The suggestion that the Federal Government might extend its guarantee to managed funds in return for the funds becoming banks is, as Glenn Dyer has observed for Crikey, sheer bunkum.

On the lender side, this sector of the finance industry largely arose to make money out of lending practices or financial products that were too adventurous for banks themselves.

On the “depositor” side, investors in these companies knew full well that they weren’t making deposits that can be withdrawn at call, as with a bank, but investments.

One consequence of this non-bank behaviour was that managed funds weren’t required to keep on hand the idle funds that banks must to meet the possibility of depositors withdrawing their funds at will. This of course increased the potential upside: less idle funds, therefore higher potential returns. When the economy was booming, this freedom from the prudential limits of a bank was a winner for both the companies and their investors. The sacrifice of liquidity was rewarded with higher returns.

But now, in the midst of this financial crisis, investors are willing to sacrifice returns to get liquidity. Only whoops, managed funds aren’t liquid because …

You get the drift.

If times were normal, then the government could happily stand by when the odd managed fund suffered a run, and had to freeze redemptions. But now that eight major fund managers have frozen $12 billion in funds, standing by doesn’t seem an option.

However, it may be a more sensible strategy than the offer to convert managed funds to banks. After all, it takes more than the wave of a magic wand to make this transition.

Becoming banks might require the funds to give up the investment strategies that have defined them to date. There is little chance that any of these funds would immediately meet Basel II risk capital requirements, for example. What should they then do? Call in the loans that are outside the pale allowed to banks? This would surely precipitate what the funds and the government are trying to avoid: the funds calling in their loans to meet redemption demands, and thus bringing many commercial construction projects to a halt (not to mention stuffing up insurance contracts a la HIH, given AXA’s insurance business).

Nor are the funds likely to have on hand the hundreds of millions of dollars of cash needed to convert investor funds to at call deposits. They’d likely have to borrow these from the RBA, dramatically increasing their idle balances and cost of funds at a time their business model was suddenly driven from adventurous to conservative.

The government has been making policy on the run during this crisis, which is the only way it can behave when the situation itself is unprecedented: there is no “how to” manual for coping with any financial crisis, let alone one of this magnitude.

Often those policies have seemed sensible, and may well prove to be so with the benefit of a far distant hindsight. The guarantee of bank deposits surely fits that bill, because the very last thing we want is a run on the banks.

But this policy suggestion may be one that is best retracted. After all, the managed funds haven’t collapsed: they are still paying dividends to investors. All they’re not able to do is to return investors capital to them immediately.

The funds are also in a legitimate position to freeze redemptions, while still meeting their dividend payment obligations. These “market-based funds” differ from shares, in that most of those who invested in them did so for the income stream rather than capital gain. A case-by-case approach to assessing alleged special needs to withdraw capital is feasible.

That may not always be possible, of course. If the economy turns sharply for the worse, many of the investments made by managed funds will sour and investors will actually lose their money, rather than simply having to tolerate their illiquidity. Losses then will be unavoidable.

Standing by would then still be the best option. Greenspan’s proclivity to rescue investors from every last market collapse is part of the reason why we’re now in the biggest collapse since The Really Big One. The real pain inflicted back then caused a fundamental shift in people’s attitudes to finance, which we have since forgotten. Re-learning that lesson may once again require some pain.