17 September 2007

EDHEC: Three Early Lessons from the Subprime Lending Crisis

Introduction of IFRS standards and Solvency II on insurance companies are more likely to increase liquidity risk on investment markets than tightening the regulation of hedge funds, according to EDHEC business school.

Responding to to comments from French president Nicolas Sarkozy and German chancellor Merkel suggesting hedge funds were to blame for the recent credit crunch, the study notes that “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”.

“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”, he writes. “Trying to protect investors from themselves, without the means to do so, is probably the greatest risk of regulation.”

“In a major EDHEC study on the effects of a substantial reform on the solvency evaluations of European insurers—and in the near future, perhaps, of pension funds—we showed that the convergence of new accounting standards (IFRS) and Solvency II would make a profound impact not just on the asset management practices of institutional investors, but also on the stability of the financial system. “

The study concludes 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.

“Centring criticism on hedge funds and on their purported need for greater transparency may divert the attention of regulators and investors from the much greater problem posed by inappropriate regulation”, Noel Amenc, professor of finance and director of the research centre notes. Amenc also finds that the crisis is linked not to underregulation but to over-regulation, and that regulation in the works will increase the risk of market illiquidity.

© Graham Bishop