Tuesday, February 28, 2012

Systemic Real and Financial Risks: Measurement, Forecasting, and Stress Testing

Systemic Real and Financial Risks: Measurement, Forecasting, and Stress Testing. By Gianni de Nicolo & Marcella Lucchetta
IMF Working Paper No. 12/58
Feb 2012

Summary: This paper formulates a novel modeling framework that delivers: (a) forecasts of indicators of systemic real risk and systemic financial risk based on density forecasts of indicators of real activity and financial health; (b) stress-tests as measures of the dynamics of responses of systemic risk indicators to structural shocks identified by standard macroeconomic and banking theory. Using a large number of quarterly time series of the G-7 economies in 1980Q1-2010Q2, we show that the model exhibits significant out-of sample forecasting power for tail real and financial risk realizations, and that stress testing provides useful early warnings on the build-up of real and financial vulnerabilities.



The 2007-2009 financial crisis has spurred renewed efforts in systemic risk modeling. Bisias et al. (2012) provide an extensive survey of the models currently available to measure and track indicators of systemic financial risk. However, three limitations of current modeling emerge from this survey. First, almost all proposed measures focus on (segments of) the financial sector, with developments in the real economy either absent, or just part of the conditioning variables embedded in financial risk measures. Second, there is yet no systematic assessment of the out-of-sample forecasting power of the measures proposed, which makes it difficult to gauge their usefulness as early warning tools. Third, stress testing procedures are in most cases sensitivity analyses, with no structural identification of the assumed shocks.

Building on our previous effort (De Nicolò and Lucchetta, 2011), this paper contributes to overcome these limitations by developing a novel tractable model that can be used as a real-time systemic risks’ monitoring system. Our model combines dynamic factor VARs and quantile regressions techniques to construct forecasts of systemic risk indicators based on density forecasts, and employs stress testing as the measurement of the sensitivity of responses of systemic risk indicators to configurations of structural shocks.

This model can be viewed as a complementary tool to applications of DSGE models for risk monitoring analysis. As detailed in Schorfheide (2010), work on DSGE modeling is advancing significantly, but several challenges to the use of these models for risk monitoring purposes remain. In this regard, the development of DSGE models is still in its infancy in at least two dimensions: the incorporation of financial intermediation and forecasting. In their insightful review of recent progress in developments of DSGE models with financial intermediation, Gertler and Kyotaki (2010) outline important research directions still unexplored, such as the linkages between disruptions of financial intermediation and real activity. Moreover, as noted in Herbst and Schorfheide (2010), there is still lack of conclusive evidence of the superiority of the forecasting performance of DSGE models relative to sophisticated data-driven models. In addition, these models do not typically focus on tail risks. Thus, available modeling technologies providing systemic risk monitoring tools based on explicit linkages between financial and real sectors are still underdeveloped. Contributing to fill in this void is a key objective of this paper.

Three features characterize our model. First, we make a distinction between systemic real risk and systemic financial risk, based on the notion that real effects with potential adverse welfare consequences are what ultimately concerns policymakers, consistently with the definition of systemic risk introduced in Group of Ten (2001). Distinguishing systemic financial risk from systemic real risk also allow us to assess the extent to which a realization of a financial (real) shock is just amplifying a shock in the real (financial) sector, or originates in the financial (real) sector. Second, the model produces real-time density forecasts of indicators of real activity and financial health, and uses them to construct forecasts of indicators of systemic real and financial risks. To obtain these forecasts, we use a dynamic factor model (DFM) with many predictors combined with quantile regression techniques. The choice of the DFM with many predictors is motivated by its superior forecasting performance over both univariate time series specifications and standard VAR-type models (see Watson, 2006). Third, our design of stress tests can be flexibly linked to selected implications of DSGE models and other theoretical constructs. Structural identification provides economic content of these tests, and imposes discipline in designing stress test scenarios. In essence, our model is designed to exploit, and make operational, the forecasting power of DFM models and structural identification based on explicit theoretical constructs, such as DSGE models.

Our model delivers density forecasts of any set of time series. Thus, it is extremely flexible, as it can incorporate multiple measures of real or financial risk, both at aggregate and disaggregate levels, including many indicators reviewed in Bisias et al. (2012). In this paper we focus on two simple indicators of real and financial activity: real GDP growth, and an indicator of health of the financial system, called FS. Following Campbell, Lo and MacKinlay (1997), the FS indicator is given by the return of a portfolio of a set of systemically important financial firms less the return on the market. This indicator is germane to other indicators of systemic financial risk used in recent studies (see e.g. Acharya et al., 2010 or Brownlee and Engle, 2010).

The joint dynamics of GDP growth and the FS indicator is modeled through a dynamic factor model, following the methodology detailed in Stock and Watson (2005). Density forecasts of GDP growth and the FS indicator are obtained by estimating sets of quantile autoregressions, using forecasts of factors derived from the companion factor VAR as predictors.  The use of quantile auto-regressions is advantageous, since it allows us to avoid making specific assumptions about the shape of the underlying distribution of GDP growth and the FS indicator. The blending of a dynamic factor model with quantile auto-regressions is a novel feature of our modeling framework.

Our measurement of systemic risks follows a risk management approach. We measure systemic real risk with GDP-Expected Shortfall (GDPES ), given by the expected loss in GDP growth conditional on a given level of GDP-at-Risk (GDPaR), with GDPaR being defined as the worst predicted realization of quarterly growth in real GDP at a given (low) probability. Systemic financial risk is measured by FS-Expected Shortfall (FSES), given by the expected loss in FS conditional on a given level of FS-at-Risk (FSaR), with FSaR being defined as the worst predicted realization of the FS indicator at a given (low) probability level.

Stress-tests of systemic risk indicators are implemented by gauging how impulse responses of systemic risk indicators vary through time in response to structural shocks. The identification of structural shocks is accomplished with an augmented version of the sign restriction methodology introduced by Canova and De Nicolò (2002), where aggregate shocks are extracted based on standard macroeconomic and banking theory. Our approach to stress testing differs markedly from, and we believe significantly improves on, most implementations of stress testing currently used in central banks and international organizations. In these implementations, shock scenarios are imposed on sets of observable variables, and their effects are traced through "behavioral" equations of certain variables of interest. Yet, the ?shocked? observable variables are typically endogenous: thus, it is unclear whether we are shocking the symptoms and not the causes. As a result, it is difficult to assess both the qualitative and quantitative implications of the stress test results.

We implement our model using a large set of quarterly time series of the G-7 economies during the 1980Q1-2010Q1 period, and obtain two main results. First, our model provides significant evidence of out-of sample forecasting power for tail real and financial risk realizations for all countries. Second, stress tests based on this structural identification provide early warnings of vulnerabilities in the real and financial sectors.

Monday, February 27, 2012

Economic crisis: Views from Greece

I asked some Greek professionals about the crisis in their country on behalf of Hanna Intelligence's CEO, Mr. Jose Navio:
dear sir, I got some questions for you, if you have the time:

1  could you please make mention of effects in the citizenry like more children abandoned in hospices because the family cannot maintain them?
2  do you know of lack of food/medicines or lower quality of them?
3  is it better in your opinion to get out of the Euro and use again the old drachma (or any other new currency)?
4  is it better in your opinion to default and to reject the troika bail-outs?

thank you very much in advance,


The answer of one of those professionals:

Date: 2/27/2012
Subject: RE: Greece and the economic crisis
Dear Mr xxx,

thank you for asking about my country's present; my comment should focus on two issues:

The first one refers to the huge "brain drain" that is in progress during this period in Greece, even to a greater extent than the period after the WWII, which was the greatest immigration period in Greek history. People of all ages and professions are migrating in foreign countries around the world seeking for a job and better living conditions, in all financial, communal and governance/ infrastructural terms.

The second one refers to the sharp rise of homeless people and unable to sustain their families' every day living, dignity and income, due to the unprecedented percentages of unemployment, wages' cuttings and increase of the prices of almost all commodities. In cooperation with the church and under the coordination of various entities and NGOs, citizens are gathering food and clothing to assist all those who suffer the "human insecurity" that prevails nowadays in Greece.

I can't say what could have been better for Greece in economic terms, since it's out of my area of expertise, and I don't want to follow the paradigm of all those who suddenly became experts in economic strategies, options, terms and conspiracy theories. I can confirm though that this situation is the result of bad Greek governance for the last thirty years and that although Greece didn't loose sovereignty through wars in it's modern history, it did through economic procedures and EU norms; in any case Greeks are experiencing a very hard austerity policy, humiliation from various (mostly) European governments and states, and most important, instead of facing a hopeful future and prospect, they see things getting worst every day, even after all this inhuman behaviors.

I don't know what the plan or EU's "Grand Strategy" might be for Greece, but definately the proud and cultural Greeks don't deserve what they experience during these years, not even what is yet to come. The civil society is a "boiling pot" due to the downgrade of the every day living standards, unpunished and "untouchable" politicians responsible for this situation,explicit inequalities and non-existing options for the future generations. Let's hope at least that we'll not experience also a bloodshed or Egypt-like uprisings..

I hope I gave you a brief and indicative picture of contemporary Greece, and been of some help to your questions.

Best regards,


Thursday, February 23, 2012

Can Institutional Reform Reduce Job Destruction and Unemployment Duration?

Can Institutional Reform Reduce Job Destruction and Unemployment Duration? Yes It Can. By Esther Perez & Yao Yao
IMF Working Paper No. 12/54
February 2012

Summary: We read search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve(IUC).The IUC is the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied Using a panel of 20 OECD countries over 1985-2008, we find employment protection legislation to have opposing efects on destructions and durations, while the effects of the remaining key institutional factors on both variables tend to reinforce each other. Implementing the right reforms could reduce job destruction rates by about 0.05 to 0.25 percentage points and shorten unemployment spells by around 10 to 60 days. Consistent with this, unemployment rates would decline by between 0.75 and 5.5 percentage points, depending on a country’s starting position.


This paper investigates how labor market policies affect the unemployment rate through its two defining factors, the duration of unemployment spells and job destruction rates.  To this aim, we look at search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve (IUC). The IUC represents the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied. We next provide micro-foundations for the link between destructions, durations and policy variables. This allows us to explore the relevance of institutional features using a sample of 20 OECD countries over the period 1985-2008.

The empirical literature investigating the influence of labor market institutions on overall unemployment rate is sizable (see, for instance, Blanchard and Wolfers, 1999, and Nickell and others, 2002). Equally numerous are the studies splitting unemployment into job creation and job destruction flows (see, for example, Blanchard, 1998, Shimer, 2007, and Elsby and others, 2008). This work connects these two strands of the literature by investigating how labor market policies shape both job separations and unemployment spells, which together determine the overall unemployment rate in the economy. The IUC schedule used in our analysis is novel and is motivated by the need to understand the nature of unemployment, as essentially coming from destructions, durations or a combination of both these factors. This can help clarify whether policy makers should focus primarily on speeding up workers’ reallocation across job positions rather than protecting them in the workplace.

One fundamental question raised in this context is whether countries with dynamic labor markets significantly outperform countries with more stagnant markets. By dynamic (stagnant) we mean labor markets displaying high (low) levels of workers’ turnover in and out of unemployment. Is it the case that countries featuring high job destruction rates but brief unemployment spells tend to display lower unemployment rates than labor markets characterized by limited job destruction but longer unemployment durations?  And how do institutional features shape destructions and durations?


This paper reads the basic unemployment equilibrium condition postulated by search theory as an Iso-Unemployment Curve (IUC). The IUC is the locus of job destruction rates and expected unemployment durations that render the same unemployment level.  We use this schedule to classify countries according to their preferences over the job destruction-unemployment duration trade-off. The upshot of this analysis is that labor markets characterized by high levels of job destruction but brief unemployment spells do not necessarily outperform countries characterized by the opposite behavior. But, the IUC construct makes it clear that high unemployment rates result from extreme values in either durations or destructions, or intermediate-to-high levels in both.

Looking at unemployment through the lenses of the IUC schedule focuses the attention on each economy’s revealed social preferences over the destruction-duration mix. Policy packages fighting unemployment should take into consideration such preferences. Some countries seem to tolerate relatively high destruction rates as long as unemployment duration is short. Others are biased towards job security and do not mind financing longer job search spells. A few unfortunate countries are trapped in a high inflow-high duration combination, seemingly condemned for long periods of high unemployment.

An optimistic message arising from this study, especially for countries located on higher IUCs, is that an ambitious structural reform program tackling high labor tax wedges, activating unemployment benefits and removing barriers to competition in key services can effectively contain job losses, limit the duration of unemployment spells and yield substantial reduction in unemployment.

Thursday, February 16, 2012

Intra-group support measures in times of stress or unexpected loss by financial groups in the banking, insurance and securities sectors

The Joint Forum: Report on intra-group support measures
Feb 2012

The Joint Forum (BIS, IOSCO, IAIS) just published a report to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors. The report provides an important overview of intra-group support measures used in practice at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress.

The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates.


Executive Summary
The objective of this report prepared by the Joint Forum is to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors.  The report provides an important overview of the use of intra-group support at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress. The report may also assist the thematic work contemplated by the Financial Stability Board (FSB) on deposit insurance schemes and feed into the ongoing policy development in relation to recovery and resolution plans.

The report is based on the findings of a high-level stock-take which examined the use of intra-group support measures available to banks, insurers and securities firms. The stocktake was conducted through a survey by the Joint Forum Working Group on Risk Assessment and Capital (JFRAC) that was completed by 31 financial institutions headquartered in ten jurisdictions on three continents: Europe, North America and Asia.  Participants were drawn from the banking, insurance and securities sectors and from many of the jurisdictions represented by Joint Forum members. Many participating firms were large global financial institutions.

The report provides an overview and analysis of the types and frequency of intra-group support measures used in practice. It is based only on information provided by participants in the survey. Responses were verified by supervisors only in certain instances.

The survey’s main findings are as follows:

1. Intra-group support measures can vary from institution to institution, driven by the regulatory, legal and tax environment; the management style of the particular institution; and the cross-border nature of the business. Authorities should be mindful of the complicating effect of these measures on resolution regimes and the recovery process in the event of failure.

2. The majority of respondents surveyed indicated centralised capital and liquidity management systems were in place. According to proponents, this approach promotes the efficient management of a group’s overall capital level and helps maximise liquidity while reducing the cost of funds. However, the respondents that favoured a “self-sufficiency” approach pointed out that centralised management potentially has the effect of increasing contagion risk within a group in the event of distress at any subsidiaries. The use of these systems impacts the nature and design of intra-group support measures with some firms indicating that the way they managed capital and liquidity within the group was a key driver in their decisions about the intra-group transactions and support measures they used.

3. Committed facilities, subordinated loans and guarantees were the most widely used measures. This was evident across all sectors and participating jurisdictions.

4. Internal support measures generally were provided on a one-way basis (eg downstream from a parent to a subsidiary). Loans and borrowings, however, were provided in some groups on a reciprocal basis. As groups surveyed generally operated across borders, most indicated support measures were provided both domestically and internationally. Support measures were also in place between both regulated and unregulated entities and between entities in different sectors.

5. The study found no evidence of intra-group support measures either a) being implemented on anything other than an arm’s length basis, or b) resulting in the inappropriate transfer of capital, income or assets from regulated entities or in a way which generated capital resources within a group. However, this does not necessarily mean that supervisory scrutiny of intra-group support measures is unwarranted. As this report is based on industry responses, further in-depth analysis by national supervisors may provide a more complete picture of the risks potentially posed by intra-group support measures.

6. While the existing regulatory frameworks for intra-group support measures are somewhat limited, firms do have certain internal policies and procedures to manage and restrict internal transactions. Respondents pointed out that the regulatory and legal framework can make it difficult for some forms of intra-group support to come into force while supervisors aim to ensure that both regulated entities and stakeholders are protected from risks arising from the use of support measures. For instance, upstream transfers of liquidity and capital are monitored and large exposure rules can limit the extent of intra-group interaction for risk control purposes. Jurisdictional differences in regulatory settings can also pose a challenge for firms operating across borders.

7. Based on the survey and independent of remaining concerns and information gaps, single sector supervisors should be aware of the risks that intra-group support measures may pose and should fully understand the measures used by an institution, including its motivations for using certain measures over others. In order to obtain further insight into the intra-group support measures put in place by financial institutions within their jurisdiction, national supervisors should, where appropriate, conduct further analysis in this area. A high-level model questionnaire is provided in Annex II with the aim of assisting national supervisors with ongoing work relating to intra-group support measures.

Thursday, February 9, 2012

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach. By German Lopez-Espinosa, Antonio Moreno, Antonio Rubia, and Laura Valderrama
IMF Working Paper No. 12/46
Feb 2012

Summary: In this paper we identify some of the main factors behind systemic risk in a set of international large-scale complex banks using the novel CoVaR approach. We find that short-term wholesale funding is a key determinant in triggering systemic risk episodes. In contrast, we find no evidence that a larger size increases systemic risk within the class of large global banks. We also show that the sensitivity of system-wide risk to an individual bank is asymmetric across episodes of positive and negative asset returns. Since short-term wholesale funding emerges as the most relevant systemic factor, our results support the Basel Committee’s proposal to introduce a net stable funding ratio, penalizing excessive exposure to liquidity risk.


That financial markets move more closely together during times of crisis is a well-documented fact. Conditional correlations among assets are much higher when market returns are low in periods of financial stress; see, among others, King and Wadhwani (1990) and Ang, Chen and Xing (2006). Co-movements typically arise from common exposures to shocks, but also from the propagation of distress associated with a decline in the market value of assets held by individual institutions, a phenomenon we dub balance sheet contraction and which is of particular concern in the financial industry. The recent crisis has shown how the failure of large individual credit institutions can have dramatic effects on the overall financial system and, eventually, spread to the real economy. As a result, international financial policy institutions are currently designing a new regulatory framework for the so-called systemically important financial institutions in order to ensure global financial stability and prevent, or at least mitigate, future episodes of systemic contagion.

In this paper, building on a global system of international financial institutions that comprises the largest banks in a sample of 18 countries, we analyze the main determinants of systemic contagion from an individual institution to the international financial system, i.e., the empirical drivers of tail-risk interdependence. We restrict our attention to a set of large-scale, complex institutions that are the target of current regulation efforts and that would likely be considered too-big-to-fail by central banks. These firms are characterized by their large capitalization, global activity, cross-border exposures and/or representative size in the local industry. Using data spanning the 2001-2009 period, we explicitly measure the contribution of the balance-sheet contraction of these institutions to international financial distress. As regulators seek for meaningful measures of interconnectedness (Walter 2011), this paper contributes to the current debate on prudential regulatory requirements by showing formal evidence that short-term wholesale funding is a major driver of systemic risk in global banking.

Financial institutions use wholesale funding to supplement retail deposits and expand their balance sheets. These funds are typically raised on a short-term rollover basis with instruments such as large-denomination certificates of deposits, brokered deposits, central bank funds, commercial paper and repurchase agreements. Whereas it is agreed that wholesale funding provides certain managerial advantages (see Huang and Ratnovski, 2011, for a discussion), the effects on systemic risk of an overreliance on these liabilities were under-recognized prior to the recent financial crisis. Banks with excessive short-term funding ratios are typically more interconnected to other banks, exposed to a large degree of maturity mismatch and more vulnerable to market conditions and liquidity risk. These features can critically increase the vulnerability of interbank markets and money market mutual funds which act as wholesale providers of liquidity and, eventually, of the whole financial system. The empirical analysis on this paper provides clear evidence on the major role played by short-term wholesale funding to spread systemic risk in global markets.

Additionally, we explore the possibility that the contribution to systemic risk may be asymmetric, i.e. that it depends on whether the market value of a bank’s balance sheet is increasing or decreasing. Because a distressed institution is likely to generate larger externalities on the rest of the financial system when its balance sheet is contracting, an empirical analysis of tail risk-dependence within a financial system should distinguish between episodes of expanding and contracting balance sheets. We deal with this previously unaddressed but key issue, finding strong evidence supporting the existence of asymmetric patterns. Finally, we also analyze the effects of the 2008-2009 global financial crisis on systemic risk and assess the impact of public recapitalizations directly targeted at individual banks.

Our study builds on the novel procedure put forward by Adrian and Brunnermeier (2009), the so-called CoVaR methodology, and generalizes it in several ways in order to deal with the characteristics of a sample of international banks and to address the asymmetric patterns that may underlie tail dependence. The main empirical findings of our analysis can be summarized as follows. First, we find that short-term wholesale funding is the most significant balance sheet determinant of individual contributions to global systemic risk. An increase of one percentage point in this variable leads to an increase in the contribution to systemic risk of 40 basis points of quarterly asset returns. These results support regulatory initiatives aimed at increasing bank liquidity buffers to lessen asset-liability maturity mismatches as a mechanism to mitigate individual liquidity risk, such as the liquidity coverage ratio standard recently laid out by the Basel Committee on Banking Supervision under the new Basel III regulatory framework.3 This paper shows that these provisions may also help to reduce the likelihood of systemic contagion. By contrast, we find little evidence that, within the class of large-scale banks, either relative size or leverage is helpful in predicting future systemic risk after accounting for short-term wholesale funding.

Second, our analysis shows that individual balance sheet contraction produces a significant negative spillover on the Value-at-Risk (VaR) threshold of the global index. Whereas the sensitivity of left tail global returns to a shock in an institution’s market valued asset returns is on average about 0.3, the elasticity conditional on an institution having a shrinking balance sheet is almost three times larger. This result reveals a strong degree of asymmetric response that has not been discussed in the extant literature and which turns out to be larger the more systemic the bank is when its balance sheet is contracting. Therefore, controlling for balance sheet contraction is crucial to rank financial institutions by their contribution to systemic risk.

Third, restricting attention to balance sheet contraction episodes, the credit crisis added up 0.1 percentage points to the co-movement between individual and global asset returns while recapitalization during the crisis period dampened co-movement by 0.2 percentage points.  Furthermore, the timing of recapitalization also matters for systemic risk. Banks that received prompt recapitalization in Q4 2008 proved able to improve their relative position during the crisis period, whereas banks that were rescued by public authorities later in Q4 2009 became relatively more systemic during the crisis period. Finally, the marginal contribution of an individual bank to overall systemic risk increases from 0.76 quarterly percent returns in an average quarter to 0.92 in a quarter characterized by money market turbulence. These results highlight the relevance of crisis episodes in measuring systemic risk and of policy actions in controlling it.

Concluding remarks and policy recommendations
In this paper we examine some of the main factors driving systemic risk in a global framework. We focus on a set of large-scale, international complex institutions which would in principle be deemed too-big-to-fail by national regulators and which are therefore of mayor interest for policy makers. For this class of firms, the evidence based on the CoVaR methodology suggests that short-term wholesale funding –a variable strongly related to interconnectedness and liquidity risk exposure-, is positively and significantly related to systemic risk, whereas other features of the firm, such as leverage or relative size, do not seem to provide incremental information over wholesale funding. This suggests that this latter variable subsumes to a large extent most of the relevant information on systemic risk conveyed by other firm characteristics. We also uncover the relevant role played by asymmetric responses when assessing the impact of individual institutions on system-wide risk, as we find that the sensitivity of system returns to individual bank returns is much higher in periods of balance sheet deleveraging.

Regulators are currently developing a methodological framework within the context of Basel III that attempts to embody the main factors of systemic importance; see Walter (2011). These factors are categorized as size, interconnectedness, substitutability, global activity and complexity, and will serve as a major reference to determine the amount of additional capital requirements and funding ratios for systemically important financial institutions. Our analysis provides formal empirical support to the Basel Committee’s proposal to penalize excessive exposures to liquidity risk by showing that short-term wholesale funding, a variable capturing interconnectedness, largely contributes to systemic risk. Furthermore, since our findings suggest that some factors are much more important than others in determining systemic risk contributions, an optimal capital buffer structure on systemic banks could in principle be designed by suitably weighting the different driving factors as a function of their relative importance. This is an interesting topic for further research. Similarly, the evidence in this paper also offers empirical support to justify the theoretical models that acknowledge the premise that wholesale funding can generate large systemic risk externalities; see, for instance, Perotti and Suarez (2011) for a recent analysis and references therein.

Given the relevance of liquidity strains as a contributing factor to systemic risk, the regulation of systemic risk could be strengthened by giving incentives to disclose contingent short-term liabilities, in particular those related to possible margin calls under credit default swap contracts and repo funding. Our study also points at the role of large trading books as a source of systemic risk –for those banks which were recapitalized during the crisis. As a result, the 2010 revamp of the Basel II capital framework to cover market risk associated with banks’ trading book positions will not only decrease individual risk but will also contribute to mitigate systemic risk.

Wednesday, February 8, 2012

The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements

The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements. By Scott Roger & Francis Vitek
IMF Working Paper No. 12/44

Summary: This paper examines the transitional macroeconomic costs of a synchronized global increase in bank capital adequacy requirements under Basel III, as well as a capital increase covering globally systemically important banks. The analysis, using an estimated multi-country model, contributed to the work of the Macroeconomic Assessment Group analysis, especially in estimating the potential international spillovers associated with a global increase in capital requirements. The magnitude of the effects found in this analysis is relatively modest, especially if monetary policies have scope to ease in response to a widening of interest rate spreads by banks.



1. This paper analyzes the transitional macroeconomic costs of strengthening bank capital adequacy requirements, including a general increase in capital requirements as well as an increase specifically for globally systemically important banks (GSIBS). In addition to estimating the impact of introducing higher capital requirements in each of 15 major economies, the analysis also includes estimates of the international spillover effects associated with the simultaneous introduction of higher capital requirements by all 15 countries. The simulations are generated within the framework of an extended and refined version of the multi-country macroeconometric model of the world economy developed and estimated by Vitek (2009).

2. This analysis contributed to the work of the Macroeconomic Assessment Group (MAG), chaired by the Bank for International Settlements (BIS), and the Long-term Economic Impact (LEI) group of the Basel Committee for Banking Stability (BCBS).1 The MAG participants, including the IMF, used a variety of models to estimate the medium-term macroeconomic costs of strengthening capital and liquidity requirements.2 The analysis presented in this paper, reflecting the MAG mandate, focuses solely on the short-term to medium-term output costs of the proposed new regulatory measures. Estimates of the net benefits of these regulatory measures can be found in the LEI report (BCBS 2010).

3. The macroeconomic effects of an increase in capital adequacy requirements are assumed in this analysis to be transmitted exclusively via increases in the spread between commercial bank lending rates and the central bank policy rate. We estimate that, in the absence of any monetary policy response, a permanent synchronized global increase in capital requirements for all banks by 1 percentage point, would cause a peak reduction in GDP of around 0.5 percentage points, of which around 0.1 percentage points would result from international spillovers. Losses in emerging market economies are found to be somewhat higher than in advanced economies. If monetary policy is able to respond, however, the adverse impact of higher capital requirements could be largely offset.

4. With regard to strengthening capital requirements specifically for GSIBs, we estimate that a 1 percentage point increase in capital requirements for the top 30 GSIBs would cause a median peak reduction in GDP of around 0.17 percentage points, of which 0.04 percentage points, or 25 percent, results from international spillovers. The aggregate figures conceal a wide range of outcomes, however, and for some countries, international spillovers would be the main source of macroeconomic effects.

5. It is important to bear in mind the limitations of the model and assumptions used in the analysis. In particular, the analysis does not take account of other possible responses by banks or other financial institutions to changes in capital requirements, or non-linearities in the response of financial systems, monetary policy, or the real economy. Nor does the model allow for changes in the macroeconomic steady state associated with very persistent widening of lending spreads. Additionally, the analysis does not take account of the different initial starting points of different countries in raising capital requirements, or differences in the speed of implementation. 

Concluding comments and caveats

28. The multi-country macroeconomic model used in this analysis contributed importantly to the MAG assessments of the potential impact over the medium term of a global increase in capital requirements, both for all banks and for a smaller group of GSIBs. The results of the multi-country analysis indicate that international spillovers associated with coordinated policy measures are important—our analysis suggests that spillovers typically account for 20- 25 percent of the total impact on output. Moreover, in the case of an increase in capital requirements for GSIBs, international spillovers may be the primary source of macroeconomic effects.

29. At the same time, it is important to recognize the important limitations associated both with the model and with the exercise it was used in. With regard to the model, the main limitations to emphasize are that:
* As discussed earlier, the model is not geared to dealing with changes in the steady state associated with permanent or very persistent shocks. Although the quantitative significance of this does not appear to be large in the context of this exercise, it suggests that the estimated effects of a permanent increase in interest rate spreads should be interpreted with caution, particularly at long horizons.

* The model has only one avenue for the increase in capital requirements to affect the real economy; though a widening of bank lending spreads over the policy rate. As discussed in the MAG reports, there are several ways in which banks can respond to higher capital requirements and some could have much more significant effects on output, while others would be more benign.

30. The exercises themselves have some important limitations that should be borne in mind in assessing the quantitative results and risks surrounding them. These include:
* The implementation of the higher capital requirements is assumed to be linear over the alternative implementation periods. In practice, the speed of implementation is quite likely to be non-linear; indeed, markets may be forcing a front-loading of adjustment.
* The scope for monetary policy responses may well vary over time and differ from one country to another. Not all countries are close to the zero lower bound for interest rates, and even those that are may not remain so over the entire implementation period.  Consequently, macroeconomic outcomes and spillovers are bound to differ from those suggested by the model analysis. The analysis should be thought of as showing bounds for potential outcomes associated with different monetary policies.

* The analyses only consider standardized increases in capital requirements by 1 percentage point. However, the effects of increases in requirements may well be nonlinear, so that increasing requirements by 2 percentage points may be not be simply twice as much as a 1 percentage point increase, and the degree of non-linearity may not be the same across time or countries. The zero lower bound constraint is one such nonlinearity, but there are likely to be others.

* The analysis of the global increase in capital requirements assumed an identical increase in capital requirements in all countries. In reality, banks in some countries will have much further to go in meeting higher capital requirements than banks in other countries. As a consequence, the pace of increases in interest rate spreads will vary across countries. As seen in the exercise with GSIBs, where spreads increased by different amounts in different countries, this would significantly modify the pattern of macroeconomic effects and their spillovers between countries.

Tuesday, February 7, 2012

U.S.-China Competition in Asia: Legacies Help America

U.S.-China Competition in Asia: Legacies Help America. BY ROBERT SUTTER
East-West Center
Feb 2012

As Sino-American competition for influence enters a new stage with the Obama administration’s re-engagement with Asia, each power’s legacies in the region add to economic, military and diplomatic factors determining which power will be more successful in the competition. How the United States and China deal with their respective histories in regional affairs and the role of their non-government relations with the Asia-Pacific represent important legacies that on balance favor the United States.

The Role of History
From the perspective of many regional government officials and observers, the United States and the People’s Republic of China both have historically very mixed records, often resorting to highly disruptive and violent measures to preserve their interests. The record of the United States in the Cold War and later included major wars in Korea and Vietnam and constant military friction along Asia’s rim as it sought to preserve military balance and deter perceived aggression. Many in Asia benefited from America’s resolve and major sacrifices. Most today see the United States as a mature power well aware of the pros and cons of past behavior as it crafts a regional strategy to avoid a potentially dangerous withdrawal and to preserve stability amid U.S. economic and budget constraints.

In contrast, rising China shows little awareness of the implications of its record in the region. Chinese officials and citizens remain deeply influenced by an officially encouraged erroneous claim that China has always been benign and never expansionist. The highly disruptive policies and practices of the People’s Republic of China under the revolutionary leadership of Mao Zedong and the more pragmatic leadership of Deng Xiaoping are not discussed. Well-educated audiences at foreign policy forums at universities and related venues show little awareness of such legacies as consistent Chinese support for the Khmer Rouge as a means to preserve Chinese interests in Southeast Asia.  China’s military invasion of Vietnam and Chinese directed insurgencies against major governments in Southeast Asia, both Western-aligned states and the strictly neutral government of Burma, seem widely unknown.

Chinese officials who should know better also refuse or are unable to deal honestly with the recent past. Speaking last year to a group of Asian Pacific including Vietnamese, American and Chinese officials and scholars deliberating over recent trends in Asia, a Chinese foreign affairs official emphasized in prepared remarks that China “has always been a source of stability in Asia.” After watching the Vietnamese participants squirm in their seats, others raised objections to such gross inaccuracy.

The Chinese lacuna regarding how it has been perceived by its neighbors encumbers China’s efforts to gain influence in the region. China has a lot to live down. Regional governments need steady reassurance that China will not employ its growing power to return to the domineering and disruptive practices that marked forty of the sixty years of the People’s Republic of China. Educated Chinese citizens and at least some responsible officials appear insensitive to this need because of ignorance. They see no requirement to compensate for the past and many criticize Chinese government actions that try to accommodate concerns of regional neighbors. The nationalistic rhetoric coming from China views neighbors as overly sensitive to Chinese assertions and coercive measures on territorial, trade and other issues which revive regional wariness that the antagonistic China of the recent past may be reemerging with greater power in the current period.

Non-government Relations

Like many countries, China’s interaction with its neighbors relies heavily on the Chinese government and other official organizations. Even areas such as trade, investment, media, education and other interchange are heavily influenced by administrative support and guidance. An exception is the large numbers of ethnic Chinese living for generations in neighboring countries, especially in Southeast Asia, which represent a source of non-government influence for China. On balance, the influence of these groups is positive for China, although suspicions about them remain in some countries.

By contrast, for much of its history, the United States exerted influence in Asia and the Pacific much more through business, religious, media, foundations, educational and other interchange than through channels dependent on government leadership and support. Active American non-government interaction with the region continues today, putting the United States in a unique position where the American non-government sector has such a strong and usually positive impact on the influence the United States exerts in the region. Meanwhile, almost 50 years of generally color-blind U.S.  immigration policy since the ending of discriminatory U.S. restrictions on Asian immigration in 1965 has resulted in the influx of millions of Asia-Pacific migrants who call America home and who interact with their countries of origin in ways that under gird and reflect well on the U.S. position in the region. No other country, with the exception of Canada, has such an active and powerfully positive channel of influence in the Asia-Pacific.

Outlook: Advantage U.S.

The primary concerns in the Asia-Pacific with stability and development mean that U.S.-Chinese competition for influence probably will focus more on persuasion than coercion. The strong American foundation of webs of positive non-government regional interchange and the Obama government’s widely welcomed re-engagement with the region contrasts with rising China’s poor awareness of its historical impact on the region and limited non-government connections.

Friday, February 3, 2012

Why did the U.S. recover faster from the Panic of 1907 than from the 2008 recession and the Great Depression?

Why did the U.S. recover faster from the Panic of 1907 than from the 2008 recession and the Great Depression?
WSJ, Feb 02, 2012

Commerce Department data released last Friday show that four years after the recession began, real gross domestic product per person is down $1,112, while 5.8 million fewer Americans are working than when the recession started.

Never before in postwar America has either real per capita GDP or employment still been lower four years after a recession began. If in this "recovery" our economy had grown and generated jobs at the average rate achieved following the 10 previous postwar recessions, GDP per person would be $4,528 higher and 13.7 million more Americans would be working today.

Behind the startling statistics of lost income and jobs are the real and painful stories of American families falling further behind: record high poverty levels, record low teenage employment, record high long-term unemployment, shrinking birthrates, exploding welfare benefits, and a crippled middle class.

As the recovery faltered, President Obama first claimed the weakness of the recovery was due to the depth of the recession, saying that it was "going to take a while for us to get out of this. I think even I did not realize the magnitude . . . of the recession until fairly far into it."

But, in fact, the 1981-82 recession was deeper and unemployment was higher. Moreover, the 1982 recovery was constrained by a contractionary monetary policy that pushed interest rates above 21%, a tough but necessary step to break inflation. It was also a recovery that required a painful restructuring of American businesses to become more competitive in the increasingly globalized economy. By way of comparison, our current recovery has benefited from the most expansionary monetary policy in U.S. history and a rapid return to profitability by corporate America.

Despite the significant disadvantages the economy faced in 1982, President Ronald Reagan's policies ignited a recovery so powerful that if it were being repeated today, real per capita GDP would be $5,694 higher than it is now—an extra $22,776 for a family of four. Some 16.9 million more Americans would have jobs.

The most recent excuse for the failed recovery is that financial crises, by their very nature, result in slower, more difficult recoveries. Yet the 1981-82 recession was at least in part financially induced by inflation, record interest rates and the dislocations they generated. The high interest rates wreaked havoc on long-term lenders like S&Ls, whose net worth turned negative in mid-1982. But even if we ignore the financial roots of the 1981-82 recession, the financial crisis rationalization of the current, weak recovery does not stand up to scrutiny.

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic "A Monetary History of the United States," found "much similarity in its early phases" between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

It is certainly true that the economy languished in the Great Depression as it has over the past four years. But today's malaise is similar to that of the Depression not because of the financial events that triggered the disease but because of the virtually identical and equally absurd policy prescriptions of the doctors.

Under President Franklin Roosevelt, federal spending jumped by 3.6% of GDP from 1932 to 1936, an unprecedented spending spree, as the New Deal was implemented. Under President Obama, spending exploded by 4.6% of GDP from 2008 to 2011. The federal debt by the end of 1938 was almost 150% above the 1929 level. Publicly held debt is projected to be double the 2008 level by the end of 2012. The regulatory burden mushroomed under Roosevelt, as it has under Mr. Obama.

Tax policy then and now was equally destructive. The top individual income tax rate rose from 24% to 63% and then to 79% during the Hoover and Roosevelt administrations. Corporate rates were increased by 36%. Under Mr. Obama, capital gains taxes are set to rise by one third, the top effective tax rate on dividends will more than triple, and the highest marginal tax rate will effectively rise by 21.4%.

Moreover, the Obama administration's populist tirades against private business are hauntingly similar to the Roosevelt administration's tirades. FDR's demagoguery against "the privileged few" and "economic royalists" has evolved into Mr. Obama's "the richest 1%" and America's "millionaires and billionaires."

Yet, in his signature style, Mr. Obama now claims our weak recovery is not because a Democratic Congress said yes to his policy prescriptions in 2009-10 but because a Republican House said no in 2011. The sad truth is this president sowed his policies and America is reaping the results.

Faced with the failed results of his own governing strategy of tax, spend and control, the president will have no choice but to follow an election strategy of blame, vilify and divide. But come Nov. 6, American voters need only ask themselves the question Reagan asked in 1980: "Are you better off than you were four years ago?"

Sadly, with their income reduced by thousands, the number of U.S. jobs down by millions, and the nation trillions deeper in debt, the answer will be a resounding "No."

Mr. Gramm, a former U.S. senator from Texas, is the senior partner at U.S. Policy Metrics, where Mr. Solon, a former senior budget staffer in both houses of Congress, is also a partner.