Showing papers in "FRBSF Economic Letter in 2002"

What is operational risk

Abstract: institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks.The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures , and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes. Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to mod-eling. Such risks are typically categorized under the rubric of " operational risk. " In this Economic Letter, we review the current status of operational risk management by financial institutions, particularly commercial banks, and the corresponding regulatory capital requirements proposed by the Basel Committee on Banking Supervision (BCBS). Defining operational risk Although the definitions of market risk and credit risk are relatively clear, the definition of operational risk has evolved rapidly over the past few years. At first, it was commonly defined as every type of unquantifiable risk faced by a bank. However, further analysis has refined the definition considerably. As reported by BCBS (September 2001), operational risk can be defined as the risk of monetary losses resulting from inadequate or failed internal processes, people, and systems or from external events. Losses from external events, such as a natural disaster that damages a firm's physical assets or electrical or telecommunications failures that disrupt business, are relatively easier to define than losses from internal problems, such as employee fraud and product flaws. Because the risks from internal problems will be closely tied to a bank's specific products and business lines, they should be more firm-specific than the risks due to external events. Measuring operational risk A key component of risk management is measuring the size and scope of the firm's risk exposures. As yet, however, there is no clearly established, single way to measure operational risk on a firm-wide basis. …

Can the Phillips curve help forecast inflation

Abstract: the early 1960s, many economists and policymakers believed that monetary policy could exploit a stable trade-off between the level of inflation and the unemployment rate. One version of the hypothesized trade-off, originally described by A.W. Phillips (1958) using U.K. data from 1861– 1957, implied that policymakers could permanently lower the unemployment rate by generating higher inflation. Some years later, economists Edmund Phelps (1967) and Milton Friedman (1968), argued persuasively that any such trade-off was bound to be short-lived: once people came to expect the higher inflation, monetary policy could not keep the unemployment rate permanently below its equilibrium or " natural " level (i.e., the rate of unemployment that prevails when inflation expectations are confirmed). This claim was later borne out by the experience of the 1970s when rising U.S. inflation did not bring about the lower unemployment rates promised by the Phillips curve. On the contrary, higher inflation coincided with higher unemployment—a combination that became known as " stagflation. " Though the Phelps-Friedman argument proved to be valid, there still remained the possibility of a short-run trade-off between inflation and unemployment .This idea led to the intellectual development of the short-run (or expectations-augmented) Phillips curve, which says that short-term movements in inflation and unemployment tend to go in opposite directions. When unemployment is below its equilibrium rate (indicating a tight labor market), inflation would be expected to rise.When unemployment is above its equilibrium rate (indicating a slack labor market), inflation would be expected to fall.The equilibrium unemployment rate is often referred to as the " NAIRU, " i.e., the Non-Accelerating Inflation Rate of Unemployment. In a recent paper, Atkeson and Ohanian (2001) challenge the usefulness of the short-run Phillips curve as a tool for forecasting inflation.This Economic Letter summarizes their results and discusses some evidence regarding the empirical instability of the short-run Phillips curve. The Atkeson-Ohanian results Atkeson and Ohanian (2001) argue that, similar to its long-run predecessor, the short-run Phillips curve does not represent a stable empirical relationship that can be exploited for the purpose of constructing reliable inflation forecasts.Their version of the short-run Phillips curve is obtained by regressing the four-quarter change in the inflation rate on the unemployment rate and a constant term. In each quarter, the most recent version of the regression equation is used to construct a forecast of average inflation over the next four quarters. Atkeson and Ohanian (2001) show that the regression …

Reforming China's banking system

Abstract: China has undertaken economic reforms that have liberalized agricultural production, allowed the growth of a dynamic private sector, and gradually opened the economy to international trade and foreign direct investment. As a result, China stands as one of the fastest growing economies in the world.Yet, Chinese policymakers face continuous pressure to improve economic performance. Some analysts estimate that China needs to maintain annual growth rates even higher than the 9.5% average achieved in 1978–2000 in order to modernize the economy and create jobs for ten million workers that enter the labor force each year. Growth is constrained by the financial sector, which functions below potential because it supports unprofitable state-owned enterprises (SOEs). Chinese authorities have attempted to ease this constraint with policies that give greater play to market forces and encourage banks to engage in commercial banking, shifting away from their traditional role as suppliers of financing to SOEs. SOEs also are being restructured to improve their financial condition.This Economic Letter discusses how the legacy of a planned economic system continues to affect economic and financial performance, as well as some of the constraints policymakers face in attempting to implement reforms. Lagging SOEs Before China began economic reforms, its economic activity was dominated by SOEs, which geared production to meet development goals and which automatically received credit from the banking sector according to a national development plan. But once liberalization began, it became apparent that SOEs could not keep up with the needs of the evolving market economy. An analysis by Heytens and Karacadag (2001) reveals that SOEs are about 60% as efficient (as measured by value added) or profitable (as measured by operating profits to assets) as foreign-funded enterprises.Their low profitability leaves SOEs financially vulnerable. For example, interest coverage (the operating profit potentially available to cover interest expenses) in SOEs is as low as one-third that observed in major industrial countries. Firm-level data for listed enterprises suggest that Chinese enterprises cannot generate enough cash flow to pay interest on about 20 to 30% of their total debt. A moderate rise in interest rates or a moderate drop in sales could cause 40% to 60% of the debts of all firms to become unserviceable. Liberalization and lagging SOE performance have allowed private enterprises to grow rapidly to meet domestic and foreign demand for Chinese goods. Firms with access to foreign financing and managerial expertise have done particularly well. As a …

Bank security prices and market discipline

Abstract: have been warming up to the idea of leveraging market forces to enhance banking supervision.This is partly motivated by the growing complexity of large banking organizations and by concerns about limiting the cost of bank supervision as well as avoiding unduly extending the bank safety net (see Kwan 2002). In order for market discipline to work, the market prices of banking securities must contain accurate and timely information about bank risk. Researchers in banking have been studying this issue for quite some time.This Economic Letter reviews the empirical evidence on the informativeness of bank security prices, focusing on the two most obvious sources of market information—stock and bond prices.

Argentina's Currency Crisis: Lessons for Asia

Abstract: This Economic Letter is based on a presentation Mark Spiegel prepared for a panel on "Optimal Currency Arrangements for Emerging Market Economies: The Experience of Latin America and Asia" organized by the Latin American and Asian Economics and Business Association on July 15, 2002, in Tokyo, Japan

The promise and limits of market discipline in banking

Abstract: The rationale for and practice of safeguarding the banking system have a long history in the U.S.The rationale is that banking firms are special in a number of ways.They perform certain unique functions in the financial system, such as providing backup liquidity to the economy and serving as one of the channels for the transmission of monetary policy. Because of their specialness, and because banks are subject to “runs” on their deposits, the government provides deposit insurance and discount window borrowings as a safety net for the banking system. Motivated by the desire for financial stability, and the protection of the safety net from abuses, the government imposes an extensive set of regulations on banks and subjects them to prudential oversight. Regulation and supervision of banks is an integral part of the financial architecture.

Competition and regulation in the airline industry

Abstract: Regulations and deregulation Before deregulation of the airline industry began in 1979, the Civil Aeronautics Board controlled both the routes airlines flew and the ticket prices they charged, with the goal of serving the public interest. With deregulation, any domestically owned airline that was deemed “fit, willing, and able” by the Department of Transportation (DOT) could fly on any domestic route.The primary regulatory role of the DOT changed from approving whether an airline was operating in the public interest to deciding whether an airline was operating in accordance with safety standards and other operating procedures.

Is there a credit crunch

Abstract: some concerns about a " credit crunch " in the U.S. economy have appeared in the business press. In the commercial paper market, a number of large firms were reportedly unable to borrow from this market, as investors reassessed the credit risk of these firms amid growing accounting concerns. In the bank loan market, total commercial and industrial (C&I) lending has fallen quite substantially. Business credit is the lifeblood of economic activity, so it is very important that the credit market function properly and smoothly.This Economic Letter examines recent developments on credit availability to businesses, focusing specifically on the issue of a credit crunch, or credit rationing, in which creditworthy borrowers are denied credit. The commercial paper market Commercial paper—short-term, unsecured promissory notes issued by corporations—is a low-cost alternative to bank loans. In order to offer commercial paper at competitive rates, the issuers must be large and reputable firms, so that institutional investors can trust in their creditworthiness.The market for nonfinancial commercial paper has grown rapidly in recent years, peaking at $351 billion in November 2000. Since then, it has fallen over 40% to about $200 billion.While some of the recent drop-off was related to the well-publicized problems faced by a few large companies that could no longer tap the commercial paper market, the decline started much earlier. Part of the decline is due to the softening demand for short-term financing as economic activity slowed in early 2001. Indeed, the current downturn in commercial paper started just a few months before the economy went into a recession. It is important to gain some perspective on the recent instances where a number of large firms were shut out of the commercial paper market. In providing very short-term, unsecured financing, commercial paper investors place a high value on safety, and they deal almost exclusively with only high-quality borrowers.Thus, whenever there is even a small doubt about a firm's creditworthiness, investors simply bypass this firm's commercial paper altogether. At the same time, it may not be economical for the firm to raise its commercial paper yield to entice investors, as the firm may find it cheaper to borrow from a specialized lender like a bank, which usually provides backup lines of credit to commercial paper issuers.Thus, the recent episode reflects more about how the commercial paper market works than about an environment of unusual credit rationing. So far, there is little evidence to …

House price dynamics and the business cycle

Abstract: parts of the nation have stayed high despite the downturn in the economy.As Figure 1 shows, real (inflation-adjusted) house price changes became negative with GDP growth during the last recession in 1991; but this time, they have remained positive and appear to be firm.The strength in the housing market also contrasts vividly with the declines in the stock market over the past couple of years. Indeed, many of the regions where house price appreciation has been strongest over the past two years have large concentrations of high-tech firms; tumbling share prices and job losses in the hightech sector would seem to represent a large shock to housing demand, yet year-over-year price changes in places like San Francisco remain stubbornly positive. Declining mortgage interest rates may have helped to support prices. But interest rates also fell around the time of the last recession, and that did not prevent real house prices from declining.

Recent trends in unemployment duration

Abstract: has ended, as national output grew moderately during the first three quarters of 2002. Unemployment, however, remains a problem. Between late 2000 and early 2002, the national unemployment rate increased by about 2 percentage points, from 3.9% to about 6%; this represents about 2.8 million additional individuals looking for work.Thus far in 2002, payroll employment has been flat to down nationwide, and the unemployment rate has stayed stubbornly close to 6%, raising the specter of a “jobless recovery” from the 2001 recession. Persistent labor market weakness implies that the amount of time spent unemployed (unemployment duration) is likely to increase, which in turn has important implications for household well-being.

The role of fiscal policy

Abstract: suggesting that the recovery of the U.S. economy from the recent recession is on a bumpy path.During the second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%, well below market expectations. Unemployment, after rising throughout 2001, has leveled off but has yet to show signs of declining.Adding some gloom to the general outlook, the stock market continued to drop through most of July and has remained volatile.

Learning from Argentina's crisis

Abstract: payments on its external debt, restricted bank deposit withdrawals, and abandoned a currency board arrangement that had pegged the peso to the U.S. dollar since 1991.Argentina faces inflation of over 70% this year and an economic contraction that rivals the U.S.’s Great Depression.These developments have surprised many observers because for most of the 1990s Argentina was considered a model of successful economic policy. Indeed, many thought that the instability that had characterized the Argentine economy for much of its history was a thing of the past.

Setting the interest rate

Abstract: To hit its interest rate target, the Fed relies primarily on open market operations—it buys and sells securities to adjust the supply of reserves available to depository institutions to meet their reserve requirements and to clear payments transactions. The Fed also can supply reserves by lending directly to depositories through the discount window. However, traditionally, banks have not used the discount window as a routine source of funding. Moreover, they have been reluctant to borrow at the window even during tight money market conditions, when the demand for reserves is exceptionally high, thus resulting in periodic spikes in the federal funds rate. The willingness of banks to make use of the discount window as a backup source of liquidity could change if the Fed were to adopt its recently proposed rule changes governing the administration of the discount window (Madigan and Nelson 2002). Under these rule changes, the Fed also would alter its operating procedures; it would effectively place a cap on the federal funds rate by standing ready to supply reserves on demand to qualified banks at that predetermined interest rate cap.

Productivity in the Twelfth District

Abstract: (or per worker hour), is a primary determinant of our long-run standard of living. More output per worker translates into higher profits, higher wages, or lower prices—or a combination of the three. Therefore, understanding why labor productivity is higher in one firm (or city, state, nation, industry, etc.) than another is of vital importance.This Economic Letter looks at the levels of output per worker in the Twelfth District, with an emphasis on California, compared to that of the rest of the nation and discusses the possible causes of regional differences in labor productivity.

On the move: California employment law and high-tech development

Abstract: critical questions include where the industry will head next, and what role Silicon Valley will play in future waves of tech innovation and investment. The Internet and tech investment bust left many failed firms and thousands of unemployed workers in its wake in the Valley.Yet this area has reinvented and reinvigorated itself before—for example, after the surge in competition from foreign semiconductor makers in the mid-1980s—and is likely to do so again. Silicon Valley’s competitive edge in tech development and marketing has been linked to several factors, including the active role of local universities and research centers and a unique set of venture capital firms. Some observers also have pointed to a business culture that provides an unusual degree of support for employee mobility and entrepreneurship, thereby spurring innovation through the rapid diffusion of the tech knowledge base. In this Economic Letter, I discuss the role of employee mobility and knowledge transfer in the development of tech centers, and I describe an underlying feature of employment law that may help support tech innovation in California and a few other states.

Inferring policy objectives from policy actions

Abstract: including the Federal Reserve, set interest rates, they do so purposefully, with particular goals and objectives in mind. But what are these goals and objectives? And if the Federal Reserve behaves systematically, what is it systematically responding to? These questions are important. Knowing what the goals of monetary policy are—and how policymakers trade off different goals when shocks hit the economy—presumably enables consumers and businesses to make better economic decisions themselves.This Economic Letter explores these questions by trying to infer Federal Reserve goals and objectives from Federal Reserve policy actions.

Is there a role for international policy coordination

Abstract: As the U.S. struggles with its first economic slowdown in a decade, so do most of the major industrialized countries. Japan is sliding again into recession, with third quarter GDP growth of -2.2%. Europe also seems to be slowing, with a third quarter growth rate of 0.4% for the euro area as a whole, and -0.6% for Germany in particular. ; This concurrent slowdown may not seem so surprising, given the increasing globalization and integration of the world's economies. For example, it may be that countries now face common shocks, such as a change in oil prices or a productivity slowdown; or, it is possible that the U.S. recession is spilling over to our major trading partners, as our demand for imports flags. ; In light of these possibilities, some have argued that macroeconomic policymakers need to take such common shocks and spillovers into consideration--and some even argue that it is appropriate to coordinate economic policies among countries. This topic of policy coordination, which received fairly little attention from researchers in the last ten years or so, has re-emerged as an important area of study. This Economic Letter examines the literature in this field, especially the recent and influential work of Obstfeld and Rogoff (2001). Their paper offers a very different perspective from the older literature on the topic, showing that increasing economic integration may not, ironically, mandate greater policy coordination.

Macroeconomic models for monetary policy

Abstract: This Economic Letter summarizes the papers presented at the conference "Macroeconomic Models for Monetary Policy" held at the Federal Reserve Bank of San Francisco on March 1-2, 2002, under the joint sponsorship of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research

Japan passes again on fundamental financial reform

Abstract: This Economic Letter focuses on two aspects of those reform efforts: reducing Japan’s extensive system of government financial intermediation and reducing government deposit guarantees.While these two reforms are widely understood to be critical to Japan’s efforts to modernize its financial system, it is less well understood that they are interdependent: so long as government financial intermediation remains a large part of the Japanese economy, the potential benefits from deposit insurance reform will remain limited, exposing the private banking system to even more stress. Koizumi promised major reforms in both areas, but continued economic and financial distress in Japan and a lack of consensus to change indicate that Japan again will fail to enact fundamental financial reform this year.

Riding the IT wave: surging productivity growth in the West

Abstract: of the 1990s after nearly two decades of lackluster gains. Several states in the West were among the leaders in this productivity growth surge, posting average annual increases well above the rest of the U.S. In the last Economic Letter (2002-33), Dan Wilson examined the District’s productivity performance advantage in terms of the level of output per worker.This Economic Letter documents the recent productivity performance in terms of growth rates and examines the sectors contributing to the West’s exceptional surge.The results show that, as in the nation, productivity growth in the District accelerated in most regions and sectors. In terms of outperforming the rest of the nation, however, much of the credit goes to the relatively rapid productivity growth in sectors related to information technology (IT).

Technical change and the dispersion of wages

Abstract: highly skilled and less skilled workers has widened noticeably. For example, in 1975 the gap in average annual earnings between high school graduates and non-graduates was 26%; by 1999, the gap was 52%. The gap widens even more when comparing workers with advanced degrees and those with relatively little education.This rise in inequality has led to considerable debate about the underlying causes. This Letter reviews some of the evidence on this issue and discusses some recent explanations relating these phenomena to another development that has been much in the news recently, namely, an increase in the pace of technical progress.

Using chain-weighted NIPA data

Abstract: glance appears to be boring and technical but that in fact turns out to be quite important: the proper interpretation of chain-weighted data.To illustrate, consider this simple question:What is the growth rate of real GDP? Figure 1 displays two different answers to this question for the period 1992 to 1998.The solid line is calculated using a chainweighted index, the method currently used by the U.S. Department of Commerce in the National Income and Product Accounts (NIPA); the dashed line is calculated using a fixed-weighted index, the method NIPA statisticians used up to 1997. According to the chain-weighted measure, the growth rate of real GDP rose to just under 4% by 1997 and 1998.Although this was relatively rapid compared to the growth rates observed earlier in the decade, it pales in comparison to the growth rate calculated using a fixed-weighted measure, which rises sharply after 1995, reaching a rate of 6.6% by 1998. By this measure, the “New Economy” of the late 1990s looks even more remarkable!

Recession in the West: not a rerun of 1990-1991

Abstract: This Economic Letter puts the current downturn in the region in perspective in several ways, including placing it in the context of broader U.S. trends and examining conditions in the District as a whole, as well as by state and by selected sectors.We also note that the impact of this downturn is quite different from the last national downturn in 1990–1991. That episode sowed the seeds of a long and difficult contraction for California, but for many other states it only damped growth and never halted their expansion. In the current downturn, California seems to be taking only a modest hit, while some other states are enduring contractions in employment for the first time in nearly 20 years.

Towards a sovereign debt restructuring mechanism

Abstract: However, the experiences in recent financial crises suggest that when a country does require a debt restructuring, the outcomes are likely to be less orderly than those obtained in the days of bank financing. Under bank financing, it was possible to assemble the major claimants of a problem debtor and work out an acceptable rescheduling. In the case of bond finance, in contrast, the set of claimants is much more numerous, widespread, and heterogeneous.As a result, it can be very difficult to work out an agreement because a small group of “holdout” creditors can veto any package that they fail to find acceptable.This difficulty is commonly known as a collective action problem. It is particularly severe for bonds written in the United States, where changes to the original terms of a bond require agreement by all bondholders. In response, there has been a call for reforming the institutions governing sovereign debt restructuring.

Searching for value in the U.S. stock market

Abstract: closed at an all-time high of 1527 on March 24, 2000. Since then, the index has declined by about 28% to 1097 as of May 14, 2002, roughly where it was four years ago. Falling stock prices have been accompanied by even larger percentage declines in corporate earnings. In 2001, the reported (GAAPbased) earnings of S&P 500 companies totaled $24.69 per share—the lowest earnings figure since 1993 and a whopping 50% drop from 2000 earnings of $50 per share.The collapse in corporate earnings caused the price-earnings (P/E) ratio of the S&P 500 index to increase sharply to a yearend 2001 value of 46.This figure exceeds the P/E ratio of 28 that prevailed at the market peak in March 2000 and is three times higher than the average P/E ratio of 15.2 going back to 1926.

Productivity in heart attack treatments

Abstract: U.S. and, at 14% of GDP, is much larger than such spending in other industrialized countries.The increase in spending reflects not only changing U.S. demographics but also the use of new, and often costly, treatments, as well as institutional factors relating to health insurance and the structure of the health care industry.The question naturally arises, then, whether the increasing cost of treatments has been accompanied by more effective, or, equivalently, more productive, health care services.