| Banks | Hedge Funds | |
| Capital | · Banks have permanent equity capital and long term hybrid capital. |
· Lock ups and gates have been controversial. Some investors dislike them while others appreciate the stability they bring. |
| Price discovery | · Bank equity and capital trade on open markets and price discovery is achieved through demand and supply. |
· Equity is subscribed and redeemed at Net Asset Value. · Secondary market remains small and specialized. |
| Leverage (size) | · Banks are typically leveraged anywhere from 10X to 50X.
· Banks are allowed to apply risk weights to assets for the purposes of calculating their leverage. |
· Hedge funds are typically leveraged between 2X to 5X although some strategies are more leveraged than others. · No risk weighting of assets. Everything counts. |
| Leverage (structure) | · Banks issue across the spectrum from hybrid capital to senior, secured, bonds as well as secured and covered bonds.
· An important source of banks’ funding is deposits. Bank deposits are a source of duration mismatch. · Some banks rely on short term, wholesale funding such as interbank, commercial paper and repo markets. |
· Hedge funds rely on prime brokers for their leverage. Prime brokers are usually the large investment banks. · Hedge funds not only borrow money but also borrow securities for shorting, leading to de facto if not financial leverage. · Cash and securities lending is usually on a short term basis and can be recalled. |
| Business | · Banks lend to households, businesses, and governments. When they do so they make money by taking credit risk.
· Banks provide services to clients earning fee income. · Banks engage in trading activities. This has been substantially reduced post 2008 as regulation has been introduced to reduce systemic risk and taxpayer bailouts. |
· Most hedge funds make money from trading and investment. · Some hedge funds provide financial services and earn fees but this is usually in conjunction with assuming some market or credit risk. · Some large hedge funds are significant lenders providing credit not only through bond investment and underwriting but in private loans. · Many hedge funds were spin outs of bank proprietary trading desks. As heavier capital requirements weighed on banks capacity for trading more traders left to join or establish hedge funds. |
| Investor base | · Equity is publicly traded and bought by institutional investors, retail investors, mutual funds, and institutional funds.
· Other claims are variously traded by investors of varying sophistication. |
· The offer of hedge funds is usually restricted to sophisticated investors. |
| Operating costs | · Borne by shareholders. |
· Investors pay management and performance fees, ostensibly 2% p.a. for management and 20% of profits. Actual management fees are lower as institutional investors obtain discounts. · Investment manager bears the operational costs which are paid out of the management and performance fees they collect. |
| Asset Valuation | · Banks have some discretion on whether assets are marked to market or not depending on whether the bank deems them to be Held To Maturity, Trading, or Available for Sale. |
· Almost all hedge funds mark all their assets and liabilities to market. The market convention is that long positions are market to bid and short to offer. · Typically an independent administrator is involved in the valuation of individual assets and the calculation of NAV. |
| Regulation | · Regulated internationally (e.g. BIS), regionally (e.g. EBA, ECB), and nationally (e.g. local central bank.) |
· Largely unregulated although AIMFD in Europe is an attempt at better regulation. · Increased regulation if they seek wi |
| History of Instability | · Bank runs have been recorded since banks were invented.
· A record of banking crises exists from 1763 with roughly one crisis per decade. · Over-leverage and a concentration in one area of collateral appear to be factors. |
· Hedge funds have not had as long a history as banks but the frequency of systemic failures has not been as frequent as in the banking industry.
· 2008 was the last time hedge funds faced forced closure en masse. Their demise was closely related to the failure of a number of investment banks which were prime brokers, notably Lehman Brothers, but also Merrill Lynch and Bear Stearns. · The last systemic crisis in hedge funds occurred 10 years earlier when LTCM failed as a result of over leverage and over dependence on theoretical models. A number of Wall Street banks were called upon to bail out the fund. Bear Stearns and Lehman did not participate. |