In a world where the mere whisper of the number 2008 can send shivers down the spines of financiers, pre-emptive regulatory measures to avoid another financial faceplant are hard to argue against. The EU last month decided to channel Minority Report in its newly agreed-to regulations on private credit funds.
In the 2002 film, based on the 1956 Philip K Dick novella, mutants foresee crime before it happens and dispatch police to arrest suspects before they commit their dastardly deeds. Prevention, it might be argued, is better than cure.
The European Council and Parliament have approved the final text for amendments to the EU Alternative Investment Fund Managers' Directive II (AIFMD II), which is set to be published in the EU’s official Journal in the next few weeks, and will be incorporated into each EU member state's legislation over the next two years.
The first big set of rules for managers of private credit funds is the latest example of regulation that is almost purely pre-emptive.
While the regulators aren’t deploying psychics bathed in milk to spot the next big market crash, the spirit of the regulation is largely preventative, based on what the market has in the past experienced with asset classes this big.
One can only wonder what the benefits would have been of some precogs at the financial regulators of the mid-noughties. They might have urged banks 'not so fast' as they leveraged up to their eyeballs in collateralised debt obligations (CDOs) and their financial spawn.
Last month’s regulation is the EU’s effort to ensure that the booming private credit fund market cannot get to that point, by imposing caps on the leverage fund managers can deploy.
Whether the rules prove effective is another matter. The leverage caps are “ceilings for very tall people”, as one source put it last week.
According to data from the Alternative Investment Management Association, 36% of private credit fund managers who responded to a recent questionnaire said they used no financial leverage, and a further 51% used debt of less than 1.5 times equity — below the caps imposed by the regulation.
Business as usual?
The market is therefore expecting business as usual in fund formation, with no meaningful changes caused by the implementation of the rules.
There is clearly no immediate problem which regulation is seeking to address, because the market isn’t operating in the way that the rules seek to constrain.
Reactions to the EU-wide rules have been varied, with some market participants calling the regulation a step too far, and others describing it as, all in all, a positive.
But whether or not you agree with the regulation will come down to what you think its purpose is.
There are always trade-offs. Would you rather be cautious now to avert potential disaster but risk stymieing business? Or let the animal spirits let rip, knowing that peril may follow?
The answer for a regulator must surely be to regulate and avoid the former.
Critics of the preventative regulation say imposing rules to prevent a future, theoretical problem can restrain trade, and the market’s ability to self-correct can be hampered by heavy-handed regulation. While disasters are possible, they are an inherent risk of any market activity, and the market is better served by mechanisms that ensure resilience and recovery rather than by attempting to prevent every conceivable mis-step.
But their memories are short. The 2008 global financial crisis was the definitive lesson that the financial markets do not exist in a bubble and that there are real world implications — and costs — when it all goes the way of the pear.
There may be no obvious problem with private credit funds now, but as the industry grows, so does the risk they pose to the financial system, as ever more risk moves from bank balance sheets to pools of private credit. A competent regulator cannot afford to be caught off guard.
The EU is right to impose what was last week called the “bare minimum” of regulation for private credit funds. The precog approach to financial misadventure may seem heavy-handed to some, but it is the responsible thing to do.