Archive for November, 2008

BIS strategy to address banking crisis – anything new?

November 21, 2008

 In a press release Basel Committee on Bank Supervision says it plans to issue a comprehensive strategy plan to address the banking crises. The objective:

to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks

The so called building blocks of strategy are:

  • strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures);
  • enhancing the quality of Tier 1 capital;
  • building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen procyclicality;
  • evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system;
  • strengthening supervisory frameworks to assess funding liquidity at cross-border banks;
  • leveraging Basel II to strengthen risk management and governance practices at banks;
  • strengthening counterparty credit risk capital, risk management and disclosure at banks; and
  • promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.
  • In all, pretty much the same thing applicable to all banking crisis.  The same guidelines apply to banks all the time irrespective whether there is a crisis or not.

    I would suggest more crucial is to understand why weren’t these basics of banking/finance applied? Why did banks take the kind of risks they did? What was risk management doing when traders/loan-makers were taking risks?  Where did corporate governance, business ethics go? It doesn’t help in any learning.

    After understanding the actual practices from the assumed only we can make some progress on designing appropriate policies. There is no point restating things which have been well-known and are obvious.


    Assorted Links

    November 21, 2008

    1. Krugman says it is economic emergency now. Mankiw says we need a prayer now

    2. WSJ Blog points to Irving Fisher paper that started discussion on deflation.

    3. WSJ Blog points to an interesting discussion comparing Lehman woes with US Automakers. IGMB points to a view from Luis Zingales on saving US automakers

    4. ICL Blog points rating the raters

    5. MR points to concerns in China

    6. Rodrik on French sovereign wealth fund

    7. DB Blog on how Georgia became a top reformer

    Will UK go the Iceland way?

    November 20, 2008

    Willem Buiter has a great blog but is always difficult to read. It is very detailed and has loads and loads of information and facts. Most of his posts are like a research paper. He says clearly he writes the blog for himself as it helps him.

    I had pointed to his superb study on how and why Iceland failed. In taht study he says:

    Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
    (1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

    Countries that come to mind are:

    • Switzerland
    • Denmark
    • Sweden

    and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

    Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

    In his latest post, he works on UK economy and provides evidence why UK could go the Iceland way. A must read.

    Comparison between US and Euro policies?

    November 20, 2008

    I came across this wonderful speechby Lorenzi Bin Smaghi, ECB member comparing the economic policies between US and Euroarea. He analyses policies across spectrum- monetary, fiscal etc.

    The United States and the euro area are the two main economic and monetary areas in the world and they are reasonably similar in size, with a population of over 300 million (300 million in the United States and 320 million in the euro area) and GDP of around €10,000 billion at current prices (at the going rate of exchange of around USD 1.30 to  the euro – US GDP is worth around €11,000 billion, while euro area GDP is worth around €9,000 billion).

    After this, he points to how policies are determined in the two regions:

    In recent years, the two economies have been compared in a largely asymmetrical way, possibly a hangover from an obsolete institutional setup and analytical reference framework. While in the United States economic policies are mainly assessed on the basis of the US economy’s underlying state, in the euro area the assessment is made on the basis not only of European economic fundamentals, but also, and indeed above all, with reference to economic policy decisions made on the other side of the Atlantic. On our continent, monetary and budgetary policies are often judged in relation to what is decided in the United States rather than in their own right. However, it is very rare that the opposite happens.

    This kind of asymmetrical assessment was perhaps alright under the Bretton Woods system, in which the European countries pegged their currencies to the dollar, and under the subsequent fluctuating system in which the individual European countries were relatively small, which allowed them to benefit from a certain amount of autonomy from the decisions reached on the other side of the Atlantic. But with the creation of the euro and the development of the euro area to levels akin to the US economy, it would have been rather ironic if economic policy decisions in Europe simply mirrored the conduct of other authorities.

    He then points why policies in Euroarea ought to be different compared to in US economy. US economy is more dynamic compared to Euro and impact of shocks differ in both regions requiring different policy responses.

    Very insightful speech.

    Assorted Links

    November 20, 2008

    1. WSJ Blog points to a new report which says that US fin system needs additional $ 1-1.2 trillion

    2. . WSJ Blog points deflation scare in US. Maniw also points to rising deflation fears.

    3.  WSJ Blog also points to 3 choices for UA automakers.

    4. TTR points to bailut fund for indian cos

    5. Krugman points corporate cost of borrowing is rising

    6. Rodrik points to a new paper on financial globalisation and emerging economies

    7. Econbrowser points – crisis in one picture

    Bank of England could have reduced rates by 200 bps!

    November 19, 2008

    In its previous meeting on 6 Nov 2008, BoE had cut rates by a shocking 150 bps making it the largest rate cut in UK’s monetary policy history and also the largest cut amidst central banks (barring Iceland). The markets had expected 50-100 bps. All eyes weer on the minutes of the meeting,

    The minutes have been released and suggest that it could have been a 200 bps rate cut!!

    The projections in the Inflation Report implied that a very significant reduction in Bank Rate – possibly in excess of 200 basis points – might be required in order to meet the inflation target in the medium term. However, a number of arguments were discussed for not moving Bank Rate by the full extent implied by those projections.

    There were 4 points which led to a 150 bps rate cut:

    First, the projections had used the normal convention that they were based on the Government’s most recent published tax and spending plans.

    Second, although the banking measures that had been introduced around the world had restored a degree of stability to the banking system, it was unclear how the supply of broad money and credit to the wider economy would respond.

    Third, a key concern was the degree of surprise to financial markets. Too large a surprise could pose upside risks to the inflation target if the resulting depreciation of sterling was excessive.

    Fourth, some members thought there was an argument for leaving some of the required policy loosening to the months ahead to support confidence as the economy weakened.

    Hence, because of the uncertainty in the economy and need to have some weapons to fight the looming collapse, BOE did not pass a 200 bps rate cut. One can expect similar/steeper rate cuts in the next meeting on 3 & 4 December. It shouldn’t be a surprise.

    Has Bank lending in US declined?

    November 19, 2008

    There was a paper in October 2008 by Minneapolis Fed Economists which said bank lending has not declined and has infact increased. This created quite a stir as all along we have been expecting it to be opposite.  They look at 4 supposed to be facts right now and say they are  myths instead:

    1. Bank lending to nonfinancial corporations and individuals has declined sharply.
    2. Interbank lending is essentially nonexistent.
    3. Commercial paper issuance by nonfinancial corporations has declined sharply, and rates have risen to unprecedented levels.
    4. Banks play a large role in channeling funds from savers to borrowers.

    There are 2 papers which look at the Minneapolis Fed paper and both disapprove the findings. One is by Boston Fed economists and other by Victoria Ivashina  and David S. Scharfstein.

    Boston Fed paper provides more disaggregated data compared to Minneapolis Fed paper and shows that first three are reality and not myths. On fourth, they say more analysis is needed.

    The second paper by Ivashina provides further analysis:

    Fact 1: New lending in 2008 was significantly below new lending in 2007, even before the peak period of the financial crisis (August-October 2008)

    Fact 2: The decline in new loans accelerated during the financial crisis, falling by 36% in the August-October 2008 period relative to the prior three-month period.

    Fact 3: Real investment loans (working capital or general corporate purposes) and restructuring loans (those for M&A, LBOs, and stock repurchases) have decreased to a similar extent.

    Fact 4: During the peak period of the financial crisis (August-October 2008), noninvestment- grade loans fell by 50% relative to the prior period, while investment grade loans fell by 19%.

    However, Ivashina provides a caveat which is quite interesting and is a further scope for research:

    New lending has declined during the financial crisis. However, it remains unclear whether this decline is supply or demand driven. Are banks withholding funding from creditworthy borrowers who need financing? Or are firms cutting investment in response to concerns about the economy, and thus choosing not to borrow?

    To address this issue, we are investigating the differences in the way banks have responded to the financial crisis. Have banks with more impaired loan portfolios scaled back their lending more? Likewise, have banks with a larger revolver overhang cut their lending more to protect themselves against the risk of large revolver drawdowns? And, how have banks responded to the credit guarantees and equity infusions that the U.S. government has recently provided?

    Loads of research expected on the issue and is going to be very interesting.

    What are covered bonds?

    November 19, 2008

    They have been discussed a lot in blogs and press. I came across a very useful primeron the topic by Chicago Fed Economist Richard J. Rosen.

    Assorted Links

    November 19, 2008

    1. WSJ Blog points worst outlook since depression is possible

    2. Fin Prof points to an interview of Ken French

    3. FCB on finance jobs

    4. CTB says concerns on microfin sector are rising

    Soros pushes his theory of reflexivity

    November 18, 2008

    After hearing on Lehman, AIG, regulators, Senate Oversight Committee had a hearing on hedge funds and its role in the crisis. The hearing was divided into 2 panels . First panel was of economists and second of hedge fund managers. Pretty big names appeared for hearing.

    On reading the testimonies, one comes across mix views and there is no clarity. However, most of them lean towards the need to regulate hedge funds.

    The most interesting of the testmonies was of George Soros ( that is a given):

    The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact-that the defect was inherent in the system-eontradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting.

    This is typical Soros stuff.  After this, he says to understand the events, we need a new theory

    This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

    Soros then explains the way the distorted views lead to bubbles and problems. It has helped a certain section:

    Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

    He then explains the political economy of financial markets and says efficient markets ideology became mainstream as crisis impacted the developing (those that had poor macro, poor institutions etc). Whenever crisis occurred in US like LTCM , Savings and Loan crisis etc authorities intervened and a largescale crisis was averted. And the ideology continued to prosper. He says he cried wolf 3 times:

    I have cried wolf times: first with The Alchemy ofFinance in 1987, then with The Crisis ofGlobal Capitalism  1998, and now. Only now did the wolf arrive.

    However, his theory lacks predicting events in fin markets. It helps more explain them. So, it still lacks a much needed aspect of fin system. He then says the regulators need to do something to manage the build oup of bubbles as their policies lead to creation of the same. He does not have very kind words for Alan Greenspan as well.

    Finally on hedge funds he says:

    Regarding hedge funds, it has to be recognized that hedge funds were also an integral part of the bubble which now has burst. Hedge funds grew to approximately $2 trillion of capital which at times controlled as much as $10 trillion or more in assets. But the bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. During the current financial crisis, many hedge fund managers forgot the cardinal rule of hedge fund investing which is to protect  investor capital during down markets. It is unfortunate that much of the money raised by hedge funds in pursuit of alpha

    Interesting throughout. Typical Soros.

    UBS releases a new compensation model

    November 18, 2008

    The role of incentives in generating this financial crisis has been much debated and criticised. As a result, some changes are happening.

    First, most of the govt. packages have this as the first condition- no bonuses, golden parachutes etc. Second, role of compensation structures has been included in various reports prepared for future financial regulation. Third, even companies are waking up to their mistakes and making changes.

    UBS has released a report detailing changes in its compensation model. The detailed report is here and there is also a FAQ on the same. In the new model, following issues have been done away with:

    • Variable compensation was strongly aligned with short-term results, without consideration for the quality or sustainiability of the bank’s performance
    • The system for determining variable compensation did not sufficiently take into account the risks assumed.

    As a result, there will be no variable pay (bonus etc) for this year for the top management and for others it will be reduced.

    This is actually in line with what Goldman Sachs has done but is different as it has issued a separate report and plans to stay committed to the plan.  Just to recall, UBS was also the first one(and I think only one) to issue a report explaning its losses to the shareholders. The report was highly complex and one could not make any sense of the problems.

    I am yet to read the compensation report. Hope this is simpler.

    Are econ/fin professors completely off the curve?

    November 18, 2008

    The economics/finance professors have been accused for not being able to predict the crisis. Infact they are often blamed for instead engaging in random academic work not benefiting anyone.

    I came across this article (thanks to ASBfor the pointer) in American which says the contrary. It summarises research of economists which has pioneered work that has led to predicting wrongdoing in certain segment of financial markets (mutual finds, backdating options etc) and economy (sub-prime borrowing). The links to the various papers cited have not been provided and would involve some google searching.

    A good article which shows things are not as bad as they are made out to be.

    However, what is needed is to make the academic work more mainstream and spread the message via newspapers, blogs etc. Apart from Ed Gramlich (who predicted risky sub-prime borrowings), Jay Ritter (IPO mismanaging), I haven’t heard of any of the professors and their work.

    Assorted Links

    November 18, 2008

    1. MR on liquidity trap

    2. WSJ Blog points Summers says fiscal stimulus has to be sustained

    3. Mankiw points to a debate on auto industry bailout

    4. Rodrik points to some papers on trade and growth

    5. Fin Prof points to an article on Fed and the next bubble

    6. ALB points to the problems with most common sources of financial advice- friends and family

    7. PSD BLog points Argentina revisits 2001

    8. CTB points to signs of crisis

    Are we facing a risk of deflation?

    November 17, 2008

    My opinion on the topic in Economic Times today. (We means India).

    BTW, this is 1003 blogpost. I never knew when it crossed 1000. Times surely fly.

    Assorted Links

    November 17, 2008

    1. TTR raises concerns on Indian banks

    2. IDB points to some articles on impact of Obama

    3. ACB points to reverse migration in China

    4. MR points where has all income gone?

    5. Mankiw says inferior goods consumption is rising

    6. Rodrik points to G-20 meeting

    7. FIn Rounds points to an article A to Z of crisis

    8. DB Blog explains how Doing Business Reports are prepared

    How the US originated crisis impacted other economies?

    November 14, 2008

    I have written a paper summarising how the crisis which originated in US has imapcted other economies.

    Let me know your comments.

    WTO raises concern over falling trade finance

    November 14, 2008

    I had pointed WTO is concerned that trade finance would be imacted by ongoing trade crisis. WTO in a meeting stressed on the problem and provided some stas as well:

    • The main one is the shortage of liquidity to finance trade credits. The market currently estimates the liquidity gap in trade finance at about $25 billion.
    • The second is a general re-assessment of the risks caused by the financial crisis and by the slowing down of the world economy.
    • These problems are being felt most acutely by traders and banks in the emerging market economies

    Further Pascal Lamy has warned the situation is likely to worsen and impact the world trade.

    CDS volumes declines marginally by 1%

    November 14, 2008

    BIS in its latest study points Credit Default Swaps have declined by 1% between Dec-07 and Jun-08. The detailed file in Pdf is here and excel files are here. The total derivative market is like this (in USD Billions):

      Dec-06 Jun-07 Dec-07 Jun-08 Dec-06 Jun-07 Dec-07 Jun-08
    Forex 40,271 48,645 56,238 62,983 1,266 1,345 1,807 2,262
    Interest rate 291,582 347,312 393,138 458,304 4,826 6,063 7,177 9,263
    Equity linked 7,488 8,590 8,469 10,177 853 1,116 1,142 1,146
    Commodity 7,115 7,567 8,455 13,229 667 636 1,899 2,209
    CDS 28,650 42,580 57,894 57,325 470 721 2,002 3,172
    Others 39,740 61,713 71,146 81,708 1,609 1,259 1,788 2,301
    Total 414,845 516,407 595,341 683,725 9,691 11,140 15,813 20,353

    As it can be seen, outstanding CDS have declined from USD 57.9 tn to 57.3 tn. All other derivative instruments, there is robust growth. This report has got much more analysis like Herfindahl index for measuring market concentration etc.

    Let me analyse it in details and point if anything interesting.

    Assorted Links

    November 14, 2008

    1. ACB says we should now call it a economic crisis

    2. WSJ Blog points Bernanke reputation has been damaged

    3. MB points to some nice explanation to recent mon pol moves.

    4. Mankiw points good time to buy stocks? Hamilton has some advice as well

    5. Rodrik points Calvo converts to supposing capital controls to manage sudden outflows

    6. Fin Prof points to a Buffet interview. It also points to historic volatility in US stock markets

    7. ALB points to a financial literacy test

    8. A new blog on finance – (by Washburn University students and faculty)

    9. CTB points to Fitch downgrading several emerging economies. It points to another blog which gives tons of pictures and charts on the crisis

    Mostly Economics ranked 12 now!

    November 12, 2008

    As per Econolog’s latest ranking, Mostly Economics is ranked 12th now. It has moved upwards from 30 to 12 in a manner of few weeks (October 27 it was ranked 30). So, the upwards march has been pretty impressive.

    Thanks a ton to all the visitors for visiting Mostly Economics.  Without you it would not be possible at all.

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