Change at the IMF: interconnectedness, financial fragility and global banks
I attended recently a workshop organized by Cornel Ban and Kevin Gallagher, with support from Governance, at Boston University on how the crisis has changed the IMF.
My presentation explored the way in which the IMF has grappled with financial innovation since the crisis, both theoretically and in its policy advice.
This is important, it argues, because the global economic crisis has brought an
important shift in the IMF’s understanding of crisis, its triggers and its
actors. Its research on macro-financial linkages now identifies large capital
inflows as the main conduit for the transmission of global shocks, in contrast
to previous concerns with current account dynamics; and transnational banks as the
key carriers of capital flows across borders. With this, the IMF has included
private financial institutions in its analytics of crisis, previously focused
on governments (fiscal policy), central banks (monetary policy) and trade
union/state-owned companies (structural reform).
Saturday, 27 April 2013
Friday, 22 March 2013
Outsourcing Financial Stability: the ECB and Cyprus
I have just finished revising a paper on the ECB's learning from the Japanese crisis management in early 2000s. The important lesson of that episode is that the shift to market-based finance confronts central banks with a trade-off between financial stability and institutional stability defined through central bank independence. To fight liquidity spirals, runs on repo and pro-cylicality induced by shadow bankign activities (as large in Europe as in the US), the central bank must abandon independence understood in the most narrow, and politically sensitive, definition of severing links with government debt markets. The traditional lender of last resort approach cannot address the systemic risks generated by market-based finance.
This matters immensly for understanding the ECB's choices since the crisis.
It is important to remember first that the ECB has no explicit mandate for financial stability of the Euro-area. European Treaties, and the ECB's institutional design, are built on the premise that national governments can, and should, provide financial stability. That design reflects a flawed theoretical assumption in pre-crisis mainstream macroeconomics that central banks could pursue price stability alone, and that would ensure financial stability. The mea-culpas from other central banks across the world, including Ben Bernanke, can be stil heard if one listens carefully. This is why those central banks abandoned indepedence and directed their considerable fire power at preserving the stability of a financial system with new sources of systemic risk.
In contrast, the ECB has played a more dangerous game that simultaneously increased its political power and financial instability. By its own addmission, the Enhanced Credit Support, and then the LTROs, outsourced financial stability to the banking sector - with fingers crossed that delevraging banks would want/be able to perform such a function. That the strategy ultimately failed became clear when Draghi announced that it would do whatever it takes (the OMT) to stabilize market-based finance. But the OMT did not solve the trade-off between independence and financial stability in the same manner that other central banks did. The OMT instrument has been designed as an escape clause from the 'no-debt monetization rule', and the ECB gained greater political powers as a non-indepedent arbiter to impose costs (conditionality) and to verify compliance.
So the Cyprus moment is just another episode in the long struggle of the ECB to use the crisis in order to cement its power while abdicating an essential central bank function. That such a paradox is possible testifies to how dangerous this institution has become to the European project. Outsourcing financial stability to the Russian government or to the political willigness of a small country to tax the big players (those with large deposits) is a risk no central bank should take. Fingers crossed over the weekend.
This matters immensly for understanding the ECB's choices since the crisis.
It is important to remember first that the ECB has no explicit mandate for financial stability of the Euro-area. European Treaties, and the ECB's institutional design, are built on the premise that national governments can, and should, provide financial stability. That design reflects a flawed theoretical assumption in pre-crisis mainstream macroeconomics that central banks could pursue price stability alone, and that would ensure financial stability. The mea-culpas from other central banks across the world, including Ben Bernanke, can be stil heard if one listens carefully. This is why those central banks abandoned indepedence and directed their considerable fire power at preserving the stability of a financial system with new sources of systemic risk.
In contrast, the ECB has played a more dangerous game that simultaneously increased its political power and financial instability. By its own addmission, the Enhanced Credit Support, and then the LTROs, outsourced financial stability to the banking sector - with fingers crossed that delevraging banks would want/be able to perform such a function. That the strategy ultimately failed became clear when Draghi announced that it would do whatever it takes (the OMT) to stabilize market-based finance. But the OMT did not solve the trade-off between independence and financial stability in the same manner that other central banks did. The OMT instrument has been designed as an escape clause from the 'no-debt monetization rule', and the ECB gained greater political powers as a non-indepedent arbiter to impose costs (conditionality) and to verify compliance.
So the Cyprus moment is just another episode in the long struggle of the ECB to use the crisis in order to cement its power while abdicating an essential central bank function. That such a paradox is possible testifies to how dangerous this institution has become to the European project. Outsourcing financial stability to the Russian government or to the political willigness of a small country to tax the big players (those with large deposits) is a risk no central bank should take. Fingers crossed over the weekend.
Tuesday, 26 February 2013
The Italian elections and the ECB - the big political beast
The Italian elections have already prompted all sorts of gloom scenarios. With Italian sovereign bond yields rising, the moment of truth for OMTs (outright market transactions) may be coming sooner than the ECB expected.
In what concerns the ECB, analysts usually rely on a narrative of political capture of a central bank otherwise justifiably concerned with its independence. Take for instance Michael Steen, of the FT. In his post-election analysis (Feb 25), he suggested the following:
Moreover, the fiscal conditions baked into OMT were designed after the ECB’s painful first experience of buying sovereign bonds under its so-called Securities Markets Programme. Figures released just last week showed that of the €208bn it deployed on SMP, by far the greatest share – some €99bn – went towards buying up Italian debt at a time when Silvio Berlusconi, the prime minister, was failing to implement structural reform.
This is the kind of rethoric that fits well with the German reading of the ECB actions and underplays at best, or mis-represents, the overtly political interventions that the ECB has resorted to for the past three years to push its view of necessary crisis adjustments. In other words, the ECB does no favours.
Take the first sentence. It suggests that the Securities Market Programme (SMP) came with little conditionality. That is not true for Greece - the ECB only introduced the SMP in May 2010 only after Greece agreed to IMF conditionality. Most large central banks had started outright purchases of government debt a year earlier, and without any conditionality attached! In turn, while we have no detailed ECB timeseries data on the 'nationality' of SMP purchases, we do know that the ECB sent secret letters to Ireland to push for a bailout, and to Spain and Italy to demand austerity in return for SMP purchases. In Spain's case, it even asked it to lower minimum wage regulations to address youth unemployment. The blogosphere recognizes this: Frances Coppola rightly describes is as an inept central bank that 'created and orchestrated' the crisis, and Karl Whelan's brilliant blog on the ECB risk management framework sheds further light on the political power of the ECB, so let's start treating this institution as the big political beast it is.
The second sentence is equally problematic. It implies that somewhat the ECB spent almost half of its SMP purchases on Italy and unwittingly endorsed Berlusconi's hesitant structural reforms. Again this paints the picture of a central bank caught out by political processes although a) many have linked the ECB pressure - the secret austerity letter included - to Berlusconi's resignation and b) it's impossible to tell, from the ECB data, how much of the SMP purchases of Italian debt happened once Monti came in! Furthermore, larger ECB purchases may simply reflect the relative size of the Italian sovereign bond market. At the end of 2012, the ECB held EUR bn 102 of Italian sov bonds, less than 10% of the outstanding EUR 1.673bn.
This narrative of political capture is helpful to obscure the repo/collateral angle that gives a different account of the ECB (in)action. In my previous post, I discussed a presentation from the Italian Treasury on the role of Sovereign Debt Offices on the repo market. It confirmed that the Italian SDO does not intervene on the repo market but is considering doing so 'for the purpose of correcting dislocations in the secondary market of government bonds and improving liquidity management'. The dislocations refer to the pro-cyclicality underpinning the repo market (recognized both in the presentation and the FSB's stream on repo markets). That shows up clearly in the Italian repo market (in the graph below) , where repos traded through MTS (an electronic repo platform) have shifted from the GC (general collateral) segment used for funding to the 'special' segment typically used for shorting. So repos help amplify selling pressures, render investors more impatient and can thus precipitate a sovereign debt crisis (as LCH Clearnet did for Ireland).
Source: Cannata, 2012.
The trouble is that the Italian SDO still needs time to adjust to the unintended consequences of financial innovation cum European integration - the rapid growth in repos as instruments for shorting - while the ECB refuses to do it without conditionality. The OMT worked through signalling but that may not be enough in a crisis, and if ECB stands true to (Trichet) form, then we may see a rapid worsening of the Eurozone crisis. The good news however is that Italian sovereign debt market remains the second most important source of collateral in European repo markets, so it may be too big to fail!
The ECB is politically powerful, and has a responsability to act to preserve the Eurozone. The trouble is that it insists on austerity and labour market flexibilty as the only answers to the European crisis. The Italian elections may force it to change this very conservative stance.
In what concerns the ECB, analysts usually rely on a narrative of political capture of a central bank otherwise justifiably concerned with its independence. Take for instance Michael Steen, of the FT. In his post-election analysis (Feb 25), he suggested the following:
Moreover, the fiscal conditions baked into OMT were designed after the ECB’s painful first experience of buying sovereign bonds under its so-called Securities Markets Programme. Figures released just last week showed that of the €208bn it deployed on SMP, by far the greatest share – some €99bn – went towards buying up Italian debt at a time when Silvio Berlusconi, the prime minister, was failing to implement structural reform.
This is the kind of rethoric that fits well with the German reading of the ECB actions and underplays at best, or mis-represents, the overtly political interventions that the ECB has resorted to for the past three years to push its view of necessary crisis adjustments. In other words, the ECB does no favours.
Take the first sentence. It suggests that the Securities Market Programme (SMP) came with little conditionality. That is not true for Greece - the ECB only introduced the SMP in May 2010 only after Greece agreed to IMF conditionality. Most large central banks had started outright purchases of government debt a year earlier, and without any conditionality attached! In turn, while we have no detailed ECB timeseries data on the 'nationality' of SMP purchases, we do know that the ECB sent secret letters to Ireland to push for a bailout, and to Spain and Italy to demand austerity in return for SMP purchases. In Spain's case, it even asked it to lower minimum wage regulations to address youth unemployment. The blogosphere recognizes this: Frances Coppola rightly describes is as an inept central bank that 'created and orchestrated' the crisis, and Karl Whelan's brilliant blog on the ECB risk management framework sheds further light on the political power of the ECB, so let's start treating this institution as the big political beast it is.
The second sentence is equally problematic. It implies that somewhat the ECB spent almost half of its SMP purchases on Italy and unwittingly endorsed Berlusconi's hesitant structural reforms. Again this paints the picture of a central bank caught out by political processes although a) many have linked the ECB pressure - the secret austerity letter included - to Berlusconi's resignation and b) it's impossible to tell, from the ECB data, how much of the SMP purchases of Italian debt happened once Monti came in! Furthermore, larger ECB purchases may simply reflect the relative size of the Italian sovereign bond market. At the end of 2012, the ECB held EUR bn 102 of Italian sov bonds, less than 10% of the outstanding EUR 1.673bn.
This narrative of political capture is helpful to obscure the repo/collateral angle that gives a different account of the ECB (in)action. In my previous post, I discussed a presentation from the Italian Treasury on the role of Sovereign Debt Offices on the repo market. It confirmed that the Italian SDO does not intervene on the repo market but is considering doing so 'for the purpose of correcting dislocations in the secondary market of government bonds and improving liquidity management'. The dislocations refer to the pro-cyclicality underpinning the repo market (recognized both in the presentation and the FSB's stream on repo markets). That shows up clearly in the Italian repo market (in the graph below) , where repos traded through MTS (an electronic repo platform) have shifted from the GC (general collateral) segment used for funding to the 'special' segment typically used for shorting. So repos help amplify selling pressures, render investors more impatient and can thus precipitate a sovereign debt crisis (as LCH Clearnet did for Ireland).
Source: Cannata, 2012.
The trouble is that the Italian SDO still needs time to adjust to the unintended consequences of financial innovation cum European integration - the rapid growth in repos as instruments for shorting - while the ECB refuses to do it without conditionality. The OMT worked through signalling but that may not be enough in a crisis, and if ECB stands true to (Trichet) form, then we may see a rapid worsening of the Eurozone crisis. The good news however is that Italian sovereign debt market remains the second most important source of collateral in European repo markets, so it may be too big to fail!
The ECB is politically powerful, and has a responsability to act to preserve the Eurozone. The trouble is that it insists on austerity and labour market flexibilty as the only answers to the European crisis. The Italian elections may force it to change this very conservative stance.
Subscribe to:
Posts (Atom)