RD News 6March12

• CPSS: Paul Tucker appointed Ch

• BIS: Collateral requirements for mandatory central clearing of over-the-counter derivatives
• By the end of 2012, all standardised over-the-counter (OTC) derivatives must be cleared with central counterparties (CCPs).
• Paper estimates the amount of collateral that CCPs should demand to clear safely all interest rate swap and credit default swap positions of the major derivatives dealers.
• Results suggest that major dealers already have sufficient unencumbered assets to meet initial margin requirements, but that some of them may need to increase their cash holdings to meet variation margin calls.
• Default funds worth only a small fraction of dealers' equity appear sufficient to protect CCPs against almost all possible losses that could arise from the default of one or more dealers, especially if initial margin requirements take into account the tail risks and time variation in risk of cleared portfolios.
• Concentrating clearing of OTC derivatives in a single CCP could economise on collateral requirements without undermining the robustness of central clearing.

• B Mahapatra (ED, RBI): Implications of Basel III for capital, liquidity and profitability of banks
• The costs for Indian banks will be less than those for banks from other jurisdictions.
• Indian banks generally have only very small trading books or exposures to complex financial instruments - the effect of Basel III on their capital structure will be “insignificant”.
• More than 50% of Indian banks would be able to implement the Basel III capital requirements without any phase in, owing to already high levels of capital. This entails a far lower impact on banks’ return on equity than for US or European banks.

• IMF: Balance-Sheet Shocks and Recapitalizations
• Gains from recapitalizing the financial sector in response to large but rare net worth losses are as large as those from eliminating business cycle fluctuations.
• Also find that:
• gains are increasing in the size of the net worth loss,
• are larger when recapitalization funds are raised from the household rather than the real sector,
• may increase with a reduction in financial intermediaries idiosyncratic risk.  

• BIS: A Comprehensive Look at Financial Volatility Prediction by Economic Variables
• Variables that proxy for credit risk and funding (il)liquidity consistently show up as common predictors of volatility across several asset classes.
• Variables capturing time-varying risk premia (such as valuation ratios for equities, or interest rate differentials in foreign exchange) also perform well as predictors of volatility.
• In contrast to these financial predictors, variables that proxy for macroeconomic conditions, are much less informative about future volatility.

• V K Sharma(ED, RBI): The framework for pre-empting systemic financial risks
• In India, we have had remarkable financial stability, not fortuitously, but thanks to pre-emptively and pro-actively delivered counter-cyclical prudential measures like the increase in risk weights for exposures to commercial real estate, capital market, venture capital funds and systemically important non-deposit accepting Non Banking Finance Companies (NBFCs).
• To contain potential systemic liquidity risk, the Reserve Bank has capped banks’ investments in Fixed Income Mutual Funds to 10% of their net worth.
• Monetary policy tools can also be deployed alongside the counter-cyclical prudential regulatory measures as a complementary companion tool to credibly, effectively and decisively address the build-up of systemic financial risks.
• The famous Taylor rule can be modified suitably to include, alongside inflation and GDP, additional terms representing systemic financial conditions based on the financial parameters for detecting asset bubbles and under-pricing of risks.

RD News 1March12

• Paul Tucker: National balance sheets and macro policy: lessons from the past 
• We must not rely entirely on central banks ‘mopping up’ after financial crises. Not only does it strain our capabilities ex post, it is counterproductive ex ante. If central banks are perceived as writing deep-out-of-the-money put options, then the market, believing it is protected by those tail-risk puts, will itself take more risks than otherwise. We need overall macro regimes that aim to make chronic imbalances and over-indebtedness less likely and less threatening.
• We must try to identify and remove microeconomic incentives that distort risk-taking behaviour into dangerous channels. And given the interconnectedness of global finance, we –especially in the UK – must be alert even to such distortions elsewhere. US housing finance was a domestic system whose structure led to problems with global spillovers.

• Lord May: Banking ecosystems interview
• Simplifying the system will help but banking also needs extra precautions against the ’super-spreaders’ of infection in the network. For example, during the SARS epidemic, certain individuals infected dozens of others while some infected very few. Applied to the banking system, problems at a major bank would infect many other institutions, while the closure of a small building society may have limited impact.
• “Excessively complicated ecosystems will be destabilised by their complexity,” he says. “There are more and more complicated products with faster and faster trading. I accept my financial knowledge is limited, but if I were supreme dictator I would ask whether we should be putting a limit on how fast you can trade.”

• Andrew Sheng: Greening urban growth: green grids of life, not gridlock
• System-wide problems cannot be solved partially. We need a systemic and systematic way of thinking and acting on the interactive and interconnected way the world evolves. Systems thinker Frithof Capra has argued that the "Development process is not purely an economic process. It is also a social, ecological, and ethical process - a multi-dimensional and systemic process".

 

• BoE: Martin Weale: From retailers’ paradise to shoppers’ strike: what lies behind the weakness in consumption?
• A tightening of the conditions on which credit is available and a fear that people will not be able to obtain credit in the event of an adverse shock to their income, will lead to an increase in saving.
• Tight credit has the effect of making consumption more sensitive to income and less sensitive to interest rates than it might otherwise be.

• IOSCO: Final recommendations on OTC derivative mandatory clearing
• Reuters report
• Recommends that the derivatives market and regulators should work together to decide which contracts should be centrally cleared.
• However, it also suggests that there should be a “top-down” approach, whereby supervisors have authority to instruct banks and clearing houses to clear certain broad classes of products even if a clearing house has yet to be licensed to do so.
• Exemptions from mandatory clearing should be narrowly defined and limited.

• IMF: Systemic Real and Financial Risks: Measurement, Forecasting, and Stress Testing
• Model for identifying real time systemic risks in the financial sector.
• The model provides forecasts of indicators of systemic real risk and systemic financial risk based on density forecasts of indicators of real activity and financial health.
• It includes stress-tests as measures of the dynamics of responses of systemic risk indicators to structural shocks identified by standard macroeconomic and banking theory.

RD News 27Feb12

• World Bank: China needs reform to support growth
• Reforms should include commercializing the banking system, gradually removing interest rate controls, deepening the capital market and further developing independent and strong regulatory bodies to support the eventual integration of China’s financial sector within the global financial system.
• Financial reforms in the next two decades should be decisive, comprehensive and well-coordinated, following a properly sequenced roadmap. A priority is to liberalize interest rates according to market principles.
• China's leaders have promised repeatedly to support entrepreneurs who create new jobs and wealth. But most bank lending still goes to state companies, and Beijing's huge stimulus in response to the 2008 crisis set back reforms by pouring money into government industry while thousands of private companies went bankrupt.

• Andy Haldane: UK Banking must change to serve SMEs
• "UK needs structural reconfiguration of the banking industry to ensure that SMEs have the financing they need to be tomorrow's growth."

• EC: High-Level Expert Group to Investigate Structural Reform for EU Banks - mandate
• List of members
• Erkki Liikanen, Gov Bank of Finland
• Jose Manuel Campa, Spanish Finance Minister, 09-11
• Louis Gallois, CEO EADS
• Monique Goyens, Director General BEUC
• Jan Pieter Krahnen, Ch Corporate Finance Goethe-Universitat
• Allessandro Profumo, CEO UniCredit 97-10
• Carol Sargeant, CRO Lloyds 04-10
• Zdenek Tuma, Governor Czech National Bank 00-10
• Herman Wijffels, ED World Bank 06-08
• The group “should have regard to ongoing regulatory reform in the EU and globally and should assess the added value of structural reform”, and should pay “particular attention to ongoing structural reforms” such as the US Volcker Rule and the UK Independent Commission on Banking.
• The group is tasked with giving recommendations to reduce the risks of the banking system as a whole, to reduce the risks that individual firms pose to the financial system, to reduce moral hazard, and to promote competition, while maintaining the integrity of the internal market.
• The group will conduct hearings and consultations, scheduled to report by the end of summer 2012. 

• IOSCO: Suitability Requirements with respect to the Distribution of Complex Financial Products
• “the growing complexity of financial products and financial innovation may make the associated investment risks less apparent to investors”, particularly when products are idiosyncratic.
• The responsibilities of intermediaries with respect to ensuring that products are suitable for particular types of clients.
• Outlines a number of principles for assessing suitability and for ensuring adequate disclosure about investment risks.

• William Dudley (Pres NY Fed): Fiscal Challenges
• The US faces substantial fiscal challenges in the years ahead. And, in one important respect—net interest expense—these challenges may be more daunting than fully appreciated currently. In particular, the interest bill on the growing federal debt burden has been temporarily restrained by the low level of interest rates and high level of remittances from the Federal Reserve to the Treasury.
• In addition, while significant fiscal adjustments must take place, it is important to recognize that such efforts will necessitate offsetting shifts in private domestic spending and production both here and abroad.

• Warren Buffett: Annual Shareholder Letter
• Washington Post report
• Buffett’s replacement decided, but not revealed.  

RD News 22Feb12

• Reserve Bank of India: Issues Guidelines on Basel III Liquidity Standards
• RBI “fully committed” to Basel III. 
• Guidelines indicate how the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) will be made operational and monitored, with Indian banks needing to comply from mid-2012, before the Basel standards come into force in 2015 and 2018 respectively.
• The Basel standards will supersede India’s existing liquidity regime of a cash reserve ratio and statutory liquidity ratio.

• EU: Adopts Regulation on Short-Selling and Ban on Naked CDS
• Rule gives regulators option to ban so-called ‘naked’ short selling and credit default swaps (CDS) on sovereign debt.
• Text argues that buying CDS without having a long position in the underlying debt or asset is economically equivalent to taking a short position on that underlying instrument, warranting the coverage of CDS in the rule.
• Authorities will have powers of intervention “in the case of adverse developments which constitute a serious threat to financial stability or to market confidence in a Member State of the Union”.
• The European Securities and Markets Authority (ESMA) will be given additional powers to override competent authorities if it is deemed that they “have not taken sufficient measures to address the threat”.
• The regulation is set to come into force by 1 November 2012.

• K C Chakrabarty: Indian banking sector – towards the next orbit
• A combination of strong regulation and supervision and a will to evolve policies that lean against the wind helped insulate the Indian financial system from the crisis. It helped too that the Indian banks were not very sophisticated and excessively leveraged.
• However, in a world where financial systems recognize no boundaries and the fortunes of nations are intertwined, no nation can consider itself an island and remain immune to the changes in the tides of the world economy for a prolonged period.
• While none of the Indian banks feature in this list of 29 G-SIBs, the BCBS and FSB are already working towards laying down a criterion for identification of domestic SIBs which would need to be subjected to additional capital and liquidity requirements on the lines of that applicable to the G-SIBs.

• BIS: Inflation Dynamics in the Presence of Informal Labour Markets
• Consider the effects of informal labour markets on the dynamics of inflation and on the transmission of aggregate demand and supply shocks.
• Results show that the informal economy generates a "buffer" effect that diminishes the pressure of demand shocks on inflation.
• Result implies that, in economies with large informal labour markets, changes in interest rates are more effective in stimulating real output and there is less impact on inflation.
• Furthermore, the model produces cyclical flows from informal to formal employment, consistent with the data.

• Usha Thorat: Recommends Tier I capital of 12% for Non-Banking Financial Companies
• The NBFC sector has been increasing its assets compared to the banking sector. Quite a lot of funds from the banking sector were flowing into NBFCs, and quite a lot of funds from the mutual funds as well.
• Proposal for NBFCs to have higher risks weights on exposure to real estate and to capital markets is a part of the various measures that were recommended for strengthening their regulatory framework.

• FT: The bank needs more than a new governor
• Banker candidates for next governor:
• Lord Green
• Douglas Flint
• Peter Sands
• John Varley
• Favourite remains Paul Tucker.

RD News 20Feb12

• Andrew Sheng: Small is beautiful
• E.F. Schumacher’s ‘Small is Beautiful’:
• "One of the most fateful errors of our age is the belief that the problem of production has been solved. The illusion…is mainly due to our inability to recognize that the modern industrial system, with all its intellectual sophistication, consumes the very basis on which it has been erected. To use the language of the economist, it lives on irreplaceable capital which it cheerfully treats as income."
• The importance of smallness in large organization - as organizations become larger and larger, they become more impersonal.
• Inherent contradictions within large organizations that have alternating phases of centralizing and decentralizing.
• Five principles:
• Subsidiarity –the upper authority should delegate to the lower level powers where it is obvious that the lower levels can function more efficiently than the central authority.
• Vindication – governance by exception. The centre delegates and only intervenes under exceptional circumstances which are clearly defined.
• Identification – the subsidiary must have clear accounting in the form of balance sheets and profit and loss account.
• Motivation –motivation at the lower levels of large organization has little motivation if everything is directed from the top.
• The Principle of the Middle Axiom. He notes that "the centre can easily look after order; it is not so easy to look after freedom and creativity". In practical terms, you set out an objective, but do not detail and direct how that objective is to be achieved, giving some degree of innovation and freedom for the subsidiary levels of the organization to achieve the objectives.

• ESMA: Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories – Discussion paper
• Asks for input on a wide range of issues, such as when ESMA should consider a derivatives contract to have a direct effect within the EU, what sort of information should be collected through CCPs, and how to ensure consistency of data storage in TRs.

• IMF: From Stress to CoStress: Stress Testing Interconnected Banking Systems
• An integrated framework for assessing systemic risk - models banks’ capital asset ratios as a function of future losses and credit growth using a generalized method of moments to calibrate shocks to credit quality and credit growth.
• Analysis is complemented by a simple measure of systemic risk, which captures tail risk comovement among banks in the system.
• Based on CreditRisk+, which uses analytical techniques—similar to those applied in the insurance industry - to estimate banks’ credit portfolio loss distributions, making no assumptions about the cause of default.

• FT: China cuts banks’ reserve ratios
• PBOC lowering the reserve requirement by 50 bps from 24th Feb.
• Cut will bring the ratio down to 20.5 per cent for the largest banks, and is expected to free up about Rmb400bn ($64bn) for new lending.
• New renminbi-denominated lending dropped Rmb288.2bn to Rmb738.1bn in January from a year earlier.

RD News 17Feb12

• BIS: Hervé Hannoun (Dep GM) Monetary policy in the crisis: testing the limits of monetary policy
• Central banks are increasingly seen by market participants as all-powerful, able to intervene without any limit.
• The trend towards unlimited intervention combined with ultra-low interest rates does not only have potentially serious side effects on the functioning of the market economy, it also gives rise to three major risks:
• financial dominance
• exchange rate dominance
• fiscal dominance
• The ultimate possible consequence is an inflation surprise that could severely damage central banks' hard-earned credibility.
• To prevent these risks from materialising, we need to forge a consensus on what could be called "the new frontier of monetary policy" in order to refocus monetary policy on maintaining lasting price stability. This also implies that central banks should reject the market illusion of unlimited intervention and the associated theory of the "printing press".

• NY Fed: Release of the Tri-party Repo Infrastructure Reform Task Force's Final Report + Statement
• The tri-party repo market's infrastructure exhibits significant structural weaknesses that undermine market stability in a stressed environment.
• Three fundamental areas of concern identified by policymakers at the Federal Reserve:
• (1) market participants' overreliance on intraday credit from tri-party clearing banks,
• (2) risk management practices that are vulnerable to procyclical pressures,
• (3) the absence of an effective and transparent process for the orderly liquidation of a defaulted broker-dealer's collateral.
• Completed improvements:
• the establishment of automated collateral substitution functionality for most trades in the market
• the implementation of a 3-way trade confirmation process for all tri-party repo transactions.
• improved transparency in the tri-party repo market by publishing a monthly report on market size, collateral composition and margining practices.
• Despite these accomplishments, the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.
• Ideas include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer's default.
• Ending tri-party repo market participants' reliance on intraday credit from the tri-party clearing banks remains a critical financial stability policy goal.
• While the bulk of the work on operational changes will fall to the clearing banks and FICC, borrowers and investors in the tri-party repo market will also need to modify their credit and liquidity risk management practices to realize the promise of these operational changes.
• Dealers should be taking steps to reduce their reliance on short-term financing and investors should be taking actions to ensure their credit risk management policies and practices are robust to stress events. Such actions can help to ensure that market participants better internalize and price the costs associated with the credit and liquidity risks they bear in tri-party repo transactions.

• Andy Haldane: The Doom Loop
• Consider the effects of the too-big-to-fail problem on risk-taking incentives. If banks know they will be bailed out, those holding their debt will be less likely to price the risk of failure for themselves. Debtor discipline will therefore be weakest among those institutions where society would wish it to be strongest. This encourages them to grow larger still: the leverage cycle isn’t merely repeated, but amplified. The doom loop grows larger. The biggest banks effectively benefit from a disguised, and growing, state subsidy.
• The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis.
• Under the so‑called Basel III agreements struck in 2010, banks’ minimum equity capital ratios will rise fivefold over the next decade, from 2 per cent to close to 10 per cent of assets for the largest global banks.
• A 10 per cent capital ratio translates into bank leverage of roughly 25. So even once Basel III is in place, an unexpected loss in a bank’s assets of just 4 per cent will be enough to render it insolvent.
• Voting rights could be extended across a wide group of stakeholders, but weighted by stake. Governance and control would then be distributed across the whole balance sheet, curbing the profit-seeking incentives of the equity minority, while weighting voting rights by size of portfolio to avoid the inertia of mutuality. Bank governance would then be a wealth-weighted democracy, a hybrid of the mutual and joint-stock models.

• BIS: Stochastic Herding in Financial Markets: Evidence from Institutional Investor Equity Portfolios
• A structural model of herding behavior in which feedback arises due to mutual concerns of traders over the unobservable "true" level of market liquidity.
• In a herding regime, random shocks are exacerbated by endogenous feedback, producing a dampened power-law in the uctuation of largest sales.
• A stock's realized illiquidity propagates herding and raises the probability of observing a sell-off. The distribution function itself has desirable properties for evaluating "tail risk".

• Reuters: EU to consult on shadow banking rules
• Draft EU rules are being readied for consultation on the shadow banking system.
• As banking regulation is tightened, incentives are created for some activities to be conducted outside of the banking system, in less regulated institutions.
• The draft reportedly recognises the “potentially useful” role of shadow banking in intermediation, but that a range of measures, from registration through to fully macroprudential tools, might be recommended.
• Possibility that banks may be required to limit their exposure to shadow banking entities, or include such entities when calculating capital, liquidity and leverage buffers.
• Paper may be published as soon as March, with a public hearing on 27 April.

RD News 15Feb12

• BCBS/Joint Forum: Report on intra-group support measures
• Overview of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors.
• Majority indicated centralised capital and liquidity management systems are in place. According to proponents, this approach promotes the efficient management of a group’s overall capital level and helps maximise liquidity while reducing the cost of funds.
• However, the respondents that favoured a “self-sufficiency” approach pointed out that centralised management potentially has the effect of increasing contagion risk within a group in the event of distress at any subsidiaries.

• Charles Plosser (Pres Philadelphia Fed): The outlook and the hazards of accelerationist policy
• Prolonged efforts to hold interest rates near zero can lead to financial market distortions and the misallocation of resources.
• Constant acceleration only makes these risks even more hazardous. Slamming on the brakes or abruptly changing course could disrupt the economy. Failing to slow down and exit at the right time risks excessive inflation.

• Jean-Pierre Danthine (SNB): Reconciling price and financial stability
• Two main dimensions of systemic risk:
• the “structural” dimension, which covers the possible risks associated with individual institutions whose failure would endanger the entire system;
• the “cyclical” dimension refers to systemic risks which are not directly linked to an individual institution, but which stem from financial institutions’ collective responses to business or financial fluctuations and adverse shocks.
• “Structural tools” strive to reduce the impact of institutional failure by strengthening individual institutions. Their potential utility is often cited with regard to institutions which are considered “too big to fail” or “too interconnected to be liquidated” and whose failure would impact the entire system.
• “Countercyclical tools” aim to address the cyclical dimension of risk by reducing feedback loops.
• By reducing the probability of a severe crisis, the benefit of countercyclical buffers is on average 10 times higher than their costs in terms of real output growth per year.

• OFR: A Survey of Systemic Risk Analytics
• Survey of 31 quantitative measures of systemic risk in the economics and finance literature.
• ‘Because systemic risk is a multifaceted problem in an ever-changing financial environment, any single definition is likely to fall short, and may create a false sense of security as financial markets evolve in ways that escape the scrutiny of any one-dimensional perspective.’
• In many cases, academic researchers have made do with publicly available data, adjusting their modeling approaches accordingly. This is a constraint that regulators will not necessarily face, given the mandates and authorities granted to them by recent legislation.
• Definitions of each risk measure—including required inputs, expected outputs, and data requirements – in appendix.
• To encourage experimentation and innovation among as broad an audience as possible, we have developed open-source Matlab code for most of the analytics surveyed.