{The G-30} Report implicitly assumes that, while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies, and other innovative activities, potentially adding to market efficiency and flexibility.

These institutions do not directly serve the general public and individually are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds, should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure.

Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity and risk management.

I do not believe it would be desirable or feasible to extend capital requirements to institutions such as hedge funds or private equity firms. But supervision has to ensure that counterparty-credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

MALONEY: Given recent news reports about hedge funds having made huge bets against the stock price of Bear Stearns during the week leading up to its collapse and now reports that Iceland is investigating whether certain hedge funds may have played a role in beating down its currency, do you believe there is a need for any new regulatory oversight of hedge funds? And, if so, what type of oversight?      

BERNANKE: Congresswoman, the concerns that you raise and similar ones are examples, if they were true, of course, of market manipulation, which is already the province of the Securities and Exchange Commission and which I am sure will look into these contentions. So I certainly don't have any objection or any problem with enforcement of securities laws and of investor protection in the context of hedge funds.

     It's been remarkable, the hedge funds have been less of a problem than we anticipated in some sense, and we've seen more problem in some other sectors.   So far, one of our main concerns had been that hedge funds that failed would create losses for their counterparties, the major financial institutions.  Thus far, we have not seen any significant losses taken by a major financial institution because of a hedge fund loss or failure. So in that respect, their behavior has not, so far, created risks for our major financial institutions.

From the Q&A session

Again, from the Federal Reserve's perspective, our principal concern is the safety and soundness of the banking system. What we have done recently is worked with other regulators, such as the SEC and the OCC, and in some cases, also with foreign regulators -- the FSA in the U.K., for example, and German and Swiss regulators -- to do what we call horizontal reviews, which is that, collectively, we look at the practices of a large set of institutions -- both commercial banks and investment banks -- to see how they're managing certain types of activities, for example, the financing of leverage buyouts, equity -- bridge equity -- and the like, and trying to make an evaluation of what are best practices, trying to give back information back to the companies and trying to use that -- those reviews to inform our own supervision.

And so we are very aware of these issues from the perspective of the risk-taking by large financial institutions, and we are studying them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance.

The Federal Reserve's supervision of counterparty risk management practices is part of a broader, more comprehensive set of supervisory initiatives. The goal of these initiatives is to assess whether global banks' risk-management practices and financial market infrastructures are sufficiently robust to cope with stresses that could accompany a deterioration of market conditions, including a deterioration that might result from the rapid liquidation of hedge funds' positions.

Thus far, the market-based approach to the regulation of hedge funds seems to have worked well, although many improvements can still be made (Bernanke, 2006). In particular, risk-management techniques have become considerably more sophisticated and comprehensive over the past decade. To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing--nor should it. If hedge funds did not take risks, their social benefits--the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others--would largely disappear.

Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified.

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.  

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

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.

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.

However, I continue to believe, as I did in the aftermath of the LTCM episode, that ensuring sound credit-risk management by the regulated banks and securities firms that are hedge funds' counterparties is the most promising approach to addressing concerns that excessive hedge fund leverage could threaten the financial system.  Some may believe that government regulation of hedge fund leverage would be more effective.  But it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds.  More important, government regulation of hedge funds could undermine the effectiveness of market discipline if counterparties incorrectly assume that government regulation is so effective that it obviates private prudence.