“Central Banks’ Easy Money Policies Could Lead to Financial Collapse”
Raghuram Rajan, former International Monetary Fund (IMF) chief economist and current Reserve Bank of India governor warned about the banking industry.
He attributes this concern to the influx of liquidity from central banks and an extended period of loose money. Rajan contends that these factors have created incentives and structures that are precarious and fragile and are at risk of collapsing once monetary policy is reversed.
A Decade of Easy Money and High Liquidity
Rajan’s warning comes as policymakers begin to reverse the accommodative approach established in the decade after the global financial crisis. In an interview in Glasgow, he noted that central bankers had been given a “free ride” and that the spillover effects of monetary policy have been ignored.
The Governor of the Reserve Bank of India has expressed his view that central banks’ excessive flooding of the financial system with liquidity has left banks susceptible to the possibility of unwinding.
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This overabundance of low-return liquid assets has forced banks to rely on riskier investments to generate profits, creating a scenario in which banks feel compelled to retain these assets and seek ways to make money from them. This has exposed banks to the risk of sudden liquidity withdrawal, as their dependence on these riskier investments can lead to financial instability.
Serious Defects in the Banking System
In 2005, Rajan lectured at Jackson Hole during his tenure as the IMF chief economist, where he issued a grim cautionary statement about the banking industry.
This warning preceded the global financial crisis and earned him the label of a “luddite” from Larry Summers, the US Treasury Secretary at the time. Rajan’s remarks lend credibility to prior warnings that the predicaments faced by SVB and Credit Suisse are indications of more significant defects in the banking sector.
Despite the decrease in bank stock prices following these crises, central banks still chose to tighten monetary policies to contain inflation. Rajan’s cautionary statement suggests that the fundamental problems in the banking system persist and may require more substantial modifications to address them.