Commentaries

What banks can learn from hedge funds

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.

Banking? Keep it simple stupid

In 1873, Walter Bagehot wrote that “the business of banking ought to be simple; if it is hard it is wrong.” He would have struggled to recognize today’s banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity — as Bagehot predicted — has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The crisis that exploded a year ago offered a salutary lesson in the dangers of complexity. Many shareholders and creditors simply did not fully comprehend their investments. Instead they were forced to trust managers and the rating agencies.

Regulators too could be forgiven for scratching their heads.

“Supervisors are at a decided disadvantage in understanding risk-taking and compliance for firms that might involve dozens of jurisdictions, hundreds of legal entities and thousands of contractual relationships,” former Fed official Vincent Reinhart has written.

Indeed Basel II — the international capital code — was an admission of defeat by regulators. The message from the banking accord was that institutions had become so convoluted that only they were able to understand the risks they were taking.

FSA barks up wrong tree on guarantees

The Financial Services Authority has since the credit crunch had a bee in its bonnet about the incentives and rewards offered by financial firms and whether these encourage risky behaviour. It’s a perfectly reasonable concern. Big bonuses probably did skew behaviour towards excessive risk taking in some cases, although the crazy risks run by employee-shareholders at Bear Stearns and Lehman Brothers suggest it might be a more complex picture.

But the FSA’s latest campaign — against long-term bonus guarantees — simply doesn’t make sense. The regulator has written to more than 40 chief executives in the financial services industry warning them against offering bonus guarantees with a duration of more than one year. This is “inconsistent with effective risk management”, the letter states.   The whole idea of guarantees is of course a loaded one in the wake of the crisis. Some feel that bankers have come through it in better shape than their shareholders.

But one has to question whether the FSA is wise to stray into this area at all. Bonus guarantees are largely used to lure employees with special knowledge or skills to move their “practice” from one firm to another. The extent to which banks should invest in building up in a new area in this way is surely a commercial matter for them and their investors. It should only be a matter for the regulator if the level of investment is so big that it might imperil the whole business.

It is also very questionable whether guarantees do encourage risky behaviour. Arguably they do precisely the opposite. After all, employees who must earn their bonuses have an incentive to take risks. Their pay will be meagre if they do not. But a long-term guarantee, for all its shortcomings, actually encourages risk aversion. If employees have been promised the full rewards up front, their objective is to avoid being fired — not to shoot the lights out.

Again, the regulator should only involve itself if and when guarantees — as a proportion of a firm’s total compensation bill — reach such a scale that they make its cost base less flexible, thereby limiting its ability to adjust to changes in markets.

This is not an argument in favour of bonus guarantees. But they are a commercial tool that should be available to employees of a people business. The FSA should keep its powder dry for more important battles, especially ones where it can actually enforce its own decision (which is doubtful in this case). That said, with the opposition Conservative party threatening to give it the chop anyway, it may not have many more to fight.

Mervyn King’s uncomfortable sermon for the City

Did Mervyn King miss his true vocation? Last night he compared the Bank of England to a church – with the Governor as the priest – as he took to the Mansion House pulpit to pour a rhetorical bucket of cold water over guests at the Lord Mayor’s banquet.

Headline writers predictably seized on King’s disagreement with Alistair Darling over Britain’s regulatory structure. But the more interesting section of his speech dealt with banks that pose a threat to the stability of the financial system.

If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Something must give. Either those guarantees to retail depositors should be limited to banks that make a narrower range of investments, or banks which pose greater risks to taxpayers and the economy in the event of failure should face higher capital requirements, or we must develop resolution powers such that large and complex financial institutions can be wound down in an orderly manner. Or, perhaps, an element of all three.

If King knows the answer, he is not saying so publicly. However, the policy implications of what he is saying are profound. During the credit bubble, banks had an incentive to become big because the market assumed – rightly, it turned out – that large banks would not be allowed to fail. Removing that implicit guarantee, or charging for it properly, is probably the thorniest problem facing policymakers today. It will take more than prayer to come up with an answer.

from Neil Collins:

Brown’s bombshell for the Bank of England

You may not have heard of Adam Posen, but you hadn't heard of David "Danny" Blanchflower before the banking crisis. Posen is Blanchflower's replacement on the Bank of England's Monetary Policy Committee and, boy, does he have some strong views. Here he is before the US Congress three months ago, with some modest proposals.

The rest of us may struggle to come up with remedies for the current malaise, but Posen has no doubts. He calls his address "a proven framework to end the US banking crisis". His framework looks more like a cross to nail up bankers, owners and regulators, since he suggests firing the lot of them, wiping out the shareholders, and wholesale nationalisation. He is wonderfully free of self-doubt:

"Making the right choices now will require money upfront, large amounts of taxpayer money, and thus it is necessary as well as right for Congress to lead on this issue. But making the right policy choices now will restore US economic growth much sooner, at much lower cost, and on a sounder basis than trying to kick the trouble down the road or waiting for events to force the issue."

There's much more in similar vein, but the real poser is why Gordon Brown has picked Posen for the MPC. Brown, as he'd rather we didn't keep reminding him, is the architect of the "tri-partite authority" which allowed Northern Rock to fall so disastrously through the regulatory cracks. The then Governor of the Bank almost quit on the spot when Brown sprang it on him, because it effectively blinded the Bank to spotting trouble before it was too late.

Posen's post on the MPC has nothing to do with regulation, but is it too much to see it as a hint that he-who-never-errs has finally seen his mistake?