Has Financial Development Made the World Riskier?

Raghuram Rajan

Raghuram G. Rajan NBER Working Paper No. 11728 Issued in November 2005 NBER Program(s): CF IFM Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk. Published: Raghuram G. Rajan, 2005. "Has financial development made the world riskier?," Proceedings, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
Raghuram Rajan at the World Economic Outlook press conference, Washington DC, IMF Headquarters
Born	3 February 1963 (age 48) Bhopal, Madhya Pradesh, India
Nationality	Indian
Institution	University of Chicago
Field	Financial economics
Alma mater	IIT-Delhi (B.Tech.) IIM Ahmedabad (M.B.A.)[1] MIT (Ph.D.)
Awards	2003 Fischer Black Prize,the Financial Times and Goldman Sachs Business Book of the Year Award for 2010.
Information at IDEAS/RePEc

Raghuram Govind Rajan (Tamil : ரகுராம் கோவிந்த் ராஜன்)(born 3 February 1963) is currently the Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. He is also an honorary economic adviser to Prime Minister of India Manmohan Singh (appointed 2008.)^[2] and the current President of the American Finance Association. He previously was the chief economist of the International Monetary Fund (IMF) and headed a committee appointed by the Planning Commission on financial reforms in India.^[3]

Rajan is also a visiting professor a for the Indian Finance Ministry, World Bank, Federal Reserve Board, and Swedish Parliamentary Commission.^[4]

Raghuram Rajan was born in Bhopal. In 1985, he graduated from the Indian Institute of Technology, Delhi, with a bachelor's degree in Electrical Engineering; he completed the Master of Business Administration at the Indian Institute of Management, Ahmedabad in 1987. He received his PhD in Economics from the Massachusetts Institute of Technology (MIT) in 1991 with a thesis entitled "Essays on Banking."

After graduation, Rajan joined the Booth School of Business at the University of Chicago.

He was the "Economic Counselor and Director of Research" (Chief Economist) at the International Monetary Fund from September 2003 until January 2007. In 2003, he was also the inaugural recipient of the Fischer Black Prize awarded by the American Finance Association for contributions to the theory and practice of finance by an economist under age 40.^[5]

In 2005, at a celebration honoring Alan Greenspan, who was about to retire as chairman of the U.S. Federal Reserve, Rajan delivered a controversial paper that was critical of the financial sector.^[6] In that paper, "Has Financial Development Made the World Riskier?", Rajan "argued that disaster might loom."^[7] Rajan argued that financial sector managers were encouraged to

(take) risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.[...] But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized.

Thus Rajan described the 2007-2008 collapse of the world's financial system.

The response to Rajan's paper at the time was negative. For example, former U.S. Treasury Secretary and former Harvard President Lawrence Summers called the warnings “misguided.”^[8]

In April 2009, Rajan penned a guest column for The Economist, in which he proposed a regulatory system that might minimize boom-bust financial cycles.^[9]

In 2010, he was named by Foreign Policy magazine to its list of top global thinkers.^[10] In a poll in The Economist, Rajan ranked first as the economist with the most important ideas in the post-financial crisis world.^[11]