Wednesday, October 17, 2012

Bipartisan Agreement On Single-Sex Education

A Right to Choose Single-Sex Education. By Kay Bailey Hutchison and Barbara Mikulski
For some children, learning in girls-only or boys-only classes pays off. Opponents of the idea are irresponsible.October 16, 2012, 7:11 p.m. ET

Education proponents across the political spectrum were dismayed by recent attempts to eradicate the single-gender options in public schools in Virginia, West Virginia, Alabama, Mississippi, Maine and Florida. We were particularly troubled at efforts to thwart education choice for American students and their families because it is a cause we have worked hard to advance.

Studies have shown that some students learn better in a single-gender environment, particularly in math and science. But federal regulations used to prevent public schools from offering that option. So in 2001 we joined with then-Sen. Hillary Clinton and Sen. Susan Collins to author legislation that allowed public schools to offer single-sex education. It was an epic bipartisan battle against entrenched bureaucracy, but well worth the fight.

Since our amendment passed, thousands of American children have benefited. Now, though, some civil libertarians are claiming that single-sex public-school programs are discriminatory and thus illegal.

To be clear: The 2001 law did not require that children be educated in single-gender programs or schools. It simply allowed schools and districts to offer the choice of single-sex schools or classrooms, as long as opportunities were equally available to boys and girls. In the vast and growing realm of education research, one central tenet has been confirmed repeatedly: Children learn in different ways. For some, single-sex classrooms make all the difference.

Critics argue that these programs promote harmful gender stereotypes. Ironically, it is exactly these stereotypes that the single-sex programs seek to eradicate.

As studies have confirmed—and as any parent can tell you—negative gender roles are often sharpened in coeducational environments. Boys are more likely, for instance, to buy into the notion that reading isn't masculine when they're surrounded by (and showing off for) girls.

Girls, meanwhile, have made so much progress in educational achievement that women are overrepresented in postgraduate education. But they still lag in the acquisition of bachelor's and graduate degrees in math and the sciences. It has been demonstrated time and again that young girls are more willing to ask and answer questions in classrooms without boys.

A 2008 Department of Education study found that "both principals and teachers believed that the main benefits of single-sex schooling are decreasing distractions to learning and improving student achievement." The gender slant—the math-is-for-boys, home-EC-is-for-girls trope—is eliminated.

In a three-year study in the mid-2000s, researchers at Florida's Stetson University compared the performance of single-gender and mixed-gender classes at an elementary school, controlling for the likes of class sizes, demographics and teacher training. When the children took the Florida Comprehensive Assessment Test (which measures achievement in math and literacy, for instance), the results were striking: Only 59% of girls in mixed classes were scored as proficient, while 75% of girls in single-sex ones achieved proficiency. Similarly, 37% of boys in coeducational classes scored proficient, compared with 86% of boys in the all-boys classes.

Booker T. Washington High School in Memphis, Tenn., the winner of the 2011 Race to the Top High School Commencement Challenge, went to a 81.6% graduation rate in 2010 from a graduation rate of 55% in 2007. Among the changes at the school? Implementing all-girls and all-boys freshman academies.

In Dallas, the all-boys Barack Obama Leadership Academy opened its doors last year. There is every reason to believe it will follow the success of the first all-girls public school, Irma Rangel Young Women's Leadership School, which started in 2004. Irma Rangel, which has been a Texas Education Agency Exemplary School since 2006, also took sixth place at the Dallas Independent School District's 30th Annual Mathematics Olympiad that year.

No one is arguing that single-sex education is the best option for every student. But it is preferable for some students and families, and no one has the right to deny them an option that may work best for a particular child. Attempts to eliminate single-sex education are equivalent to taking away students' and parents' choice about one of the most fundamentally important aspects of childhood and future indicators of success—a child's education.

America once dominated educational attainment among developed countries, but we have fallen disastrously in international rankings. As we seek ways to offer the best education for all our children, in ways that are better tailored to their needs, it seems not just counterproductive but damaging to reduce the options. single-sex education in public schools will continue to be a voluntary choice for students and their families. To limit or eliminate single-sex education is irresponsible. To take single-sex education away from students who stand to benefit is unforgivable.

Ms. Hutchison, a Republican, is the senior senator from Texas. Ms. Mikulski, a Democrat, is the senior senator from Maryland.

Tuesday, October 16, 2012

Banking Union for Europe – Risks and Challenges

Banking Union for Europe – Risks and Challenges. By Thorsten Beck


The Eurozone crisis has gone through its fair share of buzz words — fiscal compact, growth compact, Big Bazooka.  The latest kid on the block is the banking union [discussed by economists since even before the 2007 crisis]. But what kind of banking union?  For whom? Financed how?  And managed by whom?

A new collection of short essays by leading economists on both sides of the Atlantic — including Josh Aizenman, Franklin Allen, Viral Acharya, Luis Garicano, and Charles Goodhart — takes a closer look at the concept of a banking union for Europe, including the macroeconomic perspective in the context of the current crisis, institutional details, and political economy. The authors do not necessarily agree and point to lots of tradeoffs.  However, several consistent messages come out of this collection.
  • No piecemeal approach. Centralizing supervision alone at the supra-national level, while leaving bank resolution and recapitalization at the national level, is not only unhelpful but might make things worse.
  • A banking union is part of a larger reform package that has to address sovereign fragility and the entanglement of banks with sovereigns.
  • Immediate crisis resolution vs. long-term reforms. There is an urgent need to address banking and sovereign fragility to resolve the Eurozone crisis. Transitional solutions that deal with legacy problems, both at the bank and at the sovereign level, are urgently needed and can buy sufficient time to implement the many long-term institutional reforms that cannot be introduced immediately.
The push for a banking union stems from the realization that the financial safety net for the Eurozone is incomplete. Although the original Eurozone structure did not foresee it, the European Central Bank (ECB) is effectively the lender of last resort, but — as argued by Charles Wyplosz — it is ill-equipped to act as such. First, it has limited information about banks and no authority to intervene. Second, national authorities with the responsibility to intervene, restructure, and recapitalize banks procrastinate as long as possible, putting additional pressure on the ECB to intervene, but only when it is too late. Several authors criticize the sequential introduction of supervision and bank resolution, which might lead to less, rather than more, stability, as conflicts between the ECB and the national resolution authorities are bound to arise.

Banking union for whom?
One critical question is whether the banking union should be “just” for the Eurozone or for the whole European Union. In my contribution, I argue that the need for a banking union is stronger within a currency union, as it is here where the close link between monetary and financial stability plays out strongest.

The institutional details
Should the responsibilities for running the banking union be concentrated in the ECB?  There is certainly a strong argument for centralizing responsibility on the supra-national level. There are clear arguments to separate bank resolution and deposit insurance in an institution outside the ECB, to avoid conflicts between monetary and micro-stability goals and introduce additional monitoring (Dirk Schoenmaker). One argument for a supra-national supervisor is that it would help reduce the political capture of regulators that has been observed across Europe over the past years and became obvious during the current crisis. This lesson can also be learned from Spain, as Luis Garicano points out: “the supervisor must be able and willing to stand up to politicians.” In addition, there is a supervisory tendency to be too lenient toward national champions, while bailing them out is too costly, [and] Andrew Gimber argue, however, that the ECB might not necessarily be a tougher supervisor than national supervisors. It might actually be more lenient, because it is concerned about contagion across the Eurozone and it has more resources available. Tying its hands by rules might therefore be necessary.

Looking west across the Atlantic
This time is not different.  Studying history can be insightful, for both economists and policymakers. Accordingly, several observers have looked for comparisons in economic history for clues on how to solve the Eurozone crisis. Joshua Aizenman argues that the history of the United States suggests large gains from buffering currency unions with union-wide deposit insurance and partial debt mutualization. It is important to note, however, that it took the United States a long time to get to where it is now, and quite a lot of institutional experimentation and several national banking crises. And, as is currently being discussed in Europe, the United States had to address both banking fragility and state over-indebtedness. Fiscal and banking unions go hand in hand.

It’s the politics, stupid!
In addition to a banking, sovereign, macroeconomic, and currency crisis, the Eurozone faces a governance crisis.  Diverse interests have hampered the efficient and prompt resolution of the crisis. And as financial support for several peripheral Eurozone countries has involved political conflicts both between and within Eurozone countries, so the discussion on the banking union has an important political economy aspect, Geoffrey Underhill points out.  More importantly, there is an increasing lack of political legitimacy and sustainability of the Eurozone and for the move toward closer fiscal and banking integration. “Citizens in both creditor and debtor countries increasingly perceive rightly or wrongly that the common currency and perhaps European integration tout court have intensified economic risks.” A banking union can therefore only succeed with the necessary electoral support.

Sunday, October 14, 2012

Exploring the Dynamics of Global Liquidity. By Sally Chen et al.

Exploring the Dynamics of Global Liquidity. By Sally Chen, Philip Liu, Andrea Maechler, Chris Marsh, Sergejs Saksonovs, and Hyun Song Shin
IMF Working Paper WP/12/246
Oct 2012

JEL Classification Numbers: G01, G15, G18, G32, C23
Keywords: Liquidity, core and noncore financial liabilities, shadow banking, growth



Recent financial crises in the U.S. and Europe have brought the impact of liquidity on economic and financial stability into sharp relief. Much of this impact has long been documented. Domestically, liquidity has been seen as having important implications for the real economy and the financial system (for example Friedman and Schwarz, 1963). It can drive up asset prices and encourage risk-taking, with negative consequences for financial stability (Borio and Zhu, 2008). Globally, the allocation liquidity affects macroeconomic and financial developments in ways that are not directly under the control of national policymaker (a theme of recent GFSR and spillover reports, see IMF, 2011a; IMF, 2011b; IMF, 2011c; IMF, 2011d; also Matsumoto, 2011; and Darius and Radde, 2010).

At the most basic level, liquidity can be described as the amount of funding readily available to finance domestic and cross-border asset purchases. Liquidity reflects both the ability and willingness of parties to engage in financial transactions, including intermediation, as well as the capacity of financial markets to absorb temporary fluctuations in demand and supply without undue dislocations in prices. In part because of the many purposes liquidity serves, there is no straightforward way to assess developments in global liquidity conditions.

One challenge in measuring liquidity is that it is largely endogenous and highly cyclical, contributing to the build-up of risks to financial stability and be affected by them in return. While central bank injection of base money plays an important role in liquidity creation, flows in global liquidity are also driven by growth differentials, financial innovation, and market participants’ risk appetite (CGFS, 2011). For example, the recent explosion of collateralized market-based borrowing, where funding expands or contracts depending on the market value of the underlying collateral, has introduced a significant source of endogeneity (IMF, 2011e, 2011f, 2011g). Similarly, if for some reason, private agents become unwilling to transact, much of the liquidity can disappear and the same amount of liquidity as measured by quantity aggregates may go from being abundant to scarce, with attendant price increases, while exacerbating the potentially volatile nature of liquidity.

The case for monitoring global liquidity conditions is not straightforward. While there is conflicting evidence whether national monetary aggregates contain useful information about the business cycles, and possible asset price misalignments, the value of aggregating national monetary aggregates is particularly questionable given their differences. Domestic quantity measures of money aggregates have fallen out of fashion in some countries, such as the United States, because of the lack of empirically-stable relations between money aggregates and macroeconomic variables. At the same time, the global financial crisis has made clear that traditional monetary aggregates on a national level may not capture the full range of liquidity-creating instruments nor the full impact of the activities of large cross border financial intermediaries, which play an increasingly important role in globally integrated capital markets. In particular, the source of funding—whether via deposit funding or wholesale funding—matters. The crisis has also highlighted that financial structure does matter—especially in times of stress, in sharp contrast to the frictionless financial market hypothesis underlying modern monetary theory (Tirole, 2011).

Approaches to liquidity measurement generally fall along two lines: the asset side or the liability side. From the asset side, efforts involve measuring the amount of global credit extended to the private sector, providing valuable insights about the liquidity cycle through the private sector balance sheet expansion. The liability side approach, adopted in this paper, focuses on the funding available to expand financial institutions’ balance sheets and the risks associated with sudden funding reversals, as manifested during the global financial crisis. Put differently, “liquidity” as measured here, is the degree to which institutions can borrow—as measured by the liability side of the balance sheets—and to expand and contract balance sheets through increases in leverage or consolidation based on collateral valuations. A key advantage of the current funding-based approach is that it aims at capturing not only bankbased financial intermediation but also the broader range of wholesale intermediation, something which has proven difficult to do on the credit side.

The use of price and quantity measures together can help better understand developments in liquidity conditions. Quantity indicators, which reflect the size of the risk exposure, tend to be slow-moving, making them ill-suited as forward-looking indicators of crises. Similarly, price indicators are coincident indicators, spiking only when the crisis is already underway, making them equally poor early warning indicators. Combining the behavior of prices and quantities provides a richer framework of analysis. It sheds light on the paradox of risk management, where risk (as reflected by the size of exposures) is often at its highest when its perception (as reflected by the price of funding) is at its lowest. Additionally, analyzing price and quantity measures together helps disentangling the pull- and push-factors driving the behavior of liquidity. Persistent increases in liquidity supply—for example, driven by financial innovations—would result in growing liquidity (quantity) and falling interest rates (prices). By contrast, higher demand for liquidity—driven by rising risk appetite and expectations of higher returns—would result in increases in both price and quantity measures.

Important caveats are in order. First and foremost, there is no theoretical framework to determine an optimal level of global liquidity, nor do we know how global liquidity should behave to promote sound, sustainable global growth with financial stability. Second, financial markets are undergoing rapid transformation, the underlying reality that these indicators try to capture is therefore constantly evolving, at a rapid pace. Finally, serious data shortcomings remain—for example, only a few countries compute flow of funds data while cross-country reporting consistency is still lacking. Thus, any policy conclusions from our measurement exercises should depend on a thorough analysis of the underlying developments. More research is needed to improve the measurement of liquidity and develop a theoretical basis for understanding its economic and financial implications.

Friday, October 12, 2012

Basel Committee: Dealing with domestic systemically important banks

Dealing with domestic systemically important banks: framework issued by the Basel Committee
October 11, 2012

The Basel Committee on Banking Supervision issued today its Framework for dealing with domestic systemically important banks.

In November 2011, the Basel Committee issued final rules for global systemically important banks (G-SIBs). The G20 leaders endorsed these rules at their November 2011 meeting and asked the Basel Committee and the Financial Stability Board to work on extending the framework to domestic systemically important banks (D-SIBs).

While not all D-SIBs are significant from a global perspective, the failure of such a bank could have a much greater impact on its domestic financial system and economy than that of a non-systemic institution. Some of these banks may have cross-border externalities, even if the effects are not global in nature.

Against this backdrop, the Basel Committee developed a set of principles on the assessment methodology and the higher loss absorbency requirement for D-SIBs. 1 The framework takes a complementary perspective to the G-SIB framework by focusing on the impact that the distress or failure of banks will have on the domestic economy.

Given that the D-SIB framework complements the G-SIB framework, the Committee considers that it would be appropriate if banks identified as D-SIBs by their national authorities are required by those authorities to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.

Mr Stefan Ingves, Chairman of the Basel Committee on Banking Supervision and Governor of Sveriges Riksbank, noted that "the impact of the failure of a domestic systemically important bank could be significantly greater than that of a non-systemic institution. The principles developed by the Committee address this issue while retaining national flexibility to accommodate the specific characteristics of domestic financial systems. The framework will complement the measures on global systemically important banks announced last year, and contribute to a safer and sounder financial system."

A framework for dealing with domestic systemically important banks - final document
October 2012

The framework text sets out the Basel Committee's framework for dealing with domestic systemically important banks.


In November 2011, the Basel Committee issued final rules for global systemically important banks (G-SIBs). The G20 leaders endorsed these rules at their November 2011 meeting and asked the Basel Committee and the Financial Stability Board to work on extending the framework to domestic systemically important banks (D-SIBs). 

While not all D-SIBs are significant from a global perspective, the failure of such a bank could have a much greater impact on its domestic financial system and economy than that of a non-system

I. Introduction

1. The Basel Committee on Banking Supervision (the Committee) issued the rules text on the assessment methodology for global systemically important banks (G-SIBs) and their additional loss absorbency requirements in November 2011. The G-SIB rules text was endorsed by the G20 Leaders at their November 2011 meeting. The G20 Leaders also asked the Committee and the Financial Stability Board to work on modalities to extend expeditiously the G-SIFI framework to domestic systemically important banks (D-SIBs).

2. The rationale for adopting additional policy measures for G-SIBs was based on the “negative externalities” (ie adverse side effects) created by systemically important banks which current regulatory policies do not fully address. In maximising their private benefits, individual financial institutions may rationally choose outcomes that, from a system-wide level, are sub-optimal because they do not take into account these externalities. These negative externalities include the impact of the failure or impairment of large, interconnected global financial institutions that can send shocks through the financial system which, in turn, can harm the real economy. Moreover, the moral hazard costs associated with direct support and implicit government guarantees may amplify risk-taking, reduce market discipline, create competitive distortions, and further increase the probability of distress in the future. As a result, the costs associated with moral hazard add to any direct costs of support that may be borne by taxpayers.

3. The additional requirement applied to G-SIBs, which applies over and above the Basel III requirements that are being introduced for all internationally-active banks, is intended to limit these cross-border negative externalities on the global financial system and economy associated with the most globally systemic banking institutions. But similar externalities can apply at a domestic level. There are many banks that are not significant from an international perspective, but nevertheless could have an important impact on their domestic financial system and economy compared to non-systemic institutions. Some of these banks may have cross-border externalities, even if the effects are not global in nature. Similar to the case of G-SIBs, it was considered appropriate to review ways to address the externalities posed by D-SIBs.

4. A D-SIB framework is best understood as taking the complementary perspective to the G-SIB regime by focusing on the impact that the distress or failure of banks (including by international banks) will have on the domestic economy. As such, it is based on the assessment conducted by the local authorities, who are best placed to evaluate the impact of failure on the local financial system and the local economy.

5. This point has two implications. The first is that in order to accommodate the structural characteristics of individual jurisdictions, the assessment and application of policy tools should allow for an appropriate degree of national discretion. This contrasts with the prescriptive approach in the G-SIB framework. The second implication is that because a D-SIB framework is still relevant for reducing cross-border externalities due to spillovers at regional or bilateral level, the effectiveness of local authorities in addressing risks posed by individual banks is of interest to a wider group of countries. A framework, therefore, should establish a minimum set of principles, which ensures that it is complementary with the G-SIB framework, addresses adequately cross-border externalities and promotes a level-playing field.

6. The principles developed by the Committee for D-SIBs would allow for appropriate national discretion to accommodate structural characteristics of the domestic financial system, including the possibility for countries to go beyond the minimum D-SIB framework and impose additional requirements based on the specific features of the country and its domestic banking sector.

7. The principles set out in the document focus on the higher loss absorbency (HLA) requirement for D-SIBs. The Committee would like to emphasise that other policy tools, particularly more intensive supervision, can also play an important role in dealing with D-SIBs.

8. The principles were developed to be applied to consolidated groups and subsidiaries. However, national authorities may apply them to branches in their jurisdictions in accordance with their legal and regulatory frameworks.

9. The implementation of the principles will be combined with a strong peer review process introduced by the Committee. The Committee intends to add the D-SIB framework to the scope of the Basel III regulatory consistency assessment programme. This will help ensure that appropriate and effective frameworks for D-SIBs are in place across different jurisdictions.

10. Given that the D-SIB framework complements the G-SIB framework, the Committee considers that it would be appropriate if banks identified as D-SIBs by their national authorities are required by those authorities to comply with the principlesic institution. Some of these banks may have cross-border externalities, even if the effects are not global in nature. 

Against this backdrop, the Basel Committee developed a set of principles on the assessment methodology and the higher loss absorbency requirement for D-SIBs.  The framework takes a complementary perspective to the G-SIB framework by focusing on the impact that the distress or failure of banks will have on the domestic economy. 

Given that the D-SIB framework complements the G-SIB framework, the Committee considers that it would be appropriate if banks identified as D-SIBs by their national authorities are required by those authorities to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.

Wednesday, October 10, 2012

Silver Linings in the Indian Economy

Silver Linings in the Indian Economy. By Harun R Khan, Deputy Governor, Reserve Bank of India
Fifth Annual Banking Conference on “The Silver Lining of the Indian Economy” organized by NMIMS School of Banking Management
October 6, 2012, Bombay


Recent actions start the course correction but momentum needs to be kept
2. Recent policy measures taken by the government are very significant. They have started the course correction from a point where the Indian growth story was close to getting seriously damaged. However, for these measures to succeed it is important to keep up the momentum. More steps and effective implementation over next 2-3 years are necessary to fully recoup the lost ground.The economy has been facing serious headwinds as growth had slowed down to 5.5 per cent or less for the last two quarters over and above the subdued growth rate of 6.5 per cent for 2011-12, a rate even lower than crisis period low point of 6.7 per cent growth in 2007-08. Our saving and investment rate had also slipped since 2008-09. Gross domestic saving rate averaged 32.7 per cent in three years 2010-11 against 35.0 per cent in the preceding three years due mainly to fall in public sector saving rate. Our gross domestic investment rate averaged 34.1 per cent against 34.9 per cent for the same periods as corporate investment rate fell sharply. Preliminary estimates suggest a further sharp drop in household financial savings in 2011-12 at less than 8.0 per cent of the GDP from more than 12 per cent two years back. Also, corporate investment is likely to have declined further. With falling saving and investment, rise in twin deficits and inflation, potential growth had also dropped by one percentage point or more in the post-global financial crisis period. As we know, potential growth indicates the rate of growth the economy can achieve consistent with stable macro-economic conditions.On the other hand, inflation rose sharply to above comfort levels since December 2009 and averaged 9.5 per cent for next 24-months before lowering to sub-eight per cent but still proving to be intransigent. It is staying sticky at over 7 per cent. Centre’s fiscal deficit had slipped during 2011-12 to 5.8 per cent against the budgeted 4.6 per cent for the year and 4.9 per cent in 2010-11. With gross under-recoveries of oil marketing companies working out to over Rs1.8 trillion or 0.8 per cent of GDP due to unrevised prices of diesel, LPG and kerosene, there was little doubt the centre’s GFD/GDP budgeted estimate would then have overshot by a wide margin. Even after the revision of diesel prices and capping of subsidised LPG cylinders, the budget imbalances are obvious, underscoring the importance of further fiscal measures to contain deficit this year.

3. The current account deficit (CAD) had risen to an all-time high of 4.2 per cent of GDP in 2011-12 and 4.5 per cent of GDP during Q4 of 2011-12. In other words, rising twin deficit, slowing growth and sticky inflation provided all the ingredients for a possible economic crisis. Noting this macro-economic deterioration, some international credit rating agencies had already put India’s sovereign rating on a watch list for an impending downgrade that would have pushed India to a subinvestment grade.

The slew of measures in a span of less than a month should count
4. Against this background, the policy actions that were announced in September 2012 should be seen as major initiatives to reverse the course of economic growth path in the country. In a slew of measures of economic reforms, the government raised diesel prices by `5 per litre and capped subsidised LPG cooking gas cylinders to six a year per household. It permitted foreign direct investment (FDI) in multi-brand retail up to 51 per cent, in aviation sector up to 49 per cent and in some broadcasting services up to 75 per cent. It also approved sale of its minority stakes in four public sector firms -- Oil India (by 10 per cent), Hindustan Copper (9.59 per cent), MMTC (9.33 per cent) and Nalco (12.15 per cent) -- to raise up to `150 billion – half its disinvestment receipts target for the year. These measures were followed up with an announcement that withholding tax liability will be reduced to 5 percent from 20 per cent for the overseas borrowings /bond issuances for infrastructure sector by Indian firms during July 2012 and June 2015.

5. A debt relief package for the state power distribution companies (discoms) has now been approved. Once implemented efficiently, it can turnaround the investment scenario once again. This month, a package for the life insurance sector was also worked out. The package includes easing investment norms for insurers, faster clearance for new products, easing of procedures, allowing banks to sell products of more than one insurance company and possibly some tax concessions for the insurance sector. More sector-specific packages could follow allowing structural bottlenecks to be removed without sacrificing on regulatory discipline.The Cabinet has also cleared foreign equity cap in insurance sectors at 49 per cent through Insurance Laws (Amendment) Bill, 2008. It also approved certain amendments to the Pension Fund Regulatory and Development Authority (PFRDA) Bill, 2011 that included foreign investment ceiling in the pension sector at 26 per cent or such percentage as may be approved for the insurance sector, whichever is higher, may be incorporated in the present legislation. Besides, it approved several other plans that are important for the economy, such as the 12th Five Year Plan document for taking it to the National Development Council (NDC), amendments to the Companies Bill 2011, the Forward Contracts (Regulation) Amendment Bill, 2010 and the Competition Act, 2002. These moves show the intent and the policy direction though the ultimate impact would depend on the political process of law making that follows.There are several unknowns, such as, the timing of debates and votes, the floor management on the day of the vote and most importantly, the process by which political differences are narrowed enough to see the results. The foundation has been laid and one can be confident that the Indian democracy would once again stand the test of the time.

6. On our part, we certainly think that the slew of economic reforms measures undertaken by the government recently would impart a positive momentum to the economy. The Reserve Bank in its Mid-Quarter Review of Monetary Policy noted the likely positive impact of the changes in FDI policy on capital flows and over the long run on higher productivity, particularly in food supplychains. The Reserve Bank had been consistently arguing for need for supply-side responses to help contain inflation. Earlier in its Annual Report released in August 2012, it had highlighted the urgent need to step up non-debt creating inflows, especially in the form of FDI in view of the wide current account deficit (CAD). It had argued for further improving the FDI inflows in sectors such as insurance, retail, aviation and urban infrastructure. It had noted that FDI in retail may be particularly helpful in improving supply chain management through greater investment in backend infrastructure, including cold storage for farm and poultry products.

7. Considering that these steps being undertaken paved the way for a more favourable growth-inflation dynamics, the Reserve Bank moved to address possible liquidity tightening ahead by a pre-emptive 25 basis point cut in its Cash Reserve Ratio (CRR) at its Mid-term policy announced on September 17, 2012. CRR is also a potent monetary policy tool and should help in lowering the cost of credit and augmenting its supply, thus improving credit flows. The CRR cut was in addition to a 50 basis point policy rate reduction that the Reserve Bank had effected in April 2012 in anticipation of action for fiscal consolidation and supply-side initiatives.

8. Several policy measures have been taken in less than a month. When these measures get implemented and feed through the system, they would contribute significantly to recovery of India’s growth as well as growth potential. Capital flows have recovered and would go a long way in restoring confidence for business activity in the country. Growth would start improving as a result. Whether the recovery will be quick or slow-paced would depend on several factors, including global conditions, which at the moment are not very conducive in spite of some positive news on labour and housing markets in the US. What is important is that recent actions by the Government have reduced the macro-economic risks and structural impediments.

9. Part of our recent woes was self-inflicted as inadequate movement on policy and implementation fronts worsened investment climate that had already suffered due to global uncertainties and cyclical downturn in the Indian economy. This had added an element of structural retrogression in the Indian economy. The government has now shown its resolve to effectively redress this. If steps announced are well-implemented and if we stay on path of reforms, the economy would turnaround faster than what many expect. But several challenges remain and not only policy changes but effective implementation holds the key to success.

10. The most important challenge would be to further lower the twin deficits by staying on path of fiscal consolidation, keeping a tab on private consumption demand and using expenditure switching policies to lower CAD. Monetary policy would for some more time need to focus on inflation while using available space to support growth to the degree it can. Inflation, if left unattended to, can play the biggest spoil sport. The rupee has already appreciated 6.8 per cent against US dollar since the onset of this new wave of reforms on September 13, 2012. This may help lower inflation somewhat as exchange rate-pass-through takes place. However, it is important to understand that exchange rate is neither a first-best solution nor a sufficient tool for addressing the challenges of structural inflation that we face today. Ultimately, fiscal policy would need to work towards expediting supply-side responses and keeping private consumption demand in reasonable control. Monetary policy would need to be cautious in the interim.

Downward cycle may be bottoming out
11. After a downturn, there are some signs of green shoots that if nursed with appropriate policies, including continuous economic reforms, with an eye on macro-financial stability, can pave the way of recovery for the Indian economy. Falling growth was somewhat arrested in Q1 of 2012-13. At 5.5 per cent, it was marginally better than in the 5.3 per cent in Q4 of 2011-12. While this is not a material improvement, when juxtaposed with the recent policy measures there is hope that growth would improve in coming quarters and more so next year. Rainfall has been deficient by 8 per cent from the long period average in 2012 monsoon season. The deficiency during June and July 2012 has adversely impacted the Kharif crop. However, good rainfall in August and September have improved the soil moisture content and reservoir levels and raised the prospects for a good Rabi crop. As we see subsequent rounds of crop estimates, the deficiency of about 10 per cent in case of foodgrains and oilseeds is likely to be reduced, thus providing a further silver lining.

12. India grew at a rapid pace with an average growth of 8.7 per cent during 2003-04 to 2007-08 essentially because investment boomed, especially in infrastructure such as power, roads and telecom. In the last three years of this period growth averaged 9.5 per cent before the Lehman crisis changed the world. India’s potential growth was assessed at nearly 8.5 per cent during this period. India’s growth dropped to 6.7 per cent during 2007-08 due mainly to spill over from global financial crisis. India, however, stood out as an island of calm that withstood global financial Tsunami. Its growth dropped less than its peers and it staged a V-shaped recovery clocking 8.4 per cent growth over next two years. However, the euro area crisis, the rising structural problems and high inflation combined to bring about a precipitous fall in India’s growth. The growth dropped to 6.5 per cent in 2011-12 – lower than the crisis-affected growth of 6.7 per cent in 2007-08. More importantly, growth has averaged 5.4 per cent over last two quarters.

13. Is this the new normal? There are strong reasons to believe otherwise. While potential growth may have fallen, we are clearly running a negative output gap with realised growth below potential. With current momentum, we can also recoup our lost potential and after a few years start growing back at 8-8.5 per cent on a sustainable basis. What is important at this stage is to further improve macro-economic conditions by lowering twin deficits and to ensure that inflation stays below the threshold at which high growth cannot be sustained.

14. Growth came down due to exceptional reasons. Firstly, inflation had stayed high for over two years and there is enough theoretical and empirical evidence to suggest that when inflation reaches that high and becomes persistent, the costs of deflation in terms of growth sacrifice turns out to be large. Part of the growth sacrifice occurs for reasons of monetary tightening that high inflation inevitably brings if complete macro-economic destabilization and possible hyper-inflation is to be averted. Hyperinflation risk is not something that can be dismissed lightly. Growth also comes down for reasons beyond monetary tightening. High inflation erodes consumers’ real purchasing power and lowers aggregate demand. It acts as a regressive tax on poor and erodes their consumption base. Producers also postpone investment decisions in an era of heightened uncertainty. To contain the high level of inflation and manage inflationary expectations, monetary policy in India was tightened continuously since February 2010 and these risks were contained even though inflation still remains perceptibly higher than the Reserve Bank’s comfort. Monetary policy needs to factor in the growth-inflation dynamics in a forward-looking manner but keep focussing on inflation for some more time so that inflation persistence is overcome. This would have a positive spin off for growth to recover. As we have stated in the Mid-Quarter Monetary Policy Review of September 17, 2012, when the policy initiatives being taken now by the Government materialize into concrete action, monetary policy will reinforce the positive impact of such actions while continuing to maintain its focus on inflation management.

15. Secondly, growth came down because of unfavourable global climate. The euro area crisis coming on the heels of Lehman crisis is playing on animal spirits. Global trade has decelerated sharply and is impacting investments. Indian industrial growth is found to be highly correlated with global industrial growth. As we integrate more and more with the rest of the world, we have to pay price of globalization even as we reap its benefits. As we have observed in this context, global developments affect our economy through commerce, capital flows, confidence, commodity price, contamination, currency rates and credit rating channels.Global business cycles are, therefore impacting both investment demand and with a lag impacting consumption demand as incomes fall and appetite for leverage reduces.

16. Thirdly, growth came down in India because investment climate was vitiated due to emergence of serious structural bottlenecks related to land, labour, regulatory framework, linkages or availability of funding, partly due to elevated concerns for asset quality. Part of the problem occurred in the mining sector, where judicial and executive efforts to improve governance have created a sort of a hiatus in activity. When a clearer operational regime comes into play businesses would adjust to more normal functioning based on fair returns. The other part of the problem was in the power sector where bulk of the 54 GW of new investments capacities created during the 11th Plan turned into potential bad investments as coal was in short supply. Mitigation of the problem is hopefully in the offing. If debt restructuring of discoms is well executed and coal supplies are quickly ensured, the power sector investments can revive in the 12th Plan. New capacity generation can easily match and possibly surpass that in the 11th Plan. Power sector can turn out to be a major driver of growth once again. As per the plans, the SEB losses are being cut by power tariff revisions.

Investment revival is possible
17. Big steps for reforming power sector are now being taken and can pave the way for revival of investment. The debt restructuring of discoms is being done in an incentive-compatible manner and may not encourage moral hazard or regulatory forbearance. The scheme contains various measures required to be taken by state discoms and state governments for achieving the financial turnaround of the discoms. The restructuring/ reschedulement of loan are to be accompanied by concrete and measurable action by the discoms/ States to improve the operational performance of the distribution utilities. There may not be an immediate fiscal impact for the centre, given that its obligations under the scheme are medium-term in nature, the fiscal impact for the states in the near-term would be the interest outgo on 50 per cent of outstanding short-term loans which are to be taken over by them in a phased manner. While, a great deal of ground would still need to be covered for operational effectiveness of the scheme, it does have the capacity to reverse the falling fortunes of power sector investments. One hopes that the ticking clock of the potential time bomb of the power sector can now be defused. It is worth noting that the accumulated losses of the state power distribution companies (discoms) are estimated to be about `1.9 trillion as on 31st March, 2011.

Financial sector can remain robust with efforts to contain newer fragilities
18. India has stood out amongst its peers with an enviable record on financial stability. India’s gross non-performing assets (NPAs) of scheduled commercial banks as a percentage of gross advances had declined from 12.7 per cent in 1990-91 to 2.4 per cent in 2010-11. In case of public sector banks, this ration had dropped from 14.0 to 2.3 per cent over the same period. However, during the recent economic downturn, there has been a sharp deterioration in asset quality of the public sector banks (PSBs), as the ratio reversed to 3.2 per cent in 2011-12. While the NPA levels are still low by historical trends or cross-country comparison, newer fragilities were obvious by the high slippage ratio and a spurt in restructuring loans. The slippage ratio of the PSBs increased to 5.7 per cent of gross advances by at the end of 2011-12 from 4.2 per cent a year ago. The recovery also slowed down, especially in the stressed sectors. While some of these changes reflect the NPA cycle that generally tracks economic cycle, the sectoral bottlenecks also had a role to play in such deterioration.

19. There has been movement towards resolving the sector-specific issues, especially in power and aviation. With gradual improvement in economic activity, the stress may be further reduced across all sectors. This will bring back some of the strength of the bank balance sheets that had got eroded in recent years. Unlike many other countries, India is a bank-dominated financial system. Though the role of the financial markets has increased over the year, the financing pattern of the corporates suggests that banks account for over a fourth of total sources of funds for the corporates. As such, maintaining health of the banks is important so that they can nurse recovery by credit expansion with the silver linings already on the horizon. The ratio of bank credit to GDP in India is around 55 per cent, which is much below what is prevalent in many advanced economies. Therefore, the challenge for Indian banks is to facilitate the growth of the real sector through financial products and innovations subject to adequate safeguards and adoption of sound risk management policies. In the Indian context, foreign banks can potentially play a significant supplementing role of resource mobilization to fund higher growth, apart from augmenting competition and efficiency among the banks. For example, foreign banks still have a lot of leeway available for funding infrastructure projects vis-à-vis the prescribed exposure limits. Further, given the higher requirements of lending to the priority sectors under the revised policy framework, foreign banks can bring in a lot of innovations and better practices and processes to lend to the critical sectors of the economy like the SMEs and agriculture.

20. The Reserve Bank has been a conservative central bank that accords very high priority to financial stability. It is for this reason that the Reserve Bank is focussed on the implementation of the Basel III norms. It is also training its eyes on curbing increasing slippage and withdrawing regulatory forbearance that supports it in a phased manner. Some transitory sops to infrastructure loans in case genuine delays in commencement of commercial operations are possible but these should be the exceptions rather than the norm. Maintaining financial discipline is of paramount importance and this would certainly demand higher accountability and sacrifice by the promoters. On Basel III, the Reserve Bank has unveiled the broad course that the banks need to follow. With gradual improvements in market conditions, capital raising options for the banks would steadily improve. It should be possible for public sector banks (PSBs) to raise about `1.5 trillion of equity over the period of a little over 5-years till the end of 2017-18. The shareholders’ value locked in the PSBs need to be tapped by innovative means. Stronger banks are in fact needed to support credit flows for higher growth in the Indian economy.

Containment of twin deficits remains a challenge but within our realm
21. The impact of the recent governmental measures in reducing the fiscal deficit is not likely to be very large. In effect the reduction in diesel and LPG subsidies would amount to marginal fiscal correction in the current fiscal year. This underscores the importance of taking both short term measures for moving closer to the budget targets as well as long term steps to structurally correct the deficit, thus eventually lowering the fiscal dominance of monetary policy. Recently, the Kelkar Committee has estimated that GFD/GDP ratio for 2012-13 could slip by 1 percentage point to 6.1 per cent from the budgeted 5.1 per centif corrective measures are not taken. It has also made several recommendations on fiscal consolidation laying down a path to narrow it down to 5.2 per cent in 2012-13, 4.6 per cent in 2013-14 and 3.9 per cent in 2014-15, when the effective revenue deficit can be brought to zero. Improved tax collection, asset sales, pruning of subsidies and rationalization of planned spending holds the key to this path. Disinvestments, minority stake sales, higher PSU dividends, hiking urea prices and widening services tax net are part of the recommended strategy. The bottom line is that a workable path to fiscal consolidation is available – be it through the Kelkar Committee or through the rolling targets set following the 13th Finance Commission. What is important is to get there or at least very close to there through sustained efforts and not become lax in face of political or electoral cycles. It is expected that the government would take further aggressive steps to prevent fiscal slippage this year and complete its borrowing programme broadly in line with what was envisaged and without any undue pressures in the financial markets. This can make substantial contribution to keeping interest rates low and reviving the economy. In fact, the recent announcement of the Central Government’s borrowing calendar for the second half of 2012-13, which sticks to the budgeted borrowing figures reflect Government’s resolve for containing the Gross Fiscal Deficit (GFD). It is, however, imperative that further strong measures forfiscal corrections are implemented in the rest of the year broadly in line with the Kelkar Committee recommendations. Recent appreciation of the Rupee has, besides mitigating the risk of imported inflation, would also greatly aid in containment of GFD by way of reduction in subsidy burden of the Government arising out of high Rupee cost of imported oil.

22. The trends in the external sector are also showing signs of some improvement after considerable stress witnessed last year. The CAD/GDP ratio declined to 3.9 per cent in Q1 of 2012-13 from 4.5 per cent in Q4 of 2011-12. While this is a positive development, it has come about as imports contracted in face of growth slowdown and some benefits accrued from exchange rate pass-through from rupee depreciation in 2011-12 and in the first quarter this year. Macroeconomic and external sector policies would need to still factor in external sector risks in the coming period, especially as event risks emanating from global developments remain significant. Therefore, further efforts would be necessary to contain CAD and bring it in line with its sustainable level of around 2.5 per cent of GDP. The recent reform measures have brought about major change in global investor perception. These investors are now willing to continue investing in India’s long-term growth story. Another silver lining is that India’s net international investment position (NIIP) that reflects the net claims of non-residents on India has improved with the decrease in these claims by US$23.9 billion over the previous quarter to US$220.3 billion as at end-June. While this largely reflects the valuation changes, augmentation of non-debt creating flows in the new phase of economic reforms would certainly lower external financing risks, thus providing a much needed cushion against our external sector pressures.

We need to convert the silver linings to our advantages
23. I would like to conclude by saying that India in the second half of 2012-13 is shaping as very different from India in the first half. There are positives emerging across the horizon. This is reflected in our currency movement that will bring further positive spin offs by lowering inflation, fiscal deficit and reducing corporate stress. Growth could start improving into the next year. Battleagainst inflation is, however, far from over and we need careful calibration of monetary and non-monetary responses to tame it. Late revival of monsoon and steps taken/being planned to improve the supply responses should moderate the inflationary pressure overtime. Stronger fiscal measures on the path envisioned would pave the way for sustained recovery. We have seen marginal improvement in CAD. This should not, however, lull us into any complacency as the path to its sustainability requires several adjustments. It is equally important that correctives now being put in place do not attenuate regulatory prudenceor deflect the focus away from long term sustainability of the external sectorby taking a short term view of the proposed solutions for improving capital flows.

24. The slew of measures in a short span need to be turned into a habit of well-paced action, improved execution and governance and credible commitment without backtracking or reversals. A more gradual-paced reforms earlier enabled us to achieve high growth path. In the context of steps taken/planned for our reforms, one area where we need to focus seriously is on communication, both internal and external. This should encompass convincing our domestic constituency about the experience and benefits of reforms which have to be carried forward for achieving the goals of inclusive growth by having a strong and resilient macro-economy. It would also imply meaningful engagement with the international rating agencies and investor class. There is no reason to believe that these would not work though there are still many a bridge to cross to translate the intentions to deliverables on the ground. The silver linings are now visible on the horizon. We need to build upon them and implement our plans in the right earnest. The door of opportunity is again knocking at us. These silver linings lifting the dark clouds are, however,not something as part of our destiny but they are within our reach, if we work hard on them with all sincerity to convert them to our long term advantages.

Friday, October 5, 2012

Sovereign Risk and Asset and Liability Management—Conceptual Issues

Sovereign Risk and Asset and Liability Management—Conceptual Issues. By Udaibir S. Das, Yinqiu Lu, Michael G. Papaioannou, and Iva Petrova
IMF Working Paper 12/241
Oct 2012

Summary: Country practices towards managing financial risks on a sovereign balance sheet continue to evolve. Each crisis period, and its legacy on sovereign balance sheets, reaffirms the need for strengthening financial risk management. This paper discusses some salient features embedded in in the current generation of sovereign asset and liability management (SALM) approaches, including objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal SALM outcomes. These elements are used in developing an analytical SALM framework which could become an operational instrument in formulating asset management and debtor liability management strategies at the sovereign level. From a portfolio perspective, the SALM approach could help detect direct and derived sovereign risk exposures. It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources of risk. The paper also outlines institutional requirements in implementing an SALM framework and seeks to lay the ground for further policy and analytical work on this topic.


The financial crises of the last thirty years have amply demonstrated that unattended public and private sector risks can be at crises’ origins. Sovereigns are susceptible to various risks and uncertainties relating to their financial assets and liabilities, depending on the country’s level of economic and financial development. Typically, emerging market sovereigns face increased market exposure of their net foreign asset and debt portfolios, especially as they expand access to domestic and international capital markets. Many frontier market sovereigns are exposed to risks arising from terms-of-trade shocks and changes in debt refinancing terms, and tend to be more vulnerable to exogenous shocks than other countries.

Advanced markets face market risk exposure as well, particularly those that rely on capital market access and are systemically important issuers of public debt. In addition, they face other financial risks associated with an aging population, structural issues that need reform ( health and pension), and contingent liabilities arising from systemically important financial or corporate firms, and or potentially weak financial sectors and/or subnational entities. These risks, if realized, could cause a significant fiscal and financial drain and a consequent fall in the country’s domestic absorption and potential output.

To help identify and manage effectively the key financial exposures, a sovereign asset and liability management (SALM) framework, based on the balance-sheet approach, can be employed. This framework can also be used to inform the macroeconomic and financial stability policy design. SALM focuses on managing and containing the financial risk exposure of the public sector as a whole, so as to preserve a sound balance sheet needed to support a sustainable policy path and economic growth. The SALM approach entails monitoring and quantifying the impact of movements in exchange rates, interest rates, inflation, and commodity prices on sovereign assets and liabilities and identifying other debt-related vulnerabilities (Rosenberg et al., 2005) in a coordinated if not an integrated way (Figure 1).

The SALM approach can also be utilized to facilitate a country’s long-term macroeconomic and developmental objectives such as economic diversification, broadening of the export market, or reducing the dependence on key import products. Further, the SALM approach can help identify long-term fiscal challenges, such as unfunded social security liabilities, implying a future claim on resources (Traa and Carare, 2007). In this context, the SALM framework forms an integral part of an overall macroeconomic management strategy (e.g., Au-Yeung et al., 2006, Bolder, 2002, CREF South Africa, 1995, Danmarks Nationalbank, 2000, Grimes, 2001, Horman, 2002).

For commodity-exporting countries, the SALM approach can highlight the potential asset management challenges that stem from a medium-term fiscal strategy (Leigh and Olters, 2006). For example, high commodity prices lead to higher revenues, concurrently strengthening their (unadjusted) fiscal positions. However, commodity depletion leads to lower future revenues, which could be mitigated with appropriate asset management to ensure that future fiscal expenditures are sustainable.

From a portfolio perspective, the SALM approach could help detect sovereign risk exposures.  It allows analyzing the financial characteristics of the balance sheet, identifying sources of costs and risks, and quantifying the correlations among these sources ((Claessens, 2005; Lu, Papaioannou, and Petrova, 2007; Zacho, 2006). If the match of financial characteristics of the assets and liabilities is only partial, risk management could focus on the unmatched portions, i.e., net financial positions. In a short- to medium-term perspective, a financial risk management strategy could then be developed to reduce exposures. For example, if the net position results in a liability exposure, appropriate strategies should be developed to manage the risks associated with such exposure.

The application of the SALM framework could be constrained by a number of policy and institutional factors. Monetary policy objectives have an impact on SALM strategies, by affecting either market—interest rate and exchange rate—risk management or directly the size of the balance sheet. Fiscal policy objectives that aim at limiting annual debt service costs may put constraints on the duration and currency composition of public debt, since high shares of short-term debt are perceived to lead to greater volatility of service costs.

The structure of international and domestic capital markets also shapes the SALM implementation. Some developing countries cannot issue domestic debt because of illiquid and/or shallow domestic debt capital markets and a lack of a reliable local investor base. Their attempts to issue domestic-currency external debt have also not been well-received in international markets owing, in part, to their vulnerability to shocks, restrictions on foreign investors to buy local-currency debt (e.g., on type of instruments, minimum holding period), poor transparency, and/or a lack of interest rate and exchange rate hedging instruments.

In addition, some have argued that combining the management of sovereign assets and liabilities under one framework may not be optimal.5 Cassard and Folkerts-Landau (2000) points out a potential conflict of interest between monetary policy and debt management if a central bank assumes an operational role or actively participates in debt markets. For example, the central bank may be reluctant to increase the interest rates in the face of growing inflation concerns for fear of raising debt rollover costs. Also, the central bank’s intervention policy may be in conflict with its daily task of managing the liquidity of the foreign currency debt.

While risk management approaches for sovereigns may differ from those for the private sector (see Box 1), this paper discusses the salient features embedded in countries’ approaches to SALM, including main objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal debt and asset outcomes. These considerations are typically taken into account when developing an analytical SALM framework, which may evolve into an operational instrument for formulating asset and debt/liability management strategies. Also, the paper outlines common institutional requirements and constraints in implementing an SALM framework, and, based on select country experiences with the SALM approach, draws some stylized lessons and general policy guidelines on adopting an SALM approach.

Thursday, October 4, 2012

Macrofinancial Stress Testing - Principles and Practices - IMF Policy Paper

Macrofinancial Stress Testing - Principles and Practices
IMF Policy Paper
Oct 2012

Summary: The recent financial crisis drew unprecedented attention to the stress testing of financial institutions. On one hand, stress tests were criticized for having missed many of the vulnerabilities that led to the crisis. On the other, after the onset of the crisis, they were given a new role as crisis management tools to guide bank recapitalization and help restore confidence. This spurred an intense debate on the models, underlying assumptions, and uses of stress tests. Current stress testing practices, however, are not based on a systematic and comprehensive set of principles but have emerged from trial-and-error and often reflect constraints in human, technical, and data capabilities.

Macrofinancial Stress Testing - Principles and Practices—Background Material
IMF Policy Paper
Oct 2012

Summary: Staff conducted a survey of stress testing practices among selected national central banks and supervisory authorities. The online survey was undertaken in November 2011 as part of the preparatory work for the paper on ?Macrofinancial Stress Testing: Principles and Practices. The survey focused on stress testing for banks, which is more widespread and better established—and practices are therefore easier to compare across countries—but also included questions on stress testing for nonbank financial institutions.

Tuesday, October 2, 2012

Banking and Trading. By Arnoud W.A. Boot and Lev Ratnovski

Banking and Trading. By Arnoud W.A. Boot and Lev Ratnovski
IMF Working Paper No. 12/238
Oct 2012

Summary: We study the effects of a bank's engagement in trading. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large numbers). Trading is transactions-based: scalable, shortterm, capital constrained, and with the ability to generate risk from concentrated positions. When a bank engages in trading, it can use its ‘spare’ capital to profitablity expand the scale of trading. However, there are two inefficiencies. A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And a bank may use trading for risk-shifting. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepending of the financial markets in recent decades leads trading in banks to become increasingly risky, so that problems in managing and regulating trading in banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking.

We study the effects of a bank’s engagement in trading. We use the term “banking” to describe business with repeated, long-term clients (also called relationship banking), and “trading” for operations that do not rely on repeated interactions. This definition of trading thus includes not just taking positions for a bank’s own account — proprietary trading — but also other short-term activities that do not rely on private and soft information, e.g. originating and selling standardized loans. Both commercial and investment banks over the last decade have increasingly engaged in short-term trading. We need to understand the rationale for that, and the challenges that it poses.

Such challenges clearly exist. They are perhaps most vivid in Europe, where some large universal banks seem to have over-allocated resources to trading prior to the crisis, with consequent losses affecting their stability (e.g., UBS, see UBS, 2008; an earlier example is the failure of the Barings Bank due to trading in Singapore in 1995). In the United States, the development of universal banks was until recently restricted by the Glass-Steagall Act. Yet there are many examples of a shift of institutions into shortterm activities, with similar negative consequences. Since early 1980-s, many New York investment banks have turned the focus from traditional underwriting to short-term market-making and proprietary investments; these have often backfired during the crisis (Bear Stearns, Lehman Brothers, Merrill Lynch). Also, in 2000-s, commercial banks have used their franchise to expand into short-term activities, such as wholesale loan origination and funding (Washington Mutual, Wachovia), exposing themselves to risk.  And post-Glass-Steagall, there is evidence of trading being a drain on commercial bank activities in newly created universal banks, such as Bank of America-Merrill Lynch. A 2012 loss related to the market activities in JP Morgan is another example. The banks’ short-term activities, especially proprietary trading, have received significant regulatory attention: the Volcker Rule in the Dodd-Frank Act in the U.S., and the Report of the Independent Commission on Banking (the so-called Vickers report) in the UK.

The interaction between banking and trading is a novel topic. The existing literature on universal banks focuses primarily on the interaction between lending and underwriting.  Such interaction is relatively well-understood, and also was not at the forefront during the recent crisis. Our paper downplays the distinction between lending and underwriting: for us both could possibly represent examples of long-term, relationshipbased banking. We contrast them to short-term, individual transactions-based activities.  We see a shift of relative emphasis towards such “trading” as one of the major developments in the financial sector (for sure prior to the crisis).

The focus on trading as a possibly detrimental activity in banks, and its difference from underwriting in this regard, is supported by emerging empirical evidence. Brunnermeier et al. (2012) show that trading can lead to a persistent loss of bank income following a negative shock. In contrast, underwriting, while more volatile than commercial banking, is not associated with persistent losses of profitability.

The key to our analysis is the observation that the relationship business is usually profitable and hence generates implicit capital, yet is not readily scalable. The trading activity on the other hand can be capital constrained and benefit from the spare capital available in the bank. Accordingly, relationship banks might expand into trading in order to use ‘spare’ capital. This funding (liability-side) synergy is akin to the assertions of practitioners that one can “take advantage of the balance sheet of the bank”.

Opening up banking to trading, however, creates frictions. We highlight two of them. One friction is time inconsistency in the allocation of capital between the longterm relationship banking business and the short-term trading activity. Banks may be tempted to shift too much resources to trading in a way that undermines the relationship franchise. Another friction is risk-shifting: the incentives to use trading to boost risk and benefit shareholders as residual claimants. As a result of these two factors, a bank can overexpose itself to trading, compared to what is socially optimal, or ex ante optimal for its shareholders.

Both problems become more acute when financial markets are deeper, allowing larger trading positions. This increases the misallocation of capital and enables the gambles of scale necessary for risk-shifting. The problems also become more acute when bank returns are lower. Both factors have been in play in the last 10-20 years. Consequently, the costs of trading in banks may have started to outweight its benefits. These frictions are likely to persist for the foreseeable future, so a regulatory response might be necessary.

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Friday, September 28, 2012

Current economic policies: pro and con

Today’s Economic Data. By Alan Krueger
The White House, September 27, 2012 11:57 AM EDT

More than the usual amount of economic statistics were released this morning. As a whole, today’s economic news shows that while we are still fighting back from the worst economic crisis since the Great Depression, we are making progress. We lost more than 8 million jobs and GDP contracted by almost 5 percent as a result of the Great Recession. We have more work to do, but incorporating today’s preliminary benchmark revision to the employment figures released by the Bureau of Labor Statistics with their earlier data indicates that the economy has added nearly 5.1 million private sector jobs, on net, over the past 30 months. BLS announced that total employment likely grew by 386,000 more jobs than previously announced during the 12 months from March 2011 to March 2012, and by 453,000 more private sector jobs in that same time period. In the past decade, the absolute difference between the preliminary and final benchmark revision has averaged 37,000 jobs.

We also saw revised data released today showing that real GDP grew in the second quarter of 2012 by 1.3 percent at an annual rate. Real GDP growth in the second quarter was revised down due, in part, to a downward revision to agriculture inventories as a result of the devastating drought our nation faced this summer. The Obama Administration continues to take all available steps to mitigate the impacts of the drought, and has called on Congress to pass a farm bill that would spur growth and provide rural Americans with the certainty they deserve. We also learned today that the advance report of durable goods orders declined in August, largely as a result of a decline in orders for transportation equipment. Excluding the volatile transportation category, durable goods orders fell by 1.6 percent.

Today’s news shows that we must do more to strengthen our economy and promote job creation. Over a year ago, President Obama proposed the American Jobs Act – a plan that independent economists have said would create up to 2 million jobs. The President will continue to push policies that will continue this progress we have made, including incentives to strengthen the American manufacturing industry, investments in our nation’s infrastructure, and the extension of the tax cuts for 98 percent of Americans and 97 percent of small businesses.

While we are still rebuilding our economy and working to recover from the worst crisis since the Great Depression, we are making progress and the last thing we should do is return to the economic policies that failed us in the past. The revisions announced in today’s reports are a reminder that economic data are subject to large revisions. As a whole the pattern of revisions suggest that the recession that began at the end of 2007 was deeper than initially reported, and the jobs recovery over the last 2.5 years has been a bit stronger than initially reported, although much work remains to be done to return to full employment.

As Good As It Gets? WSJ Editorial
Growth of 1.7% isn't what Team Obama promised four years ago.The Wall Street Journal, September 28, 2012, page A16


Bob Schieffer: "The fact is, unemployment is up. It is higher than when [President Obama] came to office, the economy is still in the dump. Some people say that is reason enough to make a change."

Bill Clinton: "It is if you believe that we could have been fully healed in four years. I don't know a single serious economist who believes that as much damage as we had could have been healed."

CBS's "Face the Nation," September 23, 2012

[Growth Gap:]

Well, let's see. We can think of several serious people who said we could heal the economy in four years. There's Joe Biden, Nancy Pelosi, Harry Reid, Christina Romer, Jared Bernstein, Mark Zandi, and, most importantly, President Obama himself.

Mr. Obama told Americans in 2009 that if he did not turn around the economy in three years his Presidency would be "a one-term proposition." Joe Biden said three years ago that the $830 billion economic stimulus was working beyond his "wildest dreams" and he famously promised several months after the Obama stimulus was enacted that Americans would enjoy a "summer of recovery." That was more than three years ago.

In early 2009 soon-to-be White House economists Ms. Romer and Mr. Bernstein promised Congress that the stimulus would hold the unemployment rate below 7% and that by now it would be 5.6%. Instead the rate is 8.1%. The latest Census Bureau report says there are nearly seven million fewer full-time, year-round workers today than in 2007. The labor participation rate is the lowest since 1981.

So it has gone with nearly every prediction the President has made about where the economy would be today. Mr. Obama promised that the deficit would be cut in half in four years, but the fiscal 2012 deficit (estimated to be above $1 trillion) will be twice the 2008 deficit ($458 billion).

Mr. Obama said that his health-care plan would "cut the cost of a typical family's premium by up to $2,500 a year," but premiums for employer-sponsored family coverage have gone up $2,370 since 2009, according to the Kaiser Family Foundation.

He said that the linchpin for a growing economy would be renewable energy investment, and he promised to "create five million new jobs in solar, wind, geothermal" energy. Mr. Obama did invest some $9 billion in green energy, but his job estimate was off by at least a factor of 10 and today many solar and wind industry firms are fighting bankruptcy. The growth in domestic U.S. energy production that he now takes credit for has come almost entirely from the fossil fuels his Administration has done so much to obstruct.

There's nothing unusual about candidates making grandiose promises that don't come true. And it's a White House tradition to blame one's predecessor when things don't get better. (Usually these Presidents end up one-termers.)

The bad faith wasn't then. It's now. Mr. Obama really believed that government spending would unleash a robust recovery in employment and housing—an "economy built to last." Now that this hasn't happened and with the Congressional Budget Office predicting a possible recession for 2013, Team Obama claims these woeful results were the best that could have been expected.

The problem with this line is that every President who has inherited a recession in modern times has done better. (See nearby table.) Under Mr. Obama, measured on the basis of jobs, GDP growth and incomes, this has been by far the meekest recovery from the past 10 recessions.

When George W. Bush was elected, he inherited a mild recession from Mr. Clinton amid the bursting of the dot-com bubble, some $7 trillion of wealth eviscerated. Nine months later came the 9/11 terrorist attacks. Yet by 2003 the economy was growing by more than 3% and eight million jobs were created over the next four years.

The Administration and its acolytes claim that the nature of the 2008 financial collapse was different from past recessions, and that it can take up to a decade to restore growth after such a financial crisis. Economist Michael Bordo [] rebuts that claim with historical economic evidence nearby.

In reality, the biggest difference between this recovery and others hasn't been the nature of the crisis, but the nature of the policy prescriptions. Mr. Obama's chief anti-recession idea was a near trillion-dollar leap of faith in the Keynesian "multiplier" effect of government spending. It was the same approach that didn't work in the 1930s, didn't work in the 1970s, didn't work in 2008, and didn't work in such other nations as Japan. It didn't work again in 2009.

Ronald Reagan also inherited an economy loaded with problems. The stock market had been flat for 12 years, inflation rates neared 14%, and mortgage rates almost 20%. The recession he endured in 1981-82 to cure inflation sent unemployment to 10.8%, higher than Mr. Obama's peak of 10%. But the business and jobs recovery by early 1983 was rapid and lasted seven years.

Reagan used tax-rate cuts, disinflationary monetary policy and deregulation to reignite growth—more or less the opposite of the Obama policy mix. Liberals tried to explain the Reagan boom that they said would never happen by arguing that there was nothing unusual about the growth spurt after such a deep recession. So why didn't that happen this time?

When campaigning to be President in 1960, John F. Kennedy denounced slow growth under Eisenhower and Nixon and said "We can do bettah." Growth was 7.2% in 1959 and 2.5% in 1960. Since the recession ended under Mr. Obama, growth has been 2.4% in 2010, 1.8% in 2011 and, after Thursday's downward revision for the second quarter, 1.7% in 2012.


Sheila Bair: 'Insolvent Institutions Should Be Closed'

Sheila Bair: 'Insolvent Institutions Should Be Closed.' By Robert L Pollock
Political Diary
Wall Street Journal, September 27, 2012, 12:28 p.m. ET

If you were one of the people scratching your forehead in 2008 as the federal government bailed out Bear Stearns, let Lehman Brothers fail, and then showered hundreds of billions of dollars on the banking system to avert the alleged threat of a "systemic" collapse, you were hardly alone. In fact Sheila Bair, then head of the Federal Deposit Insurance Corporation, shared many of your concerns.

Ms. Bair stopped by the Journal Wednesday as part of a tour to promote her new book on the financial crisis. The headline revelations: She was very skeptical about why the likes of Citibank were deemed worthy of moving heaven and earth to save, and she also doesn't quite understand what Tim Geithner and Hank Paulson were talking about when they used the phrase "systemically important" institutions.

Of Mr. Geithner and Citi, Ms. Bair said you just have to "look at his phone logs" to see the outsized concern he had with preserving the financial giant. He was talking with Citi CEO Vikram Pandit a lot, she says. You got the impression "he was going to stand behind Citi management no matter what . . .. He viewed me as a threat with my desire to impose losses on bondholders."

So what would Ms. Bair have done? "At least make them clean up their balance sheet," instead of just throwing money at them. "If our system is so fragile that a blatantly mismanaged, poorly run bank can't be subject to some market discipline because the whole system is gonna come down, let's just socialize everything."

"It was a joke" what happened, Ms. Bair continued. Now "they're a zombie bank," like so many Japanese financial institutions.

So does Ms. Bair think the concept of systemic risk makes any sense at all? "I think it's a really, really overused word. It's never backed with analysis. It's just 'You gotta do this because it's the system.' I think if you're throwing government money around" you better have a good explanation why letting an institution fail through the normal FDIC process would be a problem.

Ms. Bair's radical alternative to panicked and inconsistent decision making in Washington? "The insolvent institutions should be closed."

"The original sin was with Bear Stearns . . .. I've never seen a good analysis why Bearn Stearns was systemic," she says. But after Bear was bailed out in early 2008, the much bigger Lehman Brothers expected a bailout, too. When it didn't get one, the crisis of fall 2008 began in earnest. "There were so many missteps leading up to this that created market uncertainty."

Wednesday, September 26, 2012

Assessing the Cost of Financial Regulation

Assessing the Cost of Financial Regulation. By Douglas Elliott, Suzanne Salloy, and André Oliveira Santos
IMF Working Paper No. 12/233

Summary: This study assesses the overall impact on credit of the financial regulatory reforms in Europe, Japan, and the United States. Long-term cost estimates are provided for Basel III capital and liquidity requirements, derivatives reforms, and higher taxes and fees. Overall, average lending rates in the base case would rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States. These results are similar to the official BIS assessments of Basel III and an OECD analysis, but lower as a result of including expense cuts and reductions in the returns required by investors. As a result, they are markedly lower than those of the IIF.

Executive Summary:

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.

There is serious disagreement about how much the additional safety margins will cost.  The Institute of International Finance (IIF), a group sponsored by the financial industry, estimated the proposed reforms will reduce economic output in the advanced economies by approximately 3 percent during 2011–15. Official estimates suggest a much smaller drag. 
Finding an intellectually sound consensus on the costs of reform is critical. If the true price is too high, reforms must be reassessed to improve the cost-benefit ratio. But, if reforms are economically sound, they should be pursued to increase safety and reduce the uncertainty about rules that creates inefficiencies and makes long-term planning difficult.

This study assesses the overall impact on credit of the global financial regulatory initiatives in, Europe, Japan, and the United States. It focuses on the long-term outcomes, rather than transitional costs, and does not attempt to measure the economic benefits of reforms. Academic theory is combined with empirical analyses from industry and official sources, plus financial disclosures by the major financial firms, to reach specific cost estimates. The analysis here does not address the significant adjustments triggered by the financial and Eurozone crises and the potential transitional effects of adjusting to the new regulations.

The study focuses principally on the effects of regulatory changes on banks and their lending. This is for three reasons: banks dominate finance; the reforms are heavily focused on them; and it is harder to estimate the effects on other parts of the system, such as capital markets. Loans, in particular, are a major part of overall credit provision and there is substantially greater data available on lending activities. Where possible, the study also looks at the effects of new regulations on securities holdings by banks and on securities markets.

Measuring the cost of financial reform requires careful consideration of the baselines for comparisons. They should incorporate the higher safety margins that would have been demanded by markets, customers, and managements after the financial crisis, even in the absence of new regulation. Some studies take the approach of assuming all the increases in safety margins are due to regulatory changes, exaggerating the cost of reforms.

A simple model is used to estimate the increase in lending rates required to accommodate the various reforms. The model assumes credit providers need to charge for the combination of: the cost of allocated capital; the cost of other funding; credit losses; administrative costs, and certain miscellaneous factors. The study establishes initial values for these key variables, determines how they would change under regulatory reform, and evaluates the changes in credit pricing and other variables needed to rebalance the equation.  Cost estimates are provided for capital and liquidity requirements, derivatives reforms, and the effects of higher taxes and fees. These categories were chosen after a detailed qualitative assessment of the relative impact of different reforms on credit costs.

Securitization reform was initially chosen as well, but proved impossible to quantify.  Finally, an overall, integrated cost estimate is developed. This involves examining the interactions between these categories and including the effects of mitigating actions likely to be taken by the financial institutions as a result of the reforms in totality. This includes, for example, the room for expense cuts to counteract the need for price increases, to the extent that such cuts were not already included in stand-alone impact estimates.

Lending rates in the base case rise by 18 bps in Europe, 8 bps in Japan, and 28 bps in the United States, in the long run. There is considerable uncertainty about the true cost levels, but a sensitivity analysis shows reasonable changes in assumptions do not alter the conclusions dramatically. The results are broadly in line with previous studies from the official sector, partially because similar methodologies are employed. This paper finds similar first-order effects to the official BIS assessments of Basel III (BCBS (2010) and MAG (2010)) and the analysis at the OECD by Slovik and Cournède (2010). The cost estimates here are, however, markedly lower than those of the IIF.

Three extensions of the methodologies from the official studies, though, lead to substantially lower net costs. The base case shows increases in lending rates of roughly a third to a half of those found in the BIS and OECD studies, despite important commonalities in the core modeling approaches with these studies. First, the baselines chosen here assume a greater hike in safety margins due to market forces, and therefore less of a regulatory effect, than the OECD and IIF studies. (The BIS studies do not reach firm conclusions on the additional capital needs). Industry actions through end-2010 suggest that market forces alone would have produced reactions similar to what was witnessed to that point, even if no regulatory changes were contemplated.

Second, this paper assumes that banks will also react by reducing costs and taking certain other measures that have little effect on credit prices and availability, in addition to the actions assumed in the other studies. The official studies do not do so and the IIF study assumes a fairly low level of change. This accounts for 13 bps of cost reduction in Europe, 10 bps in Japan, and 20 bps in the United States. Third, this paper assumes that equity investors will reduce their required rate of return on bank equity as a result of the safety improvements. Debt investors are assumed to follow suit, although to a much lesser extent. The official studies assume no benefit from investor reactions, for conservatism, and the IIF assumes the benefits, although real, will arise over a longer time-frame than is covered by their projections.

There are important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, therefore not adding unnecessary costs. Despite these limitations, the results appear to be a balanced, albeit rough, assessment of the likely effects on credit. Further research would be useful to translate the credit impacts into effects on economic output.

Again, all of the analysis is based on the long-run outcome, not taking account of a transition being made in today’s troubled circumstances. To the extent that bank capital or liquidity is difficult or very expensive to raise during the transition period—as they are currently in Europe, a reduction in credit supply would be expected and any increase in lending rates would be magnified, perhaps substantially. Deleveraging is clearly occurring at European banks under today’s conditions in response to financial market, economic, regulatory, and political factors. It is impossible to tell whether any appreciable portion of this reaction is due to anticipation of the Basel III rules. Regardless of the transitional effects, it will be possible, over time, for banks to find the necessary capital and liquidity to provide credit, as long as the pricing is appropriate. Capital and liquidity will flow to banks from other sectors if the price of credit rises more than is justified by the fundamental underlying factors.

The relatively small effects found here strongly suggest that the benefits would indeed outweigh the costs of regulatory reforms in the long run. Banks have a great ability to adapt over time to the reforms without radical actions harming the wider economy.

Full text:

Dodd-Frank's 'Orderly Liquidation' Is Out of Order. By Scott Pruitt and Alan Wilson

Dodd-Frank's 'Orderly Liquidation' Is Out of Order. By Scott Pruitt and Alan Wilson
South Carolina, Oklahoma and Michigan join a federal lawsuit to uphold property rights and checks and balances.The Wall Street Journal, September 25, 2012, 7:14 p.m. ET

'The tendency of the law must always be to narrow the field of uncertainty." Justice Oliver Wendell Holmes wrote that more than a century ago, but the sentiment runs all the way to our nation's roots. Under our Constitution, the rule of law provides the certainty and transparency necessary to protect individual liberty and support economic growth.

But the 2010 federal financial-reform law known as Dodd-Frank continues to undermine economic growth and the rule of law by injecting immense uncertainty into our economy. As law professor David Skeel demonstrated recently in these pages, the law's Title II gives the Treasury secretary and the Federal Deposit Insurance Corp. unprecedented authority to "liquidate" financial companies. This grants immense power to a handful of unelected federal bureaucrats, empowering them to pick winners and losers among a liquidated company's investors. This arrangement destroys rights long protected by bankruptcy law.

For that reason and others, the attorneys general of South Carolina, Oklahoma and Michigan last week joined a federal lawsuit challenging Dodd-Frank's unconstitutional "orderly liquidation" provisions. Dodd-Frank's elimination of investors' rights directly harms our states because state pension funds are partly invested in financial companies. We must raise these constitutional objections now because once a company is liquidated, it will be too late.

Title II eliminates all meaningful judicial review and due process. Once the Treasury secretary orders the liquidation of a financial company, the company has only 24 hours to convince a federal court to overturn that order. Unless the court somehow manages to decide the entire case in the company's favor before the clock expires, the government wins by default and can begin to liquidate the company even as appeals are pending. Dodd-Frank further limits the authority of the courts by prohibiting them from reviewing whether the Treasury secretary's decision was constitutional, or whether the liquidation is actually necessary to protect financial stability.

The Treasury secretary's largely unaccountable decisions in these cases will put investments at risk, and creditors won't know until it is too late. Dodd-Frank prohibits the company from disclosing the liquidation threat before the district court decides the case. Once the liquidation goes forward, the creditors' only recourse will be to plead their case before the FDIC, with minimal judicial review—meaning that creditors' recoveries are "likely to be close to zero," as bankruptcy scholars Douglas Baird and Edward Morrison have put it.

Even more disturbing is the possibility that a company might agree to be "liquidated" and rebuilt under a new banner—like "New Chrysler" replacing "Old Chrysler"—leaving its creditors no right to block the reorganization. Instead, creditors not favored by federal bureaucrats will have little choice but to accept the deal offered to them by the government in a black-box process.

When the federal government replaced "Old Chrysler" with "New Chrysler" in 2009, it told one set of Chrysler's creditors (Indiana's state pension funds) to swallow $6 million in losses. Indiana attempted to defend its employees' pensions in court, but the government shuttered "Old Chrysler" before the Supreme Court could hear Indiana State Police Pension Trust v. Chrysler. Our states face the same threat because they have invested in the debt of financial companies that can be liquidated under Dodd-Frank.

We have taken an oath to uphold the rule of law and defend the Constitution. We are determined to uphold that oath, including defending the Constitution against the overarching power of the federal government.

Our lawsuit attempts to defend the very heart of our Constitution's structure: By committing such broad power to federal bureaucrats and nullifying critical checks and balances, Dodd-Frank's "orderly liquidation" authority violates the Constitution's separation of powers, the Fifth Amendment's guarantee of due process, and the guarantee of "uniform" bankruptcy laws.

The president and Congress can easily repair these constitutional violations by amending Dodd-Frank, restoring the rights long protected by federal bankruptcy law and reaffirming the Constitution's checks and balances. Until then, we will vigorously defend the rule of law through this litigation. The hard-earned pension contributions and tax payments of our citizens deserve nothing less.

Mr. Pruitt is attorney general of Oklahoma. Mr. Wilson is attorney general of South Carolina.