Regulation 3

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

In a few weeks I will be running a risk management seminar for a group of senior managers of a major financial institution.  The basic purpose is to bring them up to speed on some of the latest developments in risk management thinking and practice, challenge them in their thinking, create an enriching dialogue, and overall help them to hone their skills and stay risk sharp.

 

The institution I am running this session for is one of the recognized leaders in risk management practice.  As an institution they are very proactive in having best in practice risk management policies and are amongst the intuitions I work for that are at the leading edge of regulation.  They are a very interesting group to work with.  I have a huge amount of respect for their risk management team – which of course might be a self-serving bias.

 

There is one issue that will come up in the course of my session with the risk managers that will cause all to reconsider some assumptions.  As mentioned this is an institution that is on top of the changing landscape for financial institution regulation.  This institution spends a lot of time, energy and effort to be so.  However in our session we will discuss the value of regulation as a risk management tool.  We will discuss whether a financial institution really needs two sets of risk tools – those for regulation and those for risk management (much like a firm has two (or more) sets of financial statements for tax reporting, for financial reporting and for managerial reporting).

 

There is an assumption that regulation – particularly in the financial services sector – is a risk management tool.  It’s not.  Regulation might be many things, and you no doubt have your own views about the value of regulation, but we all need to remember that regulation is not risk management.  Those who depend on regulation as their risk management tool are doomed to a life of unnecessary risk.

Risk in the G10 Foreign Exchange Markets

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The G10 foreign exchange market is likely to enter a more challenging environment as problems in Spain are starting to refocus investor attention on the underlying structural problems in Europe and continued deterioration of the financial condition of European banks.  The ECB has not given any indication of injecting further liquidity into the banking system if the situation in Spain deteriorates and/or spreads to other countries.  Leading indicators in many advanced countries are starting to show weakness suggesting that growth for Q2 and Q3 could be lower than earlier estimates.  In this environment, investors and corporations may want to re-evaluate their foreign exchange exposure as the global economy enters a more risk-averse, slower growth environment. 

 

Meanwhile, policy-makers and central banks are becoming cautious about major policy changes.  The US deficit continues to overhang the Presidential election as major parties refuse to compromise over spending cuts and tax reform.  A potential showdown on raising the debt ceiling could provide temporary market uncertainty.  In Europe, a number of countries are reconsidering fiscal austerity as the economic costs could cause a shift in the political landscape.

 

Elsewhere, central banks remain cautious about providing further liquidity over concerns about central bank balance sheet size and asset quality. The ECB has not provided any indication of adding further liquidity, but may be forced to if Spanish banks have further problems.  While central banks in Japan and Australia are active in adding liquidity, most G10 central banks are content to keep policy steady.

 

In an environment of slowing global growth indicators together with the reduced prospect of a monetary policy response could make the euro more vulnerable. Currently, any tightening of global liquidity conditions suggests a negative impact on the high-risk currencies, especially the euro.  The spotlight remains on the peripheral Europe, especially after Spain’s rating downgrade, the collapse of the government in the Netherlands and the shift in political sentiment in France.  Fiscal problems at the periphery of Europe could be quickly transmitted to core countries, also adding to political uncertainty.  In this environment of stagnating growth and ongoing structural problems could keep the euro under pressure well into 2013.

 

In Japan, the continued support from the central bank and some signs of a rebound in growth should provide a base of support for the yen.  The yen will have support from better economic prospects in Asia.  In contrast, weaker growth prospects in the UK may cause temporary sterling weakness.   Recent weaker UK data has taken some of the steam out sterling and could test the BoE’s willingness to hold policy steady.

 

In other major currencies, the Aussie could experience some weakness as the key support points of stronger growth and favorable terms-of-trade are showing signs of deterioration.  Already, the RBA has started to ease policy in expectation of further economic weakness.  In contrast, the hawkish stance by the BOC, favorable fundamentals and steady growth prospects should keep the loonie well-supported against major currencies.

 

If the global economy shifts towards a slower growth and more risk-averse environment, the euro could come under further downward pressure.  This may include some modest pressure on sterling and the Aussie dollar.  Have you examined your foreign currency exposure?

 

Regulation 2

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I love cartoons.  I think they are often brilliant, conveying a message in a minimum of words, with a synergy of a minimalist drawing.  I envy cartoonist for their insight and their ability to uniquely and creatively convey that insight.  One cartoon I read every morning is Ted Goff, the business cartoonist.  Fortunately the university I work for subscribes to a daily Ted Goff cartoon.

 

A Goff cartoon last week showed two business professionals, one supposedly a risk manager, and one a senior manager having an office conversation.  The risk manager states, “We’re in full compliance with all of the contradictory and illogical regulations, but not with the absurd and pointless regulations.” 

 

I don’t think I really need to comment on this – or do I?

Risks from Reduced Asset Quality

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The financial crisis has raised concerns about sovereign debt sustainability has reinforced the notion that no asset can be viewed as truly safe. Recent rating downgrades of sovereigns previously considered to be virtually riskless have reaffirmed that even highly rated assets are subject to risks.  The notion of riskless assets—implicit in credit rating agencies’ highest ratings has created a false sense of security, especially as the demand for these assets increase while supply shrinks.

 

The International Monetary Fund Global Financial Stability Report (GFSR) Safe Assets: Financial System Cornerstone? (April 2012).  Report looks at the role of safe assets; the effects of different regulatory, pol­icy, and market distortions; and potential future pressure points.

 

Safe assets have varied functions in financial markets, including as a store of value, collateral in repurchase and derivatives markets, key instruments in fulfilling prudential requirements, and pricing benchmarks. Without distortions, safety is priced efficiently, reflecting demand-supply dynamics.

 

The demand and supply imbalances in global markets for top rated assets are not new. Prior to the crisis, current account imbalances encouraged safe asset purchases by reserve managers and sover­eign wealth funds. Now, demand is being driven by periods of uncertainty, the lack of clarity about regulatory reforms, increased collateral needs for over-the-counter (OTC) derivatives transactions and the use of such assets in central bank operations.

 

Conversely, on the supply side, GFSR report estimates the number of safe sovereigns may decline by $9 trillion by 2016, or 16 percent.  Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs. The shrinking supply of safe assets, now limited to high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. Safe asset scarcity could lead to more short-term volatility jumps, herding behavior, and runs on sovereign debt.

 

In the case of banks, the preferential treatment of sovereign debt in banking regulations can increase the use leverage. The upward bias to capitalization ratios can lead to overestimation of the capital buffer available during periods of market stress. Under current regulations, banks’ holdings of debt issued by their own governments—and in the case of the European Union, of the debt of any sovereign in the Union—are commonly assigned zero risk weights. 

 

To mitigate the risks to financial stability, policymakers need to strike a balance between flexibility, the soundness of financial institutions and the costs associated with a too-rapid acquisition of safe assets.  Specifically, the careful design of some prudential rules could help increase the differentiation in the safety characteristics of eligible safe assets and limit potential runs on individual types of assets.  On the supply side, desirable policies include improving fiscal fundamentals and encouraging the private production of safe assets through improved securitization practices.  These efforts can remove impediments that may inhibit safe asset markets from moving to a new price for “safety.”

For more on this follow the link:  http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf

 

Regulation 1

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There is a very interesting interview with Niall Ferguson.  Actually that was a redundant statement; any interview with Niall Ferguson is interesting.  He is a Harvard Professor and author of several popular books on economics (a phrase that normally is an oxymoron) including The Ascent of Money and his latest book Civilization.  In an interview printed in the April 28, 2012 issue of Barron’s (article by Vito J. Racanelli, titled “Is America Becoming an Anti-Risk Welfare State?”), Dr. Ferguson is quoted about the “anti-risk culture” that is spreading across the Atlantic from Europe.  A particular quote struck me; “Regulations that protect from every eventuality end up being paralyzing …”.

 

Google has as its mantra “Don’t be evil”.  I implore you to adopt “don’t be paralyzing”.