Superb interview with Raghuram Rajan. As advisor to the Indian Prime Minister, he has some comments on the country, but I found the earlier parts of the interview much more interesting. Thought I would summarize the interview so I understand it better.
On why banks fund long-term, projects using short-term deposits
Why the private banking sector has never chosen safe narrow banking (with finance companies issuing long-term liabilities and making illiquid loans) is really the puzzle of the ages. It’s interesting because the form of the bank seems relatively similar across countries and over time. It’s a form that has endured, perhaps longer than the corporation. You can go back to Mesopotamia perhaps, but certainly to Italy, and they had banks in much the form that we have today.His answer is that there are three benefits to this structure: a) obviously, it is always going to be cheaper to get people to lend you money short-term rather than long-term b) Since depositors keep taking money out and putting it into a bank, there is always someone checking that the bank has funds to pay the depositors. This is a credible check on the management of the bank and lowers the cost of borrowing and c) long-term loans lead to constant strategic debt renegotiation, with the borrower trying to convince the lender to change the terms of the loan. Demand deposits allow the bank to credibly commit to not attempt this, and so allow them to get funds more cheaply.
On why the "narrow banking" proposed by Marin Wolf and Mervyn King would not be a good idea
you would have much higher costs of long-term intermediation. The money market fund would be reasonably stable, presumably, and will continue to invest in fairly liquid instruments—that will not be a problem. But it would be a problem on the other side—the finance company funded with long-term debt: Long-term projects would find finance very costly...Less lending, less growthI am not convinced by this, because the liquid bond markets we have now mean that a finance company can raise large sums of money for long periods of time, without any of the lenders having to lock themselves in for long periods of time; though this will mean they are exposed to interest rate risk on their capital. The cost of borrowing would go up: I just wonder by how much, and whether it may not be worth it.
He explains why he decided that financial innovations such as CDS and other derivatives had not reduced risk in the overall system: a) Banks cannot make money without taking risk; if they get some kinds of risk of their books, they must be accepting other kinds of risk which may be harder to spot, b) Employees were being penalized for taking on obvious risks, but this meant that they were taking on hidden risks. The Insurance companies were taking on "tail risk" by writing Credit Default Swaps and acting as though they would never have to pay up.
His model for why this crisis was so severe seems to be that banks were competing ferociously, and they took on just the risks which they felt were implicitly backed up by the government. The example he gives is liquidity risk, where banks assumed there would never be any shortage of liquidity because the Fed would drop interests rates as much as required. In fact, when the crisis came, the Fed dropped rates as much as they could, but the liquidity dried up because the banks were themselves in trouble and would not lend, nor pass the rate reductions on.
One thing I just don't understand is that he describes how the actions of the Fed caused moral hazard, and also says this
There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.and this
there was also a tremendous amount of political pressure, not to protect friends, but to encourage certain kinds of low-income lending. I think that pervaded the system.but at the same time seems to believe that the cause of the crisis was excessive faith in the free market. Just don't get that.