12/1/2015: Euro Area vs US Banks and Monetary Policy: The Weakest Link

Cukierman, Alex, "Euro-Area and US Banks Behavior, and ECB-Fed Monetary Policies During the Global Financial Crisis: A Comparison" (December 2014, CEPR Discussion Paper No. DP10289: http://ssrn.com/abstract=2535426) compared "…the behavior of Euro-Area (EA) banks' credit and reserves with those of US banks following respective major crisis triggers (Lehman's collapse in the US and the 2009 [Greek crisis])".

The paper shows that, "although the behavior of banks' credit following those widely observed crisis triggers is similar in the EA and in the US, the behavior of their reserves is quite different":

• "US banks' reserves have been on an uninterrupted upward trend since Lehman's collapse"
• EA banks reserves "fluctuated markedly in both directions". 

Per authors, "the source, this is due to differences in the liquidity injections procedures between the Eurosystem and the Fed. Those different procedures are traced, in turn, to differences in the relative importance of banking credit within the total amount of credit intermediated through banks and bond issues in the EA and the US as well as to the higher institutional aversion of the ECB to inflation relatively to that of the Fed."

Couple of charts to illustrate.

As the charts above illustrate, US banking system much more robustly links deposits and credit issuance than the European system. In plain terms, traditional banking (despite all the securitisation innovations of the past) is much better represented in the US than in Europe.

So much for the European meme of the century:

1. The EA banking system was not a victim of the US-induced crisis, but rather an over-leveraged, less deposits-focused banking structure that operates in the economies much more reliant on bank debt than on other forms of corporate funding; and
2. The solution to the European growth problem is not to channel more debt into the corporate sector, thus only depressing further the reserves to credit ratio line (red line) in the second chart above, but to assist deleveraging of the intermediated debt pile in the short run, increasing bank system reserves to credit ratio in the medium term (by increasing households' capacity to fund deposits) and decreasing overall share of intermediated (banks-issued) debt in the system of corporate funding in the long run.

3/1/2015: Trade Protectionism Since the Global Financial Crisis

A year ago, ECB paper by Georgiadis, Georgios and Gräb, Johannes, titled "Growth, Real Exchange Rates and Trade Protectionism Since the Financial Crisis" (ECB Working Paper No. 1618. http://ssrn.com/abstract=2358483) looked at whether the current evidence does indeed support the thesis that "…the historically well-documented relationship between growth, real exchange rates and trade protectionism has broken down."

Looking at the evidence from 2009, the authors found that "the specter of protectionism has not been banished: Countries continue to pursue more trade-restrictive policies when they experience recessions and/or when their competitiveness deteriorates through an appreciation of the real exchange rate; and this finding holds for a wide array of contemporary trade policies, including “murky” measures. We also find differences in the recourse to trade protectionism across countries: trade policies of G20 advanced economies respond more strongly to changes in domestic growth and real exchange rates than those of G20 emerging market economies. Moreover, G20 economies’ trade policies vis-à-vis other G20 economies are less responsive to changes in real exchange rates than those pursued vis-à-vis non-G20 economies. Our results suggest that — especially in light of the sluggish recovery — the global economy continues to be exposed to the risk of a creeping return of trade protectionism."

One thing to add: the above does not deal with trade-restrictive policies relating directly to financial repression, such as outright regulatory protectionism of incumbent domestic banks and asset managers, or direct and indirect subsidies pumped into the incumbent banking system.

21/2/2014: Fed Transcripts, 2008: Icebergs, Titanic, Violins...

Marketwatch are running a live blog on Fed's release of 2008 transcripts

http://blogs.marketwatch.com/capitolreport/2014/02/21/the-feds-crisis-era-transcripts-of-its-2008-meetings-live-blog/

My comment: Fed transcripts from 2008 show a circus hit by a hurricane drowning in a surge of self-delusion.

Bernanke waffling on, in September 2008, about 'moral hazard' in a virtually academic exercise that is more about him being 'decidedly confused and muddled' shows the extent to which the Fed (and do keep in mind - this is the most competent Central Bank out there) was left completely unprepared for a systemic crisis. Forget the nature of the crisis or specific causes of it. The point is that some 14 months into huge pressure pilling up in the markets, the Fed was utterly unprepared to face a crisis.

Now, observe that having done the deed of acting outside any confidence about the impact of his actions, Bernanke subsequently defends his choices by saying that "I just don't believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem." Which, of course begs the question: does he believe that he should fail these institutions ex post after the crisis is over? And how the hell does he propose we go about that restoration of 'zero moral hazard' state? By sending in the FBI?..

In short, the man is still out of touch with reality. First, with the one he was thrown into in September 2008, second, with the one he constructed in response to September 2008 events.

Poor Ben... he goes on: "“We did not have—as the Europeans have or as we have FDICIA for banks—a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution.”"

Come again? What is that that 'the Europeans' have? "a system ...to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions"? Dear, oh dear... he needed retirement rest and relaxation back in 2008.

Still, the Fed transcripts show how the Central Bank did move to face the reality, unlike 'the Europeans' who basically used the Mongols' tactic for capturing Beijing - throw bodies against the walls. Even though Fed's 'data' included Yellen's quotes about plastic surgeons reporting customers delaying elective procedures... and she subsequently followed up on this pearl by expressing (in December 2008) concern about rising labour force participation...


In short, the transcripts make us, macroeconomists, look decidedly scientific and impossibly human, compared to the Central Bankers... And this before we get any transcripts from that bastion of surreality in Frankfurt, called the ECB...

9/10/2013: Leveraged and Sick: Euro Area Banks - Sunday Times October 6

This is an unedited version of my Sunday Times column from October 6, 2013.


Newton’s Third Law of Motion postulates that to every action, there is always an equal and opposite reaction. Alas, as recent economic history suggests, physics laws do not apply to economics.

The events of September are case in point. In recent weeks, economic data from the euro area and Ireland have been signaling some improvement in growth conditions. Physics would suggest that the reaction should be to use this time to put forward new systems that can help us averting or mitigating the next crises and deal with the current one. Political economy, in contrast, tells us that any improvement is just a signal to policymakers to slip back into the comfort of status quo.

Meanwhile, the core problems of the Financial Crisis and the Great Recession remain unaddressed, and risks in the global financial markets, are rising, not falling.

More ominously, the Euro area, and by corollary Ireland, are now once again in the line of fire. The reason for this is that for all the talk about drastic changes in the way the financial services operate and are regulated, Europe has done virtually nothing to effectively address the lessons learned since September 2008.


Last month we marked the fifth anniversaries of the Lehman Brothers’ bankruptcy and the introduction of the Irish banking guarantee. These events define the breaking points of the global financial crisis. In the same month we also saw the restart of the Greek debt negotiations ahead of the Third Bailout, the Portuguese Government announcement that its debt will reach 128 percent of the country GDP by the end of this year, a renewed political crisis in Italy, and continued catastrophic decline in the Cypriot economy. Public debt levels across the entire euro periphery are still rising; economies continue to shrink or stagnate. Financial system remains dysfunctional and loaded with risks. Voters are growing weary of this mess. In Spain, political divisions and separatist movements gained strength, while German and Austrian elections have signaled a prospect of the governments’ paralysis.

In Ireland, the poster boy for EU policies, pressures continued to build up in the banking system. The Central Bank is barely containing its dissatisfaction with the lack of progress achieved by the banks in dealing with arrears and is forcefully pushing through new, ever more ambitious, mortgages resolutions targets. Yet it is not empowered to enforce these targets and has no capacity to steer the banks in the direction of safeguarding consumer interests. Business loans continue to meltdown hidden in the accounts.

Meanwhile, the latest set of data from the banking sector is highlighting the fact that little has changed on the ground in five years of the crisis. Domestic deposits are flat or declining – depending on which part of the system one looks at. Foreign deposits are falling. Credit supply continues to shrink.


Perhaps the greatest problem faced by the euro area and Ireland is that since the late 2008, tens of thousands of pages of new regulations have been drawn up in attempting to cover up the collapse of the banking system. Well in excess of EUR 700 billion was spent on ‘repairing’ the banks. And yet, few tangible changes on the ground have taken place. The lessons of the crisis have not been learned and its legacy continues to persist.

There are three basic problems with euro area financial systems as they stand today - the very same problems that plagued the system since the start of the crisis. These are: high leverage and systemic risks, excessive concentration of the banks by size, and wrong-headed regulatory responses to the crisis.

European banks are still leveraged far above safety levels. Lehman Brothers borrowed 31 times its own capital in mid-2008. Today, euro area banks borrow even more. No new European rules on leverage have been written, let alone implemented.

New York University’s Volatility Lab maintains a current database on systemic risks present in the global banking sector. Top 50, ranked by the degree of leverage carried on their balance sheet, euro area banks had combined exposure to USD 1.376 trillion in systemic risks at the end of last week. The banks market value was half of that at USD668 billion. Average leverage in the euro area top 50 banks is 58.5 or almost double Lehman's, when measured as a function of own equity. Two flagship Irish banks, still rated internationally, Bank of Ireland and Ptsb, are ranked 37th and 46th in terms of overall leverage risks and carry combined systemic risk of USD11.4 billion. Accounting for the banks provisions for bad loans, the two would rank in top 20 most risky banks in the advanced world.

Compare this to the US banking system. The highest level of leverage recorded for any American bank is 20.4 times (to equity). Total systemic risk of the top 50 leveraged financial institutions in the entire Americas (North and South) is around USD489 billion, set against the market value of these institutions of USD1.4 trillion.

Since September 2008, systemic risk in the US banking system has more than halved. In the case of euro area, the decline is only one-fifth.

Euro area banks positions as too-big-to-fail are becoming even stronger as the result of the crisis. In the peripheral euro states, and especially in Ireland, this effect is magnified by the deliberate policies attempting to shore up their banking systems by further concentrating market power of ‘Pillar’ banks.


Another area in which change has been scarce is the regulations concerning the funding of the banks. The crisis was driven, in part, by the short-term nature of banks funding – the main cause for the issuance of the September 2008 banking guarantee in Ireland.

In the wake of the crisis, one would naturally expect the new regulatory changes to focus on increasing the deposits share in funding and on reducing banks’ reliance on and costly (in the case of restructuring) senior bonds. None of this has happened to-date and following Cypriot haircuts on depositors one can argue that the ability of euro area banks to raise funding via deposits has now been reduced, not increased.

In addition to driving consolidation of the sector, Europe’s political leaders promised to raise the capital requirements on the banks. Actions did not match their rhetoric. Higher capital holdings are not being put in place fast enough. The EU is actively attempting to delay global efforts at introduction of new minimum standards for capital. As the result, current levels of capital buffers held by the top 50 euro area banks are below those held by Lehman Brothers at the end of 2008. Irish banks capital levels, even after massive injections of 2011, are also lower than that of Lehman’s once the expected losses are accounted for.


Even more ominously, the ideology of harmonisation as a solution to every problem still dominates the EU thinking. This ideology directly contradicts core principles of risk management. By reducing diversity of the regulatory and supervisory systems, the EU is making a bet that its approach to regulation is the best that can ever be developed. History of the entire European Monetary Union existence tells us that this is unlikely to be the case.

Moving from diverse regulatory systems and competitive banking toward harmonised regulation and more concentrated financial sector dominated by the too-big-to-fail ‘Pillar’ institutions implies the need for ever-rising levels of rescue funds and capital buffers.

Currently, there are only two proposals as to how this demand for rescue funds can be addressed. You guessed it – both are utterly unrealistic when it comes to political economy’s reality.

The first one is promising to deliver a small rescue fund for future banks rescues capitalized out of a special banks levy. The fund is not going to be operative for at least ten years from its formation and will not be able to deal with the current crisis legacy debts.

The second plan was summarized this week in the IMF policy paper. Per IMF, full fiscal harmonisation is a necessary condition for existence of the common currency. A full fiscal union, and by corollary a political union as well, is required to absorb potential shocks from the future crises. The union should cover better oversight by the EU authorities over national budgets and fiscal policies, a centralised budget, borrowing and taxing authority, and a credible and independent fund for backstopping shocks to the banking sector. In more simple terms, the IMF is outlining a federal government for Europe, minus democratic controls and elections.

Under all of these plans, there is no promise of relief for Ireland on crisis-related banking debts. In fact, the IMF proposals clearly and explicitly state that the stand-alone fund will only be available to deal with future crises. Addressing legacy costs will require separate mutualisation of the Government liabilities relating to the banking sector rescues. The IMF proposal, in the case of Ireland, means accepting tax harmonisation and surrendering some of the Irish tax revenues to the federal authorities.


At this stage, it is painfully clear to any objective observer that fundamental drivers of the Financial Crisis triggered by the events of September 2008 remain unaddressed in the case of European banking. Thus, core risks contained in the financial system in Europe and in Ireland in particular are now rising once again. Politics have been trumping logic over the last five years just as they did in the years building up to the crisis. This is not a good prescription for the future.

Box-Out: 

A study by the Bank for International Settlements researchers, Stephen Cecchetti and Enisse Kharroubi, published this week, attempted to uncover the reasons for the negative relationship between the rate of growth in financial services and the rate of growth in innovation-related productivity. In other words, the study looked at what is known in economics as total factor productivity growth – growth in productivity attributable to skills, technology, as well as other 'softer' sources, such as, for example, entrepreneurship or changes in corporate strategies, etc. The authors found that an increase in financial sector activity leads to outflow of skilled workers away from entrepreneurial ventures and toward financial sector. This, in turn, results in the financial sector growth crowding out growth in R&D-intensive firms and industries. The study used data for 15 OECD countries, including some countries with open economies and significant shares of financial sector in GDP, similar to Ireland. The findings are striking: R&D intensive sectors located in a country whose financial system is growing rapidly grow between 1.9 and 2.9% a year slower low R&D intensity sectors located in a country whose financial system is growing slowly. This huge effect implies that for the economies like Ireland, shifting economic development to R&D-intensive activity will require significant efforts to mitigate the effects of the IFSC on draining the indigenous skills pool. It also implies that Ireland should consider running an entirely separate system for attracting skilled immigrants for specific sectors.

20/9/2013: "Did Capitalism Fail?" by Roman Frydman and Michael D. Goldberg

Here is an essay that is a must-read, especially if you are my student in TCD or UCD:

via @ProSyn: http://www.project-syndicate.org/commentary/the-2008-crisis-and-the-failure-of-economics-by-roman-frydman-and-michael-d--goldberg

Did Capitalism Fail?

Few quotes setting the stage:

The Global financial crisis "was not so much a failure of capitalism as it was a failure of contemporary economic models’ understanding of the role and functioning of financial markets – and, more broadly, instability – in capitalist economies."

"These models provided the supposedly scientific underpinning for policy decisions and financial innovations that made the worst crisis since the Great Depression much more likely, if not inevitable."

A "flawed assumption – that self-interested decisions can be adequately portrayed with mechanical rules – underpinned the creation of synthetic financial instruments and legitimized, on supposedly scientific grounds, their marketing to pension funds and other financial institutions around the world."

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

The “New Keynesian” models …assumed that an economy’s “true” potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured. But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus."

Years ago I run a series of interviews with Roman Frydman, one of the co-authors of the essay I quoted from. I should dust it out - it was recorded before the crisis hit and I recall Frydman's clear explicit warning about the build up of overconfidence on behalf of the financial system and its regulators that cut across his thinking so elegantly developed, together with Goldberg, in Imperfect Knowledge Economics (http://press.princeton.edu/titles/8537.html). 

8/3/2013: Why Economists Failed to Predict the Twin Crises?

Wonderfully interesting recent CEPR (DP No. 9269) paper titled THE FAILURE TO PREDICT THE GREAT RECESSION. THE FAILURE OF ACADEMIC ECONOMICS? A VIEW FOCUSING ON THE ROLE OF CREDIT by Maria Dolores Gadea Rivas and Gabriel Perez Quiros (http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=9269.asp) takes up a gargantuan task of trying to answer why (and indeed if) economists failed to predict the latest financial and real economic crises.

In addition, the real economic downturn "has also highlighted the lack of consensus in macroeconomic thinking about how far the financial system influences economic activity."

"Basic economic theory suggests that, in a frictionless world, the shocks originating in credit markets play only a minor role in explaining business cycles. However, the presence of financial imperfections can amplify their effect on the real economy and, thus, disturbances in credit markets can lead to larger cyclical fluctuations in the real economy. These frictions also provide micro-fundamentals for analyzing the channels of transmission." This is known as the financial accelerator mechanism.

However, prior to the crisis, "the most influential dynamic general equilibrium models developed just before the recession by Chistiano et al. (2005) and Smets and Wouter (2007) do not incorporate any financial accelerator mechanism. The debate at that time was about the effect of frictions, nominal and real, and the role of monetary policy to offset these effects on output and inflation."

Since the onset of the crisis, a new strand of literature has taken prominence in economics, dealing more directly with the links between the economic and credit cycles. This literature is empirical, rather than theoretical in nature and focuses on historical data of financial crises. Much of the literature concludes "that there are strong similarities between recent and past crises and, consequently, the Great Recession is nothing new" and that credit growth acts as a powerful predictor of financial crises, with external imbalances useful ind erecting the turning points. Majority of studies conclude that "credit booms tend to be followed by deeper recessions and sluggish recoveries."

Per authors, "all these papers have much in common, both in the stylized facts derived from them and in their methodological foundations. They provide considerable evidence that financial markets, and credit in particular, play an important role in shaping the economic cycle, in the probability of financial crises, in the intensity of recessions and in the pace of recoveries. The argument is that the strong growth of domestic credit and leverage that fuelled the expansion phase became the trigger for a financial crisis and, therefore, for a recession4. A common finding is that downturns associated with financial crashes are deeper and their recoveries slower."

The clarity and the robustness of the new studies' results begs a question as to why "the financial accelerator mechanism did not appear earlier on the agenda of the theoretical business cycle models"? "It seems that the link between financial and real crises is so obvious that economists should have been blind when looking at data before the crisis to miss such an important feature of the data. Significantly, however, all the papers that find this clear empirical evidence date from after the financial crisis started."

The real question to ask, therefore, is "whether this ex post evidence, could be obtained ex-ante and if it is sufficiently robust to assist with economic policy decisions"?

In other words, ex-post crisis studies do not "take into account the fact that recession dating is uncertain in real time. Furthermore, when the macroeconomic variables have the property of accumulating during the expansions periods, a potential bias may arise because these variables usually present high levels just before the turning points. For example, from this literature, an analyst could extract the lesson. However, during long periods of expansions, credit to GDP growth is high and there is no recession. Also, credit as a proportion of GDP accumulates over time endogenously in different theoretical models, …and, therefore, it is endogenously high when expansions are long. Yet these high levels before turning points do not imply any power of the credit to GDP ratio in predicting the turning points. In medical terminology, the previous literature is more interested in the ”anatomy” of financial
crises, after they have occurred, than in ”clinical medicine”, that is, diagnosis from the symptoms. …For the lessons extracted from the data to be of value to policymakers in their day-to-day policy decisions, we have to understand the dynamics of these financial variables in real time without forgetting the uncertainty about turning points."

This is a brilliantly put introduction to the core thesis of the paper: "to consider the cyclical phases and, especially, recessions in an environment of uncertainty. Policymakers that see credit to GDP growing have to decide when the growth is dangerously high and could generate a turning point. If a long expansion keeps generating a high credit to GDP ratio endogenously, to cut credit dramatically could unnecessarily shorten the period of healthy growth."

Put differently, "the key question for a policymaker is to what extent the level of credit to GDP (or its variation) observed in period ”t” increases or not the probability of being in a recession in ”t +1”, or whether it changes the characteristics of future cyclical phases."

To answer these questions, the authors propose "a novel and robust technique for dating and characterizing business cycles and for analyzing the effect of financial and other types of variables. We combine temporal and spatial data and we show that this approach is legitimate, notably reduces the uncertainty associated with the estimation of recession phases and improves forecasting ability in real time."

The key results can be summarized as follows:
-- "Credit build-up exerts a significant and negative influence on economic growth, both in expansion and recession, increasing the probability of remaining in recession and reducing that of continuing in expansion."
-- "However, these effects, although significant, are almost negligible on the business cycle characteristics.
-- The authors show that "there is no significant gain in forecast performance as a consequence of introducing credit."
-- Thus, "in contrast to the previous literature, our findings indicate that the role of credit in the identification of the economic cycle and its characteristics is very limited."

Per original (and by now secondary) question asked the authors claim that their "results also explain why financial accelerator mechanisms have not played a central role in the models that describe business fluctuations. The financial accelerator was not a key point in explaining business fluctuations simply because, empirically, it did not have such a close relationship to the business cycle, either in a sample (prior to the crisis) or in an out of sample approach, once the uncertainty in dating recession periods is included in the model."

This is a really interesting paper with fundamental implications for macroeconomics and one of the earliest attempts to reconcile empirical predictability and theoretical clarity of core modern theory (namely that of the financial accelerator) relating to the financial crises and the links between the financial and real economic crises.

3/12/2012: Current crisis systemic risk comparative

THE LIBERALIZATION AND MANAGEMENT OF CAPITAL FLOWS - an IMF paper released today has an interesting chart putting into perspective the extent of the euro area crisis in comparative terms to other crises (click on the image to enlarge):

The above clearly shows that to Q3 2011, the euro area crisis has been

1. Systemically separate from the preceding global financial crisis of Q1 2008 - Q1 2010, 
2. Much smaller in magnitude than the preceding crisis,
3. As measured by the crisis indicator - comparable in magnitude to the early stage of the Asian-Russian crises and ERM crisis, as well as to the early stages of the Scandinavian crisis
4. However, the spillover from the euro area crisis to the global economy remained more limited than contagion in previous crises, as illustrated by the systemic crisis indicator.

Another interesting feature of the chart is that it shows that the Age of Moderation (1990-2007) was actually a period with four systemic crises: the Scandinavian crisis of the 1990s, the ERM crisis, the Asian and Russian crises, and the dot.com bubble

Lastly, the above shows that both, the IMF systemic crisis indicator and Equal-weighted crisis indicator are not sufficient in providing lead-up signals for systemic stress build up.

16/7/2012: GFSR July 2012 - more alarm bells for European banks

IMF published Global Financial Stability Report update for June 2012, titled “Intense Financial Risks: Time for Action”

Per report: “Risks to financial stability have increased since the April 2012 Global Financial Stability Report (GFSR).

• Sovereign yields in southern Europe have risen sharply amid further erosion of the investor base.
• Elevated funding and market pressures pose risks of further cuts in peripheral euro area credit.
• The measures agreed at the recent European Union (EU) leaders’ summit provide significant steps to address the immediate crisis. Aside from supportive monetary and liquidity policies, the timely implementation of the recently agreed measures, together with further progress on banking and fiscal unions, must be a priority.
• Uncertainties about the asset quality of banks’ balance sheets must be resolved quickly, with capital injections and restructurings where needed.
•  Growth prospects in other advanced countries and emerging markets have also weakened, leaving them less able to deal with spillovers from the euro area crisis or to address their own home-grown fiscal and financial vulnerabilities. 
•  Uncertainties on the fiscal outlook and federal debt ceiling in the United States present a latent risk to financial stability."

Aside from the headlines, some interesting points from the report are:

• Market conditions worsened significantly in May and June, with measures of financial market stress reverting to, and in some cases surpassing, the levels seen during the worst period in November last year.  (see Figure 1)

•   The 3-year LTROs helped support demand for peripheral sovereign debt but that positive effect has waned. Private capital outflows continued to erode the foreign investor base in Italy and Spain (see Figures 3 and 4)

An interesting point on Euro area banking sector [emphasis mine]: “Notwithstanding the ample liquidity provided by the ECB’s refinancing operations, funding conditions for many peripheral banks and firms have deteriorated. Interbank conditions remain strained, with very limited activity in unsecured term markets, and liquidity hoarding by core euro area banks. Bank bond issuance has dropped off precipitously, with little investor demand even at higher interest rates.

“Banks in the euro area periphery have had to turn to the ECB to replace lost funding support, as cross-border wholesale funding dried up, and deposit outflows continue. The April 2012 GFSR noted that EU banks are under pressure to cut back assets, due to funding strains and market pressures, as well as to longer-term structural and regulatory drivers. The sharp reduction in bank balance sheets in the fourth quarter of 2011 continued, albeit at a slower pace, in the first quarter of 2012.

Growth in euro area private sector credit diverged significantly. While credit has contracted in Greece, Spain, Portugal and Ireland, it has remained more stable in some core countries.

Survey data on bank lending conditions show that credit supply remains tight, albeit less so than at the end of 2011, but that demand has also weakened more recently.

Deleveraging is also a concern for many peripheral corporations, given their historic dependence on bank funding and the risk that credit downgrades and diminished investor appetite could drive borrowing costs higher, even for high credit quality issuers.”

Now, here’s an interesting point not raised in the GFSR, but linked to the above observations: equities issuance accounts for roughly 55% of total corporate capital in US and EU. However, because the US corporates issue more bonds-backed debt than their EU counterparts, banks lending accounts for 40% of the European corporate funds raised, against 20% in the US. Which means that banks credit is about twice more important in Europe than in the US in terms of funding corporate capex. In fact, recent research from BCA clearly links US corporates ability to raise direct market funding by-passing banks to faster economic recovery in the US than in EU or Japan.

Add to this equation that European banks are worse capitalized than their US counterparts and that they are more leveraged than their US counterparts and you have a bleak prospect for the EU economy. BCA recently estimated that to bring Euro zone banks’ capital ratios to the levels comparable with the US average, the largest EU banks will have to raise some USD900 billion worth of new capital or cut their assets base by a whooping USD 9 trillion.

But wait, there’s more – you’ve heard about the latest report in the WSJ that Mario Draghi proposed to bail-in senior bondhodlers in Spanish banks? Much of the Irish commentary on this was positive, suggesting that Ireland is now in line for a retrospective deal from the ECB to recover some of the funds we paid to senior bondholders in Anglo and INBS. Setting aside the ‘wishful thinking’ nature of such comments – look at Draghi’s idea implications for EU economic activity. If bail-in does make it to the policy tool of European authorities, funding for the EA17 banks will only become more expensive in the medium and long term (risk premium on ‘bail-in probability’), which, in turn will mean even less credit for corporates, which will mean even less capex, and thus even lower prospect of recovery.

You know the story – pull one end of the carriage out of the quicksand pit, the other end sinks deeper… Let me quote BCA: “In Japan, credit contraction lasted well over nine years in the aftermath of the asset bubble bust. During that time, deflation prevailed and economic growth averaged a measly 0.5% annual pace.” Much of hope for Europe then? Not really. Recall that Japan had aggressive fiscal and monetary policies at its disposal plus booming global markets when it was undergoing credit bust. We, however, have psychotic monetary policy, no fiscal policy room and are running debt deflation cycle amidst global economic slowdown.

IMF is also on the note here: “Policymakers must resolve the uncertainty about bank asset quality and support the strengthening of banks’ balance sheets. Bank capital or funding structures in many institutions remain weak and insufficient to restore market confidence. In some cases, bank recapitalizations and restructurings need to be pursued, including through direct equity injections from the ESM into weak but viable banks…”

21/5/2012: Quick note on US Markets' Crash Indices

The risk-off thingy is starting to bite - with a few frantic calls over the weekend from across the Atlantic. People are shifting strategies like feet in Swan Lake's pas de deux. Here's an nice set of charts that shows we are in a precarious starting point to the risk-off market indeed.

The Yale University Crash Index - latest data takes us only through April, shows that the base off which we have entered May markets is already loaded with high risk:

April 2012 Institutional Index came in at 26.94 reading, which compares unfavorably to historical average of 36.86 and to crisis period average of 31.27. Jittery markets mean that 2011-present average is 29.88 - worse than crisis period average and that April 2012 was even worse than that. Meanwhile, individual investors index showed usual lags, with lower pessimism in April at 28.47, which is a better reading than 26.57 for crisis period average and better than 24.76 for 2011-present average. Still, individual investors are more risk conscious than historical average of 33.70.

One interesting bit - disregarding the issue of lags, historical correlation between two indices is 0.76 while crisis period correlation is 0.82, which suggests that May reading should come down like a hammer for individual investors. The same is confirmed by looking at changes in indices volatility. Standard errors for Institutional investors responses have compressed from historical 3.82 average to crisis period 2.99 average to 2.85 average for the period since January 2011. Similarly, for individual investors, historical average standard error is 3.36, declining to 2.731 for crisis period and 2.724 average since January 2011.

Note that per charts above, since the beginning of the crisis in mid-2007 (data shows clear break in data at June 2007), Individual investors index has been flat trending (volatile along trend), while Institutional investors index has been trending down (with loads of volatility, too).

2/4/2012: Two studies on Global Financial Crisis

An interesting analysis of the International Financial Crisis of 2007-2009 from Gary Gorton and Andrew Metrick, both Yale and NBER just out - see link here. Worth a read and contrasting with Taleb's excellent paper on same (earlier work than that of Gordon and Metrick) here.

11/3/2012: Did Global Financial Integration Contribute to Global Financial Crisis Intensity?

An interesting paper (link here) from Andrew Rose titled International Financial Integration and Crisis Intensity (ADBI Working Paper 341 ).

The study looked at the causes of the 2008–2009 financial crisis "together with its manifestations", using a Multiple Indicator Multiple Cause (MIMIC) model that allows for simultaneous causality effects across a number of variables.

The analysis is conducted on a cross-section of 85 economies. The study focuses "on international financial linkages that may have both allowed the crisis to spread across economies, and/or provided insurance. The model of the cross-economy incidence of the crisis combines 2008–2009 changes in real gross domestic product (GDP), the stock market, economy credit ratings, and the exchange rate. The key domestic determinants of crisis incidence that [considered] are taken from the literature, and are measured in 2006: real GDP per capita; the degree of credit market regulation; and the current account, measured as a fraction of GDP. Above and beyond these three national sources of crisis vulnerability, [Rose added] a number of measures of both multilateral and bilateral financial linkages to investigate the effects of international financial integration on crisis incidence."

The study covers three questions:

• First, did the degree of an economy’s multilateral financial integration help explain its crisis? 
• Second, what about the strength of its bilateral financial ties with the United States and the key Asian economics of the People’s Republic of China, Japan, and the Republic of Korea? 
• Third, did the presence of a bilateral swap line with the Federal Reserve affect the intensity of an economy’s crisis? 

"I find that neither multilateral financial integration nor the existence of a Fed swap line is correlated with the cross-economy incidence of the crisis. [Pretty damming for those who argue that the crisis was caused / exacerbated by 'global' nature of the financial markets and for those who claim that 'local' finance is more stable. Also shows that the Fed did not appeared to have subsidized european and other banks, but instead acted to protect domestic (US) markets functioning.] There is mild evidence that economies with stronger bilateral financial ties to the United States (but not the large Asian economies) experienced milder crises. [This is pretty interesting since so many European leaders have gone on the record blaming the US for causing crises in European banking, while the evidence suggests that there is the evidence to the contrary. Furthermore, the above shows that we must treat with caution the argument that all geographic diversification is good and that, specifically, increasing trade & investment links with large Asian economies - most notably China - is a panacea for financial sector crisis cycles.]"

Core conclusion: "more financially integrated economies do not seem to have suffered more during the most serious macroeconomic crisis in decades. This strengthens the case for international financial integration; if the costs of international financial integration were not great during the Great Recession, when could we ever expect them to be larger?"

Here's a snapshot of top 50 countries by the crisis impact:

Quite thought provoking. One caveat - data covers periods outside Sovereign Debt crisis period of 2010-present and the study can benefit from expanded data coverage, imo.

3/2/2012: Big Bad Speculators & Little Red Riding Hoods

That "Gotcha..." moment, you know... speaking last night at a round table discussion on the future of Europe, I was confronted with a question from the audience and a fellow panelist remarks in the same vein that, roughly speaking, attributed the entire current crisis in Europe to the derivatives markets and speculative investment. More than that, the same were blamed for everything from the environmental disasters to increases in commodity prices. Some parts of the Left just love the idea of finding a "capitalist" (even arch-capitalist - aka speculative) root to every problem - the "Gotcha..." thingy of pseudo intellectualist disdain for facts as much as for 'speculators' and 'markets'.

This of course does not mean that financial instrumentation, speculation or other forces of the financial markets did not contribute to the crisis, but it is a distinct claim from the one made by those proposing that they caused the crisis single-handedly.

By sheer accident, looking through some old research papers, I came across this study from the ECB: Lombardi, Marco J. and Van Robays, Ine, Do Financial Investors Destabilize the Oil Price? (May 20, 2011). ECB Working Paper No. 1346. Available at SSRN: http://ssrn.com/abstract=1847503

The study looks into the large oil price fluctuations that were observed in the recent years. In particular, the study considers the role of financial activities in the determination of oil prices.

Per study (emphasis is mine):

"The oil futures market has indeed become increasingly liquid, and the activity of agents that do not deal with physical oil, the so-called non-commercials, has greatly increased. This led some to hypothesize that inflows of financial investors in the futures market may have pushed oil prices above the level warranted by fundamental forces of supply and demand, whereas others argue that the impact of financial activity on the oil spot market is negligible or non-existent beyond the very short term."

The paper studies "the importance of financial activity in determining the spot price of oil relative to the role of oil market fundamentals", using a sign-restricted structural VAR model. The model allows the study authors to separate financial activities into two types: stabilizing and destabilizing. This is achieved by postulating a model that links "the oil spot market to the futures market through a no-arbitrage condition", so that:

• Destabilizing financial shock is identified as one that creates "a deviation from the no-arbitrage condition, thereby ...driving oil futures prices away from the levels justified by oil market fundamentals. 
• Stabilizing financial activity is defined as "driven by changes in oil supply and demand-side fundamentals". 

In addition, the econometric framework adopted in the study allows to identify four different types of oil shocks:

• an oil supply shock
• an oil demand shock driven by economic activity 
• an oil-specific demand shock which captures changes in oil demand other than those caused by economic activity, and 
• a destabilizing financial shock (such as a spike in speculative activity).

The results suggest that 

• Financial activity in the futures market can significantly affect oil prices in the spot market, although only in the short run. 
• The destabilizing financial shock (speculation) only explains about 10 percent of the total variability in oil prices.
• Shocks to fundamentals "are clearly more important over our sample. Indeed, looking at specific points in time, the gradual run-up in oil prices between 2002 and the summer of 2008 was mainly driven by a series of stronger-than-expected oil demand shocks on the back of booming economic activity, in combination with an increasingly tight oil supply from mid 2004 on. Strong demand-side growth together with stagnating supply were also the main driving factors behind the surge in oil prices in 2007-mid 2008, and the drop in oil prices in the second half of 2008 can be mainly explained by a substantial fallback in economic activity following the financial crisis and the associated decline in global oil demand. Since the beginning of 2009, rising oil demand on the back of a recovering global economy also drove most of the recovery in oil prices."

However, the study did find that financial investors "did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time. In general, inefficient financial activity in the futures market pushed oil prices about 15 percent above the level justified by (current and expected) oil fundamentals over the period 2000-mid 2008, when the volume of crude oil derivatives traded on NYMEX quintupled. Particularly in 2007-2008, destabilizing financial shocks aggravated the volatility present in the oil market and caused oil prices to respectively over- and undershoot their fundamental values by significant amounts, although oil fundamentals clearly remain more important."

So some speculation is harmful to fundamentals-determined pricing, although the study does not consider the potential benefits from speculation-induced greater liquidity in the markets (which was not the core objective of the study to begin with), but largely, 5-fold increase in speculative activity accounts for just 10 percent of prices variability. 

11/1/2012: Great Moderation or Great Delusion

A recent (December 2011) paper published by CEPR offers a very interesting analysis of the macroeconomic risks propagation in the current crisis. The paper, titled Great Moderation or Great Mistake: Can rising confidence in low macro-risk explain the boom in asset prices? (CEPR DP 8700) by Tobias Broer and Afroditi Kero looks at the evidence on whether the period of Great Moderation in macroeconomic volatility during the period from the mid-1980s (the decline in macroeconomic volatility that is unprecedented in modern history) had an associated impact on the rise of asset prices that accompanied this period, setting the stage for the ongoing crash.

In recent literature, this rise in asset prices, and the crash that followed, have both been attributed to "overconfidence in a benign macroeconomic environment of low volatility" or to excessively optimistic expectations of investors that the lengthy period of macroeconomic stability and upward trending is the 'new normal'. 

The study introduced learning about the persistence of volatility regimes in a standard asset pricing model of investor decision making. "It shows that the fall in US macroeconomic volatility since the mid-1980s only leads to a relatively small increase in asset prices when investors have full information about the highly persistent, but not permanent, nature of low volatility regimes." In other words, in the rational expectations setting with no errors in judgement and perfect foresight (investors are aware that volatility reductions are temporary), there is no bubble forming.

However, when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Specifically, calibrated model generates pre-collapse rise in asset prices of 77% and overvaluation of assets by 79% over the case of no learning. The subsequent collapse of asset prices is 84% in the case of imperfect information learning.

A pretty nice result!