Financial innovations Driven by technology, deregulation, new institutions

1. RaghuramRajan, Does Financial Development Make the World Riskier?2005 Presentation at Jackson Hole Conference Financial innovations Driven by technology, deregulation, new institutions Banks spin off liquid assets Increasingly specialize in illiquid assets keep high risk pieces that can’t be sold off  signal confidence New intermediaries manage financial investments Perverse incentives: principal – agent problem Incentive for high return: look good  increase assets under management Economies of scale in asset management: WIN BIG / lose small Take hidden “long tail” risks … Rajan cites CDSs Incentive for herding: don’t look bad Deviations from fundamental values persist  the herd is validated Information “beauty contest” muted incentive information acquisition  deviations from fundamental values persist  the herd is validated Financial fragility grows … the longer a market structure proves reliable, the more reliance is placed on it

2. RaghuramRajan, Does Financial Development Make the World Riskier? • Incentive for high return: Look good  Take hidden “long tail” risks Banks have incentive to feed investment manager appetite for risk • Feed the frenzy to the limit  leave little cushion of liquidity • Banks bear small, volatile tip of the “iceberg of risk they have created” Will banks be able to provide liquidity when tail risk crisis hits? • Liquidity is needed to unwind positions – to allocate loses • But bank balance sheets and off-balance sheet guarantees bode ill • If banks themselves are perceived as credit risks in a crisis, their ability to reallocate liquidity is compromised • Banks become a problem, not a solution • The real economy is vulnerable when liquidity is scarce • Rush to liquidity  fire sale of assets  credit crunch • Policy response Before crisis • Supervisory vigilance: “macro-prudential supervision” When crisis hits • Liquidity vigilance: be ready to respond to demands for liquidity Long – run: REALIGN INCENTIVES!!!