Financial Innovations Reduce Volatility Selected Macroeconomic Volatility Before and After FI Period

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Joel Kurtzman Chairman, Kurtzman Group Senior
Fellow, Milken Institute
Global Edge Using the Opacity Index to Manage
the Risks of Cross-Border Business
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Approach

• Todays hypercompetition changes the old view of
  making countries successful
• Old view countries compete on labor costs and
  raw material endowments
• New view countries compete on a range of issues
  including
• Access to capital
• Social systems and costs
• Stability
• Overall levels of risk
• Opacity

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Markets and CountriesIncluded in the Opacity
Index
Austria Belgium Czech Rep. Denmark
Finland France Germany Greece
Hungary Ireland Italy Netherlands Norway
Poland Portugal
Russia Spain Sweden Switzerland Turkey United
Kingdom
Pakistan Philippines Singapore South Korea
Taiwan Thailand
China India Hong Kong Indonesia Japan Malaysia
Canada United States
Egypt Israel Kuwait Lebanon Nigeria Saudi Arabia
Argentina Brazil Chile Colombia Ecuador Mexico V
enezuela
South Africa
Australia
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Two Types of Global Risks

• Large-Scale, Low-Frequency Risk
• Large-scale risks (earthquakes, revolutions,
  nationalizations) are dramatic and rare but
  capture attention.
• Small-Scale, High-Frequency Risk
• Small-scale risks are everyday occurrences and
  are the real bane of business. For business, this
  is where the real costs lie.

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The Impact of Small-Scale Risks Is Big

• While all eyes focus on the large but rare
  risks, businesses must watch out for the real
  risks that cost money and time.
• Corruption
• Legal systems with limited protections
• Economic policies that hinder sustained growth
• Accounting and governance standards that make it
  difficult to see inside companies
• Regulatory systems that fail to protect investors
• These five (CLEAR) factors are sand in the gear
  of commerce. They are the everyday risks of
  being a global business.

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We Call These Small-Scale Risks Opacity

• What exactly is opacity?
• Opacity is the opposite of transparency. It is
  the lack of clear, accurate, easily discernible,
  and widely accepted practices governing the
  relationships among businesses, investors, and
  governments. Opacity acts as a brake on commerce,
  and its presence hampers the smooth operation of
  business transactions.
• Joel Kurtzman and Glenn Yago
• MIT Sloan Management Review
• October 2004

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The Costs of Small-Scale Risks Can Be Measured

• Social scientists might call opacity negative
  social capital. Social capital includes
  institutions and agreements that keep a society
  functioning. It includes elements as diverse as
  laws, markets and educational institutions.
• Since opacity is a form of capital, it can be
  measured.
• Since opacity is a form of capital, its
  transformation from negative to positive can be
  noted and followed.
• Since opacity is a form of capital, its impact on
  business and growth can be plainly seen if
  leaders want to look!

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What Can We Do With Opacity?

• Understand the link between opacity and growth
• Understand price risk
• Measure global portfolio risk and balance
• Create country-based strategies
• Create new types of portfolios (green,
  sustainable, peace etc.)
• Comply with pension fund screens
• Forecast challenges/opportunities
• Compute minimum-required rates of return

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The Opacity Index Scores
Country Category Category Category Category Category Opacity Index
Country C L E A R Opacity Index
Finland 3 11 23 17 9 13
United Kingdom 20 3 25 33 13 19
Denmark 6 15 21 33 19 19
Sweden 8 24 21 25 19 19
Hong Kong 26 12 14 33 15 20
United States 28 19 27 20 10 21
Australia 19 16 26 33 10 21
Switzerland 20 27 20 25 21 23
Austria 21 11 32 33 17 23
Belgium 28 25 30 17 14 23
Canada 26 17 37 20 16 23
Singapore 15 19 25 50 10 24
Netherlands 16 21 22 38 23 24
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The Opacity Index Scores
Country Category Category Category Category Category Opacity Index
Country C L E A R Opacity Index
Germany 28 14 33 17 32 25
Ireland 33 19 29 38 9 26
Japan 38 24 31 22 22 28
Chile 41 24 30 20 27 29
Israel 33 30 44 20 25 30
Taiwan 47 33 20 40 28 34
South Africa 55 34 28 33 18 34
Spain 39 25 32 50 23 34
Malaysia 55 35 28 30 26 35
Thailand 72 33 29 20 21 35
Portugal 37 26 31 50 32 35
Hungary 51 31 26 50 24 36
France 39 47 33 33 32 37
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The Opacity Index Scores
Country Category Category Category Category Category Opacity Index
Country C L E A R Opacity Index
South Korea 61 35 22 30 37 37
Brazil 47 48 32 40 35 40
Poland 63 35 47 40 19 41
Greece 58 30 36 50 30 41
Czech Republic 61 35 32 44 35 41
Ecuador 64 60 34 25 29 42
Colombia 57 61 45 29 21 43
Italy 52 32 45 63 24 43
Turkey 67 41 27 44 36 43
Mexico 65 60 35 33 25 44
Argentina 65 64 33 30 27 44
Pakistan 75 49 47 33 22 45
Saudi Arabia 61 34 32 33 69 46
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The Opacity Index Scores
Country Category Category Category Category Category Opacity Index
Country C L E A R Opacity Index
Russia 78 44 39 40 31 46
Egypt 71 37 39 40 51 48
India 74 44 49 30 46 48
Nigeria 80 65 48 0 50 49
China 74 39 39 56 43 50
Philippines 75 56 52 33 36 50
Venezuela 75 68 49 30 30 51
Lebanon 83 60 65 44 42 59
Indonesia 82 54 90 22 49 59
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Behaviors Can Be Measured

• Every Additional Point on an Opacity Score
  Yields
• Lower average per capita income (-986)
• Lower net foreign direct investment as a percent
  of GDP (-1 percent)
• Lower Capital Access Index Score (-0.06 points)
• Lower bank assets as a percent of GDP (-4
  percent)
• Lower stock market capitalization as a percent of
  GDP (-0.9 percent)
• Lower stock market traded value as a percent of
  GDP (-0.9 percent)
• Increase average borrowing interest rate (57
  basis points)
• Increase inflation rate (0.46 percent)

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Complexity of Legal Systems

• Procedural Complexity Index
• Number of filings
• Duration
• Cost
• Employment Laws Index
• Flexibility of Hiring Index
• Conditions of Employment Index
• Flexibility of Firing Index
• Aggregate Complexity Index
• Average of Procedural Complexity and Employment
  Laws Index

Source World Bank, Doing Business
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Sources of Data (General)
Source Code Publication, Source Publication, Source
WBRS Regulation and Supervision of Banking Around the World, World Bank Regulation and Supervision of Banking Around the World, World Bank
SSBG Salomon Smith Barney Guide to World Equity Markets Salomon Smith Barney Guide to World Equity Markets
ISSA International Security Services Association Handbook International Security Services Association Handbook
IFAD International Forum on Accountancy Development, GAAP Convergence International Forum on Accountancy Development, GAAP Convergence
ICRG International Country Risk Guide, PRS Group International Country Risk Guide, PRS Group
TI Corruption Perceptions Index, Transparency International Corruption Perceptions Index, Transparency International
GCR Global Competitive Report, World Economic Forum Global Competitive Report, World Economic Forum
WBDB Doing Business, World Bank
AON Risk Management Updates
WBCRS World Bank Survey on Public Credit Registry for Central Banks World Bank Survey on Public Credit Registry for Central Banks
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Sources of Data(Economic and Regulatory)
Questions (E Effectiveness of Economic Policy) Type of Data No of Countries for which data are available Source
Average days of legal procedure from filing to enforcement Raw Data 48 WBDB
Contract Enforcement Index How inefficient (formalism) is contract enforcement? Index 48 WBDB
Business costs of terrorism (1-7, low is worse) Index 46 GCR
Transparency of policy making Index 22 GCR
Organized crime costs on business Index 46 GCR
Efficiency and transparency of tax system Index 46 GCR
Extent of bureaucratic red tape Index 46 GCR
Freedom of press Index 46 GCR
Enforce contracts cost ( GNI per capita) Raw Data 47 WBDB
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Sources of Data(Economic and Regulatory)
Questions (R Regulatory Regime) Type of Data No of Countries for which data are available Source
Government stability Index 48 ICRG
Capital Flows Restriction Index Index 48 Heritage Foundation
Government Involvement in Banking and Finance Index Index 48 Heritage Foundation
Regulatory Burden Index Index 48 Heritage Foundation
Start Business number of Procedures Raw Data 48 WBDB
Start Business duration (days) Raw Data 48 WBDB
Start Business cost ( GNI per capita) Raw Data 48 WBDB
Start Business min. capital ( GNI per capita) Raw Data 48 WBDB
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Sources of Data(Economic and Regulatory)
Questions (R Regulatory Regime) Type of Data No of Countries for which data are available Source
Close Business actual cost ( of estate) Raw Data 48 WBDB
Close Business goals of insolvency Index Index 48 WBDB
Can regulators engage in discretionary forbearance? Binary 46 WBRS
Can the banking supervisor suspend a bank's directors' decision to distribute dividends, bonuses or management fees? Binary 47 WBRS
Is there a central securities and exchange regulator? Binary 39 ISSA
Can brokers set their own fees and commissions? Binary 38 ISSA
Is there self-regulation of brokers? Binary 23 ISSA
Have exchanges established listing requirements? Binary 40 SSBG
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Sources of Data(Economic and Regulatory)
Questions (R Regulatory Regime) Type of Data No of Countries for which data are available Source
Does the central bank or independent agent (other than the fiscal authority) handle the issuance and settlement of public debt? Binary 45 Country's regulator
Is public debt distributed by auction? Binary 45 Country's regulator
Is there a system of primary dealers? Binary 45 Country's regulator
Is there a central clearinghouse for settlements? Binary 44 Country's regulator
Is debt held at a central depository? Binary 34 Country's regulator
Is there one or more consumer credit rating agency? Binary 39 WBCRS
Regulation of securities exchanges transparency, effectiveness, role of government, industry intervention (1-7, low is worse) Index 46 GCR
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U.S. GDP Growth
Source International Financial Statistics
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A Brief Period of U.S. Budget Surplus
Surplus
Deficit
Source U.S. Department of the Treasury, Bureau
of the Public Debt
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Capital Access Index 2006Gauging Entrepreneurial
Access to Capital
Source Milken Institute
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Capital Access Index, 2006
Less access
More access
Sources World Economic Outlook, Milken Institute
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Factors Affecting Financial Market Development

• Level of institutional development, including law
  and regulation (Boyd and Smith, 1996 Gurley and
  Shaw, 1955)
• Legal origin, shareholder rights and creditor
  rights (La Porta et al, 1998)
• Laws and regulations (Levine, 2002 World Bank,
  2001)
• Demographics and human capital (Black, 2002)

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Improved Capital Access Can Add Billions to
Emerging Economies
  Forgone GDP Growth Forgone GDP US Billions (2006)
Mexico 2.63 22.09
Russia 2.50 24.48
Argentina 1.97 4.19
Pakistan 1.70 2.19
India 1.66 14.72
Source Authors Calculation based upon Triphon
Phumiwasana, (2003)
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Representative Costs of Opacity Expressed in
Percent

• Finland -1.83
• UK -0.44
• Sweden -0.31
• U.S. 0.00
• Switzerland 0.40
• Belgium 0.42
• Germany 0.86
• Ireland 1.03
• Japan 1.51

• Brazil 4.29
• Czech Rep 4.56
• Turkey 4.95
• Mexico 5.01
• Saudi Arabia 5.52
• Russia 5.64
• China 6.49
• Venezuela 6.56
• Indonesia 8.54

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Opportunity Map

• Size of each bubble represents relative GDP
• Vertical (Y) location of the bubble indicates
  rate of growth
• Horizontal (X) location illustrates increasing
  procedural complexity

Opportunity is defined here as a countrys legal
and procedural complexity, relative to its
overall market size and rate of growth
GDP GROWTH RATE ()
Source CIA World Factbook World Bank, Doing
Business The Economist World in Figures 2002
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Forgone Finance, Forgone Growth

• Recent empirical estimates suggest that
• Doubling bank credit to the private sector as a
  percent of GDP in emerging markets could increase
  annual GDP growth by almost 3 percent.
• Doubling the trading volume of the stock market
  in an emerging market could increase annual GDP
  growth by almost 2 percent.