European Financial Management, Vol. 12, No. 4, 2006, 499–533
Has Finance Made the World Riskier?
Raghuram G. Monetary Fund e-mail:
Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behaviour makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.
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Keywords: financial development; financial-sector-induced turmoil; risk and derivatives
JEL classification: G20, G21, G22 1. Introduction
In the last 30 years, financial systems around the world have undergone revolutionary change. People can borrow greater amounts at cheaper rates than ever before, invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers from across the globe. Have these undoubted benefits come at a
The author is the Economic Counselor and Director of Research of the International Monetary Fund. This paper reflects the author’s views and not necessarily those of the International Monetary Fund, its management, or its Board. I thank for extremely useful conversations and suggestions, Sergei Antoshin for valuable research assistance, and , , , , , , and for valuable comments on a previous draft.
Keynote Address to the 2005 European Financial Management Association (EFMA) Meetings, Milan, Italy, 1 July 2005.
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cost? How concerned should central bankers and financial system supervisors be, and what can they do about it? These are the issues examined in this paper.
Consider the main forces that have been at work in altering the financial landscape. Technical change has reduced the cost of communication and computation, as well as the cost of acquiring, processing, and storing information. One very important aspect of technical change has been academic research and commercial development; Techniques ranging from financial engineering to portfolio optimisation, from securitisation to credit scoring, are now widely used. Deregulation has removed artificial barriers preventing entry, or competition between products, institutions, markets, and jurisdictions. Finally, the process of 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.
These changes have altered the nature of the typical transaction in the financial sector, making it more arm’s length and allowing broader participation. Financial markets have expanded and become deeper. The broad participation has allowed risks to be more widely spread throughout the economy.
While this phenomenon has been termed ‘disintermediation’ because it involves moving away from traditional bank centred ties, the term is a misnomer. Though in a number of industrialised countries, individuals do not deposit a significant portion of their savings directly in banks any more, they invest indirectly in the market via mutual funds, insurance companies, and pension funds, and indirectly in firms via (indirect) investments in venture capital funds, hedge funds, and other forms of private equity. The managers of these financial institutions, whom I shall call ‘investment man- agers’ 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 ‘plain vanilla’ transactions they originate, such as mortgages, off their balance sheets, they have to retain a portion, typically the first losses. 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. In short, as the ‘plain vanilla’ transaction becomes 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.
The expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transactions costs of investing, expanding access to capital, allowing more diverse opinions to be expressed in the marketplace, and allowing better risk sharing. However, it has potential downsides, which I will explore in this paper. This focus is not meant to minimise the enormous upsides that have been explored elsewhere (see, for example, Rajan and Zingales (2003) or Shiller (2002)), or to suggest a reversion to the days of bank dominated systems with limited competition, risk sharing, and choice. Instead, it is to draw attention to a potential source of concern, and explore ways the system can be made to work better.
My main concern has to do with incentives. Any form of intermediation introduces a layer of management between the investor and the investment. A key question is how aligned are the incentives of managers with investors, and what distortions are created by misalignment. I will argue in this paper that the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by the system, with some potential for distortions.
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In the 1950s and 1960s, banks dominated financial systems. 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 (and such incentives may 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 supervisors). 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, while shareholders, who enjoyed a steady rent because of the limited competition, were also happy. Of course, depositors and borrowers had little choice, so the whole system was very inefficient.
In the new, deregulated, competitive environment, investment managers cannot be provided the same staid incentives as bank managers of yore. Because they have to have 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. Dissatisfied investors can take their money elsewhere, but they do so with substantial inertia. Since compensation is also typically related to assets under management, the movement of investors further modulates the relationship between returns and compensation.
Therefore, the incentive structure of investment managers today differs from the incentive structure of bank managers of 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 greater incentive to take risk.1 Second, their performance relative to other peer managers matters, either because it is 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 a variety of perverse behaviour.
One is the incentive 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 risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.
A second form of perverse behaviour is the incentive to herd with other investment managers on investment choices, because herding provides insurance the manager will not under perform his peers. Herd behaviour can move asset prices away from fundamentals.
Both behaviours 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 under perform significantly if boom turns to bust. An environment of low interest rates following a period of high rates is particularly problematic, for not only does the incentive of some participants to ‘search for yield’
1In the jargon, investment manager compensation is likely to be convex in returns, while bank manager compensation in the past was more concave. This difference creates a difference in risk preference.
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go up, but also asset prices are given the initial impetus, which can lead to an upward spiral, creating the conditions for a sharp and messy realignment.
Will banks add to this behaviour or restrain it? The compensation of bank managers, while not so tightly tied to returns, has not remained uninfluenced by competitive pressures. Banks make returns both by originating risks and by bearing them. As plain vanilla risks 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. Banks cannot, however, sell all risks. 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 bank balance sheets, balance sheets have been reloaded with fresh, more complicated, risks. In fact, the data suggest that despite a deepening of financial markets, banks may not be any safer than in the past. Moreover, the risk they now bear is a small (though perhaps the most volatile) tip of an iceberg of risk they have created.
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 materialise, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimised. Past episodes indicate that banks have played this role successfully. However, there is no assurance they will continue to be able to play the role. In particular, banks have been able to provide liquidity in the past, in part because their sound balance sheets have allowed them to attract the available spare liquidity in the market. However, banks today also require liquid markets to hedge some of the risks associated with 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 today able to absorb risk, the financial risks that are being created by the system are indeed greater.2 And even though there should theoretically be a diversity of opinion and actions by participants, and a greater capacity to absorb the risk, competition and compensation may induce more correlation in behaviour than desirable. While it is hard to be categorical about anything as complex as the modern financial system, it is possible these developments may create more financial-sector-induced procyclicality than the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown.
What can policymakers do? While all interventions can create their own unforeseen consequences, these risks have to be weighed against the costs of doing nothing and hoping that somehow markets will deal with these concerns. I offer some reasons why markets may not get it right, though of course there should be no presumption that regulators will. More study is clearly needed to estimate the magnitude of the concerns
2One might think that the amount of real risk in the economy should limit the amount of financial risk – after all, the underlying cash flows have to be shared amongst participants, and for every financial instrument that inflicts a loss, there is a counterparty who gains. This is true in a static sense only if financial distress does not cause economic distress. If, however, financial losses cannot be allocated smoothly – for example, because of illiquidity – they may have real consequences. Obviously, in a dynamic sense, greater financial expansion can create greater real risk as, for example, when too many projects are started only for many of them to be shut down prematurely.
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raised in this paper. If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions, especially if conclusive analysis is likely to take a long time.
At the very least, the concerns I raise imply monetary policy should be informed by the effect it has on incentives, and the potential for greater procyclicality of the system. Also, bank credit and other monetary indicators may no longer be sufficient statistics for the quantity of finance-fuelled activity. I discuss some implications for the conduct of monetary policy.
Equally important in addressing perverse behaviour are prudential norms. The prudential net may have to be cast wider than simply around commercial or investment banks. Furthermore, while I think capital regulation or disclosure can help in some circumstances, they may not be the best instruments to deal with the concerns I raise. In particular, while disclosure is useful when financial positions are simple and static, it is less useful when positions are complex and dynamic. Ultimately, however, if problems stem from distorted incentives, the least interventionist solution might involve aligning incentives. Investors typically force a lengthening of horizons of their managers by requiring them 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, and I discuss the pros and cons of some approaches to incentive alignment.
The rest of this paper is as follows. In section 2, I start by describing the forces that have driven the changes. In section 3, I discuss how financial transactions have been changed, and in section 4 how this may have changed the nature of financial risk taking. In section 5, I discuss potential policy responses, and then conclude.
2. The Forces Driving Change
Technology
Technology has altered many aspects of financial transactions. In the area of lending, for instance, information on firms and individuals from a variety of centralised sources – such as Dun and Bradstreet – is now widely available. The increased availability of reliable timely information has allowed loan officers to cut down on their own monitoring. While, undoubtedly, some soft information that is hard to collect and communicate – direct judgments of character, for example – is no longer captured when the loan officer ceases to make regular visits to the firm, it may be more than compensated by the sheer volume and timeliness of hard information that is now available. Moreover, because it is hard information – past credit record, accounting data, etc. – the information can now be automatically processed, eliminating many tedious and costly transactions. Technology has therefore allowed more arm’s length finance, and therefore expanded overall access to finance.
Such methods undoubtedly increase the productivity of lending, reduce costs, and thus expand access and competition. Petersen and Rajan (2002) find that the distance between lenders and borrowers has increased over time in the USA, and the extent to which this phenomenon occurs in a region is explained by an increase in the bank loan to bank employee ratio in that region, a crude proxy for the increase in productivity as a result of automation.
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Technology has spurred deregulation and competition. In the 1970s, the USA had anti- competitive state banking laws. Some states did not allow banks to open more than one branch. Many states also debarred out-of-state banks from opening branches. Banks were small, risky, and inefficient. The reason, quite simply, for these laws was to ensure that competition between banks was limited so that existing in-state banks could remain profitable and fill state coffers.
As information technology improved the ability of banks to lend and borrow from customers at a distance, however, competition from out-of-state financial institutions increased, even though they had no in-state branches. Local politicians could not stamp this competition out since they had no jurisdiction over it. Rather than seeing their small, inefficient, local champions being overwhelmed by outsiders, they eliminated the regulations limiting branching (Kroszner and Strahan, 1999).
Thus technology helped spur deregulation, which in turn created a larger market in which technologies could be utilised, creating further technological advances. Both forces have come together to spur institutional change. For example, not only has there been an enormous amount of bank consolidation but also the activities of large banks have undergone change. As deregulation has increased competition for the best borrowers, and shaved margins from offering ‘plain vanilla’ products to these customers, large banks have reached out to non-traditional customers, or to traditional customers with innovative products.
Taken together, all these changes have had beneficial real effects, increasing lending, entrepreneurship, and growth rates of GDP, while reducing costs of financial transactions (Jayaratne and Strahan, 1996, 1998; Black and Strahan, 2001). Such developments can be seen throughout the world. Let me now turn to how they have changed the nature of interaction in the financial sector and then in section 3, how they may have altered the nature of risks.
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