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Highly leveraged institutions and financial stability: a case for regulation?

Second Conference on Law and Economics of Risk in Finance, University of St. Gallen, 29.06.2007

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Highly leveraged institutions (HLIs), or hedge funds, are currently a hot topic. HLIs are perceived as an opaque and highly risky industry which is not subject to supervision. Furthermore, the importance of HLIs has grown tremendously in recent years. Against this backdrop, the speech raises the question of whether HLIs are indeed a threat to financial stability. And, if so, whether there is a need for regulation.
Because of its modest size, its heterogeneity and the fact that it is not involved in financial intermediation, the HLI industry is no direct threat to financial stability. It could, however, pose an indirect threat to financial stability should a shock to HLIs be transmitted to systemically important banks. Shocks could be transmitted because banks are exposed to HLIs in their role as counterparties and creditors. Potential regulatory measures should therefore focus on the link between the HLI industry and the banking industry.