In a speech to the Managed Funds Association, the association of hedge funds, Peter J. Wallison, AEI's Arthur Burns Fellow in Financial Policy Studies, reflects on whether the bailout of Bear Stearns will lead to increased government regulation of the financial sector, including hedge funds. He argues that increased regulation is unnecessary--regulation has repeatedly failed to produce stability--and that technology, globalization, and the growing size of the private sector would render most government controls ineffective. Furthermore, the private sector, through market discipline and various risk management devices, can regulate risk more effectively and efficiently than the government.

Arthur F. Burns  Fellow Peter J. Wallison

A major debate is shaping up in Washington, and the future of the hedge fund industry is very much at stake. The fundamental question is whether the government--in the name of promoting stability in the financial markets--is going to assume responsibility for the financial condition of investment banks as it already has assumed for commercial banks. If this happens--and many commentators seem to think it's a foregone conclusion after the Bear Stearns bailout--it will fundamentally reshape and reorder the financial markets. It will also eventually bring the government to the doorstep of every major market player, including hedge funds. Although at first this seems a bit alarmist, there is an unavoidable logic once the initial steps are taken.

If you follow the arguments of those who are seeking more regulation, they begin with the idea that the Bear Stearns bailout was necessary because the world has changed. Investment banks are now so large and interconnected with the rest of the financial economy that the failure of any one of them could cause a systemic collapse.

I'd like to examine this logic. It is certainly true that several investment banks are much larger than they were 15 years ago, but so are commercial banks. The private financial markets have grown enormously since the mid-1990s. The ten largest commercial banks have an average of $1.3 trillion in assets, and the four largest investment banks have an average of $969 billion in assets. This is very significant on one level, since the Federal Reserve only has about $800 billion in assets. In other words, there are now a number of private sector financial institutions that dwarf the world's most important central bank. And the difference is growing. Since 1996, the Fed's assets have grown 88 percent, but the assets of the largest private commercial banks have grown 276 percent, and the assets of the largest investment banks have grown 292 percent.

Size itself, however, is not a reason to fear systemic risk. A systemic event occurs when the failure of one or more institutions has a direct effect on a substantial number of others. This can occur with commercial banks, but it is highly unlikely to occur with investment banks.

The reason for this difference is a key distinction between commercial banks and investment banks. Commercial banks borrow on the basis of their balance sheets; they do not generally collateralize their borrowings. If a large commercial bank fails, its depositors and other creditors suffer immediate losses until the bank can be resolved. This means that the depositors in a large bank (including many other banks) suffer losses that can impair their own financial condition or ability to meet their own payment obligations. The losses and payment failures can cascade down through the banking and payment system, causing a systemic event.

An investment bank is different. It borrows by collateralizing its assets. If an investment bank fails, most if not all its creditors can sell the collateral and reimburse themselves. There are very few losses that create systemic risk. For this reason, it's unlikely that an investment bank--no matter what its size--can create systemic risk as commercial banks do. Investment banks, therefore, if they continue to function as they have in the past, may never be too big to fail.

I'd like to mention in passing that the very size of the private markets in relation to the size of the Fed argues for not loading up the Fed with new discount window responsibilities. There is no reason to assume that the differential in growth between the central bank and the largest private financial institutions will change, so the Fed's resources will continue to shrink in relation to its responsibilities in the years to come. Under these circumstances, the sensible course for policymakers would be to find other ways to address private sector financial risk, instead of regulation. I will come to this subject in moment.  

If size alone is not the source of systemic risk, then the argument comes down to interconnectedness--that Bear Stearns was, and the other large investment banks are, interconnected with other financial institutions in a way that was not true in the past. What is the source of this new interconnectedness? Just about everything that investment banks do today they have done in the past, although their new access to sources of credit through securitization and collateralization of their assets has now made it possible for them to offer commercial loans and prime brokerage services in competition with commercial banks. That function by itself does not increase systemic risk, even if it marginally increases the risk of an investment bank's failure.

But there is in fact something truly new--a relatively recent innovation known as the credit default swap. In notional amount, there are now approximately $62 trillion in credit default swaps outstanding, and this amount is increasing rapidly. Because these instruments are relatively new and are not well understood, they have become the poster child for the proponents of more regulation, and their potential effects are often wildly distorted for this purpose.

A particularly flagrant example of this fear-mongering was a recent article by George Soros in the Financial Times. If you don't mind, I'd like to quote it at length, because it is an example of how credit default swaps are being used to promote more regulation and government control: "There is," Soros wrote, "an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts is roughly $45 trillion. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves…This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed's decision not to allow Bear Stearns to fail."

The article, accordingly, written shortly after the Bear Stearns bailout, attempts to link credit default swaps to the Bear Stearns bailout by suggesting that these instruments have created new risks through interconnections among market counterparties.

I won't go into the details of how the credit default swap works--especially for this sophisticated audience--except to say that this argument completely misstates the risks of credit default swaps and their role in financial markets.

Credit default swaps most closely resemble a surety contract or performance bond. In exchange for a stream of payments, counterparty A promises to protect counterparty B against loss if C defaults on an obligation. If Bear Stearns had been the party issuing the performance bond, its failure would have caused no losses. A loss for the protected party would only have occurred if the underlying obligation had previously defaulted, not when Bear Stearns alone defaults. In that case, Bear's counterparties would simply have gone out and found another bond insurer--another seller of protection through a credit default swap. If, on the other hand, Bear Stearns was the bonded party, a loss would have occurred to the swap counterparty that had written protection on Bear Stearns. But that loss would have occurred to someone anyway. The swap or bond was simply protecting the original Bear Stearns creditor.

The only thing that a credit default swap does is shift a risk from one place to another--just like insurance or a performance bond; it doesn't create any new risks where they didn't already exist. And just as credit default swaps don't create any new risks, they also don't create any additional interconnections. Those interconnections already existed; the swap just moves them from one party to another.

The problem, if any, is what I'll call operational risk--the chaos involved in unwinding a lot of credit default or other swaps or credit relationships. But this is a problem that can be remedied by clearinghouses or exchanges. It certainly doesn't require a new regulatory structure.

I have gone on at some length on this point because I want to make clear how weak a case there is for interconnectedness as the reason Bear Stearns was bailed out in mid-March. And the reason it's important to understand this is that the interconnectedness argument has no logical stopping place. If investment banks--because of supposed "interconnectedness"--must be regulated like commercial banks and given access to the Fed's discount window, then the same thing is going to be true of other large institutional investors, including private equity funds, insurance companies, and, yes, hedge funds.

There are many people in Washington who would like to extend regulation to segments of the financial market that are not yet regulated. The fact that failures among the unregulated hedge funds were neither the cause nor the effect of the current market turmoil has not stopped the effort to impose government controls. The idea that the interconnections in the financial markets might be a source of systemic risk--supposedly demonstrated by the bailout of Bear Stearns--gives these would-be regulators a new theory to work with. It's important for those who understand the implications of this theory to combat the idea that the Bear Stearns bailout demonstrates the necessity for a new regulatory structure.

Unfortunately, the large investment banks themselves may not necessarily oppose new and more intrusive regulation if that is the price of regular access to the Fed's discount window. An article in the Financial Times several weeks ago noted that the heads of these institutions were ambivalent about this question. Government backing can make life much easier--it eliminates competition, eases financing and reduces market discipline--and a little loss of freedom to innovate might be a good trade.

For the rest of us, it is important to recognize that increased regulation itself is a signal to the markets that the government believes it is exposed--through systemic risk--to failure or losses in the regulated industry. Why else would the government be regulating these institutions if it did not believe that it might have to step in and rescue one or more of them in the future?

Unfortunately, the speech last week by Hank Paulson seems to me to have thrown in the towel on this issue. He noted that "We have now learned that a wider range of institutions can potentially threaten the stability of the financial system. It seems clear that in the future the central bank might need to make liquidity available to a broader range of financial institutions under certain extraordinary circumstances."

This, the Secretary noted, requires new regulatory authority for the Fed. As he described it: "authority to intervene to prevent the build-up of conditions that create significant risk to the stability of the financial system." But, he continued, "It is imperative that market participants not have the expectations that lending from the Fed is readily available…The expectation that a regulator will intervene to protect the system must be limited to the greatest extent possible."

With all respect, this cannot be done. There can't be regulation that is preparing for the possibility of a bailout, and still have market discipline. Investors will always see this as implicit government backing. The Secretary's statement, regrettably, is the first major step toward introducing moral hazard into the investment banking business.

Some argue, of course, that the cat's already out of the bag. The bailout of Bear Stearns has already created moral hazard. There is nothing to do now but recognize this fact by regulating investment banks as though market discipline has already been seriously impaired. This could be true, but in a sense it depends on how the history is written.

The real question, in my view, is whether the Fed would have bailed out Bear if the market were not in such turmoil at the time the bailout occurred. In mid-March, the financial markets were seized with panic. If Bear had collapsed there was a danger of chaos--not because of Bear's own inability to meet its obligations, but because institutional investors and governments around the world were already worried about the financial condition of many other financial intermediaries, including the largest commercial banks and investment banks. If Bear had gone into bankruptcy, many of these creditors might have begun pulling their financing from other major institutions, with a nightmare of chaos the result. That's why the deal had to be wrapped up before the markets opened in Asia on Monday morning. The story would have been entirely different if the markets were functioning normally and these worries were contained. Ben Bernanke noted afterward that "Under more robust conditions, we might have come to a different decision about Bear Stearns."

This needs emphasis. The point I think Bernanke was making is that the Bear Stearns bailout was an artifact of conditions in the market at the time--not the result of a conclusion that investment banks are now so large and interconnected that the safety net has to be extended to them in order to fend off a systemic event. The difference between these two interpretations of what happened in the Bear Stearns bailout is very significant. If Bear was bailed out because of market conditions, the same won't happen again with another investment banks until or unless the same conditions prevail in the market.

In my view, the conditions in the credit markets in mid-March--with trading at a virtual standstill and the stability, liquidity and soundness of the world's largest financial institutions in question--are unlikely ever to be repeated. After all, nothing remotely like this has happened in 70 years. Accordingly, the bailout of an investment bank is also highly unlikely ever to occur again, and thus additional regulation is unnecessary.

On the other hand, if the backstory of the bailout is--as many are contending--that investment banks are so large and interconnected with the rest of the financial markets that they can't be allowed to fail, then these institutions may need regular access to the Fed's discount window--and regulation in the same way that we regulate banks would be warranted.

If this is the way the history is written, then the eventual regulation of hedge funds becomes virtually foregone conclusion; they will eventually also turn out to be interconnected with the rest of the market and a source of systemic risk when they grow large enough.

Let me return now to the question of whether traditional financial regulation--in light of the growth of the private sector--continues to make policy sense. I noted earlier that the private financial sector has grown much faster than the Fed's financial resources, and will continue to do so.

Now, I'd like to consider the implications of this extraordinary fact. First of all, the track record of regulators and regulation is far from exemplary. The current turmoil in the credit markets is the result in substantial part of the actions of commercial banks--all of which are heavily regulated. The significance of structured investment vehicles--SIVs--was apparently missed by the regulators, and the banks' underwriting of the risks they were assuming on subprime debt was clearly faulty. In addition, regulation in the past failed to prevent the collapse of the S&Ls at a taxpayer cost of $150 billion. The fact that over 1600 banks failed at the same time shows that it was not simply poor regulation of the S&Ls that was at fault.

Second, technology is driving a globalized financial world in which regulation and regulators are fast losing the ability to control regulated companies. Financial transactions can occur anywhere, including cyberspace. An excessively restrictive regulatory regime, like a high tax environment, will drive financial transactions and financial employment elsewhere. Four recent studies by respected groups--including one by Senator Chuck Schumer and Mayor Michael Bloomberg--have argued that excessive regulatory costs and high litigation risk are driving financial transactions away from the United States.

This phenomenon signals the end of any government's monopoly on regulatory power, and the advent of an international regulatory competition. When the FSA was set up as the financial services regulator in the U.K., one of its missions was to attract financial business to London--something it has done quite successfully. In this environment, the U.S. government no longer has the freedom to regulate that it had in the past.

In addition, the private sector is successfully developing risk management devices that are more effective than government regulation. The first of these was the interest rate swap, which enabled companies to substantially reduce their interest rate risk by matching inflows with outflows. This was followed by the technology of securitization, which enabled financial intermediaries to distribute financial risk globally, and beyond the financial community itself.

Relatively recently, there has been the development of the credit default swap, which permits financial companies to buy and sell specific risks. For example, using a credit default swap, a bank, insurance company or hedge fund can reduce its exposure to a particular industry and increase its exposure to a business that is negatively correlated with the risks it retains.

Regulators and regulation reduce risk by requiring additional capital, suppressing innovation, requiring regulated companies to use prescribed strategies and methods, and assuring that various boxes have been checked. These methods are very blunt instruments, which in many cases have more drawbacks than benefits. The risk-management techniques developed by the private sector are far more effective--and what's more are compatible with an innovative and competitive financial environment.

Finally, there is market discipline--the effect of creditors and investors in reducing risk by pricing it effectively and then following closely the risk-taking and operations of the enterprise. Hedge funds are a prime example of the effectiveness of market discipline. A year ago, Washington rang with calls for gaining regulatory controls over the hedge fund industry. Because it was large, growing and unregulated, it was said to be a financial disaster waiting to happen.

But when the disaster came, it was in the banking industry--the most heavily regulated financial sector. The hedge fund industry, thus far, has remained stable. According to the Wall Street Journal, in this $2 trillion industry there have been only $3.8 billion in closures through March of this year--a remarkable record in what must be the most turbulent year in financial history.

To sum up, those of us who oppose an increase in regulation and an extension of the safety net beyond the banking industry have a fight on our hands in Washington. There is a natural desire there to gain better control of the financial industry. This begins with investment banks after the Bear Stearns bailout, but the theories for doing so--that size or interconnectedness creates systemic risk--could also apply to most other players in the financial world, including hedge funds.

Still, the opponents of regulation have some strong arguments against this drift. There is no evidence that size or interconnectedness were what made the Bear Stearns bailout necessary. Regulation has failed again and again to produce stability. The Fed's shrinking assets in relation to the world's growing financial private sector argues strongly against giving it new stability responsibilities. Because of technology and globalization, governments are losing their ability to control the actions of regulated entities. Finally, the private sector, through market discipline and various private sector risk management devices, turns out to be a more effective regulator of risk than governments.

These points may not be sufficient to beat back the regulatory tide that is flooding in Washington, but I think they give us a fighting chance.

Thanks very much for your attention.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.