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The Risk Telescope — Credit Rating Agency Regulation
Finance is filled with informational asymmetries. Lenders have more information about their borrowers than outsiders (assuming the lenders have done their due diligence). Regulators have more information about the banks they oversee than outsiders (including shareholders). Periodic abuses of those informational asymmetries over the decades has led to a range of regulatory requirements designed to increase transparency and level the playing field among different types of agents that require access to information in order to make good decisions.
Investors lending through bond markets do not have the same ongoing monitoring tools that banks have when they provide loans. Capital markets thus require independent external verification of credit quality. Ever since the 1929 stock market crash, capital markets have relied on independent, external assessments of credit quality to address informational asymmetries for lending in bond markets. Failures at the CRAs as well as risk management failures among investors and banks leading up to the 2008 credit market implosion have created a major public policy shift away from this established operating system.
Today’s issue of The Risk Telescope focuses on the red-hot debate regarding what role credit rating agencies (CRA) can and should play in reducing informational asymmetries among private and public sector users of CRA analysis. A clearly definable global goal has been articulated by the Group of Twenty (G20) and the Financial Stability Board (FSB) to decrease regulatory and private sector reliance on CRA assessments. Section I reviews this recent history and suggests some implications for how market behavior could adjust if the G20 reforms are implemented.
However, major divergences are emerging across the North Atlantic regarding implementation of the G20’s policy objectives. Specifically, the U.S. proposals for amending the Basel II Market Risk Amendment framework and the European Union’s draft directive both address the role of CRAs within the financial system in dramatically different, and potentially irreconcilable, ways. Section II describes those divergences and their implications.
A focus on heated rhetoric also obscures the fact that policymakers on both sides of the Atlantic have very different views about the role CRAs should play in a market economy. Both seem to favor more political factors in the credit assessment process, but the European framework suggests only local political views will be acceptable. Such a perspective may be understandable amidst a crisis (particularly if one believes, as some Europeans do, that the market is unfairly and inappropriately discounting the nature and value of their reform efforts). But insular views that reject independent, third-party analysis can also feed echo-chambers while rejecting one of the fundamental principles of a market economy: that private market participants can and should make decisions regarding sovereigns without political interference.
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The Risk Telescope — The Great Schism Part II
Earlier this month, The Risk Telescope dissected The Great Schism in Brussels. It suggested that persistent bickering between the U.K. and its EU partners on technical financial services issues seemed likely and that the latest eurozone plan seemed destined to fall short.
Since then, various key financial regulations have failed to complete the EU legislative process due to lack of agreement with the UK. The donation package for the IMF has failed to reach its stated target funding amount, and it is unclear whether all donating members will be able to complete internal political processes necessary to effect their promised donations. The promised “treaty” package has been downgraded to an “international agreement” in part to facilitate quick approval without formal ratification and the draft text incorporates flexible escape clauses not incorporated into the December 9 Eurozone Statement.
This year-end edition of The Risk Telescope does not, however, focus on the developments in Brussels.
Instead, the lens remains focused as promised on emerging global policy trajectories whose directionality will be directly affected by eurozone developments during 2012, from Brussels to Beijing to Basel and back again…from the North Atlantic to the Trans-Pacific:
(i) Geo-economic rebalancing within the IMF;
(ii) Monetary Policy;
(iii) Financial Regulation Policy; and
(iv) Reserve Currency Politics.
A blizzard of year-end official sector reports and research makes definable global trends clearly visible on the horizon. Those trends will shape the international institutional architecture as well as the monetary policy foundations that underpin that structure.
Financial risk measurement models and stress testing will need to adapt to the new paradigm for making and executing monetary, macroprudential, and financial regulation policy. Market participants also will need to listen to policymakers differently in order to gauge more accurately the political risks driving policy at finance ministries, central banks, and regulators.
If you are looking for a way to avoid being buffeted by the news cycle and require perspective on how these and other trends fit together in a shifting geo-economic environment, there is no better way to start 2012 than with a subscription to The Risk Telescope.
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The Risk Telescope
For the last two and a half years, the eurozone crisis has been mostly a regional affair. The great questions of the day revolved around:
(i) whether (and then when and under what conditions) fiscal union might occur;
(ii) which countries might be most likely to exit; and
(iii) what kind of financial resources Europe would be willing to devote to resolve its deepening crisis.
Part I of this publication (issued today) focuses on the political and economic dynamics in Europe. It analyzes the adequacy of the answers to those questions in the Euro Area Statement(s). It suggests that none of the answers addresses persistent imbalances inside the EU today, and that the answers announced in Brussels are far from solid. Expect more change as treaty negotiations and ratification processes drag on amid likely deteriorating economic conditions in 2012.
Round Two — the global phase — begins now as European leaders begin the process of assembling their donations to the IMF and negotiating the form and terms under which at least some of that funding might find its way back to support eurozone economies. This is the most dangerous phase, as national sovereign interests will collide among countries that share less in common with each other than the eurozone shared with the United Kingdom. Part II of this publication will be published in the coming week. It will analyze the likely global implications of EU developments in the four great debates of our day:
(i) Geo-economic rebalancing within the IMF;
(ii) Monetary Policy;
(iii) Financial Regulation Policy; and
(iv) Reserve Currency Politics.
Dramatically different and strong views about the appropriate approach will need to be resolved amid likely deteriorating global economic conditions during 2012. They will need to be resolved as global policymakers within the Financial Stability Forum finalize a range of regulatory reforms promised by the Group of Twenty over the last three years and as the following major countries conduct national elections: Finland; Greece; Russia; Switzerland; France; South Korea; Egypt; France; Mexico; Czech Republic; United States.
The outlook for increased political risk and financial volatility has just increased.
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The Risk Telescope — The IMF and the Eurozone
We stand today at the threshold of a massive event horizon. The decisions taken by policymakers internationally before year-end will define the scale and scope of the fallout from the Eurozone. They will also lay the foundations for how financial systems (e.g., risk pricing formulas; risk management systems; regulatory oversight functions) will operate in the future.
We do not yet know exactly how the Eurozone sovereign bond crisis and fiscal union arrangements will be resolved. The details are unclear and remain subject to political negotiation tonight as the U.S. Secretary of the Treasury prepares for a round of shuttle diplomacy in Europe and Eurozone leaders contemplate the form and structure of treaty reform.
It is becoming increasingly clear this weekend that the International Monetary Fund (IMF) will be playing a larger role in any crisis management efforts in Europe. The technical structure through which the IMF operates will be of intense interest in the coming days. This issue of The Risk Telescope focuses on how the demands placed on the IMF by the Eurozone situation will accelerate changes in how the IMF operates.
Global economic rebalancing may ultimately lead to a new equilibrium. But the path to that equilibrium runs directly through the IMF structure and the path is likely to be discontinuous. As today’s issue of The Risk Telescope indicates, the IMF structure itself seems likely to come under severe architectural stress in the next 12-18 months. All previous assumptions about what the IMF might or might not do cannot be taken for granted and internal risk modeling systems should be reviewed accordingly.
Section I provides a brief factual recap of the situation as it stands today, largely for the benefit of readers not tapping into the news stream on an intra-day basis.. Section II focuses on the IMF’s lending facilities in the context of how those facilities might be used (or not) in Europe. Section III concludes. It is possible that Eurozone developments may also accelerate the expansion of the IMF’s role in regulatory policy generally, and macroprudential policy specifically. Macroprudential policies will be the focus of the next issue of this publication.
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European Institute Speech
On 25 October 2011, I had the honor of giving a speech to the European Institute in Washington, DC. At the time, I thought it was a rather gloomy speech. It turns out it presented the best case scenario. Having been asked by some for hard copies of the text, I post it here for others to see as well.
The Risk Telescope — Disarray & Dissonance
At the end of a wild week, we are arguably worse off than we were on Monday:
- German Chancellor Merkel has publicly admitted little investor appetite exists for the European Financial Stability Facility (EFSF) bonds, even with a sovereign guarantee. Reports indicated that Germany also rejected increased involvement by the IMF in the EFSF.
- Greece famously flirted with engaging the democratic will of the people through a referendum and negotiating yet concessions from banks, then backed off when it looked like such a move would jeopardize the flow of funds from the eurozone and the IMF to Greece.
- Italy’s bond market experienced renewed pressure despite European Central Bank (ECB) purchases. The Prime Minister indicated that the IMF had offered liquidity facilities and Italy had turned it down because it has a strong economy.
- A mid-sized U.S. brokerage house filed for Chapter 11 bankruptcy in the United States, due in large part to losses on its eurozone sovereign debt holdings.
- G20 heads of state left Cannes without agreement on what kind of lifeline — if any — the global community would provide to the eurozone or its individual members.
- Europe began considering how a member of the eurozone could leave. Eurozone leaders made clear that while they would prefer Greece to remain in the eurozone, the first priority was to protect and preserve the common currency…and they were willing to trigger a hard default in Greece by denying disbursement of the latest tranche of IMF bailout funding if Greece did not comply with the eurozone’s terms and conditions.
- Some Eurozone leaders spent the last few days seeking a change in government because only a-political “unity” caretaker governments have been able to make the unpopular decisions required to implement austerity measures that accompany EFSF/eurozone/IMF packages. As of tonight’s vote in Greece, it looks like they succeeded.
And yet the Financial Stability Board (FSB) issued no less than eight (8) major policy papers in the run-up to the G20 summit, none of which acknowledged the splintering of geopolitical interests among its members. On the regulatory and financial policy fronts, it seems, the policy mantra remains “full speed ahead” in terms of crafting global consensus-based solutions that require mostly peer pressure for enforcement…despite glaring problems in implementing the reforms agreed two or three years ago in the G20. In addition, the G20 shows signs of increasing its institutional heft by establishing a secretariat for its leadership and promising to undertake more outreach to the United Nations.
Disarray in Cannes thus seems likely to sow the seeds of increased systemic risks in the near-term. Risk managers, investors and advocates must consider carefully now whether the G20 can actually deliver on its intended goals. If the leaders of economies representing at least 85% of world GDP cannot craft a plan to provide financial stability when faced with a real and growing crisis, how can their more ambitious long-term policy goals be credible?
This issue of The Risk Telescope focuses on the main G20 outcomes and their implications. Section I focuses on the eurozone situation in the G20 context. Section II focuses on the IMF reforms that were supposed to be the centerpiece of this week’s meetings and instead have been sidelined. Section III focuses on financial and regulatory policies addressed in the communique. Section IV assesses the growing institutional footprint of the G20 and the FSB. Section V concludes with the somber assessment that the centrifugal forces identified earlier this year are accelerating, decreasing the incentives for sovereigns to cooperate.
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The Risk Telescope — Band-Aids and Beliefs
What a relief. Sufficient political will exists to continue using the euro and working together in Europe. Sufficient political will exists to permit major European banks to continue functioning. Sufficient political will now exists to transfer yet more authority to the European Commission and create more Brussels-based administrative infrastructure to support yet another EU-level President. European policymakers once again reward optimists with fine statements and perennially incremental progress towards a more unified Europe.
We have seen this show before. Relief that the world is not ending today in Europe gives way to more sober assessments that the world as we know it is indeed ending and giving way to a new equilibrium. The agreements articulated over night in Brussels can be characterized under two headings: Band-Aids and beliefs. This issue of The Risk Telescope assesses last night’s agreement and its implications for financial regulation policy, central bank collateral policy, monetary policy, derivatives markets, and sovereign bond markets.
The bottom line is that European policymakers have successfully yet again stalled for time. The question is whether that strategy can continue to gain traction over the next 12-18 months during which implementation of its convoluted agreements will need to occur amid a climate of anemic economic growth.
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The Risk Telescope — G20 outcomes analyzed
Rome is burning (but not as badly as London did in August), 951 cities in 82 countries see large protests against capitalism and finance, and the eurozone faces a growing crisis. The Financial Stability Board (FSB) released a report a few days ago stating clearly that OTC derivatives reforms are at best delayed and at risk of not being implemented as anticipated.
Yet G20 finance ministers and central bank governors never once used the word “concern” (or any related derivative) in today’s statement. Their two-page statement lists an impressively broad range of technocratic agreements and commitments, with only a passing reference to “heightened tensions and significant downside risks for the global economy.”
To be fair, resolution of the deteriorating eurozone situation was never on the agenda for this meeting. September’s ministerial and highly public brow-beatings were replaced with more determined, serious, low-key pressure on Europe to act. The U.S. veto power at the IMF was subtlety on display. The mood music may have improved since September, but the song remained the same: the world first begged and now demands that Europe deliver a concrete and credible end-game. The back-beat, however, is far more important: emerging markets and original IMF members are now openly jockeying for position in how to craft cross-border solutions. The framework that emerges this year as the event horizon approaches will define the form, content, and structure of sovereign risk analysis for the next decade.
Mixed messages were also the order of the day regarding financial regulation. Understanding the laundry list of initiatives requires having read the preceding year’s worth of status reports and recommendations from a range of entities that would be just as comfortable in an alphabet soup as in a G20 statement. A comprehensive picture was displayed, but transparency and a sense of priority/sequencing was sorely missing. Failure to agree on coordinated and convergent implementation of the original OTC derivatives regulation initiatives should raise serious questions about the G20’s ability to deliver on the more ambitious new workstreams related to macroprudential policy and shadow banking.
Section I of this The Risk Telescope focuses on macroeconomic policy and IMF issues raised in the G20 communiqué, which contemplates new instruments to address the eurozone situation despite U.S.-led rhetoric to the contrary. Section II untangles the various regulatory policy initiatives in the communiqué, highlighting which seem to be in trouble (most of them), which are getting traction (a precious few) and which are promised but not yet available for analysis. Section III concludes.
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The Risk Telescope — Playing for Time
This morning’s news from Brussels might lead readers initially to believe that yet another issue of The Risk Telescope would be devoted to the deteriorating economic situation in Europe. Instead, the telescope turns its lens to another important meeting that occurred yesterday in Europe and whose decisions have been lost amid the noise of the news cycle. Welcome to the technocratic world of the FSB, where regulatory policy, economic policy, and central banking policy are made.
Yesterday’s FSB statement presents a grab-bag of initiatives familiar to regulatory policy advocates. It promises that six different reports representing the details of their agreement will be issued in the unspecified future, presumably before the early November G20 summit. It recycles decisions already articulated by the FSB and the Basel Committee this year, signals a drop in momentum regarding a few issues, adds a few issues to the regulatory priority agenda, and quietly drops a few other issues. The loss in momentum reflects growing cross-border tensions among sovereigns grappling with increasingly negative and challenging economic policy environments. Those sovereigns are also finding it seductive to consider the possibilities for their own regulatory arbitrage strategies under the polite label of “competitiveness” considerations. Section I of this issue of The Risk Telescope assesses yesterday’s outcomes through this analytical lens.
Section II of this publication addresses a related, potentially more important implication from yesterday’s meeting in Zurich and related work products from the international official sector. Even if cross-border (not global) political cohesion existed within the G20 regarding regulatory policy, the slow down on shadow banking issues would be occurring. The slow down does not necessarily reflect only political discord regarding the role that trading markets should play in funding banks. It also reflects a much deeper debate underway among policymakers regarding the role of central banks and the contours of monetary policy first identified in the 10 December 2010 issue of The Risk Telescope and the January editions analyzing the Basel Committee’s macroprudential buffer.
Today’s edition assesses how delay in the FSB’s shadow banking agenda suits the needs of economic policy makers. Those who manage collateral policies and design modeling frameworks to price interest rate and exchange rate risk must pay close attention to this technical, serious debate now. The debate within the global economic policy community suggests that financial stability considerations and the functions of the shadow banking sector may become serious contributors to the design of monetary policy in the near future.
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The Risk Telescope — Apollo 13
In April of 1970, the secondary oxygen tank on Apollo 13 exploded as it orbited Earth with three astronauts on board. The explosion damaged the primary oxygen tank as well as the life support systems for the ship. Astronauts evacuated to the attached lunar landing module and awaited a solution from Mission Control on the ground, while life support systems slowly depleted. Those who have seen the movie chronicling these events will remember the scene on the ground. Engineers had four days to devise a solution that would bring the astronauts back down to Earth alive. They were given a bag of spare parts, which were exact duplicates of all available components that could be stripped from the orbiting vehicle to craft a solution.
Europe’s banking system and sovereign debt markets are having an Apollo 13 moment. They are similarly stranded, as finance ministers and central bank governors depart Washington DC. Eurozone policymakers have a short amount of time to craft a solution from spare parts in order to avoid a catastrophic crash. While they negotiate with each other, liquidity (the life support system for the financial system) is depleting, creating major systemic risks and imposing serious burdens on central banks.
We know the Apollo 13 story has a happy ending. Ingenious engineers devised a solution to bring the astronauts back to Earth alive, but they were not able to complete their mission of landing on the moon. The Apollo program subsequently flew four more missions without loss of life. But manned travel to the moon ended in 1972 and the U.S. space program turned towards more modest earth-orbit based projects. We do not know yet whether or how this chapter of the eurozone story will conclude.
The IMF, the Group of Twenty (G20) and the Financial Stability Board (FSB) all met in Washington over the last few days. Four groups of policymakers (BRICS; G24; G20; IMF Development Committee; IMF’s International Monetary and Financial Committee (IMFC) each issued communiqués addressing a broader range of issues than the situation in Europe. These initiatives will be analyzed in the coming weeks. Today’s focus turns to the eurozone, since failure to find a solution now will eclipse in importance all other policy initiatives.
Therefore, this issue of The Risk Telescope in Section I analyzes the key components available to European policymakers. It provides some scenarios for consideration. Section II provides a different analysis. It analyzes the possible consequences of what some Europeans and many finance ministers globally consider to be a “positive” solution: a commitment to fiscal union and/or a second bailout program for Greece.
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