Investment news

Securitization issues

admin — Mon, 29 Mar 2010 13:42:48 +0000

Securitization issues such as mortgage backed securities, credit card receivables and auto loans have made a great deal of data on default and loss rates publicly available on these types of assets than was previously the case. Such data only exists and is useful in a handful of countries where securitization issues are relatively common and have been so for a number of years.

The External Balance and the Real Exchange Rate

admin — Sat, 27 Jun 2009 21:32:17 +0000

Similar to the Balance of Payments Approach to exchange rates is that which focuses on the relationship between a long-term equilibrium value for the real exchange rate and the external balance. Under this, the long-term equilibrium exchange rate is that which generates both internal and external balance, where internal balance is deﬁned as full employment and external balance as the current account. Since the creation of this model, the emphasis has shifted away from focusing on full employment to concentrating on achieving a sustainable current account balance — not necessarily zero — which will achieve a perceived economic and exchange rate equilibrium.
As with the Balance of Payments Approach, the current account is seen as the transmission mechanism for the exchange rate, albeit this time under both ﬁxed and ﬂoating exchange rate regimes. If the current account balance is showing an unsustainably high deﬁcit relative to historic deﬁcit levels, this will require a real exchange rate depreciation to restore equilibrium. Conversely, if it is showing a very high current account surplus, this will require a real exchange rate appreciation to restore equilibrium.
The example that is often used with regard to this is Japan, which has had a structurally high current account surplus. Using the external balance approach, if that current account surplus is seen as unsustainably high relative to historical norms, it requires a rise in the yen’s real exchange rate to restore equilibrium. Barring periodic reversals, this is what we saw from 1971 to 1995. Since then, the yen has reversed course, not least because the strengthening of the nominal yen exchange rate to a record dollar–yen low of 79.85 caused such a real shock to the current account balance that it in turn required a signiﬁcant real exchange rate depreciation to restore equilibrium once more.
Within the emerging markets, another good example is that of Russia. Before the Russian rouble crisis of August 1998, Russia continued to record signiﬁcant current account deﬁcits. The external balance approach suggested that at some point a real exchange depreciation would be required to restore equilibrium. However, the Russian rouble was pegged to the US dollar and in order to maintain that peg real interest rates were kept high. Eventually, the costs of defending the Russian rouble peg — yet another case of trying to have all three of monetary independence, reasonably high capital mobility and a ﬁxed exchange rate regime — proved too much and the rouble was de-pegged and devalued, and for good value Russia defaulted on its domestic debt.

A Floating Exchange Rate Regime

admin — Fri, 26 Jun 2009 21:31:26 +0000

Under a ﬂoating exchange rate regime, we have to consider the capital account as well as the current account. Here, as national income rises, so import demand rises, in turn causing the current account balance to deteriorate. So far, this is just like the ﬁxed exchange rate regime. However, in the case of the ﬂoating exchange rate regime, the exchange rate is able to be the transmission mechanism for restoring the balance of payments to equilibrium. On the capital account side, a rise in national income, causing the current account balance to deteriorate, must be accompanied by a rise in real interest rates. The higher real interest rate will dampen import demand, which will in turn cause the current account balance deterioration to reverse. As that happens, national income will fall back, causing real interest rates also to fall back. If we start off with national income falling, we achieve the same transmission mechanism, only in reverse, with real interest rates falling, causing capital account outﬂows and current account balance improvement to the extent that these developments cause on the one hand a revival in domestic demand and on the other a loss in export competitiveness. Thus, the current account improvement reverses and real interest rates rebound. We can express this transmission mechanism from a change in national income through the balance of payments within a ﬂoating exchange rate regime with the following diagram:
Change in national income -> Change in current account balance -> Change in real interest rates -> Change in capital ﬂows -> National income change reversed -> Current account reversed -> Capital ﬂows reversed -> Real interest rates reversed -> Balance of payments equilibrium restored

A Fixed Exchange Rate Regime

admin — Fri, 26 Jun 2009 21:30:44 +0000

Under a ﬁxed exchange rate regime where capital mobility is extremely limited, the focus is on the current account rather than the capital account. Assume for the purpose of this exercise that national income is rising. As national income rises, so stronger demand sucks in an increasing amount of imports, which in turn causes current account balance deterioration. The exchange rate cannot be the transmission mechanism for restoring balance of payments equilibrium since the exchange rate is ﬁxed. Hence, the monetary authority has the choice of either selling its foreign exchange reserves in the market to alleviate pressure on the exchange rate or more practically tightening monetary policy in order to dampen domestic demand, thus reducing import demand and restoring the balance of payments equilibrium.
Equally, within that same ﬁxed exchange rate regime, say national income was falling. This would imply that weaker domestic demand would cause a decline in import demand, which would paradoxically cause an improvement in the current account balance. Because the capital account would not be a consideration given our premise that capital mobility is highly restricted and the exchange rate is ﬁxed, equilibrium in the balance of payments can only be restored through a reversal of that current account balance improvement. Such an improvement would pressure the ﬁxed exchange rate to appreciate. The monetary authority could either absorb this pressure by increasing its foreign exchange reserves and selling the domestic currency in the market to do so, or by loosening monetary policy. Either way, this would cause market interest rates to fall, spurring domestic demand and thus import demand, which in turn would cause the current account balance to move back to a position such that the balance of payments equilibrium would be restored.
The dynamic whereby a change in national income is transmitted within a ﬁxed exchange rate regime through the current account balance is expressed in the following diagram:
Change in national income -> Change in current account balance -> Monetary reaction -> Reversal of current account balance change -> Balance of payments equilibrium restored
In theory, a ﬁxed exchange rate regime should automatically be in balance as left to its own devices it should be self-correcting through changes in capital ﬂows and interest rates. An imbalance of one kind or the other should automatically be corrected, albeit after a lag. Yet, in reality, ﬁxed or pegged exchange rate regimes have faced an increasingly turbulent time during the 1990s to the extent that many of them have collapsed in the face of seemingly irresistible speculative pressure. Why has this been the case? Many of the reasons for this are case-speciﬁc. However, the underlying theme is that frequently countries simply have not been prepared to maintain the degree of economic discipline that is required to maintain the ﬁxed exchange rate regime. In addition, many appeared to forget the core rule established by the Mundell–Fleming example that you can have only two but not all three outcomes with a ﬁxed exchange rate regime, high capital mobility and an independent monetary policy. Under the misguided inﬂuence of the ofﬁcial community in Washington, many emerging market countries, which had ﬁxed or pegged exchange rate regimes, opened up their economies to high capital mobility at the same time they sought to maintain some degree of monetary independence. Looked at from this perspective, the result was inevitable.
Maintaining a ﬁxed or pegged exchange rate regime within a world of high capital mobility requires a considerable degree of economic discipline given that the transmission mechanism for restoring imbalances to the equilibrium of the balance of payments cannot be the exchange rate but instead must be the real economy. Furthermore, global ﬁnancial markets must be convinced that the monetary authority of this ﬁxed exchange rate regime will hold the line come what may. In the case of Asia, countries like Thailand, Indonesia and Korea were ultimately either unwilling or unable to maintain that discipline. Interestingly, China, Hong Kong and Taiwan were all able to weather the storm, not least because they upheld the principles of the Mundell–Fleming rule. In the case of China and Taiwan, both had monetary independence and a ﬁxed or pegged exchange rate regime (Taiwan’s cannot be called a freely ﬂoating exchange rate regime by any stretch of the imagination), but maintained signiﬁcant restrictions on capital mobility. In the case of Hong Kong, on the other hand, it had very high capital mobility and a ﬁxed exchange rate regime in the form of a self-balancing currency board, but its monetary authority, at least in theory, abandoned monetary independence in favour of following the monetary policy of its peg currency, namely that of the Federal Reserve. Granted, Hong Kong, China and Taiwan perhaps had both greater resolve and ability to resist speculative pressures, but the structure of their exchange rate regimes was crucially more secure. As the example of Argentina shows in 2002, following this two-but-not-three model is not a guarantee of success. However, one could well say that not following it is more or less a guarantee of failure.

Implications for EU Accession Candidates

admin — Thu, 25 Jun 2009 21:30:11 +0000

This simple rule of being able to maintain two policy focuses but not three has potentially important implications for the EU accession candidate countries such as Poland, Hungary, the Czech Republic and Slovakia, particularly during their transition phase between membership of the EU and entry into the Euro. During that period, it is assumed that these countries will be part of an “ERM II” grid, featuring a narrow exchange rate band, whose limits are defended by the commitment of the central bank to intervene.
For example, if in January 2005 Poland becomes a member of the EU and as a result the Polish zloty enters the ERM II grid, Poland must renounce its monetary independence at the same time. If Poland does not, it must either put limits on capital, which would be against both the spirit and the letter of the treaties of Maastricht and Nice, or eventually be forced to relinquish its ﬁxed exchange rate peg. The only way to avoid this is for ERM II to have a very wide band, otherwise at the very least EU accession candidate currencies are (once again) in for an extremely wild — and potentially unpleasant — ride.

Two Legs but not Three

admin — Thu, 25 Jun 2009 21:28:44 +0000

The ﬁnal word on the Monetary Approach and the exchange rate impact from policy combinations concerns the idea from the Mundell–Fleming model that a central bank can in a world of high capital mobility target the exchange rate or the interest rate but not both. Another way of expressing this is that you can have two of the following but not all three:
A ﬁxed exchange rate regime
Monetary policy independence
High capital mobility
The ﬁrst assumes the targeting of the exchange rate, while the second assumes the targeting of inﬂation and interest rates. The discovery of this rule was the stuff of brilliance, the monetary equivalent of the discovery of penicillin, yet history is littered with examples of policymakers who ignored it to their cost. While the example of Asia and the subsequent Asian currency crisis may spring to mind, there are also examples within the developed world, notably that of the ERM crises of 1992–1993. Here, there was indeed a commitment to a type of ﬁxed exchange rate regime under conditions of high capital mobility. At the same time however, ERM members were allowed monetary independence. In practice, some, notably the Benelux countries, appeared to all but abandon monetary independence in favour of adopting the harsh benchmark of Bundesbank monetary policy. Others, such as the UK, Italy and Spain, sought a greater degree of monetary independence. Is it any coincidence that these were either forced out of the ERM altogether or forced to devalue within it? While the argument is frequently made that the UK pound sterling went into the ERM at an overvalued level to the Deutschmark, a contrary argument could be made that sterling would have been forced out of the ERM no matter what its entry level because the UK authorities refused to relinquish monetary independence to the Bundesbank.

Judging the ITT beauty show

admin — Sun, 21 Jun 2009 18:47:13 +0000

The screening process of the suppliers can be long drawn-out, but it has to be methodical and it has to be done well. This mix of weighted-criteria process is sometimes called a beauty contest. It can be done in secrecy with sealed bids to only invited suppliers. Or it can have all interested suppliers bidding. The selection process is certainly more objective with the ‘lowest bid wins’, but it can leave out the user’s needs considerably. Therefore, the argument for user functionality has to be spelt out for all. You can include the system criteria, or priorities, you deem important.

BUSINESS FUNCTIONALITY REQUIREMENTS

admin — Sun, 14 Jun 2009 18:46:27 +0000

The supporting detail of the grid, used for further analysis and line management purposes, is contained in a risk functional cross-matrix.
Red warning lights show us the most critical systems to redesign or overhaul. Where departments are already operating well, and currently get the green risk light, then there is no immediate need to replace that subsystem. Nevertheless, systems engineers will often replace that subsystem too and install a completely new one that is guaranteed to be compatible with the rest of the new integrated system.
A lot of the system satisfaction revolves around the functionality, that is, fulﬁlling the needs of the users. The needs analysis comes out in the deﬁning document that is usually called the “user system requirements” (URS). Such a vital document, in summary, is circulated to interested system vendors in a communication ﬂow, initiated by the “request for information” (RFI). This is a preliminary document that deﬁnes the summary of needs, and the ﬁrm’s plans for upgrading systems. It gives enough data to inform systems builders if they can meet the client’s needs, or not.
The ﬁnal URS is analysed in full and sent to short-listed system vendors in a contractual document, usually called the “request for proposal” (RFP). It contains some data such as the user’s functional needs.
User’s functional priorities
When you are designing a risk management system, you are searching for best:
price
functionality
time taken to implement
conﬁdentiality/security
reliability
after-sales support.
How you prioritise and assign weightings to these criteria is a subjective matter, and it deﬁnes your company’s exact situation. Even getting the best price–quality ratio and product involves the client in a calculus that offers more room for abstract judgement, rather than costs and ﬁgures alone.
You will have to check interfacing and efﬁciency of sharing data with the new programs. Otherwise, system integration difﬁculties can bring your risk management system that “speaks” English into a German bank with a French accounts system. The company’s central IT department may specify an Esperanto of XML as a mediator language for translating between the bank’s myriad systems. XML serves as a universal format for translation that also ports well to the Internet. Shared data can be sent over all the bank’s operational centres world-wide in this way. The complex design issues and the need for linking many disparate systems grow ever more insurmountable with a global corporation.
A world-wide ﬁnancial company is likely to have several risk management systems, including all the “legacy” systems. This indicates a need for sophisticated integration, with the bank’s risk management system at the epicentre. The system can sit in the middle, linked by an EAI intermediary layer or module.
The interfacing and data conversion difﬁculties between the different business programs and suppliers may tend to work against easy linking of an enterprise-wide risk management system.
For this reason, the company may take a strategic policy for IT standards, e.g. something on the lines of:
For all global ofﬁces. To standardise our IT systems, we stipulate that:
All mainframes will be supplied by IBM, all servers by Sun Microsystems or Compaq, all PCs from Compaq or Dell, all operating systems either IBM-AIX or the latest Windows. Bloomberg will be our preferred dealing systems supplier and integrator, with MKI for back ofﬁce and Sungard for risk management. Deviation from these standards will have to be approved by IT department beforehand.

BUILDING RISK MANAGEMENT SYSTEMS

admin — Sat, 06 Jun 2009 18:45:42 +0000

After selecting the desired staff, we have to install the technical elements of risk management. It has to be emphasised that IT supports the business and not the other way around. The business department should not go out alone to shop for the “best” risk management system; neither
should the IT department.
Financial risk management has to rely on specialised software. There are relatively small ﬁrms that usually work with a limited number of clients. An extra customer won can make a difference between boom and bust. Sales overcommitment can take over the aims of delivering the most suitable product for the client at the best price. This sales scramble can lead to excessive promises.
Value-added systems rely upon the supplier’s understanding of the business in that situation, the implementation of adequate security procedures and good quality staff. The business functionality inherent within the risk management system may prove unsuitable for the speciﬁc bank or fund. You can buy technology and marketing hype instead of system utility. We can take a subjective view of technology for the sake of demonstration.
Finding the “best” risk management system
Searching for the “best” risk management system and service delivery constitutes a major project in itself. This is known as the ITT (invitation to tender) process where we follow a rigid methodology to get the best for us. It is likely that a more suitable product and service can be obtained at a better price once we have gone through all ITT steps.
The invitation to tender (ITT) process
If you consider creating critical risk management functions within your company, you have two general choices:
Build in-house, or
Buy from an outside party.
Build
This dictates that your company has the adequate internal resources and scale to undertake such a major task. With Basel II, this is further complicated by the small pool of talent able to handle compliance and technical issues for market, credit and operational risk. Given the extreme novelty of the Basel II “Three Pillars”, we will probably face a medium-term shortage of able personnel to understand and implement the new regulations.
Specialised risk management has a dearth of skills available. Thus, the company is committed to having the business skills in-house for understanding the risk management issues, and outsourcing the technical skills for implementing the new system. This entails getting the cocktail of talent right, i.e. combining ﬁnancial skills, risk management, change management, project control, mathematical and IT systems experience.
Buy
It is more probable that you do not have all or enough of all the resources to carry out this large project. “Buying in” is the preferred option when companies do not want to “reinvent the wheel”. Some external personnel will handle part of the risk management, some the IT side. This can range from speciﬁc technical tasks that require specialist advice, to wholesale design and implementation of the entire system.
There are security issues at stake here because few banks and funds wish an external party to know their ﬁnances and risk management status. Conﬁdentiality clauses are written into contracts, and “Chinese walls” emerge to promise non-disclosure of sensitive data to another client. The trust works both ways and it behoves a client to provide accurate data to the system supplier. It is likely that the project size and risk management complexity will force a combination of build and buy-in, with most companies preferring the buy-in route. Once inviting risk management ﬁrms to design and install the business solution, some methodology must be used to select the most suitable suitor. It is crucial to select the best long-term business solution provider, not just for Basel II, but quite possibly for Basel III and all the follow-on work. We have often gone into banks and fund managers and seen the client allied to the wrong business solutions provider. The ITT is a bidding process that is worth conducting carefully.

RISK PRIORITISATION

admin — Fri, 29 May 2009 18:45:06 +0000

The fundamental ﬂaws of system design in the ﬁnancial company must be addressed before technology. Errors can come about from undertaking a too short review and analysis of the company needs before quoting the price for the contract. The immediate need is to establish a coherent risk management strategy, rather than a hotch-potch buying of fashionable technologies and top names. It requires a plan and a project methodology.
What we ﬁnd when designing dealing environments for banks and funds is that risk management and IT initiatives can be conducted piece-meal. The may be happy to pay $5 million for a group of star-traders properly kitted out with the latest technology. They are reluctant to shell out $500 000 for a risk management system that backs up best-of-breed redesigned business procedures.11 Fixing the problem after the risk event occurs can cost hundreds of times more than prevention.
A clear prioritisation with coordinated goal setting is required for mapping and management of the risk areas and technologies. A risk map of designated business operations areas coded red, amber and green can demonstrate the project priorities. These can be input into the user’s needs analysis for creating the design speciﬁcations in the “user system requirements” (URS).
Giving the go-ahead
Bringing the changes required for the desired risk management processes will be an arduous task in itself. We deal with so different groups of people, crossing departmental boundaries. All these introduce something novel into the company, and change management skills will be needed to bring these new business processes to fruition. Deﬁnition of performance criteria, underperformance penalties and budgeting is likely to be contentious. Securing support from the directors will be a prerequisite for getting most large-scale projects off the ground.
Various representatives from the major departments and stakeholders involved are invited to sit in a Delphi group to offer their views on the investment project. Sometimes there are consultants brought in to present an impartial opinion of the corporate project risk map.