Healthy Hedge Funds, Sick Banks

I recently circulated an AEI Financial Services Outlook entitled Healthy Hedge Funds, Sick Banks. The essay discusses the regulatory implications of the unregulated hedge fund industry’s apparent health when compared to the financial weakness of the heavily regulated banking industry in the current subprime crisis. The principal question addressed in the essay is whether the regulation of banks allows an industry that is inherently unstable to function with a reasonable degree of stability or whether the regulation itself is responsible for the instability that has historically afflicted banking.

I argue that risk-taking and instability in the banking industry is enhanced because market discipline is reduced by moral hazard. In this context, moral hazard refers to the sense among investors and depositors that in the end the government will rescue banks and other private sector institutions from the consequences of their own errors. The numerous actions by the Federal Reserve to increase liquidity in the face of the subprime crisis provide direct support for this belief. As a result, I suggest that the actions taken to shore up banks adversely affected by the subprime collapse has increased the level of moral hazard, and thus increased the likelihood that another similar crisis will result in the future.

The positive experience of the hedge fund industry suggests strongly that market discipline is a powerful mechanism for controlling risk. In fact, it implies that market discipline may be more effective than regulation in maintaining an industry’s stability. I also argue that regulation itself must be significantly improved in order to be effective in overcoming the moral hazard it fosters. I incorporate both implications in my suggestion to introduce specialized subordinated debt into the banking industry. The subordinated debt would be designed to provide bank supervisors with a market-based signal about bank risk-taking that is roughly equivalent to what the market would do in the absence of government regulation.

The full outlook is available here.