On a personal note - ESRB
Over the past 4.5 years I have been a member of the Advisory Scientific Committee (ASC) of the ESRB. Starting this month, I will be a co-chair for the next four years, together with Loriana Pelizzon and Steve Cecchetti. The actual chair(wo)manship is rotating, with each of us taking the lead for 16 months. In addition to co-chairing the ASC, this also involves participating and voting in ESRB General Board meetings. Unlike other European institutions, the ‘academic’ branch of the ESRB has three votes in the General Board (thus as much as three countries).
What is the ESRB? It was established at the end of 2010 as part of a wider reform aiming to improve financial supervision in the EU and brings together EU central banks and supervisors, the European Commission, and the European Supervisory Authorities (ESAs). It aims to identify and mitigate risks to the stability of the EU financial system that could damage the real economy. It may issue warnings and recommendations on how to mitigate those risks, thus relying on soft law rather than hard enforcement (the recommendation on dividend restrictions during Covid-19 is a classic example).
The Advisory Scientific Committee (ASC) is made up of 15 academically oriented independent experts from across the globe. In addition to providing input to the General Board (together with the Advisory Technical Committee), it produces its own reports and insights, including some quite prominent and influential ones, such as on overbanking in Europe, and transition to a low-carbon economy and systemic risks, but also contributes prominently to ESRB reports such as on safe assets in the euro area and macroprudential implications of a low-interest rate environment.
While some might see the ESRB as a macroprudential authority without teeth, it is also Europe at its best. In the absence of clear macroprudential regulatory and supervisory responsibilities on the supranational level, it forces authorities across the EU to share their views and come to joint conclusions on financial stability risks. The involvement of academics is rather unique but also reflects the increasing importance of a close dialogue between policy world and academia.
Research conference at the SSM
Early May saw the first SSM research conference, where I had the honour to serve as chair of the programme committee. Lots of great submissions and an excellent conference programme. While there is a rich research culture in the ECB and national central banks in Europe, such a research culture is now starting to be built up in the SSM. It is important to note that there was an active participation of senior management and board members of the SSM so clearly the programme also reflected SSM priorities in the area of bank supervision and financial stability.
I will not be able to do justice to all the excellent papers that were presented, so here a quick rundown of some that caught my attention.
Several papers have gauged the impact of the extraordinary macroprudential measure of asking banks to refrain from paying dividends during the pandemic. One further contribution is by Ernest Dautovic and co-authors. Using data on planned but non-distributed dividends (thus exploiting cross-bank variation) and credit registry data they can disentangle loan demand and supply effects by focusing on firms borrowing from several banks. Their result suggests that the dividend restrictions helped support financially constrained firms, especially small and mid-sized enterprises and firms operating inCovid-19 vulnerable sectors. At the same time and reassuringly, there seems no evidence of a significant increase in lending to riskier borrowers and zombie firms.
Cyberattacks have emerged as a major new source of vulnerability for banks and other financial institutions. Antonis Kotidis and Stacey Schref="javascript:void(0)"t analyse a major multiday cyberattack that disrupted the operations of a major third-party technology service provider (TSP) in the US, on which some banks relied for core banking services, including payment services. When the TSP took its systems offline, this disrupted users’ ability to send payments (the first-round effect), which in turn disrupted payments received by non-users of the TSP, leaving them with fewer reserves available for sending their own payments. The drop in non-users’ reserves was sufficiently material for them to seek other sources of funds (the second-round effect). In addition, non-users sent payments after normal business hours to avoid sending materially fewer payments themselves, which could have disrupted yet other non-users’ ability to send payments (the third-round effect). So, certainly some domino and spillover effects. However, the authors also document that the negative effects were mitigated through actions under business continuation plans by the TSP, banks and the Federal Reserve (including switching to manual ways of sending payments, prioritizing larger payments, and extending business hours of the Fedwire system). The authors point to three important policy lessons: First, business continuity planning matters; second, liquidity buffers matter; third, support by the central bank matters.
In a theory paper, Gyöngyi Lóránth and co-authors model supervisory interventions in cross-border banks under different institutional architectures where a bank may provide voluntary support to an impaired subsidiary in a different country using resources from a healthy subsidiary. With supervisory authority on the national level, there is the risk of ring-fencing, thus authorities restricting the parent bank from supporting an impaired subsidiary in another country. This risk increases the more correlated the returns of subsidiary and parent bank are as national authorities will be worried about the costs for the national deposit insurer. Such ringfencing would be eliminated under supranational supervision (i.e., SSM). However, there are also incentive effects, with weaker cross-border banks possibly taking more risks (or exerting less effort) under supranational rather than national supervision. An important contribution to the debate on cross-border supervisory cooperation (and directly related to my own research with Wolf Wagner).
Following the Global Financial Crisis, there was pressure to move from backward-looking to forward-looking provisions to make them less cyclical (‘provisioning too little, too late’). Expected Credit Loss (ECL) approaches such as the International Financial Reporting Standard 9 (IFRS 9) were introduced (although partly suspended in March 2020 given the high uncertainty). IFRS 9 requires provisions to be based on estimated future credit losses, expected to be varied over time as credit risk evolves and usually obtained from dedicated provisioning models operated by banks themselves. Using loan-level data from the ECB’s credit registry, Anacredit, Markus Behn and co-authors gauge how the implementation of IFRS 9 has affected euro area banks’ provisioning behaviour. They find that, overall, provisioning is generally higher under IFRS 9, but the bulk of provisioning is still done at time of default. They also find evidence that IFRS 9 has increased variation in provisioning practices across banks, with banks with higher capital headroom more likely to provision to the same borrower than banks with less capital head room. Thus, accounting discretion and capital management motives seem to affect not only the overall level of provisioning, but also the distribution of provisions across a borrower’s banks.
Finally, Barry Eichengreen and Orkun Saka have a fascinating paper (that I will discuss myself later this week in a conference in Tilburg) on how cultural stereotypes influence cross-border banks’ investment decisions in sovereign bonds. They use hand collected bi-annual data on banks’ investments in European sovereign debt and show that when residents of the country or countries where a bank operates have a high level of trust in residents of another country, the bank is more likely to hold claims on that other country. Specifically, they create bank-specific measure of trust in a specific country, by calculating a weighted average of bilateral trust between two countries, where weights are the share of host-country branches in the network of the bank. They show that this bank-level measure of trust predicts banks’ entry/exit decisions vis-a-vis sovereign debt of a country and that the effect is less strong for more diversified banks, while – not surprising – it is stronger for countries that have gone through a sovereign debt crisis.
More on EU-UK financial sector cooperation
As discussed earlier, my co-author Christy Petit and I recently wrote and published a study on financial sector trends in post-Brexit UK and future EU-UK regulatory cooperation. We presented the study this week in the Committee on Economic and Monetary Affairs of the European Parliament as well as at a dinner organized by the Association of German Banks and the Representation of the German state of Hesse to the EU. Summarising an 80-page report in 15 minutes is always difficult, with the additional challenge that between publication and presentation, the agreement on the Windsor Framework did not only ease the tension over the Northern Ireland protocol but also unlocked several other options for EU-UK cooperation that had been on hold. While the most prominent (in the news) is the negotiation about UK participation in Horizon, in the financial sector cooperation it would be the signing of a Memorandum of Understanding and the establishment of a Regulatory Forum to discuss issues of common interest, as laid out in a declaration attached to the Trade and Cooperation Agreement from 2020.
Will such an MoU and Regulatory Forum be a major change in financial sector cooperation between the EU and UK? I would strongly disagree with such a hope and promise. There is a reason why the financial sector was excluded in the first place from the TCA (any reference to trade in services explicitly exclude the financial sector). Also, the provisions on financial sector cooperation in the recent trade deals signed by the UK with third countries are extremely thin, focusing on regulatory dialogue and non-discriminatory market access.
While allowing entry of foreign financial institutions and market participants into a country’s banking system, countries insist for a reason on national regulatory and supervisory power and are loath to share it. And while it is true that the last decades have seen an increase in global and cross-border cooperation (especially after 2008), the sovereignty principle rules strongly in the financial sector policy framework. There are a few cases where countries formally share regulatory and supervisory power, such as in the case of the banking union in Europe. One important reason for keeping regulation and supervision on the national level, in addition to high economic costs (including for non-stakeholders) of fragility and crisis, is the fiscal responsibility that countries often take on for financial sector losses (as nicely documented in this paper by Luc Laeven and Fabian Valencia).
It is therefore not surprising that the EU is reluctant to move beyond sector-specific equivalence agreements with the UK (or Switzerland, for this matter), currently with the UK in only one area, CCPs. And even here, this equivalence decision is temporary (extended until mid-2025), with a clear political will in the EU to attract more euro clearing away from London into the Single Market and preferably into the euro area. There is a clear stability concern, as laid out in this ESMA report, which reports on different crisis scenarios for the UK CCPs and the limited role and powers that EU regulatory authorities would have in case of their failure and resolution, even though there is failure of these CCPs would have enormous implications for EU financial markets.
In sum, I would not expect any immediate changes in the relationship between regulators on both sides of the English channel or in terms of market access for UK based financial institutions and market players. Supervisory cooperation has been ongoing, independent of the political stand-off. Regulatory dialogue is important, including to avoid dramatic regulatory divergence and planning for worst-case scenarios. Expecting more than that seems unrealistic.
SME financing gaps in Europe
My former EUI colleague Natalie Kessler and I have just published a working paper, written for an EIB evaluation project, documenting SME financing gaps across sectors and countries, using different methodologies, one reliant on firm balance sheets and one on firm-level surveys. The most striking finding for me is the limited correlation that we find between different gauges of financing gap, but then again, maybe not surprising given their very different nature.
First, we use Orbis balance sheet data to compute proxies for how much SMEs in a certain industry/sector typically borrow under ‘ideal’, i.e., friction-free conditions. We assume that the demand is similar across different countries and sectors with financial market frictions as in the benchmark country (where debt/sales is highest), given similar technologies and investment cycles. If actual financing is below the benchmark, i.e., if actual supply is lower than the potential demand (as found in benchmark country), this would suggest a financing gap. The advantage of this first method is that it is observable for a large number of enterprises with financial statements and that is objective as not self-reported by firms. On the downside, it relies on specific benchmarks for a ‘natural’ level of external funding and it does not take into account explicitly demand-side and other firm-specific factors.
The other measure relies on firm-survey data collected via the ECB’s SAFE survey and explores the difference between the self-reported desired and actual bank financing that firms receive. The advantage of this measure is that it takes demand directly into account and allows to isolate demand from supply-side constraints and thus firm-idiosyncratic circumstances. On the downside, it focuses on self-assessed and not bankable demand, is subjective, as based on survey and available for a much smaller sample than the first methodology.
Using data over 2013 to 2020, we show significant variation in financing gaps across countries and sectors. The account-based measures point to Czech Republic, Latvia, Hungary, Sweden, Poland and Bulgaria as the countries where firms have largest financing gaps, while the survey-based measures point to Greece and Slovenia as countries with firms’ largest financing gaps. Variation over time, on the other hand, is not as strong or intuitive. As already mentioned, the account- and survey-based measures are only weakly correlated with each other, reflecting their different nature, and both are only weakly correlated with a survey-based measure of self-reported firm financing constraints.
What can we learn from our analysis? First, there is not ONE correct financing gap measure. Each measure we presented captures a different dimension; the ORBIS measure a technological distance from a given benchmark and the SAFE measure distance from self-reported demand. Second, financing gap is not necessarily the same as financing constraint. Self-reported financing constraints refer to access to and conditionality of funding, while financing gap is purely focused on loan amounts. Third and consequently, properly capturing financing gaps across countries and sectors requires the simultaneous use of different methodologies and metrics.
The demise of Credit Suisse – a case study for the ages
The speed with which Credit Suisse was forced into its shot-gun marriage with UBS over a weekend is certainly an incredibly interesting case study for economists, lawyers and political scientists to study for many years to come.
The first interesting dimension to note is that this was not a resolution or liquidation, but rather a government-supported merger and acquisition. Calling it a market-based solution, however, seems a bit stretched given the heavy involvement of Ministry of Finance, Swiss National Bank and financial regulator Finma.
The second striking dimension is the wipe-out of AT1 bonds, while shareholders retained some value for their shares during the merger. There is a principle of a pecking order, which puts these claimholders ahead of equity, which was overturned with this. On the other hand and as this wipeout was done with Credit Suisse as going rather than gone concerns, the legal rules seems to have been followed.
Why did the Swiss authorities choose this and not another solution? Why not wipe out shareholder claims and create a bridge bank? Why not looking for a new investor? There are many good answers to this (too high a burden on government’s finances; not enough time for such an alternative deal). But there are certainly also political reasons: who are the shareholders and who are the AT1 holders and where are they located? Banking nationalism might have prevented authorities to sell a Swiss institution. And allowing bankruptcy would have been too hurtful for Swiss pride (“ Credit Suisse is a part of Switzerland’s modern national identity story”).
Two additional links that might be of interest:
An interview I did with a Malaysian radio station discussing the recent banking turmoil
A seminar that we are organising tomorrow (31 March) at 2 pm
Are we headed for systemic financial distress?
The failure of several mid-sized US banks over the last few weeks has raised the spectre of a new financial crisis, even though many observers have pointed (correctly, in my view) to critical differences to 2008, including stronger capital and liquidity buffers and better supervisory preparedness. But parallels to previous episodes of monetary tightening are clearly there (including the S&L crisis).
How did we get here? As far as I can see, the problem in the failed banks has arisen from a maturity mis-match than cannot be addressed by the banks in the short-term. Banks heavily exposed to fixed-rate securities on the asset side of their balance sheet (such as government bonds) have incurred losses, due to rising interest rates (and thus lower bond prices). While these losses can be considered book losses as long as the bonds are not being sold and do not have to be marked-to-market, liquidity pressures of these banks led to sales pressures and thus realization of losses. The problem is that informed large depositors and creditors can see these losses and react accordingly by withdrawing their funds even before realization of losses.
Sectoral specialization seems to be one driving force behind the failure of these banks at this specific point in time. Banks typically do not fund start-ups, especially those reliant on intangible assets, such as tech firms. That seems to be at the core of the reliance of many West Coast tech start-ups on specific lenders and their rush (or run) to withdraw funds when SVB got into trouble. Exacerbating is the fact that the crypto and fintech sector has come under pressure as well. When SVB in turn had to sell government bonds for liquidity purposes it incurred losses mentioned above, thus leading ultimately to solvency pressure and the intervention by the FDIC.
Ultimately, the US authorities decided to make all depositors whole (I am reluctant to call this a bail-out, to make the clear difference to a case where all debtholders, including non-deposit creditors or even shareholders are made whole), using the systemic risk exception. According to the FDIC, the gap will not be filled with taxpayer resources, but with future additional levies on the whole banking industry. It is important to note that this is an approach that can work in idiosyncratic bank failures but not systemic banking crises. One wonders whether it is purely stability concerns or also political reasons and lobbying pressure of a well-connected tech sector that led to this blanket insurance.
Ultimately, this bank failure shows the three externalities of bank failure: the fridge problem (milk outside the fridge going bad), as borrowers of the tech sector lose access not only to their deposits but also external funding, which cannot easily be replaced; the hostage problem, as depositors run and put further pressure not only on the bank in question but similarly positioned banks; and the domino problem, as problems spread out through the banking sector, as seen in rapidly dropping bank share prices, in this context mostly through informational contagion.
The reaction by US authorities also shows that ex-ante commitment (e.g., with respect to limits for deposit insurance) and ex-post policy implementation show the usual gap. US authorities have invoked a systemic risk exception for making all depositors whole, including uninsured deposits. One could argue that this is constructive ambiguity, with the objective of fostering market discipline. One wonders whether such constructive ambiguity really works and if ex-ante insuring all deposits (at least the ones in transaction accounts) would be more honest. An alternative would be private insurance offered to large depositors – but not a realistic business proposal as long as there is a chance of the FDIC stepping in with blanket insurance. I am not sure of the answer to this challenge but this this is a valid question to be discussed.
The current turmoil also raises additional challenges for central banks as they try to tighten monetary policy to stave off inflation and the risk of financial dominance: similarly as the Bank of England in September who had to pause its quantitative tightening programme. Similarly, the Federal Reserve’s new lending facility for banks against securities at face value goes against the idea of monetary tightening.
So far, there seems to be political consensus on the crisis management approach in Washington DC. I would not be surprised, however, if soon the bailout of primarily California-based banks will be used by Republicans (I can see the theme already: Florida and Texas taxpayers/bankers bailing out liberal/woke banks and tech firms on the West Coast). After I wrote this sentence, I found this article in the Washington Post; voila!