It has barely begun

On Thursday, I attended a Goldman Sachs investment conference in Lucerne. Jim O'Neill, the firm's chief strategist, gave the keynote presentation containing an outlook for the world economy, which was surprisingly optimistic (this year's global growth rate is expected at 4.4% vs 3.9% consensus). To my question where deleveraging was in that picture, he answered that it wasn't because there is no reliable information about leverage available, and that we shouldn't trust anyone who claims to have it.

It appears to be more than a little cavalier to ignore a presumably major phenomenon simply because it is hard to measure. It is therefore very timely that MGI has just published a major report on debt and deleveraging. MGI looks at the buildup of debt at a per country and per sector level and distills four archetypal deleveraging scenarios from past episodes: Austerity, Inflation, Default and Growth. Unsurprisingly, they find that deleveraging has only just begun in a quite moderate way, as private sector debt reduction is compensated by increasing public sector debt.

BIS on the crisis and remedies

"And, in the future, a financial firm that is too big or too interconnected to fail must be too big to exist."

The Bank for International Settlements Annual Report is probably the only one that I read regularly for its content, rather than mine it for data. It contains authoritative interpretation of recent economic and financial developments, and is thus an important source of consensus narrative. This year's report is no exception.

Of particular relevance going forward is its chapter VII, outlining the current thinking about capital requirements by evaluating a Systemic Capital Charge and a Countercyclical Capital Charge. However, these capital charges appear to continue to rely on portfolio theory's (stable?) correlations, which is conceptually flawed, as we now know. Nevertheless, it is encouraging to see that countercyclicality is addressed not with perceptional placebos such as modified accounting standards, but with measures aiming at the economic heart of the matter, namely leverage and the capital base. Last, but not least: if Too Big to Fail were a victim of the crisis, it would have been worth it.

Victims IV: The real crisis

The Economist deserves praise for having featured a special report on the impact of ageing populations in this time of crisis, which overrides longer term requirements with its fiscal profligacy. The majority of industrialised countries were already on an unsustainable fiscal path before the crisis struck. It is difficult to see how government finances will ever be able to return to a trajectory that is stable longer-term.

It goes without saying that the foreseeable instability of public finances has a dramatic impact on capital funded retirement systems. At this juncture, the jury is still out on the prefix of instability, i.e. whether we will see inflation or deflation. Either way, the contradictory demands on the investment strategy of individual funds are anything but trivial and may need to be implemented consistently in very short order once the dust settles. Scenario analysis and preparation is the name of the game. I look forward to a workshop producing a Shell/Oxford-method scenario analysis on Switzerland 2030, to which I have been invited by the federal crisis management education unit.

The tyranny of the present

In a recent issue of its flagship publication Sigma, SwissRe described Scenario analysis in insurance, identifying scenario analysis as a key tool to analyse fat-tail risks and their impact on profitability and competitive position of insurers. One of the pioneering sources of scenario analysis is the approach developed by Shell. Whereas scenario analysis is referred to as a key tool for both strategic planning as well as enterprise risk management of insurance, Sigma reports with some degree of astonishment that banks do not use it to assess their total enterprise risk exposure.

Applying the concept of scenario analysis to pension funds should be self-evident, not least if you think of a pension fund as the insurance subsidiary of your firm. It faces a set of opportunities, threats and parameters quite similar to those of an insurance, yet scenario analysis is not common in the pensions industry. Nevertheless, a number of pensions-specific scenarios easily come to mind: a jump in longevity due to unexpected medical progress, prolonged negative real interest rates, a pandemic (as explained in Sigma), regulatory changes to the competitive landscape ...

The Economist Intelligence Unit has just come up with its own bleak exercise in scenario analysis (hat tip Global Guerrillas). Its central forecast of stabilisation is assigned a probability of just 60%, whereas the more disruptive instability scenarios are assigned 30% (de-globalisation) and 10% (collapse in USD) respectively. Scenario analysis has been posted as a means to escape the tyranny of the present, but being where we are today, we are not so sure this is a good thing.

Victims (III): Prudent Person in Switzerland?

Until the beginning of this year, Swiss pension funds were obliged to follow a detailed set of investment restrictions laid down in a government regulation, or obtain a formal waiver to deviate from these restrictions. The more sophisticated institutions have made use of that opportunity, which is why what once was supposed to be an exemption now had effectively become the rule.

This has changed with the new investment guidelines of articles 49 ff. BVV 2 which have entered into force on 1 January. The number of investment restrictions has been curtailed substantively and the alternatives asset class has been made available. Yet, the government has stopped short of introducing the prudent person rule as there are still a large number of small iorps which appear to feel more comfortable following a prescribed asset allocation, despite their objective needs. That is probably the line of thought that MPs followed who criticised the changed guidelines massively.  They seem to think that parliament knows best what an appropriate asset allocation strategy should be. It is unfortunate that even the most moderate of reasonable changes come under political pressure as a consequence of the crisis.

Effectively, the new investment guidelines are a reluctant, small step in the right direction. But they clearly fall short of the EU's state-of-the-art Pensions Directive 2003/41 in fundamental ways, most evidently in the restriction on equity investments to 50% rather than 70% as per the Directive. Also, a target return in line with money and capital markets and real estate returns seems to be at odds with member interests. Consequently, it is hardly surprising that the magic triangle of Risk, Return and Liquidity is cut down to a single Risk-Return line. There is also a degree of over-diversification in the prescription that alternatives exposure can only be taken through (expensive) collective means. Finally, there seems to be an editorial error in art. 60, which appears obsolete, given art. 50.4/5 (deleted by subsequent Regulation). There is a lot left to do. Here's to hope that the crisis will not preclude the necessary changes.

Victims of the Crisis (II): McCain / Palin

And good riddance!

Victims of the Crisis (I): XBRL?

This is the first installment in an loose series about victims of the current market crisis. We'll do a triage of the patient with a bit of a health check for cases of potential resilience. To be sure: we don't think the crisis is over ...

Just a few months ago, the XBRL bandwagon seemed unstoppable, set to take the world of financial reporting in a storm. Now, �we're not so sure. The all-important US SEC rule to make XBRL mandatory for US filers is overdue, and some doubt whether it will be coming forth at all, given the SEC's backlog of far more urgent things to do and only a few more weeks to go until the administration changes.�

On top of that, XBRL is increasingly seen to acquire a stigma of failure in the public eye because it is often identified as the hobby horse that detracted Chairman Cox from attending to his real job, for which he is under heavy fire. If that stigma persists, then Mr Cox' successor may be loathe to finish up, even if he were to share a similar level of enthusiasm for XBRL (which is a tall order).�

The user community is well known for suffering from ADD, so if the momentum of the move towards global XBRL disclosure is seen to be broken and availability of comprehensive XBRL coverage becomes a thing of the distant future, it will quickly loose what little interest it has had so far.

All that being said, the case for XBRL is as strong as ever. In fact, if accounting standards convergence is on the�back-burner�for the foreseeable future (more on that in a later installment), then a new use case for XBRL as a meta-standard for comparison and valuation purposes could emerge.�