raghuram rajan
Img-credit:wikipedia.org

According to Raghuram Rajan the three forces : technical change (cost of acquiring, transmitting, processing and storing information; financial engineering, portfolio optimization, securitization and credit scoring), deregulation (removal of artificial barriers preventing competition between products, institutions, markets and jurisdictions) and institutional change (creation of new entities within the financial sector such as private equity firms and hedge funds), have over time altered the nature of intermediation between the investor and the markets.

raghuram rajan
Img-credit:wikipedia.org

Traditionally it was the bankers who intermediated between the investor and the markets, and they were by and large paid fixed salaries. Since their reward was not related to the gains generated for the bank from the intermediation, there existed no incentive for these intermediaries to chase risk. On the contrary, any decision that went bad would affect them adversely by way of a slower upward mobility or even loss of the job. In short, the incentive structure was such that the downsides were punishing and upsides not rewarding enough.

The new intermediaries, whom Rajan calls the investment managers, are driven by a diametrically reverse incentive structure : the downsides are buffered, but the upsides are highly rewarding. These are the people in mutual funds, insurance companies, pension funds, venture capital funds, hedge funds and other forms of private equity.These ‘new age banks’ have to search for good investments, that deliver attractive returns, specially returns relative to their competitors,because new investors are attracted by high returns. If this race for the return has to be run, the runners have to be incentivized based on the return : call it performance pay, call it the variable component, call it all found vacation on Coral Island, call it anything.

How far can the incentives take the runner ? That is a question that begs answer before the system gets to the brink of the cliff.