Getting in Front of the Next Crisis Requires Broad-Based Regulation

Last Updated Apr 17, 2009 7:17 PM EDT

In his rebuttal to my suggestion that we need broad regulation applied to all financial institutions that implicitly or explicitly function as banks, Houman says that I seem to assume "that all members of the shadow banking system are equally risky."

If I gave that impression, I didn't mean to. The level of regulation a firm or industry faces should match the size of the underlying threat. And for me, that means powerful firms need to be met with more powerful regulators -- or, even better, that these firms need to have limits on how large and powerful they can become.

Where we differ, I think, is in assessing the threat that hedge funds might pose in the future. As I've noted previously, continuing to allow some sectors such as hedge funds to operate without transparency and oversight opens a door that can be used to bypass new regulations in other sectors. Since this sector may well become much larger, and because of past close calls such as the near-catastrophic failure of Long-Term Capital Management, there's no shortage of reasons to regulate hedge funds more thoroughly.

Instead of being one step behind as they have in the past, regulators need to be one step ahead, to the extent possible. This will help prevent risk from building up to levels that can threaten the overall economy, while protecting pension and other funds from potential losses due to unexpected risks.

Complacency won't be a problem
Houman's second point is that measuring hedge funds' liquidity risk would be too burdensome, and therefore we shouldn't expect regulators to do a very good job of it. In addition, he suggests that even if regulators could monitor and regulate risk successfully, firms would grow complacent about the risks they undertake because they'll expect regulations to protect them.

Measuring risk may be burdensome, but given what's at stake, I don't think that's a reason to give up. I hope that after the current experience policymakers will monitor risk a whole lot more diligently than they have been. Furthermore, it's probably enough to look at the level of systemic risk in particular sectors or subsectors, which should be easier than trying to measure it at the company level. If the risk appears headed into the danger zone, then we have the opportunity to head it off at the pass.

All that said, we could certainly use more and better diagnostic measures of risk accumulation. But the current crisis seems likely to spur development of the measurements we need to monitor risk accumulations more effectively than we have in the past.

Finally, I suspect the failure of regulation to prevent our current crisis will lead firms to keep an eye their own risk even more closely. In the case of hedge funds and similar outfits, though, it's unclear how investors can get a handle on their own risks if the funds continue to operate without the transparency needed to fully assess their potential for losses. And that's another important reason to consider imposing regulation on these firms.

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