Raghuram Rajan is a bloody good economist – one of the best of his generation. Rajan, who succeeded Kenneth Rogoff at the International Monetary Fund as Chief Economist, is also a prescient voice of reason on any number of different subjects. Recently, Nobel-winning economist Paul Krugman used his New York Times column to highlight Rajan’s work. I wanted to use this post to also familiarize you with him and his work because his name should be heard much more going forward as one of the few economists to recognize the unsustainability of the global credit bubble.
In a post entitled “Economists behaving badly,” Krugman lamented the poor record of economists, who as regulators are damagingly subject to “cognitive regulatory capture.” He mentions Rajan by name as one to not follow the herd.
Two things are really striking here. First is the obsequiousness toward Alan Greenspan. To be fair, the 2005 Jackson Hole event was a sort of Greenspan celebration; still, it does come across as excessive — dangerously close to saying that if the Great Greenspan says something, it must be so. Second is the extreme condescension toward Rajan — a pretty serious guy — for having the temerity to suggest that maybe markets don’t always work to our advantage. Larry Summers, I’m sorry to say, comes off particularly badly. Only my colleague Alan Blinder, defending Rajan “against the unremitting attack he is getting here for not being a sufficiently good Chicago economist”, emerges with honor.
So, who is Rajan, and what has he said that is so at odds with the conventional wisdom. Below is what Wikipedia says about Rajan:
Raghuram Govind Rajan (Bhopal, India, February 3, 1963) was the “Economic Counselor and Director of Research” (Chief Economist) at the International Monetary Fund from September 2003 until January 2007. He replaced Ken Rogoff at the IMF in September 2003. He was the youngest individual to hold the position (beginning at the age of 40).
In 2003, he was also the inaugural winner of the Fischer Black Prize awarded by the American Finance Association for outstanding original research in finance.
In early 2007 Rajan returned to the Booth School of Business at the University of Chicago where he is the Eric J. Gleacher Distinguished Service Professor of Finance. With these credentials, at a young age, he is arguably the most prominent economist of Indian origin of his generation.
He obviously has some stellar credentials then. But, let’s get right to what he has said beginning with the paper he wrote in 2005 that Krugman alludes to. His paper says, in a nutshell, so-called disintermediation we have witnessed post-Bretton Woods (after the 1960s) has led to all manner of positive benefits. However, many are underestimating the negative implications of the new financial system.
Disintermediation
Rajan points the finger at the transaction-oriented securitization model as one of the new forms of disintermediaton with many hidden risks.
Consider an example. A fixed rate bank loan to a large corporate client has a number of embedded risks, such as the risk that interest rates will rise, reducing the present value of future repayments and the risk that the client firm will default. There is no reason the bank should hold on to interest rate risk. Why not offload it to an insurance company or a pension fund that is looking for fixed income flows? Increasingly, default risk is also being transferred. However, the bank may, want to hold on to some of the default risk, both to signal the quality of the risk to potential buyers, and to signal it will continue monitoring the firm, coaxing it to reduce default risk. The lower the credit quality of the firm, the stronger the role of the bank in monitoring and controlling default risk, as also the greater the need to signal to buyers. Hence, the size of the first-loss position the bank retains is likely to increase as the credit quality of the loan falls.
Thus, risk transfer, through loan and default risk sales, does not completely eliminate risk from bank balance sheets. In fact, bank earnings variability in the United States has not fallen, and average bank distance to default in a number of countries has not increased. It is apparent that banks have not become safer despite the development of financial markets and despite being better capitalized than in the past. In fact, they may have well become riskier in some countries. Finally, if we think bank earnings are likely to grow at the rate at which market earnings will grow over the foreseeable future, the declining price-earnings ratio of banks in the United States relative to the market suggest that the market is discounting bank earnings with an increasing risk premium. This again suggests bank earnings have not become less risky.
Instead of reducing bank risk, risk transfer allows the bank to concentrate on risks so that it has a comparative advantage in managing, making optimal use of its capital while hiving off the rest to those who have a natural appetite for it or to those with balance sheets large enough or transparent enough to absorb those risks passively. It also implies that the risk held on the balance sheet is only the tip of an iceberg of risk that is being created.
Translation: you think banks are offloading risk when they securitize loans. In fact, they are holding A LOT more risk than you think.
We know what happened then. Two years later the subprime crisis showed that this was exactly the case – banks were loaded to the nines with mortgage exposure we thought they had sloughed off onto the marketplace. The paper is a brilliant piece of analysis that explains other risks like hidden tail risk, herding, incentives from low interest rates, and illiquidity. All of these problems have been very much manifest over the past two years as the credit crisis has taken form.
Financial sector compensation schemes
This is another difficult issue which Professor Rajan takes on. In an FT Op-Ed about one year ago, he had this to say.
Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market. The chief executive, John Mack, however, assumed some responsibility and agreed to take no bonus for 2007 – although he got a $40m payout for 2006.
Even so, most readers would suspect something is not right here. Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis….
The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool. At the very least, shareholders deserve better explanations. More generally, unless we fix incentives in the financial system we will get more risk than we bargain for. Unless bankers offer these better explanations, their enormous pay, which has been thought of as just reward for performance, will deservedly come under scrutiny.
His logic is clear. He suggests that investment managers are rewarded in good times for seeking alpha (investment manager-specific good picks) but actually delivering their investors beta (systemic risk). When the downturn comes, what once seemed to be a good thing is now seen for the systemic risk it was. But as investment managers are not compensated over the entirety of the business cycle and receive huge payouts, they get to keep their bonuses and walk away without consequences. This type of hidden systemic risk is endemic to the compensation systems in finance today. It means it pays to seek risk because of an asymmetric risk reward from outsized pay and from a mismatch between actual performance over an investments lifetime and annual compensation schemes.
Liquidity versus solvency
Then, in another FT Op-Ed he takes on the thorny issue of solvency and liquidity. This is a very big problem because most companies fail due to liquidity problems that have insolvency at their heart. However, when credit crises occur, many solvent companies suffer with the insolvent such that it is difficult to distinguish who is solvent from who is insolvent.
Therefore, it is crucial to understand what the root of the problem is temporary (liquidity) or more structural and permanent (insolvency). In my view, Northern Rock and Lehman Brothers were both insolvent, Bear Stearns is harder to tell. But what happens, when the central banks steps in and provides liquidity to bankrupt institutions? That is the problem we all want to avoid and Rajan explains why quite well.
Central banks have always drawn a line between illiquidity and insolvency. Illiquidity is often viewed as something temporary, an aberration where central bank intervention is permissible. Insolvency, on the other hand, is viewed as something fundamental and abominable and thus to be discouraged. Central bank intervention to restore liquidity to an illiquid market would simply bring prices back to fundamentals. Intervening to bail out insolvent firms would, however, encourage irresponsible behaviour and should be resisted. At least, so the catechism goes.
Central bankers know, though, that the line between illiquidity and insolvency is an extremely fuzzy one, made more so with developments in financial markets. Take, for instance, a mortgage loan made against a house. If the housing market is liquid, loans are easier to come by. The reason is obvious. One of the biggest costs to a lender is that if the borrower defaults, the house has to be repossessed and resold with substantial costs. If, however, houses are selling like hot cakes, then the cost of repossession and resale is likely to be small. Housing loans will appear low risk, the risk premium lenders will charge will be small and housing credit will be plentiful. In turn, this will increase the volume of house sales, increasing liquidity in housing markets. Liquidity thus tends to be self-fulfilling.
But this leads to a problem in assessing whether lenders have been irresponsible or not. A mortgage loan might be perfectly sensible and appropriately priced taking the continued liquidity of the housing market as given. And the same loan may be viewed as reckless, driving a mortgage lender into insolvency, if liquidity in the housing market dries up. Could the mortgage lender not legitimately run to the central bank for help, pleading that illiquidity rather than fundamental insolvency drove him over the brink? What level of liquidity is it appropriate to assure market participants of? And in what markets?
Such a question is not relevant only to housing credit. Expectations of future liquidity conditions are central to the price and availability of many financial transactions. A bank selling complex customised derivatives to clients should price them taking into account its own ability dynamically to trade and hedge its exposure in financial markets. If markets are likely to become illiquid, the bank should recognise that trading will be difficult in those times and incorporate that possibility into the price. Otherwise, too many derivatives will be sold, overwhelming the capacity of sellers to hedge them when markets turn illiquid and eventually creating worse financial market turmoil.
The point is that liquidity is not a free good; it has a price, much as any cash flow would.
An unanticipated shortfall in liquidity increases risks, as does a shortfall in cash flow, and both should have similar consequences. Over the past few years, financial firms have made enormous sums of money as the potential illiquidity they charged for up front in the contracts they wrote failed to materialise. Now that that illiquidity has finally materialised, should the government bail out those who out of greed, complacency or incompetence underpriced it?
These examples also highlight the central bank’s dilemma in assuring markets of liquidity. Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious – much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.
So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value. And cutting rates dramatically, as Alan Greenspan’s US Federal Reserve did after the technology bubble burst in 2000, would be an enormous tax on savers the world over. Better let the market weed out the reckless, unless there is a risk of total market collapse.
But knowing that the political pressure to intervene is asymmetric, asserted far more strongly when markets turn illiquid and asset prices fall than when markets are excessively liquid and asset prices booming, central banks ought also to avoid bringing such situations upon themselves. Better to “lean against the wind” with prudential norms, tightening them as liquidity exceeds historical levels, than to ignore the boom and be faced with the messy political reality of forcibly picking up the pieces after the bust.
Translation: Greenspan was wrong.
These are but a few of the things Dr. Rajan has written. It is comforting to know that an institution like The IMF can turn out two very independent thinkers in Ken Rogoff and Raghuram Rajan.
Sources
Has Financial Development Made The World Riskier? – Kansas City Fed
Raghuram Rajan – Wikipedia
Bankers’ pay is deeply flawed – FT
Central banks face a liquidity trap – FT