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What banks can learn from hedge funds

November 9, 2009

Should the banking industry look more like the hedge fund sector? That’s the surprising suggestion made last week by two Bank of England officials.

In a fascinating paper, Piergiorgio Alessandri and Andrew Haldane explore the level of public support given to banks in the crisis and the problem of institutions that are too big too fail. Their main point is that if this issue is not addressed it will lead to new crises and even bigger bailouts in the future – a state of affairs they describe as a “doom loop”.

But the most eye-catching passage is a suggestion that banks have a lot to learn from hedge funds:

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.

This is quite a change of heart. Until a few years ago, regulators viewed hedge funds as the main threat to financial stability. These fears have proved unfounded. Though plenty of hedge funds have blown up – or turned out to be massive frauds – none has so far threatened to drag down the system.

Some things that currently take place in banks are probably better suited to hedge fund structures. Proprietary trading is a prime candidate. There is also a strong case to be made for private partnerships. Would investment banks have grown so large if they were owned by partners who were exposed to any losses?

Even so, it seems fanciful to suggest that the hedge fund model is better. Banks fund themselves by taking retail deposits that customers believe to be safe. That precisely the reason they are so heavily regulated. Hedge funds raise money from institutional investors and wealthy individuals who – in theory at least – realise they could lose it all. Without deposit insurance, the failure of a bank can spark a loss of confidence across the industry. The failure of a hedge fund is less likely to have systemic consequences.

But the main reason to be sceptical about hedge funds is that their incentive structures are not as conservative as Alessandri and Haldane appear to believe. Most hedge funds are management companies that charge fees for looking after third-party funds. If the fund performs well, the managers share in its success. But if the fund blows up it is the investors, not the managers, who are on the hook. Most hedge funds are private partnerships, but the partners are generally protected from losses in their funds.

Hedge funds may have proved they were not as risky as many regulators feared. But that does not mean they hold all the answers to fixing the financial system.

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