Hedge Funds Could Trigger the Next Crisis: UK Regulator

Hedge funds were not responsible for the current credit crisis, but could cause the next financial crisis if they are not under the right regulatory control, Lord Adair Turner, chairman of the Financial Services Authority, told CNBC.

AP Lord Adair Turner, chairman of the Financial Services Authority

“Hedge funds could become systemic, we need the reserve power to deal with that,” Turner said.

“The fact is that the vast majority of hedge funds … were not the key cause of this particular crisis. They could be in the future,” he said.

The role of hedge funds in the current financial turmoil has been a contested issue with many market commentators calling for tighter regulations on what they see as a highly risky and secretive industry.

The majority of existing hedge funds are not highly leveraged and do not pose systemic risk to the financial system, Turner said.

But the regulator of London's financial center, the City, said that if large, highly-leveraged hedge funds do develop, such as Long Term Capital Management, regulators need the ability to say “no.”

Long Term Capital Management required a combined rescue operation in the late 1990s having aggressively leveraged its investments. It’s an example of a hedge fund reaching the level of systemic risk and must be avoided, according to Turner. 

Following the G20 meeting in London, politicians have thrown weight behind calls for the industry to be curtailed. But the European Commission directive has unnecessarily started talking about capital limits on the existing leverage of hedge funds, according to Turner. 

To Big to Fail?

Turner played down claims that the FSA had broken away from the Bank of England Governor Mervyn King over regulating the size of banking institutions.

Turner said that both he and King favored the idea of higher capital requirements for larger banks instead of limiting the actual size of banks’ balance sheets, as has been called for by some politicians. 

“It’s effectively a tax on size rather than a precise prohibition on size,” Turner said.

“I think that is much more likely to be something round which you can get an international agreement. It is undoubtedly the way that the US going,” he said.

There is a problem of certain institutions being too big to fail and some sort of regulation needs to be implemented to combat that, according to Turner.

Irrational Exuberance

Some banks are already reverting to the risky practices seen before the crisis, according to Turner.

The race to lure top employees with inflated pay packets is returning and could reach such a level that it encourages investors “taking large, proprietary trading positions,” Turner said.

Even though it is not the FSA’s role to regulate remuneration, “there is a danger that there is a process of returning to irrational exuberance, paying very fancy amounts of money for people,” he said.

Tougher Regulation

As governments around the world scramble to form fresh regulations for the financial industry, Tuner told CNBC that he is concerned that the waters could become muddied by a potential power struggle. 

“I do have concerns. The process for making decisions can be so complicated that it takes us a long time and one almost gives up by exhaustion,” he said.

“We have to get into the system higher buffers, higher shock absorbers immediately,” he said.

• Slideshow: Largest Bank Failures of 2009

© 2009 CNBC.com