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That is the classic view of the role of the central bank. It extends beyond using monetary policy to prevent "overheating" and price inflation. Most central bank regulate the banking system, and since banks supply credit to much of the rest of the financial system -- both to investment banks and to hedge funds, the central bank therefore indirectly regulates many "unregulated" institutions and markets.
I am glad the banks are feeling a bit of regulatory heat right now. New York Federal Reserve President Tim Geithner seems to be trying to make sure that banks are not extenting too much credit to hedge funds in good times, setting themselves up for trouble should conditions change.
It is easy to say, after a crisis, that "what is really important is better crisis prevention." But effective crisis prevention is hard, because it means voluntaryily refraining from the last, often rather enjoyable drink, even when the bar is still open. For the US, it means taking steps to cut our current account deficit before the market forces us too. For the financial system, it means reigning in lending to hedge funds before some hedge fund -- or a set of hedge funds making the same fundamental bet -- gets in trouble.
The key quote -- to my mind -- in Geithner’s recent speech on hedge funds comes at the end. The note of concern is rather clear, even if it is cached in Fedspeak.
"Further progress in strengthening risk management practices is an investment worth making "
My translation: A little market discipline please -- not every 28 year old trader deserves their own hedge fund.
"particularly when the markets appear to be pricing in a relatively benign view of risk in the financial system and in the economy overall"
My translation: Probably too benign a view, given certain fundamental weaknesses in the current global economy.
In his speech, Geithner makes an important point:
Banks that both lend to hedge funds and trade for their own account need to consider two things:
a) whether they are lending to a bunch of different hedge funds that are all making the same bet (and might all have to sell at the same time to cover their margin requirements in the event of an adverse market move)
b) whether the bank itself is making the same bets as the hedge funds it is lending to. The bank’s risk management strategy for its "trading desk" might imply trying to sell certain positions in a market downturn to avoid further losses. If it is lending to hedge funds that are making the same bet, its "counterparty/credit risk desk" might be requiring that leveraged hedge funds try to sell the same position as the bank to limit the bank’s credit risk. The net effect: the favorite euphemism of central bankers -- "disorderly" markets.
Hedge funds can help to stabilize markets is they are willing to step in and buy when other types of institutions want to sell. But if leveraged hedge funds have to sell when other players in the market also want to sell, they -- and the world -- can have problems. Roger Lowenstein’s account of the LTCM crisis -- When Genius Failed -- is perhaps well worth rereading.
The argument that lending to hedge funds is "fully collateralized" so it is OK if hedge funds are heavily leveraged (i.e. borrow lots in relation to their capital) is not terribly convincing. In bad states of the world -- see 1998 -- the value of the "collateral" can fall rapidly, and the leveraged institution may need to sell its position. Lenders generally wants to be repaid in cash, not with the "collateral." Forced selling into a down market drives the market down further, aggravating the cycle, as more lenders call in their loans and demand that the hedge funds close out the positions they took with borrowed money (i.e. sell collateral).