New Setbacks – Risks to the Global Recovery

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

The Curse of Advanced Economies in Resolving Banking Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Do advanced economies have an edge in resolving financial crises? Two authors from the IMF, Luc Laevan and Fabian Valencia in recent VOXEU column, suggest that the record supports the opposite view, with the average crisis lasting about twice as long as in developing and emerging market economies. It argues that macroeconomic stabilization policies in advanced countries often delay the necessary financial restructuring.  This has important implications for risk management since the conventional wisdom is that advanced countries resolve banking crises faster.

 

Countries resort to a policy mix to contain and resolve banking crises, ranging from macroeconomic stabilization to financial sector restructuring and institutional reforms. However, despite many commonalities in the origins of crises these strategies have met with mixed success.  Successful crisis resolutions have been characterized by transparency and resoluteness in terms of resolving insolvent institutions.

 

Sweden’s policy experience during its banking crisis in the early 1990’s is seen as an example successful crisis resolution. The government moved swiftly to liquidate failing banks, recapitalize viable institutions, and remove bad assets from the system, thereby, avoiding a period of prolonged stagnation.  Yet the experience of Japan produced the opposite result.  Authorities, instead of acknowledging the true extent of losses at troubled banks, allowed insolvent institutions to continue to operate as “zombie” banks, evergreening bad credits, and using one-off gimmicks to bolster regulatory capital positions. The reluctance of these banks to resolve bad assets contributed to the Japanese lost decade.

 

Advanced economies with their stronger macroeconomic frameworks and institutional setting would have an edge in crisis resolution, the record supports the opposite:  the average crisis in advanced countries lasts twice as long.

 

The authors suggest that the greater reliance on macroeconomic policies as crisis management tools may delay financial restructuring, with the risk of prolonging the crisis.  Macroeconomic prevent a disorderly deleveraging and gives way for balance sheet repair, buying time to address solvency problems. However, by masking balance sheet problems of financial institutions, they may also reduce incentives for financial restructuring, with the risk of dampening growth and prolonging the crisis.

 

The crisis response by advanced economies, have initially relied on monetary and fiscal policy. However, these countries now use a broader range of policy measures compared to past crisis episodes, including unconventional monetary policy measures, asset purchases and guarantees, and significant fiscal stimulus packages, in part reflecting the better macroeconomic and institutional setting of the countries involved. These policies were combined with substantial government guarantees on non-deposit bank liabilities and ample liquidity support for banks, often at concessional penalty rates and at reduced collateral requirements.  

 

Taken together, these actions have mitigated the financial turmoil and contained the crisis. But it means that the bulk of the cost of this crisis has simply been transferred to the future, in the form of higher public debt and possibly a dampened economic recovery due to residual uncertainty about the health of banks and continued high private sector indebtedness. While monetary policy has avoided an even sharper contraction in economic activity, it has also discouraged more active bank restructuring. The lingering bad assets and uncertainty about the health of financial institutions risk prolonging the crisis and depressing growth for a prolonged period of time. Macroeconomic stabilization policies should supplement and support not displace financial restructuring.

 

What are the implications for risk management?

 

For more on this, please follow the link: http://www.voxeu.org/article/curse-advanced-economies-resolving-banking-crises

The (Other) Deleveraging and Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

One major role of the financial system is efficient credit allocation.  Changes happening in the modern credit creation process—referred to as “other deleveraging,” in the case of the ECB’s moves to expand the collateral it will accept—risk weakening the fabric of the market in ways that are not yet fully evident.  It is this issue that is relevant for risk management. 

 

This is discussed by Mammohan Singh & Peter Stella in a recent VOXEU communique The (Other) Deleveraging: What Economists Need to Know About the Modern Money Creation Process  dated July 2^nd.  A more detailed report is available in an IMF working paper. 

 

Traditional money creation is performed by banks (agents) taking deposits and transforming the maturity structure.  This credit creation is regulated by the central bank through reserve requirements.  The “money multiplier” depends upon inter-bank trust and when this is altered can create potential problems. 

 

A second type of credit creation has developed through the use of collateral in the shadow banking system.  In this process, hedge funds and custodians often use pledged assets similar to the lending-deposit-relending process used by the traditional banking system.  This process creates another deleveraging process in which the credit creation process is controlled by three methods: (1) the size of the haircut (or reserves held against re-pledged assets); (2) the supply of assets used for re-pledging; and (3) reducing the re-pledging of pledged collateral (supply chain).

 

The authors note concerns about the second and (more importantly) the third way. When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks.  With fewer counterparties and elevated counterparty risk, can lead to decreased market liquidity, idle collateral, missed trades and deleveraging.

 

Concerns about asset quality have reduced credit quality and the ratio of pledged collateral (credit creation) to underlying assets has shrunk the interconnectedness of the banking system.  This may be viewed positively from a financial stability perspective if one views each institution in isolation, but weakens the market’s overall structure.  However, the vulnerabilities that have resulted from the weakened fabric of the market are not fully evident.    

 

As the ‘other’ deleveraging continues, the financial system remains short of high-grade collateral that can be re-pledged.  The ECB’s attempt to accept ‘bad’ collateral has distorted the good/bad collateral ratio.  If this policy becomes part of central bankers’ standard toolkit, the fiscal aspects and risks associated cannot be ignored.  The central banks have interposed themselves as risk-taking intermediaries with the potential to bring significant and negative unintended consequences.

 

It is the understanding of the unintended consequences that is important for risk management.

 

For more on this, follow the link:  www.voxeu.org/article/other-deleveraging-what-economists

Policy or Judgment?

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Policy or judgment is a theme that I come back to again and again when I work with companies and their risk management departments on developing and implementing risk strategies.  In this age of regulation, the stress is increasingly becoming that of developing a strong airtight policy and then following that policy to the letter.  Judgment is better left solely for deciding on your sense of fashion.

 

My philosophy is that you need both.  You do not want people and groups in an organization making up decisions ad hoc in the moment – particularly when it relates to risk issues that could have major implications.  Conversely it has to be recognized that no risk policy is airtight and fool-proof.  Something is inevitably going to come up that knocks it for a loop.

 

Policy or judgment came up in the news today.  You likely heard the story about the lifeguard who was fired for saving a life.  The problem is that the life saved was that of someone who was swimming outside of the zone that the lifeguard was responsible for.  Policy was that lifeguards should only concern themselves with swimmers in their zone.  Since the lifeguard went out of his zone he was fired.  The company stated that the firing was for insurance reasons (good job on passing the buck on responsibility there!).

 

You can argue this many ways.  While the lifeguard was busy saving someone outside of the designated zone, a swimmer could have run into distress while swimming in the proper zone.  Other arguments can be made as well.  The point is that the lifeguard made a judgment call over policy.  Personally I believe it was the right call.  Imagine being a lifeguard and having someone drown within your sight, and within your ability to help them and you did nothing because of policy.  How would that feel for the rest of your life?

 

Does your company allow for exceptions of judgment, or would your company do the equivalent of letting the person drown?  What would you do if an analogous situation occurred at your company?  How would you or your colleagues deal with the authority figures at your company and the authorized policy?  What would Stanley Milgram think? 

 

For more on this, follow the link:  http://en.wikipedia.org/wiki/Milgram_experiment  

Japanese Culture

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

I just got back from a short trip to Tokyo.  I enjoyed my brief visit to the city and look forward to returning.  Interestingly enough the report on the Fukushima nuclear crisis was released a few days after my return.  The headline for my local paper read “Culture to Blame” as the lead in to the article.

 

There are many causes and catalysts for what happened at the Fukushima nuclear power plant.  There always are a plethora of issues when a major accident like that happens.  However it should never be news or a surprise when culture plays a role.  Culture almost always plays a significant role in risk management, for better or for worse.

Fiscal Sustainability and Systemic Risk

by Don Alexander , MBA

Associate, RSS Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Fiscal positions in many economies were on an unsustainable path before the financial crisis. The crisis led to a further deterioration in fiscal sustainability by increasing fiscal deficits and debt.  As a result, financial markets and credit rating agencies took a more critical view of sovereign credit risk. Government debt and deficits that had been tolerated before the crisis were no longer considered sustainable.  The BIS looks at some of these issues and potential risks in their 82^nd Annual Report in a chapter called Restoring Fiscal Sustainability.

 

Sovereigns under fiscal pressure have been losing their risk-free status, as reflected in sovereign credit default swaps (CDS) spreads and credit rating downgrades. The broad availability of safe assets aids the operation of financial markets and the conduct of monetary policy. And a sovereign whose debt is essentially free of credit risk has ample room to implement countercyclical policies to support macroeconomic stability

 

This has generated concerns sovereigns losing their risk-free status or, more specifically, about their liabilities becoming subject to non-negligible credit risk. To be sure, even from this narrow perspective, full risk-free status is an ideal goal rather than a realistic objective. Indeed, the worst possible outcome is treating an asset as risk-free when, in fact, it is not.  The existence of such assets contributes to the smooth and efficient functioning of the financial system.

 

Restoring the supply of risk-free assets requires that governments convincingly address high deficits as well as projected increases in their long-term liabilities. Governments will have to significantly improve their fiscal balances to put their finances on a sustainable path and restore confidence in their fiscal positions. Fiscal consolidation has started in anumber of economies, but more needs to be done.  Nevertheless, many of the countries that implemented deficit reduction measures were not able to meet their headline deficit-to-GDP targets. 

 

Financial markets can both help and hinder the return to fiscal sustainability. On the one hand, market discipline can provide incentives for fiscal consolidation. On the other, financial markets can remain complacent about fiscal problems for too long and react too late. Policymakers should therefore not wait for market signals to emerge in order to engage in fiscal consolidation.

 

Governments should implement pension and health care reforms now while reducing the long-term contingent liabilities to bolster confidence in the long-term sustainability of public finances.  Countries must implement reforms and delaying fiscal consolidation could weaken confidence, leading to higher borrowing costs.  Policy recommendations differ as to the best timing of fiscal consolidation.  It is important for policymakers to manage the expectations of investors and financial markets by encouraging them to look beyond the very short term. This means communicating clearly about the likely impact of planned fiscal consolidation measures at various horizons. Structural policies, including product and labor market reform, are especially important. They can facilitate the reallocation of resources, support competitiveness and boost productivity growth.

 

Longer-term, policymakers need to take measures to break the link between the banking sector and sovereign risk. One step is encouraging banks to build capital and liquidity buffers – a priority of the regulatory reforms under way – which would reduce the probability those governments would have to bail them out again.  Fiscal positions were already unsustainable before the financial crisis, which in turn led to significant further weakening. The deterioration of public finances has undermined financial stability, lowered the credibility of fiscal and monetary policy, impaired the functioning of financial markets, and increased private sector borrowing costs. Restoring sustainable fiscal positions will require implementing effective fiscal consolidation, promoting long-term growth, and breaking the adverse feedback loop between bank and sovereign risk.  Otherwise, risk managers will remain busy managing exposures.

 

For more on this follow the link: www.bis.org/publ/arpdf/ar2012e5.htm

Limits to Monetary Policy under Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The major advanced economies are maintaining extraordinarily accommodative monetary conditions, through low policy rates and the continued expansion of their balance sheets through new rounds of unconventional policy measures.  These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies (EMEs) in the form of undesirable exchange rate and capital flow volatility. As a consequence of EME efforts to manage these spillovers, the stance of monetary policy is highly accommodative globally.  The limits to monetary policy, in the current environment, are addressed in the latest 2011 BIS Annual Report.

 

There is widespread agreement that, during the crisis, decisive central bank action was essential to prevent a financial meltdown and that in the aftermath it has been supporting faltering economies. Central banks have had little choice but to maintain monetary ease because governments have failed to quickly and comprehensively address structural impediments to growth.

 

However, there are limits to what monetary policy can do; such as provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks with conflicting objectives, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally as actual achievements fall short of expectations.

 

The global monetary policy stance taken by central banks is unusually accommodative. Policy rates are well below benchmark measures while central bank balance sheets continue to expand.  Against the background of weak growth and high unemployment, sustained monetary easing is natural and compelling.  However, there is a growing risk that monetary policy, by itself, cannot solve all issues such as solvency or deeper structural problems. It can buy time, but conversely may delay the return to a self-sustaining recovery. Central banks need to recognize and communicate the limits of monetary policy, making clear that it may not address the root causes of financial fragility and economic weakness.

 

The combination of weak growth and low rates, and efforts to manage the spillovers in emerging market economies, has helped to spread monetary accommodation globally.  This has resulted in a build-up of financial imbalances and increasing inflationary expectations could have negative repercussions on the global economy. Central banks need to account for global spillovers from domestic monetary policies on financial and price stability.

 

Finally, central banks need to beware of longer-term risks to their credibility and operational independence. There can be a gap between expectations and the actual results delivered by monetary policy. This could complicate the eventual exit from monetary accommodation and threaten central banks’ credibility and operational autonomy. It is reinforced by political economy risks arising from the combination of balance sheet policies that have blurred the line between monetary and fiscal policies, on the one hand, and the risk of unsustainable fiscal positions, on the other.

 

The lesson for risk management is that monetary policy will not solve all the problems and some hard decisions are required.

 

For more on this, follow the link:  www.bis.org/publ/arpdf/ar2012e4.htm