Banks are essential (but troublesome) institutions that keep checking accounts for depositors, but only hold a fraction of deposit liabilities in reserve to pay for checks.
Normally, 15 cents on the dollar is adequate reserves for banks because those writing checks will about equal to those making deposits.
To ensure banks have enough reserves to pay on their checking accounts, borrowers pay both principal and interest.
Banks are Regulated to Ensure Their Liabilities
Because a bank’s liabilities include personal and business checking accounts, the larger society has a special need to regulate banks to make sure they have reserves to meet their account liabilities.
Even though regulations requiring minimum reserves have been around for a long time, banks have been left to decide which loans to make and which loans to refuse. Individual banks, for example, decide when to make loans to hedge funds and how much to loan.
To make payments on their loans, hedge fund managers need to have their own reserve funds from investors (or profits). But because hedge funds are unregulated, it is up to their managers to decide their reserves.
Should Hedge Funds Be Regulated Like Banks?
If banks can bring down the financial system, and hedge funds are taking even riskier action, should they also be regulated?
To judge the risk yourself, suppose it is 1993 and you are the manager at Long Term Capital Management, a new hedge fund. You notice in August that a new 30-year Treasury bond with coupon interest of 7.2 percent starts trading at 7.24 percent interest and a price of $980.84 for a $1,000 bond, but another 30-year Treasury bond first sold in February 1993 is trading for 7.36 percent interest at a price of $995.13. (Price calculations are from MS Excel function PRICE)
To exploit the difference of price — the spread — you get a loan to buy the cheaper and older $1,000 bond at $980.84. Then you borrow the other bond from a brokerage house like Merrill-Lynch and immediately sell it for $995.13 cash.
The two transactions will be profitable if the interest rates converge over time: the low one rises and the high one falls. Economic theory predicts price differences will be temporary for a product or service; low prices rise and high prices fall until all are equal.
Suppose, in two months, the interest rates do converge to 7.3 percent.
At 7.3 percent interest, you can sell the older bond for $987.83: a $6.99 profit. You buy back the newer bond for $987.77 and return it to Merrill-Lynch. Since you sold it for $995.13, you make $7.36 on the second transaction. Total profit equals $14.35.
Earning $14.35 will not make you rich, but if a bank will lend you $1 billion to buy many bonds and interest rates do converge, then you can get rich.
Banks made billions in loans to hedge funds and many made profits doing the same and similar transactions as the one above. Eventually, though, interest rates diverged and some countries and companies defaulted on the bonds in hedge fund portfolios.
Hedge funds could only sell their bonds at a loss, if at all, and without reserves or cash they defaulted on billions in loans. Banks needed those loan payments to have enough reserves to clear checking accounts: my money and yours. That was the downward spiral, the crisis.
Maybe it’s high finance? Maybe it’s gambling? Maybe it’s time to regulate hedge funds like banks?
Fred Siegmund covers America’s jobs as part of work doing labor market analysis and projections for a client base of recruiters, trainers and counselors. Visit him at www.americanjobmarket.blogspot.com
