Has Systemic Risk Declined?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

European Banking System – Systemic Risk Accident?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Basic research is like shooting an arrow into the air and,

Where it lands, painting a target (Homer Adkins)

 

The euro is heading toward an abyss. The sovereign debt crisis is evolving into a full-fledged banking crisis with global consequences.  Nicholas Veron, of the Peterson Institute, has written a short-article on issues facing European banks   “Europe Must Change Course on Banks” (Dec. 19^th).

 

The crisis is evolving along multiple dimensions.  On the sovereign debt, Greece’s debt restructuring remains unresolved, and Italy and Spain face major refinancing needs in early 2012.  Eurozone countries may have to refinance between euro 1.2-1.5 trillion in 2012.   The Eurozone summit on December 9^th, fell short of delivering a true fiscal union, and raised tensions within the euro area and with the United Kingdom.  On the growth front, a possible deep and prolonged recession looms, especially as countries place emphasis on fiscal austerity.

 

The banking system is a crucial piece of the puzzle and epitomizes the contradictions of Europe’s experiment with monetary union.  Since 2007, the system has exhibited gaps in risk management, and massive supervisory failures in some countries.  The banks are exposed to an agency problem – they are under national control, but pose risks for the euro. To keep on favorable terms with local authorities, they are often buyers of last resort after failed auctions.  In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility, especially since they depend on wholesale money markets for funding.  CDS premiums remain elevated for European sovereign debt  

 

Political affirmation of the integrity of the euro area banking system does not require new treaties, but major resistance comes from, among others, individual banks fearing the loss of national privileges or protections.  However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities.  A euro-area-level banking policy framework that will transcend interdependences between banking and political structures at the national and local level is a necessary condition for the survival of the monetary union.

 

As the euro crisis continues to unfold, there is increasing risk that the crisis could move across the Atlantic.  The near-term conduit from the banking system through money markets, derivatives or some other under radar surprise.  A longer-term mechanism is through a severe credit contraction that could induce a global recession.

 

The problem for global banks, especially for European banks, is that Basel I and II encouraged banks to hold sovereign debt as risk-free.  Basel III imposes more capital requirements and it will require additional euro hundred billions of capital over that suggested by recent stress tests.  The question is how European banks can meet the new capital shortfalls without causing growth stagnation?

 

The immediate goal for European authorities is provide standardization of regulation across the Eurozone such as national interests do not subvert the euro.  Long-term European banks have to be recapitalized without causing a severe credit contraction.  It will require prudent central bank policy and cooperation between national regulators.  The failure to implement prudent reforms could result in a near-term freeze in bank funding or a global recession.  Neither outcome is provides a favorable target for a sustainable US recovery.

 

For more on this follow the link: http://www.piie.com/realtime/?p=2581

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.