Policy or Judgment?

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Policy or judgment is a theme that I come back to again and again when I work with companies and their risk management departments on developing and implementing risk strategies.  In this age of regulation, the stress is increasingly becoming that of developing a strong airtight policy and then following that policy to the letter.  Judgment is better left solely for deciding on your sense of fashion.

 

My philosophy is that you need both.  You do not want people and groups in an organization making up decisions ad hoc in the moment – particularly when it relates to risk issues that could have major implications.  Conversely it has to be recognized that no risk policy is airtight and fool-proof.  Something is inevitably going to come up that knocks it for a loop.

 

Policy or judgment came up in the news today.  You likely heard the story about the lifeguard who was fired for saving a life.  The problem is that the life saved was that of someone who was swimming outside of the zone that the lifeguard was responsible for.  Policy was that lifeguards should only concern themselves with swimmers in their zone.  Since the lifeguard went out of his zone he was fired.  The company stated that the firing was for insurance reasons (good job on passing the buck on responsibility there!).

 

You can argue this many ways.  While the lifeguard was busy saving someone outside of the designated zone, a swimmer could have run into distress while swimming in the proper zone.  Other arguments can be made as well.  The point is that the lifeguard made a judgment call over policy.  Personally I believe it was the right call.  Imagine being a lifeguard and having someone drown within your sight, and within your ability to help them and you did nothing because of policy.  How would that feel for the rest of your life?

 

Does your company allow for exceptions of judgment, or would your company do the equivalent of letting the person drown?  What would you do if an analogous situation occurred at your company?  How would you or your colleagues deal with the authority figures at your company and the authorized policy?  What would Stanley Milgram think? 

 

For more on this, follow the link:  http://en.wikipedia.org/wiki/Milgram_experiment  

Japanese Culture

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

I just got back from a short trip to Tokyo.  I enjoyed my brief visit to the city and look forward to returning.  Interestingly enough the report on the Fukushima nuclear crisis was released a few days after my return.  The headline for my local paper read “Culture to Blame” as the lead in to the article.

 

There are many causes and catalysts for what happened at the Fukushima nuclear power plant.  There always are a plethora of issues when a major accident like that happens.  However it should never be news or a surprise when culture plays a role.  Culture almost always plays a significant role in risk management, for better or for worse.

Fiscal Sustainability and Systemic Risk

by Don Alexander , MBA

Associate, RSS Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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

Limits to Monetary Policy under Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The major advanced economies are maintaining extraordinarily accommodative monetary conditions, through low policy rates and the continued expansion of their balance sheets through new rounds of unconventional policy measures.  These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies (EMEs) in the form of undesirable exchange rate and capital flow volatility. As a consequence of EME efforts to manage these spillovers, the stance of monetary policy is highly accommodative globally.  The limits to monetary policy, in the current environment, are addressed in the latest 2011 BIS Annual Report.

 

There is widespread agreement that, during the crisis, decisive central bank action was essential to prevent a financial meltdown and that in the aftermath it has been supporting faltering economies. Central banks have had little choice but to maintain monetary ease because governments have failed to quickly and comprehensively address structural impediments to growth.

 

However, there are limits to what monetary policy can do; such as provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks with conflicting objectives, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally as actual achievements fall short of expectations.

 

The global monetary policy stance taken by central banks is unusually accommodative. Policy rates are well below benchmark measures while central bank balance sheets continue to expand.  Against the background of weak growth and high unemployment, sustained monetary easing is natural and compelling.  However, there is a growing risk that monetary policy, by itself, cannot solve all issues such as solvency or deeper structural problems. It can buy time, but conversely may delay the return to a self-sustaining recovery. Central banks need to recognize and communicate the limits of monetary policy, making clear that it may not address the root causes of financial fragility and economic weakness.

 

The combination of weak growth and low rates, and efforts to manage the spillovers in emerging market economies, has helped to spread monetary accommodation globally.  This has resulted in a build-up of financial imbalances and increasing inflationary expectations could have negative repercussions on the global economy. Central banks need to account for global spillovers from domestic monetary policies on financial and price stability.

 

Finally, central banks need to beware of longer-term risks to their credibility and operational independence. There can be a gap between expectations and the actual results delivered by monetary policy. This could complicate the eventual exit from monetary accommodation and threaten central banks’ credibility and operational autonomy. It is reinforced by political economy risks arising from the combination of balance sheet policies that have blurred the line between monetary and fiscal policies, on the one hand, and the risk of unsustainable fiscal positions, on the other.

 

The lesson for risk management is that monetary policy will not solve all the problems and some hard decisions are required.

 

For more on this, follow the link:  www.bis.org/publ/arpdf/ar2012e4.htm

Breaking the Vicious Cycles

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutioins.com

 

The global economy, after five years, has yet to overcome the legacies of the financial crisis to achieve balanced, self-sustaining growth. In different ways, vicious cycles are hindering the transition for both the advanced and emerging market economies as noted in the first chapter of the 2011 BIS Annual Report.

 

Moving the global economy to a path of balanced, self-sustaining growth remains a difficult and unfinished task.   However, a number of interacting structural weaknesses are hindering the reforms required.   Investors and politicians hoping for quick fixes will continue to be disappointed – there are none.   Central banks, already overburdened, cannot repair all these weaknesses – consumer debt reduction, stimulate investment and job creation while creating an attractive investment environment.

 

A look at the global economy suggest that there are three areas for adjustment: the financial sector needs to recognize losses and recapitalize; governments must put fiscal trajectories on a sustainable path; and households and firms need to deleverage. As things stand, each sector’s burdens and efforts to adjust are worsening the position of the other two.   All of these linkages are creating a variety of vicious cycles.

 

Central banks find themselves in the epicenter, pushed to contain the damage: expected to fund the financial sector while maintaining low interest rates to ease the strains on fiscal authorities, households and firms. This pressure puts the central banks’ price stability objective, their credibility and, ultimately, their independence at risk.

 

Taming the vicious cycles, and reducing pressure on central banks, is critical.  This goal requires cleaning up and strengthening banks at the same time as containing the riskiness of the financial sector.  Bank balance sheets must accurately reflect the value of assets; while making progress on this score more rapid movement is required.   As they do, policymakers must ensure speedy recapitalization, see that banks build capital buffers as conditions improve, authorities must implement agreed financial reforms, and extend them to shadow banking activities.

 

In the euro area, the effects of the vicious cycles have reached an advanced stage that reflects not only weaknesses seen elsewhere but also the incomplete nature of financial integration in the currency union. Europe can overcome this crisis if it can address certain issues: structural adjustment, fiscal consolidation and bank recapitalization; and unify the framework for bank regulation, supervision, deposit insurance and resolution. That approach will decisively break the damaging feedback between weak sovereigns and weak banks, delivering the financial stability required that will allow time for further development of the euro area’s institutional framework.

 

Overall, in Europe and elsewhere, the revitalization of banks and the moderation of the financial industry will end their destructive interaction with the other sectors and clear the way for the next steps – fiscal consolidation and the deleveraging of the private non-financial parts of the economy. Only then, when balance sheets across all sectors are repaired, can we hope to move back to a balanced growth path? Only then will virtuous cycles replace the vicious ones now gripping the global economy.

 

Otherwise, the job of the risk manager will prove very difficult.

 

For more on this, follow the link:  http://www.bis.org/press/p120624.htm

Twelve Signs of the Europocalypse

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

What was unthinkable two years ago – the consideration of pan-European bank regulation, cross-border deposit guarantees, joint and several Eurobonds, and the very survival of the common currency – appear to be verging on the inevitable now.  The staid European Union we knew for its first two decades is a thing of the past. 

 

Douglas Rediker and David Gordon, look at some of these issues in the Jun. 12^th issue of Foreign Policy.  The authors offer 12 key trends to watch over the next few weeks for help in projecting what the new Europe will look like if it finally emerges from the mire.  There are interesting signposts for risk management and serve as tipping points. 

 

Some of these trends such as, Greek dysfunction and Spanish banks, are already well in process.  None of them are very encouraging for a benign solution to the euro zone crisis.  Several are scarier than others.  Greece and its European partners are in for an almost unimaginable set of politically unpalatable choices, and the likelihood of Greece remaining in the Eurozone is very low. 

 

German domestic politics, with federal elections scheduled for this autumn of next year, may be the single-most crucial factor in shaping the final German response to the crisis, with German politicians gauging every move and its impact on that vote.  The United States doesn’t possess the inclination, the ideas, or the financial capacity to materially influence the endgame in Europe.

 

For the so-called Troika, ECB-EC-IMF, tensions revolve around something quite simple: who pays.  Neither of the funding programs the EU governments has set up — the EFSF and the ESM — has any significant capital, relying instead on capital markets, leverage, and to some extent “alchemy” to reach its headline funding capacity. 

 

China is not coming to Europe’s financial rescue, but will instead look for potential European investment bargains once forced sellers of distressed assets find themselves without other options.

 

The European Union remains one of the great experiments of the 20^th century.  It was a major effort by countries to give up major elements of their sovereignty, acting collectively through a set of agreed-upon rules and coordinated through supranational agencies.  The whole process was organized by great strategists and visionaries, but the next stage could be organized by anonymous and impatient financial markets dominated by responses from unknown bureaucrats and politicians. 

 

The lesson for risk management is to look at potential tipping points before the accident occurs.

 

For more on this follow the link:  http://tinyurl.com/6s6dyv9

The Dinner Table

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Ronald Regan is reputed to have said that “All great change begins at the dinner table”.  I am not sure if this is 100% true as I am believe that in certain situations that leaders need to lead and we need to loosen our infatuation with management by consensus. 

 

However in risk management there is often a general lack of understanding of why certain risk management policies are in place.  Too often edicts concerning risk management policies come “down from on high” without any rationale except that it is “good risk management”. 

 

If risk management spent more time at the kitchen table – that is explaining to the rank and file and middle managers – the purpose and rationale behind the policies, then I am confident that better risk communication would result, and with it a better set of risk policies and a better implementation of risk policy.

 

The one catch with this is that risk managers would have to make their policies understandable, and the rationale for their policies understandable.  This by itself would be a beneficial side effect of discussing issues at “the dinner table”.