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

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

Twelve Signs of the Europocalypse

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

What was unthinkable two years ago – the consideration of pan-European bank regulation, cross-border deposit guarantees, joint and several Eurobonds, and the very survival of the common currency – appear to be verging on the inevitable now.  The staid European Union we knew for its first two decades is a thing of the past. 

 

Douglas Rediker and David Gordon, look at some of these issues in the Jun. 12^th issue of Foreign Policy.  The authors offer 12 key trends to watch over the next few weeks for help in projecting what the new Europe will look like if it finally emerges from the mire.  There are interesting signposts for risk management and serve as tipping points. 

 

Some of these trends such as, Greek dysfunction and Spanish banks, are already well in process.  None of them are very encouraging for a benign solution to the euro zone crisis.  Several are scarier than others.  Greece and its European partners are in for an almost unimaginable set of politically unpalatable choices, and the likelihood of Greece remaining in the Eurozone is very low. 

 

German domestic politics, with federal elections scheduled for this autumn of next year, may be the single-most crucial factor in shaping the final German response to the crisis, with German politicians gauging every move and its impact on that vote.  The United States doesn’t possess the inclination, the ideas, or the financial capacity to materially influence the endgame in Europe.

 

For the so-called Troika, ECB-EC-IMF, tensions revolve around something quite simple: who pays.  Neither of the funding programs the EU governments has set up — the EFSF and the ESM — has any significant capital, relying instead on capital markets, leverage, and to some extent “alchemy” to reach its headline funding capacity. 

 

China is not coming to Europe’s financial rescue, but will instead look for potential European investment bargains once forced sellers of distressed assets find themselves without other options.

 

The European Union remains one of the great experiments of the 20^th century.  It was a major effort by countries to give up major elements of their sovereignty, acting collectively through a set of agreed-upon rules and coordinated through supranational agencies.  The whole process was organized by great strategists and visionaries, but the next stage could be organized by anonymous and impatient financial markets dominated by responses from unknown bureaucrats and politicians. 

 

The lesson for risk management is to look at potential tipping points before the accident occurs.

 

For more on this follow the link:  http://tinyurl.com/6s6dyv9

Cleaning up the mess: Bank resolution in a systemic crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The bailout of euro 100 billion of Spanish banks is a temporary stop gap measure to provide market stability, but does little to improve Spain’s market access.  The sovereign debt crisis in Europe has gone into a full-fledged banking crisis.  The problem for Spain is that insolvent banks could bring down the government.  In contrast, an insolvent government in Greece is bringing down the banks.  The feedback loop between the solvency of the banking system and the sovereign fiscal position is now a two way process.  The risk of full blown debt crisis will have dramatic consequences for companies with euro and European bank exposure.

 

Spain will be the fourth country to get EU support after Greece, Ireland and Portugal.  The procrastination of European politicians have increased the crisis severity and increased the risk of contagion.  Already, indicators suggest Spain needs more aid and as bond spreads widen.  Italian bond spreads are also widening 

 

Daniel Gros & Dirk Schoenmaker, in a VOXEU piece dated June 6^th, Cleaning up the mess: Bank resolution in a systemic crisis discuss some of the issues. The authors note that savers in many vulnerable euro members are withdrawing deposits from banks.  Unless the banks are recapitalized, this gradual deposit flight will turn into a full-fledged bank run and with costly consequences.   

 

Currently, the banks in countries like Spain and Greece have an immediate need for bank capital.  This can be best provided by a European institution, such as the European Stability Mechanism (ESM).  Clearly, the sovereign governments in a number of countries are not in a position to recapitalize their banks.  Once the banks are recapitalized: the ESM, ECB and national central banks should come under control of a new European authority (European Banking Authority “EBA”) governed by the EU.  The EBA should be independent of national government influence.

 

In the medium term, the creation of a European Deposit Insurance and Resolution Fund (EDIRF) could help stabilize European banks and make them less vulnerable to contagion.  Currently, the banks in Greece and Spain require an immediate solution.  This has to be done before a long-term solution is implemented.  The European Commission’s (EC) are a case of “too little too late”.  The idea of having a pan-European deposit guarantee would help banks with large cross border activities.  However, the problem today comes from local banks in Greece, Ireland and Spain where they became heavily involved in real estate lending. 

 

The general theme that emerges is the need for a European approach, especially where a number of sovereigns cannot stand behind their banks.  A general principle that emerges is the deeper the hole – the greater the need for an EU wide solution.  The general principle that emerge is: one, the private must be involved, especially with insolvency via equity haircuts or restructuring; second, the least cost principle should be followed with resolution authority at the least cost; three, swift decision making is essential and not the current procrastination that is pushing losses higher; and four, any resolution requires aligning the interest of management with those of public authorities. 

 

The authors suggest that two issues must be addressed: one, Spanish banks should only be recapitalized only after full loss recognition of problem loans and two, a mechanism needs to be established to avoid any further run on Greek bank deposits and to eventually include all of Europe.  In the medium-term, a European wide banking regulation is required followed by some form of fiscal union.

 

The lesson for risk management is that prompt action can reduce the cost of resolution and small banks can be as much of a problem as larger multinational banks.  However, the longer officials procrastinate the higher the risk and cost of resolution.

 

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/8069

   

 

The End Of The Euro: A Survivor’s Guide

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

In every economic crisis there comes a moment of clarity. In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone. The economic consequences of a failed system await them.

This is the thesis outlined by Peter Boone and Simon Johnson in their recent Baseline Scenario blog dated May 28^th.  It is also a classic failure of risk management and its failure to correct initial flaws in the creation of the euro.

Europe’s crisis to date is a series of “decisive” turning points that have been nothing but another step down a steep hill.  Currently, Greece has faced five years of recession, over 20 percent unemployment, a series of broken promises from politicians and EU bureaucrats, resulting in political backlash.  Greece’s economy can only get worse.  

Some European politicians are now telling us that an orderly euro zone exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves. They are wrong. Greece’s exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone

During the next stage of the crisis, Europe’s taxpayers will be rudely awakened to the large financial risks that have been foisted upon them in failed attempts to keep the single currency alive.  The cost to taxpayers if Greece quits the euro could easily reach euro 300 billion.  However, the ECB has taken the view that it has not taken any excessive risk.

A likely scenario is that the ECB realizes it has taken on a large amount of credit risk on its books.  Investors start to flee peripheral banks and ECB funds fail to turn the tide.  Capital flight could last for several months pushing a number of countries into a deep recession.  German taxpayers will revolt at the additional exposure.

It is time for European and IMF officials, with support from the US and others, to work on how to dismantle the euro area. While no dissolution will be truly orderly, there are means to reduce the chaos. Many technical, legal, and financial market issues could be worked out in advance.

 We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system. Some nations will soon need foreign reserves to backstop their new currencies. Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.

This should be a good lesson for risk management of a flawed system design and the failure to make corrections.  What is your euro exposure?

For more on this, follow the link: http://tinyurl.com/bsan8zc

European Banking Union and Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There is increasing agreement between policymakers and academics that a banking union, along with some form of fiscal union, is necessary if Europe is to emerge from the crisis and stabilize.  Currently, politicians tend to focus on a short-term fix and avoid making hard decisions.  Nicholas Veron, addresses some of these issues in a recent VOXEU communique dated May 23^rd, Is Europe ready for a banking union?

 

As the global financial system has become more complex, concentrated and interconnected, Europe’s vulnerability to systemic risk has increased.  The fragility of the European banking system was revealed in the subprime/Lehman shock of 2007-2008 and has never been properly addressed since then – despite several stress tests.

 

Policymakers now agree a banking union (federal framework) is required in order to break the feedback loop between sovereigns and banks, essentially through risk sharing across borders in the banking system.  The monetary union needs to be supported by stronger financial integration in the form of unified supervision, a single bank resolution authority with a common backstop and a single deposit insurance fund. 

 

Policymakers now agree that a banking union, together with a fiscal union, is a necessary condition for a sustainable Eurozone monetary union and a resolution of the current crisis.  The action taken to date is modest.  Veron notes there are certain impediments to banking integration:

 

1.      the UK, Europe’s largest financial hub, is a non-euro member and resists encroachment on supervisory authority

2.      a number of euro-member states continue to resist any encroachment on local banks closely linked to local politicians

3.      EU member states continue to resist risk-sharing agreements or cross-border transfers.  These constraints prevent Europe from a first step toward establishing a consistent architecture for its banking union.

 

Certain reforms should be urgent priorities:

 

1.      banks must share risks as widely as possible

2.      Europe also needs the ability to restructure banks without national politicians or regulators 

3.      A cross-national guarantee is needed for national deposit insurance systems to prevent a retail bank run. 

 

European-level supervisory structures should eventually be established to prevent moral hazard.

 

European authorities would like to have time to fine-tune complex legal and financial issues to combine with different pieces into a consistent banking policy framework.  However, the current moment calls for less fine-tuning and more swift and bold action to contain systemic risk.

 

What is your exposure to European banks?

 

For more on this, follow the link: www.voxeu.org/index.php?q=node/8027

 

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

 

 

Risks on new Bank Capital Standards

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Bankers, policymakers and regulators continue to debate on the content of new bank capital requirements rather than setting global standards.  In the view of recent losses by JP Morgan and recent research reports calling for more bank capital, the need for global harmonization of standards takes on a new sense of urgency.

 

Nicholas Veron, in a recent VOXEU communique of May 4^th, The European Debate on Bank Capital is Not Just About Europe looks at the European experience.  European officials are deciding on the legislation to implement Basel III agreement on bank capital, leverage, liquidity and risk management. 

 

Officials, however, have severely underestimated the importance for reaching a global standard for financial regulation.  There are two unresolved issues in Europe: (1) the legislation’s departure from Basel III provisions; and (2) whether member states would be allowed to impose their own core requirements in regards to bank capital ratios. 

 

The first issue exists for both Europe and globally since it is about the definition of bank capital and how it should be applied to subsidiaries.  EU institutions regard global harmonization as overriding good, superseding misgivings about individual provisions or national authority.  Although, EU banking regulations are done at the national level and are not standardized creating a problem to see what is “liked” or “disliked”.  This makes the regulations vulnerable to special-interest groups. 

 

The crisis has changed the dynamics between the EU and global standards.  Institutions are now focused more on content than global harmonization.  This is complicated by a lack of a consistent approach by EU policymakers and the U.S. SEC’s delay in endorsing the proposed implementation schedule for global financial reform.  An American proposal that is compliant with Basel III would encourage EU and other doubters to comply. 

 

Global harmonization would help minimize competitive distortions inside the EU.  The main problem specific to the EU is that banking services remain under national authorities.  This results in a lack of a unified approach to bank supervision/resolution and pegs banks financial health to national authorities.  A more timely U.S. response combined with a unified EU approach could help reduce risk.

 

Although, Basel III requirements do not resolve all financial regulatory issues, a global harmonization of regulatory standards would be far better than our current fragmented system.  Perhaps the losses by JP Morgan Chase might force regulators to focus on implementation of a global standard.  The alternative of a fragmented regulatory environment could be costly.

 

For more on this simply follow the link: http://www.voxeu.org/index.php?q=node/7948

 

Giant chickens and Marks!

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There’s a giant game of chicken going on and many are predicting that it will end up with Greece exiting the Euro and returning to the Drachma.  This is seen as likely to lead to disaster for the Eurozone and many others, but especially for Greece.  However, there is a simple way to make it beneficial for all.  Why should Greece return to the Drachma?  If Greece is first out, the name “Mark” is going spare.  An announcement that Greece will adopt the Mark as its currency would calm markets and lead to a dramatic reduction in Greek debt yields ……….

 

OK, totally crazy and irrational I know.  But if rationality had anything to do with things, there likely would not have been a Euro in the first place.  Even if there had been, it’s a racing certainty that Greece would not have been a participant.  Politicians running currencies and economies is a bit like the animals running the zoo.  One thing we can rely on is a mess and sub optimal outcomes.  I hope your risk management systems and processes have this assumption.

 

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?

 

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

Lessons from Sweden for Europe and Crises Resolution

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Sweden experienced a severe banking crisis in the early 1990s.  The quick moves by policymakers to resolve the crises and limit contagion have lessons today for the risk management and government policymakers.

 

Swedish authorities deregulated capital markets in the mid-1980s that helped stimulate a rapid expansion of the financial sector and a surge in real estate lending.  Highly leveraged financial institutions got caught when monetary policy was tightened and the ERM went into crisis.  Lars Calmfors, in a recent VOXEU communique, What Can Europe Learn from Sweden? Four Lessons for Fiscal Discipline (Mar. 12^th) talks about some of the lessons.

 

Several Eurozone countries are currently struggling with large budget deficits.  Calmfors argues the 1991/93 Swedish fiscal crisis has lessons for today.  The use of greater fiscal transparency combined with a high-quality economic policy debate leading to a credible medium-term deficit reduction package may be the optimal policy.  This is more important than the formal binding rules and automatic correction mechanism envisaged in the European fiscal compact. 

 

There are four lessons from the Swedish experience.  First, a fiscal crisis can create a consensus on fiscal discipline.  This leads to consensus among various political parties favoring a long-term goal of fiscal consolidation despite temporary macroeconomic deviations.  Secondly, comprehensive fiscal reforms can increase the chances of success.  The government implemented a number of unpopular structural reforms including controlling discretionary spending, limiting local government deficits, and long-term pension system reforms. Thirdly, fiscal transparency may be more important than formal enforcement as mandated under the European compact.  The Swedish government adopted greater fiscal transparency by exposing the budget to reviews from independent agencies and providing a long-term credible plan for keeping the budget balanced.  Lastly, one way to limit the deficit is to promote sustained output growth.  Fiscal consolidation becomes effective with long-term output growth. 

 

The economic recovery was helped by a large real depreciation of the exchange rate.  There were two fiscal effects from higher long-term growth: a gradual reduction in the debt-to-GDP ratio and higher growth allowed for tax cuts and targeted expenditures.  European politicians and policymakers can learn the importance of addressing risk early or face the risk of a surge in the costs for crisis resolution.  This is especially important, since the early 1990s, due to the greater complexity resulted in a greater concentration of institutions and increased interconnections that place a premium on prompt action.

 

The extension of the Sweden experience to risk management offers the following lessons: the need for accurate screening and monitoring risk, prompt recognition of risk, training in risk management for participants, a consensus agreement of all involved parties on risk resolution and prompt action to contain the cost of resolution.

 

For more information on this, follow the link:  www.voxeu.org/index.php?q=node/6368

 

 

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

Rethinking Basel III and the Regulation of Derivatives

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The imposition of Basel III and the new capital requirements was seen as a way to reduce systemic risk in the financial system.  However, in the haste to implement the proposed regulations a number of flaws have emerged that mask potential risks associated with derivatives.  Paul Atkinson & Adrian Blundell-Wignall, in a recent communique, Basel Regulation Needs to be rethought in the Age of Derivatives (VOXEU, Feb 28^th) discuss some of weaknesses of Basel III.

 

The chaos that created the Eurozone debt crisis has pushed the debate on how to fix the banking system to the back burner.  The systemic threat originating from the sovereign debt crisis points for the need for recapitalizing Eurozone banks well before the Basel III timetable. Atkinson and Bludell-Wignall argue the proposed Basel III regulations are overly complicated and desperately out of date. The proposals serve as a short-term patch for a fundamentally flawed system that is overly complex.   

 

The Basel proposals use a risk-weighting system for calculating capital charges that do not fully incorporate over-the-counter derivative exposures that currently exceeds $600 trillion (end 2010).  Banks have unlimited scope to arbitrage the system by reallocating portfolios away from assets with high risk weights to assets with low risk weights, thus saving on capital costs.  The capital charges may actually encourage more risk taking by systematically important institutions and may actually make the financial system more unstable and accident prone. 

 

Bank responses to Basel incentives lead to three major problems: capital charges are portfolio invariant and depend on the borrower’s characteristics and economic environment and not portfolio composition, risk weights act as a system of regulatory taxes and subsidies and create a bias against diversification and encouraging concentration in such hazardous asset classes as US residential real estate, and the minimum capital requirements can be arbitraged downward and create a bias toward leverage.  The distortions caused by the system are often obscured by its complexity and opacity, especially as regards derivatives and accounting for unexpected counterparty credit risk losses.  The current problems with CDS, Greece and the ISDA rulings only make the problems more complicated.     

 

The Credit Valuation Adjustment (CVA) (marking unrealized losses to market) allows for the netting of gross exposures across counterparties, but may underestimate bank exposure and ignore positions for calculating the CVA charge due to highly concentrated derivative positions and bilateral netting.  The CVA charge is additive across netted bilateral positions rewarding counterparty concentration. The result is a vast, poorly diversified; highly interconnected banking system with a small capital base and that may under estimate potential risk exposure. 

 

Events such as the US subprime real estate crisis and European sovereign debt crisis may be major problems for borrowers and lenders directly affected, but a resilient, well-capitalized banking system would not allow the crisis to become global.  The Basel system should be replaced with one whose parameters cannot be arbitraged by portfolio reallocation and derivative activity.  Despite Basel III, the current system remains vulnerable to systemic risks created by derivative exposures.

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/7672

 

Reassessment of Euro Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The Euro rebound is stronger than anticipated as investors and central banks show an increased appetite for euro denominated paper as signs of a Greek debt crisis start to fade.  The rise in oil prices and surge in central bank reserves has triggered the demand for currency diversification. The euro is one of the few safe currencies that can absorb the growth of reserves.  As we have noted in our blogs of Feb. 26^th and Feb. 15^th, USD or Canadian dollar based investors may want to hedge potential euro exposure.

 

Analysts expect the demand for euro denominated assets to persist temporarily as oil prices remain elevated and central banks, especially in emerging markets, continue to diversify reserves.  This temporary demand for euro denominated may receive temporary support from political tensions in the Middle East and the false sense that problems in the euro peripheral countries have been resolved.  Longer-term, the risks to the euro remain to the downside as the sovereign debt crisis has evolved into a banking crisis and projected economic stagnation in Europe relative to the rest of the world.

 

Spreads on sovereign debt declined since the proposed settlement for Greece was reached.  There is a link between the decline in bond spreads and the ECB announcement the creation of the long-term refinancing operations (LTROs).  There is concern that banks will borrow from the ECB at low rates and buy sovereign bonds whose yields are higher, especially where banks are subject to local political pressure.  Policymakers realize that one of the necessary conditions to stabilize financial markets was the need for an explicit guarantee (such as the ECB) for sovereign debt.    

 

However, this move along with the other temporary financing facilities falls short of what is needed.  Greece and Portugal will not be able to grow with their existing debt burdens.  This could result in contagion spreading to Italy and elsewhere.  European growth is projected to be flat to negative for 2012 and only a modest in 2013, especially with significant budget cuts.

 

The temporary financing could make things more dangerous.  Any wave of sovereign defaults would create problems for the ECB as nearly euro one trillion in sovereign debt is due for rollover in the next 12 months.  The sale of overseas assets by European financial institutions to bolster capital and continued reduction of sovereign exposure by private investors could add to euro pressure.  European politicians have failed to address any of the underlying long-term structural issues facing euro such as monitoring and implementing policies deficit reduction among member states.

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

 

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

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

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

                                                        (Samuel Karlin)

 

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

 

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

 

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

 

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

 

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

 

Can we learn anything for risk management?

 

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

 

 

 

Untitled

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

 

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

 

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

 

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

 

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

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