Shadow Banks Don't Threaten Healthy Banks

Last Updated Apr 17, 2009 7:18 PM EDT

Mark Thoma's third post endorses some important principles, in particular that companies that pose a larger risk to the system should be regulated more closely.

Certainly, all financial companies pose some risk and should be closely watched for fraud or misleading investors, and also be held accountable for manipulating market prices or insider trading. Hedge funds are subject to prohibitions on all these activities just like everyone else, and that's a good thing.

In addition, companies that have the benefit of government safety nets deserve additional scrutiny by regulators since they may potentially draw on taxpayers' money. Hedge funds by contrast, generally just buy and sell stocks and other financial instruments for their own investors, so those concerns do not apply to the funds.

So the question becomes, just how big of a risk do hedge funds pose to the system? I think the best way to answer that question is not in the abstract, but to think of it in context and ask: How big a risk would hedge funds pose if banks were well-regulated? If regulators keep banks stable and sound, as they should be doing anyways, hedge funds would likely not pose a big enough risk to the financial system to warrant greater regulation.

The biggest risk from hedge funds is when they borrow large amounts of money from banks and then make risky investments that go sour, causing big bank losses. Well-regulated banks, however, would make fewer loans than they have in recent years, and that would include extending less short-term financing to hedge funds through bank prime brokers. Well-regulated banks would also demand more collateral from hedge funds when they trade with them as counterparties.

Regulators, in fact, have already made sure that hedge funds won't pose big risks to banks. Even in recent years when the big banks took huge risks to their own demise, they did not go overboard with their investments in hedge funds. Bank prime brokers were well capitalized against hedge fund losses and hedge funds used plenty of collateral when trading derivatives with banks.

In fact, banks posed far more risks to hedge funds than the other way around. Regulators were rightly worried about a Bear Stearns collapse taking some hedge funds down with it. And when Lehman Brothers collapsed, it may have fatally wounded some hedge funds whose assets Lehman froze in bankruptcy.

Furthermore, bank collapses often come quickly and without a lot of warning, but when hedge funds shut down, it is more likely to happen after a slow decline that leaves banks much less vulnerable. Even in the largest hedge fund collapse ever -- Amaranth Advisors losing $4.6 billion during one week in September 2006 -- banks hardly even noticed.

Not everything that banks did in recent years created the financial crisis. Regulators should continue to do those things they were doing right - and indirect oversight over hedge funds through their relationships with banks was one of them.

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