Fault Lines: How Hidden Fractures Still Threaten The World Economy

by Raghuram G. Rajan

And if the firm is deemed too systemically important to be allowed by the authorities to fail, the financial firm’s investors are unlikely to ever bear the full cost of big losses. This is a situation tailor-made for encouraging tail risk taking, because the firm makes a lot of profits in good times— everyone purchases tail risk insurance from firms like AIG that will be propped up by the government—and AIG runs to the government for a bailout if the costly tail risk ever hits.

The best way to keep institutions from becoming systemically important might not be through crude prohibitions on size or activity but through the collecting and monitoring by regulators of information about interinstitution exposures as well as risk concentrations in the system.

Regulators could put less emphasis on additional permanent-equity capital and more on contingent capital, which is infused when the institution or the system is in trouble. In one version of contingent capital, systemically important banks could issue debt that would automatically convert to equity when the bank’s capital ratio falls below a certain value.14 In another, systemically important levered financial institutions would be required to buy fully collateralized insurance policies (from unlevered institutions, foreigners, or the government) that would infuse capital into these institutions when they are in trouble.

One reason the authorities bail out financial-firm claim holders is that they do not know whether these claims are held by other financial firms: by letting the claims bear losses, they could be precipitating a cascade of failures. It is therefore important that regulators prohibit any levered financial firms from holding contingent convertibles or writing capital insurance (or, for that matter, holding unsecured long-term debt issued by other leveraged financial firms). Instead mutual funds, pension funds, and sovereign wealth funds should be the holders of choice.

The problem is that domestic demand typically expands rapidly at times when the government has political aims or the financial sector has skewed incentives. In such situations, the fundamental allocation of resources is distorted.

Put differently, instead of an international agreement about economic policies à la WTO, we need an international agreement about how domestic policies can be influenced by multilateral agencies to incorporate the global good.

Put differently, exporters effectively exchange dollars for renminbi-denominated claims on the PBOC—a process that is known as sterilized intervention. The PBOC uses the exporter’s dollars to buy interest-earning U.S. assets, including the agency bonds discussed in Chapter 1, thus earning interest on dollar assets while paying interest on renminbi claims.

In order to sterilize without making huge losses, the PBOC fixes the economywide interest rate at a lower level than the dollar interest rate, both by forcing banks to pay households a low rate on their deposits and by paying a low rate on its own borrowing. A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low, China also has to keep interest rates low. Doing so risks creating credit, housing, and stock market bubbles in China, much as in the United States.