Regulation

The EU and hedge funds: silencing the dog that didn’t bark


We could see it coming, couldn’t we? Those gigantic over-leveraged hedge funds were bound to come crashing down, as their massive bets turned sour, forcing them to default on their bank loans and bringing the banking system to its knees.

Except that it never happened. Instead, the system was destroyed by the greed and incompetence of the insiders, including some of the most blue-blooded investment and commercial banks in the world. Highly regulated as they were said to be, they were allowed in every country except Spain simply to move their riskiest investments off balance sheet, where they were free to bet the bank on investments in the notoriously toxic mortgage-backed securities.

Note the absence of hedge funds and private equity – Alternative Investment Funds or AIF’s – from this story.

Nonetheless, with proposals to impose new reporting requirements and controls on management, the EU is concentrating its regulatory fire on the dog that didn’t bark, with the clear intention of reducing the competitiveness of AIF’s and tying the hands of their managers (with a side swipe at the offshore financial centres where many are legally domiciled). Since the only investors in this type of fund are high net worth individuals and institutions like pension funds, insurance companies and mutual funds who ought to be capable of looking after their own interests, official concern can only be justified if there is a potential threat to the banking system – something which you might have thought would have been best left to the banks to monitor. The fact that the EU feels the need to make these proposals amounts to a vote of no confidence in bank managements.

Now confidence in bankers may, understandably, be as low these days as in MPs. But are there any better grounds for trusting regulators who allowed the crisis to occur under their very noses? If regulators have indeed now learned the lessons of the crisis, should they not concentrate on applying them to the banks in their charge?

Ironically, hedge funds do remain problematic. First, pre-crisis academic research had already shown hedge fund managers to be incapable on average of earning high enough returns, even in a bull market, to justify their high fees. The crisis offered them a golden opportunity – which they have mostly missed – to show that they could make good on their promise to shield investors from losses in a bear market.

Second, AIF’s should carry some of the blame for the crisis, but their sin was one of omission, not commission. As major players, they could have done far more to rein in empire-building bank managements. For example, instead of short selling RBS to prevent its catastrophic purchase of ABN AMRO, they sold too little and too late – when RBS was already beyond recall. Moreover, they could have used their voting power far earlier to insist on remuneration packages for executives that were properly aligned with shareholders’ interests. Instead, by their inaction they endorsed management decisions either explicitly or by default.

But then this last is an accusation which could have been directed at any of the traditional investment vehicles – mutual funds, insurance companies, pension funds etc – though this fact is apparently of no concern to EU Commissioners, fixated as they are on their vendetta against the “locusts”.

Professor Laurence Copeland  is a contributor to Verdict on the Crash


10 thoughts on “The EU and hedge funds: silencing the dog that didn’t bark”

  1. Posted 12/06/2009 at 09:47 | Permalink

    Not necessarily disagreeing with the substance of this, but I don’t like this casual reference to greed and incompetence on the part of bankers. They got it wrong, as thousands of businesses get things wrong. But they were engaged in legal activity which they believed would bring benefits to their shareholders, as well as to themselves. Risk-taking is essential in business, and these risks were very widely believed to be manageable. With hindsight we can see they were wrong, but those pointing the finger of blame now are much more numerous than those sounding warnings at the time.

  2. Posted 12/06/2009 at 09:47 | Permalink

    Not necessarily disagreeing with the substance of this, but I don’t like this casual reference to greed and incompetence on the part of bankers. They got it wrong, as thousands of businesses get things wrong. But they were engaged in legal activity which they believed would bring benefits to their shareholders, as well as to themselves. Risk-taking is essential in business, and these risks were very widely believed to be manageable. With hindsight we can see they were wrong, but those pointing the finger of blame now are much more numerous than those sounding warnings at the time.

  3. Posted 12/06/2009 at 15:45 | Permalink

    And it is also worth mentioning that a market economy should attenuate greed but, in this case, the effects of greed (if that is the correct diagnosis) were magnified. Why was that? Partly, I would argue, because regulation has eroded market discipline. Secondly monetary policy sent false price signals through low interest rates to which bankers reacted rationally by raising leverage. Thirdly it was signalled that the ever-greater risks being taken were underwritten by monetary policy and the implicit promise of not allowing failure (especially in the US).

  4. Posted 12/06/2009 at 15:45 | Permalink

    And it is also worth mentioning that a market economy should attenuate greed but, in this case, the effects of greed (if that is the correct diagnosis) were magnified. Why was that? Partly, I would argue, because regulation has eroded market discipline. Secondly monetary policy sent false price signals through low interest rates to which bankers reacted rationally by raising leverage. Thirdly it was signalled that the ever-greater risks being taken were underwritten by monetary policy and the implicit promise of not allowing failure (especially in the US).

  5. Posted 12/06/2009 at 16:06 | Permalink

    To follow on from Len’s point, it is difficult to say that anyone – politicians included – did anything that went against their own interest. The actions of bankers, regulators and households were all rational.

    On the behaviour of AIFs, we should remember the comment made by Obama’s Chief of Staff,Rahm Emanuel: ‘Never waste a good crisis.’ A lot of what is happening in Europe and the US is what statist politicians have long wanted to do and the financial crisis has given them legitimate cover.

  6. Posted 12/06/2009 at 16:06 | Permalink

    To follow on from Len’s point, it is difficult to say that anyone – politicians included – did anything that went against their own interest. The actions of bankers, regulators and households were all rational.

    On the behaviour of AIFs, we should remember the comment made by Obama’s Chief of Staff,Rahm Emanuel: ‘Never waste a good crisis.’ A lot of what is happening in Europe and the US is what statist politicians have long wanted to do and the financial crisis has given them legitimate cover.

  7. Posted 15/06/2009 at 07:44 | Permalink

    Your analysis misses quite important point of who survived and how they managed their portfolio. Having this done accurately, it could prove your points of greed and incompetence. But now it is rather the point of shackleton I agree with, and your article is more like aftermath of what happened.
    Market is always right – as economist, don’t you agree?
    Have you ever played at Forex? Can you really forecast what is going to be the an exchange rate next day? People do it on 24hour basis, have experience and still are not able to make sound forecast which will not turn them down next minute. How can you judge and say of incompetence?

  8. Posted 15/06/2009 at 07:44 | Permalink

    Your analysis misses quite important point of who survived and how they managed their portfolio. Having this done accurately, it could prove your points of greed and incompetence. But now it is rather the point of shackleton I agree with, and your article is more like aftermath of what happened.
    Market is always right – as economist, don’t you agree?
    Have you ever played at Forex? Can you really forecast what is going to be the an exchange rate next day? People do it on 24hour basis, have experience and still are not able to make sound forecast which will not turn them down next minute. How can you judge and say of incompetence?

  9. Posted 22/06/2009 at 09:26 | Permalink

    1. Greed – bankers in effect determined their own salaries. Like MP’s and quango-bosses, people who are allowed to set their own remuneration overpay themselves. I would too, if I could.
    2. What bankers mostly did was to set up remuneration packages that rewarded failure as richly as success ($500m at Cit. The point is NOT that they did not have perfect foresight,but that they didn’t need it. In fact, it would have been a distraction. After all, is anyone seriously claiming that bank CEOs would have earned far more if their banks had not gone to the wall? With the benefit of foresight, they (or I) would have done……exactly what they did do. Take the money and live with the ignominy.

  10. Posted 22/06/2009 at 09:26 | Permalink

    1. Greed – bankers in effect determined their own salaries. Like MP’s and quango-bosses, people who are allowed to set their own remuneration overpay themselves. I would too, if I could.
    2. What bankers mostly did was to set up remuneration packages that rewarded failure as richly as success ($500m at Cit. The point is NOT that they did not have perfect foresight,but that they didn’t need it. In fact, it would have been a distraction. After all, is anyone seriously claiming that bank CEOs would have earned far more if their banks had not gone to the wall? With the benefit of foresight, they (or I) would have done……exactly what they did do. Take the money and live with the ignominy.

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