Conclusion

Hedge funds, private equity funds, and innovative financial products have each raised significant concerns about financial stability and the need for increased surveillance and regulation. Hedge funds have figured prominently in this regard, due to their light regulation, lack of disclosure, high leverage, and rapid turnover of portfolios. There were often concerns about both direct losses of core institutions on counterparty (trading) exposures to hedge funds and indirect losses on banks' trading positions caused by forced liquidation of hedge funds' positions. Since private equity funds have very illiquid portfolios, concerns about them focused on banks' potential direct losses.

However, most assessments of the origins of the current global financial crisis conclude that highly leveraged funds did not play a significant role. This is no doubt partly because their leverage was lower than often assumed, typically ranging between one and two times their equity capital. It was only the forced selling of hedge fund assets due to redemptions that aggravated market declines later on, and this phenomenon was hardly limited to hedge funds. Instead, the main sources of instability were found in the highly regulated banking sector, where leverage was sometimes far higher. Therefore, most assessments focus on the need to increase surveillance of hedge funds and other lightly regulated entities, and to maintain dialogues with major hedge funds, although there are increased calls for regulation of systemically important hedge funds.

Concerns about innovative financial products, especially derivative products such as credit default swaps and assetbacked securities, center on the need for standards in the origination, distribution, and trading of such products, as well as their capital requirements. In the case of CDS, the market has functioned more or less as expected, and losses associated with major credit events such as the bankruptcy of Lehman Brothers have turned out to be much smaller than implied by gross notional exposure levels. Proposals for reform center on standardizing contracts to facilitate trade compression and thereby minimize net exposure, and on moving over-the-counter transactions onto standardized exchanges in order to increase transparency. Capital requirements related to such contracts also need to be strengthened.

The problems are much greater with ABS, where markets remain frozen due to uncertainties about valuation and the implications of market-clearing prices for bank capital. Regulated banks, with their originate-to-distribute model, lie at the center of the production process for derivative products. A resolution of the valuation problem of asset-backed securities is a prerequisite for restoring the capital adequacy of the bank sector and restarting the lending process. Monitoring and regulation of the origination, distribution, and trading of such products needs to be strengthened, and capital requirements need to be increased.

The toxic effects of the combination of the originate-to-distribute banking model and the reliance on sophisticated but opaque financial instruments highlighted widespread failures in regulatory coverage, the Basel II capital adequacy standards, international regulatory cooperation, corporate governance, management incentives, risk management practices, accounting standards, and the behavior of regulators and credit rating agencies. These issues all need to be addressed as part of the shift to an improved global financial architecture. Regulatory gaps need to be closed, including those at the international level, and the Basel II capital adequacy rules need to be reviewed and strengthened. The education of all participants, including directors, management, regulators, accountants, and credit rating agencies, needs to be strengthened as well.

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