What is a bank?

 

In my last FT Column I wrote about why the Germans had a point about hedge fund regulation. My basic premise was that hedge funds are becoming increasingly like banks, and since we all agree that banks should be regulated, we should regulate hedge funds as well. I expected a lot of readers to disagree with my conclusion – that hedge funds should be regulated – and some did. But what really surprised me was that most readers disagreed with the premise of the argument – that hedge funds are becoming increasingly like banks.

 

This is the sentence that caused most of the offence:

 

“The business of a bank is to borrow money from a central bank, lend it to customers at a premium and apply leverage to maximise profits.”

 

I was informed by several readers that this was simply not true. Commercial banks don’t borrow from central bankers, or at least not predominantly, but from the general public who place their savings in a deposit or savings account. In fact, I was told, this is precisely why we need to regulate banks and not hedge funds, which after all take their money from wealthy investors. Some readers thought that I did not understand the basic functioning of a commercial bank.

 

What happened here is how an economic abstraction can cause confusion or, in some case, even offence. I produced an admittedly oversimplified model of a financial market, in which I did not include the depositors for the very simple reason that I had no use of them. This is quite outrageous. Am I allowed to do this?

 

Well, yes I am. I merely described a banking channel in its most simple form, where a central bank creates money, channels this money through the banking system, which lends it on to investors. It is true, of course, that savings get channelled back into the banking system. You can add a bond or equity market to this basic setup, and much other financial wizardly. But why should I bother? All I needed was a system that gave a accurate description of how a commercial bank operated from an economic perspective – which is to borrow cheap, lend dear, and incur a risk in the process that it has to manage. What difference would depositors make to this setup? Since the central banks create all the money, this is where their deposits ultimately originated from in any case.

 

There is another reason why I left out the depositors. My argument about regulation was not based on investor protection. In fact, I disagree with the standard view that we need to regulate banks to protect innocent investors. I would rather leave this to the market in the form of deposit insurance. But there exists a solid, and undisputed argument to regulate banks – which is to prevent negative network externalities. A bad bank that goes bust might bring plenty of good banks down as well. There is no private insurance system in the world that can effectively insure against the collapse of the entire financial market, of which it is part. The economic rationale for regulation is thus to protect the good banks.

 

Hedge funds that employ long-short strategies act in a very similar manner to commercial banks – in the sense that they go long on high-yield securities, short low-yield securities, incurring a risk in the process. If they go bust, they may bring down the financial system as well. This almost happened in 1998 with LTCM. A general asset manager by contrast, also incurs risks, but mainly for his or her investors, not for the financial system at large. This is why I don’t draw the line between banks and fund managers, but between financial institutions with large and with small network externalities.

 

Now I know that if you run hedge funds it does not fell like you are running a bank. In fact, the reason you became a hedge fund manager may have been precisely because you are full of contempt for traditional bankers. Running a hedge fund is pretty cool these days, and you may find my comparison insulting. But I was merely looking at it from an economic point of view, in which you are not cool, not even individual human being, but an anonymous agent, and from that perspective, you are a banker, like it or not.

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