Tuesday, January 6, 2015

Raghuram Rajan’s Fault Lines – A 2011 crisis book still interesting today

In geology, fault lines are breaks in the Earth’s surface where tectonic plates come in contact or collide. In 2011, Raghuram Rajan has written a book about the fault lines in the global economy and explains how these fault lines affect the financial sector.

The book is well written; I especially liked the good mix of storytelling and academics. Here are some examples of fault lines in the global economy:

Export-led growth strategy

Countries pursuing an export-led growth strategy rely heavily on foreign consumers to stimulate the local economy. Typical examples are Germany and Japan after the Second World War and China since 2000.

Export-led growth typically has two phases:

  • First, the exporting country benefits from low local labor costs to sell abroad.
  • Second, upon increasing labor costs, the exporting country moves up the value chain of production and to the frontiers of innovation.

On the upside, an export-led growth strategy creates strong exporting firms, which are no longer constrained by the size of their domestic market. In addition, international competition forces exporters to remain competitive. The downside is an excessive dependence on the foreign consumer, often coupled with weak local household consumption.

“There is no natural, smooth, and painless movement away from export dependence to becoming a balanced economy.”

Character of bankers

How do bankers think? Raghuram tells the following story to explain:

In the 18th century, the French Government sold annuities. Annuities were bonds guaranteeing a payment of cash flows by the French Government until the bond holder’s death. Bankers reacted by arranging for young healthy women (with high life expectancy) to buy the annuities. Then, they pooled the annuity claims together and sold the resulting cash flows to investors. This early form of securitization actually worked well until the French Government defaulted, at the outbreak of the French Revolution in 1789.

What can we learn about bankers from this story?

  • Few have a better nose for good moneymaking opportunities than bankers. This stems from the competitive nature of banking where easy opportunities to make money are rare and where a banker’s performance is almost exclusively measured in terms of the money a banker generates.
  • Bankers invariably find the biggest edge in taking advantage of unsophisticated players and players who do not have the same incentive to make money.
  • Banker behavior tends to be self-reinforcing, at least for a while: Early success drives security prices up higher (often far away from fundamentals), making the business temporarily even more profitable until prices ultimately fall dramatically.
  • There is safety in numbers, as a responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. This means that prices do not reflect proper compensation for the risks that bankers take.
  • “Pecunia non olet” (= “Money has no odor.”) means that the anonymity of money makes it a poor mechanism for guiding employees’ activities towards socially desirable ends.

“Because their [bankers’] business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money make.”

Why investment managers must assume tail risk

Investment managers are paid to generate excess returns (= alpha). This means that they have to outperform the expected return on the market. How can they do this? Here comes tail risk into play: Because it occurs very rarely, investment managers can hide it for a pretty long time and, thus, use it to generate alpha.

“It is the very willingness of the modern financial market to offer powerful rewards for the rare producer of alpha that also generates strong incentives to deceive investors.”

This is why risk-adjusted return measurement is so crucial, not only for regulatory compliance purposes but also as an instrument of management control.

Some additional quotes


Raghuram Rajan – Fault Lines – 2011