Outside Looks

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

I reside in Halifax, Nova Scotia.  The buzz over the last week in this Navy town has been about the Canadian Navy staffer who pled guilty to selling military information to the Russians.  It appears this staffer had high-level clearance and was actually working in intelligence himself.

With all of the background checks required for a secret intelligence position you might wonder how an intelligence staffer could be selling secrets to the Russians undetected.  The case is even more perplexing as the person made short term trips to out of the way places like Brazil and came back with relatively large amounts of cash.  All the signs of something funny going on were there in plain sight.

The irony continues, as it was the FBI who notified the Canadian Military and other Canadian officials about such questionable behavior for a person in such a position.  It was only at this point that the Royal Canadian Mounted Police (RCMP) began to investigate.

Sometimes situations are like that.  We do all of the audits (background checks), and tick all of the boxes for risk management, but it takes an outsider to let us know that something is amiss.  Does your risk department have the ability to utilize outside looks?

Fiscal discipline in the monetary union

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

For the euro to survive, the recession must be halted without piling on more debt. Charles Wyplosz, in a recent VOXEU communique (26^th Nov.), argues that the unpalatable conclusion is that public debts must be written down. The massive moral hazard problem this will cause must be dealt with by making sure that public debts will never again be allowed to grow to unsustainable levels. requiring US-style fiscal discipline.

Public debts are still rising in the three countries that may require aid: Italy, Spain and possibly France. These nations have three things in common: a common currency; are in recession; and adopted austerity policies.

If they remain in the Eurozone, these nations must exit recession. This will require an end to austerity policies. However, they cannot embrace expansionary fiscal policies with current debt levels; even abandoning austerity may be impossible. This leaves two issues to address: the legacy of unsustainable public debts and the need for fiscal discipline.

There are two approaches: the German centralized discipline model; and the US decentralized discipline model.  The German approach has produced mixed results with the failure of several states (lander).  However, the US approach has worked for 150 years without any state failures.

The US model is better adapted to Europe since it fully respects fiscal sovereignty at the sub-central level and is important since EZ parliaments are very unlikely to give up fiscal sovereignty.  The Eurozone’s Stability and Growth Pact belongs to the German model of centralized discipline. It was adopted in 1997 without debate. As the euro’s launch date approached, a concerned Germany proposed the pact as the practical way of implementing the Maastricht Treaty’s Excessive Deficit Procedure.

The Pact has consistently failed. Each failure lead to reform that seemed to strengthen it. These efforts, however, were thwarted by the inescapable fact that EZ members are fiscally sovereign. Until sovereignty is removed, the Pact stands no chance of being effective.

The future of the euro requires fiscal discipline. Fiscal discipline will only be achieved with a decentralized arrangement. Fiscal sovereignty is non-negotiable and the no-bail out clause needs to be the centerpiece of the Eurozone.

In the US, the no bailout rule came first; incentives then took over, leading to fiscal rules. Having effectively removed the no bailout rule, we cannot rely on incentives but, fortunately, we now have national fiscal rules. What is missing is the no bailout rule. While it is already in the European Treaties, it’s credibly was shattered by the Greek, Irish and Portuguese packages. The task facing EZ leaders is to rebuild the credibility of the no bailout clause. This will be difficult.

Any doubts? Just imagine what would have happened had the no bailout rule been invoked in May 2010. Greece would have gone to the IMF and defaulted on its smallish public debt of 120% of GDP. By now, the crisis would be over.

www.voxeu.org/article/fiscal-discipline-monetary-union

When the field is clear

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

I am writing this blog now instead of watching my beloved Steelers because of risk management – and no it is not about the risk management I talk about in this blog.  The incidence that forced me to turn off the TV and go to my office in order to prevent a heart attack was more straightforward than that.

“My” Steelers, playing their rivals Baltimore, were ahead in the game and moving the ball down the field.  The quarterback Charlie Batch threw a perfect strike downfield to wide open receiver at the Baltimore 40 yard line.  There was not a Baltimore defender within 15 yards and the receiver caught the ball with nothing but the goalposts between him and the end of the stadium.  He starts to run and I start to cheer.  A sure touchdown, a solid lead and full momentum into the fourth quarter.  He was so wide open even I could have run it in for a score.  But wait – coach said to put the ball in the other hand in order to prevent a fumble.  Well you now know how this ends …  the receiver goes to put the ball in his other hand as he is walking towards the end zone, and yup – he fumbles it.  Bats it away from himself is more like it.  Baltimore recovers, and on the following series scores a touchdown of their own and captures the momentum.

When the field is clear you have to run.  You cannot be worried about the minute things when the big picture is laid out perfectly for you.  Bad risk management – bad football.  At least I got my blogs done for the week. 

Nuts

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

Vaughan Ontario – a suburb of Toronto – is becoming the hotbed of a major issue that is threatening the well-being of Canadians.  The threat is oak trees.

It seems that some parents (well, maybe one parent) is concerned about the health effects for nut sensitive students who may be exposed to dropped nuts onto the property of a school.  They (well, maybe she) wants the oak tree cut down.

I do not want to make light of those with sensitivity to nuts.  I cannot imagine the issues that having anaphylaxis allergies cause.  However I think there are also some arguments to be made about common sense for the bigger picture.

Reading the story in the newspaper, along with the follow-up letter to the editors made me think of some of the similar policies that we put in place at organizations.  In the utopian ideal of eliminating all risks, we may also be eliminating all of the positive upside risks.  I suspect few people truly long for getting a package of peanuts on the plane anymore.  However Canada would be a much poorer country without our oak trees.  How many oak trees have we already cut down in the corporation in the name of risk management?

Global Liquidity and Financial Stability

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

In the wake of the global financial crisis, global liquidity has become a key focus of international policy debates, yet the term continues to be used in a variety of ways. For the purposes of this analysis, the focus is primarily on the financial stability implications of global liquidity conditions; it should be understood as the “ease of financing” in the international financial system.

Experience shows that very low-cost funding in global financial markets can contribute to the build-up of financial system vulnerabilities in the form of leverage, regional imbalances and large mismatches across currencies and maturities.  These are some of the issues that by Jaime Caruana, of the BIS, Assessing global liquidity from a financial stability perspective in a recent speech (Nov. 22^nd) and summarized in this column.

So, what creates global liquidity? Ultimately, it is trust, the root meaning of credit, expressed through private sector activity in which central banks play an important role.

The monetary policy stance, whether implemented by conventional or unconventional means, is best understood as the precursor of private liquidity creation. The central bank influences financing conditions by determining benchmark interest rates and the amount of funds available to settle payments. Ultimately, the generation of private liquidity depends on the capacity and willingness of market participants to supply funding or to trade in securities markets. This activity hinges on their perceptions of risk, risk appetite and broader macroeconomic conditions. Ex post, any build-up of vulnerabilities therefore arises from interactions of market participants within the private sector and with monetary authorities.

The key questions when assessing global liquidity assessments are therefore: how tight are ex-ante financing conditions, do they spur credit creation and how are they transmitted internationally? These considerations suggest that measures of global liquidity should capture actions by central banks and the private sector, particularly by bank and non-bank financial institutions and their cross-border and/or cross-currency operations.

In addition, it is important to distinguish between indicators for the ease of funding conditions per se and for their materialization in bank financing and other forms of credit. Indicators for ease of funding include broad measures of investor risk appetite and the availability of funding for financial institutions. Indicators for results include private sector credit growth, which, when rapid, can signal the emergence of financial vulnerabilities.

This suggests that no single indicator can capture all the various dimensions of global liquidity. Instead, the monitoring of global liquidity requires a mix of measures, such as global credit aggregates and price- and quantity-based indicators that capture the monetary policy stance, financial conditions and risk appetite.

Growth in international credit seems to indicate more benign global liquidity conditions in comparison to past

Imprudent Managers?

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

“They argue that ratings are merely opinions and protected by constitutional safeguards on free speech, and that only imprudent investors would take decisions based on them.”

                                    Economist, November 10, 2012

The above is a quote from an Economist article that is discussing a case in Australia that found Standard and Poor’s liable for losses suffered by an investor in a Constant Proportion Debt Obligation.

As the above quote points out, Standard and Poor’s tried to defend itself by saying that its ratings are “merely opinions”, and that only “imprudent investors” would make decisions based on them. 

Ignoring the fact that Standard and Poor’s does not make a good sales pitch for their services, perhaps we as risk managers can (should) adopt a similar approach.  For instance, have every risk report submitted with a statement such as “This risk advice is only an opinion and only imprudent managers would take decisions based on it.”  I am not too sure that would work too well – or would it?

Understanding Austerity

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

One key feature of good risk management is the ability to adapt to a rapidly changing environment.  It is also important to understand the process driving change – is a structural shift in the parameters or just a temporary outlier in the state of the economy.

This issue recently came to the forefront when the IMF raised a new estimate size of the fiscal policy multiplier – and thus the impact of austerity on GDP.  This has been a contentious issue since the crisis started.  The IMF suggests that the multiplier is much higher than previously thought in the current policy environment.

A recent VOXEU communique by Barry Eichengreen and Kevin H O’Rourke called Gauging the multiplier: Lessons from history suggest the economy is undergoing a change that is not fully understood.  The authors confirm the IMF’s estimate of a higher multiplier.  The Fund’s new estimates, which range from 0.9 to 1.7, suggest that Europe’s policies of austerity are in fact directly responsible for the fact that the continent’s recessions have been even deeper than initially forecast.

This is of course just what standard theory would suggest: that the fiscal multiplier will be unusually large when interest rates are at the zero lower bound.  What matters for the multiplier are economy-wide measures like interest rate cuts and quantitative easing?  To date, the latter has been non-existent, while the former underwhelming.  The problem is that standard theory doesn’t tell us much about the precise magnitude of the multiplier under such conditions.

The authors use better statistical estimates for the fiscal multiplier and compare it to data estimates from the 1930s.  These estimates based on 1930s data are at the higher end of the literature, but consistent with the idea that the multiplier will be greater when interest rates are at the lower bound. The 1930s experience suggests that the IMF’s new estimates are, if anything, on the conservative side.

In the classic movie Casablanca, Captain Renault expressed shock when publicly describing an uncomfortable fact of which he was privately aware.  European officials, while also expressing shock and outrage over the IMF’s uncomfortable finding, were similarly aware of what was going on 'in here' well before the Fund brought it to the world’s attention.  The question now is whether, having been forced to go public, they are finally prepared to translate that awareness into action.

Can we apply this lesson to risk management?

www.voxeu.org/article/gauging-multiplier-lessons-history