Leading article: Missing the regulatory target

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The European Union is establishing new regulations on bonuses paid by financial firms. Only 30 per cent of bonuses will be permitted to be paid upfront in cash. And at least 50 per cent must be deferred for three years. We knew regulation of remuneration in banks was coming. But the surprise is that the new rules will apparently apply to hedge funds too. Is this wise? Not necessarily.

Regulators should take an interest in private-sector remuneration when there is a potential impact of those practices on the public purse. The remuneration systems of "too-big-to-fail" banks, which encouraged recklessness in the boom, clearly enter into that category. But the remuneration systems of hedge funds do not. Many hedge funds went bust in 2008. But, unlike the banks, none was bailed out by governments.

This is not to argue that hedge fund managers are not grotesquely overpaid. Their traditional charging structure – a 2 per cent annual fee on deposits, plus 20 per cent of all profits – is a bad joke considering how badly so many of these firms performed in the 2008 meltdown. The boast of most hedge fund managers to possess a special investing genius turned out to be pure nonsense. And it is an under-reported scandal of the financial crisis that so many pension funds were ploughing money into these funds during the boom years in search of fat returns. Yet the solution is pressure on pension funds to be less idiotic. As for wealthy investors in these high-risk funds, they need to learn their own lessons.

The other problem with regulating pay in the hedge fund sector is that it is a distraction from the more important task of monitoring their activities. Hedge funds, unchecked, can become a systemic risk, as the fate of the US firm, Long Term Capital Management, which required a co-ordinated rescue by the Federal Reserve in 1998, makes clear.

And our regulators also do not seem to understand the symbiotic relationship between large investment banks and their hedge fund clients. The activities of hedge funds might not have been the root cause of the credit meltdown two years ago. But they did help push the nuclear button when they began withdrawing their deposits from investment banks at the height of the panic. This was the notorious run in the world of shadow banking. And this vulnerability in the global financial system still exists.

No one should weep for Europe's hedge fund managers over these minor restrictions on pay. But we should be concerned that a more important regulatory gap is being neglected.

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