In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create ... a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on.
The careful study and willingness to challenge dogma Rajan displayed at Jackson Hole are in evidence throughout his work. As IMF chief economist, he produced controversial reports that questioned the efficacy of foreign aid and foreign investment. In 2003, he co-authored “Saving Capitalism from the Capitalists,” suggesting that government intervention is essential, not inimical, to market capitalism, but that it must be done right.
These days, policymakers listen carefully to Rajan—in May he testified before the Senate Banking Committee on the too-big-to-fail problem; he servesas economic adviser to the prime minister of India (his birthplace)—and not simply because of his insight on the recent financial crisis, but based on the quality of his scholarship. ...
I'd also like to highlight the following comments on an earlier post. They come from an experienced practitioner, originally trained in physics but with over 15 years on Wall Street and in the City.
First point - paying bonuses in equity is idiotic. The systemic risk is banks defaulting on their counterparties. Equity investors are prepared for a loss - because they are in it for the upside. Paying bonuses in equity encourages risk-taking - you get both upside and downside. Paying in deferred debt aligns the employees with the system - avoid risk, there is no upside! At all the blown-up shops the key players were all loaded up with equity. It is very frustrating to me that this obvious point is missed.
Second point - yes, making the banks have more capital is a great idea. There are clear metrics for capital and it would be trivial to regulate that the banks need to hold more. The failure of our government to do so is straightforward proof that the administration is purely political. What is the downside to asking all banks to have a 15% common capital ratio? Answer: none.