Best mass transit system in the world?

Vox points to a regional system in Germany, Verkehrsverbund Rhein-Ruhr,

The real hub of the Germany economy is a lesser-known but more interesting urban phenomenon — the polycentric metropolitan area known as Rhine-Ruhr, stretching from Dusseldorf and Cologne in the north to Bonn in the south. None of the constituent cities of Rhine-Ruhr are especially large, but together they make a metropolitan area that's 11 million strong and hosts 26 of Germany's 50 largest companies. Knitting it all together and making it all work is the complicated but efficient Verkehrsverbund Rhein-Ruhr, the region's mass transit system. It's composed of 29 regional rail lines, 11 S-Bahn lines, 19 light rail lines, 45 streetcars, and over 900 bus routes.

Far too often we look at mass transit only in terms of its mobility improvement dimension. The more important dimension though may be its role as an instrument of shaping urban growth. As with, Rhein-Ruhr, efficient mass transit has been the critical contributor to the success of economically and socially vibrant metropolitan areas like Tokyo, Hong Kong, Singapore, Copenhagen, and Stockholm. 

The limits to human job displacement

David Autor, arguably the leading academic tracking the technology and other structural shifts induced changes in the labor market, presented an interesting paper at the recently concluded Kansas Fed's annual Jackson Hole meeting. The paper talked about the recent trend of the displacement of middle-paying jobs by computers.

He invokes Karl Polanyi's famous paradox ("we know more than we can tell" - the tacit knowledge of how the world works often exceeds our explicit understanding) to argue that the challenges to substituting machines for workers by computerizing every day tasks (especially those that require adapatability, common sense, and creativity) are possibly insurmountable. He argues that the trend of automation of "middle-skill" jobs is not likely to continue to its logical climax,

While many middle skill tasks are susceptible to automation, many middle skill jobs demand a mixture of tasks from across the skill spectrum... Why are these middle skill jobs likely to persist and, potentially, to grow? My conjecture is that many of the tasks currently bundled into these jobs cannot readily be unbundled - with machines performing the middle skill tasks and workers performing the residual - without a substantial drop in quality... routine and non-­routine tasks will generally coexist within an occupation to the degree that they are complements - that is, the quality of the service improves when the worker combines technical expertise and human flexibility. 

This reasoning suggests that many of the middle skill jobs that persist in the future will combine routine technical tasks with the set of non-routine tasks in which workers hold comparative advantage - interpersonal interaction, flexibility, adaptability and problem-solving. Medical support occupations are one leading example of this virtuous combination, but this example is not a singularity. This broad description also fits numerous skilled trade and repair occupations - plumbers, builders, electricians, HVAC installers, automotive technicians - marketing occupations, and even modern clerical occupations that provide co-ordination and decision-making functions rather than simply typing and filing.

He also argues that the strategy of "machine learning" - "applying statistics and inductive reasoning to supply best guess answers in cases where formal procedural rules are unknown" (or exposure, training, and reinforcement, by stuffing data and using inductive logic) - to overcome Polanyi's Paradox may not be successful. Such machine learning by using a large training database, while useful to recognize features and images, cannot work when the object (say, chair) is also determined by other traits like its potential use (say, a traffic cone) or its location (say, a toilet seat).

However, as FT Alphaville writes, quoting the example of driverless cars, such predictions about the future have limited value given the uncertainties involved.

Update 1 (2/9/2014)
NYT has this article which explains the failure of robots to match humans with perception and mobility, the Moravec Paradox. It highlights the latest research in haptics, study of sensations of touch, and kinematics, study of motion control in jointed bodies.

Update 2 (26/11/2014)

A study by Carl Benedikt Frey and Michael Osborne that examined the potential impact of computerization on 702 occupations in the US found,

We examine expected impacts of future computerisation on US labour market outcomes, with the primary objective of analysing the number of jobs at risk and the relationship between an occupation’s probability of computerisation, wages and educational attainment. According to our estimates, about 47 percent of total US employment is at risk. We further provide evidence that wages and educational attainment exhibit a strong negative relationship with an occupation’s probability of computerisation.

This graphic captures the potential for computerization (and the resultant probability of displacement) among different occupation categories in the US in 2010.

Update 3 (20/12/2014)

Times has another report on the emergence of robots in many areas. It highlights the examples of Botlr, a hotel bellhop robot, Sedasys, a computer assisted sedation system or anaesthesiologist, Thai Delicious, a Thai food taster, and Kinect assisted devices. 

Access to jobs - the "urban divide" visualization

This visualization tool (via Alain Bertaud) developed by the World Bank nicely illustrates the deep divide that exists in physical access to the job market for residents of Buenos Aires using various transit modes - public transit, car, bike, and walking.

The graphic maps (as color codes) the different occupational locations across the city. The interactive facility enables us to map the number of jobs accessible from any residential location, within different commute time zones, using the four transit modes.

The comparative graphic for one area, General San Martin, shows that within a 30 minute commute radius, a car user has access to 14 times more jobs than a public transit user.

Visualization graphics like these give us a great intuitive sense of how successful a city is in achieving its primary objective - connecting residents to jobs. Or how and where it is failing to achieve agglomeration economies of scale. It helps transport planners and city managers plan for urban transit and infrastructure improvement projects so as to minimize commute times. 

The pursuit of smart cities in developing countries can be better served by such (see also this) smart decision-support tools that enable more effective (detailed and real-time) urban planning than by grandiose physical infrastructure and technology projects. 

Planning mass transit for urbanizing India

As India urbanizes rapidly, metro-railway projects are being planned in many cities across the country. The Government of India (GoI) have formally declared its support for metro-rail for 2 million plus cities on public procurement, as a joint-venture between the central and state governments. But given the massive upfront expenditures and consequent debt-financing burden, as well as high operating costs, it is important that we critically examine our urban mass transit policy.

Consider this. Experience from across the world, developed and developing, shows that mass transit systems, even the most efficient, are very expensive and have to be heavily subsidized. Not only do they consume massive public grants for construction, generally raised through taxes or federal government grants, but also their operation and maintenance (O&M) require subsidy support. In fact, apart from East Asia, where major share of revenues is from real estate developments, the farebox recovery ratio is less than half the operating expenses. This is all the more so for the most capital intensive of them all, metro rail systems, at-grade, elevated, or underground.

In countries like India, with fiscally strapped state and local governments and a very tariff sensitive demand-side, the risks associated with operating and maintaining good quality metro systems are considerable. State governments will find it difficult to subsidize metro rail systems for too long. Given the difficult political economy surrounding tariff increases, large volumes are the only insurance to atleast slightly mitigate commercial risks. Unfortunately, it is here that many of the Tier II city metro rail project stumble badly.

In this context, let us examine three of the newest metros under planning or development - Kochi, Nagpur, and Vijayawada. 

The Kochi metro, spanning 25.6 km and being built at a cost of over Rs 6000 Cr, is estimated to have a peak passenger per hour per direction (phpdt) of 23621 in 2030. It also estimates annual peak and total traffic growth of 4.4% and 3.5%  respectively in 2015-25 and an initial ridership of 381868, or 19% (a fifth) of the entire 2 million population of the larger Greater Cochin Development Authority (GCDA). The metro rail is most likely to fall short of realizing these traffic forecasts. It didn't help that the traffic forecasts, project DPR, and project construction in Kochi is being done by the same agency, possibly the first time ever for such a large project anywhere in the world. 

Nagpur's City Development Plan (CDP) indicates that public transit forms just 7% of the city's vehicle trips. The Nagpur Metro Project estimates that by 2021, 12.2% of the city population of 2.9 million will use the metro. This assumes a very high displacement from existing buses and other modes. Even assuming this, a number of 363000 commuters per day looks more suited to a BRT or a light rail system than a full-fledged metro. 

As regards Vijayawada, the traffic estimates are even more depressing. Assuming the entire current bus traffic gets displaced and an equivalent volume of traffic gets induced by the formation of a new capital city, both highly unlikely, the total daily traffic in the Vijayawada-Tenali-Guntur corridor would still be only about 50000. To put this in perspective, this is just a little more than the minimum peak phpdt to sustain a metro. Clearly the region just cannot sustain a metro. 

In fact, as this graphic shows, metro is clearly suitable only for very high density corridors in large cities, while other mode choices are superior for less dense corridors.

At a time when state and city government across India have come to view metro rail projects as an aspirational symbol and pressure mounts on GoI to sanction them, it is important that such sanctions be de-politicized and made based on rigorous analysis of traffic forecasts. Urban transit mode choices should be made strictly based on demographic trends and professional traffic forecasts.

This assumes even greater significance since experience from across the world and India show that urban transit traffic forecasts invariably fall short, forcing governments to step in with even more subsidies or skimping on maintenance. If the latter happens, as is more likely, it will pose considerable safety risks and quality deterioration, thereby engendering a negative spiral of lower demand, larger O&M deficits, even more skimping, and so on. Furthermore, as these trends play out, the physical infrastructure, already a blight on urban form, will fall into disuse, dragging down property values in the neighborhood. It could be a very short distance between urban regeneration and urban degeneration. 

Is labor market regulations a binding constraint on Indian economy?

Even as the interest on reforming India's undoubtedly restrictive labor regulations mount, Pranab Bardhan has an excellent op-ed where he questions whether it is the "only or one of the main constraints" on the revival of India's manufacturing sector. All his arguments are compelling and I am inclined to agree that whether there are other even bigger constraints.

To the list of arguments posited by Prof Bardhan, there is more from the World Bank's Doing Business and Enterprise Surveys. The Enterprise Survey of business owners and top manager sin 4234 firms done in 2006 revealed the following snapshot of binding constraints faced by businesses (small, medium, and large) in both services and manufacturing.

As can be seen, labor regulations come way down in the worry list for businesses. Infrastructure, especially electricity, tax rates, corruption, and credit come much before. Only 5% of firms identified labor regulations as the binding constraint. 

Consider the following two graphics on the distribution of employees by firm size. The first graphic is on distribution of establishment sizes as a share of plants. It does not show a discontinuity anywhere. There is nothing to show that there is a sharp drop in the share of firms at the 100 employees mark, as would have been the case if the Industrial Disputes Act (IDA) were indeed a critical factor.  

The second graphic is a distribution of establishment sizes as a share of all workers employed. Here too, not only is there is no discontinuity but also the share of employees appear to increase monotonically on both sides of the 100 mark.  

Clearly, empirical evidence atleast does not appear to indicate any egregiously disruptive adverse contribution from the IDA or other legislations on the expansion of Indian manufacturing firms into medium and large firms with employment greater than 100. 

None of this is to deny the undoubted damaging influence of our restrictive labor regulations. Their reform would surely contribute to improving the country's business environment. But to claim that labor market reforms can dramatically improve economic prospects, as argued by the likes of Aravind Panagariya, is to basically elevate anecdotes as objective evidence. Such anecdotes gain prominence from high-profile labor disputes and factory lock-outs. 

There are two stories here. One, the overwhelming majority of Indian enterprises start small and informal, and remain like that. Since the typical firm starting operations is likely to start with far less than 100 employees, there is little reason to suggest that the IDA or the Contract Labor Act are important barriers to starting a business. This leads us to the second story of business expansion from small into medium enterprises. Here, the restrictions imposed by IDA surely adds a layer of regulatory cost and is a potential deterrent to growth of business, though far from a prohibitive one, leave alone being a binding constraint. 

Update 1 (26/08/2014)

A recent KPMG-CII report on India's business environment examined, among other areas, the impact of labor market regulations. It finds that labor related approvals are not among the biggest obstacles, as cited by businesses, for starting a business.

Similarly, for running businesses, respondents claimed that skill gap and recruitment problems were a much bigger obstacle than the cost and time required to comply with labor regulations. 

Finally, the regulation of employment - in terms of hiring and redundancy of workers and rigidity of working hours - as captured in the Doing Business Survey finds that India's employee redundancy dismissal requirements are far less onerous than most of its emerging market competitors. 

Update 1

More in Business Standard countering the conventional wisdom, 

The argument that it is inflexible labour regulations that have incentivised firms to substitute regular workers with contract workers deserves closer scrutiny for several reasons. First, labour regulations have not become more rigid over the time period when contract worker intensity has surged. Second, even states which made amendments to their labour laws to make them more amenable to employers have witnessed a sharp increase in contract worker usage. Third, it is capital-intensive and not labour-intensive industries, where pro-labour regulations hurt the most, which have seen a larger increase in contract worker usage. And finally, if firms were hiring contract workers only to circumvent legislation such as IDA, we should have observed the highest intensity of contract worker usage across firms which hired less than 100 workers. However, the largest share of contract workers is in fact seen in firms hiring more than 300 workers. This reiterates the fact that firms are clearly induced to hire contract workers for reasons other than rigidities in labour regulations.

The rise and decline of Roman Empire

(HT: Vox and Wikimedia)

Reviving India's Manufacturing Sector

The Prime Minister has declared his goal of "made in India" with "zero-defect" (quality) and "zero-effect" (on environment).

In this context, much of the discussion on reviving India's manufacturing sector revolves around the development of industrial clusters like special economic zones (SEZs) or national manufacturing zones (NMZs). This forms the centerpiece of the National Manufacturing Policy 2011 itself. There is nothing to suggest much has changed even with a change in government.

But, as Rahul Jacob wrote in an excellent recent op-ed, an SEZ-led manufacturing revival plan is not likely to lead us too far. A more prudent strategy, as this blog has consistently advocated, would be a concerted campaign to improve the country's business environment. The gains, especially to small and medium enterprises, from simplifying procedures and limiting regulatory discretion would be much more than those from government's fiscal and other incentives to firms in SEZs. Importantly, for fiscally strapped governments, this is as close to a free lunch as it can get.

The gains would come from both lowering the number of procedures and reducing the time (by simplifying and IT-enabling) for each of the activities defined in the chart below.

This is tough and long-drawn slog, un-sexy and diffuse, multi-dimensional and incremental. So, if the Prime Minister needs to walk the talk on making in India, he needs to get his bureaucrats to embrace the challenge of getting this right. 

The globalization opportunity in secular stagnation

Consider this parable of a two-country world.  Stagnation Land is a prosperous country with high per-capita incomes while Emerging Land is poor.

However, in recent years while the former has been experiencing declining productivity growth, the latter has been experiencing large gains in productivity. A large majority of people in Emerging Land have been moving out of agriculture into more productive manufacturing and services sectors. This transition has been accompanied by sharp increase in consumption and aggregate demand. Further, Stagnation Land has an aging population while Emerging Land is at the demographic sweet-spot. This has had the effect of increasing savings and dragging down aggregate demand in the former. As a result of these trends, businesses in Stagnation Land have declining investment opportunities and lower returns on their investments whereas those in Emerging Land have a rapidly expanding supply of investment opportunities and higher rate of returns.

Faced with such a situation, Econ 101 teaches us that the natural response would be expand trade and other economic linkages between the two countries. Stagnation Land has the technologies, businesses, and even capital, all searching for opportunities. It also faces an aging population and resultant demand for different kinds of labor. Emerging Land has rising productivity, remunerative investment opportunities, growing consumer demand, and a large pool of labor. The complementarity could not have been any more mutually beneficial. The scope for a new growth compact between the two countries could not have been more opportune.

Now replace Stagnation Land with the developed economies and the Emerging Land with the developing economies, and the context to the prevailing socio-economic prospects of both parts. Commentators in developed countries have been wailing at the prospect of a long period of economic stagnation, popularly described as "secular stagnation". If the aforementioned parable has any significance, then we should see the current problems in the developed world as a great opportunity to construct a new paradigm of economic and social co-operation between the developed and developing countries driven by mutually beneficial imperatives.

This paradigm would have to be constructed on a platform of cross-border business trade and investments, technology transfers, relaxation of labor migration controls, and so on. In simple terms, more global economic and social integration. 

India's agriculture and manufacturing productivity failures

Three graphics from a recent cross-country study on drivers of economic growth involving more than 100 countries shows why India's economic growth lags behind China.

1. For a country where more than half the population is involved in agriculture, India's agriculture productivity gains have been smaller than all major emerging economies, despite having the catch-up advantage from lower productivity levels. In fact, as the graphic below shows, global agricultural productivity has exhibited a divergence trend between the more productive and less productive economies.

2. An even bigger failure in aggregate value added terms has been the poor performance of India's manufacturing productivity. While both countries started off with similar productivity levels in early 1990s, China has pulled ahead spectacularly. India's performance looks even more dismal given the distinct global trend of manufacturing productivity convergence between developing and developed economies.

3. The importance of manufacturing is underlined by its dominant contribution to China's GDP growth itself. As the graphic shows, India's agriculture performance has been poorer than even the low income countries.

Weekend visualization graphics

The Times has been pioneer in great data visualization journalism. A few weekend graphics

1. This interactive graphic illustrates how the market capitalization of Wall Street firms shrank and then grew during the peak of the sub-prime crisis (October 2007-September 2009).

2. This interactive graphic shows how the different components and the sub-components of the Consumer Price Index in the US changed from March 2007 to March 2008.

3. This interactive graphic (Voronoi tree map) shows the proportions of people in each US state in 2012 based on their places of birth. This is a series of state-wise graphic of the places of birth since 1900.

4. This interactive graphic from Atlanta Fed is a spider chart which tracks 13 US labor market indicators covering four categories for the period from December 2007 to July 2014.

5. Superb Times essay on how businesses play states and local governments against each other and pocket large fiscal incentives. Such incentives, mainly in the form of income tax and sales tax credits for long periods, amount to $80 bn a year in the US. However, there is little to suggest that these incentives, by themselves, generate jobs. This interactive graphic shows how much was provided as concessions by different US states and who pocketed them.  

Urban renewal, gentrification, and inequality

I have blogged earlier about the increasing contribution of urban real estate prices to the widening if inequality in many countries. The rising property prices in most major cities across the world have made them a very attractive investment opportunity for the city's richest residents. In many cities, developers have re-developed blighted areas, creating expensive residential and commercial spaces, which have also had the effect of displacing the less well-off to the suburbs.

In this context, the Times has an article about the re-development taking place in a Parisian block. The project involves the redevelopment of a couple of streets, involving 36 store fronts, into a sleek epicurean village, La Jeune Rue (The Young Street), dedicated to farm-fresh gastronomy and a culture of the chic. It writes,

The trend of gentrification has become almost unstoppable. Paris, New York, London and other major metropolises have undergone waves of urban renewal for decades, each ushering in more wealth than the last, while also pricing out those with less money. While the essence of Paris has hardly disappeared, property prices have jumped an average of 165 percent in 20 years, with a 30 percent surge in the last five. The impact has been striking, cutting Paris’s working-class population to 27 percent from more than 40 percent over the same period. 

Much the same story has been a feature of Michael Bloomberg tenure at New York as he oversaw a massive redevelopment of blighted areas. While it has transformed the landscape of those areas and contributed to the overall economic growth of the City, it has had adverse demographic consequences. As the supply of lower rental housing units, concentrated in these areas, has shrunk, rents for properties at the bottom of the market have risen sharply and the less well-off have been marginalized into the suburbs. 

"Living Wills" are no answer to TBTF

The US Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) last week rejected the "living wills" submitted by 11 large financial institutions as "unrealistic or inadequately supported". The "living wills" are detailed plans, as required by the Dodd-Frank Bill, that outline how banks will dismantle their operations and financial contracts in an orderly manner in the event of impending failure. The Vice Chairman of FDIC, Thomas Hoenig said,

Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support. 

Though the Fed has asked these banks to re-submit their "wills" in an year, the revised ones are not likely to be any more useful. While logically appealing, such pre-defined resolution plans are not likely to be of much use in a crisis involving the largest banks. They are too complex to be resolved with such plans. Their complexity spans atleast three dimensions - correlatedness among atleast some of the assets held by them, interconnectedness among several institutions, and opacity in their corporate structures - all of which are amplified many times over by their massive sizes. Taken together they constitute the too-big-to-fail (TBTF) problem.

Even assuming the "living wills" bridge all information asymmetry and provide a very clear understanding of the banks' operations and its assets and liabilities, itself highly doubtful, there is no guarantee that it will enable the implementation of a resolution plan when faced with the crisis. Even if AIG had a detailed "living will" it would not have been in a position to liquidate itself without threatening to pull the entire system down. The correlatedness and interconnectedness dimensions threaten both specific markets as well as other larger firms respectively, both with potentially catastrophic consequences for the financial markets as a whole. It is therefore unlikely that regulators and policy makers will let large institutions collapse in the belief that the "living wills" and the Orderly Resolution Authority (OLA) will limit the panic from its collapse.

The orderly resolution of large financial institutions cannot be divorced from the more important issue of addressing TBTF. For example, though the "living wills" lay out the steps the banks will take to distribute its large losses among stakeholders - creditors and bond holders, and even when all those stakeholders know it well in advance, its actual enforcement will be constrained by the TBTF problem. The only way around this is addressing the complexity problem in all its three dimensions. And that in turn takes us back to more stringent macro-prudential and micro-prudential regulations. Unfortunately, the likelihood of such tough measures appears very remote. 

Public procurement Vs private contracting

Sometime back the Times ran a nice article explaining how the economy of Washington benefited from the massive federal government contracting industry. But this, in particular, caught attention,

Washington’s economy did well under Reagan (added military spending gave it a boost), but the move to contract out more and more government work proved to be a crucial long-term change. In 1993, Bill Clinton announced a “reinventing government” initiative, which ultimately included cutting the federal work force by about 250,000 positions. The agencies winnowed their rolls, but over the course of the Clinton years, their budgets expanded, and in many cases, the work just went to contractors. Those contractors often came at a bloated cost, too. In a study released in 2011, the Project on Government Oversight found that using contractors can cost the federal government about twice as much as federal employees for comparable work. According to the study, the salary for a federally employed computer engineer would be about $135,000; a contractor might bill the government around $270,000 for similar work. 

This is the classic paradox. Conventional wisdom has it that public systems are both inefficient and expensive in managing service delivery. In contrast, the perception is that private providers can deliver the same service more efficiently and at a lower cost. But reality is that private provision of public services is more expensive than their provision by public providers. So what gives?

This apparent paradox arises from the differences in the quality of service delivered as well as differences in the nature of public provisioning and private contracting. Private contractors are notionally held accountable for delivering a bench-marked quality of service. This adds significantly to the total cost of provisioning by bringing in the need for higher quality of consumables, maintaining redundancies, preventive maintenance, adequate insurance and risk mitigation measures and so on.

Irrespective of whether they meet those requirements and deliver on the bench-marks, most likely not given the lackadaisical contract management by public managers, private contractors price their bids at the cost of the bench-marked quality of service. This also means that private contractors generally end up delivering more or less similar (bad) quality of service as public providers, but at a much higher cost. In case of public providers, the absence of any accountability to deliver a similarly bench-marked service means that the cost of delivery is anyways smaller.

What is a Smart City?

The graphic below apparently represents a "smart" city.

It does in turn beg the question, what is a good "normal" city? Stripped off all the jargon, both are essentially the same. If we want to split hairs, we can define a "smart" city as a "normal" city which uses technology and progressive urban planning to create a highly liveable urban environment. 

Instead of focusing urban development agenda around delivering good quality civic services and creating the enabling conditions for entrepreneurship and sustainable economic growth, we have taken the easy way out by re-packaging all those essential elements of good urban governance and presenting it as an innovation! 

Correlatedness and interconnectedness risks in bank failures

The conventional wisdom on systemic risk in banking is that the size of institutions is the risk propagation mechanism. Accordingly, the failure of a very large financial institution, who is one of the largest counterparties or whose holdings are likely to constitute a significant share of the market for a particular financial instrument, pose prohibitive risks. Regulators across the world have therefore designated certain institutions, based on their asset size, as “systemically important financial institutions” (SIFIs) who pose a too-big-to-fail (TBTF) risk.

In a recent paper, two economists from the Minneapolis Fed, refute this conventional wisdom, arguing that policy makers intervene to rescue big banks “not simply because they are too big” but “because the potential systemic costs resulting from the bank failure are considered too big”. They point to similarity in risk profiles of asset portfolios held by the institutions, or correlatedness, as the risk propagation mechanism. Regulators intervene when the “aggregate assets of threatened financial institutions are sufficiently large to represent a substantial risk to the broader economy should those institutions fail”. They write,

Proponents of bank size limits as a solution to the moral hazard problem induced by bailouts implicitly assume that the combined portfolio of a collection of smaller banks will be less risky than the portfolio of a large bank of equivalent size. This assumption is unwarranted, we contend. In fact, the very prospect of government bailouts creates an incentive for banks—regardless of size—to take on highly correlated risks, which, in turn, raises the likelihood of financial crisis. … the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe.

So their prescription for regulators,

What truly matters to the well-being of the broad economy is not the risk profile of any given bank portfolio, large or small, but the risk profile of the entire banking system. Regulators therefore need to understand what kinds of events are likely to threaten a significant fraction of the aggregate assets of the entire banking system, rather than concentrate (as current policies do) on a limited number of large banks. In particular, they must focus on how the portfolio of the entire banking system is exposed to such events. Regulation of a given bank then should deal with whether that particular bank’s behavior is mitigating or aggravating the risk exposure of the entire system. In brief, we need stress tests of the entire banking system, not just of individual banks.

While the authors are right to point to the importance of correlatedness over size, they overlook the role of another contributor, interconnectedness in assets or liabilities among institutions. Accordingly, in the US, AIG’s failure to honor its over-the-counter CDS obligations threatened a large number of institutions, especially pension funds, holding that asset. Similarly, the failure of Lehman froze the money market mutual funds which had investments in institutions like Lehman. Taken together, correlatedness and interconnectedness in asset/liability portfolios are a more reliable measure of systemic risk that mere size. 

Regulators ought to focus on measures of correlation and interconnection and put in place counter-cyclical macro-prudential measures, central clearing houses for standardized OTC derivatives with higher and variable margin requirements, and greater information sharing on exposures of individual institutions to mitigate the risks arising from them. Merely focusing on size would be tantamount to missing the woods for the trees. 

Calibrated push, not headlong rush on PPPs

I have an op-ed today with Dr TV Somanathan on why realization of efficiency gains should be the only reason for entering into PPP contracts. Our other op-eds on infrastructure are here, here, and here.