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Why We Need Hedge Funds To Make Financial Reform Work

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
June 20, 2010
Washington Post

You can't blame Congress for wanting to squeeze risk out of the big Wall Street firms. In 2008, mishandled risk cratered the economy, triggering a sharp expansion of the national-debt burden and leaving at least one in 10 Americans without work. But if the big guys take less risk, what other institutions will shoulder it? Once you ask this question, the financial reform emerging from Congress acquires a new complexion. Some controversial measures seem surprisingly attractive. Some uncontroversial ones appear absurd.

The first thing to recognize is that, however much we might wish otherwise, financial risk is here to stay. There have been crashes ever since the tulip bubble of the 17th century, and they are not going away. In a complex economy, currencies will fluctuate, interest rates will undulate and impossibly difficult decisions will be made about allocating scarce capital to millions of families and thousands of firms. Finance consists of uncertain judgments about an unknowable future. Inevitably, financiers will periodically get burned.

Nor is it possible to close down the casino. If Wall Street stopped taking bets on the future of the dollar, it would effectively force Main Street to take those same bets instead. Today, an exporter that fears that a strong dollar will harm its competitiveness can sell that risk to a financial firm. Abolish currency derivatives, and the exporter would have to retain that risk on its balance sheet. It would therefore have to set aside more capital as a buffer against currency uncertainty, locking up resources that might otherwise be used to build a factory and create jobs. Multiply that outcome across thousands of firms and dozens of types of financial exposure, and you begin to see how the financial sector contributes to the welfare of ordinary Americans.

So the question isn't how to abolish risk; it's how to entrust it to responsible players. The crash of 2008 demonstrates that risk was shouldered by the wrong people. On the one hand, unsophisticated consumers took out crazy mortgages -- this is why the proposed consumer protection agency makes sense. On the other hand, too-big-to-fail behemoths gambled recklessly, forcing the government to throw taxpayer dollars at them -- this is why the much pilloried "Volcker rule" and "Lincoln amendment," which would force some types of risk out of banks that have a government backstop, are also attractive in principle (though implementing them would be hard).

But it is not enough to prevent risk from building in the wrong places. Congress should also take a view on where the risk should go. Lawmakers should be asking themselves what type of financial vehicle survived the stress test of the recent crisis. Then they should encourage that type of firm.

What firms am I talking about? Hedge funds. In 2007, when the mortgage market imploded, hedge funds were almost unique in avoiding disastrous losses; as a group that year, they were up 10 percent. In 2008, when the Lehman collapse caused a seizure in the payments system, hedge funds lost money -- but far less than everybody else.

This wasn't just luck. Because of their design, hedge funds are the best risk managers in the world. Unlike the too-big-to-fail banks and investment banks, which are encouraged to be reckless by their government backstop, hedge funds have the great virtue of being small enough to fail. Over the past decade, about 5,000 went under, none of which required a taxpayer bailout.

Traders at big banks gamble with OPM -- Wall Street's contemptuous term for "other people's money." Again, the incentives at hedge funds are better. Hedge fund managers risk their personal savings alongside those of their investors, so they have good reason to avoid gambling too hard.

If hedge funds have healthy incentives, is Congress doing what it should? Unfortunately, it isn't. The bills under consideration require hedge funds with more than a paltry $100 million in assets to register with the Securities and Exchange Commission, and they threaten other burdens that will be especially onerous for smaller funds lacking armies of lawyers. This is an absurdity. Congress is creating obstacles for entrepreneurial boutique financiers -- precisely the players who must absorb the risks that were appallingly mishandled by too-big-to-fail behemoths.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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