Contagion – Definition by Worldbank
The World Bank has a fairly comprehensive overview over different definitions of contagion and documents related to recent contagious events in the financial markets.
Some excerpts:
Topics of this post: contagion, definition, General, world bank
- Broad Definition: Contagion is the cross-country transmission of shocks or the general cross-country spillover effects.
- Restrictive Definition: Contagion is the transmission of shocks to other countries or the cross-country correlation, beyond any fundamental link among the countries and beyond common shocks. This definition is usually referred as excess co-movement, commonly explained by herding behavior.
- Very Restrictive Definition: Contagion occurs when cross-country correlations increase during “crisis times” relative to correlations during “tranquil times.”
- Fundamental Links Among Countries:
- Financial links exist when two economies are connected through the international financial system through portfolio investment.
- Real links are the fundamental economic relationship among economies through trade and foreign direct investment (more papers here).
- Political links are the political relationships among countries because of “clubs of countries” with similar exchange rate arrangements (more papers here.
- Herding Behavior: Asymmetric information makes markets move jointly. Herding may be rational for a private investor due to transaction costs when gathering information. On the public level, contagion can cause market excuberance, balance of payments and banking crises (more papers here).
- Papers on Policy Options
See also
Contagion – Definition by Calomiris
In his article on Global Financial Architecture, Charles Calomiris defines “Contagion”:
Topics of this post: charles calomiris, contagion, definition, DiscussionsCorrelations in asset returns are much higher across emerging market countries during crises than at other times, and even government bond yields move together to an unusual degree during financial crises. There are several explanations for this “contagion.”
- One is irrationality on the part of investors.
- A second is rational portfolio rebalancing by international investors; if portfolio investors (like banks) target a given default risk on the debt they issue, then they will endogenously shrink asset risk in one country in response to capital losses or exogenous increases in asset risk in another country.
- A third explanation revolves around linkages in international trade that can transmit economic decline, which is then reflected in asset prices.
- A fourth explanation revolves around multiple equilibria (either through changes in speculators views about the probability of bad equilibria, or through reductions in central bank liquidity following a global flight to quality).
See also
Hedge Funds and Benfords Law
Glyn Holton wrote an article about how to detect fraud in the reports by Hedge Funds: using Benford’s Law.
Benford’s law, also called the first-digit law, states that in lists of numbers from many real-life sources of data, the leading digit is 1 almost one third of the time, and larger numbers occur as the leading digit with less and less frequency as they grow in magnitude, to the point that 9 is the first digit less than one time in twenty. This is based on the observation that real-world measurements are generally distributed logarithmically, thus the logarithm of a set of real-world measurements is generally distributed uniformly.Source: Wikipedia
This characteristic of Benford’s Law can be used to detect fraud, writes Holton. He cites a paper by Nicolas Bollen and Veronika Pool Source: Bollen, Nicolas P.B. and Pool, Veronika Krepely, “Conditional Return Smoothing in the Hedge Fund Industry“. Journal of Financial and Quantitative Analysis.
The authors used statistical analysis to examine the financial reports of Hedge Funds for manipulation. More specifically, they look at reports of Hedge Funds with returns falling close to zero.
Glyn Holton writes:
It indicates the distribution of hedge funds’ returns that happen to fall near zero. The discontinuity Bollen and Pool found is pronounced, and it falls precisely at 0. Wow, isn’t that interesting! Anyone who analyzes data for a living knows there is something profoundly wrong with this distribution. The conclusion is inescapable. Hedge fund managers are inflating their returns to avoid reporting negative returns. The fact that they don’t do so in the months prior to an audit suggests they know what they are doing is wrong.
Holton writes that reports by Hedge Funds can be manipulated in three ways:
- Fraud
- Arbitrary Assumption of Asset Prices in Illiquid Markets
- Cherry-Picking from Brokers reporting higher prices
Pool and Bollen discuss some additional explanations of the statistical discontinuity, but also come to the conclusion that false reporting is the most likely explanation.
Topics of this post: financial regulation, General, glyn holton, hedge fund, Nicolas Bollen, Veronika PoolSee also
Pro-Cyclicality – Discussion of the problem and possible solutions
How to define pro-cyclicality
Procyclicality is used in the context of discussing the effects of Basel II on the financial system. A simplified definition of pro-cyclicality is:
International rules have encouraged banks to act more aggressively when the economic cycle is in the middle of an upswing, when some argue that is precisely when they should be putting money away for a rainy day. The global economy has become more volatile as a result. Source: Thisismoney.co.uk
Claudio Borio, Craig Furfine and Philip Lowe express the same statement in more sophisticated words:
Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors.
These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy.
In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
José Viñals, Director General International Affairs at the Banco de Espagna, reminds us that a certain procyclicality of the financial system is wanted, but excessive procyclicality can be a burden:
In the financial sphere, a certain degree of procyclicality is a natural, sensible and desirable outcome as it reflects the extent to which the financial sector is influenced by developments in the real economy and viceversa. The issue is nevertheless to what extent there is an excessive degree of procyclicality. The financial system is excessively procyclical when it unnecessarily amplifies swings in the real economy and/or reduces the stability and soundness of the financial sector. Source: José Viñals in “Procyclicality of the financial system and regulation“
Indicators of pro-cyclicality
According to Claudio Borio, Craig Furfine and Philip Lowe periods of growth are often associated with:
- significant increases in the ratio of credit to GDP
- large increases in equity and property prices
- decreasing bond spreads between corporate and government securities
- credit rating agencies failing to predict changes in the probability of crises
- unaltered bank provisions
- increasing bank profitability and increasing bank equity prices
Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
Causes of Pro-Cyclicality in the financial system
Nancy Masschelein, from the National Bank of Belgium, has listed various sources of pro-cyclicality. Source: Nancy Masschelein in “Monitoring pro-cyclicality under the capital requirements directive : preliminary concepts for developing a framework“
- Fluctuations in the quality of banks’ and borrowers’ balance sheets.An increase in bank profits during periods of growth supports the extension of credit, while decreasing bank profits due to defaulted loans reduce this extension of credit. At the same time, a recession causes declining profits, increases demand for new credit and increases the interest rates.Claudio Borio, Craig Furfine and Philip Lowe have labelled this the Incentive Explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
- Information asymmetries between borrowers and lenders.During periods of growth, the value of collateral rises and borrowers with riskier projects can find lending. Under recessions, due to the decreased value of collateral, even borrowers with very profitable projects will find it difficult to obtain funding. These cyclical effects are especially relevent for borrowers which are more prone to asymmetric information effects (such as SMEs).Claudio Borio, Craig Furfine and Philip Lowe call this explanation the Financial-accelerator-explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“.
- Inappropriate responses by participants in the financial system and lack of institutional memory.Euphoric expectations which arise from an investment boom driven by the business cycle or a disaster myopia which shows in a reduced subjective probability of a major shock if the last shock has already a few years past, is another source of excessive lending by banks during periods of growth.Allen N. Berger and Gregory F. Udell raise the problem of a lack of institutional memory. Source: Allen N. Berger and Gregory F. Udell in”The Institutional Memory Hypothesis and the Procyclicality of Bank Lending Behavior“
Under the institutional memory hypothesis, as time passes since the last “learning experience” with problem loans – the last time that the bank suffered a loan “bust” – loan officer skills decline.
Part of this decline in lender ability is attributable to a proportional increase in inexperienced lenders who have never had such a “learning experience.”
Part of the decline in lender ability is also due to the atrophying skills of experienced loan officers as time passes since they last addressed significant loan problems.
- New financial innovative instruments.The use of new financial instruments facilitated the spreading and the diversification of credit risks and increased the possibilities of hedging. In favourable circumstances, banks can easily transfer credit risk using innovative credit risk transfer (CRT) products, which could induce banks to increase lending as credit risk can be transferred.
Regulation and pro-cyclicality
The most important dimension of pro-cyclicality that is being adressed in the remaind of this article is regulation. Minimum capital requirements imposed by regulators to reduce systemic risk from collapse of systemically important financial intermediaries may force banks to reduce lending in an recession, increasing the above pro-cyclical mechanisms of the financial system.
George G. Pennacchi warned that Basel II increases the sensitivity of a bank’s capital requirement to the risk of its assets and creates incentives which make bank lending more procyclical.
During recessions, loan losses reduce bank capital and, even if capital requirements are insensitive to risk, a capital-deficient bank must increase its capital ratio. In addition, recessions tend to raise the default risk of loans, and Basel II’s more refined risk-based standards would further pressure banks to strengthen their capital ratios. This response of capital ratios to default risks can reduce banks’ incentives to lend during a recession and worsen economic activity. Thus, capital requirements as envisioned under Basel II increase macroeconomic instability.Source: George G. Pennacchi, Journal of Financial Intermediation “Risk-based capital standards, deposit insurance, and procyclicality“
Besides miminum capital requirements, there are other ways that regulation can increase pro-cyclicality. Philipp Turner has listed them and discussed their relevance. Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“
- Timing of tightening of capital rulesDuring and immediately after a financial crisis, policy-makers have large incentives to tighten bank regulation which further curtails bank lending. Turner says that this problem is not that revelant in practice, most countries allow a phase-in period for the tightening of prudential ratios or in dealing with generalised problems.
- Regulatory bias in favour of short-term lendingUnder Basel I, international interbank lending of up to one year maturity had a 20% risk-weight irrespective of country, but lending of more than one year to non-OECD countries carried a 100% risk weight which would make bank lending to emerging markets “too” short term. According to Turner, Data does not suggest that this effect is important, nevertheless Basel II adresses these ambivalent distinctions.
- Cyclicality of minimum capital ratiosThis will be discussed later in this article in relation to bank provision and IAS 39, but the general idea is that because of certain minimum capital rations banks will reduce lending to meet the required minimum capital rations, if they have not made sufficient provisions for losses.
- Cyclicality of capital ratios due to the use of external credit ratingThis will also be discussed later in relation to the impact of Basel II on risk management in banks, but the general idea is that an increased reliance on external credit rating in determining risk weights can lead to the necessity for increased capital ratios in times of recession.
Basel II, Credit Rating Agencies and Pro-Cyclicality
According to José Viñals the philosophy of modern monetary politics and approaches to financial stability incorporated in Basel II is quite similar:
- both are forward-looking in nature and have a medium-term horizon
- both have an anticipatory character that seeks prevention rather than cure
- both attempt to incorporate market views through the role played by expectations and market discipline.
He argues that Basel II reduces pro-cyclicality by improving banking supervision.
By contributing to a better assessment and management of risks, Basel II should reduce the scope for surprises and thus for procyclicality.Source: José Viñals in “Procyclicality of the financial system and regulation“
The influence of Basel II on the real economy would work along the following mechanism
Basel II would increase the risk-sensitiveness of minimum capital requirements which, in turn, would lead to higher cyclicality of the overall regulatory capital and to more procyclical capital. Consequently, this would be reflected onto more procyclical lending and onto a higher degree of procyclicality in the real economy.Source: José Viñals in “Procyclicality of the financial system and regulation“
The influence on Basel II on the real economy through capital requirements is the reliance on external credit assessment for calculating risk weights. Philip Turner states that under Basel I, risk weight for sovereign and corporate debt were based on OECD membership wich was not sufficiently responsive to risk. Basel II relies more on “credit assessment agencies”, so not only credit-rating agencies, but also export insurance agencies, credit registers, market data.
However, credit rating agencies are often more backward-looking rather than forward-looking, their assessments are strongly negatively correlated with the real effective exchange rates, even though depreciation in the wake of a crisis should not lead to a downgrade but to a recognition of medium-term strenght due to a more competitive exchange rate.Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“
Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos more specifically identify the choice of rating system as an important element in pro-cyclicality:
The proposed new Basel Accord, in contrast to the Current Accord, makes provision for time varying risk weights for individual loans. Although the Basel Committee will set fixed weights for loans with a given probability of borrower default, banks will choose the probability of default band into which a loan will be slotted.
It then becomes very important how the banks carry out this ‘slotting’. When banks assess a borrower’s probability of default the assessment can be based on current economic conditions (where the rating will be conditioned on the point in the cycle) or can take into account the effect on the borrower of a possible adverse change in the climate. [...] The new element under Basel II is the additional procyclicality which will come from the latter element. [...]
Strongly procyclical capital requirements could cause severe macro economic effects by creating credit crunches in recessions, thereby exacerbating the economic downturn. They could also encourage excessive lending in booms. An important policy issue is therefore whether banks would choose to adopt more stable ratings across the cycle, which would moderate the procyclical effects, or whether they would adopt ratings conditioned on the point in the cycle even though this could lead to an inability to meet demands for credit in a downturn.Source: Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos in “Procyclicality and the new Basel Accord–banks’ choice of loan rating system“
Procyclicality, bank provisions and IAS 39
In addition to the minimum capital requirements, the role of bank provision is important. Turner argues that the ideal response to procyclicality is for banks to make adequate provisions for possible loan losses. Often however, he says, tax laws limits the tax deductibility of precautionary provisioning because loan loss provisions increase internal funding for the bank only to the extent that they reduce taxes. Furthermore, securities authorities like the SEC have argued that precautionary provisioning distorts financial reports and may mislead investors. The building up of provisions may conflict with the demand for well-document accounting. Philipp Turner in “Procyclicality of Regulatory Ratios?“
More specificially, the introduction of International Accounting Standard 39 requiring fair-value accounting make bank provisions more pro-cyclical, as José Viñals discusses:
IAS39 adds to procyclicality in the financial system through the introduction of fair-value accounting. [...] There is also a serious risk that, if the new rules are interpreted too rigidly, they could discourage, complicate and even prevent the implementation of some solutions to the procyclicality problem such as forward-looking provisioning.
Consequently, IAS39 might not only exacerbate procyclicality but also make it more difficult for regulatory policy to deal with procyclicality. In particular, Basel II is mainly about capital (to cover unexpected losses) and thus does not deal in depth with provisions (e.g. to cover expected losses, as in the case of forward-looking provisions). In turn, IAS39 contemplates only ‘incurred losses’ as far as provisions are concerned. Hence, under a rigid interpretation, IAS39 would not be compatible with a system of forward-looking provisions.
Solutions for Pro-Cyclicality
The problem of pro-cyclicality reflects a deeper problem of financial regulation. On the one hand, financial regulation for banks under Basel II was made more sensitive to the business cycle by relying on external credit assessment (in pillar 1 of Basel II) and fair-value-accounting (in pillar 3 of Basel II). The motivation behind these changes was to move away from the often arbitrary risk-weights assigned in Basel I. However, with more risk sensitivity of financial regulation, banks amplify the business cycles and contribute to systemic risk. In other word, the methods to avoid systemic risk are contributing to increase systemic risk.
There are a handful of proposals to change various aspects of Basel II. George G. Pennacchi, for example, suggests moving to a risk-based deposit insurance system which encourages less procyclicality of bank loans then risk-based capital ratios. In a policy brief from the FSA, the authors discuss between adjusting “Pillar 1″ or “Pillar 2″ approach to counter procyclicality. “Pillar 1″-approach would be the modification of rating methodologies for capital requirements, “Pillar 2″-approach would mean relying increasingly on procyclicality stress tests to increase, if necessary, regulatory capital. The authors argue that the “Pillar 2″-approach is politically more feasible while the “Pillar 1″-approach would make more sense.
Several authors call for a more comprehensive approach to tackle the problem. In a speech given by William R White, Economic Adviser and Head of Monetary and Economic Department of the Bank for International Settlements, advocates a “new macrofinancial stability framework” which encourages regulators and central banks to resist the pro-cyclicality of the financial system.
Such a system would pay attention to the impact of systemic shocks, a close cooperation between central bankers and regulators in assessing the build-up of systemic risks, and a countercyclical use of policy instruments. Monetary policy and regulation would push in the same direction: credit tightening in times of growth and credit expansion in recession would go together with a biased regulatory policy of risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being increased in good times and decreased in bad times. He proposes to alter the capital required for credit risk with a formula based on estimates of system-wide increases in exposure. The formula could make use of the rate of growth of aggregate credit and asset prices from longer-term trends.
White advocates a international agreement for such a framework and improving risk management procedures under Basel II. The biggest impediment against moving towards such an international agreement, assuming consensus on the causes of the crisis and availability of the appropriate tools, is the act to will. Policy makers face the bureaucratic inertia and vigorous lobbying (against reacting) from the many people being made rich by the crisis. Central bankers face the problem that counter-cyclical regulation and tightened credit could strangulate an economy more than necessary. Regulators face the problem of not having long cultural tradition of concern for macroprudential issues and not seeing the big-picture of macro-financial stability. White suggests to include an automatic response to the procyclical tendencies of the financial system. (See also Whites paper “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?” and the similar suggestions by Claudio Borio, Craig Furfine and Philip Lowe).
Conclusion
Business cycles are a necessary characteristic of an open economy. The fact that the financial systems moves along with the business cycle is a necessesary consequence of the fact that the actions of the financial system reflect the underlying changes in the real economy.
Regulators, central banks and policy-makers have a natural tendency to dampen the business cycle: through the use of fiscal, monetary and regulatory policy. To some extent it is however not possible to get rid of both things at the same time: financial instability and pro-cyclicality.
Financial stability rests on using the information about the state of risk provided by the market, but at the same time pro-cyclicality is increased by relying to heavily on the market for providing information about risk. Pro-cyclicality and financial stability are two sides of the same coin.
Topics of this post: basel II, bis, central banks, Claudio Borio, Craig Furfine, credit rating agencies, definition, Dimitrios P Tsomocos, Discussions, Eva Catarineu-Rabell, financial regulation, financial stability, fsa, George G. Pennacchi, ias, iasb, Jose Vinals, monetary policy, Nancy Masschelein, Patricia Jackson, Philip Lowe, Philip Turner, pro-cyclicality, regulators, subprime crisis, William R WhiteSee also
Concepts and Measurement of Risk – Article by Borio, Furfine, Lowe
Claudio Borio, Craig Furfine and Philip Lowe discuss concepts of risks in their article “Pro-cyclicality of the financial system and financial stability: issues and policy options“:
They distinguish several types of risk:
- expected and unexpected losses (in the statistical sense)
- “Expected losses” refer to the average or mean losses anticipated over a particular period
- “Unexpected losses” refer to a measure of the dispersion, or degree of uncertainty that surrounds that outcome
- relative and absolute risk
- Relative risk relates to the risk, in a cross section, of a particular financial instrument, portfolio or institution (“Bond A is riskier than Bond B”)
- Absolute risk relates to the specific value that the measure of risk takes at a particular point in time (“Portfolio X is more risky today than it was last year”)
- idiosyncratic and systematic risk
- Systematic risk is associated with the correlation between components of a financial system arising from exposures to common factors, such as specific industries or the business cycle.
- risk of individual portfolios and risk of the financial system as a whole.
According to the authors, measuring risk is difficult because it entails
- assessing the riskiness of each individual borrower
- assessing how the correlations between borrowers are changing
- assessing how the institutions collectively affect the health of the economy
- assessing how the health of the economy affects the collective health of individual institutions.
The authors also claim that systemic risk is often related to a common exogenous shock resulting from a change in the business/financial cycle:
Widespread financial system stress rarely arises from the contagion or domino effects associated with the failure of an individual institution owing to purely institution-specific factors. More often, financial system problems have their roots in financial institutions underestimating their exposure to a common factor, most notably the financial/business cycle in the economy as a whole.
Risk measurement in banks often falsely assesses the development of risk:
Many of the risk measurement methodologies used by banks, rating agencies and bank supervisors imply that risk falls during booms and periods of financial market stability and increases only during recessions and periods of financial turmoil. But it is better to think of risk as increasing in booms, not recessions, and that the increase in defaults in recessions simply reflects the materialisation of risk built up in the boom.
The business-cycle has an impact on the emergence of systemic risk, at least in the long-run:
Despite recent research suggesting that a number of financial variables are useful in predicting recessions, macroeconomic forecasters have a poor record in predicting the exact timing of recessions or turning points in the business cycle. Being able to predict the exact timing of a downturn is by no means necessary to design an appropriate response to it. Using longer horizons would help lessen some of the emphasis on short-term forecasting, and promote a more thorough analysis of financial vulnerabilities associated with business and financial cycles. This would promote better assessments of systematic risk.
The set of factors that can result in either misperceptions of risk are:
- Use of the “wrong” model of the economy to interpret developments
- Disaster myopia = tendency to underestimate the likelihood of high-loss low-probability
- Cognitive dissonance = tendency to interpret information in a biased way, so that it reinforces the prevailing belief entertained by the economic agent.23
The set of factors that can result in inappropriate responses to risk are:
- failure to internalise the consequences of the actions of others
- the impossibility of coordinating responses
- costs borne by other groups in society
- “herding behaviour” = agents conform their behaviour to that of their peers
- shortcomings in contractualarrangements stressing short-term performance
See also
Subprime Losses
This table summarizes the losses by banks and securities firms as a result of the subprime crisis. Source: Bloomberg. If you are faced with a question on how to rank the losses resulting of the subprime crisis (see video here, via Bayesian Heresy), you might want to have the right answer ready.
Bloomberg writes on the difference between writedown and credit loss:
Investment banks and the investment-banking units of financial conglomerates mark their assets to market values, whether they’re loans, securities or collateralized debt obligations, and label that a “writedown” when values decline. Commercial banks take charge-offs on loans that have defaulted and increase reserves for loans they expect to go bad, which they label “credit losses.” Commercial banks can have writedowns on holdings of bonds or CDOs as well.
| Firm | Writedown | Credit Loss | Total |
| UBS | 38 | 38 | |
| Merrill Lynch | 25.1 | 25.1 | |
| Citigroup | 21.4 | 2.5 | 23.9 |
| HSBC | 3 | 9.4 | 12.4 |
| Morgan Stanley | 11.7 | 11.7 | |
| IKB Deutsche | 9 | 9 | |
| Bank of America | 7.3 | 0.9 | 8.2 |
| Deutsche Bank | 7.4 | 7.4 | |
| Credit Agricole | 6.5 | 6.5 | |
| Credit Suisse | 6.3 | 6.3 | |
| Washington Mutual | 0.3 | 5.5 | 5.8 |
| JPMorgan Chase | 2.9 | 2.1 | 5 |
| Wachovia | 2.9 | 2 | 4.9 |
| Canadian Imperial (CIBC) | 4 | 4 | |
| Societe Generale | 3.8 | 3.8 | |
| Mizuho Financial Group | 3.4 | 3.4 | |
| Lehman Brothers | 3.3 | 3.3 | |
| Barclays | 3.2 | 3.2 | |
| Royal Bank of Scotland | 3.1 | 3.1 | |
| Goldman Sachs | 3 | 3 | |
| Dresdner | 2.7 | 2.7 | |
| Bear Stearns | 2.6 | 2.6 | |
| ABN Amro | 2.4 | 2.4 | |
| Fortis | 2.3 | 2.3 | |
| Natixis | 1.9 | 1.9 | |
| HSH Nordbank | 1.7 | 1.7 | |
| Wells Fargo | 0.3 | 1.4 | 1.7 |
| BNP Paribas | 1.3 | 0.3 | 1.6 |
| DZ Bank | 1.5 | 1.5 | |
| National City | 0.4 | 1 | 1.4 |
| Bank of China | 1.3 | 1.3 | |
| Bayerische Landesbank | 1.3 | 1.3 | |
| Caisse d‘Espagne | 1.3 | 1.3 | |
| LB Baden-Wuerttemberg | 1.3 | 1.3 | |
| Nomura Holdings | 1 | 1 | |
| Sumitomo Mitsui | 1 | 1 | |
| Gulf International | 1 | 1 | |
| European banks not listed above | 8.4 | 8.4 | |
| Asian banks not listed above | 4 | 0.7 | 4.7 |
| Canadian banks excluding CIBC | 2.4 | 0.1 | 2.5 |
| TOTALS | 206 | 25.8 | 231.8 |
- European banks whose losses are smaller than $1 billion each are in this group: ING Groep, Allied Irish Banks, Bradford & Bingley, Aareal Bank, Deutsche Postbank, Lloyds TSB Group, Standard Chartered, Northern Rock, HBOS, Dexia, WestLB, Commerzbank, NordLB, Rabobank, HVB Group, Sachsen LB, Intesa Sanpaolo.
- Asian banks with writedowns smaller than $1 billion: Mitsubishi UFJ, Shinsei, Sumitomo Trust, Aozora Bank, DBS Group, Australia & New Zealand Banking Group, Abu Dhabi Commercial, Bank Hapoalim, Arab Banking Corp., Fubon Financial, Industrial & Commercial Bank of China, Citic International, BOC Hong Kong, Bank of East Asia.
- Canadian banks included in this group: Bank of Montreal, National Bank of Canada, Bank of Nova Scotia, Royal Bank of Canada.
See also
Thoughts on transnational networks of private international bodies in the financial architecture
In most fields of regulation, even on the national level, organisation representing private interests or corporations have a saying. Private interestes are expressed through lobbyism and public relation activities, but the governance system in most states is characterized by representatives from the relevant industries having their say in standard-setting and standard-implementation.
It certainly makes sense to involve private bodies and the representatives of business when creating standards. The technical expertise of these bodies is valuable for ensuring that the goals of the regulation are feasible and achievable.
However, standards are not neutral, they not only provide a public good of a market framework which lowers transaction costs and deters fraudulent behaviour, they also serve those who are setting the standards. One interest of a private body could be to exclude competitors from gaining market share by obligating standards which these competitors can’t fulfill.
In the debate on the causes of the sub-prime crisis, media and academia are discussiong the incentives set by standards. They claim that Basel II has encouraged pro-cyclicality of Bank lending, or that reliance on Credit Rating Agencies in regulation has reduced the banks effort to conduct their own diligent risk management. The overall criticism is levered at governments, central banks and regulators for setting up the wrong system of financial regulation.
Attached to this criticism is the challenge that the current system of co-ordinating financial regulation is not working. Calls for a World Financial Architecture (see book by John Eatwell and others) are being heard.
However, it is often ignored that for standards to be functional, the private sector needs to be a consistent advocator of good standards. This should be reflected in a financial architecture which involves the private sectors in the crucial decisions on standard-setting, impact assessment, implementation and enforcement. Such an involvement is only possible if the private sector can give a coherent response to the demand for consultation coming from the public sector.
What is most striking is that the private sector does not speak with one voice. With ICMA, SIFMA and the IIF there are three private institutions speaking on behalf of the capital market. The G30, as a quasi corporative think-tank, ammends these views on serves as a coordinating body between highly influential individuals in the international financial institutions.
It would be interesting to have a closer look at this network of institutions and individuals:
- Which companies are members of which institution?
- Which individuals are members of which institution?
- Which companies and which individuals are key nodes in this network?
- Is there an overlap of tasks of the private institutions?
- Which formal and informal coordination groups exist between the bodies representing the views of the financial actors?
Would financial institutions disclose this kind of information?
Topics of this post: financial institutions, financial markets, financial regulation, Memo, subprime crisisSee also
Global Financial Architecture – Article by Charles W. Calomiris
Charles Calomiris article on a New Global Financial Architecture from October 1998 is an interesting document, outlining the criticism of the International Financial Institutions (IFIs).
He starts with an interesting claim:
Economics normally provides rather dismal news, emphasizing tradeoffs among objectives and hard choices. In the case of redesigning the global financial architecture, however, such is not the case. It is not difficult to construct a set of mechanisms that resolve problems of illiquidity (by providing a responsive lender of last resort facility) while avoiding the governance and incentive problems attendant to counterproductive bailouts of risk takers.
Critique of the Global Financial Structure
The particularity of the financial crises in the late 1990s was the simultaneous collapse of banks and fixed exchange rates. Calomiris says that these were the reasons for these crises:
- Counterproductive financial bailouts of insolvent banks, their creditors, and debtors by governments, often assisted by the IMF, at large social costs because of the transfer of resources from average citizens to wealthy risk-takers through taxation and thus encouraging excessive risk-takings by banks and corporations relying on the financial safety net by governments.
- Asymmetric information about the incidence of observable shocks within the financial system, especially when combined with short-term debt finance can magnify the economic consequences of fundamental shocks by leading to a liquidity crisis or bank runs especially in emerging market economies, which can however be avoided if investors hold a diversified bundle of securities.
- The expectations of speculators can exaggerate the effects of adverse shocks, and can even precipitate self-fulfilling financial collapses when weakened financial systems are also illiquid, which can be avoided if countries have enough reserves.
- “Contagion” across countries in securities and loan markets increases the severity of the crisis.
- Because of IMF protection, the costs of liquidity risk from government depending on short-term debt are not internalized
He concludes:
When a country suffers a banking system-cum-exchange rate collapse, its government protects politically influential domestic stakeholders by bailing out banks, their debtors, and their creditors, all at the expense of taxpayers. IMF loans to countries suffering financial collapse serve as bridge loans to permit the rescheduling of debt. The conditions imposed by the IMF along with its financial support help to ensure that tax increases to finance the bailout will be forthcoming, making the IMF an accomplice to the transfer of wealth from taxpayers to domestic oligarchs and global lenders.
Instruments for a stable global financial system
According to Calomiris, regulation ought to avoid the moral-hazard problems and protect against the four “liquidity” problems that can magnify fundamental shocks. There is a need to find a balance between liquidity assistance and market discipline.
In order to find that balanced global financial safety net, three “tranches of risk” must be defined: private exposure, government exposure and international (IMF-type)-exposure to risk.
Bank regulation consisting of capital requirements, “reserve” requirements, deposit insurance and “free banking” (capital market liberalization for financial institutions that comply with regulatory standards. These regulatory requirements should be mandatory for IMF membership, Calomiris argues, to provide a credible first tranche of private loss by ensuring that uninsured bank claimants (stockholders and subordinated debt holders) will lose wealth when banks suffer adverse shocks to the values of their risky assets. Minimum cash reserve ratio requirements ensure a margin of protection for insured debt), and also enhance bank liquidity. Minimum amount of “global securities” helps to diversify bank risk.
For the government exposure to risk, he wants the IFM to set standards for debt management and exchange rate policy, central bank reserve requirements, and require governments to allow banks to offer accounts denominated in both domestic and foreign currency)
The IMF role would be to provide liquidity to central banks in cases of speculative attacks against an exchange rate peg. He proposes that the IMF operates a discount window when lending to central banks which are normally solvent, but at a penalty rate. The IMF would finance the lending by borrowing cash from the central-banks.
Calomiris acknowledges that sharing reaching a system is not easy, especially since it will be strongly objected by governments, central bankers, banks and regulators.
See also
Summary of the recommendations of the Meltzer-Report
To assess the evolution of the Financial Architecture after the Asian Crisis, the Meltzer Report provides a good gauge for the critique of the USA and other G7 countries towards the International Financial Institution. The report is named after Allan H. Meltzer, an economist and prominent critic of the Bretton-Woods-Institutions.
In this post, the main recommendations are going to be listed and assesses whether they have been implemented.
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The IMF should serve as quasi lender of last resort (LOLR) to emerging economies.
The IMF is acting less and less as LOLR to emerging economies. Most loans to emerging economies hit by the Asian or the Russian crisis have been paid back (see paper by William Cline). To become LOLR, the IMF would need more funds and more access to supervision, as Olivier Jeanne and Charles Wyplosz argue in this IMF paper.
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Eligible member countries must permit freedom of entry and operation for foreign financial institutions.
Financial integration of emerging economies has increased to some extent – mostly in Europe, leastly in Latin-America and Asia in the middle (see BIS-Paper by Alicia García-Herrero and Philip Wooldridge. The main integration was regional rather than global.
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Every country that borrows from the IMF must publish, regularly and in a timely manner, the maturity structure of its outstanding sovereign and guaranteed debt and off-balance sheet liabilities.
Measuring public debt is not an easy taks because of the different types and issuers of public debt. The BIS, the World Bank, the IMF and the OECD maintain the Joint External Debt Hub which collects and publishes information about sovereign debt. A list of central government debt for 89 countries between 1991-2005 is available at the Inter-American Development Bank.
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Commercial banks must be adequately capitalized either by a significant equity position, in accord with international standards, or by subordinated debt held by non-governmental and unaffiliated entities.
Standards for minimum capital for banks and other financial institutions are given by Basel II, but the final decision on how to implement Basel II was not reached until July 2007.
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The IMF in cooperation with the BIS should promulgate new standards to ensure adequate management of liquidity by commercial banks and other financial institutions so as to reduce the frequency of crises due to the sudden withdrawal of short-term credit.
The adequate bodies would not be the IMF and the BIS, but the BCBS and other international bodies such as IOSCO or IAIS.
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The IMF should establish a proper fiscal requirement to assure that IMF resources would not be used to sustain irresponsible budget policies.
The IMF has introduced and updated several codes for fiscal transparency.
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The IMF should use its policy consultations to recommend either firmly fixed rates (currency board, dollarization) or fluctuating rates.
Just like in 2001, the world is still far away from completely floating exchange rates for all currencies (see IMF overview of Exchange Rate Arrangements in 2006).
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The IMF should cease lending to countries for long-term development assistance (as in sub-Saharan Africa) and for long-term structural transformation (as in the post-Communist transition economies). The Enhanced Structural Adjustment Facility and its successor, the Poverty Reduction and Growth Facility, should be eliminated.
The Poverty Reducation and Growth Facility is still active. Togo has been the most recent recipient in April 2008.
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The IMF should write-off in entirety its claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy in conjunction with the World Bank and the regional development institutions.
Through co-operation of creditors in the Paris Club and together with IMF and World Bank, several debt relief initiatives for heavily indebted poor countries have been implemented. The IMF estimates that about 40% of debt has been cancelled.
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Further quota increases for the IMF are not necessary.
Adjusting quota shares is necessary to reflect the economic development of various IMF Members. Often this was done by increasing quota for some countries. If the USA wants to keep its defacto veto of having more than 15% of votes, then it also needs to increase its quota.
The Development Banks
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The development banks must be transformed from capital-intensive lenders to sources of technical assistance, providers of regional and global public goods, and facilitators of an increased flow of private sector resources to the emerging countries.
The World Bank has programs for technical assistance and co-operation with the private sector through the International Finance Corporation.
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The focus of their individual financial efforts should be on the 80 to 90 poorest countries of the world that lack capital market access.
This would not only be counterproductive, because the World Bank provides technical assistance along with financial help, but it would also set the wrong incentives because countries with difficult capital market access would then stop their efforts to achieve that goal.
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All resource transfers to countries that enjoy capital market access (as denoted by an investment grade international bond rating) or with a per capita income in excess of $4000, would be phased out over the next 5 years.
Poverty and a good bond rating are not mutually exclusive. Often countries might still be in financial need even though their treasury bonds might have excellent ratings. This proposal contradicts with the previous one, because some countries have access to bond markets but their per capita income is well below US-$ 4000.
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In poor countries without capital market access, poverty alleviation grants to subsidize user fees should be paid directly to the supplier upon independently verified delivery of service. Costs would be divided between recipient countries and the development agency. The subsidy would vary between 10% and 90%, depending upon capital market access and per capita income.
The World Bank is more and more engaging with the private sector and funds directly the supplier. Often however governments supply certain goods and then financial support from the World Bank becomes an indirect transfer of funds to goverments.
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The government of each developing economy would present its own reform program for institutional change which would be supported by the World Bank and audited independently.
Institutional change needs to go along with changes in social and political norms. The problem is not drafting a reform agenda, but implementing them and creating the mechanisms for a continuous evolution.
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To underscore the shift in emphasis from lending to development, the name of the World Bank would be changed to World Development Agency. Similar changes should be made at the regional development banks.
A name change has not occured and would most likely be strongly contested by United Nations institutions reponsible for development.
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All country and regional programs in Latin America and Asia should be the primary responsibility of the area’s regional bank.The World Bank should become the principal source of aid for the African continent until the African Development Bank is ready to take full responsibility. The World Bank would also be the development agency responsible for the few remaining poor countries in Europe and the Middle East.
There is still considerable overlap between the various regional development banks.
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The World Bank and the regional development banks should write off in entirety their claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy under the Banks’ combined supervision.
See above to a comment on the similar IMF reform proposal.
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The United States should be prepared to increase significantly its budgetary support for the poorest countries if they pursue effective programs of economic development.
Even though the USA is the largest donor of development aid, compared to its economic power it only donates a marginal amount to development (about 0.17% of GNI)
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The Commission recommends that the BIS remain a financial standard setter.
The main standard-setting bodies are the BCBS, the IOSCO, the IASB, the IAIS and the FATF. All cooperate with the BIS, but are not the same.
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Implementation of standards, and decisions to adopt them, should be left to domestic regulators or legislatures.
Especially in Europe, the Commission was a driver of implementation of already negotiated standards, thus it is not always clear whether national discretion to implement at will is the best way to establish international standards.
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The Basel Committee on Bank Supervision should align its risk measures more closely with credit and market risk.
Basel II is the attempt to do exactly that.
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Rulings or decisions by the WTO, or any other multilateral entity, that extend the scope of explicit commitments under treaties or international agreements must remain subject to explicit legislative enactment by the U.S. Congress and, elsewhere, by the national legislative authority.
WTO Agreements have to be ratified and implemented in national legislation, but non-compliance can be countered by sanctions and other enforcement mechanism. Whether the Dispute Settlement Mechanisms at the WTO undermine national sovereignty or create a fair playing field for all countries under international trade law is a different matter.
IMF
The Bank for International Settlements
The World Trade Organization
See also
Deutsche Bank – Banking and Stock Glossary
Deutsche Bank has a glossary for market and stock terms. They list the following international financial institutions:
- AIBD – Association of International Bond Dealers, now ICMA.
- BIS – Bank for International Settlements
- EBR – European Bank for Reconstruction and Development
- ECB – European Central Bank
- EIB – European Investment Bank
- ECSDA – European Central Securities Depositories Association
- IASB – International Accounting Standards Board
- IASC – International Accounting Standards Committee
- ICMA – International Capital Market Association
- IMF – International Monetary Fund
- ISSA – International Securities Services Association
More can be found here
Topics of this post: aibd, banks, bis, definition, deutsche bank, ebr, ecb, ecsda, eib, iasb, iasc, icma, imf, issa, Memo, stocks