The True Lessons of the Recession, Policy Regime & Risk Paradigm

by Don Alexander, MBA

Associate,  RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Raghuram Rajan wrote an interesting article in the current issues of Foreign Affairs (May/June 2012) called The True Lessons of the Recession: The West Can’t Borrow and Spend Its Way to Recovery. The article has a number of interesting observations on the limited policy options available to advanced countries, but also for risk management and the potential increase of financial market vulnerability to systemic risks. 

 

The conventional interpretation of the global economic recession is that growth has stagnated due to the massive amount of debt accumulated by the government and private sector in the West.  A number of policymakers have attributed the anemic recovery to lack of sufficient fiscal stimulus or inadequate demand.  However, households and governments cannot borrow the funds to spend for growth as investors are concerned about rising debt levels. 

 

Rajan suggests the problem is caused not just by inadequate demand, but by a distorted supply side.  Western countries need to address the underlying flaws in the economy and avoid the quick, politically expedient fix such as financial deregulation. 

 

The post WWII economic expansion was driven by several factors: postwar reconstruction, resurgence of trade, better educated workforces, and effective use of new technologies.  As the boom ended with high oil prices in the 1970s, western governments’ quick fixes such as deficit spending, deregulation and low rates produced mixed results and did not address long-term problems.  In addition, productivity growth remained weak in many countries that did not attempt to implement necessary structural reforms.

 

Rather, these policies produced economic distortions such as concentrated job creation, financial excesses, a distorted tax system and a growing income disparity.  Politicians tended to focus on their short-term goals and ignored worker training and education.  Currently, the educational gap between job skills required and education achievement is creating further dislocations in a number of countries.  Recent economic growth has been distorted by misguided policies and governments have limited options to restore demand quickly. 

 

The way out of the crisis cannot be still more spending and borrowing.  Politicians can no longer opt for the easiest answer, but must be held accountable for making the necessary decisions.  A return to the status quo is not the answer. 

 

The best short-term policy response is to focus on long-term sustainable growth.  Fiscal austerity will not be painless and reforms should be phased in gradually over time.  Financial excess pushed the global economy into a crisis, but a return to excessive regulation is not the optimal alternative.  Finance needs to be vibrant to encourage entrepreneurship and innovation. 

 

Industrial countries should treat the crisis as a wake-up call and deal with structural issues papered over by politicians in the last few decades.  Otherwise, the West will be exposed to a long period of anemic growth.

 

The lesson for risk management is that the lack structural reforms and a system of quick fixes will leave financial markets more vulnerable to systemic risk as seen with the euro and deficit gridlock in Washington.  

 

For more on this, follow the link: http://tinyurl.com/8y5qo2k

   

Systemic Risk, Shadow Banking and Governance

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Capital Shortfall: A New Approach to Ranking and Regulating Systemic

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Viral Acharya, Robert Engle & Matthew Richardson, members of the faculty at NYU Stern School, provide an update on their work on systemic risk in a short VOXEU communique (dated 14^th March).  The authors discuss their method to estimate capital that a financial firm would need to raise if we have another financial crisis.

 

The effective regulation of banks requires identification of systemically important institutions.  The measure of capital shortfall is based on publically available information and is conceptually similar to the stress tests conducted by European and US regulators.

 

The authors note three potential approaches: (1) how much capital is required for an orderly rescue; (2) what is required for an orderly liquidation of systemically important institutions; and lastly, (3) how to regulate institutions according to their economic impact.  The authors prefer the latter where effective and efficient regulation requires the identification of systemically important financial institutions. 

 

A definition from Federal Reserve Governor Daniel Tarullo (2009): “Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy.”   The definition makes two points: (1) what happens to the institution when it cannot perform its function due to a capital shortfall; and (2) systemic risk matters when there is an impact on the broader economy.  Systemic risk should not be described as a firm’s failure per se, but the firm’s contribution to system-wide failure.  The real systemic risk of the firm is a function of the social cost of a crisis per dollar of capital, the probability of a crisis, and the capital shortfall of the firm in a crisis. 

 

The authors provide a methodology to estimate the capital shortfall of a financial institution from its various business activities in the event of another financial crisis.  The expected capital shortfall captures in a single measure the important characteristics of systemic risk: size, leverage and interconnectedness.  All of these characteristics capture widespread losses in the financial sector are reflected in the capital shortfall and also provide information of the co-movement of a firm’s assets with the aggregate financial sector.

 

The information is based on public financial information and provides timely, accurate estimates compared to the time consuming methodology of the BIS-type stress tests.  The reader is referred to their VOXEU column and their NYU website.

 

A key lesson from this approach for risk management is that a simple, well thought out methodology, that is not time consuming, can provide the same answers as a more-complex approach.  However, the value of the results is limited by the quality of the input data.  The potential under-reporting of risk exposure, such as under Basel III, may not appear in the calculations.    

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/7722

  

The Real Effect of Debt – Rising Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The Real Effect of Debt (Federal Reserve of Kansas City Jackson Hole Economic Policy Symposium, Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, Aug. 2011) Cecchetti et al, in a recent paper referenced below, looked at the debt levels and saw in moderate levels, it can improve welfare and enhance growth.  However, high levels can have damaging effects. 

The authors extend the work of Reinhart & Rogoff (2009) on government debt by including non-corporate and household debt.  Based on estimations that include government, corporate and household debt from 1980 to 2010, the authors find that excessive debt levels can have a damaging impact on economic activity.  The safe level for government debt is in a range of 80-100% of GDP.  This was consistent with earlier studies, but the study was limited to advance countries and looked at data from the last 30 years. 

The implication is that countries with high government debt levels must act quickly to address fiscal problems.  Otherwise, these countries can experience a sustained period of stagnation.  Long-term, a fiscal cushion is needed as a buffer for extraordinary events. 

Similarly, the authors find that moderate levels of corporate and household debt can enhance economic prospects.  The results suggest the threshold level for corporate debt is 90% of GDP and the level for household debt is 85% of GDP, although the result is less robust.  Total debt levels in all three sectors have increased from 165% of GDP to 310% of GDP over the last 30 years.  The most striking implication is that advanced countries are in worse shape than previously thought. 

The problem is compounded by future promises made to the people, an aging workforce and slower population growth, and lower long-term economic growth prospects.  As a result, debt rises faster, reinforcing its downward impact while raising the return demanded by investors.  The authors, economists at the Bank for International Settlements, conclude that advanced countries need to act decisively to address fiscal problems before the adjustment costs become prohibitive.

Systemic risk will be elevated for the immediate future until the debt overhang is addressed.  

 

For more information on this, follow the link:  http://tinyurl.com/3lwhww2  

 

Systemic Risks Remain Elevated According to the IMF

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

(Global Financial Stability Report – Market Update, IMF, June 2011)  Since the publication of the semi-annual Global Financial Stability Report (GSFR) in April, financial risks have increased, particularly systemic risk.  The Market Update offered three reasons. First, the multi-speed recovery remains intact as the base case, but growth could become more fragile during the second half and certain downside risks have emerged for some countries.  Second, the concern about debt sustainability and lack of political support for adjustment efforts in Europe’s periphery has increased market pressure and contagion risk. European policymakers continue to avoid making the necessary political decisions about debt restructuring (including bank balance sheet restructuring and recapitalization) and hope the problem will evaporate with another liquidity facility.  Elsewhere, certain advanced countries such as the US and Japan remain in political gridlock about how to deal with growing budget deficits. Third, despite a recent pullback from risk taking, a prolonged period of low rates could see a reversal of this view as investors search for yield. This trend could contribute to financial imbalances, particularly in emerging markets. 

 

Policymakers continue to face increased vulnerability to future shocks to the financial system, as rising systemic risk and market volatility add to existing concerns. Against these risks, a number of challenges remain.  This includes challenges on budget deficits, debt sustainability, system vulnerabilities and financial sector reforms.  Reforms are moving in the right direction, but the progress is slow and insufficient. Markets may lose patience if political developments and vested interests derail momentum on fiscal consolidation and financial repair/reform. Policy makers face a number of challenges to reduce systemic risk before the window closes.   

My Car is a Fraud

by Rick Nason PhD, CFA

Partner RSD Solutions Inc

www.rsdsolutions.com

info@rsdsolutions.com

 

There has been a whole lot of writing lately about how Value at Risk (VAR) is a fraud as a risk measure. Not quite sure what all of these writers are complaining about so I thought I would try out some of their reasoning. To do so I tried to make a latte with my car. You know what – the people who claim that VAR is a fraud are right – I could not make a latte with my car – although it is what I consider to be quite a nice car.

After reading that paragraph you are probably thinking that I have gone loco. Of course I cannot make a latte with my car. My car (any car) is for driving, not for making lattes. Even a child knows that. However those who argue that VAR is a fraud because it did not allow financial institutions to see the crisis coming are missing the point – just as I am missing the point thinking that my car could make a latte.

VAR and other risk measures and tools are actually quite good at what they are designed for. VAR however is not a prediction tool for a crisis, and VAR is not a great tool for assessing systematic risk.

All too often in risk – as in other fields – we have a temptation to use whatever tools we have for whatever purpose. It is just like the old saying that “to the inexperienced builder holding a hammer that everything looks like a nail.” Just because you have a specific tool or metric that some smart people developed, does not mean it is appropriate in all cases and for all situations. That is simply common sense.

Meanwhile I have to go get into my car so I can go get a latte at Starbuckys.

Common Risk Networks

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc

www.rsdsolutions.com

info@rsdsolutions.com 

 

In risk management one of the mantras is to get everyone communicating with the same language on the same page with the same information network?  While intuitively appealing, this may be counterproductive.  Let me provide three quick examples. 

 

1.  Ants – as discussed in a previous blog, ants find food through feedback loops based on a sent trail left by other ants.  What is less known is that ant colonies also have dedicated ants that intentionally do not follow the path of others but instead seek out other sources of food via random searches. 

2.  In his book “Gut Feelings”, Gerd Gigerenzer explains how too much information can actually lead to less optimal decision making.  Essentially knowing too much about a situation, having too much information available, or believing that you have too much information leads to inferior decisions. 

3.  If everyone has the same information then you get systemic risk as everyone acts en masse – to frequently counterproductive outcomes.  This is seen in stock market bubbles and crashes, it is seem in program trading, it is evidenced by a form of groupthink.

 

Having the same language, frameworks and metrics sounds ideal in theory – but perhaps a little bit of confusion can ironically be helpful.