We know that recoveries from financial crises tend to be slow; it takes on average about eight years to reach the pre-crisis level of real per capita income following financial crises. 3 Distorted and damaged financial sectors don’t allocate resources effectively. We may not pay the price for a number of years as the boom builds up. But in the end the price we pay is large when a financial system misallocates resources in the boom and in the following bust. Real GDP per head – the best measure of our aggregate living standard – remains 1% below its pre-crisis peak. This high cost to the economy and to society is why we need not only robust regulation of financial institutions but also of the financial system as a whole. Financial stability and sustainable growth are complements. They are not alternatives. Turning back to the reallocation mechanism, there are now some positive signs. The financial sector is well into its recovery. Bank lending growth to non-financial businesses was positive in 2015 Q1 for the first time since the crisis. Beyond the banking system, the Bank’s agents are reporting private equity firms purchasing debt-laden companies and restructuring their funding. The creation of new firms, a sign of vibrancy and reallocation in the economy, increased by 30% in 2013. And labour market ‘churn’, the movement of workers between firms is almost back to its pre-crisis average having fallen sharply in the crisis. In addition, we have seen a return of business investment over the past two years.

Conclusions Free of narrow constraints embedded in traditional investment guidelines, hedge funds have been an important source of innovation in the asset management industry. Lucrative compensation structures have played an important role in attracting talented individuals to the industry. Admittedly, these same financial incentives have encouraged many lesser talents to disguise themselves as hedge fund managers. I suspect, over time, investors will only be willing to pay prevailing hedge fund fees for truly outstanding managers. Hedge funds have rendered financial markets more liquid, more efficient and, ultimately, more flexible. Nonetheless, market observation suggests that in some specific cases, certain segments of the hedge fund industry may have recently had some impact on market volatility, either by accentuating existing market trends or by causing sharp price reversals or gapping price movements. The use of leverage is a central characteristic of the hedge fund industry. Overall industry leverage is extremely difficult to measure. Market and survey evidence suggests that it is currently moderate. However, such leverage estimates must be interpreted with great caution. They are unlikely to capture the real extent of leverage embedded in the hedge fund industry. Leverage matters in a number of ways. One particular concern is that diminishing hedge fund returns in the aftermath of large capital inflows might motivate hedge fund managers to use extreme leverage to generate returns commensurate with the prevailing hedge fund fee structure. Systemic risks could conceivably result from such elevated levels of financial leverage, primarily through large credit risk transfers to the global banking system.