The Financial Times appears to have scooped the Wall Street Journal, Bloomberg, and the New York Times on a Bank of International Settlements report due out today, which says that investment banks are too cozy with hedge funds and that isn’t very good for the financial system. The BIS report calls for greater disclosure of hedge fund positions to investment banks and for more rigorous stress testing by hedge funds.
These findings are a serious matter. Though no regulator is well situated to take on the challenge of coming up with a regulatory regime for dealing with hedge funds, since they operate out of so many domiciles, the BIS, as the central banks’ central banker, has considerable scope and sway, and enjoys the further advantage of being seen as less partisan than national regulators. It will be difficult for the relevant bodies to ignore its report. And the BIS’s recommendations are tough, far more demanding than anything contemplated by the Fed or the Bank of England.
It will be difficult to require hedge funds to do anything, but investment banks are another matter. Hedge funds have always resisted telling their counterparties anything about their positions (the argument is that the firms’ trading desks, which are direct competitors, would use it against them). However, only large, sophisticated financial institutions have both the capital bases and the systems (particularly risk management, reporting, and increasingly fund administration) to be prime brokers to large hedge funds. If the relevant regulators put their heads together (and they are already talking) a consistent regime could be put in place.
So the question is not feasibility, but will. The article acknowledges a reluctance in the US and UK to impose a regulatory burden on funds. This is truly bizarre. The hedge fund industry does not employ many people, many of them are domiciled offshore and pay little in the way of US taxes. So why are they getting kid gloves treatment? If the argument is that they are important to investment bank profits, what good are they as customers if they threaten the health of the financial system? The very fact that a regulator is even weighing the argument of lost profits versus its statutory mandate of safety shows how topsy turvy this world has gotten. Even regulators are cowed by the skewed logic of market ascendency.
From the Financial Times:
Investment banks have become less disciplined in their dealings with hedge funds, the Bank for International Settlements will warn on Monday.
The warning will come as efforts to introduce stronger controls over the hedge fund industry increased over the weekend.
Germany expressed confidence that it could persuade the US and UK to support a self-policing code of conduct for the industry.
Peer Steinbrück, German finance minister, said after meeting colleagues from the Group of Eight industrial nations that Washington and London would support a code that emerged “spontaneously” and “voluntarily” from the industry. This would overcome US and UK scepticism about governments imposing a regulatory burden on funds.
Evidence that action is needed comes in a report from the Basel-based BIS, saying investment banks’ declining financial discipline is making them more vulnerable to future turbulence. It says the underlying problem is that banks are competing fiercely to win business from the hedge fund sector, which has expanded greatly this decade.
Consequently, the BIS warns that regulators may need to press hedge funds and investment banks to reveal more data about their market activities, and relationships. And it urges banks and hedge funds to step up their level of stress-testing, to cope with the accelerating pace of financial innovation in areas such as derivatives.
“There has been some erosion of counter-party discipline [among banks] recently,” warns the report, which was drawn up by the Financial Stability Forum, a committee of international regulators organised by the BIS, and released over the weekend.
It adds: “This complements other signs of complacency about risks in markets . . . such as the weakness of covenants in credit contracts that could impose significant challenges for market participants”.
The report by the FSF marks the first full analysis of the hedge fund industry by this body for several years. The last such report was done at the start of the decade, soon after the implosion of Long Term Capital Management hedge fund.
The report indicates that global policy-makers are becoming concerned by the difficulty of assessing overall market conditions without monitoring the hedge funds, given the increasing role they play.
