by Don Alexander, MBA
Associate, RSD Solutions Inc.
Rene Stulz in a 2008 paper, Risk Management Failures: What Are they and When Do They Happen, looked at risk management failures and how various types occur. Stulz noted there are six types: mismeasurement of known risks, failure to take risks into account, failure to communicate the risks to top management, failure to monitor risks, failure in managing risks and failure to use appropriate risk metrics. Can we apply these failures to the management of the Eurozone?
Charles Wyplosz in a communique, Happy 2012, (VOXEU, 3rd January) looks at the problems of the Eurozone and proposes what issues can be addressed without the pain of a new EU treaty. The crisis continues to linger on despite the ECB liquidity facility. Wyplosz asks why the crisis continues, discusses what can be done and offers a proposed solution.
The persistence of the crisis is due to policy mistakes, the lack of fiscal discipline, ongoing imbalances and focus on moral hazard without specific solutions. Political leaders do not understand the complexity of the financial crisis and propose only partial solutions without technical staff involved in the decision process. Politicians cater to their national electorate and will any avoid unpopular decisions.
The crisis is complicated because it combines financial turmoil with governance issues under challenging macroeconomic conditions. As result, the economics profession has not converged on a shared diagnosis contributing to policymaker confusion. Government and bank bailouts raise a moral hazard issue not addressed in the current EU structure.
Wyplosz outlines four conditions to be addressed for crisis resolution: governments that lose market access must be bailed out effectively (restructuring) and there are limits to moral hazard (investors may be exposed to a haircut), the ECB should lead the bailout since the amount maybe large and unknown, banks need to be recapitalized before a sovereign default and limiting moral hazard will require fiscal discipline. The current proposal for a new treaty and suspension of sovereignty to manage fiscal discipline is intrusive, takes too long and could cause economic stagnation.
According to Wyplosz, the best alternative is work through the ECB, an independent entity. The ECB can manage the amounts involved; they can determine their own collateral requirements and work with an independent board to monitor fiscal developments (details to be determined). The cost continues to increase as it moves from a sovereign to a banking crisis.
If we look back at the six types of risk management failures, they are all present in the management of the Eurozone. A few of the lessons we learned: sovereign debt is not a riskless asset, how do we monitor and control these risks, the lack of effective communication can increase crisis severity, the lack of an effective control system comes at a price, the interests of policymakers must be aligned with investors/electorate and professional management is required. We can conclude that the events in the Eurozone reflect all six failures of risk management.
For more on this follow the links:
For Rene Stulz http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1278073
And for Charles Wyplosz http://www.voxeu.org/index.php?q=node/7487
