By James Hamilton, J.D., LL.M.
European Central Bank President Jean-Claude Trichet has rejected a call by a member of the European Parliament for the direct regulation of hedge funds in light of the recent crisis in the financial markets. Similarly, the President endorsed the continued private sector role of credit rating agencies to assess securities and their issuers.
Werner Langen, member from Germany, urged the ECB to introduce reporting requirements and greater transparency for hedge funds, so as to enable central banks and investors to obtain adequate information on constantly emerging new structures. But, in a letter to Member Langen, the ECB chief confirmed the existing international consensus on the prevailing indirect regulatory approach based on the close scrutiny of hedge funds.
This indirect regulation is based on the close scrutiny of hedge fund counterparties and investors along the lines of recommendations in a report of the Financial Stability Forum. The ECB head called on counterparties, hedge fund managers and investors to implement the recommendations. The report triggered a market-led initiative to review best practices and to work out industry-wide voluntary standards which, the central banker said, is an initiative the ECB has always called for.
In earlier remarks, he has noted an emerging consensus for a voluntary code of conduct for hedge funds. He envisions that the code of conduct would cover risk management and disclosure issues, as well as relationships with prime brokers
With regard to credit ratings agencies, Member Langen raised fundamental questions about the lack of transparency and the need for monitoring. Since a few high-profile rating agencies control the business worldwide, he noted, and the assessment rules are opaque, uncertainty is on the rise both in the banking sector and among investors.
In his view, the responsibility for creditworthiness assessment should be transferred to independent establishments and institutions which do not have a vested interest in achieving the maximum number of the best possible assessments. One option mentioned by the Member would be to build up assessment capacity at national central banks or, where appropriate, the European Central Bank, thus enabling the banking sector to obtain reliable ratings for funds and undertakings. He also emphasized that best practice would be to deal with credit ratings on an international level.
While recognizing the concerns over the ratings of complex structured securities products, Mr. Trichet essentially rejected the call to give central banks a role in assessing the creditwortiness of funds and firms. This would be a huge undertaking also requiring international regulation, he said, and would necessitate a flow of confidential financial information from issuers that could be difficult to obtain.
Overall, the ECB chief believes that credit assessments of securities and their issuers should continue to be predominantly provided by the private sector. That said, he will support initiatives enhancing the transparency of rating methodologies and facilitating more competition in the market for credit assessments. In this regard, he mentioned that European Commissioner for the Internal Market Charlie McCreevy has requested CESR to examine specific issues relating to the rating process of structured finance products. According to the President, CESR’s reply might allow for a more definitive assessment of possible regulatory action.