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The Risk Telescope — IMF Firewalls and Political Math
Today’s issue of The Risk Telescope focuses on the political math supporting the IMF’s expanded firewall facilities, relying heavily on pie charts and tables. The conclusion is that the firewall is neither as large nor as solid as initial media and official statements suggest. Moreover, by potentially over-reaching on the rhetoric in order to generate good headlines, the process may be raising expectations about the capacity of the IMF or the euro area to meet near-term needs without more drama.
Section II assesses the FSB’s latest progress report to the G20 and the prospects for global convergence regarding financial regulation in the near term. The conclusion is that the FSB’s excessively optimistic and superficial assessments of success combined with expansion into new areas lay the groundwork for significant disconnects as the year progresses and implementation delays continue to materialize.
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Six months ago, clients and subscribers to The Risk Telescope were alerted to building centrifugal forces placing pressure on global and euro area economic integration that took generations to build. Six months ago as well, clients and subscribers to The Risk Telescope were alerted to looming supply and demand pressures in the high-rated sovereign bond sector. At the end of the year, The Risk Telescope dubbed 2012 as the “year of living dangerously” and explained why. Yesterday, the IMF’s Global Financial Stability Review validated this analysis in chapters 1, 2, and 3.
Curious about what lies around the corner this weekend and for the rest of the year and the implications of building trends for risk management, strategic asset allocation, and global rebalancing? Become a client and find out.
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On opposite sides of the world in the last 24 hours global leaders laid out their respective visions for the trajectory of global economic policy. Leaders from Brazil, Russia, India, China and South Africa met in New Delhi yesterday and issued the “Delhi Declaration.” EU and eurozone leaders (and their finance ministers) met in Copenhagen, and Eurozone leaders issued a statement today. In between, physically and philosophically, sit the International Monetary Fund (IMF) and the United States. Last week, the two key U.S. policymakers responsible for IMF and G-20 leadership at the ministerial level (Treasury Secretary Geithner and Federal Reserve Chairman Bernanke) provided testimony to the U.S. House of Representatives last week. Their respective views establish the foundation for next month’s meetings of the IMF Board and G20 ministers.
Today’s issue of The Risk Telescope analyzes the Delhi and Copenhagen outcomes. It highlights the subtle but important differences of approach and vision between the BRICS and the European Union that go far beyond the cosmetic issue of which country gets to nominate an individual to lead the World Bank or the IMF. It also highlights how emerging views inside the IMF seem to be supporting one view or the other.
Section I summarizes the policy environment within which policymakers met in the respective cities of New Delhi, Copenhagen and Washington DC. Section II focuses on key issues considered by the three major policymaking sessions: macroeconomic policy; eurozone sovereign debt resolution; and IMF governance reform/evolution. Section III concludes. Overall, it is difficult to avoid concluding that centrifugal forces at the global level continue to accelerate. Policymakers in the three large blocks analyzed in today’s publication increasingly seem to be talking past each other rather than crafting a foundation for global compromise.
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The Risk Telescope — The Day After
A collective sigh of relief is nearly audible this weekend. At least one set of contractual obligations (credit default swaps) will be honored on time, in full, and in the manner anticipated when the contracts were written. The months-long anticipation of this event, paired with generous (3-year) bank liquidity support by the European Central Bank and the direction of official sector support for European banks through the second bailout for Greece, means that paying out on these contracts will not be as catastrophic as would have been the case last year.
The largest sovereign default in history was paired with a functioning market mechanism in the OTC derivatives space, supported by a wide range of direct and indirect official sector support. Contemplate this Sunday afternoon the extreme irony and inherent contradictions of the situation. This is not a sustainable or solid foundation.
- Global policy initiatives within the G20 since 2008 have all pointed in the direction of vilifying destabilizing and volatile OTC derivatives markets. Yet those markets served their function on Friday with comparatively less drama than their official sector counterparts.
- Global initiatives within the G20 since 2008 have all pointed in the direction of vilifying policies that enshrine or promote “too big to fail” in the banking system. Yet the ECB’s LTRO and the second Greek bailout suggest that this policy is alive and well in Europe. This suite of crisis management tools seems likely to be endorsed by the global community through IMF participation in the second Greek bailout this coming week.
- Arguably, markets had the space in which to maneuver and declare a “credit event” had occurred regarding Greek CDS instruments because central banks in Europe and the United States are providing unprecedented, unconventional, and open-ended support for financial markets which lengthen maturities and twist traditional mechanisms for formulating and executing monetary policy.
Relief that any market mechanism functioned as intended is rational. But as we turn to face the post-LTRO, post-CDS credit default world, it would be better to focus on the related risk management and strategic issues that remain on the table, unresolved, at the G20, the IMF, and Europe. This issue of The Risk Telescope thus focuses on the risk pricing, collateral management, and risk modeling implications raised by the new status quo in Europe.
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The Risk Telescope — Mexico City Ministerial Outcomes
One day, when the history of the G20 is written, the G20’s first Mexico ministerial will be remembered as the meeting when the emerging markets stood with the United States to ask Europe please to stand behind the eurozone construct with real money, not guarantees or promises or endless talks. But today and tomorrow the headlines will largely focus on practical reality: no real decisions have been taken. Decisions have been delay until mid-March, mid-April (after crucial decisions on Greece’s second bailout must occur) and June. Regular readers of G20 Communiques will recognize artful crafting designed to obscure the lack of consensus regarding coordinated action on a range of issues. Restrain the urge to cynicism.
This issue of The Risk Telescope probes below the surface to show how tectonic shifts are underway in how the global community interacts with each other. It will take years to reach another stable equilibrium to rival the one that dominated the post-World War II era (1945—2008). This publication chronicles the messy transition process.
Section I highlights the economic policy dilemmas and the few real decisions made today in Mexico. Section II is extremely short. It focuses on the regulatory policy agenda that increasingly is held hostage to the geopolitical and geo-economic dramas that have been elevated from the euro-area to the global stage. In both, the trajectories anticipated by this publication recently and over the last 12 months remain on track. Regular readers of this publication will not be surprised about the outcomes, even if they may be concerned about the trajectory.
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The Risk Telescope — G20 Preview
Once upon a time, the G20’s ambitions were expansive. The London, Pittsburgh, Toronto, and Seoul summits were premised on a belief that a second Bretton Woods moment had appeared. Policymakers united in fear found consensus on reform measures relatively easily. How the world has change. 2012 opens with the world’s major economies increasingly on divergent pathways and with starkly different economic growth prospects. Consensus is harder to reach. Implementation momentum is waning.
This weekend in Mexico City, Group of Twenty (G20) finance ministers and central bank governors will convene. They will do so the weekend before the German Bundestag considers the second Greek bailout and a week before European Union (EU) leaders meet in their first, long-awaited summit of the year. In the interim, the Greek Parliament is expected to continue passing legislation to implement austerity measures and reforms required for approval of the second bailout by EU heads of state and government at their summit next week.
The struggle of wills among Athens, Berlin, and Brussels now adds Mexico City to the mix. The global community is pressuring an increasingly isolated Germany to bolster significantly the EU’s regional rescue fund (the not-yet-ratified European Stability Mechanism or ESM). The quid pro quo of course is the size and structure of continued International Monetary Fund (IMF) support for Europe and the global economy.
The regulatory issues that have long served as a major centerpiece of G20 ministerials and summits are set to take a back seat. In part, this is understandable. Continuing stress in European sovereign debt markets diverts political energy and attention. But the eurozone debt crisis obscures a more fundamental simmering set of divisions and concerns within the G20 process. As predicted by this publication early last year, centrifugal forces are accelerating amid economic austerity and diverging economic growth paths. These divergences undermine the informal, consensus-driven process for articulating and implementing cross-border standards in the G20 as well as its regulatory subsidiary, the Financial Stability Board (FSB).
Today’s issue of The Risk Telescope previews the main pressure points within the G20 process as ministers converge physically (if not substantively) on Mexico City and suggests what to watch for as the news cycle and statements are released. Section I focuses on economic policy. Section II focuses on regulatory policy, including the brewing global storm over the Volcker Rule (which technically is not a G20 initiative). A supplementary edition on Sunday, before Asian markets open for trading, will analyze the G20 outcomes.
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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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