On Regulating Hedge Funds

Mark Thoma on Economist’s View, sums up his view in his headline, “Kenneth Rogoff: German Leaders Are Right About Hedge Fund Transparency and Regulation“. Rogoff takes issue with Paulson’s dismissal of the idea of making hedge funds more accountable.

It’s odd that Paulson even thinks he had a vote on this issue, since the Treasury is not a regulator, but one supposes as a former Wall Street chief (oh, and of a firm that has been accused of being more a hedge fund than a market maker) he feels entitled to an opinion. Oh, but of course. He was a member of a committee that made a solidly pro-industry set of recommendations (ironically, he joined the group as head of Goldman, but the report got an extra boost since it was issued after Paulson went to Treasury).

Paulson has almost made it sound as if Europeans are trying to rein in one of America’s most successful new industries (he might well have recycled Rumsfeld’s “old Europe” charge if Rumsfeld himself hadn’t gone by the wayside).

Now the regulator that has the most reason to worry about hedge funds, namely the Fed, actually made statements that would seem to argue for more oversight. From a January 11, 2007 speech by the president of the Federal Reserve Bank of New York, Tim Geithner:

The global financial system is in the process of very dramatic change. The changes of even just the last five years are extraordinary, in terms of the size, and strength, and scope of the major global firms, the role of private leveraged funds, the extent of risk transfer and the increase in the size of the derivatives market, the change in the structure of the credit market, the increase in and changes in the pattern of cross border financial flows.

These changes, and others, seem likely to have made the financial system both more effective in moving capital to its most productive use and more stable and resilient over time. But they do not, of course, mean the end of systemic risk in financial markets. They could in some circumstances work to magnify rather than mitigate stress. Central banks, supervisors and those running the major private financial institutions need to continue to work to ensure that what Jerry Corrigan calls the “shock absorbers” in the financial system—capital and liquidity and the operational infrastructure—are sufficiently strong and robust to withstand economic and financial conditions more adverse than we have seen in the recent past.

Although Geithner doesn’t come out and say it, one has the impression that he is acknowledging that the pace of innovation has been so rapid, and the nature of the changes so far reaching, that the regulators don’t have a good handle on the institutions themselves or on the risks they might be collectively creating.

That alone would seem to make more disclosure, at least to the supervisory bodies, a priority. But even if that could be achieved, the Fed has limited resources and many other responsibilities, particularly inspecting banks. Thus a more transparency, and more regulation, could produce a double benefit. Regulation, while it might limit some business opportunities and increase costs, would presumably also curtail some exterme behavior, such as excessive leverage, that could endanger counterparties. More transaprency would enable investors, consultants, rating agencies, and counterparties, to have a better picture of the risks, and come up with better ways of measuring and monitoring risk. It would allow the marketplace to serve a quasi-regulatory function, and enable the Fed to build on this understanding.

But no. For some reason beyond my comprehension (perhaps campaign conribution) the Fed and the other regulatory bodies are staunchly pro-industry, rather than taking the more traditional role of balancing the needs of the companies and their customers.

From Rogoff’s piece, “Hegemony Through Hedge Funds” (apologies if the link doesn’t work, I was having trouble with it just now):

The recent volatility in global capital markets should give pause to those who say German leaders, who have been arguing for greater transparency in global hedge funds, are just sore losers.

American and British policymakers, in particular, say the German whining is nonsense, and that hedge funds, along with other New Age financial entities such as private equity firms, are key innovators in today’s global economy.

This debate is … clouded by a healthy dose of national self-interest. With New York and London the centres of global finance, the United States and Britain have enormous profits at stake. So it is convenient for them to downplay the likelihood that risks to the world’s financial system will be spread more evenly than the benefits.

German leaders, by contrast, must reckon with a populace that is deeply resistant to rapid change, particularly when it involves job cuts. Many German workers believe, as one trade unionist recently lamented, that takeovers are being driven by a philosophy of “buy it, strip it and flip it”….

The big question is whether this Wild West mentality poses broader risks to the global financial system, particularly given circumstances where a large number of firms are all collectively making the same bet. If they lose, a long string of bankruptcies can cut deeply into banking systems…

At the moment, the most glaring weakness is the so-called “yen carry trade”. Hedge funds have borrowed hundreds of billions of dollars at ultra-low interest rates in Japan, and invested the proceeds in countries such as Brazil and Turkey, where interest rates are high.

As long as the yen remains weak, this investment strategy will be a money machine. But if the yen appreciates sharply, as it easily could given Japan’s huge current account surplus, some hedge funds will suffer huge capital losses and the yen carry trade will implode.

And while today’s main risk is the yen, in a couple months it could be something completely different. So pressure outside the US and Britain to put the hedge fund industry on a tighter regulatory leash is hardly surprising. The Germans, for example, want to reduce risk by forcing hedge funds to adhere to stricter reporting requirements.

The funds respond to such proposals by arguing that if they are required to reveal their investment strategies, they will lose their incentive to innovate, and a recent US government report — a multi-agency effort headed by Treasury Secretary Hank Paulson (formerly of Goldman Sachs) — supports that position.

Greater regulation would be a mistake, the report argues, because the global economy’s best defence against systemic risk is the exercise of common sense and “due diligence” by each and every person who invests or interacts with hedge funds.

In other words, the US is telling investors to carry their own guns, because, as in the Wild West, there might not be a sheriff around to help. But frankly, as we are reminded by recent events, it is hard to see how at least a small increase in transparency can hurt. The Germans, in chairing the G8 this year, should not surrender on this issue. …

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