The economist Raghuram Rajan wrote a prescient paper in 2005 when he warned that innovations in financial development and risk management can make the world a riskier place—that “the longer a market’s superstructure proves to be reliant, the more reliance will be placed on it.” A few years later, the subprime housing bubble popped, financial markets buckled, and economies around the world plunged into recession.
If we are to understand and minimize the risks of a second Global Financial Crisis, it is important to remember the broad strokes that led us here in the first place. Modern finance, in many ways, is a story about “technical change.” Advances in academia, industry, computing, and communications, alongside extensive deregulation, helped contribute to the financial boom. Techniques like dynamic arbitrage, pass-through securities, and portfolio optimization grew to dominate the sector’s attention and activities.
As competition for clients grew, the industry began to slice and dice and bundle future cash flows into products with glamorous names—tailormade to the fads and fancies of their customers. Elsewhere, venture capital funds, hedge funds, and other partnerships “emerged in search for returns in newer, more exotic areas”, Ragan writes.
Financial development, he suggests, expanded the economy’s capacity for risk spreading, risk bearing, and risk taking, and participation among families and firms. This is not necessarily a bad thing. The financial sector, after all, is the circulatory system of commerce, and has played a crucial role in our economic development.
We have to remember, however, that financial markets are far more vast and integrated today. The speed and scale of today’s transactions puts much more demands on our systems, from information to credit to insurance, that make up the financial “superstructure”. The structure in turn may prove unreliable if the systems cannot keep up.
One recurring source of superstructure strain, Rajan notes, is the role of incentives. Indeed, the incentives that fund managers and bankers face today are quite different to those of bygone eras. Today, compensation is tied more so towards relative performance. While this encourages the agent to do his or her job well, it can also incentivize dangerous behavior. In particular, managers may take on undisclosed risks to earn higher returns relative to their benchmark.
Now, if the rat race induces every manager into doing so in fear of losing, the system as a whole may generate more risk than it should. This is especially problematic when each manager individually feels that he or she has little to lose and plenty to gain by behaving excessively.
Zero to one
For an illustration, Ragan points to insurers and pension funds that sell disaster insurance to companies. Because companies usually have a low chance of going bust, these contracts tend to produce high returns on paper for sellers. So managers with short horizons are happy to indulge in them to boost their bonuses.
But as Rajan asks, “what happens if catastrophe strikes?” Might the insurers themselves go bust? The managers in these firms will argue otherwise. They will say that they have accounted for all the possible dangers in their exposure. But as Rajan reminds, “a hedged position can become unhedged at the worst times.”
The geniuses at Long Term Capital Management learned this the hard way during the 1998 Russian financial crisis when the correlations in their positions turned from zero to one. Their hemorrhage necessitated a $3.6 billion bailout to stave off further contagion and widespread damage.
Bigger yet was the collapse of the insurer AIG, just a few years after Rajan’s paper, as their gambles on credit default swaps unraveled during the subprime meltdown. This time the Federal Reserve had to commit $180 billion in “extraordinary assistance” to the insurer to avoid a complete financial implosion.
Moreover, as Rajan and many others have observed, modern finance may also incentivize herding. Managers with short horizons may mimic one another to avoid individual failure and relative underperformance. After all, failing with the crowd is safer, both professionally and psychologically. Of course, if everybody is behaving in the same way, then the diversity and wisdom of crowds, on which the market depends, deteriorates. Herds and mobs can move prices beyond their fundamentals.
Rajan suggests that “the young and unproven are likely to take more tail risk, while the established are likely to herd more.” Together, these ingredients make for a “volatile combination.” They “may create more financial-sector-induced procyclicality” and “a greater probability of a catastrophic meltdown.” Other factors, like falling interest rates, financial liberalization, political short-termism, and regulatory oversight may further intensify this cocktail. They can “engender excessive tolerance for risk on both sides of financial transactions.”
As Rajan notes, financial markets are usually reliable but not always. It is dangerous to celebrate financial innovation and forget that markets are reflexive and performative. It is well known, for example, that helmets are essential to protect cyclists during accidents. Unfortunately, studies also find that cyclists are more prone to risky maneuvering when they wear helmets.
That’s not to say, however, that we should do away with helmets. That would be ludicrous. The point is that innovation can introduce countervailing effects and unintended consequences. Improvements in our capacity to spread and bear risk may also result in greater risk taking.
“The consequence is greater fragility”, Rajan writes, “to errors, to misinformation, and simple bad luck.” Indeed, while greater sophistication and integration may help institutions and nations to withstand minor financial shocks, we might remain vulnerable to perfect storms on the tail-end.
Most recently, our superstructure was stress tested during the global financial meltdown and the coronavirus pandemic, and not without significant cost. But it is also unclear if we have learned and adapted sufficiently through these experiences. Might something more severe lurk in the near-horizon?
Unsurprisingly, Rajan calls for better supervision, disclosures, capital requirements, and incentives. While we won’t get into the policy details here, this is consonant at least with George Akerlof and Robert Shiller’s view for better management of our animal spirits and confidence multipliers. Ben Bernanke and colleagues emphasize likewise the need to restore our political goodwill, regulatory systems, and financial firefighting arsenal for future economic disasters.
Rajan admits, however, that there is probably no panacea in sight yet. More work is necessary to understand the true nature of financial and economic instability.
“We have to steer between the Scylla of excessive intervention and the Charybdis of a belief that the markets will always get it right.”
Raghuram Rajan. (2005). Has Financial Development Made the World Riskier?
Sources and further reading
- Surowiecki, James. (2004). The Wisdom of Crowds.
- Akerlof, George., & Shiller, Robert. (2009). Animal Spirits.
- Shiller, Robert. (2000). Irrational Exuberance.
- Soros, George. (2009). General Theory of Reflexivity.
- MacKenzie, Donald., & Millo, Yuval. (2003). Constructing a Market, Performing Theory.
- Rajan, Raghuram. (2005). Has Financial Development Made the World Riskier?