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Streamline Training & Documentation
Streamline Training & Documentation
Wednesday, April 07, 2010
What to Do about the Shadow Banking System
If you've been following discussions of the players involved in the financial crisis, you're aware that broker/dealers in the headlines, such as the now defunct Bear Stearns, are referred to as members of the "shadow banking system."
The shadow banking system consists of nonbank financial firms that borrow funds — often through the short-term money market and commercial paper market — and then lend those funds to borrowers such as corporations or use the funds to purchase relatively long-term assets such as mortgage-backed securities.
A key point is that such firms do not take deposits and, therefore, are not subject to the regulations that depository institutions — commercial banks, savings institutions, and credit unions — must adhere to.
In a July 2009 paper (pdf), Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin, a professor of economics at Princeton, analyze in reasonably accessible fashion, how financial regulations might be revised in order to reduce the potential for the shadow banking system to exacerbate financial instability in the future. Adrian and Shin note that, as of the end of June 2007, the shadow banking system's $16.6 trillion in assets stood well above the assets of the conventional banking system, which amounted to $12.8 trillion.
After detailing the way in which leverage of financial firms grows to an excessive level during a boom period, Adrian and Shin argue that this market failure should be mitigated through regulations that constrain systemic risk, especially since systemic risk has risen substantially as a result of burgeoning securitization.
Adrian and Shin explain:
One element of improved regulation will be a ... systemic regulator who could take on two important tasks. First, the system regulator should gather, analyze, and report systemic information. This will require reporting from a broader range of financial institutions, such as hedge funds, and the shadow banking system. Second, the systemic regulator will operate capital rules [rules regarding how much capital a firm must hold relative to the amounts of various types of liabilities on its balance sheet] with a systemic focus. ... Given the central bank's intimate connections with the financial market through its monetary policy role, it is likely to have the best market intelligence in performing the role of the macroprudential regulator. Furthermore, the fact that the central bank is the lender of last resort (LOLR) gives it the capacity to intervene in the market when necessary. ...
In the new, post-crisis financial system, many familiar features of the system before the crisis will cease to be in place. The role of securitization is likely to be held in check by more stringent financial regulation and the recognition of the importance of preventing excessive leverage and maturity mismatch [short-term liabilities funding long-term assets] in undermining financial stability. Institutional changes and the conduct of monetary policy will flow from the recognition of the role of the financial system as the servant of the real economy, rather than an end in itself. In particular, we might see the return of a more staid "utilities" version of banking based on the model of banking as a support to the real economy.
Adrian and Shin emphasize that the effectiveness of regulations such as those they discuss depends on the diligence of the regulators. It remains to be seen exactly what new US regulatory legislation emerges from Congress, which is currently working on Senator Dodd's proposed bill, a more strict bill having already passed in the House of Representatives.
In the nineteenth century, the largest immigrant groups arriving in Holyoke were the Irish and, later, French Canadians. More recently, the population of Puerto Rican extraction has grown to the point that it now comprises over a third of the total.
Many of the Puerto Ricans come from a rural background, so there was a logic back in 1992 to creation of an organization — Nuestras Raíces (Our Roots) — that promotes and enables small-scale farming within the city by adults and youth.
Senorita Ada's Casita at la Finca (The Farm) of Nuestras Raíces (2008) (masslive.com)
Urban agriculture has proven to be an effective way to promote community development because it is a way for the residents of downtown Holyoke to maintain a connection to their culture while putting down roots in their new home. Most of our members grew up on the farms of rural Puerto Rico and many first came to the Northeast as migrant farm workers. Though they may live in the city now, they are farmers at heart. They have lifetimes of experience in agriculture and it is part of their heritage. Projects based on agriculture, such as markets and community gardens, build on the skills and knowledge that participants already have, and are proud to have the opportunity to use to improve their community and to teach to a younger generation.
To read about Nuestras Raíces' various projects, including La Finca (The Farm), a thirty-acre spread on the shore of the Connecticut River within the city limits, you can start at this page of their website. A nine-minute video showing an exhibition of paso fino horses, some of which are stabled at La Finca, is below.
Alfred Sloan's Memoir VI: Getting Dealers Up to Speed
The woes of discontinued General Motors dealers have been much in the news lately. It's interesting to go back in time some eight decades to see how Alfred Sloan viewed the issue of developing a strong distribution system based on franchised dealerships. In Chapter 16 of My Years with General Motors, Sloan recalls: Alhough in the 1920s we had made great advances in getting the facts about General Motors' economic position, we did not then have the facts regarding the economic position of our dealers, and so were handicapped in thinking through dealer problems. When a dealer's profit position was failing, we had no way of knowing whether this was due to a new-car problem, a used-car problem, a service problem, a parts problem, or some other problem. Without such facts is was impossible to put any sound distribution policy into effect.
In the Proving Ground address which I mentioned earlier [delivered to the Automobile Editors of American Newspapers on September 28, 1927 in Milford MI], I made the following observations on this subject:
... I want to outline to you what I believe to be a great weakness in the automotive industry today and what General Motors is trying to do to correct that weakness.
I have stated frankly to General Motors dealers, in almost every city in the United States, that I was deeply concerned with the fact that many of them, even those who were carrying on in a reasonably efficient manner, were not making the return on their capital that they should. Right here let me say that so far as General Motors dealers are concerned, from what facts I have — I realize there has been much improvement during the past two or three years, but interested as the management of General Motors must be in every step from the raw material to the ultimate consumer, and recognizing that this chain of circumstances is no stronger than its weakest link, I feel a great deal of uncertainty as to the operating position of our dealer organization as a whole. I hope that this feeling of uncertainty is unwarranted. I am sure that with a responsibility so great, all elements of uncertainty must be eliminated and that our dealers should know the facts about their operating position as clearly and as scientifically as I have outlined to you we feel that we know the facts about General Motors' operating position.
This brings us back to ... two words — proper accounting. Many of our dealers, and the same thing applies to dealers of other organizations, have good accounting systems. Many of them have indifferent ones and I regret to say that too large a percentage of them have practically no accounting system at all. Many of those who have accounting systems, through lack of their being properly developed, are not able to effectively use them. In other words, they are not so developed that they give the dealer the facts about his business; where the leaks are; what he should do to improve his position. As I said before, uncertainty must be eliminated. Uncertainty and efficiency are as far apart as the North Pole is from the South. If I could wave a magic wand over our dealer organization, with the result that every dealer could have a proper accounting system, could know the facts about his business and could intelligently deal with the many details incident to his business in an intelligent manner as a result thereof, I would be willing to pay for that accomplishment an enormous sum and I would be fully justified in doing so. It would be the best investment General Motors ever made.Accordingly, in 1927 we set up an organization called Motors Accounting Company. We developed a standardized accounting system applicable to all dealers and sent a staff into the field to help install it and to establish an audit system.
Alfred Sloan's Memoir III: Management of Cash Flow
Until Alfred Sloan and his senior management colleagues stepped into the breach, handling of cash flow at GM was a shambles. For instance, in Chapter 8 of My Years with General Motors, Sloan reports: The way cash was handled at that time [1920] is almost unbelievable. Each division controlled its own cash, depositing all receipts in its own accounts and paying all bills from those same acounts. Since only the divisions sold products, none of these cash receipts flowed directly to the corporation itself. We had no effective procedure for getting cash from the points where we happened to have some to the points where we happened to need some. When the corporation, as an operating company, had to pay dividends and taxes, and such items as rent, salaries and other expenses of the general staff, the usual procedure was for the treasurer to request cash from the divisions. That was not so simple as it sounds, however, for the divisions, operating independently, tried to keep their cash balances high enough to satisfy their own peak requirements. Therefore, when they had more cash than they needed at the moment, they were not eager to turn it over to the corporation.
I remember that Buick, for example, at that time was very loath to give up its cash. This profitable division was, of course, the most prolific source of cash for the corporation, and long experience had made Buick's financial staff highly adept at delaying its report of the cash they had on hand. Buick made a practice of maintaining large cash balances in its factory sales branches. The amounts of these balances were not ascertainable at headquarters until Buick had submitted its monthly financial statement for the division as a whole — and this was usually a month or two after the fact. When the corporation needed cash, the treasurer, Meyer Prentis, would try to guess how much Buick actually had and how much of it he could probably get from them. Then he would go to Flint, discuss whatever other questions might be outstanding between Buick and headquarters, and at last casually bring up the subject of cash. Buick's financial people would invariably express surprise at the size of Mr. Prentis' request and occasionally would try to resist the transfer of such a large amount. Naturally, this cat-and-mouse game did not result in the most efficient utilization of funds, especially when some divisions had more operating cash than they needed, at the same time that other divisions were short of operating cash.
In 1922 we changed all this by setting up a consolidated cash-control system. This was a new concept for a large corporation. Depository accounts were established in some one hundred banks in the United States, and all incoming receipts were deposited in these accounts to the credit of General Motors Corporation. All withdrawals from them were administered by the central Financial Staff; the divisions had no control over cash transfers from these deposit accounts.
Portrait of Alfred P. Sloan, Jr. (1875-1966) Sloan Building (E52) MIT Sloan School of Management (MIT Sloan Japan Club)
For instance, in Chapter 3, "Concept of the Organization," Sloan writes about his frustration in 1918, when General Motors acquired United Motors, a group of parts and accessory companies of which Sloan was president: ... I found that if I followed the prevailing practice of intercorporate relations I would no longer be able to determine the rate of return on investment for these accessory divisions individually or as a group. This would necessarily mean that I would lose some degree of managerial control over my area of operations. At that time, material within General Motors was passing from one operating division to another at cost, or at cost plus some predetermined percentage. My divisions in the United Motors Corporation had sold both to outside customers and to their allied divisions at the market price. I knew that I operated a profit-making group, and I wished to continue to be able to demonstrate this performance to the general management, rather than to have my operating results on interdivisional business swallowed up in the extra bookkeeping profits of some other division. It was a case of keeping the information clear.
It was not, however, a matter of interest to me only with respect to my divisions, since as a member of the Executive Committee, I was a kind of general executive and so had begun to think from the corporate viewpoint. The important thing was that no one knew how much was being contributed — plus or minus — by each division to the common good of the corporation. And since, therefore, no one knew, or could prove, where the efficiencies and inefficiencies lay, there was no objective basis for the allocation of new investment. This was one of the difficulties with the expansion program of that time. It was natural for the divisions to compete for investment funds, but it was irrational for the general officers of the corporation not to know where to place the money to best advantage. In the absence of objectivity it was not surprising that there was a lack of real agreement among the general officers. Furthermore, some of them had no broad outlook, and used their membership on the Executive Committee mainly to advance the interests of their respective divisions.
I had taken up the question of interdivisional relations with Mr. Durant [president of GM at the time] before I entered General Motors and my views on it were well enough known for me to be appointed chairman of a committee "to formulate rules and regulations pertaining to interdivisional business" on December 31, 1918. I completed the report by the following summer and presented it to the Executive Committee on December 6, 1919. I select here a few of its first principles which, though they are an accepted part of management doctrine today, were not so well known then. I think they are still worth attention.
I stated the basic argument as follows:
The profit resulting from any business considered abstractly, is no real measure of the merits of that particular business. An operation making $100,000.00 per year may be a very profitable business justifying expansion and the use of all the additional capital that it can profitably employ. On the other hand, a business making $10,000,000 a year may be a very unprofitable one, not only not justifying further expansion but even justifying liquidation unless more profitable returns can be obtained. It is not, therefore, a matter of the amount of profit but of the relation of that profit to the real worth of invested capital within the business. Unless that principle is fully recognized in any plan that may be adopted, illogical and unsound results and statistics are unavoidable ...
Today what caught my eye was an article by Scott Leibs, the editor-in-chief of CFO, about Lewis Booth, a long-time Ford employee who became the company's CFO in November 2008. Of particular interest to me, as someone focused on training, was what Lewis told Seibs concerning his discussions with executives and other operations people about how they can assist the finance department's ongoing efforts to repair Ford's balance sheet.
As Seibs explains, Lewis has made it his business to teach Ford employees about the link between finance and operations.
Within a month of assuming the CFO post, he began to walk Ford's senior-most executives through the grim realities of the company's balance sheet [which was and is heavily burdened with debt]. A month later, he extended that tutorial to an additional 400 Ford managers. "When I was in operations, the balance sheet was really viewed as a finance problem," he says. "We've managed to make it a collective responsibility."
Booth's aim was not to make Ford more finance-centric but rather to "identify what we thought was an appropriate road map" for restructuring the balance sheet. ... "The goal was to show where we are, where we want to be in three to four years, and what contribution to that effort can come from operations" versus the treasury department.
The message, Booth says, is that "it's not about borrowing more money, it's about making more money so you can pay back some of those debts." Indeed, debt is perhaps the top challenge of Ford now. GM and Chrysler face the same hurdle but to a much smaller degree, thanks to their respective bankruptcy agreements. One analyst estimates that debt servicing adds $1,500 to the cost of every vehicle Ford sells. Booth takes issue with that particular metric, arguing that "it's not particularly helpful to frame debt in $X-per-vehicle terms. I view it more in terms of what you will pay over the period of a given product program, because that excites people and keeps us focused on why we're in debt in the first place: to invest in new products."
In sum, Lewis is giving high priority to communicating to employees the importance of producing products that generate revenue at a pace that enables the company to reduce debt to a more healthy level. He is also explaining specifics of what company employees can do to help strenghthen cash flow.
For the record, Ford's ratio of long-term debt to total capital was 1.07 as of September 30, 2009.
A central premise of the course is that companies need to define an operating model in order to be able to optimize their IT investments. Ross explains (pdf):
An operating model is the necessary level of business process integration and standardization for delivering goods and services to customers. By identifying integration and standardization requirements an operating model defines critical IT and business process capabilities ... [and thus] guides IT investment and enhances business agility. (emphasis in original)
The graphic below lays out the four types of operating model that are determined by a company's integration and standardization choices.
A company using the Coordination model operates unique business units with a need to know each other's transactions. Its key IT capability is providing access to shared data through standard technology interfaces. MetLife is an example.
A company using the Unification model operates as a single business with global process standards and global data access. Its key IT capability is providing enterprise systems that reinforce standard processes and provide global data access. UPS is an example.
A company using the Diversification model operates independent business units with different customers and expertise. Its key IT capability is providing economies of scale without limiting independence. Johnson & Johnson is an example.
A company using the Replication model operates independent but similar business units. Its key IT capability is providing standard infrastructure and application components for global efficiencies. Marriott is an example.
You can find further details concerning the characteristics of each of these models in a briefing Ross published in 2005 that serves as the assigned reading for the third session of the course.
In the August 2009 issue of Nature, J. Doyne Farmer, a professor at the Sante Fe Institute, and Duncan Foley, an economist at the New School for Social Research, published an opinion piece (pdf) in which they argue that the types of economic models most commonly used to make economic predictions — predictions that businesses often use in their planning — are seriously flawed.
Farmer and Foley explain the two types of macroeconomic model that are currently available:
Econometric models that base predictions essentially on extrapolating from past economic data. If the economy experiences major changes from what has occurred in the past, predictions from these models go seriously off-track
Idealized models that assume a well-functioning economy, i.e., one that does not experience crises.
Farmer and Foley advocate development of an alternate type of model, one that incorporates realistic assumptions about how economic decision-makers, aka agents, behave. Such agent-based models are computerized simulations in which the agents — e.g., consumers, government policy makers, financiers, and business firms — interact through rules (preferably, derived from research) concerning the agents' actual decision-making processes.1
In such a model,
... at any given time, each agent acts according to its current situation, the state of the world around it and the rules governing its behaviour. An individual consumer, for example, might decide whether to save or spend based on the rate of inflation, his or her current optimism about the future, and behavioural rules deduced from psychology experiments. The computer keeps track of the many agent interactions to see what happens over time. ... Policy makers can ... simulate an artificial economy under different policy scenarios and quantitatively explore their consequences.
The article offers as an example the model Farmer and colleagues have created to explore how hedge funds' use of leverage — borrowing from banks to finance their investments — affects fluctuations of stock prices. The model "shows that the standard ways banks attempt to reduce their own risk can create more risk for the whole system." Admittedly, this model covers only a subportion of the larger economy, but its structure and use are nonetheless illustrative of the principles of agent-based modeling.
Framer and Foley acknowledge that there are technical issues that make creation of agent-based models a challenge, most importantly the difficulty
... in specifying how agents behave and, in particular, in choosing the rules they use to make decisions. In many cases this is still done by common sense and guesswork, which is only sometimes sufficient to mimic real behaviour. An attempt to model all the details of a realistic problem can rapidly lead to a complicated simulation where it is difficult to determine what causes what. To make agent-based modeling useful we must proceed systematically, avoiding arbitrary assumptions, carefully grounding and testing each piece of the model against reality and introducing additional complexity only when it is needed.
Farmer and Foley close their article by advocating investment of public funds in creating an agent-based model of the whole economy in order to have a more reliable tool than those currently available for "quantitatively exploring how the economy is likely to react under different [policy] scenarios."
__________ 1 You can read about some of the other areas besides economics in which agent-based models are used in this earlier post about US Army counterinsurgency training, in this wiki entry on use of agent-based models in biology and medicine, and in this paper (pdf) describing agent-based modeling of the airline industry.
The Federal Reserve Bank of Kansas City has created a guide for bank boards of directors that has much of relevance to the work of those serving on nonbank boards.
As a prime example of the useful guidance in Basics for Bank Directors, I offer the set of questions on pp. 59-60 of the current edition (the fifth) which boards can use to evaluate management: Is the bank operated in a safe and sound matter?
Is the bank operated in compliance with laws and regulations?
Does the bank compare favorably with other banks in major performance areas such as capitalization, asset quality, earnings, liquidity, and sensitivity to market risk?
Does management respond quickly to address shortcomings identified in audits and supervisory examinations?
Does management keep the board informed and provide sufficient and timely information on the bank to enable the board to judge the bank's operational and financial status?
Are decisions made by management consistent with goals, plans, and policies set out for the bank?
Is management responsive to requests, directives, and questions from the board, including complying with board-approved policies?
Does management have the knowledge and expertise to supervise the affairs of the bank effectively, instill confidence, and demonstrate an ability to lead the bank?
Is management informed about the affairs of the bank and knowledgeable about events in the community that may affect the bank?
Are management's presentations and recommendations to the board done on a timely basis, of high quality, and accurate?
Has management put in place a corporate structure that establishes lines of authority and accountability; provides for delegation of authority and monitoring of delegated responsibilities; and permits open communication and free flow of information within the bank?
Has management seen to the staffing needs of the bank: established job descriptions, hired qualified staff, offered competitive compensation, provided training, and planned for management succession?
Has management established information systems to provide timely information on the status of the bank in order to identify evolving problems quickly?
Has management put in place sufficient procedures to direct the bank's operation and instituted sufficient internal controls to protect the bank's resources?
Does management plan for the bank and develop reasonable strategies for carrying out these plans?
Does management, in conjunction with the board, develop budgets for the bank and keep the board informed of the bank's progress in meeting budget goals?
Basics for Bank Directors was written by Forest E. Myers, who served as policy economist at the Kansas City Fed for over 30 years prior to his retirement in 2008.
About a year ago, I wrote a brief post about the Ethiopia Commodity Exchange (ECX), launched in April 2008 as a mechanism for helping farmers gauge their crop sales in light of up-to-date information about world commodity prices.1
A similar effort to promote market efficiency is the subject of a study by Aparajita Goyal (pdf), an economist at the World Bank.2 Goyal studied data relating to soybean sales in the Indian state of Madhya Pradesh before and after introduction of internet kiosks and warehouses that provided "wholesale price information and an alternative marketing channel to soy farmers in the state."
The aim of setting up the kiosks and warehouses was to mitigate exploitation of farmers by middlemen. Due to poor rural transport and storage infrastructure, lack of reliable price information, and an inability on the part of purchasers — processing companies and exporters — to verify produce quality, middlemen were able to get away with paying lowball prices to farmers while often overcharging purchasers.
Goyal found that the availability of the kiosks,3 which began being installed in Madhya Pradesh villages in October 2000, produced a significant increase in prices received by farmers and in the amount of land farmers allocated to soy production. The rise in prices — driven by increased competition among buyers — resulted in a 33% increase in profit for farmers. Land cultivated in soybeans went up 19%.
ITC Ltd., the large Indian conglomerate that deployed the kiosks and built the warehouses — at which farmers could sell directly to ITC — benefited from the improvement in quality of soybeans procured (ITC tested beans for oil and protein content before purchasing them), from the creation of a direct marketing channel, and from a reduction in its transaction costs (principally, costs of storage, weighing, loading, and bagging). The value of these benefits fully offset the cost of the kiosks.
__________ 1 ECX trades five commodities: maize, wheat, beans, sesame and coffee. You can read remarks by Eleni Gabre-Madhin, ECX's CEO, concerning the first eighteen months of ECX's operation here.
2 Members of the American Economic Association can access Goyal's paper, "Information, Direct Access to Farmers, and Rural Market Performance in Central India" (forthcoming in American Economic Journal: Applied Economics), here.
3 The kiosks are called "e-Choupals." "Choupal" is a Hindi word meaning "village gathering place." In addition to price information, the kiosks provide agricultural information and weather forecasts.
From Book I, Chapter XI, of Adam Smith's Wealth of Nations. . . The interest of the dealers, however, in any particular branch of trade or manufacture, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.
From Book I, Chapter II, of the original 1776 edition of Adam Smith's Wealth of Nations. . . ... thus the certainty of being able to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men's labour as he may have occasion for, encourages every man to apply himself to a particular occupation, and to cultivate and bring to perfection whatever talent or genius he may possess for that particular species of business.
The difference of natural talents in different men is, in reality, much less than we are aware of; and the very different genius which appears to distinguish men of different professions, when grown up to maturity, is not upon many occasions so much the cause as the effect of the division of labour. The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature as from habit, custom, and education. When they came into the world, and for the first six or eight years of their existence, they were perhaps very much alike, and neither their parents nor playfellows could perceive any remarkable difference. About that age, or soon after, they come to be employed in very different occupations. The difference of talents comes then to be taken notice of, and widens by degrees, till at last the vanity of the philosopher is willing to acknowledge scarce any resemblance. But without the disposition to truck, barter, and exchange, every man must have procured to himself every necessary and conveniency of life which he wanted. All must have had the same duties to perform, and the same work to do, and there could have been no such difference of employment as could alone give occasion to any great difference of talents.
From Book I, Chapter II, of the original 1776 edition of Adam Smith's Wealth of Nations. . . ... man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
You only have to glance at any large newspaper to recognize how closely changes in the gross domestic product — GDP — of countries around the world are followed. And, assuming there are no dramatic changes in the composition of a countries' output, generally a safe assumption in the short run, this makes good sense.
If, on the other hand, you're trying to measure the value of a country's output in its own right (rather than focusing on economic growth), there are substantial problems with using GDP as your metric. For example, all underground and non-market economic activity (such as work done by homemakers) is excluded. Also, changes in the quality of products, such as high-tech items, are poorly captured, and output that one would happily avoid if it were possible, such as spending on war materiel, is treated the same as spending on benign goods.
There are various alternative measures that have been designed in an effort to develop a more meaningful measure of national output. For instance, the Levy Economics Institute of Bard College has developed the Measure of Economic Well-Being, and the country of Bhutan gauges its socioeconomic situation with Gross Domestic Happiness.
Another perspective on the shortcomings of GDP as a measure of the value of national output appears in the Fall 2009 issue of the MIT Sloan Management Review. Erik Brynjolfsson, a professor at MIT's Sloan School of Management, and Adam Saunders, a lecturer at the University of Pennsylvanias Wharton School, argue that the information sector (software, publishing, motion picture and sound recording, broadcasting, telecom, and information and data processing services) is seriously undermeasured in GDP. Why? Because the prices of modern digitized information sources are so low (zero in some cases) relative to the prices of the physical information sources (e.g., encyclopedias and CDs) that they substitute for.
Brynjolfsson and Saunders say:
The irony of the information age is that we know less about the sources of value in the economy than we did 25 years ago. GDP is a more accurate metric of value in industrial-age industries like steel or automobiles than in information industries, and can miss most of the value in information goods.
Brynjolfsson and Saunders recommend looking instead at consumer surplus, "the aggregate net benefit that consumers receive from using goods or services after subtracting the price they paid."
Measuring consumer surplus is harder than measuring GDP because the amount of consumer surplus must be inferred. This is done by running price experiments from purchase data, running lab experiments, and conducting surveys.
Brynjolfsson and Saunders walk their readers through an example taken from the music recording industry that clarifies the concept of consumer surplus and how it can give a more accurate picture of value being created in an economy — with specific focus on the information sector.
Blythe McGarvie on Business Performance Management
The CFO Project is a periodic publication of Montgomery Research that offers "ideas, points of view, vendor profiles, and company case studies" that launched in October 2002. Three volumes have been published so far:
Competitive Financial Operations (2002) — "designed to provide insights for finance executives interested in creating transaction processing and performance reporting solutions that are efficient and effective on a global scale."
Business Analytics and Performance Management (2003 – the only volume, so far, with a distinctive title) — "focused on targeting value opportunities, improving performance management capabilities, and delivering analytics to drive improved results across geographies, business units, and customer segments."
Competitive Financial Operations: The CFO Project (2007) — explores "the way CFOs are managing [the] tricky balancing act between serving as internal 'traffic cop' and forward-thinking business leader" and presents "expertise on corporate governance, risk management, achieving compliance and transparency, business planning, executive compensation and more."
The papers are available online to anyone who registers for a membership or subscription.
The only item I can personally vouch for is an excellent four-page case study (pdf) that I encountered a few days ago and was quite taken with. Blythe J.McGarvie, currently CEO of LIF [Leadership for International Finance] Group, writes about her experience over thirty years with the gradual maturation of tools and techniques of business performance management (BPM).
As you would expect of an expert in accounting and finance, McGarvie evaluates advances in the technology and techniques available to finance departments in terms of how substantial has been their impact on capacity for analysis and effective decision-making. She identifies several stages in her own experience with advances in BPM:
Integration of reporting and planning, which enabled companies "to determine which products and customers were driving — or dragging — profitability." This, in turn, enabled better decision-making concerning how to improve the profitability of particular products and customers.
Making the budgeting process a bona fide planning process, i.e., "budgeting became a more integrated, holistic and foundational business management exercise. Strategy was determined through the budgeting processes, and compensation incentives were married to business objectives."
Integration of the operating and capital budgeting processes, so that managers were forced to take the cost of capital into account in making spending decisions. This is the economic value added (EVA) concept.
Extending BPM beyond finance, e.g., by using BPM techniques to improve inventory management in retail operations. McGarvie describes how Hannaford Supermarkets built a detailed model — broken down by product and category — of their revenue and costs. The model enabled granular measurement of product and category profitability, an advance that "changed the way the store managers ordered inventory and how they did business."
The above is a drastic condensation of what McGarvie has to say in her case study. Reading the whole thing is highly recommended.
A complete listing of the CFO Project white papers is here. A list of "solutions," organized by topic, is here. A list of all the case studies is here. Note that these three types of content are not mutually exclusive.
Among those weighing in on the root causes of the current global financial crisis is Hyun Song Shin, an economics professor at Princeton. He has written a number of academic papers on the subject, but you can also find a quite accessible version of his analysis, "Securitisation and Financial Stability," at www.VoxEU.org.1
Shin's column is only about four pages, so easy to read in its entirety. In sum, Shin's argument is that
... [securitisation] undermined financial stability by concentrating risk. Securitisation allowed banks to leverage up in tranquil times while concentrating risk in the banking system by inducing banks and other financial intermediaries to buy each other's securities with borrowed money.
Shin rejects the idea that the basic problem was banks issuing risky loans, which they then passed off like "hot potatoes" to investors who, in come cases, weren't fully aware of the risk they were assuming.
In Shin's view, of much more significance was the fact that banks bought each other's subprime mortgage-backed securities. The banks then used those assets to back their own subprime lending. What resulted was an interlocking of bank balance sheets (including balance sheets of related special purpose entities), pockmarked with risky assets, that produced dangerously elevated systemic risk.
__________ 1 VoxEU.org is a portal set up by the Centre for Economic Policy Research. Professional economists are encouraged to submit columns that are policy-related, research-based, and written at a level accessible to VoxEU's intended audience, namely, "economists in governments, international organisations, academia and the private sector as well as journalists specializing in economics, finance and business."
You can both learn about how Google has structured its AdWords search advertising program, and see a good (but not flashy) teacher in action, by watching the ten-minute video below. The teacher is Hal Varian chief economist at Google (on leave from his professorship at Berkeley).
The video explains how the price of an ad is determined, how ad quality figures into the ranking of ads, and, in overview, how ad quality is measured.
Google provides detailed guidance to people interested in the AdWords program at adwords.google.com/support/. Google also offers online training here. Some of the topics covered in the tutorials are presented in videos on YouTube here.
Al Roth, an economics and business administration professor at Harvard, has put together an informative post linking to further sources of information on Google's ad auctions and on Hal Varian's work.
Taking a look at the support Google provides to AdWords users not only helps you get up-to-speed on a method of reaching prospective customers that may be suitable for your own business, but also offers a model of how to build sales by helping customers make optimum use of your services. You may very well see things you would do differently in your own approach to providing customers with online support, but Google's set-up serves as a benchmark.
The Criteria for Serving as an International Reserve Currency
The value of the dollar gets close scrutiny for, among other reasons, its role as an international reserve currency. A reserve currency is one that is held by countries and institutions as a store of value, for managing exchange rates, and for carrying out some international transactions.
Anders Aslund, a senior fellow at the Peterson Institute for International Economics, has a helpful article in today's Moscow Times that lays out the criteria a country must meet in order for its currency to challenge the dollar, the euro, the pound, and the yen for status as an international reserve currency.1 (Aslund's immediate reason for walking his reader through these criteria is to show that Russia's aspirations for making the ruble a reserve currency are pie in the sky for the foreseeable future.)
As Aslund explains, a reserve currency country must meet the following criteria. It must have:
low inflation and a stable economy
a large economy
financial depth, i.e., large market capitalizaton (the total value of securities issued within its borders), substantial availability of securities for trade on the securities markets, and a non-politicized banking system
a good regulatory framework and strong rule of law
network externalities, "which include various international uses [for the country's currency], for example, for pricing, invoicing, or transactions outside the country"
Aslund concludes by noting the importance of "the power of incumbency," by which he means the self-reinforcing nature of choosing to invest funds in securities denominated in a reserve currency. These securities are favored because they are liquid, and, in turn, the purchasers they attract help maintain liquidity.
Aslund cites Barry Eichengreen, an economics and political science professor at Berkeley, as our leading scholar of reserve currencies. You can read some of Eichengreen's recent commentary on the international role of the dollar here.
__________ 1 Aslund reports, "In the last decade, the euro has emerged with 27 percent of global currency reserves, while the dollar still holds two-thirds. Sterling and yen account for 3 percent to 4 percent each, leaving less than 1 percent for other currencies."
As a follow-on to yesterday's post, I'd like to call attention to the excellent training for microfinance organizations that is available at the Rural Finance Learning Centre. RFLC is
RFLC, publicly available since 2004, has collected and organized, by type and topic, a wealth of learning resources — 1,804 "knowledge objects" as of today. Visitors can navigate the site in English, Spanish, French, and Russian.
I've browsed through all the sections of the site and would encourage anyone with an interest in learning about microfinance to do the same. As examples of what's available I'd cite two of the online lessons RFLC has posted. The entire set of lessons is divided into four sections:
1. Basic concepts 1.1 New paradigm rural finance - what is it? 1.2 Microfinance - the hope and the hype 1.3 The importance of savings 1.4 Financial service providers and the law 1.5 Commercial banks and microfinance
2. Understanding client enterprises 2.1 The financial reality of enterprise 2.2 Collecting and analysing financial information from enterprises 2.3 Rates of return and the cost of money
3. Managing financial services 3.1 Understanding the accounts of financial service providers 3.2 Moving towards self-sufficiency — subsidies and profitability planning 3.3 Avoiding the "downside" of microfinance 3.4 Managing arrears and defaults
4. Choosing strategies 4.1 Using and promoting groups 4.2 Taking gender into account 4.3 Adopting a client-driven approach
The lessons I reviewed were 3.2 Moving towards self-sufficiency — subsidies and profitability planning, and 3.3 Avoiding the "downside" of microfinance. Both were exemplary in their use of accessible, colloquial language; incorporation of interactivity in a way that encourages active learning (snd without resorting to extraneous bells and whistles); and solid grounding in the practical aspects of microfinance.
In today's Wall Street Journal, Joann Lublin has an article about the more numerous and more challenging hoops that some companies are having job seekers jump through in today's environment of relatively high unemployment.
Aside from the useful information in the article itself, Lublin points toward some further material elsewhere on the Internet that job seekers can consult to prepare themselves for a relatively demanding hiring process.
Of particular interest to me was the practice case study that Capital One has posted at their website to help applicants prepare for the actual case study discussion that is part of Capital One's hiring process "for all on-campus recruiting and analyst applicants, as well as for some management and information technology applicants," assuming the applicant gets past initial screening.
The case study sets up a problem, which happens to involve cross-selling a product from a third-party vendor, and then asks the applicant "to determine what are the most important factors that will help you decide to accept or reject" this particular cross-sell opportunity.
A model response is provided, followed by further details that enable the applicant to assess the potential profitability of the opportunity, taking into account such important considerations as mark-up over the vendor's wholesale price and marketing costs for Capital One.
The case study is well-presented and admirably concise. It's well worth a look, whether or not you're in the job market, because it provides good reminder of some fundamental business concepts, such as cost analysis, competitive analysis, opportunity cost, breakeven point, and systems thinking.
