Are hedge funds a source of instability in the global financial system? While their role in the Asian crisis remains controversial, the LTCM incident shows clearly that on occasion hedge funds can be destabilising, through their sheer size and leverage. Banning hedge funds altogether is not the solution. Many other institutions make similar plays as the hedge funds. Indeed hedge funds can play a positive role in international financial markets. Their signature contrarian and arbitrage strategies can help to stabilise and even enhance the efficiency of financial markets. However, checks are necessary to prevent them from accumulating excessive positions, unknown to the market and to regulators. Directly regulating hedge funds will also not work. There is the practical problem of regulatory arbitrage – such players can easily relocate if regulation is forced on them. Besides, not all hedge funds are large and highly leveraged. There is no need to regulate all of them in the same way. One possible approach is indirect regulation, through their lenders and other counterparties. This means bringing the private sector into the surveillance picture. We should create incentives in the supervisory framework for the counterparties of hedge funds to become more vigilant and prudent. Lenders must strengthen their own credit assessment systems, while regulators should find ways to encourage risky borrowers to disclose more, voluntarily, to their creditors. For example, we could introduce a higher risk weighting for borrowers who are large and highly leveraged and who do not disclose enough to either their creditors or the credit rating agencies.

CONCLUSION Norges Bank has assessed whether the equity share in the GPFG’s strategic benchmark index should be changed. The current equity share is slightly higher than 60 percent. In Norges Bank’s assessment, the equity allocation can be increased to 75 percent. The Bank’s proposal is based on a broad analysis of changes since the equity allocation was last assessed. In financial markets, bond portfolio characteristics in particular have changed over the past ten years. Expected returns on investment grade bonds have fallen sharply. At the same time, the expected excess returns on equities over bonds are now estimated to be somewhat higher than when the equity allocation was last assessed. Moreover, there is reduced covariance between bond and equity returns. In short, bonds have become a better, but also more costly, hedge against fluctuations in the fund’s value. Both of these factors suggest that some increase in the equity allocation would be appropriate. If the analysis is expanded to include the relationship between return and risk for overall 6/7  BIS central bankers' speeches  petroleum wealth, we arrive at a similar conclusion. Today, the GPFG accounts for a far larger share of petroleum wealth. This means that the fund’s owner can accept a higher level of risk associated with the return on the fund while keeping the level of risk associated with petroleum wealth unchanged. A higher equity allocation means that the expected return on the fund will increase. The realised return, however, may differ considerably from expectations.