Talk by Raghu on monetary policy & asset prices

Raghuram Rajan has done a wonderful talk linking up agency problems in fund management with monetary policy. I have sketched a quick summary of his argument here. But the talk (~ 3000 words) is wonderful and well worth reading.

The literature has long emphasised the difficulties of the principal-agent problem between fund managers and their customers. Index funds only cost 1 bps to manage; so the only justification for almost all of fees & expenses is alpha. But there are only five sources of alpha:

• To be a Warren Buffet and identify undervalued assets.
• To create value out of activism - whether a hostile takeover of a poorly managed/governed company, or private equity investment.
• Financial engineering - innovate with creating new kinds of cashflow-streams.
• Liquidity provision.
• Sell deep out of the money puts, to generate an appearance of a steady stream of income. For many years, this will look nice, and then occasionally things will blow up. Raghu calls this "tail risk seeking" behaviour.

The first is truly hard. The 2nd and 3rd are feasible but highly competitive. That leaves the fourth and the fifth that are an ideal field of play for ordinary fund managers. A great deal of "active fund management" is really about earning alpha as a fee for giving out liquidity services or giving out tail risk insurance. (This argument is generic, and holds whether r_f is high or low).

Even if you are a smart fund manager, your customers can be stupid. Customers seem to do stupid things, taking assets-under-management (AUM) away from poorly performing managers and giving them to managers who have recently produced high returns. They thus generate wrong incentives for managers, and send AUM towards managers who exhibit these kinds of behaviours.

How does this situation link up to interest rates? Suppose interest rates are low. A finance company that has put out an assured return product promising (say) 6% returns is hard-pressed to produce 6% returns when r_f is low. It gets pushed into high risk assets. Similarly, the 2+20 hedge-fund compensation structure delivers higher absolute compensation when r_f is high. When r_f drops, the manager has an incentive to take bigger risks (or go into illiquid assets) to hang on to old levels of compensation. This is particularly the case when the compensation for the manager starts after a `hurdle rate' of an absolute level of returns is attained. When r_f is lower, expected returns on all assets are lower, and the hurdle rate is harder to reach.

In an ideal world, shifts towards high risk and low liquidity assets by some speculators should be compensated by other rational investors - e.g. a person trading with his own money who does not get into the issues of principal-agent problems of fund managers. But in a world where the bulk of liquid wealth of the planet is managed by external fund managers, institutional investors are large compared with rational speculators. Aberrations in their behaviour can then generate systematic distortions in asset prices.

Raghu's conjecture is that when r_f is low, agency problems generate incentives for institutional investors to go into illiquid assets, high risk assets, and returns from tail risk. The size of these investors is big enough that on the scale of the world economy, it looks like there is "heightened risk tolerance" - e.g. the very low values of the VIX when Greenspan had low interest rates. These flows are reversed when r_f becomes higher. Raghu cites Kashiwase & Kodres who find relationships between the VIX and emerging market spreads also.

In addition to traditional notions of monetary transmission, such effects constitute an additional channel through which monetary policy impacts upon the economy (though disentangling the channels of influence will be hard). This could have many implications for our understanding of how monetary policy works, and how optimal monetary policy should be crafted.

From an emerging markets perspective, this could be particularly important, because emerging markets offer risky and illiquid assets. I think it further undermines the case for a pegged exchange rate in India, for autonomous monetary policy would be a precious thing to have when faced with capital flows and trade flows which are strongly correlated with the world business cycle, and a local fiscal policy that can't stabilise. The only thing that can stabilise is local monetary policy, but there is a need for greater autonomy of local monetary policy.