THE CORPORATE scandals of two years ago have triggered an expensive expansion in federal regulation. This cost has been justified, because inadequate, loophole-ridden oversight has proved even more costly for the economy. But the growth in regulation creates a higher hurdle for those seeking to increase federal scrutiny still more. In proposing last week to register hedge funds as a prelude to monitoring them, the Securities and Exchange Commission failed to leap that hurdle.
There are two reasons to regulate financial institutions. The first is that, if one goes bust, its sudden inability to repay creditors can bring other institutions down too, setting off a chain reaction of financial distress that can disrupt an economy. This argument applies primarily to banks, whose core business is to take in deposits -- that is, to accumulate creditors. It does not apply to hedge funds, whose explicit purpose is to take large risks with money provided by a small roster of rich clients. Admittedly, banks provide capital to hedge funds, and the collapse in 1998 of the hedge fund Long-Term Capital Management caused regulators to fear that several banks might go down with it. But the way to address this fear is to use existing bank supervision to limit banks' exposure to hedge funds. It is not necessary for the SEC to monitor hedge funds directly.
The second reason to regulate financial institutions is to protect consumers. A mutual fund, for example, is a bit like a medicine: The product's creator knows whether it's safe, but the average consumer can't tell one way or the other. But this argument has not traditionally worked for hedge funds either. The minimum investment in such funds tends to be $1 million or even $5 million. People with that sort of money can hire advisers to tell them what they're getting into. They have every incentive to monitor the fund's practices and may do this job as effectively as a government regulator.
The SEC objects that hedge funds are being democratized. Their clients increasingly include pension schemes serving ordinary workers, the endowments of public colleges and less wealthy individuals who get access to hedge funds by buying mutual funds that invest in them. But pension plans and endowments hire advisers to tell them what to do with their money: They should be able to look after their own interests. Mutual funds offering access to hedge funds are more troubling. But it would be better to impose high minimum-investment limits on those rather than saddling the SEC with a whole new regulatory responsibility for a formidably complex product. The time may come when the challenge of regulating hedge funds may appear worthwhile. But right now the SEC is already facing a large expansion in its responsibilities. This is not the right moment.