Financial Hocus-Pocus? From managed fund to bank?

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The sug­ges­tion that the Fed­er­al Gov­ern­ment might extend its guar­an­tee to man­aged funds in return for the funds becom­ing banks is, as Glenn Dyer has observed for Crikey, sheer bunkum.

On the lender side, this sec­tor of the finance indus­try large­ly arose to make mon­ey out of lend­ing prac­tices or finan­cial prod­ucts that were too adven­tur­ous for banks them­selves.

On the “depos­i­tor” side, investors in these com­pa­nies knew full well that they weren’t mak­ing deposits that can be with­drawn at call—as with a bank—but invest­ments.

One con­se­quence of this non-bank behav­iour was that man­aged funds weren’t required to keep on hand the idle funds that banks must to meet the pos­si­bil­i­ty of depos­i­tors with­draw­ing their funds at will. This of course increased the poten­tial upside—less idle funds, there­fore high­er poten­tial returns. When the econ­o­my was boom­ing, this free­dom from the pru­den­tial lim­its of a bank was a win­ner for both the com­pa­nies and their investors—the sac­ri­fice of liq­uid­i­ty was reward­ed with high­er returns.

But now, in the midst of this finan­cial cri­sis, investors are will­ing to sac­ri­fice returns to get liquidity—only whoops, man­aged funds aren’t liq­uid because…

You get the drift.

If times were nor­mal, then the gov­ern­ment could hap­pi­ly stand by when the odd man­aged fund suf­fered a run, and had to freeze redemp­tions. But now that eight major fund man­agers have frozen $12 bil­lion in funds, stand­ing by does­n’t seem an option.

How­ev­er, it may be a more sen­si­ble strat­e­gy that the offer to con­vert man­aged funds to banks. After all, it takes more than the wave of a mag­ic wand to make this tran­si­tion.

Becom­ing banks might require the funds to give up the invest­ment strate­gies that have defined them to date. There is lit­tle chance that any of these funds would imme­di­ate­ly meet Basel II risk cap­i­tal require­ments, for exam­ple. What should they then do? Call in the loans that are out­side the pale allowed to banks? This would sure­ly pre­cip­i­tate what the funds and the gov­ern­ment are try­ing to avoid: the funds call­ing in their loans to meet redemp­tion demands, and thus bring­ing many com­mer­cial con­struc­tion projects to a halt (not to men­tion stuff­ing up insur­ance con­tracts a la HIH, giv­en AXA’s insur­ance busi­ness).

Nor are the funds like­ly to have on hand the hun­dreds of mil­lions of dol­lars of cash need­ed to con­vert investor funds to at call deposits. They’d like­ly have to bor­row these from the RBA—dramatically increas­ing their idle bal­ances and cost of funds at a time their busi­ness mod­el was sud­den­ly dri­ven from adven­tur­ous to con­ser­v­a­tive.

The gov­ern­ment has been mak­ing pol­i­cy on the run dur­ing this cri­sis, which is the only way it can behave when the sit­u­a­tion itself is unprece­dent­ed: there is no “how to” man­u­al for cop­ing with any finan­cial cri­sis, let alone one of this mag­ni­tude.

Often those poli­cies have seemed sen­si­ble, and may well prove to be so with the ben­e­fit of a far dis­tant hind­sight. The guar­an­tee of bank deposits sure­ly fits that bill, because the very last thing we want is a run on the banks.

 But this pol­i­cy sug­ges­tion may be one that is best retract­ed. After all, the man­aged funds haven’t col­lapsed: they are still pay­ing div­i­dends to investors—all they’re not able to do is to return investors cap­i­tal to them imme­di­ate­ly.

The funds are also in a legit­i­mate posi­tion to freeze redemp­tions, while still meet­ing their div­i­dend pay­ment oblig­a­tions. These “mar­ket-based funds” dif­fer from shares, in that most of those who invest­ed in them did so for the income stream rather than cap­i­tal gain. A case-by-case approach to assess­ing alleged spe­cial needs to  with­draw cap­i­tal is fea­si­ble.

That may not always be pos­si­ble, of course—if the econ­o­my turns sharply for the worse, many of the invest­ments made by man­aged funds will sour and investors will actu­al­ly lose their mon­ey, rather than sim­ply hav­ing to tol­er­ate their illiq­uid­i­ty. Loss­es  then will be unavoid­able.

Stand­ing by would then still be the best option. Greenspan’s pro­cliv­i­ty to res­cue investors from every last mar­ket col­lapse is part of the rea­son why we’re now in the biggest col­lapse since The Real­ly Big One. The real pain inflict­ed back then caused a fun­da­men­tal shift peo­ple’s atti­tudes to finance—which we have since for­got­ten. Re-learn­ing that les­son may once again require some pain.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.