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 Curse of Advanced Economies in Resolving Banking Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

What are the implications for risk management?

 

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

The (Other) Deleveraging and Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

   

 

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 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

 

The Coming Revolt Against Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The push toward austerity as cure-all for rising debt levels resulting from the financial crisis is losing credibility with the euro zone electorate.  The elections in Greece and France have served as a shift in the electorate toward a more pro-growth view.  Charles Wyplosz discusses these issues in a recent VOXEU communique dated May 2^nd. 

 

Wyplosz argues that governments should not mix long-term growth and fiscal discipline objectives with short-term goals to contain rising debt levels.  Instead, countries should focus on a framework for fiscal policy cooperation, restructure debts, and implement fiscal discipline in the long-run.  The German view, however, is that countries with excessive debt levels should focus on deficit reduction. 

 

This recipe has produced two years of economic contraction and surging unemployment for Greece.  There is growing debate among academics and international agencies that advocacy of pro-cyclical austerity is not producing the desired results as the situation is more complicated.

 

The sovereign debt crisis implies that highly indebted countries cannot simply borrow their way out of the crisis.  Financial markets want growth as a necessary condition for deficit reduction, but this is complicated by the fact countries cannot borrow their way out of their predicament nor borrow at reasonable interest rates. 

 

Wyplosz makes five recommendations: (1) do not mix long-term growth with fiscal discipline since they should be treated as independent objectives since there is only evidence that high debt levels can stunt growth, not fiscal discipline; (2) do not create another Lisbon accord that produces another layer of regulations and bureaucrats and serves as a means for politicians to avoid making hard decisions; (3) establish a framework for fiscal policy cooperation at the Eurozone level since recent results implemented by national authorities have been sub-optimal – a fiscal framework may allow for countercyclical policies as needed; (4) authorities should implement debt restructuring ahead of the curve limiting contagion before the market imposes penalty rates and limit market access; and (5) de-emphasize  short-term deficit targets which do not have economic justification. 

 

National cooperation on long-term objectives is needed to limit potential risks.  However, these types of national agreements need to include short-term flexibility so as to any problems created by short-term market fluctuations.  The rigid structure of the infamous Stability and Growth Pact is the exact opposite of what is needed.

 

As more countries question the role of austerity and attempt to establish long-term fiscal policy cooperation and restructure debt, what kind of surprises can we expect?  Risk managers need to focus on this shift to avoid any JP Morgan Chase type of surprises.

 

For more on this, please follow the link:  www.voxeu.org/index.php?q=node/7933

 

Credit Default Swaps: Useful, Misleading, Dangerous?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Richard Portes, in a recent VOXEU communique (April 30^th), asks this question about the use of Credit Default Swaps (CDSs).  In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.

 

CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party.  The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses.  These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position.  This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity. 

 

The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread.  European politicians blamed the CDS market for destabilizing Greece.  As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt. 

 

The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt.  Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.

 

CDS contracts can provide a useful function for price discovery and hedging positions.  However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.

 

Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market.  He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis.  In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated. 

 

Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets.  However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous.  In this case, naked CDS positions, however, may increase systemic risk.   Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7922

Systemic Risk, Shadow Banking and Governance

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The costs from the recent financial crisis in terms of asset write-downs by financial institutions, wealth destruction and the lost output and job creation have refocused regulators attention on the role of hedge funds in the management of systemic risk.

 

Andrew Patton, Tarun Ramadorai and Michael Streatfield note in a recent VOXEU communique (9th April) Are Voluntary Hedge Fund Disclosures Reliable? Discuss some of these issues. In the wake of the financial crisis, the Securities and Exchange Commission (SEC) proposed a rule requiring US-based hedge funds to provide regular reports on their performance, trading positions, and significant counterparties.  

 

Currently, hedge funds are part of the unregulated shadow banking system that perform financial intermediation (estimated at 50% of total intermediation process) and account for a significant portion of trading volume (over 50%) in different asset classes.  Before the policy is implemented, Patton et al argue that such a move will benefit both regulators and investors.

 

Recent policy debates on the pros and cons of imposing stricter reporting requirements on hedge funds have raised various arguments. The benefits of disclosures include market regulators having a better view on systemic risks in financial markets, a better understanding of asset price dislocations, and investors and regulators being able to better determine the true, risk-adjusted performance of funds. Costs include the administrative burden of preparing such reports, and the risk of leakage of valuable proprietary information on trading strategies that may be derived from portfolio holdings.  

 

The authors’ analysis suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC last year and due to be implemented in 2012 would be beneficial to regulators.  They also suggest considering whether these reporting guidelines could also apply to disclosures to prospective and current investors.  Currently they only apply to the funds' disclosures to regulators...  They conclude that such information would help hedge fund and other investors make more informed investment decisions.

 

The IMF estimated that global financial institutions wrote down over $2 trillion in the value of assets on their balance sheet from the financial crisis from 2007 to 2010.  If you add the loss of potential economic output and job creation the cost of the crisis makes it very expensive.  The implementation of governance in the management of systemic risk is much less costly than the alternative.

 

For more on this follow the link: www.voxeu.org/index.php?q=node/7858

 

Managing Risk: The How and How Much

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

A key question for risk management is how to manage risk and by how much.  A recent short VOXEU communique  (3rd April) called The Austerity Question: ‘How’ is as Important as ‘How Much’ by Alberto Alesina & Francesco Giavazzi asked the same question when policymakers attempt to implement austerity measures.

 

Alesina & Giavazzi note that in Europe’s embrace of fiscal austerity has sparked a debate among economists.  These authors argue that the debate has gone astray – focusing exclusively on the size of the deficit reductions.  The focus of policymakers should be on the budget tightening’s composition (tax versus spending) and the accompanying policies.  The key question is not “how far” governments go but “how” they go far enough.  

 

Until the critical principle – ‘how’ as important as ‘how much’ – is embraced, the austerity debate in Europe will continue to be completely out of line with the real economic trade-offs.

 

Economists note the following evidence by the implementation of austerity: spending cuts are less recessionary than those achieved through tax increases, and the use of spending cuts with the right policy may limit the economic impact when compared to other policy measures.

 

Policymakers should stop focusing fiscal policy discussions on the size of austerity programs.  Recent IMF research suggests a relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts.  Likewise, a small spending-based adjustment could be more effective at stabilizing debt-to-GDP ratios than a larger tax-based adjustment.  

 

A number of questions need to be considered: what spending cuts are more effective, can tax reforms achieve the same revenue with minimal distortions and how should market liberalization be implemented?  In general moving taxation towards the VAT and away from income taxes is preferable.  In some countries, there is no solution without a substantial raise in retirement age and cuts in government employment.  This includes the implementation of labor-market reforms, especially in the public sector.

 

Until the critical principle “how” is as important as “how much” is embraced the austerity debate in Europe is out of whack with the real economic consequences.  Europe is in for a big disappointment on the centerpiece of Eurozone austerity – the fiscal compact.  The compact bears the seeds of its own failure: the treaty change makes no mention of the composition of fiscal packages, and encourages adjustments mostly on the tax side, suggesting that European economies will remain stagnant and debt ratios will not come down.   In the end, as was the case with the Growth and Stability Pact, the rules will be abandoned.

 

The lesson for risk management is not just the identification of potential risk, but the methodology used to manage it and its potential consequences.

 

For more on this, follow the link:  http://www.voxeu.org/index.php?q=node/7836

 

 

Unconventional Wisdom – Rethinking Fiscal Austerity 2

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

We recently discussed the issue of fiscal austerity (March 1st) and the implications of being the wrong policy under certain macroeconomic conditions.  It has a certain parallel to risk management where conventional measures may not produce the optimal solution.

 

Giancarlo Corsetti, in a recent VOXEU communique (April 2nd), revisits the issue in "Has austerity gone too far?"  He asks the question is austerity self-defeating by keeping Europeans underemployed and destroying the growth required to service the debt.   Austerity has not served as a cure-all for market concerns about sustainability, especially with signs of renewed economic slowdown in Europe. Currently, austerity measures in Europe have not produced the desired consequences, but the loss of creditability by not applying it could have made things worse.

 

The debate is not about the desire for a stronger fiscal stance to manage government debt, but when should the policy mix change during periods of signs of weakness.  Under what circumstances should this change be made and limit the damage to policy creditability.  Corsetti suggests that countries fall into three categories: one, a group of countries facing a high, volatile risk premium, second, countries with strong fiscal stance and negative risk premium, and a third set that are highly vulnerable to contagion, weak financial sector and high unemployment.  The question is how to ensure debt sustainability where countries are subject to different domestic and regional differences.

 

Corsetti notes the fiscal policy debate has gone through several phases: the first phase was a call for fiscal action to avoid another Great Depression, a second phase, the focus shifted to fiscal consolidation as public debt levels surged, and a third phase, the need for austerity has become less popular with slower global growth.  Recent research suggests the emergence of a new paradigm, where fiscal contraction in a liquidity trap environment can be counterproductive.  In this paradigm, a number of advanced countries are experiencing high unemployment and underemployment of resources is a self-reinforcing policy.  The problem in the current context is fiscal austerity, alone, is not sufficient to tame nervous markets with upfront tightening.

 

The author notes the government is charged with dealing with the sovereign risk premium. Countries, with high sovereign risks, can adversely impact borrowing conditions in the broader economy and increase the cost correlation between the public and private sectors.   Private sector institutions are exposed to sovereign risk: through their holdings of government bonds and they ration credit to repair damaged balance sheets.   There are two implications from the sovereign risk channel: first, when sovereign risk is high and fiscal multipliers tend to be lower and second, highly indebted economies become more vulnerable to self-fulfilling fluctuations.

 

The presence of a sovereign risk channel provides a strong argument to focus on policies that limit the transmission of sovereign risk into private-sector borrowing conditions.  Policy options may include: the existence of strongly capitalized banks, policies that may offset high sovereign risk premia and policies that make liquidity available to the private sector.  Fiscal austerity is a necessary condition to reduce deficits and lower the risk premium.  Under certain economic conditions, austerity may have adverse consequences and other policies are required to reduce the risk premium and limit the impact on the broader economy.

 

As with risk management, conventional thinking may not produce the desired results.

 

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7836

The Global Financial crisis – What caused the build-up?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.comvox 

 

Five years have passed since the onset of the financial crisis and there is little agreement on the root causes or potential indicators of rising financial system stress.  Erlend Nier and Ouarda Merrouche address a number of these issues in a recent (25^th March) VOXEU communique called The global financial crisis – What caused the build-up?

 

Nier and Merrouche, IMF economists, summarize some of their recent research.  They start off asking a couple of questions: did central banks keep policy rates too low too long? Or were rising global imbalances the underlying cause of the crisis?  The answers to these questions are important to help contain and prevent the build-up of systemic risk.   

 

The authors noted the following results: net capital inflows can account for the differences between countries in the build-up of financial imbalances, the compression of the spread between long and short rates contributed to the rise in leverage and balance-sheet expansion, a weak supervisory and regulatory environment along with macroeconomic factors added to financial system stress and the relative importance of external imbalances relative to monetary policy.

 

Their research suggests that net capital inflows, rather than monetary policy stance, emerges as the key determinant of differences in the growth of financial imbalances across OECD countries over the pre-crisis period.

 

Capital flows along with weak regulation and supervision were the key drivers of the financial crisis.  The authors note that inadequate prudential policies failed to address systemic problems by over-reliance on wholesale funding.  The financial crisis corresponded with a sustained period of low interest rates globally, but the path of monetary policy (different across countries) was not a main contributor to the build-up of financial imbalances.  This suggests caution against a re-orientation of monetary policy frameworks in response to the crisis.

 

The lesson for policymakers and regulators is the need for effective macroprudential policy tools and effective/efficient regulation.   Otherwise, the use of the wrong policy options combined with over-regulation may result in rising systemic risk and increased contagion.

 

For more on this follow the link: http://www.voxeu.org/index.php?q=node/7774

Risks from Financial Repression

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Many advanced countries worldwide are experiencing a problem with surging levels of debt.  One of the tactics used to contain the surge of debt is called “financial repression”.  Given the recent global and European crises, there is expected to be resurgence in the use of this tactic for debt management.  In a recent VOXEU (26^th March) communique, “Financial repression: Then and now” authors Jacob Kirkegaard and Carmen Reinhart discuss how it is applied    

 

In the past, policymakers dealt with rising debt levels by a mix of strategies: economic growth, fiscal adjustment and austerity, explicit default or debt restructuring, surprise inflation and financial repression often accompanied by steady inflation.  Financial repression is defined as policies that allow governments to capture and under-pay domestic savers and investors.  These policies may include forced government lending from pension funds and financial institutions, interest-rate caps, capital controls and other policy options.  Countries will now focus on this strategy as one way to reduce the cost of the rising debt burden.  Countries will only use outright default or surprise inflation as a desperate measure or as a strategy of last resort.

 

This is why financial repression is now back as a policy option.  Financial repression in conjunction with steady inflation works in debt reduction by two methods: low nominal interest rates reduce debt servicing costs and negative real interest rates erode the debt-to-GDP ratio (tax on savers).  The repression tax rate (or rates) can be determined by financial regulations and inflation performance.

 

Currently, financial repression is represented in the context of macroprudential regulation.  The current financial regulatory measures are biased to keeping international capital out of emerging markets and in advanced countries.  Emerging market controls are meant to counter loose monetary policy in advanced countries and discourage hot money while regulatory changes create a captive audience for domestic debt.  This offers advanced and emerging economies common ground on tighter restrictions on international financial flows as the world is returning to a tightly regulated domestic financial markets.

 

One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail.  This reduces governments’ interest expenses for a given stock of debt and contributes to deficit reduction.  However, when this produces negative real rates and helps liquidate existing debt, it serves as a wealth transfer from creditors (savers/investors) to borrowers (governments).  The prevalence of a strong regulatory environment during the post WWII Bretton Woods arrangement helped to keep real interest rates negative or lower than levels that would prevail in an environment of greater capital mobility.  This allowed many of the advanced countries to use financial repression dramatically reduce accumulated debt burdens from WWII at a lower cost.  As countries emerge from the most recent crisis, low real rates are expected to persist as countries struggle for a sustainable recovery.        

 

Currently, many advanced countries have debt (public & private) levels that approach the post WWII levels.   Policymakers will be preoccupied with debt reduction, debt management, and generally trying to contain debt servicing costs.  The high level of unemployment will be further motivation for keeping rates low.  In this environment, financial repression (with dual aim of low rates and captive investor base) will regain renewed favor as many countries struggle with unsustainable levels of debt and a new regulatory environment with a new set of risks. 

 

For more on this follow the link:  www.voxeu.org

/index.php?q=node/776

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

 

 

Basel Regulation Needs to be Rethought in the Age of Derivatives, Part

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Paul Atkinson and Adrian Blundell-Wignall, in a second VOXEU communique (Feb 29^th) suggest that further reforms are needed to change and simplify of Basel III capital rules. 

 

Atkinson and Blundell-Wignall note that the design in the Basel framework for regulating bank capital adequacy has resulted in a “vast, poorly diversified, highly interconnected banking system” supported by a far too-small capital base.  The system is inflexible to adjust to external shocks, so local problems can become systemic.  They suggest the system can be placed on a firmer foundation by the following changes:   (1) simplification of capital requirements; (2) realistic and less complex financial supervision; and (3) more reliance on market discipline. 

 

The authors suggest that a risk-weight system for capital charges be replaced by a leverage ratio with an upper limit.  This includes reporting of gross derivative positions, according to international accounting standards, in the asset base that require equity support without the distortions using netting permitted GAAP reporting rules for calculating capital charges (not always zero risk).  Otherwise, Basel III capital rules may produce outcomes that are less stable.  Bank activities should be separated into low-risk and high-risk activities (through separate subsidiaries – legal vehicles) to limit equity base exposure to losses from any single activity (trading).  This allows each subsidiary to have its own equity base while limiting government guarantee programs to specific activities such as retail banking—but not derivative trading.  This eliminates the cross-subsidization of other activities and makes the banking system less vulnerable to shocks.  

 

Liquidity management rules serve little purpose and should be replaced with a better capital-adequacy framework and resolution structure.  There are limits to supervisor’s abilities and resources which places limits on what they can accomplish.  This might suggest simplification of the regulatory structure and strive for accident prevention rather than micro management of large, complex financial institutions.

 

Lastly, there is a need to simplify and reduce bank interconnectedness to increase the reliance on market discipline.  This would allow large creditors that provide a much larger fraction of bank funding than shareholders, to be exposed to losses for their mistakes.  This combined with the leverage limits might reduce reliance on wholesale funding and trading activity.  The simplification of the complex bank interconnections could lower counterparty vulnerability to systemic risk.   The idea is to reduce the too-big-to-fail syndrome and the implicit guarantee that is associated with it.  Large bank creditors are exposed to more losses and may help limit government exposure to those activities that require high levels of capital support.

 

The failure to identify and mitigate the risks left by Basel III could be a costly mistake.

 

For more on this, follow the link: www.voxeu.org/index.php?q=node/7678

        

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

 

Has Austerity Gone Too Far? Unconventional Wisdom

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

As we noted in our blog dated Feb. 24^th on Risk Washing, managers/companies (policymakers) often cloak themselves with conventional risk management measures to produce results.  However, there are times when conventional policies may not produce the desired result.Giancarlo Corsetti & Gernot Mueller discuss the application of fiscal austerity and when it might not produce desired results in a VOXEU piece called Has Austerity Gone Too Far, Feb. 20^th,

 

Numerous countries facing debt problems have recently embarked on fiscal tightening.  Yet it is not clear if it is a cure or a self-defeating strategy.  The measures adopted so far are not seen as sufficient to stabilize market concerns about debt sustainability.     

 

The weak output growth caused by fiscal austerity when combined with a renewed economic slowdown may itself fuel market doubts about government solvency.  Higher funding costs, combined with lower activity, might thus worsen fiscal positions, defeating the very purpose of the initial tightening measures.  The evidence suggests that where sovereign risk is high, fiscal tightening remains an important avenue to reduce deficits while limiting the cost to economic activity. 

 

There are cases in which monetary policy is constrained in supporting aggregate demand and governments should avoid immediate fiscal contraction while committing to a credible medium-term deficit reduction.  The authors note the fundamental importance of sovereign risk for macroeconomic stability.  The problem is that countries experiencing debt and sovereign-risk issues are more vulnerable to adverse borrowing conditions in the broader economy. 

 

This has three implications: (1) fiscal multipliers are lower when sovereign risk is high; (2) pro-cyclical fiscal policy may help macroeconomic stability; and (3) there’s a need for policies beyond austerity.  The authors suggest policies to counter the output costs of fiscal austerity.  One way is to reduce the impact of sovereign risk on private-sector borrowing conditions.  Options include: existence of strongly capitalized banks; policies that may offset higher sovereign risk premia; and the availability of extra funds to provide liquidity.

 

Fiscal austerity is a necessary condition to bring down deficits and reduce sovereign risk.  However, in certain cases of high sovereign risk, austerity may have unintended consequences and other options are needed to contain sovereign risk premia and/or limit the impact on broader economic conditions.

 

As with risk management, conventional policies may not always produce the desired results.  Do you have this problem?   

 

For more on this follow the link: www.voxeu.org/index.php?q=node/7642