Treasury: Banks Should Rule Hedge Funds

Rather than trying to add to their own power, regulators are focusing on boosting banks' ability to discipline the funds.

Federal regulators don’t feel they need any more power in their efforts to protect investors in hedge funds and guard against risks to the global financial system spawned by the lightly regulated funds, a U.S Treasury Assistant Secretary told hedge-fund managers Tuesday.

Instead, Treasury Secretary Henry Paulson and the President’s Working Group on Financial Markets (PWG) he chairs want to boost “market discipline” to rein in hedge-fund excesses, says U.S. Treasury Assistant Secretary for Financial Markets Anthony Ryan. By market discipline, the rule-makers mean the ability of banks to tighten lending terms on hedge funds if their reporting is overly opaque or their investment strategy is too risky.

Speaking at the World Hedge Fund Forum in Greenwich, Conn., Ryan asserted that if the perils posed by the funds could be easily managed by giving the regulators more clout, they would have definitely asked for it. “The fact of the matter is–at this time, no regulator feels that it needs additional regulatory authority to achieve its goals of protecting investors or mitigating systemic risk,” he said.

Two weeks ago, the PWG, which consists of the chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, released an agreement outlining its views on private pools of capital, including hedge funds. The most effective way to curb systemic risk is market discipline, according to the agreement. The best way to guard investors is a combination of market discipline and regulatory policies, the PWG added.

The regulators’ stress on market discipline stems from the close correlation of their interests and those of the banks, according to Ryan. “Thus, when these counterparties make appropriate self-interested assessments and decisions, these decisions help to make our system more stable and resilient,” he said.

The Treasury official defined the key hedge-fund counterparties as investment banks with big brokerage operations and commercial banks that provide derivatives and repo loans to the funds. “While relatively few in number, these entities facilitate the implementation of many of the hedge fund managers’ strategies and provide the capital that enable managers to leverage their exposures,” he said. “All of this adds up to not only the possibility for greater financial rewards, but also potential risks.”

Similarly, the PWG feels that fiduciaries in charge of pension plans and other institutional investors in hedge funds are in the best position to protect the less sophisticated investors who participate in the investment plans, according to Ryan.

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