This article is based on relevant extracts from an uncorrected transcript of evidence taken in public and reported to the House of Commons. Neither the witnesses nor Members of Parliament have had the opportunity to correct the record. The transcript shouldnot therefore be considered an approved record of these proceedings.

The following extracts from the oral evidence given to the Committee on 25 February relate specifically to hedge funds.

Witnesses:

Hector Sants, Chief Executive, Financial Services Authority
Lord Turner of Ecchinswell, Chairman, Financial Services Authority
Loretta Minghella, Chief Executive, Financial Services Compensation Scheme

Committee members present were:

John McFall (Chairman): Labour and Cooperative Party MP for West Dunbartonshire
Nick Ainger Labour MP for Carmathen West and South Pembrokeshire
Graham Brady Conservative MP for Sale West
Colin Breed Liberal Democrat MP for South East Cornwall
Jim Cousins Labour MP for Newcastle Central
Michael Fallon Conservative MP for Sevenoaks
Sally Keeble Labour MP for Northampton North
Andrew Love Labour MP for Edmonton
John Mann Labour MP for Bassetlaw
George Mudie Labour MP for Leeds East
John Thurso Liberal Democrat MP for Caithness, Sutherland, and Easter Ross
Mark Todd Labour MP for South Derbyshire
Andrew Tyrie Conservative MP for Chichester
Sir Peter Viggers Conservative MP for Gosport

Sally Keeble (SK): You also, in [Economist City lecture, 21 January 2009], identified some of the institutions which have been particularly associated with some of the more complex products which might need tighter regulation, and you mentioned in particular the mutual funds and the hedge funds. I am sure you do not want to pre-empt your March report, but could you just say what your thinking is there and how you are thinking that you might regulate?
Lord Turner of Ecchinswell (LTE): The issue relating to mutual funds is not fundamentally a UK situation, because we do not have this category of mutual funds; the issue is mutual funds in which you make an investment but which then give you a close-to-categoric promise that they will not, as it is called, “break the buck” – i.e. they will not allow the value of your investment of £1,000 to go below £1,000 – and who, thus, end up performing a bank-like function – a product which is not legally a bank deposit but has the economic characteristics of a bank deposit. As it happens, we have almost no such institutions. So that issue of extending the regulatory boundary is fundamentally an issue for the US authorities, not for us.

SK: And hedge funds?
LTE: On hedge funds, I think we certainly believe that we need to gather enough information on hedge funds (and this will require more information from them) to assess what risks they are creating at the macro level and an individual institution level, and if at any time we believe they have become sufficiently bank-like in their activities or large in their scale that they are systemically important, then we should extend bank style capital and liquidity to their activities. We need that power.

Hector Sants (HS): We also recognise that we regulate hedge fund managers here whose standard is above the rest of the world. So a good first step, quite frankly, is that the rest of the world catches up with us. In this area we are ahead of the game. We can go further, but the first step, actually, is the rest of the world catches up with us.

John Mann: That is one significant problem. I come to a second one that may impinge on your ability to do your job as effectively as you might like. Offshoring in UK dependencies, of which many of the offshoring centres are, of course, British dependencies, how much is that a problem in terms of your inability to oversee what is going on in places like Belize, the Cayman Islands, Gibraltar, et cetera?
HS: There are two different issues here and there is a wider philosophical point the Chairman may want to pull out here, but in terms of practical points, of course, I do not think the offshore problem isa significant contributor per se to the prudential oversight of the major banks because they are not normally domiciled in those types of location, so in terms of the principal discussion to date I think I would not draw attention to that. However, there are two key issues. This shadow banking sector, to use the phrase that has been used, which includes the hedge funds we referred to earlier and various other types of structures that are used to facilitate, if I can use clear language, financing transactions, these types of structure are not, as we reflected, as transparent to the regulators as they should be, so we support ensuring that you cannot use those types of devices to escape the oversight of the regulator. That is an issue, and the other issue, of course, is consumer protection.

John Thurso: I want to move on because time is limited, but can I just put this one point to you? The real problem is that we have discovered that the money utilities are too important to the system to be allowed to go down. What we have ended up having, because we have got the casino attached to the money utility, is the taxpayer saving the casino. What we need is a system that allows the casinos to fail so that the utilities can be saved.
LTE: I think it is possible to imagine that you would create banks narrow enough that they were not in the casino. I think the idea that we can with certainty create casino banking such that we could definitely say it would fail and we would never rescue it is a delusion. I think that would take us down the path in precisely the opposite way that Sally Keeble suggested of saying it does not matter what the hedge funds do or the investment banks do because they are non-systemic. I think whatever we do to these structures we have to have everybody in the regulatory environment because what we realised on the evening of Bear Stearns in February – which was not a commercial bank but when it went down it was systemically important – is that although I could have some sympathy with the idea that there are narrow banks the idea that we will ever define the casino sufficiently tightly that it is not systemically important I think is a delusion.

Chairman: Can I just add, Paul Volcker yesterday at Columbia University made a speech and he stressed the importance of preventing financial institutions large enough to pose a threat to the entire system from engaging in risky behaviour such as running hedge funds or trading on its own accounts. Are you in favour of allowing institutions to be complex only if they are not systematically important?
LTE: I am very much in favour of Paul Volcker’s statement on this. I think we have to accept that there will be some large complex financial institutions which will be doing some things which we associate with investment banks like making markets in government bonds, providing forward FX cover, FX swaps, et cetera, but will not be doing nearly as much proprietary trading as they have done in the past.

Colin Breed (CB): Two quick questions. Firstly, to what extent do you think potential hedge fund failures present a threat to their prime brokers?
LTE: I think our best judgment would be to only a relatively limited extent at the moment. It is an area which, as we said, we want to gather more information on but I think it is important to realise that contrary to the belief that hedge funds are all incredibly highly leveraged, some of them in particular strategies are reasonably highly leveraged but quite a lot of them are not terribly highly leveraged, they are leveraged 2:1 or something like that rather than 10:1 or so in a bank and indeed that leverage has already come down quite significantly over the last year. Because there is not enough international gathering of data we cannot be precise on this but it is quite possible that average levels of leverage in the vast majority of hedge funds have come down from a bit above 2 to not much above 1 in the course of the last year. We cannot exclude the possibility that there are particular hedge funds in particular strategies which are a risk but I think it is not an area where we believe there are huge risks at the moment. Hector, would you like to comment?

HS: The key point is the point you made. The Hedge Fund Standards Board itself has said they believe leverage has come down to around 11½ and of course the prime brokerage industry has seen significant change, that having been a major factor in the demise of Bear Stearns and Lehman’s so they have adjusted their systems in the light of those events. There is a risk, there is always a risk, but I think it is a diminished one.

CB: You are not looking at any increased regulation on hedge funds at the present time?
HS: Back to our earlier point, I think, we do regulate the fund managers in the UK. We would certainly like global standards of regulations to come up to ours and we would like to go further; as Lord Turner said earlier, we would like to increase our ability to properly assess the very point you are bringing up which is the financial stability impact of hedge fund failures. We see them essentially as wholesale vehicles so it is not so much concerned about individual failures, hedge funds have failed in the past, they will fail in the future but the overall global regulatory architecture would benefit from greater visibility of systemic risk. We need to work with the US in particular to achieve that. We have been at the forefront of pushing that argument and we will continue to do so.

CB: How concerned are you at the moment about the levels of fraud which seem to be appearing within a number of financial institutions?
LTE: It is obviously the case that at the end of the boom period, as people have often commented, that a set of frauds which had been covered up have been revealed. We are continually trying to make sure that we are tracking the possibility for this stuff as closely as possible. It has not been so far, in the UK, a major part of the story but it is an area that we do focus on.

HS: We should also just make clear here, in terms of the focus of this debate, that certainly we primarily focus on market-related issues in terms of our criminal prosecutions and related perimeter issues. Conventional financial fraud we see to be taken forward by the lead agency in that respect which is the SFO but obviously we do require firms to have adequate systems and controls but we are not the lead agency on the conventional financial fraud of the type you have just referred to in those US hedge funds.