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
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
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
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
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.