Commentary: The Wrong Way to Regulate Hedge Funds

Banks bear plenty of blame for the 1998 crisis over Long-Term Capital Management, the overleveraged Greenwich (Conn.) hedge fund. They loaned it too much money, demanded too little collateral, and knew too little about its huge, risky bets. When its collapse jeopardized the world financial system, the Federal Reserve Bank of New York had to broker a $3.6 billion takeover by creditors.

Regulators think they know how to avoid a repeat of the LTCM debacle. Although they don't regulate hedge funds, they think they can discipline them through the banks that supply them with credit. Regulators hope to reduce risk two ways: First, by requiring more disclosure of risks by banks and their clients. Second, by demanding the use of risk controls that force leveraged players to sell assets when prices fall.

But beware the law of unintended consequences. In trying to increase stability, regulators could inadvertently destabilize markets. Market-savvy critics argue that regulators put too much faith in fallible risk-management systems--and don't understand how markets operate in the chaotic periods that put regulatory systems to their ultimate test.

WORK IN PROGRESS. The controversy centers on the proposed new Basel Capital Accord, known as Basel II, which tells commercial banks how much capital they need to back up loans of all kinds. (Investment banks, which also lend to hedge funds, aren't covered.) It was issued last month by an international committee of banking regulators under the chairmanship of New York Fed President William J. McDonough, who was instrumental in brokering LTCM's takeover. The Basel committee is taking public comments until May 31. More than 100 countries, including the U.S., are expected to bring their national rules into compliance with the accord once the final version is issued later this year.

Leading the criticism of the Basel accord is a mild-mannered banker, Avinash D. Persaud, the London-based managing director of global research for Boston's State Street Bank. State Street doesn't lend to hedge funds, and Persaud says he finds hedge-fund operators a bit arrogant. But he believes that efforts to rein them in via their lenders could backfire. And his views are getting attention everywhere from Basel to London to Washington.

Start with disclosure. Some is essential, but Persaud says too much can be dangerous. If lenders know that a hedge fund needs to sell something quickly, they will sell the same asset--driving the price down even faster. Goldman, Sachs & Co. and other counterparties to LTCM did exactly that in 1998. (Goldman admits it was a seller but says it acted honorably and had no confidential information.) Persaud says disclosure would be less destabilizing if borrowers had to disclose their positions only once a month or so. "Disclosure," he says, "must not be a religion."

ON AUTOPILOT. Even more destabilizing, says Persaud, are "value-at-risk" systems that prompt players to sell assets when their portfolio's riskiness hits a trigger level. These systems, required under Basel II, force players to sell into a down market. If only one company used the strategy, it might work. But when everyone uses it, they all try to sell at the same time. Persaud blames value-at-risk systems for exacerbating panics like the Asian contagion of 1997. He should know: State Street Bank is the world's largest custodian of financial assets, so it sees who's trading what and when.

Hedge funds are often operated by contrarians who buy when everyone else is selling or vice versa. But they can't perform that stabilizing function if their banks--following the dictates of value-at-risk models--snatch away loans right when the money is needed most. Persaud says value-at-risk models lead banks to overlend in good times and cut back too drastically when things go sour. He says Basel II, by relying on banks' own risk models, abdicates regulatory responsibility. To him, trusting the banks to calibrate their own risks is "putting the inmates in charge of the asylum." He prefers old-fashioned government supervision that's less concerned with momentary trends in asset prices and more concerned with risky practices--such as having your assets in one currency, your liabilities in another.

Defenders of the Basel II accord say that Persaud exaggerates the dangers and understates the benefits of disclosure and value-at-risk methods. But even they admit he has a point: The International Institute of Finance, a financial-industry group, gave him its first prize last year for an essay called Sending the Herd Off the Cliff Edge. Yes, hedge funds can wreak havoc. But let's make sure the cure isn't worse than the disease.

By Peter Coy

Coy is associate economics editor.

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