Welcome to the ECB & Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The current ECB President, Mario Draghi has said in his latest statements that the ECB is now determined to act as lender in last resort to governments by offering the services of the ECB’s unbounded purse.  In effect, the ECB head is willing to backstop public debts to restore the effectiveness of monetary policy as the markets continue to test its’ resolve.  This could indeed bring the euro zone close to the end of the crisis.  This is part of a recent discussion by Charles Wyplosz in Welcome to the ECB (VOXEU, 30^th July).

 

By stating that preservation of the euro is an ECB obligation, he indicated that he will have no choice but “to do whatever it takes”.  This means optimism may be justified – if only because it suggests that the Eurozone has a great central banker who is both a serious economist and an astute politician.  Draghi made an implicit commitment to act as lender of last resort to Eurozone governments. 

Draghi has political cover: every single summit since 2010 has repeated – and this quite formally and explicitly – that Eurozone leaders are ready to do whatever it takes to preserve the euro.  The time to deliver is coming.  This will be a gigantic political challenge for Merkel, but in many cases she has already changed her position in front of pressing danger to the euro zone.

 

On 11 December 2011, Mr. Draghi said:  “What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.” A fiscal compact was initiated and the Treaty on Stability, Coordination and Governance in the EMU, is now under ratification. The ECB delivered starting its massive liquidity support for Eurozone banks – the LTRO (Long Term Refinancing Operation).

 

Secondly, On 31 May 2012, Mr. Draghi famously called for a banking union, pointedly noting:  "We can have a big pot of money, but if people can't touch it, it's like we don't have it."  Although the term is vague and therefore open to much watering down, the prospect of a single European bank supervisor, a long-rejected yet indispensable element of a monetary union, is now on track.

 

The latest statement signals that the ECB is now determined to act as lender in last resort to governments.  The Draghi method is becoming clear: offer the services of the ECB’s unbounded purse, but require what it takes to alleviate the moral hazard that it entails.  Put differently, Draghi is willing to backstop public debts to restore the effectiveness of monetary policy. This would indeed bring us close to the end of the crisis.  The question is can he deliver.

 

Optimism may become justified now, if indeed the ECB is in the hands of serious economists and astute politicians.  But then, Wyplosz worries that there always is a risk of reading too much in a central banker’s unavoidably cryptic statements.

 

The lesson for risk management is not just the discussion, but what is actually delivered.

For more on this follow the link: http://www.voxeu.org/article/welcome-to-the-ecb

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

Risks to Continued Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

French and Greek voters are rejecting austerity, forcing politicians to take the austerity debate seriously.  Voters are correct in that it is a bad idea to tighten fiscal policy when growth is so feeble as argued by Charles Wyplosz in recent VOXEU communique (14th May) The impossible hope to an end of austerity.  However, the road away from austerity is blocked by conventional policy views that debt reduction has the highest priority – often used to justify risk taking without considering potential implications.  

 

Evidence from Greece and elsewhere is that growth is disappointing and the debt-to-GDP decline is negative and deficits are “surprisingly resistant”.  The problem is that most policies take time to work, such as structural reforms that may take several years and do not provide prompt relief. 

 

It is a poor idea to tighten fiscal policy when growth is feeble or negative.  The results from budget consolidation are disappointing as the levels of gross public debt remain above earlier estimates and in some countries have increased.  European voters do not feel that the economic and personal costs have produced any significant results.  The case for fiscal consolidation remains weak when countercyclical action is required.  

 

Monetary policy has some importance as lower rates are needed, but with rates near zero any effect would be largely symbolic.  The results from quantitative easing have yet to prove its effectiveness as banks’ focus is on deleveraging.  The recent ECB liquidity facility seems largely used by banks to hoard cash rather than make new loans.  

 

Fiscal expansion remain a weak option as a number of countries have lost market access or on the verge of losing it.  Financial markets continue to clamor for growth and no austerity, but do not want to provide financing at attractive rates for growth.  Even if countries can borrow at attractive rates, can they serve as a locomotive role for growth?   

 

Wyplosz offers several ideas around the policy debate to provide some stimulus: 1) The European Investment Bank (EIB) could borrow and finance spending without adding to the members’ public debt burden; 2) The European Commission could speed up spending on infrastructure to produce some stimulus; 3) Eurobonds could be issued and collectively underwritten by member states; 4) The bonds could be made senior to existing bonds: and 5) The debt of some countries could be restructured.  The author concludes that all the policies combined would not be enough of a stimulus.  

 

The problem is holding governments to infeasible debt reductions for a couple of years that will take decades to resolve.  Otherwise, voters will continue the protest and the austerity debate will remain a “hot” political issue.  As in risk management, conventional wisdom does not always provide the best answer.   

 

For more on this follow the link: www.voxeu.org/index.php?q=node/7988

 

 

Risk in the G10 Foreign Exchange Markets

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The G10 foreign exchange market is likely to enter a more challenging environment as problems in Spain are starting to refocus investor attention on the underlying structural problems in Europe and continued deterioration of the financial condition of European banks.  The ECB has not given any indication of injecting further liquidity into the banking system if the situation in Spain deteriorates and/or spreads to other countries.  Leading indicators in many advanced countries are starting to show weakness suggesting that growth for Q2 and Q3 could be lower than earlier estimates.  In this environment, investors and corporations may want to re-evaluate their foreign exchange exposure as the global economy enters a more risk-averse, slower growth environment. 

 

Meanwhile, policy-makers and central banks are becoming cautious about major policy changes.  The US deficit continues to overhang the Presidential election as major parties refuse to compromise over spending cuts and tax reform.  A potential showdown on raising the debt ceiling could provide temporary market uncertainty.  In Europe, a number of countries are reconsidering fiscal austerity as the economic costs could cause a shift in the political landscape.

 

Elsewhere, central banks remain cautious about providing further liquidity over concerns about central bank balance sheet size and asset quality. The ECB has not provided any indication of adding further liquidity, but may be forced to if Spanish banks have further problems.  While central banks in Japan and Australia are active in adding liquidity, most G10 central banks are content to keep policy steady.

 

In an environment of slowing global growth indicators together with the reduced prospect of a monetary policy response could make the euro more vulnerable. Currently, any tightening of global liquidity conditions suggests a negative impact on the high-risk currencies, especially the euro.  The spotlight remains on the peripheral Europe, especially after Spain’s rating downgrade, the collapse of the government in the Netherlands and the shift in political sentiment in France.  Fiscal problems at the periphery of Europe could be quickly transmitted to core countries, also adding to political uncertainty.  In this environment of stagnating growth and ongoing structural problems could keep the euro under pressure well into 2013.

 

In Japan, the continued support from the central bank and some signs of a rebound in growth should provide a base of support for the yen.  The yen will have support from better economic prospects in Asia.  In contrast, weaker growth prospects in the UK may cause temporary sterling weakness.   Recent weaker UK data has taken some of the steam out sterling and could test the BoE’s willingness to hold policy steady.

 

In other major currencies, the Aussie could experience some weakness as the key support points of stronger growth and favorable terms-of-trade are showing signs of deterioration.  Already, the RBA has started to ease policy in expectation of further economic weakness.  In contrast, the hawkish stance by the BOC, favorable fundamentals and steady growth prospects should keep the loonie well-supported against major currencies.

 

If the global economy shifts towards a slower growth and more risk-averse environment, the euro could come under further downward pressure.  This may include some modest pressure on sterling and the Aussie dollar.  Have you examined your foreign currency exposure?

 

European Bank Funding and Deleveraging

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The BIS Quarterly Report, (N. Vause, G. von Peter, M. Drehmann and V. Sushko, March 2012) notes European banks have experienced a liquidity crisis as continued financial deleveraging is placing a fragile recovery at risk, but fail to address long-term solvency issues.

 

European banks experienced extreme pressure to deleverage in late 2011 as funding strains intensified, increasing pressure to sell assets and ration credit as economic activity was weaker. Capital adequacy issues surfaced due to bank sovereign debt exposure.  New regulatory measures requiring banks to meet more stringent capital standards by mid-2012 added to these fears. 

 

European banks did sell certain assets and cut some types of lending, notably those denominated in dollars and those attracting higher risk weights.  This led to government policymaker concerns that the reduced lending would impact real economic activity.  Other credit suppliers (asset managers, other financial institutions & bond investors) helped to mitigate the credit squeeze, so there was little evidence from the BIS of a major impact on lending volumes or asset prices.

 

European central banks introduced special policy measures in December, resulting in improved European banks' funding conditions.  Previously, many banks had been unable to raise funds in the unsecured senior bond market, and the cost of unsecured money market funding had risen to levels previously exceeded only during the 2008 crisis.  Dollar funding had become especially expensive.  Two three-year lending operations (LTRO) by the ECB and a wider set of collateral than was previously eligible relieved much of the stress.  Furthermore, the cost of swapping euros into dollars fell in December, as central banks reduced the costs of their international swap lines.  Short-term borrowing costs then declined and unsecured bond issuance revived.  The view is these measures should limit the impact on financial markets and economic activity. 

 

The measures adopted by the central banks helped to mitigate near-term funding and capital concerns, but the long-term solvency issues remain unresolved.  However, the impact of the central banks’ action remains uneven across the European Union.

 

The massive injections of liquidity by the ECB helped avoid a crisis, there is little evidence that this funding has trickled down to countries and households in the peripheral countries.  The result is the credit contraction in countries such as Portugal and Spain lead to more bankruptcies, even-higher unemployment and a deeper economic contraction that will limit any recovery.  This suggests that ECB actions may provide only temporary relief.

 

The lesson for risk management is that temporary, stop-gap measures are not the best long-term solution and may come at a price.

 

For more information on this follow the link: www.bis.org/press/p120312.htm

Untitled

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Charles Wyplosz in a recent communique discusses the shift in risk from various European countries to a “de facto” implied guarantee by the ECB  (The ECB’s Trillion Euro Bet, VOXEU, Feb. 13^th.).  The amounts could be staggering as the ECB is taking enormous risk.  Currently, the ECB is holding over euro 200 billion in sovereign bonds from recent intervention and will face nearly euro 1 trillion rollover of European sovereign debt in 2012.  

 

Eurozone sovereign spreads have recently declined with the exception of Greece.  Charles Wyplosz argues that a good part of the drop in spreads is due to the perception that the ECB is “de facto” acting as the guarantor for Eurozone government debts.  The ECB leadership suggests that the decline in sovereign spreads is the result of country reforms. 

 

There is a link between bond spread contraction and the ECB’s long-term refinancing operations (LTROs).  The LTRO bought euro zone leaders time to get their act together.  Fiscal deficits are slowly declining as the sovereign debt overhang persists, the EU banking system remains undercapitalized (current estimates of euro 100 – 200 billion), and a euro-wide recapitalization facility for banks is missing.  Analysts suggest one method for crisis resolution is through the explicit guarantee of government debt. 

 

Previously, ECB officials argued this was not their mandate; it created moral hazard, exposed the system to increased financial risk and reduced politician’s incentive to make the necessary cuts.  The new ECB regime made the LTRO available to commercial banks, but does not do enough to resolve the crisis such as providing a long-term growth strategy.  Greece and Portugal will be unable to grow with their existing debt burden and this may also be the case risk for Italy and other countries as contagion takes hold.  

 

LTROs could make things more dangerous, especially if banks use LTRO cash to acquire more sovereign bonds.  Banks could borrow money from the ECB at very low rates (about 1%) and buy bonds whose yields are much higher.  A wave of sovereign default could turn these bonds into toxic assets and a trillion-euro problem.  The more the banks accumulate these bonds the riskier the situation becomes.  The problem is compounded by the fact that banks are regulated by national authorities and under pressure to increase their domestic bond holdings.

 

The ECB seems to be making a bet that the market is swayed by its recent action and provides a stable equilibrium.  Holding sovereign debt will be seen as safe and the ECB has saved the euro at a minimal cost.  However, the reversion to a stable equilibrium is not guaranteed.  Should markets conclude crucial policy actions are missing, the debt defaults will spread and Eurozone banks might fail imposing a massive cost to taxpayers and leading to further euro problems.

 

The ECB has bought time for authorities and has involved taking on enormous risks.  The lack action on long-term restructuring of the underlying euro treaty and the promotion of a long-term growth strategy could negate their action.

 

For more information on this follow the link:  http://www.voxeu.org/index.php?q=node/7617

 

Foreign Exchange Risk for 2012

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

As we enter 2012, the euro has emerged as the weakest currency against the US dollar among the major currencies.   Investors still continue to short the euro on expectations the currency move lower is not finished.  This view is based on the ECB facility is a stop-gap measure and does not resolve the solvency issues.  Investors note the following: the Greece refinancing led by the IMF is still not functioning as expected, the cost of Italian and Spanish debt still remains around 7%, European banks are having a difficult time raising new capital and real investors lack additional appetite for further euro risk exposure.

 

Global economic indicators have started to improve, especially in the US.  However, the demand for European risk assets remains weak as the focus remains on a potential recession and contagion impact to the global economy.  Previously in 2011, anytime the euro came under pressure it was often followed by a countertrend rally.  However, 2012 could be different as real non-European investors continue reducing their euro sovereign bond exposures.  The supply surge of sovereign debt, euro $1 - 1.2 trillion, coming to the market in 2012 and the rollover, euro 700-800 billion, of bank paper/new capital could cause digestion problems as global investors to reduce European exposure.

 

In 2011, the US dollar was used as the funding currency for risky assets.  Given the prospect of a European recession, will cause the ECB to further cut rates and keep them low for an extended period.  The poor reception of capital market issues of European banks suggests that further balance sheet contraction is needed to meet the higher capital ratios.  Banks continue to place funds with the ECB and not employing the central bank liquidity in the real economy.  Real yields have moved into negative territory as the ECB tries to promote an investor shift into riskier assets.  The problem is that the time lag between liquidity creation and a move into risky assets has a time lag.  However, the uncertain outlook suggests this delay may take an extended period of time.

 

The use of the euro as a funding currency rather than an asset currency, a prolonged period of low ECB rates, the prospect of a European recession and uncertainty from the overhang of sovereign/bank debt will push the euro lower.  There will be limited countercyclical euro rallies compared to 2011.  The euro downtrend should continue through the summer until either political gridlock in Washington grabs investor attention as the November election approaches and/or policymakers can provide a resolution for the sovereign debt/banking crisis in Europe.   

Happy 2012 – The Failure of Risk Management in Europe

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Rene Stulz in a 2008 paper, Risk Management Failures: What Are they and When Do They Happen, looked at risk management failures and how various types occur.  Stulz noted there are six types: mismeasurement of known risks, failure to take risks into account, failure to communicate the risks to top management, failure to monitor risks, failure in managing risks and failure to use appropriate risk metrics.  Can we apply these failures to the management of the Eurozone?

 

Charles Wyplosz in a communique, Happy 2012, (VOXEU, 3^rd January) looks at the problems of the Eurozone and proposes what issues can be addressed without the pain of a new EU treaty. The crisis continues to linger on despite the ECB liquidity facility.  Wyplosz asks why the crisis continues, discusses what can be done and offers a proposed solution. 

 

The persistence of the crisis is due to policy mistakes, the lack of fiscal discipline, ongoing imbalances and focus on moral hazard without specific solutions.  Political leaders do not understand the complexity of the financial crisis and propose only partial solutions without technical staff involved in the decision process.  Politicians cater to their national electorate and will any avoid unpopular decisions. 

 

The crisis is complicated because it combines financial turmoil with governance issues under challenging macroeconomic conditions. As result, the economics profession has not converged on a shared diagnosis contributing to policymaker confusion.  Government and bank bailouts raise a moral hazard issue not addressed in the current EU structure. 

 

Wyplosz outlines four conditions to be addressed for crisis resolution: governments that lose market access must be bailed out effectively (restructuring) and there are limits to moral hazard (investors may be exposed to a haircut), the ECB should lead the bailout since the amount maybe large and unknown, banks need to be recapitalized before a sovereign default and limiting moral hazard will require fiscal discipline. The current proposal for a new treaty and suspension of sovereignty to manage fiscal discipline is intrusive, takes too long and could cause economic stagnation. 

 

According to Wyplosz, the best alternative is work through the ECB, an independent entity.  The ECB can manage the amounts involved; they can determine their own collateral requirements and work with an independent board to monitor fiscal developments (details to be determined).  The cost continues to increase as it moves from a sovereign to a banking crisis.

 

If we look back at the six types of risk management failures, they are all present in the management of the Eurozone.  A few of the lessons we learned: sovereign debt is not a riskless asset, how do we monitor and control these risks, the lack of effective communication can increase crisis severity, the lack of an effective control system comes at a price, the interests of policymakers must be aligned with investors/electorate and professional management is required.  We can conclude that the events in the Eurozone reflect all six failures of risk management.     

 

For more on this follow the links:

For Rene Stulz http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1278073

And for Charles Wyplosz http://www.voxeu.org/index.php?q=node/7487

Step by Step Approach to Crisis Resolution

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSdsolutions.com

                                    

 

Politics is not the art of the possible.

It consists of choosing between

                                            The disastrous and the unpalatable 

                                                          (JKGalbraith)

Eurozone officials and politicians have adopted a mini step-by-step approach to crisis resolution.  This approach has back-fired as cost of crisis resolution has increased dramatically as the sovereign debt crisis is turning into a full blown banking crisis.  The European Central Bank (ECB) finally took a big step last week when they made nearly euro 500 billion in three-year low rate loans available to 500 banks across the region.  This comes ahead of a crucial time for policymakers as a large volume of sovereign and bank debt has to be refinanced in the first quarter of 2012.  The ECB has provided a near-term fix for the Eurozone crisis, but what has to be addressed longer-term?

 

Charles Goodhart & Dirk Schoenmaker in “The Political Endgame for the Euro Crisis” (VOXEU, Dec. 14^th) discuss some of these issues.  The euro crisis is deepening, as European leaders continue with their “too little too late” policy reforms.  Solving Eurozone problems requires a strong direction for fiscal and banking policy.  This in turn needs greater political integration through an elected president of the European Commission and a two-chamber parliament representing EU citizens and EU member states. 

 

The euro has a supranational monetary policy framework, while the fiscal side is still national or inter-governmental.  With political legitimacy, the President of the European Commission could: first, enforce budget discipline on participating members and restrict the impact of fiscal spending, and second oversee Eurozone banking supervision and resolution to foster banking system stability. 

 

One step is the establishment of a Eurozone Minister of Finance with power to enforce provisions of the Stability and Growth Pact on fiscal deficits.  A second step is a reform of the parliamentary side of the political union by establishing one chamber to address issues of the electorate and a second chamber to represent interests of the separate member countries.  This would allow a gradual transition of banking supervision and resolution from the national level toward a wider European scale.  The new Eurozone Finance Minister would need specific authority from the European Parliament to establish budgetary and banking powers and the European equivalent of the FDIC, SEC, etc. 

 

The resolution of the euro crisis needs both political reforms as well as a technocratic solution.  There are major issues that need to be addressed, but the min-step approach to financial crisis resolution or risk management has a cost – often a higher cost.

 

For more on this follow the link:

 www.voxeu.com/index.php?q=node/7420

 

 

Trouble in Paradise

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

                                                                  There’s trouble in paradise

                                                                  And Heaven’s not the same,

 

These are lyrics from a doo-wop song by the Crests that can be applied to risk management and stop-gap measures proposed by Eurozone officials to stabilize financial markets.  This can describe the Brussels deal last week that attempts to reformulate the underlying rules for the euro zone.  The problem is that the full details were not disclosed and already it is falling short of market expectations.

 

There are a number of unresolved issues from the meeting:  there are no details on how much money will be needed to protect the market from further speculative attacks and prevent contagion, how will the banks be recapitalized to cover losses on their sovereign debt holdings, there is limited information on what measures will be implemented to reduce the borrowing costs and does the cure proposed in Brussels actually work?

 

The amount of European debt that needs to rollover in the next 12-24 months is staggering compared to the amounts discussed for a temporary financing facility.  The outstanding sovereign debt of Italy is nearly $3 trillion that would dwarf any temporary financing facility being considered.  A rating down-grade could spark another speculative attack.

 

The recent stress tests for the European banks suggest a further need for $150 - $200 billion in new capital.  This does not take into account any further write-offs of existing debt.  In addition, the banks are often under intense pressure in their country of domicile to take on additional sovereign debt after poor auctions.   If the sovereign debt crisis moves into a full blown banking crisis, the speed of contagion will increase rapidly.

 

The borrowing costs of a number of countries have increased to near-record levels in recent auctions.  The issue of borrowings costs has not been adequately addressed and may not be reduced until financial markets are stabilized.  Details of how this is being implemented are lacking.

 

There have been a number of measures proposed to promote fiscal discipline, central oversight by Eurozone authorities and rules to discipline countries that break the debt limits.  The idea is that once these rules are in place, the ECB and Eurozone officials could do more to resolve the underlying problems.  However, this is rehashing old issues that were in the earlier treaty and raise issues about national sovereignty.  There is some doubt that all countries will accept the proposed changes.

 

There is another issue not addressed by authorities and that is the persistence of imbalances and the lack of economic growth.  A number of countries are experiencing problems from lack of growth and not budget management.  There is concern that fiscal austerity will blunt growth and actually worsen the debt problem.  Eurozone officials need to consider lessons from the 1930s and not just the 1990s.

 

The ECB needs to take a more active role in ring-fencing the crisis and act as a lender of last-resort (such as debt purchases in the secondary market).  Officials need to provide a larger financing facility to deal with the crisis.  Otherwise, there will be further trouble in paradise.      

The Cost of ECB Inaction as Lender of Last Resort

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The recent newspaper headlines have included such items as “S&P Warns on 15 Euro-Zone Nations”.  Other topics include the size of a temporary bailout fund may rise to $1.0-2.0 trillion to stabilize financial markets and the European banks may eventually need $150-200 billion of new capital to offset potential losses on their holdings of sovereign debt.  The point is that the cost of stabilizing financial markets has risen dramatically – it might help to understand why policymakers delay decisions and provide some lessons for risk management.  A recent communique “Why the ECB refuses to be a Lender of Last Resort” (VOXEU, Paul de Grauwe, Nov. 28^th) looks at some of these issues.

 

The euro is under intense pressure, as it has a number of weeks to save itself, as a number of institutions prepare for a potential restructuring or its actual demise.  Analysts are calling for the ECB to act as lender of last resort for the Eurozone bond market.  Why does the ECB hesitate to act as a lender of last resort?  If a central bank is to do so, it must evaluate the costs and benefits of its inaction of not providing last resort buying service.

 

The cost of inaction arises from the risk that inaction will lead to a collapse of the banking system.  The benefit of inaction is the avoidance of future moral hazard risk which is beneficial to long-run the banking system stability.  When evaluating the cost and benefit, the time horizon which these costs and benefits materialize matters a great deal.  The cost of not providing lender-of-last-resort is almost instantaneous, since bank liabilities are short-term.  The results of inaction are likely to be realized quickly while the benefits will be realized sometime in the future, possibly far in the future.

 

The asymmetry of the timing costs and benefits helps explain central bank behavior.  Viewing the government bond markets, the sovereign debt crises occur at a much slower pace than banking crises.  When facing a sovereign debt crisis, the conservative central bank view will weigh the long-term importance of reducing moral hazard unless the banking system is in immediate danger of collapse.  

 

The implication is ECB inaction unless the cost is immediate and clear and the sovereign debt crisis leads to an immediate banking crisis.  The implication of ECB caution suggests two results:  this means the amount of the liquidity/aid the ECB eventually may have to inject into the banking system is likely to be far higher than the amount required to stabilize government bond markets and a banking crisis will also trigger a deep and long-lasting Eurozone recession.

The ECB may well be behaving rationally, but it is both foolish and dangerous. The lessons for risk management – address potential risks or pay the consequences. 

 

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7352 

 

Confronting and Managing Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The recent confrontation between Greece and EU officials provide a good lesson for risk managers.  EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation.  These are all symptoms of a failure of risk management.  

 

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course.  The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.  

 

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis.  It may finally awaken Eurozone leaders to the futility of the path they’ve chosen.  One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France.  The cost of a default could be much larger than delaying the inevitable Greek restructuring.

 

Dazed and Confused?  Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem.  Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal.  However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years.  There is a cost for their negligence. 

 

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all.  An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates. 

 

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection.  That means wiping out shareholders and, if need be, unsecured bondholders.  The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions.  A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

 

Can we learn anything for risk management?

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7222

Eurozone Rescue Package Euro Implications: Fundamentals vs. Sentiment

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Financial markets loved the rescue package as equity markets rallied and the euro surged.  However, this short-term good news for markets did not last as Greek politicians feuded among themselves and Eurozone officials.  As Eurozone policymakers threaten to with hold Greek aid, it raises the question of whether Greece may exit the euro.  The fallout for financial markets could be costly. 

Near-term, the package avoided sovereign default and a banking crisis.  .The rescue package accomplished three objectives: it provided a temporary fix for Greece, backstopped banks writing down Greek sovereign debt and provided a temporary backstop for sovereign debt.  

Long-term, the rescue package is bad news for banks, financial markets and the euro.  Banks will experience a credit crunch as they struggle to meet capital adequacy ratios, the resulting austerity could create a fiscal contraction and provide a negative feedback loop for banks and sovereigns.  It failed to address three specific long-term issues: the package is too small to cover fallout from Italy or Spain, the lack of ECB involvement is a mistake and failed to address treaty reform and long-term monitoring of budget deficits by Eurozone authorities.  Eurozone policymakers may need to consider another rescue package by next summer.

The Euro rallied, after the package was announced, from the positive sentiment.  However, this rally does not appear related to yield differentials.  Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar.  Economic fundamentals and market sentiment are clearly out of line and pose potential downside currency risks once the market digests long-term implications of the package.

Bond investments tend to be one of the largest cross border flows.  Any divergence between currency values and rate differentials suggests that decision to buy and sell currencies may be related to other factors.  It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets.  The rising losses on Greek sovereign debt and bank shares trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.

When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential.  A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro.  In particular, this could impact trade finance and commodity finance where European banks are major players.

The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro.  This has allowed the euro to withstand selling pressure against the dollar.  This may allow the euro to be well supported against the dollar as long as repatriation flows continue.  As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices.  These policies will serve to weaken the fiscal positions of Eurozone governments, add additional pressure to bank balance sheet and increase the potential default pressure on Greece.  The only long-term answer is ECB involvement and implementation of euro-wide reforms in Brussels.  Otherwise, there is growing sentiment that Greece may exit the euro

Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation are negative for financial markets and could spell euro weakness as economic fundamentals reassert themselves or Greece decides to exit the euro.  What is your hedging strategy?  

Eurozone Leaders still don’t get it

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Eurozone policymakers have put together another plan to save the euro.  Will it work – only time will tell?  Charles Wyplosz, in a communiqué They still don’t get it (VOXEU, 25^th Oct.) reviews recent progress.  He is not optimistic they will take the necessary steps.  He notes that by rejecting an ECB role, leaders have guaranteed that any package will fail as too little too late.  They are addressing two of the three needed steps: putting Greece on a sustainable path and backstopping banks.  The last stop still needed is to backstop all European sovereign debt to avoid contagion. 

 

The author identified three issues in an earlier VOXEU column (22^nd Aug 2011) for policymakers: a clear misunderstanding of the situation, understanding the danger ahead, and unwilling to take the necessary steps to resolve the situation.  The real danger is contagion has spread to Italy and Spain pass the point of no return and the risk of spreading to core countries.

 

The European Financial Stability Facility (EFSF) is too small to deal with the amounts involved, even under the new proposal.  The authorities must move ahead of the curve and put together policies to contain the crisis and avoid further contagion – the new proposal may not be enough.  This can be accomplished by placing a floor under public debt valuation.  This can be accomplished two ways: the ECB can act as a guarantor of public debt as maturing debt is rolled over and the second approach is to replace maturing Eurozone debt with Eurobonds. 

 

The ECB is the only institution that can deal with the amounts involved and provide breathing space to address bank recapitalization.  The continued rescue packages for banks and government are creating moral hazard problems.  Long-term, authorities must address the weakness of the Stability and Growth Pact and enact restrictive fiscal policies with monitoring.  Wyplosz notes that recapitalizing Greek banks is a temporary solution, but could undermine its purpose by increasing debt levels.  The only solution is to tap the EFSF short-term and involve the ECB to provide a backstop for public debt.

 

The worst outcome is to reject a role for the ECB.  The lack of a backstop for public debt prices will allow the crisis to fester and deepen pushing up the cost of resolution. 

 

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/6845

Welcome to Phase 2 of the Eurozone Crisis – What are the Risks?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The Eurozone crisis moved into phase 2 when the contagion spread to Italy, Spain and European banks.  ECB purchases of government debt have provided a temporary solution, but may have political problems and legal implications that make them unsustainable and may include the need for time-consuming changes in the underlying treaties. 

 

Baldwin notes that phase 2 bank problems are entwined with government debt concerns.  The line separating illiquidity and insolvency for nations and banks was crossed last month.  The ECB provided a temporary solution, but the financing facility (EFSF) itself remains insufficient to cover government debt service and banking system assistance/recapitalization.  The estimated facility could need funding well above $1 trillion. The only policy combination that policymakers may agree on, and implemented in a timely manner, involves political cover for ECB bond buying in exchange for credible national fiscal reforms.  The ECB’s actions are unsustainable politically (acting for politicians) and illegal without changes in the underlying treaties. 

 

The near-term need is for ECB to backstop the debt of solvent European countries that would help temporarily stabilize financial markets.  There are two options: either the ECB continues to backstop European bonds with political coverage or leaders create a Eurobond scheme for government debt.  These are short-term solutions, both requiring credible control of new debt issuance.  This can be accomplished if national governments adopt credible fiscal policy (Germany) and/or it is shifted to a supranational level.  The best policy option in terms of timing is ECB backstopping of government debt with political support and domestic fiscal reforms.  But the implementation of fiscal union or Eurobond issuance would take too long. 

 

Given the magnitude of the problem, the current EFSF will not work since it is capped at €440 billion.  The risk is that policy paralysis and contagion may require a more radical solution if prompt action is not taken.  The more likely scenario is for a restructuring of the eurozone and increasing chances of reduced membership until countries get their fiscal house in order. 

 

For more on Welcome to Phase 2 of the Eurozone (EZ) Crisis (VOXEU, Richard Baldwin, Sept. 5^th), follow the link: http://www.voxeu.org/index.php?q=node/6942

Unforeseen Risk - The ECB’s Stealth Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The ECB, through its payment mechanism - European System of Central Banks (ESCB), acts as a de facto lender of last resort for troubled banks and member-country central banks across Europe.  The troubled banks, largely from deficit countries, obtain funding through the ESCB and indirectly finance the deficits, by central banks lending money against discounted public debt.  

 

The funds flow through the ESCB’s settlement system (real-time) called “target”.  Since 2007, when private capital flows dried up, large asset and liability positions emerged on the balance sheet of central banks.  The Bundesbank is the dominant creditor and dominant debtor central banks are those of Greece, Ireland, Portugal and Spain (GIPS).  The imbalances correspond to the cumulative current account deficits of those countries. 

 

A problem will emerge if these countries become insolvent and it impacts the solvency of the debtor country central banks.  This imposes large losses on the creditor central banks that are under pressure to aid domestic banks.  Taxpayers of the creditor country would have to bailout the central bank and recapitalize the banking system.  This mechanism serves as an indirect fiscal transfer.

 

This backdoor financing scheme shifts credit away from the surplus countries stifling growth.  This process can only be stopped, barring a major crisis, by a government takeover and adding central bank debt to government debt, already at alarmingly high levels.  This makes debt restructuring inevitable, increases the chances for a banking crisis and redenominating debt in a new, weaker currency.  The Eurozone has two choices, according to Sinn: a default/restructuring or open-ended support.

 

For more on the ECB’s stealth bailout click on the link to VoxEU, a policy portal set up by the Centre for Economic Policy Research:  http://www.voxeu.org/index.php?q=node/6599

The Underpricing of Risk – What Can We Learn?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Jeffrey Frankel, in a recent Vox communiqué called “The ECB’s Three Mistakes in the Greek Crisis and How to Get Sovereign Debt Right in the Future”, reviews the failure of the European Central Bank (ECB) and policymakers to fully integrate Greece into the Euro and fulfill the necessary conditions for membership. .

 

The first mistake, by the ECB and the European Commission, was to allow Greece to join the Euro in 2000 when it failed to meet the economic criteria established by the Maastricht Treaty, particularly the 3% ceiling on the budget deficit expressed as a share of GDP.  The second failure by European authorities, was to monitor budget deficits and debt levels that exceeded limits established by the Stability and Growth Pact, resulting in Greek borrowing costs similar to that of Germany.  As a result, international investors grossly underestimated potential risks.   The third mistake was not to send Greece to the IMF earlier.  European policymakers looked at the events in Greece as a temporary liquidity crisis rather than outright insolvency.  The result is a higher cost for a bailout.

 

There are two major lessons learned by policymakers from the Greek experience.  The first is that when specific criteria are established, such as the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability and Growth Pact (1997), someone has to take responsibility for monitoring and enforcing them. The second lesson is that European authorities are not equipped to impose policy conditionality in rescue loan packages; this is the IMF’s job. International politics is less likely to prevent the IMF from enforcing painful fiscal retrenchment and other difficult conditions. Europe is no different in this respect than Latin America or Asia.

 

The failure to price risk correctly is now resulting in European policymakers discussing the possibility of a “soft restructuring” of Greek debt.  The term soft restructuring is used as a euphemism for extending the maturity of outstanding debt.  European authorities are looking for further spending cuts and increased privatization by Greece.  However, the failure to do the large-scale debt restructuring, increasingly demanded by investors, will increase the ultimate costs.