SINGAPORE (June 18): Raghuram Rajan, the famous economist and former governor of the Reserve Bank of India, outlined with great insight the reasons banks need to be regulated when he spoke at the 2018 MAS Lecture earlier this month. For me, his presentation was a timely reminder of how things can quickly go wrong in the finance sector. And, it was especially relevant as we approach the 10th anniversary of the collapse of Lehman Brothers, amid a heightened degree of risk taking in the market.
Some of the key reasons for bank regulation that Rajan cited are widely acknowledged in the finance sector. He pointed out that banks operate with highly levered balance sheets, and bank failures have huge negative externalities for the rest of the economy. Moreover, central banks have the power to create liquidity when it is needed. And, because there is broad expectation that the authorities will act to save the banking system, the authorities have to intervene even more, setting rules and regulations to keep everyone in line.
However, the most interesting reason for regulation cited by Rajan has to do with what he calls “perverse incentives” in the finance sector. Notably, banks often continue fighting to maintain market share in a particular business even as the risks rise and returns fall. To make the point, Rajan brought up an infamous statement by Charles “Chuck” Prince, who was chairman and CEO of Citigroup when the global financial crisis began unfolding.