“The riskiest loans are outside the banking system.” Regulators fear hedge funds could trigger the next financial crisis.


In the aftermath of the 2008 financial crisis, regulators closely monitored America’s largest banks, subjecting them to regular stress tests and imposing new rules designed to keep them safe during times of financial turbulence.

These new rules may have made the banking system safer, experts say, but they have also fueled the growth of a shadow financial system that provides a growing share of financing to American businesses and takes on new risks that are difficult to measure in treat him.

“The riskiest loans right now are outside the banking system,” Christina Padgett, head of leveraged finance research at Moody’s Investors Service, told MarketWatch.

Policymakers are taking note. Gary Gensler, Chairman of the Securities and Exchange Commission noted earlier this month that the private fund industry – including hedge funds, private equity funds and private credit funds – has grown 150% since 2011, and that the strategies of these funds have “evolved in terms of business practices , complexity of fund structures, investment strategies and exposures.”

These trends were the motivation behind a january rule SEC proposal and a joint proposal earlier this month with the Commodity Futures Trading Commission to expand the types of information private fund advisers must report to regulators and to increase the frequency of reporting through a revised disclosure document known as Form PF.

The Financial Stability Supervisory Board – a body made up of the heads of the major US financial regulators responsible for detecting systemic risks to the US economy – has also seen fit to highlight the growing importance of private funds in its most recent annual report.

The FSOC pointed to rapid growth in private equity in particular, as the industry’s gross asset value reached $8.3 trillion in the last quarter of 2021 – the most recent data available – up 118 % over five years.

The regulator also expressed concern about concentration in the private equity industry and the growing trend of private equity managers extending credit to private companies, helping to double the global private debt market to 1,000 billion dollars between 2015 and 2020.

According to Mark Wasden, Padgett’s colleague at Moody’s, there are restrictions on lending from a private credit arm to companies owned by a private equity arm of the same asset manager. But the concentrated nature of the private equity industry and regulators’ lack of knowledge about these markets still raise concerns, he said.

“Our concern is that you find pockets of risk accumulation that escape the sight of regulators and are not even observable by many market participants until it is too late,” Wasden said.

Treasury market turmoil

Stress in the US government debt market is another reason financial regulators say more data is needed on the activities of private funds.

In a statement from February on the role of non-bank financial institutions on financial stability, the FSOC said that hedge funds “contributed significantly to the disruption of the Treasury market” during the March 2020 COVID-induced market crisis.

The FSOC said hedge funds were the main sellers of US government debt TMUBMUSD10Y,
during this period, when liquidity dried up to such an extent that the Federal Reserve was forced to step in to announce an open-ended commitment to buy Treasury debt in the amounts needed to stabilize markets.

“Private funds have become increasingly important in Treasury markets,” Scott Farnin, legal counsel for financial reform advocacy group Better Markets, told MarketWatch. “In March 2020, we saw Treasury markets crashing and a lot of liquidity running out,” and the FSOC needs detailed and timely information on such events in order to effectively monitor systemic risk, a- he added.

SEC mission slip

Attempts by the SEC and CFTC to expand their oversight of private funds have drawn criticism not only from the industry, but also from former and current regulators and outside observers.

The proposed changes to the disclosure rules “are not related to systemic risk oversight and investor protection, and therefore are inconsistent with the primary intent of Congress and the agency for which Form PF was adopted” , wrote Jason Mulvihill, chief operating officer of the American Investment Council, a private equity and credit trade group, in a March letter to the SEC.

Michael Piwowar of the Milken Institute, former acting chairman of the SEC, said in an interview that following the passage of the Dodd-Frank Act, the agency embarked on a “creeping mission” so that it is grappling with the growth of private markets that has been fueled in part by Dodd-Frank itself.

“There are pieces of data that they propose to collect that would arguably be useful in their regulatory oversight role that are not really related to systemic risk,” he said.

Kelley Howes, who heads the investment management group at law firm Morrison Foerster, said regulators are “not even trying to hide the ball” and say in their proposed rule changes that the additional data will help routine regulatory scrutiny of investment advisers.

Another concern raised by SEC Commissioner Mark Uyeda is whether information collected about private funds will remain confidential, as required by law.

“The information collected on the PF form is proprietary and highly confidential in nature,” Uyeda, a Republican, said in a statement opposing August’s proposal to change rules for disclosing private funds.

“Inadvertent disclosure of such information could cause significant harm,” he added. “Furthermore, it is simply not possible for the many employees of the Commission, Office of Financial Research and FSOC member agencies who have access to Form PF data to unlearn what they saw when they’re leaving federal jobs and moving into private sector positions.”

Howes argued that many of the proposed rule changes would significantly increase compliance costs for funds, costs that will ultimately be borne by pension funds and other investors who buy these products.

The new rules would require private funds to report within 24 hours certain “key events” such as extraordinary investment losses and large default and redemption events. Such rules would require funds to significantly expand their compliance departments to engage in “constant monitoring” to avoid violating new regulations, Howes said.

The comment period has ended on the SEC’s January proposal. The public will have until Oct. 11 to comment on the joint SEC-CFTC proposal, after which regulators will review the proposed rule and vote on its implementation.

The enigmatic FSOC

Opponents of the new rule proposals also point out that it is unclear what the FSOC is doing with the data it has already collected and how its efforts would be improved with more granular data.

When the FSOC was created by the Dodd-Frank Financial Reform Act, many imagined it would be a sizeable institution, given its power to designate non-bank financial institutions as “systemically important” and therefore subject to strict supervision by the Federal Reserve.

The FSOC initially designated four of these institutions as systemically important, but one company narrowed to get the de-designation and during the Trump administration the other three were also de-designated. President Joe Biden’s Treasury Department has not moved to reverse those changes.

“The FSOC hasn’t become the powerful regulator that people expected,” David Zaring, who teaches financial regulation at the Wharton School at the University of Pennsylvania, told MarketWatch. “The FSOC is supposed to be an information collector that identifies risks and somehow takes action to address them.”

But the public doesn’t know if the FSOC fulfills this role and if the data it collects is worth the cost of collecting it. The COVID crisis, Zaring said, was attacked through close collaboration between the Federal Reserve and the Treasury Department, and the role of the FSOC in that process is unclear.

Karen Petrou, co-founder of banking advisory firm Federal Financial Analytics, Inc., said in an interview that the steady march toward greater oversight of private funds is the inevitable consequence of regulations aimed at ensuring financial stability.

With the major KBE banks,
in the face of restrictions on leverage, capital will move to less regulated areas “like water flowing down hills”, she said, while insisting that this does not mean not that the post-2008 regulations on big banks are wrong.

Nevertheless, she is skeptical about the effective use by the FSOC of the data it intends to collect with private funds.

“Regulators and the FSOC have a very bad history of collecting data, that they don’t do anything until the data goes into the red zone,” she said. “By then it’s usually too late.”


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