Tuesday, December 22, 2009

Macroeconomics Take-Home Exam: 2009 Crisis Version

During the hearings to reappoint Ben Bernanke to another term as chairman of the Federal Reserve, US senators asked many questions. The WSJ's Real Time Economics blog posted several questions from economists and Sen. David Vitter submitted them in writing. Mr. Bernanke replied and I find the  one below particularly interesting (beware, long read).

Two comments:
i) It's very nice to see public officials being held accountable and presenting their answers to questions from academic experts rather than journalists. All too often they lack the brainpower to reply and pin down inconsistencies and attempts by officials to avoid replying "tough" questions. In Brazil officials are never properly quizzed and there is no culture of being held accountable. Another thing is our list of needed improvements.

ii) The optimal size of banks is a fascinating topic. My hunch is that retail banks should be very large, benefiting from the large returns to scale they have and the relatively low risks associated with the business. On the other hand,  investment banks should not be as large, specially due to systemic risk. Unless we find a good way to measure/manage it, we'll still observe some too-big-to-fail institution making wrong bets (or their clients) in poorly-understood financial instruments. Perhaps this was one of the ideas being the Glass-Steagall Act.

Mark Thoma, University of Oregon and blogger: "What is the single, most important cause of the crisis and what s being done to prevent its reoccurrence? The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?"

Answer: The principal cause of the financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn. This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. Much of this occurred outside of the supervisory framework currently established. An effective agenda for containing systemic risk thus requires elimination of gaps in the regulatory structure, a focus on macroprudential risks, and adjustments by all our financial regulatory agencies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firm-wide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or system-wide, approach that should help us better anticipate and mitigate broader threats to financial stability. 

Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.

Some observers have suggested that existing large firms should be split up into smaller, not-too big- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

Monday, December 21, 2009

Happy Holidays everyone!

I'm in Brazil for the spring break and while Europe is freezing to a halt I'd like to wish a merry Christmas and a great 2010 to all my three readers!

To warm the European ones, I went to a fantastic region in Brazil this weekend (Angra dos Reis, about 2 hours from Rio) and took the two pictures below right from my window.

Of course Photoshop and the HDR technique helped a bit, but it is as close to the definition of paradise you can get.

Cheers everyone!

Monday, December 14, 2009

How to know you are from a civilized country - Instrumental Variables proposal

I've just arrived in Brazil for the Holidays, taking one of those crowded flights with a random sample of those that left the country in search of a better life and are also returning for Christmas. I am usually ashamed about the average Brazilian immigrant's behavior and this last flight just reinforced my beliefs (or prejudices...).

During the flight, I was thinking that what really sets apart "civilized" from "non-civilized" societies (or groups of people) is how much individuals from this group respect others around them There are so many niceties simply forgotten by people that show, at least to me, a clear display of the lack of development of human beings.

I think that economists could use the intensity of clapping when a plane lands in their home country as a measure of low development. Shouting "Thank you pilot!" or "My mother loves you for landing us safely" gives your extra bonus points. From my small sample, here goes the ranking so far on a 1-10 scale:

Brazil: Average 10. My last flight: 134.53
Egypt: 9
Italy 7.5
Spain: 6.5
Portugal: 3
US: 2 (although there were many Brazilians in it).
France, Iceland, Sweden, UK: 0.

Perhaps a binary variable would work better... Anyway, suggestions accepted!

R.I.P - Paul Samuelson

Today was a sad day for Economics with the passing of Paul Samuelson.

My first textbook in college was his classic "Economics" and I'll never forget talking about "guns and butter" when talking about resource allocation.

Let his soul rest in peace.

Wednesday, December 2, 2009

New Paper!

I haven't reached that stage in my career in which I can write 10 great papers per year (hope springs eternal so maybe one day...), so I'm happy whenever I have something.

"Equity Lending Markets and Ownership Structure" is joint work with Jason Sturgess (now at Georgetown) and it talks about how equity lending markets are influenced by institutional ownership structure. We are currently exploring how previous results on return predictability given short selling demand shocks are influenced by ownership measures.

Here is the link if you're interested:

Comments are more than welcome!