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!
Greenwashing – a panel discussion
I had the honour of moderating a panel discussion on greenwashing at the CEPS Ideas Lab in Brussels. An important and timely discussion, given also recent legislative developments on the European level. The discussion was under the Chatham House Rule, so I will only summarise the main points.
What is the problem? There is increasing pressure on banks and other financial institutions and market participants to take into account the carbon footprint of their asset holdings. This pressure comes from the general public, investors, activist groups and regulators. As predicted by Goodhart’s Law, once a metric (how green is a bank’s balance sheet) becomes a policy target, it ceases to be a good measure, because it becomes subject to manipulation, such as greenwashing or greenwishing.
And while one might think that transparency and court cases might be sufficient to minimize this risk, the financial sector itself has asked the European Commission to step in with their taxonomy. Given the variation in ESG ratings, an increasing numbers of greenwashing scandals and overall lack of globally agreed standards, maybe not surprising. However, beyond setting rules and defining shades of green, one critical challenge is the lack of data! What financial institutions also need is a change in culture (rather than renaming the CSR the ESG department, ingraining green thinking throughout the institution) and capacity building.
Focusing on the banking sector carries the risk of regulatory arbitrage – there is evidence for this on the cross-border level (here and here). There is also (anecdotal) evidence for this across segments of the financial system - the banks involved in lending to the Dakota Access Pipeline ultimately sold off their exposures to hedge funds that are not subject to the same disclosure standards. A question of regulatory perimeter, as seen in other circumstances.
One important question is whether we are too ambitious in our expectations of the financial sector to transition from supporting brown to supporting more green industries and firms. There is clear evidence that banks might drag their feet given their asset exposure to existing traditional ‘brown’ firms and thus delay the necessary transition. But even ignoring this incentive constraint, one might not be able to expect banks to change their portfolio composition over night; but maybe we have to be overambitious to get at least half-way there.
A final important issue I would like to flag is that the financing of the transition requires looking beyond the banking system. Given the amount of funding needed but also the need to fund new projects and enterprises (not necessarily the forte of the banking system), there is thus a clear link to the capital market union and the strengthening of the non-bank segment of Europe’s financial sector.
In sum, making the financial sector part of the solution for climate change mitigation and transition to net zero implies action by many players: regulators, investors, independent think tanks and advocacy groups. More transparency is needed as basis for more accountability.
Is Brexit Done?
At the end of the movie “The Truman Show” the protagonist takes a bow and exits the stage, putting an end to a 20-year plus reality show. Similarly, observers might be asking themselves: Does the agreement named Windsor Framework mark the end of the Brexit soap opera? Fear not: this is not the end, even though it is a somewhat surprising twist.
As Chris Grey recently pointed out, there is currently a struggle on-going in the Tory party, between those who want to settle into some kind of reasonable relationship between the UK, making the best out of a bad situation, and those that want to continue living their endless Brexit dream.
It is clear that Rishi Sunak belongs to the first group. He seems to have pulled off a trick that his predecessors never managed: striking a deal with the EU without lying about it, without rancour on either side and uniting most of his party. It is clear that he managed to create a new atmosphere of trust between the EU and UK. It is also welcome that Labour is supporting the Prime Minister in his endeavour, which clearly establishes them as the adults in the room. It again shows the importance of interpersonal skills and trust-building in getting to policy successes, confirming what we have seen during the Greek euro-standoff in 2015.
On the EU side, one can argue that concessions in form of a more flexible and risk-based approach show that the EU can be very adaptable and does indeed care about peace in Northern Ireland (more than many in England and Northern Ireland itself). The EU side also sends a strong signal that a rule-based system rules and adherence to it comes with awards!
So, is Brexit done? In spite of this agreement I very much doubt. It is not clear that future governments, especially on the Tory side, will feel bound by this agreement – after all, Boris Johnson never considered him and his government bound by the withdrawal agreement he signed, praised and won an election with. One swallow does not make a summer! There is much more trust-building to be done before we ban the expression Perfidious Albion back into the history books.
There is still the complication that the unionist parties in Northern Ireland might refuse to accept the agreement, raising the political temperature further. Also, there are a lot of possibilities for future clashes in this framework, including the Stormont brake being more of an ornament than an instrument. Part of the problem is inherent to Northern Ireland and is special status, part is the Brextrimist fringe of the Tory party using this special status for their own ideological wet dreams.
Finally, there is the ongoing domestic argument about the revocation of EU law by the end of the year and (related) the ongoing debate on the post-Brexit economic model. And the Brexit culture wars will certainly be revived in due time for the next General Elections.
In sum, I don’t believe the Brexit soap opera is over but the rest of the 2023 season might be a bit more boring than expected – and that is good news.
Ukraine – one year on
A year ago, we woke up to the news that Russia had invaded Ukraine. The initial shock has given way to a new normal – a war in the centre of Europe for the first time since World War II and an aggressive Russia that will not stop at anything. A fragile consensus has emerged on both sides of the North Atlantic that Ukraine has to be supported at any price, as even a limited victory for Russia will only invite more aggression, not only against Ukraine but against other countries.
There are still those that on the left and right extremes of European politics who continue to be clearly outside this consensus, though for different reasons; the left in its naivety, calling for negotiations (what part of Ukraine and its population are they willing to give up to the Russian butchers? What would be an acceptable outcome of such negotiations, I wonder), the right because it is Russophile, prefers cheap energy over freedom and is part of an anti-democratic front, which includes Trump, some of the Brexiters and Hungary’s Orban.
The Great Power hypothesis (as pushed by Mearsheimer) has been completely discredited. As much as I have referred to Russia as aggressor so far, it is not the country Russia that has decided to brutally invade Ukraine, but its autocratic dictator Putin, with support of its elite. This is not a struggle between Great Powers but between democracy and autocracy. Which again means that negotiations and settlements as done in the 19th century between European powers are not an option.
The economic fallout for Western and Central Europe has been less severe than feared. Adjustments in Europe’s energy markets have been quicker than expected. Doomsayers that predicted a collapse of German manufacturing if cut off from Russian energy have been proven wrong. There is thus the tendency to go back to normality (and I am guilty as charged). However, as important as gains on the battlefield in Ukraine are, this struggle against autocracy is a long-run with many enemies within the EU, ranging (as mentioned above), from the current Hungarian government to many populist parties across Europe, mostly (though not exclusively) on the political right.
Development Banks in Time of Great Volatility
The pendulum between markets and governments has gone back and forth over the past decades. When I became a professional eonomist, it was the tail end of the Washington Consensus era, with a focus on market-based solutions and governments focusing on providing the institutional and macroeconomic framework. One controversial part of this Consensus was the role of state-owned banks and, more specifically, development finance institutions (DFI). Often set up with the help of the World Bank in the 1960s and 70s, they developed mostly a rather dismal track record (one of my colleague commented on the 80% plus NPL ratio of one African agricultural DFI rather cynically, “why would they not make the extra effort to get to 100%?"). Political interference was ripe (one African finance minister in the same country commented to me once that the cotton farmers in his district really depended on the agricultural DFI for funding; on the way out a local colleague told that there were no cotton farmers in his district ☹).
But pure reliance on market forces has not really helped address many of the failings we observe in developing countries, partly because there are market failures and the challenge is to develop markets rather than to purely rely on them. This has also opened a new role for DFIs, not so much in retail lending but in second-tier activities – on-lending. Almost 20 years ago, my former World Bank colleagues Augusto de la Torre and Sergio Schmukler framed the concept of the visible hand of the government, with tools that include partial credit guarantees, platforms to match small supplier with financiers and large buyers, and start-up subsidies for new market segments. Public-private partnerships in infrastructure financing has become the state-of-the art approach, even though the devil is in the detail.
DFIs might also have a counter-cyclical role. Bank lending is procyclical and typically retrenches most when you need it most, i.e., during recessions and crises. The obvious trade-off is macroeconomic stabilization through DFI (or more broadly state-owned bank) lending and risk of resource misallocation.
Late last year, we organised an on-line workshop with Oliver Wyman to discuss some of these issues, with representatives from different multinational, regional and national development banks. The event was under Chatham House rule, but here are some highlights: While the economic outlook is somewhat better now in February than back in December, the current macroeconomic environment poses major challenges for SME, while governments have limited fiscal space and monetary tightening will make funding conditions even harder and commercial banks more reluctant to lend. That is where DFIs can come in! However, it is hard to reach out directly to SMEs, and might be better to do so through targeted credit lines through commercial banks (if funding constraints are binding) or credit guarantees (if risk premiums are a binding constraint). Beyond access to funding there is also the challenge of formality in many developing countries. The IDB Lab has deployed a combination of grants and advisory services to support innovative ventures that help address the informal sector, such as digital payment solutions.
Going forward, climate change and transition to net zero will be a challenge, especially for SMEs. This will also be relevant for the focus of DFIs. For example, the Brazilian development bank BNDES is to shift the organization’s focus from purely financial value creation to one of positive socio-environmental impact.
Finally, let me mention that together with some colleagues at the FBF, we are currently working on a project with the IDB advising the new government of Colombia on how to strengthen DFIs in Colombia, drawing on examples of other countries, in the areas of financial inclusion, innovation and sustainable finance. More to come…
Quo vadis financial centre UK post Brexit?
My former EUI colleague Christy Petit and I have written a report for the European Parliament, published last week on recent trends in UK financial sector regulation and implication for financial sector cooperation between EU and UK. A short summary.
Brexit has posed unique challenges for financial sector policymakers in the EU as the most important financial centre in Europe is now outside its regulatory framework. The Trade and Cooperation Agreement agreed in December 2020 between the UK and the EU includes a very thin financial sector chapter, with eight out of 783 articles directly covering this sector. A Memorandum of Understanding to establish EU-UK structured regulatory cooperation on financial services has not been signed and any regulatory cooperation has been paused due to the conflict about the Northern Ireland Protocol, part of the UK Withdrawal Agreement.
Divergence of UK regulation from EU regulation is almost a given outcome following Brexit. The UK’s rationale to actively diverge from the EU pertains to broader political choices and regulatory objectives: flexibility, common law principles-based, competitiveness, growth, and innovation. In addition to such active divergence, there can also be passive divergence, with the UK not keeping up with EU legislative changes or not following new EU regulation in the financial services sector. While there has not been that much divergence yet, one can expect a fair amount over the coming years.
We discuss different scenarios of low, medium and high divergence in the report. Which scenario will materialise is almost impossible to predict, but will to a large extent depend on the resolution of the current stand-off between the EU and the UK over the Northern Ireland Protocol. Before the resolution of this conflict, it is difficult to see any progress happening in terms of regulatory cooperation in the financial sector. A lot will also depend on future governments in the UK and whether they want to bet the economic future of the country on an aggressive strategy to grow the financial sector, including in new segments, such as crypto.
Since 1 January 2021, the UK is a third country and access to the European Single Market can only be given through equivalence decisions by the European Commission, based on the principle of proportionality and a risk-based assessment, but also with some degree of unilateralism and discretion, including political factors. One specific challenge for European authorities is the treatment of CCPs in London. On the one hand, there is the intention to build more clearing capacity within the EU, in particular with the legislative proposals from the European Commission to further develop the EU Capital Markets Union in December 2022. On the other hand, there are financial stability concerns on having a large part of transactions be cleared outside the EU. Supervisory cooperation is therefore critical, but equivalence decisions are not exclusively driven by technical criteria but also by (legal/political) risks stemming from a scenario where such an equivalence would be withdrawn.
Writing this report was not without challenges, the main one being that things change rapidly in London, with new political initiatives popping up frequently, but not always followed through. One can also clearly see a tension between the current government wanting to grow the financial centre UK, similarly as before the Global Financial Crisis, as engine for the overall UK economy, while regulatory and supervisory authorities are much more cautious and more focused on stability. This tension will continue to play out and partly drive the degree of active divergence we will observe between regulation in the UK and the EU.