IMF and G-20 See Hedge Fund Regulation as Component of Overall Reform

The International Monetary Fund has recommended the regulation of hedge funds that pose a systemic threat to the financial markets as part of the overhaul of financial regulation being planned in the US and the European Union. This view is part of the growing consensus that what some call the parallel banking system must be brought under stricter regulation.
At the time, the finance ministers and central bank governors from the Group of Twenty (G-20) said it was imperative to ensure that all systemically important financial institutions, markets, and financial instruments are subject to regulation and oversight, and that hedge funds or their managers are registered and disclose information to assess the risk they pose. The G-20 asked the IMF to monitor the regulatory response to the need for systemic risk regulation.

The IMF report said that the shadow banking system, including investment banks, and hedge funds, has long been lightly regulated by a patchwork of agencies, and generally not supervised prudentially. This reflected a philosophy that only insured deposit-taking institutions need to be tightly regulated and supervised, noted the IMF, so that financial innovation might thrive under a regime of market discipline. But not only did market discipline fail, observed the IMF, so did the effectiveness of regulation, as banks evaded capital requirements by pushing risk to affiliated entities in the shadow system on whose activities regulators had little information. The sheer size of the shadow system, which by the start of the crisis had grown as large as the formal banking system, meant that major failures here were never really an option. The result was a huge moral hazard cost to the taxpayer.

In the IMF’s view, the perimeter of regulation should be extended to ensure that all activities that pose economy-wide risks are covered and known to a systemic stability regulator with wide power. This would include investment banks, hedge funds, or special investment vehicles issuing collateralized debt obligations or companies writing credit default swaps. Hedge funds and other entities within the expanded regulatory cordon should have disclosure obligations to allow the authorities to determine their contribution to systemic risk and to differentiate the intensity of prudential oversight accordingly.

In a second layer, all systemic institutions should be under prudential rules, potentially covering capital, liquidity, orderly resolution, and early intervention. Differentiated layers of oversight should stress incentives, such as longer term horizons in decisions, strong governance and risk management processes, capital charges to favor safer exchange trading environments or robust clearing systems. Regulatory standards should foster a process to enforce the regulations and minimize regulatory arbitrage. The standards should also be based on the risk of the underlying activity rather than on the type of institution undertaking it. Finally, to cope with systemic changes over time, the approach should involve what the IMF called a “flexible perimeter of regulation.’’