RSD Solutions - Blogs

(Mr. Alexander is also a lecturer at NYU and SunySB)

It is been four years since Lehman went under. There have been important initiatives on the regulatory front to minimize taxpayer bailouts to the financial sector (aimed at the banking sector). The payouts (i.e., taxpayer bailouts) in various forms were provided by governments to a variety of financial institutions and markets that were outside the regulatory perimeter—the ―shadow‖ banking system, although, a few recent regulatory proposals attempt to reduce these ― imputed puts.

These issues are examined in a recent IMF working party called “Puts” in the Shadows by Manmohan Singh (Sept. 2012). This study provides examples from non-banking activities within a bank, money market funds, Triparty repo, OTC derivatives market, collateral with central banks, and issuance of floating rate notes etc., that these risks remain. The results suggest that a regulatory environment where puts are not ambiguous will likely lower the cost of bail-outs after a crisis.

There are a plethora of views on reducing systemic risks at banks, including reverting to the Glass Steagall Act that separates commercial banking (i.e., depository type of business) with the non-depository business. Intermediate solutions like the Vickers and Volcker Rule that insulate (or provide buffers) to the depository part of the banks, or push out riskier activities outside the BHC (Bank Holding Companies) have gained momentum in various key jurisdictions. However, proposed regulation (via Basel III, Dodd Frank Act etc.), is unlikely to remove all the puts within the BHC, as it is one legal entity. The recent FSB (Financial Stability Board) list of SIFIs (Systemically Important Financial Institutions) acknowledges that the overall BHC is systemic.

The nonbank/bank nexus is an important part of financial system. However, nonbanks are separate legal entities outside a bank and thus the puts do not legally pass from the bank to the nonbank (and they shouldn‘t). There is sound economics behind the existence of nonbanks and these entities should not be driven only by regulatory arbitrage due to the puts. On non-bank resolution, no country has a comprehensive regime for addressing non-bank SIFIs, mostly because until recently nonbanks were rarely considered systemic. Thus, resolution of non-banks has become an increasing priority aside from the push for ―living wills. Regulators are starting to address this and the U.K.‘s Treasury and EC intend to publish consultation papers on this issue.

A less ambiguous regulatory environment will lower moral hazard; this will likely reduce cost to taxpayer if/when bailing out the shadow banking system. However, by intent, or political/policy choice, or by limited foresight, if ―puts are not removed ex-ante a crisis, there will always be room for bailouts. An example of an intended (but implicit) put is the creation of CCPs (Central Counter Party)―despite earnest efforts to reduce the size of SIFIs, the creation of new SIFIs (i.e. CCPs) is not clear. Another example is the political/policy choice not to explicitly remove the put from the MMFs industry in the U.S―it continues to offer par NAV (net asset value) with no capital supporting the business. Similarly, an example of limited foresight is bailing out money-like collateral at subsidized haircuts―recall Fed‘s PDCF (Primary Dealer Credit Facility), and the ECB‘s LTROs (Longer-Term Refinancing Operations) and the respective Eurozone national bank‘s ELA (Emergency Liquidity Assistance) efforts.

There will always remain some (unintended) puts ex-post a crisis. However, the puts that can be removed ex-ante should be addressed; otherwise "shadow banking" will continue to be a pejorative term and the issue of systemic risk is not fully addressed in reform proposals.

For more on this follow the link: www.imf.org/external/pubs/ft/wp/2012/wp12229.pdf

Tuesday, September 18, 2012

The Cost & Effectiveness of Regulation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences. The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past. The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.

However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments. There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction. The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.

The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.

There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.

Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy. The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.

For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf

Monday, September 17, 2012

Veil of Conceptions

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

The Scottish philosopher Thomas Reid claimed that “We see the world not as it is but through a veil of conceptions.” What is the veil of conceptions that your organization works from?

Friday, September 14, 2012

Words and Numbers

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Words and numbers are both used to communicate – particularly in risk management. However have you ever considered the difference in how they are perceived and internalized? Words are known to be full of biases and nuances. Words are a function of the person who spoke them or wrote them. Numbers are the same. Most of us realize that numbers can also have built in biases and slants and can be a function of who produced them. However I suspect that we are generally more aware of the biases and nuances in words than we are in numbers. Something to think about.

Thursday, September 13, 2012

Meaning of Life

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

I like George Carlin. He was one of my favorite comedians. His ability to bring out the absurdities of life in that goofy way of his rarely failed to bring a smile to my face. And yes, I will freely admit to listening to the “Dirty Words” album that we borrowed from a friend’s older sister. (The humour of it was quite different when you were in grade 7.)

One of the great skits of George Carlin was on the meaning of life and his quote “Just when I found out the meaning of life they changed it”. It is a funny line, but it is also quite true. Life evolves, as do organizations. Just when you think you have figured something out you realize that it has evolved, it has changed. It is a fact of life and a fact of organizations. Something we need to keep in mind as risk managers.

Wednesday, September 12, 2012

The Dog and the Frisbee

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity. Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans (Haldane speech at Jackson Hole 2012).

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among the The general message here is that the more complex the environment, the greater the perils of complex control. The optimal response to a complex environment is often not a fully state-contingent rule. Rather, it is to simplify and streamline. In complex environments, decision rules based on one, or a few, good reasons can trump sophisticated alternatives. Less may be more.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity. Haldane explores is why the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.

Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. Finance has been built on often stringent assumptions about humans’ state of knowledge and cognitive capacity.

As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.

Take decision-making in a complex environment. Under risk, policy should respond to every raindrop; it is fine-tuned. Under uncertainty, that logic is reversed. Complex environments often instead call for simple decision rules. That is because these rules are more robust to ignorance. Under uncertainty, policy may only respond to every thunderstorm; it is coarse-tuned.

The density and complexity of financial regulation has had predictable consequences for the scale and scope of regulatory resources. One metric for that would be the number of human resources devoted to financial regulation, the exponential growth of regulations and the number of regulatory departments.

Of course, the costs of this regulatory edifice would be considered small if they delivered even modest improvements to regulators’ ability to avert future financial crises. The public policy question is – will they? In financial regulation, is more more or is more less?

In forgone output, financial crises can be as costly as wars. The public policy issue, then, is whether the war on crises is best waged with the weapons of the past. Einstein wrote that: “The problems that exist in the world today cannot be solved by the level of thinking that created them”. Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise.

An alternative point of reference when regulating a complex system would be to simplify and streamline the control framework. Based on the evidence here, this might be achieved through a combination of five, mutually-supporting policy measures: de-layering the Basel structure; placing leverage on a stronger regulatory footing; strengthening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system.

Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.

For more on this follow the link: www.bankofengland.co.uk/publications/Pages/news/2012/075

Tuesday, September 11, 2012

Risk Lab

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Does your company have a risk lab? Do you have a place where you can test ideas about risk management? Or do you just take risk ideas at face value and assume they are correct? Not everything can be tested, but have you thought about risk assumptions you are making that should be tested?

Monday, September 10, 2012

Last Year

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

You have probably heard the saying about the two workers who started at the same organization at the same time. One got rapidly promoted and was well known throughout the organization for their intelligence and their value to the organization. This worker was rapidly and continually promoted until they were one of the most senior and most respected people in the organization. The other worker worked just as hard, but ten years later was still working at the same job, while the other was a senior executive.

Both people started at the same time, and thus both had the same amount of experience. Why did one rise rapidly through the organization, while one stayed stagnant in the same job? The answer of course is that one learned and changed and evolved. They built on ten years of experiences. They changed each year and developed. The other worker had 10 one year experiences which they repeated year after year. They refused to learn, and they refused to evolve. They did the same things, in the same way, and while they became very practised and proficient in working that way, they never evolved and never developed the skills and competencies to take on ever more challenging tasks.

As a risk manager are you developing and evolving and building new competencies, or are you doing things the same way that you did them last year, and the year before that, and the year before that …

Friday, August 10, 2012

Olympic Visualization

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

A key aspect of sports psychology is visualization. Before competing, many athletes have been trained to visualize themselves performing the event in the best possible manner. This has proven to be a very powerful technique for producing improved performance. If you see a TV close-up of an athlete in the moments before an event, you will often see them with their eyes closed. This is them going through their visualization technique and preparation.

Let’s take a moment and step away from athletics. Suppose there was a form of visualization that worked for business management that proved to be as powerful as visualization for sports. For your risk management function, what would you visualize? In other words, what would be the perfection of risk management implementation that you would run through in your mind? Not so easy to come up with an image is it? However if you cannot visualize it in your mind, how can you mange towards it?

Thursday, August 9, 2012

Olympic Failure

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

Gold medal Olympians for the most part go on to fame and fortune. We remember their names and they are paraded before us all as heroes, and justifiably so. Silver medalists less so, and bronze medalists even less. Fourth place finishers barely get mentioned and those who finish fifth or below are quickly forgotten after the pre-Olympic hype is over. However the difference between first and last can literally be fractions of a second, or a minute amount of performance. The Olympics are a winner take all series of events. Perfection is needed for success, and anything less than perfection is relegated to the hazy memory pile and quickly forgotten. Finishing off the podium is often considered to be Olympic failure.

We often treat risk management as a winner take all event. The thinking is frequently that risk management needs to be perfect in order to be successful. The tragedy of this is that it is not possible to be perfect in risk management. It is not possible to be even close to perfect in risk management. Striving for perfection only leads to missed expectations and frustration. However being good, and trying to always be better, will lead to a strong competitive advantage, and the equivalent of a gold medal performance.

Not being on the risk management podium is not failure. However just striving to be an Olympic quality competitor in risk management does almost automatically put you on the podium. It is concentrating on being perfect, or not trying at all that makes you a risk management failure of Olympic proportions.

Wednesday, August 8, 2012

Olympic Coaches

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

While watching the Olympics, have you ever looked at the physiques of the coaches? Many of them are old, pot-bellied and out of shape. No one doubts their expertise, but not for a minute does someone thing that they would be able to perform the feats of the competitors.

I point this out to highlight the fact that knowing, and being able to do are often two very different things. Knowing a lot about risk management is not the same as doing risk management. Banker’s Trust knew how to do risk management, but they could not, would not, or did not do risk management.

Olympic coaches are great assets. Not so great doers.

Tuesday, August 7, 2012

Welcome to the ECB & Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Friday, August 3, 2012

Fiscal Balances & Systemic Risk

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by Don Alexander, MBA

Associate, RSD Solutions Inc.

The IMF’s noted in its’ Interim Fiscal Monitor (July 2012) that fiscal adjustment is proceeding generally as expected in advanced economies, with headline and underlying fiscal deficits that are broadly in line with projections made in the April 2012. In advanced economies with easier market access, fiscal adjustment in 2012–13 is broadly on track to meet medium-term targets. Overall, advanced economy deficits are forecast to decline by about ¾ percentage point of GDP this year and about 1 percent of GDP next year in headline and cyclically adjusted terms, a rate that strikes a compromise between restoring fiscal sustainability and supporting growth.

Deficits in emerging economies are expected to be somewhat weaker than projected in April, as some draw on fiscal space in response to slowing economic activity. No significant fiscal consolidation is on tap in 2012–13, reflecting generally stronger fiscal positions than in advanced economies and downside risks to global growth. However, some emerging economies need to be more ambitious to reduce vulnerabilities.

Europe developments remain a problem where sovereign debt is in a negative feedback loop with the banking sector. The continued focus on nominal deficit targets runs the risk of compelling excessive fiscal tightening if growth weakens. The two largest such countries, Italy and Spain, are implementing sizeable fiscal consolidation in the next two years in efforts to improve debt dynamics and regain market confidence. Market turbulence has intensified in Spain due to renewed concerns about the health of the financial system and its possible fiscal implications. Italy’s headline and cyclically adjusted deficits for 2012–13 continue to be broadly in line with expectations could achieve a small structural surplus in 2013. The situation in Greece remains in flux with revenue under pressure and slow pace of reforms.

Elsewhere, there is a risk in the United States of political gridlock that puts fiscal policy on autopilot and results in a sharp and sudden decline in deficits—the “fiscal cliff.” The United States’ fiscal position is projected to improve, but the outlook for 2013 remains a significant concern. Expiring tax provisions and automatic spending cuts mandated by the 2011 Budget Control Act would imply a fiscal withdrawal of more than 4 percent of GDP—the so-called ‘fiscal cliff’—which would severely affect growth in the short term. A more modest retrenchment in 2013—of around 1 percent of GDP in structural terms—would be a better option.

In most advanced economies, a steady pace of adjustment focused on the measures to be implemented rather than on headline deficit targets is preferable, especially in light of heightened downside risks to the outlook. Japan’s budget deficit and high debt level remains a problem and aging population defies any near-term solutions. The proposal to increase the consumption tax sends a positive signal of commitment to fiscal adjustment and reform. However, the tax increase would remain only part of the consolidation necessary to put the debt ratio on a downward path.

Governments face the task of credibly dealing with large fiscal adjustment needs in a time of slow and uncertain growth. Reconciling these needs may be challenging, but following some basic fiscal principles (to be adapted on a case- by-case basis) should help.

The risk remains that fiscal deficits persist accompanied by stagnant growth posing a challenging environment for risk management.

For more on this follow the link: www.imf.org/external/pubs/ft/fm/2012/update/02/fmindex.htm

Thursday, August 2, 2012

Finance, Growth & Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

One of the principal conclusions of modern economics is that finance is good for growth. The idea that an economy needs intermediation to match borrowers and lenders, channeling resources to their most efficient uses, is fundamental to our thinking. There is evidence supporting the view that financial development is good for growth and a causal link between finance and growth. This, in turn, was one of the key elements supporting arguments for financial deregulation.

Recent research by Steve Cecchetti & Enisse Karroubi from the BIS paper, Reassessing the impact of finance on growth, investigates how financial development affects aggregate productivity growth. This question is addressed by examining the impact of the size and growth of the financial system on productivity growth at the level of aggregate economies. Based on a sample of developed and emerging economies, the authors show that the level of financial development is good only up to a point, after which it becomes a drag on growth. Second, focusing on advanced economies, they indicate that a fast-growing financial sector can be detrimental to aggregate productivity growth.

At first, these results may seem surprising. After all, a more developed financial system is supposed to reduce transaction costs, raising investment directly, as well as improving the distribution of capital and risk across the economy. These two channels, operating through the level and composition of investment, are the mechanisms by which financial development improves growth. But the financial industry competes for resources with the rest of the economy. It requires not only physical capital, in the form of buildings, computers and the like, but highly skilled workers as well. Overall, the lesson is that big and fast-growing financial sectors can be very costly for the rest of the economy. They draw in essential resources in a way that is detrimental to growth at the aggregate level.

The authors suggest the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth. The authors’ interpretation is that because the financial sector competes with the rest of the economy for scarce resources, financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads to a conclusion that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better.

The increased role of finance has increased the complexity of risk management. Perhaps, it might be time to simplify the process.

For more on this, follow the link: www.bis.org/publ/work381.htm

Friday, July 27, 2012

CRO Spock

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

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

Thursday, July 26, 2012

ArtScience Museum

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

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

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

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

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

Tuesday, July 24, 2012

The Other Coast

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

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

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

Keep up the good work Adrian.

Thursday, July 19, 2012

New Setbacks – Risks to the Global Recovery

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Tuesday, July 17, 2012

The Curse of Advanced Economies in Resolving Banking Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Monday, July 16, 2012

The (Other) Deleveraging and Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.