The Greenspan Era: Lessons for the Future, Speech by Raghuram G. Rajan, Economic Counsellor and Director of the IMF's Research Department
IMF News, August 27, 2005
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- The Greenspan Era: Lessons for the Future, Speech by Raghuram G. Rajan, Economic Counsellor and Director of the IMF's Research Department
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- Published: August 27, 2005
Overview and framing
- Delivered at a Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, Saturday, August 27, 2005.
- Speaker’s stance: personal views, selective high-level (30,000 feet) perspective intended to provoke discussion.
- Central claim: financial systems have undergone revolutionary change over the past thirty years with large benefits but also new sources of systemic risk arising from incentives and market structure.
Major drivers of financial change
- Technical change: reduced costs of communication, computation, and information processing.
- Risk-management techniques: financial engineering, portfolio optimization, securitization, credit scoring.
- Deregulation: entry of new firms and increased competition across products, institutions, markets, and jurisdictions.
- Institutional change: emergence of private equity firms, hedge funds, central bank independence, and the institutional apparatus for inflation targeting.
- Illustrative statistics and figures:
- Credit default swaps (blue line in Figure 1) expanding from about 5% of private sector bank credit in 2001 to over 30% last year, with the pace of growth accelerating.
- Gross external assets (claims of a country on foreigners) growing from 20 percent of world GDP in 1970 to 140 percent of world GDP today.
- Reference to Figures 2–7 to show trends in disintermediation, investment manager growth, bank earnings volatility, distance to default, and relative price-earnings ratios.
Incentives, investment managers, and risky behaviors
- Shift in compensation and incentives:
- Investment managers’ compensation is convex in returns: strong upside with good performance and milder downside with poor performance.
- Performance relative to peers matters and can induce both superior performance and perverse behavior.
- Two particularly worrisome behaviors:
- Concealed risk: taking “tail” risks that present low-probability severe losses while appearing to outperform peers most of the time.
- Herding: managers aligning on investment choices to avoid underperforming peers, which can move asset prices away from fundamentals.
- Interaction with low interest rates:
- Low rates increase incentives to “search for yield” (e.g., fixed obligations force higher risk-taking; hedge fund compensation pressures).
- Asset price spirals and greater likelihood of sharp realignments.
Banks, reintermediation, and liquidity provision
- Reintermediation: mutual funds, insurance companies, pension funds, venture capital, hedge funds and private equity act as intermediaries between individuals and markets, displacing traditional bank-centered ties.
- Banks’ evolving role:
- Sell portions of originated risk (e.g., mortgages) but often retain equity tranches / first-loss pieces.
- Move toward riskier, more illiquid transactions where explicit contracts are hard to specify (e.g., backup lines of credit).
- Competition pushes banks to “flirt continuously with the limits of illiquidity.”
- Empirical signals on bank risk:
- Figure 5: bank earnings volatility in the United States has increased over the last twenty years.
- Figure 6: bank distance to default has remained constant or fallen across a number of industrial countries.
- Figure 7: the price-earnings ratio of banks relative to the market is falling, suggesting bank earnings are being discounted at a higher rate.
- Bottom line: banks are not demonstrably safer than in the past and may be riskier despite deeper markets and better capitalization.
- Provision of liquidity in crises:
- Historical role: banks attracted spare liquidity during 1998 (Russian crisis) and intermediate liquidity back into the system; central banks (e.g., Federal Reserve in 1998) augmented liquidity.
- New vulnerability: banks’ reliance on market liquidity to hedge complex products makes their balance sheets more suspect in crises, potentially limiting their ability to supply liquidity when needed.
Systemic implications and limits of private sector discipline
- Despite more participants able to absorb risk, system-wide risks may be greater due to correlated incentives and compensation-driven herding.
- Procyclicality: developments may create more financial-sector induced procyclicality and a greater (albeit still small) probability of catastrophic meltdown.
- Limitations of private solutions:
- Investors have limited incentive or ability to restrain managers from short-term risk-taking.
- Past performance is not a reliable predictor of future performance; investor flows driven by short-run returns can exacerbate problems.
- Private actors underprovide liquidity because benefits are shared widely while costs are private.
- Examples of private equilibrium failures: late trading in mutual funds; money market funds “breaking the buck” in the early 1990s.
Policy recommendations and tools
- General principle: applaud and encourage beneficial financial innovation, but update regulatory policy to address new risks.
- Two broad policy tools emphasized:
1. Monetary policy
- Monetary policy must account for incentive effects.
- Rapid, large changes in monetary policy have significant costs across interconnected markets; policy changes should happen at a measured (though not necessarily predictable) pace.
- Persistent low interest rates can distort financial sector incentives and asset prices; supervisory vigilance is required when rates are low to contain asset price bubbles.
- Policymakers should not solely rely on banking system metrics to assess aggregate credit creation or financial stability.
- Central banks must monitor and be ready for possible shortfalls in aggregate liquidity.
2. Prudential supervision
- The prudential net may need to widen beyond commercial and investment banks to include institutions such as hedge funds.
- Instruments: greater transparency and disclosure, enhanced capital regulation, and consideration of incentive regulation for managerial compensation.
- Example incentive regulation proposal: require top investment managers to invest a portion (example given: say 10 percent) of their pay in the assets they manage, with the investment locked until one year after they quit — a form of "own capital regulation" with countercyclical properties.
- Cautions: avoid making managers overly conservative, avoid bureaucratic complexity, involve the private sector, and recognize no panacea (managers of LTCM had sizeable equity stakes yet failed).
Historical context and closing observations
- Financial system has survived major shocks under effective policy response: the crash of 1987, the world panic of 1998, and the bursting of the stock market bubble in 2000-2001.
- Warning: long periods of calm do not imply absence of risk, especially for tail credit risks; systemic tests may be inadequate if shocks have been limited in type or severity.
- Specific concern noted: housing prices are at elevated levels globally.
- Closing quote attributed to Chairman Greenspan as guidance: "Proceed cautiously, facilitate and participate in prudent innovation, allow markets to signal the winners and losers among competing technologies and market structures, and overall-as the medical profession is advised-do no harm."
Source: The Greenspan Era: Lessons for the Future, Speech by Raghuram G. Rajan, August 27, 2005.