Tuesday, September 27, 2011

A New Way of Bank Stress Testing


In January 2009, during the depths of the financial crisis, the Basel Committee on Banking Supervision published its view that the bank stress-testing which had so-far taken place across Europe and the US was insufficient for a number of reasons.

While the financial market had grown considerably more complex and less transparent since the previous round of financial crises at the end of the 20th century, stress-testing had not kept up with the times. Forward-looking information was not-being taken into account. 

Rather, stress-test so far has been undertaken in the so-called frequentist way, meaning that purely quantitative and statistical approaches have been used. By definition, this way of doing things only examines historical data. Subjective data, which, in expert hands could be used to detect when it is that the current circumstances are likely to change -perhaps even in a heretofore unseen way- is overlooked. Also overlooked is forward-looking information of any kind. Nassim Taleb's famous book The Black Swan swan points to precisely this sort of thinking as being a major weakness in daily wisdom of financial economists prior to the start of the crisis. The idea that the situation might change was not appreciated. Nor was the idea that we may need to update our information to take into account current happenings.

In 2009 and 2010 Committee of European Banking Supervisors (CEBS) implemented the first and second EU-wide stress tests which were conducted along frequentist lines, examining at first only the largest 22 banks in Europe and later all of the systemically most important bank at the national level in Europe. Not surprisingly, the first two European stress-tests were widely considered failures. In 2011, the newly commissioned European Banking Authority (EBA) has thus taken to the task. Because the European stress tests tried to answer the question of what would happen in the event of both current loss expectations as well as a worst-case scenario whereby losses far exceeded current loss expectations but overlooked the possibility of multi-stage economic shocks, they represented the frequentist point of view. Essentially, they do not revise losses in a dynamic way. Thus, they have left something to be desired, irrespective of the number of banks or percentage of GDP investigated. 

Many experts now consider that the key missing ingredient from stress testing procedures is a solid way of capturing the co-relationships between the various stress events. With this in mind, the Bayesian net can help us understand the relationship between some of the key events. Consider for example the relationship between events A and C. 

The Bayesian Net

The most important aspect needed in stress testing in order to overcome black swan events is a forward-looking element. Subjective probability is a plausible way in which this can be achieved. A subjective probability is essentially an opinion – hopefully a well-informed one – regarding the probability distribution of an event occurring. While there is no mathematical proof behind the answer, one can expect that in addition to historical probability distribution, a subjective probability might be influenced by expectations, indicators as to what may occur in the future, and indicators as to why this time might be different. The most significant upsides to this approach are the incorporation of a wide range of indicative and qualitative data, as well as the non-reliance on vast and often difficult-to-obtain amounts of data. The latter factor would render this approach particularly valuable during scenarios involving one or more extremely rare (statistical tail) events.

Another important issue which needs to be addressed in stress testing is correlation of shocks. In many stress tests, this has truly come to be a key missing ingredient. The simple fact that a financial institution survives an economic shock may might not be perfectly indicative of bank-survivability when the economic shock in question might also set off (or might otherwise be associated with) a chain reaction of economic shocks.  
About the Authors:
-Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.
-Kevin Hoefman is a lecturer of software programming at Hogeschool West-Vlaanderen and a former software engineer and video game programmer. 

Wednesday, September 14, 2011

German Constitutional Court Accepts Eurozone Bailout - Of Course

German Court Rejects Challenge to Eurozone Bailouts
On September 6, 2011, the German Constitutional Court reached the decision to reject the challenge posed by six prominent German Eurosceptics to Germany bailing out Eurozone countries. The bailouts shall be subject of course to German parliamentary approval. 

As the BBC article states, the German decision has implications for the whole region in light of that fact that it is the largest economy in the entire region. 

Not a Surprising Ruling
To those who have a good understanding of Germany's national interests, this ruling should come as no surprise. In fact, what has just been decided, is that the German Parliament shall essentially decide the future fate of the Eurozone, in absence of (or possibly in advance of) strong and well-organized EU-wide Eurozone stability measures. This means that the German Parliament may come into a position to decide the terms of not only future bailouts, but also of the wider economic infrastructure of the Eurozone. Indeed, as Constitutional Court President Andreas Voßkuhle was quoted as saying "this is not a blank check". This means that German politicians may even come to dictate national-level economic policy guidelines for other Eurozone member nations. 

In other words, this ruling is really a question of German national interest.

Why This Makes Economic Sense
Aside from reasons of control and regional influence, there are concrete economic reasons why Germany would be interested in maintaining the Eurozone, even at the cost of bailouts. In light of the Eurozone, The following facts must be realized. 

1: Germany, is the world's second largest exporter. That is, Germany is an export-dependent economy. This is particularly the case for the industrial and manufacturing sectors in Germany.

2: The presence of the Mediterranean-area member-states brings down confidence in the euro as well as in the stability of the Eurozone. This causes prices for the Euro to be lower than what they otherwise would be. Moreover, this is achieved without interference in the currency markets of any kind. 

3: Having an undervalued currency means having under-priced exports. This is good for German exporters. Its quite straightforward really. Nevertheless, the traditional method of achieving this - devaluing the currency on international markets - is now considered to be a beggar-thy-neighbor policy. This means that while such a policy has worked for Japan in the past and works for China today, it might bring Germany afoul of international trade (WTO) law. Therefore, another mechanism is needed. Preferably one not elaborated in the law, and which would be beyond the reach of Germany's major trade competitors for emulation purposes as well. The common currency is perfect for that. 

German Export-Led Growth Needs the Euro
In light of the troubles in the Eurozone, and the decline of international confidence in the Euro, German GDP growth has recovered in 2009-2010, lead by strong export figures, which have also influenced the growth of the German DAX since 2009. 

German exports are the main source of German GDP growth. Both of these figures have been on the rise since 2009, while the Greek sovereign debt crisis marched onward and confidence in the Euro as well as in the stability of the Eurozone languished.

In 2009 and 2010, this relationship was also reflected in the performance of the DAX. While the Eurozone was suffering a crisis of confidence the DAX saw a strong post-crisis recovery. 

While it is indeed true that the DAX has seemed rather unstable in the last month, this is only because the markets have begun to signal that the bailout is simply taking too long and it does not have the support of the people on the street in Mediterranean Eurozone countries because of the austerity. Furthermore, on September 14,  researchers at the  Institute for Economic Research Halle (IWH) identified lack of political as the key economic threat. "Due to lack of political support from the Member States there no longer seems impossible that the institutions that currently guarantee the stability of financial markets in the euro area no longer can fulfill their role so that the European financial system falters again.

About the Author:
Max Berre is an economist who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands

Tuesday, September 6, 2011

Central Banks as Agents of Development

The Overlooked Role of Credit Policy
UN University Study

What is the precise role of a central bank? What are its tools? While the common-consensus has focused on the central bank's role concerning price-stability and economic growth by means of manipulating key interest rates and money supply. During times of crisis, (as we have seen), this has been expanded to managing the supply of other financial instruments as well. e.g. MBS, bonds.

What we have not considered lately are questions about not simply how much credit and money supply there is in the economy, but also where and under which conditions this money and credit is allocated in the economy. Nevertheless, these questions are highly relevant to both crisis response and to economic development. In other words, the current paradigm in monetary policy only considers half the story. 

Front-page news or not, Many of the world's principal central banks actually have thought about this question  since the 2008 collapse of Lehman Bros. Since then, the Liability side of central bank balance sheets in the US, EU, and UK (representing funds flowing from the banks into the economy at large) have undergone broad diversification.

The UN University Study
In this UN University study focusing the role of credit policy in development economics, the history of central bank involvement in sectoral development policy, industrial policy, export-promotion. The tools of these policies were primarily credit allocation, subsidized loans, and capital controls. They were used to:

1.       To finance government debt at lower interest rates
2.        to reduce the flow of credit to  the private sector without raising domestic interest rates
3.       to influence the allocation of real resources to priority uses and
4.       to block channels of financial intermediation and thus to assist restrictive general monetary policy

This study outlines the historical role that credit policy in the industrialization of continental Europe, as well as the development the of  UK's financial sector. Japan's industrialization was also underwritten by strategically-placed funds and subsidized loans.

What does this mean for developing countries ?
The New York Federal Reserve’s historian, Arthur I. Bloomfield reported in 1957 “the central bank can seek to influence the flow of bank credit and indeed of savings in directions more in keeping with development ends.” The fact is that virtually throughout their history, central banks have financed governments, used allocation methods and subsidies to engage in ‘sectoral policy’ and have attempted to manage the foreign exchanges, often with capital and exchange controls of various kinds.

This is was what developed countries needed then, and it is what developing countries need today.

About the Author:
Gerald Epstein is the chair of the department of economics at University of Massachusetts Amherst since 1997 and a former UN University researcher. He holds a PhD in Economics from Princeton University. 

Friday, September 2, 2011

An open letter to Dr. Paul De Grauwe

Een open brief aan Dr. Paul De Grauwe over de Europese overheidsschuld crisis
(August 3, 2011 9:42 pm)
We moeten niet overreageren ten opzichte van de Europese schuldencrisis. Hoe kan het zijn dat een schuldencrisis in Griekenland wordt een existentiële crisis voor de Eurozone, terwijl een schuldencrisis in Californië geen internationale nieuws is? Het verschil heeft te doen met vertrouwen in de sterkte van het het financiële systeem.

Prof. De Grauwe is helemaal correct te zeggen dat de ECB alsook Europa moet een grotere rol spelen om credibiliteit in de economie van de Eurozone op te bouwen. Hij is ook correct te zeggen dat de ECB moet  meer meer serieus zijn met betrekking tot zijn rol als Lender of Last Resort. Het is ook jammer dat inflatiebeheer en prijsstabiliteit is de enige taak van de ECB.

Maar, de situatie is minder sterke dan wat legt hij uit. De EFSF kan in het toekomst een credible verzekering zijn. Vooraal als het gaat door the EFSM versterkt worden.

Een essentieel punt dat tot nu vergeten is in dit debat is manier dat nieuw geld in de economie geplaatst is. Tijdens the Britse Eerste Wereldoorlog financiële crisis geanalyseerd door Skidelsky, het belangrijk punt was dat nieuwe geld werd direct bij de import-export banken geplaatst om het effect van de Duitse embargo te annuleren. Het nieuwe geld werd gestuurd naar de bron van het probleem.

Daarom moeten we ook vandag proberen om nieuwe geld te plaatsen  naar de bron van het probleem. Dus niet alleen een kwestie van hoe veel, maar waar.

An open letter to Dr. Paul De Grauwe regarding the European sovereign debt crisis
(August 3, 2011 9:42 pm)
We should not over-react vis-à-vis the European debt crisis. How can it be that a debt crisis in Greece is an existential crisis for the euro zone, while a debt crisis in California is no international news? The difference has to do with confidence in the strength of the financial system.

Dr. De Grauwe is also completely correct to say that the ECB and Europe must play a greater role in building the credibility in the Eurozone economy and that the ECB should take seriously its role as lender of last resort. I also agree that it's really a shame that the inflation and price-stability is the only goal of the ECB.

However, the situation is less alarming than what is outlined by Dr. De Grauwe. EFSF should evolve into a credible insurance scheme in future. Especially when it goes through the EFSM strengthened.

A crucial point which has until now been overlooked in this debate is manner whereby new money is placed in the economy. During the First World War British financial crisis analyzed by Skidelsky, the important point was that new money was directly placed in the import-export banks in order to counteract the effects of the German embargo. New money was sent to the source of the problem.

We should therefore adopt a similar approach today, sending new funds directly to the source of the problem. Thus its not only a question of how much but also of where.
About the Author:
Max Berre is an economist who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.
Paul De Grauwe is  is Professor of international economics at the KU Leuven and former Belgian senator for the Flemish VLD Party.