Liquidity Risk and Limited Arbitrage: Are Taxpayers Helping Hedge Funds Get Rich?

Evan Gatev

Volume 7, Number 2, Second Quarter 2009

Hedge funds facing capital constraints during market-wide liquidity shocks use bank credit lines to reduce the limits to arbitrage. During shocks, government-protected bank deposits receive inflows and this exclusive low cost funding enables banks to lend to hedge funds. In effect, banks compete away the government subsidy while tax-avoiding hedge funds reap the lion share of the benefits. After the advent of hedge funds, the existing government safety net protecting banks is no longer optimal in the sense of maximizing social surplus.