“Has Financial Development Made the World Riskier?” Rajan 2005 Jackson Hole
The annual Jackson Hole Symposium is on this week. It was here in 2005 that the Chicago economist,
Raghuram Rajan presented his paper “Has Financial Development Made the World Riskier?" which was derided by Larry Summers and many others for its criticism of outgoing Fed Chairman, Alan Greenspan.
In the paper he speaks of the difference in incentive compensation between investment managers and bank managers. He also notes the dramatic shift in the industry that attempted to shift risk off balance sheet, but actually had the opposite effect by shifting assets off balance sheet but retaining the risk.
Fast forward to 2007, a mere 2 years later, and it was ominously clear he was right. Then in September 2008 when markets completely froze and no bank would trust any other bank, Rajan was part of history.
Here are two key quotes, but if you really want to understand the difference between a bank manager and an investment manager, read the paper.
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.
And this – emphasis mine.
Will banks add to this behavior 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.