Merryn's Blog

How to fix the financial system - make banks more like hedge funds

If banks were more like hedge funds - where there is genuine competition, real consequences to excessive risk-taking, but less regulation and government interference - we might not be in the mess we are in now.

At MoneyWeek we've been pointing out for years that the root cause of the credit crisis and our bubble economy in general is 'moral hazard' the notion that if you protect people or institutions from the negative consequences of their actions, then they'll take more risks.

In recent years, Federal Reserve chairman Alan Greenspan (dubbed the 'Maestro' before the credit crunch annihilated his reputation) raised the creation of moral hazard to a fine art form, by slashing interest rates every time a sniff of danger threatened US stock prices. This became known as the 'Greenspan put'.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

The trouble is, if you keep bailing out banks and investors, then they'll just take more risks, making the system increasingly unstable. This seems self-evident, yet many economists dismiss moral hazard as some sort of fuddy-duddy concern to be brushed aside in the heat of the crisis. "You don't worry about the foundations when the roof is on fire," was the general cry as governments poured money into the financial system during the crisis. "We'll sort that out later."

Of course, once these drama queens are done with their fire-fighting and the banks are apparently saved, bank lobbyists come charging back into the political chambers and the opinion columns, and suddenly no one wants to rock the boat. Financial reform gets abandoned, and the next bubble grows even bigger.

Advertisement
Advertisement - Article continues below

Pretty depressing stuff. The good news is that a recent paper - Banking on the State [pdf] - from Bank of England economists Andrew Haldane and Pergiorgio Alessandri has given some hefty academic backing to the moral hazard argument. It's a little bit technical in places, but there are some cracking quotes in it, so persevere if you can.

Basically, what Haldane and Alessandri are saying is that as governments have intervened more and more to catch banks when they fall, the banks have gone on to take more and more risk, safe in that knowledge that they'll be bailed out. After a crisis, politicians and monetary authorities "talk tough, but act weak". Serious reforms never arrive, which in turn encourages banks to take even more risks next time around. "This adds to the cost of future crises. And the larger these costs, the lower the credibility of 'never again' announcements'. This is a doom loop."

So how do you solve the problem before we have another blow-up? Haldane and Alessandri make the usual suggestions about increasing capital ratios and insurance schemes. But one point in particular stands out. "Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked." Hedge funds, they point out, have been able to go bust at a rate of knots since the crisis began, with little lasting impact on the rest of the market. That's because they're smaller, there are lots of them, and their founders have a great deal of their own wealth at stake.

"It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that despite their moniker of "highly-leveraged institutions", most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system."

In other words, genuine competition and risk exists in the hedge fund industry, and that's created a much more stable structure than attempts by regulators to create a suitable structure for bankers. So the free market works, it seems. Now we just have to figure out how to make that apply to bankers.

Advertisement

Recommended

Visit/519858/how-long-can-the-good-times-roll
Economy

How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
Visit/516758/beyond-the-brexit-talk-the-british-economy-isnt-doing-too-badly
Economy

Beyond the Brexit talk, the British economy isn’t doing too badly

The political Brexit pantomime aside, Britain is in pretty good shape. With near-record employment, strong wage growth and modest inflation, there is …
17 Oct 2019
Visit/economy/uk-economy/brexit/600791/will-britain-close-its-doors-to-immigrants-post-brexit
Brexit

Will Britain close its doors to immigrants post-Brexit?

Details have not yet been forthcoming, but Britain will soon have a new immigration policy. What will that mean for businesses and investors?
8 Feb 2020
Visit/investments/property/house-prices/600795/uk-house-price-rise-brexit-bounce
House prices

Is the jump in house prices just a Brexit bounce, or is it more durable?

UK house prices rose sharply in January. Some of that is down to the end of Brexit uncertainty – but not all. There is a real risk that prices will ke…
7 Feb 2020

Most Popular

Visit/economy/inflation/600799/federal-reserve-inflation-money-printing
Inflation

Here’s why the Federal Reserve might print more money before 2020 is out

The Federal Reserve wants to allow US inflation to run “hot” for a while. But that’s just an excuse to keep interest rates low – and possibly print mo…
10 Feb 2020
Visit/investments/investment-strategy/600804/the-secret-to-avoiding-being-panicked-out-of-your-portfolio
Investment strategy

The secret to avoiding being panicked out of your portfolio

With the coronavirus continuing to occupy headlines, investors still aren’t sure how to react. But the one thing you mustn’t do is panic. Tim Price ex…
11 Feb 2020
Visit/economy/600796/money-minute-monday-10-february-lacklustre-growth-in-the-uk-and-europe
Economy

Money Minute Monday 10 February: lacklustre growth in the UK and Europe

Today's Money Minute looks ahead to the week's GDP growth estimates for the UK and the eurozone, plus inflation figures for the USA.
10 Feb 2020
Visit/517625/tr-european-growth-trust-why-investors-shouldnt-overlook-europe
Sponsored

Why investors shouldn’t overlook Europe

SPONSORED CONTENT - Ollie Beckett, manager of the TR European Growth Trust, tackles investor questions around Europe’s economic outlook and the conseq…
6 Nov 2019