EU funds regulation hits the wrong target

May 5, 2009

REUTERS— Margaret Doyle is a Reuters columnist. The opinions expressed are her own —

If generals have a habit of fighting the last war, regulators are prone to fighting the war that they think they ought to have fought.

So it is in Brussels, where the European Commission last week (April 29) published a proposed directive on Alternative Investment Fund Managers (AIFMs).

Under this regime, AIFMs — chiefly hedge fund managers and private equity groups — would have to register with their home country regulator and provide extensive information on their business plans and activity, including risk controls, valuation metrics, safe-keeping arrangements and reporting systems.


Under the circumstances, this was probably the least that Charlie McCreevy, the Internal Market Commissioner, could do.

The French and Germans have been agitating for hedge fund regulation for years, and the European Parliament had demanded that the Commission bring forward proposals for binding regulation.

The British (aided by the Americans in international forums) have traditionally held out against more onerous financial regulation. However, battered by the credit crisis, they have caved in. Adair Turner, the newish chairman of the Financial Services Authority has called for a “new European institution” to coordinate bank supervision. Alistair Darling, the Chancellor of the Exchequer, then wrote to his fellow finance ministers backing such an endeavour.

While aimed at banks, this represents a softening of approach by the British towards a greater European role in financial regulation. The regulatory impetus has been strengthened by the election of Barack Obama.

At the G20 meetings in London last month, the American president backed calls for stronger regulation of hedge funds. G20 leaders agreed explicitly to oversee “systemically important hedge funds” for the first time.

However, even if this directive is the least that might have been expected given the popular anger against financiers, it should be resisted.


The directive claims worthy aims: improving “macro-prudential” supervision. This means assessing how the risks of individual institutions may interact with and reinforce each other. The Commission also hopes to enhance investor protection, improve accountability and encourage a single market in alternative investments.

However, this directive is not the best way to go about achieving these aims. And with regard to the creation of a single market in investment, it is a retrograde step.

First, the regulators have the wrong target in their sights. Contrary to popular expectation, hedge funds did not cause this financial crisis. Instead, it was investment banks who lent out up to 50 times their equity, leaving themselves exposed to very small deterioration in the quality of those loans.

The EU does not even pretend to think that hedge funds or private equity managers are to blame. Hedge funds were leveraged up by a factor of two before the crisis, less than a 10th of the leverage at most investment banks.

Rather, the Commission acknowledges that hedge funds and private equity were to some extent victims of the credit crunch, saying “recent events have placed severe stress on the sector”.
However, the losses that have arisen from this stress have been taken by private investors in those funds with little or no assistance from governments.

The appropriate response here is then not to interfere with how hedge funds run themselves, but to regulate the prime brokers who sell to hedge funds.

Likewise, the Commission admits that private equity managers “did not contribute to increase macro-prudential risks”.

If this is the case, you might wonder why the Commission is going to the effort of regulating these entities in the first place. McCreevy has resisted previous attempts to regulate hedge funds. And his department goes out of its way to portray the new regulation as minimal.

The Commission will regulate managers and not funds, which will be allowed to remain offshore. Moreover, there will be a threshold of 100 million euros before managers have to register (or 500 million euros if there is no leverage and if funds are locked up for at least 5 years).


However, this ignores a fundamental principle that should underpin any government action: if it ain’t broke, don’t fix it.

The regulators say they are worried about investor protection, but investors in these asset classes are wealthy individuals or institutions.

This is a game for consenting adults. Their losses hurt no one but themselves. And they did not endanger the provision of credit to healthy businesses, as the foolish loans and naïve investments of the banks have done.

Regulators tend to assume away the costs of regulation, but any form-filling or bureaucracy is a hassle and a distraction, especially if it carries with it the threat of criminal sanction or of losing one’s licence.

In London, the hedge fund capital of Europe, managers are already required to prove themselves to be fit and proper persons to get into the investment management business.

Private equity groups are also cleaning up their act. It’s true that they have not been open in the past. However, Britain’s private equity firms — accounting for 57 percent of the European industry — have recently signed up to a new disclosure regime under which they reveal previously-sacrosanct performance data.

London’s hedge fund managers and private equity firms are lobbying hard against the proposals, which they see as another attack on Britain’s prized financial services industry.

They suspect that, at best, their continental cousins fail to understand the true costs of the proposals and, at worst, that this is an attempt to stymie London’s competitive strength.

The regulators contend that this directive will improve the single market. But they are asking alternative fund managers to notify regulators of new markets where they plan to raise money.

This will surely discriminate against investors in smaller markets. Fewer funds will bother with small countries, and investors in those countries will therefore suffer less competition over fees and other terms.

This directive should be thrown out. It is a distraction in itself. But if implemented, it will open the door to further attacks on the competitive financial markets with little benefit in terms of economic stability.

One comment

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I can hardly believe I’m reading this well: “This is a game for consenting adults. Their losses hurt no one but themselves.” Oh yes? Like the investors in CDSes and CDOs and all the alphabet soup of yesterday’s “risk free” finance? They were all consenting adults who were only going to hurt themselves, right, until taxpayers had to bail them all out. Lehman, Bear Stearns, AIGFP, all sophisticated financial players playing a zero sum game?

But what happens exactly when these adult hedge funds start losing big? Don’t they dump securities in plain vanilla markets that affect everybody to make up their losses, because these markets are more liquid? And what about all the pension funds that have been drawn into hedge funds to manage risk and target absolute returns? Is it really going to hurt no one if they lose the funds they are entrusted with?

No regulation is ever perfect. But unfettered deregulation has really worked either to say the least. The pendulum had swung too far in one direction. Now it’s swinging the other way. This is how it works. Trial and error. Not ideological absolutes.

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