Hedge Fund Fisticuffs: Does Anyone Really 'Get It'?

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Let's talk about risk.

As I pointed out this morning , the backlash against Goldman Sachs president Gary Cohn's remarks about hedge fund regulation continues.

Let's begin at the beginning.

The tempest began earlier in the week when Cohn's remarks at the World Economic Forum in Davos were widely covered in the financial press.

Francesco Guerrera and Gillian Tett quoted Cohn in the Financial Times:

“'In the next few years, the unregulated sector will grow at an exponential rate,' he said. 'Risk is risk. My concern is that?...?risk will move from the regulated, more transparent banking sector to a less regulated, more opaque sector.'"

And then the recriminations began.

(For example, Sam Jones , quotes Richard Baker, the president and chief executive of the Managed Funds Association, the industry’s main trade group, in yesterday's Financial Times:

“These statements are just false. Hedge funds are regulated. We didn’t cause the financial crisis. We didn’t take bail-out money.")

But let's return for a moment to Cohn's original contention.

His tautological claim—that risk is risk—is, by definition, true. As far as it goes. Which isn't quite far enough.

Risk, in and of itself, is not the problem with Too Big to Fail.

The problem is concentration of risk in systemically important institutions—which, by their very nature, must not be allowed to fail.

Thus, moral hazard.

In a capitalist system you have the right to succeed as well as the right to fail. Badly managed businesses—and badly managed banks—fail so that their well-managed counterparts can supplant them. (Hence, the phrase 'creative destruction'—at least in the sense that Schumpeter intended.)

And so, in consequence, the focus shifts to identifying systemically important institutions. The idea is to ensure that excessive risk is not concentrated in a few colossal money center banks, but rather spread throughout the system. In so doing, the thinking goes, bad financial institutions within the banking system can fail—without destroying the broader economy.

That said, it's worth pointing out that no one seems to have the faintest idea how such a feat may be accomplished.

In fact a third article, written by Tom Braithwait, which appeared in the Financial Times earlier this month, makes precisely that point.

No less august a source than the Secretary of Treasury himself seems flummoxed:

"Tim Geithner has questioned the feasibility of identifying financial institutions as 'systemically important' in advance of a crisis, just as the regulatory council the Treasury secretary chairs is supposed to start doing precisely that."

Geithner is later quoted in the article as saying: "What size and mix of business do you classify as systemic? … It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock."

Geithner analysis is very candid—and highly disconcerting.

It speaks in a very direct way to the necessary limitations of our knowledge. And, in sobering consequence, of our ability to prevent the next economic cataclysm—though we may see the storm clouds gathering on the horizon.

Perhaps the most fitting way to end the discussion is with a quote from Peter Sands, the chief executive of Standard Chartered Bank.

“The current regulatory debate is a bit like discussing having better seat belts on planes. It’s hard to argue against, but when the plane crashes, it’s all a bit marginal ...?the real focus of regulation should be on making the air traffic control system safe.”

What does that mean, you ask?

Well, I have absolutely no idea.

But, I suspect, neither does anyone else.

Which is really the whole point, when you think about it.


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