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Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008: Written Testimony for the House Oversight Committee Hearing on Hedge Funds

This document is the written testimony submitted to the House Oversight Committee for its hearing on hedge funds and the financial crisis, held November 13, 2008, and is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned - this paper is not research, but is instead a summary of the policy implications that I have drawn from my interpretation of that research. I begin with a proposal to measure systemic risk, and argue that this is the natural starting point for regulatory reform since it is impossible to manage something that cannot be measured. Then I review the relation between systemic risk and hedge funds, and show that early warning signs of the current crisis did exist in the hedge-fund industry as far back as 2004. However, I argue that financial crises may be an unavoidable aspect of human behavior, and the best we can do is to acknowledge this tendency and be properly prepared. This behavioral pattern, as well as traditional economic motives for regulation - public goods, externalities, and incomplete markets - are relevant for systemic risk or its converse, systemic safety, and I suggest applying these concepts to the functions of the financial system to yield a rational process for regulatory reform. Also, I propose the formation of a new investigative office patterned after the National Transportation Safety Board to provide the kind of information aggregation and transparency that is called for in the previous sections. Another aspect of transparency involves fair-value accounting, and I review some of the recent arguments for its suspension and propose developing a new branch of accounting focusing exclusively on risk. I conclude with a discussion of the role of financial technology and education in the current crisis, and argue that more finance training is needed, not less.