Monitoring hedge funds

Date: Wednesday, February 25, 2009
Author: International Herald Tribune.com

Hedge funds and the rest of the so-called shadow banking system are almost certainly going to face more regulation. But governments should not try to supervise them directly; instead, it would be far more productive for governments to monitor how they borrow to leverage their investments.

The political momentum for regulating shadow banks is building in advance of a meeting in April in London of representatives of the Group of 20 industrial and emerging economies. That much is clear from the European leaders' meeting over the weekend.

Even Britain, home to most European hedge funds, signed on to a proposal for "appropriate oversight" for hedge funds and other "pools of capital" that could pose a systemic risk. That idea sounds similar to one advocated last month by Paul Volcker, one of President Barack Obama's economic advisers, in a report for the Group of 30, a research group.

Although hedge funds themselves have not caused the larger problems of the current crisis, the broader shadow banking system has. Hedge funds, structured investment vehicles, collateralized debt obligations and other members of the alphabet-soup brigade took on oodles of leverage in the good times to buy assets that turned out to be toxic.

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

There is a strong case for regulation. Watchdogs are justified in wanting information that could help them identify systemically risky operations - by virtue of size, leverage, investment style or otherwise. They also have a duty to encourage or insist upon disclosure and practices that help protect investors, especially where relatively unsophisticated investors can access hedge funds and other potentially risky holdings.

But supervising the myriad shadow banks will be impractical on a daily basis. Regulators have failed to monitor banks adequately; the notion that they can keep on top of every hedge fund manager is fanciful.

In addition, focusing on only the biggest shadow banks - on the theory that they are the systemically important ones - will not necessarily work, either.

To circumvent regulation, giant hedge funds could just split themselves into smaller units. Given the herding mentality, lots of little shadow banks can cause havoc as easily as a few big ones.

The better solution is for regulators to concentrate on the biggest single risk factor: the lending of money by ordinary banks to their shadow brethren. More specifically, regulators should monitor the interface between ordinary banks and shadow banks.

Each part of the shadow banking system may require its own solution. But with hedge funds, the right approach should be to set detailed rules on margin lending by the banks' prime brokerage units. Indeed, most prime brokerages already have the ability to apply such rules, and do so up to a point. That is one reason hedge funds have weathered the crisis somewhat better than banks, which did not apply the same discipline to their own borrowing.

With both hedge funds and lenders doubly cautious in the wake of market turmoil, hedge fund leverage has declined substantially. A Thomson Reuters Lipper survey found last month that nearly 80 percent of hedge funds were now borrowing a dollar or less for each dollar of investor capital.

Regulators, though, need to plan for reversing of that trend in the future.

A one-size-fits-all policy won't work. Certain assets require fatter margins than others. But regulators do already have some sort of framework for assessing the riskiness of different assets. They do it in the context of setting capital requirements for banks and insurance companies, for example.

Regulators also should not necessarily insist on an outright ban on leverage above a certain level. An alternative could be to say that if banks want to provide high levels of debt to their clients, they should hold extra capital themselves. That would ensure that the overall financial system - banks and shadow banks - was adequately capitalized.

Such a system would still be hard to police. But it would be far easier to control a few dozen prime brokerage firms than thousands of shadow banks. - Hugo Dixon and Richard Beales