Real effects of exchange rate depreciation, now forthcoming in JMCB
A paper we (Peter Bednarek, Daniel te Kaat and Natalja von Westernhagen and I) started before the pandemic but finally managed to get published. While the topic seemed somewhat less important over the past years, it has certainly taken on new importance with recent sharp movements in exchange rate markets, which affects banks’ balance sheet in case of asset-liability mis-matches in foreign currencies (which are typically not or not completely hedged). In this paper we assess what effect such exchange rate movements and consequent changes in banks’ solvency position can have on their lending and on the real economy, using the 2014 depreciation of the euro vis-à-vis the USD. We rely on matched bank-firm-level data from Germany and estimate difference-in-differences regressions 2014:Q2 and 2015:Q1, during which the euro depreciated by more than 20%.
We find that the exchange rate depreciation raised banks’ net worth and subsequently led to higher interbank lending by large banks with high net dollar exposure to smaller banks without foreign-currency asset exposure but with a high
share of exporting firms in their portfolio. These smaller banks in turn increased lending to export-oriented firms. This is evidence that the exchange rate depreciation, by increasing the liquidity of distinct tiers of the domestic banking sector, can have sizeable economic effects, even when local banks have low foreign-currency asset exposure and are therefore not affected directly by the exchange rate shock.
In terms of real effects we show that exporting firms borrowing from smaller banks that have higher interbank market dependence increase their investment following the exchange rate depreciation, and that regions with local banks benefiting from this increase in interbank borrowing experience significantly higher GDP growth than less exposed regions. While some of this effect might be driven by the classical trade (firm demand) channel, with more export-dependent firms typically experiencing higher demand following a domestic currency depreciation, even after controlling for firm demand effects more exposed regions grow by 1.3-1.4 percentage points more than less exposed regions, cumulatively, in the two years after the depreciation relative to the two pre-depreciation years.
Overall, these findings show the importance of banks’ balance sheet structure and interbank markets in transmitting exchange rate shocks to the real economy. As discussed above, recent exchange rate movements might have similar effects (though they might be dominated by other macroeconomic developments, such as tariffs or higher macroeconomic uncertainty).
15. July 2025
Stablecoins – the future of finance or the cause of future fragility?
There is a lot of talk about stablecoins, which originally were meant to link the crypto (decentralised finance) and the traditional finance worlds. As the name says, stablecoins are supposed to have a stable value vis-à-vis traditional financial assets, such as the US dollar or the euro, which can be achieved by holding reserves in these currencies.
What is the use case for stable coins? 6 years ago, when Libra as new global private digital currency was announced by Facebook/Meta, there was an immediate backlash by the regulatory and central banking community, afraid that such a global stable coin would undermine monetary sovereignty and seignorage. Today, the reception in the regulatory (and political) community is very different.
The clearest use case for stablecoins seems to be in the area of payments, especially cross-border payments. Rather than going through the banking system, payments can be done on the blockchain, in the form of an ‘atomic settlement’ –swap of tokenised money vs. tokenised asset. This can reduce margins, However, it is not clear why this has to be done outside the traditional banking and central banking system, as such a tokenised system can run with tokenised bank accounts, stablecoins or central bank digital currencies (CBDC). Though, as Lorenzo Bini Smaghi points out, European banks might be reluctant to embrace innovation, being happy with the current costly but profitable (for them) technology. There is obviously the strong argument that innovation often comes from outside the financial system, but with such innovation outside the regulatory perimeter come stability risks, as I will argue below.
The new US administration has been at the forefront of welcoming new stable coins, prohibiting the development of a CBDC and embracing the crypto world. One cynical argument would be that the expansion of stable coins would require them to hold US treasuries, thus helping finance the increasing US government debt. It would also help promote the international use of the dollar for payment and invoicing purposes, at a time, when geopolitical changes might undermine the global role of the US dollar. Dollar-pegged stablecoins may also be highly attractive to citizens of countries with low levels of financial inclusion and unstable currencies. According to the foreseen regulatory framework (as per the Genius Act), supervision can be done either on the state or the federal level; at the first look this seems rather lax supervision, not comparable with bank supervision.
There are those who say that then EU should follow, relax regulation of stable coins and actively foster the emergence of stablecoins. With the rise of US dollar linked stablecoins, the EU would then face an even stronger international role of the US dollar, hindering key EU interests in trade and stable multilateral relations; it might also undermine attempts to strengthen the role of the euro in global financial markets. On the other hand, there is a clear case that the growth of such investment funds might pose new financial risks.
Ultimately, stable coins seem to be the new money market funds (MMF), which have an important role in the US financial system as alternative to bank deposits (and increasingly but less so in the euro area). The most stable ones, investing primarily in sovereign and (possibly) high-rated corporate papers and bank deposits, MMFs offered a higher-yield alternative to bank deposits and they became especially attractive as interest rates dropped to zero before the recent inflation bout. In 2008, however, MMFs ‘broke the buck’, i.e., investors could no longer redeem their shares at par. Ultimately, the Federal Reserve had to step in and take the MMFs under the financial safety net umbrella, fearing for contagion effects, including in the banking system. Somehow, the structure of the stable coins, pegged to the US dollar and investing in US securities, looks scarily similar (even though here stablecoin holders would be debt and not equity claimants). And as before, these stablecoins are not considered banks and not subject to bank regulation. However, rapid interest rate movements or the failure of one of these stable coins could result in run risk and contagion effects into other parts of the financial system, including the banking system. Ultimately and as in 2008, central banks might be forced to extend the financial safety net ad-hoc to stablecoins in times of crises. As clearly described in the recent BIS Annual Economic Report, while the technological advance of tokenisation should be embraced, the institutional innovation of stablecoins might add more costs of possible fragility than benefits to the financial system.
Regulators have the tendency to see risks whenever they see innovation. Financial innovation is critical for the financial system (as for any other sector); however, given the connectedness within the financial system and the externalities on financial stability not being taken into account by individual players, a careful monitoring of the development of such new institutions and players is certainly called for. This holds even more in a world, where cross-border cooperation is not as obvious as it was in 2008. There is no reason to fight against stablecoins, but there is no reason to consider them the panacea for the future of the financial system; a sceptical approach might serve us best in Europe.
12. July 2025
The rise of populism and fascism – is there a ceiling?
There were two contrasting presidential elections in recent weeks in Central Europe. While the Romanian elections yielded a small but decisive majority against the right-wing candidate, in Poland it was the right-wing (though unlike in Romania, not Russophile) candidate who won. It is surprising that 35 years after the transition from Soviet-dominated totalitarian regimes there is so much appetite for authoritarian governments and (in many Central and Eastern European countries) for Russophile candidates. What explains this? And why now? Some observations, though certainly not conclusive ones.
As someone pointed out recently, the rise of authoritarian parties is very different from their rise in the 1920s and 30s, when socio-economic problems (much worse than now) led to a disillusion with democracy (which was not as entrenched in many European countries to start with). Looking at the 21st century, the Global Financial and Eurodebt crises gave rise to left- and right-wing populist parties, especially in countries affected by the crisis; in spite of the economic recovery over the past ten years, these parties have become even stronger, including in Central and Eastern Europe. I very much doubt that the inflation bout would be the decisive factor explaining this.
The second half of the 20th century was in most Western European countries characterised by a political competition between centre-left and centre-right; this has now been replaced by competition between centrist democratic and populist-authoritarian parties. In France, the last two presidential elections were between a centrist and a far-right candidate; in Italy, the centre-right government is dominated by a neo-fascist party (it is notable, however, that Prime Minister Meloni has moved towards the centre and seems supportive of centrist policies such as support of Ukraine); in the Netherlands, the government that just resigned was dominated by populist and right-wing parties; finally, in the UK, Nigel Farage (pied piper of Brexit) is leading the polls.
Not all is lost – in the Netherlands there is a revival of the centre-left and centre-right parties, at least according to opinion polls. The last UK elections showed a clear majority of centre and centre-left parties. But even where centre-right and centre-left parties are still dominating (e.g., in Portugal), a right-wing party has become a strong third force. One thing that clearly does not seem to work is to follow the agenda as dictated by the populists, such as Labour’s Starmer is doing in the UK, where he primarily tries to offer more efficient solutions to problems created or defined by the populists, including Brexit and immigration, rather than offering a new vision and a clear alternative.
What drives the rise of right-wing populism? Is it frustration and fatigue with the status-quo? Are Western Europeans economically and socially so comfortable after 80 years of peace that trying something more radical seems attractive to more and more people? Or is it that simple messages and creating nostalgia for what supposedly were the good old times capture the imagination of many? Is migration the main factor – even though support for right-wing parties is strongest where migration is lowest. One important factor is certainly the increased uncertainty, even if not reflected in economic terms quite yet. There is certainly also heterogeneity across countries, including between former transition economies and Western European countries. One important challenge is that the socio-economic problems will only become bigger over the next decade, including with demographic transition and climate change, but the fiscal space even tighter. There will be hard choices to be made, and easy populist solutions will become even more attractive.
As laid out clearly by Timothy Garton Ash last weekend in the FT, Europe is facing new challenges and is entering a new era. The next few years will show whether a democratic or a more nationalist, more populist and possibly more authoritarian Europe will prevail. It is important to stress that if Europe is to stand its ground in the new geopolitical and -economic landscape, only an economically stronger and thus more integrated European Union will be able to do so – a red rag for right-wing populists who keep dreaming about a Europe of Nations. It is the strength in numbers (population and GDP) that allows the EU to stand up to Trump (and that’s why he hates it so much) and Putin.
There is of course a third option – muddle through further, with more countries trending towards right-wing governments but others staying in the hands of democratic parties of the centre. In some cases, new populist governments might see the advantage of further European integration, even if they have campaigned against it (like Meloni in Italy). In other cases, we might get more Orban-style copy cats that undermine Europe in letter and spirit.
The next decade will be critical for Europe, both for its democratic future and its standing in the new geopolitical order (including defending itself against Putin’s Russia). Both hang closely together!
30. June 2025
And the winner is….
The 2025 Ieke van den Burg Prize for research on systemic risk has been awarded to the paper entitled “Better be careful: the replenishment of ABS backed by SME loans” by Arved Fenner, Philipp Klein and Carina Schlam. This Prize is decided upon by the Advisory Scientific Committee of the ESRB and is targeted at junior researchers. As previous winners, this paper addresses an important systemic risk topic, relevant for analysts and policymakers alike.
Securitisation has again moved to the top of policymakers’ agenda in Europe. So, understanding how the sausage is being made, i.e., which loans make into the pool, is important. Contrary to ]general opinion, securitised loan portfolios may change their composition after being taken off from banks’ balance sheets. For asset-backed securities (ABS) backed by SME loans in particular, the reason is that the time to maturity of ABS is usually much longer than that of the underlying loans. Thus, banks need to reinvest the released capital arising from the borrowers’ repayments and transfer further loans to the securitised loan portfolios after the transactions’ closing. This is known as portfolio replenishment.
The authors study the replenishment of 102 ABS backed by more than 1.7 million small- and medium-sized enterprise loans. Based on granular data from 2012 to 2017 obtained from the central loan-level repository for ABS in Europe, the authors show that loans added to securitised loan portfolios after the transactions' closing perform worse than loans that are part of the initial portfolio. On average, loans added to securitised loan portfolios demonstrate a 0.42 percentage points higher probability of default. The authors provide evidence that originators exploit their information advantage vis-à-vis investors by deliberately adding lower-quality loans to securitised loan portfolios. On the other hand, this adverse behaviour can be mitigated (i) by originators' reputation efforts, i.e., by originators wanting to return to the market and thus aiming at building a reputation,(ii) by increasing transparency in the ABS market, as for example per the European Central Bank's loan-level initiative, and, most effectively, (iii) by the interaction of reputation efforts and transparency.
24. June 2025
Capital market union – is third time the charm?
Two weeks ago, the Florence School of Banking and Finance organised a joint conference with the European Stability Mechanism in Luxembourg on Savings and Investment Union – bringing capital markets to people and firms. The concept of a Savings and Investment Union (SIU) replaces that of a Capital Market Union (CMU), that has gone through two not very successful attempts. However, SIU is also broader than that of a CMU as it can be seen as comprising both banking and market/non-bank finance.
The first day was focused on academic studies related to capital market integration while the second day to policy panels. Here are some of my take aways.
First, the Savings and Investment Union (SIU) is not about increasing savings in the EU; it is not necessarily about increasing investment (though completing the Single Market in Goods and Services and reducing red tape might also offer additional investment opportunities). Rather, it is about improving intermediation efficiency, with positive effects on innovation, productivity growth and economic growth. This is in line with the financial intermediation-growth literature that has shown that the relationship between financial development and economic growth works through more efficient resource allocation and productivity growth rather than capital accumulation and higher savings (see e.g., my old paper from 2000, with Ross Levine and Norman Loayza). While the aggregate savings rate in the EU is much higher than in the US, a large share of its saving is channelled to investments outside the EU. While in macroeconomic terms this is the mirror of the large current account surplus of the EU, it might also be explained by inefficient intermediation within the EU.
Second, one important objective of the SIU is to turn people from savers to investors, i.e., encourage them from looking beyond bank accounts to higher-return (but also higher-risk) asset classes. Financial literacy is important in this context, but so is effective investor protection. It is not to simply push retail investors into risky securities, but teach them to take well-informed decisions, allow them to take these decisions based on transparent and correct information, and protect them from mis-selling and post-sale misconduct.
Third, SIU relates to a lot of different products and institutions. There has often been made the comparison between banking and capital market union, with the former focused on banks and clearly defined in terms of the necessary institutional and regulatory framework. In the case of the CMU (and thus SIU, comprising both banking and capital market union), there are many different products and institutions involved; to name just a few: (i) securitisation, involving banks and special purpose vehicles packaging loans (while redeveloping this market segment seems low-hanging fruit, there is the question whether this will really be a game changer as it primarily helps deepen the lending market), (ii) venture capital, which implies both venture capitalists, but also deeper and more liquid equity markets as exit option; (iii) strengthening contractual savings institutions, including pension funds, which implies regulatory reforms, but possibly also pension reforms (see below)
Fourth and related to the above, SIU affects lots of different players. There are different regulators, on national and European level, there are financial service providers, including investment fund companies, venture capitalists and stock exchanges. There are important infrastructure elements, including clearing systems and securities depositaries. There are decisions to be taken on the political level (e.g., supervisory integration), legislative level and regulatory level. The agenda is expansive and prioritisation is critical.
Fifth, there are lots of moving parts within the SIU agenda, with policy levers on the national (e.g., financial literacy, taxation) and on the EU level (e.g., more centralised supervision). Most prominently and most difficult on the national level would be pension reform towards a capital-based pension system. Unfortunately, for those countries that rely primarily on pay-as-you-go pension system, the timing for a shift towards capital-based pension systems is demographically very challenging. More generally, there is a lot that countries can do on the national level to foster the diversification of their financial systems. To achieve the necessary scale, however, coordinated action is needed.
Sixth, policymakers have limited attention span. To get momentum, some early wins are to be aimed at and hopefully this will be reflected in the Commission’s timetable. Shifting more supervisory powers to ESMA as part of a transition to a ‘European SEC’ can provide a certain moment by creating a champion for further capital market integration in Europe. Creating an attractive (including with tax benefit) long-term retail savings/investment product can popularise the concept of the SIU across Europe.
Seventh, strong political will is needed to overcome vested interests trying to maintain the status-quo. Maintaining 27 clearing systems and stock exchanges will prevent Europe from achieving scale, critical for deep and liquid capital markets. While capital market development might seem less urgent than, e.g., than strengthening defence and fighting trade wars, only an effective SIU can guarantee long-term growth and thus welfare in the EU.
Finally, and coming back to my initial point, third time better be the charm. Europe often moves forward during times of crisis (as the construction of the banking union has shown). Given changes in geopolitical and geoeconomic fault lines, Europe has to rely more on European intermediation and capital markets. This time, we are condemned to success.
19 June 2025