Sectoral bank specialisation – new measures, new results
Olivier De Jonghe, Klaas Mulier and I just finished a new version of our sectoral specialization paper and also just published a Vox column on it.
Although the importance of sectoral concentration for bank performance and stability has been discussed by economists and regulators alike, there is little empirical evidence, mostly due to lack of data. Olivier, Klaas and I take a new and broader approach to measuring sectoral specialization: a factor-based model, where we gauge whether banks’ stock returns react to sectoral stock indices after controlling for global and domestic stock indices, a financial sector index and the Fama-French factors. Using a return-based approach allows us to take into account that banks are over (or under) exposed to specific economic sectors not only through lending, but also through derivative positions, taken to hedge lending positions or create sectoral exposures without lending.
Our results for over 1,500 banks across 24 countries show that: (i) more sectorally specialized banks experience lower volatility and lower exposure to systemic banking distress and (ii) banks that have more similar sectoral exposures to their peers in the same country and year also experience lower volatility and lower exposure to systemic banking distress, though the last results is driven by the 2008/9 crisis years. These findings are not consistent with the traditional portfolio theory that focuses on diversification benefits, but they are consistent with theories focusing on information asymmetries between lenders and borrowers that can be reduced if lenders specialize. On the first look these findings are not consistent with theories focusing on similarity of banks resulting in higher banking distress; however, we argue that the discount for being different from your peers might stem from information problems in the case of systemic banking distress and from the too-many-to-fail bailout bonus.
9. May 2017
Interesting papers I have been reading
Some interesting papers from recent conferences.
There is no such thing as finance without politics! In Politicizing Consumer Credit, Pat Akey and co-authors show how exogenous “promotions” of senators to committee chairman in the U.S. Senate result in more regulatory leniency in the senators’ home states vis-à-vis consumer lending by banks. Specifically, lending to disadvantaged groups (supposedly protected by the Community Reinvestment and Equal Credit Opportunity Acts) decreases significantly, an effect independent of the senator being Republican or Democrat. One wonders though whether this only benefitted the banks in questions or also had a dampening effect on the overindebtedness of risky borrowers.
Everyone talks about the geographically concentrated effect of Chinese imports into the U.S. on manufacturing employment. Import Competition and Household Debt shows that areas that were more hit by Chinese imports and thus job losses in manufacturing saw a more rapid increase in household debt. Is this consumption smoothing or too slow adjustments to permanent income shocks? Does consumer credit serve as opium of the 21st century? It certainly shows the powerful role of consumer credit and household debt in the socio-economic development of the US over the past two decades.
Ugo Panizza and co-author document in a recent paper that the post-2008 expansion in city-level government debt across China has not only led to fragility concerns (see this recent report) but has also crowded out lending by banks to private sector firms. Interestingly, state-owned and foreign-owned companies have not been significantly affected. So, short-term crisis stimulus results in long-term lower growth perspectives!
And to prove that I do (sometimes!) look beyond finance, here is an interesting paper by Alex Trew and co-authors (“East Side Story: Historical Pollution and Persistent Neighborhood Sorting”) who gauge why the East sides of former industrial cities like London or New York are poorer and more deprived? It seems to be pollution going back to the Industrial revolution that made richer people settle on the side of industrial chimneys where they were less exposed to the pollution. And as so often in history, these neighborhood differences are persistent, as these patterns continue to hold today!
7. May 2017
Macron gagne! Not a triumph, but a wake-up call
At the end the results were clearer than predicted and feared. 65% for the candidate of the liberal and democratic centre. As much as this looks like a win, there was not really a democratic choice, as the main opposition party is a nationalistic, backward-looking, anti-European movement. If there is no choice between two democratic opponents, we cannot call it a democratic choice!
So, as much as we are supposed to celebrate Macron’s win tonight, this is the clearest warning signal yet that we cannot take the progress Europe has made over the past seven decades for granted. A wake-up call to make the gains from globalization and European integration accessible to all. A wake-up call to more fairly distribute the benefits and losses from globalization and technological change. Certainly, a wake-up call for France whose socio-economic model has been broken for a long time. But also a wake-up call for Europe, for a more inclusive Europe, a more solidary Europe, a Europe not beholden by the legacy of past crises but future opportunities.
7. May 2017
Resolution frameworks matter even if they permit bail-outs
There are many parts of the U.S. regulatory framework under attack (or: under review, in the more bureaucratic language), even though there is no evidence that the slow-down of entrepreneurship in the U.S. is related to federal regulation. One of the many aspects of the regulatory framework is the resolution framework for large systemically financial institutions in the Dodd-Frank Act.
The suggestion to throw out the resolution mechanism, which allows the use of taxpayer money, to thus minimize moral hazard risk and foster market discipline sounds intellectually honest and logical. After all, if there is a chance to be bailed out if things go wrong, this provides incentives for aggressive risk-taking, an effect that is stronger the larger the bank – commonly known as too-big-to-fail effect - and the lower the capital buffer of the bank – known as betting the bank effect. So, increasing capital buffers further and getting rid of potential bail-outs should firmly consolidate market discipline.
However, that is where economic theory meets economic reality and political economy. In 2008, none of the European countries had a proper bank resolution framework. The U.S. had such a regime (successfully used by the FDIC) for commercial banks, but not for investment banks and bank holding companies. As U.S. and European supervisors and governments looked into the abyss of not only a systemic banking crisis but a complete melt-down of the financial system, they found themselves empty-handed when considering how to resolve the failing banks. Using the regular corporate insolvency framework was not an option, as the Lehman Brothers bankruptcy had just shown. So, the only option was a tax-payer funded bail-out of these banks. Over the past nine years, governments have reacted, introducing bank resolution regimes that combine bail-in rules (i.e., making sure that shareholders and junior bond holders lose their shirts) with ensuring that the financial system and thus ultimately, the real economy, does not offer. To ensure the latter, options for government support have to exist, though as last resort, not as first resort, as in 2008. Not having such a clause would make it non-credible and result in creditor run and contagion effects at the slightest sign of trouble.
But wouldn’t scrapping any possibility for government support strengthen market discipline? Only if it were credible, i.e., nothing short of a constitutional restriction would do, given a history of government responses to previous crises. And it would certainly reduce the flexibility of policy makers in the eye of a crisis. Ultimately, effective bank resolution is about a trade-off between enforcing market discipline on stakeholders in failing banks and protecting the rest of the financial system and the real economy. While tying your hands might reduce the number of bank failures by strengthening market discipline, it will not eliminate them and will make their negative effects for the real economy even worse.
But wouldn’t very high capital buffers reduce the need for a resolution regime? While capital requirements under Basel III might still not be at the level where they should be, increasing capital buffers to a level where bank failure is all but esxcluded would ultimately drive banks towards narrow banking, with the consequence that risk taking would move away from the regulated into currently less or even non-regulated segments of the financial system. As more and more households are excluded from fixed-return passive long-term investment strategies, such as relying on a defined-benefit pension, active management of their investment portfolio, which includes maximizing a risk-adjusted return, would ultimately increase pressure on regulators to extend the financial safety net beyond narrow banking if households are pushed away by minimal interest rates in a narrow banking system.
In summary, governments have a comparative advantage in providing certainty and they are most asked to do so during systemic banking crises. Tying their hands by pretending there will never be a bail-out will leave governments with the choice between a melt-down of the financial system with terrible repercussions for the real economy or violating the no-bail-out rules, no matter how binding they were meant to be. It is clear what a democratically elected government will do!
So beware of easy solutions, as economic reality does not always comply with good intentions!
29. April 2017
A signal of hope from France?
The French voter has spoken and the choice for the second round is clear – the candidate of an open, tolerant and liberal society vs. the candidate of a closed, fearful and illiberal system. This is a critical choice, not just for France but for Europe. Brexit might have been an accident, a Le Pen presidency would be a heads-on collision, the start of a very slippery road away from European integration and ultimately peace.
There are those who favour giving the populists the chance to prove how disastrous their policies are. History should warn us: in 1933, German conservative politicians thought they could contain Adolf Hitler by allowing him to become chancellor and yielding two more ministerial positions to his party; the rest of the cabinet was filled with technocrats and conservative politicians. We all know how this ended! No inch can be yielded to fascists, no matter how nicely they dress and how nicely they might talk!
But there is more than just fear in the second round! There is the hope that a new French administration will use the chance to rejuvenate social and economic policies, will overcome its bias in favour of the haves and include the have-nots, be they unemployed youth or entrepreneurs, low-skilled high-school drop-outs or high-skilled university graduates without job perspective. This can also finally give impetus for the reforms that the Eurozone needs to avoid a second lost decade. I discuss one of the necessary solutions here and in a few weeks, there will be another Vox eBook on solutions for the Eurozone. However, there is the broader issue of the identity crisis of Europe and what solutions (economically, institutionally and politically) are needed to rejuvenate Europe, as discussed in this eBook by economists and political scientists.
There is still hope in Europe! Let’s hope this chance will not be squandered!
24. May 2017
AMC for the Eurozone – reviving a good idea
Academics have been calling for it for some time now, but it is finally being picked up by policy makers. The latest Financial Stability Review by the ECB has a long appendix (special feature B) discussing Asset Management Companies (AMC) and their potential use in the Eurozone and the European Banking Authority has openly called for the establishment of one. In this , I discuss the benefits of such centralized solutions to banking crises and their challenges and argue for an ambitious version of an AMC for the Eurozone. Time to address the legacy problems of the Eurozone – after one lost decade, it is time to avoid a second one.
24. April 2017
Economic Policy Panel in Malta
I am off to the 65th Economic Policy Panel in Valletta, Malta. Again, lots of interesting papers, among others, on the Brexit vote, on the trade implications of different Brexit options, on evaluating market consolidation in mobile telephony and whether federal regulation is to blame for the decline in US entrepreneurship (answer: NO). More here: http://www.economic-policy.org/
20. April 2017
Another election – another Brexit debate?
Theresa May just called snap general elections for 8 June. The optimist in me thinks that the upcoming election campaign will finally allow the country to have a real debate on Brexit. While voters had only a yes/no choice last June on UK’s EU membership, there was no choice and no debate on what the future relationship of the UK with Europe should look like after Brexit. So, now might be a good moment to move beyond fake facts (remember 350m for Brussels every week, to be rededicated to the NHS?) and fake arguments (millions of Syrian refugees about to cross the channel) and empty though powerful slogans (take back control) to a real debate on the benefits and costs of different cooperation forms between the UK and the EU post-2019.
The pessimist in me thinks that the election will be all about personalities. Two female party leaders, widely popular in their respective countries, England/Wales and Scotland, and two male party leaders, one that most voters do not know and one that most voter rather not know. As it stands right now, this will be a confidence vote on Theresa May and on a full and unconditional mandate for her to negotiate whatever she thinks to be best for the UK.
18. April 2017
Quo vadis Europe? In London, Frankfurt, Brussels and Paris
Together with Geoffrey Underhill (political scientist from the University of Amsterdam) and Dennis Novy (economists from Warwick University) I have been presenting the Quo vadis book (that Geoffrey and I jointly edited) across Europe over the past couple of weeks. While our presentations were similar across the four cities, the focus of the discussions with the audience was quite different, which is interesting in itself.
In London, there were – not surprisingly – lots of questions on the factors explaining the Brexit vote. Dennis Novy, co-author of a recent paper on the factors explaining variation in the referendum outcome across the UK, pointed to socio-demographic (age and education – or the lack thereof) as well as domestic economic (policy) factors driving the vote, including the recent cutbacks in welfare and NHS and the long-term decline in manufacturing, with immigration playing only a secondary role and here only immigration from Central and Eastern Europe. Or as Diane Coyle and Rob Ford argue in their chapter, the Brexit vote was a vote against Westminster not vote against Brussels. This obviously raises the question on future policy making in the UK, currently heavily London-centered and the appropriateness of a political system where a party with over 10 percent of votes has no representation in the House of Commons.
In Frankfurt, there was a lot of discussion on rules and how to make sure they are being followed, with a clear undertone that Germans (and other creditor countries) are being taken for a ride by debtor countries. While on the one hand, there is a time consistency problem if rules cannot be fixed, I argued that senseless rules (such as the original Maastricht criteria) and changing circumstances (such as a once-in-three-generations economic and financial crisis) very much call for adjustments. Ultimately, we need the right mix of rules and flexibility, together with transparency and accountability. Are we at the right equilibrium yet? I very much doubt.
In Brussels, there were lots of questions on European identity and how to make Europeans fall again in love with the European dream and on the future of EU policy making after Brexit. On the first question, many contributors of our eBook would argue that the impetus has to start from the member states rather than from Brussels. At the same time, better enabling non-university graduates to live the dream of European mobility is a critical dimension to strengthen the European identity. On the future of EU policy making after Brexit, I very much doubt that anything will become easier on the really tricky questions, especially within the Eurozone. As long as Eurozone governments do not recognize and allocate the legacy losses of the Eurozone crisis, progress will be hampered.
In Paris, finally, there were again many questions concerning Brexit and populism, maybe not surprising given the upcoming French elections. However, there were also intensive discussions on how to revive the European project and make the Eurozone a sustainable currency union. The view of most of the contributors to the book is that the European project has to be revived bottom-up, i.e., the initiative has to come from national governments rather than from the European Commission. While it seems unrealistic to consider a new Treaty at this stage, strong political leadership is called for. And such leadership is also called for in turning the Eurozone into a long-term sustainable currency union. There are many policy ideas in this area, from completing the banking union over creating a common budget for the Eurozone for stabilization purposes to reforming the fiscal policy regime to balance national sovereignty with the need for fiscal sustainability. There is certainly no silver bullet, but there are lots of policy options.
14. April 2017
Gibraltar and Brexit
When I spent my first summers in the UK as high school student in the early 1980s, two things struck me – the discipline with which British people queued at bus stops and the war movies that were shown every day at prime time in at least one of the four TV channels available back then. Both seemed to have gone when I moved to the UK some three years ago, at least in London. Listening to Michael Howard over the weekend implicitly threatening Spain with war over the Gibraltar dispute, I feel transported back into the 1980s, though not necessarily in a good sense. Threatening another European country with a democratically elected government with war at the beginning of what promise to be very difficult two-year Brexit negotiations seems like getting off on the wrong foot – or shall I say: on the wrong boot? But it also helps remind us what the EU has accomplished over the past 60 years – peace and a forum to settle conflicts like these one in a peaceful manner, a situation we take too easily as granted!
And just to make sure we all understand the difference between the Falklands war that Michael Howard referred to and the current stand-off. In 1982, the military dictatorship in Buenos Aires, with their back to the wall did what many regimes do in these circumstances do – try to get an easy win in “foreign policy” by invading the Falklands. The UK reacted swiftly and forcefully – and correctly in my opinion though I found myself in a minority in my high school class surrounded by peace loving fellow students who defended Argentina’s right to an island, 500 kilometers away from the continent, which had never really been party of Argentina in the first place. The current stand-off is based on a sentence in the draft of the EU’s negotiation guidelines that states the obvious – Spain (like 26 other EU countries) has a veto right over any post-Brexit deal between the UK and the EU. And while it can be interpreted as an early diplomatic snub to the UK, it will not be the last one – as everyone predicted, the negotiating powers have shifted from London to Brussels and 27 EU capitals after 29 March. Threatening to send in the troops won’t change that!
The Brexiters claiming that the future after Brexit will be nothing but bright with great free trade agreements, full sovereignty and amazing freedom have very much resembled young children whistling in the dark forest to overcome their fears. Turning up the volume to sabre-rattling does not make the situation any easier. Or is someone looking for easy gains in “foreign policy” to make up for weaknesses at home?
3. April 2017
Brexit Trigger – How much cake is left?
With the triggering of Article 50, the easy part is ending and the hard part is starting – after the Theresa May’s cabinet realised that after all you cannot have your cake and eat it as promised by Boiris during the Brexit campaign, the fight is on over what little cake is left for the UK.
What does this imply for banking and finance? There are two major trends – one is for financial institutions finding a home for the EU operations with different financial centres competing with each other and new champions crowned every month – yesterday it was Dublin, today it is Frankfurt, tomorrow maybe Amsterdam. Most analysts agree that there will not be one financial centre replacing London in the short- to medium-term and London will continue to function as global financial centre, though most likely on a smaller scale. The second trend is a race against the time for the UK government in defining the status of London with respect to EU regulation and access. The longer the uncertainty, the stronger the exodus. The levers in this negotiations are more on the European and the British side, as are the incentives to delay this process as long as possible.
Will the UK regain its sovereignty? It seems naive to think that any country (maybe bar US and China) can extract itself completely from the jurisdiction of international agencies and courts and it seems that the British government is slowly realizing that. And it seems that certain part of the UK are happier being subject to Brussels jurisdictions than Westminster jurisdiction.
What does the Article 50 trigger imply for the EU? It is another milestone in the long-running European crisis and another wake-up call for the renewal of the European Union, as discussed in this eBook, with contributions from both political scientists and economists: New eBook: Quo vadis? Identity, Policy and Future of the European Union. On an upside, EU member governments seem to have realized the need for renewal; it is critical that this renewal comes from the nation states and is not another Brussels project.
Will 29 March 2017 be a day for the history books? I very much doubt - there have been and will be more important dates - 23 June 2016 and the actual Brexit date. But it reminds everyone what is at stake for the (still) United Kingdom and the European Union and hopefully helps focus minds.
29. March 2017
Quo vadis European Union?
This just out – a new eBook from Vox, co-edited by political scientist Geoffrey Underhill and me on the future direction of the EU, with 18 columns from economists and political scientists. The motivation is clear: the EU project is in a big crisis, with the Brexit vote being only one of many disruptors. There rather seems a deeper identity crisis, The institutions and even the very idea of the EU are under fire, with feelings of disenfranchisement among large parts of the population driving support for populist movements across the continent. At the same time, the EU faces external threats from the East (Putin) and the West (Trump), both eager to weaken, if not destroy, European unity, including the EU. It is no exaggeration to say that Europe, as a political entity, is facing its greatest existential challenge of the past 70 years.
Some key findings:
There are several events coming up; the first on 20 March at Cass.
1. March 2017
Is there a natural resource curse in finance?
The natural resource curse has many different aspects to it but in general it refers to a crowding out mechanism where natural resource abundance in a country results in less competitiveness of the non-resource sectors, lower investment in human capital and contractual institutions. Given the dependence of the financial sector on contractual institutions and property right protection, more generally, it is not surprising that resource-abundant countries have less developed financial systems, as I have documented in earlier work. But it is not clear that correlation implies causality; there could be demand-side factors (resource-abundant countries demanding fewer financial services) or third factors driving both.
In a just released working paper with Steven Poelhekke we address the identification challenge by looking at the effect of exogenous windfall gains in natural resource rents, as measured by price shocks (which can be assumed to the exogenous for individual countries), on financial intermediation. We find a relative decline in the volume of financial sector deposits in countries that experience an unexpected natural resource windfall. Moreover, we find a similar relative decline in lending, which is mostly due to the decrease in deposits. The smaller role for the financial sector in intermediating resource booms is accompanied by a stronger role of governments in channeling resources into the economy, mostly through higher government consumption. Overall, this is consistent with the idea that natural resource windfalls are not being intermediated through the financial system, at the expense of long-term economic development of these countries.
A non-technical summary in the form of a Vox column here
26. February 2017
Rethinking the effects of deindustrialisation
There has been lots of discussion recently on the value of having a large manufacturing industry. High (productivity) growth and export strength of Germany is often associated with its large manufacturing sector, which has shrunk much less over the past decades than in other advanced countries. In the UK there is a lot of angst on the loss of manufacturing jobs in the wake of Brexit. On the other side of the Atlantic, the new U.S. administration wants to regain manufacturing jobs with protectionism and presidential tweets. Beyond politics, there is also an economic argument in that only manufacturing can provide for the necessary productivity gains that fuel economic growth. Martin Sandbu has recently taken on some of these arguments in the FT Free Lunch.
But maybe we should stop staring at the forest and focus on the trees!
A just published paper in Economic Policy (for which I was the responsible editor) sheds some new light on this. Andrew B. Bernard, Valerie Smeets and Frederic Warzynski use Danish micro-data to take an in-depth look into the de-industrialization process that has also taken place in Denmark. The authors show that a non-negligible portion of the deindustrialization is due to firms switching industries, from manufacturing to services. These firms are small, highly productive, import-intensive firms and grow rapidly in terms of value-added and sales after they switch. By 2007, employment at these former manufacturers equaled 8.7 percent of manufacturing employment, accounting for half the decline in manufacturing employment.
There are mainly two types of former manufacturing firms that are relabelled as service firms: firms conducting the traditional activities of wholesalers and firms mostly focused on the design and distribution, but not involved in production. These firms have also upgraded their workforce and employ a larger proportion of high tech workers. They are generally more productive than firms staying in manufacturing, thus also alleviating concerns that deindustrialization is behind the slow-down in productivity.
There is also good news on the labor market front: employees losing their jobs at the switching companies are not worse off than employees at firms in comparable manufacturing companies in the medium- to long-term, five years after losing their jobs their labour market status is actually better than workers at ex-ante comparable firms that remain in manufacturing. In summary, deindustrialization is not a story of disappearing industries or failing firms, but rather of the changing nature of firms, transitioning from focus on production towards services. These findings also suggest that attempts to revive manufacturing might be mis-targeted and might ultimately undermine the global supply chain and innovation in these countries.
Now, one might argue that Denmark is a special case, because of its geographic and socio-demographic structure. At a minimum, however, these findings should prompt economists and policy analyst to take a closer look at the deindustrialization process. And maybe they should also incentivize policy makers to think more about how to make deindustrialization a success story rather than trying to gain votes with nostalgia.
20. February 2017
Another Groundhog Day in Greece
Groundhog Day is late this year in Greece, but Groundhog Day it is. Some two years ago, I wrote a Vox column on the situation in Greece, titled Groundhog Day in Greece. Reading it again, not much seems to have changed. As the can is being kicked down the road, the Greek economy and society are not given a chance to exit the permanent crisis. And as it looks like, there is little that anything will change for the better in the near future.
The situation in February 2017 feels indeed like Groundhog Day. The same old discussion on debt sustainability (or the lack thereof as the IMF has pointed out correctly). And increasing conflict between the creditors on whether and how much debt relief to grant Greece and at what point. The positions of IMF, on the one side, and the Eurozone countries, on the other hand, are not surprising. IMF staff takes a purely technocratic view assessing the debt repayment capacity of the Greek government, but also taking into account political economy constraints, such of extremely low probability that a democratically elected government will be able to maintain a primary surplus of 3.5% over longer time periods. The latter has been clearly shown by Barry Eichengreen and Ugo Panizza in this Economic Policy paper. And even if there might not be an immediate cash flow problem as often pointed out by Eurozone officials, simply delaying debt repayments amounts to kicking the can down the road, but not to solving any debt overhang. At the same time, the certainty of further stand-offs between Greece and its creditors down the road undermines economic recovery (which is ultimately needed for debt repayment). A vicious cycle, indeed! The European creditors’ view are backed by one economic and one (more important) political argument. The economic argument is that of necessary reforms in Greece only being implemented if there is continuous pressure on the Greek government, pressure that would go away in the case of a big debt relief at this stage. However, the evidence over the past seven years should have clearly shown that reforms imposed from the outside simply do not work, no matter what the color of the Greek government and how long the list of reforms included in the Troika programs. The political argument is that of the upcoming elections in the Netherlands, France and Germany – governments simply do not want to recognize the losses they have already incurred.
The Greek crisis of the past seven years has been primarily and predominantly a political crisis where in the absence of an early debt restructuring and with banks having enough time to offload their Greek government debt to official creditors an initial fiscal crisis has turned into a stand-off between Greece and the rest of the Eurozone. The political character of the crisis also suggests that it will not be the IMF that will carry the day with its analysis but the Eurozone creditors with their Groundhog Day approach and an early Monday morning solution, waking up the citizens of the Eurozone with the sound of a huge can being kicked down the road.
Solutions bridging these two approaches are available. One would be to move away from a program approach with loans-for-austerity/reform approach to imposing a hard budget constraint on Athens, i.e., no fresh loans, while at the same time delaying any repayment for at least five years. At the same time, one can envision a reduction in the Greek debt level over time linked to broad performance indicators reflecting institutional quality, macroeconomic management and openness of markets. Rather than focusing on individual laws and regulations, regarded as political interference and micro-management in Greece, broader performance indicators should be reviewed every few years and thus linked to further debt relief. At the same time, it is critical that the link between Greek government and Greek banks is cut permanently, to thus reduce the risk that Greek depositors and banks are held hostage as they did in summer 2015. I have made such a proposal here and Willem Buiter has made a similar proposal. This might finally turn the political back into a fiscal crisis. Given the current circumstances, this might already be progress.
15. February 2017
Alternative Fact of the Month
Somewhere in a parallel universe, Queen Elizabeth has used the occasion of her Sapphire jubilee to take back control over North America:
https://www.linkedin.com/pulse/john-cleese-letter-united-states-america-rob-perik
I wonder how many US citizens in this universe wish this to be true
15. February 2017
Competition and Regulation in Financial Markets
I participated in an interesting conference on Competition and Regulation in Financial Markets at the Bank of England (co-organized by CEPR) earlier this week. Competition is with no doubt one of the most important, controversial but also broadest concepts in finance. While we teach our students in Introductory Economics the benefits of competition for efficiency, resource allocation and innovation, there are quite some countervailing effects in finance. Many of these are related to information asymmetries (and thus the necessary incentives to create such information) and the limited liability character. This has resulted in a long-standing paradigm that too much competition is detrimental to stability in banking, as it undermines franchise values and entices banks to take aggressive risks resulting in a higher failure probability. However, there are opposing theories focusing on the effect of lower interest rates in more competitive banking system on reducing agency problems between lenders and borrowers and thus enhancing stability. The empirical evidence has not been clear cut, partly related to differences in the measurement of both competition (market structure measures, behavioural measures or regulatory gauges) and fragility (market- or account-based, idiosyncratic or systemic).
One important dimension is the interaction between regulation and competition. As shown in my 2013 paper with Olivier De Jonghe and Glenn Schepens, the institutional and regulatory framework has important consequences for the degree to which higher competition results in higher or lower stability and the strength of this relationship. One can also see this from the viewpoint of regulatory tools, as shown in a paper by David Martinez Miera and Eva Schliephake, presented at the conference: the optimal level of capital requirements depends on the degree of competition in the banking system and from outside the banking system.
Another question that came up in discussions is that of reducing moral hazard in banking, i.e. the risk that banks or financial market participants in general take aggressive risks, not taking into account the externalities that their possible failure imposes on the rest of the financial system and the real economy. While capital requirements, regulatory restrictions and an effective bank resolution framework have gained quite a lot of attention in the wake of the crisis, other areas such as whistle blower rewards and the effectiveness of fines have received less attention although there seems quite some evidence (according to Giancarlo Spagnolo) that whistle blower rewards can be quite effective. In the context of fines, I am getting more and more convinced that a return to more personal liability for risk decision takers seems the most straightforward and maybe most effective tool (in spite of possible downsides such as reducing the amount of risk taking below its optimum).
As in other areas of the economy, it is important to define the appropriate market to assess competition. This also implies that one has to look beyond banking or maybe even outside the regulatory perimeter. Recent developments have provided ample examples. In the area of payment services, fintech companies have provided innovative solutions to get around excessive foreign exchange charges and more convenient transaction services. Peer-to-peer lending and crowdfunding platforms have stepped in where banks have withdrawn (or never have been) in micro- and small business lending. While these new providers can provide the necessary competition to enhance efficiency and thus improve financial service provision, it is clear that they come with risk (especially when it comes to intermediation and lending) and thus the question of regulatory responses arises. And there is a clear trade-off of not suppressing innovation, while at the same time stepping in in-time to avoid fragility risks building up.
9. February 2017
From Ms. May-be to: yes, we may!
Theresa May has spoken and made a first clear statement about Brexit this week. Looking backward, her reluctance to speak out can be interpreted in a positive way - she might have been testing the waters and gauging the opportunities that the UK government would get in its negotiations with the EU. While EU leaders refused any pre-negotiations, the UK government could gain a clear feeling for the steep hill they were facing in the coming months during the actual negotiations from the pre-negotiation public statements of different government officials and politicians across Europe. It has become clear that Single Market membership cannot be reconciled with migration controls and avoiding oversight by the European Court of Justice. The approach favoured by her (Single Market membership no, but possible Custom Union membership or a similar tailor-made arrangement) thus makes sense from the British view, though it might still be far away from the ultimate outcome. The new approach suggests a slow moving away from the “having the cake and eating it” approach, though she still seems to claim a part of the cake while eating all of it.
Theresa May had to cater in her speech to two different audiences – a domestic one and a foreign one. And she obviously spoke not only as prime minister of a divided country, but as the leader of an equally if not more divided party. The mix of conciliatory tone towards Europe and the strong statements on sovereignty thus made perfect sense. The reactions on both sides of the channels have shown that she has achieved this only partly – great joy on the British side of the channel among Brexiters, less so on the Continental side, though relief that there seems to be finally a plan in place. (On a minor note, As German I am used to British politicians and journalist using WW II against German politicians and football teams even more than 70 years after the end of this war, but against the French president?!?)
However well received Ms. May’s speech was, words come cheap, ultimately it will be all in the actions and the ultimate outcome. Her speech was obviously closely followed across European capitals, easy to do so given the status of English as lingua franca. It seems that the British side, on the other hand, faces a clear shortcoming by not speaking the languages of the other party on the negotiation table, which reduces their capacity to understand the details of European politics and policy making. Simon Kuper had recently a very interesting article in the FT Magazine on this disadvantage for the UK (as for the US) of English being the lingua franca.
One striking statement (and in line with earlier statement by the Chancellor of the Exchequer) was the threat to walk away from Europe and the European socio-economic model if negotiation do not yield what the UK government would consider a good deal. Would that really imply a move towards low-tax, low-regulation, cheap labour economy attracting away investment and jobs from the Continent? The Brexit vote is often seen as a vote against the globalized “neo-liberal” capitalism. The Prime Minister seems to “understand” that, with a focus more on a more inclusive economy, even if at the expense of growth. It seems doubtful a new economic model along the lines described above would match this narrative. Ultimately, the Brexit vote was not a vote in favour of Thatcher 2.0!! So, it seems to be a rather empty threat!
The decision to leave the Single Market obviously leads a lot of companies now to reassess their investment choices. Of particular concern here in London is obviously the financial sector. A very interesting recent paper by Tobias Berg, Anthony Saunders, Larissa Schaefer and Sascha Steffen has assessed first effects of the Brexit vote on syndicated lending. The authors show in very preliminary analysis that issuances in the UK syndicated loan market dropped by 25% after the Brexit referendum relative to a set of comparable syndicated loan markets. Quite a big effect. It remains interesting to see how this develops further in the next two years in the run-up to the actual Brexit (or maybe transition agreement?)
21. January 2017
Economists in crisis
Andy Haldane, the Bank of England's Chief Economist and known for thoughtful and sometimes provocative statements (remember the dog and the frisbee), has again stirred controversy acknowledging that economists have been wrong in their predictions about the immediate economic effect of the Brexit vote last June. Does this imply our profession is in crisis? Here are my two cents:
First, economic forecasting has always been rather inaccurate and - unlike weather forecasts - I am not convinced that it has become better over the past decades - rather given the ever increasing complexity of economies and interdependence across countries, forecasting might have become more difficult. The simple reason: we are dealing with humans whose behaviour and reaction to events is never perfectly predictable. This also explains why recessions and crises are hard if not impossible to predict (especially in terms of their timing).
Second, economists are in much better shape when it comes to explaining economic relationships and predicting longer-term reactions (e.g., increase interest rates and you will see a reaction in both financial and real economy; disrupt trade relationship and societies as a whole will be worse off). Though even here, we often get it wrong and partly for the same reason as above. While we often predict the correct direction of changes in economic aggregates and ratios, we are often off in terms of the magnitude. And where we are even off in terms of the direction of changes, there might be opposing factors whose relative importance we mis-estimate. In addition, to dealing with human behavior, we also face constantly changing environments and limited data.
Where does this leave us? One, be more humble in stating what we know and what we still have to learn and that current knowledge is no guarantee of not having to update this knowledge constantly. Two, constantly questioning conventional wisdoms and pushing forward the knowledge frontier, with new models, data and methods.
Does this imply our profession is in crisis or we are facing a continuous challenge? I'd prefer to think it is the latter rather than the former. But I am glad that people like Andy remind of the challenges!
7. January 2017
When Arm’s Length is Too Far
After a long review process, my paper with Hans Degryse, Ralph De Haas and Neeltje van Horen “When Arm’s Length Is Too Far: Relationship Banking over the Credit Cycle” has been conditionally accepted at the Journal of Financial Economics.
The paper assesses the relative effectiveness of different lending techniques during boom and bust times. Theory suggests that while relationship and transaction-based lenders (where the former rely on soft information and longer-term relationships with their borrowers, while the latter rely more on hard assets and hard information for screening and monitoring) can be substitutes during good times, relationship lenders have an advantage in crisis times given their deeper information on borrowers. We combine a bank-level survey on lending techniques with firm-level survey information financing constraints across 21 Central and Eastern European countries. Matching the geographic coordinates of these banks’ branches and firms’ location, we then test whether firms’ financing constraints vary with the relative geographic proximity of relationship lenders, during good times (2005) and crisis times (2008/9). We find that while relationship lending is not associated with credit constraints during a credit boom, it alleviates such constraints during a downturn. This positive role of relationship lending is stronger for small and opaque firms and in regions with a more severe economic downturn. Moreover, our evidence suggests that relationship lending mitigates the impact of a downturn on firm growth and does not constitute evergreening of loans.
As always, papers change during the review process and we have certainly benefitted a lot from this process. One important improvement (and, in my humble opinion) a contribution in itself was to test the consistency of our bank-level survey data on lending techniques with credit registry data from one specific country. Using credit registry data from Armenia (courtesy Larissa Schӓfer who also has a fascinating paper on relationship vs. transaction based lenders) we find that banks that classify themselves as relationship lenders engage in significantly longer and broader lending relationships, deal with smaller clients, and are less likely to require collateral, and thus consistent with what the previous empirical literature on relationship lending has shown. Another improvement was that we show the robustness of our findings to using firms’ balance sheet data rather than survey data, which reassures us that our findings are not driven by the survey nature of our credit constraint data.
7. January 2017