A European Deposit Insurance and Resolution Fund: An Update

A European Deposit Insurance and Resolution Fund: An Update. By Dirk Schoenmaker, Duisenberg School of Finance; VU University Amsterdam, and Daniel Gros, Centre for European Policy Studies, Brussels; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
Duisenberg School of Finance Policy Paper Series No. 26
September 12, 2012
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2052886

Abstract:    

Cross-border banking is currently not stable in Europe. Cross-border banks need a European safety net. Moreover, a truly integrated European-level banking system may help to break the diabolical loop between the solvency of the domestic banking system and the fiscal standing of the national sovereign.

This policy paper first sketches the building blocks of a Banking Union. Importantly, a new European Deposit Insurance and Resolution Authority (EDIRA) should start simultaneously with the ECB assuming supervisory powers. A combination of European supervision and local resolution cannot work because it is not ‘incentive compatible’. Next, this paper proposes a transition period to gradually phase in the European deposit insurance coverage. Finally, we calculate that a European Deposit Insurance Fund would amount to about €30-50 billion for the 75 euro area banks that were subject to the EBA stress tests. This Fund could be created over a period of time through risk-based deposit insurance premiums levied on these banks. Once up and running, the Fund would then turn into a European Deposit Insurance and Resolution Fund to also deal with the resolution of one or more of these European banks.

Keywords: financial stability, banking, deposit insurance, resolution
JEL Classification: F36, F42, F51, G28

The Rough Road to Progress Against Alzheimer's Disease

The Rough Road to Progress Against Alzheimer's Disease
 PhRMA
Sep 13, 2012
http://www.innovation.org/index.cfm/NewsCenter/Newsletters?NID=205


Two high-profile Alzheimer’s drug development failures were announced in recent weeks shining a spotlight on the challenges and frustrations inherent in Alzheimer’s research. Alzheimer’s disease is among the most devastating and costly illnesses we face and the need for new treatments will only become more acute as our population ages.

Understanding a disease and developing medicines to treat it is always a herculean task but Alzheimer’s brings particular challenges and long odds. A new report from the Pharmaceutical Research and Manufacturers of America (PhRMA), "Researching Alzheimer’s Medicines: Setbacks and Stepping Stones", examines the complexities of researching and treating Alzheimer’s and drug development success rates in recent years.

Since 1998, there have been 101 unsuccessful attempts to develop drugs to treat Alzheimer’s—or as some call them “failures,” according to the new analysis. In that time three new medicines have been approved to treat the symptoms of Alzheimer’s disease; however, for every research project that succeeded, 34 failed to yield a new medicine.

These “failures” may appear to be dead ends – a waste of time and resources – but to researchers they are both an inevitable and necessary part of making progress. These setbacks often contribute to eventual success by helping guide and redirect research on potential new drugs. In fact, the recent unsuccessful trials have provided a wealth of new information which researchers are now sifting through to inform their ongoing research.

Alzheimer’s disease is the sixth leading cause of death in the United States today, with 5.4 million people currently affected.^[i]  By 2050, the number of Americans with the disease is projected to reach 13.5 million at a cost of over $1.1 trillion unless new treatments to prevent, arrest or cure the disease are found.^[ii]  According to the Alzheimer’s Association a new medicine that delays the onset of the disease could change that trajectory and save $447 billion a year by 2050.

According to another new report, researchers are currently working on nearly 100 medicines in development for Alzheimer’s and other dementias. Although research is not a straight, predictable path, with continued dedication, we will make a difference for every person at risk of suffering from this terrible, debilitating disease.

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^[i]Alzheimer's Association, “Factsheet,” (March 2012), http://www.alz.org/documents_custom/2012_facts_figures_fact_sheet.pdf 
^[ii]Alzheimer's Association, 2012 Alzheimer's Disease Facts and Figures, Alzheimer's and Dementia, Volume 8, Issue 2

China's Solyndra Economy. By Patrick Chovanec

China's Solyndra Economy. By Patrick Chovanec
Government subsidies to green energy and high-speed rail have led to mounting losses and costly bailouts. This is not a road the U.S. should travel.WSJ, September 11, 2012, 7:21 p.m. ET
http://online.wsj.com/article/SB10000872396390443686004577634220147568022.html

On Aug. 3, the owner of Chengxing Solar Company leapt from the sixth floor of his office building in Jinhua, China. Li Fei killed himself after his company was unable to repay a $3 million bank loan it had guaranteed for another Chinese solar company that defaulted. One local financial newspaper called Li's suicide "a sign of the imminent collapse facing the Chinese photovoltaic industry" due to overcapacity and mounting debts.

President Barack Obama has held up China's investments in green energy and high-speed rail as examples of the kind of state-led industrial policy that America should be emulating. The real lesson is precisely the opposite. State subsidies have spawned dozens of Chinese Solyndras that are now on the verge of collapse.

Unveiled in 2010, Beijing's 12th Five-Year Plan identified solar and wind power and electric automobiles as "strategic emerging industries" that would receive substantial state support. Investors piled into the favored sectors, confident the government's backing would guarantee success. Barely two years later, all three industries are in dire straits.

This summer, the NYSE-listed LDK Solar, the world's second largest polysilicon solar wafer producer, defaulted on $95 billion owed to over 20 suppliers. The company lost $589 million in the fourth quarter of 2011 and another $185 million in the first quarter of 2012, and has shed nearly 10,000 jobs. The government in LDK's home province of Jiangxi scrambled to pledge $315 million in public bailout funds, terrified that any further defaults could pull down hundreds of local companies.

Chinese solar companies blame many of their woes on the antidumping tariffs recently imposed by the U.S. and Europe. The real problem, however, is rampant overinvestment driven largely by subsidies. Since 2010, the price of polysilicon wafers used to make solar cells has dropped 73%, according to Maxim Group, while the price of solar cells has fallen 68% and the price of solar modules 57%. At these prices, even low-cost Chinese producers are finding it impossible to break even.

Wind power is seeing similar overcapacity. China's top wind turbine manufacturers, Goldwind and Sinovel, saw their earnings plummet by 83% and 96% respectively in the first half of 2012, year-on-year. Domestic wind farm operators Huaneng and Datang saw profits plunge 63% and 76%, respectively, due to low capacity utilization. China's national electricity regulator, SERC, reported that 53% of the wind power generated in Inner Mongolia province in the first half of this year was wasted. One analyst told China Securities Journal that "40-50% of wind power projects are left idle," with many not even connected to the grid.

A few years ago, Shenzhen-based BYD (short for "Build Your Dreams") was a media darling that brought in Warren Buffett as an investor. It was going to make China the dominant player in electric automobiles. Despite gorging on green energy subsidies, BYD sold barely 8,000 hybrids and 400 fully electric cars last year, while hemorrhaging cash on an ill-fated solar venture. Company profits for the first half of 2012 plunged 94% year-on-year.

China's high-speed rail ambitions put the Ministry of Railways so deeply in debt that by the end of last year it was forced to halt all construction and ask Beijing for a $126 billion bailout. Central authorities agreed to give it $31.5 billion to pay its state-owned suppliers and avoid an outright default, and had to issue a blanket guarantee on its bonds to help it raise more. While a handful of high-traffic lines, such as the Shanghai-Beijing route, have some prospect of breaking even, Prof. Zhao Jian of Beijing Jiaotong University compared the rest of the network to "a 160-story luxury hotel where only 11 stories are used and the occupancy rate of those floors is below 50%."

China's Railway Ministry racked up $1.4 billion in losses for the first six months of this year, and an internal audit has uncovered dangerous defects due to lax construction on 12 new lines, which will have to be repaired at the cost of billions more. Minister Liu Zhijun, the architect of China's high-speed rail system, was fired in February 2011 and will soon be prosecuted on corruption charges that reportedly include embezzling some $120 million. One of his lieutenants, the deputy chief engineer, is alleged to have funneled $2.8 billion into an offshore bank account.

Many in Washington have developed a serious case of China-envy, seeing it as an exemplar of how to run an economy. In fact, Beijing's mandarins are no better at picking winners, and just as prone to blow money on boondoggles, as their Beltway counterparts.

In his State of the Union address earlier this year, President Obama declared, "I will not cede the wind or solar or battery industry to China . . . because we refuse to make the same commitment here." Given what's really happening in China, he may want to think again.

Mr. Chovanec is an associate professor of practice at Tsinghua University's School of Economics and Management in Beijing, China.

Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman

Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman
Anyone facing losses from a government default should be able to protect himself by hedging.WSJ, September 11, 2012, 7:22 p.m. ET
http://online.wsj.com/article/SB10000872396390443686004577639753399337204.html

Many regulators, politicians and academics consider credit default swaps to be insurance contracts. These folks then use the insurable-interest rule—which limits life-insurance claims to individuals adversely affected by the death of the insured—to recommend banning "naked" CDS purchases, that is, buying sovereign credit default swaps without holding the underlying sovereign bond. Financial Times columnist Wolfgang Munchau, for example, says that a naked CDS has "not one social or economic benefit."

The premise that only sovereign-debt holders suffer when a country defaults is false. Many other agents are adversely affected by a default, and they should be allowed to purchase sovereign CDS.

A 2006 Bank of England study found that the output losses for 45 sovereign defaults between 1970 and 2000 "appear to be very large—around 7% a year on the median measure—as well as long lasting." The haircut taken by investors after sovereign defaults ranges from 20%-70%. But many spectators to a sovereign-default drama also suffer significant losses of wealth and livelihood.

Domestic importers and foreign exporters suffer when the default is accompanied by a devaluation. Financial institutions and holders of domestic corporate debt suffer as their asset values fall. Domestic companies suffer as their credit risk increases, with smaller businesses being especially harmed as banks reduce loan availability. And of course all consumers suffer as the economy retrenches.

In Mexico after its 1982 default, new lending dried up, trade suffered, incomes dropped and economic growth stagnated. In Russia after its 1998 default, food prices doubled, input prices quadrupled and many banks collapsed. In Argentina after its 2002 default, inflation touched 80%, unemployment rose to 25%, the peso lost 70% of its value, bank credit was halved and many businesses closed.

Today, many participants in the Greek, Irish, Italian, Portuguese and Spanish economies suffer as their governments struggle to prevent bank runs and avoid default. Millions of Europeans will undoubtedly lose wealth and work if defaults are not avoided.

If one or more of these sovereigns do default, there will also be serious consequences for participants in other linked markets. Commercial banks will suffer losses on the defaulted debt, possibly triggering bank runs if investors fear they will be unable to honor their commitments.

Many other foreign participants will also suffer, as contagion concerns cause investors to downgrade many assets, including sovereign and corporate debt, and to demand increased collateral. This in turn may force the selling of distressed assets, pushing prices even lower.

While there are other ways of insuring against corporate defaults—shorting stocks or buying put options, for instance—credit default swaps provide the only cost-effective way of hedging against sovereign defaults.

Rather than restricting access to the sovereign debt CDS market, regulators should encourage the introduction of standardized, exchange-traded "mini" sovereign debt CDS contracts, which would allow small buyers to better protect themselves against default.

There is also little evidence to support the argument that access to the sovereign CDS market should be restricted because of excessive speculation. Although credit default swaps written on Greek government bonds paid out a relatively high 78.5 cents on the dollar in March 2012, the owners of these swaps only received $2.5 billion—a small fraction of the $140 billion losses suffered when Greece defaulted.

Rather than destabilizing the market for euro-zone sovereign debt, credit default swaps, by providing a mechanism to shift risk, grow the market and reduce government financing costs.

In addition, CDS prices are useful signals of sovereign credit worthiness—which may explain the hostility of some politicians toward them.

Mr. Turnbull is a business professor at the University of Houston. Mr. Wakeman is a consultant at Risk Analysis & Control.

As regulation has become more complex, it has also become less effective - Haldane and Madouros paper

Speech of the Year. WSJ Editorial
A regulator, of all people, shows how complex regulations contributed to the financial crisis.
WSJ, September 11, 2012, 7:13 p.m. ET
http://online.wsj.com/article/SB10000872396390444273704577637792879194380.html


While Americans were listening to the bloviators in Tampa and Charlotte, the speech of the year was delivered at the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. The orator of note was a regulator from the Bank of England, and his subject was "The dog and the frisbee."

In a presentation that deserves more attention, BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can't provide accurate measurements of a bank's health.

The paper's title refers to the fact that border collies can often catch frisbees better than people, because the dogs by necessity have to keep it simple. But the impulse of regulators, if asked to catch a frisbee, would be to encourage the construction of long equations related to wind speed and frisbee rotation that they likely wouldn't even understand.

Readers will recall how ineffective the Basel II international banking standards were at ensuring the health of investment banks like Bear Stearns. The inspector general of the Securities and Exchange Commission, which adopted the Basel standards in 2004, would report in 2008 that Bear remained compliant with these rules even as it was about to be rescued.

Messrs. Haldane and Madouros looked broadly at the pre-crisis financial industry, and specifically at a sample of 100 large global banks at the end of 2006. What they found was that a firm's leverage ratio—the amount of equity capital it held relative to its assets—was a fairly good predictor of which banks ended up sailing into the rocks in 2008. Banks with more capital tended to be sturdier.

But the definition of what constitutes capital was also critical, and here simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to be more precise because it assigned "risk weights" to each category of assets and required banks to perform millions of complex calculations. Yet it was hardly of any use in predicting disasters at too-big-to-fail banks.

We've argued that Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as "safe." Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes.

Messrs. Haldane and Madouros also describe the larger problem: a belief among regulators that models can capture all necessary information and then accurately predict future risk. This belief is new, and not helpful. As the authors note, "Many of the dominant figures in 20th century economics—from Keynes to Hayek, from Simon to Friedman—placed imperfections in information and knowledge centre-stage. Uncertainty was for them the normal state of decision-making affairs."

A deadly flaw in financial regulation is the assumption that a few years or even a few decades of market data can allow models to accurately predict worst-case scenarios. The authors suggest that hundreds or even a thousand years of data might be needed before we could trust the Basel machinery.

Despite its failures, that machinery becomes larger and larger. As Messrs. Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the world today cannot be solved by the level of thinking that created them.' Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise."

Exploding the myth that regulatory agencies are underfunded, they note that in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance.

Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely.

Here's a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting" and other fantasies of regulatory omniscience. In financial regulation, as in so many other areas of life, simpler is better.

Original paper: http://www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx

Estimating the Costs of Financial Regulation. By Andre Santos and Douglas Elliott

Estimating the Costs of Financial Regulation. By Andre Santos and Douglas Elliott
IMF Staff Discussion Notes No. 12/11
September 11, 2012
ISBN/ISSN: 978-1-61635-435-0 / 2221-030X
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26231.0

This study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy.  In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth.

A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors. There is considerable uncertainty about these cost assumptions, but a sensitivity analysis shows that reasonable changes in assumptions do not dramatically alter the conclusions of this study. Cost estimates are based on several references, including academic theory, empirical analyses from industry and official sources, as well as financial disclosures by large banks.

The findings are based on methodologies that were used in previous studies by academics and the official sector. This study, however, estimates that lending rate increases will likely be significantly smaller, for the following reasons. First, the baseline scenario implies a smaller regulatory effect, with market forces accounting for some of the expected increases in safety margins. Second, banks are expected to absorb part of the higher costs by cutting expenses. Third, investors are expected to reduce their required rate of return on bank equity modestly as a result of the safety improvements. Debt investors are expected to follow suit, although to a much lesser extent.

There are important limitations to the analysis presented here. It does not address the potential transition costs as banks adjust to the new regulations. Nor does it assess the economic benefits of financial reforms. A number of regulatory reforms are not modeled; judgment has been required in making many of the estimates; and the modeling approach is relatively simple. Nevertheless, the results appear to be a balanced, albeit rough, assessment of the likely effects on bank lending. Further research would be useful to translate these credit impacts into effects on economic output.

Our Future World: Global megatrends that will change the way we live

Our Future World: Global megatrends that will change the way we live (2012 update)
Sep 5, 2012
http://www.csiro.au/resources/Our-Future-World?goback=.gde_128402_member_159431416

The six interrelated megatrends identified in the report are:

1. More from less. The earth has limited supplies of natural mineral, energy, water and food resources essential for human survival and maintaining lifestyles.
2. Going, going ... gone? Many of the world's natural habitats, plant species and animal species are in decline or at risk of extinction.
3. The silk highway. Coming decades will see the world economy shift from west to east and north to south.
4. Forever young. The ageing population is an asset. Australia and many other countries that make up the Organisation for Economic Cooperation and Development (OECD) have an ageing population.
5. Virtually here. This megatrend explores what might happen in a world of increased connectivity where individuals, communities, governments and businesses are immersed into the virtual world to a much greater extent than ever before.
6. Great expectations. This is a consumer, societal, demographic and cultural megatrend.It explores the rising demand demand for experiences over products and the rising importance of social relationships.

A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing. By Nassim N Taleb et alii

A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing. By Nassim N Taleb et alii
IMF Working Paper No. 12/216
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26222.0

Summary:This paper presents a simple heuristic measure of tail risk, which is applied to individual bank stress tests and to public debt. Stress testing can be seen as a first order test of the level of potential negative outcomes in response to tail shocks. However, the results of stress testing can be misleading in the presence of model error and the uncertainty attending parameters and their estimation. The heuristic can be seen as a second order stress test to detect nonlinearities in the tails that can lead to fragility, i.e., provide additional information on the robustness of stress tests. It also shows how the measure can be used to assess the robustness of public debt forecasts, an important issue in many countries. The heuristic measure outlined here can be used in a variety of situations to ascertain an ordinal ranking of fragility to tail risks.

Global Housing Cycles. By Deniz Igan and Prakash Loungani

Global Housing Cycles. By Deniz Igan and Prakash Loungani
IMF Working Paper No. 12/217
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26229.0

Summary: Housing cycles and their impact on the financial system and the macroeconomy have become the center of attention following the global financial crisis. This paper documents thecharacteristics of housing cycles in a large set of countries, and examines the determinants of house price movements. Empirical analysis shows that house price dynamics are mostly driven by income and demographics but fluctuations in these fundamentals and credit conditions can create deviations from the implied equilibrium path. We conclude with a discussion of the macroeconomic implications of house price corrections.

Effects of Culture on Firm Risk-Taking: A Cross-Country and Cross-Industry Analysis. By Roxana Mihet

Effects of Culture on Firm Risk-Taking: A Cross-Country and Cross-Industry Analysis. By Roxana Mihet
IMF Working Paper No. 12/210
Aug 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012210

Summary: This paper investigates the effects of national culture on firm risk-taking, using a comprehensive dataset covering 50,000 firms in 400 industries in 51 countries. Risk-taking is found to be higher for domestic firms in countries with low uncertainty aversion, low tolerance for hierarchical relationships, and high individualism. Domestic firms in such countries tend to take substantially more risk in industries which are more informationally opaque (e.g. finance, mining, IT). Risk-taking by foreign firms is best explained by the cultural norms of their country of origin. These cultural norms do not proxy for legal constraints, insurance safety nets, or economic development.

http://www.imf.org/external/pubs/cat/longres.aspx?sk=26204.0

Excerpts:

Introduction

Understanding whether national culture affects a society‟s likelihood to generate risk-seeking firms is important for effective policy-making and for improving corporate governance. It can enrich discussions on government policies that encourage entrepreneurship and innovation. A grasp of the impact of cultural influences on corporate risk-taking would allow policy-makers to better customize their policies for firms with different risk appetites, thus promoting more competitive business environments. Understanding the impact of culture on corporate risk-taking decisions is also important to the internal conduct of multinational firms. Internal decisions in multinational firms, such as the decision to pursue a risky R&D project, require well-orchestrated responses from executives with diverse cultural backgrounds. Even in firms with standardized operating procedures, the interpretation of various financial decisions can vary among executives from different societies as a result of their cultural differences (Tse et al. 1988). Accounting for the impact of cultural influences on decision-making allows the firms themselves to accommodate and adapt to such differences, hence diminishing “noisy” interactions among executives and errors in decision-making.

This study employs four dimensions of national culture identified by Hofstede (2001) and an international sample of 50,000 firms spread across 400 industries in 51 countries to analyze the effects of cultural differences on corporate risk-taking. More specifically, it tries to identify the channels through which cultural values can influence corporate risk-taking. Culture can affect the institutional and economic development at the macro level, the industrial diversification and industry concentration at the market structure level, as well as the corporate and individual decision-making at the micro level, all of which may in turn influence firm risk-taking decisions.

Previous literature has shown that national culture does in fact predict cross-country differences in the degree of institutional and economic development. Culture has been linked with creditor rights and investor protection (Stulz and Williamson 2003), with judicial efficiency (Radenbaugh et al. 2006), with corporate governance (Doidge et al. 2007), with bankruptcy protection and insolvency management (Beraho and Elisu 2010) and with overall levels of transparency and corruption (Husted 1999). Research has further established that national culture has an impact on the composition and leadership structure of boards of directors (Li and Harrison 2008) and also on individual decision-making at the micro level (Hilary and Hui 2009; Halek and Eisenhauer 2001; and Graham et al. 2009). On the other hand, attitudes towards risk are likely to be indirectly affected by culture through many of the factors listed above, as well as directly by national cultural norms, which may encourage or deter risk-taking.

This paper is not the first to study the impact of cultural values on corporate risk-taking. The extant literature has briefly studied the relation between culture and risk-taking, but has mostly focused on firms in the banking and the financial sectors (Houston et al. 2010; Kanagaretnam et al. 2011; Lehnert et al. 2011; Li and Zahra 2012). For example, Kanagaretnam et al. (2011) show that aggressive risk-taking activities by banks are more likely in societies with low uncertainty avoidance and high individualism. They show that cultural differences between societies have a profound influence on the level of bank risk-taking, and the ability to explain bank financial troubles during the recent financial crisis. On the other hand, Griffin et al. (2012) show that uncertainty avoidance is negatively and individualism is positively associated with firm-level riskiness in the non-financial sector (in the manufacturing sector).

This paper innovated in at least four ways. First, this paper takes a more holistic approach to the study of cultural influences on corporate risk-taking by studying not only the banking and the financial sectors, but all industries in a market economy. We take this approach in order to capture cross-industrial differences in risk-taking. The influence of cultural factors, such as national uncertainty aversion, may be of greater importance for firms in more informationally opaque industries such as information technologies, financial services, oil extraction, and chemicals, where information uncertainty is higher relative to manufacturing and industrial firms, because of the greater complexity of operations and the difficulty of assessing and managing risk. Thus, we test whether corporate risk-taking in informationally more opaque industries is more sensitive to a country‟s national cultural norms. Second, we differentiate between the direct and indirect effects of national culture on firm risk-taking. We specifically test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Third, unlike previous research which has used standard ordinary least squares analyses, we model both the direct and indirect effects of culture on risk-taking by employing a hierarchical linear mixed model. The hierarchical linear mixed model allows testing multi-level theories, simultaneously modeling variables at the firm, industry and country level without having to recourse to data aggregation or disaggregation as previous cultural economics studies have had to do. Fourth, by using a hierarchical linear model in explaining firm-level risk-taking, we can model not only the firm, industry and country-level influences on risk-taking, but also their cross-level interactions.

This paper finds that:
 Culture impacts corporate risk-taking directly and not merely though indirect channels such as the legal and regulatory frameworks.
 Corporate risk-taking is higher in societies with low uncertainty avoidance, low tolerance for hierarchical relationships and in societies which value individualism over collectivism, with these effects even more accentuated in societies with better formal institutions.
 Additionally, firms in countries ranking high in uncertainty-aversion and low in individualism take significantly less risk in industrial sectors which are more informationally opaque (e.g. finance, IT, oil refinery and mining), compared to firms in countries lower in uncertainty-aversion and higher in individualism.
 Risk-taking by foreign firms is best explained by the cultural norms of their country of origin.
 These cultural dimensions are not proxying for legal constraints, economic development, bankruptcy costs, insurance safety nets, or many other factors.

The results of this study inform both theory and policy in several ways. First, these findings strengthen the argument that the same institutional rules can produce different economic outcomes in culturally-different societies. Second, they imply that policy-makers should take into account cross-cultural values and norms when drafting policies that promote competitive business environments. Third, they enrich governmental discussions on policies that address risk-taking in informationally opaque sectors.


Literature review

Several research studies in the financial, accounting, and management literatures have explored the importance of cultural values in decision-making. These studies find that culture can explain the institutional, legal and economic environments of a country at the macro level which can influence corporate risk-taking decisions, and offer evidence of the impact of culture on financial decision-making by individuals at the micro level beyond traditional economic arguments.

At the micro level, culture has (unsurprisingly) been shown to affect individual risk-taking behaviors. Breuer et al. (2011) find that individualism is linked to overconfidence and overoptimism and has a significantly positive effect on individual financial risk-taking and the decision to own stocks. Tse et al. (1988) show that home culture has predictable, significant effects on the decision-making of executives. Two decades later, Graham et al. (2010), using survey data in the U.S., also show that CEOs are not immune to the effects of culture. They find that CEOs‟ decision-making is strongly influenced by cultural values such as uncertainty-aversion.

At the macro level, cultural heritage has been linked to corporate governance, investor protection, creditor rights, bankruptcy protection, judicial efficiency, accounting transparency, and corruption. Doidge et al. (2007) find that cross-cultural differences explain much more of the variance in corporate governance than observable firm characteristics. Hope (2003a) shows evidence that both legal origin and culture (as proxied by Hofstede‟s cultural dimensions) are important in explaining firms‟ disclosure practices and investor protection. In fact, he finds that although legal origin is a key determinant of disclosure levels, its importance decreases with the richness of a firm‟s information environment, while culture still remains a significant determinant. Licht et al. (2005) find that social norms of governance correlate strongly and systematically with high individualism and low power distance. Stulz et al. (2003) find that cultural heritage, proxied by religion and language, predicts the cross-sectional variation in creditor rights better than a country‟s trade openness, economic development, legal origin, or language. Other studies find that culture predicts judicial efficiency and the transparency of accounting systems. Radenbaugh et al. (2006) find that countries in the Anglo cluster have an accounting system which is more transparent and less conservative than either the Germanic or the Latin accounting systems. Beraho et al. (2010) show that cross-cultural variables have a direct influence on the propensity to file for bankruptcy and on insolvency laws. Lastly, both Getz and Volkema (2001) and Robertson and Watson (2004) link cultural differences to corruption levels.

Furthermore, recent research has also linked cultural variables to economic and market development, although the evidence is mixed. Guiso et al. (2006) find that national culture impacts economic outcomes, by influencing national savings rates and income redistributions. Kwok and Tadesse (2006) find that culture explains cross-country variations in financial systems, with higher uncertainty-avoidance countries dominated by bank-based financial systems, rather than by stock-markets. Kirca et al. (2009) show that national culture impacts the implementation of market-oriented practices (i.e., generation, dissemination, and utilization of market intelligence) and the internalization of market-oriented values and norms (i.e., innovativeness, flexibility, openness of internal communication, speed, quality emphasis, competence emphasis, inter-functional cooperation, and responsibility). Lee and Peterson (2000) show that only countries with specific cultural tendencies (i.e., countries which emphasize individualism) tend to engender a strong entrepreneurial orientation, hence experiencing more entrepreneurship and global competitiveness. On the other hand, Pryor (2005) argues that cultural variables do not seem related to the level of economic development and are not useful in understanding economic growth or differences in levels of economic performance across countries. Additionally, Herger et al. (2008) also argue that cultural beliefs do not seem to support or impede financial development. This mixed evidence points to the idea that national culture might only indirectly influence economic and market development through its effects on the legal and institutional contexts.

The institutional and economic environments have been shown to affect corporate risk-taking decisions. There is a small strand of literature which has explored corporate risk-taking around the world which reflects countries‟ institutional and economic environments. For example, Laeven and Levine (2009) show that risk-taking by banks varies positively with the comparative power of shareholders within each bank. Moreover, they show that the relations between bank risk-taking and capital regulation, deposit insurance mechanisms, and bank activities restrictiveness, depend critically on the bank‟s ownership structure. Claessens et al. (2000) show that corporations in common law countries and market-based financial systems have less risky financing patterns, and that the stronger protection of equity and creditor rights is also associated with less financial risk. Overall, while the literature is relatively small, national culture has been indirectly linked with corporate risk-taking decisions in formal studies, although most of them only analyze the banking sector.

Culture has also been directly linked with corporate risk-taking, although again, most studies have focused on either the financial or the manufacturing sectors separately. Kanagaretnam et al. (2011) show that banks in high uncertainty avoidance societies tend to take less risk, whereas banks in high individualism societies take more risk. However, they do not control for institutional variables such as corporate governance, bankruptcy protection, judicial efficiency, transparency, and corruption, which have shown to be affected by national cultural norms and which could at their turn affect corporate risk-taking. Griffin et al. (2012) study the impact of culture on firms in the manufacturing sector in the period 1997-2006. To the best of our knowledge, they are the only ones who use a hierarchical linear mixed model to analyze the impact of culture on corporate risk-taking. They show that individualism has positive and significant direct effects, while uncertainty avoidance has negative and significant direct effects on corporate risk-taking.

This paper contributes to the literature on the impact of culture on firm risk-taking in several ways. While previous studies have studied either the direct or the indirect effects of culture on risk-taking, this paper tries to reconcile the two strands of literature and assess them simultaneously by using a hierarchical linear mixed model. This allow to test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Moreover, this paper extends the analyses of Griffin et al. (2012) and Kanagaretnam et al. (2011) to capture cross-industrial differences in risk-taking. Given the importance to national and global economies of the highly leveraged sector of finance, or the highly innovative sector of IT, or the highly risky commodity industries1, and given that firms in these industries are markedly different from manufacturing firms and have been more adversely affected by the recent global economic crisis, it is very important to understand the role of culture on cross-industrial variation in corporate risk-taking.

Incentivizing Calculated Risk-Taking: an Experiment with Commercial Bank Loan Officers. By Martin Kanz and Leora Klapper

Incentivizing Calculated Risk-Taking: an Experiment with Commercial Bank Loan Officers. By Martin Kanz and Leora Klapper
Mon, Aug 27, 2012    08:42am
http://blogs.worldbank.org/allaboutfinance/incentivizing-calculated-risk-taking-an-experiment-with-commercial-bank-loan-officers

In the aftermath of the global financial crisis, there has been much criticism of compensation practices at banks. Although much of this debate has focused on executive compensation (see the recent debate on this blog), there is a growing recognition that non-equity incentives for loan officers and other employees at the lower tiers of a bank’s corporate hierarchy may share some of the blame — volume incentives for mortgage brokers in the United States that rewarded high-risk lending at wildly unsustainable terms are a particularly striking case in point.

The view that excessive risk-taking in the run-up to the crisis had its roots in flawed incentives at all levels of financial institutions — not just at the top — has made inroads in policy circles, and has been reflected in efforts to regulate how banks can pay their loan officers. Well-intentioned as these efforts may be, they mask the fact that providing performance incentives in lending is, in fact, a very difficult problem. Assessing a borrower’s creditworthiness requires a complex tradeoff between risk and return; it contains an inherent element of deferred compensation and requires the interpretation of a noisy signal about an applicant’s actual creditworthiness. Whether and how performance incentives work in this setting is unclear: the limited evidence that exists about the impact of performance pay on employee behavior comes from the labor economics literature and suggests that — even in simple production tasks — the behavioral response to incentives tends to be much more complex than a simple mapping from stronger incentives to greater effort and performance.

So how does “pay-for-performance” affect the risk-appetite and lending decisions of loan officers? In a recent paper, coauthored with Shawn Cole of Harvard Business School we designed a field experiment with real-life loan officers to examine the impact of performance incentives on loan officer behavior. Working with a number of leading commercial banks in India, we recruited more than 200 loan officers with an average of more than ten years of experience in banking and brought them to a behavioral economics lab. In the lab, participants were asked to evaluate a set of loan applications under different, exogenously assigned incentives. This cross-over between an actual field experiment and a controlled lab setting allowed us to study risk-taking behavior using a real life population of highly experienced loan officers, while being able to get detailed measurements of risk-assessment and risk-taking behavior — the kind of data that would usually only be available from a lab experiment.

We deliberately set up our experiment in an informationally challenging emerging credit market — the Indian market for unsecured small enterprise loans. Borrowers in this market typically lack reliable credit scores and an established track record of formal sector borrowing. This generally rules out the use of predictive credit scoring and other advance loan approval technologies, making banks particularly reliant on the risk-assessment of their frontline employees. The credit files that our loan officers evaluated in the experiment consisted of actual loan applications from small enterprises applying for their first formal-sector loan. Each loan was matched with ten months of repayment history from the lender’s proprietary database (not surprisingly, more than 90% of defaults occur in the first three months of a loan’s tenure). This allowed us to compare the actual outcome of the loan with the loan officer’s decision and risk assessment in the experiment and to offer incentive payments based on the profitability of lending decisions loan officers took in the lab.

The reassuring news is that basic incentives seem to work quite well in lending. We find that pay for performance (incentives that reward profitable lending and penalize default) indeed induces loan officers to exert much greater effort in reviewing the information that is presented to them. This is all well, but the real question is whether this translates into improved lending decisions. One common concern with performance pay in lending is that stronger incentives may indeed make loan officers much more conscientious, so conscientious in fact that they may shy away from risks that would be profitable from the viewpoint of the bank and simply stop lending. In our experiment, we find this not to be the case: when loan officers faced high-powered incentives, the probability that they would approve a non-performing loan was reduced by 11% while overall lending went down by only 3.6%. In other words, more stringent incentive schemes actually made loan officers better at identifying and eliminating bad credits from the pool of loan applicants. Profits per loan increased by up to 4% over the median loan size and by more than 40% compared with the case when loan officers faced volume incentives.

These strong results highlighting the negative impact of volume incentives are in line with much recent evidence using observational data (Agarwal and Ben-David 2012; Berg, Puri, and Rocholl 2012). So is pay-for performance the solution to all of a bank’s internal agency problems? Unfortunately not. In an additional set of experiments, we varied the time horizon of the loan officer’s compensation contract — an important second dimension of the incentive scheme over which a bank typically has control. Interestingly, our results show that performance incentives quickly lose their bite as they are deferred even by a couple months. Given that in real life performance pay typically occurs in the form of a quarterly or annual bonus, this casts some doubt on the wisdom of trying to fix agency problems within financial institutions with monetary incentives alone. Interestingly, however, deferred compensation also makes permissive incentive schemes less tempting and can attenuate many of the negative effects of volume incentives. Some direct advice that comes out of this finding is that if a bank finds it necessary to provide volume incentives, it can limit the potential damage through deferred compensation.

Perhaps most interestingly, the results from our experiment also show that incentives affect not only actual lending decisions, they also distort loan officers’ subjective assessment of credit risk. Put simply, we find that when participants faced incentives that emphasize lending volume over loan quality, they started viewing their clients’ creditworthiness through rose-colored glasses. They inflated internal risk ratings — which were neither seen by any supervisor nor tied to incentives — by up to .3 standard deviations for the same loan. This finding resonates with the psychological concept of “cognitive dissonance” (Akerlof and Dickens 1982) and is in line with behavioral economics explanations that have tried to make sense of seemingly irrational behavior in sub-prime lending prior to the crisis, which are nicely summarized in a recent article by Nicholas Berberis (2012) from the Yale School of Management.
What are we to take away from these results? The question of how to better align private incentives with public interest is a major unresolved policy question that has arisen from the global financial crisis. Our experiments provide some of the first rigorous evidence on the link between performance pay and behavior among loan originators, which we hope will be a first step that can help tackle this important issue from the angle of corporate governance —– with the ultimate aim of making compensation policy a more effective component of a bank’s risk management mechanisms. Much work has recently gotten underway in this exciting research agenda, but it is clear that much more evidence is needed to translate these findings into meaningful policy prescriptions. To contribute to this agenda, we are currently working on a number of follow-up experiments to more fully understand the behavioral and psychological implications of the problem of incentives and individual risk-taking. Stay tuned.


References

Agarwal, Sumit, and Itzhak Ben-David. 2012. “Do Loan Officer Incentives Lead to Lax Lending Standards?” Ohio State University, Fisher College of Business. Working Paper WP-2012-7.

Agarwal, Sumit, and Faye H. Wang. 2009. “Perverse Incentives at the Banks? Evidence from a Natural Experiment.” Federal Reserve Bank of Chicago. Working Paper WP-09-08.

Akerlof, George A., and William T. Dickens. 1982. “The Economic Consequences of Cognitive Dissonance.” American Economic Review 72 (3):307–19.

Baker, George, Michael Jensen, and Kevin Murphy. 1988. “Compensation and Incentives: Practice vs. Theory.” Journal of Finance 43 (3):593–616.

Bandiera, Oriana, Iwan Barankay, and Imran Rasul. 2007. “Incentives for Managers and Inequality among Workers: Evidence from a Firm-Level Experiment.” Quarterly Journal of Economics 122 (2):729–73.

_____. 2009. “Social Connections and Incentives in the Workplace: Evidence from Personnel Data.” Econometrica 77 (4):1047–94.

_____ Team Incentives: Evidence from a Firm Level Experiment. Journal of the European Economic Association, forthcoming.

Barberis, Nicholas. 2012. “Psychology and the Financial Crisis of 2007-2008.” In Financial Innovation and the Crisis, edited by M. Haliassos. Cambridge, MA: MIT Press.

Berg, Tobias, Manju Puri, and Jorg Rocholl. 2012. “Loan Officer Incentives and the Limits of Hard Information.” Duke University Fuqua School of Business Working Paper.

Measuring Systemic Risk-Adjusted Liquidity (SRL) - A Model Approach. By Andreas Jobst

Measuring Systemic Risk-Adjusted Liquidity (SRL) - A Model Approach. By Andreas Jobst
IMF Working Paper No. 12/209
Aug 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012209

Summary: Little progress has been made so far in addressing—in a comprehensive way—the externalities caused by impact of the interconnectedness within institutions and markets on funding and market liquidity risk within financial systems. The Systemic Risk-adjusted Liquidity (SRL) model combines option pricing with market information and balance sheet data to generate a probabilistic measure of the frequency and severity of multiple entities experiencing a joint liquidity event. It links a firm’s maturity mismatch between assets and liabilities impacting the stability of its funding with those characteristics of other firms, subject to individual changes in risk profiles and common changes in market conditions. This approach can then be used (i) to quantify an individual institution’s time-varying contribution to system-wide liquidity shortfalls and (ii) to price liquidity risk within a macroprudential framework that, if used to motivate a capital charge or insurance premia, provides incentives for liquidity managers to internalize the systemic risk of their decisions. The model can also accommodate a stress testing approach for institution-specific and/or general funding shocks that generate estimates of systemic liquidity risk (and associated charges) under adverse scenarios.

Excerpts:

A defining characteristic of the recent financial crisis was the simultaneous and widespread dislocation in funding markets, which can adversely affect financial stability in absence of suitable liquidity risk management and policy responses. In particular, banks’ common asset exposures and their increased reliance on short-term wholesale funding in tandem with high leverage levels helped propagate rising counterparty risk due to greater interdependence within the financial system. The implications from liquidity risk management decisions made by some institutions spilled over to other markets and other institutions, contributing to others’ losses, amplifying solvency concerns, and exacerbating overall liquidity stress as a result of these negative dynamics. Thus, private sector liquidity (as opposed to monetary liquidity), which is created largely through banks and other financial institutions via bilateral arrangements and organized trading venues, is invariably influenced by common channels of market pricing that can amplify cyclical movements in system-wide financial conditions with the potential of negative externalities resulting from individual actions (CGFS, 2011).

The opportunity cost of holding liquidity is invariably cyclical, resulting in a notorious underpricing of liquidity risk, which tends to perpetuate a disregard for the potential inability of markets to sustain sufficient liquidity transformation under stress. Banks have an incentive to minimize liquidity (and mitigate the opportunity cost of holding excess liquidity in lieu of return-generating assets) in anticipation that central banks will almost certainly intervene in times of stress as lenders-of-last-resort. Even without central bank support, liquidity risk is most expensive when it is needed most while generating little if any additional return in good times. While central banks can halt a deterioration of funding conditions in order to maintain the efficient operation of funding markets (see Figure 1), prevent financial firms from failing, and, thus, limit the impact of liquidity shortfalls on the real economy, their implicit subsidization of bank funding accentuates the magnitude of liquidity risks under stress. Central bank measures during the credit crisis have further reinforced this perception of contingent liquidity support, giving financial institutions an incentive to hold less liquidity than needed (IMF, 2010a).

Current systemic risk analysis—as a fundamental pillar of macroprudential surveillance and policy—is mostly focused on solvency conditions. Disruptions to the flow of financial services become systemic if there is the potential of financial instability to trigger serious negative spillovers to the real economy. Macroprudential policy aims to limit, mitigate or reduce systemic risk, thereby minimizing the incidence and impact of disruptions in the provision of key financial services that can have adverse consequences for the real economy (and broader implications for economic growth). Substantial work is underway to develop enhanced analytical tools that can help to identify and measure systemic risk in a forward-looking way, and, thus, support improved policy judgments. While systemic solvency risk has already entered the prudential debate in the form of additional capital rules that apply to systemically important financial institutions (SIFIs), little progress has been made so far in addressing systemic liquidity risk.

In contrast, proposals aimed at measuring and regulating systemic liquidity risk caused by the interconnectedness across financial institutions and financial markets have been few and far between. Systemic liquidity risk is associated with the possibility that maturity transformation in systemically important institutions and markets is disrupted by common shocks that overwhelm the capacity to fulfill all planned payment obligations as and when they come due. For instance, multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding (much less longterm funding). However, progress in developing a systemic liquidity risk framework have been hampered by the rarity of system-wide liquidity risk events, the multiplicity of interactions between institutions and funding markets, and the conceptual challenges in modeling liquidity conditions affecting institutions and transactions separately or jointly. The policy objective of such efforts would be to minimize the possibility of systemic risk from liquidity disruptions that necessitate costly public sector support. While a financial institution’s failure can cause an impairment of all or parts of the financial system, firms are not charged for the possibility that their risk-taking affects the operation of the financial system as a whole. In fact, individual actions might cause losses elsewhere in the system through direct credit exposures and financial guarantees, forced asset sales, and greater uncertainty regarding mutual exposures (possibly in combination with greater risk aversion of investors), which increases the cost of funding for all financial institutions. These “negative externalities” impose costs to the system, which increases the greater the importance of a single institution to the system (“too-important-to-fail”) and the higher the level of asymmetric information as coordination failures accentuate the impact of common shocks. Thus, more stringent prudential liquidity requirements, much like higher capital levels, might be beneficial ex ante by creating incentives of shareholders to limit excessive risk-taking, which would otherwise increase the potential loss in case of failure (Jensen and Meckling, 1976; Holmstrom and Tirole, 1997). However, certain liquidity standards might also encourage greater concentrations in assets that receive a more favorable regulatory treatment based on their liquidity characteristics during normal times (which remains to be tested during times of stress).

A number of prudential reforms and initiatives are underway to address shortcomings in financial institutions’ liquidity practices, which have resulted in more stringent supervisory liquidity requirements. Under the post-crisis revisions of the existing Basel Accord, known as Basel III, the Basel Committee on Banking Supervision (BCBS, 2010a, 2010b and 2009) has proposed two quantitative liquidity standards to be applied at a global level and published a qualitative guidance to strengthen liquidity risk management practices in banks. Under this proposal, individual banks are expected to maintain a stable funding structure, reduce maturity transformation, and hold a sufficient stock of assets that should be available to meet its funding needs in times of stress—as measured by two standardized ratios:

*  Liquidity Coverage Ratio (LCR). This ratio is intended to promote short-term resilience to potential liquidity disruptions by requiring banks to hold sufficient highquality liquid assets to withstand the run-off of liabilities over a stressed 30-day scenario specified by supervisors. More specifically, “the LCR numerator consists of a stock of unencumbered, high-quality liquid assets that must be available to cover any net [cash] outflow, while the denominator is comprised of cash outflows less cash inflows (subject to a cap at 75 [percent] of total outflows) that are expected to occur in a severe stress scenario (BCBS, 2011 and 2012b).”
*  Net Stable Funding Ratio (NSFR). This structural ratio limits the stock of unstable funding by encouraging longer term borrowing in order to restrict liquidity mismatches from excessive maturity transformation. It requires banks to establish a stable funding profile over the short term (i.e., the use of stable (long-term and/or stress-resilient) sources to continuously fund short-term cash flow obligations that arise from lending and investment activities). The NSFR reflects the proportion of long-term assets that are funded by stable sources of funding with maturities of more than one year (except deposits), which includes customer deposits, long-term wholesale funding, and equity (but excludes short-term funding). A value of this ratio of less than 100 percent indicates a shortfall in stable funding based on “the difference between balance sheet positions after the application of available stable funding factors and the application of required stable funding factors for banks where the former is less than the latter (BCBS, 2011 and 2012b).”

However, these prudential measures do not directly targeting system-wide implications.  The current approach assumes that sufficient institutional liquidity would reduce the likelihood of knock-on effects on solvency conditions in distress situations and complement the risk absorption role of capital—but without considering system-wide effects. Larger liquidity buffers at each bank should lower the risk that multiple institutions will simultaneously face liquidity shortfalls, which would ensure that central banks are asked to perform only as lenders of last resort—and not as lenders of first resort. However, this rationale underpinning the Basel liquidity standards ignores the impact of the interconnectedness of various institutions and their diverse funding structures across a host of financial markets and jurisdictions on the probability of such simultaneous shortfalls. Moreover, in light of the protracted adoption of both the LCR and the NSFR (whose implementation is envisaged in 2015 and 2018, respectively) and the associated risk of undermining timely adjustment of industry standards, Perotti (2012) argues for strong transitional tools in the form of “prudential risk surcharges.” These would be imposed on the gap between current liquidity positions of banks and the envisaged minimum liquid standards at a level high enough to compensate for and discourage the creation of systemic risk in order to ensure early adoption of safer standards while offering sufficient flexibility of banks to chart their own path towards compliance.

An effective macroprudential approach that targets systemic liquidity risk presupposes the use of objective and meaningful measures that can be applied in a consistent and transparent fashion (and the attendant design of appropriate policy instruments).  Ideally, any such methodology would need to allow for extensive back-testing and should benefit from straightforward application (and avoid complex modeling (or stress-testing)).  While it should not be too data intensive to compute and implement, enough data would need to be collected to ensure the greatest possible coverage of financial intermediaries in order to accommodate different financial sector characteristics and supervisory regimes across national boundaries. In addition, the underlying measure of systemic risk should be time-varying, and, if possible, it should offset the procyclical tendencies of liquidity risk and account for changes to an institution’s risk contribution, which might not necessarily follow cyclical patterns. Finally, it would also motivate a risk-adjusted pricing scheme so that institutions that contribute to systemic liquidity risk are assigned a proportionately higher charge (while the opposite would hold true for firms that help absorb system-wide shocks from sudden increases in liquidity risk).

In this regard, several proposals are currently under discussion (see Table 1), including the internalization of public sector cost of liquidity risk via insurance schemes (Goodhart, 2009; Gorton and Metrick, 2009; Perotti and Suarez, 2009 and 2011), capital charges (Brunnermeier and Pedersen, 2009), taxation (Acharya and others, 2010a and 2010b), investment requirements (Cao and Illing, 2009; Farhi and others, 2009), as well as arrangements aimed at mitigating the system-wide effects from the fire sale liquidation of assets in via collateral haircuts (Valderrama, 2010) and modifications of resolution regimes (Roe, 2009; Acharya and Oncu, 2010). In particular, Gorton (2009) advocates a systemic liquidity risk insurance guarantee fee that explicitly recognizes the public sector cost of supporting secured funding markets if fragility were to materialize. Roe (2009) argues that the internalization of such cost would ideally be achieved by exposing the lenders to credit risk of the counterparty (and not just that of the collateral) by disallowing unrestricted access to collateral even in case of default of the counterparty. In this way, lenders would exercise greater effort in discriminating ex ante between safer and riskier borrowers. Such incentives could be supported by time-varying increase in liquidity requirements, which also curb credit expansion fueled by short-term and volatile wholesale funding and reduce dangerous reliance on such funding (Jácome and Nier, 2012).

In this paper, we propose a structural approach—the systemic risk-adjusted liquidity (SRL) model—for the structural assessment and stress testing of systemic liquidity risk.  Although macroprudential surveillance relies primarily on prudential regulation and supervision, calibrated and used to limit systemic risk, additional measures and instruments are needed to directly address systemic liquidity risk. This paper underscores why more needs to be done to develop macroprudential techniques to measure and mitigate such risks arising from individual or collective financial arrangements—both institutional and marketbased—that could either lead directly to system-wide distress of institutions and/or significantly amplify its consequences. The SRL model complements the current Basel III liquidity framework by extending the prudential assessment of stable funding (based on the NSFR) to a system-wide approach, which can help substantiate different types of macroprudential tools, such as a capital surcharge, a fee, a tax, or an insurance premium that can be used to price contingent liquidity access. 

The SRL model quantifies how the size and interconnectedness of individual institutions (with varying degrees of leverage and maturity mismatches defining their risk profile) can create short-term liquidity risk on a system-wide level and under distress conditions. The model combines quantity-based indicators of institution-specific funding liquidity (conditional on maturity mismatches and leverage), while adverse shocks to various market rates are used to alter the price-based measures of monetary and funding liquidity that, in turn, form the stress scenarios for systemic liquidity risk within the model (see Table 2 and Box 2). In this way, the SRL model fosters a better understanding of institutional vulnerabilities to the liquidity cycle and related build-ups of risks based on market rates that are available at high frequencies and which lend themselves to the identification of periods of heightened systemic liquidity risk (CGFS, 2011).

This approach forms the basis for a possible capital charge or an insurance premium—a pre-payment for the contingent (official) liquidity support that financial institutions eventually receive in times of joint distress—by identifying and measuring ways in which they contribute to aggregate risk over the short-term. Such a liquidity charge should reflect the marginal contribution of short-term funding decisions by institutions to the generation of systemic risk from the simultaneous realization of liquidity shortfalls. Proper pricing of the opportunity cost of holding insufficient liquidity—especially for very adverse funding situations—would help lower the scale of contingent liquidity support from the public sector (or collective burden sharing mechanisms). The charge needs to be risk-based, should be increasing in a common maturity mismatch of assets and liabilities, and would be applicable to all institutions with access to safety net guarantees. Since liquidity runs are present in the escalating phase of all systemic crises, our focus is on short-term wholesale liabilities, properly weighted by the bank's maturity mismatch.


http://www.imf.org/external/pubs/cat/longres.aspx?sk=26203.0

Regulators Captured - WSJ Editorial about the SEC and money-market funds

Regulators Captured
The Wall Street Journal, August 24, 2012, on page A10
http://online.wsj.com/article/SB10000872396390444812704577607421541441692.html


Economist George Stigler described the process of "regulatory capture," in which government agencies end up serving the industries they are supposed to regulate. This week lobbyists for money-market mutual funds provided still more evidence that Stigler deserved his Nobel. At the Securities and Exchange Commission, three of the five commissioners blocked a critical reform to help prevent a taxpayer bailout like the one the industry received in 2008.

Assistant editorial page editor James Freeman on the SEC's nixing a proposed rule that would hold money market funds more accountable.

SEC rules have long allowed money-fund operators to employ an accounting fiction that makes their funds appear safer than they are. Instead of share prices that fluctuate, like other kinds of securities, money funds are allowed to report to customers a fixed net asset value (NAV) of $1 per share—even if that's not exactly true.

As long as the value of a fund's underlying assets doesn't stray too far from that magical figure, fund sponsors can present a picture of stability to customers. Money funds are often seen as competitors to bank accounts and now hold $1.6 trillion in assets.

But during times of crisis, as in 2008, investors are reminded how different money funds are from insured deposits. When one fund "broke the buck"—its asset value fell below $1 per share—it triggered an institutional run on all money funds. The Treasury responded by slapping a taxpayer guarantee on the whole industry.

SEC Chairman Mary Schapiro has been trying to eliminate this systemic risk by taking away the accounting fiction that was created when previous generations of lobbyists captured the SEC. She made the sensible case that money-fund prices should float like the securities they are.

But industry lobbyists are still holding hostages. Commissioners Luis Aguilar, Dan Gallagher and Troy Paredes refused to support reform, so taxpayers can expect someday a replay of 2008. True to the Stigler thesis, the debate has focused on how to maintain the current money-fund business model while preventing customers from leaving in a crisis. The SEC goal should be to craft rules so that when customers leave a fund, it is a problem for fund managers, not taxpayers.

The industry shrewdly lobbied Beltway conservatives, who bought the line that this was a defense against costly regulation, even though regulation more or less created the money-fund industry. Free-market think tanks have been taken for a ride, some of them all too willingly.

The big winners include dodgy European banks, which can continue to attract U.S. money funds chasing higher yields knowing the American taxpayer continues to offer an implicit guarantee.

The industry shouldn't celebrate too much, though, because regulation may now be imposed by the new Financial Stability Oversight Council. Federal Reserve and Treasury officials want to do something, and their preference will probably be more supervision and capital positions that will raise costs that the industry can pass along to consumers. By protecting the $1 fixed NAV, free-marketeers may have guaranteed more of the Dodd-Frank-style regulation they claim to abhor.

The losers include the efficiency and fairness of the U.S. economy, as another financial industry gets government to guarantee its business model. Congratulations.

The South China Sea's Gathering Storm. By James Webb, US Senator

The South China Sea's Gathering Storm. By James Webb
The Wall Street Journal, August 19, 2012, page A11
http://online.wsj.com/article/SB10000872396390444184704577587483914661256.html

Since World War II, despite the costly flare-ups in Korea and Vietnam, the United States has proved to be the essential guarantor of stability in the Asian-Pacific region, even as the power cycle shifted from Japan to the Soviet Union and most recently to China. The benefits of our involvement are one of the great success stories of American and Asian history, providing the so-called second tier countries in the region the opportunity to grow economically and to mature politically.

As the region has grown more prosperous, the sovereignty issues have become more fierce. Over the past two years Japan and China have openly clashed in the Senkaku Islands, east of Taiwan and west of Okinawa, whose administration is internationally recognized to be under Japanese control. Russia and South Korea have reasserted sovereignty claims against Japan in northern waters. China and Vietnam both claim sovereignty over the Paracel Islands. China, Vietnam, the Philippines, Brunei and Malaysia all claim sovereignty over the Spratly Islands, the site of continuing confrontations between China and the Philippines.

Such disputes involve not only historical pride but also such vital matters as commercial transit, fishing rights, and potentially lucrative mineral leases in the seas that surround the thousands of miles of archipelagos. Nowhere is this growing tension clearer than in the increasingly hostile disputes in the South China Sea.

On June 21, China's State Council approved the establishment of a new national prefecture which it named Sansha, with its headquarters on Woody Island in the Paracel Islands. Called Yongxing by the Chinese, Woody Island has no indigenous population and no natural water supply, but it does sport a military-capable runway, a post office, a bank, a grocery store and a hospital.

The Paracels are more than 200 miles southeast of Hainan, mainland China's southernmost territory, and due east of Vietnam's central coast. Vietnam adamantly claims sovereignty over the island group, the site of a battle in 1974 when China attacked the Paracels in order to oust soldiers of the former South Vietnamese regime.

The potential conflicts stemming from the creation of this new Chinese prefecture extend well beyond the Paracels. Over the last six weeks the Chinese have further proclaimed that the jurisdiction of Sansha includes not just the Paracel Islands but virtually the entire South China Sea, connecting a series of Chinese territorial claims under one administrative rubric. According to China's official news agency Xinhua, the new prefecture "administers over 200 islets" and "2 million square kilometers of water." To buttress this annexation, 45 legislators have been appointed to govern the roughly 1,000 people on these islands, along with a 15-member Standing Committee, plus a mayor and a vice mayor.

These political acts have been matched by military and economic expansion. On July 22, China's Central Military Commission announced that it would deploy a garrison of soldiers to guard the islands in the area. On July 31, it announced a new policy of "regular combat-readiness patrols" in the South China Sea. And China has now begun offering oil exploration rights in locations recognized by the international community as within Vietnam's exclusive economic zone.

For all practical purposes China has unilaterally decided to annex an area that extends eastward from the East Asian mainland as far as the Philippines, and nearly as far south as the Strait of Malacca. China's new "prefecture" is nearly twice as large as the combined land masses of Vietnam, South Korea, Japan and the Philippines. Its "legislators" will directly report to the central government.

American reaction has been muted. The State Department waited until Aug. 3 before expressing official concern over China's "upgrading of its administrative level . . . and establishment of a new military garrison" in the disputed areas. The statement was carefully couched within the context of long-standing policies calling for the resolution of sovereignty issues in accordance with international law and without the use of military force.

Even so, the Chinese government responded angrily, warning that State Department officials had "confounded right and wrong, and sent a seriously wrong message." The People's Daily, a quasi-official publication, accused the U.S. of "fanning the flames and provoking division, deliberately creating antagonism with China." Its overseas edition said it was time for the U.S. to "shut up."

In truth, American vacillations have for years emboldened China. U.S. policy with respect to sovereignty issues in Asian-Pacific waters has been that we take no sides, that such matters must be settled peacefully among the parties involved. Smaller, weaker countries have repeatedly called for greater international involvement.

China, meanwhile, has insisted that all such issues be resolved bilaterally, which means either never or only under its own terms. Due to China's growing power in the region, by taking no position Washington has by default become an enabler of China's ever more aggressive acts.

The U.S., China and all of East Asia have now reached an unavoidable moment of truth. Sovereignty disputes in which parties seek peaceful resolution are one thing; flagrant, belligerent acts are quite another. How this challenge is addressed will have implications not only for the South China Sea, but also for the stability of East Asia and for the future of U.S.-China relations.

History teaches us that when unilateral acts of aggression go unanswered, the bad news never gets better with age. Nowhere is this cycle more apparent than in the alternating power shifts in East Asia. As historian Barbara Tuchman noted in her biography of U.S. Army Gen. Joseph Stillwell, it was China's plea for U.S. and League of Nations support that went unanswered following Japan's 1931 invasion of Manchuria, a neglect that "brewed the acid of appeasement that . . . opened the decade of descent to war" in Asia and beyond.

While America's attention is distracted by the presidential campaign, all of East Asia is watching what the U.S. will do about Chinese actions in the South China Sea. They know a test when they see one. They are waiting to see whether America will live up to its uncomfortable but necessary role as the true guarantor of stability in East Asia, or whether the region will again be dominated by belligerence and intimidation.

The Chinese of 1931 understood this threat and lived through the consequences of an international community's failure to address it. The question is whether the China of 2012 truly wishes to resolve issues through acceptable international standards, and whether the America of 2012 has the will and the capacity to insist that this approach is the only path toward stability.

Mr. Webb, a Democrat, is a U.S. senator from Virginia.

Recovery and resolution of financial market infrastructures, consultative report issued by CPSS-IOSCO

Recovery and resolution of financial market infrastructures, consultative report issued by CPSS-IOSCO
July 31, 2012
http://www.bis.org/press/p120731.htm

The Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) have today published for public comment a consultative report on the Recovery and resolution of financial market infrastructures.

Financial market infrastructures (FMIs) play an essential role in the global financial system. The disorderly failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Accordingly, all types of FMIs should generally be subject to regimes and strategies for recovery and resolution.

The CPSS-IOSCO Principles for financial market infrastructures (Principles) published in April 2012 require that FMIs have effective strategies, rules and procedures to enable them to recover from financial stresses. The Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) published in 2011 further require that jurisdictions establish resolution regimes to allow for the resolution of a financial institution in circumstances where recovery is no longer feasible. An effective resolution regime must enable resolution without systemic disruption or exposing the taxpayer to loss. To achieve this in the context of FMIs, relevant authorities must have powers to maintain an FMI's critical services.

The purpose of the report released today is to outline the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes that are consistent with the Principles and Key Attributes. The report also seeks consultees' views on a number of technical points related to these issues.

Paul Tucker, Deputy Governor, Financial Stability of the Bank of England and CPSS Chairman said, "The vital role of the financial system's infrastructure makes it essential that credible recovery plans and resolution regimes exist. FMIs need to be a source of strength and continuity for the financial markets they serve."
"This is even more important as a safeguard given the commitment made by G20 Leaders in 2009 that all standardised OTC derivatives should be cleared through central counterparties," added Masamichi Kono, Vice Commissioner for International Affairs, Financial Services Agency, Japan and Chairman of the IOSCO Board.

Amongst its conclusions, the report states that the Key Attributes will provide a framework for resolution of FMIs under a statutory resolution regime.

Published alongside the report is a cover note that lists the specific issues on which the committees seek comments during the public consultation period.

Comments on the report are invited from all interested parties and should be sent by 28 September 2012 (see note 1 below). After the consultation period, CPSS-IOSCO will report on how the methodology for assessing compliance with the Key Attributes, currently being prepared by the Financial Stability Board, should be revised to reflect FMI-specific elements taking into account the conclusions of this report and the comments received.

Notes

1. Comments on the report should be sent by 28 September 2012 to both the CPSS secretariat (cpss@bis.org) and the IOSCO secretariat (fmiresolution@iosco.org). The comments will be published on the websites of the BIS and IOSCO unless commentators have requested otherwise.
2. The CPSS serves as a forum for central banks to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The CPSS secretariat is hosted by the BIS. More information about the CPSS, and all its publications, can be found on the BIS website at www.bis.org/cpss.
3. IOSCO is an international policy forum for securities regulators. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns.
4. Both committees are recognised as international standard-setting bodies by the Financial Stability Board (www.financialstabilityboard.org)
5. The documents are on the websites of the BIS at http://www.bis.org/publ/cpss103.htm and IOSCO at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD388.pdf.
   
6. The CPSS-IOSCO Principles for financial market infrastructures, can be found on the websites of the BIS at http://www.bis.org/publ/cpss101.htm and IOSCO at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf.
   
7. The Financial Stability Board's Key attributes of effective resolution regimes for financial institutions can be found on the FSB's website at http://www.financialstabilityboard.org/publications/r_111104cc.pdf.

Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo

Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo
IMF Working Paper No. 12/194
Jul 31, 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012194

Summary: I construct a systemic liquidity risk index (SLRI) from data on violations of arbitrage relationships across several asset classes between 2004 and 2010. Then I test whether the equity returns of 53 global banks were exposed to this liquidity risk factor. Results show that the level of bank returns is not directly affected by the SLRI, but their volatility increases when liquidity conditions deteriorate. I do not find a strong association between bank size and exposure to the SLRI - measured as the sensitivity of volatility to the index. Surprisingly, exposure to systemic liquidity risk is positively associated with the Net Stable Funding Ratio (NSFR). The link between equity volatility and the SLRI allows me to calculate the cost that would be borne by public authorities for providing liquidity support to the financial sector. I use this information to estimate a liquidity insurance premium that could be paid by individual banks in order to cover for that social cost.

Excerpts:

Introduction

Liquidity risk has become a central topic for investors, regulators and academics in the aftermath of the global financial crisis. The sharp decline of real estate prices in the U.S.  and parts of Europe and the consequent collapse in the values of related securities created widespread concerns about the solvency of banks and other financial intermediaries. The resulting increase in counterparty risk induced investors to shy away from risky short-term funding markets [Gorton and Metrick (2010)] and to store funds in safe and liquid assets, especially U.S. government debt. The dry-up in funding markets hit levered financial intermediaries involved in maturity and liquidity transformation hard [Brunnermeier (2009)], propagating the initial shock through global markets.

Central bankers in major countries responded to the contraction in liquidity by pumping an unprecendented amount of funds into securities and interbank markets, and by creating and extending liquidity backstop lines to rescue troubled financial intermediaries.  Such measures have exposed public finances, and ultimately taxpayers, to the risk of substantial losses. Understanding the origins of systemic liquidity risk in financial markets is, therefore, an invaluable tool for policymakers to reduce the chance of facing these very same challenges again in the future. In particular, if public support in periods of widespread distress cannot be prevented—due to commitment problems—supervisors and regulators should ensure that financial intermediaries are properly monitored and charged to reflect the contingent benefits they enjoy.

The present paper brings three contributions to the topic of systemic liquidity risk:

1) It produces a systemic liquidity risk index (SLRI) calculated from violations of “arbitrage” relationships in various securities markets.

2) It estimates the exposure of 53 global banks to this aggregate risk factor.

3) It uses the information in 2) to devise an insurance system where banks pre-pay for the costs faced by public authorities for providing contingent liquidity support.

Results indicate that systemic illiquidity became a widespread problem in the aftermath of Lehman’s bankruptcy, and it only recovered after several months. Systemic liquidity risk spiked again during the Greek sovereign crisis in the second quarter of 2010, albeit at much more moderate levels. Yet, the renewed concerns regarding sovereign default in peripheral Europe observed in the last quarter of 2010 did not induce global liquidity shortfalls.

In terms of exposures of individual institutions, I find that, in general, systemic liquidity risk does not affect the level of bank stock returns on a systematic fashion.  However, liquidity risk is strongly correlated with the volatility of bank stocks: system wide illiquidity is associated with riskier banks. Estimates also show that U.S. and U.K. banks were relatively more exposed to liquidity conditions compared to Japanese institutions, with continental European banks lying in the middle of the distribution. More specifically, the results indicate that U.S. and U.K. banks’ stocks became much more volatile relative to their Asian peers when liquidity evaporated. This likely reflects the higher degree of maturity transformation and the reliance on very short-term funding by Anglo-Saxon banks. A natural question is whether bank specific characteristics beyond geographic location reflect the different degrees of exposure to liquidity risk.

I start the quest for those bank characteristics by looking at the importance of bank size for liquidity risk exposure. Market participants, policymakers and academics have highlighted the role of size and interconnectedness as a source of systemic risk. To verify this claim, I form quintile portfolios of banks based on market capitalization and test whether there are significant differences in the sensitivity of their return volatility to the SLRI. The estimates suggest that size has implications for liquidity risk, but the relationship is highly non-linear. The association between size and sensitivity to liquidity conditions is only relevant for the very large banks, and it becomes pronounced only when liquidity conditions deteriorate substantially.

Recently, the Basel Committee on Banking Supervision produced, for the first time, a framework (based on balance sheet information) to regulate banks’ liquidity risk. In particular, it proposed two liquidity ratios that shall be monitored by supervisors: the Liquidity Coverage Ratio (LCR), which indicates banks’ ability to withstand a short-term liquidity crisis, and the Net Stable Funding Ratio (NSFR), which measures the long-term, structural funding mismatches in a bank. Forming quintile portfolios based on banks' NSFR, I find that, if anything, the regulatory ratio is positively associated with the exposure to the SLRI. In other words, banks with a high NSFR (the ones deamed to be structurally more liquid) are in fact slightly more sensitive to liquidity conditions. This counterintuitive result needs to be qualified. As noted later, the SLRI captures short-term liquidity stresses, whereas the NSFR is designed as a medium to long-term indicator of liquidity conditions. Certainly, it would be more appropriate to test the performance of LCR instead. However, the data necessary for its computation are not readily available.

The link between bank stock volatility and the SLRI allows me to calculate the cost faced by public authorities for providing liquidity support for banks. Relying on the contingent claims approach (CCA), I use observable information on a bank’s equity and the book value of its liabilities to back out the unobserved level and volatility of its assets. I then estimate by how much the level and volatility of implied assets change as liquidity conditions deteriorate, and how such changes affect the price of a hypothetical put option on the bank’s assets. Because the price of this put indicates the cost of public support to banks, variations in the put due to fluctuations in the SLRI provide a benchmark for charging banks according to their exposure to systemic liquidity risk, a goal that has been advocated by many experts on bank regulation. 


http://www.imf.org/external/pubs/cat/longres.aspx?sk=26131.0

Austerity Debate a Matter of Degree -- In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart

Austerity Debate a Matter of Degree. By Stephen Fidler
In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Wall Street Journal, February 17, 2012
http://online.wsj.com/article/SB10001424052970204792404577227273553955752.html

Excerpts

In the U.S., the debate about whether the government should start cutting its budget deficit opens up a deep ideological divide. Many countries in Europe don't have that luxury.

True, there may be questions about how hard to cut budgets and how best to time the cuts, but with government-bond investors going on strike, policy makers either don't have a choice or feel they don't. Budget austerity is also a recipe favored by Germany and other euro-zone governments that hold the Continent's purse strings.

Once upon a time, the International Monetary Fund, which also provides bailout funds and lend its crisis management expertise to euro-zone governments, would have been right there with the Germans: It never handled a financial crisis for which tough austerity wasn't the prescribed medicine. In Greece, however, officials say the IMF supported spreading the budget pain over a number of years rather than concentrating it at the front end.

That is partly because overpromising the undeliverable hurts government credibility, which is essential to overcoming the crisis. But it is also because the IMF's view has shifted.

"Over its history, the IMF has become less dogmatic about fiscal austerity being always the right response to a crisis," said Laurence Ball, economics professor at Johns Hopkins University, and a part-time consultant to the IMF.

These days, the fund worries more than it did about the negative impact that cutting budgets has on short-term growth prospects—a traditional concern of Keynesian economists.

"Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1% of [gross domestic product] typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point," the IMF said in its 2010 World Economic Outlook:

But that isn't the full story. In the first place, the IMF agrees that reducing government debt—which is what austerity should eventually achieve—has long-term economic benefits. For example, in a growing economy close with strong employment, reduced competition for savings should lower the cost of capital for private entrepreneurs.

That suggests that, where bond markets give governments the choice, there is a legitimate debate to be had about timing of austerity. The IMF economic models suggest it will be five years before the "break-even" point when the benefits to growth of cutting debt start to exceed the "Keynesian" effects of austerity.

There is an alternative hypothesis that has a lot of support in Germany, and among the region's central bankers. This is the notion that budget cutbacks stimulate growth in the short term, often referred to as the "expansionary fiscal contraction" hypothesis.

Manfred Neumann, professor emeritus of economics at the Institute for Economic Policy at the University of Bonn, said the view is also called the "German hypothesis" since it emerged from a round of German budget cutting in the early 1980s.

"The positive effect of austerity is much stronger than most people believe," he said. The explanation for the beneficial impact is that cutting government debt generates an improvement in confidence among households and entrepreneurs, he said.

The IMF concedes there may be something in this for countries where people are worried about the risk that the government might default—but only up to a point. It concedes that fiscal retrenchment in such countries "tends to be less contractionary" than in countries not facing market pressures—but doesn't conclude that budget cutting in such circumstances is actually expansionary.

Each side of the debate invokes its own favored study. Support for the "German hypothesis" comes from two Harvard economists with un-German names—Alberto Alesina and Silvia Ardagna. But their critics, who include Mr. Ball, say their sample includes many irrelevant episodes for which their model fails to correct—including, for example, the U.S. "fiscal correction" that was born out of the U.S. economic boom of the late 1990s.

Mr. Alesina didn't respond to an email asking for comment, but Mr. Neumann said he isn't confident that studies, such as the IMF's, that appear to refute the hypothesis manage to isolate the effects of the austerity policy from other effects of a financial crisis.

Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.

The first is that the contractionary effects of fiscal retrenchment are often partly offset by an increase in exports—but less so in countries where the exchange rate is fixed. Second, the pain is greater if central banks can't offset the fiscal austerity through a stimulus in monetary policy. With interest rates close to zero in the euro zone, such a stimulus is hard to achieve. Third, when many countries are cutting budgets at the same time, the effect on economic activity in each is magnified.

If you are a government in budget-cutting mode, there are, however, better and worse ways of doing it. The IMF says spending cuts tend to have less negative impact on the economy than tax increases. However, that is partly because central banks tend to cut interest rates more aggressively when they see spending cuts.

Mr. Neumann sees an austerity hierarchy. It is better to cut government consumption and transfers, including staff costs, than government investment—though it may be harder politically. If you are raising taxes, better to raise those with no impact on incentives—such as inheritance or wealth taxes—than those that hurt incentives, such as income or payroll taxes.

Raising sales or value-added taxes may have less impact on incentives—but have other undesirable effects, such as increasing inflation, that could deter central banks from easing policy.