Why smartcars will not beat wearable technology

Tom Chatfield, author on digital culture, published an article in the Guardian this month on how smart wearables fade in importance compared to smartcars. Yet a discussion about whether people want to “connect their smartphones to their wrists and faces” is reductive. We may want to look at it from the following viewpoint: just how much control do we want to give to technology in our lives and how far are we ready to go with the trade-off between complete control and “easier”?

Positing this debate from an economist’s point of view, individuals will take up an action if benefits for doing so outweigh the costs. The value of the benefit of a technology is sometimes easy to figure out – tracking someone’s blood sugar through an eye lens to cope with diabetes, or monitoring a baby’s sleep to warm up milk at night is useful. But just how costly is it? Beyond the monetary price, how much trust can we put in a mechanism that is meant to act as a nano doctor attached to our bodies, telling us when to apply an injection of insulin? How much can we trust a “connected” baby romper to understand a child’s sleep state? Further, should we allow being driven by a computer-controlled car?

Hypothesizing about “which smart device will bring about the revolution” should rely on a framework of axioms we can agree on. People have heterogeneous tastes, they face information barriers and budget constraints, so not everyone will be able to give up control or enhance trust in technology, let alone afford it. How many people once argued against cars, television, or even calculators? Clearly, these devices have facilitated many tasks in our lives but they are also associated with a certain opportunity cost – higher accident rate, TV addiction or possibly a decrease in capacity to do mental calculations. Yet the rate of success of some inventions has shown that overall the benefits of these devices outweighed the costs that people observed, and trust increased.

So people want to trust a technology – and a great way of doing so is by observing what others are doing. Also, we could imagine that the adoption rate depends on the time that a useful technology has been around – it could be an exponential or an otherwise increasing function, but essentially my propensity to adopt a technology depends on how many people have adopted it so far and whether it has been available for a long time.

P (Probability of a marginal adopter) = F (Other people’s adoption rate, Time the useful technology has been available)

Further research could explore what this relationship is likely to be. We could imagine that the first variable will have a positive impact on the outcome and the second variable may have a quadratic relationship with the marginal probability of adoption. Clearly, the so-called early adopters will have a high P and the laggards will have a low P. Different industries and products may have different functions F.

In addition, the factor of “other people’s adoption rate” encompasses various variables, such as price of the technology and uncertainty of the benefit associated with it. Network effects also may be important, as people are likely to adopt a technology if their immediate peers use it. We could imagine that certain industries could have a marginal adopter function of this kind:

We could also suppose that the overall adoption rate increases and decreases back again with time –  which is the benchmark inverted U of a technology adoption lifecycle. After a technology has been around for a while, its use decreases as something else becomes available.

Thus the debate of whether smartcars or smarwatches/lenses/rompers will come first may be of a lesser interest than understanding how people’s characteristics such as taste, risk aversion, peer pressure or income interact with the specificity of a technology – or how indispensable it is thought to be compared to its financial or other costs.

Our cars have gotten much smarter recently. But Chatfield argues that smartcars will free our hands of driving, implying so much benefit that people are likely to jump right into using them. Yet, if we look at it through the lenses of cost vs. benefit and complete information vs. information barriers, it may be more likely that people will adopt all kinds of other smart devices first – as long as they find them useful and accessible enough.

We need female quotas back on the agenda

“I am 26, married, and I can’t get hired because all my employers think – and ask me explicitly whether – I am planning to have children soon”. So goes the story of many a woman today. It is no secret that rigid labor markets in Europe, combined with persistent gender discrimination, perpetuate inequality among men and women at work. Halfway through the second decade of the 2000s, it is clear that change “from below” is too slow and we need more women in power to generate positive outcomes for younger women.

First, we have to acknowledge that some disparities between men and women have been decreasing. For instance, the gap in unemployment rates in France is over 4 times lower than it was in 1985.

However, a high level of inequality persists. A study by the French National Institute of Statistics and Economic Studies cites the region of Lorraine as the “good student” in the matter, yet 32% of women work part-time while this figure only reaches 5% for men. Another pair of stark figures is the following: one out of eight women is a stay-at-home mom, while only one man in 700 is a stay-at-home dad in this region. In addition, women have higher unemployment rates for any level of education.

NISES also looks at wages for different kinds of jobs. In all categories, women earn considerably less.

The Statistics Institute also explores the notion of overqualification (déclassement). In Lorraine, 40% of women are over-qualified for what they do, against the 24% of men.

Finally, no matter the age, French women are still more likely to be unemployed.

As a result, finding a good match on the labor market is still a tough task for a young woman in France. Yet unless there is a critical mass of women able to steer the change from above, limited micro-level policies will not trigger a ground-breaking change. Jean-Claude Juncker was right in invoking the need of more female representation at the European Commission before he became the new president. It is up to Vera Jourova, the European Union’s Commissioner for Justice, Consumers and Gender Equality, to follow through with Viviane Reding’s idea and put the quota requirements back on the agenda.

*Some of the presented data may have evolved. Follow-up studies by the Statistics Institute should study the subject further.

Central Europe is your next business idea destination

It is true that today in Europe, the bitter after-taste of the crisis is still present. Unemployment is high, businesses have a hard time waking up the demand and governments are confused between the Southern austerity and the Junckerian investment plans. I would like to share what I think could be a source of inspiration for all those undiscovered entrepreneurs, giving the impetus to go see how Europeans think and figure out how to make it a business.

This is probably the best website you will have seen in weeks or even months, although I may be biased because I worked on it myself. But bear with me for two minutes. Would you like to know how many people in your country have a smartphone? How often people go online? Whether they do research online before buying? Why do they watch online videos? Now, say, you want to split that by age, gender or income? Compare different countries? the Consumer Barometer lets you do all that and a lot more.

After diving into the data just a bit you’ll see that people around the world have more and more devices, they go online all the time and use the internet for a variety of needs. This is the reality of the age of the ICT, when most of the decisions we take are influenced by the internet. People search online for everything, from how to get a job to whether Santa exists to what is the best pension plan. Often we think we are very much ahead of our neighbors, but this website may show you that many people around us are even further.

Taking a small country as a case study example, we can illustrate how extraordinary this change has been. Ten years ago in Lithuania, a Nokia 3310 cost over 200 euros, while a minimum wage was 130 euros – hence very few people could afford a mobile phone. Today, people are obsessed with devices and internet usage. In 2012, everyone had one device per person. Today Lithuanian people have on average 2.1 devices per person – often a computer and a smartphone and sometimes a tablet. If you take the tiniest bus to the most remote town in the country, chances are it will have wifi. Arrived to Vilnius and have no idea how to get a bus ticket? Just go online and pay with a click. Cannot figure out how to pay for parking? Send a text to make the transaction. Three out of four Lithuanians use the internet – same ratio as in France – and 43% of those internet users who recently bought a TV, purchased online. Very similar trends are also true in the neighboring markets.

What does that mean for European businesses? Well, today it is sensible to sell and advertise online, especially where growth and technology adoption rates are high. It makes sense to figure out what people want before they even think about it. Online tools can tell us what the trends are, the trick is to jump in front of them. They may show us which markets are still under-served while signs of demand sit there as all those unanswered search queries. What would happen if people replaced their procrastination online habits with research about their future business?

 

Should we change the paradigm of measuring welfare?

While the FT may not like the UK government fiddling with the economy too much, it does acknowledge such need in the developing world. This recent article shed light on the debate around the definition of poverty. The Asian Development Bank has declared that the number of poor people in Asia is twice as high than previously thought, as it claimed that the threshold of $1.25/day should in fact be raised to a $1.51. These remarks have engendered an uproar against the audacious conclusion, but it also raised the issue of how we measure poverty and welfare at large.

If we look at the GDP growth in East Asia in the past ten years, the trend is definitely positive – ultimately growth correlates with jobs that lead to creation of value and a more comfortable life. However, just how efficiently a government can distribute its new riches, or whether it gets to tap into them in the first place, remains an ambivalent question.

Besides aiming for GDP growth, healthcare and education should be among the top priorities in the developing world. My very first attempt in research was in healthcare insurance in Ghana. I found that insured people were more likely to see a doctor and spent significantly less in case of emergencies as well as on medicine on a regular basis. Membership at the financial NGO I worked with, ID Ghana, also seemed to have a positive effect on savings. I argued that programs that facilitate access to the National Health Insurance Scheme should be supported and replicated in other contexts outside Accra in order to reduce spending on health-related issues and improve access to medical services.

The cost of the premium of the public insurance scheme in Ghana was under $10/year in 2012. According to different sources, the take-up rate was somewhere between 18%-45%. Even assuming the most conservative scenario, it left one half of the population out of the insuree pool. Yet we are looking at one of the African leaders in economic and democratic advancement. Add the lack of adequate education system and you find yourself with a destitute labor force, ill-equipped to generate innovation and progress for its communities.

Paradoxically, economists love obscure models and simplistic comparisons. Could we measure poverty in other terms than $/day? How about looking at children out of school, or girls/boys at school ratio interacted with access to education? According to the World Bank, primary school enrollment rate in Nepal was 139% in 2012. Odd, isn’t it? It turns out many children who are too old to be in primary school end up taking basic mathematics and language classes, while only 66% of the children who should be in secondary school make it so far. Absolute figures tell other alarming stories – around 60,000 boys were out of primary school, compared to 460,000 girls in Angola in 2012. In Bangladesh, on the other hand, the trend is just as disturbing yet the opposite: 500,000 boys were out of school compared to around 130,000 girls that year. The figures get more appalling in Nigeria with its 3,750,000 boys and 4,960,000 girls taken out of primary school. Millions of children do not get primary education in other places either – 2,320,000 boys and 3,050,000 girls in Pakistan were out of school according to the latest statistics.

It is definitely hard to come up with a comparable international currency for poverty measurement. But if we had a set of metrics that combined a country’s material wealth, access to education and healthcare, we’d be building a more realistic paradigm about welfare. I wonder where it would put the US, with its population comprising 1,800,000 unschooled primary school age children and the 15% of uninsured citizens.

World Cup tickets should be much more expensive – but host countries do not have the bargaining power

The World Cup will have cost Brazil at least 2.5 times more than to the second largest single spender, Germany, in 2006. Yet the propensity to use the 12 state-of-the art stadiums is significantly lower in Brazil – South Africa, for instance, is said to have recovered a mere 11% of total costs of its 2010 Cup. At the same time, Brazil is to host Rio 2016, which will make use of… 1/12 of these stadiums. The graph sums up the national spending on the World Cup in the past 20 years, showing the disproportionality of the costs with countries’ GDP.

Minimizing the cost and maximizing the usage would seem the most desirable formula, and the US, Germany and France appear as the ultimate winners according to post-World Cup calculations on stadium use. Protests in Brazil over exaggerated, inefficient spending have led to little change, and Brazil risks having to close many of the stadiums built in cities were football games are rarity, let alone the capacity that will definitely be unused. Paradoxically, with the elections in Brazil this October, gold could lead to more unity but less investment in Brazil, as Dilma Rousseff’s victory would become more likely but possibly scare off investors. Could it be that the high cost burden on the host explains why authoritarian countries will welcome the upcoming World Cups?

My humble assumption would be that given the apparent inelastic demand regarding the World Cup, the tickets for different games leading to the final that range between 400 and 1000USD should definitely cost at least twice as much. Broadcasting should be made more expensive as well, making TV companies plan their budgets and charges for advertisement accordingly. In this largely indirect way, consumers of brands who do find the budget to advertise during the precious time around the games would also find themselves take part in cost-sharing. This reasoning, of course, relies on several assumptions, including fair income channeling by FIFA, which is far from given.

In spite of the fact that such arrangements may still not help cover the costs incurred by the host country, the difference could be significantly smaller (possibly 1/5 of costs recovered in the South African case). However, the bargaining power must be on the host’s side, which, clearly, it is not for the 8 years to come.

 

 

 

 

One globally minded French woman defying the nationalist image of France

How can it be that France’s Front National and the UK’s UKIP will be sent to the European Parliament as principal representatives of the electorate in these two countries? Not only will the mainstream parties have to reinvent themselves and offer a solid societal proposal if they are to keep power in the future national elections; they will have to find ways to work with the extremist parties meanwhile. One thing is clear – we will get even more amusing yet sad discourses of people like Nigel Farage or Marine Le Pen from Brussels and Strasbourg.  

While some play politics, others go out there and set the agenda. Few French women speak English without a hint of an accent, still fewer get to the top of one of the most influential institutions in the world and reshuffle l’ordre du jour to the extent where one is not sure if we are dealing with the IMF or the World Bank. This is definitely Christine Lagarde, who, despite the shaky history of her institution, is changing the face of global policy making.

Lagarde is currently on a visit to Mozambique, where she is participating in the Africa Rising conference. Talking about intolerable levels of poverty, the need to tackle climate change and search for more integrity in capitalism is not a recurrent topic on bankers’ lips. Yet this is what she essentially is – the CEO of the biggest fund of support to sovereigns, which has till recently been known for its punitive conditionality and stringent policy requirements upon loan disbursement. Notwithstanding these one-size-fits-all experiences, the IMF appears to be changing direction, to a great extent, thanks to its current leader.  

To what extent this positive breeze of change will extend to more case-by-case solutions, accommodating for often needed counter-cyclical measures in order to boost consumption in periods of crisis, remains to be seen. As a reminder, it was the head of the IMF who was one of the first global leaders to speak out about the too heavy an approach regarding austerity in Spain and the UK, and to admit that the fiscal multiplier effect was clearly underestimated – deepening the recession based on misguided economic policy advice.

I sometimes wonder if the board of directors at the IMF knew what they were embarking on when they recruited Lagarde. In any case, her leadership, unlike the outcome of the recent elections, has definitely been a welcome surprise to the world.

Bankers should be held accountable for risk mismanagement – but regulation has to be transparent

Understanding the magic of incentives in banking – a risky, interconnected business, that is subject to myopic behavior when under stress – is an exciting endeavor. Often, same rules that apply elsewhere – such as personal liability for one’s actions at work – do not apply, while odd rules of thumb – implying a less complicated regulation package – may be more optimal.

Should bank managers have their skin in the game?

When it comes to banking, almost no one was jailed for steering their and other people’s ships into peril (with some exceptions such as Fabulous Fab for Goldman Sachs, Jérôme Kerviel for Société Générale, and several bankers in Iceland) in the recent crisis. Many invoke the impossibility of trial where lines of responsibility are blurred, but as with any type of delegation, the person in charge is the one with reins in hand. More recently, JP Morgan’s $2 bn trading loss, triggering a considerable fall in its market value, coupled with the Libor cartel scandal only added dark colors to bankers’ perceptions. As long as investment and retail banking are not split – whether that should be the case is a whole different question – such cases will continue contributing to financial instability and future crises. Clearly, rewards must be conditioned on responsibility. If the bank itself is likely to repay any fines that may be imposed, as in the case of the failed Countrywide in the US, acting in own self-interest may be seen as greedy but privately optimal.

The beauty of finance is that it is an ever-evolving medium, thus creative measures, leading to better incentive streaming could be envisaged. The associate editor of the Financial Times, Martin Wolf set out his vision clearly and aptly. He suggests that the level of pay should not be regulated but its structure should: managers should have a large chunk of their bonuses withheld for a long period of time on a rolling basis, without the possibility of hedging against losses – just as there is no insurance against criminal penalties. Stock and stock options should not make up any part of the withheld compensation, as that merely realigns managers’ incentives with those of shareholders, but not of creditors, who ensure the vast chunk of banks’ financing (are the likely beneficiaries of a government guarantee). Hence, targeted measures may generate lower revenues from fines but deliver a safer financial system.

The dog and the Frisbee

The executive director for financial stability at the Bank of England, Andrew Haldane, could not be more graphic when he describes the dog and the Frisbee problem. Calculating the trajectory of a thrown Frisbee involves considerations in physics and mathematics, including speed, wind, gravity, the Frisbee’s rotation and flight path. However, most dogs seem to go with intuition that allows them to catch the Frisbee easily. Sometimes simple rules of thumb override complicated models.

The financial industry is tired of bank-bashing, and calls for more cooperation. In turn, governments are tuning down their once-pompous discourse on regulation, but the ever-growing amount of regulatory text is a flourishing medium for the indispensability of specialized law firms, a cause for increasing compliance expenditure and, unfortunately, ever-more-opaque adaptive measures. Haldane is right when he says that a simple leverage ratio – equity divided by total assets – is a far more telling metric than the capital ratio – equity divided by a self-determined proportion of total assets, the risk-weighted assets (see my previous post explaining the differences graphically). Paradoxically, the ever-growing regulation is becoming a swamp where much of the upcoming financial innovation, circumventing the currently intended regulatory measures, may be engineered.

This boils down to two pieces of advice for policy:

• make top managers personally accountable for taking unmeasured risks by withholding bonuses and
• aim for simple – yet targeted – regulation, focusing on leverage in particular.

Basel 3 in 4 diagrams: a stylized approach to banking regulation

On March 10th, the European Commission held a public meeting on leverage and liquidity coverage ratios. Not surprisingly, contributions of the banking industry give the impression that these regulations will choke the economy. There have been, and surely will be a lot of discussions and literature on banking regulation as the global Basel III requirements become increasingly more binding (with fully-pledged Basel III as of 2019, if regulators do not back off in the meantime). Regulations are often portrayed as a morass for business, and a nourishing medium for intrusive bureaucrats. However, banking is no regular business, as it is backed by potentially limitless guarantee of the State. It is hence important to understand what Basel III regulations are about, which issues they are trying to address and what leakages are still likely given the incentives anchored within the financial industry.

There are two axes of focus in Basel III: capital and liquidity. The former is intended to cover any losses on the asset side of the balance sheet (if money lent is lost), the second deals with ensuring a sustained source of financing (if lenders stop providing funding to the bank). Bank borrows money to lend it, making profit on its maturity transformation. Wearing “balance-sheet-goggles” simplifies understanding of Basel III, as regulatory requirements can be explained with stylized diagrams.

We proceed with a simple view of a bank as a balance sheet : bank borrows, creating liabilities (right hand side), and lends, creating assets (left hand side). All liabilities equal X, all assets equal Y and both sides of the balance sheet are equal:

Basel III tackles both sides of the balance sheet, requiring compliance with 4 proportions: leverage, capital, liquidity coverage and net stable funding ratios.

1. Capital framework

Leverage ratio

Within capital requirements, it is easier to first look at the leverage ratio, as it has no dynamic parameters attached. It is the sum of the bank’s capital over the sum of its assets[1]. If the capital (shares issued, retained profits, other high quality capital falling under the changing Tier 1 requirements) equals 3 units, and the assets total 100, then the leverage ratio is 3/100=0.03, or 3%. This is the minimum set by Basel III requirements – the US regulators are currently considering setting an even higher requirement, between 5% and 6%, depending on the type of the bank. In addition, off-balance sheet asset inclusion in the denominator (such as derivatives and repurchase agreements) will imply yet a higher required amount of capital to back those holdings[2].

Capital ratio

The capital ratio looks much like the leverage ratio at a first glance. There is a β on the asset side of the balance sheet, which represents the complicated internal bank models to weigh the risk associated to their lending. For instance, sovereign bonds receive 0% risk weight, meaning that it is thought impossible for a State not to pay its debt, which, given the high yields in the past years in the European “periphery” and the upcoming regulation, made them an attractive investment niche (as discussed in a previous post). But the risk weights of other assets – based on probabilities of default and likely losses given default of counterparties –are subject to the black box algorithms of financial engineers. The losses experienced by Goldman Sachs in 2007 had been forecast to happen once-in-every-fourteen universes on several consecutive days[3]. Now that’s quite a miscalculation!

In the example below we only calculate Tier 1 (best quality capital) ratio, that will equal 6%, coming into force as of January 1^st , 2015, through the EU’s Capital Requirements Directive and Regulation. Additional capital conservation buffer of 2.5% and 2% of Tier 2 capital, as well as requirements for  will be phased in through 2019. If we let Y=100,then β=1/2, implying that half of the balance sheet is discounted due to the limited percieved riskiness.

2. Liquidity framework

Liquidity coverage ratio

In order to avoid the detrimental consequences of illiquid markets, Basel III requires banks to be able to finance themselves during 30 days in times of stress. Perry Mehrling has argued brilliantly that credit liquidity is ultimately the very core of the banking business, as profits as well as crises revolve around its intertemporal qualities[4].

High quality liquid assets (HQLA) must be sufficient to cover 100% of the cash outflows of a 30-day period under stress, which may be related to either side of the balance sheet (losses on assets, debt redemption, interest payments etc.). Hence, an outflow of 30 units over 30-day period must be matched by at least 30 units of high quality liquid assets. However, this requirement, too, is phased in, implying that only as of 2019 will it apply in full.

Net stable fund ratio

Finally, having made sure that any losses on assets are covered and that funding is available in times of stress, the last requirement tackles the maturity mismatch between debt liabilities and assets. If every long-term, high yield loan could be financed by cheap short-term debt, banks would be the best business to be in. In effect, many were running in such fashion in the lead-up to the crisis. However, we have witnessed that things may also go wrong, with debtors of the bank defaulting or failing to pay on time, putting repayment of the bank’s own debt at risk. A perceived or apparent maturity mismatch triggers liquidity risk, potentially leading to a credit crunch. In order to avoid it, banks should not be overly reliant on wholesale short-term lending.

In the example below, a part of the asset side of the balance sheet, ζ*Y, requiring stable funding (long-term, encumbered assets), should be matched by at least ε*X quantity of long-term liabilities, or available stable funding.

In conclusion, Basel III relies on rather intuitive principles. The whole package of regulations can be explained in a rather unadorned – although admittedly reductive manner. Surely, the devil is in the detail – the many adjustable pieces, based on legal nuances and private-incentive-based microeconomics make up a complex regulatory mosaic. However, the phasing-in of the regulations through 2019 should not be seen as a chance to curb them but rather as a sufficient timeframe to enhance compliance with these rules.

 

[1] Definitions of capital are evolving – they are phased in through the period leading to 2019. In different years, different types of liabilities will qualify as certain kinds of capital, with the definitions becoming increasingly more stringent

[2] If a bank holds twice as many assets off-balance sheet, it will need twice as much capital, or 6 units in our example. Banks are said to run very substantial off-balance sheets which would imply more high quality capital to back assets: http://dealbook.nytimes.com/2014/02/28/why-the-bank-leverage-ratio-is-important/?_php=true&_type=blogs&_r=0

[3] Skidelsky 2009

[4] Perry Mehrling is an economics professor at Columbia University

 

 

Application of H. C. Andersen’s insights to the banking business

In the 19^th century Copenhagen, H. C. Andersen wrote a short tale that derided the society’s inability to see the obvious, that he called the Emperor’s New Clothes. As a legacy for his brilliance, we can still find this innocent story relevant in today’s world. Hardly anyone on this planet has not experienced or heard of the hardships provoked by the global financial crisis. A whole generation wondering where to find a job and how to leave mama and papa in dignity, lost life-long savings and (not so creative) destruction of enterprises – to name but a few social and economic calamities – were the dire consequences of the crisis in the industrialized countries in particular, while emerging countries had to put up with their frantic, uncoordinated policy spillovers. Yet the very same industry having caused the global economic – and wellbeing – downturn is seemingly easily getting away with business as usual. In the beginning of the year, the global regulator, Basel committee, weakened leverage requirements to the banks, leaving chunks of trading activities off-balance sheet and favoring banks’ netting out of repos, that are an important part of their short-term debt whereby securities are pledged for borrowing. A. Admati and M. Hellwig in their book “Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It” (2013) explain exactly this – namely, the fact that banks are still able to impart erroneous messages that allow them to continue performing a balancing act with other people’s money daily.

Basel III sets out a phased-in schedule of strengthening regulation, with the new Capital Requirements Directive transposing increasing capital requirements into the EU law.

Source: BIS

Against this backdrop, why are bankers still so reticent to decrease leverage? Let’s dwell in their world for a minute. Banks fund themselves through equity and debt. Equity holders, or the shareholders, own the company, and get the profits and cover losses of their business – the bank’s operations. Debt holders, or creditors, lend money to banks for a certain period of time in return of receiving a fixed income, defined by an interest rate. Among others, depositors fall into this group. Banks then use this money to carry out their business – lend to the economy and trade. Now banks like leveraging, or issuing a lot of debt and little equity, because equity holders are the first ones to bear any losses, and equity investment is seen as riskier and thus more expensive. Hence, pushing the limit of equity down to the minimum allows to realize more profits in the short term, while remaining insouciant about the possibility of something going slightly wrong on the asset side of the balance sheet. The issue with high leverage is that creditors’ runs on banks – caused by panic in the market – are damaging to the whole economy through the fall in asset prices, so the government feels compelled to step in and inject money in the banks. Despite the due unfairness of it, this is socially the least costly once in a crisis, given the possible disastrous repercussions leading to a complete collapse of the economy. Governments thus provide an implicit guarantee or insurance ex-ante on saving banks’ creditors. Hence, the higher the level of debt relative to equity,  or the leverage ratio, the higher the – free, if we assume that the tax system is well-tuned – government insurance.

The logical implication would establish that in order to avoid crises in the first place, banks should hold less debt and more equity, so any losses on banks’ activity – mismanagement in lending or trading – should be covered by people who own the firm. This would then seem comparable to any other kind of industry or business, where implicit government insurance is absent. However, here the emperor goes nude with stark statements that seem absurd but that few policy makers appear to be able to acknowledge. Bankers, or the owners of the banks, would like to have less equity, because the opposite implies a risk reshuffling from the implicit government insurance to the owners. The argument that seems to sell among regulators is that increasing equity will hurt the real economy, because banks will have to increase interest rates on loans. This would be the case if the return on equity for some mysterious reason, and contrary to any market logic, should remain the same whatever the level of equity. However, as equity increases, risk per share decreases, and hence average price of shares must decrease, too[1]. When The Economist tells regulators to tighten their oversight and resist bank lobby, you are sure there is much at stake.

In addition, with a large quality capital pool (such as equity and retained profits) in the investee bank, creditors too may require lower interest rates and less liquid assets to be held by the bank as they need not worry about the bank going insolvent (running out of capital) easily. Finally, hybrid or convertible debt, that “becomes” capital when higher quality capital runs out is still suboptimal a choice of financing, as its conversion instantly signals substantial stress in the bank.

The upcoming “bail-in” legislation in the EU should contribute to removing government insurance to banks. However, without a fundamental shift in the equity/debt mix in banks’ balance sheets, the risk of a large banking crisis remains present, and ultimately is at the mercy of short-sighted, tangible incentive-driven bank management. While Basel III raises capital requirements, definitions of capital are shifting and each bank defines their own model for weighing risky assets. Given that required capital level is set relative to these assets, we may be back to square one as capital ratios are yet another venue for differentials from what regulators had in mind. Regulators and policy makers should be the child of Andersen’s story – point at the obvious diversions of reality and assume a more committed role with regard to risk weighing models, classification of capital and leverage.

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[1] Taking it to the extreme, assume that there is one shareholder of the bank with little equity. Then each share bears a lot of weight of any losses made by the bank – hence making the shares expensive, as the owner may want to feel that their remuneration is adequate to the risk borne. However, if the amount of equity increases, the risk borne per share decreases. More equity implies that each share is exposed to a lower risk pressure. The risk premium of equity drops. Hence, assuming a constant return on equity is inadequate and misleading.

What are the repercussions of Russia’s intrusion in Ukraine on the euro area country composition?

After the recent events reaffirming Russia’s aggressive geopolitical strategy, the EU member states openly question much of their future focus – including trade, energy and even monetary policies. The governor of Poland’s central bank, Marek Belka, spoke up in favor of resumption of talks considering the possibility of joining the eurozone, after the Polish government had strayed from such prospect during the turmoil of the debt crisis in the euro area. It is likely that other countries will give it more thought, and some will most probably roll up the sleeves to ensure that the euro adoption takes place as soon as possible.

In November 2013, a Eurobarometer survey found that 49% of Lithuanians were against having one European currency in all member states, including their own country. However, being part of the EU and NATO gives the Baltic States a great sense of security vis-à-vis their land-grabbing neighbor. Despite the many economic advantages of the adoption of the euro – including reduction of costs for trade, lower interest rates on borrowing, increase in foreign investment, obligation of financial discipline through enhanced fiscal monitoring as well as euro area-wide system of financial stability insurance through the European Stability Mechanism – the geopolitical argument may prove the most relevant to the wider population. With the security threat lingering in the air (and the US sending six fighter jets for air policing in the Baltics), the increase in the pro-euro sentiment may accelerate in the coming months in Lithuania. The government should seize this opportunity to ensure that citizens and businesses support and actively contribute to a smooth euro adoption. Lithuania tried to join the euro area in 2007, when the inflation criterion overshot the reference value of 2.6% (calculated as the average of the 12-month average inflation rates in the three best-performing member states –Sweden, Finland and Poland at the time – plus 1.5 percentage points). Back then, the convergence report by the European Commission showed that inflation was 2.7%, while Lithuanian authorities were all too sure about the potential euro changeover. As a result, this is the second, and, possibly, last attempt to enhance Lithuania’s integration in the EMU. This time around, the government must strike a balance between its promises and a disciplined approach regarding spending in order to comply with the budget deficit criterion.

For a country that has not had an independent monetary policy since WWII (after the end of the Soviet occupation, Lithuania pegged its litas to the dollar in 1994, then to the euro in 2002), not reaping the benefits of joining one of the strongest currencies in the world is equal to all costs with barely any benefits. Lithuania, whose first import source and export destination is a neighbor that is erratic and ever-menacing regarding trade, let alone political issues, has but to gain by further shifting its policy focus Westward. And it definitely is not the only one.