Not making the grade: Report on global financial reform

By Don Alexander, MBA,
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

While financial reform is underway around the world, this communique argues that more needs to be done.  The reform agenda aims to make the financial system safer while allowing it to provide the intermediation services needed to promote stable economic growth. The intentions of policymakers are clear with a host of reforms in the right direction. The system, however, remains vulnerable; the pre-crisis financial structures have not changed much, and they will need to change.

Laura Kodres, of the IMF, in a recent VOXEU communique Not making the grade: Report card on global financial reform (15^th Oct.) discussed these issues.  Progress was defined by:  (1.) Compared to the pre-crisis period, the financial system should be more transparent with better governance. (2.) Both regulators and investors should be able to understand the location of risks, and be able to price them properly. (3.) The system should have less leverage and be made less prone to booms and busts.

This can be accomplished with stronger financial institutions that are better equipped to withstand the distress of downturns by holding more loss-absorbing capital and higher liquidity buffers.  The reformed system should allow risks to be diversified – reaping the benefits of interconnectedness and globalization, but without the risk of contagion. Resolution of unviable financial institutions should occur in a timely manner and minimum cost.

 The research on reforms focuses on the features of financial systems related to the crisis that need to be addressed to achieve the goal of a stable and effective system.  These include: 1) large, dominant, and highly interconnected institutions 2) the heavy role of non-banks, and 3) the development of, for instance, complex financial products.

While the results should be interpreted as very preliminary, the results are in line with the priors. Progress on Basel capital rules are driving banks to alter their liability structures to economize on regulatory costs.  Progress is also muting the severe drop in securitization – a result tied closely to the fact that the countries that have made the most progress on Basel 2 and 2.5 are in Europe, where securitization is being used to produce postable collateral at the ECB.  

The reforms are moving the structures in the right direction, but progress is slow. Some regions are still in a crisis.  There are built-in, long implementations for the agreed reform agenda.  However, the basic financial structures that are problematic before the crisis are still present: (1.) financial systems are still overly complex. (2.) Banking assets are highly concentrated, with strong domestic interlinkages. (3.) The too-important-to-fail issues are unresolved. (4.) Banking systems are still over-reliant on wholesale funding.

Going forward, the following issues need to be addressed: (1.) more discussion on what it takes to break the 'too-important-to-fail' conundrum, including a global level discussion of the pros and cons of direct restrictions on business models. (2.) We need further progress on recovery and resolution planning for large institutions, especially cross-border resolution. (3.) Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector. (4.) Careful thought about how to encourage simpler financial products and simpler organizational structures.

Even with new rules on the books, their success depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer. Policymakers need to press ahead at a faster pace to avoid another accident.

www.voxeu.org/article/not-making-grade-report-card

US Economic Recovery and Risk of Policy Gridlock

by Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The US recovery is painfully slow and monetary policy is at its limits in a balance sheet recession. Pervasive economic uncertainty appears to be holding the US back in terms of lost output and job creation. But what is the root cause of this uncertainty?

This is what Nicholas Bloom, Scott Baker, Steven J. Davis, John Van Reenen attempt to answer in a VOXEU communique dated Oct. 29^th called  Economic recovery and policy uncertainty in the US . The authors argue that a polarized political system is to blame. Without a political mechanism that incentivizes the election of moderate politicians, the authors predict further political divergence between Republicans and Democrats and a consequent intensification of policy uncertainty.

There are several potential causes of slow recovery:  (1.) one explanation attributes low demand to the financial crisis and the consequent dislocation of capital markets.   Although monetary policy has been aggressive, it has reached its limits as quantitative easing has hit a point of diminishing returns. (2.) An additional explanation in this demand-shock story is an increase in uncertainty. Uncertainty can retard both investment and hiring as firms become reluctant to make costly decisions.

Greater uncertainty increases risk premiums in financial markets which in turn raises the cost of borrowing for firms and households.  Previous research has identified additional mechanisms whereby uncertainty undermines macroeconomic performance. The authors find that high levels of policy uncertainty foreshadow lower levels of output, investment, and employment.  In recent months, uncertainty about the US election and the ‘fiscal cliff’ has contributed to a recurrence of policy uncertainty.

The authors try to separate the effect of policy uncertainty from other factors, such as low demand and estimate that the increase in policy uncertainty after 2007 reduced employment by 2.3 million.

The authors blame high levels of policy uncertainty with both political parties. However, politicians see it otherwise: Republicans are blaming the President and Democrats for creating regulatory uncertainty, and failing to face up to the main long-term social programs causing rising debt. Democrats accuse Republicans of obstructionism on tax and spending cuts while not providing meaningful details on their healthcare reform proposals and fiscal programs.

This move to the extremes can be partly explained by the ability of incumbents to gerrymander political districts, that is, to change Congressional district boundaries along partisan lines in order to maximize an incumbent’s chances of re-election. Gerrymandering, in turn, encourages primary election campaigns that focus on appealing to extreme political bases rather than moderate voters.

It is unclear whether the November elections will significantly alleviate US policy uncertainty.  A clear victory for one party could greatly clarify the policy outlook, but that outcome appears unlikely based on polling data.  Regardless of who wins the presidency, the two houses of Congress are likely to remain divided by party.  Thus, the increasing political polarization of the last 30 years is also very likely to continue.  Until the advent of a political mechanism that creates incentives to elect moderate representatives who can reach across the ideological divide, it seems the US is destined to entrench high levels of policy uncertainty with below trend output growth and job creation.

www.voxeu.org/article/economic-recovery-and-policy

Policy uncertainty website:  www.policyuncertainty.com

Uncertainty and the Global Recovery

by Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Bouts of elevated uncertainty are defining features of the sluggish global recovery from the financial crisis.    A number of analysts suggest a link between the high level of uncertainty and the weak recovery.  Uncertainty is associated with escalating financial stress in the Eurozone, stalling US labor markets, and slowing growth elsewhere.  The authors ask two questions: how has uncertainty evolved and how does it affect growth and business cycles?  This is asked by Kose and Terrones is a recent VOXEU communique Uncertainty Weighing on the Global Recovery. 

Economic uncertainty refers to an environment in which little or nothing is known about the future.  There is a great variety of sources of economic uncertainty, including changes in economic and financial policies, dispersion in future growth prospects, productivity movements, political events, and natural disasters 

The authors consider four measures of uncertainty: (1) the standard deviation of daily stock returns, (2) an indicator of the implied equity volatility, (3) an uncertainty index of economic policies; and (4) a global uncertainty index.  Both macroeconomic and policy measures of uncertainty rise during global recessions.

Policy uncertainty in the US and the Eurozone has remained high since the global financial crisis and the recent sovereign-debt problems. Moreover, during the lethargic global recovery, uncertainty has been unusually high and volatile in contrast to other global recessions, which were accompanied by steady declines in uncertainty.  Uncertainty is highly countercyclical at a national level while macroeconomic uncertainty varies over the business cycle.

Economic theory suggests that macroeconomic uncertainty can have an adverse impact on output through a variety of channels.  The authors find the growth rate of output is negatively correlated with macroeconomic uncertainty.  Policy-induced uncertainty is also negatively associated with growth.  The recent increase in policy uncertainty may have stunted growth in advanced economies by 2.5%. The degree of economic uncertainty appears related to the depth of recessions and strength of recoveries.  In particular, recessions accompanied by high uncertainty are often deeper than other recessions. Similarly, recoveries coinciding with periods of elevated uncertainty are weaker than other recoveries.   

Elevated uncertainty historically coincides with periods of lower growth, and the recent pickup in uncertainty raises the specter of another global recession. Policymakers can do little to alleviate the intrinsic uncertainty economies typically face over the business cycle.  However, policy uncertainty is unusually high, and it contributes significantly to macroeconomic uncertainty.  By implementing bold and timely measures, policymakers can reduce policy-induced uncertainty and help kick-start economic growth.

www.voxeu.org/article/uncertainty-weighing-global-recovery