Benign Financial Conditions, Asset Management, and Political Risks: Trying to Make Sense of Our Times, Luncheon Address by Raghuram G. Rajan, Economic Counselor and Director of Research, IMF
IMF News, October 6, 2006
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- Published: October 6, 2006
Context and overview
- Luncheon Address by Raghuram G. Rajan at the Conference on International Financial Instability: Cross-Border Banking and National Regulation organized by the Federal Reserve Bank of Chicago.
- Dates: October 5-6, 2006; publication date on the IMF site: October 6, 2006.
- Central question: With equity markets high, risk premia and measures of risk aversion at extremely low levels, and the housing market and U.S. economy slowing, why are markets not pricing in risks?
The Productivity Revolution
- Key argument: A worldwide surge in productivity (driven by information technology and global supply chains) is a major factor behind recent strong global growth.
- Implications of productivity surge described:
- Explains strong commodities demand, buoyant household incomes, and corporate profits despite rising raw material costs.
- Heterogeneous domestic demand responses tied to financial market sophistication:
- United States: deep financial markets translated productivity gains into a late-1990s investment boom and enabled household borrowing (including home equity loans), contributing to a large current account deficit.
- Emerging markets: less sophisticated financial systems limited reallocation to productive areas; investment muted in many countries (with exceptions like China).
- Advanced countries such as Germany: limited productivity increases, muted consumption, and high savings.
The Savings–Investment Imbalance
- Characterization: An imbalance between desired savings and realized investment—variously called a "savings glut" or "investment restraint"—has led to low real long-term interest rates.
- Observations:
- Even as the Federal Reserve raised policy rates, long-term interest rates fell further.
- Historical perspective: low real interest rates of the period may be more representative than the previously high rates (see Catao and Mackenzie (2005) referenced).
- Rebalancing expectations: with aging populations in developed countries, the shift toward higher investment will likely occur mainly in non-industrial countries via foreign direct investment and financial development in emerging markets.
- Changing net capital flow patterns are implied as necessary to accommodate demographics.
Increasing institutionalization of savings and asset management dynamics
- Shift from bank intermediation to institutional investment managers: mutual funds, insurance companies, pension funds, venture capital, hedge funds, private equity.
- Distinction between beta and alpha:
- Beta: systematic risk sources that investors can obtain cheaply (e.g., Vanguard S&P 500 index fund).
- Alpha: excess returns attributable to manager skill; rare and difficult to predict.
- Sources of alpha identified:
- Exceptional security selection skill (rare; Warren Buffet as example).
- Activism (venture capital, private equity, vulture investing).
- Financial entrepreneurship/engineering (innovation in securities and cash flows).
- Liquidity provision (managers holding illiquid or arbitrage positions until closure).
Illiquidity seeking, tail risk, herding, and risk seeking
- Illiquidity seeking:
- With abundant liquidity and compressed returns, many managers pursue liquidity provision—an accessible but competitive source of alpha—leading to “illiquidity seeking” behavior.
- Tail risk and hidden beta:
- Managers may disguise returns from taking on beta or rare disaster risks as alpha.
- Example activities: selling guarantees via credit derivatives (collecting premia most of the time but exposed to large payouts in rare defaults).
- Term used: "peso" or "tail" risks produce steady returns with rare catastrophic losses.
- Historical precedent: 1994 near "breaking the buck" of some money market funds driven by risky derivatives; bailouts by parent companies followed.
- Hedge fund fixed-income arbitrage examples: worst average monthly return 2.58 percent (1990–1997), with losses of 6.45 percent in September 1998 and 6.09 percent in October 1998.
- Herding:
- Managers mimic peers to avoid underperformance relative to competitors; herding and tail-risk loading can reinforce each other in booms.
- Risk seeking induced by low rates:
- Example: insurance companies promising 6 percent to premium holders while matching long-term bond rates are 4 percent face incentives to take on risk or invest in alternative assets.
- Pension funds with long-dated obligations similarly face incentives to seek higher returns through extra risk.
- Overall effect: search for yield compresses risk premia globally.
Consequences: financial stability and political risk
- Favorable scenario (soft landing):
- Non-industrial domestic demand picks up, growth recovers in Europe and Japan, U.S. consumption slows; interest rates rise slowly; illiquidity seeking and risk seeking reverse without major blow-ups.
- Adverse scenario (abrupt reversal):
- Potentially severe impacts especially in the non-bank financial sector, which accounts for "80 percent of value added by the financial sector that is outside the banking system."
- Non-banks (insurance companies, some hedge funds) are subject to runs.
- Political risk amplification:
- Historical pattern: anti-finance political constituencies gain strength after financial crises (examples across U.S. history cited).
- Three specific political risks identified:
- Public pension funds and other public monies invested in risky alternatives create political vulnerability (example: state pension investments in a risky hedge fund like Amaranth).
- High investment manager fees and compensation growth (Kaplan and Rauh (2006) suggest investment manager pay growth has probably exceeded CEO pay growth) may provoke public envy and political backlash.
- The public finds it less clear how many investment manager activities (spreading risk, improving governance, revealing information) benefit "Main Street," making political support fragile.
- Cross-border capital flows: sudden retrenchment could inflict pain on recipient countries and generate foreign political pressure to impede free capital flows.
- Regulatory and systemic implications:
- Large losses, perceived "greedy" managers, and public anger are a fertile ground for political interventions that could impose regulatory impediments damaging to value-adding investment managers and the financial sector writ large.
- Even if questionable practices do not produce systemic financial stress, widespread questionable practices could stress the political system and thereby create systemic consequences.
Policy recommendations and sector actions
- Main recommendation: the financial sector should discuss and, where necessary and possible, adjust practices—particularly compensation structures—to reduce incentives to take excessive risk and better link pay to long-term performance.
- Rationale: proactive sector-level adjustments can reduce the risk of excessive political reaction that could inflict systemic damage and undermine the gains finance has delivered.
Luncheon Address by Raghuram G. Rajan, International Monetary Fund, October 6, 2006.