For anybody who has seen the documentary Inside Job, you likely heard them mention a research paper written by Raghuram G. Rajan in 2005 entitled, “Has Financial Development Made the World Riskier?” I decided to read the document, and was impressed by the depth of the analysis and the conclusions that Mr. Rajan came to. This article will make note of some of the more interesting points discussed, and their implications today (certainly not a substitute for the paper itself; read it here).
Investment managers are constantly fighting for their paychecks by maintaining assets under management (AUM). With many investors simply chasing the “hot hand” (emerging markets, etc), managers of young firms have a perverse incentive to seek excess returns regardless of risk in order to drive management fees, as well as performance fess. Essentially, we are left with scenarios of substantial upside and very limited downside for the manager.
Considering that managers are benchmarked against their peers, they have become involved in certain behaviors to drive this necessary excess performance. These include taking risks that generate attractive results the majority of the time as compared to serve downside rarely (“selling disaster insurance;” common among the young, unproven firms), as well as herd behavior (common among more established firms). These two actions have a reinforcing effect during asset price booms, when managers willingly bear the possibility of risk from an abrupt correction, and are comforted by the realization that any bust will hurt the herd collectively and guarantee comparable relative performance (even if terrible by absolute measures). As Rajan notes, “Overall incentives to take risk have increased”.
From reading this paper, it is astonishing how spot on Mr. Rajan’s analysis ended up being. He notes changes that could be made (including interest rate hikes and incentive changes at banks) to mitigate the potential danger, which were not implemented in any noticeable way. The most revealing part is his focus on incentives, and how they were misaligned (in some manner) for nearly every party involved in the economic collapse. As we have seen over the past 3-4 years, his own words were quite accurate: “While it is hard to be categorical about anything as complex as the modern financial system, it is possible these developments may create more financial-sector-induced procyclicality than the past. They also may create a greater (albeit a small) probability of a catastrophic meltdown… Tail events may prompt a flight to quality and liquidity. Unfortunately, traditional providers of liquidity could find it harder to step up at such times.”
Investment managers are constantly fighting for their paychecks by maintaining assets under management (AUM). With many investors simply chasing the “hot hand” (emerging markets, etc), managers of young firms have a perverse incentive to seek excess returns regardless of risk in order to drive management fees, as well as performance fess. Essentially, we are left with scenarios of substantial upside and very limited downside for the manager.
Considering that managers are benchmarked against their peers, they have become involved in certain behaviors to drive this necessary excess performance. These include taking risks that generate attractive results the majority of the time as compared to serve downside rarely (“selling disaster insurance;” common among the young, unproven firms), as well as herd behavior (common among more established firms). These two actions have a reinforcing effect during asset price booms, when managers willingly bear the possibility of risk from an abrupt correction, and are comforted by the realization that any bust will hurt the herd collectively and guarantee comparable relative performance (even if terrible by absolute measures). As Rajan notes, “Overall incentives to take risk have increased”.
From reading this paper, it is astonishing how spot on Mr. Rajan’s analysis ended up being. He notes changes that could be made (including interest rate hikes and incentive changes at banks) to mitigate the potential danger, which were not implemented in any noticeable way. The most revealing part is his focus on incentives, and how they were misaligned (in some manner) for nearly every party involved in the economic collapse. As we have seen over the past 3-4 years, his own words were quite accurate: “While it is hard to be categorical about anything as complex as the modern financial system, it is possible these developments may create more financial-sector-induced procyclicality than the past. They also may create a greater (albeit a small) probability of a catastrophic meltdown… Tail events may prompt a flight to quality and liquidity. Unfortunately, traditional providers of liquidity could find it harder to step up at such times.”
