{ "title": "The Greenspan Era: Lessons for the Future, Speech by Raghuram G. Rajan, Economic Counsellor and Director of the IMF's Research Department", "publication": "IMF News, August 27, 2005", "sourceUrl": "https://www.imf.org/en/news/articles/2015/09/28/04/53/sp082705", "canonical": "https://www.imf.org/en/news/articles/2015/09/28/04/53/sp082705", "overlayPath": "/en/news/articles/2015/09/28/04/53/sp082705/index.md", "summary": "Given at a Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming", "publishDate": "2005-08-27", "sections": [ { "heading": "Overview and framing", "content": "- Delivered at a Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, Saturday, August 27, 2005.\n- Speaker’s stance: personal views, selective high-level (30,000 feet) perspective intended to provoke discussion.\n- 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." }, { "heading": "Major drivers of financial change", "content": "- Technical change: reduced costs of communication, computation, and information processing.\n- Risk-management techniques: financial engineering, portfolio optimization, securitization, credit scoring.\n- Deregulation: entry of new firms and increased competition across products, institutions, markets, and jurisdictions.\n- Institutional change: emergence of private equity firms, hedge funds, central bank independence, and the institutional apparatus for inflation targeting.\n- Illustrative statistics and figures:\n - 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.\n - 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.\n - Reference to Figures 2–7 to show trends in disintermediation, investment manager growth, bank earnings volatility, distance to default, and relative price-earnings ratios." }, { "heading": "Incentives, investment managers, and risky behaviors", "content": "- Shift in compensation and incentives:\n - Investment managers’ compensation is convex in returns: strong upside with good performance and milder downside with poor performance.\n - Performance relative to peers matters and can induce both superior performance and perverse behavior.\n- Two particularly worrisome behaviors:\n - Concealed risk: taking “tail” risks that present low-probability severe losses while appearing to outperform peers most of the time.\n - Herding: managers aligning on investment choices to avoid underperforming peers, which can move asset prices away from fundamentals.\n- Interaction with low interest rates:\n - Low rates increase incentives to “search for yield” (e.g., fixed obligations force higher risk-taking; hedge fund compensation pressures).\n - Asset price spirals and greater likelihood of sharp realignments." }, { "heading": "Banks, reintermediation, and liquidity provision", "content": "- 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.\n- Banks’ evolving role:\n - Sell portions of originated risk (e.g., mortgages) but often retain equity tranches / first-loss pieces.\n - Move toward riskier, more illiquid transactions where explicit contracts are hard to specify (e.g., backup lines of credit).\n - Competition pushes banks to “flirt continuously with the limits of illiquidity.”\n- Empirical signals on bank risk:\n - Figure 5: bank earnings volatility in the United States has increased over the last twenty years.\n - Figure 6: bank distance to default has remained constant or fallen across a number of industrial countries.\n - Figure 7: the price-earnings ratio of banks relative to the market is falling, suggesting bank earnings are being discounted at a higher rate.\n - Bottom line: banks are not demonstrably safer than in the past and may be riskier despite deeper markets and better capitalization.\n- Provision of liquidity in crises:\n - 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.\n - 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." }, { "heading": "Systemic implications and limits of private sector discipline", "content": "- Despite more participants able to absorb risk, system-wide risks may be greater due to correlated incentives and compensation-driven herding.\n- Procyclicality: developments may create more financial-sector induced procyclicality and a greater (albeit still small) probability of catastrophic meltdown.\n- Limitations of private solutions:\n - Investors have limited incentive or ability to restrain managers from short-term risk-taking.\n - Past performance is not a reliable predictor of future performance; investor flows driven by short-run returns can exacerbate problems.\n - Private actors underprovide liquidity because benefits are shared widely while costs are private.\n - Examples of private equilibrium failures: late trading in mutual funds; money market funds “breaking the buck” in the early 1990s." }, { "heading": "Policy recommendations and tools", "content": "- General principle: applaud and encourage beneficial financial innovation, but update regulatory policy to address new risks.\n- Two broad policy tools emphasized:\n 1. Monetary policy\n - Monetary policy must account for incentive effects.\n - Rapid, large changes in monetary policy have significant costs across interconnected markets; policy changes should happen at a measured (though not necessarily predictable) pace.\n - 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.\n - Policymakers should not solely rely on banking system metrics to assess aggregate credit creation or financial stability.\n - Central banks must monitor and be ready for possible shortfalls in aggregate liquidity.\n 2. Prudential supervision\n - The prudential net may need to widen beyond commercial and investment banks to include institutions such as hedge funds.\n - Instruments: greater transparency and disclosure, enhanced capital regulation, and consideration of incentive regulation for managerial compensation.\n - 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.\n - 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)." }, { "heading": "Historical context and closing observations", "content": "- 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.\n- 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.\n- Specific concern noted: housing prices are at elevated levels globally.\n- 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.\"\n\nSource: The Greenspan Era: Lessons for the Future, Speech by Raghuram G. Rajan, August 27, 2005.\n\n---\n\n\n References\n\n- Speeches\n- Raghuram G. Rajan\n- PRESS CENTER\n- https://www.imf.org/en/home\n\nSource: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp082705" } ], "bullets": [ "[Markdown version](/en/news/articles/2015/09/28/04/53/sp082705/index.md)", "[Structured JSON version](/en/news/articles/2015/09/28/04/53/sp082705/index.json)", "[Bundle manifest](/en/news/articles/2015/09/28/04/53/sp082705/bundle-manifest.json)", "Published: August 27, 2005", "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.", "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:", "Shift in compensation and incentives:", "Two particularly worrisome behaviors:", "Interaction with low interest rates:", "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:", "Empirical signals on bank risk:", "Provision of liquidity in crises:", "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:", "General principle: applaud and encourage beneficial financial innovation, but update regulatory policy to address new risks.", "Two broad policy tools emphasized:", "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.\"", "[Speeches](https://www.imf.org/en/news/searchnews)", "[Raghuram G. Rajan](https://www.imf.org/external/np/bio/eng/rr.htm)", "[PRESS CENTER](http://presscenter.imf.org/)", "[https://www.imf.org/en/home](https://www.imf.org/en/home)" ], "alternates": { "markdown": "/en/news/articles/2015/09/28/04/53/sp082705/index.md", "json": "/en/news/articles/2015/09/28/04/53/sp082705/index.json", "bundleManifest": "/en/news/articles/2015/09/28/04/53/sp082705/bundle-manifest.json" }, "generatedAtUtc": "2026-09-27T10:24:01.237Z" }