The Alan Greenspan era is not over yet. His bubbles may yet come home to burst . If Alan Greenspan could stand in front of a TV camera today and say, . He could not have known that the tax cuts would precede a period of. You can download Era zawirowań: krok w nowy wiek in pdf format. due to the efforts of the then Chairman of the Federal Reserve Board, Alan Greenspan.
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Let me state at the outset that these are my personal views.
The topic for this session covers an enormous landscape. I simply could not do justice to it if I tried to be comprehensive – that would require a few volumes. At the same time, this conference deserves a view from 30, feet rather than a view from the trenches. So I will be selective in what I focus on, emphasizing what I believe to be a broad and important trend.
Ultimately, though, the job of many of us in this room is to recognize the broad trend, and then get down to the nitty gritty of figuring out how to deal with it. I confess that the nitty gritty is far more difficult, so I will only speculate on what, if anything, ought to be done. My intention is to provoke discussion rather than to attempt to end it.
People can borrow greater amounts at cheaper rates, invest in a multitude of instruments catering to every possible profile of risk and return, zawirwoa share risks with strangers across the globe.
Financial zawirowaa have expanded and deepened, and the typical transaction involves more players and is carried out at greater arm’s length. These changes have undoubtedly benefited all of us. 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. In addition, techniques to assess and manage risks, ranging from financial engineering to portfolio optimization, and from securitization to credit scoring, are now widely used.
Deregulation has removed artificial barriers preventing apan 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 zawirlwa private equity firms and hedge funds-as well as new political, legal, and regulatory arrangements. For example, within the last two decades we have seen the emergence of the entire institutional apparatus behind the practice of inflation targeting, ranging from central greenspann independence to the publication of regular inflation reports.
The pace zawiroowa these zawirowx are so well known to this audience that I will illustrate it with only two figures. In figure 2, we have the gross external assets in the world – these are claims of a country on foreigners growing from 20 percent of world GDP in to percent of world GDP today.
These figures illustrate the rapid move to more arm’s length transactions. Something as intimate as credit risk is now being traded with strangers. In fact, in the same way as parents are asked “Do you know where your children are?
The tendency towards arm’s length transactions has been termed “disintermediation” because it involves moving away from traditional bank-centered ties. However, the term is a misnomer. To see one reason why, look at Figure 3.
Greendpan in a number of industrialized countries, individuals don’t deposit a significant portion of their savings directly in banks anymore, they don’t invest directly alaj the market either. They invest indirectly 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 zawirowaa these financial institutions, whom I shall call “investment managers,” have displaced banks and “reintermediated” themselves between individuals and markets. While these data are for the United States, similar trends are observable elsewhere. 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 equity tranche or the first loss, that is, the loss from the first few mortgages in the package that stop paying. Moreover, with the space that is freed up on their balance sheets, banks now focus far more on transactions where sawirowa 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 zawiroqa a larger pattern: Competition forces them to flirt continuously with the limits of illiquidity. The expansion in the variety of intermediaries and financial transactions has major benefits, including reducing the transaction costs grdenspan investing, expanding access to capital, allowing more diverse opinions to be expressed in the marketplace, and permitting better risk sharing.
These changes have made society better off.
Greenspan Era At The Fed Comes To A Close
But along with the opportunities to do good, they have created opportunities to make things worse. The balance between the two is determined by the incentives of players. I will now turn to incentives and potential sources of distortion, without in any way intending to minimize the enormous benefits we have derived.
In the s and s, before the changes that aoan swept the financial world, bank managers wra paid a largely fixed salary. Given that regulation kept competition muted, there was no need for shareholders to offer managers strong performance incentives such incentives might even have been detrimental as it would have tempted bank managers to reach out for risk.
The main check on bank managers making bad investment decisions was the bank’s fragile capital structure and possibly regulators.
If bank management displayed incompetence or knavery, depositors would get jittery and possibly run. The threat of this extreme penalty, coupled with the limited upside from salaries that were not buoyed by stock or options compensation, combined to make bankers extremely conservative. This served depositors well since their capital was safe. Shareholders, who enjoyed a zawrowa rent because of the limited competition, were also happy.
Of course, customers suffered but it is only in the new deregulated, competitive environment that the customer is king. In this new environment, however, investment managers can’t be provided the same staid incentives as bank managers of yore. Because they need the incentive to search for good investments, their compensation has to be sensitive to investment returns, especially returns relative to their competitors. Furthermore, the market provides its own incentives.
Greenspan Era At The Fed Comes To A Close : NPR
New investors are attracted by the high returns generated by a manager. And current investors, if dissatisfied, do take their money elsewhere although they often suffer from inertia in doing so. Figure 4 plots the flows into an average U. As you can see, positive excess returns generate substantial inflows while negative returns generate much milder outflows. Since compensation also varies with assets under management, overall, investment managers face a compensation structure that moves up very strongly with good performance, and falls, albeit more mildly, with poor performance.
In the jargon of economists, the compensation structure is convex in returns. The compensation structures for hedge fund managers or venture capitalists are not dissimilar in shape. Therefore, the incentive structure for investment managers today differs from the incentive structure for bank managers of the past in two important ways. First, there is typically less downside and more upside from generating investment returns, implying that these managers have the incentive to take more risk.
Second, their performance relative to other peer managers matters, either because it is directly embedded in their compensation, or because investors exit or enter funds on that basis. The knowledge that managers are being evaluated against others can induce superior performance, but also perverse behavior of various kinds.
Let me highlight two particularly worrisome behaviors, worrisome because they can feed on each other. One type is to take risk that is concealed from investors. Since risk and return are related, when the manager conceals risk, it looks as if he outperforms peers given the risk he apparently takes. Typically, the kinds of risks that can most easily be concealed, given the requirement of periodic reporting, are “tail” risks-that is, risks that have a small probability of generating severe adverse consequences and, in exchange, offer generous compensation the rest of the time.
For example, I could write guarantees against a creditor defaulting. I will earn the premiums on this guarantee most of the time, without any additional volatility on my portfolio holdings. Most of the time, I will look as if I am outperforming my comparison group for I will have generated returns with no apparent risk. But every once in a while, disaster will strike and the creditor will default.
My true risk profile will then be revealed but too late for my investors. Every generation of investment managers finds a new way to goose up returns for seemingly no additional risk, only to reconfirm the old adage: There is no return without risk. A second behavior is to herd with other investment managers on investment choices, because herding provides insurance the manager will not underperform his peers.
Alan Greenspan – Wikipedia
However, herd behavior can move asset prices away from fundamentals. Both behaviors can reinforce each other during an asset price boom, when investment managers are willing to bear the low probability “tail” risk that asset prices will revert to fundamentals abruptly, and even write guarantees against it, while the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust.
These behaviors can be compounded in an environment of low interest rates. Some investment managers have fixed rate obligations which force them to take on more risk as rates fall. Others like hedge funds have compensation structures that offer them a fraction of the returns generated, and in an atmosphere of low returns, the desire to goose them up increases. Thus not only does the incentives of some participants to “search for yield” increase in a low rate environment, but also asset prices can spiral upwards, creating the conditions for a sharp and messy realignment.
So long as there are some sober participants who can come in to pick up the pieces when the frenzy is over, financial sector volatility will affect the real sector only indirectly, for example by changes in wealth affecting consumption.
One key source of sobriety is the banks. Will they remain immune to the frenzy? Let us turn to that question now. The compensation of bank managers, while not so tightly tied to returns, has not been left completely untouched by competitive pressures. Banks make returns both by originating risks and by bearing them. As traditional risks such as mortgages or loans can be moved off bank balance sheets into the balance sheets of investment managers, banks have an incentive to originate more of these risks.
Thus they will tend to feed rather than restrain the appetite for risk. As I argued earlier, however, banks cannot sell all risk.
In fact, they often have to bear the most complicated and volatile portion of the risks they originate, so even though some risk has been moved off their balance sheets, they are being reloaded with fresh, more complicated, risks. The data support this assessment-despite a deepening of financial markets, banks in industrial countries may not be any safer than greeenspan the past.
In Figure 5, we plot the average level of bank earnings residuals, as well as their volatility, using a standard earnings prediction model. The graphs indicate that bank earnings volatility in the United States has increased over the last twenty years. In Figure 6, we plot bank distance to default, one measure of the default risk of banks. That distance has remained constant or fallen across a number of industrial countries, again indicating banks are no less gdeenspan than in the past, and perhaps riskier.
Finally, turn to Figure 7.