Exactly ten years ago, Governor Rajan (then the Economic Counsellor and Director, IMF's research department) delivered an address titled, "The Greenspan Era: Lessons For The Future" at an symposium organized by the Kansas Fed. I thought it might be a good idea to excerpt a few portions from the address and throw in some analysis, in this blog post.
Rajan states: "....[T]the incentive structure of investment managers today is very different from the incentive structure of the bankers from the past in two important ways. First, the way compensation relates to returns implies there is typically less downside and more upside from generating investment returns. Managers therefore have a greater incentive to take risk. Second, their performance relative to other peer managers matters; ... the knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior. Firstly, the incentive to take tail risks" (the type of risks that have low probability of occurring but can bring in destructive losses when they occur and herding (so as to create bubbles)...."
Rajan then spoke of securitization and how it had enabled banks to transfer the risks they originate to the balance sheets of asset managers and in the process retaining the more volatile portion of assets it transfers. Pointing out that the retained risk on the banks' balance sheet is the most volatile of their assets, Rajan wondered if the banks continued to be able to perform the role of supplier of liquidity, in the unlikely event that the "tail risk" did come to pass. This is because banks themselves required liquid markets to hedge some of the risks associated with the products they have created. "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.
"What Can policymakers do? .... At the very least, the concerns that I raise imply that monetary policy should be informed by the effect it has on incentives, and the potential for greater pro cyclicality of the system. .... Equally important in addressing perverse behavior are prudential norms. The prudential net may have to be cast wider than simply around commercial or investment bankers...."
All this sounds pretty ominous to free market proponents. Thankfully, he goes on to add: ..."Ultimately however, if problems stem from distorted incentives, the least interventionist solution might involve aligning incentives. Investors typically force a lengthening of the horizons of their managers by requiring to invest some fraction of their personal wealth in the assets they manage. Some similar market-friendly way of ensuring personal capital is at stake could be contemplated..."
[To be continued]
Rajan states: "....[T]the incentive structure of investment managers today is very different from the incentive structure of the bankers from the past in two important ways. First, the way compensation relates to returns implies there is typically less downside and more upside from generating investment returns. Managers therefore have a greater incentive to take risk. Second, their performance relative to other peer managers matters; ... the knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior. Firstly, the incentive to take tail risks" (the type of risks that have low probability of occurring but can bring in destructive losses when they occur and herding (so as to create bubbles)...."
Rajan then spoke of securitization and how it had enabled banks to transfer the risks they originate to the balance sheets of asset managers and in the process retaining the more volatile portion of assets it transfers. Pointing out that the retained risk on the banks' balance sheet is the most volatile of their assets, Rajan wondered if the banks continued to be able to perform the role of supplier of liquidity, in the unlikely event that the "tail risk" did come to pass. This is because banks themselves required liquid markets to hedge some of the risks associated with the products they have created. "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.
"What Can policymakers do? .... At the very least, the concerns that I raise imply that monetary policy should be informed by the effect it has on incentives, and the potential for greater pro cyclicality of the system. .... Equally important in addressing perverse behavior are prudential norms. The prudential net may have to be cast wider than simply around commercial or investment bankers...."
All this sounds pretty ominous to free market proponents. Thankfully, he goes on to add: ..."Ultimately however, if problems stem from distorted incentives, the least interventionist solution might involve aligning incentives. Investors typically force a lengthening of the horizons of their managers by requiring to invest some fraction of their personal wealth in the assets they manage. Some similar market-friendly way of ensuring personal capital is at stake could be contemplated..."
[To be continued]
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