The Hindu Business Line : How to better ride out the downturns

A LITTLE learning is a dangerous thing, said George Bernard Shaw, and added, "But we must take that risk because a little is as much as our biggest heads can hold."

A risk that is eminently worth taking, especially by professionals who are leaning on the learning curve, is reading up Raghuram G. Rajan's latest paper on www.nber.org, "Has Financial Development Made the World Riskier?"

The author, as you may be aware, is the Economic Counsellor and Director of Research of the International Monetary Fund, and his book `Saving Capitalism from the Capitalists' hit the popularity charts not long ago.

Raghu's paper opens on a positive note, about how, over the last three decades, our financial systems have improved so well that we can "borrow greater amounts at cheaper rates than ever before, invest in a multitude of instruments catering to every possible profile of risk and return, and share risks with strangers from across the globe". Then comes the tug in the form of a question: "Have these undoubted benefits come at a cost?"

Three forces on the financial landscape

Before answering that, the author dwells on three main forces that have been at work `in altering the financial landscape': one, `technical change', which has reduced "the cost of communication and computation" and ensured a wider use of "techniques ranging from financial engineering to portfolio optimisation, from securitisation to credit scoring"; two, `deregulation', which has broken barriers to entry and competition; and three, `institutional change', resulting in "new entities within the financial sector such as private equity firms and hedge funds." All these have made the typical transaction in the financial sector more `arm's length' and also achieved greater market width.

"This phenomenon has been termed `disintermediation' because it involves moving away from traditional bank-centred ties," notes Raghu. But that's `a misnomer', he'd say, because "`investment managers' have displaced banks and `reintermediated' themselves between individuals and markets." Money goes to market through mutual funds, insurance companies, and pension funds, rather than to banks as earlier. An insightful statistic is that even as equity markets have grown, the share of direct investment by households in markets has fallen off in the US, as the paper shows with the help of an area chart depicting `ownership of corporate equities' in percentages of total market value.

How are banks responding "as the `plain vanilla' transaction becomes more liquid and amenable to being transacted as the market"? They are moving on to greener and `more illiquid' pastures. "Competition forces them to flirt continuously with the limits of illiquidity," observes the author.

He is not, however, arguing for a return to "bank dominated systems with limited competition, risk sharing, and choice", but exhorting us to look into an area of concern, viz., incentives. "How aligned are the incentives of managers with investors?" he asks.

"Investment manager compensation is likely to be convex in returns, while bank manager compensation in the past was more concave. This difference creates a difference in risk preference," explains a footnote saving the reader from jargon, because the paper itself is in plain English, something unusual for most economists. "Bank managers were paid a largely fixed salary," and "In the new, deregulated, competitive environment, investment managers cannot be provided the same staid incentives as bank managers of yore," are instances of readable lingo.

Two differences and two perversions

Raghu notices two differences in the present incentive structure compared to the old. One, with `less downside and more upside from generating investment returns', managers have `greater incentive to take risk'. And two, `managers are being evaluated against others', so we may get `superior performance' plus `a variety of perverse behaviour'.

Perverse goes with many other qualities, as you can find in King Henry VI, part I, where Bishop of Winchester asks, "If I were covetous, ambitious or perverse, as he will have me, how am I so poor?" There seems to be some perverse human characteristic that likes to make easy things difficult, Warren Buffett comments. Well, that doesn't apply to the paper on hand, which explains in simple language what sort of perversions can ensue.

"One is the incentive to take risk that is concealed from investors," writes Raghu, referring to what are called `tail-risks' generating `severe adverse consequences with small probability' while offering `generous compensation the rest of the time'. The second, `herd behaviour', arises when the investment manager herds with other managers on investment choices, as insurance against underperformance in comparison to peers.

Dangerously, "Both behaviours can reinforce each other during an asset price boom." Also, banks are not insulated from these distorted conducts. Disturbing one-liners about banks are: That they often have to bear `the most complicated and volatile portion of the risks they originate'; that their balance sheets have been `reloaded with fresh, more complicated, risks'; that they `may not be any safer than in the past'; that "bank credit and other monetary indicators may no longer be sufficient statistics for the quantity of finance-fuelled activity"; and that "the risk they now bear is a small (though perhaps the most volatile) tip of an iceberg of risk they have created".

Of great concern to the central banker should be this doubt: "Whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialise, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimised."

To the logical question whether with `far more participants today', we wouldn't be able to absorb risk, Raghu answers, grimly though, "the financial risks that are being created by the system are indeed greater." He doesn't, therefore, rule out the possibility of these developments to create `more financial-sector-induced procyclicality than in the past', and `a greater (albeit still small) probability of a catastrophic meltdown'.

Unfortunately, we won't know whether these are, in fact, serious worries until the system has been tested, he notes wryly, because we don't know whether the disasters that have occurred thus far were shocks "large enough and in the right places to fully test the system". Perhaps we can sleep better at night if we pray, "Lord, if there be shocks, let them be varied and preferably moderate ones, so we can stress test our systems," muses the author.

Should we not get our regulators to jump in and stop the runaway train? Wait, "all interventions can create their own unforeseen consequences," warns Raghu. Weigh these risks against "the costs of doing nothing and hoping that somehow markets will deal with these concerns," he advises, before delving into reasons why both the markets and the regulators `may not get it right'.

Hot money and wrong model

One of the many examples in the paper studies the relationship between politics and economics, especially in emerging economies that receive `hot money' and are, therefore, `most likely to be damaged' when investment managers move the funds when `developed country rates rise'. Falling risk premia and better credit ratings tempt "the emerging market politician to assign the credit to his own policies (and if they have not actually changed, to the fact that foreign investors have finally recognised how wonderful the policies have been)," writes the author, reminding one of what netas say, closer home.

"It is possible politicians might mistake a cyclical phenomenon for a secular trend and initiate a plethora of long-term projects on that basis, only to be forced to liquidate them when the cycle turns." But politicians themselves have short horizons defined by elections, and asymmetric compensation functions, rues Raghu. "If they can produce high growth before the elections, they will be re-elected... while low growth (or high growth) post-elections is discounted," he reasons. That's a case of an economist looking at things with the politician's eye, and decoding `political business cycle', where politicians have "every incentive to accept hot money even if they fully recognise its true character".

Moral is that what's sauce for the goose isn't necessarily sauce for the gander. "An industrial country's monetary policy, while appropriate for its domestic circumstances, may be inappropriate taking into account spill-over effects on other economies." An elaborate discussion on `monetary and regulatory responses' offers suggestions about `credit expansion and contraction', and `prudential supervision', in what I'd say is a must-read paper for policy makers and professionals.

Scylla and Charybdis

Raghu concedes that risk can never be reduced to zero. Nor should it be made a zilch, he adds. "We should be prepared for the low probability but highly costly downturn," reads his bleak warning. "In such an eventuality, it is possible the losses that emanate from a financial catastrophe cannot be entirely borne by current generations and are best shared with future generations."

Look around, and that's happening, in the form of changes to retirement benefits and social security, which will impact the future beneficiaries. What a pity that we pass on our costs to the young and the unborn, to ensure sustainability! Raghu isn't in favour of overstretching `the inter-generational risk sharing mechanism'. Instead, we need to continue improving the intrinsic flexibility of our economies, so as to better ride out the downturns that, almost inevitably, will occur, he advises.

"What is clear is that we are a long way from knowing all the answers on how to reduce the risk of financial instability," admits Raghu. Yet, we have to deploy `all the innovations that finance has created' and weather the storm of market forces creating excessive risk. "We have to steer between the Scylla of excessive intervention and the Charybdis of a belief that the markets will always get it right," he sums up, with the immediacy of a mission for tackling what lies straight ahead.

AccountSpeak@TheHindu.co.in

D. Murali

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