Archive for November 11th, 2009

Too complex to Fail

November 11, 2009

As if Too Big to Fail was not enough to digest, IMF warns of a new risk- Too Complex to Fail. In its new paper, IMF adds the real problem is too complex to fail.

A snapshot of the paper findings is here.

According to the paper, factors that might be considered indicators of a firm’s vulnerability, and its increasing risk to the financial system overall, include:

• Leverage, which is borrowed capital used to increase a firm’s potential returns

• Illiquid assets, which may need to be sold in order for a firm to raise funds

• The complexity of a firm, coupled with the availability of reliable information about a firm’s investments in a particular security or industry

The paper also lays out a framework to identify which firms/markets are risky etc

It sets out the criteria and principles to help countries determine which firms and markets are systemically important. The paper outlined three main principles:

• The size of a financial firm or market, and the volume of financial services it provides

• The extent to which other parts of the financial system can provide the same services in the event of a firm or financial market’s failure

• The linkages between financial institutions, which might create repercussions in the event of a firm’s failure

I have  always felt Too Complex to Fail is as big an issue. In times of crisis, most financial firms become too complex as information about their assets and liabilities becomes opaque. It is important to remember financial services as it is are farly hiogh on information asymmetry. This escalates in times of crisis and makes everything fairly complex to fail.

 Smaghi of ECB explains:

if you buy a financial product you are, by definition, buying risk. If you only want to preserve the nominal value of your savings, you should just hold cash. The return on an investment compensates you for the inherent risk of the asset you acquire. In other words, the value of a financial instrument is uncertain because it is subject to risk. The greater the risk, the greater the return should be.

 The second part of the answer is that it is not always easy to assess risk. Anyone who enters into a transaction should make his or her own assessment. That may vary not only because of the probability of a specific event, such as the default of the counterparty, but also because of the probability of other events, affecting for instance the other assets held in the portfolio of an investor. But, more importantly, the buyer and seller may value the risk of an asset differently because they might have different information about the asset itself, and its characteristics. In particular the seller – by which I mean the originator – of the asset tends to have more information than the buyer. If the former can hide some of the information, in particular about the risk of the asset, he can sell it at a higher price. In other words, the rate of return will not cover the intrinsic risk of the asset.

This is where the difference between financial products and other products is relevant, not only for individuals but also for society. 

Too complex to fail is a far bigger idea which needs to be understood. The smaller firms if complex can pose large problems as well. LTCM was one example.

 

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Shiller, Thaler, Barberis, Laibson etc interviews/articles

November 11, 2009
Well all these are behavioral economics/finance professors. To have their interviews/articles in one publication on various aspects of behavioral economics is an absolute treat.
Qn is a magazine taken out by Yale School of Management. Its first version was Q3 and the latest version is Q6. Q6 is dedicated to behavioral economics. The full magazine in pdf version is here (heavy file of around 2.5 mb). It features following articles:

First Discussion Paper on Goods and Service Tax in India

November 11, 2009

The first discussion paper on India’s GST is here. I haven’t read it so far, so no comments.

I came to know y’day that first discussion paper on India’s GST is to be released. So have been looking at all possible govt websites- Finance Ministry, Taxation websites, Prime Minister’s Office, Planning Commission etc etc. But could not find it.

After a lot of google searching managed to locate the paper finally. Thanks a ton to etaxindia.org.


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