Limited Progress on Banking Reform and What is Needed

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

Banking regulators, supervisors and politicians have failed to do their job for implementing reforms to limit damage from financial crises.  This failure of political will enabled stakeholders to pursue bad practices, and suggests a roadmap for reform.  Enforcing a reform agenda marked by simplicity is plausible, and would avoid much of the collateral damage that comes from many hundreds of pages of complex, costly and misguided mandates that typically act as substitutes for credible reform.

This is a case presented by Charles Calomiris in a recent VOXEU communique (Jan. 8^th) called Meaningful Bank Reform and Why it is Unlikely to Happen.

He notes that regulators and supervisors consistently failed in three key areas: (1.) they did not measure banks’ risks accurately or capital buffers needed to absorb losses; (2.) they failed to enforce the capital requirements and identify bank losses; and (3.) they failed to design or enforce intervention protocols for timely resolution of the affairs of weakened banks.

The failure to prevent the crisis was not a failure of thinking, but a failure of will on the part of our political system.  Politicians and regulators have found it expedient to offer hidden subsidies for risk taking to bankers through safety net protection and ineffectual regulation.  Overall, the cause for pessimism is a simple reason: politicians don’t really have strong incentives to solve the problems of banking regulation; they have strong incentives to pretend.

Deficiencies are supposedly remedied by ever-more-complex sets of rules for measuring risk, by granting increased supervisory discretion to a variety of new government officials with varying mandates, by scores of new research initiatives pursued by increasingly fragmented research and supervisory divisions at central banks and supervisory agencies, by the creation of new international study groups. Is it too cynical to see this exponential increase in complexity of rules, and of the regulatory and supervisory authorities charged with designing and enforcing them, as deliberately designed to reduce accountability by dividing responsibility and by making the regulatory process less comprehensible to outsiders?

The need is not for more complex rules, and more supervisory discretion, but rather for rules that: (1.) are meaningful in measuring and limiting risk; (2.) are hard for market participants to circumvent; and (3.) are credibly enforced by supervisors.  These qualities are best achieved by constructing simpler rules that are grounded in an understanding of the incentives of market participants and supervisors.

The keys to effective reform in all these categories are, recognizing the core incentive problems that have encouraged excessive risk taking and ineffective regulation and supervision, and designing reforms that are ‘incentive-robust’ – that is, reforms that are likely not to be undermined by the self-seeking regulatory arbitrage of market participants, or the self-seeking avoidance of the recognition of problems by supervisors.

This program of reform would be effective in addressing the real challenges that threaten the financial system.  This approach must avoid the collateral damage that comes from the many pages of complex, costly and misguided mandates that are substitutes for credible reform. Politicians dislike simple ideas, based on observable criteria, since they work by removing the discretionary control that politicians, bankers, and regulators enjoy and abuse over the enforcement of regulatory standards. Overcoming that challenge will require more than good economic thinking and a simpler, credible approach for risk management

www.voxeu.org/article/meaningful-banking-reform-and-why

Safe Assets, Complex Networks & Systemic Risk

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

The notion that the global economy could be faced with a shortage of safe assets has become a significant theme in recent policy debates. Safe assets are a cornerstone of modern financial systems. They provide a reliable store of value, serve as collateral in financial transactions, and serve as a pricing benchmark. Should they disappear, the danger is that the financial system itself might crumble. Markets for collateralized transactions (repos) would collapse; financial institutions would have difficulties meeting their prudential requirements, and the pricing and well-functioning of riskier segments of the financial system could be derailed altogether. Without a safe anchor, the financial system would experience greater systemic instability.

This is a link that Pierre-Olivier Gouchinas and Olivier Jeanne seek to examine in a recent BIS WP (Dec. 2012) called Global Safe Assets.  The authors suggest a link between macroeconomic shortages of safe assets and some of the most disturbing features of our recent global financial history.  This shortage has depressed  world interest rates and fueled ‘global imbalances.’ This growing external demand for safe stores of value also proved a powerful stimulant for US and European financial markets as they manufactured large amounts of ‘private label’ safe assets through the securitization of riskier assets .

The global financial crisis arose when many of these ‘private label’ safe assets –perceived as safe because they were bestowed with a AAA rating– lost that quality. The sudden realization that many of the safe assets undergirding the entire financial system were of questionable value led to a ‘sudden financial arrest’. In the subsequent unraveling, most of these ‘private label’ safe assets disappeared. In the euro area, the strains associated with the crisis quickly morphed into concerns about the safety of sovereign debts, as governments simultaneously tried to shore up their financial sector and to sustain domestic economic activity. This led to further shrinkage in the global supply of safe assets at the same time that deleveraging financial institutions, panicked investors and anxious reserve managers all tried to fly to safety.

In short, macroeconomic shortages of safe assets can create financial instability. Crises, when they occur, further exacerbate the shortage that gave rise to it. Policy responses designed to cope with the crisis such as liquidity injections and monetary easing prolong the conditions for financial instability and delay the necessary balance sheet adjustment of households and financial institutions.  However, it ignores that the global economy also exhibits powerful stabilizing mechanisms such as a decline in the natural real interest rate, resulting from the excess demand for stores of value.

Monetary policy plays two important roles.  First, it will need to accompany the decline in the natural rate that occurs when the scarcity of stores of value becomes more acute. Second, monetary policy can also play an important role as a backstop for public securities.

The more interesting question lies in the composition of this asset supply and how to make it less ‘fragile.’ It is of the essence of a safe asset that it cannot become unsafe. The definition of safe assets has a key impact on the financial sector and should not be left entirely to the private sector.  The authorities should commit themselves to a clear definition of safe assets and back it with a policy regime that makes those assets credibly safe. Claims on the private sector are inherently risky and should stay so to limit moral hazard: for this reason they may not provide a good basis to produce safe assets. Besides money, government debt remains the best candidate for the status of safe asset. Central banks, furthermore, have a role to play in making government debts safe.

The previous analysis has a number of implications for the global economy. First, it suggests that global banking will naturally take place in the currency that offers an appropriate supply of safe assets. This role is fulfilled now primarily by the US dollar.  Second, there are important distinctions to be made between inside and outside liquidity and between public and private liquidity. In tranquil times, these different forms of liquidity are close substitutes and trade at similar prices. In times of global stress, all liquidity dries up, as counterparty risk rises. The only relevant form of liquidity comes from the public sector, through liquidity injections of the monetary authorities, or the injection of public funds in troubled financial institutions.

The global scarcity of safe assets is bound to increase as the global demand for safe assets—-tied to global economic growth—-outstrips the supply—tied to US economic growth and fiscal sustainability. This might be resolved by the emergence of new safe assets. One question is how multiple safe assets will compete on a global stage. This can be done by increasing the supply of safe assets, a multipolar world will remove some sources of financial instability. However, the feedback loop that supports the status of safe assets may also turn vicious, and the arbitrage between safe assets might generate rather than reduce volatility. In other words, the transition to a more multipolar world may not be monotonous, nor smooth, if and when it occurs. A multipolar world may therefore itself need a global backstop such as the IMF.

http://www.bis.org/events/conf120621/gourinchas_paper.pdf

A Flawed Approach to Marriage – Basel III & Dodd Frank

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

Rejigging and increasing financial regulation is back in vogue. But, in the world of international finance, how well do different regulatory systems join up? There is increased evidence the US Dodd Frank Act and Basel III are, in part, incompatible and that harmonizing them may lead to unintended consequences. The US ought to tread carefully here but should also try hard to maintain the spirit of better financial regulation.

This is an issue that Takeo Hoshi discusses in a recent VOXEU communique (Dec. 23^rd) titled Implementation of Basel III in the US will bring back the regulatory arbitrage problems under Basel I.

In the aftermath of the global financial crisis, many countries are redesigning their financial regulatory frameworks. In the US, the Dodd Frank Act of 2010 specified the direction for new financial regulations. The US financial regulatory agencies (over 40), including those that were newly created by Dodd-Frank, have been busy writing and rewriting the rules.

At the international level, the Basel Committee on Banking Supervision has come up with the third implementation of the international standard for minimum capital regulation, ‘Basel III’ along with other nations writing their own regulations. However, in several areas, the requirements of Dodd-Frank and other regulations being written at the national level are apparently inconsistent with those of Basel III and thus US regulators face a difficult task of reconciling and implementing the two regulatory initiatives.

Recently, the US Office of the Comptroller of the Currency, the Federal Reserve System, and the Federal Deposit Insurance Corporation came up with three ‘Notices of Proposed Rulemaking’ on regulatory capital rules. These proposals entail new capital regulations for the US banks, reconciling apparent discrepancies between Dodd-Frank and Basel III, but could have serious unintended consequences, if implemented.

Dodd-Frank sets “the generally applicable risk-based capital requirements” as a floor that regulated financial institutions must satisfy in addition to any other minimum risk-based capital requirements that the regulators may impose.  Banks that calculate the risk-weighted assets using advanced approaches are required to hold enough capital required by the standardized approach. The problem is that the standardized approach is based on the old methodology of classifying assets into several risk buckets, which was originally used in Basel I regulation.

As a result, this led some banks to shift their portfolios to hold more risky (and hence higher return) assets within the same risk assets category, thereby increasing their risk without increasing regulatory capital. Because all the sovereign bonds of investment grade had the same risk weights (zero), banks were able to increase the return by increasing the holding of the most risky ones.

Because highly rated tranches of securitized loan products carried lower risk weights than individual loans, banks were able to economize on regulatory capital by selling the loans that they originated and by buying (highly rated) securitized loan products.

It is now well understood that the incentive for these regulatory arbitrages created by the Basel regulation increased risk in the banking system without a corresponding increase in risk-weighted assets – and hence regulatory capital.  The Basel III classification system is an improvement, but is still insufficient to make the risk-weighted assets sensitive enough to risks calculated by more advanced approaches.

Another problem is caused by the inevitably ad hoc nature of assignment of a risk weight to each category of assets. Because of this problem, creation of finer “buckets” can actually distort bank behaviors even more if the allocated risk weights differ from the risk differentials that banks perceive. For example, a 30-year amortizing mortgage with the loan-to-value ratio between 60% and 80% gets risk weight of 50%, while an interest-only loan with the same loan-to-value ratio receives increase the 100% risk weight.  This works if the bank sees the interest-only loan as twice as risky as the 30-year amortizing loan and requires twice as much capital. If that is not the case, the bank will have an incentive to reduce one type of loan and increase the other.

The international Basel III allows banks to use the advanced approach to calculate the regulatory capital, so the banks in Europe and Japan that are qualified to use the advanced approach do not have the problem faced by US banks. The problem is that Dodd-Frank requirements for US banks set a floor of the “generally applicable risk-based capital requirements”. To avoid reviving the problems we know from Basel I regulation, US regulators should find a way around imposing the standard approach to advanced approaches banks, while respecting the spirit of Dodd-Frank at the same time.  A patchwork regulatory system is not the answer.

www.voxeu.org/article/implementation-basel-iii-us-will

The Financial Cycle and Macroeconomics: What have we learnt?

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

It is time policymakers rediscovered the role of the financial cycle in macroeconomics. In the environment that has prevailed for at least three decades now, it is not possible to understand business fluctuations and the corresponding analytical and policy challenges without understanding the financial cycle. This calls for a rethink of modeling strategies and for significant adjustments to macroeconomic policies. This is what Claudio Borio discusses in a recent BIS WP 395 (Dec. 2012) The Financial Cycle and Macroeconomics: What have we learnt?

Understanding in economics does not proceed cumulatively. So-called “lessons” are learnt, forgotten, re-learnt and forgotten again. They do so because the economic environment changes, sometimes slowly but profoundly, at other times suddenly and violently. But they do so also because the discipline is not immune to fashions and fads.

The notion of the financial cycle, and its role in macroeconomics, is no exception. The notion, or at least that of financial booms followed by busts, actually predates the much more common and influential one of the business cycle, but for most of the postwar period it fell out of favor. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations. And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state. Economists are now trying hard to incorporate financial factors into standard macroeconomic models.

The purpose of the study is to summarize what we learned about the financial cycle over the last ten years and to identify the most promising way forward. The main thesis is that macroeconomics without the financial cycle is like Hamlet without the Prince. Three themes emerge. The financial cycle is much longer than the traditional business cycle. Modeling the financial cycle correctly, rather than simply mimicking some of its features superficially, requires recognizing fully the fundamental monetary nature of our economies: the financial system does not just allocate, but also generates, purchasing power, and has very much a life of its own. The global economy, with its financial, product and input markets, is highly integrated.

 There are five stylized empirical features of the financial cycle that stand out. (1.) The financial cycle is best captured by the joint behavior of credit and property prices. (2.) It is much longer, and has much larger amplitude, than the traditional business cycle. (3.) It is closely associated with systemic banking crises, which tend to occur close to its peak. (4.) It permits the identification of the risks of future financial crises in real time and with a good lead. (5.) And it is highly dependent of the financial, monetary and real-economy policy regimes in place.Modeling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, i.e., a richer notion of potential output – all features outside the mainstream.

More generally, the emergence of the financial cycle as a major force highlights a growing tension between “economic” and “calendar” time. The financial cycle slows down economic time, as it stretches out the period over which the relevant economic phenomena play themselves out. Financial vulnerabilities take a long time to grow and the wounds they generate in the economic tissue a long time to heal. But the horizon of policymakers does not seem to have adjusted accordingly. If anything, it has shrunk in an attempt to respond to the high-frequency vagaries of the markets. This tension can be a major source of economic damage. The short horizons of market participants and policymakers contributed in no small measure to the financial crisis. They should not be allowed to generate the next one.

www.bis.org/publ/work395.htm

The Economic Costs of Natural Disasters

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

A series of tragic events (US and elsewhere – Katrina & Sandy) in recent years has rekindled interest in the economic consequences of natural catastrophes. There is growing debate whether disasters are harmful or conducive to economic activity. While the immediate destruction they cause triggers a range of adverse socio- economic consequences, natural disasters may also have growth-enhancing effects since investment for reconstruction is part of measured GDP (a flow), whereas the destruction of physical capital (a stock) is not. Replacing dated capital with more recent vintages might also raise long-term growth. Weighing against this optimistic view are the disarray and loss of productive capacity depressing output in the immediate aftermath of a major catastrophe.

This is a question that G. von Peter, S. von Dahlen & S. Saxena of the BIS examine in a recent working paper (BIS WP 394) Unmitigated disasters? New evidence on the macroeconomic cost of natural catastrophes (Dec. 2012). The authors note existing studies differ widely on their results and reach no firm conclusions on disaster-related growth effects.

This study measures the response of growth to major natural catastrophes, and examines the extent to which risk transfer to insurance markets may facilitate economic recovery. The study makes the link between natural catastrophes and economic growth conditional on risk transfer. This nuances the transmission channels, thereby helping to resolve the conflicting findings on catastrophe-related growth.  

The findings suggest that risk transfer to insurance markets has a macroeconomic value. This value may be particularly high for smaller nations that lack the capacity to (re)insure themselves against major natural disasters. The analysis thus contributes to the policy debate on different forms of post-disaster spending, as well as the balance between prevention ex ante and compensation ex post. The study notes that catastrophes have permanent output effects are also relevant for a growing literature that explains asset pricing puzzles through rare disasters. The extent to which risk transfer mitigates the macroeconomic cost of disasters is pertinent to the literature on finance and growth, which focuses on banks and stock markets but not on insurance. Considering the macroeconomic value of risk transfer could also enrich the macro prudential approach to the regulation and supervision of insurance companies.

The main result is that it is the uninsured part of catastrophe-related losses that drives macroeconomic costs, whereas well insured catastrophes can be inconsequential or even positive for economic activity. The strongest growth-enhancing effects from insured losses appear in the three years following a catastrophe, in line with the average timing of insurance payouts. This suggests that insurance facilitates the financing of the reconstruction effort that contributes to measure GDP. Distinguishing the effects by physical type of catastrophe shows that insurance coverage at best neutralizes the contractionary effects of earthquakes and volcanic eruptions, while the growth effects of storms, flooding and climatological events can be weakly positive when insured.

Insurance can therefore play an important role in mitigating the macroeconomic costs arising from major natural catastrophes. This form of risk transfer can be useful at any stage of development. Splitting the sample by land area and income group shows that small and low- to middle-income countries suffer more when uninsured but also recover faster when insured against catastrophes. Hence the mitigating role of insurance appears to be more pronounced for this group, especially in the year after a disaster when reconstruction takes place. Whether it is desirable for countries to seek high coverage depends, of course, on the frequency of disasters and on the terms and cost of insurance.

Major natural catastrophes have large and significant negative effects on economic activity, both on impact and over the longer run.  However, it is mainly the uninsured losses that drive the subsequent macroeconomic cost, whereas sufficiently insured events are inconsequential in terms of foregone output. This result helps to disentangle conflicting findings in the literature, and puts the focus on risk transfer mechanisms to help mitigate the macroeconomic costs of natural catastrophes.

www.bis.org/index.htm

Banking reform: What has to be done?

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

The recent financial overhang in Europe crisis has revealed the vulnerabilities of the Eurozone financial sector and the critical role the sector plays in the real economy. It also made it clear that the banking system needs fixing.

This is a question Wouter den Haan, asks in a recent VOXEU communique Nov. 30^th called Banking Reform: Do we know what has to be done? The question is what reforms should be implemented? It is critical that much better legislation be both discussed and implemented to properly regulate the financial sector.

Better regulation is important for reducing the chances of another major financial crisis, but better regulation may also be an essential factor in re-establishing confidence in the financial sector itself. Indeed, it is thought that such confidence may be an essential ingredient for a healthy economic recovery.

Even before the crisis, it was well known that our financial system was exposed to some key risks. Despite this wisdom, the risks were clearly underestimated and the mechanisms to prevent severe disruptions were clearly not in place. Now we are designing new legislation, it is important that we understand what went wrong.

During the postwar period, there had been numerous innovations in the financial sector and there were plausible reasons to believe that these innovations would stabilize the system. Securities rapidly became more complex. Financial regulators, rating agencies and risk managers did not have the resources and expertise to deal with this increased complexity.

It was assumed that a new set of rules would not only fix known problems, but any new ones that may arise. The financial system is dynamic and as new vulnerabilities appear, financial institutions will try to find ways around legislation. So the new regulatory system should be flexible enough to deal with a changing world and it also should be such that complacency cannot put our economy at risk again. Recent research indicates that countries exposed to a financial crisis do not reduce a country's probability of being hit by another financial crisis. The explanation may be due to the inability of regulators to keep up with the dynamic evolution of modern banking.

There is a need for better funded oversight and better in-depth knowledge among financial regulators and academics about what is actually going on in the financial sector. The likelihood of risk reduction will also require a change of culture in the financial sector itself. The decisions made by individuals working in financial institutions ought to be in line with the long-run growth and stability of the overall institution and the overall economy, not any one individual’s short-term prospects.

A number of questions remain on financial reform:

·       Has enough been done to reduce the chance of another financial crisis?

·       Are governments overreaching and is the new regulation going to stifle growth in the financial sector?

·       Will the higher capital adequacy requirements of Basel III make the system sufficiently safe? And will they make lending (much) more expensive?

·       Will the countercyclical buffers of Basel III be enough to avoid systemic downward spirals?

·       Are the new liquidity requirements going to avoid contagion in the interbank market?

·       What kind of institutional change in the markets for derivative trading will take care of counter-party risk? How can we tackle the possibility of institutions falling like dominos, and by doing so solve the ‘too connected to fail’ problem?

·       What kind of division should there be between traditional commercial banking and other activities? Is it enough to implement limits to proprietary trading, that is, trading of financial assets with the institutions own money? Or should there be a stricter separation between commercial and investment banking activities?

·       Can or should regulation be (somewhat) different across countries? And will countries with stricter regulation face capital flight?

www.voxeu.org/article/banking-reform-do-we-know-what-has-to-be-done?

Simple

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

In my previous blog I wrote about the Canadian military intelligence staffer who was caught selling military secrets to the Russians.   It is an embarrassing case for the Canadian military as the person involved had high level clearance, and it was the FBI and not any of the Canadian agencies who picked up on the very suspicious activity of the person involved.

You might think that in this day and age of high tech spying that the person was a mastermind using the most sophisticated of equipment.  The irony is that if they were they would have likely been caught much earlier.  It seems that the Canadian military was so concerned about high tech electronic cyber spying that they totally forgot about the lowly USB key.  Yup – that’s right – the staffer sneaked the information out using a plain old USB key that could be bought at any office supply store.

Sometimes in our focus on being up to date and sophisticated, we forget about the simple risks in front of us.