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

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'.

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."

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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.

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.