By Amol Agrawal
In the last days of August, leading economists and policymakers gather to attend the annual Jackson Hole economic policy symposium hosted by the Federal Reserve Bank of Kansas City. Unlike most economics conferences, Jackson Hole (JH) is widely quoted in the media. Financial markets keenly await the inaugural remarks by the chairperson of the Federal Reserve Board for monetary policy signals.
The 2025 edition is also notable as it marks the 20th anniversary of the 2005 symposium. Then Federal Reserve chair Alan Greenspan was retiring after a record 18 years. In the “Greenspan era”, the US economy fared well despite facing several crises and Greenspan was credited for steering it. As such, the symposium was held to commemorate and discuss the “Greenspan era”, recognised as a pragmatic mix of monetary and financial policies.
Rajan’s warnings at Jackson Hole
The Greenspan era also saw wide-scale development of financial markets. A research paper titled “Has Financial Development made the World Riskier?” was presented by Raghuram Rajan, then economic counsellor at the International Monetary Fund, in which he questioned whether the very development made the world riskier. Let us unpack Rajan’s research for more clarity.
First, what led to financial development? Rajan cited three forces. The first was technical change that reduced costs of communication and information processing, which enabled financial engineering and portfolio optimisation. The second was deregulation, which increased competition across the financial sector. The third was institutional change, which created new financial entities such as private equity and hedge funds (termed as investment managers or IMs) and brought new policy frameworks such as inflation targeting.
Second, why did financial development create risks? Financial development shifted the financial intermediation function traditionally undertaken by banks to IMs. While this transition led to lower transaction costs and higher access to finance, it created risks too. To attract talented IMs who constantly generated high yields, compensations were structured to reward IMs for taking more risks with limited downsides. This skewed compensation leads to perverse behaviours such as hiding true risks of portfolios and herding other IMs. In good times, the two behaviours can reinforce the boom, and by the time tide turns it is too late. Even though the number of players has increased, the risks resulting from this are far larger.
Third, what were the policy suggestions? First, monetary policy should be aware that persistently low interest rates feed into asset prices and only fuel risks. Second, the prudential supervision has to be cast wider and include IMs. They should be asked to invest a percentage of their income in their managed funds for one year after their exit. The incentive structure should balance the development and risks.
In the beginning of his remarks, Rajan said his “intention is to provoke discussion”, and provoke it did. There was a storm in the symposium as the research hinted that though the Greenspan era had promoted financial development, it had created high risks too. The discussions veered from calling the presentation premised on Luddites (who oppose innovation) to high appreciation for highlighting unseen new risks. The discussants used examples of innovations in transportation, which has made rapid strides despite accidents, to innovation in bridges which shake/collapse despite the best engineering.
Lessons still unlearned
We know how the story played out eventually. The 2008 crisis laid open the risks of financial development. In the symposium, Rajan had expressed that we will only know the risks of the system in case of a credit crisis. The crises of the last 30 years impacted mainly equity markets but had not tested credit markets. It was quite surreal to see the prognosis of Rajan’s research playing out in the 2008 crisis, stunning one and all. The research accused of being based on Luddite premises was suddenly compared to a Cassandra, who few believed during the symposium.
Fast forward to 20 years later. Have any lessons been learnt? After the 2008 crisis, there were sweeping regulations, but the core problems raised in the paper remain unchanged, and perhaps even got worse. Monetary policy kept interest rates low till the Covid pandemic and then increased interest rates suddenly due to high inflation. Central banks are again under pressure to lower interest rates due to struggling growth. The prudential regulations have struggled to keep tabs on mushrooming non-bank finance intermediaries which are now in different avatars of fintech, big tech, etc. The compensation structures continue to reward IMs for taking higher risks with very little downside.
It is also interesting to note that the trends outlined in Rajan’s paper are now being seen in India. India’s financial sector has seen a mix of deregulation, and technical and institutional change, as suggested by Rajan. In a play of irony, two years after his research and one year before the 2008 crisis, Rajan chaired a committee to reform India’s financial sector—its suggestions have either been implemented or are being implemented. The retail investors are gradually re-intermediating their savings from banks to markets, leading the Securities and Exchange Board of India as well as the Reserve Bank of India to raise risk concerns. Taking a 30,000-feet view (in Rajan’s words), it is perhaps inevitable that financial development leads to high unseen risks.
The writer teaches at the National Institute of Securities Markets.
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