An "A Ha" Moment for the BIS: Hedge Funds Really ARE Regulated

Shortly after Germany's call for a voluntary hedge fund "code of conduct" was roundly defeated, the BIS released the results of a year-long study indicating that lending practices geared towards hedge funds have slackened. This then prompted the BIS's call for more intensive monitoring of investment banks' portfolio exposures and more stringent risk management practices. From today's Financial Times:

Evidence that action is needed comes in a report from the Basel-based BIS, saying investment banks’ declining financial discipline is making them more vulnerable to future turbulence. It says the underlying problem is that banks are competing fiercely to win business from the hedge fund sector, which has expanded greatly this decade.

Consequently, the BIS warns that regulators may need to press hedge funds and investment banks to reveal more data about their market activities, and relationships. And it urges banks and hedge funds to step up their level of stress-testing, to cope with the accelerating pace of financial innovation in areas such as derivatives.

“There has been some erosion of counter-party discipline [among banks] recently,” warns the report, which was drawn up by the Financial Stability Forum, a committee of international regulators organised by the BIS, and released over the weekend.

It adds: “This complements other signs of complacency about risks in markets . . . such as the weakness of covenants in credit contracts that could impose significant challenges for market participants”.

Hey now, BIS. You are on the right track. Banks lend to hedge funds. Banks are regulated institutions. Banks should be able to provide data indicating their risk management practices and a granular review of their portfolio exposures. In fact, I know that banks are asked to produce this information as I've sat through many of these meetings over the years with various regulators. This is what regulators are supposed to do. Regulate. But in order to do so effectively, they need to ask the right questions. Which means really understanding the industry you are regulating. As I've noted previously, the SEC has been doing a much better job of understanding hedge fund risks over the past five years. Whether banking regulators have been keeping up with the rapid changes in the alternative investment landscape I'm not so sure. But in any event, the opportunity exists to proactively manage systemic risks through the effective monitoring of regulated institutions (read: prime brokers), namely, those which are providing the lion's share of credit for hedge funds.

The other piece of the puzzle is really being on the leading-edge of hedge fund investment practices and strategies. And likely the best way to stay in the information flow is to do what the FSA does, which is to develop dialogues with the largest and most influential hedge funds in their jurisdiction. Rather than providing incentives to be evasive and withholding by virtue of heavy-handed and illogical regulation, the FSA approach encourages the kind of voluntary transparency that the German regulators would like to hit you over the head with. Between having an insider's view of the market through light-touch regulation of hedge funds and the sheer power to impact lending practices through the oversight of banks and prime brokers, the BIS, FSA, SEC et al should be in pretty good shape. And now if they'd just put their heads down and focus on doing this in the best way possible we could get on with it and stop the never-ending tug-of-war across borders and regulatory bodies. This is what would really protect those whom they purport to be protecting - and not simply politicians' jobs.