Don't Blame All the Shadow Banks

Last Updated Apr 17, 2009 7:16 PM EDT

As almost everyone knows now, the financial world experienced a major earthquake when mortgage-backed securities and other types of structured debt crashed and took down with them or badly damaged the world's largest and most important financial institutions. The earthquake came from banks and insurance companies using the lightly regulated off-balance sheet entities and non-exchange traded financial instruments they controlled and subsidized to take on excessive risks. The result was the creation of large, fragile institutions unable to withstand the nationwide downturn in housing prices.

Yet not all lightly regulated companies and instruments pose the same risks. Hedge funds, for example, did not pose excessive risks to the banks they traded with, and the vast majority of credit default swap derivatives were not written on troubled structured securities. These hedge funds and CDSes did not cause the collapse of financial institutions, but because of their potential to be misused, new rules should ensure that regulated companies use them safely.

Bank regulators should continue to and even increase monitoring of banks' exposure to hedge funds to guard against the potential that banks may lend too much money to hedge funds or be overexposed to the funds as derivatives counterparties. Regulators should also consider limiting the ability of banks to sponsor and manage their own internal hedge funds to guard against depositors' money being put at risk. What they should not be doing is adding to the regulations that already apply to hedge funds.

The deeper problems
Hedge funds and CDSes did not themselves create unmanageable risks. As I noted in my testimony before Congress last November, and as likewise recognized by several New York University financial economists, hedge funds did not initiate the financial crisis. Hedge funds have felt and will continue to feel major pain as a result of the crisis, but their lack of direct involvement in the financial crisis suggests that they're already properly regulated as private investment companies and well governed as limited partnerships. This is reflected in the fact that hedge funds' average use of leverage in recent years was an estimated 3.9 to 1 and was decreasing before the shakeout in the second half of 2008, whereas major U.S. investment banks kept increasing their leverage which ranged from 20 to 1 to as high as 33 to 1 (see this SEC Report, Appendix IX).

The main problem with CDSes, which allow any party to sell protection against credit risks that the buyer may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed security risk in their portfolios. Unmanageable losses from CDSes reflected but did not create the deeper problems in the structured securities owned by banks and the failure of private parties and regulators to diligently supervise that risk.

It was solely AIG's CDSes written on structured mortgage-related securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout this past September, for example. Those CDSes made up only about 10 percent of AIG's total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision, which oversaw AIG, failed to prevent the company's subsidiary from selling too many CDSes. To best prevent the over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit the use of CDSes when sold by insurance companies or their unregulated subsidiaries and affiliates.

It would be a mistake to interpret the financial crisis as having shown that there is a simple relationship between risk and regulation. There is not. The task for policymakers is to make sure that sectors of the economy subject to different types of regulation have healthy relationships and creating a system where private risk management is encouraged and not taken for granted.

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