Has Financial Development Made the World Riskier

Raghuram G. Rajan
This presentation represents my views and not necessarily the view of the International Monetary Fund, its management, or its Board.

Tremendous financial development

Technological change
 Financial

engineering, portfolio optimization : products, institutions

Deregulation
 Competition

Institutional change
 Private

equity  Inflation targeting

and the United States. Canada. 30 25 20 ISDA Credit Default Swaps 15 BBA Forecast 10 BBA Credit Derivatives 5 0 1999H1 1999H2 2000H1 2000H2 2001H1 2001H2 2002H1 2002H2 2003H1 2003H2 2004H1 2004H2 . the euro area. Credit default swaps from International Swaps and Derivatives Association Market Surveys. Japan.Figure 1: Credit Derivatives and Credit Default Swaps 1/ (In Percent of Private Sector Bank Credit 2/) 35 1/ Credit derivatives from British Banker's Association Credit Derivatives Reports. 2/ Includes IFS data on deposit money banks and--where available--other banking institutions for Australia. the United Kingdom.

Arm’s length transactions  Disintermediation?  Credit Default Swaps  Loan sales  Money market funds  Reintermediation  Investment managers :  Mutual Funds  Pension Funds  Hedge Funds  Venture Capital  Insurance Companies .

Flow of Funds.S. Ownership of Corporate Equities in the United States (In percent of total market value) 100 Other institutions Life insurance companies State & local pension funds 100 90 90 80 Private pension funds 70 Foreign sector 60 Mutual funds 80 70 60 50 50 40 40 30 30 20 Households & nonprofit orgs 10 20 10 0 1969 1973 1977 1981 1985 1989 1993 1997 2001 0 2005 Source: U. .Figure 3.

turn to more illiquid transactions  Back-up lines of credit  Warehouse Risk .Banks  Can sell much of risk associated with commodity transaction but have to hold a piece. more retention  As simple transactions become commodities.  Riskier transaction.

therefore can take more  Greater access to capital  Is there a potential downside?  .Tremendous benefits Spread risk.

so compensation has to be sensitive to returns generated Relative performance evaluation  By organization  By market .Incentives     Limited competition => franchise value Little risk taking by bank managers Not any more Competition.

20 -0.10 0.25 -0.3 -0.S.10 -0. 0.15 -0.6 -0.Figure 4.6 0. 1/ Data for young funds (age 2 years).0 -0.20 0.9 Expected Year t+1 Net Flow 0.5 1. Mutual Funds' Returns and Net Flows 1/ 1.2 0.00 Year t Excess Return Source: Chevalier and Ellison (1997).25 .15 0.3 90% confidence bands Flow-performance relationship 0. U.05 0.05 0.

write disaster insurance ⇒ Herd on same investments Both behaviors come together in asset price booms. especially in an environment of low rates. substantial upside ⇒ Incentive to take risk  Relative performance evaluation ⇒ Take risk that is concealed from investors: tail risk – e..Effective compensation structures  Convex in returns – limited downside from losses. .g.

Low interest rates  Fixed rate obligations contracted at time of high rates increases incentive to take risk.  Guaranteed Investment Contracts  Compensation structures with minimum return hurdles also increase incentive to take risk. .

Too much incentive to take risk? Private incentive to generate returns exceeds social  Private ability to punish small  Moral hazard – breaking the buck in the 1990s  .

Are banks immune Stand against the trend?  Feed it?  Leveraged position on boom?  .

S&P 1500 Banks: Earnings Volatility Sample Average of Estimated AR(1)-Process Residuals 0.1 0.4 0.8 0.7 0.9 0.0 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 All banks with some missing data Smaller sample without missing data Source: Datastream. .0 -0. each residual is normalized by dividing by the average for that bank across the entire time frame then averaged across banks in the same period.4 -0.5 0.6 0.2 0.Figure 5.4 0.3 0. and IMF staff estimates. Notes: The residual is obtained from regressing annual bank earnings against lagged earnings. In the bottom panel.8 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 All banks with some missing data Smaller sample without missing data Sample Average of Rolling 3-Year Standard Deviations of Estimated AR(1)-Process Residuals 0. a rolling standard deviation of the residuals is computed for each bank and then averaged across banks.6 -0.2 0.6 0. In the top panel.2 -0.

Figure 6. . and IMF staff estimates. Bank Distance to Default and Trend Component United States 20 18 16 14 12 10 8 6 4 2 0 1991 1994 1997 2000 2003 20 18 16 14 12 10 8 6 4 2 0 1991 1993 1995 1997 1999 2001 2003 Canada 20 18 16 14 12 10 8 6 4 2 0 1991 1993 1995 Germany 20 18 16 14 12 10 8 6 4 2 France 1997 1999 2001 2003 0 1991 1993 1995 1997 1999 2001 2003 20 18 16 14 12 10 8 6 4 2 0 1991 1993 United Kingdom 20 18 16 14 12 10 8 6 4 2 1995 1997 1999 2001 2003 0 1991 1993 Netherlands 1995 1997 1999 2001 2003 Source: Datastream.

Figure 7. S&P 500 Banks: Price-to-Earnings Ratios (In percent of S&P 500 P/E Ratios) 180 160 140 120 100 80 60 40 20 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Source: Datastream. .

 Russian Crisis  Banks need liquidity   Dynamic hedging  Opacity of balance sheets  Will banks attract sufficient liquidity? .Even if not immune to the frenzy. will banks be able to provide liquidity if a big shock hits? Why liquidity important.

Implications  Monetary Policy Measured change  Costs of low rate environment  Banking system tip of iceberg of credit  Aggregate liquidity critical  .

. which stays invested till a year after manager leaves.Implications  Prudential regulation  More capital?  More disclosure?  Better incentives?  Invest 10 percent of pay in assets under management.

Smart regulation Light  Facilitate market competition and innovation.  .  Don’t trust market participants to always get it right.

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