Ex-RBI governor Raghuram Rajan says banking system headed for more trouble

Raghuram Rajan — the former International Monetary Fund chief economist who predicted the global financial crisis more than a decade ago — warned that the banking system is headed for more turmoil after the rescues of Silicon Valley Bank and Credit Suisse.

Rajan, who was also governor of Reserve Bank of India, said a decade of easy money and a flood of liquidity from central banks has caused an “addiction” and a fragility within the financial system as policy makers tighten policy.

“I hope for the best but expect that there might be more to come, partly because some of what we saw was unexpected,” Rajan said in an interview in Glasgow. “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.”

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His comments add to warnings that the troubles at SVB and Credit Suisse are indicative of deeper underlying problems in the financial system.

While IMF chief economist in 2005, Rajan gave a prescient warning on the banking sector ahead the global financial crisis in a Jackson Hole speech that prompted former US Treasury Secretary Larry Summers to call him a “luddite.” Rajan, now a professor at University of Chicago Booth School of Business, also won acclaim for his handling of the Indian economy while leading its central bank from 2013 to 2016.

Bank shares slumped following the crises at SVB and Credit Suisse but central banks have pushed ahead with policy tightening to rein in inflation.

Rajan said central bankers have been given a “free ride” as policy makers rapidly reverse the ultra-accommodative stance taken in the decade following the financial crisis.

“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 said banks are vulnerable to unwinding after central banks “flooded the system with liquidity.”

“It’s an addiction that you’ve forced into the system because you flood the system with low return liquid assets and banks are saying, ‘we’ve got to hold this, but what do we do with it? Let’s find ways to make money off it’ and that gives makes them vulnerable to the withdrawal of liquidity.”