Economics 21/11/10: How much funding will we need?

I've run through some figures for the expected amount of bailout drawdown for Ireland. Here are the sums:

• 2011-2014 deficit financing: €17bn in 2011 (accounting for expected increase in interest payments), €16bn in 2012-2014 annually (allowing for €15bn adjustment in 2011-2014 framework to be published by the Government) = €65bn
• Banks capital demand: €37bn in residual capital losses including Nama and incorporating expected mortgages defaults of €12bn
• Bonds redemptions forthcoming (hat tip to Brian Lucey): commercial paper =€ 6.4bn in 2011, redeemable out of IMF loan and thus non-replicative over 2012-2014, bond issues €4.4bn in 2011, €5.6bn in 2012 and €6bn in 2013, to the grand total of €22.4bn
• Banks liquidity supply - immediate draw on IMF funds - €28-35bn

Adding these up: total demand for funds in the amount of €152.4-159.4bn

Government has available ca €20bn (nominal) reserves from NTMA and ca €12bn in liquid funds from NPRF that can be accessed, implying net demand on IMF/ECB funding is €120-127bn.

Assuming the expected haircut on all bondholders in Irish 6 covered institutions implies additional savings of ca €10bn not factored in the above. However over the years 2012-onward I expect Nama to start showing losses. In addition, I suspect that the Exchequer will have to cover losses in the Central Bank of Ireland relating to their lending to the Anglo, which can be in excess of €10bn.

Interest charge on the IMF/ECB loan is likely to be around 5%, providing for a demand for €6bn in annual interest repayments.

Economics 20/11/10: Irish labour taxes are too restrictive

We often think of Ireland as low tax economy. We also think of ourselves as inhabiting flexible labour markets and enterprising world of work-hungry people.

Here is an interesting angle from which we can look at the labour markets. Suppose the cost of labour for an hour of work goes up 1% - due to an earnings increase or benefits rise. What does a worker get to keep out of this?

The higher the number is, the greater is the incentive to supply labour post wage/earnings or employer social security tax increases. The lower it is, the lesser are the incentives to work in the face of rising earnings or social security contributions.

Ex-ante, we would expect Ireland to see significantly higher returns to workers efforts from rising earnings and/or social security (PRSI) contributions by employers (reduced burden on employees and higher expected future benefits of PRSI funding). This, however, is not true.

Here are few charts from the latest OECD data set - for 2009, so not reflective of the Budget 2010 changes in taxes.

OECD defines the main parameter under consideration as: "Net income is calculated as gross earnings minus personal income tax and employees' social security contributions family benefits. The increase reported [in charts below] represents a form of elasticity. In a proportional tax system the plus elasticity would equal 1. The more progressive the system at these income levels, the lower is the elasticity."

Now, as you look at these charts, remember, the Irish Times crowd love droning on about the lack of 'progressive' tax system in Ireland.

First chart shows single person returns to 1% increase in labour costs with 3 sub-groups identified by their earnings:
AW refers to average wage.

Clearly, single people in Ireland have little incentives to supply more labour in response to an increase in their earnings. Alternatively, we do have a severely progressive system of taxation for labour when it comes to single individuals. Actually, for a single person earning 100% of average wage, Ireland is second to Hungary in the OECD in terms of progressivity of our labour income taxes. That's right - we have second lowest incentives to supply more labour (or in other words, we keep second lowest amount of added cost of labour in our pockets) in the entire OECD. For a higher earners (167% of AW) the picture is not much better - we are actually fourth from the bottom of the OECD league (or 4th highest degree of progressivity).

Now on to families with 2 kids:
Here, we have a slightly improved picture. For a family with 1 earner bringing in 100% of AW, we are ranked 16th in the OECD in terms of incentives to provide more work in return for increased earnings or contributions. For a family with one earner on 100% AW and another on 67% of AW, the same rank is 14th. Progressivity of our labour taxes in all 3 scenarios in the chart above is still above the average for the OECD.

Now on to comparing single person with no children and a family with 2 children:
Doesn't look like there's a great deal of premium to being married in Ireland, does it? Nope. If labour costs go up by 1 Euro, a single person on 167% of AW would keep 74 cents, a family with 2 kids with exactly same combined income will keep 80 cents. Both are worse off in Ireland than their counterparts in 27 countries (single person with no children) and 13 countries (married couple with two earners and 2 kids). Again, much of Irish Times-loved progressivity in either household income taxes.

What if we take lower earning individuals for the above comparison?
Here, the picture changes - average wage earners face much smaller progressivity of tax system than higher earners (notice, this is 'smaller progressivity', not 'smaller burden of tax').

But does having children actually help or penalises working households? Take a look below:
So working households with both parents working and 2 kids are allowed by our tax system to keep less of their higher income than their childless counterparts and single childless earners. That's really does begin to look like a perverse system of income tax 'justice'.

Let me summarise the data in a handy table:
By all metrics and for all categories, Ireland simply qualifies as a country where

• labour income taxation is significantly more progressive (in 7 out of 8 categories of earners it is more progressive than OECD average, 5 out of 8 than EU15 average and 5 out of 8 than advanced economies average)
• labour income taxation is significantly more restrictive of incentives to supply labour in response to higher earnings than the OECD or EU15 average

Not exactly a flexible market with great incentives to work, is it?

Economics 17/11/10: The road we traveled

Amidst this crisis, it is worth taking a look back at the road that we have traveled on our way to the current predicament. It is fashionable today to make claims that the past - the recent past in fact - has been a place of greater fiscal responsibility, the age of 'sustainable' public finances. But is the claim true? Have lost our way all of a sudden around 2005-2007, or have we always been traveling along the same route.

Here are few charts looking back to 1983...
In absolute levels terms, spending and tax receipts have clearly grown dramatically over the years. These are nominal figures, of course. But notice that total expenditure line almost invariably exceeds total receipts levels. The chart also shows pretty dramatic changes that took place since 2007.


Now, let's take a look at the decomposition of the Exchequer balance sheet:
Clearly, gross current spending has been a core of the overall Exchequer financing. The most dramatic departure from 'investment' focus toward current spending focus took place around the turn of the century. Looking at the comparatives across the shares of GNP taken up by capital and current spending shows this even more dramatically. If during 1985-2000 period current expenditure declined as a share of GNP, capital spending first fell (through 1988) then stagnated (through 1997), and then rose through 2002. Capital spending stagnated in the boom years of 2003-2007 and then rose again (due to contraction in GNP) through 2009. However, from 2006 through today, current spending went through the roof.

Another interesting feature of the chart above is that during the current crisis there was not a single year when the current expenditure declined - either in terms of absolute level of spending or in terms of spending relative to GNP.

Total government spending both in levels and as a share of GNP is expected to fall this year for the first time since the beginning of the crisis. This, of course, is driven solely by the decline in capital spending, as charts above indicate.

Now, let us plot primary Exchequer balances - the difference between the total receipts and expenditure.
In broad terms, over the long run, Irish Exchequer has been historically on a non-sustainable path. In only 3 years since 1983 did our total receipts cover total expenditure: 1999, 2000 and 2006.

It is worth noting that we are, despite what Minister Lenihan says, firmly back into the 1980s territory:

• Our current expenditure will stand around 48.7% of GNP this year - a level consistent with 1986-1987 average
• Our capital expenditure as the share of GNP is now 5.7% - the level also attained in 1986
• Our total government expenditure stands at 54.4% this year - the level close to the one last seen in 1986 (54.7%)
• In 2008 our balance was -9.8% which was between 1986 and 1987 levels of balance
• In 2009-2010 we have posted worse deficits than in any other year recorded in the abvoe charts.

So what about good cop - bad cop game of blame going across the Dail isles?
It turns out that on average annual basis, Brian Cowen leads the recent history team of profligate Taoisigh with a whopping (albeit obviously crisis-related) average annual shortfall of €26.5bn so far. Together - Bertie & Cowen come distant second with €5.5bn in annual shortfalls. But overall, there is not a single Toiseach in the modern history of Ireland who managed to balance the books at the primary level. Hardly a sign of any fiscal 'golden age' in the past.

Economics 13/11/10: EFSF, Ireland and a matter of contagion

let me ask the following question: if Ireland is nearing (or already in - see here) a bailout from the EFSF, what does this imply to the overall Euro area stability? Funny thing - it turns out that a little old Ireland can give a big young Euro quite a headache because of the way EFSF is structured.

Let’s step back and take a look at the promise EFSF attempts to deliver.

The fund, set up back in May this year, was supposed to provide an emergency funding backstop to countries finding themselves in a liquidity squeeze (unable to borrow in the markets).

There two basic problems with this idea from the point of view contagion from Ireland

• Ireland’s crisis is that of insolvency, not of a liquidity squeeze 9although it is increasingly looking like the latter will come in the end). If EFSF were to be explicitly used to address Ireland crisis, then Irish Government will be de facto borrowing from the fund with no hope of repaying it ever back (recall – the lending rates under EFSF should be set close to the market rates, which means, say 7-8% currently, which in turn automatically means we can’t be expected to repay this). If so, then any borrower, I repeat – any borrower – from EFSF will not repay the funds borrowed. And this means EFSF borrowings will have to be covered collectively out of the joint funds of the entire Eurozone. You can pretty much count PIIGS out of funding it – they’ll be the very same borrowers. Which leaves it to France and Germany (Belgium hardly can pay much and Austria has it’s own problems etc) to cover the entire fund.
• EFSF own structure implies high risk of contagion from Ireland.
  

That second point is slightly technical and requires some explaining to do.

One can make an argument that Ireland, if it borrows from EFSF, will trigger an increase in the Euro zone systemic risk. EFSF is set up similar to Collateralized Debt Obligation (CDO) with a "credit enhancement" that allows the senior debt tranche to retain higher risk rating because junior tranches are the ones that will carry the first hit on the whole package in the case of default.

The lags in the disbursement of funding and the capped nature, plus ‘enhancement’ bit of the CDO implies that countries in trouble will have to get into the funding stream as early as possible – as there is quick exhaustion of drawdown funds in the EFSF due to the knock on effect on CDO rating. This is known as an accelerated negative feedback mechanism – as sovereign comes under pressure, sovereigns are encouraged to race into EFSF, which removes their own bonds and capacity to carry debt out of the senior CDO tranche and increases their presence in the junior tranches.

So the guaranteed pool of liabilities increases by the amount country borrows from the fund, but the senior pool decreases by the contribution of this country to the fund. This means that as Ireland joint EFSF, it’s past ‘good credit’ rating falls to zero in the senior CDO tranche, its ‘bad debt’ risk contributes to the reduced quality of the liabilities held by the EFSF. Pressure rises on AAA rating of EFSF, unless EFSF draws more of AAA-rated countries debt into its senior tranche to offset this. EFSF will have to expand to be able to do both: lend out to Ireland and maintain AAA rating. Which, of course means that other EFSF contributors will need to issue more debt to recapitalize EFSF. Which means their own AAA ratings are becoming threatened as well.

You see where it all leads, now, don’t you?

The greater is the number of countries seeking help and/or the greater is the overall demand for EFSF funds, the greater the required buffer funding increases from the remaining EFSF-lending AAA-rated sovereigns. All of which, in plain English means that the EFSF will run into its own lending limits quicker if Ireland were to go into borrowing from it. Much quicker than a simple level of our borrowing would suggest.

Now, any sovereign with an once of sense now will know that a race to tap EFSF is on. The faster you get to it to borrow from it, the more likely you’ll arrive to the borrowing window before the limits are reached. Portugal, Spain and possibly even Italy are in the race.

This is why the markets have never been easy about the entire EFSF – they know that Ireland tapping into EFSF simply does two things:

1. It delays the inevitable restructuring of the massive debts accumulated on the Irish economy side – either sovereign or banks or households or any two or all three. EFSF does not remove the need for such a restructuring. It simply delays it.
2. It signifies an exponential increase in the probability of EFSF acting as a conduit for contagion from the PIIGS to the rest of the Euro area.
   

Economics 9/10/10: Bond market comparatives

Another day, two tables courtesy of CMA ... Greece improves, Ireland... well:
CPD refers to the priced probability of default. 40.83% for Ireland within 5 years on 40% loss at recovery.

Economics 8/10/10: We are not Ireland

I just had to reproduce this statement in full (hat tip to Brian Lucey)... the link to the source is here.

LONDON, Nov 8 (Reuters) - Greek Finance Minister George Papaconstantinou on Monday argued that his country was not suffering the same banking problems as Ireland. Speaking in London he also said that he expected the country's deficit would be 5.5 percentage points lower by the end of the year. "Greece is not Ireland, it doesn't have banking stability problems," he said in a speech.


Well, I'd say Minister Lenihan could have said 'We are not Greece, we don't have a liquidity crisis... yet'... but then he won't be really far from his usual rhetorical corner. For another Reuters story tonight showed that we are heading for a possible liquidity crunch:

"LONDON, Nov 8 (Reuters) - A widening in bid/offer spreads on Irish and Portuguese sovereign bonds this month is possibly an even bigger worry than the rising premium these bonds offer over German Bunds or widening credit default spreads.

Liquidity is the grease in the wheels of financial markets and if there is a reduction in liquidity then this will show up in the way prices move and in bid/offer spreads.

While the bid/offer spread on the Irish 10-year cash bond is not as wide as it was before the European Central Bank said in May it was prepared to buy government bonds in the secondary market, it has definitely broken higher.

Since the ECB's May announcement, the bid/offer spread had largely stayed below 30 basis points. However, it has now widened to 40 basis points.

Ignoring such price action in its early stages can be risky since it could lead to a vicious spiral. This is what happened with Greek debt in March when a widening in bid/offer spreads was ignored, leading to a significant deterioration in the supply/demand dynamics.

Those holding long positions became increasingly keen to dump their holdings while those who might have potentially taken on new long positions refrained for fear of catching the proverbial falling knife.

What has been of concern over the last few sessions is that the widening in bid/offer spreads has also started to shift to the medium- to short-end of the yield curve.

There has even been an acceleration in the widening in the bid/offer spreads for two-year and five-year Irish sovereign debt.

This widening has continued even though the latest data shows the European Central Bank resumed its government bond buying programme after a three-week pause.

That suggests the ECB needs to step up its intervention beyond the 711 million euros it spent last week if it is to meet its aim of ensuring "depth and liquidity in those market segments which are dysfunctional".

Unless there is a marked escalation in the ECB's bond purchases, contagion-related risks suggest the potential for a further widening in Spanish yield spreads against Bunds. Against this backdrop, investors might prefer to focus on the relative value trade of a widening in the 10-year Spain/Italy yield spread."

Ouch!

Economics 7/11/10: Irish competitiveness - myths and facts

As of late, the official Ireland - from the Central Bank to the Minister for Finance, to a host of 'attached' economics experts have been drumming up the tale of our rapidly improving competitiveness. In fact, in his speech this week, Minister Lenihan once again referred to the topic, saying:

"Price and earnings data confirm that significant competitiveness adjustments have taken place since 2008." The press release to accompany DofF latest efforts to predict the near term future also stated that "Further details on the nature of the adjustment for 2011 and the distribution and composition of the measures over the remaining years of the forecast period will be announced in the Four-Year Plan. In addition the Plan will outline a programme of structural reform, which will help to further restore competitiveness and support economic growth."

All of these alleged 'competitiveness gains' are routinely attributed to the heroic efforts of the Government.

But:

• Are these claims true? Did our competitiveness increase significantly over the recent months?
• Have increases in Irish competitiveness been exceptional (as would be consistent with Government claims to credit) compared to our peers in the EU?

Here are some facts. Source for data below is the European Central bank. Keep in that in all charts, higher numbers imply lower competitiveness.

First chart shows two alternative metrics for harmonized competitiveness indicators for Ireland. The first metric is deflated by GDP, showing much higher degree of competitiveness than the second metric - deflated by the unit labour cost.
So per chart above, our competitiveness has been underpinned by the direct outcome of recession (GDP effects) and less by the labour costs relative to labour productivity (allegedly - a policy target). Table below details some of the less than pleasant dynamics in the two series:
To summarize the above data: our competitiveness gains so far -

• In the last 12 months through Q2 2010 our competitiveness gains were, in absolute terms ranging between 5.96% and 7.4% with GDP effects outweighing labour costs effects by ca 25%
• In the last 24 months the same gains were more impressive - 12.03% to 12.68%
• But over the crisis years in total these gains were five times higher for GDP effects than for labour competitiveness gains: 11.41% (not all too great to begin with) and just 2.67% - a tiny number barely noticeable on the charts
• Per averages, since 2000 on we had pretty poor record of competitiveness overall and year to date performance is pretty much a disaster.

In my opinion, the claim of 'gains in competitiveness' is about as true as a 'glass half-full' claim. The gains are there, but they are small by historical standards and we are only back to Q1 2007 levels of labour competitiveness, after experiencing a wholesale destruction of this economy during this crisis.

Ok, enough of the absolute numbers, let's compare ourselves to our EU peers. All comparisons are based on unit labour cost HCIs.

First, all countries together:
All's clear in this picture -

• We are the least competitive country in the union.
  
• And were such since Q3 2005.
• All countries experienced improvement in their competitiveness during the crisis
• Many countries have experienced as fast of an adjustment in competitiveness as Ireland, while experiencing far slower wages deflation than us. In other words, it appears that in many other countries productivity of the workforce was growing faster than it was in Ireland during this crisis.

Let's look at the least healthy countries in Europe - the PIGS (Italy will be treated separately, as it is a large economy):
Same story as with the total EU group. Ireland is far from catching up with any of the countries in the group in terms of labour competitiveness.

Of course, what matters is how we do compared to our immediate trade and investment peers - the small open economies of Europe. Chart below illustrates:
No reason to comment on the above - the picture says it all.
The really sad thing is - we are not even competitive compared to the larger, less mobile, EU states. Embarassingly, Italy and Spain are beating us. I am not sure if their Governments brag about 'great sacrifices that lead to improved competitiveness', but given the figures above - they should.

Chart above relates relative competitiveness in Ireland to the EU16 as a whole. Again, the chart is self-explanatory, but couple of points worth mentioning:

• In the last year, our gains in competitiveness have been on average almost exactly identical to those in the EU16
• The above is also true for the last 3 years

Summarizing in a table:Should I say it? Well, the figures above show that

1. Irish gains in competitiveness during this crisis have been rather smaller than asserted; and
2. Irish Government hardly had much to do with these gains, as the gains were pretty much matched by changes across other EU countries, so unless Messrs Lenihan and Cowen have some secret effect on EU16, it's hard to single out Ireland as a 'uniquely' competitiveness improving land of promise.
   

Economics 6/11/10: Is Modern Academia Failing?

A very interesting paper titled "Withering Academia?" by Bruno S. Frey was published by CESIFO Working Paper 3209, October 2010 (download here).

From the abstract: "Strong forces lead to a withering of academia as it exists today. The major causal forces are:

• the rankings mania,
  
• increased division of labor in research,
  
• intense publication pressure,
• academic fraud,
  
• dilution of the concept of “university,” and
  
• inadequate organizational forms for modern research.

Academia, in a broader sense understood as “the locus of seeking truth and learning through methodological inquiry,” will subsist in different forms. The conclusion is therefore pessimistic with respect to the academic system as it presently exists but not to scholarly endeavour as such. However, the transformation predicted is expected to be fundamental."

This some pretty strong stuff.

"Today, in many disciplines, the importance of a scientific idea and the position of a scholar are defined by rankings. What matters nowadays is the recognition produced by a general rankings system, normally based only on the quantity of scientific output, irrespective of quality. If quality is considered, this is done by counting the number of citations. Rankings provide simple measures of relative position in science... Dependence on rankings has been substituted for consideration of content."

"The scientific production process has increasingly been divided into neatly separated steps. ...The division of labor has led to a more efficient and rapid output of scientific results but favors partial views and discourages comprehensive considerations." Interestingly, Frey refers here to the tendency to co-author papers, not to the more worrying (from my point of view) reduction in researchers' ability to think across disciplines and deeper into broader subjects.

"The incentives to publish are not necessarily the ideal ones to gain valuable new knowledge." The need to publish as much and as well as possible may influence the choice of:

• Subjects studied
• Methods used
• Type of collaboration
• Presentation of the results
• "Extent scholars are ready to engage in “academic prostitution,” that is, to revise their paper according to the “suggestions” of the referees even if they know that they are questionable or even plainly wrong (see Frey 2003)."
  

"The stronger the publication pressure, the stronger are these deviations from how scholars
are ideally assumed to behave (Anderson et al. 2007). Overall, such practices undermine
the claim of academia to pursue true knowledge."

We've recently seen a massive scale exposure of these outcomes of research pressures in the case of environmental science publications. But Frey's arguments are much stronger than that - they are systemic in nature.

"It can be predicted that academic misconduct and fraud have increased over recent
decades. The major reason is not that scholars are less moral then they used to be. Instead, the incentives to cheat have greatly increased due to higher stress in academia." Frey offers an excellent, iconclastic outlook on the drivers and methods used in fradulent 'research' - well worth reading.

Frey also deals with the issue of grade inflation and courses overproliferation that can lead to reduced standards of teaching, research and general public good inquiry. "The high reputation of a university is a public good shared by all professors and students, but it is undermined by having too many students of lower quality."

In my view - this is an excellent paper that is worth reading for anyone concerned with the nature of learning and discovery as well as broader concept of academia in our modern society. It is strongly polemical, provocative and certainly deserves a deeper debate.

But let me add to Frey's concerns - based on personal experieince - modern academia, in pursuit of quantitive (teaching & research) targets has lost much of its real societal relevance. Vast majority of senior faculty members are withdrawn from broader social and scientific debate, residing in their own isolated towers of specialist knowledge. This problem is most acute in social sciences, where the unwritten and often unspoken rules for younger faculty are:

• Don't engage in political, social and economic policy debates outside academic research,
• Don't engage with broader community outside the walls of academia.

As a young academic, I was told on numerous occasions that writing in press is 'below academic standards', that speaking at non-academic conferences 'doesn't earn one any credit within the University walls', that 'peers don't look kindly on those who disagree with their philosophies in public', etc. The victim in all of this will be the entire academia, which is at a risk of ceasing to be “the locus of seeking truth" risks becoming a Faculty of Useless Knowledge, irrelevant to the society.

Economics 6/11/10: Regulation in Financial Services Sector

This an unedited version of my column in the current issue of Business & Finance magazine.

The New Regulatory Normal: banking and financial services future

The latest poll of public opinion on the issues of domestic and cross-border competition, released in late October, has found that citizens across the EU identified energy (44%), the pharmaceutical products (25%) and telecommunication (21%) as the main sectors where they perceive lack of competition to remain a major problem. Irony has it, banking and financial services (18% concerned) came out closer to the bottom of the list in terms of perceived competition deficit.

Even though more than a quarter of Greek (31%), Irish (28%) and British (27%) residents said that, based on their own experiences, a lack of competition was causing problems for consumers in the financial services sector, these proportions are still below those for other sectors. For example 30% of Irish respondents are concerned with lack of competition in transport sector, and 41% in pharmaceutical sector.

This is despite the fact that across the EU, and indeed the entire developed world, banks are being supported directly (via taxpayers’ financed measures) and indirectly (via the Central Banks supply of liquidity) to the extent well in excess of the combined subsidies delivered to all of the aforementioned sectors of concern. Writedowns of banks assets remain a top priority for policymakers and the adverse newsflow from the sector is abating extremely slowly (chart below).

Total asset write downs by category, October 2009–April 2010
$ billions, Revisions to estimates
Source: IMF GFSR database, 2010

In addition, banks and financial services companies are facing a tsunami of regulatory reforms, which dominate the newsflow and will likely result in more restricted competition and lending in the sector in years ahead.

Banks and financial services companies across the EU play by far much more dominant role in financing economic activity of firms and households than they do elsewhere in the world, as was highlighted in the latest Global Financial Stability Report from the IMF. In contrast with consumers, business leaders worldwide perceive the financial services to be the current hot spot for adverse pressures on the economy. Banks and financial services providers are expected to be more significantly impacted by the uncertainty induced by the policymakers responses to the crisis. For example, Global CEO Study, 2010 conducted by the Institute for Business Value, IBM shows that a large number of CEOs worldwide expect the Banking and Financial Services sector to be subject to greater structural change and volatility over time than the public sector, despite the fact that public sector itself is experiencing unprecedented debt and deficit pressures.

So the latest public opinion polls seem to be at odds with the reality of the potential crisis-and reforms-induced distortions to competition in the banking sector.

This is an unfortunate oversight, for today, more than ever before financial services need a serious debate about the role for and the future direction of regulatory and supervisory regimes in the sector.

Regulatory structures in the traditional banking and financial services sector have failed to keep up with the increasing complexity, demand for services and interdependence of products and service providers. At the heart of the current crisis, by all accounts, were the imbedded conflicts of interest and outdated regulatory regimes.

For example, the overreliance on prescriptive regulation, an approach that is now being promoted as the panacea to the future crises, is itself partially to be blamed for the meltdown in the rated instruments. Per IBM research paper “The yin yang of financial reform: Embracing maxims to enable financial stability and healthy financial innovation”, when regulations mandated that institutions use of the credit rating agencies to assess risks inherent in MBSs and CDOs, “internal credit research essentially died. Had institutions done their own credit analyses, perhaps the ultimate outcome would have been different or, at the very least, less severe.”

This points to a major potential pitfall in the ongoing process of increasing regulatory systems reliance on prescriptive rules as a protection against future crises.

Since the Lehman collapse, governments in the US and Europe have been addressing the imbalances in their national financial systems by passing both structural and operational reforms. These focus on size, scope, societal costs and “too big to fail” institutions (i.e., cross-firm reforms). Operational reforms, typically implemented by regulators or multilateral international organizations, focus on capital, liquidity, incentives and taxation (i.e., what firms need to do within their own organizations).

As our research at the IBM’s Global Centre for Economic Development (GCED) highlights, on a nutshell, the direction of reforms adopted by the US and EU legislators to-date can be described by a stylized formula measuring the returns on equity (ROE) in the banking sector. So far, new regulatory regimes being introduced imply that in the future banking sector will see “Lower R + Higher E = Lower ROE”. This is a structural threat to the viability of the sector, and many new regulations coming on-line globally are the main culprit.

From the international Basel III framework to the Dodd-Frank Act in the US, increased quality and quantity of capital reserves on the financial services companies is likely to drive down global credit supply both in the short term (as banks engage in rebuilding their balancesheets) and in the long run (as financial services providers compete for a severely reduced capital pool).Per Josef Ackermann, the Deutsche Bank CEO, “There can be no doubt that [Basel III] will produce a drag on economic recovery.”

This statement relates to the core headlines coming out of Basel III and to the auxiliary parts of the framework. Specifically, higher capital reserves under Basel III, increasing common equity capital to 4.5% of risk-weighted assets by 2015 and to 7% by 2019, are expected to cost global economy some 3.1% of overall worldwide income over 2011-2015, implying a loss of almost 10 million jobs worldwide.

Ratio of capital to risk weighted assets held on balance sheet
% of Assets
Source: World Bank Financial Stability Indicators

In addition to the cost of rising capital reserves, Basel reforms include the idea of imposing a tax on the systemically important (aka larger) institutions, known as SIFIs. In addition to amounting to a tax on consumers (especially in the markets where a small number of larger banks controls the market for services, such as the Euro zone), such a charge will not address the issues of product (rather than institutions) specific risks.

Finally, Basel III introduction of the new liquidity and funding rules offers another example of a potentially market-restricting intervention that can end up costing the sector dearly, while producing little real benefit in alleviating systemic risks. The idea behind these measures is to ensure that financial institutions hold sufficient liquid reserves buffers to withstand a bank run, as well as to reduce the banks over-reliance (especially in Europe) on short-term wholesale funding. At the very best, these measures will lead to a significant cut in the banks’ ability to generate credit in the future.

At the same time, it is highly doubtful that any level and quality of reserves can ever guarantee a sufficient insurance against significant asset busts or even large liquidity events. Past history, as for example, analysed by a recent research paper from the University of Pennsylvania, clearly shows that regulatory tightening following previous episodes of major financial markets corrections had inevitably failed to prevent or even to significantly alleviate future financial busts. Instead, every episode of deep markets corrections was followed by severe tightening of financial regulation, prompting lenders to increase their reliance on more complex financial products. The levels of reserves never once were found sufficient to cover the sector.

More specific potential adverse effects of Basel III and Dodd-Frank Wall Street Reform and Consumer Protection Act changes relate to all three core sides of financial services business models: the trading side, the capital side and the funding side. On the trading side, increased capital reserves will likely constrain trading exposures, and cover for securitization and counterparties. The positive here will be a shift from narrowly traded derivatives to exchange-traded and centrally cleared derivatives. The net effect, however, will be smaller new products base in the sector and tighter margins, leading to a pressure on the returns.

Another study, titled “Global financial services: a New Regulatory Normal” prepared by the GCED identified a series of other potential risks in the latest regulatory reforms processes worldwide. In addition to the main headlines on capital side of the reforms outlined earlier, ongoing regulatory changes imply introduction of pro-cyclical capital bases, tighter restriction of capital allowances to paid up capital and retained earnings, elimination of hybrid products from capital base, as well as deferred taxes and intangibles. Restriction of minority equity and leverage ratios alongside with aforementioned capital rules changes will also likely lead to higher cost of banks capital and origination bases, implying restricted lending and associated jobs and income losses in the real economy. Lastly, stressed liability-linked liquidity provisions and efforts to reduce maturity mismatch via reduced reliance on short-term funding will further depress lending.

All of this suggests that going forward, banking sector in Europe and the US will face significant difficulties in generating new lending. In line with this, financial services growth is likely to shift away from traditional banking and brokerage, and toward less regulated and liquidity-rich sovereign wealth players and alternative lenders and investors.

This, in turn, will have profound effects on economic development, as the aforementioned GCED research highlights. In addition to tighter credit markets for companies and households, new rules are likely to lead to significant increases in costs and access barriers to capital for long term assets, such as infrastructure and plant investment. This development can also amplify, not reduce, the links between the exchequers and the banks. As banks will play an increasingly important role as the holders of public debt and as the source of tax revenue, current liquidity traps will be deepened. Liquidity supply and velocity of money will be reduced and M2 and broader money supply metrics will continue to lag liquidity injections from the central banks.

The resulting risk of closer political and economic integration between the financial services providers and the states can create simultaneously a new layer of inefficiency in financing of economic growth. It can also amplify shared risks, setting up the next crisis, this time around – with potential for a full contagion from the financial services to the sovereigns.

In the light of these regulatory changes and the convergence of regulatory regimes, banking and other financial services institutions face the need to provide sufficient internal buffers against the rising regulatory risk. These buffers require service providers to:

1. Rethink their business models to simplify operations and enhance ability to deal with systems and models complexity
2. Rebuild their balance sheet and focus on the new capital and leverage requirements
3. Actively pursue opportunities for mergers and divestitures
4. Improve their understanding of clients’ behaviors and preferences
5. Reconnect with their clients by investing in client analytics to gain insights
6. Provide clients with more and more complex and better responding services and data
   

In short, addressing business challenges presented by the ongoing processes of regulatory reforms worldwide, the banking and financial services sector will have to get much smarter in structuring future strategies for growth and operational processes.

Economics 6/11/10: Private sector response to DofF estimates

Yesterday’s morning note from Eurointelligence.com – a politically neutral economics site read: “A really bad day for European peripheral bond markets, as market participants realise that the Irish recovery plan is a pile of baloney, based on wishful thinking and unrealistic forecasts (which are shocking also believed by private sector forecasters in Ireland). The assumption is essentially that the crisis has no real GDP effect. This is the Irish government’s official forecast for the growth, inflation and unemployment for the next four years, contained in the Irish budget plan."

Summary here:

Their analysis is illustrated by a chart from Calculated Risk showing scary dynamics:


But the ‘happy-to-parrot DofF’ quasi-official analysts of IRL Inc took a different view of the numbers. So was Eurointelligence right in being sarcastic about ‘private sector forecasters’ misfiring in their enthusiasm for DofF numbers?

Per one ‘research note’ Irish deficit problems are attributable, at least this year, to things like ‘decrease in GDP’ (apparently, something no one could have foreseen). And palatable comparisons are being made between the UK adjustments planned ahead (less than 6% of GDP over next 5 years) and Irish adjustments envisioned by DofF (9.5% of GDP through 2014), without actually bothering to check what’s happening between Euro and Sterling lately, or possibly worse – without understanding the relationship between currency value and deficits.

One of our most cheerleading ‘analysts’ remarked that markets “may take some consolation from the depth of next year's adjustment, which is at the high end of expectations” obviously confusing their own sales pitch to the clients with the market view. Markets promptly corrected this by bidding up our bond yields.

Defending DofF ‘forecasts’ was done on a reference to a single figure that almost matches this broker’s view and a claim that we can’t really tell much about their realism because there isn’t enough detail provided by DofF. It sounds like an argument that famines are caused by the lack of food. The entire point of the DofF 'forecasts' was to provide certainty. The fact that the Department failed to do so escaped the broker.

Funny thing – the same broker lauded the details provided on interest payments from the recapitalization promissory notes. “The general government balance will reflect no promissory interest charge until 2013, when the charge will be €1.75bn for two years, reducing thereafter. Alleviating uncertainty around these charges is a positive but also reinforces the reality of a challenging fiscal situation.” Alleviating uncertainty? Did anyone notice the fact that DofF is projecting forward 4.7% interest rate – the average for 2009 – despite the fact that the entire universe expects ECB rates to rise by 2013? You’d expect the brokers to understand that no yield curve in this world remains flat for 5 years. Then again, may be this is not something our official ‘economists’ are aware of.

Another broker produced an equally priceless analysis: “The revised forecast [of 1.75% real growth next year] is below the median projection of 2.0% growth in the latest Reuters monthly Irish economists’ poll.” Oh, mighty, that wouldn’t be the same economists’ poll that missed the Great Recession and predicted soft landing for the property markets, failed to detect the beginning of collapse in Exchequer revenues and spot a market crash. Oh, and just in case you still doubt the powers of the Reuters ‘Irish economists’ poll’ – the poll covers only the 'economists' who thought Irish banks shares back in 2007 were not overvalued and Anglo was a great little bank besieged by bad short-sellers…

About the only research note on Irish Government announcement that didn’t cause a severe tooth-ache like reaction when I read them was NCB’s note.

The prize for the least readable (and least informative) commentary goes to Goodbody’s note, which spots a host of typos, grammatical errors, confusion and absolutely ludicrous assertions that “recent bond market jitters have been caused by factors outside of Ireland’s control, namely the fear that some European nations are considering a mechanism for restructuring of euro-area member’s sovereign debt at some stage in the future.” I mean what can you make of an ‘economics’ analysis that claims that ‘factors outside’ country control can override the fact that we have 32% deficit this year?! To me, it looks like a worldview which would miss a nuclear blast for a match strike.

Economics 6/11/10: Two charts - IRL & Spain

Two interesting charts on 5 year bonds for Ireland and Spain, courtesy of CMA:
What's clear from these charts is the extent of inter-links between banks and sovereign credit default swaps. In Spain at least three core banks - La Caixa, BBVA and Banco Santander act as relative diversifiers away from the sovereign risk since late October. In Ireland - all of the banks carry higher risk than sovereign. Another interesting feature is a significant counter-move in the Anglo CDS since late September. This, undoubtedly underpinned by the large-scale bonds redemption undertaken by Anglo at the end of September. Thirdly, an interesting feature of the Irish data is that CDS contracts on Anglo, IL&P and AIB are now trading at virtually identical implied probability of default.

Lastly, Irish sovereign debt is now trading at probability of default higher than that of the Spanish banks!

Economics 4/11/10: Early DofF Estimates for Budget 2011

DofF has published some preliminary projections for Budget 2011 tonight, titled "Information Note
on the Economic and Budgetary Outlook 2011 – 2014 (in advance of the publication of the Government’s Four-Year Budgetary Plan)". Catchy, isn't it?

Here's my high-level read through:

1) pages 2-3 (note DofF couldn't even number actual pages in the document) present some rosy scenarios concerning growth. Most notably, DofF doesn't seem to think that Dollar is going to devalue against the Euro significantly in 2011. As if QE2 will have no effect or will be offset, under DofF expectations by a QETrichet. This is non-trivial, of course. Price of oil is expected to rise by 10.4% over 2011, but dollar will devalue by just 3.7% and sterling by 2.3%. Absent robust demand growth (per DofF-mentioned global slowdown) what would drive oil up at a rate more than 4 times dollar devaluation? This is non-trivial - any devaluation of sterling and dollar will impact adversely our exports and will increase our imports bills, chipping at GDP and GNP from both ends.

2) "in overall terms, real GDP is projected to increase by 1¾% next year (GNP by 1%). This takes account of budgetary adjustments amounting to €6 billion, which are estimated to reduce the rate of growth by somewhere in the region of 1½ - 2 percentage points. Nominal GDP is set to grow by 2.5% in 2011, implying a GDP price deflator of ¾%." Errr... ok, I can buy into low inflation, but... folks - DofF is talking tough budget. which will mean inflation on state-controlled sectors is going to be rampant. To keep total inflation at just 0.75%, you have to get either a strong revaluation of the euro (ain't there, as we've seen in (1)) or a strong deflation in the private sectors (possible, but if so, what would that do to Exchequer returns and to domestic activity? Interestingly, DofF refer to HICP, not CPI when they talk about moderate inflation of 3/4%. Of course, they wouldn't dare touch upon the prospects of our banks skinning their customers (err... also shareholders, rescuers etc) with mortgage costs hikes.

3) Now, consider that 1.75% growth in real GDP and 1% growth in GNP. Where, exactly will this come from? IMF projection for WEO October 2010 (before Government latest adjustment in deficit announcement) factored in 2.277% growth in constant prices GDP for 2011. DoF says that the reduction in Government consumption will amount to 1.2-2% point in the rate of growth. This is, I assume, before factoring in second order effects of higher taxation measures - just a brutal cut. So IMF, less DofF estimate leads to growth rate of 0.227-1.077%, which is less than what DofF assumes. Of course, that range - with a mid-point of 0.652% still does not capture the adverse effects of increased taxes and other charges, which - if we are to take €6bn headline figure for deficit reductions, applying 1.2-2% of GDP net adjustment on expected Government consumption side and factoring in stabilizers of 20% implies that DofF is aiming to get well in excess of €1.9-3bn in new revenues in 2011. Of these, maximum of €1.1-1.2 billion can be expected to arise from DofF forecast growth, leaving €0.8-1.9bn to be raised from tax increases and other charges. Apart from being optimistic, it does look to me like DofF didn't factor the effects of this into their growth projections.

4) About the only realistic assumption that DofF makes is that investment will contract by far less next year than in 2010. The reason is simple - stuff is going to start falling apart in private sector, so companies will have to replace some of the capital stock sooner or later. I can tell from here whether investment will fall 6% (as DofF assume) or 10%, but I doubt there is much upside from DofF assumption. The problem is that if you expect investment goods decline to be reversed on plant and machinery side (continuing to allow for investment to fall further on housing and construction sides) you are going to get an increase in imports, as we import much of equipment we use. So I suspect imports are going to rise more than 2.75% that DofF factored into their estimates.

5) I also think DofF are too optimistic on the employment contraction side. The Department assumes -0.25% change in overall employment levels in the Republic. I would say that several longer term trends are going to push this deeper into the red: pharma sector restructuring, continued shutting down of MNCs-led manufacturing, declines in public contracts etc.

6) All of the above is crucial, as per Table 3 we can see that even with the €6bn taken out, 2011 Exchequer balance will be exactly the same as in 2010: €19.25bn deficit in cash terms. In other words, folks - of the total €6bn in cuts almost €3.1bn will go to cover... errr... you've guessed it - BANKS! another €1.25bn to cover interest on the BANKS rescue notes (net under Non-voted expenditure). More bizarre, unless you understand our Government's logic, which escapes me - our Current Expenditure will not fall next year at all. Instead it will rise from €47.25bn in 2010 to €49.75bn in 2011, while Current Revenue will fall by €500mln, leaving our Current Budget Balance at -€16.25bn - deeper than -€13.5bn achieved this year. Under this arithmetic, the only way this Government can claim that it will be on any track in the general direction of 3% deficit by 2014 is by building in some mighty optimistic assumptions on growth side, plus projecting no further demands for funding from the banks.

7) Now, let me touch upon the last part of the concluding sentence in (6) above. Oh, boy. The Government, therefore is reliant on €31bn in promisory notes to cover the entire rescue of the banking sector. Yet, not reflected in any of DofF estimates, AIB's latest failure to raise requisite capital is likely to cost this Government additional €2bn on top of already promised funds. Toss into the mix expected losses for 2011-2012 on all banks balancesheets, and you get pretty quickly into high figures. Let's suppose that the whole banking sector will cost the state ca €60bn (this is well below my estimate of 67-70bn, Peter Mathews' estimate of 66.5bn, etc). The state will be on the hook for some €29bn more in 'promisory' notes. Suppose none are redeemed and no new borrowing against them takes place. The gross cost per annum of these notes will be roughly at least what DofF estimated for €31bn or €150mln in 2011, while the borrowing requirement for the state will have to go up by €2.9billion annually (if structured as previous promisory notes).

Overall, I have significant doubts that the numbers presented in these early estimates will survive the test of reality. However, the Department of Finance seemed to have gotten slightly more realistic in these estimates, when compared to the stuff produced a year ago. It remains to be seen if the learning curve is steep enough to get them to reach full realism by the Budget 2011 day.