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A quarterly magazine of the IMF
September 2005, Volume 42, Number 3

Straight Talk
Risky Business

Skewed incentives for investment managers may be adding to global financial risk

Raghuram Rajan

In the past thirty years, financial systems around the world have undergone revolutionary change. People can borrow greater amounts at cheaper rates, invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers across the globe. Financial markets have expanded and deepened, and the typical transaction involves more players and is carried out at greater arm’s length.

At least three forces are behind these changes. Technical change has reduced the cost of communication and computation, as well as the cost of acquiring, processing, and storing information. For example, techniques ranging from financial engineering to portfolio optimization, and from securitization to credit scoring, are now widely used. Deregulation has removed artificial barriers preventing entry of new firms, and has encouraged competition between products, institutions, markets, and jurisdictions. And institutional change has created new entities within the financial sector—such as private equity firms and hedge funds—as well as new political, legal, and regulatory arrangements (for example, the emergence over the past two decades of the entire institutional apparatus behind the practice of inflation targeting, ranging from central bank independence to the publication of regular inflation reports).

While these changes in the financial landscape have been termed "disintermediation" because they involve moving away from traditional bank-centered ties, the term is a misnomer. Although in a number of industrialized countries, individuals don’t deposit a significant portion of their savings directly in banks anymore, they invest indirectly in the market via mutual funds, insurance companies, and pension funds, and in firms via venture capital funds, hedge funds, and other forms of private equity. The managers of these financial institutions, whom I shall call "investment managers," have displaced banks and "reintermediated" themselves between individuals and markets.

What about banks themselves? While banks can now sell much of the risk associated with the "commodity" transactions they originate, such as mortgages, by packaging them and getting them off their balance sheets, they have to retain a portion. This is typically the first loss, that is, the loss from the first few mortgages in the package that stop paying. Moreover, they now focus far more on transactions where they have a comparative advantage, typically transactions where explicit contracts are hard to specify or where the consequences need to be hedged by trading in the market. For example, banks offer back-up lines of credit to commercial paper issuances by corporations. This means that when the corporation is in trouble and commercial paper markets dry up, the bank will step in and lend. Clearly, these are risky and illiquid loans. And they reflect a larger pattern: as traditional transactions become more liquid and amenable to being transacted in the market, banks are moving on to more illiquid transactions. Competition forces them to flirt continuously with the limits of illiquidity.

No doubt, the expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transaction costs of investing, expanding access to capital, allowing more diverse opinions to be expressed in the marketplace, and permitting better risk sharing. But it also has potential downsides, raising the question of whether we have unwittingly accepted a Faustian bargain, trading greater welfare most of the time for a small probability of a catastrophic meltdown. My view is that the world may be riskier because of skewed incentives among investment managers, which I will now describe, but it’s unlikely we will know for sure. Thus, the message for central bankers and financial system regulators is simple: best to be prepared.

Getting the incentives right

In the past, bank managers were paid a largely fixed salary. Given that regulation kept competition muted, there was no need for shareholders to offer managers strong performance incentives (such incentives might even have been detrimental as it would have tempted bank managers to reach out for risk). The main check on bank managers making bad investment decisions was the bank’s fragile capital structure (and possibly regulators). If bank management displayed incompetence or knavery, depositors would get jittery and possibly run. The threat of this extreme penalty, coupled with the limited upside from salaries that were not buoyed by stock or options compensation, combined to make bankers extremely conservative. This served depositors well since their capital was safe. Shareholders, who enjoyed a steady rent because of the limited competition, were also happy.

In the new, deregulated, competitive environment, investment managers can’t be provided the same staid incentives as bank managers of yore. Because they need the incentive to search for good investments, their compensation has to be sensitive to investment returns, especially returns relative to their competitors. Furthermore, new investors are attracted by high returns. And current investors, if dissatisfied, do take their money elsewhere (although they often suffer from inertia in doing so). Since compensation also varies with assets under management, overall, investment managers face a compensation structure that moves up very strongly with good performance, and falls, albeit more mildly, with poor performance.

Therefore, the incentive structure for investment managers today differs from the incentive structure for bank managers of the past in two important ways. First, there is typically less downside and more upside from generating investment returns, implying that these managers have the incentive to take more risk. Second, their performance relative to other peer managers matters, either because it’s directly embedded in their compensation, or because investors exit or enter funds on that basis. The knowledge that managers are being evaluated against others can induce superior performance, but also perverse behavior of various kinds (see box).

Perverse behaviors

Performance-based pay can induce risky behavior among investment managers. One type is to take risk that is concealed from investors. Since risk and return are related, the manager then looks as if he outperforms peers given the risk he takes. Typically, the kinds of risks that can most easily be concealed, given the requirement of periodic reporting, are "tail" risks—that is, risks that have a small probability of generating severe adverse consequences and offer generous compensation the rest of the time. A second type is to herd with other investment managers on investment choices, because herding provides insurance the manager will not underperform his peers. However, herd behavior can move asset prices away from fundamentals.

Both behaviors can reinforce each other during an asset price boom, when investment managers are willing to bear the low probability "tail" risk that asset prices will revert to fundamentals abruptly, and the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust. These behaviors can be compounded in an environment of low interest rates, where the incentives of some participants to "search for yield" not only increase, but where asset prices also spiral upwards, creating the conditions for a sharp and messy realignment.

Do banks add to this behavior or restrain it? The compensation of bank managers, while not so tightly tied to returns, has not been left completely untouched by competitive pressures. Banks make returns both by originating risks and by bearing them. As traditional risks such as mortgages or loans can be moved off bank balance sheets into the balance sheets of investment managers, banks have an incentive to originate more of them. Thus they will tend to feed rather than restrain the appetite for risk. As I argued earlier, however, banks cannot sell all risk. In fact, they often have to bear the most complicated and volatile portion of the risks they originate, so even though some risk has been moved off their balance sheets, balance sheets are being reloaded with fresh, more complicated risks. The data support this assessment—despite a deepening of financial markets, banks may not be any safer than in the past. Moreover, even though the risks banks now bear are seemingly smaller, such risks are only the tip of an iceberg.

But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the "tail" risk does materialize, financial positions can be unwound and losses allocated so as to minimize the consequences to the real economy. Past episodes indicate that banks have played this role successfully. However, there is no assurance they will continue to be able to do so. Banks have in the past been able to provide liquidity in part because their sound balance sheets allowed them to attract available spare liquidity in the market. However, banks today require more liquid markets to hedge some of the risks associated with the complicated products they have created or guarantees they have offered. Their greater reliance on market liquidity can make their balance sheets more suspect in times of crisis, making them less able to provide the liquidity assurance that they have provided in the past.

Taken together, these trends suggest that even though there are far more participants who are able to absorb risk today, the financial risks that are being created by the system are indeed greater. And even though there should theoretically be a diversity of opinion and actions by market participants, and a greater capacity to absorb risk, competition and compensation may induce more correlation in behavior than is desirable. While it is hard to be categorical about anything as complex as the modern financial system, it’s possible that these developments are creating more financial–sector induced procyclicality than in the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown.

Unfortunately, we won’t know whether these are, in fact, serious worries until the system has been tested. The best hope is that the system faces shocks of increasing size, figures out what is lacking each time, and becomes more resilient. To paraphrase St. Augustine, we should therefore pray: "Lord, if there be shocks, let them first be small ones." The danger is that the economy will be hit unexpectedly by a perfect storm before it has been stress-tested.

If indeed risk taking is excessive, why don’t investors offer their managers compensation contracts that restrain the short-term emphasis on returns and associated risk taking? The answer is that there may be too little private incentive to do so. For one, there is very little systematic evidence that past performance in financial investment is an indicator of future performance, Warren Buffet or Peter Lynch notwithstanding. This implies that the constant movement by investors between funds has little social value. But investors in an individual fund benefit when new investments pour in because the fund’s average costs go down. As a result, the private gains from attracting investors through a fund’s superior short-term performance exceed the social value, and investors have too little incentive to restrain managers from focusing on the short term.

Of course, if in addition investors don’t have complete control over managers—because of weaknesses in corporate governance, for example—and managers have private incentives to generate returns in the short term (to preserve their jobs or for the public adulation that success brings), the private equilibrium may again generate excessive risk taking. It’s also hard for a private actor to fully capture the benefits of providing liquidity—if prices are higher and more closely reflect fundamentals, all those who trade will benefit, not just the actor who injected liquidity into the market. Therefore, the private sector has too little incentive to provision for it also.

Limiting the fall out

So what can policymakers do? While too much regulation can stifle the competition that drives financial sector innovation, not doing anything at all doesn’t seem like a good option either. While we still know little about the complex workings of financial markets, two main tools come to mind.

Monetary policy. Monetary policy must be informed by its effects on incentives. As already pointed out, both a low level as well as an unanticipated sharp fall in interest rates can have perverse effects on incentives. This implies that rapid, large, changes in monetary policy have significant costs, not just in the domestic economy but in all interconnected markets. One implication is that policy changes ought to happen at a measured (though not necessarily predictable) pace rather than abruptly. Second, while deflation can be immensely harmful for the real economy, an unanticipated but persistent low interest rate can be a source of significant distortions for the financial sector, and thence for asset prices. Not only does this mean staying further away from deflation so that extremely low policy rates don’t have to be used as a tool, it also implies exercising greater supervisory vigilance when those rates are in place to contain asset price bubbles. Third, and somewhat obviously, one can no longer just examine the state of the banking system and its exposure to credit to reach conclusions about aggregate credit creation, let alone the stability of the financial system. Finally, the financial sector may experience greater liquidity and solvency problems in some situations, so central banks have to be vigilant for any possible shortfalls in aggregate liquidity.

Prudential supervision. The prudential net may have to be cast wider than simply around commercial or investment banks to include institutions such as hedge funds. What instruments might be used? Certainly, greater transparency and disclosure, along with capital regulation, have a role to play. But policymakers might also need to consider using the managerial compensation system to align the behavior of investment managers with the public interest. Rather than limiting or constraining compensation, compensation regulation might simply require long-term investment of a portion of top investment managers’ compensation in the claims issued by the investment that is being managed. Given that some investors already require this of their investment managers, such a requirement may not be excessively intrusive. Of course, one has to be careful about making investment managers overly conservative, and thus losing the benefits their risk-taking behavior brings to the economy. This is why the optimal probability of a financial sector meltdown will never be zero.

* * * * *

Financial markets are currently in extremely healthy shape. Yet it is at such times that excesses typically build up. One source of concern is housing prices that are at elevated levels globally. While the techniques and instruments to absorb fluctuations have improved, there is a great deal of uncertainty about how they will perform in a serious downturn. Even as financial markets evolve, we have to constantly rethink the ways they are regulated and supported by policy, all the while being careful not to snuff out creativity and innovation. Only then will we be able to utilize their true potential.

This article draws from the author’s August 2005 paper, "Has Financial Development Made the World Riskier?" available at

Raghuram Rajan is Economic Counsellor and Director of the IMF’s Research Department.