Magazine~HEALTH,ENVIRONMENT,RAGHURAM RAJAN{POLITICS IN RBI},MESSI{SPORTS},
Raghuram Rajan - Fin Devt and Risk - PPT
Transcript of Raghuram Rajan - Fin Devt and Risk - PPT
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Has Financial
Development Madethe World Riskier
Raghuram G. Rajan
This presentation represents my views and not necessarilythe view of the International Monetary Fund, itsmanagement, or its Board.
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Tremendous financial development
Technological change
Financial engineering, portfolio optimization
DeregulationCompetition : products, institutions
Institutional changePrivate equity
Inflation targeting
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Figure 1: Credit Derivatives and Credit Default Swaps 1/(In Percent of Private Sector Bank Credit 2/)
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10
15
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1999H1 1999H2 2000H1 2000H2 2001H1 2001H2 2002H1 2002H2 2003H1 2003H2 2004H1 2004H2
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.
BBA Credit Derivatives
ISDA Credit Default Swaps
BBA Forecast
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Arms length transactions
Disintermediation? Credit Default Swaps Loan salesMoney market funds
Reintermediation Investment managers :
Mutual Funds
Pension Funds Hedge Funds Venture Capital Insurance Companies
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Figure 3. Ownership of Corporate Equities in the United States(In percent of total market value)
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1969 1973 1977 1981 1985 1989 1993 1997 2001 2005
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Source: U.S. Flow of Funds.
Households & nonprofit orgs
Mutual funds
Foreign sector
Private pension funds
State & local pension funds
Life insurance companies
Other institutions
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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
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Tremendous benefits
Spread risk, therefore can take more
Greater access to capital
Is there a potential downside?
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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
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Figure 4. U.S. Mutual Funds' Returns and Net Flows 1/
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-0.3
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-0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15 0.20 0.25
Year t Excess Return
ExpectedYeart+1NetFlow
Source: Chevalier and Ellison (1997).
1/ Data for young funds (age 2 years).
Flow-performance relationship
90% confidence bands
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Effective compensation structures
Convex in returns limited downside fromlosses, substantial upside Incentive to take risk
Relative performance evaluationTake risk that is concealed from investors: tail risk
e.g., write disaster insuranceHerd on same investments
Both behaviors come together in asset pricebooms, especially in an environment of lowrates.
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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.
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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
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Are banks immune
Stand against the trend?
Feed it?
Leveraged position on boom?
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Figure 5. S&P 1500 Banks: Earnings Volatility
Source: Datastream; and IMF staff es timates.
Notes : The residu al is obta ined from regres sing a nnu al bank earn ings a gains t lagged earning s. In
he top pan el, each residual is normalized by dividing by the average for that ba nk across th e entire
ime frame then averaged a cross banks in the same period. In the botto m panel, a rolling standarddeviation of the residuals is computed for each bank and then averaged across banks.
Sample A verage of Estimated A R(1)-Process Residuals
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1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
All banks with so me
missing dat aSmaller sample without
missing dat a
Sample Average of Rolling 3-Year Standard Deviations
of Estimated AR(1)-Process Residuals
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1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
All banks with so me
missing d ata
Smaller sample without
missing d ata
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Figure 6. Bank Distance to Default and Trend Component
Source: Dat astream; and IMF staff estimates.
United States
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Canada
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Germany
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France
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Netherlands
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Figure 7. S&P 500 Banks: Price-to-Earnings Ratios(In percent of S&P 500 P/E Ratios)
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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Source: Datastream.
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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 liquidityDynamic hedging
Opacity of balance sheets
Will banks attract sufficient liquidity?
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Implications
Monetary Policy
Measured change
Costs of low rate environment
Banking system tip of iceberg of credit
Aggregate liquidity critical
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Implications
Prudential regulation
More capital?
More disclosure?
Better incentives? Invest 10 percent of pay in assets under
management, which stays invested till a year aftermanager leaves.
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Smart regulation
Light
Facilitate market competition and
innovation.
Dont trust market participants to always
get it right.