BIS Quarterly Review

BIS Quarterly Review

Dec 07, 2009

The BIS Quarterly Review released today is divided into two parts. We begin with an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial activity. This is followed by five special feature articles: the first discusses the use and limitations of macro stress tests; the second analyses the relationship between monetary policy and risk-taking by banks; the third provides estimates of the link between government size and macroeconomic stability; the fourth draws lessons from loan provisioning regimes set up in Asia after the crisis of the late 1990s; and the fifth looks at factors driving the appreciation of the US dollar in late 2008.

Overview: continued record low rates spur markets

From early September to late November, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around, but investor confidence remained fragile. This was clearly illustrated towards the end of the period under review, when prices of risky assets dropped sharply as investors reacted nervously to news that government-owned Dubai World had asked for a delay in some payments on its debt.

Market participants expected the recovery to continue, but at times grew wary about its pace and shape due to uncertainty about the timing and speed of withdrawal of monetary and fiscal stimulus as well as the associated risks to economic activity. The unease was compounded by the unevenness of the recovery among different regions of the world, which in turn was seen as increasing the risk that harmful imbalances could build, thereby adding to challenges for policymakers.

In this environment, market developments continued to be driven to a significant degree by ongoing and expected policy stimulus, in particular expansionary monetary policy. As investorsd priced in expectations that interest rates in major advanced economies would remain low, prices of risky assets continued to increase. Equity prices generally rose, in particular in emerging markets. Investment grade credit spreads were little changed, while sub-investment grade spreads narrowed further. Expectations of a prolonged period of low policy rates kept long-term government bond yields down, as did low term premia. Some market commentary pointed to the risk of higher inflation going forward, but both market- and survey-based indicators continued to suggest that price pressures in the largest advanced economies were expected to remain well contained.

The low interest rates in the advanced economies, together with the earlier and stronger recovery in a number of emerging economies, continued to drive significant capital inflows into emerging markets, particularly in Asia and the Pacific. Although difficult to quantify, a related development was increasing FX carry trade activity funded in US dollars and other low interest rate currencies. This resulted in rapid asset price increases in several emerging economies as well as substantial exchange rate appreciation with respect to the US dollar.

Highlights from the BIS statistics

Banks’ international balance sheets continued to contract during the second quarter of 2009, albeit at a much slower pace than in the preceding six months. The $477 billion decline in the total gross international claims of BIS reporting banks was considerably smaller than the reductions registered in the prior two quarters, but was still the fourth largest in the last decade. The shrinkage in international balance sheets was entirely driven by a contraction in interbank claims, which fell by $481 billion. By contrast, international claims on non-banks increased slightly (by $4 billion). Reporting banks’ cross-border claims on emerging market borrowers also showed signs of stabilising. Conversely, their local positions in local currencies in many countries contracted modestly for the first time since the onset of the crisis.

In the first half of 2009, notional amounts of all types of over-the-counter (OTC) derivatives contracts rebounded somewhat to stand at $605 trillion at the end of June, 10% higher than six months before. In contrast, gross credit exposures fell by 18% from an end-2008 peak to $3.7 trillion. Gross credit exposures take into account bilateral netting agreements but not collateral, so they provide a measure of counterparty exposures. The increase in outstanding amounts was due in large part to interest rate derivatives. By contrast, continuing a trend that began in the first half of 2008, outstanding notional amounts of CDS contracts fell to $36 trillion at the end of June 2009.

Activity on the international derivatives exchanges stabilised at around 60% of the pre-crisis level in the third quarter of 2009. Total turnover based on notional amounts was unchanged from the previous quarter, at $425 trillion.

Seasonal factors weighed on activity in the primary market for international debt securities in the third quarter of 2009. Net issuance almost halved to $475 billion, the lowest level since the third quarter of 2008. Depending on the method used, seasonally adjusted issuance either remained stable at a high level or went up slightly. The decline in activity was mainly driven by lower net issuance by borrowers resident in developed economies (–45%), which account for the bulk of borrowing on the international debt securities market. Residents in emerging market economies took advantage of the improved financing conditions and issued $34 billion of international debt securities. This was 52% more than in the second quarter and well above the quarterly average for 2006 and early 2007, prior to the crisis.

Special features

Macro stress tests and crises: what can we learn?

Few, if any, of the macro stress tests undertaken before the current crisis uncovered significant vulnerabilities. Rodrigo Alfaro (Central Bank of Chile) and Mathias Drehmann (BIS) examine the reasons for this poor performance by comparing the outcomes of simple stress tests with actual events for a large sample of historical banking crises. Their results highlight the fact that structural assumptions underlying stress testing models do not match output patterns in many of the past crises. Furthermore, unless macro conditions are already weak prior to the eruption of the crisis, the vast majority of stress scenarios based on historical data are not severe enough. Last, the authors go on to emphasise that stress testing models are not robust, as statistical relationships tend to break down during crises. These insights have important implications for the design and conduct of stress tests in the future.

Monetary policy and the risk-taking channel

In this feature, Leonardo Gambacorta (BIS) argues that low interest rates can encourage banks to take on more risks. He notes that monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) through the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure and price risk. Using a comprehensive dataset of listed banks, Gambacorta goes on to show that low interest rates over an extended period cause an increase in banks’ risk-taking.

Government size and macroeconomic stability

M S Mohanty and Fabrizio Zampolli (BIS) examine the potential role of government size in stabilising the economy. They find that larger government size, as measured by the share of expenditure in GDP, had been associated with a modest reduction in output volatility in OECD economies since 1970, but that this link, which was small to begin with, seems to have weakened even further since the mid-1980s. Instead, output volatility is driven by factors such as trade openness and exposure to terms-of-trade shocks as well as the volatility of inflation. Interestingly, the same set of factors help to explain the severity of recessions.

Issues and developments in loan loss provisioning: the case of Asia

In the aftermath of the Asian financial crisis of the late 1990s, many jurisdictions in Asia strengthened their approaches to loan loss provisioning, including the adoption of discretionary measures. In this feature, Sarawan Angklomkliew (Bank of Thailand), Jason George and Frank Packer (BIS) discuss how authorities in Asia changed the provisioning regimes in their jurisdictions, and how these changes have strengthened banking systems in the region.

Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging

Many observers were surprised by the US dollar’s appreciation in late 2008, the sharpest in the period since generalised floating began in 1973. In their feature, Robert McCauley and Patrick McGuire (BIS) argue that a combination of factors contributed to this development. First, the US dollar benefited from the global flight to safety into US Treasury bills. Second, the dollar profited from the reversal of carry trades. Third, a dollar shortage in the international banking market resulted in high dollar interest rates in private markets, which supported the currency. Finally, writedowns of dollar assets left European banks and institutional investors outside the United States overhedged. The resultant squaring of their positions in turn may also have boosted the dollar.

Ozawa's power, Hatoyama's ulterior motives lie behind Futenma delay

Ozawa's power, Hatoyama's ulterior motives lie behind Futenma delay. By Mariko Yasumoto
Japan Today, Dec 06, 2009

TOKYO — Behind Prime Minister Yukio Hatoyama’s indecisiveness on the future of a U.S. military base in Okinawa Prefecture seems to be the firm determination of his former boss, Ichiro Ozawa, to keep a grip on parliament and even a bigger ulterior motive of the two politicians.

Hatoyama, head of the ruling Democratic Party of Japan, has put on hold a decision on where to relocate the U.S. Marine Corps’ Futenma Air Station, as the leader of a junior partner in the coalition has threatened to leave it if the DPJ goes ahead and moves the base within the prefecture under the existing Japan-U.S. deal.

The threat by Social Democratic Party leader Mizuho Fukushima came as Foreign Minister Katsuya Okada and Defense Minister Toshimi Kitazawa were seeking to solve the relocation issue by the end of this year.

Hatoyama is putting more weight on maintaining power in parliament over the already soured relationship with Washington, which has pressed Japan to resolve it quickly and move the Futenma base in line with the accord.

The DPJ, which won a landslide victory in the August election for the House of Representatives, had to form a coalition with two small partners despite differences over security and foreign policies, as it needs their cooperation in the House of Councillors.

Speculation is now growing that a decision on the U.S. base issue will not be made until after next year’s upper house election, in which the DPJ is widely expected to secure a majority and it can decisively break off what appears to be an awkward coalition.

Political observers say that behind the delay is DPJ Secretary General Ozawa who is widely believed to have wielded his influence behind the scenes over the Hatoyama government since its launch in mid-September.

According to sources close to Ozawa, he has pressured the prime minister’s office and Defense Minister Kitazawa to deal with the relocation issue in a way that would not result in the collapse of the coalition.

At the upper house, the DPJ currently holds less than a majority and needs to join hands with the two parties—the SDP and the People’s New Party—to ensure smooth passage of legislation.

Eiken Itagaki, an independent political analyst who is well-versed in DPJ politics, said that Ozawa warned that the government needs to avoid what the previous Liberal Democratic Party-led government had gone through in a divided parliament.

But there is also a view among some pundits that Hatoyama simply used the coalition partner’s threat as a reason for delaying a decision, as he himself hopes to move not just the Futenma air station but also the entire U.S. military facility outside Okinawa or even outside the country and wanted to take time to find a better solution.

Since the DPJ was in the opposition camp, Hatoyama has repeatedly made comments to that effect.

‘‘I truly wonder if it is appropriate that a military of another country will continue to station in this country forever,’’ he said a few weeks after taking office in mid-September.

Kazuhiro Asano, professor in politics at Sapporo University, said should the DPJ kick the SDP out of the coalition after the election, ‘‘I don’t think Prime Minister Hatoyama will decide to move the Futenma facility to Henoko.’‘

Under the 2006 deal, Tokyo and Washington agreed to transfer the Futenma air station, which currently sits in the center of a residential area in the city of Ginowan, to the coastal area of the Henoko district in Nago, another Okinawa city, by 2014.

Hatoyama has indicated that he wants to wait and see the results of the Nago city mayoral election scheduled for January to determine the will of local voters before making any decision on the relocation.

‘‘He is looking for evidence and reasons that would help him decide to move the base outside the prefecture,’’ Asano of Sapporo University said.

Ozawa, a former DPJ chief, is also against hosting another country’s military in Japan and once advocated for the stationing of a United Nations-sponsored military for the defense of the country.

Itagaki said both Ozawa and Hatoyama are truly seeking a foreign policy stance that depends less on the United States and more on close relationships with such other countries as China and Russia, as promised in the party’s campaign pledges.

Ozawa has once expressed the view that the role of the U.S. military in Japan should be trimmed down, saying the U.S. Navy’s 7th Fleet based in Yokosuka would be ‘‘enough for the U.S. presence in the Far East.’‘

At the bottom of it, the foreign policy that Ozawa and Hatoyama are pursuing over a long term is not so different from that of Fukushima, chief of the pacifist, leftist SDP, the analyst said, suggesting that the DPJ may end up keeping the party in the coalition even after the upper house election.

Recently floated ideas include transferring the Futenma facility to the U.S. territory of Guam, a Japanese coastal airport or a remote island, according to several government sources.

Unconventional monetary policies: an appraisal

Unconventional monetary policies: an appraisal. By Claudio Borio and Piti Disyatat
BIS Working Papers No 292
November 2009

Abstract:

The recent global financial crisis has led central banks to rely heavily on "unconventional" monetary policies. This alternative approach to policy has generated much discussion and a heated and at times confusing debate. The debate has been complicated by the use of different definitions and conflicting views of the mechanisms at work. This paper sets out a framework for classifying and thinking about such policies, highlighting how they can be viewed within the overall context of monetary policy implementation. The framework clarifies the differences among the various forms of unconventional monetary policy, provides a systematic characterisation of the wide range of central bank responses to the crisis, helps to underscore the channels of transmission, and identifies some of the main policy challenges. In the process, the paper also addresses a number of contentious analytical issues, notably the role of bank reserves and their inflationary consequences.

JEL Classification Numbers: E40, E50, E52, E58, E60

Keywords: unconventional monetary policy, balance sheet policy, credit policy, quantitative easing, credit easing, monetary policy implementation, transmission mechanism, interest rates

Ten propositions about liquidity crises

Ten propositions about liquidity crises. By Claudio Borio
BIS Working Papers No 293
November 2009

Abstract:

What are liquidity crises? And what can be done to address them? This short paper brings together some personal reflections on this issue, largely based on previous work. In the process, it questions a number of commonly held beliefs that have become part of the conventional wisdom. The paper is organised around ten propositions that cover the following issues: the distinction between idiosyncratic and systematic elements of liquidity crises; the growing reliance on funding liquidity in a market-based financial system; the role of payment and settlement systems; the need to improve liquidity buffers; the desirability of putting in place (variable) speed limits in the financial system; the proper role of (retail) deposit insurance schemes; the double-edged sword nature of liquidity provision by central banks; the often misunderstood role of "monetary base" injections in addressing liquidity disruptions; the need to develop principles for the provision of central bank liquidity; and the need to reconsider the preventive role of monetary (interest rate) policy.

JEL Classification Numbers: E50, E51, E58, G10, G14, G18, G28

Keywords: market and funding liquidity, liquidity crises, deposit insurance, central bank operations, monetary base

What Can the U.S. Learn from China’s Energy Policy?

What Can the U.S. Learn from China’s Energy Policy?
IER November 20, 2009

How to Break Up the Banks - Solving the "too big to fail" problem in the future structure of the global financial system

How to Break Up the Banks. By Adrian Blundell-Wignall
Solving the "too big to fail" problem in the future structure of the global financial system.
The Wall Street Journal, page A13

The financial crisis that sparked the worst recession in decades is in abeyance, but not yet over. Nonperforming loans and other assets of doubtful quality still weigh on many banks. Financial reform to date has focused on improving capital rules and processes. What has not yet been addressed is the future structure of the global financial system.

Contagion risk and counterparty failure have been the main hallmarks of the crisis. While some large diversified banks that focused mainly on commercial banking survived very well, other smaller and less diversified banks, particularly those focused on mortgages, and financial conglomerates that built on investment banking, the structuring of complex derivatives and proprietary trading as the main drivers of growth, suffered crippling losses. In principle, sound corporate governance and a strong risk-management culture should enable banks to avoid excess leverage and risk taking. But human nature being what it is, there are likely always to be some players eager to push complex products and trading beyond the sensible needs of industry and long-term investors in order to drive profits. Indeed, right now such activity is driving the rapid profit growth of some banks, with little having been learned from the past.

As the system will always be hostage to the "gung-ho" few, the question is whether there is a better way to structure large conglomerates in order to isolate commercial banking functions from such high-risk activities. In discussions at the OECD, we have been reviewing possible options. One proposal, which we now submit for consideration, is that banking and financial service groups could be structured under a variant of non-operating holding companies (NOHCs), in all countries.

Under such a structure, the parent would be non-operating, raising capital on the stock exchange and investing it transparently and without any double-gearing in its operating subsidiaries—say a bank and a securities firm that would be separate legal entities with their own governance. The subsidiaries would pay dividends through the parent to shareholders out of profits. The nonoperating parent would have no legal basis to shift capital between affiliates in a crisis, and it would not be able to request "special dividends" in order to do so.

These structures allow separation insofar as prudential risk and the use of capital is concerned without the full divestment required under Glass-Steagall or in response to the recently-expressed concerns of Paul Volcker and Mervyn King—such extreme solutions should remain the proper focus of competition authorities. With an NOHC structure, technology platforms and back office functions would still be shared, permitting synergies and economies of scale and scope. Such a transparent structure would make it easier for regulators and market players to see potential weaknesses. Mark-to-market and fair value accounting would affect those affiliates most associated with securities businesses, while longer-term cost amortization would dominate for commercial banking. It would create a tougher, non-subsidized environment for securities firms, but a safer one for investors.

If a securities firm under this structure had access to limited "siloed" capital and could not share with other subsidiaries, and this were clear to the market, this would be priced into the cost of capital and reflected in margins for derivative transactions. The result would likely be smaller securities firms that are more careful in risk-taking than has been the case under the "double gearing" scenarios seen in mixed or universal bank groups.

Finally, if a securities affiliate were to fail under such a structure, the regulator could shut it down without affecting its commercial banking sister firm in a critical way—obviating the need for "living wills." Resolution mechanisms for smaller, legally separate entities would be more credible than those needed in the recent past for large mixed conglomerates—helping to deal with the "too big to fail" issue. To protect consumers, deposit insurance and other guarantees could apply to the bank without being extended to the legally separate securities firm.

The world is still waiting for a full reassessment of what banks do and how they compete. Until now, the implementation of regulatory standards and accounting rules has been eased. Fiscal policy has supported the economy and interest rates are being kept low to support the underlying earnings of banks and their ability to issue new equity in rising markets. This strategy may work in the short term. But it can't go on forever. Sooner or later we will have to exit from the extraordinary measures that have used trillions of taxpayer dollars to save the institutions that took the world economy to the brink of another Great Depression.

The structure of organizations and how they compete will be critical to future stability. Going forward, the aim must be to keep the "credit culture" and the "equity culture" separate so that government implicit and explicit insurance does not extend to cross-subsidizing high-risk market activity, and so that contagion and counterparty risk can be reduced. The right balance must also be struck between sufficient size conducive to diversification and strong competition to meet consumer needs at reasonable costs.

The capital and derivative markets are inherently interconnected globally, so counterparty risk looms large. Under present structures, if one participant fails, everyone is in trouble. We can't let the world go through that turmoil again.

Mr. Blundell-Wignall is deputy director of financial and enterprise affairs at the OECD.

"[C]reating a new entitlement program, which, once established, will be virtually impossible to rescind"

Confessions of an ObamaCare Backer. WSJ Editorial
A liberal explains the political calculus.
The Wall Street Journal, page A24

The typical argument for ObamaCare is that it will offer better medical care for everyone and cost less to do it, but occasionally a supporter lets the mask slip and reveals the real political motivation. So let's give credit to John Cassidy, part of the left-wing stable at the New Yorker, who wrote last week on its Web site that "it's important to be clear about what the reform amounts to." [http://www.newyorker.com/online/blogs/johncassidy/2009/11/some-vaguely-heretical-thoughts-on-health-care-reform.html]

Mr. Cassidy is more honest than the politicians whose dishonesty he supports. "The U.S. government is making a costly and open-ended commitment," he writes. "Let's not pretend that it isn't a big deal, or that it will be self-financing, or that it will work out exactly as planned. It won't. What is really unfolding, I suspect, is the scenario that many conservatives feared. The Obama Administration . . . is creating a new entitlement program, which, once established, will be virtually impossible to rescind."

Why are they doing it? Because, according to Mr. Cassidy, ObamaCare serves the twin goals of "making the United States a more equitable country" and furthering the Democrats' "political calculus." In other words, the purpose is to further redistribute income by putting health care further under government control, and in the process making the middle class more dependent on government. As the party of government, Democrats will benefit over the long run.

This explains why Nancy Pelosi is willing to risk the seats of so many Blue Dog Democrats by forcing such an unpopular bill through Congress on a narrow, partisan vote: You have to break a few eggs to make a permanent welfare state. As Mr. Cassidy concludes, "Putting on my amateur historian's cap, I might even claim that some subterfuge is historically necessary to get great reforms enacted."

No wonder many Americans are upset. They know they are being lied to about ObamaCare, and they know they are going to be stuck with the bill.

Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations Report & Background Paper

Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations Report & Background Paper
Nov 07, 2009

Prepared by staff of the International Monetary Fund, the Bank for International Settlements and the Financial Stability Board and submitted to G20 Finance Ministers and Governors.

November 7, 2009

The report and background paper respond to a request made by the G20 Leaders in April 2009 to develop guidance for national authorities to assess the systemic importance of financial institutions, markets and instruments. The report outlines conceptual and analytical approaches to the assessment of systemic importance and discusses a possible form for general guidelines.

The report recognizes that current knowledge and concerns about moral hazard limit the extent to which very precise guidance can be developed. Assessments of systemic importance will necessarily involve a high degree of judgment, they will likely be time-varying and state-dependent, and they will reflect the purpose of the assessment. The report does not pre-judge the policy actions to which such assessments could be an input.

The report suggests that the guidelines could take the form of high level principles that would be sufficiently flexible to apply to a broad range of countries and circumstances, and it outlines the possible coverage of such guidelines. A set of such high level principles appropriate for a variety of policy uses could be developed, further, by the IMF, BIS and FSB, taking account of experience with the application of the conceptual and analytical approaches described here.

There are a number of policy issues where an assessment of systemic importance would be useful. One critical issue is the ongoing work to reduce the moral hazard posed by systemically important institutions. The FSB and the international standard setters are developing measures that can be taken to reduce the systemic risks these institutions pose, and the attached papers will provide a useful conceptual and analytical framework to inform policy discussions. A second area is the work to address information gaps that were exposed by the recent crisis (the subject of a separate report to the G20 from IMF staff and the FSB Secretariat), where assessments of systemic importance can help to inform data collection needs. A third area is in helping to identify sources of financial sector risk that could have serious macroeconomic consequences. We will keep you informed on our respective future policy work in these important areas.

Report to G-20 Finance Ministers and Central Bank Governors (PDF 29 pages, 679 kb) & background paper (PDF 46 pages, 955 kb) downloadable @ http://www.bis.org/publ/othp07.htm?sent=091109

At the Ends of the World: Projects at Remote Locations

At the Ends of the World: Projects at Remote Locations. By Fabio Teixeira de Melo, PMP
PMI eNews, Nov 06, 2009

We have all heard that the world is getting smaller and smaller. However, some projects challenge that view: namely, those performed at remote locations.

For project management, a remote location is a place where:

Access to resources is more difficult; Both public and private sectors have less presence, or no presence at all; Local communities have little connection with the “civilized world.” Successfully executing a project at these locations requires a specific approach for some of the unique challenges you’ll face. Here are a few suggestions:

Logistics:
You should creatively explore what alternatives are available for supplying materials and consumables, and know the risk for each one. You have to consider natural factors, such as flood and dry seasons and their impact in site access, as well as frozen, blocked and / or dangerous access roads.

Consulting local communities is vital for gaining knowledge on alternatives, potential risks and contingency plans. Keep in mind that it is not only about bringing equipment in: it is about feeding and supporting your site team.

Communication:
Communication depends heavily on wireless phone and internet access. These options facilitate working at remote locations, but they do not always function properly. Between thunderstorms, heavy rain, energy shutdowns and frozen equipment, many things can go wrong.

Communicating through traditional, hard-copy mail is safe and reliable, but takes more time. Consider adding redundancy—exchanging data electronically but also sending hard copies through traditional mail—to the communications management plan, logistics plan and schedule. It can make the difference between taking advantage of wireless communication and suffering from the lack of it.

Local Community:
With very few exceptions, remote locations are inhabited, usually by poor and unassisted communities living in a subsistence economy. They often lack proper authorities, which is an invitation to the actions of drug producers, smugglers and others who interact with the local community. You should consider them as a part of it – in fact, sometimes they even act as the “local authority.”

Base your approach on the core values of respect and honesty. Show interest for the community and try to build trust without interfering in their relationship with potential outlaw groups. For those groups, try to negotiate your relationship in the basis of non-interference, but consider their presence in your risk management: it’s not unheard of for project managers to be kidnapped by local gangs or terror groups.

Social Responsibility:
Your project will probably impact the local community. Hiring its people is a good way to inject money to the local economy, but you have to be cautious as to how many people will be employed and what jobs they will take.

Resist the temptation to hire everybody, since they will have to continue to live after you demobilize. If you train them to work on your project—for example, to operate your bulldozers—when you finish they either will be unemployed or will have to leave the region in search for a job.

Instead, give them insight and training on how to improve and market what they currently produce for their living. Help them get more productive and organized. Your project will certainly bring them closer to “civilization,” and you should help them make that encounter more of an opportunity than a risk.

When you plan for a project at a remote location, don’t associate the challenge with logistics only. Remember that the communications and stakeholder management for these projects have particular requirements, which, if not properly performed, can be as harmful to your project as a natural disaster.

Fabio Teixeira de Melo, PMP, is a Site Manager working for Odebrecht, a Brazilian multinational construction company with projects in over 20 countries. An LI ’04 graduate with more than 15 years of experience in construction project planning and management, he was founder and first President of PMI Pernambuco – Brazil Chapter; participated in the elaboration of the Construction Extension to the PMBOK® Guide, served a 5-year term as DPC SIG Latin America Chair and contributed with articles for the SIG’s newsletter. You can contact him writing a comment to this post.

A ground-breaking study shows that New York City's calorie labeling law is ineffective

After Calorie Warnings, Diners Order More Calories. By ALLYSIA FINLEY
A ground-breaking study shows that New York City's calorie labeling law is ineffective.
WSJ, Nov 06, 2009

Before food czars get any more punch-happy on their own Kool-Aid, they need to be purged of the illusion that their laws are actually working. Last month, New York University and Yale medical professors published a ground-breaking study, which shows that New York City's law requiring fast food chains to post calories on their menus doesn't reduce their customers' caloric intake.

Lawmakers everywhere should take note. Efforts to require fast food restaurants to post nutritional information on their menus have been gaining ground across the country. Sixteen municipalities including California, Seattle, and Portland have passed laws similar to NYC's, and the Menu Education and Labeling Act, which would impose labeling regulations nationwide, is pending in Congress. The bill would extend the Nutrition Labeling and Education Act of 1990, which requires food manufacturers to include nutritional information on their packaging, to restaurants. We all know how effective that law was. Since 1990, obesity has more than doubled.

Published online in the journal Health Affairs, the NYU and Yale study is noteworthy because it considers the practical significance of food labeling laws. The researchers examined 1,100 restaurant receipts from McDonald's, Wendy's, Burger King and KFC franchises in low income, high-minority neighborhoods where obesity is most prevalent. They found that the poor fast-food customers that the law intended to help weren't affected.

Only half of the customers said they noticed the caloric information, and only about 15% said they used the information. But the researchers' most striking finding was that customers actually ordered more caloric items after the law went into effect than before, despite the fact that nine out of ten customers who reported using the information said they made healthier choices as a result of the law. This disconnect can partly be explained by response bias in which people tell surveyors what they think the surveyors want to hear.

But the problem may also be more complex. It's possible that people who are less educated may actually think they are eating more healthily than they are notwithstanding the calorie numbers staring them in the face. Calories as a measure of food intake (or more precisely, energy consumption and output) may be as foreign to them as the metric system is to many Americans.

The poor are also extremely price sensitive---especially in a bad economy. Give them the choice between a $2 double quarter pounder with cheese and a $5 chicken salad, and they'll make an economically rational decision and order the $2 burger. And with the extra three bucks saved, they'll order a side of fries and a Coke. Why should they care how many calories they're eating if they're getting good value?

Under pressure to subvert the NYU and Yale study, the New York City Health Department last week came out with its own report, which it nicely packaged in a press release and power point presentation (evidently, the Department didn't want to confuse the media with an actual scientific study). Though the Department's results are equivocal, New York City lawmakers are using the data to argue the efficacy of the law.

The Department is boasting that 56% of customers saw the caloric information and that 15% said they used it. But these figures demonstrate the law's failure---not success. Despite the fact that people were readily presented with the nutritional information, 85% of them ignored it.

The lawmakers who enacted the calorie posting regulations succumbed to the fallacy that everyone thinks like them. They probably reasoned that because they would make healthier choices if presented with nutritional information, everyone else would as well. But maybe what consumers actually want is a delicious meal at a low price.

While information is important, even fully informed people won't always act as lawmakers think they should, especially if it's economically irrational. Any public health legislation won't significantly change people's behavior unless it 1) provides proper incentives for people to put their long-term well-being above temporary gratification and 2) takes into account the economic rationality of people's behavior.

Unfortunately, many lawmakers refuse to swallow this inconvenient truth, preferring the taste of their Kool-Aid.

Ms. Finley is Assistant Editor of OpinionJournal.com

When Regulators Fail - 'Systemic risk' is not only for banks

When Regulators Fail. WSJ Editorial
'Systemic risk' is not only for banks.
WSJ, Nov 04, 2009

Financial Services Authority chief Adair Turner has finally stopped attacking bankers for their paychecks and started talking about the real issue—what to do about the banks deemed too-big-to-fail. Unfortunately, he's still worrying too much about how to prevent failure and not enough about how to facilitate it.

In his speech Monday to an international group of central and private bankers, Lord Turner identified three possible approaches to the problem:

• Make failure less likely by increasing capital requirements;
• Make banks smaller or less "systemic" by either narrowing what they can do or making them less interconnected;
• Or, finally, make failure easier by developing bankruptcy procedures or other "resolution" mechanisms for large financial institutions.

Of these, the last is the most important for reducing the moral hazard that did so much to contribute to the financial panic, as Bank of England Governor Mervyn King has persuasively argued. Even before the panic, systemically important banks enjoyed considerable advantages over their less "important" rivals, and many of these advantages were created by or made more acute by government regulation and rules.

As Lord Turner noted Monday, the Basel II standards on bank capital actually allowed large financial firms to hold less capital than their smaller brethren, on the theory that large meant diversified and sophisticated and so less risky. Looking back, this was clearly a crazy policy—but it's worth recalling that it was propagated by the same luminaries who are now proposing to prevent the next crisis by tinkering with the regime that contributed to the last one. At a minimum, this should be an occasion of some humility from the wise men of bank regulation.

We now know that this presumption of safety in size was false. We also know that the costs of being wrong about such things—both for the public fisc and the real economy as a whole—are much greater than was commonly assumed before the panic.

So the price that large banks pay for the privileges of size should be a great deal higher than it was before. Whether banks benefit from the explicit guarantees of deposit insurance or the implicit protection of being too-big-to-fail, or both, governments have a right to demand that banks not ride free on the backs of taxpayers.

But whether it's less leverage, more capital, or restrictions on banking activities, no one should be under any illusion that the same people who failed to detect the last bubble and crash will be able to design a system capable of catching the next one in time. The relative risks of being too lax or too restrictive may be hard to gauge, but either way the odds of getting it wrong are substantial if not overwhelming.

This is why putting the risk of failure back into the system should be the sine qua non of any effort at reform. If regulators around the world get nothing else right, the final backstop has to be bankruptcy and/or dissolution for firms that have earned it.

So it's too bad Lord Turner spent precious little time on this particular question, preferring to ruminate on the relative merits of really narrow banking vs. moderately narrow banking, and how to make capital requirements more countercyclical.

We understand that regulators find it uncomfortable to ponder what should happen when all their best laid plans fail. The bankruptcy of a systemically important bank is, necessarily, also a failure of the regulators who were overseeing it.

Implementing US Gov't Wildlife Surveillance Project to Detect and Predict Emerging Infectious Diseases

Implementing USAID Wildlife Surveillance Project to Detect and Predict Emerging Infectious Diseases
USAID, November 3, 2009

[There is a collection of articles on this. This is one of them, titled Implementing USAID Wildlife Surveillance Project to Detect and PREDICT Emerging Infectious Diseases, using Predict as an acronym. Other articles are here and here]

Washington, D.C. - The United States Agency for International Development (USAID) Bureau for Global Health is pleased to announce a partnership with UC Davis to monitor for and increase the local capacity in "geographic hot spots" to identify the emergence of new infectious diseases in high-risk wildlife such as bats, rodents, and non-human primates that could pose a major threat to human health. UC Davis leads a coalition of leading experts in wildlife surveillance including Wildlife Conservation Society, Wildlife Trust, The Smithsonian Institute, and Global Viral Forecasting, Inc. This is a five-year cooperative agreement with a ceiling of $75 million.

This project, named PREDICT, is part of the USAID Emerging Pandemic Threats Program - a specialized set of projects that build on the successes of the Agency's 30 years of work in disease surveillance, training and outbreak response. PREDICT will focus on expanding USAID's current monitoring of wild birds for H5N1 influenza to more broadly address the role played by wildlife in spreading of new disease threats.

PREDICT will be active in global hot spots where important wildlife hosts species have significant interaction with domestic animals and high-density human populations. In these regions, the team will focus on detecting disease-causing organisms in wildlife before they lead to human infection or death. Among the 1,461 pathogens recognized to cause diseases in humans, at least 60 percent are of animal origin. Predicting where these new diseases may emerge , and detecting viruses and other pathogens before they spread to people, holds the greatest potential to prevent new pandemics.

PREDICT will be led by Dr. Stephen S. Morse of Columbia University Mailman School of Public Health, a leading emerging disease authority. Other key staff include Dr. Jonna Mazet, the project's Deputy Director; Dr. William Karesh, Senior Technical Advisor; Dr. Peter Daszak, Technical Expert; and Dr. Nathan Wolfe, Technical Expert.

America's Natural Gas Revolution - A 'shale gale' of unconventional and abundant U.S. gas is transforming the energy market

America's Natural Gas Revolution. By DANIEL YERGIN AND ROBERT INESON
A 'shale gale' of unconventional and abundant U.S. gas is transforming the energy market.

The biggest energy innovation of the decade is natural gas—more specifically what is called "unconventional" natural gas. Some call it a revolution.

Yet the natural gas revolution has unfolded with no great fanfare, no grand opening ceremony, no ribbon cutting. It just crept up. In 1990, unconventional gas—from shales, coal-bed methane and so-called "tight" formations—was about 10% of total U.S. production. Today it is around 40%, and growing fast, with shale gas by far the biggest part.

The potential of this "shale gale" only really became clear around 2007. In Washington, D.C., the discovery has come later—only in the last few months. Yet it is already changing the national energy dialogue and overall energy outlook in the U.S.—and could change the global natural gas balance.

From the time of the California energy crisis at the beginning of this decade, it appeared that the U.S. was headed for an extended period of tight supplies, even shortages, of natural gas.

While gas has many favorable attributes—as a clean, relatively low-carbon fuel—abundance did not appear to be one of them. Prices had gone up, but increased drilling failed to bring forth additional supplies. The U.S., it seemed, was destined to become much more integrated into the global gas market, with increasing imports of liquefied natural gas (LNG).

But a few companies were trying to solve a perennial problem: how to liberate shale gas—the plentiful natural gas supplies locked away in the impermeable shale. The experimental lab was a sprawling area called the Barnett Shale in the environs of Fort Worth, Texas.

The companies were experimenting with two technologies. One was horizontal drilling. Instead of merely drilling straight down into the resource, horizontal wells go sideways after a certain depth, opening up a much larger area of the resource-bearing formation.

The other technology is known as hydraulic fracturing, or "fraccing." Here, the producer injects a mixture of water and sand at high pressure to create multiple fractures throughout the rock, liberating the trapped gas to flow into the well.

The critical but little-recognized breakthrough was early in this decade—finding a way to meld together these two increasingly complex technologies to finally crack the shale rock, and thus crack the code for a major new resource. It was not a single eureka moment, but rather the result of incremental experimentation and technical skill. The success freed the gas to flow in greater volumes and at a much lower unit cost than previously thought possible.

In the last few years, the revolution has spread into other shale plays, from Louisiana and Arkansas to Pennsylvania and New York State, and British Columbia as well.

The supply impact has been dramatic. In the lower 48, states thought to be in decline as a natural gas source, production surged an astonishing 15% from the beginning of 2007 to mid-2008. This increase is more than most other countries produce in total.

Equally dramatic is the effect on U.S. reserves. Proven reserves have risen to 245 trillion cubic feet (Tcf) in 2008 from 177 Tcf in 2000, despite having produced nearly 165 Tcf during those years. The recent increase in estimated U.S. gas reserves by the Potential Gas Committee, representing both academic and industry experts, is in itself equivalent to more than half of the total proved reserves of Qatar, the new LNG powerhouse. With more drilling experience, U.S. estimates are likely to rise dramatically in the next few years. At current levels of demand, the U.S. has about 90 years of proven and potential supply—a number that is bound to go up as more and more shale gas is found.

To have the resource base suddenly expand by this much is a game changer. But what is getting changed?

It transforms the debate over generating electricity. The U.S. electric power industry faces very big questions about fuel choice and what kind of new generating capacity to build. In the face of new climate regulations, the increased availability of gas will likely lead to more natural gas consumption in electric power because of gas's relatively lower CO2 emissions. Natural gas power plants can also be built more quickly than coal-fired plants.

Some areas like Pennsylvania and New York, traditionally importers of the bulk of their energy from elsewhere, will instead become energy producers. It could also mean that more buses and truck fleets will be converted to natural gas. Energy-intensive manufacturing companies, which have been moving overseas in search of cheaper energy in order to remain globally competitive, may now stay home.

But these industrial users and the utilities with their long investment horizons—both of which have been whipsawed by recurrent cycles of shortage and surplus in natural gas over several decades—are inherently skeptical and will require further confirmation of a sustained shale gale before committing.

More abundant gas will have another, not so well recognized effect—facilitating renewable development. Sources like wind and solar are "intermittent." When the wind doesn't blow and the sun doesn't shine, something has to pick up the slack, and that something is likely to be natural-gas fired electric generation. This need will become more acute as the mandates for renewable electric power grow.

So far only one serious obstacle to development of shale resources across the U.S. has appeared—water. The most visible concern is the fear in some quarters that hydrocarbons or chemicals used in fraccing might flow into aquifers that supply drinking water. However, in most instances, the gas-bearing and water-bearing layers are widely separated by thousands of vertical feet, as well as by rock, with the gas being much deeper.

Therefore, the hydraulic fracturing of gas shales is unlikely to contaminate drinking water. The risks of contamination from surface handling of wastes, common to all industrial processes, requires continued care. While fraccing uses a good deal of water, it is actually less water-intensive than many other types of energy production.

Unconventional natural gas has already had a global impact. With the U.S. market now oversupplied, and storage filled to the brim, there's been much less room for LNG. As a result more LNG is going into Europe, leading to lower spot prices and talk of modifying long-term contracts.

But is unconventional natural gas going to go global? Preliminary estimates suggest that shale gas resources around the world could be equivalent to or even greater than current proven natural gas reserves. Perhaps much greater. But here in the U.S., our independent oil and gas sector, open markets and private ownership of mineral rights facilitated development. Elsewhere development will require negotiations with governments, and potentially complex regulatory processes. Existing long-term contracts, common in much of the natural gas industry outside the U.S., could be another obstacle. Extensive new networks of pipelines and infrastructure will have to be built. And many parts of the world still have ample conventional gas to develop first.

Yet interest and activity are picking up smartly outside North America. A shale gas revolution in Europe and Asia would change the competitive dynamics of the globalized gas market, altering economic calculations and international politics.

This new innovation will take time to establish its global credentials. The U.S. is really only beginning to grapple with the significance. It may be half a decade before the strength of the unconventional gas revolution outside North America can be properly assessed. But what has begun as the shale gale in the U.S. could end up being an increasingly powerful wind that blows through the world economy.

Mr. Yergin, author of the Pulitzer Prize-winning "The Prize: The Epic Quest for Oil, Money, & Power" (Free Press, new edition, 2009) is chairman of IHS CERA. Mr. Ineson is senior director of global gas for IHS CERA.

CIT's Bankruptcy Lesson - Treasury proves it can't identify systemic risk

CIT's Bankruptcy Lesson. WSJ Editorial
Treasury proves it can't identify systemic risk.
The Wall Street Journal, page A20

The $2.3 billion of Troubled Asset Relief Program money that will likely be lost in the bankruptcy of commercial lender CIT is hard to swallow, but it may be the most instructive loss taxpayers absorb all year.

Just as the Treasury Department is urging Congress to junk the bankruptcy process and hand over virtually unlimited bailout authority to the executive branch, CIT is proving two things: Bankruptcy works—even for financial firms—and the U.S. Treasury judges systemic risk out of its political hip pocket.

Treasury provided the $2.3 billion TARP injection last December. Then when CIT was on the ropes last July, Treasury urged the Federal Deposit Insurance Corp. to provide debt guarantees to help the company raise capital. Treasury made the case that a CIT failure posed a systemic risk given the number of small and medium-sized companies that rely on CIT for short-term financing.

We argued against this in July. More importantly, FDIC Chair Sheila Bair rejected it. Since her wise decision, CIT has been providing a laboratory to observe the recuperative pain of bankruptcy in an experiment uncontrolled by politicians.

With no federal lifeline coming, the company's major bondholders quickly agreed to a $3 billion secured loan facility and the company began restructuring its liabilities. It became clear that bankruptcy would be necessary and the company recently gained the support of almost 90% of its voting debt holders for a prepackaged reorganization plan that could allow the lender to emerge from Chapter 11 by the end of the year.

While the holding company declared bankruptcy on Sunday, its operating subsidiaries remain outside Chapter 11 and continue to serve customers. Some are choosing to continue with CIT, others are choosing to go with a competitor. Armageddon it is not.

Bankruptcy is a process under the rule of law that is demanded by the Constitution. "Markets not ministers," says former SEC Chairman Richard Breeden in summing up his preference for bankruptcy guided by judges over interventions crafted by politicians. Let's hope CIT's example brings the former back into fashion.

Bank Regulation and the Resolution of Banking Crises course: PDFs of articles

hi, I found useful to get the electronic version of the PDFs of these articles/texts in the Bank Regulation and the Resolution of Banking Crises course reader:

Unit 1 (updated Dec 23, 2009, & Dec 30, 2009):

• Dewatripont & Tirole: http://www.cefims.ac.uk/pdfs/U1Dewatripont.pdf
• Feldstein, M (1993), Comment to Boyd and Gertler (1993), p 375, in John Boyd & Mark Gertler, US Commercial Banking - Trends, Cycles and Policy, in NBER Macroeconomics Annual 1993, Volume 8, Olivier Blanchard and Stanley Fischer (eds), MIT Press. http://www.nber.org/chapters/c11003
• Financial Services Authority (2009) The Turner Review: A regulatory response to the global banking crisis, London: Financial Services Authority, March, http://www.fsa.gov.uk/pubs/other/turner_review.pdf
• WSJ Editorial (2009) 'One Cheer for Barney Frank - The credit raters lose their oligopoly.' WSJ, Dec 23, 2009. http://bipartisanalliance.blogspot.com/2009/12/credit-raters-lose-their-oligopoly.html
  

Unit 2:

• Frederic Mishkin (1992): 'The Causes and Propagation of Financial Instability: Lessons for Policymakers', Symposium Proceedings of the Federal Reserve Bank of Kansas City. http://ideas.repec.org/a/fip/fedkpr/y1997p55-96.html
• Jaime Caruana and Aditya Narain (2008) 'Banking on More Capital', IMF’s Finance and Development. http://www.naider.com/upload/caruana.pdf (the IMF page for June 2008 articles fail).

That way, I need not to carry the reader with me, I can read the articles on any computer. I'll update this post with links to further units' articles.

If anyone has problems accessing some text I can send it via e-mail. Just drop a note in this blog.

Best Regards,


UPDATED twice: I found the PDFs for these three:

Unit 3:

• Basel Committee on Banking Supervision (2006) ‘Core Principles for Effective Banking Supervision’, Basel: Bank for International Settlements. http://www.bis.org/publ/bcbs129.pdf
• Beck T, A Demirgüç-Kunt and R Levine (2003) ‘Bank Supervision and Corporate Finance’, World Bank Policy Research Working Paper 3042, May. http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2003/05/30/000094946_03051604080286/Rendered/PDF/multi0page.pdf
• International Monetary Fund (2007) 'Turkey: Financial System Stability Assessment', IMF Country Report Number 07/361, November, Washington DC: IMF. http://www.imf.org/external/pubs/ft/scr/2007/cr07361.pdf

As always, you can ask the files to be sent by e-mail.


UPDATED again Nov 09, 2009:

Unit 4:

Bagehot W (1873): Lombard Street: a description of the money market. London: HS King. http://www.gutenberg.org/etext/4359

Basel Committee on Banking Supervision (2002) ‘Supervisory Guidance on Dealing with Weak Banks’, Basel: Bank for International Settlements. http://www.bis.org/publ/bcbs88.pdf

Diamond D and P Dytvig (1983) ‘Bank Runs, Deposit Insurance and Liquidity’, Journal of Political Economy, Vol. 91, pp. 401–19. DiamondDytvig-BankRunsDepositInsuranceandLiquidity.pdf & .html

Dong He (2002) ‘Emergency Liquidity Facilities’, Chapter 5 of C Enoch, D Marston and M Taylor, Building Strong Banks through Surveillance and Resolution, Washington DC: International Monetary Fund. It can be enough to read http://www.imf.org/external/pubs/ft/wp/2000/wp0079.pdf (DongHe-EmergencyLiquiditySupportFacilities2000.pdf), IMF Working Paper 00/79

Freixas Xavier, Curzio Giannini, Glenn Hoggarth and Farouk Soussa (1999) ‘Lender of Last Resort: A Review of the Literature’, Bank of England, Financial Stability Review, November. http://www.bankofengland.co.uk/publications/fsr/1999/fsr07art6.pdf

James C (1991) ‘The Losses Realised in Bank Failures’, Journal of Finance, September, pp 1223–42. James-TheLossesRealisedinBankFailures1991.pdf


UPDATED again Dec 12, 2009:

Unit 5:

Chopra, Ajai, Kang, Kenneth, Karasulu, Meral, Liang, Hong, Ma, Henry and Richards, Anthony J., From Crisis to Recovery in Korea Strategy, Achievements, and Lessons (October 2001). IMF Working Paper, Vol. , pp. 1-94, 2001. http://ssrn.com/abstract=879974 Chopraetalii-FromcrisistorecoveryinKorea-strategyachievementsandlessonsOct2001.pdf (40 Mby)

Demirgüç-Kunt A and E Detragiache (2002) ‘Does deposit insurance increase banking system stability?’, Journal of Monetary Economics, Vol 49(7), October, pp 1373–406. You can request the PDF.

Dong He (2004) ‘The Role of KAMCO in Resolving Non-Performing Loans in the Republic of Korea’ IMF Working Paper, No. WP/04/172, International Monetary Fund, Washington D.C. You can request the PDF.

Glenn Hoggarth, Jack Reidhill and Peter Sinclair (2004) ‘On the resolution of banking crises: theory and evidence’, Bank of England Working Paper, No. 229. You can request the PDF.

Gillian Garcia (2000) Chapter 3: ‘A Survey of Deposit Insurance Practices’ Deposit Insurance – Actual and Good Practices, Occasional Paper, No. 197, International Monetary Fund, Washington D.C. I cannot find the PDF. There are two precursor papers published by the IMF previously, you can request them.

International Association of Deposit Insurers 2009 'Core Principles for Effective Deposit Insurance Systems'. June 2009. Request the PDF.

Optional:

David Hoelscher (2002) Chapter 9: ‘Guidelines for Bank Resolution’ in Enoch, C., D. Marston and M. Taylor Building Strong Banks Through Surveillance and Resolution, International Monetary Fund, Washington D.C. I cannot find the PDF.


Unit 6:

Abrams, R and M Taylor (2002) ‘Issues in the Unification of Financial Sector Supervision’, Chapter 6 in Charles Enoch, David Marston and Michael Taylor (eds) Building Strong Banks Through Surveillance and Resolution, Washington DC: International Monetary Fund.
Also: Abrams, Richard K. & Michael Taylor 2000 'Issues in the Unification of Financial Sector Supervision'. IMF Working Paper No. 00/213. Washington, DC: International Monetary Fund. http://www.imf.org/external/pubs/cat/longres.cfm?sk=3939.0

Elizabeth Brown (2007) ‘E Pluribus Unum – Out of Many: Why the United States Needs a Single Financial Services Agency’, University of Miami Business Law Review, Fall/Winter. Request the article.

Financial Stability Institute (2007) ‘Institutional Arrangements for Financial Sector Supervision’, Occasional Paper No. 7, Basel, Switzerland: Financial Stability Institute, BIS. http://www.bis.org/fsi/fsipapers07.htm

Goodhart, C (2000) ‘The Organisational Structure of Banking Supervision’, FSI Occasional Paper No. 1, November, Basel, Switzerland: Financial Stability Institute, BIS. http://www.bis.org/fsi/fsipapers01.pdf

The International Bank for Reconstruction and Development/The World Bank/The International Monetary Fund (2005) 'Financial Sector Assessment: A Handbook', Appendix F: ’Institutional Structure of Financial Regulation and Supervision’. Washington DC: IBRD, WB, IMF. Request the whole book.

Sinclair, Peter JN (2000) ‘Central Banks and Financial Stability’, Bank of England Quarterly Bulletin, November: 377–89. http://www.bankofengland.co.uk/publications/quarterlybulletin/qb000403.pdf

Taylor, Michael (1995) Twin Peaks: A Regulatory Structure for the New Century, London: Centre for the Study of Financial Innovation (December). I cannot find this publication in PDF.

US Treasury Department (2008) ‘The Department of the Treasury Blueprint for a Modernised Regulatory Financial Structure’ (April), Washington DC: US Treasury Department. http://www.treas.gov/press/releases/reports/Blueprint.pdf


Unit 7:

Armstrong, A. and M. Spencer (1998), ‘Will the Asian Phoenix Rise Again? Global Emerging Markets, Vol. 1 No. 3, October. I cannot find this paper.

Bordo, M., B. Eichengreen, D. Klingebiel and M. Soledad Martinez-Peria (2001) ‘Is the crisis problem growing more severe?’, Economic Policy, vol. 16(32) pages 51–82. BordoEichengreenKlingebielMartinez-Peria-Isthecrisisproblemgrowingmoresevere_EconomicPolicyv16(32)pp51–82.-2001.pdf

Financial Stability Forum (2008) ‘Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience’, April 07, http://www.financialstabilityboard.org/publications/r_0804.pdf

Caprio, G. and P. Honohan (1999) ‘Beyond Capital Ideals: Restoring Banking Stability’, World Bank Policy Research Working Paper No. 2235, Washington DC: The World Bank. http://ideas.repec.org/p/wbk/wbrwps/2235.html

Freixas, X., C. Giannini, G. Hoggarth and F. Soussa (2000) ‘The Lender of Last Resort: what have we learnt since Bagehot?’, Financial Services Research, 18(1), October, pp. 63–87.

Geithner, T. (2008) ‘Reducing Systemic Risk in a Dynamic Financial System’, Remarks at The Economic Club of New York, 12 June 2008, Federal Reserve Bank of New York. http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html

Group of 30 (1993) ‘Derivatives: Practices and Principles’, Basel Switzerland: Global Derivatives Study Group. I cannot find the PDF.

Herring, R. (2003) ‘International Financial Conglomerates: Implications for Bank Insolvency Regimes’, Philadelphia Pennsylvania: Wharton School, University of Pennsylvania’, www.wharton.upenn.edu Request the paper.

Honohan, P. and A. Klingebiel (2000) ‘Controlling the Fiscal Costs of Banking Crises’, World Bank, Policy Research Working Paper WPS 2441, Washington DC: The World Bank. http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2000/11/04/000094946_0010200530432/Rendered/PDF/multi_page.pdf


UPDATED Dec 27, 2009:

Unit 8:

Alexander K, R Dhumale and J Eatwell (2006) 'Global Governance of Financial Systems: The International Regulation of Systemic Risk'. Oxford: Oxford University Press. No PDF.

Barth J, G Caprio Jr and R Levine (2006) Rethinking Bank Regulation – Till Angels Govern, Chapter 3 Section 3.H.3, Cambridge: Cambridge University Press. Files in JPEG format.

Crockett A (2001) ‘Issues in Global Financial Supervision’, speech given at the 36th SEACEN Governors’ Conference held in Singapore, 1 June. http://www.bis.org/speeches/sp010601.htm

Eatwell J and L Taylor (1998) ‘International Capital Markets and the Future of Economic Policy’, paper prepared for the Ford Foundation Project International Capital Markets and the Future of Economic Policy, New York: Center for Economic Policy Analysis; London: Institute for Public Policy Research. http://www.newschool.edu/cepa/publications/workingpapers/archive/cepa0309.pdf

Fischer S (1999) ‘On the Need for an International Lender of Last Resort’, Journal of Economic Perspectives, Fall, Volume 13, Number 4, 85–104.
Original speech: Stanley Fischer (1999) 'On the Need for an International Lender of Last Resort'. This is a slightly revised version of a paper prepared for delivery at the joint luncheon of the American Economic Association and the American Finance Association. New York, January 3, 1999. http://www.imf.org/external/np/speeches/1999/010399.htm

Geithner, T (2008) ‘Reducing Systemic Risk in a Dynamic Financial System’, Remarks at The Economic Club of New York, 12 June 2008, Federal Reserve Bank of New York. http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html

Six Steps to Revitalize the Financial System

Six Steps to Revitalize the Financial System. By SANFORD I. WEILL, former chairman and CEO of Citigroup, AND JUDAH S. KRAUSHAAR, managing partner of Roaring Brook Capital
We need one regulator that can see a company's entire balance sheet. Pay caps will only drive talent abroad.
WSJ, Oct 26, 2009

The debate over financial services reform has meandered for weeks without a clear sense of urgency. It would be a huge opportunity lost if our political, regulatory and business leaders cannot craft a credible new regulatory foundation for one of America's pre-eminent industries. It's time to set politics and regulatory infighting aside and establish the new rules of the road for this critically important business.

Several principles should guide reform. Our country needs to strive for transparency in financial-company balance sheets and recognize the direct correlation between clarity in asset value and how financial enterprises are valued by investors. Mark-to-market based accounting must be revitalized, and complex instruments and securities must be subject to regular market-valuation tests whenever possible.

To accomplish this, a single regulator needs to be tasked with overseeing systemic risks and must be empowered to monitor risks in all sorts of financial institutions. There should be no more balkanization of regulation.

At the same time, regulators and industry leaders must come together and develop workable arrangements whereby innovation in financial services can once again flourish. We need to agree upon new capital requirements and rules for how the securitization market will operate. All parties need to operate with dispatch because the revitalization of the U.S. economy is what's at stake.

One thing our public officials should not do is get caught up in a debate over "too big to fail." It's a catchy phrase, but that's about it. Indeed, it is important to recognize that our recent financial crisis was provoked by last year's failure of Lehman Brothers, a company that few, if anyone, would have argued was too big to fail. Rather than get side-tracked on this and other complex questions, our policy leaders should focus directly on how to create and enhance market discipline.

We have six specific recommendations for reforming the financial services business:

1) Make the Federal Reserve the super-regulator responsible for overseeing systemic risk. It is vital that one regulator be able to see the entire balance sheet of the country's largest financial institutions, and this regulator needs to cut across artificial institutional lines. Large banks, securities firms, insurers and hedge funds should all come under the Fed's aegis. Anything less risks a perpetuation of regulatory arbitrage, where industry participants house their riskiest activities in the unit overseen by the most lenient regulator.

Other regulators would continue to focus on their respective industry segments exclusive of the largest, most complex institutions. Policy makers should avoid creating new bureaucracies, as some have recommended. Existing regulatory bodies should be given a broader charge to oversee consumer protection for credit-related products.

2) As much as possible, complex instruments should be subject to regular market valuation tests and clear through a central clearing house. We need a system that encourages valuations to be based on real markets and not on "mark-to-model." These last 18 months have demonstrated to us all that models work until they don't work. For underwritten offerings, a financial institution must be able to find a real public market value or the transaction should not be done. Derivatives with standardized features should be subject to daily valuation marks, and owners of these instruments should be required to maintain a reasonable amount of equity to support the position (i.e., akin to the traditional margin requirement on other securities).

For highly customized products and newer instruments that might not yet be mature enough to enjoy a large and deep market, we would allow an exemption to encourage innovation. Nonetheless, these exemptions should be regularly reviewed with regulators who should establish disclosure and trading rules that would promote maximum transparency or a means of public market price discovery. Lastly, everyone should apply the basic principle that if you don't understand something, you probably shouldn't be doing it in the first place.

3) Reform and revitalize the securitization market. Though the securitization process has been given a black eye over the past couple of years, it is important to recall that this market adds value by allowing issuers and investors to efficiently match risk, return and duration preferences. While portions of the market were abused, it is important that the baby not be thrown out with the bathwater. In the future, issuers should be required to retain on their balance sheets a substantial portion of the securitization and should be required to periodically test for current market values by selling into the market a portion of their holdings. In this fashion, both the issuing institution and the investors who bought the securitized asset would value the same asset equally.

4) The regulators need to engage the rating agencies. Going forward, the rating agencies should develop clearer standards for rating complex securities. The integrity of principal must be paramount whenever a security is given an investment grade rating. Moreover, the activities of the rating agencies should be subject to an annual review by the systemic regulator (i.e., the Federal Reserve), which in turn should publicly report issues that might compromise the safety and soundness of the country's largest financial institutions.

5) Capital requirements and reserve policies need to be overhauled. While excess leverage and imploding asset values provoked the recent crisis, pro-cyclical loan-loss reserve methodologies aggravated the situation. This has been particularly true in consumer credit where the Securities and Exchange Commission in recent years has forced banks to lower reserves as delinquencies have declined and reverse course when problems moved higher. This sort of regime seems foolhardy. Formulas work no better than mark to model.

To address the matter, financial companies should be encouraged (or perhaps required) to securitize credit wherever possible and carry the instruments at current market value. The greater the transparency in asset valuation, the better. For instruments that may not lend themselves to securitization, such as business loans with highly customized terms, the financial institutions should be allowed—in close coordination with the regulators—to set forward-looking reserves that would smooth earnings (and confidence) during periods of credit stress. Assuming an increased percentage of large financial institutions' assets could be subject to market-value accounting, earnings volatility might increase, but improved transparency would be a net positive for how these institutions would be valued. Of course, higher regulatory capital requirements could go a long way toward dampening earnings volatility; and we'd favor a relatively simple and conservative definition for regulatory capital, namely focusing on tangible common equity as a percentage of assets.

6) Align executive compensation with long-term returns. Policy makers need to move past polemics and recognize the importance of fostering loyal and motivated employees in the financial services business. Knee-jerk caps on pay will only drive talented human capital to foreign companies and erode the traditional leadership of U.S. financial institutions. We recommend a system in which equity-based pay and cash compensation be vested over a relatively long period.

The cash portion should be allowed to increase or decrease in value over the vesting period at a rate consistent with the company's return on equity. In this manner, employees would not be allowed to benefit from inherently short-term results, and risk-taking within institutions would be better controlled.

U.S. financial markets are at a unique moment in history. Without comprehensive and thoughtful reform, American leadership in global finance could be compromised, and lingering uncertainty regarding the "rules of the road" could undermine economic recovery and growth. To restore confidence, U.S. policy makers need to create a muscular super-regulator and promote market-based valuations for financial company balance sheets. Such a program would send a powerful message of transparency and integrity to the markets.

Mr. Weill is former chairman and CEO of Citigroup. Mr. Kraushaar is managing partner of Roaring Brook Capital.

The Chamber of Commerce is only the latest target of the Chicago Gang in the White House

The Chicago Way. By KIMBERLEY A. STRASSEL
The Chamber of Commerce is only the latest target of the Chicago Gang in the White House.
WSJ, Oct 23, 2009

They pull a knife, you pull a gun. He sends one of yours to the hospital, you send one of his to the morgue. That's the Chicago way.

–Jim Malone,
"The Untouchables"

When Barack Obama promised to deliver "a new kind of politics" to Washington, most folk didn't picture Rahm Emanuel with a baseball bat. These days, the capital would make David Mamet, who wrote Malone's memorable movie dialogue, proud.

A White House set on kneecapping its opponents isn't, of course, entirely new. (See: Nixon) What is a little novel is the public and bare-knuckle way in which the Obama team is waging these campaigns against the other side.

In recent weeks the Windy City gang added a new name to their list of societal offenders: the Chamber of Commerce. For the cheek of disagreeing with Democrats on climate and financial regulation, it was reported the Oval Office will neuter the business lobby. Obama adviser Valerie Jarrett slammed the outfit as "old school," and warned CEOs they'd be wise to seek better protection.

That was after the president accused the business lobby of false advertising. And that recent black eye for the Chamber (when several companies, all with Democratic ties, quit in a huff)—think that happened on its own? ("Somebody messes with me, I'm gonna mess with him! Somebody steals from me, I'm gonna say you stole. Not talk to him for spitting on the sidewalk. Understand!?")

The Chamber can at least take comfort in crowds. Who isn't on the business end of the White House's sawed-off shotgun? First up were Chrysler bondholders who—upon balking at a White House deal that rewarded only unions—were privately threatened and then publicly excoriated by the president.

Next, every pharmaceutical, hospital and insurance executive in the nation was held out as a prime obstacle to health-care nirvana. And that was their reward for cooperating. When Humana warned customers about cuts to Medicare under "reform," the White House didn't bother to complain. They went straight for the gag order. When the insurance industry criticized the Baucus health bill, the response was this week's bill to strip them of their federal antitrust immunity. ("I want you to find this nancy-boy . . . I want him dead! I want his family dead! I want his house burned to the ground!")

This summer Arizona Sen. Jon Kyl criticized stimulus dollars. Obama cabinet secretaries sent letters to Arizona Gov. Jan Brewer. One read: "if you prefer to forfeit the money we are making available to the state, as Senator Kyl suggests," let us know. The Arizona Republic wrote: "Let's not mince words here: The White House is intent on shutting Kyl up . . . using whatever means necessary." When Sens. Robert Bennett and Lamar Alexander took issue with the administration's czars, the White House singled them out, by name, on its blog. Sen. Alexander was annoyed enough to take to the floor this week to warn the White House off an "enemies list."

House Minority Whip Eric Cantor? Targeted for the sin of being a up-and-coming conservative voice. Though even Mr. Cantor was shoved aside in August so the Chicago gang could target at least seven Democratic senators, via the president's campaign arm, Organizing for America, for not doing more on health care. ("What I'm saying is: What are you prepared to do??!!")

And don't forget Fox News Channel ("nothing but a lot of talk and a badge!"). Fox, like MSNBC, has its share of commentators. But according to Obama Communications Director Anita Dunn, the entire network is "opinion journalism masquerading as news." Many previous White House press officers, when faced with criticism, try this thing called outreach. The Chicago crowd has boycotted Fox altogether.

What makes these efforts notable is that they are not the lashing out of a frustrated political operation. They are calculated campaigns, designed to create bogeymen, to divide the opposition, to frighten players into compliance. The White House sees a once-in-a-generation opportunity on health care and climate. It is obsessed with winning these near-term battles, and will take no prisoners. It knows that CEOs are easily intimidated and (Fox News ratings aside) it is getting some of its way. Besides, roughing up conservatives gives the liberal blogosphere something to write about besides Guantanamo.

The Oval Office might be more concerned with the long term. It is 10 months in; more than three long years to go. The strategy to play dirty now and triangulate later is risky. One day, say when immigration reform comes due, the Chamber might come in handy. That is if the Chamber isn't too far gone.

White House targets also aren't dopes. The corporate community is realizing that playing nice doesn't guarantee safety. The health executives signed up for reform, only to remain the president's political piñatas. It surely grates that the unions—now running their own ads against ObamaCare—haven't been targeted. If the choice is cooperate and get nailed, or oppose and possibly win, some might take that bet.

There's also the little fact that many Americans voted for this president in thrall to his vow to bring the country together. It's hard to do that amid gunfire, and voters might just notice.
("I do not approve of your methods! Yeah, well . . . You're not from Chicago.")

Don't be fooled by the bond market. Banks are holding prices down because they can buy Treasurys with free money from the Fed

Preventing the Next Financial Crisis. By ALLAN H. MELTZER
Don't be fooled by the bond market. Banks are holding prices down because they can buy Treasurys with free money from the Fed.
WSJ, Oct 23, 2009

The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon.

As long ago as the 1960s, then French President Charles de Gaulle complained that the U.S. had the "exorbitant privilege" of financing its budget deficit by issuing more dollars. Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.

Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows. Do we have to wait for a crisis before we replace promises with effective restraint?

Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.

Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.

The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?

While Chinese government purchases of our debt may delay a dollar and debt crisis, they also delay any effective program to reduce the size of that crisis. It is far better to begin containing the problem before we blow a hole in the dollar and start another downturn.

A weak economy is a poor time to reduce current government spending or raise tax rates, but we don't require draconian immediate changes. We do need a fully specified, multi-year program to restore fiscal probity by reducing spending, and a budget rule that limits the size and frequency of deficits. The plan should be announced in a rousing speech by the president. The emphasis should be on reducing government spending.

The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.

Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing.

One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.

Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.

Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.

A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being.

Mr. Meltzer is professor of political economy at Carnegie Mellon University and the author of the multi-volume "A History of the Federal Reserve" (University of Chicago, 2004 and 2010).

Wage controls are politically easier than genuine reforms

Our New Paymasters. WSJ Editorial
Wage controls are politically easier than genuine reforms.
The Wall Street Journal, page A20, Oct 23, 2009

In the annals of what used to be known as American capitalism, yesterday will go down as a sorry day: The Treasury and Federal Reserve announced wage controls on private American companies. So once again our politicians are blaming bankers, rather than addressing the incentives the politicians themselves created for bankers to take excessive risks.

President Obama cheered the pay reductions as "an important step forward" and urged Congress to "continue moving forward on financial reform to help prevent the crisis we saw last fall from happening again." The pay curbs are intended to feed the official political narrative that the bankers caused the entire crisis, and that cutting their future pay will prevent the next one. Only a politician could really believe this, or at least pretend to.

We certainly have no sympathy for bankers who've been bailed out, and the most defensible of yesterday's pay curbs are those announced by Treasury "pay czar" Ken Feinberg. He was handed the task of determining compensation for 175 executives at seven companies that are still using money from the Troubled Asset Relief Program: Citigroup, AIG, Bank of America, General Motors, Chrysler, GMAC and Chrysler Financial. These companies—and executives—owe their survival to political intervention, and the price of such taxpayer help is inevitably some populist retribution.

Mr. Feinberg thus has the impossible job of navigating between Congress's desire for revenge and the incentives needed to motivate business success at companies that still need to repay taxpayers. His strategy seems to be to slash cash compensation to $500,000 or less for most of the affected workers, while the bulk of their compensation will come in the form of stock tied to future corporate performance. This seems reasonable enough in principle. But the danger is that these pay limits will drive the most talented people at these firms to other companies without such onerous pay limits.

Far more dangerous is yesterday's announcement that the Fed plans to impose new pay guidelines on all of the banks it regulates. While the Fed imposed no pay cap, and it was at pains to say it didn't want to impose a "one size fits all" standard, the implication is that any large single-year payouts will be frowned upon by regulators. The Fed wants what it refers to as more "balanced" pay standards, which in practice is likely to mean smaller bonuses up front and longer time frames to see if "risks" pay off over several years.

The irony is that judgments about what constitutes "excessive risk" at banks will presumably be made by the same Fed regulators who let Citigroup put hundreds of billions in SIVs off its balance sheet. That certainly looks "excessive" now, though apparently it didn't amid the credit mania. The point is that Fed officials aren't likely to have a clue what kind of risks warrant tighter compensation rules. And these new guidelines may also drive the best and brightest out of the banks and into less regulated institutions.

Paul Volcker must be smiling at that one. Like Bank of England Governor Mervyn King (see below), the former Fed Chairman argued in Obama circles that a better way to regulate banks is to separate the riskiest trading activities from those that accept taxpayer guaranteed deposits. That reform would have moved the riskiest proprietary trading out of taxpayer-protected institutions. But the White House and Treasury deemed this too politically difficult, so instead they are now regulating the pay of bankers as an alternative way to diminish those risks. Good luck.

Meanwhile, the Administration still hasn't done anything to change the incentives for excessive risk-taking that are embedded in its own "too big to fail" doctrine. As long as bankers and their creditors believe they have a federal safety net, they will have a cheaper cost of capital that will encourage them to take greater risks. New pay rules will quickly be worked around or through.

As Mr. King put it this week, "The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the 'too important to fail' question. The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion." The same can be said for pay curbs.

The most profound mistake in these rules is the terrible precedent they set for wage controls
across the economy. The Obama Administration will say that banks are a special case, and that is true. But once politicians feel free to regulate executive pay for one industry, it is no great leap to do it for everyone. Our guess is that these pay rules will prove to be both ineffectual and destructive—a perfect Washington combination.