Saturday, January 23, 2010

Raghuram Rajan and the view from a financier

NYU economist Dave Backus sends this link to an excellent interview with Raghuram Rajan, whose thinking we've referenced more than once on this blog.

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.


Ian Smith said...

The focus on banks and new regulations is misleading.

Underconsumption and underemployment (in the BS services sector) will drag this recession out for decades.

Jeff K. said...

Regarding the splitting of banks, and the need to maintain accountability while reducing systemic risk, Rajan says:

"Now if there is value to the way banks
are structured today, what we would like
to do is reduce the probability of systemic
breakdown. The truth is it’s hard
to do this without eliminating the discipline.
What you really want to do is prevent
bank runs when it’s truly a systemic
panic, but not when it’s because of the
fault of the bank itself. You want a bank
to face the full costs of any stupid thing
it does on its own."

Is there real difference between these cases...that of systemic panic and individual bank fault? With the demand for returns and the high level of uniformity in banking practices across the system, is it really useful to talk about a bank acting individually (and irresponsibly)? In short, do banks actually do anything on their own any more?

LondonYoung said...

Jeff - is there real difference between Islamic terrorists and individual Muslims? With the demand for complete faith in Allah, does one Muslim do anything any differently than another?

Banks have existed in the East for at least 1000 years, and in the West for at least 500 years. A few bad apples do not spoil the bunch.

But more broadly, I would like to add this: It seems the Feds will not end up taking ANY losses from banks - zero, goose egg, nada - in fact, they will earn a profit from their forced capital injections. If the federal goverment takes any losses on "bailouts" it will be due to auto companies, the housing agencies, and insurance companies. So, why so down on the banks?

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