Large Private Investment Funds Need Closer Oversight

Large funds pose systemic risk to the U.S. and global financial system

Commentary

Recent news reports that the top Justice Department antitrust lawyer, Jonathan Kanter, is planning to scrutinize large private investment funds’ practice of “rolling up” competing companies to create monopolies and oligopolies.

That may be a good idea on the antitrust front, but let’s take a step back and look at the risk front.

In 1995, a young trader in Singapore named Nick Leeson, who was supposed to be doing low-profit, high-volume, arbitrage trades on the Nikkei, was approving his own trades. When he entered into a short straddle of the Nikkei and Singapore exchanges, the Kobe Earthquake cratered the markets in the region, causing Leeson’s trade to fail catastrophically. To hide it, Leeson entered into a number of risky trades that, ultimately, drove his employer, Barings Bank—chartered in 1764—into bankruptcy with losses of $1.4 billion.

Just 13 years later, another young trader, Jerome Kerviel, engaged in unauthorized trades that cost Societe Generale some 4.9 billion euros (US$7.2 billion). Then, in the same year, 2008, Bernie Madoff became the biggest financial fraudster in history, fleecing investors of as much as $65 billion.

Today, the world’s largest private equity fund, BlackRock, controls upwards of $10 trillion (yes, that’s with a “T”) in investment assets. That’s nearly half the U.S. GDP. It is about one-third more than annual federal expenditures. It’s about 10 percent of the total value of the entire U.S. stock market in 2020. It is an enormous amount of money. By comparison, Warren Buffet’s Berkshire Hathaway and KKR are valued at less than half a trillion dollars. Most other funds, although worth hundreds of billions, are veritable pikers by comparison.

These funds have enormous influence. The annual letters from financiers like Larry Fink and Warren Buffett earn national headlines and are scrutinized by both Wall Street and Washington, and make policy decisions based on them. Nevertheless, these huge funds somehow manage to escape the definition of a “Systemically Important Financial Institution,” or SIFI.

A SIFI, simply put, is a non-bank entity that, were it to be in “material financial distress—or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities—could pose a threat to U.S. financial stability.“ In other words, SIFIs are those deemed ”too big to fail” by regulators. They came about after the 2008 financial crisis as part of the sweeping Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) that became law in 2010.

Since then, the Financial Stability Oversight Council has designated—and rescinded—a number of SIFIs, including insurance companies, finance companies, and other non-bank entities.

But these super-sized investment entities that, simply by their utterances, can influence not only the markets, but social and governmental policy, have none of the governmental oversight of a SIFI.

When Bernie Madoff’s scam was finally discovered after decades of malfeasance, Cornell University determined that—in addition to Madoff’s own victims—people who knew his victims, or who were located near where they were located, pulled some $363 billion from investment funds.

Now imagine if a fund the size of BlackRock—or even one a tenth its size—were to have a rogue trader of the likes of Nick Leeson if even a trillion-dollar fund were to be exposed as a Ponzi scheme.

Markets would crater. People’s pension funds and institutions would run for cover the same as they did when Madoff was exposed, only it would be several orders of magnitude above Bernie Madoff, who was relative small-fry. Not only would markets crater, it might take years—decades—to resume public confidence. The financial catastrophe that would follow might even create an existential threat to the republic.

Putting aside for a moment the enormous political influence of a fund as large BlackRock, or even some of its smaller competitors—which should not be dismissed as the heavy political lift it would be—common sense would dictate a need to oversee some of these funds.

I am, of course, not so naive to believe that a failure of these funds could be prevented by closer government oversight. The SEC missed obvious inconsistencies that should have exposed the scam, and even failed to act when a concerned citizen pointed them out. But the notion that there is a “cop on the beat” might deter bad actors.

Congress, act! Make funds with $1 trillion or more under management SIFIs.