Opinion: Cracking down on hedge funds the wrong approach

Bloomberg has a story on several politicians from the EU attempting to heavily regulate hedge funds and private equity funds. The goal seems to be to crack down on the risky strategies employed by these funds:

The EU proposal would require managers to gain regulatory authorization and report their strategies and exposures so that authorities can monitor risks. They also would have to post capital against potential losses and safeguard investor assets in custodial banks. The legislation gives regulators powers to restrict a firm’s borrowing and allows for future setting of industrywide debt limits.

Ignoring the fact that this is just an idea being put to the floor, I think this is not going to solve anything and misses the core problem.

As it should be obvious to any observer, stand-alone hedge funds and private equity funds were not the ones that de-stabilized the financial system. They also were not the ones running to the government for bailouts. I'm not a fan of hedge funds in general—too short-term-oriented, costly for investors, etc—but they should be allowed free rein. Similar to traders, who are also short-term-oriented and don't accomplish much in the grand scheme of things (many don't even know the companies or assets they trade), alternative investment funds provide liquidity to the market and make it more efficient. Sure, they can propagate bubbles or cary out all sorts of irrational things (like buying GM stock that is bankrupt and has very little value simply because of momentum signals and what their option models imply.) Yet, in the grand scheme of things, they are benefitial in improving capital flows.

If someone, such as wealthy investors or pension funds, invest in hedge funds or private equity and lose their shirt, that's their problem. I think participants accept that scenario for the most part. Yes, there are some disgruntled wealthy investors blaming the SEC for the Madoff affair but, for the most part, investors putting their money into unregulated funds know what they are getting into and generally don't call for government aid.

The problem, and I hope Poul Nyrup Rasmussen realizes it soon, is not with the hedge funds and private equity funds. Instead, it is with financial intermediaries that finance hedge funds and private equity. Historically it seems only investment banks performed this role but nowadays any bank may be funding hedge funds and private equity. I am of the opinion that regulators need to cut off those who finance the shadow banking system from the rest of banking (traditional banking.)

The regulators should get the power to cut off traditional banks from funnelling retail savings into hedge funds or private equity. There is very strong lobbying from banks, including all former investment banks who are now banks in America, against such a tactic. I suspect similar lobbying strength in Europe. But I think the government should ignore the banking interests and pursue a separation.

The government should also crack down on banks using alternative investment techniques with their internal funds. You may recall how the second signal of impending doom—first was the surprising HSBC loss—was when two of Bear Stearns' hedge funds imploded in early 2007. Perhaps Bear Stearns itself was dead on arrival, but, nevertheless, it was actually their hedge funds that blew up and caused financing difficulties for Bear Stearns early on. Laws already exist in most jurisdictions to take a hard line against banks running loose (if they don't exist, politicians should consider strengthening regulation.) No one has been enforcing them but the regulators should start now, even though it's too late for the current crisis.

Lastly, just to show how dumb the EU proposal is, how are regulators supposed to know whether a hedge fund is engaging in risky behaviour, or whether it is using too much debt? If the sophisticated investors investing in them, who spend millions on external advisors and analysts who vet the hedge funds and private equity funds, can't figure it out on their own, how is a regulator supposed to? Wouldn't an investor have a greater interest risking their own money than a regulator who is just doing a job? Did we also not have the regulators completely missing the shoddy mortgage assets being purchased by banks (banks' actions are generally far less complex than what hedge funds or private equity may engage in)? How are regulators going to help anything?

I commend Rasmussen's attempt to preserve the social welfare state in the EU but his suggestions don't solve the root problems. I suggest he spend his effort on preventing citizen savings from being channelled to shadow interests in the unregulated arena. Trying to regulate the shadow actors themselves will be almost impossible and accomplish very little.


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