Incentive Structures, Central Banks, and Economic Policies: A Conversation with Raghuram Rajan

Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at University of Chicago’s Booth School of Business. He is also the Vice-Chairman of the Bank for International Settlements (BIS). From September 2013 to September 2016, he was the 23rd Governor of the Reserve Bank of India. Prior to that, from 2003 to 2006, Rajan served as the Chief Economist and Director of Research at the International Monetary Fund (IMF).

At the 2005 Jackson Hole Symposium, Dr. Rajan delivered a paper titled “Has Financial Development Made the World Riskier?” In his paper, Rajan analyzed how financial managers’ incentive structures, which were based on short-term profits, encouraged bankers to take large risks that could lead to a financial crisis. To avoid such an outcome, Rajan advocated for an incentive structure based on risk-adjusted returns. Rajan’s comments were critical of the policies of then Federal Reserve chairman Alan Greenspan. Three years later, in 2008, Rajan’s warnings regarding excess risk in the financial system were revealed to be prophetic.

Chicago Policy Review sat down with Rajan to discuss the role of incentives in the financial industry, economic policy recommendations, independence and autonomy of central banks, and his advice for young economists.

In your 2005 Jackson Hole speech, you claimed that the incentive structures in the financial industry were not aligned with risk-adjusted performance, such that financial managers were inclined to invest in financial products promising high return but involving huge risks. In the aftermath of the credit crisis, several regulations such as the Basel III and Dodd-Frank Acts were introduced to prevent risky investment strategies. Do you believe the systematic problem of risk-promoting incentive structures has been resolved?

I think from a mechanical perspective, we have made some immense strides to solve the problem of incentives. Now a large part of the incentive structures are tailored toward long-term compensation. So now there’s a lot more suspicion if an entity is generating profits for a sustained period of time because we know there’s a strategy to generate these profits until it collapses.

Previously, because implicit guarantees were offered, we made money on the premiums, and initially it looked like we were doing a great job because nobody was properly measuring the risks we were taking. But then things exploded. That’s when we realized the magnitude of the risks we were taking. So, I think we are doing a better job on that front.

How do we know if we have the right incentive structures?

I think that there are two areas where we need to think about whether we have the right incentive structures or not. The first is within the organization. For example, suppose you have a boss who is being subjected to immense pressure to show profitability, but the boss usually has limited power to shield subordinates from this expectation. So, we have this unrealistic and strong expectation that banks will return to the level of profitability they showed pre-crisis. This expectation from the boss goes down on to subordinates to make them find a way to generate returns similar to the ones they had pre-crisis. And what if those returns are not possible without taking undue risks? We need to think more about the kinds of pressures that the government and top management teams are subjected to. The worst possibility is that you constrain your people in certain ways but leave them unconstrained in others and, given the pressure you are putting on them, they may move into these other areas which are beyond your control.

The second aspect is really one of values, which is much harder. Ultimately what guarantees moral and safe behavior is whether the values of the traders and bankers are in the direction where they think, “My job here is to create value in an appropriate fashion.” It’s harder to have a sense of value when your inputs are papers (referring to money) and outputs are papers. In this sense, bringing value to the process is harder in the financial sector, especially when you are doing pure intermediation (financial transactions). For example, it is much easier for a person who is building a power plant to feel value and responsibility to maintain safety since it’s incumbent on them, else employees may lose their lives. It’s much harder to give the same sense of value to somebody who is churning out exotic securities, which is an important task. But with paper (referring to money again) at both ends of the process, how do we give them a sense of a job well done? Is it when they design the most exotic security? And is that value added to the society?

In your book “Fault Lines” (2010) you talked about the “Three Major Economic Fault Lines”: rising inequality and debt, government stimulus programs, and international capital mobility. Do you think these fault lines still persist?

I would say, whatever we have seen since then—rising inequality and loss of jobs—is part of the same process. In “Fault Lines,” I talk about the possibility of rising anti-trade and anti-immigrant sentiments. That’s exactly what we have seen now. I think some of it is driven by the inability of the stimulus to have a strong growth impact. The underlying factors that have always been, are that significant parts of the population are unable to compete. Unless we fix this problem, no amount of stimulus can help. These are the people who are crying out and saying, “You are not doing anything for me.” So, to some extent, the message that we need to do something for them is still very strong.

Often central banks have dual mandates. For example, they are supposed to control inflation as well as ensure low unemployment. The presence of two goals implies that trade-offs between them have to be made. Hence, monetary policy involves trade-offs that are fundamentally political in nature. Do you believe independence and autonomy of a central bank are politically justifiable when the central bank targets a single policy variable?

In general, central banks have been given a fairly well-defined mandate. Typically, what they have asked for is operational independence, which is similar to saying, “Don’t tell me what to do, let me just fulfill the mandate.” That automatically means that they’ll have to react to the government’s policy—not in a threatening way, but suppose if the government insists on running larger fiscal deficits, then the central bank has to react to the government to fulfill its mandate. In fact, the government should fully understand this, because they are the ones who gave the central bank the mandate. If they don’t like it, then they should change the mandate.

The difficulty is that in recent years, the central banks have not actually had a problem with high inflation but with low inflation. So they have employed a number of tools that have been unconventional. Some politicians see this as exceeding the mandate. But the central banks are just trying another way to achieve the mandate. The greater concern is not from the domestic perspective, whether this is appropriate or not; rather, it is from the international perspective and whether this has spillover effects. But I think there should not be a reason why central banks should be questioned; questioning typically becomes an excuse.

Finally, do you have any advice for budding economists at the University of Chicago and beyond?

(Laughs) Yes, I am old enough to give advice. The advice that one will give to young people is that you are young enough to explore. All too often we think, “The train is leaving the station; it’s better to get on it” or “My career will be held way back, so don’t jump into this job and rather start moving up on the corporate ladder.”

One should be careful while translating personal experience into general statements. I think if you like what you are doing, you have much greater chances of success. It doesn’t matter if you are successful or not in those narrow terms in which we define success.

I’d say use whatever freedom you have. Sometimes people don’t have that freedom—like flexibility and time. But if you have freedom, use it to find areas and organizations that you would like to work in. Once you do that, stay with it. But don’t stay too long. Sometimes, moving out of your comfort zone is most useful to having an interesting life. If you think things are going really well and you understand everything that needs to be done, this may be the time to start thinking of moving somewhere else.

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