Why Too Much Regulation <em>Increases</em> Risk

Last Updated Apr 17, 2009 7:17 PM EDT

Mark Thoma makes the case for improving regulation by subjecting all financial companies, including those that are a part of the so-called "shadow banking" sector such as hedge funds and private equity firms, to the same regulatory framework applicable to the traditional banking sector. By contrast, I argued that the main problem is not the scope of regulation but rather making sure that regulated companies like banks do not take on excessive risks through their relationships with lightly regulated entities like hedge funds or by using instruments such as derivatives. Mark seems to recognize that even if all financial firms were under the same regulatory umbrella, a fundamental problem would still be ensuring that companies do not find ways to wriggle out of regulations.

Mark also seems to assume that all members of the shadow banking system are equally risky. But they are not. Only some members of the shadow banking sector-most especially those controlled or subsidized by regulated institutions-created the risks that eventually resulted in the financial crisis. In fact, some shadow banking members have reduced those risks or mitigated losses to investors. In particular, hedge funds lost a comparatively much smaller amount for their investors than did the overall stock market. As noted in a report by Credit Suisse, in 2008 global stocks lost 42 percent of their value while hedge funds worldwide lost a comparatively smaller 19 percent for their investors and did so with lower monthly volatility.

Hedge funds also brought much-needed liquidity to markets with thinly traded financial instruments. Although it is not clear what it would mean to bring in hedge funds under the scope of traditional banking regulation, these benefits would probably not be possible if hedge funds were subject to the same restrictions as regulated mutual funds on their use of leverage, derivatives, and short-selling.

The Feds can't actually regulate hedge funds

A second problem with attempts at comprehensive bank-like regulation of hedge funds is the more practical issue of making those rules effective. Because governmental officials have limited resources and financial expertise, bringing hedge funds under the direct oversight of federal regulators may simply be too burdensome. It could also lead parties to become more complacent about risk. In a May 2006 speech, Federal Reserve Chairman Ben Bernanke explained these problems when he commented on a proposal for federal regulators to monitor hedge fund liquidity risk directly:
To measure liquidity risks accurately, the authorities would need data from all major financial market participants, not just hedge funds. As a practical matter, could the authorities collect such an enormous quantity of highly sensitive information in sufficient detail and with sufficient frequency (daily, at least) to be effectively informed about liquidity risk in particular market segments? How would the authorities use the information?... Perhaps most important, would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds' risk-taking? A risk of any prescriptive regulatory regime is that, by creating moral hazard in the marketplace, it leaves the system less rather than more stable.
One lesson that the financial crisis should have taught us are the dangers of relying on federal regulators and other third parties such as credit rating agencies to monitor the risks that market participants should investigate and monitor themselves. Given the failures of governmental oversight and private risk-management that helped lead to the financial crisis, we should be extremely wary of any government proposals to also oversee hedge funds and other nonbank firms.

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