The U.S. economy continues to demonstrate extraordinary resilience, no doubt supported by the ability of financial markets to absorb substantial shocks. Financial markets have been buffeted by a number of significant events, including a spate of corporate accounting scandals, the bond rating downgrades of Ford Motor Company and General Motors Corporation to speculative-grade status, the failure of Refco, (at the time the largest broker on the Chicago Mercantile Exchange), and the imposition (and pullback) of capital controls in Thailand. But the effects on broader markets appear to have been remarkably contained. Even the episode last year involving the hedge fund, Amaranth, which accumulated losses of $6 billion in a few short weeks, seemingly had little impact beyond its direct stakeholders.

Our principal focus should ... be not in the search for the capacity to preemptively diffuse conditions of excess leverage or liquidity, but in improving the capacity of the core of the financial system to withstand shocks and on mitigating the impact of those shocks.  And, as always, central banks need to stand prepared to make appropriate monetary policy adjustments if changes in financial conditions would otherwise threaten the achievement of the goals of price stability and sustainable economic growth.  

But other forces have also led central banks and other financial supervisors around the world to increase their emphasis on financial stability. Perhaps most important, the financial system, once essentially bank-centered, has become more market-centered. Of course, banks continue to be core participants in the financial system and to provide an indispensable window on market activities. But the development of a relatively market-oriented system has been accompanied by a large number of new participants, many with global reach, and a much larger array of financial instruments. This vastly expanded web of participants and instruments has increased the number of potential channels for the creation and transmission of financial shocks.

The approach that regulators have taken since the report of the president's working group after the LTCM crisis has been a market-based approach, an indirect regulation approach, whereby we put a lot of weight on good risk management by the counter-parties to the hedge funds, such as the prime dealers, the lenders, as well as the good oversight of the investors, the institutions and so on that invest in hedge funds.

 And we found that that's a very useful way to control leverage and to provide market discipline on those funds.

The original report of the president's working group also suggested disclosures, and that never went anywhere in Congress. And I think part of the problem was it was difficult to agree upon what should be disclosed and what would be useful.

The hedge funds are naturally reluctant to disclose proprietary information about their trading strategies and approaches, and their positions change very quickly, and so therefore position information can be overwhelming and perhaps not very useful. I think it's important to continue to think about hedge funds.

     They certainly play an important role in our financial system. Exactly what a disclosure regime would look like, though, is not yet clear to me how that best would be organized.

So we believe {counterparty risk management} is a very important and, so far, successful method of overseeing hedge funds. I would be very reluctant to get involved in heavy-handed, direct regulation of hedge funds.

They are a very diverse group of institutions. They have a wide variety of strategies, and one of their key characteristics is that they're very nimble. They change very quickly, and that's good for the economy, because they help to create more liquidity in markets. They help to spread risks around more broadly.

From Senate Q&A session

"I don't care if you ride your motorcycle without a helmet," was how Barney Frank, incoming Democratic chairman of the House of Representatives' financial services committee, recently described his attitude to wealthy individuals investing in hedge funds.

From a Financial Times interview

Finally, when innovation occurs outside of the banking industry, regulators' main concern should be with the interactions between the regulated and unregulated sectors. For example, supervisors and institutions have focused heavily in recent years on strengthening counterparty risk management practices and the settlement infrastructures undergirding important new financial markets. As I noted earlier, supervising this boundary requires that regulators broadly understand the activities of the unregulated sector, but perhaps even more important, it also requires regulators to understand how innovations change the ways in which exposures can flow back into the banking sector.

Some observers have viewed the large expansion of hedge funds as a rising danger to financial stability, requiring additional regulation and Fed readiness to intervene. I myself believe the dangers of systemic problems from hedge fund failures are vastly overrated. The hedge fund industry is indeed large but it is also highly diverse and competitive. Many and perhaps most of the large positions taken by individual firms have other hedge funds on the opposite side of the transactions. I trust normal market mechanisms to handle any problems that might arise.

I think we have ample authority today to satisfy the objectives we've been given for supervision regulation. I do think, though, that there's been enough change in the financial system over the last two decades or so, that we have to be prepared occasionally to reassess whether we've got the broad balance right. Whether this overall framework, ... where we have capital base supervision over a diminished and smaller share of the system as a whole, works in delivering the balance between efficiency and stability is so important. That's a judgment that we've got to be prepared to look at over time.

I do think, though, that there's been enough change in the financial system over the last two decades or so, that we have to be prepared occasionally - reassess whether we got the broad balance right. Whether this overall framework we have of supervision regulation where we have capital base supervision over a diminished and smaller share the system as a whole works in delivering the balance between efficiency and stability it's so important. That's a judgment that we've got to be prepared to look at over time. I don't think you can look at the balance today and say it's clearly wrong, it's clearly inadequate, but we may come to the point in the future that we're going to have to revisit that - both the scope and the design of that basic framework.

Hedge funds, private equity funds and other leveraged financial institutions control increasingly large shares of aggregate financial capital and play very active roles in many asset markets and in credit markets. Although assets under management in hedge funds still represent a relatively small share of total financial assets, their relative share has increased significantly and their ability to take on substantial leverage magnifies their potential impact on financial market conditions. These private leveraged funds have become an important source of protection to regulated institutions by being large sellers of credit insurance in the rapidly growing market for credit default swaps.

Experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy. The Working Group's recommendations were aimed, instead, at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.

Authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again.

The more critical role played by hedge funds and other nonbank financial institutions in credit and other markets has the potential to magnify the impact of distress in those institutions on market dynamics and liquidity if counterparty risks are not managed appropriately.

It's important for the Federal Reserve to be aware of what's going on in the market, particularly working through the banks, which are the counter-parties of a lot of hedge funds to understand their strategies and their positions. Nevertheless, broadly speaking, my understanding is that the hedge fund industry has become more sophisticated, more diverse, less leveraged and more flexible in the years since LTCM. So, again, while it's very important to understand that industry and particularly to make sure that the banks are dealing in appropriate ways with hedge funds, my sense is that on net they are a positive force in the American financial system.