Risky Business

• Author: Raghuram Rajan
• Position: Economic Counsellor and Director of the IMF's Research Department

Skewed incentives for investment managers may be adding to global financial risk

In the past thirty years, financial systems around the world have undergone revolutionary change. People can borrow greater amounts at cheaper rates, invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers across the globe. Financial markets have expanded and deepened, and the typical transaction involves more players and is carried out at greater arm's length.

At least three forces are behind these changes. Technical change has reduced the cost of communication and computation, as well as the cost of acquiring, processing, and storing information. For example, techniques ranging from financial engineering to portfolio optimization, and from securitization to credit scoring, are now widely used. Deregulation has removed artificial barriers preventing entry of new firms, and has encouraged competition between products, institutions, markets, and jurisdictions. And institutional change has created new entities within the financial sector-such as private equity firms and hedge funds-as well as new political, legal, and regulatory arrangements (for example, the emergence over the past two decades of the entire institutional apparatus behind the practice of inflation targeting, ranging from central bank independence to the publication of regular inflation reports).

While these changes in the financial landscape have been termed "disintermediation" because they involve moving away from traditional bank-centered ties, the term is a misnomer. Although in a number of industrialized countries, individuals don't deposit a significant portion of their savings directly in banks anymore, they invest indirectly in the market via mutual funds, insurance companies, and pension funds, and in firms via venture capital funds, hedge funds, and other forms of private equity. The managers of these financial institutions, whom I shall call "investment managers," have displaced banks and "reintermediated" themselves between individuals and markets.

What about banks themselves? While banks can now sell much of the risk associated with the "commodity" transactions they originate, such as mortgages, by packaging them and getting them off their balance sheets, they have to retain a portion. This is typically the first loss, that is, the loss from the first few mortgages in the package that stop paying. 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. For example, banks offer back-up lines of credit to commercial paper issuances by corporations. This means that when the corporation is in trouble and commercial paper markets dry up, the bank will step in and lend. Clearly, these are risky and illiquid loans. And they reflect a larger pattern: as traditional transactions become 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.

No doubt, the expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transaction costs of investing...