RSD Solutions - Blogs

(Mr. Alexander is also a lecturer at NYU and SunySB)

It is been four years since Lehman went under. There have been important initiatives on the regulatory front to minimize taxpayer bailouts to the financial sector (aimed at the banking sector). The payouts (i.e., taxpayer bailouts) in various forms were provided by governments to a variety of financial institutions and markets that were outside the regulatory perimeter—the ―shadow‖ banking system, although, a few recent regulatory proposals attempt to reduce these ― imputed puts.

These issues are examined in a recent IMF working party called “Puts” in the Shadows by Manmohan Singh (Sept. 2012). This study provides examples from non-banking activities within a bank, money market funds, Triparty repo, OTC derivatives market, collateral with central banks, and issuance of floating rate notes etc., that these risks remain. The results suggest that a regulatory environment where puts are not ambiguous will likely lower the cost of bail-outs after a crisis.

There are a plethora of views on reducing systemic risks at banks, including reverting to the Glass Steagall Act that separates commercial banking (i.e., depository type of business) with the non-depository business. Intermediate solutions like the Vickers and Volcker Rule that insulate (or provide buffers) to the depository part of the banks, or push out riskier activities outside the BHC (Bank Holding Companies) have gained momentum in various key jurisdictions. However, proposed regulation (via Basel III, Dodd Frank Act etc.), is unlikely to remove all the puts within the BHC, as it is one legal entity. The recent FSB (Financial Stability Board) list of SIFIs (Systemically Important Financial Institutions) acknowledges that the overall BHC is systemic.

The nonbank/bank nexus is an important part of financial system. However, nonbanks are separate legal entities outside a bank and thus the puts do not legally pass from the bank to the nonbank (and they shouldn‘t). There is sound economics behind the existence of nonbanks and these entities should not be driven only by regulatory arbitrage due to the puts. On non-bank resolution, no country has a comprehensive regime for addressing non-bank SIFIs, mostly because until recently nonbanks were rarely considered systemic. Thus, resolution of non-banks has become an increasing priority aside from the push for ―living wills. Regulators are starting to address this and the U.K.‘s Treasury and EC intend to publish consultation papers on this issue.

A less ambiguous regulatory environment will lower moral hazard; this will likely reduce cost to taxpayer if/when bailing out the shadow banking system. However, by intent, or political/policy choice, or by limited foresight, if ―puts are not removed ex-ante a crisis, there will always be room for bailouts. An example of an intended (but implicit) put is the creation of CCPs (Central Counter Party)―despite earnest efforts to reduce the size of SIFIs, the creation of new SIFIs (i.e. CCPs) is not clear. Another example is the political/policy choice not to explicitly remove the put from the MMFs industry in the U.S―it continues to offer par NAV (net asset value) with no capital supporting the business. Similarly, an example of limited foresight is bailing out money-like collateral at subsidized haircuts―recall Fed‘s PDCF (Primary Dealer Credit Facility), and the ECB‘s LTROs (Longer-Term Refinancing Operations) and the respective Eurozone national bank‘s ELA (Emergency Liquidity Assistance) efforts.

There will always remain some (unintended) puts ex-post a crisis. However, the puts that can be removed ex-ante should be addressed; otherwise "shadow banking" will continue to be a pejorative term and the issue of systemic risk is not fully addressed in reform proposals.

For more on this follow the link: www.imf.org/external/pubs/ft/wp/2012/wp12229.pdf

Tuesday, September 18, 2012

The Cost & Effectiveness of Regulation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences. The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past. The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.

However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments. There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction. The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.

The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.

There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.

Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy. The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.

For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf

Friday, August 3, 2012

Fiscal Balances & Systemic Risk

Normal 0 false false false EN-US X-NONE X-NONE

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The IMF’s noted in its’ Interim Fiscal Monitor (July 2012) that fiscal adjustment is proceeding generally as expected in advanced economies, with headline and underlying fiscal deficits that are broadly in line with projections made in the April 2012. In advanced economies with easier market access, fiscal adjustment in 2012–13 is broadly on track to meet medium-term targets. Overall, advanced economy deficits are forecast to decline by about ¾ percentage point of GDP this year and about 1 percent of GDP next year in headline and cyclically adjusted terms, a rate that strikes a compromise between restoring fiscal sustainability and supporting growth.

Deficits in emerging economies are expected to be somewhat weaker than projected in April, as some draw on fiscal space in response to slowing economic activity. No significant fiscal consolidation is on tap in 2012–13, reflecting generally stronger fiscal positions than in advanced economies and downside risks to global growth. However, some emerging economies need to be more ambitious to reduce vulnerabilities.

Europe developments remain a problem where sovereign debt is in a negative feedback loop with the banking sector. The continued focus on nominal deficit targets runs the risk of compelling excessive fiscal tightening if growth weakens. The two largest such countries, Italy and Spain, are implementing sizeable fiscal consolidation in the next two years in efforts to improve debt dynamics and regain market confidence. Market turbulence has intensified in Spain due to renewed concerns about the health of the financial system and its possible fiscal implications. Italy’s headline and cyclically adjusted deficits for 2012–13 continue to be broadly in line with expectations could achieve a small structural surplus in 2013. The situation in Greece remains in flux with revenue under pressure and slow pace of reforms.

Elsewhere, there is a risk in the United States of political gridlock that puts fiscal policy on autopilot and results in a sharp and sudden decline in deficits—the “fiscal cliff.” The United States’ fiscal position is projected to improve, but the outlook for 2013 remains a significant concern. Expiring tax provisions and automatic spending cuts mandated by the 2011 Budget Control Act would imply a fiscal withdrawal of more than 4 percent of GDP—the so-called ‘fiscal cliff’—which would severely affect growth in the short term. A more modest retrenchment in 2013—of around 1 percent of GDP in structural terms—would be a better option.

In most advanced economies, a steady pace of adjustment focused on the measures to be implemented rather than on headline deficit targets is preferable, especially in light of heightened downside risks to the outlook. Japan’s budget deficit and high debt level remains a problem and aging population defies any near-term solutions. The proposal to increase the consumption tax sends a positive signal of commitment to fiscal adjustment and reform. However, the tax increase would remain only part of the consolidation necessary to put the debt ratio on a downward path.

Governments face the task of credibly dealing with large fiscal adjustment needs in a time of slow and uncertain growth. Reconciling these needs may be challenging, but following some basic fiscal principles (to be adapted on a case- by-case basis) should help.

The risk remains that fiscal deficits persist accompanied by stagnant growth posing a challenging environment for risk management.

For more on this follow the link: www.imf.org/external/pubs/ft/fm/2012/update/02/fmindex.htm

Thursday, July 19, 2012

New Setbacks – Risks to the Global Recovery

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The IMF noted in its latest interim World Economic Outlook (July 2012) noted the global recovery did not have a firm base and was showing a loss of momentum. Financial market and sovereign stress in the euro area periphery have ratcheted up. Growth in a number of major emerging market economies has been lower than forecast.

The setback was partly because of a somewhat better-than-expected first quarter, the revised baseline projections in this WEO Update suggest that these developments will only result in a minor setback to the global outlook, with global growth at 3.5 percent in 2012 and 3.9 percent in 2013, These forecasts, however, are predicated on two important assumptions: that there will be sufficient policy action to allow financial conditions in the euro area periphery to ease gradually and that recent policy easing in emerging market economies will gain traction.

Developments during the second quarter, however, have been worse. Relatedly, job creation has been hampered, with unemployment remaining high in many advanced economies, especially among the young in the euro area periphery.

Growth in advanced economies is projected to expand by 1.4 percent in 2012 and 1.9 percent in 2013. The downward revision mostly reflects weaker activity in the euro area periphery from a further escalation in financial market stress, triggered by increased political and financial uncertainty in Greece, banking sector problems in Spain, and doubts about governments' ability to deliver on fiscal adjustment and reform as well as about the extent of partner countries' willingness to help.

United States data suggest less robust growth than forecast in April. While distortions to seasonal adjustment and payback from the unusually mild winter explain some of the softening, there also seems to be an underlying loss of momentum.

Growth momentum has also slowed in various emerging market economies, notably Brazil, China, and India. This partly reflects a weaker external environment, but domestic demand has also decelerated sharply in response to capacity constraints and policy tightening over the past year. Growth in emerging and developing economies will moderate to 5.6 percent in 2012 before picking up to 5.9 percent in 2013.

Global consumer price inflation is projected to ease as demand softens and commodity prices recede. Overall, headline inflation is expected to slip from 4½ percent in the last quarter of 2011 to 3–3½ percent in 2012–13.

The utmost priority is to resolve the crisis in the euro area. The recent agreements, if implemented in full, will help to break the adverse links between sovereigns and banks and create a banking union. These tasks require policy measures in several areas: a credible commitment toward a complete monetary union, the monetary union must also be supported by wide-ranging structural reforms and resolve intra-area current account imbalances, demand support and crisis management are essential to cushion the impact of the region's adjustment efforts and maintain orderly market conditions, monetary policy has to ease further and fiscal consolidation plans must be implemented.

Clearly, downside risks continue to loom large, importantly reflecting risks of delayed or insufficient policy action. In Europe, the measures announced at the European Union (EU) leaders' summit in June are steps in the right direction. The very recent, renewed deterioration of sovereign debt markets underscores that timely implementation of these measures, together with further progress on banking and fiscal union, must be a priority. In the United States, avoiding the fiscal cliff, promptly raising the debt ceiling, and developing a medium-term fiscal plan are of the essence. In emerging market economies, policymakers should be ready to cope with trade declines and the high volatility of capital flows.

For more on this, follow the link: www.imf.org/external/pubs/ft/weo/2012/update/02/index.htm

Thursday, June 21, 2012

Credit Booms, Policy & Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Credit booms encourage investment and consumption and can contribute to long-term financial growth. However, some end up in costly balance sheet dislocations, and, others, in devastating financial crises with costly consequences. These risks have long been recognized. Yet, there is little consensus about how to manage the risks and when policy should intervene.

The IMF explores some of these issues in a Staff Discussion paper on Credit Booms that looks at past events with the objective of assessing policy effectiveness policies to reduce the risk or limiting its consequences. There is no policy panacea for credit booms.

Credit booms are often triggered by financial reform, capital inflows from capital account liberalizations, and followed by periods of strong economic growth. They are often characterized by weak regulation and loose policy. Not all booms are bad as some produce long-term periods of steady growth. Only a third of boom cases end up in financial crises, but others can be followed by extended periods of below-trend economic growth. It is difficult to tell “bad” from “good” booms in real time, but bad booms tend to be larger and last longer (balance sheet).

Monetary policy is in principle the natural lever to contain a credit boom, but some occur in low-inflation environments, a conflict may emerge with its primary objective. Given its time lags, fiscal policy is ill-equipped to timely stop a boom. Consolidation during the boom years can help create fiscal room to support the financial sector or stimulate the economy. Finally, macroprudential tools have at times proven effective in containing booms and in limiting their consequences of busts through buffers they build, but can cause distortions.

Prolonged credit booms are a harbinger of financial crises and have real costs. While only a minority of booms end up in crises, those that do can have long lasting and devastating real effects if left unaddressed. Yet it appears to be difficult to identify bad booms as they emerge, and the cost of intervening too early and running the risk of stopping a good boom therefore has to be weighed against the desire to prevent financial crises.

The optimal macroprudential policy response to credit booms, as well as the optimal policy mix, will likely depend on the type of credit boom. Policy coordination, across different authorities and across borders, may increase the effectiveness of monetary tightening and macroprudential policies. Cooperation and a continuous flow of information among national supervisors, especially regarding the activities of institutions that are active across borders, are crucial. Equally important is the coordination of regulations and actions among supervisors of different types of financial institutions. Whether and how national policymakers take into account the effects of their actions on the financial and macroeconomic stability of other countries is a vital issue, calling for further regional and global cooperation in the setup of macroprudential policy frameworks and the conduct of macroeconomic policies.

The failure to understand credit booms and busts can have devastating and costly consequences for risk management.

For more information on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1206.pdf

Tuesday, May 1, 2012

Risks from Reduced Asset Quality

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Thursday, April 26, 2012

Risks to Global Growth & Recovery

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The International Monetary Fund’s World Economic Outlook (WEO) (April 2012) assesses the prospects for the global economy, which has gradually strengthened after a major setback during 2011. Global prospects are gradually strengthening again but remain fragile. Downside risks remain elevated with unemployment still high in many advanced countries.

The threat of a sharp global slowdown eased with improved activity in the United States and better policies in the euro area. Weak recovery will likely resume in the major advanced economies, and activity will remain relatively solid in most emerging and developing economies. However, recent improvements are not deeply rooted. Global growth is projected 3.5% for 2012 and 4.1% for 2013. The breakdown for advanced countries is 1.4% and 2% and emerging/developing countries the outlook is 5.7% and 6%, respectively.

Highlights by region

In North America, US growth should rise from 2.1% to 2.5% next year reflecting ongoing fiscal consolidation and the continued overhang from housing. Canada is projected to grow at a 2% pace.

Japan, recovering from last year’s earthquake, should see output growth by 2% next year. In the rest of Asia, weaker external demand has somewhat dimmed the overall outlook. China, if it can avoid financial spillovers, should be able to maintain growth of a little over 8% driven by domestic demand. The rest of Asia, including India, should be able to maintain growth of around 6-7%.

In Europe, growth is projected to contract in the first half of 2012, but then show signs of recovery in the inner core. However, growth in peripheral countries will remain anemic, most likely below 1% next year. A major problem for most European countries is to limit the impact of spillovers from the banking sector to the real economy. UK prospects remain dim for 2012, but could see a recovery toward 2% in 2013.

In other parts of the world, Latin America should grow by 4% a year while other emerging countries could see growth approaching 5%. Russia could see some moderation of growth towards 4% as exports to Europe are weak and policy tightening is implemented.

The most immediate concern to the IMF outlook is still further escalation of the euro area crisis that could trigger a more generalized flight from risk. This scenario might produce a global and euro area output decline over a two-year horizon.

Alternatively, geopolitical uncertainty may cause a sharp increase in oil prices: a 50% price increase could lower global output by over 1%. The effects on output could be larger if the tensions were accompanied by financial volatility and a loss in confidence. Furthermore, excessively tight macroeconomic policies could push other of the major economies into sustained deflation or a prolonged period of weak activity.

Additionally, latent risks include disruption in global bond and currency markets as a result of high budget deficits and debt in Japan and the United States and rapidly slowing activity in some emerging economies.

However, growth could also be better than projected if policies improve further, financial conditions continue to ease, and geopolitical tensions recede. Policies must be strengthened to solidify the weak recovery and contain the many downside risks. In the short term, this will require more efforts to address the euro area crisis, a temperate approach to fiscal restraint in response to weaker activity, a continuation of very accommodative monetary policies, and ample liquidity to the financial sector. Policymakers must calibrate policies to support growth in the near term and implement fundamental changes to achieve healthy growth in the medium term. This challenge will include winding down unconventional monetary policies implemented during the crisis and the need to establish credible deficit reduction programs.

The risks to the recovery, while improving, continue to be very fragile.

For more on this follow the link: www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm

Wednesday, April 25, 2012

Balancing Fiscal Risks

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The International Monetary Fund noted in their latest Fiscal Monitor (April 2012) that fiscal risks still remain elevated; although there are signs that in some key respects they are less acute than six months ago. Past efforts with fiscal consolidation are beginning to bear fruit, particularly when buttressed by credible institutional commitments.

Policymakers face the dilemma of how best to respond to slackening global activity and continued financial volatility without losing medium-term adjustment needs. The main conclusions of the report include: 1. countries remain vulnerable to unexpected external shocks with limited margin for policy errors, 2. the negative impact of fiscal adjustment remains large and usually unavoidable, 3. gross government debt ratios may overstate short-term problems from the accumulation of assets on central bank balance sheets, and 4. some countries still have short-term flexibility without having it in the long-term and 5. Some countries are implementing fiscal rules.

The use of fiscal rules, while not a substitute for specific long-term adjustment plans, can help build confidence and facilitate the establishment of a political consensus on fiscal policy. Second-generation fiscal rules are typically more complex than earlier versions, providing greater flexibility to respond to economic cycles but with more-binding corrections for past deviations. As such, they also raise significant enforcement and monitoring challenges.

Debt ratios in many advanced economies are at historic levels and rising, borrowing requirements remain large, financial markets are in a state of alert, and downside risks to the global economy predominate. They are projected to decline by 1% of GDP in 2012 and slightly more in 2013.

This is appropriate, although some countries with fiscal space may slow the pace of adjustment to reduce downside risks or avoid deteriorating economic conditions. IMF policymakers examine the concept of fiscal space, or the scope that policymakers have to calibrate the pace of fiscal adjustment without undermining fiscal sustainability.

In this uncertain environment, the challenge for fiscal policy is to find the right balance between exploiting short-term space to support the fragile recovery and rebuilding longer-term space by advancing fiscal consolidation. Policymakers have to balance the risk of reducing budget deficits, the overhang and potential reduction of central bank balance sheet and the need to return many advanced countries to more sustainable debt levels.

For more on this, follow the link: www.imf.org/external/pubs/ft/fm/2012/01/fmindex.htm

Tuesday, April 24, 2012

Has Systemic Risk Declined?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Yes according to the International Monetary Fund’s Global Financial Stability Report (GSFR) (April 2012). The report notes that financial stability has improved in recent months, although markets still remain fragile, yet policymakers seem committed to long-term reforms to restore confidence.

Recent policy steps have brought some relief to euro area financial markets, but remain under pressure from weak growth and high debt payments. Sovereign spreads have declined, bank funding markets are reopened, and equity prices have recovered.

Nevertheless, European banks remain under pressure from sovereign exposure, weak euro growth, high rollover requirements, and the need for more capital. EU-based banks are under pressure to deleverage with the IMF estimating that their balance sheets could shrink by euro 2 trillion (7%) by the end of 2013. They estimate that 25% of the reduction will occur in lending (reduces outstanding credit by l.7%) and the remainder from securities and non-core asset sales.

The IMF identified two near-term priorities: limiting the consequences of a large-scale deleveraging through close supervision to avoid damage to asset prices, credit supply, and economic activity, and prevent the outbreak of downside risks by establishing a financial backstop or firewall. In addition, long-term European policymakers need to establish a euro-wide financial stability framework and pan-European bank supervision and resolution. The IMF also noted that Europe needs central oversight of fiscal policy and greater fiscal risk-sharing.

The recent decision to combine the European Stability Mechanism with the European Financial Stability Facility will strengthen the European crisis mechanism and support the IMF’s global firewall.

Elsewhere, emerging markets need to adopt policies to reduce fallout from Europe particularly from European banks. The United States and Japan, with their high fiscal deficits, need to establish a political consensus for medium-term deficit reduction, to maintain financial stability.

Housing issues need to be addressed in a number of countries.

Meanwhile, the global financial regulatory framework is being strengthened, but key agreements still need to be concluded, while the transition to this new setting could add to cyclical challenges facing financial institutions. Elsewhere, the report noted increased structural risks from lower rated assets used for collateral and the underestimation of longevity risk.

The jury is still out on the reduction of systemic risk or has it been kicked down the road?

For more information on this, follow the link: www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c1.pdf

Tuesday, February 14, 2012

Fiscal Adjustment: Too Much of a Good Thing – Lessons for Risk Management

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The purpose of models is not to fit the data, but sharpen the questions.

(Samuel Karlin)

Carlo Cottarelli, in a VOXEU communique “Fiscal Adjustment: Too Much of a Good Thing” dated Feb. 8^th notes that a sharp reduction in budget deficits in certain circumstances can actually increase risk. This raises a question when we attempt to mitigate risks: Does a rapid adjustment actually increase risk?

Almost everyone agrees that the fiscal accounts of several advanced economies are in bad shape and need to be strengthened. But how fast should the adjustment be in the present circumstances. At time over the last couple of years, the IMF has called on countries to step up the pace of adjustment when they were perceived as moving too slowly. The IMF has argued that countries should reduce public-debt ratios through a gradual and steady process. However in the current environment, some countries are moving too fast.

The IMF Fiscal Monitor (Jan. 2012) indicates deficits are projected to fall by 2% of GDP in 2011-12 in the advanced economies, 3% in Eurozone countries. Adjustment is reasonable in a good growth environment, but in a weaker macroeconomic environment bringing down this quickly can increase risk to the economic recovery. IMF research suggests fiscal adjustment that lower debt ratios and deficits can reduce government bond spreads when the impact on growth is limited. Conversely, when tightening fiscal policy reduces growth, bond spreads can widen, especially with weak growth and fiscal tightening is large.

In advanced countries with limited financial options, deficit reduction is the best alternative. Structural reforms to boost competitiveness and growth along with deficit reduction are critical, but take time to work. It is important for countries to adjust at an appropriate pace and have adequate financing to boost confidence as market perceptions adjust (such as through the European Financial Stability Facility and the European Stability Mechanism). Markets eventually respond to better fundamentals with stronger growth and reduced deficits, but this can take a while.

If growth slows, countries should avoid further fiscal tightening. Countries with flexibility, such as some Eurozone members with lower interest rates, can slow the pace of deficit reduction. The projected 2% reduction in the U.S. deficit in 2012, the largest in forty years, is excessive. It is more important for countries, such as the United States, to formulate credible medium-term adjustment plans and gradually reduce the deficit. The adoption of credible medium-term adjustment plans, which is missing in many advanced countries, would reduce uncertainty. The cost of policy uncertainty is high, especially if growth starts to slow.

Can we learn anything for risk management?

For more on this follow the link: www.voxeu.org/index.php?q=node/7604

Friday, February 10, 2012

As Downside Risks Rise, Fiscal Policy Has To Walk a Narrow Path

by Don Alexander, MBA

Assocate, RSD Solutions Inc.

The IMF noted in its latest Fiscal Monitor (24^th Jan.) that countries continue to make progress on deficit reduction.

Fiscal deficits in many advanced economies fell significantly during 2011, and most plan substantial adjustment this year. The pace of fiscal consolidation may slow as too rapid consolidation could exacerbate risks. Continued adjustment is necessary for medium-term debt sustainability, but should ideally occur at a pace that supports adequate growth in output and employment. Conversely, too rapid a consolidation in a slowing growth scenario could exacerbate risks.

Given the large adjustment already in train this year, governments should avoid responding to any unexpected downturn in growth by further tightening policies, and should instead allow the automatic stabilizers to operate, as long as financing is available and sustainability concerns permit. When economic conditions deteriorate they can cushion the impact on demand.

Countries with enough fiscal space (the room in a government's budget that allows it to provide resources for a desired purpose without damaging the sustainability of its financial position or the stability of the economy), including some in the euro area, should reconsider the pace of near-term adjustment. At the same time, some countries—notably, the United States and Japan—need to clarify their medium-term debt-reduction strategies. Adjustment should be supported by the availability of adequate nonmarket financing when, as in the euro area, market confidence is slow to respond to reforms.

Some emerging economies with low debt and deficits and declining inflationary pressure have room to make policy more supportive of economic activity. Others have little space for more than the operation of automatic stabilizers if growth slows. Emerging economies highly dependent on commodity revenues and external capital inflows also need to consider the risk of a large and protracted decline in these flows.

Corporations, like governments, should have contingency plans for meeting funding requirements as part of their risk management plans.

For more on this follow the link: www.imf.org/external/pubs/ft/fm/2012/update/01/pdf/0112.pdf

Tuesday, February 7, 2012

Untitled

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The increased strains from the euro area debt crisis continue to weigh on global economic prospects and caused the IMF to sharply cut its forecast for global growth this year, have dimmed prospects and financial stability risks have increased noted in the latest market update (IMF Global Market Stability Report “GMSR” Market Update, Jan. 2012).

Since the last GMSR, the risks for stability have increased, despite various policy steps to contain the euro area debt crisis and banking crisis. European policymakers have outlined significant policy measures to address the medium-term issues contributing to the crisis, and some of these have helped improve market sentiment, but sovereign financing remains challenging and downside risks remain.

If funding challenges result in a round of de-leveraging by banks, this could ignite an adverse feedback loop to euro area economies. The US and other advanced countries have homegrown challenges in the removal of financial tail risks, including overcoming obstacles to achieving an appropriate pace of fiscal consolidation. Developments in the euro area also threaten emerging Europe and may spillover elsewhere.

Further policy actions are needed to restore market confidence. This effort will require building larger backstops for sovereign financing, assuring adequate bank funding and capital, and maintaining a sufficient flow of credit to the economy possibly establishing a “gatekeeper” charged with prevent a disorderly bank deleveraging.

Emerging markets, outside of Europe, and Asian countries are exposed to downside risks as weaker macroeconomic prospects make them vulnerable to spillovers from the European debt crisis. Authorities in advanced countries will need to address banking issues, make necessary adjustments without a large impact on growth prospects. Policymakers in other areas may need to address issues relating to funding and credit strains, especially if global growth continues to stall

For more information on this follow the link: www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm

Tuesday, January 31, 2012

Global Recovery Stalls, Downside Risks Intensify

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated. This was noted in the IMF’s latest semi-annual update World Economic Outlook (WEO) released on January 24^th.

Global output is projected to expand by 3¼ percent in 2012—a downward revision of about ¾ percentage from the September 2011 WEO. The euro area crisis entered a perilous new phase as the sovereign debt crisis has evolved into a banking crisis. As a result, the euro area economy is now expected to go into a mild recession in 2012 as a result of the rise in sovereign yields, the effects of bank deleveraging on the real economy, and the impact of additional fiscal consolidation.

Growth in other advanced economies remains mixed, the US, Canada and Australia are seeing some internal dynamics that may offset the spillover effects from Europe. While the recovery for Japan and the UK will be more modest. For major advanced economies, the key policy requirements are to address medium-term fiscal imbalances and to repair and reform financial systems, while sustaining the recovery.

Growth in emerging and developing economies is also expected to slow because of the worsening external environment and a weakening of internal demand. Despite a modest downward revision to growth (including China), these countries are still expected to see steady growth in 2012. A number of these countries are expected to benefit from firm commodity prices.

The most immediate policy challenge is to restore confidence and put an end to the crisis in the euro area by supporting growth, while sustaining adjustment, containing deleveraging, and providing more liquidity and monetary accommodation. In emerging and developing economies, near-term policy should focus on responding to moderating domestic growth and to slowing external demand from advanced economies.

For further information on this, follow the link: www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm

Wednesday, January 18, 2012

Systemic Risks in the Shadow Banking System

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The role of alternative investments in the financial intermediation process has moved into the background as Basel III, Dodd-Frank and other proposed reforms are thought to solve all problems. However, these reforms do not address all the issues, in particular the role of asset managers in the intermediation process and the role of derivatives. Zoltan Pozsar & Manmohan Singh, two IMF economists, in The Nonbank-Bank Nexus and the Shadow Banking System (IMF Working Paper WP/11/289, December 2011) look at the role of asset managers.

The current view of financial regulation does not incorporate the rise of asset managers as a source of funding through the shadow banking system. Asset managers are sources of demand for non-M2 types of money and serve as source collateral “mines” for the shadow banking system. Banks receive funding through the re-use of pledged collateral “mined” from asset managers. This has allowed asset managers to replace traditional creditors, primarily household retail deposits, as a key funding source to the banking system.

In this process, asset managers, normally long-term investors, transform the maturity of the long-term assets into short-term liabilities (similar to bank retail deposits). This follows the tendency to use these short-term liabilities to boost returns. Asset managers receive cash collateral in return for the securities they loan. It’s a gain for both parties since the cash they receive helps them to manage their funds liquidity needs (however they act like wholesale funds).

Using this methodology, the US shadow banking system reached $25 trillion in 2007 and declined to $18 trillion in 2010, higher than earlier estimates. The authors suggest regulators incorporate the re-use of pledged collateral when defining prudent bank liquidity and leverage position ratios.

The lack of sufficient disclosure will become apparent during a period of a collateral crunch to the financial system (lack of acceptable collateral). This will lead to greater funding stresses during a credit squeeze. According to the authors, there was approximately US$ 5.8 trillion in off-balance sheet items of banks used for collateral mining and collateral re-use. This is down from nearly US$ 10 trillion at the end of 2007. The size of the number should be of concern, especially with events in Europe.

Monitoring the shadow banking system will warrant closer attention beyond current regulatory parameters. Regulatory reform is focused on fortifying the equity base of the banking system and limit leverage through caps and capital adequacy requirements. Pozsar and Singh note that the present framework of financial intermediation and data collection does not fully incorporate asset managers as funding sources for banks through the shadow banking system. Non-bank sources of funding are thought to be sticky like retail deposits. They note a number of weaknesses in current data availability: a broader definition of bank leverage, a breakdown of non-bank funding sources and a closer look at dealer’s ability to borrow and re-pledge collateral from various sources.

They suggest an improvement in the current regulatory framework by increasing incentives for banks to move away from wholesale short-term funds into retail deposits and term funds. Otherwise, the shadow banking system will fill the role, especially for riskier activities. Other changes they suggest incorporating the unregulated shadow banking system more into Basel III and Dodd-Frank. Lastly, making changes in the flow of funds data to incorporate derivatives, off-balance sheet transactions and breaking down short-term funding sources for better monitoring. The use of off-balance sheet sources of funding should be included in risk management monitoring.

For more on this follow the link: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf

Friday, October 7, 2011

IMF Fiscal Monitor – Progress on Deficit Reduction

by Don Alexander, MBA

Associate, RSD Solutions Inc.

According to a recent IMF report, governments are making progress in addressing fiscal policy issues, but downside risks remain elevated as 2011 growth prospects are reduced. The rising public debt levels in advanced countries are projected to top 100 percent of GDP in 2011. A large portion of the increase came since 2007 from a drop in GDP, lower revenues and elevated spending damaging government balance sheets.

Overall, fiscal adjustment in advanced countries has declined by over 2% of GDP since 2010. The improvement in most cases was at or better than expectations. Progress in fiscal adjustment is better than expected.

For Europe, the challenge is to sustain fiscal consolidation while minimizing the growth fallout. Europe needs to focus on crisis resolution mechanisms to help resolve the solvency issues and limit contagion. Overall, the deficits in the euro area are expected to decline by 2% of GDP this year and 1% next year. The speed and severity of the spread of financial pressures in the euro should serve as a lesson for the United States and Japan.

In the United States, a focus is needed on entitlement and tax reforms as well as measures needed to raise revenues and broaden the tax base. The U.S. deficit is projected to decline by 1% of GDP to 9.6% for 2011. For Japan, disaster relief and reconstruction are short-term objectives, but more detailed medium-term planning is needed to focus on reducing the debt and budget deficit ratio and raising tax revenues through reforms.

Emerging markets emerged from the crisis in relatively good shape, with continued progress expected on deficit reduction. A few countries could be vulnerable to shift in capital inflows. Low-income countries survived based on buffers built-up in good times, but need to address social spending and their vulnerability to rising food and commodity prices.

However, despite the IMF’s relative slightly optimistic view markets remain concerned about growth prospects. The IMF noted two risks in the outlook: that public sector insolvency and/or that excessive fiscal tightening are not sources of instability. The optimal policy is to reduce the deficit in a timely manner without severely impacting growth.

For more on this click on the link to the IMF site: www.imf.org/external/pubs/ft/fm/2011/02/fmindex.htm

Thursday, September 29, 2011

IMF World Economic Outlook September 2011

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global economy has entered a dangerous new phase as the signs of an emerging recovery on 2010 have given way to a decline in confidence and the emergence of downside risk. A number of shocks have hit the international economy from which it has not fully recovered: including the earthquake in Japan, political unrest in Arab countries, the fallout from political gridlock in Washington over deficit reduction and the unresolved sovereign debt crisis in Europe. The structural problems facing crisis-hit advanced countries have proven more intractable than expected, but emerging markets have been the bright spot despite concerns about vulnerability to shocks.

The IMF World Economic Outlook (WEO) projections indicate that global growth will fall to 4% in 2011 from 5% in 2010. In the advanced countries, growth is expected to be an anemic 1 ½% in 2011 from 2% last year. This assumes that European policymakers can contain the sovereign debt crisis and US policymakers can reach a compromise on fiscal consolidation. Emerging market should be able to maintain a solid pace of 6%. The advanced countries will be paced by the US at 1.8%, Europe at 1.1% and Japan at 2.3% for 2012. While China and India will pace emerging market countries at 9% and 7.5%, respectively.

The report noted two lingering risks that could have severe negative consequences for global growth. The first is the debt crisis in Europe spirals out of policymakers control and spills over into the global economy. The US might be vulnerable if political gridlock remains over fiscal consolidation and the housing market remains in the doldrums from underwater mortgages.

The report noted that further progress was needed structural reforms for the global economy could return to a more stable growth trajectory. First, private demand must take over from public demand. On this issue, many countries have made progress, but the advanced countries have been the laggards. Second, economies with large external surpluses must shift to reliance on domestic demand, while those with large deficits must do the opposite. All countries must do more to advance rebalancing and to hedge against potential downside risks.

The optimism that greeted a rebound in the global economy in 2010 has given way to caution in 2011 as downside risks emerged. The lack of prompt action by policymakers to address key issues could lead to another year of anemic economic prospects.

For more on the IMF’s views follow the link: www.imf.org/external/pubs/ft/survey/so/2011/RES092011A.htm

Sunday, September 25, 2011

IMF Global Financial Stability Report – Grappling with Crisis Legacies

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The latest Global Financial Stability Report (GFSR) from the IMF noted financial stability risks have increased for the first time since early 2008. The weaker growth prospects have had an adverse impact on private and public balance sheets that are coping with heavy debt burdens. The financial system has been buffeted by market turbulence emanating from peripheral Europe, a U.S. credit downgrade with political gridlock and an adverse feedback loop between the banking system and the real economy. The IMF estimates that the need to recapitalize European banks and insurance could eventually be as high as euro 350 billion (US$400-500 billion). The continued political gridlock in Washington is already damaging financial market prospects.

Low policy rates are required under current conditions, but carry long-term threats to financial stability. Some sectors of the advanced economies remain in repair-and-recovery phase of the credit cycle as balance sheet repair remains incomplete, while the search for yield is pushing some segments to become more leveraged and vulnerable. Low rates are pushing credit creation into non-traditional sources such as the shadow banking system.

Emerging markets provide a better story as they are in a more advanced phase of the credit cycle, but could be vulnerable to contagion, especially from advanced countries. The combination of low rates and capital inflows leave emerging markets vulnerable to a gradual buildup of financial imbalances and potential fallout from a sharp reversal of financial flows.

The GFSR notes that risks are elevated and time is running out to tackle vulnerabilities that could affect the financial system and fragile recovery. The IMF offered four areas for policy action: (1) reduce sovereign risk in advanced countries and prevent contagion; (2) strengthen the resilience of financial system and contain against excesses; (3) in emerging market policymakers need to guard against overheating and a buildup of financial imbalances through the use of prudent macroeconomic and financial policies; and (4) the completion of financial reform agenda implemented internationally in a consistent manner.

For more on the IMF’s views click on the link: http://tinyurl.com/62hwbgn

Wednesday, September 21, 2011

Understanding Risk: IMF Treating the Symptoms and not the Cause

by Don Alexander, MBA

Associate, RSD Solutions Inc.

A recent paper “The Eurozone debt crisis: Is this a banking problem? (VOXEU, Jordi Gual, September 13^th”) provides a valuable lesson for risk management. In this case, it is the focus on the consequences and not the cause of risk.

The IMF recently suggested that recapitalization of Europe’s banks as the most prudent way out of the continent’s economic crisis. Gual argues that such thinking is based on a flawed analysis and at best it serves as a distraction to policymakers. The primary problem facing Europe is a sovereign debt crisis.

The call for a recapitalization of the banking system is a distraction and if the sovereign debt crisis was resolved, the banks would not be in trouble. According to the Institute of International Finance (IIF), European banks raised $414 billion in new capital since 2008 compared to their American counterparts which raised $314 billion in the same period. The perception problem is that European banks hold more of their assets in public debt than their American counterparts.

One by product of the euro is the pricing of most private and public sector debt at eurozone reference rates. This has resulted in a mispricing of eurozone risk, poor investment choices and a misallocation of capital. The current proposal of bank recapitalization arises from the potential losses from mark-to-market of government debt. The idea is that investors should suffer from the poor investment decisions made by the banks despite having a potential economic cost (credit availability).

The real problem is that Europe has built a monetary union with an inherent flaw – the absence of a sovereign safety net, since the debts are accumulated by member states have been incurred in a currency that none control. This is the issue, and not bank recapitalization.

Have you correctly identified your source of risk?

For more on this follow the link: http://www.voxeu.org/index.php?q=node/6970

Tuesday, July 12, 2011

The Risk of Contagion in Europe – Evidence from Credit Default Swap Spreads

by Don Alexander, MBA

Associate, RSD Solutions Inc.