Raghuram Rajan - Fin Devt and Risk - PPT

7/22/2019 Raghuram Rajan - Fin Devt and Risk - PPT

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Has Financial

Development Madethe World Riskier

Raghuram G. Rajan

This presentation represents my views and not necessarilythe view of the International Monetary Fund, itsmanagement, or its Board.


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Tremendous financial development

Technological change

Financial engineering, portfolio optimization

DeregulationCompetition : products, institutions

Institutional changePrivate equity

Inflation targeting


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Figure 1: Credit Derivatives and Credit Default Swaps 1/(In Percent of Private Sector Bank Credit 2/)

0

5

10

15

20

25

30

35

1999H1 1999H2 2000H1 2000H2 2001H1 2001H2 2002H1 2002H2 2003H1 2003H2 2004H1 2004H2

1/ Credit derivatives from British Banker's Association Credit Derivatives Reports. Credit default

swaps from International Swaps and Derivatives Association Market Surveys.

2/ Includes IFS data on deposit money banks and--where available--other banking institutions

for Australia, Canada, the euro area, Japan, the United Kingdom, and the United States.

BBA Credit Derivatives

ISDA Credit Default Swaps

BBA Forecast


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Arms length transactions

Disintermediation? Credit Default Swaps Loan salesMoney market funds

Reintermediation Investment managers :

Mutual Funds

Pension Funds Hedge Funds Venture Capital Insurance Companies


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Figure 3. Ownership of Corporate Equities in the United States(In percent of total market value)

0

10

20

30

40

50

60

70

80

90

100

1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

0

10

20

30

40

50

60

70

80

90

100

Source: U.S. Flow of Funds.

Households & nonprofit orgs

Mutual funds

Foreign sector

Private pension funds

State & local pension funds

Life insurance companies

Other institutions


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Banks

Can sell much of risk associated with commodity

transaction but have to hold a piece.

Riskier transaction, more retention As simple transactions become commodities,

turn to more illiquid transactions Back-up lines of credit

Warehouse Risk


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Tremendous benefits

Spread risk, therefore can take more

Greater access to capital

Is there a potential downside?


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Incentives

Limited competition => franchise value

Little risk taking by bank managers

Not any more Competition, so compensation has to be

sensitive to returns generated

Relative performance evaluation By organization

By market


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Figure 4. U.S. Mutual Funds' Returns and Net Flows 1/

-0.6

-0.3

0.0

0.3

0.6

0.9

1.2

1.5

-0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15 0.20 0.25

Year t Excess Return

ExpectedYeart+1NetFlow

Source: Chevalier and Ellison (1997).

1/ Data for young funds (age 2 years).

Flow-performance relationship

90% confidence bands


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Effective compensation structures

Convex in returns limited downside fromlosses, substantial upside Incentive to take risk

Relative performance evaluationTake risk that is concealed from investors: tail risk

e.g., write disaster insuranceHerd on same investments

Both behaviors come together in asset pricebooms, especially in an environment of lowrates.


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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.


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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


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Are banks immune

Stand against the trend?

Feed it?

Leveraged position on boom?


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Figure 5. S&P 1500 Banks: Earnings Volatility

Source: Datastream; and IMF staff es timates.

Notes : The residu al is obta ined from regres sing a nnu al bank earn ings a gains t lagged earning s. In

he top pan el, each residual is normalized by dividing by the average for that ba nk across th e entire

ime frame then averaged a cross banks in the same period. In the botto m panel, a rolling standarddeviation of the residuals is computed for each bank and then averaged across banks.

Sample A verage of Estimated A R(1)-Process Residuals

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

All banks with so me

missing dat aSmaller sample without

missing dat a

Sample Average of Rolling 3-Year Standard Deviations

of Estimated AR(1)-Process Residuals

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

All banks with so me

missing d ata

Smaller sample without

missing d ata


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Figure 6. Bank Distance to Default and Trend Component

Source: Dat astream; and IMF staff estimates.

United States

0

2

4

6

8

10

12

14

16

18

20

1991 1994 1997 2000 2003

Canada

0

2

4

6

8

10

12

14

16

18

20

1991 1993 1995 1997 1999 2001 2003

Germany

0

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6

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12

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18

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1991 1993 1995 1997 1999 2001 2003

France

0

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1991 1993 1995 1997 1999 2001 2003

United Kingdom

0

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1618

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1991 1993 1995 1997 1999 2001 2003

Netherlands

0

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6

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1991 1993 1995 1997 1999 2001 2003


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Figure 7. S&P 500 Banks: Price-to-Earnings Ratios(In percent of S&P 500 P/E Ratios)

20

40

60

80

100

120

140

160

180

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Source: Datastream.


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Even if not immune to the frenzy, will banks be

able to provide liquidity if a big shock hits?

Why liquidity important.

Russian Crisis

Banks need liquidityDynamic hedging

Opacity of balance sheets

Will banks attract sufficient liquidity?


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Implications

Monetary Policy

Measured change

Costs of low rate environment

Banking system tip of iceberg of credit

Aggregate liquidity critical


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Implications

Prudential regulation

More capital?

More disclosure?

Better incentives? Invest 10 percent of pay in assets under

management, which stays invested till a year aftermanager leaves.


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Smart regulation

Light

Facilitate market competition and

innovation.

Dont trust market participants to always

get it right.

Raghuram Rajan - Fin Devt and Risk - PPT

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