Has Financial Development Made the World Riskier

Raghuram G. Rajan
This presentation represents my views and not necessarily the view of the International Monetary Fund, its management, or its Board.

Tremendous financial development

Technological change
Financial

engineering, portfolio optimization : products, institutions

Deregulation
Competition

Institutional change
Private

equity Inflation targeting

Figure 1: Credit Derivatives and Credit Default Swaps 1/

(In Percent of Private Sector Bank Credit 2/)
35 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.

30

25

20

ISDA Credit Default Swaps

15 BBA Forecast 10

BBA Credit Derivatives 5

0 1999H1 1999H2 2000H1 2000H2 2001H1 2001H2 2002H1 2002H2 2003H1 2003H2 2004H1 2004H2

Arms length transactions

Disintermediation?
Credit

Default Swaps Loan sales Money market funds

Reintermediation
Investment managers : Mutual Funds Pension Funds Hedge Funds Venture Capital Insurance Companies

Figure 3. Ownership of Corporate Equities in the United States

(In percent of total market value)
100 Other institutions Life insurance companies State & local pension funds 100

90

90

80 Private pension funds 70 Foreign sector 60 Mutual funds

80

70

60

50

50

40

40

30

30

20 Households & nonprofit orgs 10

20

10

0 1969 1973 1977 1981 1985 1989 1993 1997 2001

0 2005

Source: U.S. Flow of Funds.

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

Tremendous benefits
Spread risk, therefore can take more Greater access to capital Is there a potential downside?

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

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

1.5

1.2

0.9 Expected Year t+1 Net Flow

0.6

0.3

90% confidence bands Flow-performance relationship

0.0

-0.3

-0.6 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 Year t Excess Return Source: Chevalier and Ellison (1997). 1/ Data for young funds (age 2 years). 0.05 0.10 0.15 0.20 0.25

Effective compensation structures

Convex in returns limited downside from losses, substantial upside

Incentive

to take risk

Relative performance evaluation

Take

risk that is concealed from investors: tail risk e.g., write disaster insurance Herd on same investments

Both behaviors come together in asset price booms, especially in an environment of low rates.

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.

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

Are banks immune

Stand against the trend? Feed it? Leveraged position on boom?

Figure 5. S&P 1500 Banks: Earnings Volatility

Sample Average of Estimated AR(1)-Process Residuals 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 All banks with some missing data Smaller sample without missing data

Sample Average of Rolling 3-Year Standard Deviations of Estimated AR(1)-Process Residuals 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 All banks with some missing data Smaller sample without missing data

Source: Datastream; and IMF staff estimates. Notes: The residual is obtained from regressing annual bank earnings against lagged earnings. In the top panel, each residual is normalized by dividing by the average for that bank across the entire time frame then averaged across banks in the same period. In the bottom panel, a rolling standard deviation of the residuals is computed for each bank and then averaged across banks.

Figure 6. Bank Distance to Default and Trend Component

United States
20 18 16 14 12 10 8 6 4 2 0 1991 1994 1997 2000 2003 20 18 16 14 12 10 8 6 4 2 0 1991 1993 1995 1997 1999 2001 2003

Canada

20 18 16 14 12 10 8 6 4 2 0 1991 1993 1995

Germany

20 18 16 14 12 10 8 6 4 2

France

1997

1999

2001

2003

0 1991

1993

1995

1997

1999

2001

2003

20 18 16 14 12 10 8 6 4 2 0 1991 1993

United Kingdom
20 18 16 14 12 10 8 6 4 2 1995 1997 1999 2001 2003 0 1991 1993

Netherlands

1995

1997

1999

2001

2003

Source: Datastream; and IMF staff estimates.

Figure 7. S&P 500 Banks: Price-to-Earnings Ratios

(In percent of S&P 500 P/E Ratios)
180

160

140

120

100

80

60

40

20 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Source: Datastream.

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 liquidity

Dynamic

hedging Opacity of balance sheets

Will banks attract sufficient liquidity?

Implications

Monetary Policy
Measured change Costs of low rate environment Banking system tip of iceberg of credit Aggregate liquidity critical

Implications

Prudential regulation
More

capital? More disclosure? Better incentives?

Invest 10 percent of pay in assets under management, which stays invested till a year after manager leaves.

Smart regulation
Light Facilitate market competition and innovation. Dont trust market participants to always get it right.