Financial Market Regulation after the Crisis: The Case for Hedge Fund Regulation via Basel III

Wulf A. Kaal Ph.D., Mississippi College School of Law

Abstract

Hedge funds have been blamed for their part in the financial market crisis of 2008-09. The exact role and the scope of hedge funds’ involvement in the financial crisis is unclear. Regulators increasingly scrutinize the hedge fund industry worldwide. Regulation of hedge funds could help minimize moral hazard, social externalities and systemic risk generated by the hedge fund industry. The paper evaluates recent regulatory changes including the US Dodd-Frank Act, the European Union Directive on Alternative Investment Fund Managers and other pertinent regulation. Using the methodological tool of New Institutional Economics, the paper provides an impact analysis of regulatory changes, de lege lata and de lege ferenda, with a special emphasis on, and historical analysis of, hedge fund registration rules and asymmetric regulation in Dodd-Frank and the AIFM Directive. Other pertinent issues discussed include moral hazard and its adverse effects on Counterparty Credit Risk Management in the aftermath of the 2009 bank bailout, the free-rider problem of CCRM and its potential to create externalities and the issue of systemic risk. After analyzing the shortcomings of Basel II, the paper suggests that Basel III could introduce a charge for banks’ lending exposure to hedge funds, i.e. Basel III capital requirements for banks could introduce a charge for a bank’s assets based on its systemic risk contribution. Measuring the systemic risk contribution could include a measure for hedge fund lending exposure.