.jpg)
The convulsions in our financial markets, and the collateral damage to the real economy, are prompting a review of our financial system. The root cause of our current distress was a combination of overly lax monetary policy and macroeconomic imbalances. These conditions encouraged the build-up of excess leverage in certain Western economies.
As the De Larosière Report, published yesterday, states “Liquidity and low interest rates have been the major underlying factors behind the present crisis, but financial innovation amplified and accelerated the consequences of excess liquidity and rapid credit expansion”.
While our regulation was not the root cause, our financial regulatory and supervisory system aided and abetted the super-bubble. It did not stem the flow of leverage through the financial system. It allowed the emergence of business models based on flimsy and highly leveraged foundations. It tolerated relaxed lending practices and the accumulation of unsustainable debt by households, individuals and companies. It facilitated the gaming of prudential capital requirements. And it has exacerbated the depth of this crisis because of the pro-cyclical effects of some of its key provisions.
But let us be honest with ourselves and – more importantly – with our citizens. We shall not regulate ourselves out of this crisis. Fixing regulation and supervision will not extract us from the present mess. But we must draw the consequences from today’s crisis and take action. On my initiative, the Commission was the first regulatory body in the world to propose that fundamental changes in the originate-to-distribute model be made. We have stipulated that all originators of securitised products must hold a 5% share so as to make sure that they maintain a real interest in the products they originate. We have also proposed stringent due diligence requirements on purchasers of securitised assets. Regulators will be able to impose additional capital penalties for breaches of due diligence. In addition, we have come forward with strong measures to regulate Credit Rating Agencies so as to try to restore credibility and soundness to the rating process, which has become so discredited as a result of their appalling performance in rating securitised assets.
In proposing these and other measures last Autumn to strengthen deposit insurance and capital requirements I have identified perceived weaknesses that needed attention immediately. Likewise for Credit Default Swaps where the industry have now signed up to put these through central clearing in the EU.
We are now at the stage where we need to examine what further measures might be warranted. Our aim is to put the financial system back on a more secure and sustainable footing. And to prevent a recurrence of recent catastrophic events.
Role of hedge funds (and private equity) in the financial crisis
Hedge funds and private equity have become central in this debate. In political terms, this may be understandable. Hedge funds and private equity were the poster-boys of the new finance. They surfed the wave of abundant liquidity and cheap credit. Now as the financial system crumbles, they are easy scapegoats for more deep-rooted problems. Before we rush out to point the finger of blame we should not forget that hedge funds and private equity have not been central to the crisis, and it is not just me that says so.
Let me quote again from the De Larosière Report: “Concerning hedge funds, the Group considers they did not play a major role in the emergence of the crisis. Their role has largely been limited to a transmission function, notably through massive selling of shares and short-selling transactions. We should also recognise that in the EU, unlike the US, the great bulk of hedge fund managers are registered and subject to information requirements. This is the case in particular in the UK, where the largest 30 hedge funds are subject to direct information requirements often obtained on a global basis as well as to indirect monitoring via the prime brokers.”
However, that said and as the report goes on to say there are objective reasons for taking another look at the need for regulation of hedge funds and private equity. As regulators, we have to ask ourselves some tough questions: Did we underestimate some of the risks associated with the break-neck growth of alternative investments? Were we perhaps complacent that existing regulatory and self-regulatory measures covered all the bases? Has the financial crisis revealed unexpected vulnerabilities?
Let's look at the case of hedge funds first. In the past, we regarded hedge fund losses as a matter for the managers and their largely professional or well-to-do investors. We did not consider hedge fund failure as a direct threat to financial stability as long as systemically relevant counterparties held sufficient capital against hedge fund exposures.
Hedge funds don't need to bring down a large bank before they become a source of systemic risk. They can also affect the wider financial system through the direct effects of their trading in the markets where they have become important – and sometimes dominant – traders. In benign conditions, hedge fund trading was a welcome source of liquidity and pricing efficiency. In troubled markets, hedge fund trading has not always been the stabilising force that we expected. Instead, hedge funds have found themselves caught between a rock and a hard place - investor redemptions and tighter leverage have led to forced selling of assets, fuelling price declines. This is forcing us to think about the "systemic-ness" not of individual hedge funds – but of hedge funds in the aggregate.
As far as private equity is concerned, the issues are very different – and have little to do with the financial crisis. Here concerns centre most on the fear that many of the large buy-out transactions have saddled companies with unserviceable levels of debt. And that private equity portfolio companies are now too dependent on hard-to-come-by bank loans – this seems to be a problem faced by many companies, private equity-owned or not. There are also concerns about how private equity funds manage their relations with stakeholders in companies – other investors, work-force – and civil society at large.
Hedge funds. Private equity. Different industries. Different policy concerns. But part of the same political agenda. To extend the scope of regulatory oversight and supervision in order to ensure that all financial activities which are capable of affecting the wider market or real economy are subject to appropriate checks and balances. The direction of travel is clear. However, much remains to be done to find solutions that respond to legitimate concerns – while recognising the useful role that these industries continue to play in our economic system.
Lessons to guide policy action on hedge funds and private equity
I would like to propose six lessons that need to be borne in mind when thinking about any regulatory or legislative initiatives in respect of hedge funds and private equity:
- Any action should make the necessary distinctions between hedge funds, private equity and other forms of alternative investment. When people worry about hedge funds, they worry about the impacts of hedge fund activity on financial stability and the efficiency of our financial markets. When people worry about private equity, their concerns centre on over-gearing of some portfolio companies and the way private equity manages its relations with other stakeholders in those companies. These are very different issues and call for suitably differentiated responses. Any policy intervention needs to be clear about which problems it is trying to fix. It must avoid unfocused actions which impose ineffective and irrelevant provisions on actors.
- Action should build on the already extensive experience with regulation of alternative investment managers and industry in Europe. It is fallacious to talk about European alternative investment as being unregulated or as part of a shadow financial system. European alternative investment managers are already subject to registration and oversight at national level. What we need is a clearer view of how authorities should supervise these entities. How they will use the disclosures given to them by authorised hedge funds and private equity. Until now, there have not been clear answers to these questions. Discussions today may take us one step further towards such an understanding.
- When it comes to thinking about protecting investors in hedge funds and private equity, it must be remembered that these funds raise the bulk of their money from experienced or institutional investors. These investors do not need the types of regulatory protection or disclosure which are designed to protect small household investors. They are well placed to implement their own 'due diligence' when selecting investments. It will nevertheless be important to ensure that they receive the information needed to perform effective due diligence on the funds liquidity and risk management, valuation process as well as on the basic investment proposition.
- Any action should recognise that the first line of defence against undesirable levels of leverage in hedge funds, or excessive lending to private equity managed companies is to limit the flow of credit at source. Not by turning off the tap. But by ensuring that lending institutions manage their exposures to the hedge fund and private equity sector. Smoothly. Much of the present difficulty encountered by hedge funds and private equity portfolio companies stems from the sudden tightening in cash and securities lending.
- Any action should recognise that many of the criticisms and accusations levelled at hedge funds and private equity are not unique to them. For example, short selling is not only used by hedge funds. It is employed by many other participants in financial markets. The difficulties of obtaining new credit are not limited to private equity portfolio companies. They are faced by all companies which rely on debt financing. Those who do not like activist investors should not have a fixation with hedge funds. There are many activist investors – only a few of which are hedge funds. Any policy responses that seek to tackle wider problems by targeting hedge funds and private equity will fail.
- Any action must recognise the highly trans-national character of these industries. Actions taken should ideally be supported by international consensus to the greatest extent possible. First steps in building a common regulatory approach are under way. To be fully effective, action should be implemented in a coherent way across the most important jurisdictions. Information about the systemic impact of hedge funds will be most useful and effective if it is pooled at global level and informs concerted international action.
This does not mean that policy intervention should lack ambition. But it should be proportionate and targeted on clearly identified market failures. The Commission is committed to bringing forward an appropriate legislative initiative which I intend to present to the College before end-April so as to respect the engagement given by President Barroso. This is an ambitious agenda. But thanks to the more than 100 substantive responses to our open consultation and the outcome of today’s discussion, I believe we can find the right approach. The right approach that ensures the necessary level of regulation and oversight whilst at the same time not stifling the investment that our economies need.
Concluding remarks
Ladies and gentlemen,
This conference occurs at a tipping-point in the debate about the policies to be adopted with respect to hedge funds and private equity.
The financial crisis has thrown some issues into sharper relief. It has profoundly altered the economic and political context in which decisions on the regulation of hedge funds and private equity will be made. The ground has shifted in this debate.
Closer, direct regulatory and supervisory oversight of hedge funds and private equity is inevitable. As I said earlier, we need to be careful in designing regulation that is effective – not counterproductive.
It would be wrong to take from today’s conference that the Commission’s response to the financial crisis is all about hedge funds and private equity. Because it is not. Next week the Commission will be adopting a Communication for the Spring European Council which will cover the economic, financial and social aspects of today’s crisis. In regards to financial markets, I will be proposing to the Commission that we include a range of initiatives tackling weaknesses identified. These will include measures to remove unnecessary risk from the system. They will include our intended approach on executive remuneration the aim being to align rewards more closely to longer term benefits to financial companies. I also want to reduce leverage in the financial system as well as continuing with our efforts to improving transparency and managing counterparty risk in complex structured products. I will also bring forward ideas on measures to strengthen depositor protection particularly in Insurance and Securities sector as well as reinforcing general consumer protection.
In framing our response to the crisis, I want to continue to move quickly where this is necessary and justified. At the same time, we need to continue to carefully evaluate and measure any proposals we bring forward Regulation is framed in stone. I want us to get it as right as we can, because undoing it afterwards is well nigh impossible.
That is why this hearing over the next day and a half is an essential contribution to this process.
*************************
I am now happy to welcome Mr Poul Nyrup Rasmussen, former Danish Prime Minister and MEP – author of the EP report on alternative investments. I invited Mr. Rasumssen here today because he has been a constant critic of the role of hedge funds and private equity. I should add he is also very critical of me as well. Even in my home country he took the opportunity at the Irish Labour Party Conference last weekend to launch another attack on me. I am though pleased he is here today since I have not had the opportunity to discuss with him in the European Parliament my approach to financial markets reform. He used to be a regular participant in the Economic and Monetary Affairs Committee but he has missed out on my recent visits to the Committee where I have had the opportunity to set out in more detail our thinking on many of these issues. Even if we will not agree on all details or even some of the actions, I want to assure Mr. Rasmussen that this Commissioner in particular is committed to having robust financial markets and institutions in the European Union that underpin our economic and social well-being. The internal market is facing challenges due to the economic recession. I am convinced that without a properly functioning internal market our emergence from this crisis will be all the slower. I hope in the campaign for the forthcoming election for the European Parliament all the main political parties will continue to defend the integrity of our internal market which is our biggest asset and hope for recovery.
