Improved Systemic Risk Management: How Do Hedge Funds Fit into Current Federal Efforts?
Improved Systemic Risk Management: How Do Hedge Funds Fit into Current Federal Efforts?
Thank you, Glenn, for that introduction. I am happy to be here at Brookings to provide my thoughts on the evolving regulatory environment.
As we aggressively pursue an economic recovery package in Congress, we are also committed overall to substantial reform of the oversight of financial market regulation.
The current economic climate and state of the financial services industry
As you are gathered here today to discuss hedge funds and the future of regulation in this area, we stand amidst a great crisis in our financial markets.
This crisis transcends cratering employment numbers and contracting credit markets and touches on fundamental confidence confidence in our economy, our financial institutions, and our regulators.
The early warning signs started with a Bear Stearns hedge fund in July 2007. Few would have guessed then that less than a year later the firm would disappear as part of a weekend agreement hashed out between the Federal Reserve and JP Morgan Chase.
After that, it only got worse.
All of these losses undercut our sense of financial security. Investors feel it, and the volatility of the markets shows it.
Major causes for these problems
Many of our present challenges can be traced to bad mortgage lending and underwriting, securitization that occurred with little due diligence, and the inability of our financial institutions to manage their risks.
These business lapses were amplified by extraordinary leverage.
Some of the investment banks were leveraged as high as 34 to 1. Leverage at the Bear Stearns hedge funds was reported to go as high as 60 to 1 on some deals.
As a Forbes article pointed out, " in rocky times, this kind of leverage can sink the ship in no time at all." In fact, that is what happened.
We also know that complexity in the markets contributed to the problem.
The ingenuity of financial engineering in an environment of low interest rates and high leverage outstripped the ability of our markets and our regulators when the housing bubble burst.
These failures have made one thing clear:
The markets that once were a source of security for investors and for the American economy have now become a source of anxiety.
Role of hedge funds
While we can point to many problems, we must acknowledge the important role that private pools of capital such as hedge funds have played.
When others had no capital or funding, it was hedge funds that were providing liquidity in certain markets.
It is also clear that many hedge fund managers have been adept at identifying market trends early and accurately.
As we discuss the need for more oversight of hedge funds, and talk about the problems in the economy, it is with awareness of the contribution these funds have made to robust capital markets and capital formation.
A crisis of confidence in our regulators
The problems have not only been with the private sector.
Regulators have not provided necessary and effective oversight, in part because of the outdated regulatory structure.
For securities, much of this regulatory structure was created in response to the Great Depression. Our country's leaders then had the foresight to see that there was a need to prevent the return of such economic devastation to our country.
But the last two years have taught us hard lessons about the present effectiveness of regulatory oversight.
Many of the failed or currently struggling institutions were under direct supervision of our regulatory agencies. For example:
The Federal Reserve did not see in advance, or act upon, insights it gained from overseeing bank holding companies
The SEC did not effectively oversee investment banks, and that program ended in failure
The Office of Thrift Supervision (OTS) failed in its holding company oversight. The examples of AIG, Washington Mutual, and Wachovia provide ample evidence
But, there were also other areas of potential systemic risk that were beyond the scrutiny of regulators and demonstrates why we need entity-based regulation as well as product-based regulation.
One market that has been of concern to me is over-the-counter credit derivatives, particularly the growing market in credit default swaps.
Last July I held a hearing on this topic and invited all of the regulators to discuss their authority.
The general response was that they had no direct oversight of Credit Default Swaps but they could manage these risks indirectly by overseeing the regulated entities that trade Credit Default Swaps.
They also said they had plenty of information to monitor the markets.
Three months later, I heard a different story. Then-SEC Chairman Cox was asking for explicit authority from Congress to oversee this market. Regulators suddenly awoke to the need to have visibility into the risks that have accumulated in a market estimated at over $50 trillion in notional value.
The latest news is that we are in a regulatory approval holding pattern on establishing a clearinghouse for these products.
At the very least, I believe that we need a central clearing mechanismwith strong risk management systemsto reduce counterparty risks and absorb unanticipated shocks to the market.
I am looking forward to seeing movement on this front very soon.
This is just one example of an area that has received little oversight and no direct regulation.
Need for Regulatory Reform
Today, the American people are demanding significant regulatory reform. As our new President stated at his inaugural address, our challenges "will not be met easily or in a short span of time but they will be met." And this commitment applies particularly to regulatory reform.
I want to just outline for you a few reform ideas I have before talking more directly about hedge funds.
Enhancing the Regulatory Structure
Last week the Banking Committee held the first in what will be a series of hearings on reforming the regulatory structure in the United States.
At this moment, Congress is considering many ideas on reforming our system to be more proactive in addressing emerging crises. The failures of our financial regulators point to the need for significant change.
On the Subcommittee for Securities, Insurance, and Investmentwhich I chairI hope to start with the SEC.
I plan to hold a series of hearingswith a range of stakeholders and expertsreviewing the SEC from top to bottom, to see where we need to make improvements, including how to deploy additional resources.
Credit Rating Agency Reform
One area of obvious concern is the proper oversight of credit rating agencies, which in the past year saw unprecedented failures in the accuracies of their ratings.
Though the SEC recently issued new rules to address some of these failures, I do not see these rules as going far enough. Congress will be considering the implementation of these new rules and whether further action might be necessary.
Domestic and International Regulatory Arbitrage
With regard to institutional supervision of financial institutions, appropriate reform means treating similar institutions in similar ways. Our current regulatory system does not always do this.
As a result, regulatory arbitrage continues to be a source of concern in our markets. Reducing the many banking-related charters, at least at the federal level, will ensure that we reduce the gaps and regulatory arbitrage that have contributed to our economic problems.
Just as we attempt to remove regulatory arbitrage domestically, it is critical that we remove opportunities for international regulatory arbitrage.
One example of this is accounting standards.
We need to be more deliberate in converging accounting standards to International Financial Reporting Standards, or IFRS. Any convergence must be to a high common standard and should not misleadingly suggest a global uniformity that we have not yet achieved.
Future Oversight of Under- and Un-Regulated Markets
As I noted in the beginning of my remarks, throughout this crisis we have faced challenges posed by new financial products and unregulated markets.
These are in some cases emerging markets but also at times markets that have been deliberately left untouched, such as over-the-counter credit derivatives.
We must provide our regulators with visibility into those areas that pose systemic risks to our economy. These risks include:
Products that currently are not regulated, such as OTC credit derivatives;
Markets lacking transparency, such as dark pools, and
Institutions that do not have formal, structured oversight, such as hedge funds
Future Oversight for Hedge Funds
Hedge funds currently lack a comprehensive form of required prudential oversight. At the moment, the SEC relies on a voluntary registration system.
The SEC attempted to mandate hedge fund advisor registration by rule, but that rule was struck down by a federal district court in 2006, after being in effect for about 7 months. The SEC declined to appeal, unwilling to press the issue.
Because of this decision, some hedge fund advisors withdrew their registration, but about 1800 still remain registered with the SEC.
Consequently, oversight remains voluntary and does not provide the SEC with the necessary tools.
From the beginning, this registration program was envisioned as "light touch." It provided a little more visibility into the hedge fund world, but nothing comprehensive.
Such indirect, voluntary, light-touch regulatory approaches were the recurring theme with the Bush administration.
But, in the present crisis, these themes are no longer compelling.
Oversight for Hedge Funds
Because of the problems brought on by excessive leverage, poorly understood complex financial products, and failures in risk management, many are concerned about whether regulatory gaps are leading to buildups in risk that can then prompt systemic failures.
As the Group of 30 report notes, the current approach to hedge fund oversightbased largely on market discipline and indirect oversight through regulated entitiesis not adequate.
The G-30 report also concludes that hedge funds posing risks that are "potentially systemically significant," should have standards set by a prudential regulator "to establish appropriate standards for capital, liquidity, and risk management."
This conclusion represents an emerging consensus that I share.
However, how these standards are set, and how they are monitored, remains to be determined. In fact, that is part of why all of you are here, to discuss issues such as these. We in Congress look forward to receiving your advice as we address a range of questions:
Which federal agency or agencies should have oversight over hedge funds?
What kind of information should be reviewed by the regulators?
o For example, would they look at real-time position information or concentration risks with counterparties, industries, asset classes, etc.?
What size hedge fund should require oversight and what extent of oversight should be applied based on that size?
o I recognize that the ability to redeploy capital in innovative ways is important to our economy and if losses can be effectively absorbed by private parties they do not pose systemic problems
To what extent should leverage be reviewed and in some cases constrained?
o How can the regulators best measure this and how can they measure the embedded leverage that certain financial products contain?
What is the nature of the risks in various business models and strategies that these funds use?
o Again, I recognize that proprietary information is sensitive; however, financial institutions provide such information to regulators regularly, and this information is kept confidential.
Should structures of corporate governance be reviewed, to ensure that the interests of investors are taken into consideration?
How might feeder fund activities be evaluated, particularly in reviewing the due diligence that such funds conduct on behalf of investors?
Finally, how can hedge funds improve transparency on the information they provide to potential and current investors regarding their investment strategies?
o Information disclosed in private placement and offering memorandums, which are provided to potential hedge fund investors, have been found in some cases to be incomplete, inaccurate, or outdated.
Once we answer these questions, we need to ensure that regulators have the right resources and authority to prevent systemic problems.
Let me make a few final points.
Many may reject the idea of regulation because "sophisticated investors" are involved, but we can see that many of these investors have found themselves more exposed than they probably anticipated.
I understand that markets should rest on individual decisions. However, when those decisions collectively endanger the broader economy, we must consider whether this concept of the "sophisticated investor" is sufficient justification for avoiding oversight and regulation.
Also, implementing hedge fund oversight changes in accord with foreign regulators will be key to successfully overseeing systemic risks.
The G-30 reports acknowledgment of the need for prudential supervision of systemically important private pools of capital represents an encouraging international appreciation of the problem.
The implementation, however, will need to be carefully managed by regulators to prevent regulatory arbitrage and flight of capital to lightly regulated jurisdictions.
Conclusion
With all of that said, we are all interested in a vibrant American economy, and in innovative financial institutions, such as hedge funds, that provide liquidity and much-needed capital.
All of you are a part of contributing to effective and efficient reform and the restoration of confidence in our financial markets.
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