restructuring of existing, typically more established,
companies. The buyout segment tends to be associated
with highly leveraged deals, whereby the target company
is expected to generate high and stable cash flows in
order to service the debt burden created by the buyout.
132 Financial Stability Report 2007
Deals of this nature are commonly referred to as
leveraged buyouts (LBOs). Buyouts can also come in the
form of management acquisitions, whereby an attempt
is made to restructure, improve efficiency or sell on
unprofitable sections of a target firm. In this context
buyout activity is referred to as management buyouts
(MBOs) or management buy-ins (MBIs). In general,
investment in the venture capital segment is considered
to be more risky than the buyout segment.
The survey responses can be categorised within the
context of three varying definitions of private equity
models, namely:
● the ‘‘portfolio’’ business model generally involves
commercial and retail banks providing leveraged
finance with the aim of retaining a share of the
debt in their books to generate interest income
and diversification benefits. This model also
involves banks setting up the transaction and/or
entering into deals organised by other banks. The
purpose of the portfolio approach is to generate
fees from arranging the deal financing and interest
revenues from holding the positions;
● the ‘‘capital turnover’’ business model in turn is
typically adopted by investment banks and
generally entails the distribution (via syndications,
assignments and sub-participations) of (nearly) all
of the debt to other market participants, reducing
banks’ economic risk exposure. This approach,
which also involves extensive use of credit
derivatives, focuses on earning fees rather than
interest revenue;
● a combination of both models.
The private equity market has grown significantly over
the last number of years. It has played a significant role
in the recent surge of merger and acquisition activity and
has also become an integral part of the efficient capital
markets. However, there are significant concerns
associated with the growth of the private equity industry.
‘‘The recent resurgence of leveraged buyouts and the
concomitant rise of ‘‘private equity’’ markets in the US
and internationally has been accompanied by renewed
concerns about their effects. These concerns emphasise
a need to evaluate the impact of these transactions on
organisations and society’’, according to [Cumming,
Siegel and Wright (2007)]. These concerns primarily
reflect the large size and highly leveraged nature of
certain private equity deals. There are also a number of
inbuilt risks associated with the private equity sector.
— Complexity of Private Equity Deals
The complex nature and highly leveraged status of
private equity deals creates the risk that potential
investors do not fully recognise or understand the risks
involved.
— Leveraged Buyout Exposures
In the event that a significant private equity-backed firm
defaults there would potentially be significant
repercussions for lenders, holders of debt and the
orderly operation of markets.
In the context of the survey reported in this article, credit
institutions can gain exposures to private equity in a
variety of ways. Credit institutions can invest directly in
private equity firms, with a mixture of venture capital and
leveraged buyout exposures. Institutions can also
provide credit facilities in the form of debt to private
equity firms. Alternatively, credit institutions would also
become exposed to the private equity sector by lending
to those firms that have been subject to leveraged
buyouts instigated by private equity firms.
2. Survey Results
2.1 Subprime Sector Survey Responses
The questions submitted to the surveyed credit
institutions in relation to the subprime sector were
organised into two separate parts, a qualitative and a
quantitative section. The qualitative section helps to
expand our understanding of what credit institutions2
perceive to be the main risks and opportunities
associated with the subprime sector, as well as providing
a general overview of how credit institutions approach
the sector. The quantitative section is used to gauge the
current level of direct and indirect exposures that credit
institutions hold in relation to the subprime sector.
2.1.1 Qualitative Results
The qualitative questions attempted to identify the main
characteristics, the most pertinent risks, the key
mitigation techniques and the overall approach that
credit institutions associate with the subprime sector.
This section provides an overview of the key responses
received in relation to these issues.
The key characteristics, which credit institutions,
associate with subprime lending included:
2
Credit Institutions refers to Licensed Credit Institutions operating in the Irish market.
3
FICO (Fair Isaac Corporation) score is a commonly used measure of credit risk. The FICO score is the most commonly used measure of credit risk
in the mortgage industry.
4
With the introduction of Basel II any risk weighting will be based on the external rating of the respective bond.
● subprime borrowers (are those individuals) who
have typically suffered some form of credit
impairment in the past. They are usually those
borrowers who can be identified as having a FICO3
score of less than 670/680;
● individuals who had previously shown difficulty in
meeting their financial obligations but who have
since demonstrated the ability to recover their
situation or hold it in abeyance (i.e., avoiding
lending to people who have a deteriorating credit
profile, as this does not demonstrate the ability to
repay);
● customers with irregular or impaired income
sources such as the self employed, recently
employed or those in temporary employment; and
● customers without life insurance cover.
Typically, respondent credit institutions holding
subprime exposures have been involved with the
subprime sector for two to three years, only one
institution indicated that they had been involved with
the sector for longer than three years. Virtually all of the
respondent credit institutions indicated that the main
purpose for subprime loans was mortgages.
In relation to credit polices, information pertaining to
subprime exposures is generally submitted to the
relevant board or risk committee on a quarterly basis.
The majority of institutions do not provide specific
information on subprime exposures (as the exposures
are too small in magnitude) but instead address
subprime risks within wider portfolio- or credit-risk
briefings. In a similar fashion, due to the small magnitude
of subprime exposures, none of the responding credit
institutions indicated that they perform separate stress
testing exercises on subprime exposures; instead
subprime exposures are examined with wider, more
generic stress testing exercises. Only one responding
institution indicated that they had established an SPV in
order to engage with the subprime sector.
Concerning the risks associated with engaging with the
subprime sector, Table 1 outlines some of the key risks
and mitigation techniques identified by responding
credit institutions. The subprime sector responses also
indicated that usually a risk weighting of 50 per cent was
applied to securities backed by subprime loans.4
Financial Stability Report 2007 133
Table 1

Key Risks
● Higher risk of default (and associated administration costs).

● Repossession of property and potential losses as borrowers may be accustomed to avoiding making payments and delaying creditors.
● Value of the property being insufficient to cover the remaining capital in the event of a foreclosure.
● In terms of CDO investments, the ability of the CDO manager to effectively monitor risks pertaining to the CDO.

Mitigation Techniques
● Outsourcing recoveries to specialised providers.

● Performing a survey on each property before underwriting each loan.

● In terms of CDO investment, the institution monitors and reviews the CDO’s performance and the underling capital.
● Ensuring that investments backed by subprime loans have a high AAA/AA rating.
● Not exceeding 90 per cent loan-to-value (LTV).

2.1.2 Quantitative Results directly-exposed institutions have closed their subprime

In total 38 credit institutions replied to the survey; eleven
credit institutions indicated that they have some
exposure to the subprime sector.
— Direct Exposures
Direct exposures are defined as only those subprime
exposures that credit institutions have originated in a
given market. Two institutions indicated that they hold
direct exposures to the subprime sector i.e., originating
subprime loans. However, the magnitude of these
exposures was very small. The subprime exposures of
these institutions’ individually did not exceed either 0.13
per cent of the total personal loan book or 0.07 per cent
of total assets. These direct exposures originated in
Ireland and the United Kingdom, respectively. The total
value of direct exposures represented 0.03 per cent of
total assets and 0.55 per cent of Tier 1 capital of the
institutions that hold direct subprime exposures. The
total value of direct exposures was less than 0.01 per
cent of the total assets of the Irish banking sector. Both
portfolios (i.e., they are not currently offering subprime-
related products) and are focused solely on collecting
out their subprime books. None of the surveyed credit
institutions indicated they had any direct exposure to the
US subprime market.
— Indirect (Investment Exposures)
The exposures of the remaining nine credit institutions
were of an indirect nature. These primarily took the form
of an investment in RMBSs. In general, these investments
were of high AAA/AA type quality, and of a relatively
small magnitude (see Table 2). The indirect investment
exposures to the US subprime market are estimated to
be worth 0.09 per cent of total assets and 1.92 per cent
of Tier 1 capital of the Irish banking sector. The total
indirect exposures are equivalent to 0.42 per cent of
total assets and 8.5 per cent of Tier 1 capital of the
institutions that hold indirect subprime exposures. The
total indirect exposures represent 0.14 per cent of the
Irish banking sector’s total assets.

Table 2: Indirect Exposures to the Subprime Sector

% total assets of the exposed institutions

US UK Other markets5

RMBSs 0.41 0.17 <0.01

(3 institutions) (5 institutions) (2 institutions)

CDOs 0.17 — —
(3 institutions)

5
‘‘Other markets’’ primarily refers to the Australian subprime market.

134 Financial Stability Report 2007

Table 3
Liquidity line (not drawn down)
— Off-Balance Sheet Commitments
Credit institutions can also engage with the subprime
sector through off-balance sheet exposures arising from
credit or liquidity lines provided to entities such as SPVs,
which have exposures to subprime ABSs. Irish
institutions reported very limited such exposures to the
US non-prime market (see Table 3).
— Shortcomings of the Survey
The survey captures the subprime exposures of credit
institutions operating in the Irish market. However, a
number of these institutions may participate in joint
ventures or create special purpose entities in order to
access the subprime sector. The results of the survey do
not capture such entities where they are not regulated
credit institutions (for example, if an institution indicated
that they had no exposures to the subprime market, it is
still possible that they might participate in a joint venture
with another organisation or create their own SPV,
engaging with the subprime sector).
2.2 Hedge Fund Survey Responses
In a similar fashion to that of the subprime section, the
survey questions relating to hedge funds were divided
into both qualitative and quantitative questions. The
qualitative questions were subdivided into five separate
categories. First, a number of generic qualitative
questions addressed issues such as how credit
institutions define hedge funds and also what they
perceive to be the main risks and mitigation techniques
surrounding hedge fund exposures. Secondly, the
Table 4: Credit Institutions responding ‘‘Yes’’, confirming Exposures to Hedge Fund Structures
Activity
Provision of credit facilities to hedge fund structures
Investment in hedge fund structures
Supply of prime brokerage services to hedge fund structures
Provision of administration services to hedge fund structures
Note: In total 10 credit institutions responded ‘‘yes’’ to having exposures to hedge funds.
% assets % Tier 1 Amount drawn
assets \ billion % assets % Tier 1
0.005 0.11 0 0 0
qualitative questions were subdivided into four separate
categories in order to fully address the four principal
types of exposures that credit institutions may hold in
relation to hedge fund structures (see Table 4). The four
categories examined here were: the provision of credit
facilities to hedge fund structures, investment in hedge
fund structures, the supply of prime brokerage services
to hedge funds structures and the provision of
administration services to hedge fund structures. In total,
ten responding credit institutions indicated that they held
some form of exposure to hedge fund structures.
The quantitative questions contained within the survey
were intended to capture an overall view of the
exposures that credit institutions held in relation to the
hedge fund sector. These questions were also designed
to estimate the importance of the hedge fund industry
to the respective institution’s overall strategy.
2.2.1 Qualitative Results
— Generic Questions
In general there is no universally accepted definition of a
hedge fund; however, the most common characteristics
associated with hedge funds as indicated by the
respondent credit institutions’ include:
● the hedge fund seeks to generate an absolute
positive return (by exploiting market inefficiencies
while minimising exposure and correlation to
traditional stock and bond investments) rather than
seeking a relative return against a benchmark or
index i.e., to generate a positive return in both bull
and bear markets;
Number of institutions
with exposures
7
6
0
2
Financial Stability Report 2007 135
 ● hedge fund managers are free to operate in a
variety of markets and are also allowed to use
investment strategies generally not available to
mutual funds in order to reach their objectives,
including the use of leverage, derivatives and
adopting short positions in securities;
● an entity (i.e., hedge fund) which holds a pool of
securities or other assets, which has not registered
its securities offering with a regulator and which is
not registered and not regulated as an investment
company;
● the fund manager is principally remunerated based
upon a performance fee of the fund’s capital gains
and capital appreciation;
● hedge funds typically provide less disclosure than
traditional funds; and
● generally hedge funds are not widely available to
the public — the investor base typically comprises
professional or accredited investors (although this
has been changing in recent times, it is still
predominately true).
Table 5
Main risks identified in relation to lending to/investing in
hedge funds
A lack of transparency in relation to the underlying
assets/positions of the hedge fund.
Due to the fund’s complex nature, there is difficulty in the
valuation/pricing of the fund’s underlying assets.
Ability to monitor the underlying hedge fund managers.
An absence of regulatory oversight/disclosure.
Systematic Risk — arising from previously uncorrelated market
movements suddenly becoming synchronised.
Structural Risk — where complex, multi-layered fund structures
with several legal entity levels result in there being a distance
between the investor and the ultimate marketable security.
Fraud/Operational Risk
Leverage Risk
Liquidity Risk
Default on a loan facility
136 Financial Stability Report 2007
Typically, information relating to hedge fund exposures
was submitted to the relevant board/risk committee on
either a quarterly or annual basis. The majority of
surveyed institutions did not submit specific hedge fund
exposure reports, but instead reported hedge fund
exposures as part of wider-reaching credit/investment
risk statements. In relation to the ten surveyed credit
institutions having exposures to hedge fund structures,
eight submitted some information to the board/risk
committee regarding the institution’s involvement with
hedge funds. The remaining two institutions indicated
that the magnitude of their hedge fund exposures was
too small to warrant direct approval from the board or
risk committee. In relation to the risks of engaging with
the hedge fund sector, Table 5 summaries the key risks
and mitigation techniques identified by the surveyed
credit institutions regarding their hedge fund exposures.
Three of the ten credit institutions with exposures to
hedge funds conduct stress testing in relation to their
hedge fund exposures. However, the stress testing is
conducted at the portfolio level and not specifically
intended to examine hedge fund exposures.
Mitigation technique
These issues are inherent to hedge fund structures in general. Typically credit
institutions mitigate these risks by conducting due diligence on the hedge fund
managers, monitoring security values on a regular basis and limiting exposures to
individual hedge funds to a percentage of the NAV or a predefined specific limit.
Addressed through the use of dynamic risk analytics, which allow for risks to
change through time and in response to market conditions.
Mitigated through a rigorous credit application process, that requires the provision
of detailed structural flow diagrams, ensuring that all parties have a clear
understanding of the structures being presented.
Mitigated by thorough due diligence and compliance approval processes.
In terms of lending to hedge funds, mitigated by capping the amount of leverage
an institution provides to a hedge fund structure. In terms of investing in hedge
funds, mitigated by investing in well-diversified funds managed by reputable
managers.
Addressed through diligent research of a fund prior to initial contact. Strengthened
through continued due diligence and monitoring regular performance reports.
Mitigated via conservative lending values i.e., either a set maximum value or a
maximum percentage of the fund’s NAV. Loan and collateral agreements are also
put in place, in which loans are typically over collateralised.
Table 6
Type of hedge funds credit facilities are provided to:
—fund-of-hedge-funds
—hedge funds
Note: In total 7 institutions provide credit facilities to hedge fund structures.
2.2.2 In Terms of providing Credit Facilities to Hedge
Fund Structures
Seven credit institutions confirmed that they provide
credit facilities to hedge fund structures. The survey
responses from these institutions indicated that the main
types of credit facilities offered to hedge fund
structures were:
1. short-term overdraft facilities (90 days max), to
accommodate timing differences in relation to
subscriptions/redemptions and trading activity
on the fund;
2. loan facilities in the form of variable- or fixed-
term advances for periods of up to twelve
months;
3. an extension of credit facilities to hedge funds
for working capital purposes (not for structural
leverage) and to hedge currency and interest-rate
risk; and
4. short-term credit facilities.
These credit facilities were typically utilised by hedge
fund structures for overdraft, short-term borrowing (for
liquidity) and bridging finance6 purposes. In the majority
of instances a mixture of the credit, legal, custody and
compliance departments conducted the due diligence in
relation to a respective hedge fund as a potential
borrower. A higher number of the surveyed credit
institutions had extended credit facilities to fund-of-
hedge-funds (FOHFs) structures than to single hedge
fund structures (Table 6). Of the ten institutions
providing credit facilities, five extended credit facilities to
FOHFs while three extended credit facilities to single
hedge fund structures.
Table 7
Domiciles of countries hedge funds receiving credit facilities
Bermuda
Republic of Ireland
USA (onshore)
Guernsey
6
Credit facilities are required to bridge investor redemptions (timing difference between paying an investor and liquidating fund assets) and for asset
allocation purposes (timing difference between investing in new assets and exiting existing investments).
7
The remaining institution classified its hedge fund exposures by investment style or asset class.
Number of institutions
5
3
In terms of collateral, six of the seven institutions
providing credit facilities to hedge fund structures have
collateralised loans; only one institution indicated that it
did not have collateralised loans in relation to hedge
fund exposures. The loans involved are typically
collateralised with first priority security (charge or lien)
over the assets of the hedge fund. The traditional hubs of
the hedge fund industry proved to be the most popular
jurisdiction for hedge fund structures receiving credit
facilities (see Table 7).
2.2.3 In Terms of investing in Hedge Fund
Structures
Regarding investment, six credit institutions indicated
that they invested in hedge fund structures. The three
primary types of hedge fund structures receiving
investment from credit institutions were: single hedge
funds, fund-of-hedge-funds and also seed capital
originated hedge funds (see Table 8). Typically, credit
institutions provided seed capital to their own managed
hedge funds. In terms of classification, three institutions
classified their hedge fund investments as part of the
banking book while two credit institutions classified their
investments as part of the trading book.7 The underlying
strategies utilised by those hedge fund structures in
which the surveyed institutions invested was quite
varied. A wide array of investment strategies such as
long/short, equities, distressed debt, high yield bonds
and futures were reported. There was no one particularly
dominant type of underlying strategy among the hedge
fund structures in which the surveyed credit institutions
invested.
Isle of Man
Cayman Islands
British Virgin Islands
Luxembourg
Financial Stability Report 2007 137
Table 8
Type of hedge funds invested in:
—fund-of-hedge-funds
—hedge funds
—seed capital to an institutions’ own hedge fund structures
Note: In total 6 institutions invest in hedge fund structures.
Hedge fund investments did not exceed 6 per cent of
the trading book for those credit institutions classifying
hedge fund investments as part of the trading book. Two
of the responding institutions indicated that their Assets
and Liability Committee (ALCO) monitored their
exposures to hedge fund structures, while a mixture of
credit committees and investment governance
committees oversaw the remaining four institution’s
exposures. Only one institution indicated that they
provide seed capital as a form of hedge fund investment.
2.2.4 In Terms of providing Administration Services
to Hedge Funds
Two institutions indicated that they provide
administration services to hedge fund structures. The
institutions providing administration services to hedge
fund structures have been doing so for approximately
two to three years. In terms of an overall strategy, the
primary reasons given by responding credit institutions
for the provision of administration services included:
● generation of fee income;
● diversification of the institution’s revenue stream;
● compliance with the institution’s cross selling
strategy;
● in order to complement existing systems; and
Table 9: Key Risks and Mitigation Techniques
Risks
Pricing of complex securities whilst remaining independent in
the process.
Reputational and legal risks emanating from the danger that
the service falls below agreed standards.
138 Financial Stability Report 2007
Number of institutions
3
5
1
● part of a wider strategy to seek further
opportunities in fund-of-hedge-funds.
The provision of administration services also brings with
it certain risks and challenges. One of the respondent
institutions indicated that as its service was considered a
premium service, it was burdened with reputational and
quality concerns. Table 9 outlines some of the key risks
and mitigation techniques associated with providing
administration services to hedge fund structures.
2.2.5 In Terms of providing Prime Brokerage Services
to Hedge Funds
No responding credit institution indicated a provision of
prime brokerage services to the hedge fund industry.
2.2.6 Quantitative Questions
Of the 38 credit institutions replying to the survey, ten
indicated that they have some exposure to the hedge
funds sector. The total value of an institution’s exposure
to the hedge fund sector comprises both investment and
credit exposures. Similarly income generated from
exposures to hedge fund structures is derived from a
variety of sources, such as credit income, investment
income, interest income, transaction fees, and custody
fees. In relation to regulatory capital associated with
exposures to hedge fund structures, a requirement of 8
per cent applies.
Mitigation Techniques
The institution utilises a third party vendor to perform the required tasks.
Recruitment and selection of quality staff.
Internal Quality Control.
Limited liability through legal documentation.
Implementation of service parameters.
Regular meeting with clients to gauge suitability of service.
Table 10: Investment and Credit Facilities
As of March 2007 The value of investment in hedge fund
structures
% total assets (of the exposed institutions)
% total assets of the Irish banking sector
Table 10 outlines the exposures of the surveyed credit
institutions in relation to investing in and lending to
hedge fund structures. In terms of investing in hedge
fund structures, the total value of investment equated
to approximately 0.11 per cent of total assets of the six
institutions investing in hedge fund structures. The total
value of investment represented approximately 0.03 per
cent of the Irish banking sector’s total assets. Turning to
the provision of credit facilities, the total value of credit
facilities extended to hedge fund structures was
equivalent to approximately 0.08 per cent of total assets
of the institutions lending to hedge fund structures. This
lending exposure represented 0.03 per cent of the Irish
banking sector’s total assets.
In general, exposures of these magnitudes would
represent a very low degree of risk to the institutions
involved. Similarly, none of the responding credit
institutions indicated that they rely upon the hedge fund
sector as a key source of income. All of the responding
institutions indicated that they held no arrears in terms
of their hedge fund exposures.
2.3 Private Equity Survey Responses
In the same manner as the subprime and hedge funds
sections, the private equity component of the survey was
divided into an individual qualitative and quantitative
section. The qualitative questions were intended to
assess what type of exposures and which types of
finance surveyed credit institutions extended to private
equity firms. The qualitative questions also provided a
general overview of the main risks and mitigation
techniques, relevant credit polices and overall strategy
that credit institutions attach to interaction with private
equity firms. The quantitative questions were designed
to identify the level of exposures and the value of
income derived from involvement with the private
equity sector.
The value of credit facilities extended to hedge
fund structures
0.11 0.08
0.03 0.03
2.3.1 Qualitative Questions
Of the 38 credit institutions responding to the survey, six
indicated that they held exposures to the private equity
sector. In general, there was a wide variety of exposure
types identified by those credit institutions with private
equity interaction. The majority of these exposures took
the form of debt finance; however, a number of
institutions indicated that, under certain circumstances,
investment equity could possibly be offered. The most
common types of exposures declared were:
● direct investment in a private equity fund;
● lending exposures i.e., revolving credit facilities
(RCFs) to private equity managed funds;
● lending to firms that have been the subject of
leveraged buyouts (LBOs) instigated by private
equity funds; and
● loan facilities to private equity fund of funds.
Surveyed credit institutions had been involved with
private equity deals between twelve months and fifteen
years. However, most institutions had been involved for
approximately five years. In general, both investing in
and lending to private equity firms required approval
from the relevant board or risk committee. Many of the
exposed institutions had specific credit polices governing
LBO/MBO financing. These credit policies were
principally reviewed on an annual basis. In terms of
private equity investments, the average deal length was
27 months. In terms of lending to private equity firms or
firms subject to leveraged buyouts instigated by private
equity firms, the average deal length was 6.7 years. In
general, most institutions do not conduct separate stress
tests in relation to their private equity exposures.
Typically, investing in and lending to private equity firms
was accounted for by broader stress testing frameworks
or credit assessment processes. Under Basel II, private
equity fund investments receive a risk weighting of 300
per cent while lending exposures receive a 100 per cent
risk weighting. The key risks and mitigation techniques
are summarised in Table 11.
Financial Stability Report 2007 139
Table 11

Risks Mitigation Techniques

● Degree of leverage
● Management track record
● Investment strategy and time horizon
● The firm’s due diligence processes ● Regular meetings with the private equity firm’s management
● Market performance ● Analysis of the private equity firm’s market reputation
● Default on the loan facility
● Analysis of the historic returns
● Identification of the likely escape routes as well as risk diversification
Venture Capital Risks
●
criteria within the funds
Level of diversification ●
●
Analysis of the post-investment fund performance
Stage of investment (early, mid, late) ●
●
Prior knowledge of market
Number of portfolio companies and people management ● Conservative lending values
● Credit Committee Assessment
LBO Risks
● Gearing levels
● Repayment capacity
● Probability of default

Regarding the surveyed institutions’ overall strategy in
relation to lending to/investing in private equity-related
firms, the primary reasons given for investing in private
equity was to enhance market knowledge and to
generate reciprocal deal flow from a core set of private
equity relationships in the mid-market. The principal
approach taken in relation to lending to private equity-
related firms was to take risk/reward decisions (thereby
enhancing shareholder returns) or to target specific
private equity firms that met appropriate asset quality
levels.
2.3.2 Quantitative Questions
The primary focus of the quantitative questions was to
establish the general level of exposures that the surveyed
credit institutions held, in terms of both investing in and
lending to, private equity-related firms. Total exposures
comprise private equity investments and debt finance
provided to private equity-related firms8. The
comparative importance of private equity-related income
was also ascertained within the private equity survey
responses.
The total exposures derived from interaction with the
private equity sector are illustrated in Table 12. The total
exposures of the six institutions are estimated to be
worth approximately 2.15 per cent of the institutions’
total assets and 37.1 per cent of their Tier 1 capital. The
average total exposure is estimated to be valued at 0.36
per cent of the total assets and 6.2 per cent of Tier 1
capital of the respective institutions. Although the total
exposures identified within this sector initially seem to
be quite substantial, they still represent only a relatively
small proportion of the institutions’ total assets. The
income derived from the private equity sector was also
reported to be quite modest.

Table 12: Private Equity Total Exposures

As of 2007Q1

Total Exposures (Investing in/Lending to private equity-related firms) \ million

% total assets of the six institutions % Tier 1 capital of the six institutions

Total exposure of the six institutions engaged with the private 2.15 37.1
equity sector
Average exposure of the six institutions engaged with the 0.36 6.2
private equity sector

8
Private equity-related firms refers to investment in/lending to both private equity firms and the firms which have been subject to leveraged buyouts
instigated by private equity firms. Although it is possible not all responding institutions provided their exposures relating to firms that have been
subjected to LBOs instigated by private equity firms, those firms that did provide their exposures have been included in the total exposures.

140 Financial Stability Report 2007

Table 13: Breakdown of Sectoral Exposures
Subprime Exposures
—Direct Exposures
—Indirect Exposures
Hedge Fund Exposures
—Investment in hedge fund structures
—Lending to hedge fund structures
—Providing administration services to hedge fund
structures
—Providing prime brokerage services to hedge fund
structures
Private Equity Exposures
—Investing in Private-Equity related firms
—Lending to Private-Equity related firms
Note: Subtotals do not tally with sectoral totals as institutions may engage with more than one category.
3. Summary of Results
This article summarised the results of the survey
submitted by the Central Bank & Financial Services
Authority of Ireland (CBFSAI) of 47 licensed credit
institutions operating in the Irish market. A total of 38
credit institutions have responded in detail to the survey.
The survey responses have provided an overall view as
to the number of credit institutions operating in the Irish
market that are exposed to the hedge fund, private
equity and subprime sectors (see Table 13). Eleven credit
institutions are exposed to the subprime sector, ten to
hedge funds and six to the private equity sector although
the relative amounts involved are very small.
The results in Section 2.1 (subprime survey responses)
indicate that credit institutions operating in the Irish
market are not substantially exposed to the subprime
sector. In an assessment of the three main channels
through which credit institutions can become exposed
to the subprime sector, it was evident that the direct
exposures (i.e., originated subprime loans) were limited
in terms both of the number of institutions exposed and
in relation to the magnitude of the exposures that these
institutions held. The total value of direct exposures was
estimated to be 0.03 per cent of the respective
institutions’ total assets. Notwithstanding the fact that a
higher number of institutions held indirect (investment)
exposures to the subprime sector, the magnitude of
these exposures was also quite small. The value of total
indirect exposures was approximately 0.42 per cent of
% total assets of % total assets of
Number of the Irish the exposed
institutions banking sector institutions
11
2 <0.01 0.03
9 0.14 0.42
10
6 0.03 0.11
7 0.03 0.08
2 — —
0 — —
6 0.84 2.15
2
6
total assets of indirectly exposed credit institutions.
Finally, subprime exposures derived from conduits were
very limited.
The corresponding results in Section 2.2 (hedge funds
survey responses) reveal that the surveyed credit
institutions are not substantially exposed to hedge fund
structures. In terms of investing in hedge fund structures,
the magnitude of the majority of investments typically
represents a negligible share of the institution’s trading
book. The total value of investment in hedge fund
structures was estimated to be worth 0.11 per cent of
total assets of the institutions investing in those
structures. In terms of providing credit facilities to hedge
fund structures, the majority of credit facilities are
provided to fund-of-hedge-funds structures. Typically,
credit facilities are used for short-term borrowing or
bridging finance purposes (i.e., not for leverage). The
magnitude of these credit facilities was also negligible,
with the total value estimated to be worth less than 0.08
per cent of the lending institution’s total assets.
Reflecting their limited involvement in the sector, the
income generated from hedge fund exposures did not
represent a significant contribution for any of the
respondent credit institutions.
The results in Section 2.3 (private equity survey
responses) illustrated that the surveyed credit institutions
held more substantial exposures to the private equity
sector than those held in relation to either the subprime
Financial Stability Report 2007 141
or hedge fund sectors. However, the number of
institutions engaging with the private equity sector is
quite small. Notwithstanding the fact that the private
equity exposures were larger in magnitude, they still only
accounted for a small proportion of the institutions’ total
assets. The total exposures were estimated to be worth
approximately 2.15 per cent of total assets of the
institutions engaged with the private equity sector.
Finally, the level of income emanating from private
equity exposures did not appear to represent a
significant contribution to the surveyed credit
institutions’ overall income.
4. Conclusions
The proposition articulated at the beginning of this paper
referred to the possibility that, from an international
perspective, as the profitability of traditional banking
activities had been declining, financial institutions might
have an incentive to engage with non-traditional banking
activities. It was, however, postulated that the Irish
market was not subject to the same set of incentives, as
economic growth over the last number of years had
been particularly strong and, in particular, the housing
market had experienced a boom. These factors seemed
to suggest that the traditional banking activities in the
Irish market had remained profitable. The aim of this
paper was to ascertain whether credit institutions
operating in the Irish market had engaged to a significant
degree with non-traditional banking activities (i.e., hedge
funds, subprime and private equity). The results of a
survey of credit institutions provides evidence that
licensed credit institutions operating in the Irish market
are not substantially exposed to either the subprime
sector or hedge fund structures. The survey has identified
exposures of a somewhat greater magnitude in relation
to the private equity sector but these only account for
a relatively small fraction of total assets of those credit
institutions involved. The results of the survey would lead
one to conclude that credit institutions operating in the
Irish market are not therefore substantially exposed to
non-traditional banking activities.
Glossary of Terms
ABS — Asset Backed Security
Securities issued in order to convert the illiquid assets of
an originating institution into transferable securities.
ALCO — Assets and Liabilities Committee
This committee is usually concerned with asset and
liability management (the structure of the balance sheet)
rather than risk. It also has responsibility for treasury
activities in some banks.
142 Financial Stability Report 2007
CBFSAI — Central Bank & Financial Services Authority
of Ireland — www.centralbank.ie
CDO — Collateralised Debt Obligation
A CDO refers to a type of asset-backed security or
structured credit product. CDOs gain exposure to the
credit of a portfolio of fixed income assets and divide
the credit risk among different tranches: senior tranches
(rated AAA), mezzanine tranches (AA to BB), and equity
tranches (unrated).
ECB — European Central Bank — www.ecb.int
ESCB — European System of Central Banks
Consists of the European Central Bank and the national
Central Banks of the EU Member States.
FICO — Fair Isaac Corporation score
This score is a commonly used measure of credit risk.
The FICO score is the most commonly used measure of
credit risk in the mortgage industry.
FOHF — Fund-Of-Hedge-Funds
A fund-of-hedge-funds is a fund that invests in several
different hedge funds to spread the risks involved.
LBO — Leveraged Buyout
A leveraged buyout (LBO) occurs when a financial
sponsor gains control of a majority of a target company’s
equity through the use of borrowed money or debt.
LTV — Loan-to-Value Ratio
The loan-to-value (LTV) ratio is a mathematical
calculation which expresses the amount of a first
mortgage lien as a percentage of the total appraised
value of real property. For instance, if a borrower wants
\450,000 to purchase a house worth \500,000, the LTV
ratio is \450,000/\500,000 or 90 per cent.
MBI — Management Buy-In
Management buy-in (MBI) occurs when a manager or a
management team from outside the company raises the
necessary finance, buys it, and becomes the company’s
new management. The difference to a management
buyout is in the position of the purchaser: in the case of
a buyout, they are already working for the company. In
the case of a buy-in, however, the manager or
management team is from another source.
MBO — Management Buyout
A management buyout (MBO) is a form of acquisition
where a company’s existing managers acquire a large
part or all of the entity concerned.
NAV — Net Asset Value
The Net Asset Value or NAV is a term used to describe
the value of an entity’s assets less the value of its
liabilities. The term is commonly used in relation to
collective investment schemes.
RCF — Revolving Credit Facilities
Revolving credit is a type of credit that does not have a
fixed number of payments, in contrast to instalment
credit. Examples of revolving credits used by customers
include credit cards. Corporate revolving credit facilities
are typically used to provide liquidity for companies day-
to-day operations.
RMBS — Residential Mortgage-Backed Securities
A mortgage-backed security (MBS) is an asset-backed
security whose cash flows are backed by the principal
and interest payments of a set of mortgage loans. A
mortgage-backed security that is backed by residential
mortgages is known as an RMBS. Subprime RMBSs refer
to a securities backed by subprime residential
mortgages.
SPV — Special Purpose Vehicle
An SPV is an entity that is both legally and bankruptcy
remote from the originating institution. Typically, special
purpose vehicles are created in order to issue asset-
backed securities.
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Financial Stability Report 2007 143