Restrictions on big banks could boost possible benefits for hedge funds and private equity funds.  The Regulatory Reform package and other bills such as the “Volcker rule” could push investors from big banks towards their funds instead.  The Volcker rule is a plan to ban proprietary trading.  Another key element in the rule is to limit banks involvement with hedge funds and private equity funds.  The current Administration is not making sufficient efforts to limit the size and risk profiles of banks.  A goal is to stop Wall Street banks from gambling in markets with subsidized deposits.  This is good news for hedge funds and private equity funds.

Hedge Funds and Private Equity funds will definitely have a chance to absorb former bank investors when tighter restrictions are levied against the big banks.  Current bank investors will either get spooked from the new regulations or will be forced to seek other options because of new regulations.  This now gives hedge funds and private equity funds more potential investors and ultimately more power.  These investors will not hesitate to move to hedge funds and private equity shops outside of the big banks.  An investor’s main interest is to make money and are they willing to take the risks inherent with these types of firms.

The main impact will be proprietary trading.  Markets will become less liquid which in turn means wider spreads and higher costs for investors.  This may be something some investors feel is worth paying for – a safer banking system.  What will most likely happen are proprietary traders will move to hedge funds.

If hedge funds do not already have proprietary trading strategies, it would be wise for them to start getting into that business or increase their current proprietary trading desks.  Fund subscriptions are likely to increase.  Private Equity funds will also be able to take advantage if big banks are forced to dissolve or separate their private equity arms.  Private equity funds will most likely see an increase of investors to their funds.  Therefore, more money will start to flow into these funds that are leaving the banks.  The larger funds will get bigger and other small to medium sized funds will start to adapt and create new strategies in order to accommodate new investors and new positions.

During President Obama’s State of the Union address, he made a remark of how the bank bail-out was “as popular as a root canal”.  He vowed to take on lobbyists who are trying to stifle financial reform and that it is a fight he is willing to have.  For President Obama, bank bashing is good politics for him now especially after the bruising he has taken on Health Care reform.

Previous financial reforms have had some unintended results.  Regulation Q was a reform that restricted the interest rate that banks could pay on deposits.  Many investors ended up in the Euromarket and with money-market funds where dollars were then accumulating outside of the US.  Enforcement of the Basel Rules was another example.  This was an incentive for banks to hold AAA rated securities which required less capital to be held against them.  Eventually, there was a shortage of AAA rated bonds.  The financial gurus then devised complex securities called collateralized debt obligations (CDO’s) based on sub-prime mortgages.  CDO’s did not have a happy ending.

In conclusion, big bank reform will have benefits for hedge funds and private equity funds.  When investors move away from big banks, hedge funds and private equity funds will be sure to grow.  Investors will invest more in these funds where regulation is not as stringent yet.  This leaves one final question for the readers.  Will the unregulated hedge funds and private equity funds pose a financial systemic risk in the future that will cause regulatory authorities to second guess themselves if another financial crisis occurs in the future?  Only time will tell.   For the near term, hedge funds and private equity funds will be sure to capitalize on bank reform.

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