Weekend Reading: 2005 Comments on and Discussion of Raghu Rajan: "Has Financial Development Made the World Riskier?"

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Raghu's paper itself is at: https://www.kansascityfed.org/publicat/sympos/2005/PDF/Rajan2005.pdf: Federal Reserve Bank of Kansas City (2005): Discussion of: Raghu Rajan: "Has Financial Development Made the World Riskier?" https://www.kansascityfed.org/publicat/sympos/2005/pdf/Kohn2005.pdf https://www.kansascityfed.org/Publicat/sympos/2005/PDF/Shin2005.pdf https://www.kansascityfed.org/publicat/sympos/2005/PDF/GD5_2005.pdf: Donald Kohn: "My perspective on this interesting paper by Raghu Rajan has been very much influenced by observing Alan Greenspan’s approach to the development of financial systems and their regulation over the past 18 years. I believe that the Greenspan doctrine, if I may call it that, has reflected the chairman’s analysis and deeply held belief that private interest and technological change, interacting in a stable macroeconomic environment, will advance the general economic welfare...

...Chairman Greenspan has welcomed the ability of new technologies in financial markets to reduce transactions costs, to allow the creation of new instruments that enable risk and return to be divided and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations to be securitized and traded, and to make obsolete previous divisions among types of financial intermed aries and across the geographical regions in which they operate. At the intersection of market developments and monetary policy, he has led the Federal Reserve’s efforts to understand the implications of changing financial technology, such as the growing ease of housing equity extraction, and to use the newly available information about market expectations and the price of risk embodied in market prices.

The Greenspan doctrine holds that these developments, on balance, improve the functioning of financial markets and the real economies they support. By allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they do take on, they have made institutions more robust. By making intermediaries more robust and by giving borrowers a greater variety of lenders to tap for funds, these developments also have made the financial system more resilient and flexible—better able to absorb shocks without increasing the effects of such shocks on the real economy. And by facilitating the flow of savings across markets and national boundaries, these developments have contributed to a better allocation of resources and have promoted growth.

That is not to say that the Greenspan doctrine holds that private markets always get it right. Prices in these markets are driven by the tendency of human nature to project the recent past—to waves of complacency and gloom—and, hence, are subject to overshooting. And private parties, left entirely to their own devices, do not always produce a market structure and market relationships consistent with adequate protection of financial stability. However, the actions of private parties to protect themselves—what Chairman Greenspan has called private regulation—are generally quite effective. Government regulation risks undermining private regulation and financial stability by distorting incentives through moral hazard and by promising a more effective role in promoting financial stability than it can deliver.

In this situation, government regulation has a function, but it should be based on clear objectives, narrowly tailored to meet those objectives, and, given the iron law of unintended consequences, it should be clearly superior to private regulation. Regulation can be justified if incentives for private regulation are weak—perhaps because of other government programs, such as deposit insurance—or if market participants are likely to be ineffective, as for example small savers and borrowers. Regulation also may be justified to promote greater flow of accurate information to enable private participants to make better informed decisions.

New technologies and changing market structures imply that regulation should be constantly under review; at times, rolling back regulation—for example, by lifting the Glass-Steagall restrictions on banking organizations—will benefit competition and help the financial sector deliver services more efficiently and effectively. Moreover, regulation itself can benefit from competition. Running regulated and unregulated markets side by side gives people a choice of whether they want protection and helps to constrain regulation. Some of the same purposes can be served by having multiple regulators for the same function. In some circumstances, the possible adverse consequences of competition in laxity may be smaller than the potential for regulatory conformity and regulator risk-aversion to impinge on innovation and change.

The Greenspan doctrine has had a perceptible influence on the evolution of markets and the regulatory structure that applies to them. Raghu Rajan voices some concerns about this evolution. In particular, he posits that the shift from depository intermediation to professional asset management has increased tail risk to socially excessive levels and has left the world more vulnerable to rare but potentially very serious tail events; he suggests some ways in which regulation should be increased.

In assessing this argument, we might find it useful to separate the question of whether the world is riskier from the question of whether systemic risk has risen. The increased ability to disentangle risk and tailor risk profiles should mean that risk has come to be lodged more in line with investor appetites, a change that has probably tended to reduce the price of risk and encouraged riskier capital projects to be funded. But individual investors at greater risk need not imply increased systemic risk—fatter tails and greater potential for losses feeding back on the macroeconomy.

In fact, industrial economies have been marked by much less variability in output and inflation over the past 20 years. Many reasons have been given for this so-called great moderation, but developments in financial markets have likely played a role in making the economy more resilient. As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market.

The experience of 2001-2003 is instructive. Unusually large declines in equity prices and increases in defaults and risk spreads—surely tail events by most definitions—reduced wealth and raised the cost of capital but did not aggravate the downturn by impinging on the flow of funds. Financial intermediaries were not so troubled as to cut off the provision of credit, and in any case, many borrowers had alternative sources of funds.

In addition, we have not seen a clear upward trend in volatility of financial asset prices over the past 25 years, as one might expect if herding had increased in importance. Judging from options prices, market participants are expecting the volatility of financial asset prices to be damped in the future; they also are requiring lower term premiums for placing funds for longer terms.

I do not share Raghu’s nostalgia for the systemic-risk implications of bank-dominated finance. Old-style crises involving impaired depository institutions had substantial spillover effects; their repair took time, during which, economic activity was affected, and emergency measures to deal with them often involved moral hazard because they were aimed at stabilizing ailing intermediaries. I think we would all agree the industrial economy that has suffered the greatest systemic strains from problems in the financial sector in the past 15 years is that of Japan, which remained tied to the commercial bank model Raghu finds safest. The macroeconomic effects of new-style crises involving market liquidity, as in 1998, or outsized movements in asset prices may be more readily cushioned by monetary policies aimed at bolstering the general level of liquidity and reducing interest rates. Such policies also carry less risk of increasing moral hazard.

Although investment managers receive substantial funds directly from households, many of their counterparties are sophisticated investors in positions of fiduciary responsibility. In addition, most asset managers are employees of institutions—mutual fund families, bank holding companies—that are in the market for the long haul. It is not in their interest to reach for short-run gains at the expense of longer-term risk, to disguise the degree of risk they are taking for their customers, or otherwise to endanger their reputations. I would expect these counterparties and employers to enforce compensation schemes that foster their objectives. As a consequence, I did not find convincing the discussion of market failure that would require government intervention in compensation. Moreover, compensation regulation is likely to be easily evaded and fraught with risks of untoward consequences. One only has to recall the congressional action of 1993 that, by imposing less-favorable tax treatment on some forms of executive compensation, fostered the shift to stock options that in turn was thought to have contributed to some of the transparency and corporate governance problems of the late 1990s.

Regulatory and supervisory systems do need to evolve to reflect the shift to market-based transactions. As intermediation shifts from depositories, with their specialized knowledge of borrowers, to markets, disclosure and transparency become more important to allow diverse private parties to assess risk properly, exert appropriate discipline, and contribute to the efficient allocation of resources. Greater reliance on markets also elevates the importance of the safety of clearing and settlement systems. Private-sector participants have every incentive to demand these disclosures and to ensure that their trades go through as contracted. But government may need to act in concert with private parties to arrive at collective decisions that strengthen markets and reduce systemic risk but might not be in the interest of individuals acting separately. And with more of the fluctuations in asset prices passing through to a large number and wide variety of households, educating people to make informed choices and protecting retail customers from abusive practices remain key governmental functions.

A particularly interesting strand of the debate about excessive risk taking concerns the interaction of monetary policy and perceptions of risk in financial markets. Some analysts are concerned that several aspects of the conduct of monetary policy in the United States have induced market participants to reduce their expectations about risk too far, setting up the financial markets and the economy for an unpleasant and possibly destabilizing surprise.

In this view, the low short-term interest rates that policymakers have thought were required over the past few years to meet macroeconomic objectives are said to have encouraged reaching for yield—settling for risk compensation that the investors themselves view as probably inadequate but which they feel compelled to accept, perhaps to achieve targeted levels of real or nominal returns. The tendency of policy to react strongly to sharp declines in key asset prices, and thereby limiting the extent of the decreases, has been thought to induce risk taking by imparting an asymmetry to asset price movements. Finally, a concern is that the fairly new practice of telling the public about our expectations for the path of the federal funds rate may have given market participants a false sense of security about the future path of policy.

These practices have been the result of a monetary policy focused on price and economic stability over the intermediate term interacting with the particular characteristics of the economy. The global decline of inflation and spending induced a global reduction in interest rates to unusually low levels in recent years. Those low rates were, in fact, intended to stimulate risk taking and investment when private agents pulled back. The tendency for asset prices to fall more quickly than they rise has largely produced the more rapid and noticeable response of stabilizing monetary policy to declines than to increases. And the importance for economic performance of more accurate expectations about monetary policy, along with the unusually low policy rates, led the Federal Open Market Committee to undertake a more extended discussion of its policy expectations.

To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and contain financial crises, risks are genuinely lower, and that development should be reflected in the prices of assets. To the extent that the central bank can convey something useful about its intentions, markets that take account of these intentions will be priced more accurately.

The risk is that private agents overestimate the ability or willingness of central banks to damp volatility in asset prices or the economy, or that they fail to appreciate that future policy actions depend on an imperfectly predictable economic outlook. But developments should have partially alleviated some of these concerns. Investors have had an opportunity to observe that policy actions in 1987, 1998, and 2001-2003 cushioned the economy, but they did not stop major declines in the prices of equity in 1987 and 2001 or of risky credits in 1998. Short-term rates have risen substantially in the past year, reducing the profitability of “carry trades” without triggering an unwinding that drove long-term interest rates higher or widened risk premiums. And expectations that policy tightening would remain gradual over the near-term have not stopped long-term rates from fluctuating substantially in response to incoming data; the movements of future or forward rates out the yield curve after surprises in data have been at least as large since 2003 as they were before. That is not to say that we have nothing to worry about. As I already noted, Alan Greenspan, himself, often has been concerned about market complacency—as recently as his latest monetary policy testimony. People may well perceive the economy as more stable than it is or central banks with greater power than we have to smooth the economy or to foresee our own actions.

Clearly, reminders to the public of the inherent uncertainty in economic developments and policy responses are appropriate and should have some effect. The question is whether these warnings should be supplemented by actions to inject uncertainty into policy pronouncements by saying less than we can or into the economy by shifting our objectives away from seeking the best outcome for the economy over the intermediate term. In my view, such policies would result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.


Hyun Song Shin: It is a great privilege to participate in the symposium and to comment on Raghu’s paper. Raghu has written a lucid, thoughtful, and indeed, thought-provoking piece on an issue of great relevance to central bankers.

The main theme running through Raghu’s paper is liquidity, but you’ll have noticed that he is careful not to give a formal definition of liquidity. This is understandable since liquidity defies a simple definition. But we know two things about liquidity:

  • It has attributes of a public good,
  • but it’s a public good that arises from the diversity of intended actions.

So, when I buy or sell, it is only by virtue of the fact that there are other people doing the opposite that I am contributing to liquidity. Just as with any other public good, a very natural question is whether we can have market failure. Raghu’s diagnosis is that yes, on occasion, this public good can give rise to market failure, and financial development has, in some ways, made the problem worse. Unlike Don Kohn, I have more sympathy with Raghu’s diagnosis.

For the sceptics among you, I’d like to tell you about the Millennium Bridge in London. You may wonder why a bridge is relevant for financial markets, but it turns out that the Millennium Bridge offers a classic case study of market failure from engineering.

Many of you will be familiar with the Millennium Bridge. As the name suggests, the bridge was built as part of the millennium celebrations in the year 2000. It’s a pedestrian bridge that used an innovative “lateral suspension” design, built without the tall supporting columns that are more familiar with other suspension bridges. The vision was of a “blade of light” across the Thames.

The bridge was opened by the queen on a sunny day in June, the press was there in force, and many thousands of people turned up to savor the occasion. However, within moments of the bridge’s opening, it began to shake violently. The shaking was so severe that many pedestrians clung on to the side rails. The BBC’s Web site has some interesting video news clips, in case you’re interested. The bridge was closed later on its opening day and was to remain closed for more than 18 months.

When engineers used shaking machines to send vibrations through the bridge, they found that horizontal shaking at 1 hertz (that is, at one cycle per second) set off the wobble seen on the opening day.

Now, this was an important clue, since normal walking pace is around two strides per second, which means that we’re on our left foot every second and on our right foot every second. And because our legs are slightly apart, our body sways from side to side when we walk. Those of you who have ever been on a rope bridge will need no convincing from me.

But why should this be a problem? We all know that soldiers should break step before they cross a bridge. And for thousands of pedestrians walking at random, one person’s sway to the left should be cancelled out by another’s sway to the right. If anything, the principle of diversification suggests that having lots of people on the bridge is the best way of cancelling out the sideways forces on the bridge.

Or, to put it another way, what is the probability that a thousand people walking at random will end up walking exactly in step, and remain in lock-step thereafter? It is tempting to say “close to zero.” After all, if each person’s step is an independent event, then the probability of everyone walking in step would be the product of many small numbers—giving us a probability close to zero.

However, we have to take into account the way that people react to their environment. Pedestrians on the bridge react to how the bridge is moving. When the bridge moves from under your feet, it is a natural reaction to adjust your stance to regain balance.

But here is the catch. When the bridge moves, everyone adjusts his or her stance at the same time. This synchronized movement pushes the bridge that the people are standing on, and makes the bridge move even more. This, in turn, makes the people adjust their stance more drastically, and so on. In other words, the wobble of the bridge feeds on itself. The wobble will continue and get stronger even though the initial shock (say, a small gust of wind) has long passed.

The wobble results from shocks that are generated and amplified within the system. It is very different from a shock that comes from a storm or an earthquake, which come from outside the system. Stress testing on the computer that looks only at storms, earthquakes, and heavy loads on the bridge would regard the events on the opening day as a “perfect storm.” But this is a perfect storm that is guaranteed to come every day.

So, what does all this have to do with financial markets? Actually, quite a lot. Financial markets are the supreme example of an environment where individuals react to what’s happening around them, and where individuals’ actions affect the outcomes themselves. The pedestrians on the bridge are like banks adjusting their stance and the movements of the bridge itself are like price changes. You want diversity, but the market price is a lightning rod that imposes uniformity.

There have been many instances of failure of liquidity of this type. Take the 1987 stock market crash for example. The Brady Commission highlighted practices such as portfolio insurance and dynamic hedging in amplifying the price fall. As you know, dynamic hedging attempts to position one’s portfolio in reaction to price changes in order to mimic the payoffs from a put option. And since put options pay out when prices are low, this means maintaining a short position in the asset that becomes steeper as the price falls. In other words, dynamic hedging dictates that when the price falls, you sell more of the asset. This is a strategy that relies on liquid markets—on others who will buy when you sell. When the price falls, dynamic hedging dictates even larger sales. And as the market adage goes, one should never try to catch a falling knife, and so potential buyers stand on the sidelines until the knife drops to the ground.

We can all name many more episodes of market distress of this type since the 1987 crash. The events of the summer 1998 are still fresh in our minds.

Both the 1987 crash and the events of summer 1998, as serious as they were, were restricted to small segments of the economy. Financial development has meant that the potential for feedback is now much more pervasive. The advent of credit derivatives has brought closer the prospect of marking bank loan books to market, so that the galvanizing role of market prices soon will reach into every nook and cranny of the financial system.

Even previously boring banks are now at the cutting edge of price- sensitive incentive schemes and price-sensitive risk-management systems. And mark-to-market accounting ensures that any price change shows up immediately on the balance sheet. So, when the bridge moves, banks adjust their stance more than they used to, and marking to market ensures that they all do so at the same time.

The engineers for the Millennium Bridge found that there was a critical threshold for the number of pedestrians on the bridge at which the wobble kicked in (160, as it happens). Below that threshold, there were no outward signs of trouble.

As ever, engineers have the advantage over economists in being able to conduct controlled experiments. For financial markets, it is very difficult to ascertain what the tolerance threshold for maket liquidity is, beyond which we see events such as the financial distress of summer 1998.

But we know two things:

  • Below the threshold, markets will function well, shocks are absorbed, and volatility will be dampened as the market performs its task.
  • But beyond that threshold, all the elements that formed a virtu- ous circle to promote stability now will conspire to undermine it. There is a big difference between risk and volatility.

What we don’t know is where that threshold is. It is possible that the threshold is so distant that we needn’t worry. On the other hand, it would be safe to assume that the developments Raghu highlights have moved us just a little closer to that threshold.

Now, let me turn to Raghu’s policy proposal. The engineers for the Millennium Bridge decided to attach shock absorbers underneath the bridge. For financial markets, this solution would be rather like increasing market frictions so as to make trading more difficult—somewhat like Tobin’s notion of throwing sand into the wheels of financial markets.

Raghu’s proposal for the regulation of incentives is an alternative way to address the problem. I realize that my bridge analogy is already creaking under the strain, but let me push it a little further.

Raghu’s proposal is intended to alter the way that banks react to short-run price changes. It would be rather like giving pedestrians on the bridge balancing frames (picture those baby walkers with wheels on the side), so that they do not have to adjust their stance if the bridge were to move from under their feet. If they do not react, then the bridge will stabilize.

For financial markets, Raghu is surely right that balancing frames are far superior to shock absorbers. Indeed, Raghu himself has written extensively on the benefits that we all reap from financial development. Shock absorbers would be like throwing the baby out with the bath water.

But I think Raghu himself would recognize that his proposal is a non-starter, at least under current circumstances. There just isn’t the appetite for this kind of reform. And there are many practical hurdles. Don has mentioned some. Let me add a couple more. Lawyers will point out that interfering in contractual arrangements between willing parties will not be looked upon kindly by the courts. There are also competitive level-playing-field considerations. Piecemeal implementation by one country will succeed only in weakening one’s own financial industry.

But this sounds strangely familiar. Indeed, we have been here before. The Basel Capital Accord of 1988 was precisely such an attempt at collective de-escalation. The question is one of political appetite. Or as Raghu might say, the appetite for reform will be a matter of how severe the next crisis will be.

It is apt that Malcolm Knight is chairing this morning’s session, because when the time comes, this will be a matter for a Bank for International Settlements committee.


Mr. Summers: "I speak as a repentant, brief Tobin tax advocate, and someone who has learned a great deal about the subject, like Don Kohn, from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely misguided. I want to use an analogy, not unlike the one Hyun Song Shin did, but to a rather different conclusion.

One can think of the history of transportation over the last two centuries as reflecting a gradual and determined move away from arm’s length transactions. People once supplied their own power. Then, they started carrying on transportation using tools that they owned. Then, they increasingly relied on tools that other people owned that were provided by intermediaries.

In that process, the volume of transportation activity increased very substantially. Over time, people became almost entirely complacent about the safety of the transportation arrangements on which they relied. Large sectors of the economy came to be organized in reliance on the capacity of planes to fly and trains to move. The degree of dependence on individual hubs—like O’Hare Airport—increased substantially. The worst accidents came to be substantially greater conflagrations than they had ever been in an earlier era.

Yet, we all would say almost certainly that something very positive and overwhelmingly positive has taken place through this process. Something that is overwhelmingly positive for individuals is that the number of people who die in transportation-related episodes is substantially smaller than it was in an earlier era.

The best single way to think about the process of financial innovation is as representing a similar process of movement across spaces, spanned not by physical space, but by different states of nature. It seems to me that the overwhelming preponderance of what has taken place has been positive. It is probably true that—as we didn’t use to have transportation safety regulation and we do now—an evolving system does require an evolving regulatory response.

But it seems to me that one needs to be very careful about stressing the negative aspects of the evolution, relative to the positive aspects of the evolution. I was going to make the same point that Don Kohn made about the Japanese financial system and the Scandinavian financial system standing out for the magnitude of damage done and the reliance on vanilla banking, relative to other activities.

Something similar could be said about the history of U.S. business cycles. The history of the business cycles prior to 1970 would place very substantial reliance on problems that came out of the financial sector and the regulation of the financial sector.

I was surprised by the tone of the recommendation around the incentives because it seems that if you take what is the central, most plausible area of concern that is suggested by what takes place in the paper, it is the notion that speculation involves negative feedback over a certain range, then positive feedback once you get outside of that corridor, and that process is very substantially exacerbated by hedge fund phenomena. Indeed, if one looks at the Shleifer-Vishny paper that Mr. Rajan refers to, hedge funds and the behavior induced by hedge funds and hedge fund liquidations are the central example. Yet, hedge funds would be the primary example we have of a financial institution where those who were running it did in fact have, as Raghu Rajan recognized in his comment on long-term capital management, very substantial wealth that was involved.

While I think the paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets, the tendency toward restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.

I would say as a final example of what has come out of the discussion for the 1987 crisis is that if those who wish to protect their assets had bought explicit puts rather than portfolio insurance, the situation would have been substantially more stable. That also argues for the benefits of more open and free financial markets, rather than for the concerns they bring.

Mr. Fraga: I’m a former regulator and now a hedge fund manager. Unlike Mr. Shin and Mr. Summers who talked about bridges, trucks, and planes, I am going to talk about banks and hedge funds. I will be brief because a lot of what I wanted to say Don Kohn covered in magnificent fashion. I also should say at the outset that I was very stimulated by this paper. It is very rich and insightful. Being a reader of many of your papers, I think one more revision with a little more structure or perhaps a framework would be the final touch needed on what is an otherwise stimulating piece. My first remark is slightly academic. We are moving toward more complete markets. Presumably, this is a good thing. I do see from my vantage point at the ground level that risk is going where it belongs. What we see in the hedge fund industry now is really several different things. It is, in fact, a good innovation because small investors don’t like banks to take a lot of risk. So, traders and banks move out to hedge funds and they are there met by more sophisticated investors.

First, we must look at distortions and look for ways to improve the system. I am not so sure that what Raghu Rajan mentions is a step in that direction. He says: “Investment managers get performance-based compensation, and they have a tendency to conceal risks, especially tail risks...and that banks somehow were better.”

Banks in the old days were paid to grow their loan books. I can’t think of a worse incentive, and that is the way they were compensated. A lot of the things we’ve seen have to do with that. Investment managers today, however risky their businesses may be, tend to care about their reputations and tend to have their money on the line. If you were to do a study, you would find there are substantial amounts of investment managers invested in their own funds. That is healthy and is being delivered by the market on its own. Also, banks are tricky because they don’t mark to market their loans. It’s not doable. Moreover, they have liabilities that trade at par, with deposit insurance. So, talk about moral hazard—there really is plenty of it in banking.

I also must say, as an investor, I have a pretty easy time looking at funds and figuring out what they are doing. It is nearly impossible to know what the large financial institutions we have in this planet are doing these days. I am being cautious here. I think it is impossible.

That is, in my view, probably an argument to say we may be better off than before. The fact that funds mark to market their portfolios every day means if people want to withdraw, there will be a natural protection against a run. People may give up on withdrawing after values decline, and anyway, if they do, it is their own loss. Moreover, these investors are more sophisticated—as I said, I run one of these institutions—and they really watch over what we are doing. This is quite healthy. In these days, we see endowments and other sophisticated long-term investors doing this job very efficiently.

Perhaps because of all this we see less of an impact of all these finan- cial accidents on the real economy now than we did see in the 1980s when it took years to clear markets, for banks to start lending again, and for the economies to start moving.

Lastly, I should report to you that it seems also very clear that the terms that fund managers get these days are changing. The better fund managers are getting longer terms, and they still get paid in a very convex fashion. I would have a concern if we saw retail investors going into hedge funds. I should just make a note of that.


Mr. Fischer: This is a very interesting paper. It gives a sophisticated answer to the question a lot of people ask about financial innovations: whether they make the markets more efficient and more stable. I think the answer is they make the markets more efficient, they reduce the probability of a financial crisis, and they increase the extent of those crises that are likely to occur. That is my interpretation of what it says.

Then, the question is what to do about the extreme prices. There is improved internal risk management, which certainly is happening in all institutions. It is very complicated, particularly as instruments get more complex. Like Arminio Fraga, having been inside one of those machines, the need to mark to market inside banks is very clear.

Anybody who wants to take too much comfort from this should remember a lunchtime speech here by the then-CEO of Bankers Trust on how perfect their internal risk management systems were. The trouble is you never quite know. Secondly, you could argue that you could rely on market discipline, but that is really about internal risk management as well.

Then there is prudential supervision, which is extremely tough, because the size of the prudential supervision team is way smaller and the amount of information it has is way less than the internal risk managers have. What it can do is inspect systems, which is good. It certainly put the fear of hell into the institutions, which is probably the best thing it could do. When talking about that, you had better remember insurance companies because these risks are being spread more and more and ending up there. It is said—I have no direct knowledge of it—that the quality of risk management in insurance companies is less and prudential supervision is less than in the banks.

Rajan emphasized that the residual risks are in the banks. I don’t know if that is true, but what is true is that all the market risks end up affecting the banks. That is especially true in a non-Glass-Steagall world, which is the world we have now. Finally, what to do about the lender of last resort. Rajan emphasized liquidity, and so did the discussants. That is what central banks can provide in a crisis, but you have to bear in mind the rule that the lender of last resort should lend to the market and not to specific institutions. This whole development is paradoxically reemphasizing the role of the central bank in the management of the system. If he is right, Raghu said the key problem is going to be liquidity. That is what central banks are about.

I have reflected a long time on the Long-Term Capital Management crisis. The thing that struck me most was the story of LTCM could have appeared in Clappin’s book on 19th century crises. It is a very modern crisis, but the way it was resolved was almost identical to the way that crises always used to be resolved. The central bank was brought in and banged a few heads together. There was an argument about whether they should have done it, but in the end, that was how it was resolved.

Mr. Trichet: First of all, I think the discussion has been absolutely stimulating and of extreme quality. I would echo what Stan Fischer just said. My first point is that we are, as central bankers, at the heart of these issues and threats. I would mention second that the Financial Stability Forum, in my opinion, chaired by Roger Ferguson, is certainly the place where one can have the best assessment of the situation. It is the only place, to my knowledge, where you are sure that every institution, and I would say every concept, is taken into consideration. There is no other place. All international institutions are there, all public authorities and the major marketplaces.

Third, herd behavior, in my opinion, remains of course a permanent threat. I like very much all the metaphors that have been used. I remember a meeting in Jackson Hole in 1997, where we were more or less discussing what became known as the Asian crisis. I have the very vivid memory of the private sector warning us—meaning the public authorities—that herd behavior was extremely likely to materialize. And it did. I realized two major conclusions on these episodes of turbulence that, I would say, are episodes of both risk turbulence and market turbulence. First, transparency is absolutely of the essence and is the best way to counter herd behavior, as has been proved—it seems to me—over the last period of time. There are areas where transparency does not exist. I am a little bit puzzled when Arminio Fraga says, “It is impossible to know what major institutions are presently doing.”

I don’t know whether I capture exactly what you said, but that, to me, is contrary to the major lesson we have been drawing from the dramatic events of the recent years. We have to work much more on that. Second, I would mention that the spread of codes of conduct and good practices has been a major advancement, drawing from the dramatic events I was mentioning. I trust that it is essential, and we still have a lot more to do in this domain.


Mr. Sinai: I have a comment and several questions for Raghu and Don Kohn. On the intermediation by what, Raghu, you call investment managers versus bank intermediation. I also have the sense that there is increased risk, perhaps ultimately systemic in the financial system innovations and changes that you described in your paper, despite mark to market discipline. It, in part, stems from the liquidity effects on economic activity, potentially inflation from the new intermediaries. I lack empirical evidence for that discomfort. So, I have a series of questions.

Are there any size measures—absolute or relative—of what institutions now do most of the intermediation and by how much? Is the traditional intermediation function, as we know it, of banks eventually or already dwarfed by intermediaries such as investment banks, pension funds, venture funds, private equity funds (this is what makes me uncomfortable when I list this totality), buyout funds, hedge funds, and new not transparent, not well-supervised others that might evolve in the system? Again, what is the size of the new intermediation pool or lump? Do you have any estimates?

My second question is about monetary policy effectiveness. Monetary policy accommodation, as we know, is interest rates and the availability of funds or credit. With so much availability of funds, the animal spirits of the financial system, and the aggressive nature of the financial system, we may not get the same availability restriction as we used to get from rising interest rates. My next question is more directed at Don. Would there be extra upside inflation risk, given the animal spirits in the system and the availability of funds that come from all these intermediaries?

Mr. Blinder: I’d like to defend Raghu a little bit against the unremitting attack he is getting here for not being a sufficiently good Chicago economist and just emphasize the sentence in his paper which says, “There is typically less downside and more upside risk from generating investment returns.” This is very mildly said. The way a lot of these funds operate, you can become richer than Croesus on the upside, and on the downside you just get your salary. These are extremely convex returns.

I’ve wondered for years why this is so. You don’t need to have public regulatory concerns to worry about it. Take the perspective from inside a big company. The traders don’t own the capital. The traders are taking all this risk and putting the company’s capital at enormous risk. I don’t quite understand why the incentives are as they are.

I remember a discussion I had with—I won’t name him—one of the principals of the LTCM, while it was riding high. He agreed with me that the skewed incentives are a problem. But they weren’t solving it, obviously. So far, that is just an internal problem to the firm.

What can make it a systemic problem is herding, which Raghu mentioned, or bigness, which is related to the discussion that Fraga raised, and so on. If you are very close to the capital—for example, if the trader is the capitalist—then you have internalized the problem. So, it may be that bigness has a lot to do with whatever systemic concerns we have. Thus, I’d draw a distinction between the giant organizations and the smaller hedge funds. Whether that thinking leads to a regulatory cure, I don’t know. In other domains, we know, bigness has been dealt with in a regulatory way.


Mr. Weber: I enjoyed reading the paper. I had a few issues in the monetary policy section, which is very short. I would encourage you to elaborate a bit more on that. You said it is plain vanilla, and I think you should add some flavor there. You mentioned three issues where there is a tradeoff between the monetary policy mandate and the financial supervisory mandate of central banks. You point out the constructive ambiguity issue, where there is the transparency issue in the measured pace policy. You also point out that staying further away from deflation to avoid having to resort to low policy rates is important. My guess is this has implications for the inflation target, and I encourage you also to elaborate a bit on that—how to deal with this tradeoff and what should govern this tradeoff.

Lastly, you say greater supervisory vigilance should be exercised in periods of low rates to contain asset price inflation. We more or less all agree with these issues. But what should govern these choices? The big issue really is how you implement this if a central bank has a dual mandate. Even if they have dual mandates, there have to be some priorities in the setting, and it may be state dependent. So, I encour- age you to work a bit on that.


Mr. Kohn: The only response is to Allen’s point about the effectiveness of monetary policy when availability constraints aren’t present. I agree with the sense that there used to be a policy channel

Everybody recognized that, as regulations came off, interest rates were going to have to vary over a wider range up and down. But there is no cost to that really, and there is a huge advantage to not having availability constraints. There is no reason why we can’t change those interest rates sufficiently to accomplish our objective, except for the very rare occasion of the zero bound. I don’t see the absence of a credit channel as impinging on monetary policy effectiveness.


Mr. Rajan: Let me start by rejecting the allegation that I really have nostalgia for the bank-dominated systems—absolutely not! I have written a whole book suggesting that we are really much better off in this market-dominated system. All I am arguing is that this creates new concerns. And every responsible regulator and supervisor has to address what these new concerns mean for his or her job. All I am doing is trying to suggest that we need to pay attention to this.

In addition, a number of people have raised the concern that we don’t want to interfere with the markets. Again, that is absolutely right. We don’t want to interfere in the natural risk taking of the markets. So, you want to apply market-friendly approaches. As Arminio Fraga said, a number of organizations already use this method of having their managers invest part of their compensation in it. Larry Summers said something about the investigation prompting a wide variety of misguided policy impulses. That may well be true, but that is no reason to not point attention to the possible concerns that are raised. After all, it is our responsibility to do that.

Let me say, we have come a long way. But I do think we need to keep considering how we can make the system work better. Here I want to cite Chairman Greenspan for any changes in regulation: “Proceed cautiously. Facilitate and participate in prudent innovation. Allow markets to signal winners and losers among competing technologies and market structures. And, overall, as the medical profession is advised, do no harm.”

I fully subscribe to this. Therefore, we should examine all possibilities and see whether they meet these tests, which I think are very important.

Summers talked about transportation. Well, we never examined the buggy whips to determine whether they were safe because there were two people riding in them. But since we have moved to airplanes, we have the FAA—as you’ve pointed out—doing a very good job. In the same way, as we get more concentration of risk, it does raise the issue of whether we should investigate more carefully.

I am not in any way saying, “Let’s go back to banks.” Let me stress that again. I am also not saying that banks are in any way better than hedge funds. All I am saying is that we need to pay more attention.

As far as the issue of transparency goes, I agree with Jean-Claude Trichet that transparency is very useful. But for some of these organ- izations is transparency enough? Do we actually know enough from knowing the immediate positions, so that we don’t have to know their strategies? If we do have to know their strategies, would that not become too complicated, given the limited resources with supervi- sors, in which case we might have to move eventually to incentives. If they have the right incentives, we wouldn’t worry. We need to figure out whether they, in fact, do have incentives. Fraga’s comment about restructuring the paper makes good sense...