Comment: Three early lessons from the sub-prime crisis - a French answer to French criticism

Noël Amenc, professor of finance and director of the Edhec Risk and Asset Management Research Centre, argues that regulators and political leaders such as French President Nicolas Sarkozy are wrong to blame hedge funds for the sub-prime crisis and the contagion that has spread throughout the credit market.

European leaders, eager for an explanation absolving them of responsibility, have once again laid blame on the seemingly detrimental role played by hedge funds in this summer's crisis. This crisis is the result of a sudden fall in asset prices, combined with increased aversion to risk on the part of investors.

To suggest that hedge funds are to blame for this crisis is simplistic but tempting, as their speculative, unregulated and opaque nature make them easy targets - all the while, more delicate market and regulatory issues are avoided. So, as a counterpoint to these accusations that often come from France, it seemed necessary to us to provide a French perspective on the lessons to be learned with respect to financial regulation in France.

Lesson one: hedge funds are not responsible for the current financial crisis
The sharp fall in value and the temporary illiquidity of asset-backed securities, commercial paper secured against high-risk mortgages supplied by sub-prime lenders, has sparked a crisis of confidence that quickly spread to the credit market as a whole, going so far as to affect the market for investment grade corporate bonds.

It is hardly possible to deplore the lack of information about the risk exposure of hedge funds and, at one and the same time, to publish precise data on the asset-backed securities held by these very hedge funds.

Investment in hedge funds makes up less than 5 per cent of total institutional investment, and strategies with high exposure to credit risk account for 20 per cent or less of assets invested in hedge funds, so it is hard to believe that all transfers of credit risk (in 2006, in the US market alone, USD4.6trn worth of securitised debt, derivatives, claim transfers on secondary markets, and other debt instruments was issued) could have been done with hedge funds alone as counterparties.

The problem is that banks, not hedge funds, have been affected by excessive investment in asset-backed securities and in structured credit products that have turned out to be illiquid, and that those banks have thus appeared insolvent to their counterparties in the money market.

So it is the most heavily regulated institutions in the world - institutions whose new capital rules (Basel II) were presented three years ago as the result of reflection on the lessons learned from the financial crises of the previous two decades, especially with respect to credit risk - that have required the intervention of central banks on a massive scale. It is, in any case, hard to imagine central bankers' coming to the rescue of 'speculators' and running the risk of increased moral hazard.

Lesson two: the crisis is linked not to under-regulation but to over-regulation
The use of credit derivatives has been subject to codes of conduct as well as to both domestic and international regulation. So the funds that have symbolised the sub-prime crisis in France are those that respected the rules on the use of credit derivatives put in place in 2003 by the Autorité des Marchés Financiers.

In fact, the crisis of confidence in the financial information reported by lenders was caused by the unexpected halt by a major bank in the valuation, subscription, and redemption of so-called dynamic funds. So it was caused not by unregulated parties or by forbidden or murky practices but by regulation that failed utterly to take into account the major risk of illiquidity that goes along with the default risk traditionally associated with credit instruments.

As it happens, French and European regulations that attempt to define rules for the eligibility of assets and the classification of investment funds are a failed approach to the protection of investors and to the resolution of the problems posed by asymmetric information, goals that justify regulatory intervention.

Regulators would do well to settle for a smaller but more effective role. One possibility, for example, would be for regulators to replace an approach linked to classifications, to enforcement of the rules of risk management, or to the certification of aptitudes for investment in particular financial instruments (credit derivatives, alternative investments, and so on) - an approach that is at best inefficient and at worst deceptive - with requirements for information on the risk factors these funds are exposed to, which would thus facilitate risk analyses as well as the work on classification done by investors and rating agencies. Trying to protect investors from themselves, without the means to do so, is probably the greatest risk of regulation.

Lesson three: regulation in the works will increase the risk of market illiquidity
New accounting standards (IFRS) and insurance industry rules for risk management (Solvency II), which ban volatility and penalise risk-taking, will have two consequences. The 'better' of the two will dissuade investors from taking risks.

From a microeconomic point of view, the assumption is that insurance policyholders will pay far higher premiums in order to continue enjoying current levels of service. From a macroeconomic point of view, this approach will lead to the disappearance of institutional investors capable of taking risks, a phenomenon that will discourage equity capital investment and, more generally, lead to the creation of a rentier economy with disastrous social consequences.

The 'worse' consequence is that the financial industry will attempt to skirt these rules through risky financial engineering. This summer's crisis is but an early warning.

Conclusion
Edhec's brief paper is the first phase in the larger work Edhec plans to do on the crisis in regulation. We believe that by preferring information requirements, codes of conduct, and certificates of aptitude to modest but justified solutions to the problems of information asymmetry encountered by suppliers of financial products and investors, regulatory authorities - having relieved investors of the burden of seeking information on the risks of their investments and fostered an illusion of confidence that reinforces moral hazard - are complicit in the increase of this asymmetry.

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