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How and When To Fsoc It To the Hedge Funds

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
July 15, 2010
Financial Times

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Among the regulatory headaches created by the Dodd-Frank bill which finally passed Congress on Thursday night, consider just one. Should the government fsoc it to hedge funds?

Fsoc-ing is a term with which we are doomed to grow familiar. It derives from an offspring of the new law which is to issue hundreds of new rules, each one a Rubik's cube of moving pieces: the Financial Stability Oversight Council, which will be set up to keep tabs on all systemically risky institutions. Until now, no single regulator has enjoyed such a broad mandate. So crises have often germinated outside the traditional regulatory net – in insurance subsidiaries, over-the-counter derivatives and so on. In future, the FSOC will have the right to shine its light on whatever looks risky.

It sounds good. But how should the FSOC decide whom to fsoc? Hedge funds seem an obvious candidate – they are opaque, growing like topsy and only lightly regulated. But hedge fund history teaches two lessons: only a tiny proportion deserves regulatory attention; identifying these risky exceptions is an inexact science.

Most hedge funds are too small to threaten the financial system. Over the past decade, something like 5,000 went bust, and not one significantly destabilised markets or required a taxpayer bail-out. Because they are small enough to fail, hedge funds represent an appealing alternative to too-big-to-fail behemoths. If the FSOC were to burden hedge funds with oversight and hamper their growth, it would reduce the amount of risk that they absorb, paradoxically making the financial system less stable.

Under certain conditions, however, hedge funds may reach a point where they do threaten stability. In 1998, the Nobel Prize-heavy Long-Term Capital Management famously went bust, scaring the New York Fed into browbeating bankers into recapitalising the fund. A fire sale of assets could have driven markets into a tailspin.

How can the FSOC spot the next LTCM in time? Certainly not by looking at the amount of capital it manages. LTCM's equity, at a bit under $5bn, was half that of Amaranth, a hedge fund that collapsed in 2006. Yet the systemic consequences of Amaranth's demise were zero.

Size measured by assets gets closer to the answer. Because of its high leverage, LTCM's assets (not counting derivatives) came to an impressive $120bn. But that was a fraction of the combined $800bn managed by the black-box equity funds that went wrong in the so-called “Quant Quake” of August 2007. The $800bn quake fell far short of a systemic crisis. Beyond size, what other tests should regulators look at? One answer is the markets that a hedge fund trades in. LTCM's failure was scary partly because of its penchant for complex over-the-counter bets that gave it exposure, for example, to the volatility of French stocks.

Finally, regulators should consider whether a hedge fund has strayed from the private partnership structure. If yes, they should be more inclined to fsoc it. Managers of private partnerships tend to monitor risk carefully because they have their own skin in the game; by contrast, publicly listed hedge funds are likely to share the principal/agent problems that bedevil other financial companies. Equally, hedge funds that are subsidiaries of banks tend to take risk carelessly because they foresee deep-pocketed parents coming to the rescue. In 2007 Bear Stearns and Goldman Sachs were among the banks that recapitalised troubled hedge fund units.

All this suggests a graduated response. Once a hedge fund amasses $120bn in assets – the size of LTCM – the FSOC should start to ask questions, notably about exposure to over-the-counter markets. Once it gets significantly larger regulators might want to impose capital requirements. Finally, when a hedge fund company goes public, the presumption of sound risk management must be diluted. But these guidelines suggest that, out of 9,000 or so hedge funds, fewer than 50 warrant regulatory scrutiny.

With hedge funds, the FSOC may be tempted to cast a wide net: it will not be criticised for erring on the safe side. But it needs to resist such populist cop-outs. Scrutinising non-systemic players would be a costly distraction – especially for regulators who already have their work cut out implementing a 2,300-page law in all its vast complexity.

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

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