Volcker is correct in that banks conflicts of interests need to be stemmed. One would not have to worry about over regulation if one does not attempt to regulate every single act or attempt to guess what might go wrong. What needs to be done is to use regulation to disincentivize banks from engaging in activities that engender systemic risks and/or harm clients. By putting everybody on the same side of the table, you don't have to worry about outsmarting the private sector.

From CNBC:

"In his testimony, Volcker will say there are strong conflicts of interest inherent in participation by commercial banks in proprietary or private investment activity.

"I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses," Volcker said in his prepared remarks.

"But neither am I so naive as to think that, even with the best efforts of boards and management, so-called Chinese walls can remain impermeable against the pressures to seek maximum profit and personal remuneration," he said."

Currently, banks that own PE funds and hedge funds have a perverse incentive to maximize AUM over actual returns in a down market. This provides an implicit call option on the market that is funded by the banks admin and management fees. These are fees that the banks get anyway, and if the market goes up the bank also benefits by riding the beta through incentive fees. The client does not truly have the banks as a partner as an equity investor even though the bank may put its own capital in the fund alongside the clients. The incentives are not aligned, to the detriment of the client.

This also gives the banks the incentive to take outsized risks at precisely the exact times that they should be curtailing risks.

A good example is the outrageous losses Morgan Stanley has been taking through its private real estate investment funds. It is not as if it was difficult to see that CRE market was overheated when these funds kicked into high gear purchasing mode. See Doesn't Morgan Stanley Read My Blog? where I detailed exactly how insanely priced the Zell/Blackstone CRE flip was in 2007. Then reference Wall Street is Back to Paying Big Bonuses. Are You Sharing in this New Found Prosperity? where I show how much money was lost by the MS fund when they purchased that insanely priced flip, as well as monies lost in other overpriced acquisitions at the top of a bubble using max leverage.

The following is an excerpt from the afore-linked blog post:

Needless to say, Morgan Stanley, the GP and effective holder of the "Call Option", actually saw significant cash flow from carried interest, management and acquisition fees despite its investor's losses.

Upon a close examination of the structure of funds such as the Morgan Stanley's MSREF, it has been observed that fund sponsors, acting as the GP (general partner) collect sufficient cash flows through fees to insulate themselves from negative returns on their equity contribution in the case of a severe price correction (Please refer to the hypothetical example below, constructed as an illustration of a typical real estate fund). The annual management fees (usually 1.5% of the committed funds) along with acquisition fees provide the cash flow cushion to absorb any likely erosion in the capital contribution (usually 10% of the total equity). Further, the provision of "GP promote" (the GP's right to a disproportionate share in profits in excess of an agreed upon hurdle rate of return) rewards the fund sponsor in case of gain, but does not penalize in case of a loss. Herein lies the "Call Option"! With cash flows increases that are contingent upon assets under management and the volume of deals done combined with this implicit "Call Option" on real estate, the incentive to push forward at full speed at the top of an obvious market bubble is not only present, but is perversely strong - and in direct conflict with the interests of the Limited Partners, the majority investors of the fund!

A hypothetical example easily illustrates how the financial structure of a typical real estate fund is so tilted to the advantage of the fund sponsor as to be analogous to a cost-free "Call Option" on the real estate market.

The example below illustrates the impact of change in the value of real estate investments on the returns of the various stakeholders - lenders, investors (LPs) and fund sponsor (GP), for a real estate fund with an initial investment of $9 billion, 60% leverage and a life of 6 years. The model used to generate this example is freely available for download to prospective Reggie Middleton, LLC clients and BoomBustBlog subscribers by clicking here: Real estate fund illustration. All are invited to run your own scenario analysis using your individual circumstances and metrics.

To depict a varying impact on the potential returns via a change in value of property and operating cash flows in each year, we have constructed three different scenarios. Under our base case assumptions, to emulate the performance of real estate fund floated during the real estate bubble phase, the purchased property records moderate appreciation in the early years, while the middle years witness steep declines (similar to the current CRE price corrections) with little recovery seen in the later years. The following table summarizes the assumptions under the base case.

Under the base case assumptions, the steep price declines not only wipes out the positive returns from the operating cash flows but also shaves off a portion of invested capital resulting in negative cumulated total returns earned for the real estate fund over the life of six years. However, owing to 60% leverage, the capital losses are magnified for the equity investors leading to massive erosion of equity capital. However, it is noteworthy that the returns vary substantially for LPs (contributing 90% of equity) and GP (contributing 10% of equity). It can be observed that the money collected in the form of management fees and acquisition fees more than compensates for the lost capital of the GP, eventually emerging with a net positive cash flow. On the other hand, steep declines in the value of real estate investments strip the LPs (investors) of their capital. The huge difference between the returns of GP and LPs and the factors behind this disconnect reinforces the conflict of interest between the fund managers and the investors in the fund.

Under the base case assumptions, the cumulated return of the fund and LPs is -6.75% and -55.86, respectively while the GP manages a positive return of 17.64%. Under a relatively optimistic case where some mild recovery is assumed in the later years (3% annual increase in year 5 and year 6), LP still loses a over a quarter of its capital invested while GP earns a phenomenal return. Under a relatively adverse case with 10% annual decline in year 5 and year 6, the LP loses most of its capital while GP still manages to breakeven by recovering most of the capital losses from the management and acquisition fees..

Anybody who is wondering who these investors are who are getting shafted should look no further than grandma and her pension fund or your local endowment funds...