Costs of European Monetary Union: Evidence of monetary and fiscal policy effectiveness

Costs of a monetary union are typically analysed in the context of the optimum currency area approach, looking at the likelihood of asymmetric real disturbances, the degree of real wage flexibility and of labour mobility. But it is also important to consider the leeway of monetary and fiscal policy to respond to country-specific real shocks prior to entering the monetary union. Applying a structural VAR model to Austria, Belgium, the Netherlands, Sweden, Finland, France, Italy and the United Kingdom indicates that costs of giving up autonomous monetary policy in a European Monetary Union (EMU) would generally not be too high. Only in Italy and the United Kingdom autonomous monetary policy has shown positive short-run output effects in the past, in all other countries such effects are negligible or not significant. Some cushioning influence of adverse EMU effects, then, could be expected from autonomous fiscal policy measures, since results suggest that, with the exception of Finland and again Italy and the United Kingdom, autonomous fiscal policy had positive short-run output effects in the past in all cases, those effects being somewhat more pronounced in Belgium and Sweden.

Exchange Rate-Based Stabilization: Pleasant Monetary Dynamics?

High inflation economies have ultimately been successful in stabilising their prices using the exchange rate as a nominal anchor. Besides stabilization, these recent examples have shown boom-recession cycles, contrary to what can be expected from (pure) money-based stabilizations. Various theoretical explanations of such boom-cycles are discussed and a model of aggregate supply and demand generating such an outcome is developed. There the boom dynamics depend mainly on a slump in real interest rates and wage flexibility.Macroeconomic modelling; exchange rate-based stabilization;high inflation; Latin America.

Lessons from the financial market turmoil: Challenges ahead for the financial industry and policy makers

This financial crisis, ending a period of search for yield and increased risktaking, has triggered various policy responses, ranging from more ad-hoc measures initially to more structured and co-ordinated financial sector rescue actions as the crisis evolved. Lessons drawn so far should help to devise longer-term, more encompassing and more consistent policies. Various reforms are being proposed by the financial industry as well as by official authorities and international standard-setting bodies, many of which arrive at similar conclusions regarding the causes of and remedies for the crisis. Shortcomings in risk management, including compensation schemes, governance structures, liquidity and counterparty risk, need to be addressed.

Sovereign Debt Challenges for Banking Systems and Bond Markets

Discussions at the October 2010 OECD Financial Roundtable conveyed a rather sombre view regarding the current outlook and risks, heightened by financial sector weaknesses, ongoing deleveraging and sovereign debt. Policy makers should be prepared for downside risks to materialise along the way to recovery. Low interest rates and low returns pose specific challenges for institutional investors. While sovereign risk is currently a major concern, its measurement is rather complex and markets do not always provide proper guidance. Sovereign ratings can serve as a useful point of reference but should be made more forward-looking and less procyclical. Should default or debt restructuring become necessary, strong political backing can minimise its costs. The European Financial Stability Facility (EFSF) was seen as helpful in providing a backstop. Some optimism was expressed as to the current fiscal adjustments underway to bring public finances back onto a sustainable path. Banking sectors remain fragile, especially in Europe, where, however, the transparency provided by recent stress tests has calmed some fears. Reactivating the wholesale markets for bank funding will be essential going forward. Capitalisation of the US banking sector has improved, but pockets of risk remain in exposures to commercial property by regional and small banks. Contingent convertible (bail-in) bonds could become a useful instrument for sharing the costs of crises, but they need to be made attractive for investors. JEL Classification: G01, G12, G15, G18, G21, G32, H06, H60, H62, H63, H68 Keywords: financial crisis, sovereign risks, public deficits and debt, bond markets, banks

Risks Ahead for the Financial Industry in a Changing Interest Rate Environment

The current interest rate environment has been conducive to financial institutions assuming exposure to interest rate risks. As interest rates are expected to rise globally, albeit slowly, and current steep yield curves may soon flatten, such risks may materialise in the near future. At the same time, weaknesses in the banking sector still exist, especially for some segments of the European banking sector. While the effects of changes in interest rates and their structure on financial institutions differ, recent changes in asset and funding structures of banks make them generally more vulnerable to a changing interest rate environment. Currency risk exposure has also grown, and regional concentration may pose specific risks. An unravelling of carry trades will have a negative effect on some institutions. Proper risk management can help during an adjustment process, and regulatory reforms underway will better support risk management functions in financial institutions that are, in any case, already adjusting to the new environment. JEL Classification: G01, G12, G15, G21, G32 Keywords: financial crisis, interest rate risks, sovereign risks, bond markets, banks

The financial industry and challenges related to post-crises exit strategies

Financial markets have recovered substantially but vulnerabilities remain significant. Ample liquidity may lead to new bubbles, particularly in some emerging markets, and uncertainties about government exit strategies and regulatory changes threaten a fledgling upswing. Co-ordination and communication of exit policies will be important, and exit from policy stimulus should not be precipitated at the current juncture. While financial institutions have increasingly obtained market financing and paid back state aid, the sector remains fragile; thus, such voluntary pay-backs should meet preconditions aimed at ensuring the soundness and sustainability of the concerned institutions’ balance sheets. At the same time, expectations of future writedowns and more stringent capital rules put pressure on bank lending more generally. Restarting securitisation to support lending would be important and could be fostered by government initiatives focussing on standardisation, transparency and due diligence to restore investor confidence. Regulatory reforms currently being proposed concern accounting rules, capital requirements and compensation issues. However, further reforms are required to address such systemic issues as moral hazard created by public support. Measures would include resolution mechanisms for large and systemically important banks as well as appropriately fire-walled business structures for the financial sector. Peer pressure via co-operation in international standard-setting and relevant bodies should help to keep the reform momentum, overcome political impediments to reform and maintain a level playing field.