Bernanke: Let the Counterparties Regulate Hedge Fund Risk

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Most of the news coverage of Federal Reserve chairman Ben Bernanke’s comments on hedge funds yesterday seemed to have underplayed what struck us as the most important aspect of Bernanke’s speech—his insight that the way to control the potential for “systemic risk” posed by hedge fund failures is through hedge fund counterparties, the investment banks providing margin leverage for hedge fund investment.
Those who seeks tighter regulation over hedge funds have marshaled a number of rationales. Mutual fund and pension fund investment in hedge funds raises the risk that ordinary investors—rather than wealthy, accredited investors permitted to invest directly in hedge funds—might lose their retirement savings, some say. Inflation creep combined with a run-up in housing prices has permitted some of the not-so-very rich to meet the minimum asset tests to qualify as accredited investors, others fear. But by far the most persuasive case for hedge fund regulation has probably been the argument that hedge funds pose a “system risk”—that the risks taken by hedge funds could spread to the broader financial system in the case of a collapse where a hedge fund could not meet its margin calls and found itself unable to repaid money borrowed from banks.
In the course of a speech as NYU Bernanke praised the role hedge funds play in the economy by creating liquidity, taking on risk and engaging in financial innovation. But more importantly he noted that the best way to control systemic risk is by placing the responsibility squarely on the shoulders of hedge fund counterparties. The banks providing credit and trading platforms for hedge funds are not only in the best position to evaluate hedge fund risk, they are also some of the primary beneficiaries of the risk, collecting vast sums in fees and interest from their hedge fund clients.
Of course, many banks would like to pass along the cost of hedge fund regulation to the broader public. They argue that it is unfair that they should have to become regulators of their clients, and even that this might not be possible since it requires them to perform a regulatory role that conflicts with their responsibility to serve their clients. But this a deft verbal jujitsu—more bold than it is true. Banks are not being required to keep watch over their hedge fund clients—because they are not required to have hedge fund clients. The only requirement is that if they are going to collect the coin, then they have to play the tune, to reverse a popular saying.
Hedge-fund oversight doesn't need overhaul [Associated Press in the Charlotte Observer]