RSD Solutions - Blogs

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

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, 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 3, 2012

Fiscal Sustainability and Systemic Risk

by Don Alexander , MBA

Associate, RSS Solutions Inc.

Fiscal positions in many economies were on an unsustainable path before the financial crisis. The crisis led to a further deterioration in fiscal sustainability by increasing fiscal deficits and debt. As a result, financial markets and credit rating agencies took a more critical view of sovereign credit risk. Government debt and deficits that had been tolerated before the crisis were no longer considered sustainable. The BIS looks at some of these issues and potential risks in their 82^nd Annual Report in a chapter called Restoring Fiscal Sustainability.

Sovereigns under fiscal pressure have been losing their risk-free status, as reflected in sovereign credit default swaps (CDS) spreads and credit rating downgrades. The broad availability of safe assets aids the operation of financial markets and the conduct of monetary policy. And a sovereign whose debt is essentially free of credit risk has ample room to implement countercyclical policies to support macroeconomic stability

This has generated concerns sovereigns losing their risk-free status or, more specifically, about their liabilities becoming subject to non-negligible credit risk. To be sure, even from this narrow perspective, full risk-free status is an ideal goal rather than a realistic objective. Indeed, the worst possible outcome is treating an asset as risk-free when, in fact, it is not. The existence of such assets contributes to the smooth and efficient functioning of the financial system.

Restoring the supply of risk-free assets requires that governments convincingly address high deficits as well as projected increases in their long-term liabilities. Governments will have to significantly improve their fiscal balances to put their finances on a sustainable path and restore confidence in their fiscal positions. Fiscal consolidation has started in anumber of economies, but more needs to be done. Nevertheless, many of the countries that implemented deficit reduction measures were not able to meet their headline deficit-to-GDP targets.

Financial markets can both help and hinder the return to fiscal sustainability. On the one hand, market discipline can provide incentives for fiscal consolidation. On the other, financial markets can remain complacent about fiscal problems for too long and react too late. Policymakers should therefore not wait for market signals to emerge in order to engage in fiscal consolidation.

Governments should implement pension and health care reforms now while reducing the long-term contingent liabilities to bolster confidence in the long-term sustainability of public finances. Countries must implement reforms and delaying fiscal consolidation could weaken confidence, leading to higher borrowing costs. Policy recommendations differ as to the best timing of fiscal consolidation. It is important for policymakers to manage the expectations of investors and financial markets by encouraging them to look beyond the very short term. This means communicating clearly about the likely impact of planned fiscal consolidation measures at various horizons. Structural policies, including product and labor market reform, are especially important. They can facilitate the reallocation of resources, support competitiveness and boost productivity growth.

Longer-term, policymakers need to take measures to break the link between the banking sector and sovereign risk. One step is encouraging banks to build capital and liquidity buffers – a priority of the regulatory reforms under way – which would reduce the probability those governments would have to bail them out again. Fiscal positions were already unsustainable before the financial crisis, which in turn led to significant further weakening. The deterioration of public finances has undermined financial stability, lowered the credibility of fiscal and monetary policy, impaired the functioning of financial markets, and increased private sector borrowing costs. Restoring sustainable fiscal positions will require implementing effective fiscal consolidation, promoting long-term growth, and breaking the adverse feedback loop between bank and sovereign risk. Otherwise, risk managers will remain busy managing exposures.

For more on this follow the link: www.bis.org/publ/arpdf/ar2012e5.htm

Saturday, June 16, 2012

Cleaning up the mess: Bank resolution in a systemic crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Friday, June 1, 2012

The End Of The Euro: A Survivor’s Guide

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

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

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

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

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

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

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

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

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

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

Thursday, May 24, 2012

Risks to Continued Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

French and Greek voters are rejecting austerity, forcing politicians to take the austerity debate seriously. Voters are correct in that it is a bad idea to tighten fiscal policy when growth is so feeble as argued by Charles Wyplosz in recent VOXEU communique (14th May) The impossible hope to an end of austerity. However, the road away from austerity is blocked by conventional policy views that debt reduction has the highest priority – often used to justify risk taking without considering potential implications.

Evidence from Greece and elsewhere is that growth is disappointing and the debt-to-GDP decline is negative and deficits are “surprisingly resistant”. The problem is that most policies take time to work, such as structural reforms that may take several years and do not provide prompt relief.

It is a poor idea to tighten fiscal policy when growth is feeble or negative. The results from budget consolidation are disappointing as the levels of gross public debt remain above earlier estimates and in some countries have increased. European voters do not feel that the economic and personal costs have produced any significant results. The case for fiscal consolidation remains weak when countercyclical action is required.

Monetary policy has some importance as lower rates are needed, but with rates near zero any effect would be largely symbolic. The results from quantitative easing have yet to prove its effectiveness as banks’ focus is on deleveraging. The recent ECB liquidity facility seems largely used by banks to hoard cash rather than make new loans.

Fiscal expansion remain a weak option as a number of countries have lost market access or on the verge of losing it. Financial markets continue to clamor for growth and no austerity, but do not want to provide financing at attractive rates for growth. Even if countries can borrow at attractive rates, can they serve as a locomotive role for growth?

Wyplosz offers several ideas around the policy debate to provide some stimulus: 1) The European Investment Bank (EIB) could borrow and finance spending without adding to the members’ public debt burden; 2) The European Commission could speed up spending on infrastructure to produce some stimulus; 3) Eurobonds could be issued and collectively underwritten by member states; 4) The bonds could be made senior to existing bonds: and 5) The debt of some countries could be restructured. The author concludes that all the policies combined would not be enough of a stimulus.

The problem is holding governments to infeasible debt reductions for a couple of years that will take decades to resolve. Otherwise, voters will continue the protest and the austerity debate will remain a “hot” political issue. As in risk management, conventional wisdom does not always provide the best answer.

For more on this follow the link: www.voxeu.org/index.php?q=node/7988

Tuesday, May 15, 2012

The Coming Revolt Against Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Tuesday, May 1, 2012

Risks from Reduced Asset Quality

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The financial crisis has raised concerns about sovereign debt sustainability has reinforced the notion that no asset can be viewed as truly safe. Recent rating downgrades of sovereigns previously considered to be virtually riskless have reaffirmed that even highly rated assets are subject to risks. The notion of riskless assets—implicit in credit rating agencies’ highest ratings has created a false sense of security, especially as the demand for these assets increase while supply shrinks.

The International Monetary Fund Global Financial Stability Report (GFSR) Safe Assets: Financial System Cornerstone? (April 2012). Report looks at the role of safe assets; the effects of different regulatory, policy, and market distortions; and potential future pressure points.

Safe assets have varied functions in financial markets, including as a store of value, collateral in repurchase and derivatives markets, key instruments in fulfilling prudential requirements, and pricing benchmarks. Without distortions, safety is priced efficiently, reflecting demand-supply dynamics.

The demand and supply imbalances in global markets for top rated assets are not new. Prior to the crisis, current account imbalances encouraged safe asset purchases by reserve managers and sovereign wealth funds. Now, demand is being driven by periods of uncertainty, the lack of clarity about regulatory reforms, increased collateral needs for over-the-counter (OTC) derivatives transactions and the use of such assets in central bank operations.

Conversely, on the supply side, GFSR report estimates the number of safe sovereigns may decline by $9 trillion by 2016, or 16 percent. Shortages of safe assets could also lead to more short-term spikes in asset volatility, and shortages of liquid, stable collateral. If collateral became too expensive, funding markets would be compelled to accept lower-quality collateral, raising funding costs. The shrinking supply of safe assets, now limited to high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. Safe asset scarcity could lead to more short-term volatility jumps, herding behavior, and runs on sovereign debt.

In the case of banks, the preferential treatment of sovereign debt in banking regulations can increase the use leverage. The upward bias to capitalization ratios can lead to overestimation of the capital buffer available during periods of market stress. Under current regulations, banks’ holdings of debt issued by their own governments—and in the case of the European Union, of the debt of any sovereign in the Union—are commonly assigned zero risk weights.

To mitigate the risks to financial stability, policymakers need to strike a balance between flexibility, the soundness of financial institutions and the costs associated with a too-rapid acquisition of safe assets. Specifically, the careful design of some prudential rules could help increase the differentiation in the safety characteristics of eligible safe assets and limit potential runs on individual types of assets. On the supply side, desirable policies include improving fiscal fundamentals and encouraging the private production of safe assets through improved securitization practices. These efforts can remove impediments that may inhibit safe asset markets from moving to a new price for “safety.”

For more on this follow the link: http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf

Tuesday, April 24, 2012

Has Systemic Risk Declined?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

Yes according to the International Monetary Fund’s Global Financial Stability Report (GSFR) (April 2012). The report notes that financial stability has improved in recent months, although markets still remain fragile, yet policymakers seem committed to long-term reforms to restore confidence.

Recent policy steps have brought some relief to euro area financial markets, but remain under pressure from weak growth and high debt payments. Sovereign spreads have declined, bank funding markets are reopened, and equity prices have recovered.

Nevertheless, European banks remain under pressure from sovereign exposure, weak euro growth, high rollover requirements, and the need for more capital. EU-based banks are under pressure to deleverage with the IMF estimating that their balance sheets could shrink by euro 2 trillion (7%) by the end of 2013. They estimate that 25% of the reduction will occur in lending (reduces outstanding credit by l.7%) and the remainder from securities and non-core asset sales.

The IMF identified two near-term priorities: limiting the consequences of a large-scale deleveraging through close supervision to avoid damage to asset prices, credit supply, and economic activity, and prevent the outbreak of downside risks by establishing a financial backstop or firewall. In addition, long-term European policymakers need to establish a euro-wide financial stability framework and pan-European bank supervision and resolution. The IMF also noted that Europe needs central oversight of fiscal policy and greater fiscal risk-sharing.

The recent decision to combine the European Stability Mechanism with the European Financial Stability Facility will strengthen the European crisis mechanism and support the IMF’s global firewall.

Elsewhere, emerging markets need to adopt policies to reduce fallout from Europe particularly from European banks. The United States and Japan, with their high fiscal deficits, need to establish a political consensus for medium-term deficit reduction, to maintain financial stability.

Housing issues need to be addressed in a number of countries.

Meanwhile, the global financial regulatory framework is being strengthened, but key agreements still need to be concluded, while the transition to this new setting could add to cyclical challenges facing financial institutions. Elsewhere, the report noted increased structural risks from lower rated assets used for collateral and the underestimation of longevity risk.

The jury is still out on the reduction of systemic risk or has it been kicked down the road?

For more information on this, follow the link: www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c1.pdf

Thursday, April 12, 2012

Managing Risk: The How and How Much

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Thursday, April 5, 2012

Unconventional Wisdom – Rethinking Fiscal Austerity 2

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Wednesday, March 28, 2012

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

Thursday, March 22, 2012

Lessons from Sweden for Europe and Crises Resolution

by Don Alexander, MBA

Associate, RSD Solutions Inc.

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

Monday, March 12, 2012

The Cost of Reducing Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

The global financial system is facing a number of especially complex changes and challenges. This uncertain environment has prompted calls to reconsider or weaken financial reform and for it to take a back seat to more immediate concerns, such as sovereign risk, weak global growth and inflation risk. In this view, financial institutions and regulators are being asked to do too much, too soon.

Jaime Caruna, BIS General Manager addresses some of these issues in a recent speech Building a Resilient Financial System (Speech, Feb.7^th). He notes with the current uncertainty and vulnerabilities makes it all the more important to strengthen global financial institutions and establish a reform agenda to avoid further unexpected strains. As a result, authorities and banks should move faster and further to create a more robust financial system rather than taking the maximum time to achieve minimum capital strength. A recovery is based on a stable financial system so that business and households can invest and spend with confidence.

A number of broad principles guide this work. First, financial stability is about resilience and should be prepared in advance. Second, preserving financial stability involves a wide range of policy areas. Third, a globalized financial system requires global rules. And fourth, stay focused on the end result, namely a system characterized by less leverage, better liquidity management, sounder incentives, less moral hazard, stronger oversight, and more transparency. With this in mind, the appropriate timetables can be established, and their implementation monitored for unintended consequences.

The key challenges in carrying forward this agenda are: (1) implementing what has been agreed, especially with regard to bank capital; (2) designing the right transition given a still weak recovery; (3) completing the regulatory reform agenda, notably in the areas of liquidity standards, resolution regimes, OTC derivatives, and the shadow banking system; and (4) ensuring sound micro- and macro prudential oversight.

Authorities have a challenge for completing the regulatory agenda, establishing macroeconomic stability at a global level, reducing debt back to sustainable levels, normalizing monetary policy and continuing to guide the recovery. All three elements of policy – fiscal, monetary and prudential – are needed to work together to deliver a strong, sustainable global growth.

A question becomes what is the cost of this effort? The Institute of International Finance, in their recent report The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework (Sept. 2011), suggests that impact of these changes will be a global loss of output of 3.2% GDP through 2020 (assumptions and results differ across countries). This contrasts to recent BIS and IMF estimates (BIS Macroeconomic Assessment Report 2010 & 2011and IMF WP Macroeconomic Costs of Higher Bank Capital and Liquidity Requirements 2011)suggest the impact is much smaller or a loss of global output of 0.5-0.6% GDP through 2020. Alternatively, what is the cost of doing nothing?

For more on this follow the link: www.bis.org/speeches/sp120208.pdf

Thursday, March 8, 2012

Rethinking Basel III and the Regulation of Derivatives

by Don Alexander, MBA

Associate, RSD Solutions Inc.