CRO Spock

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

How would a hyper rational Spock do as a risk manager?  “That’s a very human thing to do Captain Kirk.  Most irrational!”  Face it, Spock would bomb as a CRO.  Humans are humans, and Spock was … (actually – I don’t know, most of my Spock knowledge comes from watching Big Bang Theory).  The point is that organizations are made up of humans, and industries are made up of humans, and economies are made up of humans.  Why do we assume everyone is hyper rational like Spock and design regulations and risk management systems as if they are.

ArtScience Museum

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Many of you might think that I have a typo in my title.  I do not.  On my recent trip to Singapore where I delivered a three day seminar for Asia Bankers on Derivatives, I had the opportunity to drop into the ArtScience Museum at the Marina Bay Sands Singapore.  http://www.marinabaysands.com/singapore-museum/ 

 

The main reason I went to the Museum was to see the Andy Warhol exhibit, which was fantastic, with one of the best museum commentaries I have listened to in quite a while.  The building in which the ArtScience Museum is housed is really fantastic – a striking piece of architecture, and if you take the time to examine it from the inside you discover it is an even more fascinating structure.

 

However what caught my attention and got me thinking was the name of the institute – which is more fully explained if you visit the third floor.  The ArtScience in the name of the museum is intentional.  In a plaque leading up to the third floor exhibits on creativity you read “ArtScience: A Journey Through Creativity opens a dialog about art, science and the symbiotic relationship between them”

 

As risk managers, we also need to open up a dialogue between the art and science of our field, and recognize the symbiotic relationship between them.

The Other Coast

 

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Those who know me know that I never lost my childhood love of comic strips.  I was never into the action comics like many of my friends, but the “funnies” were always, and still are, my favorite part of the paper.  I also have quite an extensive collection of comic book treasuries and collections.

 

One of the strips I like is The Other Coast by Adrian Raeside.  It is one of those comics that take a gentle swipe at our too politically correct lives and the built in stupidity that it sometimes involves. Today’s (July 23) strip takes a swipe at both risk managers and regulators.  Hopefully we all see the humour, as well as the lesson in it. 

 

Keep up the good work Adrian.

 

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