But what has made the current crisis so disastrous is the behaviour of large, regulated banks

TO BE NOTED: From the FT:

"Insight: A harmful hedge-fund fixation

By Gillian Tett

Published: May 7 2009 20:00 | Last updated: May 7 2009 20:00

Almost exactly two years ago, at the craziest peak of the credit bubble, Western leaders gathered in a conference room at the World Bank in Washington to discuss what they should do about the financial world.

These days it is clear what those grandees ought to have discussed – notably the wild excesses afoot in subprime lending, structured credit, monoline insurance, credit ratings and bank leverage.

In practice, though, those issues were barely discussed. Instead, the hot topic for debate in that April 2007 meeting (as I describe in a book published this month) was how to clamp down on hedge funds – a topic dear to German leaders, who were chairing the G7 at that point.

“It was really hard to get anything apart from hedge funds on the agenda back then,” laments one international bank regulator, who tried – and failed – to divert the debate onto more pressing matters.

These days, there is an unnerving sense of déjà vu bubbling in some political quarters of Europe. Over in America the financial community is currently consumed with the matter of banking stress tests.

In London, however, there is another hot topic worrying financiers – what Brussels plans to do about hedge funds.

Last week the European Commission shocked the City of London by unveiling plans to impose potentially tough new controls on the hedge fund and private equity industry. The European parliament bayed for more.

Then, this week the French government warned that they might strengthen these measures, apparently because they, like many other Continental leaders, think that lax hedge fund controls have sparked the recent crisis.

In fairness, some of these calls for a clampdown are not ridiculous. Regulators need to get better information about what the hedge fund world is doing, and to prevent the abuse of off-balance sheet entities. There is also a strong case to reduce the scale of tax avoidance associated with the hedge fund sector.

But the real danger with the current debate – as two years ago – is that it risks missing the wider point. For sure, some unregulated hedge funds have taken crazy risks in recent years. And unregulated shadow banks have also messed up.

But what has made the current crisis so disastrous is the behaviour of large, regulated banks, which have spent the last decade operating with ridiculously high levels of leverage, and purchasing vast quantities of toxic assets.

And the only thing more remarkable than the scale of those bank follies is that they went unnoticed for so long, partly because many regulators spent the last decade so obsessed with hedge funds. Pace that Washington G7 meeting in the spring of 2007.

Given that, it seems self-evident that the real priority now in Europe is to ask hard questions about banks – and bank regulation. If I was a German voter, for example, I would want to know why nobody in Frankfurt tried to stop German banks from dashing into structured finance on such a spectacular scale – and why the only people who ever warned of those dangers before the summer of 2007 were investors who went short (ie, the hedge funds.)

I would also want to know why rumours remain widespread that German banks are still holding vast quantities of toxic assets which have been barely marked to market value. And why not ask what the German government will do if it turns out that the entire German system is insolvent (as the German press has recently suggested after leaked documents suggested German regulators privately fear that their banks hold over €800m of toxic and illiquid assets.)

Such questions, let me stress, do not entirely remove the need for some debate about hedge funds. But the issue is priority and scale. The global hedge funds sector is estimated to command about $1,500bn of assets on a global basis. The balance sheet of some individual European banks, by contrast, is not wildly different in scale – even today.

Of course, it is possible that European politicians have cannily spotted that logic and are simply focusing on hedge funds as a convenient, distracting scapegoat. It is also possible all the heat about hedge funds will disappear once the European parliamentary elections are over. That is what some senior UK government figures and bankers hope.

But even if that argument is right – and it remains a big “if” – the lesson from the spring of 2007 about the danger of policy distraction remains clear. If European politicians were squealing about the need to clean up big banks – say, by demanding that Europe hurry up and impose its own version of bank stress test – then they might have the right to worry about reforming hedge funds too.

Unfortunately, though, they are not. As a result, the likelihood is that Europe will remain plagued with doubts about the health of its financial system for the forseeable future. And that is a scenario which should worry everybody, hedge fund lovers and haters alike.

gillian.tett@ft.com"