Editor Pick – Hedge Funds’ Role in the Current Credit Crisis
Three Early Lessons from the Subprime Lending Crisis: a French Answer to President Sarkozy
Noël Amenc / EDHEC
Lesson one: hedge funds are not responsible for the current financial crisis.
The problem is that banks, not hedge funds,
have been affected by excessive investment in
asset-backed securities and in structured credit
products that have turned out to be illiquid and
that those banks have thus appeared insolvent
to their counterparties in the money market. So
it is the most heavily regulated institutions in
the world–institutions whose new capital rules
(Basel 2) were presented three years ago as the
result of reflection on the lessons learned from
the financial crises of the previous two decades,
especially with respect to credit risk—that have
required the intervention of central banks on a
massive scale.
Lesson two: the crisis is linked not to underregulation but to over-regulation.
French and European regulations
that attempt to define rules for the eligibility
of assets and the classification of investment
funds are a failed approach to the protection of
investors and to the resolution of the problems
posed by asymmetric information, goals that
justify regulatory intervention.
One possibility, for example, would
be for regulators to replace an approach linked
to classifications, to enforcement of the rules
of risk management, or to the certification of
aptitudes for investment in particular financial
instruments (credit derivatives, alternative
investments, and so on)—an approach that is at
best inefficient and at worst deceptive—with
requirements for information on the risk factors
these funds are exposed to, requirements that
would thus facilitate the risk analyses as well
as the work on classification done by investors
and rating agencies.
Lesson three: regulation in the works will increase the risk of market illiquidity.
New accounting standards (IFRS) and insurance industry
rules for risk management (Solvency II),
which ban volatility and penalise risk-taking, will
have two consequences.
From a microeconomic point
of view, the assumption is that insurance
policyholders will pay far higher premiums in
order to continue enjoying current levels of
service. From a macroeconomic point of view,
this approach will lead to the disappearance of
institutional investors capable of taking risks,
The “worse” consequence is that the financial
industry will attempt to skirt these rules through
risky financial engineering. This summer’s crisis is
but an early warning.
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