By Neil Wilson
Paul Volcker is right, of course. Public money “should not be used to support risk-prone capital market activities simply because they are housed within a commercial banking organization,” as the respected former chairman of the Federal Reserve told a recent conference in Los Angeles.
But Bob Diamond, the head of Barclays Capital, has a point too. As Diamond said in a recent U.K. television interview, banks need to take risks—as well as to be properly capitalized—for a modern free-market economy to function effectively and grow.
So where should the limit be to risk-taking by banks in the capital markets—and the limit to implied taxpayer support? And what role does this leave for private risk-takers such as hedge funds?
In the U.S. after the Great Depression, there once was a simple set of rules—laid down by the Glass-Steagall Act. Commercial banks, which held the public’s saving deposits, were to be supported by the lender of last resort—the central banking system—in order to protect the public. But investment banks, which made their living in the capital markets by issuing and trading securities, were not. They had to survive by their wits.
Of course, the world has become much more complicated since the 1930s. Particularly since the invention of financial derivatives, money markets and securities trading have become ever more linked.
The onset of the credit crunch and global financial crisis subsequently demonstrated the downside of all this. The big investment banks—supposedly not backed by any federal guarantees—had become uncomfortably too big or interconnected to fail. Hence the U.S. authorities offered such a helping hand in the takeovers of Bear Stearns and Merrill Lynch by JPMorgan and Bank of America respectively.
Both of these events, and particularly the first one, excited furious debate about moral hazard and whether the Treasury and the Fed were helping too much. Though when they finally did let one major investment bank—Lehman Brothers—fail, the result on markets was, of course, calamitous. That, in turn, led the government very quickly to cave in completely and offer the direct lender of last resort facilities to the remaining big investment banks—Morgan Stanley and Goldman Sachs—masked by the fig leaf (convenient fiction) that they had suddenly become commercial banks.
The public’s reaction has been one of quite understandable fury—and not just in the U.S. but in the U.K. and all around the world as well. Everybody knows that many banks would very likely not still be standing were it not for the huge taxpayer-supported bailouts, most especially of AIG, that allowed contracts to be honored and thus prevent a tidal wave of defaults.
So, when the public sees those firms pay out huge bonuses again, it should be understandable that commentators such as Matt Taibbi at Rolling Stone conclude that Goldman Sachs is like “a giant vampire squid wrapped around the face of humanity.”
Perhaps Goldman is somewhat more respectable than that. But Volcker is surely right that trading firms that are not deposit-taking institutions should not benefit systematically from any actual or implicit taxpayer guarantees. Whatever the new system is to be post-crisis, such guarantees need to be stopped or the whole system really will be undermined by moral hazard.
Arguably, hedge funds also benefited indirectly from the taxpayer-funded bailouts, because the bailouts prevented a cascade of failures among their counterparties. That point must be admitted. But there were no direct bailouts for hedge funds.
It is important to remember that there never have been any bailouts for hedge funds; nor should there be. Even in the most tumultuous case of a hedge fund’s collapse—that of Long-Term Capital Management in 1998—the Fed got Wall Street to club together and clear up the mess. And despite much intense debate through the years about the potential systemic risk posed by hedge funds, when we finally did have the most serious crisis in decades, hedge funds were barely if at all an aspect of the problem.
Post-crisis, the world, of course, still needs risk capital. And if the banks must be curtailed, then it is the more independent actors such as hedge funds that should have a much greater role in supplying it.
It is possible, of course, that further down the road we could be in a world where some hedge funds—like the big investment banks—become too big to fail. We are a long way from that point.