The European Assault on Hedge Funds

Date: Wednesday, April 25, 2007
Author: Jurgen Reinhoudt, American.com

In a speech to NYU Law School on April 11, Federal Reserve Chairman Ben Bernanke said that “because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified.” Bernanke may be right—but among elite figures, he is rather lonely in his views about these highly liquid, largely unregulated pools of capital.

The same day that Bernanke delivered his speech, across the pond Dutch lawmakers heard testimony on hedge fund regulation from top Dutch policymakers and bankers, including former ABN Amro CEO Jan Kalff. Kalff said that “This sector has become too big to be left alone,” while retired Professor Arie van der Zwan told MPs about the “perversity of financial incentives” created by hedge funds.

The leader of the world’s third largest economy, German Chancellor Angela Merkel, wants to increase oversight of hedge funds. On April 10 of this year she proposed “regular round table discussions between the world's 20 biggest hedge funds and Group of Eight regulatory authorities.” In Germany, hedge funds have been a hot political potato since 2005, when former SPD-Chairman Franz Müntefering harshly criticized international investors:

“Many financial investors don’t give thought to the people whose jobs they destroy. They stay anonymous, don’t have a face, fall over companies like crowds of locusts, graze them to the bone, and move on.”

For all the criticism in recent years, regulation across the EU has been comparatively benign. That may be changing.

In equally strong terms, Müntefering said that internationally imposed profit-maximizing strategies "threaten our democracy." Merkel’s recent proposals show that Müntefering’s critical attitude has now effectively crossed German party lines.

Similarly, in France, hedge funds have come under heavy political fire. Former Prime Minister Lionel Jospin, a Socialist, harshly criticized hedge funds as early as 1997 in a speech in Tokyo:

Certain financial actors escape control as well: “hedge funds” and other speculative funds have practically no regulatory obligations, not even those of simple transparence. Their situation is completely unjustifiable in economic terms. The crisis provoked by the LTCM fund in October 1998 shows it: in and of themselves, [hedge funds] can endanger a national or international market. Controlling them indirectly, that is to say in their relations with banks, is necessary. It is not sufficient. They must be regulated directly.”

What is remarkable is that, for all the criticism in recent years, regulation across the EU has been comparatively benign. That may be changing.

Nicolas Sarkozy, the center-right French Presidential candidate on whom many economic reformers have pinned their hopes, declared recently that an important “topic for European debate would be "moralizing" the region's model of financial capitalism.” Sarkozy attacked “these aggressive [hedge] funds ... that buy up a company, sell it off in pieces, sack 25 percent of the staff in the meantime, collect 25 percent profit and create zero wealth”

And criticism is spreading at the European Union level, a bad sign for hedge funds given the EU’s love of centralized regulation. Unlike his American counterpart, European Central Bank Chief Jean-Claude Trichet does believe the current system of regulating hedge funds is inadequate. In 2005, Trichet proposed regulating hedge funds at the international level (in conjunction with the United States), saying that “Given the global nature of the hedge fund industry, a regulatory response can only be given on the basis of a solid international consensus and in particular a trans-Atlantic consensus.”

On March 29, the European Parliament Socialist group released a report on hedge funds in which it argued for heavy-handed regulation. In the words of the Socialist MEPs: “We still believe in the market, but we insist on 'a social market economy' not on a ‘market society.’” They called on hedge funds “to behave responsibly and focus not just on what may give them the highest bonus and lowest tax.” MEP Ieke Van den Burg, one of the authors of the report, said: “I don't believe that the market will solve [existing problems] and I don't want to wait for a major crisis.” The report advocates far stricter transparency and disclosure requirements, as well as changes to corporate governance and taxation rules, including the “introduction of ‘fiscal discrimination...against off-shore projects,’ one of a series of measures designed to limit the sector's influence on what its authors describe as the ‘real economy’.”

Criticism is spreading at the European Union level, a bad sign for hedge funds given the EU’s love of centralized regulation.

In their report, members of the Socialist Group blast European Internal Market Commissioner McCreevy, saying: “With the exception of Commissioner McCreevy, all others have reached recognition that some change is needed to ensure a better-functioning capital market.” McCreevy, like the American Fed’s Bernanke, has said he thinks the current situation is decent. But in this, as the Socialists note, McCreevy finds himself uncomfortably isolated, with the exception of the UK (where many European hedge funds are headquartered) and Switzerland, which is not a member of the EU and is trying to lure hedge funds away from the UK by cutting the tax rate for hedge funds. In February, the alpine nation already came under verbal fire from the EU for its low tax rates, with the EU calling tax breaks for foreign profits of companies “unfair” and hinting at repercussions. As such, Switzerland is not the best European fiscal bellwether.

Hedge funds are not the first institutions to be vilified in Europe even though they perform highly useful functions—think of pharmaceutical companies, Microsoft, and defense contractors. Hedge funds, too, perform useful functions, but like any industry, they are not perfect, nor are they populated with angels; the high-risk climate of hedge funds tends to attract savvy financiers who focus on the bottom line.

As Sebastian Mallaby has written, hedge funds perform three highly useful economic functions. First, hedge funds absorb risk: “The funds can be viewed as quasi insurers; by shouldering risks that others wish to avoid, they remove a potential obstacle to business… Hedge funds are willing to buy credit derivatives that transfer the default risk from the banks to themselves—freeing the banks to finance more economic activity… Hedge funds help to manage” companies’ exposure to risky foreign currencies “by trading in the currency derivatives that companies use to insure themselves.”

Second, “hedge funds can also reduce the danger that economies will overrespond to shocks. If a currency or stock market starts to plummet, the best hope for stability lies in self-confident, deep-pocketed investors willing to bet that the fall has gone too far, and hedge funds are well designed to perform this function… Many hedge funds have "lock-up" rules that prevent investors from withdrawing money on short notice; when crises strike, [hedge] funds have the freedom to be buyers.” Mallaby notes that, unlike what some claim, “it was banks [and not hedge funds] that caused the flight of ‘hot money’ from East Asia during the 1997-98 crisis—with hedge funds being among the first to go back in.”

Third, “hedge funds can reduce the chances that markets will rise to unsustainable levels in the first place.”

To help turn the tide of public opinion, hedge funds could at least attempt to balance the socialist smoke and mirrors emanating from various European capitals and Brussels. This will require publicity-shy hedge funds to come out of the shadows and explain to the European public what exactly it is that they do—and why they perform a useful economic function.

At present, hedge funds are being defined and described by their enemies, not a good position for anyone to be in. Microsoft’s fate at the European Commission (at the mercy of large fines), or that of European pharmaceutical companies (facing  stringent government price controls from national governments), should serve as warnings to hedge funds.

Hedge funds should remember that strong verbal denunciations by European politicians are usually followed by significant government intervention. Foretold is forewarned.

Jurgen Reinhoudt is a Research Assistant at the American Enterprise Institute.