The Economic Costs of Natural Disasters

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

A series of tragic events (US and elsewhere – Katrina & Sandy) in recent years has rekindled interest in the economic consequences of natural catastrophes. There is growing debate whether disasters are harmful or conducive to economic activity. While the immediate destruction they cause triggers a range of adverse socio- economic consequences, natural disasters may also have growth-enhancing effects since investment for reconstruction is part of measured GDP (a flow), whereas the destruction of physical capital (a stock) is not. Replacing dated capital with more recent vintages might also raise long-term growth. Weighing against this optimistic view are the disarray and loss of productive capacity depressing output in the immediate aftermath of a major catastrophe.

This is a question that G. von Peter, S. von Dahlen & S. Saxena of the BIS examine in a recent working paper (BIS WP 394) Unmitigated disasters? New evidence on the macroeconomic cost of natural catastrophes (Dec. 2012). The authors note existing studies differ widely on their results and reach no firm conclusions on disaster-related growth effects.

This study measures the response of growth to major natural catastrophes, and examines the extent to which risk transfer to insurance markets may facilitate economic recovery. The study makes the link between natural catastrophes and economic growth conditional on risk transfer. This nuances the transmission channels, thereby helping to resolve the conflicting findings on catastrophe-related growth.  

The findings suggest that risk transfer to insurance markets has a macroeconomic value. This value may be particularly high for smaller nations that lack the capacity to (re)insure themselves against major natural disasters. The analysis thus contributes to the policy debate on different forms of post-disaster spending, as well as the balance between prevention ex ante and compensation ex post. The study notes that catastrophes have permanent output effects are also relevant for a growing literature that explains asset pricing puzzles through rare disasters. The extent to which risk transfer mitigates the macroeconomic cost of disasters is pertinent to the literature on finance and growth, which focuses on banks and stock markets but not on insurance. Considering the macroeconomic value of risk transfer could also enrich the macro prudential approach to the regulation and supervision of insurance companies.

The main result is that it is the uninsured part of catastrophe-related losses that drives macroeconomic costs, whereas well insured catastrophes can be inconsequential or even positive for economic activity. The strongest growth-enhancing effects from insured losses appear in the three years following a catastrophe, in line with the average timing of insurance payouts. This suggests that insurance facilitates the financing of the reconstruction effort that contributes to measure GDP. Distinguishing the effects by physical type of catastrophe shows that insurance coverage at best neutralizes the contractionary effects of earthquakes and volcanic eruptions, while the growth effects of storms, flooding and climatological events can be weakly positive when insured.

Insurance can therefore play an important role in mitigating the macroeconomic costs arising from major natural catastrophes. This form of risk transfer can be useful at any stage of development. Splitting the sample by land area and income group shows that small and low- to middle-income countries suffer more when uninsured but also recover faster when insured against catastrophes. Hence the mitigating role of insurance appears to be more pronounced for this group, especially in the year after a disaster when reconstruction takes place. Whether it is desirable for countries to seek high coverage depends, of course, on the frequency of disasters and on the terms and cost of insurance.

Major natural catastrophes have large and significant negative effects on economic activity, both on impact and over the longer run.  However, it is mainly the uninsured losses that drive the subsequent macroeconomic cost, whereas sufficiently insured events are inconsequential in terms of foregone output. This result helps to disentangle conflicting findings in the literature, and puts the focus on risk transfer mechanisms to help mitigate the macroeconomic costs of natural catastrophes.

www.bis.org/index.htm

Banking reform: What has to be done?

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

The recent financial overhang in Europe crisis has revealed the vulnerabilities of the Eurozone financial sector and the critical role the sector plays in the real economy. It also made it clear that the banking system needs fixing.

This is a question Wouter den Haan, asks in a recent VOXEU communique Nov. 30^th called Banking Reform: Do we know what has to be done? The question is what reforms should be implemented? It is critical that much better legislation be both discussed and implemented to properly regulate the financial sector.

Better regulation is important for reducing the chances of another major financial crisis, but better regulation may also be an essential factor in re-establishing confidence in the financial sector itself. Indeed, it is thought that such confidence may be an essential ingredient for a healthy economic recovery.

Even before the crisis, it was well known that our financial system was exposed to some key risks. Despite this wisdom, the risks were clearly underestimated and the mechanisms to prevent severe disruptions were clearly not in place. Now we are designing new legislation, it is important that we understand what went wrong.

During the postwar period, there had been numerous innovations in the financial sector and there were plausible reasons to believe that these innovations would stabilize the system. Securities rapidly became more complex. Financial regulators, rating agencies and risk managers did not have the resources and expertise to deal with this increased complexity.

It was assumed that a new set of rules would not only fix known problems, but any new ones that may arise. The financial system is dynamic and as new vulnerabilities appear, financial institutions will try to find ways around legislation. So the new regulatory system should be flexible enough to deal with a changing world and it also should be such that complacency cannot put our economy at risk again. Recent research indicates that countries exposed to a financial crisis do not reduce a country's probability of being hit by another financial crisis. The explanation may be due to the inability of regulators to keep up with the dynamic evolution of modern banking.

There is a need for better funded oversight and better in-depth knowledge among financial regulators and academics about what is actually going on in the financial sector. The likelihood of risk reduction will also require a change of culture in the financial sector itself. The decisions made by individuals working in financial institutions ought to be in line with the long-run growth and stability of the overall institution and the overall economy, not any one individual’s short-term prospects.

A number of questions remain on financial reform:

·       Has enough been done to reduce the chance of another financial crisis?

·       Are governments overreaching and is the new regulation going to stifle growth in the financial sector?

·       Will the higher capital adequacy requirements of Basel III make the system sufficiently safe? And will they make lending (much) more expensive?

·       Will the countercyclical buffers of Basel III be enough to avoid systemic downward spirals?

·       Are the new liquidity requirements going to avoid contagion in the interbank market?

·       What kind of institutional change in the markets for derivative trading will take care of counter-party risk? How can we tackle the possibility of institutions falling like dominos, and by doing so solve the ‘too connected to fail’ problem?

·       What kind of division should there be between traditional commercial banking and other activities? Is it enough to implement limits to proprietary trading, that is, trading of financial assets with the institutions own money? Or should there be a stricter separation between commercial and investment banking activities?

·       Can or should regulation be (somewhat) different across countries? And will countries with stricter regulation face capital flight?

www.voxeu.org/article/banking-reform-do-we-know-what-has-to-be-done?

Simple

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

In my previous blog I wrote about the Canadian military intelligence staffer who was caught selling military secrets to the Russians.   It is an embarrassing case for the Canadian military as the person involved had high level clearance, and it was the FBI and not any of the Canadian agencies who picked up on the very suspicious activity of the person involved.

You might think that in this day and age of high tech spying that the person was a mastermind using the most sophisticated of equipment.  The irony is that if they were they would have likely been caught much earlier.  It seems that the Canadian military was so concerned about high tech electronic cyber spying that they totally forgot about the lowly USB key.  Yup – that’s right – the staffer sneaked the information out using a plain old USB key that could be bought at any office supply store.

Sometimes in our focus on being up to date and sophisticated, we forget about the simple risks in front of us.