Economist's View: Hedge Fund Worries

リンク: Economist's View: Hedge Fund Worries.

September 15, 2006

Hedge Fund Worries

New York Fed president Tim Geithner is worried that market failures such as "lack of information, incentive conflicts and moral hazard" are causing risk levels in hedge fund markets to grow and, if the growth of risk continues, increased regulation of the markets may be required. He's cautious because, "With too much government intervention, innovation is constrained and the system is stifled." However, "With too little, the probability of systemic crisis may rise to levels that are unacceptably high":

NY Fed chief warns on hedge funds, by David Wighton and Peter Thal Larsen, Financial Times: Hedge funds may need to be regulated because of the increasing risk they could pose to the financial system, according to the head of the New York Federal Reserve... Geithner ... said supervision of core banks and investment banks had encouraged the transfer of risk to unregulated institutions such as hedge funds.

Their growth was now increasing the risk that if they ran into problems, it could damage the regulated core. ... Mr Geithner said that, for the moment, regulators should continue to focus on encouraging the banks and brokers that lend to hedge funds to improve their “counterparty discipline” of the funds.

But, over time, the growth in hedge funds “will force us to consider how to adapt the design and scope of the supervisory framework to achieve the protection against systemic risk that is so important to economic growth and stability.” ...

Mr Geithner ... [said] ... the ... effectiveness of this market discipline may be compromised by “market failures” such as lack of information, incentive conflicts and moral hazard. “Supervision and regulation have the potential to help mitigate these sources of market failure,” he said.

We don't know enough about these markets, particularly their vulnerability to large shocks.

Posted by Mark Thoma on September 15, 2006 at 12:09 AM in Economics, Fed Speeches, Financial System | Permalink

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Comments

I have said before, that there is something else that worries me about hedge funds. They are a misuse of limited liability. They allow rich individuals to limit their exposure to very risky leveraged positions.

Posted by: reason | Sep 15, 2006 2:50:01 AM

One thing I should add, this misuse of the limited liability status is not limited to hedge funds. Enron was another example - or is it. Maybe Enron was just another hedge fund after all.-) Limited liability companies shouldn't make highly leveraged bets full stop.

Posted by: reason | Sep 15, 2006 2:56:00 AM

"We don't know enough about these markets, particularly their vulnerability to large shocks."

I guess we know about traditional banks and their vulnerability to large shocks. Or do we?

Posted by: a | Sep 15, 2006 4:01:52 AM

Concurring strongly with reason's point above, limited liability investment funds have every incentive to take on leverage recklessly, so long as they can find a counterparty foolish enough to lend the money. (More here)

In an era where huge funds of money are lent by the official sector for reasons other than maximizing direct return, and where the most foolish lender sets the price of securitized credit, economists should not be surprised when fund managers respond rationally by making large gambles with other people's money. This applies both to much maligned hedge-funds, as well as to often lionized private equity.

I prefer changes in market structure and technology to regulation, but the problem seems to me quite real.

Posted by: Steve Waldman | Sep 15, 2006 4:30:18 AM