Peter Wallison of the American Enterprise Institute has written a thought-provoking piece contrasting the banking industry’s recent problems with the relatively strong performance of hedge funds.

In Wallison’s opinion, the difference has much to do with the way banks are regulated. He says that

… increased willingness by regulators to use their powers to prevent instability and the consequent losses to the public … has led to increased moral hazard and a corresponding reduction in market discipline.

In other words, bankers take risks because they know that, if they become unstable, the government will bail them out. Even if it’s not a direct bailout (as in the S&L crisis) it may an indirect one, like the measures taken by the Federal Reserve to inject extra reserves into the banking system. It’s a difficult incentive problem to solve, Wallison writes:

Thus, the problem seems to be circular: the more regulation, the less market discipline; the less market discipline, the greater the incentive to grow; the larger the bank, the more reasonable it seems that the bank will not be allowed to fail; the smaller the probability of failure, the more latitude for risk-taking the bank gets from its depositors and other creditors. That seems to be the mechanism that created the current paradox — unregulated hedge funds seem stable but heavily regulated banks do not.

Wallison doesn’t delve too deeply into the hedge fund data, though. Other work has shown that indexes of hedge-fund performance have an upward bias, because poor-performing funds get liquidated and stop reporting their results. It’s also probably true that as hedge funds become a more important part of the financial system, they too may acquire a too-big-to-fail patina that creates a moral hazard. Remember Long-Term Capital Management?

Wallison makes some important points about the inadequacy of bank regulation, but I’m not sure the hedge fund model is the answer.