Many investment managers compete with each other, and are often paid on a short-term performance basis. There are few incentives to under-perform the market in the short-term, even if seeking longer-term gains: you could lose your job for doing worse than everyone else, but not if everyone else also does badly. This has combined with the growing complexity of financial derivatives. The result has been a herd behaviour in the market, and the possibility that some investors don't understand the risks they're taking on. This has heightened the risk of bubbles forming, and of systemic financial collapse if strategies become too closely aligned and something unexpected happens.
What, then, can economic regulators do to address some of the emerging dangers?
Asset bubbles are notoriously difficult for central banks to stop in their tracks. The Reserve Bank could raise interest rates whenever one starts to form (if it can identify it), but this risks needlessly slowing down the rest of the economy. The interest rate transmission lag would also make it impossible to respond fast enough should boom turn to bust.
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Interest rates are blunt and, besides, the Reserve's statutory obligation is to target inflation, not asset prices or debt levels. If the Reserve ever tried to raise rates to target bubbles specifically, there'd also be a lot of public opposition.
Indeed, there's very little the Reserve Bank can do.
What about regulations then? There have been recent calls for private equity and hedge funds to be subjected to greater regulation, perhaps similar to that governing accounting and reporting standards of public companies. However, this risks imposing unnecessary burdens and limiting commercial opportunities. In a corporate debt bubble, when the negative consequences of private equity are most likely to arise, governance and accounting standards may even prove ineffective (although they may make the bust easier to deal with).
The best available strategy, however, may be to tackle bubbles through tightening lending standards on a variable basis. The amount of money that can be borrowed as a proportion of asset values (which usually rise during booms) could be altered when bubbles look to be forming. This could help stave off the worst collapses in a bust, and would signal to the market that debt will be restricted in a bubble.
But even this may not be of much use if markets get carried away. The conundrum of dealing with bubbles in the era of private equity, hedge funds and rising corporate debt is hard to resolve.
Regulators, policymakers and market participants must pay close attention to these issues now, and try to stem any excess build-up in corporate debt before it's too late. Staying vigilant and acting early on can ensure that, in the long term, markets are stable, prosperous and free.
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