Background and Welcome:
Professor Susanna Morato welcomed attendees to the London School of Economics and Political Science (LSE) for a special celebration to honor Professor Raghuram Rajan with an honorary doctorate. She emphasized LSE’s commitment to recognizing extraordinary distinction in scholarship and public activity aligned with its mission to understand the causes of things for the betterment of society.

Oration by Professor Lord Nicholas Stern:
Professor Stern introduced Professor Rajan as a scholar of extraordinary distinction, citing his outstanding articles and books, including “Saving Capitalism from the Capitalists” and “Fault Lines.” He highlighted Rajan’s ability to reframe and change the understanding of significant issues like inequality, financial deregulation, and economic instability. Stern also commended Rajan’s service as Chief Economist at the IMF, where he demonstrated foresight and courage in warning about the growing risks in the financial system before the 2008 global financial crisis. He further praised Rajan’s tenure as Chief Economic Advisor to the Government of India and Governor of the Reserve Bank of India, where he was respected for his independence, wisdom, and commitment to economic development and tackling poverty.

Response by Professor Raghuram Rajan:
Professor Rajan expressed his gratitude for the honor and acknowledged the influence of his friends and colleagues, particularly those at the University of Chicago’s Booth School of Business. He recognized the support of his wife, Radhika Puri, as a constant source of encouragement and critique. Rajan also thanked his parents for providing him with a happy home, a love of reading, and strong values.

Introduction to the Lecture:
Professor Stern welcomed attendees to the Charles Goodhart Lecture, supported by PGIM. He paid tribute to Professor Charles Goodhart for his significant contributions, including his role in overcoming the financial crisis in Hong Kong and his membership in the Monetary Policy Committee of the Bank of England. Stern emphasized Goodhart’s famous “Goodhart’s Law” and his ability to spot ineptitude.

Focus of the Lecture:
Professor Rajan’s lecture centered around central bank balance sheet expansion and financial stability, exploring the concept that “less can be more.” Stern highlighted the importance of Rajan’s insights in light of current economic circumstances.

Key Concepts:
Quantitative Easing (QE): A central bank policy involving the expansion of its balance sheet by purchasing assets from the market, typically long-term treasuries. Balance Sheet Expansion: An increase in the assets and liabilities of a central bank or commercial bank. Financial Fragility: A situation where the financial system is vulnerable to shocks, leading to instability and potential crises. Uninsured Demand Deposits: Liabilities of commercial banks that are not covered by deposit insurance, making them more susceptible to withdrawals. Liquidity: The ease with which an asset can be converted into cash without affecting its price.

Main Points:

1. Central Bank Balance Sheet Expansion and Commercial Bank Behavior:
Central banks expand their balance sheets through QE by purchasing assets from the market and issuing reserves to commercial banks. Commercial banks react to this balance sheet expansion by holding more reserves and reducing other liabilities like time deposits. This process consumes the liquidity provided by the central bank, leaving the financial system stretched.

2. Withdrawal of Liquidity and Financial Fragility:
When the central bank withdraws liquidity through quantitative tightening (QT), commercial banks face difficulties unwinding their claims. The system becomes strained, leading to fragile financial conditions and potential instability. Examples include the repo market spike in 2019, the market freeze in March 2020, and recent issues with gilts in the UK.

3. Interest Rate Increases and Financial Fragility:
Rapid increases in interest rates can exacerbate financial fragility. Higher interest rates make it more expensive for borrowers to repay debts, increasing the risk of defaults. This can lead to a tightening of credit conditions and a slowdown in economic growth.

4. Policy Implications:
Central banks should consider the potential unintended consequences of balance sheet expansion, including increased financial fragility. Policymakers should be cautious in withdrawing liquidity too quickly, especially when interest rates are rising rapidly. Central banks should communicate their policy intentions clearly to market participants to avoid surprises and maintain market stability.

Differences between QE and QT:
When the Federal Reserve buys treasury securities from the public, it takes them off their balance sheet. The public, including pension funds and mutual funds, cannot hold reserves. The public deposits the money received from the Federal Reserve into banks, expanding the banking sector’s balance sheet. Commercial banks issue uninsured demand deposits to the public, and the banks have more reserves on their balance sheet.

QT’s impact on the banking system:
When the Federal Reserve withdraws liquidity from the system, it buys securities from banks, reducing their reserves. However, the demandable claims on the banking system remain, creating a situation where banks have fewer reserves to satisfy more liabilities. This makes the banking system more fragile and prone to illiquidity episodes.

QE and QT’s overall effect:
QE increases reserves and issues uninsured demand deposits, while QT decreases reserves but leaves demandable claims unchanged. As QT proceeds, the banking system becomes more constrained and fragile.

Hysteresis in the Banking System:
QE ratchets up the demand for liquidity in the banking system, making it more dependent on higher levels of liquidity. When QT is implemented, the banking system becomes tighter, leading to an inability to respond to liquidity shocks. This hysteresis effect makes QT more challenging and QE less effective than initially thought.

Changes in Reserves, Deposits, and Credit Lines:
QE led to a significant increase in reserves, while QT resulted in a sharp decrease. Deposits, particularly uninsured demand deposits, have been rising over time. Credit lines, which are undrawn claims on liquidity, initially decreased during the global financial crisis but later started to increase.

Claims on Liquidity Relative to Reserves:
The ratio of claims on liquidity (deposits and credit lines) to reserves was high at the start of QE. QE caused this ratio to decrease due to the substantial increase in reserves. In the interim period without QE or QT, the ratio started to increase again as reserves decreased. QT led to a significant increase in this ratio, reaching a peak in September 2019 when the Federal Reserve intervened.

Time Deposits as a Bank’s Protection:
Time deposits have been steadily decreasing over time. Time deposits serve as a bank’s protection, providing a buffer against potential liquidity shocks.

QE and Bank Fragility:
As QE increases, banks’ demand deposits (uninsured) increase significantly and remain high, making them more runnable. This increase in runnable liabilities is accompanied by a decrease in time deposits, making the banking system more fragile.

Quantitative Evidence:
Careful regressions show that QE affects overall quantities. The liquidity price reflects both reserves and claims.

Cross-Sectional Analysis:
Banks that receive more reserves finance it with more demandable claims, reduce time deposits, and issue more lines of credit. This causal relationship suggests that reserves influence banks’ funding and lending behavior.

Reason for Behavior:
Banks’ behavior is driven by the low yield on reserves, which incentivizes them to seek higher-yielding assets, even if it means taking on more risk.

Reserve Financing:
Banks finance excess reserves through demand deposits and credit lines due to their low cost and premium, respectively. This practice resembles fractional reserve banking on a larger scale, making the system prone to reserve withdrawals and liquidity issues. The system consumes liquidity provided by the Federal Reserve and faces problems when the central bank withdraws it.

Reserve-Deposit Relationship:
Increased reserves lead to a corresponding increase in deposit-like claims, primarily demand deposits. Every dollar of reserve is associated with $1.3 of demand deposits, while time deposits decrease by a similar amount. Banks issue credit lines to further utilize excess reserves.

Pricing of Liquidity:
The price of liquidity, measured by the difference between the effective Fed funds rate and interest on reserves, decreases with higher reserves. However, this relationship becomes significant when demand deposits or lines of credit are accounted for. This indicates that banks’ liquidity claims affect the pricing of liquidity in the market.

Implications for Quantitative Easing (QE) and Quantitative Tightening (QT):
Banks tend to reduce their time deposits and increase demand deposits when they receive more reserves. The interest rate on time deposits is lowered to discourage new deposits and promote demandable claims. During QT, banks may not immediately shrink their claims due to the availability of ample excess reserves.

Liquidity Issues in the Banking System:
Analyzing claims divided by reserves, including treasury securities, revealed a concerning trend during quantitative tightening (QT). Banks became more strained, with a significant number facing liquidity challenges.

Bank Vulnerability During COVID Shock:
Banks with higher claims relative to reserves were hit hardest by the COVID shock. These banks experienced significant stock price declines and high credit line drawdowns. Firms lost trust in the ability of these banks to fulfill credit line obligations.

COVID Shock Impact:
Despite the severity of the COVID shock, there were no large-scale bank failures. Fiscal stimulus and stable interest rates provided support to the banking system. However, banks with stressed credit lines faced challenges.

Post-Pandemic QE and QT:
Massive pandemic QE flooded banks with demandable claims. Banks invested heavily in long-term treasuries, which proved to be a risky strategy.

Bank Runs Due to Insolvency:
When pandemic QE ended and interest rates rose, banks faced a double whammy. They had large runnable liabilities and long-term assets that lost value. This combination led to bank runs due to insolvency, despite losses being initially hidden in held-to-market portfolios.

Monetary Policy and Financial Stability:
Raghuram Rajan emphasizes the interrelation between monetary policy and financial stability, challenging the view that central banks can pursue monetary policy without considering its impact on the financial sector.

QE and Bank Balance Sheets:
Rajan highlights the unintended consequences of quantitative easing (QE) on bank balance sheets, particularly the accumulation of demand deposits and investments in long-term fixed-rate loans.

Asset Quality and Liability Problems:
The combination of asset quality problems and volatile liability problems, especially in the case of Silicon Valley Bank, contributed to the recent financial turmoil.

Losses on Bank Portfolios:
Rajan presents data showing significant losses on bank treasury portfolios due to rising interest rates and the expansion of bank balance sheets during QE.

QE Reversal and Financial Sector Problems:
The reversal of QE, known as quantitative tightening (QT), has exacerbated the losses on bank portfolios, leading to financial sector problems.

Aggressive Monetary Policy and Future Problems:
Rajan warns that aggressive monetary policy often lays the ground for future financial sector problems, as banks take undue risks to eke out returns.

Importance of Supervision:
While supervisors play a role in ensuring financial stability, they are not infallible, and central banks cannot rely solely on them to address monetary policy-related problems.

Banking Crises and Easy Money:
Rajan emphasizes the historical pattern of banking crises following periods of easy money and tightening of money, suggesting that the QE episode is not an exception.

Exiting QE and Unintended Consequences:
Rajan stresses the need for careful consideration of the consequences of exiting QE, as the unintended consequences can be significant and not always easy to manage.

Interest Rates Outlook:
IMF predicts real interest rates will return to pre-pandemic low levels due to offsetting forces, including demographics, productivity, and deglobalization. Deglobalization may reduce capital productivity and increase the cost of capital in different countries.

Technology and Economic Growth:
Technological advancements can lead to increased prosperity and wealth. Wise and responsible use of technology is crucial for a better future.

Banking Turmoil:
Movement of funds from US banks to money market funds offering higher interest rates has been observed. Banks may need to increase deposit rates to counter this, leading to potential challenges in managing long-term investments. Moral hazard is a concern, as bailouts and lack of accountability can lead to increased risk-taking by banks and uninsured depositors.

Qualities of a Central Banker:
Raghuram Rajan emphasizes the importance of experience, knowledge, and judgment in central banking. A central banker should be able to balance short-term and long-term goals, considering both economic stability and financial stability.

Silicon Valley Bank and Banking Mistakes:
Raghuram Rajan highlights recurring banking mistakes, particularly the maturity mismatch issue, despite prior awareness and supervision efforts. He questions the common incentive driving banks’ actions and the role of supervisors in preventing these mistakes.

Moral Hazard and Consequences:
Rajan emphasizes the moral hazard created by bailing out banks, perpetuating the problem and potentially leading to more bank failures. He argues that letting Silicon Valley Bank fail would have limited depositor losses and allowed for targeted bailouts of subsequent banks.

Central Banker Qualities:
Rajan declines to define the best qualities of a central banker, suggesting a need for wisdom and restraint in communication. He recommends finding a good role model for guidance.

Lack of Growth and Bank Lending:
Teresa Cascino raises the issue of banks not lending during periods of liquidity injections. Nicholas Stern seeks clarification on why investment-led growth has not occurred, despite banks’ excess reserves.

Banking Regulations and QE:
Harneet asks about the effectiveness of international banking regulations like Basel III in reducing bank balance sheet size and unintended consequences before quantitative tapering. Amlan Roy mentions internal Fed papers suggesting that QE’s success has often been in financial stability rather than output and price stability. He inquires about the role of market microstructure changes in financial markets and the lack of bank lending.

Pandemic QE and Banking Fragility:
Raghuram Rajan expresses concern that banks may have lent excessively during the pandemic, leading to losses due to insufficient due diligence. Rajan suggests that banks should have invested in short-term rather than long-term treasuries to minimize interest rate risk. The search for yield motivated banks to take on more risk, resulting in potential bonuses.

Basel III and Regulatory Failures:
Rajan believes Basel III regulations, if followed, could have forced banks to address duration mismatches and recognize risks. He highlights the need to investigate why these regulations were not fully observed in the US, particularly in the case of Silicon Valley Bank. Rajan emphasizes the importance of supervisory oversight to ensure banks adhere to regulatory measures and manage risks effectively.

International Experiences with Pandemic QE:
Rajan acknowledges that other countries may have different experiences with pandemic QE compared to the US. He cites the example of Israel, where similar issues have been observed, but the outcomes may vary.

Financial Stability Concerns and Monetary Policy:
Rajan emphasizes the need to balance monetary policy objectives with financial stability concerns. Rapid interest rate increases can exacerbate fragility in the banking system, potentially leading to unintended consequences. This dynamic creates a difficult situation for central banks, as they must consider both inflation control and financial stability.

Central Banks’ Expanding Role and Regulatory Oversight:
Rajan expresses concern about central banks’ growing role as a backstop for the financial system. He believes that central banks should not be the primary safety net and that regulations should be strengthened to mitigate risks.

Pension Funds and Quantitative Easing:
Rajan explains the causal chain between quantitative easing and deposit expansion. When the Fed purchases assets from pension funds, it injects liquidity into the banking system, leading to increased deposits.

Silicon Valley Bank and Regulatory Oversight:
Rajan highlights the importance of effective supervision in preventing crises like the collapse of Silicon Valley Bank. He suggests that the Fed’s warning to Silicon Valley Bank about its risky practices were not accompanied by strict deadlines or penalties, leading to insufficient action to address the problems. Rajan emphasizes the need for clear and timely communication between regulators and banks to ensure compliance and mitigate risks.

Central Bank Activities and Interventions:
Raghuram Rajan highlights the increasing involvement of central banks in various areas, altering asset prices, and intervening in multiple ways. He emphasizes the need for a debate on whether this level of intervention is beneficial or creates potential problems.

Central Bank Balance Sheet Expansion:
Rajan explains the impact of central bank balance sheet expansion on the banking system. He mentions that banks often offset the duration impact of central bank actions by adjusting their liabilities, limiting the intended effect.

Quantitative Tightening (QT):
Rajan discusses the potential consequences of focusing QT on purchases from the non-bank sector. He raises the question of why banks do not rebalance their balance sheets when central banks reduce reserves.

SVB Bailout:
Rajan considers the hypothetical scenario of SVB not being bailed out and acknowledges that it’s a complex issue with various perspectives. He suggests that a blanket guarantee could have been implemented to protect uninsured depositors temporarily.

Managing Liquidity with Central Bank Digital Currencies (CBDC):
Rajan expresses skepticism about the effectiveness of CBDCs in managing liquidity and reducing the need for balance sheet expansion. He highlights the existence of fast payment systems as alternatives to CBDCs and questions the need for a retail digital currency.

Benefits and Drawbacks of CBDCs:
Rajan emphasizes the need for specific use cases that leverage the power of CBDCs, such as smart contracts. He suggests that CBDCs may improve efficiency in wholesale transactions but require further exploration for retail applications.

Appreciation for Raghuram Rajan:
Nicholas Stern expressed gratitude to Raghuram Rajan for his insightful presentation. Stern praised Rajan’s ability to make complex concepts accessible and clear, making it a pleasure to listen to him. Stern acknowledged Rajan’s achievement of earning an LSE PhD with flying colors and encouraged him to continue spending time with the LSE community.

Reception and Photo Session:
Stern announced a reception with refreshments on the ground floor for invited guests. A photo session was arranged for Rajan, Stern, sponsors, and other attendees who wished to participate.

Appreciation for Charles Goodhart and PGIM:
Stern acknowledged Charles Goodhart, the namesake of the lecture series, for his contributions. Stern thanked PGIM for their support in organizing the event.