Beware of hedge funds bearing gifts, the easiest way to rob a bank is to run one
Published 30/07/2014 | 02:30
A "shadow banking system" is being constructed in Ireland. It has enormous potential to torpedo the future growth path and risks another banking crisis in time.
The term shadow banking system was coined by my former boss, the economist Paul McCulley, to describe the activities of all sorts of funds that are in his words "a whole alphabet soup of levered-up investment conduits, vehicles and structures". The term perfectly captures the nature of a business, which significantly contributed to the global economic crisis.
A shadow banking system is a parallel banking system. It behaves like a banking system but it's not. It is all sorts of investment funds which lend money. But the institutions aren't places you go into with your deposit and open an account. A shadow banking system manages to get finance in other ways and then lend this money into the economy
The Irish Central Bank has just announced that it will allow hedge funds - the most greedy, unscrupulous, short-termist financial subspecies out there - to lend money to Irish corporations. This truly beggars belief.
Hedge funds are the most highly speculative, profit-driven financial companies in a vast avaricious eco-system that is the financial markets. The aim of the hedge fund is to maximize profits in the very short-term. This involves taking big bets on certain assets - usually stocks or bonds - and if you make money, great - but if the asset is not performing you sell as quickly as possible. Involving these people in the business of lending to ordinary companies will completely destabilize the economy and lead to much more amplified boom/bust credit cycles than we have even seen in the past fifteen years.
The incentive structure built into hedge funds means the hedge fund manager has to take big bets.
As financial markets continue to rise, most hedge fund managers are worried about investing in expensive markets now. Therefore, they are looking for new pastures to make money and lots of it.
When the only objective of the lenders is to make lots of money, you can be sure that this is not good news for the borrower!
To make this money, the hedge fund raises money from rich investors or institutions and takes a fixed management fee of maybe 2pc of the total capital committed. After that, the hedge fund manager gets 20pc of any profits the fund makes over a certain minimum amount.
Because the hedge fund managers share the profits but not the losses, they are always incentivized to take big bets and are less concerned about losing money than making it. In addition, what distinguishes hedge funds from mutual funds is that they can borrow as much as they like in their pursuit of profit.
Are these the types of people that should be lending into the Irish economy? Is this the type of financing which is designed to create a sustainable growth path in the future?
They are moneylenders of the old-fashioned type. Yet according to the reports yesterday, hedge funds based in Ireland will be able to lend to companies under new rules drawn up by the Central Bank.
Apparently, the Central Bank has issued a consultation paper on its proposed rules and expects them to be in place by the end of the year.
Because banks are still reducing their lending to households and corporations six years after the financial crisis, the Central Bank claims that there has been increased demand for new sources of lending from firms in Ireland and abroad.
Under the new rules, a loan fund will not be able to lend more than a quarter of its assets to one borrower and the amount of debt the fund can take on will be capped at a ratio of one to one, meaning that if a fund has assets of €100m it can borrow another €100m.
But the issue is not how much money they lend; it is how they lend it and why.
The banking crisis in Ireland was caused by a combination of too many big loans and far too many little loans. The reason the banks lent too much money is that they were driven by short-term profiteering and the short-term movement of their share prices. They paid themselves in the shares of their banks, so self-interest drove them to push up the share price.
Such activity gives credence to the observation that the easiest way to rob a bank was to run one.
Traditionally banks were robbed by criminals breaking in, but in recent years banks were robbed by executives on the inside breaking out.
The managers of hedge funds will have an even bigger incentive to take risks because the link between their own pay and the profits of the fund are even more direct. If the central bank is prepared to allow hedge funds lend in Ireland how big might this move be?
In 2009, it was reported that there are over 350 financial companies operating in the Republic, despite the fact that many have little or no employees and are experts in tax avoidance. The 'shadow banking' system's assets comes in at a whopping €1.7 trillion.
The proposed new regulations over the shadow banking sector specifies that there will be a cap on the amount of debt a fund can hold, with a ratio of 1-1. Thus, considering that the total value of the Irish shadow banking system's assets to be €1.7trillion, it can borrow a further €1.7trillion.
This is a huge amount of money in the hands of people who are incentivized to take risks with it in the real economy. Is this a sensible route? Imagine if a fraction of that gets into the south Dublin housing market?
I suggest we hold onto our seats!