## 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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## Bibliographic details
- Published: August 27, 2005

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### 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.*

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## References

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- [PRESS CENTER](http://presscenter.imf.org/)
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_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp082705_