Raghuram G. Rajan

We develop a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. We find that internal governance can mitigate agency problems and ensure firms have substantial value, even without any external governance. Internal governance seems to work best when both top management and subordinates are important to value creation. We then allow for governance provided by external financiers and find situations where external governance, even if crude and uninformed, complements internal governance in improving efficiency. Interestingly, this allows us to develop a theory of dividend policy, where dividends are paid by self-interested CEOs to maintain a balance between internal and external control. Finally, we explore how the internal organization of firms may be structured to enhance the role of internal governance. Our paper could explain why young firms with limited external oversight, and firms in countries with poor external governance, can have substantial value, and why improving external governance may not be a panacea for all governance problems.

“Rethinking Capital Regulation”, with Anil Kashyap and Jeremy Stein.

Recent estimates suggest that U.S. banks and investment banks may lose up to $250 billion from their exposure to residential mortgages securities. The resulting depletion of capital has led to unprecedented disruptions in the market for interbank funds and to sharp contractions in credit supply, with adverse consequences for the larger economy. A number of questions arise immediately. Why were banks so vulnerable to problems in the mortgage market? What does this vulnerability say about the effectiveness of current regulation? How should regulatory objectives and actual regulation change to minimize the risks of future crises? These are the questions we focus on in this paper.

“Landed Interests and Financial Underdevelopment in the United States”, with Rodney Ramcharan

Landed elites in the United States in the early decades of the twentieth century played a significant role in restricting the development of finance. States that had higher land concentration passed more restrictive banking legislation. At the county level, counties with very concentrated land holdings tended to have disproportionately fewer banks per capita. Banks were especially scarce both when landed elites’ incentive to suppress finance, as well as their ability to exercise local influence, was higher. Finally, the resulting financial underdevelopment was negatively correlated with subsequent manufacturing growth. We draw lessons from this episode for understanding economic development.

“A Pragmatic Approach to Capital Account Liberalization”, with Eswar Prasad, forthcoming, Journal of Economic Perspectives.

Cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for developing countries and emerging markets. This suggests that the lack of domestic savings is not the primary constraint on growth in these economies, as implicitly assumed in the benchmark neoclassical framework. We explore emerging new theories on both the costs and benefits of capital account liberalization, and suggests how one might adopt a pragmatic approach to the process.

“The Future of the IMF and the World Bank”, forthcoming, AEA Papers and Proceedings 2008.

“Rent Preservation and the Persistence of Underdevelopment” forthcoming, American Economic Journals: Macroeconomics

Initial inequality in endowments and opportunities, together with low average levels of endowments, can create constituencies in a society that combine to paralyze reforms, even though the status quo hurts them collectively. Each constituency prefers reforms that expand its opportunities, but in an unequal society, this will typically hurt another constituency’s rents. Competitive rent preservation ensures no comprehensive reform path may command broad support. Though the initial conditions may well be a legacy of the colonial past, persistence does not require the presence of coercive political institutions, perhaps one reason why underdevelopment has survived independence and democratization. Instead, the roots of underdevelopment may lie in the natural tendency towards rent preservation in a divided society.

Foreign Capital and Economic Growth with Eswar Prasad and Arvind Subramanian, Brookings Papers on Economic Activity, 2007, 1, 153-209

We document the recent phenomenon of “uphill” flows of capital from nonindustrial to industrial countries and analyze whether this pattern of capital flows has hurt growth in nonindustrial economies that export capital. Surprisingly, we find that there is a positive correlation between current account balances and growth among nonindustrial countries, implying that a reduced reliance on foreign capital is associated with higher growth. This result is weaker when we use panel data rather than cross-sectional averages over long periods of time, but in no case do we find any evidence that an increase in foreign capital inflows directly boosts growth. What explains these results, which are contrary to the predictions of conventional theoretical models? We provide some evidence that even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.

“Has Financial Development Made the World Riskier?” EUROPEAN FINANCIAL MANAGEMENT 12: 499, 2006.

Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would curtail the incentive of intermediary managers to take excessive risk.

“Aid, Dutch Disease, and Manufacturing Growth” with Arvind Subramanian, mimeo, IMF.

We examine one of the most important and intriguing puzzles in economics: why it is so hard to find a robust effect of aid on the long-term growth of poor countries, even those with good policies. We look for a possible offset to the beneficial effects of aid, using a methodology that exploits both cross-country and within-country variation in the data, and corrects for possible reverse causality. We find that aid inflows have systematic adverse effects on a country’s competitiveness, as reflected in the lower relative growth rate of labor intensive and exporting industries, as well as a lower growth rate of the manufacturing sector as a whole. We provide evidence suggesting that the channel for these effects is the real exchange rate overvaluation caused by aid inflows.

“Failed States, Vicious Cycles, and a Proposal”, mimeo, University of Chicago.

Why should people’s choice of government be restricted, even if that government drags them into the abyss?

Growth and Development

“Landed Interests and Financial Underdevelopment in the United States”, with Rodney Ramcharan

“Rent Preservation and the Persistence of Underdevelopment” forthcoming, American Economic Journals: Macroeconomics

Foreign Capital and Economic Growth with Eswar Prasad and Arvind Subramanian Brookings Papers on Economic Activity, 2007, 1, 153-209

Does Aid Affect Governance? With Arvind Subramanian, 2007, AER Papers and Proceedings.

Modernizing China’s Growth Paradigm With Eswar Prasad, 2006, AER Papers and Proceedings.

Making Capitalism Work for Everyone With Luigi Zingales

India’s Pattern of Development: What Happened, What Follows? With Kalpana Kochhar, Utsav Kumar,

Arvind Subramanian, and Ioannis Tokatlidis, Journal of Monetary Economics, vol 53, 2006, p 981-1019.

“What Undermines Aid’s Impact on Growth?” with Arvind Subramanian, mimeo, IMF.

“Aid and Growth: What Does the Cross-Country Evidence Really Show?” with Arvind Subramanian, Review of Economics and Statistics, forthcoming.

“Failed States, Vicious Cycles, and a Proposal”, mimeo, University of Chicago.

The Great Reversals: The Politics of Financial Development in the 20^th Century with Luigi Zingales, Journal of Financial Economics, vol 69, 1, July 2003, 5-50.

Financial Systems, Industrial Structure and Growth with Luigi Zingales, Oxford Review of Economic Policy. 17 (4): 467-482 WIN 2001

Which Capitalism? Lessons from the East Asian Crisis: with Luigi Zingales, Journal of Applied Corporate Finance, Fall 1998.

"Financial Dependence and Growth", (pdf) with Luigi Zingales, American Economic Review, June 1998, vol 88, pp 559-586.

Banking (General)

“Rethinking Capital Regulation”, with Anil Kashyap and Jeremy Stein.

“The Real Effects of Banking Crises”, with Giovanni Dell’Ariccia, Enrica Detragiache, Journal of Financial Intermediation, 2008, vol 17, 89-112

“Dollar Shortages and Crisis”, with Ioannis Tokatlidis, International Journal of Central Banking, vol 1, no 2, 177-220.

“Money in a Theory of Banking” with Douglas Diamond, American Economic Review, 2006, 96, (1), 30-53

“Does Function Follow Organizational Form? Evidence from the Lending Practices of Large and Small Banks”, with Allen Berger, Nathan Miller, Mitchell Petersen, and Jeremy Stein, forthcoming, Journal of Financial Economics

Liquidity Shortages and Banking Crises (pdf) with Douglas Diamond, Journal of Finance, 2005, 60, (2), 615-647.

"Banks and liquidity", with Douglas Diamond, American Economic Review (Papers and Proceedings), May 2001.

"Banks, Short-term Debt, and Financial Crises: Theory, Policy Implications, and Applications", 2001, with Douglas Diamond, Journal of Monetary Economics, Proceedings of Carnegie Rochester Conference on Public Policy.

Banks as Providers of Liquidity: An Explanation for the Co-Existence of Lending and Deposit-Taking, with Anil Kashyap and Jeremy Stein, Journal of Finance. 57 (1): 33-73 FEB 2002

“A Theory of Bank Capital”, 2000, with Douglas Diamond, Journal of Finance, vol 55, no 6, 2431-2465.

"Liquidity risk, liquidity creation and financial fragility: A theory of banking" 2001, with Douglas Diamond, Journal of Political Economy , vol 109, 2, 287-327.

"The Past and Future of Commercial Banking Viewed through an Incomplete Contract Lens" (pdf), Journal of Money, Credit, and Banking, August 1998, vol 30: (3), pp 524-550."

The Paradox of Liquidity" (pdf) with Stewart Myers, Quarterly Journal of Economics, August 1998, vol 113: (3), pp 733-771.

"Why Banking Has a Future: Towards a New Theory of Banking",(pdf) Journal of Applied Corporate Finance, July 1996.

"Covenants and Collateral as Incentives to Monitor",(pdf) with Andrew Winton, Journal of Finance, 1995, vol 50, pp 1113-1146.

"Why Bank Credit Policies Fluctuate: A Theory and Some Evidence",(pdf) Quarterly Journal of Economics, 1994, vol 109, pp 399-442.

"Insiders and Outsiders: The Choice between Informed and Arm's-length debt"(pdf) Journal of Finance, 1992, Vol 47, pp 1367-1400

Banking Relationships

"Does Distance Still Matter? The Revolution in Small Business Lending", 2002, with Mitchell Petersen, Journal of Finance, 57 (6): 2533-2570 Dec 2002.

"The Effect of Credit Market Competition on Lending Relationships"(pdf), with Mitchell Petersen, Quarterly Journal of Economics, 1995, vol 110, pp 407-443.

"The Benefits of Firm-Creditor Relationships: Evidence from small business data", (pdf) with Mitchell Petersen, Journal of Finance, 1994, Vol 49, pp 3-37.

Universal Banking

"Organization Structure and Credibility: Evidence from Commercial Bank Securities Activities before the Glass-Steagall Act", (pdf) with Randall Kroszner, Journal of Monetary Economics, 1997, vol 39, no 3, 475-516.

"Commercial Bank Entry into the Securities Business: A Survey of Theories and Evidence",(pdf) in Universal Banking, Anthony Saunders and Ingo Walter ed.

"Is the Glass-Steagall Act Justified?: Evidence from the U.S. experience with Universal Banking 1921-1933",(pdf) with Randall Kroszner, American Economic Review, 1994, vol 84, pp 810-832.

"An Investigation into the Economics of Extending Bank Powers", Journal of Emerging Market Finance, 2002.

International Finance

“Landed Interests and Financial Underdevelopment in the United States”, with Rodney Ramcharan

Controlled Capital Account Liberalization: A Proposal with Eswar S. Prasad

“Has Financial Development Made the World Riskier?” EUROPEAN FINANCIAL MANAGEMENT 12: 499, 2006.

The Great Reversals: The Politics of Financial Development in the 20^th Century with Luigi Zingales, Journal of Financial Economics, vol 69, 1, July 2003, 5-50.

Financial Systems, Industrial Structure and Growth with Luigi Zingales, Oxford Review of Economic Policy. 17 (4): 467-482 WIN 2001

Which Capitalism? Lessons from the East Asian Crisis: with Luigi Zingales, Journal of Applied Corporate Finance, Fall 1998.

"Financial Dependence and Growth", (pdf) with Luigi Zingales, American Economic Review, June 1998, vol 88, pp 559-586.

"Is There an Optimal Capital Structure? Some Evidence from International Data.", with Luigi Zingales, (pdf) Journal of Finance, 1995, vol 50, pp 1421-1460.

Miscellaneous Finance:

"The Eclipse of the U.S. Tire Industry" (pdf) with Luigi Zingales, 2000, in Mergers and Productivity, edited by Steven Kaplan, University of Chicago Press.

"Trade Credit : Some Theories and Evidence" with Mitchell Petersen, Review of Financial Studies, 1997, vol 10, no 3, 661-692.

"Analyst Following of Initial Public Offerings" with Henri Servaes, Journal of Finance, 1997, vol 52, 2, 507-530.

"The Effect of Market Conditions on Initial Public Offerings", 1994, with Henri Servaes, Mimeo, University of Chicago.

Organizations, Power and the Theory of the Firm.

“ The Internal Governance of Firms”, with Viral Acharya and Stewart Myers.

Are perks purely managerial excess? with Julie Wulf, Journal of Financial Economics, 2006, 79, (1), 1-33.

“Entry Regulation as a Barrier to Entrepreneurship”, with Leora Klapper and Luc Laeven, Journal of Financial Economics, 2006, 82, (3), 591-629

“The Flattening Firm: Evidence from Panel Data on the Changing Nature of Corporate Hierarchies”, with Julie Wulf, The Review of Economics and Statistics, 2006, 88, (4), 759-773

Does Function Follow Organizational Form? Evidence From the Lending Practices of Large and Small Banks with Allen Berger, Nathan Miller, Mitchell Petersen, and Jeremy Stein, Journal of Financial Economics, 2005, 76, (2), 237-269

"The Influence of the Financial Revolution on the Nature of Firms.", with Luigi Zingales, American Economic Review (Papers and Proceedings), 91 (2): 206-211 MAY 2001.

"The firm as a dedicated hierarchy: A theory of the origins and growth of firms, (pdf), Luigi Zingales, Quarterly Journal of Economics, 116 (3): 805-851 AUG 2001.

What Determines Firm Size? (Pdf) With Krishna Kumar and Luigi Zingales

The Governance of the New Corporation, 2000, with Luigi Zingales, in Xavier Vives ed. Corporate Governance, Cambridge University Press.

"The Costs of Diversity: The diversification discount and inefficient investment", with Henri Servaes and Luigi Zingales, Journal of Finance, vol 55, no 1, 35-80.

"Power in a Theory of the Firm", (pdf) with Luigi Zingales, Quarterly Journal of Economics, May 1998, vol 113, pp 387-432.

"The Tyranny of the Inequality: An Enquiry into the Adverse Consequences of Power Struggles", (ps) 2000, with Luigi Zingales, Journal of Public Economics, 2000, 76, (3), 521-558