Summary
Stress testing and improvement of corporate governance within banks, not rules for counterparty choice should be strengtheneed in order to make them more resilient, in particular also where it has become clear that they do not adequately assess counterparty risk. Hedge funds are generally efficient capital allocation mechanisms because they are unregulated. Regulating them will lead to such capital allocation mechanisms to migrate to unregulated areas, be they geographical (offshores) or legal (private companies). The crisis has been caused by the overflow of liquidity not allowing for adequate risk reward for fixed income investments. Introducing limitations to capital allocation will exacerbate this problem further to the additional liquidity that is in the market supposedly to combat the crisis.
Analysis
Before the crisis, it was the fashion of the day to neglect symptoms of misbalances, namely the low in interest rates, trade and budget deficits, and one sided flow of investments. Now, it seems that curing symptoms along a non reflected Keynes model seems on the order of the day. What would rather be required are rules for risk allocation. On the one hand, as a result of the crisis and the impact of the Lehman bankruptcy, there is a feeling that the state will save every bigger entity and therefore there is the danger that risk assessment is sloppy. On the other hand, there is a need for providing at least some risk free counterparties because otherwise transaction costs would rise to prohibitive levels. Current reform proposals seem to have the general aim to make the market risk free, which is absurd. In terms of hedge funds, because they are and should be high risk/high rewards entities, this is how they should be treated as counterparties and oversight should be limited to where they have impact on the stability of regulated entitles. Everything other is only likely to add to the lack of clarity that already now is preventing markets from functioning.
