The Global Financial crisis – What caused the build-up?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.comvox 

 

Five years have passed since the onset of the financial crisis and there is little agreement on the root causes or potential indicators of rising financial system stress.  Erlend Nier and Ouarda Merrouche address a number of these issues in a recent (25^th March) VOXEU communique called The global financial crisis – What caused the build-up?

 

Nier and Merrouche, IMF economists, summarize some of their recent research.  They start off asking a couple of questions: did central banks keep policy rates too low too long? Or were rising global imbalances the underlying cause of the crisis?  The answers to these questions are important to help contain and prevent the build-up of systemic risk.   

 

The authors noted the following results: net capital inflows can account for the differences between countries in the build-up of financial imbalances, the compression of the spread between long and short rates contributed to the rise in leverage and balance-sheet expansion, a weak supervisory and regulatory environment along with macroeconomic factors added to financial system stress and the relative importance of external imbalances relative to monetary policy.

 

Their research suggests that net capital inflows, rather than monetary policy stance, emerges as the key determinant of differences in the growth of financial imbalances across OECD countries over the pre-crisis period.

 

Capital flows along with weak regulation and supervision were the key drivers of the financial crisis.  The authors note that inadequate prudential policies failed to address systemic problems by over-reliance on wholesale funding.  The financial crisis corresponded with a sustained period of low interest rates globally, but the path of monetary policy (different across countries) was not a main contributor to the build-up of financial imbalances.  This suggests caution against a re-orientation of monetary policy frameworks in response to the crisis.

 

The lesson for policymakers and regulators is the need for effective macroprudential policy tools and effective/efficient regulation.   Otherwise, the use of the wrong policy options combined with over-regulation may result in rising systemic risk and increased contagion.

 

For more on this follow the link: http://www.voxeu.org/index.php?q=node/7774

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

Diversity Challenge

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Diversity is a big topic in management circles.  Studies show that we need diversity in managers, diversity on Boards and diversity in education.  What are you doing about your personal diversity?  What areas of personal risk management development are you exploring that are new, different, out of the normal – i.e. sources that are making you more diverse?

 

We all read the same newspapers, look at the same websites, and read the same books.  And then we have the collective stupidity to wonder how in heck we got to such a state of systemic risk.

 

You have all heard about the difference between having ten years of experience or one year of experience repeated ten times in a row.  Which class of employee / risk manager do you fall into?  What are you going to do about it?

 

Here is a two week challenge:  (1) go to a magazine store and buy the magazine that you think is the magazine that would be the last magazine on earth you would purchase, (2) watch a documentary that you think will be more boring than watching paint dry, (3) go to a lecture at a university in a department from which you have never taken a course, (4) learn a new skill – such as how to knit.

 

You might say that all of this takes time and energy.  I agree, but I will also argue that it creates even more time and energy in your brain and in your risk management efficiency.  Oh – and you also get all the benefits of diversity that everyone says that we need – and you don’t even have to worry about the political correctness backlash.

 

Lessons from Sweden for Europe and Crises Resolution

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

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

 

 

Little Bets

Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I just finished reading the book Little Bets: How Breakthrough Ideas Emerge From Small Discoveries by Peter Sims.  It is a pretty good book which I highly recommend.  (One thing I liked about it was that it was short – it had one idea and did not spend 200 extra pages trying to pretend to be something it was not.)

 

One of the principles of Little Bets is to try things (in a small way) and not to be afraid of making small mistakes.  This strategy in turn will lead to large insights and grand successes.

 

In risk management we do not like mistakes at all, whether they be large or small.  Perhaps it is time that we rethink mindset role of risk management.

 

As readers of my blogs know, I am of the school that believes that risk management departments should help firms make money as well as help prevent them from losing money – as opposed to solely prevent them from losing money.  It is a philosophical stance that not everyone will agree with.  However for those who do agree with me, then little bets is something to seriously consider.

 

European Bank Funding and Deleveraging

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The BIS Quarterly Report, (N. Vause, G. von Peter, M. Drehmann and V. Sushko, March 2012) notes European banks have experienced a liquidity crisis as continued financial deleveraging is placing a fragile recovery at risk, but fail to address long-term solvency issues.

 

European banks experienced extreme pressure to deleverage in late 2011 as funding strains intensified, increasing pressure to sell assets and ration credit as economic activity was weaker. Capital adequacy issues surfaced due to bank sovereign debt exposure.  New regulatory measures requiring banks to meet more stringent capital standards by mid-2012 added to these fears. 

 

European banks did sell certain assets and cut some types of lending, notably those denominated in dollars and those attracting higher risk weights.  This led to government policymaker concerns that the reduced lending would impact real economic activity.  Other credit suppliers (asset managers, other financial institutions & bond investors) helped to mitigate the credit squeeze, so there was little evidence from the BIS of a major impact on lending volumes or asset prices.

 

European central banks introduced special policy measures in December, resulting in improved European banks' funding conditions.  Previously, many banks had been unable to raise funds in the unsecured senior bond market, and the cost of unsecured money market funding had risen to levels previously exceeded only during the 2008 crisis.  Dollar funding had become especially expensive.  Two three-year lending operations (LTRO) by the ECB and a wider set of collateral than was previously eligible relieved much of the stress.  Furthermore, the cost of swapping euros into dollars fell in December, as central banks reduced the costs of their international swap lines.  Short-term borrowing costs then declined and unsecured bond issuance revived.  The view is these measures should limit the impact on financial markets and economic activity. 

 

The measures adopted by the central banks helped to mitigate near-term funding and capital concerns, but the long-term solvency issues remain unresolved.  However, the impact of the central banks’ action remains uneven across the European Union.

 

The massive injections of liquidity by the ECB helped avoid a crisis, there is little evidence that this funding has trickled down to countries and households in the peripheral countries.  The result is the credit contraction in countries such as Portugal and Spain lead to more bankruptcies, even-higher unemployment and a deeper economic contraction that will limit any recovery.  This suggests that ECB actions may provide only temporary relief.

 

The lesson for risk management is that temporary, stop-gap measures are not the best long-term solution and may come at a price.

 

For more information on this follow the link: www.bis.org/press/p120312.htm

Bridgeway

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.,

www.RSDsolutions.com

info@RSDsolutions.com 

 

Last Friday I had the pleasure of interviewing Lucinda Low who is the founder and director of Bridgeway Academy which is a school that develops children with learning disabilities. 

 

Bridgeway Academy has been successful by any stretch of the imagination.  It is a model for several other schools across North America and Ms. Low is sought out for her expertise.  Based on the success of Bridgeway it is reasonable to assume that Ms. Low has advanced degrees in education.  It would also be reasonable to assume that she has done extensive research on child education.  Nope – she simply developed a school that teaches students with disabilities “the way they learn”.  No grand research studies.  No grand 10 year plans.  No extensive controlled research studies.  Just great success. 

 

Risk managers have lots to learn from Ms. Low.  Forget the grand theories and the approved frameworks that everyone says that you need to implement.  Forget the credentials.  Just deal with organizations the way they work, keeping in mind the context in which they work.  Simple.  Successful.