Silver Linings in the Indian Economy. By Harun R Khan, Deputy Governor, Reserve Bank of India
Fifth Annual Banking Conference on “The Silver Lining of the Indian Economy” organized by NMIMS School of Banking Management
October 6, 2012, Bombay
http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/SSLIE091012.pdf
Excerpts:
Recent actions start the course correction but momentum needs to be kept
2. Recent policy measures taken by the government are very significant. They have started the course correction from a point where the Indian growth story was close to getting seriously damaged. However, for these measures to succeed it is important to keep up the momentum. More steps and effective implementation over next 2-3 years are necessary to fully recoup the lost ground.The economy has been facing serious headwinds as growth had slowed down to 5.5 per cent or less for the last two quarters over and above the subdued growth rate of 6.5 per cent for 2011-12, a rate even lower than crisis period low point of 6.7 per cent growth in 2007-08. Our saving and investment rate had also slipped since 2008-09. Gross domestic saving rate averaged 32.7 per cent in three years 2010-11 against 35.0 per cent in the preceding three years due mainly to fall in public sector saving rate. Our gross domestic investment rate averaged 34.1 per cent against 34.9 per cent for the same periods as corporate investment rate fell sharply. Preliminary estimates suggest a further sharp drop in household financial savings in 2011-12 at less than 8.0 per cent of the GDP from more than 12 per cent two years back. Also, corporate investment is likely to have declined further. With falling saving and investment, rise in twin deficits and inflation, potential growth had also dropped by one percentage point or more in the post-global financial crisis period. As we know, potential growth indicates the rate of growth the economy can achieve consistent with stable macro-economic conditions.On the other hand, inflation rose sharply to above comfort levels since December 2009 and averaged 9.5 per cent for next 24-months before lowering to sub-eight per cent but still proving to be intransigent. It is staying sticky at over 7 per cent. Centre’s fiscal deficit had slipped during 2011-12 to 5.8 per cent against the budgeted 4.6 per cent for the year and 4.9 per cent in 2010-11. With gross under-recoveries of oil marketing companies working out to over Rs1.8 trillion or 0.8 per cent of GDP due to unrevised prices of diesel, LPG and kerosene, there was little doubt the centre’s GFD/GDP budgeted estimate would then have overshot by a wide margin. Even after the revision of diesel prices and capping of subsidised LPG cylinders, the budget imbalances are obvious, underscoring the importance of further fiscal measures to contain deficit this year.
3. The current account deficit (CAD) had risen to an all-time high of 4.2 per cent of GDP in 2011-12 and 4.5 per cent of GDP during Q4 of 2011-12. In other words, rising twin deficit, slowing growth and sticky inflation provided all the ingredients for a possible economic crisis. Noting this macro-economic deterioration, some international credit rating agencies had already put India’s sovereign rating on a watch list for an impending downgrade that would have pushed India to a subinvestment grade.
The slew of measures in a span of less than a month should count
4. Against this background, the policy actions that were announced in September 2012 should be seen as major initiatives to reverse the course of economic growth path in the country. In a slew of measures of economic reforms, the government raised diesel prices by `5 per litre and capped subsidised LPG cooking gas cylinders to six a year per household. It permitted foreign direct investment (FDI) in multi-brand retail up to 51 per cent, in aviation sector up to 49 per cent and in some broadcasting services up to 75 per cent. It also approved sale of its minority stakes in four public sector firms -- Oil India (by 10 per cent), Hindustan Copper (9.59 per cent), MMTC (9.33 per cent) and Nalco (12.15 per cent) -- to raise up to `150 billion – half its disinvestment receipts target for the year. These measures were followed up with an announcement that withholding tax liability will be reduced to 5 percent from 20 per cent for the overseas borrowings /bond issuances for infrastructure sector by Indian firms during July 2012 and June 2015.
5. A debt relief package for the state power distribution companies (discoms) has now been approved. Once implemented efficiently, it can turnaround the investment scenario once again. This month, a package for the life insurance sector was also worked out. The package includes easing investment norms for insurers, faster clearance for new products, easing of procedures, allowing banks to sell products of more than one insurance company and possibly some tax concessions for the insurance sector. More sector-specific packages could follow allowing structural bottlenecks to be removed without sacrificing on regulatory discipline.The Cabinet has also cleared foreign equity cap in insurance sectors at 49 per cent through Insurance Laws (Amendment) Bill, 2008. It also approved certain amendments to the Pension Fund Regulatory and Development Authority (PFRDA) Bill, 2011 that included foreign investment ceiling in the pension sector at 26 per cent or such percentage as may be approved for the insurance sector, whichever is higher, may be incorporated in the present legislation. Besides, it approved several other plans that are important for the economy, such as the 12th Five Year Plan document for taking it to the National Development Council (NDC), amendments to the Companies Bill 2011, the Forward Contracts (Regulation) Amendment Bill, 2010 and the Competition Act, 2002. These moves show the intent and the policy direction though the ultimate impact would depend on the political process of law making that follows.There are several unknowns, such as, the timing of debates and votes, the floor management on the day of the vote and most importantly, the process by which political differences are narrowed enough to see the results. The foundation has been laid and one can be confident that the Indian democracy would once again stand the test of the time.
6. On our part, we certainly think that the slew of economic reforms measures undertaken by the government recently would impart a positive momentum to the economy. The Reserve Bank in its Mid-Quarter Review of Monetary Policy noted the likely positive impact of the changes in FDI policy on capital flows and over the long run on higher productivity, particularly in food supplychains. The Reserve Bank had been consistently arguing for need for supply-side responses to help contain inflation. Earlier in its Annual Report released in August 2012, it had highlighted the urgent need to step up non-debt creating inflows, especially in the form of FDI in view of the wide current account deficit (CAD). It had argued for further improving the FDI inflows in sectors such as insurance, retail, aviation and urban infrastructure. It had noted that FDI in retail may be particularly helpful in improving supply chain management through greater investment in backend infrastructure, including cold storage for farm and poultry products.
7. Considering that these steps being undertaken paved the way for a more favourable growth-inflation dynamics, the Reserve Bank moved to address possible liquidity tightening ahead by a pre-emptive 25 basis point cut in its Cash Reserve Ratio (CRR) at its Mid-term policy announced on September 17, 2012. CRR is also a potent monetary policy tool and should help in lowering the cost of credit and augmenting its supply, thus improving credit flows. The CRR cut was in addition to a 50 basis point policy rate reduction that the Reserve Bank had effected in April 2012 in anticipation of action for fiscal consolidation and supply-side initiatives.
8. Several policy measures have been taken in less than a month. When these measures get implemented and feed through the system, they would contribute significantly to recovery of India’s growth as well as growth potential. Capital flows have recovered and would go a long way in restoring confidence for business activity in the country. Growth would start improving as a result. Whether the recovery will be quick or slow-paced would depend on several factors, including global conditions, which at the moment are not very conducive in spite of some positive news on labour and housing markets in the US. What is important is that recent actions by the Government have reduced the macro-economic risks and structural impediments.
9. Part of our recent woes was self-inflicted as inadequate movement on policy and implementation fronts worsened investment climate that had already suffered due to global uncertainties and cyclical downturn in the Indian economy. This had added an element of structural retrogression in the Indian economy. The government has now shown its resolve to effectively redress this. If steps announced are well-implemented and if we stay on path of reforms, the economy would turnaround faster than what many expect. But several challenges remain and not only policy changes but effective implementation holds the key to success.
10. The most important challenge would be to further lower the twin deficits by staying on path of fiscal consolidation, keeping a tab on private consumption demand and using expenditure switching policies to lower CAD. Monetary policy would for some more time need to focus on inflation while using available space to support growth to the degree it can. Inflation, if left unattended to, can play the biggest spoil sport. The rupee has already appreciated 6.8 per cent against US dollar since the onset of this new wave of reforms on September 13, 2012. This may help lower inflation somewhat as exchange rate-pass-through takes place. However, it is important to understand that exchange rate is neither a first-best solution nor a sufficient tool for addressing the challenges of structural inflation that we face today. Ultimately, fiscal policy would need to work towards expediting supply-side responses and keeping private consumption demand in reasonable control. Monetary policy would need to be cautious in the interim.
Downward cycle may be bottoming out
11. After a downturn, there are some signs of green shoots that if nursed with appropriate policies, including continuous economic reforms, with an eye on macro-financial stability, can pave the way of recovery for the Indian economy. Falling growth was somewhat arrested in Q1 of 2012-13. At 5.5 per cent, it was marginally better than in the 5.3 per cent in Q4 of 2011-12. While this is not a material improvement, when juxtaposed with the recent policy measures there is hope that growth would improve in coming quarters and more so next year. Rainfall has been deficient by 8 per cent from the long period average in 2012 monsoon season. The deficiency during June and July 2012 has adversely impacted the Kharif crop. However, good rainfall in August and September have improved the soil moisture content and reservoir levels and raised the prospects for a good Rabi crop. As we see subsequent rounds of crop estimates, the deficiency of about 10 per cent in case of foodgrains and oilseeds is likely to be reduced, thus providing a further silver lining.
12. India grew at a rapid pace with an average growth of 8.7 per cent during 2003-04 to 2007-08 essentially because investment boomed, especially in infrastructure such as power, roads and telecom. In the last three years of this period growth averaged 9.5 per cent before the Lehman crisis changed the world. India’s potential growth was assessed at nearly 8.5 per cent during this period. India’s growth dropped to 6.7 per cent during 2007-08 due mainly to spill over from global financial crisis. India, however, stood out as an island of calm that withstood global financial Tsunami. Its growth dropped less than its peers and it staged a V-shaped recovery clocking 8.4 per cent growth over next two years. However, the euro area crisis, the rising structural problems and high inflation combined to bring about a precipitous fall in India’s growth. The growth dropped to 6.5 per cent in 2011-12 – lower than the crisis-affected growth of 6.7 per cent in 2007-08. More importantly, growth has averaged 5.4 per cent over last two quarters.
13. Is this the new normal? There are strong reasons to believe otherwise. While potential growth may have fallen, we are clearly running a negative output gap with realised growth below potential. With current momentum, we can also recoup our lost potential and after a few years start growing back at 8-8.5 per cent on a sustainable basis. What is important at this stage is to further improve macro-economic conditions by lowering twin deficits and to ensure that inflation stays below the threshold at which high growth cannot be sustained.
14. Growth came down due to exceptional reasons. Firstly, inflation had stayed high for over two years and there is enough theoretical and empirical evidence to suggest that when inflation reaches that high and becomes persistent, the costs of deflation in terms of growth sacrifice turns out to be large. Part of the growth sacrifice occurs for reasons of monetary tightening that high inflation inevitably brings if complete macro-economic destabilization and possible hyper-inflation is to be averted. Hyperinflation risk is not something that can be dismissed lightly. Growth also comes down for reasons beyond monetary tightening. High inflation erodes consumers’ real purchasing power and lowers aggregate demand. It acts as a regressive tax on poor and erodes their consumption base. Producers also postpone investment decisions in an era of heightened uncertainty. To contain the high level of inflation and manage inflationary expectations, monetary policy in India was tightened continuously since February 2010 and these risks were contained even though inflation still remains perceptibly higher than the Reserve Bank’s comfort. Monetary policy needs to factor in the growth-inflation dynamics in a forward-looking manner but keep focussing on inflation for some more time so that inflation persistence is overcome. This would have a positive spin off for growth to recover. As we have stated in the Mid-Quarter Monetary Policy Review of September 17, 2012, when the policy initiatives being taken now by the Government materialize into concrete action, monetary policy will reinforce the positive impact of such actions while continuing to maintain its focus on inflation management.
15. Secondly, growth came down because of unfavourable global climate. The euro area crisis coming on the heels of Lehman crisis is playing on animal spirits. Global trade has decelerated sharply and is impacting investments. Indian industrial growth is found to be highly correlated with global industrial growth. As we integrate more and more with the rest of the world, we have to pay price of globalization even as we reap its benefits. As we have observed in this context, global developments affect our economy through commerce, capital flows, confidence, commodity price, contamination, currency rates and credit rating channels.Global business cycles are, therefore impacting both investment demand and with a lag impacting consumption demand as incomes fall and appetite for leverage reduces.
16. Thirdly, growth came down in India because investment climate was vitiated due to emergence of serious structural bottlenecks related to land, labour, regulatory framework, linkages or availability of funding, partly due to elevated concerns for asset quality. Part of the problem occurred in the mining sector, where judicial and executive efforts to improve governance have created a sort of a hiatus in activity. When a clearer operational regime comes into play businesses would adjust to more normal functioning based on fair returns. The other part of the problem was in the power sector where bulk of the 54 GW of new investments capacities created during the 11th Plan turned into potential bad investments as coal was in short supply. Mitigation of the problem is hopefully in the offing. If debt restructuring of discoms is well executed and coal supplies are quickly ensured, the power sector investments can revive in the 12th Plan. New capacity generation can easily match and possibly surpass that in the 11th Plan. Power sector can turn out to be a major driver of growth once again. As per the plans, the SEB losses are being cut by power tariff revisions.
Investment revival is possible
17. Big steps for reforming power sector are now being taken and can pave the way for revival of investment. The debt restructuring of discoms is being done in an incentive-compatible manner and may not encourage moral hazard or regulatory forbearance. The scheme contains various measures required to be taken by state discoms and state governments for achieving the financial turnaround of the discoms. The restructuring/ reschedulement of loan are to be accompanied by concrete and measurable action by the discoms/ States to improve the operational performance of the distribution utilities. There may not be an immediate fiscal impact for the centre, given that its obligations under the scheme are medium-term in nature, the fiscal impact for the states in the near-term would be the interest outgo on 50 per cent of outstanding short-term loans which are to be taken over by them in a phased manner. While, a great deal of ground would still need to be covered for operational effectiveness of the scheme, it does have the capacity to reverse the falling fortunes of power sector investments. One hopes that the ticking clock of the potential time bomb of the power sector can now be defused. It is worth noting that the accumulated losses of the state power distribution companies (discoms) are estimated to be about `1.9 trillion as on 31st March, 2011.
Financial sector can remain robust with efforts to contain newer fragilities
18. India has stood out amongst its peers with an enviable record on financial stability. India’s gross non-performing assets (NPAs) of scheduled commercial banks as a percentage of gross advances had declined from 12.7 per cent in 1990-91 to 2.4 per cent in 2010-11. In case of public sector banks, this ration had dropped from 14.0 to 2.3 per cent over the same period. However, during the recent economic downturn, there has been a sharp deterioration in asset quality of the public sector banks (PSBs), as the ratio reversed to 3.2 per cent in 2011-12. While the NPA levels are still low by historical trends or cross-country comparison, newer fragilities were obvious by the high slippage ratio and a spurt in restructuring loans. The slippage ratio of the PSBs increased to 5.7 per cent of gross advances by at the end of 2011-12 from 4.2 per cent a year ago. The recovery also slowed down, especially in the stressed sectors. While some of these changes reflect the NPA cycle that generally tracks economic cycle, the sectoral bottlenecks also had a role to play in such deterioration.
19. There has been movement towards resolving the sector-specific issues, especially in power and aviation. With gradual improvement in economic activity, the stress may be further reduced across all sectors. This will bring back some of the strength of the bank balance sheets that had got eroded in recent years. Unlike many other countries, India is a bank-dominated financial system. Though the role of the financial markets has increased over the year, the financing pattern of the corporates suggests that banks account for over a fourth of total sources of funds for the corporates. As such, maintaining health of the banks is important so that they can nurse recovery by credit expansion with the silver linings already on the horizon. The ratio of bank credit to GDP in India is around 55 per cent, which is much below what is prevalent in many advanced economies. Therefore, the challenge for Indian banks is to facilitate the growth of the real sector through financial products and innovations subject to adequate safeguards and adoption of sound risk management policies. In the Indian context, foreign banks can potentially play a significant supplementing role of resource mobilization to fund higher growth, apart from augmenting competition and efficiency among the banks. For example, foreign banks still have a lot of leeway available for funding infrastructure projects vis-à-vis the prescribed exposure limits. Further, given the higher requirements of lending to the priority sectors under the revised policy framework, foreign banks can bring in a lot of innovations and better practices and processes to lend to the critical sectors of the economy like the SMEs and agriculture.
20. The Reserve Bank has been a conservative central bank that accords very high priority to financial stability. It is for this reason that the Reserve Bank is focussed on the implementation of the Basel III norms. It is also training its eyes on curbing increasing slippage and withdrawing regulatory forbearance that supports it in a phased manner. Some transitory sops to infrastructure loans in case genuine delays in commencement of commercial operations are possible but these should be the exceptions rather than the norm. Maintaining financial discipline is of paramount importance and this would certainly demand higher accountability and sacrifice by the promoters. On Basel III, the Reserve Bank has unveiled the broad course that the banks need to follow. With gradual improvements in market conditions, capital raising options for the banks would steadily improve. It should be possible for public sector banks (PSBs) to raise about `1.5 trillion of equity over the period of a little over 5-years till the end of 2017-18. The shareholders’ value locked in the PSBs need to be tapped by innovative means. Stronger banks are in fact needed to support credit flows for higher growth in the Indian economy.
Containment of twin deficits remains a challenge but within our realm
21. The impact of the recent governmental measures in reducing the fiscal deficit is not likely to be very large. In effect the reduction in diesel and LPG subsidies would amount to marginal fiscal correction in the current fiscal year. This underscores the importance of taking both short term measures for moving closer to the budget targets as well as long term steps to structurally correct the deficit, thus eventually lowering the fiscal dominance of monetary policy. Recently, the Kelkar Committee has estimated that GFD/GDP ratio for 2012-13 could slip by 1 percentage point to 6.1 per cent from the budgeted 5.1 per centif corrective measures are not taken. It has also made several recommendations on fiscal consolidation laying down a path to narrow it down to 5.2 per cent in 2012-13, 4.6 per cent in 2013-14 and 3.9 per cent in 2014-15, when the effective revenue deficit can be brought to zero. Improved tax collection, asset sales, pruning of subsidies and rationalization of planned spending holds the key to this path. Disinvestments, minority stake sales, higher PSU dividends, hiking urea prices and widening services tax net are part of the recommended strategy. The bottom line is that a workable path to fiscal consolidation is available – be it through the Kelkar Committee or through the rolling targets set following the 13th Finance Commission. What is important is to get there or at least very close to there through sustained efforts and not become lax in face of political or electoral cycles. It is expected that the government would take further aggressive steps to prevent fiscal slippage this year and complete its borrowing programme broadly in line with what was envisaged and without any undue pressures in the financial markets. This can make substantial contribution to keeping interest rates low and reviving the economy. In fact, the recent announcement of the Central Government’s borrowing calendar for the second half of 2012-13, which sticks to the budgeted borrowing figures reflect Government’s resolve for containing the Gross Fiscal Deficit (GFD). It is, however, imperative that further strong measures forfiscal corrections are implemented in the rest of the year broadly in line with the Kelkar Committee recommendations. Recent appreciation of the Rupee has, besides mitigating the risk of imported inflation, would also greatly aid in containment of GFD by way of reduction in subsidy burden of the Government arising out of high Rupee cost of imported oil.
22. The trends in the external sector are also showing signs of some improvement after considerable stress witnessed last year. The CAD/GDP ratio declined to 3.9 per cent in Q1 of 2012-13 from 4.5 per cent in Q4 of 2011-12. While this is a positive development, it has come about as imports contracted in face of growth slowdown and some benefits accrued from exchange rate pass-through from rupee depreciation in 2011-12 and in the first quarter this year. Macroeconomic and external sector policies would need to still factor in external sector risks in the coming period, especially as event risks emanating from global developments remain significant. Therefore, further efforts would be necessary to contain CAD and bring it in line with its sustainable level of around 2.5 per cent of GDP. The recent reform measures have brought about major change in global investor perception. These investors are now willing to continue investing in India’s long-term growth story. Another silver lining is that India’s net international investment position (NIIP) that reflects the net claims of non-residents on India has improved with the decrease in these claims by US$23.9 billion over the previous quarter to US$220.3 billion as at end-June. While this largely reflects the valuation changes, augmentation of non-debt creating flows in the new phase of economic reforms would certainly lower external financing risks, thus providing a much needed cushion against our external sector pressures.
We need to convert the silver linings to our advantages
23. I would like to conclude by saying that India in the second half of 2012-13 is shaping as very different from India in the first half. There are positives emerging across the horizon. This is reflected in our currency movement that will bring further positive spin offs by lowering inflation, fiscal deficit and reducing corporate stress. Growth could start improving into the next year. Battleagainst inflation is, however, far from over and we need careful calibration of monetary and non-monetary responses to tame it. Late revival of monsoon and steps taken/being planned to improve the supply responses should moderate the inflationary pressure overtime. Stronger fiscal measures on the path envisioned would pave the way for sustained recovery. We have seen marginal improvement in CAD. This should not, however, lull us into any complacency as the path to its sustainability requires several adjustments. It is equally important that correctives now being put in place do not attenuate regulatory prudenceor deflect the focus away from long term sustainability of the external sectorby taking a short term view of the proposed solutions for improving capital flows.
24. The slew of measures in a short span need to be turned into a habit of well-paced action, improved execution and governance and credible commitment without backtracking or reversals. A more gradual-paced reforms earlier enabled us to achieve high growth path. In the context of steps taken/planned for our reforms, one area where we need to focus seriously is on communication, both internal and external. This should encompass convincing our domestic constituency about the experience and benefits of reforms which have to be carried forward for achieving the goals of inclusive growth by having a strong and resilient macro-economy. It would also imply meaningful engagement with the international rating agencies and investor class. There is no reason to believe that these would not work though there are still many a bridge to cross to translate the intentions to deliverables on the ground. The silver linings are now visible on the horizon. We need to build upon them and implement our plans in the right earnest. The door of opportunity is again knocking at us. These silver linings lifting the dark clouds are, however,not something as part of our destiny but they are within our reach, if we work hard on them with all sincerity to convert them to our long term advantages.
Wednesday, October 10, 2012
Friday, October 5, 2012
Sovereign Risk and Asset and Liability Management—Conceptual Issues
Sovereign Risk and Asset and Liability Management—Conceptual Issues. By Udaibir S. Das, Yinqiu Lu, Michael G. Papaioannou, and Iva Petrova
IMF Working Paper 12/241
Oct 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40037.0
Summary: Country practices towards managing financial risks on a sovereign balance sheet continue to evolve. Each crisis period, and its legacy on sovereign balance sheets, reaffirms the need for strengthening financial risk management. This paper discusses some salient features embedded in in the current generation of sovereign asset and liability management (SALM) approaches, including objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal SALM outcomes. These elements are used in developing an analytical SALM framework which could become an operational instrument in formulating asset management and debtor liability management strategies at the sovereign level. From a portfolio perspective, the SALM approach could help detect direct and derived sovereign risk exposures. It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources of risk. The paper also outlines institutional requirements in implementing an SALM framework and seeks to lay the ground for further policy and analytical work on this topic.
Excerpts:
The financial crises of the last thirty years have amply demonstrated that unattended public and private sector risks can be at crises’ origins. Sovereigns are susceptible to various risks and uncertainties relating to their financial assets and liabilities, depending on the country’s level of economic and financial development. Typically, emerging market sovereigns face increased market exposure of their net foreign asset and debt portfolios, especially as they expand access to domestic and international capital markets. Many frontier market sovereigns are exposed to risks arising from terms-of-trade shocks and changes in debt refinancing terms, and tend to be more vulnerable to exogenous shocks than other countries.
Advanced markets face market risk exposure as well, particularly those that rely on capital market access and are systemically important issuers of public debt. In addition, they face other financial risks associated with an aging population, structural issues that need reform ( health and pension), and contingent liabilities arising from systemically important financial or corporate firms, and or potentially weak financial sectors and/or subnational entities. These risks, if realized, could cause a significant fiscal and financial drain and a consequent fall in the country’s domestic absorption and potential output.
To help identify and manage effectively the key financial exposures, a sovereign asset and liability management (SALM) framework, based on the balance-sheet approach, can be employed. This framework can also be used to inform the macroeconomic and financial stability policy design. SALM focuses on managing and containing the financial risk exposure of the public sector as a whole, so as to preserve a sound balance sheet needed to support a sustainable policy path and economic growth. The SALM approach entails monitoring and quantifying the impact of movements in exchange rates, interest rates, inflation, and commodity prices on sovereign assets and liabilities and identifying other debt-related vulnerabilities (Rosenberg et al., 2005) in a coordinated if not an integrated way (Figure 1).
The SALM approach can also be utilized to facilitate a country’s long-term macroeconomic and developmental objectives such as economic diversification, broadening of the export market, or reducing the dependence on key import products. Further, the SALM approach can help identify long-term fiscal challenges, such as unfunded social security liabilities, implying a future claim on resources (Traa and Carare, 2007). In this context, the SALM framework forms an integral part of an overall macroeconomic management strategy (e.g., Au-Yeung et al., 2006, Bolder, 2002, CREF South Africa, 1995, Danmarks Nationalbank, 2000, Grimes, 2001, Horman, 2002).
For commodity-exporting countries, the SALM approach can highlight the potential asset management challenges that stem from a medium-term fiscal strategy (Leigh and Olters, 2006). For example, high commodity prices lead to higher revenues, concurrently strengthening their (unadjusted) fiscal positions. However, commodity depletion leads to lower future revenues, which could be mitigated with appropriate asset management to ensure that future fiscal expenditures are sustainable.
From a portfolio perspective, the SALM approach could help detect sovereign risk exposures. It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources ((Claessens, 2005; Lu, Papaioannou, and Petrova, 2007; Zacho, 2006). If the match of financial characteristics of the assets and liabilities is only partial, risk management could focus on the unmatched portions, i.e., net financial positions. In a short- to medium-term perspective, a financial risk management strategy could then be developed to reduce exposures. For example, if the net position results in a liability exposure, appropriate strategies should be developed to manage the risks associated with such exposure.
The application of the SALM framework could be constrained by a number of policy and institutional factors. Monetary policy objectives have an impact on SALM strategies, by affecting either market—interest rate and exchange rate—risk management or directly the size of the balance sheet. Fiscal policy objectives that aim at limiting annual debt service costs may put constraints on the duration and currency composition of public debt, since high shares of short-term debt are perceived to lead to greater volatility of service costs.
The structure of international and domestic capital markets also shapes the SALM implementation. Some developing countries cannot issue domestic debt because of illiquid and/or shallow domestic debt capital markets and a lack of a reliable local investor base. Their attempts to issue domestic-currency external debt have also not been well-received in international markets owing, in part, to their vulnerability to shocks, restrictions on foreign investors to buy local-currency debt (e.g., on type of instruments, minimum holding period), poor transparency, and/or a lack of interest rate and exchange rate hedging instruments.
In addition, some have argued that combining the management of sovereign assets and liabilities under one framework may not be optimal.5 Cassard and Folkerts-Landau (2000) points out a potential conflict of interest between monetary policy and debt management if a central bank assumes an operational role or actively participates in debt markets. For example, the central bank may be reluctant to increase the interest rates in the face of growing inflation concerns for fear of raising debt rollover costs. Also, the central bank’s intervention policy may be in conflict with its daily task of managing the liquidity of the foreign currency debt.
While risk management approaches for sovereigns may differ from those for the private sector (see Box 1), this paper discusses the salient features embedded in countries’ approaches to SALM, including main objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal debt and asset outcomes. These considerations are typically taken into account when developing an analytical SALM framework, which may evolve into an operational instrument for formulating asset and debt/liability management strategies. Also, the paper outlines common institutional requirements and constraints in implementing an SALM framework, and, based on select country experiences with the SALM approach, draws some stylized lessons and general policy guidelines on adopting an SALM approach.
IMF Working Paper 12/241
Oct 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40037.0
Summary: Country practices towards managing financial risks on a sovereign balance sheet continue to evolve. Each crisis period, and its legacy on sovereign balance sheets, reaffirms the need for strengthening financial risk management. This paper discusses some salient features embedded in in the current generation of sovereign asset and liability management (SALM) approaches, including objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal SALM outcomes. These elements are used in developing an analytical SALM framework which could become an operational instrument in formulating asset management and debtor liability management strategies at the sovereign level. From a portfolio perspective, the SALM approach could help detect direct and derived sovereign risk exposures. It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources of risk. The paper also outlines institutional requirements in implementing an SALM framework and seeks to lay the ground for further policy and analytical work on this topic.
Excerpts:
The financial crises of the last thirty years have amply demonstrated that unattended public and private sector risks can be at crises’ origins. Sovereigns are susceptible to various risks and uncertainties relating to their financial assets and liabilities, depending on the country’s level of economic and financial development. Typically, emerging market sovereigns face increased market exposure of their net foreign asset and debt portfolios, especially as they expand access to domestic and international capital markets. Many frontier market sovereigns are exposed to risks arising from terms-of-trade shocks and changes in debt refinancing terms, and tend to be more vulnerable to exogenous shocks than other countries.
Advanced markets face market risk exposure as well, particularly those that rely on capital market access and are systemically important issuers of public debt. In addition, they face other financial risks associated with an aging population, structural issues that need reform ( health and pension), and contingent liabilities arising from systemically important financial or corporate firms, and or potentially weak financial sectors and/or subnational entities. These risks, if realized, could cause a significant fiscal and financial drain and a consequent fall in the country’s domestic absorption and potential output.
To help identify and manage effectively the key financial exposures, a sovereign asset and liability management (SALM) framework, based on the balance-sheet approach, can be employed. This framework can also be used to inform the macroeconomic and financial stability policy design. SALM focuses on managing and containing the financial risk exposure of the public sector as a whole, so as to preserve a sound balance sheet needed to support a sustainable policy path and economic growth. The SALM approach entails monitoring and quantifying the impact of movements in exchange rates, interest rates, inflation, and commodity prices on sovereign assets and liabilities and identifying other debt-related vulnerabilities (Rosenberg et al., 2005) in a coordinated if not an integrated way (Figure 1).
The SALM approach can also be utilized to facilitate a country’s long-term macroeconomic and developmental objectives such as economic diversification, broadening of the export market, or reducing the dependence on key import products. Further, the SALM approach can help identify long-term fiscal challenges, such as unfunded social security liabilities, implying a future claim on resources (Traa and Carare, 2007). In this context, the SALM framework forms an integral part of an overall macroeconomic management strategy (e.g., Au-Yeung et al., 2006, Bolder, 2002, CREF South Africa, 1995, Danmarks Nationalbank, 2000, Grimes, 2001, Horman, 2002).
For commodity-exporting countries, the SALM approach can highlight the potential asset management challenges that stem from a medium-term fiscal strategy (Leigh and Olters, 2006). For example, high commodity prices lead to higher revenues, concurrently strengthening their (unadjusted) fiscal positions. However, commodity depletion leads to lower future revenues, which could be mitigated with appropriate asset management to ensure that future fiscal expenditures are sustainable.
From a portfolio perspective, the SALM approach could help detect sovereign risk exposures. It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources ((Claessens, 2005; Lu, Papaioannou, and Petrova, 2007; Zacho, 2006). If the match of financial characteristics of the assets and liabilities is only partial, risk management could focus on the unmatched portions, i.e., net financial positions. In a short- to medium-term perspective, a financial risk management strategy could then be developed to reduce exposures. For example, if the net position results in a liability exposure, appropriate strategies should be developed to manage the risks associated with such exposure.
The application of the SALM framework could be constrained by a number of policy and institutional factors. Monetary policy objectives have an impact on SALM strategies, by affecting either market—interest rate and exchange rate—risk management or directly the size of the balance sheet. Fiscal policy objectives that aim at limiting annual debt service costs may put constraints on the duration and currency composition of public debt, since high shares of short-term debt are perceived to lead to greater volatility of service costs.
The structure of international and domestic capital markets also shapes the SALM implementation. Some developing countries cannot issue domestic debt because of illiquid and/or shallow domestic debt capital markets and a lack of a reliable local investor base. Their attempts to issue domestic-currency external debt have also not been well-received in international markets owing, in part, to their vulnerability to shocks, restrictions on foreign investors to buy local-currency debt (e.g., on type of instruments, minimum holding period), poor transparency, and/or a lack of interest rate and exchange rate hedging instruments.
In addition, some have argued that combining the management of sovereign assets and liabilities under one framework may not be optimal.5 Cassard and Folkerts-Landau (2000) points out a potential conflict of interest between monetary policy and debt management if a central bank assumes an operational role or actively participates in debt markets. For example, the central bank may be reluctant to increase the interest rates in the face of growing inflation concerns for fear of raising debt rollover costs. Also, the central bank’s intervention policy may be in conflict with its daily task of managing the liquidity of the foreign currency debt.
While risk management approaches for sovereigns may differ from those for the private sector (see Box 1), this paper discusses the salient features embedded in countries’ approaches to SALM, including main objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal debt and asset outcomes. These considerations are typically taken into account when developing an analytical SALM framework, which may evolve into an operational instrument for formulating asset and debt/liability management strategies. Also, the paper outlines common institutional requirements and constraints in implementing an SALM framework, and, based on select country experiences with the SALM approach, draws some stylized lessons and general policy guidelines on adopting an SALM approach.
Thursday, October 4, 2012
Macrofinancial Stress Testing - Principles and Practices - IMF Policy Paper
Macrofinancial Stress Testing - Principles and Practices
IMF Policy Paper
Oct 2012
http://www.imf.org/external/pp/longres.aspx?id=4702
Summary: The recent financial crisis drew unprecedented attention to the stress testing of financial institutions. On one hand, stress tests were criticized for having missed many of the vulnerabilities that led to the crisis. On the other, after the onset of the crisis, they were given a new role as crisis management tools to guide bank recapitalization and help restore confidence. This spurred an intense debate on the models, underlying assumptions, and uses of stress tests. Current stress testing practices, however, are not based on a systematic and comprehensive set of principles but have emerged from trial-and-error and often reflect constraints in human, technical, and data capabilities.
Macrofinancial Stress Testing - Principles and Practices—Background Material
IMF Policy Paper
Oct 2012
http://www.imf.org/external/pp/longres.aspx?id=4703
Summary: Staff conducted a survey of stress testing practices among selected national central banks and supervisory authorities. The online survey was undertaken in November 2011 as part of the preparatory work for the paper on ?Macrofinancial Stress Testing: Principles and Practices. The survey focused on stress testing for banks, which is more widespread and better established—and practices are therefore easier to compare across countries—but also included questions on stress testing for nonbank financial institutions.
IMF Policy Paper
Oct 2012
http://www.imf.org/external/pp/longres.aspx?id=4702
Summary: The recent financial crisis drew unprecedented attention to the stress testing of financial institutions. On one hand, stress tests were criticized for having missed many of the vulnerabilities that led to the crisis. On the other, after the onset of the crisis, they were given a new role as crisis management tools to guide bank recapitalization and help restore confidence. This spurred an intense debate on the models, underlying assumptions, and uses of stress tests. Current stress testing practices, however, are not based on a systematic and comprehensive set of principles but have emerged from trial-and-error and often reflect constraints in human, technical, and data capabilities.
Macrofinancial Stress Testing - Principles and Practices—Background Material
IMF Policy Paper
Oct 2012
http://www.imf.org/external/pp/longres.aspx?id=4703
Summary: Staff conducted a survey of stress testing practices among selected national central banks and supervisory authorities. The online survey was undertaken in November 2011 as part of the preparatory work for the paper on ?Macrofinancial Stress Testing: Principles and Practices. The survey focused on stress testing for banks, which is more widespread and better established—and practices are therefore easier to compare across countries—but also included questions on stress testing for nonbank financial institutions.
Tuesday, October 2, 2012
Banking and Trading. By Arnoud W.A. Boot and Lev Ratnovski
Banking and Trading. By Arnoud W.A. Boot and Lev Ratnovski
IMF Working Paper No. 12/238
Oct 2012
http://www.imfbookstore.org/IMFORG/9781475511215
Summary: We study the effects of a bank's engagement in trading. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large numbers). Trading is transactions-based: scalable, shortterm, capital constrained, and with the ability to generate risk from concentrated positions. When a bank engages in trading, it can use its ‘spare’ capital to profitablity expand the scale of trading. However, there are two inefficiencies. A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And a bank may use trading for risk-shifting. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepending of the financial markets in recent decades leads trading in banks to become increasingly risky, so that problems in managing and regulating trading in banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking.
Excerpts
We study the effects of a bank’s engagement in trading. We use the term “banking” to describe business with repeated, long-term clients (also called relationship banking), and “trading” for operations that do not rely on repeated interactions. This definition of trading thus includes not just taking positions for a bank’s own account — proprietary trading — but also other short-term activities that do not rely on private and soft information, e.g. originating and selling standardized loans. Both commercial and investment banks over the last decade have increasingly engaged in short-term trading. We need to understand the rationale for that, and the challenges that it poses.
Such challenges clearly exist. They are perhaps most vivid in Europe, where some large universal banks seem to have over-allocated resources to trading prior to the crisis, with consequent losses affecting their stability (e.g., UBS, see UBS, 2008; an earlier example is the failure of the Barings Bank due to trading in Singapore in 1995). In the United States, the development of universal banks was until recently restricted by the Glass-Steagall Act. Yet there are many examples of a shift of institutions into shortterm activities, with similar negative consequences. Since early 1980-s, many New York investment banks have turned the focus from traditional underwriting to short-term market-making and proprietary investments; these have often backfired during the crisis (Bear Stearns, Lehman Brothers, Merrill Lynch). Also, in 2000-s, commercial banks have used their franchise to expand into short-term activities, such as wholesale loan origination and funding (Washington Mutual, Wachovia), exposing themselves to risk. And post-Glass-Steagall, there is evidence of trading being a drain on commercial bank activities in newly created universal banks, such as Bank of America-Merrill Lynch. A 2012 loss related to the market activities in JP Morgan is another example. The banks’ short-term activities, especially proprietary trading, have received significant regulatory attention: the Volcker Rule in the Dodd-Frank Act in the U.S., and the Report of the Independent Commission on Banking (the so-called Vickers report) in the UK.
The interaction between banking and trading is a novel topic. The existing literature on universal banks focuses primarily on the interaction between lending and underwriting. Such interaction is relatively well-understood, and also was not at the forefront during the recent crisis. Our paper downplays the distinction between lending and underwriting: for us both could possibly represent examples of long-term, relationshipbased banking. We contrast them to short-term, individual transactions-based activities. We see a shift of relative emphasis towards such “trading” as one of the major developments in the financial sector (for sure prior to the crisis).
The focus on trading as a possibly detrimental activity in banks, and its difference from underwriting in this regard, is supported by emerging empirical evidence. Brunnermeier et al. (2012) show that trading can lead to a persistent loss of bank income following a negative shock. In contrast, underwriting, while more volatile than commercial banking, is not associated with persistent losses of profitability.
The key to our analysis is the observation that the relationship business is usually profitable and hence generates implicit capital, yet is not readily scalable. The trading activity on the other hand can be capital constrained and benefit from the spare capital available in the bank. Accordingly, relationship banks might expand into trading in order to use ‘spare’ capital. This funding (liability-side) synergy is akin to the assertions of practitioners that one can “take advantage of the balance sheet of the bank”.
Opening up banking to trading, however, creates frictions. We highlight two of them. One friction is time inconsistency in the allocation of capital between the longterm relationship banking business and the short-term trading activity. Banks may be tempted to shift too much resources to trading in a way that undermines the relationship franchise. Another friction is risk-shifting: the incentives to use trading to boost risk and benefit shareholders as residual claimants. As a result of these two factors, a bank can overexpose itself to trading, compared to what is socially optimal, or ex ante optimal for its shareholders.
Both problems become more acute when financial markets are deeper, allowing larger trading positions. This increases the misallocation of capital and enables the gambles of scale necessary for risk-shifting. The problems also become more acute when bank returns are lower. Both factors have been in play in the last 10-20 years. Consequently, the costs of trading in banks may have started to outweight its benefits. These frictions are likely to persist for the foreseeable future, so a regulatory response might be necessary.
Full text: http://www.imf.org/external/pubs/cat/longres.aspx?sk=40031.0
IMF Working Paper No. 12/238
Oct 2012
http://www.imfbookstore.org/IMFORG/9781475511215
Summary: We study the effects of a bank's engagement in trading. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large numbers). Trading is transactions-based: scalable, shortterm, capital constrained, and with the ability to generate risk from concentrated positions. When a bank engages in trading, it can use its ‘spare’ capital to profitablity expand the scale of trading. However, there are two inefficiencies. A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And a bank may use trading for risk-shifting. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepending of the financial markets in recent decades leads trading in banks to become increasingly risky, so that problems in managing and regulating trading in banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking.
Excerpts
We study the effects of a bank’s engagement in trading. We use the term “banking” to describe business with repeated, long-term clients (also called relationship banking), and “trading” for operations that do not rely on repeated interactions. This definition of trading thus includes not just taking positions for a bank’s own account — proprietary trading — but also other short-term activities that do not rely on private and soft information, e.g. originating and selling standardized loans. Both commercial and investment banks over the last decade have increasingly engaged in short-term trading. We need to understand the rationale for that, and the challenges that it poses.
Such challenges clearly exist. They are perhaps most vivid in Europe, where some large universal banks seem to have over-allocated resources to trading prior to the crisis, with consequent losses affecting their stability (e.g., UBS, see UBS, 2008; an earlier example is the failure of the Barings Bank due to trading in Singapore in 1995). In the United States, the development of universal banks was until recently restricted by the Glass-Steagall Act. Yet there are many examples of a shift of institutions into shortterm activities, with similar negative consequences. Since early 1980-s, many New York investment banks have turned the focus from traditional underwriting to short-term market-making and proprietary investments; these have often backfired during the crisis (Bear Stearns, Lehman Brothers, Merrill Lynch). Also, in 2000-s, commercial banks have used their franchise to expand into short-term activities, such as wholesale loan origination and funding (Washington Mutual, Wachovia), exposing themselves to risk. And post-Glass-Steagall, there is evidence of trading being a drain on commercial bank activities in newly created universal banks, such as Bank of America-Merrill Lynch. A 2012 loss related to the market activities in JP Morgan is another example. The banks’ short-term activities, especially proprietary trading, have received significant regulatory attention: the Volcker Rule in the Dodd-Frank Act in the U.S., and the Report of the Independent Commission on Banking (the so-called Vickers report) in the UK.
The interaction between banking and trading is a novel topic. The existing literature on universal banks focuses primarily on the interaction between lending and underwriting. Such interaction is relatively well-understood, and also was not at the forefront during the recent crisis. Our paper downplays the distinction between lending and underwriting: for us both could possibly represent examples of long-term, relationshipbased banking. We contrast them to short-term, individual transactions-based activities. We see a shift of relative emphasis towards such “trading” as one of the major developments in the financial sector (for sure prior to the crisis).
The focus on trading as a possibly detrimental activity in banks, and its difference from underwriting in this regard, is supported by emerging empirical evidence. Brunnermeier et al. (2012) show that trading can lead to a persistent loss of bank income following a negative shock. In contrast, underwriting, while more volatile than commercial banking, is not associated with persistent losses of profitability.
The key to our analysis is the observation that the relationship business is usually profitable and hence generates implicit capital, yet is not readily scalable. The trading activity on the other hand can be capital constrained and benefit from the spare capital available in the bank. Accordingly, relationship banks might expand into trading in order to use ‘spare’ capital. This funding (liability-side) synergy is akin to the assertions of practitioners that one can “take advantage of the balance sheet of the bank”.
Opening up banking to trading, however, creates frictions. We highlight two of them. One friction is time inconsistency in the allocation of capital between the longterm relationship banking business and the short-term trading activity. Banks may be tempted to shift too much resources to trading in a way that undermines the relationship franchise. Another friction is risk-shifting: the incentives to use trading to boost risk and benefit shareholders as residual claimants. As a result of these two factors, a bank can overexpose itself to trading, compared to what is socially optimal, or ex ante optimal for its shareholders.
Both problems become more acute when financial markets are deeper, allowing larger trading positions. This increases the misallocation of capital and enables the gambles of scale necessary for risk-shifting. The problems also become more acute when bank returns are lower. Both factors have been in play in the last 10-20 years. Consequently, the costs of trading in banks may have started to outweight its benefits. These frictions are likely to persist for the foreseeable future, so a regulatory response might be necessary.
Full text: http://www.imf.org/external/pubs/cat/longres.aspx?sk=40031.0
Friday, September 28, 2012
Current economic policies: pro and con
Today’s Economic Data. By Alan Krueger
The White House, September 27, 2012 11:57 AM EDT
http://www.whitehouse.gov/blog/2012/09/27/today-s-economic-data
More than the usual amount of economic statistics were released this morning. As a whole, today’s economic news shows that while we are still fighting back from the worst economic crisis since the Great Depression, we are making progress. We lost more than 8 million jobs and GDP contracted by almost 5 percent as a result of the Great Recession. We have more work to do, but incorporating today’s preliminary benchmark revision to the employment figures released by the Bureau of Labor Statistics with their earlier data indicates that the economy has added nearly 5.1 million private sector jobs, on net, over the past 30 months. BLS announced that total employment likely grew by 386,000 more jobs than previously announced during the 12 months from March 2011 to March 2012, and by 453,000 more private sector jobs in that same time period. In the past decade, the absolute difference between the preliminary and final benchmark revision has averaged 37,000 jobs.
We also saw revised data released today showing that real GDP grew in the second quarter of 2012 by 1.3 percent at an annual rate. Real GDP growth in the second quarter was revised down due, in part, to a downward revision to agriculture inventories as a result of the devastating drought our nation faced this summer. The Obama Administration continues to take all available steps to mitigate the impacts of the drought, and has called on Congress to pass a farm bill that would spur growth and provide rural Americans with the certainty they deserve. We also learned today that the advance report of durable goods orders declined in August, largely as a result of a decline in orders for transportation equipment. Excluding the volatile transportation category, durable goods orders fell by 1.6 percent.
Today’s news shows that we must do more to strengthen our economy and promote job creation. Over a year ago, President Obama proposed the American Jobs Act – a plan that independent economists have said would create up to 2 million jobs. The President will continue to push policies that will continue this progress we have made, including incentives to strengthen the American manufacturing industry, investments in our nation’s infrastructure, and the extension of the tax cuts for 98 percent of Americans and 97 percent of small businesses.
While we are still rebuilding our economy and working to recover from the worst crisis since the Great Depression, we are making progress and the last thing we should do is return to the economic policies that failed us in the past. The revisions announced in today’s reports are a reminder that economic data are subject to large revisions. As a whole the pattern of revisions suggest that the recession that began at the end of 2007 was deeper than initially reported, and the jobs recovery over the last 2.5 years has been a bit stronger than initially reported, although much work remains to be done to return to full employment.
-----------------------------------------------------
As Good As It Gets? WSJ Editorial
Growth of 1.7% isn't what Team Obama promised four years ago.The Wall Street Journal, September 28, 2012, page A16
http://online.wsj.com/article/SB10000872396390444813104578016873186217796.html
Excerpts:
Bob Schieffer: "The fact is, unemployment is up. It is higher than when [President Obama] came to office, the economy is still in the dump. Some people say that is reason enough to make a change."
Bill Clinton: "It is if you believe that we could have been fully healed in four years. I don't know a single serious economist who believes that as much damage as we had could have been healed."
CBS's "Face the Nation," September 23, 2012
---
[Growth Gap: http://si.wsj.net/public/resources/images/ED-AP847A_1obam_D_20120927170003.jpg]
Well, let's see. We can think of several serious people who said we could heal the economy in four years. There's Joe Biden, Nancy Pelosi, Harry Reid, Christina Romer, Jared Bernstein, Mark Zandi, and, most importantly, President Obama himself.
Mr. Obama told Americans in 2009 that if he did not turn around the economy in three years his Presidency would be "a one-term proposition." Joe Biden said three years ago that the $830 billion economic stimulus was working beyond his "wildest dreams" and he famously promised several months after the Obama stimulus was enacted that Americans would enjoy a "summer of recovery." That was more than three years ago.
In early 2009 soon-to-be White House economists Ms. Romer and Mr. Bernstein promised Congress that the stimulus would hold the unemployment rate below 7% and that by now it would be 5.6%. Instead the rate is 8.1%. The latest Census Bureau report says there are nearly seven million fewer full-time, year-round workers today than in 2007. The labor participation rate is the lowest since 1981.
So it has gone with nearly every prediction the President has made about where the economy would be today. Mr. Obama promised that the deficit would be cut in half in four years, but the fiscal 2012 deficit (estimated to be above $1 trillion) will be twice the 2008 deficit ($458 billion).
Mr. Obama said that his health-care plan would "cut the cost of a typical family's premium by up to $2,500 a year," but premiums for employer-sponsored family coverage have gone up $2,370 since 2009, according to the Kaiser Family Foundation.
He said that the linchpin for a growing economy would be renewable energy investment, and he promised to "create five million new jobs in solar, wind, geothermal" energy. Mr. Obama did invest some $9 billion in green energy, but his job estimate was off by at least a factor of 10 and today many solar and wind industry firms are fighting bankruptcy. The growth in domestic U.S. energy production that he now takes credit for has come almost entirely from the fossil fuels his Administration has done so much to obstruct.
There's nothing unusual about candidates making grandiose promises that don't come true. And it's a White House tradition to blame one's predecessor when things don't get better. (Usually these Presidents end up one-termers.)
The bad faith wasn't then. It's now. Mr. Obama really believed that government spending would unleash a robust recovery in employment and housing—an "economy built to last." Now that this hasn't happened and with the Congressional Budget Office predicting a possible recession for 2013, Team Obama claims these woeful results were the best that could have been expected.
The problem with this line is that every President who has inherited a recession in modern times has done better. (See nearby table.) Under Mr. Obama, measured on the basis of jobs, GDP growth and incomes, this has been by far the meekest recovery from the past 10 recessions.
When George W. Bush was elected, he inherited a mild recession from Mr. Clinton amid the bursting of the dot-com bubble, some $7 trillion of wealth eviscerated. Nine months later came the 9/11 terrorist attacks. Yet by 2003 the economy was growing by more than 3% and eight million jobs were created over the next four years.
The Administration and its acolytes claim that the nature of the 2008 financial collapse was different from past recessions, and that it can take up to a decade to restore growth after such a financial crisis. Economist Michael Bordo [http://online.wsj.com/article/SB10000872396390444506004577613122591922992.html] rebuts that claim with historical economic evidence nearby.
In reality, the biggest difference between this recovery and others hasn't been the nature of the crisis, but the nature of the policy prescriptions. Mr. Obama's chief anti-recession idea was a near trillion-dollar leap of faith in the Keynesian "multiplier" effect of government spending. It was the same approach that didn't work in the 1930s, didn't work in the 1970s, didn't work in 2008, and didn't work in such other nations as Japan. It didn't work again in 2009.
Ronald Reagan also inherited an economy loaded with problems. The stock market had been flat for 12 years, inflation rates neared 14%, and mortgage rates almost 20%. The recession he endured in 1981-82 to cure inflation sent unemployment to 10.8%, higher than Mr. Obama's peak of 10%. But the business and jobs recovery by early 1983 was rapid and lasted seven years.
Reagan used tax-rate cuts, disinflationary monetary policy and deregulation to reignite growth—more or less the opposite of the Obama policy mix. Liberals tried to explain the Reagan boom that they said would never happen by arguing that there was nothing unusual about the growth spurt after such a deep recession. So why didn't that happen this time?
When campaigning to be President in 1960, John F. Kennedy denounced slow growth under Eisenhower and Nixon and said "We can do bettah." Growth was 7.2% in 1959 and 2.5% in 1960. Since the recession ended under Mr. Obama, growth has been 2.4% in 2010, 1.8% in 2011 and, after Thursday's downward revision for the second quarter, 1.7% in 2012.
[...]
The White House, September 27, 2012 11:57 AM EDT
http://www.whitehouse.gov/blog/2012/09/27/today-s-economic-data
More than the usual amount of economic statistics were released this morning. As a whole, today’s economic news shows that while we are still fighting back from the worst economic crisis since the Great Depression, we are making progress. We lost more than 8 million jobs and GDP contracted by almost 5 percent as a result of the Great Recession. We have more work to do, but incorporating today’s preliminary benchmark revision to the employment figures released by the Bureau of Labor Statistics with their earlier data indicates that the economy has added nearly 5.1 million private sector jobs, on net, over the past 30 months. BLS announced that total employment likely grew by 386,000 more jobs than previously announced during the 12 months from March 2011 to March 2012, and by 453,000 more private sector jobs in that same time period. In the past decade, the absolute difference between the preliminary and final benchmark revision has averaged 37,000 jobs.
We also saw revised data released today showing that real GDP grew in the second quarter of 2012 by 1.3 percent at an annual rate. Real GDP growth in the second quarter was revised down due, in part, to a downward revision to agriculture inventories as a result of the devastating drought our nation faced this summer. The Obama Administration continues to take all available steps to mitigate the impacts of the drought, and has called on Congress to pass a farm bill that would spur growth and provide rural Americans with the certainty they deserve. We also learned today that the advance report of durable goods orders declined in August, largely as a result of a decline in orders for transportation equipment. Excluding the volatile transportation category, durable goods orders fell by 1.6 percent.
Today’s news shows that we must do more to strengthen our economy and promote job creation. Over a year ago, President Obama proposed the American Jobs Act – a plan that independent economists have said would create up to 2 million jobs. The President will continue to push policies that will continue this progress we have made, including incentives to strengthen the American manufacturing industry, investments in our nation’s infrastructure, and the extension of the tax cuts for 98 percent of Americans and 97 percent of small businesses.
While we are still rebuilding our economy and working to recover from the worst crisis since the Great Depression, we are making progress and the last thing we should do is return to the economic policies that failed us in the past. The revisions announced in today’s reports are a reminder that economic data are subject to large revisions. As a whole the pattern of revisions suggest that the recession that began at the end of 2007 was deeper than initially reported, and the jobs recovery over the last 2.5 years has been a bit stronger than initially reported, although much work remains to be done to return to full employment.
-----------------------------------------------------
As Good As It Gets? WSJ Editorial
Growth of 1.7% isn't what Team Obama promised four years ago.The Wall Street Journal, September 28, 2012, page A16
http://online.wsj.com/article/SB10000872396390444813104578016873186217796.html
Excerpts:
Bob Schieffer: "The fact is, unemployment is up. It is higher than when [President Obama] came to office, the economy is still in the dump. Some people say that is reason enough to make a change."
Bill Clinton: "It is if you believe that we could have been fully healed in four years. I don't know a single serious economist who believes that as much damage as we had could have been healed."
CBS's "Face the Nation," September 23, 2012
---
[Growth Gap: http://si.wsj.net/public/resources/images/ED-AP847A_1obam_D_20120927170003.jpg]
Well, let's see. We can think of several serious people who said we could heal the economy in four years. There's Joe Biden, Nancy Pelosi, Harry Reid, Christina Romer, Jared Bernstein, Mark Zandi, and, most importantly, President Obama himself.
Mr. Obama told Americans in 2009 that if he did not turn around the economy in three years his Presidency would be "a one-term proposition." Joe Biden said three years ago that the $830 billion economic stimulus was working beyond his "wildest dreams" and he famously promised several months after the Obama stimulus was enacted that Americans would enjoy a "summer of recovery." That was more than three years ago.
In early 2009 soon-to-be White House economists Ms. Romer and Mr. Bernstein promised Congress that the stimulus would hold the unemployment rate below 7% and that by now it would be 5.6%. Instead the rate is 8.1%. The latest Census Bureau report says there are nearly seven million fewer full-time, year-round workers today than in 2007. The labor participation rate is the lowest since 1981.
So it has gone with nearly every prediction the President has made about where the economy would be today. Mr. Obama promised that the deficit would be cut in half in four years, but the fiscal 2012 deficit (estimated to be above $1 trillion) will be twice the 2008 deficit ($458 billion).
Mr. Obama said that his health-care plan would "cut the cost of a typical family's premium by up to $2,500 a year," but premiums for employer-sponsored family coverage have gone up $2,370 since 2009, according to the Kaiser Family Foundation.
He said that the linchpin for a growing economy would be renewable energy investment, and he promised to "create five million new jobs in solar, wind, geothermal" energy. Mr. Obama did invest some $9 billion in green energy, but his job estimate was off by at least a factor of 10 and today many solar and wind industry firms are fighting bankruptcy. The growth in domestic U.S. energy production that he now takes credit for has come almost entirely from the fossil fuels his Administration has done so much to obstruct.
There's nothing unusual about candidates making grandiose promises that don't come true. And it's a White House tradition to blame one's predecessor when things don't get better. (Usually these Presidents end up one-termers.)
The bad faith wasn't then. It's now. Mr. Obama really believed that government spending would unleash a robust recovery in employment and housing—an "economy built to last." Now that this hasn't happened and with the Congressional Budget Office predicting a possible recession for 2013, Team Obama claims these woeful results were the best that could have been expected.
The problem with this line is that every President who has inherited a recession in modern times has done better. (See nearby table.) Under Mr. Obama, measured on the basis of jobs, GDP growth and incomes, this has been by far the meekest recovery from the past 10 recessions.
When George W. Bush was elected, he inherited a mild recession from Mr. Clinton amid the bursting of the dot-com bubble, some $7 trillion of wealth eviscerated. Nine months later came the 9/11 terrorist attacks. Yet by 2003 the economy was growing by more than 3% and eight million jobs were created over the next four years.
The Administration and its acolytes claim that the nature of the 2008 financial collapse was different from past recessions, and that it can take up to a decade to restore growth after such a financial crisis. Economist Michael Bordo [http://online.wsj.com/article/SB10000872396390444506004577613122591922992.html] rebuts that claim with historical economic evidence nearby.
In reality, the biggest difference between this recovery and others hasn't been the nature of the crisis, but the nature of the policy prescriptions. Mr. Obama's chief anti-recession idea was a near trillion-dollar leap of faith in the Keynesian "multiplier" effect of government spending. It was the same approach that didn't work in the 1930s, didn't work in the 1970s, didn't work in 2008, and didn't work in such other nations as Japan. It didn't work again in 2009.
Ronald Reagan also inherited an economy loaded with problems. The stock market had been flat for 12 years, inflation rates neared 14%, and mortgage rates almost 20%. The recession he endured in 1981-82 to cure inflation sent unemployment to 10.8%, higher than Mr. Obama's peak of 10%. But the business and jobs recovery by early 1983 was rapid and lasted seven years.
Reagan used tax-rate cuts, disinflationary monetary policy and deregulation to reignite growth—more or less the opposite of the Obama policy mix. Liberals tried to explain the Reagan boom that they said would never happen by arguing that there was nothing unusual about the growth spurt after such a deep recession. So why didn't that happen this time?
When campaigning to be President in 1960, John F. Kennedy denounced slow growth under Eisenhower and Nixon and said "We can do bettah." Growth was 7.2% in 1959 and 2.5% in 1960. Since the recession ended under Mr. Obama, growth has been 2.4% in 2010, 1.8% in 2011 and, after Thursday's downward revision for the second quarter, 1.7% in 2012.
[...]
Sheila Bair: 'Insolvent Institutions Should Be Closed'
Sheila Bair: 'Insolvent Institutions Should Be Closed.' By Robert L Pollock
Political Diary
Wall Street Journal, September 27, 2012, 12:28 p.m. ET
http://online.wsj.com/article/SB10000872396390443328404578022363414879722.html
If you were one of the people scratching your forehead in 2008 as the federal government bailed out Bear Stearns, let Lehman Brothers fail, and then showered hundreds of billions of dollars on the banking system to avert the alleged threat of a "systemic" collapse, you were hardly alone. In fact Sheila Bair, then head of the Federal Deposit Insurance Corporation, shared many of your concerns.
Ms. Bair stopped by the Journal Wednesday as part of a tour to promote her new book on the financial crisis. The headline revelations: She was very skeptical about why the likes of Citibank were deemed worthy of moving heaven and earth to save, and she also doesn't quite understand what Tim Geithner and Hank Paulson were talking about when they used the phrase "systemically important" institutions.
Of Mr. Geithner and Citi, Ms. Bair said you just have to "look at his phone logs" to see the outsized concern he had with preserving the financial giant. He was talking with Citi CEO Vikram Pandit a lot, she says. You got the impression "he was going to stand behind Citi management no matter what . . .. He viewed me as a threat with my desire to impose losses on bondholders."
So what would Ms. Bair have done? "At least make them clean up their balance sheet," instead of just throwing money at them. "If our system is so fragile that a blatantly mismanaged, poorly run bank can't be subject to some market discipline because the whole system is gonna come down, let's just socialize everything."
"It was a joke" what happened, Ms. Bair continued. Now "they're a zombie bank," like so many Japanese financial institutions.
So does Ms. Bair think the concept of systemic risk makes any sense at all? "I think it's a really, really overused word. It's never backed with analysis. It's just 'You gotta do this because it's the system.' I think if you're throwing government money around" you better have a good explanation why letting an institution fail through the normal FDIC process would be a problem.
Ms. Bair's radical alternative to panicked and inconsistent decision making in Washington? "The insolvent institutions should be closed."
"The original sin was with Bear Stearns . . .. I've never seen a good analysis why Bearn Stearns was systemic," she says. But after Bear was bailed out in early 2008, the much bigger Lehman Brothers expected a bailout, too. When it didn't get one, the crisis of fall 2008 began in earnest. "There were so many missteps leading up to this that created market uncertainty."
Political Diary
Wall Street Journal, September 27, 2012, 12:28 p.m. ET
http://online.wsj.com/article/SB10000872396390443328404578022363414879722.html
If you were one of the people scratching your forehead in 2008 as the federal government bailed out Bear Stearns, let Lehman Brothers fail, and then showered hundreds of billions of dollars on the banking system to avert the alleged threat of a "systemic" collapse, you were hardly alone. In fact Sheila Bair, then head of the Federal Deposit Insurance Corporation, shared many of your concerns.
Ms. Bair stopped by the Journal Wednesday as part of a tour to promote her new book on the financial crisis. The headline revelations: She was very skeptical about why the likes of Citibank were deemed worthy of moving heaven and earth to save, and she also doesn't quite understand what Tim Geithner and Hank Paulson were talking about when they used the phrase "systemically important" institutions.
Of Mr. Geithner and Citi, Ms. Bair said you just have to "look at his phone logs" to see the outsized concern he had with preserving the financial giant. He was talking with Citi CEO Vikram Pandit a lot, she says. You got the impression "he was going to stand behind Citi management no matter what . . .. He viewed me as a threat with my desire to impose losses on bondholders."
So what would Ms. Bair have done? "At least make them clean up their balance sheet," instead of just throwing money at them. "If our system is so fragile that a blatantly mismanaged, poorly run bank can't be subject to some market discipline because the whole system is gonna come down, let's just socialize everything."
"It was a joke" what happened, Ms. Bair continued. Now "they're a zombie bank," like so many Japanese financial institutions.
So does Ms. Bair think the concept of systemic risk makes any sense at all? "I think it's a really, really overused word. It's never backed with analysis. It's just 'You gotta do this because it's the system.' I think if you're throwing government money around" you better have a good explanation why letting an institution fail through the normal FDIC process would be a problem.
Ms. Bair's radical alternative to panicked and inconsistent decision making in Washington? "The insolvent institutions should be closed."
"The original sin was with Bear Stearns . . .. I've never seen a good analysis why Bearn Stearns was systemic," she says. But after Bear was bailed out in early 2008, the much bigger Lehman Brothers expected a bailout, too. When it didn't get one, the crisis of fall 2008 began in earnest. "There were so many missteps leading up to this that created market uncertainty."
Wednesday, September 26, 2012
Assessing the Cost of Financial Regulation
Assessing the Cost of Financial Regulation. By Douglas Elliott, Suzanne Salloy, and André Oliveira Santos
IMF Working Paper No. 12/233
http://www.imfbookstore.org/IMFORG/9781475510836
Summary: This study assesses the overall impact on credit of the financial regulatory reforms in Europe, Japan, and the United States. Long-term cost estimates are provided for Basel III capital and liquidity requirements, derivatives reforms, and higher taxes and fees. Overall, average lending rates in the base case would rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States. These results are similar to the official BIS assessments of Basel III and an OECD analysis, but lower as a result of including expense cuts and reductions in the returns required by investors. As a result, they are markedly lower than those of the IIF.
Executive Summary:
Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.
There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF), a group sponsored by the financial industry, estimated the proposed reforms will reduce economic output in the advanced economies by approximately 3 percent during 2011–15. Official estimates suggest a much smaller drag.
Finding an intellectually sound consensus on the costs of reform is critical. If the true price is too high, reforms must be reassessed to improve the cost-benefit ratio. But, if reforms are economically sound, they should be pursued to increase safety and reduce the uncertainty about rules that creates inefficiencies and makes long-term planning difficult.
This study assesses the overall impact on credit of the global financial regulatory initiatives in, Europe, Japan, and the United States. It focuses on the long-term outcomes, rather than transitional costs, and does not attempt to measure the economic benefits of reforms. Academic theory is combined with empirical analyses from industry and official sources, plus financial disclosures by the major financial firms, to reach specific cost estimates. The analysis here does not address the significant adjustments triggered by the financial and Eurozone crises and the potential transitional effects of adjusting to the new regulations.
The study focuses principally on the effects of regulatory changes on banks and their lending. This is for three reasons: banks dominate finance; the reforms are heavily focused on them; and it is harder to estimate the effects on other parts of the system, such as capital markets. Loans, in particular, are a major part of overall credit provision and there is substantially greater data available on lending activities. Where possible, the study also looks at the effects of new regulations on securities holdings by banks and on securities markets.
Measuring the cost of financial reform requires careful consideration of the baselines for comparisons. They should incorporate the higher safety margins that would have been demanded by markets, customers, and managements after the financial crisis, even in the absence of new regulation. Some studies take the approach of assuming all the increases in safety margins are due to regulatory changes, exaggerating the cost of reforms.
A simple model is used to estimate the increase in lending rates required to accommodate the various reforms. The model assumes credit providers need to charge for the combination of: the cost of allocated capital; the cost of other funding; credit losses; administrative costs, and certain miscellaneous factors. The study establishes initial values for these key variables, determines how they would change under regulatory reform, and evaluates the changes in credit pricing and other variables needed to rebalance the equation. Cost estimates are provided for capital and liquidity requirements, derivatives reforms, and the effects of higher taxes and fees. These categories were chosen after a detailed qualitative assessment of the relative impact of different reforms on credit costs.
Securitization reform was initially chosen as well, but proved impossible to quantify. Finally, an overall, integrated cost estimate is developed. This involves examining the interactions between these categories and including the effects of mitigating actions likely to be taken by the financial institutions as a result of the reforms in totality. This includes, for example, the room for expense cuts to counteract the need for price increases, to the extent that such cuts were not already included in stand-alone impact estimates.
Lending rates in the base case rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States, in the long run. There is considerable uncertainty about the true cost levels, but a sensitivity analysis shows reasonable changes in assumptions do not alter the conclusions dramatically. The results are broadly in line with previous studies from the official sector, partially because similar methodologies are employed. This paper finds similar first-order effects to the official BIS assessments of Basel III (BCBS (2010) and MAG (2010)) and the analysis at the OECD by Slovik and Cournède (2010). The cost estimates here are, however, markedly lower than those of the IIF.
Three extensions of the methodologies from the official studies, though, lead to substantially lower net costs. The base case shows increases in lending rates of roughly a third to a half of those found in the BIS and OECD studies, despite important commonalities in the core modeling approaches with these studies. First, the baselines chosen here assume a greater hike in safety margins due to market forces, and therefore less of a regulatory effect, than the OECD and IIF studies. (The BIS studies do not reach firm conclusions on the additional capital needs). Industry actions through end-2010 suggest that market forces alone would have produced reactions similar to what was witnessed to that point, even if no regulatory changes were contemplated.
Second, this paper assumes that banks will also react by reducing costs and taking certain other measures that have little effect on credit prices and availability, in addition to the actions assumed in the other studies. The official studies do not do so and the IIF study assumes a fairly low level of change. This accounts for 13 bps of cost reduction in Europe, 10 bps in Japan, and 20 bps in the United States. Third, this paper assumes that equity investors will reduce their required rate of return on bank equity as a result of the safety improvements. Debt investors are assumed to follow suit, although to a much lesser extent. The official studies assume no benefit from investor reactions, for conservatism, and the IIF assumes the benefits, although real, will arise over a longer time-frame than is covered by their projections.
There are important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, therefore not adding unnecessary costs. Despite these limitations, the results appear to be a balanced, albeit rough, assessment of the likely effects on credit. Further research would be useful to translate the credit impacts into effects on economic output.
Again, all of the analysis is based on the long-run outcome, not taking account of a transition being made in today’s troubled circumstances. To the extent that bank capital or liquidity is difficult or very expensive to raise during the transition period—as they are currently in Europe, a reduction in credit supply would be expected and any increase in lending rates would be magnified, perhaps substantially. Deleveraging is clearly occurring at European banks under today’s conditions in response to financial market, economic, regulatory, and political factors. It is impossible to tell whether any appreciable portion of this reaction is due to anticipation of the Basel III rules. Regardless of the transitional effects, it will be possible, over time, for banks to find the necessary capital and liquidity to provide credit, as long as the pricing is appropriate. Capital and liquidity will flow to banks from other sectors if the price of credit rises more than is justified by the fundamental underlying factors.
The relatively small effects found here strongly suggest that the benefits would indeed outweigh the costs of regulatory reforms in the long run. Banks have a great ability to adapt over time to the reforms without radical actions harming the wider economy.
Full text: http://www.imf.org/external/pubs/cat/longres.aspx?sk=40021.0
IMF Working Paper No. 12/233
http://www.imfbookstore.org/IMFORG/9781475510836
Summary: This study assesses the overall impact on credit of the financial regulatory reforms in Europe, Japan, and the United States. Long-term cost estimates are provided for Basel III capital and liquidity requirements, derivatives reforms, and higher taxes and fees. Overall, average lending rates in the base case would rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States. These results are similar to the official BIS assessments of Basel III and an OECD analysis, but lower as a result of including expense cuts and reductions in the returns required by investors. As a result, they are markedly lower than those of the IIF.
Executive Summary:
Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.
There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF), a group sponsored by the financial industry, estimated the proposed reforms will reduce economic output in the advanced economies by approximately 3 percent during 2011–15. Official estimates suggest a much smaller drag.
Finding an intellectually sound consensus on the costs of reform is critical. If the true price is too high, reforms must be reassessed to improve the cost-benefit ratio. But, if reforms are economically sound, they should be pursued to increase safety and reduce the uncertainty about rules that creates inefficiencies and makes long-term planning difficult.
This study assesses the overall impact on credit of the global financial regulatory initiatives in, Europe, Japan, and the United States. It focuses on the long-term outcomes, rather than transitional costs, and does not attempt to measure the economic benefits of reforms. Academic theory is combined with empirical analyses from industry and official sources, plus financial disclosures by the major financial firms, to reach specific cost estimates. The analysis here does not address the significant adjustments triggered by the financial and Eurozone crises and the potential transitional effects of adjusting to the new regulations.
The study focuses principally on the effects of regulatory changes on banks and their lending. This is for three reasons: banks dominate finance; the reforms are heavily focused on them; and it is harder to estimate the effects on other parts of the system, such as capital markets. Loans, in particular, are a major part of overall credit provision and there is substantially greater data available on lending activities. Where possible, the study also looks at the effects of new regulations on securities holdings by banks and on securities markets.
Measuring the cost of financial reform requires careful consideration of the baselines for comparisons. They should incorporate the higher safety margins that would have been demanded by markets, customers, and managements after the financial crisis, even in the absence of new regulation. Some studies take the approach of assuming all the increases in safety margins are due to regulatory changes, exaggerating the cost of reforms.
A simple model is used to estimate the increase in lending rates required to accommodate the various reforms. The model assumes credit providers need to charge for the combination of: the cost of allocated capital; the cost of other funding; credit losses; administrative costs, and certain miscellaneous factors. The study establishes initial values for these key variables, determines how they would change under regulatory reform, and evaluates the changes in credit pricing and other variables needed to rebalance the equation. Cost estimates are provided for capital and liquidity requirements, derivatives reforms, and the effects of higher taxes and fees. These categories were chosen after a detailed qualitative assessment of the relative impact of different reforms on credit costs.
Securitization reform was initially chosen as well, but proved impossible to quantify. Finally, an overall, integrated cost estimate is developed. This involves examining the interactions between these categories and including the effects of mitigating actions likely to be taken by the financial institutions as a result of the reforms in totality. This includes, for example, the room for expense cuts to counteract the need for price increases, to the extent that such cuts were not already included in stand-alone impact estimates.
Lending rates in the base case rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States, in the long run. There is considerable uncertainty about the true cost levels, but a sensitivity analysis shows reasonable changes in assumptions do not alter the conclusions dramatically. The results are broadly in line with previous studies from the official sector, partially because similar methodologies are employed. This paper finds similar first-order effects to the official BIS assessments of Basel III (BCBS (2010) and MAG (2010)) and the analysis at the OECD by Slovik and Cournède (2010). The cost estimates here are, however, markedly lower than those of the IIF.
Three extensions of the methodologies from the official studies, though, lead to substantially lower net costs. The base case shows increases in lending rates of roughly a third to a half of those found in the BIS and OECD studies, despite important commonalities in the core modeling approaches with these studies. First, the baselines chosen here assume a greater hike in safety margins due to market forces, and therefore less of a regulatory effect, than the OECD and IIF studies. (The BIS studies do not reach firm conclusions on the additional capital needs). Industry actions through end-2010 suggest that market forces alone would have produced reactions similar to what was witnessed to that point, even if no regulatory changes were contemplated.
Second, this paper assumes that banks will also react by reducing costs and taking certain other measures that have little effect on credit prices and availability, in addition to the actions assumed in the other studies. The official studies do not do so and the IIF study assumes a fairly low level of change. This accounts for 13 bps of cost reduction in Europe, 10 bps in Japan, and 20 bps in the United States. Third, this paper assumes that equity investors will reduce their required rate of return on bank equity as a result of the safety improvements. Debt investors are assumed to follow suit, although to a much lesser extent. The official studies assume no benefit from investor reactions, for conservatism, and the IIF assumes the benefits, although real, will arise over a longer time-frame than is covered by their projections.
There are important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, therefore not adding unnecessary costs. Despite these limitations, the results appear to be a balanced, albeit rough, assessment of the likely effects on credit. Further research would be useful to translate the credit impacts into effects on economic output.
Again, all of the analysis is based on the long-run outcome, not taking account of a transition being made in today’s troubled circumstances. To the extent that bank capital or liquidity is difficult or very expensive to raise during the transition period—as they are currently in Europe, a reduction in credit supply would be expected and any increase in lending rates would be magnified, perhaps substantially. Deleveraging is clearly occurring at European banks under today’s conditions in response to financial market, economic, regulatory, and political factors. It is impossible to tell whether any appreciable portion of this reaction is due to anticipation of the Basel III rules. Regardless of the transitional effects, it will be possible, over time, for banks to find the necessary capital and liquidity to provide credit, as long as the pricing is appropriate. Capital and liquidity will flow to banks from other sectors if the price of credit rises more than is justified by the fundamental underlying factors.
The relatively small effects found here strongly suggest that the benefits would indeed outweigh the costs of regulatory reforms in the long run. Banks have a great ability to adapt over time to the reforms without radical actions harming the wider economy.
Full text: http://www.imf.org/external/pubs/cat/longres.aspx?sk=40021.0
Dodd-Frank's 'Orderly Liquidation' Is Out of Order. By Scott Pruitt and Alan Wilson
Dodd-Frank's 'Orderly Liquidation' Is Out of Order. By Scott Pruitt and Alan Wilson
South Carolina, Oklahoma and Michigan join a federal lawsuit to uphold property rights and checks and balances.The Wall Street Journal, September 25, 2012, 7:14 p.m. ET
http://online.wsj.com/article/SB10000872396390444180004578016953529778498.html?mod=WSJ_Opinion_LEFTTopOpinion
'The tendency of the law must always be to narrow the field of uncertainty." Justice Oliver Wendell Holmes wrote that more than a century ago, but the sentiment runs all the way to our nation's roots. Under our Constitution, the rule of law provides the certainty and transparency necessary to protect individual liberty and support economic growth.
But the 2010 federal financial-reform law known as Dodd-Frank continues to undermine economic growth and the rule of law by injecting immense uncertainty into our economy. As law professor David Skeel demonstrated recently in these pages, the law's Title II gives the Treasury secretary and the Federal Deposit Insurance Corp. unprecedented authority to "liquidate" financial companies. This grants immense power to a handful of unelected federal bureaucrats, empowering them to pick winners and losers among a liquidated company's investors. This arrangement destroys rights long protected by bankruptcy law.
For that reason and others, the attorneys general of South Carolina, Oklahoma and Michigan last week joined a federal lawsuit challenging Dodd-Frank's unconstitutional "orderly liquidation" provisions. Dodd-Frank's elimination of investors' rights directly harms our states because state pension funds are partly invested in financial companies. We must raise these constitutional objections now because once a company is liquidated, it will be too late.
Title II eliminates all meaningful judicial review and due process. Once the Treasury secretary orders the liquidation of a financial company, the company has only 24 hours to convince a federal court to overturn that order. Unless the court somehow manages to decide the entire case in the company's favor before the clock expires, the government wins by default and can begin to liquidate the company even as appeals are pending. Dodd-Frank further limits the authority of the courts by prohibiting them from reviewing whether the Treasury secretary's decision was constitutional, or whether the liquidation is actually necessary to protect financial stability.
The Treasury secretary's largely unaccountable decisions in these cases will put investments at risk, and creditors won't know until it is too late. Dodd-Frank prohibits the company from disclosing the liquidation threat before the district court decides the case. Once the liquidation goes forward, the creditors' only recourse will be to plead their case before the FDIC, with minimal judicial review—meaning that creditors' recoveries are "likely to be close to zero," as bankruptcy scholars Douglas Baird and Edward Morrison have put it.
Even more disturbing is the possibility that a company might agree to be "liquidated" and rebuilt under a new banner—like "New Chrysler" replacing "Old Chrysler"—leaving its creditors no right to block the reorganization. Instead, creditors not favored by federal bureaucrats will have little choice but to accept the deal offered to them by the government in a black-box process.
When the federal government replaced "Old Chrysler" with "New Chrysler" in 2009, it told one set of Chrysler's creditors (Indiana's state pension funds) to swallow $6 million in losses. Indiana attempted to defend its employees' pensions in court, but the government shuttered "Old Chrysler" before the Supreme Court could hear Indiana State Police Pension Trust v. Chrysler. Our states face the same threat because they have invested in the debt of financial companies that can be liquidated under Dodd-Frank.
We have taken an oath to uphold the rule of law and defend the Constitution. We are determined to uphold that oath, including defending the Constitution against the overarching power of the federal government.
Our lawsuit attempts to defend the very heart of our Constitution's structure: By committing such broad power to federal bureaucrats and nullifying critical checks and balances, Dodd-Frank's "orderly liquidation" authority violates the Constitution's separation of powers, the Fifth Amendment's guarantee of due process, and the guarantee of "uniform" bankruptcy laws.
The president and Congress can easily repair these constitutional violations by amending Dodd-Frank, restoring the rights long protected by federal bankruptcy law and reaffirming the Constitution's checks and balances. Until then, we will vigorously defend the rule of law through this litigation. The hard-earned pension contributions and tax payments of our citizens deserve nothing less.
Mr. Pruitt is attorney general of Oklahoma. Mr. Wilson is attorney general of South Carolina.
South Carolina, Oklahoma and Michigan join a federal lawsuit to uphold property rights and checks and balances.The Wall Street Journal, September 25, 2012, 7:14 p.m. ET
http://online.wsj.com/article/SB10000872396390444180004578016953529778498.html?mod=WSJ_Opinion_LEFTTopOpinion
'The tendency of the law must always be to narrow the field of uncertainty." Justice Oliver Wendell Holmes wrote that more than a century ago, but the sentiment runs all the way to our nation's roots. Under our Constitution, the rule of law provides the certainty and transparency necessary to protect individual liberty and support economic growth.
But the 2010 federal financial-reform law known as Dodd-Frank continues to undermine economic growth and the rule of law by injecting immense uncertainty into our economy. As law professor David Skeel demonstrated recently in these pages, the law's Title II gives the Treasury secretary and the Federal Deposit Insurance Corp. unprecedented authority to "liquidate" financial companies. This grants immense power to a handful of unelected federal bureaucrats, empowering them to pick winners and losers among a liquidated company's investors. This arrangement destroys rights long protected by bankruptcy law.
For that reason and others, the attorneys general of South Carolina, Oklahoma and Michigan last week joined a federal lawsuit challenging Dodd-Frank's unconstitutional "orderly liquidation" provisions. Dodd-Frank's elimination of investors' rights directly harms our states because state pension funds are partly invested in financial companies. We must raise these constitutional objections now because once a company is liquidated, it will be too late.
Title II eliminates all meaningful judicial review and due process. Once the Treasury secretary orders the liquidation of a financial company, the company has only 24 hours to convince a federal court to overturn that order. Unless the court somehow manages to decide the entire case in the company's favor before the clock expires, the government wins by default and can begin to liquidate the company even as appeals are pending. Dodd-Frank further limits the authority of the courts by prohibiting them from reviewing whether the Treasury secretary's decision was constitutional, or whether the liquidation is actually necessary to protect financial stability.
The Treasury secretary's largely unaccountable decisions in these cases will put investments at risk, and creditors won't know until it is too late. Dodd-Frank prohibits the company from disclosing the liquidation threat before the district court decides the case. Once the liquidation goes forward, the creditors' only recourse will be to plead their case before the FDIC, with minimal judicial review—meaning that creditors' recoveries are "likely to be close to zero," as bankruptcy scholars Douglas Baird and Edward Morrison have put it.
Even more disturbing is the possibility that a company might agree to be "liquidated" and rebuilt under a new banner—like "New Chrysler" replacing "Old Chrysler"—leaving its creditors no right to block the reorganization. Instead, creditors not favored by federal bureaucrats will have little choice but to accept the deal offered to them by the government in a black-box process.
When the federal government replaced "Old Chrysler" with "New Chrysler" in 2009, it told one set of Chrysler's creditors (Indiana's state pension funds) to swallow $6 million in losses. Indiana attempted to defend its employees' pensions in court, but the government shuttered "Old Chrysler" before the Supreme Court could hear Indiana State Police Pension Trust v. Chrysler. Our states face the same threat because they have invested in the debt of financial companies that can be liquidated under Dodd-Frank.
We have taken an oath to uphold the rule of law and defend the Constitution. We are determined to uphold that oath, including defending the Constitution against the overarching power of the federal government.
Our lawsuit attempts to defend the very heart of our Constitution's structure: By committing such broad power to federal bureaucrats and nullifying critical checks and balances, Dodd-Frank's "orderly liquidation" authority violates the Constitution's separation of powers, the Fifth Amendment's guarantee of due process, and the guarantee of "uniform" bankruptcy laws.
The president and Congress can easily repair these constitutional violations by amending Dodd-Frank, restoring the rights long protected by federal bankruptcy law and reaffirming the Constitution's checks and balances. Until then, we will vigorously defend the rule of law through this litigation. The hard-earned pension contributions and tax payments of our citizens deserve nothing less.
Mr. Pruitt is attorney general of Oklahoma. Mr. Wilson is attorney general of South Carolina.
Monday, September 24, 2012
Benchmarking Financial Systems with a New Database - by Martin Cihak, Asli Demirgüç-Kunt, and Erik Feyen
Benchmarking Financial Systems with a New Database
By Martin Cihak, co-authors: Asli Demirgüç-Kunt, Erik Feyen
Mon, Sep 24, 2012 4:23pm
How do financial systems around the world stack up? Which one has the highest number of bank accounts per capita? Where in the world do we find the lowest interest rate spreads, and where are they the highest? Which country has the most active stock market? Has competition among banks increased or decreased in recent years? Are financial institutions and financial markets in developed economies more or less stable than those in developing ones? Answers to these and many other interesting questions can be found in the Global Financial Development Database, accompanying the 2013 Global Financial Development Report. Both the database and the report were published earlier this month.
The Global Financial Development Database is the most comprehensive publicly available dataset on financial development. It contains over 70 financial system indicators for more than 200 economies on an annual basis from 1960 to 2010. All these indicators are categorized in four broad categories: (a) size of financial institutions and markets (financial depth), (b) degree to which individuals can and do use financial services (access), (c) efficiency of financial intermediaries and markets in intermediating resources and facilitating financial transactions (efficiency), and (d) stability of financial institutions and markets (stability). The selection of these indicators, their detailed definitions and links between the empirical data and the conceptual literature on financial development are discussed in an underlying working paper.
Considerable effort was involved in collecting, cleaning and checking this unique database, which builds upon and improves upon several existing data sources. One of the earlier efforts in this area was the Database on Financial Development and Structure, introduced in Beck, Demirgüç-Kunt, and Levine (2000), and subsequently updated several times. The Global Financial Development Database extends, updates and recalculates these country-by-country indicators, many of which are based on underlying data for individual institutions and markets. (For completeness, the Database on Financial Development and Structure has now been updated again, to be consistent with the more comprehensive Global Financial Development Database.)
In addition to the large electronic file with the Global Financial Development Database, there is also a smaller, pocket version of the dataset, published as the Little Data Book on Financial Development. The booklet shows a subset of indicators for the four categories of financial system characteristics (depth, access, efficiency, and stability) explored in the main database. The data are shown for individual countries as well as for country groups.
Complete text: http://blogs.worldbank.org/allaboutfinance/benchmarking-financial-systems-with-a-new-database
By Martin Cihak, co-authors: Asli Demirgüç-Kunt, Erik Feyen
Mon, Sep 24, 2012 4:23pm
How do financial systems around the world stack up? Which one has the highest number of bank accounts per capita? Where in the world do we find the lowest interest rate spreads, and where are they the highest? Which country has the most active stock market? Has competition among banks increased or decreased in recent years? Are financial institutions and financial markets in developed economies more or less stable than those in developing ones? Answers to these and many other interesting questions can be found in the Global Financial Development Database, accompanying the 2013 Global Financial Development Report. Both the database and the report were published earlier this month.
The Global Financial Development Database is the most comprehensive publicly available dataset on financial development. It contains over 70 financial system indicators for more than 200 economies on an annual basis from 1960 to 2010. All these indicators are categorized in four broad categories: (a) size of financial institutions and markets (financial depth), (b) degree to which individuals can and do use financial services (access), (c) efficiency of financial intermediaries and markets in intermediating resources and facilitating financial transactions (efficiency), and (d) stability of financial institutions and markets (stability). The selection of these indicators, their detailed definitions and links between the empirical data and the conceptual literature on financial development are discussed in an underlying working paper.
Considerable effort was involved in collecting, cleaning and checking this unique database, which builds upon and improves upon several existing data sources. One of the earlier efforts in this area was the Database on Financial Development and Structure, introduced in Beck, Demirgüç-Kunt, and Levine (2000), and subsequently updated several times. The Global Financial Development Database extends, updates and recalculates these country-by-country indicators, many of which are based on underlying data for individual institutions and markets. (For completeness, the Database on Financial Development and Structure has now been updated again, to be consistent with the more comprehensive Global Financial Development Database.)
In addition to the large electronic file with the Global Financial Development Database, there is also a smaller, pocket version of the dataset, published as the Little Data Book on Financial Development. The booklet shows a subset of indicators for the four categories of financial system characteristics (depth, access, efficiency, and stability) explored in the main database. The data are shown for individual countries as well as for country groups.
Complete text: http://blogs.worldbank.org/allaboutfinance/benchmarking-financial-systems-with-a-new-database
Wednesday, September 19, 2012
New Report Aims to Improve the Science Behind Regulatory Decision-Making
New Report Aims to Improve the Science Behind Regulatory Decision-Making
http://www.americanchemistry.com/Media/PressReleasesTranscripts/ACC-news-releases/New-Report-Aims-to-Improve-the-Science-Behind-Regulatory-Decision-Making.html
WASHINGTON, D.C. (September 18, 2012) – Scientists and policy experts from industry, government, and nonprofit sectors reached consensus on ways to improve the rigor and transparency of regulatory decision-making in a report being released today. The Research Integrity Roundtable, a cross-sector working group convened and facilitated by The Keystone Center, an independent public policy organization, is releasing the new report to improve the scientific analysis and independent expert reviews which underpin many important regulatory decisions. The report, Model Practices and Procedures for Improving the Use of Science in Regulatory Decision-Making, builds on the work of the Bipartisan Policy Center (BPC) in its 2009 report Science for Policy Project: Improving the Use of Science in Regulatory Policy.
"Americans need to have confidence in a U.S. regulatory system that encourages rational, science-based decision-making," said Mike Walls, Vice President of Regulatory and Technical Affairs for the American Chemistry Council (ACC), one of the sponsors of the Keystone Roundtable. "For this report, a broad spectrum of stakeholders came together to identify and help resolve some of the more troubling inconsistencies and roadblocks at the intersection of science and regulatory policy."
Controversies surrounding a regulatory decision often arise over the composition and transparency of scientific advisory panels and the scientific analysis used to support such decisions. The Roundtable's report is the product of 18 months of deliberations among experts from advocacy groups, professional associations and industry, as well as liaisons from several key Federal agencies. The report centers on two main public policy challenges that lead to controversy in the regulatory process: appointments of scientific experts, and the conduct of systematic scientific reviews.
The Roundtable's recommendations aim to improve the selection process for scientists on federal advisory panels and the scientific analysis used to draw conclusions that inform policy. The report seeks to maximize transparency and objectivity at every step in the regulatory decision-making process by informing the formation of scientific advisory committees and use of systematic reviews. The Roundtable's report offers specific recommendations for improving expert panel selection by better addressing potential conflicts of interest and bias. In addition, the report recommends ways to improve systematic reviews of scientific studies by outlining a step-by-step process, and by calling for clearer criteria to determine the relevance and credibility of studies.
"Conflicted experts and poor scientific assessments threaten the scientific integrity of agency decision making as well as the public's faith in agencies to protect their health and safety," said Francesca Grifo, Senior Scientist and Science Policy Fellow for the Union of Concerned Scientists. "Given the abundance of inflamed partisan dialogue around regulatory issues, it was refreshing to be a part of a rational and respectful roundtable. If adopted by agencies, the changes recommended in the report have the potential to reduce the ability of narrow interests to weaken regulations' power to protect the public good."
The Keystone Center and members of the Research Integrity Roundtable welcome additional conversations and dialogue on the matters explored in and recommendations presented in this report.
For more information, access the Roundtable's website at: www.Keystone.org/researchintegrity.
Friday, September 14, 2012
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
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
Thursday, September 13, 2012
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.
[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
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.
[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
Wednesday, September 12, 2012
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.
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.
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
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
Tuesday, September 11, 2012
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.
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.
Wednesday, September 5, 2012
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:
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:
- More from less. The earth has limited supplies of natural mineral, energy, water and food resources essential for human survival and maintaining lifestyles.
- Going, going ... gone? Many of the world's natural habitats, plant species and animal species are in decline or at risk of extinction.
- The silk highway. Coming decades will see the world economy shift from west to east and north to south.
- 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.
- 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.
- 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.
Friday, August 31, 2012
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.
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.
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.
Tuesday, August 28, 2012
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.
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.
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