Well, that at least is my initial take on a subject that ought to be dominating economic policymaking in the next few weeks: what to make of his banking reforms, described by the FT as a declaration of war on Wall Street.   They must be pretty full-on, if even Baseline Scenario seems to approve.

I have not had a real chance to go over all the proposals.  But the idea of not letting banks own hedge funds and private equity seems to have some merit.  Some people argue that in creating and selling on securitized instruments and derivatives (RMBS’s, CDO’s, etc) the banks were left with insufficient ‘skin in the game’.  Surely, on some important level, this was nonsense.  They were flayed alive, losing $ trillions: that is a lot of skin.

The textbook model for how securitization was meant to help improve financial stability imagines the banks as intermediaries, and the end users of these products being the entities with lots of capital and the right attitude to risk to take them on.  So, insurance and pension funds, for the less risky tranches; hedge funds and so forth for the riskier bits.  The Banks – with their essential role in intermediation, maturity transformation and transaction-handling – are then left much more immune to a fall in those asset prices.  Their assets are now liquid, unlike Banking 101 when they hold a bunch of mostly local, bespoke and untradeable loans to people for 20 years.

This model, beloved of Greenspan when he said financial innovation had made the system more robust, was not put in place.  Instead, the banks ended up holding on their trading books all or most of the nasty bits.  Or they sort-of owned hedge funds that did this, off-balance sheet, but with enough of a real or presumed obligation to stand behind them that when they went sour the risk belonged to the banks.

This was a banking crisis, not a financial market crisis.  If it had manifested itself through the collapse of non-banking assets held somewhere else – like, for the most part, the dot com crash – it would have had nothing like the same serious implications.

So stopping the banks having this dual role makes quite a lot of sense, on this interpretation. Whether they can make the separation without massive unintended consequences is another thing – particularly if, as EoC observes, this is driven by short-term politics.  How will the market making be distinguished from the position taking, for example? (see same link).  Will this mean a sudden loss of liquidity on exchanges?  The FT (see that link) suggests a move towards hedge funds instead:

However, some believe that would not last long, as traders regrouped outside banks and set up their own “prop shops”. Christian Katz, chief executive of SIX Swiss Exchange, and a former Goldman Sachs banker, says: “The net effect, longer term, could be neutral; it doesn’t have to be a collapse.” However, any immediate exit could benefit hedge funds and independently operated proprietary trading firms – including “high-frequency” trading firms.

The immediate conclusion from Obama choosing this route is that he prefers the hedge fund model to banks.  He has a good reason to: hedge funds are less leveraged, can collapse without systemic implications, and in fact do collapse; can allow private investors to share the extraordinary high returns that from time to time occur; and have a better aligned compensation model.  They also offer the sort of competition to banks that may drive down some of their oligopolistically high profits (see Philip Stephens).  What is not to like?

IN OTHER NEWS.  My hunch about the popularity of MyDavidCameron was right: it is more popular than griping Guido.  Now that I am no longer linked to (fair enough: I am not as rabidly anti-Tory as most of its albeit very funny content), I can discover just how few mates I have

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4 thoughts on “Obama prefers hedge funds to banks

  1. “…hedge funds are less leveraged, can collapse without systemic implications…”

    I’m not sure how you account for Long Term Capital Management. It was tremendously leveraged (25:1 in normal times, 250:1 on the way down). The only reason that the Fed didn’t have to bail it out was that Greenspan and the New York Fed managed to organise a private bailout, but it’s doubtful that they could have done this if LTCM were much bigger.

    And if many of the asset holdings of the banks are displaced to hedge funds, then the LTCMs of the future will be much bigger, and are likely to require bailouts.

    If I were (a cynical) president, I’d probably just pretend to do something and hope that the next crisis hit once I was gone.

    1. In my view, LCTM was the exception that proved the rule, and even in that extraordinary circumstance, the amount needed to save it was privately raised, £5bn at the most. Other massive hedge fund failures have taken place, and the consequences have barely hit the headlines. I believe the typical leverage of hedge funds is 2-4, compared to banks of 20-40. They are able to be profitable at such low levels of leverage, so don’t in general have to go much higher, unless like Meriwether and LCTM they are chasing tiny profits and need to gear them up.

      Compare with the problems of banking – I would far prefer that model. We are agonising over how to make banks failable. Hedge funds already are.

  2. Obama’s proposals are a good start, but not enough. Here’s what else is needed at least for me:

    1. Measures to deal with the shadow banking sector as Krugman says:

    http://krugman.blogs.nytimes.com/2010/01/21/glass-steagal-part-deux/

    2. Some form of clearing house for the derivatives and so on so everything is out in the open.

    3. Some form of what Keynes dubbed an “International Clearing Union” to deal with any future balance of trade problems (I see virtually no chance of this while China is the way it is):

    http://en.wikipedia.org/wiki/International_Clearing_Union

    4. Something must be done about the Rating Agencies. What that should be I don’t know. But populist anger would be better served directed at them, not the bankers really. [I see the bankers as being mainly driven by animal spirits, so I reckon most people in their shoes would have been just as “greedy” (aside from the selection of bias of the type of people who do go into banking).]

    5. I do also want to see something like what those at Baseline Scenario want. Certainly the size limits are too lenient. While an International agreement for how to deal with banks like RBS (which was/is something stupid like twice the size of the British economy) does not exist, they have to be broken up. And if such an agreement did exist, then the moral hazard would be worse than ever. Globalization has meant that capitalist institutions have outgrown the nation state, and that is not healthy when a bubble bursts.

    Saying all that, I do wonder if Minsky was right, that crashes are inevitable, and whether there is much we can do about them.

    [Btw, am I the only that’s noticed George Osborne trying to position the Tories as the populist reformers by coming out and saying they want to do what Obama has proposed? Here was me thinking that Vince had proposed to do this months ago (he has a way of doing that).]

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