22/8/2013: Sovereign Default Risk & Banks in the Euro Area Setting: Harald Uhlig

Harald Uhlig's latest paper "Sovereign Default Risk and Banks in a Monetary Union" (CEPR DP9606, August 2013, http://www.cepr.org/pubs/dps/DP9606) "seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union".

The rationale for the paper is that the "European Monetary Union is in distress. Mechanisms that were meant to safe-guard key institutions and to assure stability have become sources of balance sheet risk for these very institutions. Liquidity provision within
the European Monetary Union rests upon repurchase agreements, by which banks guarantee the repurchase of assets deposited with the ECB. If either the bank fails or the asset fails, but not both, this mechanism safe-guards the repayment to the ECB, since it can either rely on the repurchase by the bank or sell the asset. However, when both fail as well as the bank home country fails, the ECB incurs a loss."

Abstracting away from the (important) debate about the implications of such a 'loss', the theoretical framework described by Uhlig is insightful and interesting. The author assumes "that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses, should the banks not be able to repurchase the bonds."

Furthermore, "In the model, banks pursue their investment strategy voluntarily: it is up to regulators to potentially constrain them. Other explanations are conceivable, of course". This is different from the currently dominant views, as per Reinhart (2012a) as well as Claessens and Kose (2013). Specifically, it is distinct from Reinhart (2012b) argument as to why banks hold bonds of their home country. Reinhart argues that in a “financial repression” setting the regulators "make
[the banks] hold the sovereign bonds, perhaps with strong-arm tactics, perhaps in exchange for “looking the other way” concerning weak portfolios of commercial loans and mortgages, or simply as a “favor” in a long, ongoing relationship. Since the banks could potentially refuse, though at considerable cost, it still must ultimately be preferable to them to hold own-country bonds rather than invest elsewhere or to close: so, in some ways, this paper may also be understood as a model of financial repression." Another view for the system by which the banks end up holding rising exposures to domestic sovereign bonds is a political economy argument: "if sovereign bonds are held by home banks, it makes it politically harder to default on these bonds, as this will hurt domestic banks and savers. If so, then such a portfolio arrangement might serve as a commitment device for the government in trouble."

Uhlig's (2013) paper is not covering the underlying reasons for the holding of the bonds.

Overall, "the issue of sovereign default risk, bank portfolios and the role of the central bank has received considerable attention in the recent literature. Acharya and Steffen (2013) is a careful empirical analysis of the “carry trade” by banks, which fund themselves in the wholesale market and invest in risky sovereign bonds. They document, that “over time, there is an increase in ’home bias’ – greater exposure of domestic banks to its sovereigns bonds – which is partly explained by the ECB funding of these positions"… Relatedly, Corradin and Rodriguez-Moreno (2013) show that USD-denominated sovereign bonds of Euro zone countries became substantially cheaper (i.e., delivering a higher yield) than Euro-denominated bonds during the Euro zone crisis, and ascribe it to the usefulness to banks of Euro-denominated bonds as collateral vis-a-vis the ECB, while USD-denominated bonds do not offer this advantage." In addition, "Drechsler et. al. (2013) document “a strong divergence among banks’ take-up of” Lender-of-Last-Resort assistance “during the financial crisis in the euro area, as banks which borrowed heavily also used increasingly risky collateral”. They test several hypothesis and argue that their “results strongly support the riskshifting explanation”…"

The above supports the Uhlig (2013) model that concludes that:
-- "…Regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, while regulators in other “safe” countries will impose tighter regulation."
-- "…Governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank."
-- "As a result, the monetary union has become a system engineered to deliver underpriced loans from country banks to their sovereigns, and to implicitly shift sovereign default risk onto the balance sheet of the ECB and the rest of the Eurosystem."

The last sentence is the key to it all: the euro system is now "engineered to deliver underpriced" credit "from country banks to their sovereigns", while shifting "sovereign default risk onto… the ECB and the rest of the Eurosystem".

Economics 18/01/2010: Systemic Risk Regulation EU-style

Before we dive into the issue of Systemic Risk Regulation, a quick note on travel industry troubles (those who would like to do so can skip down to the second topic)

Some of the readers of this blog and of my articles in press disagree with my assertion that high charges at the Dublin Airport and the travel tax imposed on passengers matter to our travel figures. I have wrote before about:

• an independent Government group report calling for abolition of the tax, and 
• on an independent economic assessment from international transport economics consultancy linking travel tax to jobs losses and revenue collapse in the sector; and
• evidence on routes closures and aircraft cut backs that were explicitly linked by the airlines (Ryanair, EasyJet and Aer Lingus amongst them) to the charges and taxes collected in Dublin. 
• Withdrawal of BMI earlier this year from Dublin, with a loss of 30 jobs and some 300,000 passengers was also not enough.
  

This was not enough to convince some. Sadly, many continue to insist that protectionist barriers to travel (trade) are an effective means for ensuring viability of Irish tourism and domestic sectors (see last Sunday Times letters page).

Now, Irish media reports that the DAA will be offering substantial discounts to airlines that launch new short and long haul services, amounting to 25-100% cuts in charges for the first five years of a route opening.

Of course, DAA had seen a 17% year-on-year drop in traffic in December 2009, while Cork saw a decline of 15.5% and Shannon – 29.9%.

Offering deep discounts is a funny thing to do, if the charges and taxes were not the problem with traffic in the first place. Unless, that is, people like myself have been all along correct in stating that high costs of services provided by the DAA (inclusive of travel tax – which DAA had nothing to do with) act as an impediment to sustaining tourism and business travel to Ireland.

It is a basic feature of international trade theory and practice – tariff protection does not work. Not in the short run, nor in the long run. Visitors to Ireland are price-elastic, while many of us, living here with families and connections (personal and business ones) overseas are less so.

Hike tax and foreign tourists will have a greater ability to avoid coming here, while domestic travellers will have to adjust their expenditure (abroad and at home) to cover the additional cost.

What the former means is that a Spanish person deciding on where to take a city break will be less inclined to chose Dublin or Ireland in general because of a higher tax/cost.

The latter means that an Irish person going to, say, Paris, will have an added incentive to shop there more (to generate greater savings over the comparable purchases in Ireland and thus compensate herself for extra costs incurred in travelling) or equivalently – to shop less in Ireland (to avoid incurring added cost). Both effects act in the direction of reducing total revenue to businesses based here.

Ann Siebert has weighed in on the issue of systemic risk regulation in Europe in today’s voxeu column (here):

"Any committee dealing with assessment of systemic risks “should be small and diverse. …ideally it should be composed of five people: a macroeconomist, a microeconomist, a financial engineer, a research accountant, and a practitioner. …As the size of a group increases so does the pool of human resources, but motivational losses, coordination problems, and the potential for embarrassment become more important. The optimal size for a group that must solve problems or make judgements is an empirical issue, but it may not be much greater than five. The reason for diversity is that spotting systemic risk requires different types of expertise. A board composed of entirely of macroeconomists might, for example, see the potential for risk pooling in securitisation, whereas a microeconomist would see the reduced incentive to monitor loans.”

Needless to say, these are not the principles taken on board by Nama and the Irish banks. Nor is it an approach even being discussed for the Irish Financial Regulator or the Government. Why? Why not?

“The committee should be composed of researchers outside of government bodies and international organisations; career concerns may stifle the incentive of a bureaucrat to express certain original ideas. It is of particular importance that the board not include supervisors and regulators. [Again, look at Nama – virtually the entire top management of this organization is composed of  people unqualified to deal with the task of spotting structural risks]. This is for two reasons. First, it is often suggested that supervisors and regulators can be captured by the industry that they are supposed to mind, and this may make them less than objective and prone to the same errors. Second, a prominent cause of the recent crisis was supervisory and regulatory failures, and these are more apt to be spotted and reported by independent observers than the perpetrators.” [No illusions here - Nama is captured by the industry, and to boot - by the worst parts of the industry, not the best.]

"Finally, it is important that the board be made sufficiently visible and prominent that a member’s career depends on his performance. Given the importance of the task, pay should be high to attract the best qualified, and the members should not have outside employment to distract them.” [Good luck to anyone who thinks that Nama board or any of its risk structures will come close to these parameters, except one - they will be handsomely remunerated for their work].

Alas, this dreamy transparent and professionally sound proposal is too late, even in the EU case, for: “The Eurozone has already swung into action, creating the European Systemic Risk Board (ESRB), set to begin this year. Unfortunately, this board, responsible for macro-prudential oversight of the EU financial system and for issuing risk warnings and recommendations, is far from the ideal. It is to be composed of the 27 EU national central bank governors, the ECB President and Vice-President, a Commission member and the three chairs of the new European Supervisory Authorities. In addition, a representative from the national supervisory authority of each EU country and the President of the Economic and Financial Committee may attend meetings of the ESRB, but may not vote. This lumbering army of 61 central bankers and related bureaucrats is a body clearly designed for maximum inefficiency; it is too big, it is too homogeneous, it lacks independence, and its members are already sufficiently employed.”

Pretty much on the ball, I would say.

Economics 08/05/2009: ECB - a bark, but no bite..., Obama's Frying Pen for Ireland

ECB's latest rate cut has a bark, but little real bit...

As we all know by now - the ECB has cut the rate by 25bps to a 'historic' low of 1%. The word 'historic' is suppose to impress us, yet it does not - the US rates are at zero, UK at 0.5%, Japan at 0.1%, Canada at 0.25% and these countries have seen significant devaluations vis-a-vis the Euro and quantitative easing...

Some say - this is the seventh reduction in seven months. "Geez Louise!", as Woody Allen would say. It would have been better if they were to cut the rate once - seven months ago - to 1.25% and not pretend to be 'conservative'. More medicine quickly is what gets the sick back on their feet. Drip-feeding vitamins to a dying patient is not going to do much good. And hence, I am not impressed by today's cut.

More significant was the statement that the ECB delivered alongside the decision. This is worth to be discussed on several fronts:

1) It suggests (and Trichet hinted at the same) that the forthcoming growth data for Q1 2009 is going to be poor. Does ECB know something we don't? My forecast (see April 24 post) was for 1.1% decline - monthly. So quarterly decline of ca 3.3% or more than double on Q4 2008 (-1.6%). Can it be worse? Yes, it can - Germany is forecast to fall 5.6% in 2009, with most of the falling to be done in Q1-Q2 2009. My gut feeling is that no matter what the fall off in Q1 can be (and we will know today), we are now in a 3.5-4% decline territory for Q2 as well. Hold on to your seats, because if this is the case, ECB's posturing that we are at the end of the cuts cycle is a fantasy. Expect a cut to 0.75% in June-July. Why? Because if H1 contraction were to be in a 4-5% territory, we are going to post a similarly deep contraction for the whole year. And that would warrant serious intervention.

So on the net, I must revise my forecast - yet to be quantitatively confirmed (which I will do tomorrow once the Q1 figures are in) - downward, and my feeling is that the full year 2009 figure is now shaping to look like a 4-4.5% fall in the eurozone.

2)Trichet had to mention the 'tentative signs of stabilization' in the economy. Presuming he was not talking about the US, the phrase reflects lack of agreement within the council as to what is taking place in the real economy. This is good news for us, analysts, since we now are no longer alone in not knowing what is going on, but it is bad for the markets. Uncertainty is something that usually spurs the Fed to act, and ECB to stall. Hence, I suspect we will see a month-long pause before another 25bps cut is enacted. Remember, the patient - the euro area economy - is still in ICU...

3)Whether you call it quantitative easing or not, but the plan to purchase €60bn in covered bonds (CBs) is a joke. Brian Cowen alone would burn through that amount in a year (with NAMA - in a blink of an eye). And there are Austria, Italy, Greece, Portugal, Spain still waiting in line for a handout. CBs are debts backed by cash flows from underlying loans (e.g mortgages). It is the sort-of securitization product, with all the stuff - however toxic, as long as it is paying some sort of interest - bunched in. It does appear that Ireland and Spain are the two leading contenders for the first slot at the new 'ECB pawn brokers' window, as our banks have been shifting all sorts of pesky stuff across their books into the ECB already.

The only question to ask here - what will be the associated terms and conditions? We will know these only about a month from now when ECB actually sketches these. But I suspect Brian Lenihan will be phoning Trichet's people to find out the details starting from tomorrow. After all, survival of the Irish financials and the Exchequer is now hanging by the thread, and Mr Trichet has a pair of sharp scissors at his disposal. Significantly, of course, the ECB's newest plan is to come ahead of NAMA legislation, so here is a question: Is this new CBs-purchasing plan a tailor-made device for Ireland to be tested as a guinea pig in European financial rescue experimentation?

On a bit more positive note, the ECB stretched liquidity provision terms to 12 months. It also added the European Investment Bank to the eligible counterparties list, in effect creating an additional supply of credit - ca €40bn. Now, combined the ECB €60bn, plus the EIB's €40bn are just about covering the borrowing requirements for Biffonomics and Lenihanama.

Obamanomics might, just might, spell a real disaster for Ireland Inc...
It was 100-days in the Hot Seat for Barak Obama last week and, true to his promises to change America, the President has gone for his big pledge: to crack down on the use of offshore tax havens. This time around Ireland will have to do better than sending Mary Coughlan to Washington in order to keep the US taxman at bay.

A key initiative, announced Monday, would partially close a provision that allowed US companies to defer paying taxes on the profits they make on their overseas investments. Another proposed change is to close completely the loophole that allowed companies to treat foreign subsidiaries as non-resident in the US for tax purposes.

A report by the Congressional General Accounting Office found that 83 out of the US top 100 companies have set up subsidiaries in tax havens. Some $20bn in allegedly ‘lost’ annual revenue for Uncle Sam is at stake, as in 2004 – the latest year for which data is available – US MNCs paid just $16bn in Federal tax on foreign earnings of $700bn. That’s an effective rate of tax of ca 2.3%.

Now, an interesting twist in the proposals is to allow deferring tax payments only on R&D investments, so expect Ireland suddenly jump to the top of the league of nations in per capita R&D spending, should the White House plan go through Congress.

It is worth remembering that our much-loved Bill Clinton prepared an even more ambitious plan for shutting down tax havens that would have seen US investment here dry-out like a salty pond in the middle of Sahara. Much-disliked George Bush shelved it, saving our US MNCs-led economy. Now, another Democrat - ah they are such 'friends of Ireland' those Democrats - is going to fry us up crispy...

How're those 4% growth forecasts from DofF looking now?

Trichet's latest interview - much hype, little substance

Here is an exclusive interview, Jean-Claude Trichet (ECB) gave to Foundation Robert Schuman. And here is my quick and dirty walk through its main points:

"Since the introduction of the euro on 1 January 1999, European citizens have enjoyed a level of price stability which had been achieved in only a few countries. This price stability directly benefits all European citizens, as it protects income and savings and helps to reduce borrowing costs, thereby promoting investment, job creation and lasting prosperity. The euro has been a factor in the dynamism of the European economy. It has enhanced price transparency, it has increased trade, and it has promoted economic and financial integration, not only within the euro area, but also globally."

Not really. Price stability in the eurozone has been pretty average - not as good as in Germany and several other countries over the years before the euro, similar to that in the UK, US and pretty much the rest of the developed world in the 2000-2008 period. A picture is worth a thousand words: since the adoption of the euro through mid 2008 (before deflation), inflation in the euroarea exceeded that in the non-euro EU states...
But it is in growth, dynamism and employment where the 10 years of the euro have recorded a very poor performance. I have already posted on this topic (here, here, and here). EU's growth rates since the early 1990s on have been sluggish (lagging behind the US and UK and only notching above a recessionary Japan). Euro area's unemployment remained well above the US, UK and almost all of the rest of the OECD. Eurozone's employment growth has been better than Japan's, but worse than any other OECD economy. So while the euro did enhance price transparency marginally, it did have very little real benefit in improving the quality of life for an average European. Not surprisingly, the euro is not enjoying a strong ride in terms of its democratic legitimacy (here).

"In recent months we have seen another benefit of the euro: the financial crisis has already demonstrated that... Would Europe have been able to act as swiftly, decisively and coherently if we had not had the single currency uniting us? Would we have been able to protect many separate national currencies from the fallout of the financial crisis? European authorities, parliaments, governments and central banks have shown that Europe is capable of taking decisions, even in the most difficult circumstances."

Again, largely untrue - as of today, there is no coherent eurozone-wide response to the crisis. The EU joint response to date is to issue a €5bn in stimulus, and this is yet to be disbursed. While the euro did protect some countries from a run on their currencies, it also boxed majority of eurozone's exporters into a corner of over-valued medium of exchange. Perhaps most importantly, lack of agreement between the European governments - exemplified in a series of failed summits since Autumn 2008 through today - shows unequivocally that "European authorities, parliaments, governments and central banks" are not "capable of taking decisions, even in the most difficult circumstances". The EU itself. this week, put the total size of its recession busting plans at between 3.3 and 4% of GDP, including welfare spending and yet to be specified and agreed measures. This is still short of the US plan to devote 5.5% of GDP to recovery efforts (source: here).

I agree with Mr Trichet that much-talked-about price increases in the wake of euro adoption have been small across the eurozone, but he is plain wrong in claiming that:

"With the benefit of hindsight, it has become clear that the Governing Council of the ECB ...took the correct decisions in order to guarantee price stability in the euro area in line with our mandate and as required by the Treaty establishing the European Community."

This statement is bordering on being offensive and arrogant. Mr Trichet is fully aware that his action of raising interest rates at the very end of the bubble has done too little too late to cool the markets. Similarly, his reckless increases in the interest rates in July-October 2008, as well as keeping the rates high in the first half of 2008 have spelled a disaster for the eurozone economies and also led to an overvaluation of the euro. His failure to act in July-August 2007 to lower rates was an act of mad denial of the unfolding credit crisis. Between July 2007 and September 2008, Mr Trichet stubbornly insisted that the credit crisis was not a problem for the eurozone.

"According to the ECB staff macroeconomic projections published on 5 March 2009, annual real GDP growth in the euro area is projected to be between -3.2% and -2.2% in 2009, and between -0.7% and +0.7% in 2010."

This is a much more gloomy (and much more realistic) outlook than the EU Commission -1.9% forecast for GDP growth in 2009. But note 2010 figures -0.7 to +0.7 or a central point of 0%. An optimist at heart.

"Since the outbreak of the financial turbulence in August 2007, the Governing Council of the ECB has taken unprecedented action in a timely and decisive manner."

Chart below illustrates...
So nothing short of a failure above.

But what about rescuing troubled countries (APIIGS)? "...My response to questions of the type "What would happen if...?" is that I never comment on absurd hypotheses. I have confidence that the Member States will face up to their responsibilities, including with regard to fiscal policy." In other words, is the answer yes or is it no? Is this answer consistent with what Mr Lenihan told reporters about ECB's readiness to rescue Irish banking system (here)?

Overall, a pretty vacuous interview from a man who obviously has no way of re-assuring anyone that he can handle the current economic crisis in the eurozone. A bit more competent than our Brian^2+Mary partial-indifferential-equation, but a lot less competent than, say, the US Fed&Treasury gang.