Former IMF chief economist warns banks are headed for more turmoil

After the bailouts of Silicon Valley Bank and Credit Suisse, former International Monetary Fund (IMF) chief economist Raghuram Rajan warned that the banking industry is destined to experience further instability. 

Rajan, who had anticipated the global financial crisis almost a decade earlier and is now the Reserve Bank of India governor, warned that the financial system is fragile due to a decade of loose money and a deluge of liquidity from central banks, per a report by The Economic Times on April 7. 

Rajan stated in an interview in Glasgow. “I hope for the best but expect that there might be more to come, partly because some of what we saw was unexpected. The entire concern is that very easy money (and) high liquidity over a long period creates perverse incentives and perverse structures that become fragile when you reverse everything.”

His words give weight to earlier warnings that the issues at SVB and Credit Suisse are symptoms of larger flaws in the banking system. In a 2005 Jackson Hole lecture as IMF chief economist, Rajan issued a dire warning about the banking industry just before the global financial crisis, for which he was dubbed a “luddite” by then-US Treasury Secretary Larry Summers.

Bankers given a ‘free ride’

Although bank stocks dropped after the SVB and Credit Suisse crises, central banks continued to tighten monetary policy in an effort to curb inflation. As policymakers swiftly reverse the accommodative approach that was established in the decade after the financial crisis, Rajan said that central bankers have been given a “free ride.”

“This sense that the spillover effects of monetary policy are huge and aren’t dealt with by ordinary supervision has just escaped our consciousness over the last so many years,” Rajan said.

He argued that since central banks “flooded the system with liquidity,” it leaves banks open to the possibility of unwinding. 

According to Rajan, the excessive supply of low-return liquid assets in the financial system leads to a dependence on riskier investments for generating profit. This creates a situation where banks feel compelled to hold onto these assets but also seek ways to make money from them, leaving them exposed to the risk of sudden liquidity withdrawal.