Measuring Systemic Risk-Adjusted Liquidity (SRL) - A Model Approach. By Andreas Jobst
IMF Working Paper No. 12/209
Aug 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012209
Summary: Little progress has been made so far in addressing—in a comprehensive way—the externalities caused by impact of the interconnectedness within institutions and markets on funding and market liquidity risk within financial systems. The Systemic Risk-adjusted Liquidity (SRL) model combines option pricing with market information and balance sheet data to generate a probabilistic measure of the frequency and severity of multiple entities experiencing a joint liquidity event. It links a firm’s maturity mismatch between assets and liabilities impacting the stability of its funding with those characteristics of other firms, subject to individual changes in risk profiles and common changes in market conditions. This approach can then be used (i) to quantify an individual institution’s time-varying contribution to system-wide liquidity shortfalls and (ii) to price liquidity risk within a macroprudential framework that, if used to motivate a capital charge or insurance premia, provides incentives for liquidity managers to internalize the systemic risk of their decisions. The model can also accommodate a stress testing approach for institution-specific and/or general funding shocks that generate estimates of systemic liquidity risk (and associated charges) under adverse scenarios.
Excerpts:
A defining characteristic of the recent financial crisis was the simultaneous and widespread dislocation in funding markets, which can adversely affect financial stability in absence of suitable liquidity risk management and policy responses. In particular, banks’ common asset exposures and their increased reliance on short-term wholesale funding in tandem with high leverage levels helped propagate rising counterparty risk due to greater interdependence within the financial system. The implications from liquidity risk management decisions made by some institutions spilled over to other markets and other institutions, contributing to others’ losses, amplifying solvency concerns, and exacerbating overall liquidity stress as a result of these negative dynamics. Thus, private sector liquidity (as opposed to monetary liquidity), which is created largely through banks and other financial institutions via bilateral arrangements and organized trading venues, is invariably influenced by common channels of market pricing that can amplify cyclical movements in system-wide financial conditions with the potential of negative externalities resulting from individual actions (CGFS, 2011).
The opportunity cost of holding liquidity is invariably cyclical, resulting in a notorious underpricing of liquidity risk, which tends to perpetuate a disregard for the potential inability of markets to sustain sufficient liquidity transformation under stress. Banks have an incentive to minimize liquidity (and mitigate the opportunity cost of holding excess liquidity in lieu of return-generating assets) in anticipation that central banks will almost certainly intervene in times of stress as lenders-of-last-resort. Even without central bank support, liquidity risk is most expensive when it is needed most while generating little if any additional return in good times. While central banks can halt a deterioration of funding conditions in order to maintain the efficient operation of funding markets (see Figure 1), prevent financial firms from failing, and, thus, limit the impact of liquidity shortfalls on the real economy, their implicit subsidization of bank funding accentuates the magnitude of liquidity risks under stress. Central bank measures during the credit crisis have further reinforced this perception of contingent liquidity support, giving financial institutions an incentive to hold less liquidity than needed (IMF, 2010a).
Current systemic risk analysis—as a fundamental pillar of macroprudential surveillance and policy—is mostly focused on solvency conditions. Disruptions to the flow of financial services become systemic if there is the potential of financial instability to trigger serious negative spillovers to the real economy. Macroprudential policy aims to limit, mitigate or reduce systemic risk, thereby minimizing the incidence and impact of disruptions in the provision of key financial services that can have adverse consequences for the real economy (and broader implications for economic growth). Substantial work is underway to develop enhanced analytical tools that can help to identify and measure systemic risk in a forward-looking way, and, thus, support improved policy judgments. While systemic solvency risk has already entered the prudential debate in the form of additional capital rules that apply to systemically important financial institutions (SIFIs), little progress has been made so far in addressing systemic liquidity risk.
In contrast, proposals aimed at measuring and regulating systemic liquidity risk caused by the interconnectedness across financial institutions and financial markets have been few and far between. Systemic liquidity risk is associated with the possibility that maturity transformation in systemically important institutions and markets is disrupted by common shocks that overwhelm the capacity to fulfill all planned payment obligations as and when they come due. For instance, multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding (much less longterm funding). However, progress in developing a systemic liquidity risk framework have been hampered by the rarity of system-wide liquidity risk events, the multiplicity of interactions between institutions and funding markets, and the conceptual challenges in modeling liquidity conditions affecting institutions and transactions separately or jointly. The policy objective of such efforts would be to minimize the possibility of systemic risk from liquidity disruptions that necessitate costly public sector support. While a financial institution’s failure can cause an impairment of all or parts of the financial system, firms are not charged for the possibility that their risk-taking affects the operation of the financial system as a whole. In fact, individual actions might cause losses elsewhere in the system through direct credit exposures and financial guarantees, forced asset sales, and greater uncertainty regarding mutual exposures (possibly in combination with greater risk aversion of investors), which increases the cost of funding for all financial institutions. These “negative externalities” impose costs to the system, which increases the greater the importance of a single institution to the system (“too-important-to-fail”) and the higher the level of asymmetric information as coordination failures accentuate the impact of common shocks. Thus, more stringent prudential liquidity requirements, much like higher capital levels, might be beneficial ex ante by creating incentives of shareholders to limit excessive risk-taking, which would otherwise increase the potential loss in case of failure (Jensen and Meckling, 1976; Holmstrom and Tirole, 1997). However, certain liquidity standards might also encourage greater concentrations in assets that receive a more favorable regulatory treatment based on their liquidity characteristics during normal times (which remains to be tested during times of stress).
A number of prudential reforms and initiatives are underway to address shortcomings in financial institutions’ liquidity practices, which have resulted in more stringent supervisory liquidity requirements. Under the post-crisis revisions of the existing Basel Accord, known as Basel III, the Basel Committee on Banking Supervision (BCBS, 2010a, 2010b and 2009) has proposed two quantitative liquidity standards to be applied at a global level and published a qualitative guidance to strengthen liquidity risk management practices in banks. Under this proposal, individual banks are expected to maintain a stable funding structure, reduce maturity transformation, and hold a sufficient stock of assets that should be available to meet its funding needs in times of stress—as measured by two standardized ratios:
* Liquidity Coverage Ratio (LCR). This ratio is intended to promote short-term resilience to potential liquidity disruptions by requiring banks to hold sufficient highquality liquid assets to withstand the run-off of liabilities over a stressed 30-day scenario specified by supervisors. More specifically, “the LCR numerator consists of a stock of unencumbered, high-quality liquid assets that must be available to cover any net [cash] outflow, while the denominator is comprised of cash outflows less cash inflows (subject to a cap at 75 [percent] of total outflows) that are expected to occur in a severe stress scenario (BCBS, 2011 and 2012b).”
* Net Stable Funding Ratio (NSFR). This structural ratio limits the stock of unstable funding by encouraging longer term borrowing in order to restrict liquidity mismatches from excessive maturity transformation. It requires banks to establish a stable funding profile over the short term (i.e., the use of stable (long-term and/or stress-resilient) sources to continuously fund short-term cash flow obligations that arise from lending and investment activities). The NSFR reflects the proportion of long-term assets that are funded by stable sources of funding with maturities of more than one year (except deposits), which includes customer deposits, long-term wholesale funding, and equity (but excludes short-term funding). A value of this ratio of less than 100 percent indicates a shortfall in stable funding based on “the difference between balance sheet positions after the application of available stable funding factors and the application of required stable funding factors for banks where the former is less than the latter (BCBS, 2011 and 2012b).”
However, these prudential measures do not directly targeting system-wide implications. The current approach assumes that sufficient institutional liquidity would reduce the likelihood of knock-on effects on solvency conditions in distress situations and complement the risk absorption role of capital—but without considering system-wide effects. Larger liquidity buffers at each bank should lower the risk that multiple institutions will simultaneously face liquidity shortfalls, which would ensure that central banks are asked to perform only as lenders of last resort—and not as lenders of first resort. However, this rationale underpinning the Basel liquidity standards ignores the impact of the interconnectedness of various institutions and their diverse funding structures across a host of financial markets and jurisdictions on the probability of such simultaneous shortfalls. Moreover, in light of the protracted adoption of both the LCR and the NSFR (whose implementation is envisaged in 2015 and 2018, respectively) and the associated risk of undermining timely adjustment of industry standards, Perotti (2012) argues for strong transitional tools in the form of “prudential risk surcharges.” These would be imposed on the gap between current liquidity positions of banks and the envisaged minimum liquid standards at a level high enough to compensate for and discourage the creation of systemic risk in order to ensure early adoption of safer standards while offering sufficient flexibility of banks to chart their own path towards compliance.
An effective macroprudential approach that targets systemic liquidity risk presupposes the use of objective and meaningful measures that can be applied in a consistent and transparent fashion (and the attendant design of appropriate policy instruments). Ideally, any such methodology would need to allow for extensive back-testing and should benefit from straightforward application (and avoid complex modeling (or stress-testing)). While it should not be too data intensive to compute and implement, enough data would need to be collected to ensure the greatest possible coverage of financial intermediaries in order to accommodate different financial sector characteristics and supervisory regimes across national boundaries. In addition, the underlying measure of systemic risk should be time-varying, and, if possible, it should offset the procyclical tendencies of liquidity risk and account for changes to an institution’s risk contribution, which might not necessarily follow cyclical patterns. Finally, it would also motivate a risk-adjusted pricing scheme so that institutions that contribute to systemic liquidity risk are assigned a proportionately higher charge (while the opposite would hold true for firms that help absorb system-wide shocks from sudden increases in liquidity risk).
In this regard, several proposals are currently under discussion (see Table 1), including the internalization of public sector cost of liquidity risk via insurance schemes (Goodhart, 2009; Gorton and Metrick, 2009; Perotti and Suarez, 2009 and 2011), capital charges (Brunnermeier and Pedersen, 2009), taxation (Acharya and others, 2010a and 2010b), investment requirements (Cao and Illing, 2009; Farhi and others, 2009), as well as arrangements aimed at mitigating the system-wide effects from the fire sale liquidation of assets in via collateral haircuts (Valderrama, 2010) and modifications of resolution regimes (Roe, 2009; Acharya and Oncu, 2010). In particular, Gorton (2009) advocates a systemic liquidity risk insurance guarantee fee that explicitly recognizes the public sector cost of supporting secured funding markets if fragility were to materialize. Roe (2009) argues that the internalization of such cost would ideally be achieved by exposing the lenders to credit risk of the counterparty (and not just that of the collateral) by disallowing unrestricted access to collateral even in case of default of the counterparty. In this way, lenders would exercise greater effort in discriminating ex ante between safer and riskier borrowers. Such incentives could be supported by time-varying increase in liquidity requirements, which also curb credit expansion fueled by short-term and volatile wholesale funding and reduce dangerous reliance on such funding (Jácome and Nier, 2012).
In this paper, we propose a structural approach—the systemic risk-adjusted liquidity (SRL) model—for the structural assessment and stress testing of systemic liquidity risk. Although macroprudential surveillance relies primarily on prudential regulation and supervision, calibrated and used to limit systemic risk, additional measures and instruments are needed to directly address systemic liquidity risk. This paper underscores why more needs to be done to develop macroprudential techniques to measure and mitigate such risks arising from individual or collective financial arrangements—both institutional and marketbased—that could either lead directly to system-wide distress of institutions and/or significantly amplify its consequences. The SRL model complements the current Basel III liquidity framework by extending the prudential assessment of stable funding (based on the NSFR) to a system-wide approach, which can help substantiate different types of macroprudential tools, such as a capital surcharge, a fee, a tax, or an insurance premium that can be used to price contingent liquidity access.
The SRL model quantifies how the size and interconnectedness of individual institutions (with varying degrees of leverage and maturity mismatches defining their risk profile) can create short-term liquidity risk on a system-wide level and under distress conditions. The model combines quantity-based indicators of institution-specific funding liquidity (conditional on maturity mismatches and leverage), while adverse shocks to various market rates are used to alter the price-based measures of monetary and funding liquidity that, in turn, form the stress scenarios for systemic liquidity risk within the model (see Table 2 and Box 2). In this way, the SRL model fosters a better understanding of institutional vulnerabilities to the liquidity cycle and related build-ups of risks based on market rates that are available at high frequencies and which lend themselves to the identification of periods of heightened systemic liquidity risk (CGFS, 2011).
This approach forms the basis for a possible capital charge or an insurance premium—a pre-payment for the contingent (official) liquidity support that financial institutions eventually receive in times of joint distress—by identifying and measuring ways in which they contribute to aggregate risk over the short-term. Such a liquidity charge should reflect the marginal contribution of short-term funding decisions by institutions to the generation of systemic risk from the simultaneous realization of liquidity shortfalls. Proper pricing of the opportunity cost of holding insufficient liquidity—especially for very adverse funding situations—would help lower the scale of contingent liquidity support from the public sector (or collective burden sharing mechanisms). The charge needs to be risk-based, should be increasing in a common maturity mismatch of assets and liabilities, and would be applicable to all institutions with access to safety net guarantees. Since liquidity runs are present in the escalating phase of all systemic crises, our focus is on short-term wholesale liabilities, properly weighted by the bank's maturity mismatch.
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26203.0
Monday, August 27, 2012
Friday, August 24, 2012
Regulators Captured - WSJ Editorial about the SEC and money-market funds
Regulators Captured
The Wall Street Journal, August 24, 2012, on page A10
http://online.wsj.com/article/SB10000872396390444812704577607421541441692.html
Economist George Stigler described the process of "regulatory capture," in which government agencies end up serving the industries they are supposed to regulate. This week lobbyists for money-market mutual funds provided still more evidence that Stigler deserved his Nobel. At the Securities and Exchange Commission, three of the five commissioners blocked a critical reform to help prevent a taxpayer bailout like the one the industry received in 2008.
Assistant editorial page editor James Freeman on the SEC's nixing a proposed rule that would hold money market funds more accountable.
SEC rules have long allowed money-fund operators to employ an accounting fiction that makes their funds appear safer than they are. Instead of share prices that fluctuate, like other kinds of securities, money funds are allowed to report to customers a fixed net asset value (NAV) of $1 per share—even if that's not exactly true.
As long as the value of a fund's underlying assets doesn't stray too far from that magical figure, fund sponsors can present a picture of stability to customers. Money funds are often seen as competitors to bank accounts and now hold $1.6 trillion in assets.
But during times of crisis, as in 2008, investors are reminded how different money funds are from insured deposits. When one fund "broke the buck"—its asset value fell below $1 per share—it triggered an institutional run on all money funds. The Treasury responded by slapping a taxpayer guarantee on the whole industry.
SEC Chairman Mary Schapiro has been trying to eliminate this systemic risk by taking away the accounting fiction that was created when previous generations of lobbyists captured the SEC. She made the sensible case that money-fund prices should float like the securities they are.
But industry lobbyists are still holding hostages. Commissioners Luis Aguilar, Dan Gallagher and Troy Paredes refused to support reform, so taxpayers can expect someday a replay of 2008. True to the Stigler thesis, the debate has focused on how to maintain the current money-fund business model while preventing customers from leaving in a crisis. The SEC goal should be to craft rules so that when customers leave a fund, it is a problem for fund managers, not taxpayers.
The industry shrewdly lobbied Beltway conservatives, who bought the line that this was a defense against costly regulation, even though regulation more or less created the money-fund industry. Free-market think tanks have been taken for a ride, some of them all too willingly.
The big winners include dodgy European banks, which can continue to attract U.S. money funds chasing higher yields knowing the American taxpayer continues to offer an implicit guarantee.
The industry shouldn't celebrate too much, though, because regulation may now be imposed by the new Financial Stability Oversight Council. Federal Reserve and Treasury officials want to do something, and their preference will probably be more supervision and capital positions that will raise costs that the industry can pass along to consumers. By protecting the $1 fixed NAV, free-marketeers may have guaranteed more of the Dodd-Frank-style regulation they claim to abhor.
The losers include the efficiency and fairness of the U.S. economy, as another financial industry gets government to guarantee its business model. Congratulations.
The Wall Street Journal, August 24, 2012, on page A10
http://online.wsj.com/article/SB10000872396390444812704577607421541441692.html
Economist George Stigler described the process of "regulatory capture," in which government agencies end up serving the industries they are supposed to regulate. This week lobbyists for money-market mutual funds provided still more evidence that Stigler deserved his Nobel. At the Securities and Exchange Commission, three of the five commissioners blocked a critical reform to help prevent a taxpayer bailout like the one the industry received in 2008.
Assistant editorial page editor James Freeman on the SEC's nixing a proposed rule that would hold money market funds more accountable.
SEC rules have long allowed money-fund operators to employ an accounting fiction that makes their funds appear safer than they are. Instead of share prices that fluctuate, like other kinds of securities, money funds are allowed to report to customers a fixed net asset value (NAV) of $1 per share—even if that's not exactly true.
As long as the value of a fund's underlying assets doesn't stray too far from that magical figure, fund sponsors can present a picture of stability to customers. Money funds are often seen as competitors to bank accounts and now hold $1.6 trillion in assets.
But during times of crisis, as in 2008, investors are reminded how different money funds are from insured deposits. When one fund "broke the buck"—its asset value fell below $1 per share—it triggered an institutional run on all money funds. The Treasury responded by slapping a taxpayer guarantee on the whole industry.
SEC Chairman Mary Schapiro has been trying to eliminate this systemic risk by taking away the accounting fiction that was created when previous generations of lobbyists captured the SEC. She made the sensible case that money-fund prices should float like the securities they are.
But industry lobbyists are still holding hostages. Commissioners Luis Aguilar, Dan Gallagher and Troy Paredes refused to support reform, so taxpayers can expect someday a replay of 2008. True to the Stigler thesis, the debate has focused on how to maintain the current money-fund business model while preventing customers from leaving in a crisis. The SEC goal should be to craft rules so that when customers leave a fund, it is a problem for fund managers, not taxpayers.
The industry shrewdly lobbied Beltway conservatives, who bought the line that this was a defense against costly regulation, even though regulation more or less created the money-fund industry. Free-market think tanks have been taken for a ride, some of them all too willingly.
The big winners include dodgy European banks, which can continue to attract U.S. money funds chasing higher yields knowing the American taxpayer continues to offer an implicit guarantee.
The industry shouldn't celebrate too much, though, because regulation may now be imposed by the new Financial Stability Oversight Council. Federal Reserve and Treasury officials want to do something, and their preference will probably be more supervision and capital positions that will raise costs that the industry can pass along to consumers. By protecting the $1 fixed NAV, free-marketeers may have guaranteed more of the Dodd-Frank-style regulation they claim to abhor.
The losers include the efficiency and fairness of the U.S. economy, as another financial industry gets government to guarantee its business model. Congratulations.
Monday, August 20, 2012
The South China Sea's Gathering Storm. By James Webb, US Senator
The South China Sea's Gathering Storm. By James Webb
The Wall Street Journal, August 19, 2012, page A11
http://online.wsj.com/article/SB10000872396390444184704577587483914661256.html
Since World War II, despite the costly flare-ups in Korea and Vietnam, the United States has proved to be the essential guarantor of stability in the Asian-Pacific region, even as the power cycle shifted from Japan to the Soviet Union and most recently to China. The benefits of our involvement are one of the great success stories of American and Asian history, providing the so-called second tier countries in the region the opportunity to grow economically and to mature politically.
As the region has grown more prosperous, the sovereignty issues have become more fierce. Over the past two years Japan and China have openly clashed in the Senkaku Islands, east of Taiwan and west of Okinawa, whose administration is internationally recognized to be under Japanese control. Russia and South Korea have reasserted sovereignty claims against Japan in northern waters. China and Vietnam both claim sovereignty over the Paracel Islands. China, Vietnam, the Philippines, Brunei and Malaysia all claim sovereignty over the Spratly Islands, the site of continuing confrontations between China and the Philippines.
Such disputes involve not only historical pride but also such vital matters as commercial transit, fishing rights, and potentially lucrative mineral leases in the seas that surround the thousands of miles of archipelagos. Nowhere is this growing tension clearer than in the increasingly hostile disputes in the South China Sea.
On June 21, China's State Council approved the establishment of a new national prefecture which it named Sansha, with its headquarters on Woody Island in the Paracel Islands. Called Yongxing by the Chinese, Woody Island has no indigenous population and no natural water supply, but it does sport a military-capable runway, a post office, a bank, a grocery store and a hospital.
The Paracels are more than 200 miles southeast of Hainan, mainland China's southernmost territory, and due east of Vietnam's central coast. Vietnam adamantly claims sovereignty over the island group, the site of a battle in 1974 when China attacked the Paracels in order to oust soldiers of the former South Vietnamese regime.
The potential conflicts stemming from the creation of this new Chinese prefecture extend well beyond the Paracels. Over the last six weeks the Chinese have further proclaimed that the jurisdiction of Sansha includes not just the Paracel Islands but virtually the entire South China Sea, connecting a series of Chinese territorial claims under one administrative rubric. According to China's official news agency Xinhua, the new prefecture "administers over 200 islets" and "2 million square kilometers of water." To buttress this annexation, 45 legislators have been appointed to govern the roughly 1,000 people on these islands, along with a 15-member Standing Committee, plus a mayor and a vice mayor.
These political acts have been matched by military and economic expansion. On July 22, China's Central Military Commission announced that it would deploy a garrison of soldiers to guard the islands in the area. On July 31, it announced a new policy of "regular combat-readiness patrols" in the South China Sea. And China has now begun offering oil exploration rights in locations recognized by the international community as within Vietnam's exclusive economic zone.
For all practical purposes China has unilaterally decided to annex an area that extends eastward from the East Asian mainland as far as the Philippines, and nearly as far south as the Strait of Malacca. China's new "prefecture" is nearly twice as large as the combined land masses of Vietnam, South Korea, Japan and the Philippines. Its "legislators" will directly report to the central government.
American reaction has been muted. The State Department waited until Aug. 3 before expressing official concern over China's "upgrading of its administrative level . . . and establishment of a new military garrison" in the disputed areas. The statement was carefully couched within the context of long-standing policies calling for the resolution of sovereignty issues in accordance with international law and without the use of military force.
Even so, the Chinese government responded angrily, warning that State Department officials had "confounded right and wrong, and sent a seriously wrong message." The People's Daily, a quasi-official publication, accused the U.S. of "fanning the flames and provoking division, deliberately creating antagonism with China." Its overseas edition said it was time for the U.S. to "shut up."
In truth, American vacillations have for years emboldened China. U.S. policy with respect to sovereignty issues in Asian-Pacific waters has been that we take no sides, that such matters must be settled peacefully among the parties involved. Smaller, weaker countries have repeatedly called for greater international involvement.
China, meanwhile, has insisted that all such issues be resolved bilaterally, which means either never or only under its own terms. Due to China's growing power in the region, by taking no position Washington has by default become an enabler of China's ever more aggressive acts.
The U.S., China and all of East Asia have now reached an unavoidable moment of truth. Sovereignty disputes in which parties seek peaceful resolution are one thing; flagrant, belligerent acts are quite another. How this challenge is addressed will have implications not only for the South China Sea, but also for the stability of East Asia and for the future of U.S.-China relations.
History teaches us that when unilateral acts of aggression go unanswered, the bad news never gets better with age. Nowhere is this cycle more apparent than in the alternating power shifts in East Asia. As historian Barbara Tuchman noted in her biography of U.S. Army Gen. Joseph Stillwell, it was China's plea for U.S. and League of Nations support that went unanswered following Japan's 1931 invasion of Manchuria, a neglect that "brewed the acid of appeasement that . . . opened the decade of descent to war" in Asia and beyond.
While America's attention is distracted by the presidential campaign, all of East Asia is watching what the U.S. will do about Chinese actions in the South China Sea. They know a test when they see one. They are waiting to see whether America will live up to its uncomfortable but necessary role as the true guarantor of stability in East Asia, or whether the region will again be dominated by belligerence and intimidation.
The Chinese of 1931 understood this threat and lived through the consequences of an international community's failure to address it. The question is whether the China of 2012 truly wishes to resolve issues through acceptable international standards, and whether the America of 2012 has the will and the capacity to insist that this approach is the only path toward stability.
Mr. Webb, a Democrat, is a U.S. senator from Virginia.
The Wall Street Journal, August 19, 2012, page A11
http://online.wsj.com/article/SB10000872396390444184704577587483914661256.html
Since World War II, despite the costly flare-ups in Korea and Vietnam, the United States has proved to be the essential guarantor of stability in the Asian-Pacific region, even as the power cycle shifted from Japan to the Soviet Union and most recently to China. The benefits of our involvement are one of the great success stories of American and Asian history, providing the so-called second tier countries in the region the opportunity to grow economically and to mature politically.
As the region has grown more prosperous, the sovereignty issues have become more fierce. Over the past two years Japan and China have openly clashed in the Senkaku Islands, east of Taiwan and west of Okinawa, whose administration is internationally recognized to be under Japanese control. Russia and South Korea have reasserted sovereignty claims against Japan in northern waters. China and Vietnam both claim sovereignty over the Paracel Islands. China, Vietnam, the Philippines, Brunei and Malaysia all claim sovereignty over the Spratly Islands, the site of continuing confrontations between China and the Philippines.
Such disputes involve not only historical pride but also such vital matters as commercial transit, fishing rights, and potentially lucrative mineral leases in the seas that surround the thousands of miles of archipelagos. Nowhere is this growing tension clearer than in the increasingly hostile disputes in the South China Sea.
On June 21, China's State Council approved the establishment of a new national prefecture which it named Sansha, with its headquarters on Woody Island in the Paracel Islands. Called Yongxing by the Chinese, Woody Island has no indigenous population and no natural water supply, but it does sport a military-capable runway, a post office, a bank, a grocery store and a hospital.
The Paracels are more than 200 miles southeast of Hainan, mainland China's southernmost territory, and due east of Vietnam's central coast. Vietnam adamantly claims sovereignty over the island group, the site of a battle in 1974 when China attacked the Paracels in order to oust soldiers of the former South Vietnamese regime.
The potential conflicts stemming from the creation of this new Chinese prefecture extend well beyond the Paracels. Over the last six weeks the Chinese have further proclaimed that the jurisdiction of Sansha includes not just the Paracel Islands but virtually the entire South China Sea, connecting a series of Chinese territorial claims under one administrative rubric. According to China's official news agency Xinhua, the new prefecture "administers over 200 islets" and "2 million square kilometers of water." To buttress this annexation, 45 legislators have been appointed to govern the roughly 1,000 people on these islands, along with a 15-member Standing Committee, plus a mayor and a vice mayor.
These political acts have been matched by military and economic expansion. On July 22, China's Central Military Commission announced that it would deploy a garrison of soldiers to guard the islands in the area. On July 31, it announced a new policy of "regular combat-readiness patrols" in the South China Sea. And China has now begun offering oil exploration rights in locations recognized by the international community as within Vietnam's exclusive economic zone.
For all practical purposes China has unilaterally decided to annex an area that extends eastward from the East Asian mainland as far as the Philippines, and nearly as far south as the Strait of Malacca. China's new "prefecture" is nearly twice as large as the combined land masses of Vietnam, South Korea, Japan and the Philippines. Its "legislators" will directly report to the central government.
American reaction has been muted. The State Department waited until Aug. 3 before expressing official concern over China's "upgrading of its administrative level . . . and establishment of a new military garrison" in the disputed areas. The statement was carefully couched within the context of long-standing policies calling for the resolution of sovereignty issues in accordance with international law and without the use of military force.
Even so, the Chinese government responded angrily, warning that State Department officials had "confounded right and wrong, and sent a seriously wrong message." The People's Daily, a quasi-official publication, accused the U.S. of "fanning the flames and provoking division, deliberately creating antagonism with China." Its overseas edition said it was time for the U.S. to "shut up."
In truth, American vacillations have for years emboldened China. U.S. policy with respect to sovereignty issues in Asian-Pacific waters has been that we take no sides, that such matters must be settled peacefully among the parties involved. Smaller, weaker countries have repeatedly called for greater international involvement.
China, meanwhile, has insisted that all such issues be resolved bilaterally, which means either never or only under its own terms. Due to China's growing power in the region, by taking no position Washington has by default become an enabler of China's ever more aggressive acts.
The U.S., China and all of East Asia have now reached an unavoidable moment of truth. Sovereignty disputes in which parties seek peaceful resolution are one thing; flagrant, belligerent acts are quite another. How this challenge is addressed will have implications not only for the South China Sea, but also for the stability of East Asia and for the future of U.S.-China relations.
History teaches us that when unilateral acts of aggression go unanswered, the bad news never gets better with age. Nowhere is this cycle more apparent than in the alternating power shifts in East Asia. As historian Barbara Tuchman noted in her biography of U.S. Army Gen. Joseph Stillwell, it was China's plea for U.S. and League of Nations support that went unanswered following Japan's 1931 invasion of Manchuria, a neglect that "brewed the acid of appeasement that . . . opened the decade of descent to war" in Asia and beyond.
While America's attention is distracted by the presidential campaign, all of East Asia is watching what the U.S. will do about Chinese actions in the South China Sea. They know a test when they see one. They are waiting to see whether America will live up to its uncomfortable but necessary role as the true guarantor of stability in East Asia, or whether the region will again be dominated by belligerence and intimidation.
The Chinese of 1931 understood this threat and lived through the consequences of an international community's failure to address it. The question is whether the China of 2012 truly wishes to resolve issues through acceptable international standards, and whether the America of 2012 has the will and the capacity to insist that this approach is the only path toward stability.
Mr. Webb, a Democrat, is a U.S. senator from Virginia.
Thursday, August 2, 2012
Recovery and resolution of financial market infrastructures, consultative report issued by CPSS-IOSCO
Recovery and resolution of financial market infrastructures, consultative report issued by CPSS-IOSCO
July 31, 2012
http://www.bis.org/press/p120731.htm
The Committee on Payment and Settlement Systems (CPSS) and the
International Organization of Securities Commissions (IOSCO) have today
published for public comment a consultative report on the Recovery and resolution of financial market infrastructures.
Financial market infrastructures (FMIs) play an essential role in the global financial system. The disorderly failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Accordingly, all types of FMIs should generally be subject to regimes and strategies for recovery and resolution.
The CPSS-IOSCO Principles for financial market infrastructures (Principles) published in April 2012 require that FMIs have effective strategies, rules and procedures to enable them to recover from financial stresses. The Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) published in 2011 further require that jurisdictions establish resolution regimes to allow for the resolution of a financial institution in circumstances where recovery is no longer feasible. An effective resolution regime must enable resolution without systemic disruption or exposing the taxpayer to loss. To achieve this in the context of FMIs, relevant authorities must have powers to maintain an FMI's critical services.
The purpose of the report released today is to outline the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes that are consistent with the Principles and Key Attributes. The report also seeks consultees' views on a number of technical points related to these issues.
Paul Tucker, Deputy Governor, Financial Stability of the Bank of England and CPSS Chairman said, "The vital role of the financial system's infrastructure makes it essential that credible recovery plans and resolution regimes exist. FMIs need to be a source of strength and continuity for the financial markets they serve."
"This is even more important as a safeguard given the commitment made by G20 Leaders in 2009 that all standardised OTC derivatives should be cleared through central counterparties," added Masamichi Kono, Vice Commissioner for International Affairs, Financial Services Agency, Japan and Chairman of the IOSCO Board.
Amongst its conclusions, the report states that the Key Attributes will provide a framework for resolution of FMIs under a statutory resolution regime.
Published alongside the report is a cover note that lists the specific issues on which the committees seek comments during the public consultation period.
Comments on the report are invited from all interested parties and should be sent by 28 September 2012 (see note 1 below). After the consultation period, CPSS-IOSCO will report on how the methodology for assessing compliance with the Key Attributes, currently being prepared by the Financial Stability Board, should be revised to reflect FMI-specific elements taking into account the conclusions of this report and the comments received.
July 31, 2012
http://www.bis.org/press/p120731.htm
Financial market infrastructures (FMIs) play an essential role in the global financial system. The disorderly failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Accordingly, all types of FMIs should generally be subject to regimes and strategies for recovery and resolution.
The CPSS-IOSCO Principles for financial market infrastructures (Principles) published in April 2012 require that FMIs have effective strategies, rules and procedures to enable them to recover from financial stresses. The Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) published in 2011 further require that jurisdictions establish resolution regimes to allow for the resolution of a financial institution in circumstances where recovery is no longer feasible. An effective resolution regime must enable resolution without systemic disruption or exposing the taxpayer to loss. To achieve this in the context of FMIs, relevant authorities must have powers to maintain an FMI's critical services.
The purpose of the report released today is to outline the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes that are consistent with the Principles and Key Attributes. The report also seeks consultees' views on a number of technical points related to these issues.
Paul Tucker, Deputy Governor, Financial Stability of the Bank of England and CPSS Chairman said, "The vital role of the financial system's infrastructure makes it essential that credible recovery plans and resolution regimes exist. FMIs need to be a source of strength and continuity for the financial markets they serve."
"This is even more important as a safeguard given the commitment made by G20 Leaders in 2009 that all standardised OTC derivatives should be cleared through central counterparties," added Masamichi Kono, Vice Commissioner for International Affairs, Financial Services Agency, Japan and Chairman of the IOSCO Board.
Amongst its conclusions, the report states that the Key Attributes will provide a framework for resolution of FMIs under a statutory resolution regime.
Published alongside the report is a cover note that lists the specific issues on which the committees seek comments during the public consultation period.
Comments on the report are invited from all interested parties and should be sent by 28 September 2012 (see note 1 below). After the consultation period, CPSS-IOSCO will report on how the methodology for assessing compliance with the Key Attributes, currently being prepared by the Financial Stability Board, should be revised to reflect FMI-specific elements taking into account the conclusions of this report and the comments received.
Notes
- Comments on the report should be sent by 28 September 2012 to both the CPSS secretariat (cpss@bis.org) and the IOSCO secretariat (fmiresolution@iosco.org). The comments will be published on the websites of the BIS and IOSCO unless commentators have requested otherwise.
- The CPSS serves as a forum for central banks to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The CPSS secretariat is hosted by the BIS. More information about the CPSS, and all its publications, can be found on the BIS website at www.bis.org/cpss.
- IOSCO is an international policy forum for securities regulators. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns.
- Both committees are recognised as international standard-setting bodies by the Financial Stability Board (www.financialstabilityboard.org)
-
The documents are on the websites of the BIS at http://www.bis.org/publ/cpss103.htm and IOSCO at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD388.pdf.
-
The CPSS-IOSCO Principles for financial market infrastructures, can be found on the websites of the BIS at http://www.bis.org/publ/cpss101.htm and IOSCO at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf.
- The Financial Stability Board's Key attributes of effective resolution regimes for financial institutions can be found on the FSB's website at http://www.financialstabilityboard.org/publications/r_111104cc.pdf.
Tuesday, July 31, 2012
Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo
Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo
IMF Working Paper No. 12/194
Jul 31, 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012194
Summary: I construct a systemic liquidity risk index (SLRI) from data on violations of arbitrage relationships across several asset classes between 2004 and 2010. Then I test whether the equity returns of 53 global banks were exposed to this liquidity risk factor. Results show that the level of bank returns is not directly affected by the SLRI, but their volatility increases when liquidity conditions deteriorate. I do not find a strong association between bank size and exposure to the SLRI - measured as the sensitivity of volatility to the index. Surprisingly, exposure to systemic liquidity risk is positively associated with the Net Stable Funding Ratio (NSFR). The link between equity volatility and the SLRI allows me to calculate the cost that would be borne by public authorities for providing liquidity support to the financial sector. I use this information to estimate a liquidity insurance premium that could be paid by individual banks in order to cover for that social cost.
Excerpts:
Introduction
Liquidity risk has become a central topic for investors, regulators and academics in the aftermath of the global financial crisis. The sharp decline of real estate prices in the U.S. and parts of Europe and the consequent collapse in the values of related securities created widespread concerns about the solvency of banks and other financial intermediaries. The resulting increase in counterparty risk induced investors to shy away from risky short-term funding markets [Gorton and Metrick (2010)] and to store funds in safe and liquid assets, especially U.S. government debt. The dry-up in funding markets hit levered financial intermediaries involved in maturity and liquidity transformation hard [Brunnermeier (2009)], propagating the initial shock through global markets.
Central bankers in major countries responded to the contraction in liquidity by pumping an unprecendented amount of funds into securities and interbank markets, and by creating and extending liquidity backstop lines to rescue troubled financial intermediaries. Such measures have exposed public finances, and ultimately taxpayers, to the risk of substantial losses. Understanding the origins of systemic liquidity risk in financial markets is, therefore, an invaluable tool for policymakers to reduce the chance of facing these very same challenges again in the future. In particular, if public support in periods of widespread distress cannot be prevented—due to commitment problems—supervisors and regulators should ensure that financial intermediaries are properly monitored and charged to reflect the contingent benefits they enjoy.
The present paper brings three contributions to the topic of systemic liquidity risk:
1) It produces a systemic liquidity risk index (SLRI) calculated from violations of “arbitrage” relationships in various securities markets.
2) It estimates the exposure of 53 global banks to this aggregate risk factor.
3) It uses the information in 2) to devise an insurance system where banks pre-pay for the costs faced by public authorities for providing contingent liquidity support.
Results indicate that systemic illiquidity became a widespread problem in the aftermath of Lehman’s bankruptcy, and it only recovered after several months. Systemic liquidity risk spiked again during the Greek sovereign crisis in the second quarter of 2010, albeit at much more moderate levels. Yet, the renewed concerns regarding sovereign default in peripheral Europe observed in the last quarter of 2010 did not induce global liquidity shortfalls.
In terms of exposures of individual institutions, I find that, in general, systemic liquidity risk does not affect the level of bank stock returns on a systematic fashion. However, liquidity risk is strongly correlated with the volatility of bank stocks: system wide illiquidity is associated with riskier banks. Estimates also show that U.S. and U.K. banks were relatively more exposed to liquidity conditions compared to Japanese institutions, with continental European banks lying in the middle of the distribution. More specifically, the results indicate that U.S. and U.K. banks’ stocks became much more volatile relative to their Asian peers when liquidity evaporated. This likely reflects the higher degree of maturity transformation and the reliance on very short-term funding by Anglo-Saxon banks. A natural question is whether bank specific characteristics beyond geographic location reflect the different degrees of exposure to liquidity risk.
I start the quest for those bank characteristics by looking at the importance of bank size for liquidity risk exposure. Market participants, policymakers and academics have highlighted the role of size and interconnectedness as a source of systemic risk. To verify this claim, I form quintile portfolios of banks based on market capitalization and test whether there are significant differences in the sensitivity of their return volatility to the SLRI. The estimates suggest that size has implications for liquidity risk, but the relationship is highly non-linear. The association between size and sensitivity to liquidity conditions is only relevant for the very large banks, and it becomes pronounced only when liquidity conditions deteriorate substantially.
Recently, the Basel Committee on Banking Supervision produced, for the first time, a framework (based on balance sheet information) to regulate banks’ liquidity risk. In particular, it proposed two liquidity ratios that shall be monitored by supervisors: the Liquidity Coverage Ratio (LCR), which indicates banks’ ability to withstand a short-term liquidity crisis, and the Net Stable Funding Ratio (NSFR), which measures the long-term, structural funding mismatches in a bank. Forming quintile portfolios based on banks' NSFR, I find that, if anything, the regulatory ratio is positively associated with the exposure to the SLRI. In other words, banks with a high NSFR (the ones deamed to be structurally more liquid) are in fact slightly more sensitive to liquidity conditions. This counterintuitive result needs to be qualified. As noted later, the SLRI captures short-term liquidity stresses, whereas the NSFR is designed as a medium to long-term indicator of liquidity conditions. Certainly, it would be more appropriate to test the performance of LCR instead. However, the data necessary for its computation are not readily available.
The link between bank stock volatility and the SLRI allows me to calculate the cost faced by public authorities for providing liquidity support for banks. Relying on the contingent claims approach (CCA), I use observable information on a bank’s equity and the book value of its liabilities to back out the unobserved level and volatility of its assets. I then estimate by how much the level and volatility of implied assets change as liquidity conditions deteriorate, and how such changes affect the price of a hypothetical put option on the bank’s assets. Because the price of this put indicates the cost of public support to banks, variations in the put due to fluctuations in the SLRI provide a benchmark for charging banks according to their exposure to systemic liquidity risk, a goal that has been advocated by many experts on bank regulation.
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26131.0
IMF Working Paper No. 12/194
Jul 31, 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012194
Summary: I construct a systemic liquidity risk index (SLRI) from data on violations of arbitrage relationships across several asset classes between 2004 and 2010. Then I test whether the equity returns of 53 global banks were exposed to this liquidity risk factor. Results show that the level of bank returns is not directly affected by the SLRI, but their volatility increases when liquidity conditions deteriorate. I do not find a strong association between bank size and exposure to the SLRI - measured as the sensitivity of volatility to the index. Surprisingly, exposure to systemic liquidity risk is positively associated with the Net Stable Funding Ratio (NSFR). The link between equity volatility and the SLRI allows me to calculate the cost that would be borne by public authorities for providing liquidity support to the financial sector. I use this information to estimate a liquidity insurance premium that could be paid by individual banks in order to cover for that social cost.
Excerpts:
Introduction
Liquidity risk has become a central topic for investors, regulators and academics in the aftermath of the global financial crisis. The sharp decline of real estate prices in the U.S. and parts of Europe and the consequent collapse in the values of related securities created widespread concerns about the solvency of banks and other financial intermediaries. The resulting increase in counterparty risk induced investors to shy away from risky short-term funding markets [Gorton and Metrick (2010)] and to store funds in safe and liquid assets, especially U.S. government debt. The dry-up in funding markets hit levered financial intermediaries involved in maturity and liquidity transformation hard [Brunnermeier (2009)], propagating the initial shock through global markets.
Central bankers in major countries responded to the contraction in liquidity by pumping an unprecendented amount of funds into securities and interbank markets, and by creating and extending liquidity backstop lines to rescue troubled financial intermediaries. Such measures have exposed public finances, and ultimately taxpayers, to the risk of substantial losses. Understanding the origins of systemic liquidity risk in financial markets is, therefore, an invaluable tool for policymakers to reduce the chance of facing these very same challenges again in the future. In particular, if public support in periods of widespread distress cannot be prevented—due to commitment problems—supervisors and regulators should ensure that financial intermediaries are properly monitored and charged to reflect the contingent benefits they enjoy.
The present paper brings three contributions to the topic of systemic liquidity risk:
1) It produces a systemic liquidity risk index (SLRI) calculated from violations of “arbitrage” relationships in various securities markets.
2) It estimates the exposure of 53 global banks to this aggregate risk factor.
3) It uses the information in 2) to devise an insurance system where banks pre-pay for the costs faced by public authorities for providing contingent liquidity support.
Results indicate that systemic illiquidity became a widespread problem in the aftermath of Lehman’s bankruptcy, and it only recovered after several months. Systemic liquidity risk spiked again during the Greek sovereign crisis in the second quarter of 2010, albeit at much more moderate levels. Yet, the renewed concerns regarding sovereign default in peripheral Europe observed in the last quarter of 2010 did not induce global liquidity shortfalls.
In terms of exposures of individual institutions, I find that, in general, systemic liquidity risk does not affect the level of bank stock returns on a systematic fashion. However, liquidity risk is strongly correlated with the volatility of bank stocks: system wide illiquidity is associated with riskier banks. Estimates also show that U.S. and U.K. banks were relatively more exposed to liquidity conditions compared to Japanese institutions, with continental European banks lying in the middle of the distribution. More specifically, the results indicate that U.S. and U.K. banks’ stocks became much more volatile relative to their Asian peers when liquidity evaporated. This likely reflects the higher degree of maturity transformation and the reliance on very short-term funding by Anglo-Saxon banks. A natural question is whether bank specific characteristics beyond geographic location reflect the different degrees of exposure to liquidity risk.
I start the quest for those bank characteristics by looking at the importance of bank size for liquidity risk exposure. Market participants, policymakers and academics have highlighted the role of size and interconnectedness as a source of systemic risk. To verify this claim, I form quintile portfolios of banks based on market capitalization and test whether there are significant differences in the sensitivity of their return volatility to the SLRI. The estimates suggest that size has implications for liquidity risk, but the relationship is highly non-linear. The association between size and sensitivity to liquidity conditions is only relevant for the very large banks, and it becomes pronounced only when liquidity conditions deteriorate substantially.
Recently, the Basel Committee on Banking Supervision produced, for the first time, a framework (based on balance sheet information) to regulate banks’ liquidity risk. In particular, it proposed two liquidity ratios that shall be monitored by supervisors: the Liquidity Coverage Ratio (LCR), which indicates banks’ ability to withstand a short-term liquidity crisis, and the Net Stable Funding Ratio (NSFR), which measures the long-term, structural funding mismatches in a bank. Forming quintile portfolios based on banks' NSFR, I find that, if anything, the regulatory ratio is positively associated with the exposure to the SLRI. In other words, banks with a high NSFR (the ones deamed to be structurally more liquid) are in fact slightly more sensitive to liquidity conditions. This counterintuitive result needs to be qualified. As noted later, the SLRI captures short-term liquidity stresses, whereas the NSFR is designed as a medium to long-term indicator of liquidity conditions. Certainly, it would be more appropriate to test the performance of LCR instead. However, the data necessary for its computation are not readily available.
The link between bank stock volatility and the SLRI allows me to calculate the cost faced by public authorities for providing liquidity support for banks. Relying on the contingent claims approach (CCA), I use observable information on a bank’s equity and the book value of its liabilities to back out the unobserved level and volatility of its assets. I then estimate by how much the level and volatility of implied assets change as liquidity conditions deteriorate, and how such changes affect the price of a hypothetical put option on the bank’s assets. Because the price of this put indicates the cost of public support to banks, variations in the put due to fluctuations in the SLRI provide a benchmark for charging banks according to their exposure to systemic liquidity risk, a goal that has been advocated by many experts on bank regulation.
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26131.0
Sunday, July 29, 2012
Austerity Debate a Matter of Degree -- In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Austerity Debate a Matter of Degree. By Stephen Fidler
In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Wall Street Journal, February 17, 2012
http://online.wsj.com/article/SB10001424052970204792404577227273553955752.html
Excerpts
In the U.S., the debate about whether the government should start cutting its budget deficit opens up a deep ideological divide. Many countries in Europe don't have that luxury.
True, there may be questions about how hard to cut budgets and how best to time the cuts, but with government-bond investors going on strike, policy makers either don't have a choice or feel they don't. Budget austerity is also a recipe favored by Germany and other euro-zone governments that hold the Continent's purse strings.
Once upon a time, the International Monetary Fund, which also provides bailout funds and lend its crisis management expertise to euro-zone governments, would have been right there with the Germans: It never handled a financial crisis for which tough austerity wasn't the prescribed medicine. In Greece, however, officials say the IMF supported spreading the budget pain over a number of years rather than concentrating it at the front end.
That is partly because overpromising the undeliverable hurts government credibility, which is essential to overcoming the crisis. But it is also because the IMF's view has shifted.
"Over its history, the IMF has become less dogmatic about fiscal austerity being always the right response to a crisis," said Laurence Ball, economics professor at Johns Hopkins University, and a part-time consultant to the IMF.
These days, the fund worries more than it did about the negative impact that cutting budgets has on short-term growth prospects—a traditional concern of Keynesian economists.
"Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1% of [gross domestic product] typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point," the IMF said in its 2010 World Economic Outlook:
But that isn't the full story. In the first place, the IMF agrees that reducing government debt—which is what austerity should eventually achieve—has long-term economic benefits. For example, in a growing economy close with strong employment, reduced competition for savings should lower the cost of capital for private entrepreneurs.
That suggests that, where bond markets give governments the choice, there is a legitimate debate to be had about timing of austerity. The IMF economic models suggest it will be five years before the "break-even" point when the benefits to growth of cutting debt start to exceed the "Keynesian" effects of austerity.
There is an alternative hypothesis that has a lot of support in Germany, and among the region's central bankers. This is the notion that budget cutbacks stimulate growth in the short term, often referred to as the "expansionary fiscal contraction" hypothesis.
Manfred Neumann, professor emeritus of economics at the Institute for Economic Policy at the University of Bonn, said the view is also called the "German hypothesis" since it emerged from a round of German budget cutting in the early 1980s.
"The positive effect of austerity is much stronger than most people believe," he said. The explanation for the beneficial impact is that cutting government debt generates an improvement in confidence among households and entrepreneurs, he said.
The IMF concedes there may be something in this for countries where people are worried about the risk that the government might default—but only up to a point. It concedes that fiscal retrenchment in such countries "tends to be less contractionary" than in countries not facing market pressures—but doesn't conclude that budget cutting in such circumstances is actually expansionary.
Each side of the debate invokes its own favored study. Support for the "German hypothesis" comes from two Harvard economists with un-German names—Alberto Alesina and Silvia Ardagna. But their critics, who include Mr. Ball, say their sample includes many irrelevant episodes for which their model fails to correct—including, for example, the U.S. "fiscal correction" that was born out of the U.S. economic boom of the late 1990s.
Mr. Alesina didn't respond to an email asking for comment, but Mr. Neumann said he isn't confident that studies, such as the IMF's, that appear to refute the hypothesis manage to isolate the effects of the austerity policy from other effects of a financial crisis.
Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.
The first is that the contractionary effects of fiscal retrenchment are often partly offset by an increase in exports—but less so in countries where the exchange rate is fixed. Second, the pain is greater if central banks can't offset the fiscal austerity through a stimulus in monetary policy. With interest rates close to zero in the euro zone, such a stimulus is hard to achieve. Third, when many countries are cutting budgets at the same time, the effect on economic activity in each is magnified.
If you are a government in budget-cutting mode, there are, however, better and worse ways of doing it. The IMF says spending cuts tend to have less negative impact on the economy than tax increases. However, that is partly because central banks tend to cut interest rates more aggressively when they see spending cuts.
Mr. Neumann sees an austerity hierarchy. It is better to cut government consumption and transfers, including staff costs, than government investment—though it may be harder politically. If you are raising taxes, better to raise those with no impact on incentives—such as inheritance or wealth taxes—than those that hurt incentives, such as income or payroll taxes.
Raising sales or value-added taxes may have less impact on incentives—but have other undesirable effects, such as increasing inflation, that could deter central banks from easing policy.
In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Wall Street Journal, February 17, 2012
http://online.wsj.com/article/SB10001424052970204792404577227273553955752.html
Excerpts
In the U.S., the debate about whether the government should start cutting its budget deficit opens up a deep ideological divide. Many countries in Europe don't have that luxury.
True, there may be questions about how hard to cut budgets and how best to time the cuts, but with government-bond investors going on strike, policy makers either don't have a choice or feel they don't. Budget austerity is also a recipe favored by Germany and other euro-zone governments that hold the Continent's purse strings.
Once upon a time, the International Monetary Fund, which also provides bailout funds and lend its crisis management expertise to euro-zone governments, would have been right there with the Germans: It never handled a financial crisis for which tough austerity wasn't the prescribed medicine. In Greece, however, officials say the IMF supported spreading the budget pain over a number of years rather than concentrating it at the front end.
That is partly because overpromising the undeliverable hurts government credibility, which is essential to overcoming the crisis. But it is also because the IMF's view has shifted.
"Over its history, the IMF has become less dogmatic about fiscal austerity being always the right response to a crisis," said Laurence Ball, economics professor at Johns Hopkins University, and a part-time consultant to the IMF.
These days, the fund worries more than it did about the negative impact that cutting budgets has on short-term growth prospects—a traditional concern of Keynesian economists.
"Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1% of [gross domestic product] typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point," the IMF said in its 2010 World Economic Outlook:
But that isn't the full story. In the first place, the IMF agrees that reducing government debt—which is what austerity should eventually achieve—has long-term economic benefits. For example, in a growing economy close with strong employment, reduced competition for savings should lower the cost of capital for private entrepreneurs.
That suggests that, where bond markets give governments the choice, there is a legitimate debate to be had about timing of austerity. The IMF economic models suggest it will be five years before the "break-even" point when the benefits to growth of cutting debt start to exceed the "Keynesian" effects of austerity.
There is an alternative hypothesis that has a lot of support in Germany, and among the region's central bankers. This is the notion that budget cutbacks stimulate growth in the short term, often referred to as the "expansionary fiscal contraction" hypothesis.
Manfred Neumann, professor emeritus of economics at the Institute for Economic Policy at the University of Bonn, said the view is also called the "German hypothesis" since it emerged from a round of German budget cutting in the early 1980s.
"The positive effect of austerity is much stronger than most people believe," he said. The explanation for the beneficial impact is that cutting government debt generates an improvement in confidence among households and entrepreneurs, he said.
The IMF concedes there may be something in this for countries where people are worried about the risk that the government might default—but only up to a point. It concedes that fiscal retrenchment in such countries "tends to be less contractionary" than in countries not facing market pressures—but doesn't conclude that budget cutting in such circumstances is actually expansionary.
Each side of the debate invokes its own favored study. Support for the "German hypothesis" comes from two Harvard economists with un-German names—Alberto Alesina and Silvia Ardagna. But their critics, who include Mr. Ball, say their sample includes many irrelevant episodes for which their model fails to correct—including, for example, the U.S. "fiscal correction" that was born out of the U.S. economic boom of the late 1990s.
Mr. Alesina didn't respond to an email asking for comment, but Mr. Neumann said he isn't confident that studies, such as the IMF's, that appear to refute the hypothesis manage to isolate the effects of the austerity policy from other effects of a financial crisis.
Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.
The first is that the contractionary effects of fiscal retrenchment are often partly offset by an increase in exports—but less so in countries where the exchange rate is fixed. Second, the pain is greater if central banks can't offset the fiscal austerity through a stimulus in monetary policy. With interest rates close to zero in the euro zone, such a stimulus is hard to achieve. Third, when many countries are cutting budgets at the same time, the effect on economic activity in each is magnified.
If you are a government in budget-cutting mode, there are, however, better and worse ways of doing it. The IMF says spending cuts tend to have less negative impact on the economy than tax increases. However, that is partly because central banks tend to cut interest rates more aggressively when they see spending cuts.
Mr. Neumann sees an austerity hierarchy. It is better to cut government consumption and transfers, including staff costs, than government investment—though it may be harder politically. If you are raising taxes, better to raise those with no impact on incentives—such as inheritance or wealth taxes—than those that hurt incentives, such as income or payroll taxes.
Raising sales or value-added taxes may have less impact on incentives—but have other undesirable effects, such as increasing inflation, that could deter central banks from easing policy.
Saturday, July 28, 2012
The Statistical Definition of Public Sector Debt. An Overview of the Coverage of Public Sector Debt for 61 Countries
What Lies Beneath: The Statistical Definition of Public Sector Debt. An Overview of the Coverage of Public Sector Debt for 61 Countries.By Robert Dippelsman, Claudia Dziobek, and Carlos A. Gutiérrez Mangas
IMF Staff Discussion Note
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26101.0
Excerpts
Executive Summary
While key macroeconomic indicators such as Gross Domestic Product (GDP) or Consumer Price Index (CPI) are based on internationally accepted methodologies, indicators related to the debt of the public sector often do not follow international standards and can have several different definitions. As this paper shows, the absence of the standard nomenclature can lead to major misunderstandings in the fiscal policy debate. The authors present examples that show that debt-to-GDP ratios for a country at any given time can range from 40 to over 100 percent depending on the definition used. Debt statistics, for example, may include or exclude state and local governments and may cover all debt instruments or just a subset. The authors suggest that gross debt of the general government (―gross debt‖) should be globally adopted as the headline indicator supplemented by other measures of government debt for risk-based assessments of the fiscal position. Broader measures, including net debt and detailed information on contingent liabilities and derivatives, could be considered. The standard nomenclature of government and of debt instruments helps users understand the concepts in line with the Public Sector Debt Statistics Guide. Use of more standard definitions of government debt would improve data comparability, would benefit IMF surveillance, programs, and debt sustainability analysis, and would help country authorities specify and monitor fiscal rules. Data disaggregated by government subsector and debt instrument for 61 countries from the IMF‘s Government Finance Statistics Yearbook (GFSY) database are presented to illustrate the importance and viability of adopting this approach.
Most key macroeconomic indicators such as GDP, the consumer price index (CPI), data on monetary aggregates or balance of payments follow internationally accepted definitions. In contrast, countries often do not follow international guidelines for public debt data. As this paper shows, failure to apply global standards can lead to important misunderstandings because of the potentially large magnitudes involved. International guidelines on the compilation of public sector debt are well established and are summarized in the recently published Public Sector Debt Statistics Guide (Debt Guide). The Debt Guide also describes applications of these guidelines for the analysis of debt sustainability, fiscal risk, and vulnerability.
The authors seek in this paper to provide a more intuitive application of the various concepts and definitions found in the Debt Guide, and propose that global standard definitions of ―gross debt‖ referring to the ―general government‖ be adopted as a headline measure. As with other headline indicators, a variety of narrower and wider indicators remain valuable and useful for different purposes. The notion of gross debt will be familiar to macroeconomic statisticians, but, as a practical matter, the adoption of global standard statistical definitions of debt will require some development efforts in terms of source data availability and training for compilers of debt statistics. A particular challenge is complete coverage of all relevant institutions and financial instruments. Detailed information on contingent liabilities and derivatives should also be considered. Coordination across agencies that work with debt related data is also critical, as with other complex datasets such as GDP.
Many users are not aware of the extent to which differences in concepts and methods matter. Box 1 below highlights the four key dimensions of public sector debt. Countries publish data, for example, either including or excluding state and local governments, pension funds, and public corporations. Also, while much of the policy debate centers on government liabilities, some countries have begun to publish and focus policy analysis on net debt (financial assets minus liabilities). Debt data frequently only include two (of the six) debt instruments available: debt securities and loans. Debt instruments such as other accounts payable or insurance technical reserves are often not taken into account. In many cases the method of valuation is not explicitly mentioned even though market versus nominal valuation can be significantly different. Consolidation, which refers to the process of netting out intra-governmental obligations, is another important factor rarely specified in published data. And finally, debt data may be compiled using cash data and excluding non-cash items such as arrears or using accrual (or partial accrual) methods to reflect important non-cash obligations.
Conclusions
The headline indicator for government debt should be defined as ―gross debt of the general government‖ or GL3/D4 in this paper‘s nomenclature. The authors suggest that countries should aspire to publish timely data on the broader concept of gross debt.
Data on the institutional level of the general government (GL3) would be consistent with a broad range of data uses and with the data requirements of other macroeconomic datasets, notably the national accounts. Including the full range of debt instruments is desirable particularly because some of these may expand in times of financial distress and could thus serve as valuable indicators of distress. Clarity of what the debt data cover would help build understanding of the data and their comparability across countries.
A global standard would facilitate communication on the main concepts in public sector debt statistics and it would bring greater precision to research on fiscal issues, and lead to improved cross-country comparison. This framework uses a nomenclature inspired by the approach in monetary data where M1 through M4 (monetary aggregates) reflect institutional and instrument coverage as well.
The methodological framework of government debt presented here is widely accepted among statisticians. The relevant definitions, concepts, classification, and guidance of compilation are summarized in GFSM 2001 and the Debt Guide. These standards are fully consistent with the overarching statistical methodology of the 2008 SNA and other international macroeconomic methodologies such as the Sixth Edition of Balance of Payments and International Investment Position Manual (BPM6) and broadly consistent with the European System of Accounts (ESA) manual and the more specialized manuals of deficit and debt that govern the Excessive Deficit Procedure.
However, the methodology is not always well defined in the policy debate. An international convention to view GL3/D4 as the desirable headline indicator of government debt, consistent with the international standards, would go a long way to create more transparency and better comparability of international data.
Our contribution is to provide a presentational framework and nomenclature that highlights the importance of different instruments, institutional coverage, and valuation and consolidation as key indicators of debt. Indeed, we have noted that other, more narrowly defined concepts can meaningfully supplement the comprehensive measure of debt. These narrower measures may be important for a risk-based assessment of the fiscal position, but they are not substitutes for a global indicator.
Further extensions of this work are the development of the statistical reporting of broader measures, for example net debt of the general government and the presentation of information on derivatives, and contingent liabilities.
The new debt database launched by the IMF and World Bank in 2010 is structured along government levels, debt instruments, consolidation and valuation as discussed in this paper. However, some countries report data only on the GL2 level and cover mostly D1. Developing data on the broader statistics will take some time, although Australia, Canada, and some other countries already publish or plan to publish GL3/D4 data or publish components that would allow the calculation of GL3/D4.
Debt statistics for various levels of government and instruments were shown for 61 countries and these data highlight some interesting patterns that merit further analysis such as the degree of fiscal autonomy of state and local government to issue debt, the degree of development of markets for government debt securities. The authors conclude that further research would be worthwhile on the advantages of a global standard of government debt for such topics as data comparability, IMF surveillance, programs, debt sustainability analysis, and the analysis of fiscal rules.
IMF Staff Discussion Note
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26101.0
Excerpts
Executive Summary
While key macroeconomic indicators such as Gross Domestic Product (GDP) or Consumer Price Index (CPI) are based on internationally accepted methodologies, indicators related to the debt of the public sector often do not follow international standards and can have several different definitions. As this paper shows, the absence of the standard nomenclature can lead to major misunderstandings in the fiscal policy debate. The authors present examples that show that debt-to-GDP ratios for a country at any given time can range from 40 to over 100 percent depending on the definition used. Debt statistics, for example, may include or exclude state and local governments and may cover all debt instruments or just a subset. The authors suggest that gross debt of the general government (―gross debt‖) should be globally adopted as the headline indicator supplemented by other measures of government debt for risk-based assessments of the fiscal position. Broader measures, including net debt and detailed information on contingent liabilities and derivatives, could be considered. The standard nomenclature of government and of debt instruments helps users understand the concepts in line with the Public Sector Debt Statistics Guide. Use of more standard definitions of government debt would improve data comparability, would benefit IMF surveillance, programs, and debt sustainability analysis, and would help country authorities specify and monitor fiscal rules. Data disaggregated by government subsector and debt instrument for 61 countries from the IMF‘s Government Finance Statistics Yearbook (GFSY) database are presented to illustrate the importance and viability of adopting this approach.
Most key macroeconomic indicators such as GDP, the consumer price index (CPI), data on monetary aggregates or balance of payments follow internationally accepted definitions. In contrast, countries often do not follow international guidelines for public debt data. As this paper shows, failure to apply global standards can lead to important misunderstandings because of the potentially large magnitudes involved. International guidelines on the compilation of public sector debt are well established and are summarized in the recently published Public Sector Debt Statistics Guide (Debt Guide). The Debt Guide also describes applications of these guidelines for the analysis of debt sustainability, fiscal risk, and vulnerability.
The authors seek in this paper to provide a more intuitive application of the various concepts and definitions found in the Debt Guide, and propose that global standard definitions of ―gross debt‖ referring to the ―general government‖ be adopted as a headline measure. As with other headline indicators, a variety of narrower and wider indicators remain valuable and useful for different purposes. The notion of gross debt will be familiar to macroeconomic statisticians, but, as a practical matter, the adoption of global standard statistical definitions of debt will require some development efforts in terms of source data availability and training for compilers of debt statistics. A particular challenge is complete coverage of all relevant institutions and financial instruments. Detailed information on contingent liabilities and derivatives should also be considered. Coordination across agencies that work with debt related data is also critical, as with other complex datasets such as GDP.
Many users are not aware of the extent to which differences in concepts and methods matter. Box 1 below highlights the four key dimensions of public sector debt. Countries publish data, for example, either including or excluding state and local governments, pension funds, and public corporations. Also, while much of the policy debate centers on government liabilities, some countries have begun to publish and focus policy analysis on net debt (financial assets minus liabilities). Debt data frequently only include two (of the six) debt instruments available: debt securities and loans. Debt instruments such as other accounts payable or insurance technical reserves are often not taken into account. In many cases the method of valuation is not explicitly mentioned even though market versus nominal valuation can be significantly different. Consolidation, which refers to the process of netting out intra-governmental obligations, is another important factor rarely specified in published data. And finally, debt data may be compiled using cash data and excluding non-cash items such as arrears or using accrual (or partial accrual) methods to reflect important non-cash obligations.
Box 1. Key Dimensions to Measure Government Gross Debt
Institutional Coverage of Government
Instrument Coverage of Debt
Valuation of Debt Instruments (market and nominal)
Consolidation of Intra-Government Holdings
Source: Public Sector Debt Statistics Guide.
Conclusions
The headline indicator for government debt should be defined as ―gross debt of the general government‖ or GL3/D4 in this paper‘s nomenclature. The authors suggest that countries should aspire to publish timely data on the broader concept of gross debt.
Data on the institutional level of the general government (GL3) would be consistent with a broad range of data uses and with the data requirements of other macroeconomic datasets, notably the national accounts. Including the full range of debt instruments is desirable particularly because some of these may expand in times of financial distress and could thus serve as valuable indicators of distress. Clarity of what the debt data cover would help build understanding of the data and their comparability across countries.
A global standard would facilitate communication on the main concepts in public sector debt statistics and it would bring greater precision to research on fiscal issues, and lead to improved cross-country comparison. This framework uses a nomenclature inspired by the approach in monetary data where M1 through M4 (monetary aggregates) reflect institutional and instrument coverage as well.
The methodological framework of government debt presented here is widely accepted among statisticians. The relevant definitions, concepts, classification, and guidance of compilation are summarized in GFSM 2001 and the Debt Guide. These standards are fully consistent with the overarching statistical methodology of the 2008 SNA and other international macroeconomic methodologies such as the Sixth Edition of Balance of Payments and International Investment Position Manual (BPM6) and broadly consistent with the European System of Accounts (ESA) manual and the more specialized manuals of deficit and debt that govern the Excessive Deficit Procedure.
However, the methodology is not always well defined in the policy debate. An international convention to view GL3/D4 as the desirable headline indicator of government debt, consistent with the international standards, would go a long way to create more transparency and better comparability of international data.
Our contribution is to provide a presentational framework and nomenclature that highlights the importance of different instruments, institutional coverage, and valuation and consolidation as key indicators of debt. Indeed, we have noted that other, more narrowly defined concepts can meaningfully supplement the comprehensive measure of debt. These narrower measures may be important for a risk-based assessment of the fiscal position, but they are not substitutes for a global indicator.
Further extensions of this work are the development of the statistical reporting of broader measures, for example net debt of the general government and the presentation of information on derivatives, and contingent liabilities.
The new debt database launched by the IMF and World Bank in 2010 is structured along government levels, debt instruments, consolidation and valuation as discussed in this paper. However, some countries report data only on the GL2 level and cover mostly D1. Developing data on the broader statistics will take some time, although Australia, Canada, and some other countries already publish or plan to publish GL3/D4 data or publish components that would allow the calculation of GL3/D4.
Debt statistics for various levels of government and instruments were shown for 61 countries and these data highlight some interesting patterns that merit further analysis such as the degree of fiscal autonomy of state and local government to issue debt, the degree of development of markets for government debt securities. The authors conclude that further research would be worthwhile on the advantages of a global standard of government debt for such topics as data comparability, IMF surveillance, programs, debt sustainability analysis, and the analysis of fiscal rules.
Thursday, July 26, 2012
BIS - Capital requirements for bank exposures to central counterparties + Basel III counterparty credit risk FAQs + other doc
Basel III counterparty credit risk - Frequently asked questions (update of FAQs published in November 2011) (25.07.2012 12:10)
http://www.bis.org/publ/
Regulatory treatment of valuation adjustments to derivative liabilities: final rule issued by the Basel Committee (25.07.2012 12:05)
http://www.bis.org/press/
Capital requirements for bank exposures to central counterparties (25.07.2012 12:00)
http://www.bis.org/publ/
http://www.bis.org/publ/
Regulatory treatment of valuation adjustments to derivative liabilities: final rule issued by the Basel Committee (25.07.2012 12:05)
http://www.bis.org/press/
Capital requirements for bank exposures to central counterparties (25.07.2012 12:00)
http://www.bis.org/publ/
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