Does risk management minimise or add risks?

The recent Bernanke speech is another (read this Volcker speech for instance) of those ongoing illustrations of the ongoing practices in financial sector.

This Bernanke speech focuses on the risk management practices being followed in the industry. On reading the speech I have two questions to ask:

1. The Title of the post
2. Risk management is one of the most sought and highly paid job. So what were these people doing really? It is useful to debate this issues post crisis but what was going on really?

 

inflation targeting is being questioned

The sub-prime crisis and economic conditions (low growth and high inflation) is questioning most tenets of economics and financial systems. Like the one on inflation targeting.

What has been advocated as a successful strategy for Central banks-inflation targeting is now being questioned. I had earlier pointed BoE has instead become a growth targeting central bank. Similarly, concerns are now being felt on Australia and New Zealand Central banks who have nut cut rates but have expressed the difficulty to manage the state of affairs. Now, the academicians are joining in the debate as well.

The recent article by Joseph Stigilitz is already creating enough furors. Here he really lambasts inflation targeting central banks. I came across this article by Axel Leijonhufvud ( read his CEPR paper for details as well) which questions both – independence and inflation targeting. I am sure more are to follow arguing both sides of the story.

The Regulatory Response to the Financial Crisis

This is a good paper (with some humor) by Charles Goodhart where he writes on the subprime crisis looking in particular at the UK economy. He also has some lessons to offer:

There are, at least, seven aspects relating to financial regulation where the recent, and still current, financial turmoil has thrown up issues for discussion. These include: 1. The scale and scope of deposit insurance; 2. Bank insolvency regimes, also known as ‘prompt corrective action’; 3. Money market operations by Central Banks; 4. Commercial bank liquidity risk management; 5. Procyclicality of capital adequacy requirements (and mark-to-market), Basel II; lack of counter-cyclical instruments; 6. Boundaries of regulation, conduits, SIVs and reputational risk; 7. Crisis management:- (a) domestic, within countries, e.g. UK Tripartite Committee; (b) cross-border; how to bear the burden of cross-border defaults? This paper describes how the current crisis has exposed regulatory failings, drawing largely on recent UK experience, and suggests what remedial action might be undertaken.

Literature survey on Central Bank communication

Recently, there has been a lot of criticism of RBI (see thisIMF selected issuesfor instance). The main target areas have been managing the impossible trinity and commmunication. I have critiqued the developments on first here. Though, I did make a case for better communication I have never been sure what it means.

Like experts say RBI’s monetary policy documentis too lengthy (usually about 80-90 pages) and should be shortened like that of other central banks. Going through the document it does appear lengthy but has a lot of information for the public. It is tough reading it but tells much more about the economy (Indian) than statements given by any other Central bank.

But then other Central Banks come out with similar reports on a regular basis – economic reviews, financial stability reports, monthly reviews (which even RBI does) etc- and RBI releases them all at one go . So it is not as if other Central banks don’t have detailed documents. Infact, sometimes there is a deluge which is really difficult to manage.

My thoughts have been confirmed by this paper by Alan Blinder et al. You can also read the  short summary here.  It is a liertaure survey on Central bank communications. The abstract goes like this:

Over the last two decades, communication has become an increasingly important aspect of monetary policy. These real-world developments have spawned a huge new scholarly literature on central bank communication — mostly empirical, and almost all of it written in this decade. We survey this ever-growing literature. The evidence suggests that communication can be an important and powerful part of the central bank’s toolkit since it has the ability to move financial markets, to enhance the predictability of monetary policy decisions, and potentially to help achieve central banks’ macroeconomic objectives. However, the large variation in communication strategies across central banks suggests that a consensus has yet to emerge on what constitutes an optimal communication strategy.

So, it is important but there is no standard way of doing it. We just can’t say this particular approach is good and this bad. Every Central Bank has its own way of doing it. As long as they do their job of managing inflation it is good enough.

Actually, I am increasingly getting sceptic of academics who talk about standardising things. It reminds you of Washington Consensus times when there was an emphasis on standardisation of fiscal and monetary frameworks on lines of the western world which failed for obvious reasons. This is not to say we shouldn’t change but there should be a case for it as well. the more I read,  increasingly I agree with Dani Rodrik that second best institutions are as good.

Assorted Links

1. WSJ Blog points to Mishkin speech an emerging hot topic- asset bubbles. It also points to Stern’s comments

2. Ajay Shah points to tale of 2 countries- Botswana and Zimbabwe

3. MR points to Pixar touch

4. Take the Nudge poll

5. Mankiw humor 

6. Rodrik defends Larry Summers

7. Fin Rounds points to a new website on investment banking