Prominent London bankers have described the summer seizure in the global money markets as the worst financial crisis they have seen for 20 years. To some extent this is special pleading, because the British banks have been affected worse than those in America or Europe, largely because the Bank of England has been surprisingly reluctant to fulfil its obligations as a lender of last resort.

Thus the gap between official interest-rate benchmarks and the rates actually paid for three-month loans is now almost twice as wide in London as it is in Frankfurt and three times wider than in New York. Despite the Bank’s protestations that it can operate only on overnight rates and can do nothing about the more important three-month bank rates, the Federal Reserve Board and the European Central Bank have worked hard on their three-month rates - and have get them under much better control.

Yet regardless of technical questions about the Bank’s operations, has the Bank been fundamentally right in its hands-off approach? A glance at broader financial markets suggests that this banking crisis may, indeed, be a storm in a teacup. At last Friday’s closing prices, the S&P 500 is 0.5 per cent lower than it was on July 31.

The MSCI World index and the FTSE 100 are 2.5 per cent lower. The Hong Kong market is up 3 per cent, largely offsetting a 6 per cent loss in Japan. Even more surprising is what has happened to corporate bonds. On July 31, American Baa bond yields yielded 6.63 per cent, according to Moody’s. Last Friday the corresponding figure was 6.59 per cent. The risk premium of 2.1 per cent paid on Baa bonds in relation to government issues is exactly the average level of the past 20 years.

So what really happened in August to justify all the lurid stories about a global financial collapse?

To judge by the steadiness of equity and corporate bond prices, the summer crisis was not really caused by a change in the macroeconomic environment or even a classic liquidity crunch. Rather, it represented a testing to destruction of a new business idea that overwhelmed the world of banking and thus influenced financial markets as a whole. This was the idea that hedge funds and other innovative investment vehicles could provide investors with a safe and immediately accessible home for their money in the same way as traditional banks.

Investors in low-volatility hedge funds and special investment vehicles (SIVs), which are now at the heart of this crisis, were offered three desirable features: First, a return somewhat higher than what was available on cash in the bank; second, capital safety, since all the money would be invested in high-quality assets and none of these funds had ever suffered losses greater than a fraction of 1 per cent; third, investors were assured that they could withdraw their money at any time, provided only that they give notice of one month.

The question that nobody bothered to ask was how the managers of hedge funds and SIVs could provide this desirable combination of liquidity and safety, while still paying high returns and pocketing very handsome fees for themselves.

The usual answer was that the hedge fund managers are much cleverer than ordinary bankers and use all sorts of ingenious new analytical and trading techniques. Maybe. But there was another, less flattering, explanation.

To most investors, the difference between the immediate and full repayment of deposits guaranteed by a bank and a hedge fund’s promise of redemption after one month at market prices seemed of little importance. After all, a properly organised corporate treasury or pension fund could easily predict its cash requirements a month ahead.

But to commercial bankers, the difference between guaranteed overnight deposits and one-month money market obligations was the difference between day and night.

To provide continuous overnight liquidity on a significant proportion of their liabilities, banks are forced to submit to elaborate government regulations, to maintain a large amount of capital as a guarantee and to balance their books precisely at the end of each day.

This is a very costly process, which makes banks much less profitable than hedge funds or money market funds, even if they try to provide very similar services to their clients, investing in the same loans and assets and using the same trading techniques. Conversely, a well-run money fund can easily offer better returns than a commercial bank and still make big profits for the managing partners – provided that the liquidity it offers to clients does not have to be guaranteed.

Until last month’s crisis, this proviso seemed almost irrelevant, but suddenly that has changed. The world has discovered that the main difference between hedge funds and banks lies not in the quality of their assets or their trading skills, but in their obligations to return their customers’ money in full and on demand. This obligation of banks pointed to a basic flaw that was widely missed in the hedge fund and money-market business model. Fund managers who claimed to offer better returns than the banks, investment safety and repayment of capital on demand, could achieve two of these desirable objectives, but not all three.

If investment was confined to high-quality assets, above-market returns could be achieved only by using leverage. Leverage could, with luck, be compatible with capital safety if the fund’s assets genuinely faced almost no risk of default. But, even then, the leverage used by hedge funds and SIVs was inconsistent with the promise of repayment at any time.

A sudden demand for liquidity from investors would automatically cause a fall in the market value of a fund’s assets, even if there was no extra risk of default. This is essentially what happened in August.

Investors in SIVs and hedge funds suddenly wanted their money back, forcing these funds to sell mortgages and other assets. These asset values declined, even though the prospects for defaults and permanent losses had not changed very much. The fall in asset values, in turn, undermined investors’ assumptions about the safety of their capital and so encouraged even bigger liquidity demands.

Nobody can be certain whether the crisis is now almost over or whether another panic will ensue. What we do know is that the financial world will never be the same again as it was before the summer – and neither will the profits of the hedge funds and investment banks.

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