Don't Leave the Door Open to Another Financial Crisis

Last Updated Apr 17, 2009 7:17 PM EDT

In his response, Houman Shadab says the problems in financial markets did not originate with hedge funds or CDS contracts. That is true -- the problems arose from people investing in mortgage-backed and other securities that they thought were safe because they had AAA ratings, but which in fact were much more exposed to the risk that the entire system would break down than anyone realized.

People investing in hedge funds or CDS contracts knew, or should have known, that they could lose everything -- that's part of the bargain, after all -- so they should have invested money they could afford to lose. People who invested in AAA-rated securities, however, thought they had made safe choices with their money.

But the fact that hedge funds weren't the culprit this time does not mean that problems could never develop in the hedge fund sector, something Houman's response recognizes. And in this regard, I think we should take two warnings seriously. The first is from MIT's Andrew Lo who says that while hedge fund assets have shrunk by 40 percent, he expects large amounts of money to flow back into them once the crisis ends as pension funds try to make up for losses:
In another six to nine months, these pension funds are going to figure out they need to reallocate to higher yielding investments. And what is that higher yielding investment? ... The only thing that will provide the kind of returns they need ... will be hedge funds, because hedge funds by definition can engage in much more risky investments. Pension funds will ultimately have to take on more risk to generate those returns. ... In about two or three quarters,... we'll see even more assets flow to the industry than ever before.
The second is the warning in my first post from Nobel prize-winning economist Robert Lucas that if we have two sectors, one that is regulated and one that is not, then money will somehow find its way into the unregulated, unprotected sector and end up at risk.

Why we need to be concerned
When the fact that large amounts of pension money are likely to flow into hedge funds in the future and be put at risk is coupled with the fact that many people have little control over how their pension money is invested, at least in the short run, I think there is reason to worry, and a reason to extend regulatory changes to this sector. If institutional investors are going to put money into this sector, then the risks they are taking need to be made much more transparent. We need to monitor the level of risk -- particularly systemic risk -- that these firms take on.

And this brings up my main point, one not confined to hedge funds. We did a very poor job of monitoring the buildup of systemic risk that caused the crash. We hear a lot about institutions that are "too big to fail," but being big, while a problem, isn't the only or most important characteristic to monitor. The interconnectedness of these firms is also essential to track, and a key source of systemic risk. When firms are highly connected, a default by any one of them can lead to problems in many others in a domino-style effect.

Constructing new ways to measure connectedness
To get at this problem, perhaps the work on complexity analysis used in analyzing network connections in fields like physics and computer science can be used to analyze the connectedness of financial firms. The mathematics to do this are already well-developed, and this should be feasible. Both the number and size of the connections would need to be tracked, and a risk index could then be developed.

Then, and this is the regulation part, I would propose developing something like the measures used to assess market or monopoly power discussed here. To determine if a firm is too large and powerful, a measure of its market share is constructed, and if that share crosses a predetermined threshold, further action is pursued by regulators. There's no reason we can't do the same with measures of connectedness among financial firms.

There are other regulatory goals that I believe we should pursue over and above monitoring and reducing systemic risk, such as monitoring levels of leverage, and I hope to get to these in later posts. But for me the degree of connectedness is our biggest blind spot and hence the area most in need of attention. I would urge regulators to do all they can, with proposals like this or in other ways, to monitor and reduce systemic risk in financial markets.

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