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

 

Reflections on Mr. Bernanke’s Speech at Jackson Hole and Future Monetary Policy

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Unlike at his Jackson Hole speech in 2010 when QE2 was presented, Fed Chairman Bernanke did not pull a rabbit out of the policy hat last week.  The focus was not on the immediate outlook for the economy or monetary policy, but more on the structural headwinds facing the US economy and other long-term issues such as fiscal policy.  Mr. Bernanke made two surprises on short-term policy: the lack of discussion about further asset purchases or other easing options and that further policy options will be considered at upcoming FOMC meetings.     

 

He differentiated between the cyclical and structural/secular role of monetary policy, noting that the Fed is less effective when it comes to the latter role.  He reminded his listeners that the Fed alone cannot carry such a heavy policy burden and that fiscal policy was needed to promote growth and stability.  Fiscal policymakers face a fine balancing act “the need to place fiscal policy on a sustainable path” and to avoid “severe economic and financial damage” while noting the fragility of the current environment.  He noted reforms are needed in other areas of economic management, emphasizing the need for a better process for making fiscal decisions.  

 

Mr. Bernanke noted economic policies that support robust economic growth in the long run are outside the province of the central bank.  He implied in the President’s upcoming speech on needed fiscal stimulus and job creation – a constructive and collaborative approach by the Administration and Congress was required.  Another round of damaging policy dithering and political bickering would have strong adverse consequences on the economy.

 

The Fed continues to have a more optimistic view on US economic prospects than most private sector analysts.  The major difference is the Fed assumes that a number of temporary factors that depressed economic activity in the first half will not be present in the second half.  If this view is correct, it would imply that chances for QE3 are minimal.  However, if the Fed view converges to that of private sector, the chances for QE3 increase.  The most likely form would be through increased asset purchases of longer-dated maturities.

 

Other extreme measures would not be considered, unless the economy and financial markets substantially deteriorate below current prospects.  The Fed would have three possible policy options: the extension of the QE program into other markets such as corporate bonds, a sharp increase in the program that extends the Fed’s balance sheet and an explicit or implicit change in the Fed’s policy targets.  However, US economic prospects have not deteriorated enough to consider these options.

US Economic Developments & Conventional Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions,com 

 

Recent US Economic Developments

 

S & P has downgraded the US long-term sovereign debt rating from AAA to AA+ and kept the rating outlook as negative.  They noted a further improvement in the fiscal situation will be required to avoid further downgrades (reducing the deficit by $4tr not $2tr).  Moody’s & Fitch have not altered their AAA rating at the current time.  The US short-term rating remains intact at A1+, with no impact expected on money market funds.

 

US non-farm payrolls showed gains of a little over 115,000 with unemployment rate at 9.1%.  The gains in the private sector were partially offset by a decline in government employment.  The US economic growth was revised lower to 0.8% in the first half of the year.  Overall, a number of investment firms have lowered growth estimates through 2012 year-end to a little over 2%.

 

Conventional Fed Policy Options

 

Fed officials enter August with weaker than expected economic growth and projections of extended period of below trend growth increasing the pressure for further monetary easing.  This has a similar parallel to last year and if further downside risks persist, the Fed may implement QE III.  Currently, the Fed’s three conventional policy options: communication to investors & the public, asset purchases & sales and interest rate policy.

 

The first option the Fed might consider is “forward guidance” given the size of the Fed’s balance sheet.  This might have a minimal economic impact, but could be combined with a link to a specified period of low policy rates or an economic event.  Asset purchases or sales are a second policy option, but are limited by the size of the Fed’s balance sheet.  One application is to keep the balance sheet size the same, but to increase the duration risk by buying longer-term securities.  This could be combined with a reinvestment of maturing mortgage holdings.  Any proposed increase in the aggregate duration risk would be considered as policy easing.   The last option is to cut the interest paid on excess reserves left at the Fed.  This would have minimal impact since effective fed funds are already 0.08% and a zero rate on excess reserves could damage market institutions.  

 

Fed action would only be driven by increased downside risk.  Any change in communication or composition of the balance sheet would have at best a symbolic impact on the economy.  The US economy stands on the risk of falling into a double-dip recession; the Fed clearly lacks conventional policy tools to do much about it unless combined with other policy alternatives.

 

A Square Peg in a Round Hole – Politicians Create Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

European politicians, in their attempt to create the euro, did so with the view that one size fits all.  In this case, they overlooked basic economic fundamentals such as competitiveness, labour productivity and assumed a uniform monetary policy should be the same for all countries.  They did not think to establish guidelines to monitor potential risks.  This question is now being asked.

 

Is Europe an optimal currency area? Is the euro doomed?  The author, Carlo Faverro, argues that economic differences within Europe, exposed by the current crisis, are reasons to doubt the sustainability of the single currency.  One element is an optimal currency is an area-wide monetary policy associated with country-specific and very heterogeneous nominal and real long-term rates. 

 

The author looks at the relationship between long-term rates from the pre-EMU period through the next 10-11 years after EMU formation in 1998 and the subprime financial and euro debt crises.  The first period showed nominal yield differentials associated with inflation differentials.  After the euro introduction, nominal and real long-term rates converged as inflation differentials disappeared.  However, in the crisis period, long-term rates have diverged as long-term real rate spreads have gapped higher, despite minimal inflation differentials. 

 

The ECB’s common monetary policy controls short-term policy rates, but does not control investment and consumption -- key components of growth that depend on real bond yields.  High real long-term rates negatively impact consumption and investment, especially in peripheral countries where growth is needed to help fiscal stabilization.  The common currency has prevented exchange rate movements that normally offset emerging growth differentials.  The peripheral countries are experiencing higher labour costs, loss of competitiveness and surging deficits: factors that could dampen growth prospects.  The inability to reduce fiscal deficits may not be enough to restore real long-term yield convergence.  The doubtful attempt to sustain a common monetary policy with differential economic impacts casts doubt on the sustainability of the euro as a common currency area.  However, it might be reduced to a smaller area.

 

Do you know your potential exposures and risks?

 

For more on the Euro’s current issues, click on the link:  http://tinyurl.com/42c23vj  

 

Risk Management in Large, Complex Organizations – Lessons from the Eurozone

By Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Guillermo de la Dehasa wrote an interesting paper for Voxeu called “Eurozone Design and Management Failures” (May 2011).  The paper provides an interesting perspective on the role of risk management in a large, complex organization.  The risk management failures include: taking into account and ignoring known risks, monitoring and managing risk, and using the appropriate risk metrics.

 

Europe’s sovereign-debt crisis is a defining moment for the Eurozone in that it exposed the weakness of the monetary union’s design, governance and management.  Academics pointed out three basic initial design flaws overlooked by policy makers in their haste to create the euro:  the lack of price and wage flexibility, a monetary policy where one size fits all and the lack of monitoring of individual countries’ fiscal policy.

 

The Eurozone sovereign-debt crisis uncovered more serious flaws:  the Eurozone policymakers (IMF was) were not equipped to deal with a solvency crisis; the European Financial Stability Fund (EFSF) only provided a short-term liquidity facility.  A liquidity facility may delay the day of reckoning and raise the cost and lastly there was no provision in various Eurozone agreements for resolving a solvency crisis.  The present system, at best, contributes to the creation of a debt overhang increasing the cost of crisis resolution.

 

The three current bailouts were triggered by policymaker management failure to address the solvency issue.  The failure to incorporate risk analysis into Eurozone policymaker culture and strategic thinking could prove extremely costly for investors and painful for Eurozone citizens. 

Unquestioned Assumptions

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Does your company revisit assumptions upon which your approach to risk is based?  Are assumptions challenged?  Is there a dynamic process to do this?  Throughout most of my career, U.S. government obligations have been considered to be the definitive risk free debt.  No longer, now that S&P has placed it on negative outlook.  Willem Buiter, a former member of the Monetary Policy Committee and now chief economist at Citigroup, told the CFA Institute annual conference in Edinburgh[1]: “S&P’s negative outlook (on the US) is likely to be followed by a negative watch and then a downgrade early in 2013, unless a miracle happens …”.

 

Should this have been foreseen some time ago?  I would argue that this assumption about U.S. government debt should have been questioned several years ago.  In fact, perhaps it should never have been taken as an assumption. 

 

Nothing is risk free and no assumptions are valid beyond the moment they are made.  That is why a risk management system must be dynamic, and not imposed statically and left to apply until someone new comes in and decides to do an update, perhaps years later.

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[1] As reported in the Herald www.heraldscotland.com/business/markets-economy/us-economy-may-face-debt-downgrade-1.1100695