Beginning in the late 1980s, traditional banks began complaining that they were losing market share and profits and all their best people to investment banks, which had cleverly constructed a "shadow," banking system that was less regulated and backed by less capital. Their incessant whining and well-financed pleading eventually paid off in the late 1990s, when Congress dismantled the Depression-era wall between the two and let banks and investment banks merge. And it all worked — until, of course, it didn't.
Recently, during the financial regulation debate, the new megabanks have been complaining that if they're not allowed to continue outlandish bonuses, or if their activities are restricted, or they're saddled with extra requirements and leverage limits, they'll lose market share and their best people to the hedge funds.
You see the pattern here. The consistent line from the banks is that because we can't really stop the things we don't like — the excessive pay, the conflicts of interest, the lack of transparency, the unbridled speculation and market manipulation — it's better to have these things go on within banks, where there's at least some government supervision.
The problem with this argument is that it wasn't the unregulated hedge funds that were responsible for the crisis. Rather, it was the regulated banks that caused most of the problems, mainly when they began to think and behave like hedge funds.
That, anyway, is the conclusion of a splendid new book, More Money Than God by Sebastian Mallaby, a former Washington Post columnist and editorial writer. Years before the crisis, Mallaby set out to pull back the veil of secrecy on a corner of the financial world that had become immensely rich and powerful and, in the minds of many, rather menacing as well.
Mallaby's painstaking research resulted in the definitive history of the hedge fund game, a compelling narrative full of larger-than-life characters and dramatic tales of their financial triumphs and reversals. Mallaby weaves into his narrative just the right amount of economic theory and market history, and he has a wonderful knack for explaining complex trading strategies in simple and elegant prose.
But for me, the most eye-opening aspect of Mallaby's account is how much energy the hedge funds spend in trying to discover one another's trading strategies and how ruthless they can be in trying to profit from one another's miscalculations and misfortunes. Their obsessive secrecy isn't a lifestyle choice, it's a tactical imperative — no less than those huge bonuses, which serve as insurance against defections.
Mallaby is a market man, so it should be no surprise that he offers a sympathetic account of hedge funds. But you can't come away from More Money Than God without thinking that there ought to be a bright line between hedge funds and banks in terms of what they do and how they do it. As a general rule, the investment and trading strategies used by hedge funds are inappropriate for a regulated financial institution, and no bank should be taking on the kinds of risks that generate hedge fund-like returns. By the same logic, the kind of people who thrive at hedge funds probably don't belong at banks, and banks should not be offering the big bonuses to attract them.
Indeed, as Mallaby argues, it should be considered progress, not a problem, if regulatory reform forces some of the riskier financial activities out of big banks that are considered too big to fail, and into smaller hedge funds that pose little risk to the financial system. If bankers want to lead the exciting hedge-fund life, earning hedge-fund-like profits and bonuses, let them go work for a hedge fund.