By James Hamilton, J.D., LL.M.
I have consistently taken the position that any collective entities that account for 50 percent of the equity trading on the NYSE on any given day should be subject to federal regulation. I am referring to hedge funds; and I want to cite a recent speech by Timothy Geithner, President of the NY Federal Reserve Bank, regarding hedge fund regulation. I view Mr. Geithner as one of the most thoughtful and insightful of regulators. His remarks are always very substantive.
In remarks before the Hong Kong Association of Banks, the senior official said that the Fed and other regulators will have to adapt the current regulatory framework to protect against systemic risk. As the size and importance of hedge funds increases, he continued, distress among financial institutions can have a greater impact on the markets and potentially increase risk. Although for the present, the central banker is content to improve regulatory incentives in an effort to make counterparty discipline more effective, he holds out the option that regulation may be needed, and it would have to be globally coordinated.
What is most interesting about his remarks is the view that risk management, while it is improving, cannot be the final answer on protecting against systemic risk in this area. One problem is that, just as generals are often accused of preparing to fight the last war, risk management tends to chase measures of direct exposure implicated in past crises. Another problem with relaying primarily on risk management is that individual firms may see only a piece of the hedge fund’s positions and, if their direct exposure to the fund is small, may perceive less need to worry about the overall risk profile of the fund. And public disclosure requirements designed to compensate for this information problem do not exist
The remarks of the NY Fed chief have been widely reported. But I think that the most important signal being sent here is that the mantra of risk management cannot be used to block federal regulation of hedge funds. We are well beyond the point where individual risk management initiatives will suffice.