A Case for Tighter Regulation of Hedge Funds

Robert Waldmann

One of the puzzling aspects of the European debate over how to increase financial regulation after the crash was the idea that hedge funds should be regulated more. This is odd as they didn’t destabilize the system. I just assumed the Europeans can’t stand unregulated people making huge amounts of money. Now I have a rationalization. The idea is that all the smart investment bankers set up hedge funds leaving behind the fools. Then the smart hedge fund managers bet against the fools and destroy the investment banks. So the problem is that hedge fund managers make too much money compared to you poor long suffering traders at investment banks.

I am not joking.

The argument came to my mind when I think of restricting the compensation of investment bankers. I agree with all many disinterested people that driving smart people out of finance is a feature not a bug. However, driving smart people from investment banks to hedge funds might not be such a great idea.

Fortunately there is a useful regulation of compensation of investment bank employees which wouldn’t drive them to set up hedge funds. It is requiring bonuses to be paid in shares which can’t be sold for years (say 5 years). This forces the investment bankers to think of the long term. Notably this is the way in which hedge fund managers make money – they do not cash out most of it – the investors aren’t as dumb or in on the scam as investment bank CEOs or as diffuse as investment bank shareholders.

In any case, restrictions on compensation have to be designed recognizing the facts that financiers can choose whether to work for investment banks or set up hedge funds and that it is not socially optimal for all of the smart ones to set up hedge funds.