Systemic Risk

The WSJ reports that dems seek to regulate VCs out of fear that Hedge Funds might otherwise avoid the yoke of regulation by labelling themselves VCs. Hedge Funds, of course, must be regulated in the name of "Systemic Risk". As a stress tested matter of fact, they actually pose little such.

The most common notion of systemic risk is: the risks imposed by interdependencies in a system/market, where the failure of a single entity can bring down the entire system/market.

This is simply not true of most Hedge Funds. There have been many notable blow-ups with only one -- LTCM -- raising the spectre of systemic risk. And, as described in a previous post, in any reasonable frame, the systemic risk posed by the LTCM collapse had far more to do with reckless (despite being regulated) banks then the fund. In the current crisis, while Hedge Funds are hemorrhaging capital, only those owned by banks have received Government support.

As a software developer, I tend to see systemic risk, in the sense above, as one type of, for lack of a better term: "structural risk". By which I mean: bad architecture; A system designed, or structured, in such a way that it will more often than not produce bad outcomes.

To take an example from my undergrad EE, imagine a chain of Christmas lights designed such that if any one bulb died, all bulbs follow. Such a chain would not long last. Re-architecting the chain to decouple a bulb's life from its neighbor's would be a far more sensible strategy then adding intrusive and expansive monitoring and micro-control on top of the flawed design. Which, if you are following the analogy, is what financial regulators -- eschewing the simpler "too big to fail is too big" -- seem to have in mind.

Large public banks fundementally pose "Structural Risk" in that their behavior is dominated by agency costs. Public shareholders are almost guarranteed to be absent and incapable owners. Banks are not subject to meaningful market discipline (which would be a structural check on agency risk) both because (a) their biggest clients are large institutional investors (eg: pension funds) who themselves personify agency risk and FDIC insured account holders who, as such, are more concerned with cheap promotions then sound operation, and (b) being too big to fail they operate in the market with implicit Government guarrantees. Given this environment, large public banks can be expected to, more often then not, behave irresponsibly. This is not true of most Hedge Funds which tend to be managed by expert owners, with, historically, wealthy individual or family office clients and, of course, no Government backstop.

Which is all to say that, while it is reasonable to tightly regulate exceptionally large funds, funds owned by banks and funds who manage a meaningful amount of institutional money, there is little reason to regulate most funds. The push for unnecessarily expansive regulation is especially unseemly given the far weaker push for meaningfully re-designing regulation controlling those companies most directly responsible for the current mess -- Fannie Mae, Freddie Mac, the credit rating agencies, the large banks, etc -- all of whose behavior was strongly influenced by existing regulation.

A cynic might note that more regulated companies make better donors and are more responsive to the desires of government officials. Perhaps the ultimate structural risk is having racketeers at the top of the food chain.