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The way to regulate hedge funds is through their providers of leverage

Date: Tuesday, February 24, 2009
Author: Hugo Dixon, Breakingviews.com

Hedge funds and the rest of the shadow banking system are almost certainly going to be brought into the regulatory net.

But governments should not try to supervise them directly. It will be far more productive to focus on how they get their leverage - in other words, to regulate them via their prime brokers.

The political momentum for regulating shadow banks in advance of April's G20 summit in London is building. That much is clear from this weekend's European summit. Even the UK, home to the lion's share of Europe's hedge funds, signed up to a proposal for "appropriate oversight" for hedge funds and other "pools of capital" which could pose a systemic risk.

That proposal sounds very similar to one advocated last year by Paul Volcker, one of President Obama's top economic advisers.

Although hedge funds themselves have not caused big problems in the current crisis, the broader shadow banking system has. Conduits, specialised investment vehicles (SIVs), CDOs and other members of the alphabet-soup brigade took on oodles of leverage in the good times to buy assets which turned out to be toxic.

This caused two problems. First, because the shadow banks moved as a herd, they helped both inflate the bubble and exacerbate the bust. Second, shadow bank losses knocked holes in the balance sheets of the ordinary banks which had lent to them.

There is a strong case for regulation. But supervising the myriad of shadow banks - hedge funds, SIVs, conduits, CDOs and any other vehicles that have yet to be invented - will be impractical. Regulators have failed to monitor banks adequately. The notion that they can keep on top of every hedge fund manager is fanciful.

An alternative idea is to just focus on the biggest shadow banks - on the theory that they are the systemically important ones. But this won't work. Giant hedge funds and the like will just split themselves into smaller units. And, given the herding mentality, lots of little shadow banks can cause as much havoc as a few big ones.

The better solution is to focus on the key issue: the provision of leverage by the banks to their shadow brethren. If there wasn't any leverage, there would be no problem. Not only would the shadow banks not contribute to the boom and bust; ordinary banks would not be threatened by shadow bank losses.

More specifically, regulators should monitor the interface between banks and the shadow banks. This means setting detailed rules on margin lending by banks' prime broking units. Of course, it won't be possible to have one-size-fits-all policy. Some types of assets will require fatter margins than others. But regulators do at least have some sort of framework for assessing the riskiness of different assets.

Equally, regulators shouldn't necessarily even insist on a hard and fast rule banning leverage above a certain level. An alternative could be to say that if banks want to provide excessive leverage to their clients, they should then hold extra capital themselves. That would ensure that the overall financial system - banks plus shadow banks - was adequately capitalised.

Critics may say that such a system will be hard to police. That is true.

But it will certainly be far easier to control a few dozen prime brokers than thousands of shadow banks.