Looking beyond the borders of the banking union
As I wrote in an earlier post, the establishment of the banking union has had not only implications for the participating countries, but also for other countries in and outside the EU with Eurozone bank presence. Over the past year, I have been participating in a World Bank project analysing the challenges for small host countries in Central, Eastern and South Eastern Europe and the report has now been published.
At the core of the report is the asymmetry between the systemic importance of the subsidiary in the host country and the irrelevance of the host country operation for the overall operation of the parent bank; therefore we refer to these countries as “small host countries”. This exacerbates an asymmetry in rights and powers that can be typically found between home and host supervisors across the globe.
While all of these countries in the region share the characteristics of being host to several Western European banks, they are also quite diverse in terms of their relationships with home country supervisors; specifically, the group includes Eurozone countries, such as Slovenia and the Slovak Republic, non-Euro EU member countries, such as Croatia and non-EU member countries (though some candidate countries) such as Albania or Serbia. This differentiation is quite important as we detail in the report.
In the Eurozone the distinction between home and host supervisors has disappeared for significant institutions, where the SSM and the SRM are the only authority within the Eurozone left – while this implies loss of supervisory independence, small host countries gain through participation in Joint Supervisory Teams and Internal Resolution Teams, as long it is host to a subsidiary or significant branch.
Contrary to Eurozone hosts, other EU Member States retain their full competences as individual or sub-consolidated host supervisors and resolution authorities. However, they are bound by new rules on supervision and resolution on the EU level. They have the right to participate in Supervisory and Resolution Colleges, thus gaining access to critical information on the consolidated level about the subsidiaries in their countries. At the same time, dealing with one supranational authority as home supervisor rather than several national ones can be an advantage.
Non-EU member countries, on the other hand, have few rights vis-à-vis home supervisors within the EU. They can be invited as observers to join supervisory and resolution colleges, but have no right to be invited and their participation is conditional on an equivalence assessment by the EBA and agreement of other college members. Unlike EU members, non-EU hosts do not have access to the EBA mediation process and there is no basis for joint decisions as under BRRD for home and host supervisors in the EU. This reduces the bargaining position of non-EU small hosts rather drastically and results – in our opinion – in an uneven playing field.
What are the conclusions (and policy implications) of our report?
First, non-EU host supervisors, particularly candidate countries, should participate in all relevant EU supervisory and resolution colleges, as well as crisis management groups as observers.
Second, EU authorities should reach out to non-EU small host countries and improve cooperation with them.
Third, Small EU host countries outside the Banking Union should make more use of the EBA mediation service when relevant to ensure their interests are properly protected when it comes to joint decision making in colleges.
Fourth, non-EU host candidate countries should adapt EU regulations to fit their national circumstances rather than adopting them blindly, while non-candidate countries should take an even more flexible approach. An approach very much in line with the one we recommend in the recent Making Basel III Work for EMDEs report.
8. May 2019
Making Basel III work for the emerging world
As I have mentioned in a previous blog entry, I have been co-leading a taskforce on Making Basel III Work for Emerging Markets and Developing Economies (EMDEs). The report was formally launched at a G-24 meeting during the Spring Meetings in Washington DC and is now available, with another blog entry by Liliana and me.
I will not repeat the blog entry or executive summary here, just point to some of the main messages:
Our conceptual framework starts from specific characteristics of EMDEs that, while not universal, have been widely documented: variable access conditions to international capital markets; high macroeconomic and financial volatility; less developed domestic financial markets; limited transparency and data availability; and capacity, institutional, and governance challenges.
These characteristics help explain why the impact of regulatory reforms, such as those under Basel III, is expected to be different in EMDEs than in advanced countries. They also imply the need for a differentiated approach to bank regulation to make Basel III work in these countries and lead us to the following principles underpinning our recommendations:
These principles have guided our analysis and have led us to certain recommendations, of which I will highlight a few:
Minimizing Potential Spillovers on EMDEs: One important area of concern are the significant changes in the volume and composition of cross-border financing to EMDEs since the Global Financial Crisis, including a reduction in cross-border lending from global banks, a heavier reliance by EMDEs on debt issues rather than cross-border lending, and an increasing role of South-South lending. These three developments have important policy implications, but also call for more analysis than before, undertaken by central banks and regulators in advanced countries and EMDEs as well as by international institutions.
One specific area of concern in this context is infrastructure finance. While far from clear that Basel III has been a primary factor behind the relative reduction in private infrastructure finance in EMDEs, an ongoing challenge is that infrastructure is currently not an asset class in itself. If projects can be developed in a more standardized fashion and there is agreement on the different dimensions of risk and how they should be quantified, then it may become easier to issue securities backed by infrastructure projects.
Another area of concern (that pre-dates Basel III) is the potential for spillover effects through the large presence of subsidiaries of global banks in EMDEs. Home supervisors in advanced economies require that regulations, including Basel III, be applied and enforced on a consolidated basis, that is including its foreign affiliates. But this can mean that the same sovereign exposure might get different regulatory treatment by home-country than by host-country supervisors. Currently, for example, in calculating capital requirements, most EMDE authorities assign a risk weight of zero to papers issued by their sovereign and denominated in local currency, whereas global banks largely use their own internal rating models for this purpose. Thus, it is plausible that the same sovereign paper issued by an EMDE government could be treated as a foreign currency-denominated asset, with higher risk weight requirements, if held by a local subsidiary of a global bank. This, in turn, increases the cost to the subsidiary to hold the sovereign paper and might increase the financing costs of EMDE governments. One possible solution would be to agree on threshold values for a set of easily verifiable and widely available macrofinancial indicators (including, but not limited to, international credit ratings). For host countries whose indicators surpass the thresholds, home-country supervisors and global banks would accept, at the consolidated level, the host country’s regulatory treatment of these exposures.
Aiming for Proportionality: As EMDEs proceed to adopt and implement Basel III in their countries, proportionality implies adjusting capital and liquidity requirements to the capacities and needs in EMDEs. Many emerging markets “gold-plate” capital requirements, increasing them beyond international standards to reflect higher risks. It might be better to use a data-driven process to determine the riskiness of assets and thus the necessary capital buffers. Where available, micro-data can be used to calibrate risk weights to the realities and stability needs of emerging markets. When it comes to liquidity requirements, simpler ratios might be called for if the data requirements for the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) are not easily fulfilled. On the other hand, the typical characteristics of EMDEs, as discussed above, might make a centralized, systemic liquidity management tool necessary. Specifically, banks could be mandated to maintain a fraction of the liquid assets required to fulfil Basel III requirements with a centralized custodian such as the central bank.
Minimizing Trade-offs between Financial Stability and Development: While the financial stability goal in Basel III is necessary, the growth benefits from deeper and more efficient financial systems are larger in emerging than in advanced markets. And when banks are – correctly – subject to increasingly tighter regulatory standards, there is a bigger premium on developing non-bank segments of the financial system, such as insurance companies, pension funds, and public capital markets – segments that are still underdeveloped in most developing economies.
As happy as I am to have finalised this report, the launch of the report is not the end of the work! I will be presenting the report at an IMF/BIS conference in May and at a conference of the Community of African Bank Supervisors in June. Stay tuned for a follow-up.
23. April 2019
Brexit – the long view
What a nice quiet week the Easter week was! No action in the House of Commons, only few if any new crazy Brexit proposals. And at least here in London, attention has been drawn to the real future problems of our planet! Just before the Brexit craziness starts again tomorrow and the campaign for the European Parliamentary Elections will turn ugly, a few notes on the longer-term perspectives on Brexit.
First, Northern Ireland: the murder of journalist Lyra McKee has shown yet again the fragility of the peace process in Northern Ireland. While no one would accuse Brexiters of any direct responsibility, the uncertainty on the future of the border in Northern Ireland caused by Brexit plays directly into the hands of extremists! It is sad to see that 21 years after the Good Friday Agreement peace cannot be taken as granted anymore! And it reminds us what damage nationalism can do in Europe!
Second, the future of banking in London. My colleagues Barbara Casu and Angela Gallo found in a recent report that London continues to have competitive advantages as financial centre, even as banks shift some staff and activities to the continent. Different corporate forms are discussed to continue providing financial services into the EU after Brexit, but the bigger picture prediction is certainly that in the near future, London will not lose its status as global financial centre. This is also consistent with recent research by Sascha Steffen and co-authors that the reduction in syndicated lending after Brexit is mostly due to reduced lending to domestic firms and by domestic banks.
This brings me to the broader point of the future economic structure of UK after Brexit. I really enjoyed this insightful piece by Martin Sandbu on Brexit and the Future of UK Capitalism. One of the main messages is that “both in high‐value manufacturing and services, the best performers are successful precisely because their activities pool resources from all of Europe and sell to all of Europe. They are not good British jobs as much as good European jobs located in Britain.” I think this last sentence really drives home the point how the four freedoms hang together and are hard to disentangle even on the economic level. The harder Brexit, the more likely are these jobs to disappear. However, a Brexit from the Single Market will hit manufacturing more than services (which are already oriented more toward non-Europe), so that “a hard Brexit will not only ensure the most loss of growth in aggregate, but stands to exacerbate the polarising characteristics of the UK's existing economic model and harshen the social tensions to which it has given rise.” Scary thoughts!
On a final note, and before we all get drawn back into the daily Brexit chaos, I really enjoyed this film about the Barnier team – it shows a human side to the negotiating team. And without rubbing it too much to the British side, it makes clear that the EU team went about the negotiations in a systematic and rational way.
Now, let me get the popcorn and get ready for tomorrow’s first episode of the new season of Brexit – the soap opera.
22. April 2019
Off to Tallinn
I am escaping the Brexit craziness for a few days. First, for the April version of the Economic Policy Panel in Tallinn. As always, exciting set of papers, including one on the European Deposit Insurance, showing that such a scheme does not necessarily lead to cross-subsidisation as often feared in Germany. We also have a special issue coming on the economics of automation and jobs, with exciting papers, discussing if and under which circumstances labour-saving technology can boost employment; how technology has changed the composition of labour demand toward more skilled, older and male employees; how competition from China pushes investment into automation; and how technology drives the falling labour share of income. We will also have a public session together with the Bank of Estonia on automation, with short presentations and a panel discussion later today. More to come…
3. April 2019
Postcard from Mumbai
I am just coming back from Mumbai from an exciting conference on financial intermediation in emerging markets, jointly organised with Franklin Allen, Manju Puri and Co-Pierre Georg and co-sponsored by the Brevan Howard Centre at Imperial College and CAFRAL at the Reserve Bank of India. This was the third in a series of BRICS conferences, which started with a conference in Rio de Janeiro in 2015, followed by a conference in Cape Town in 2016. We hope for a repeat event in China, Russia or another major emerging market in the next few years.
India is certainly an appropriate place to host such a conference, given the rich and varied history of financial sector policies the country has gone through. As deputy governor N.S. Vishwanathan discussed in his policy keynote, there was an ongoing learning process, which resulted in policy experimentation over the decades and which has also been used as identification strategy by researchers in research papers, such as myself in this paper (currently under revision). And there is now also exciting research work going on in CAFRAL in banking and finance.
Tarun Ramadorai gave a keynote address on household finance in emerging markets and presented fascinating statistics based on detailed household surveys across different emerging markets on households’ balance sheets. The most striking findings were that households hold much more real estate assets (rather than financial assets) in emerging markets than in advanced countries, while at the same time they have less secured (mortgage) debt. Estimates also show that shifting from such a rather inefficient balance sheet to more financialisation could bring quite a boost in income growth. Not surprisingly, Tarun’s finding match with my own work on financial sector structure in develolping countries (limited mortgage loans, focus on short-term lending) and to work showing that more efficient financial markets have an important growth benefit for developing and emerging markets. An interesting challenge that arises out of this work is for researcher to focus more on middle classes (20th to 80th percentiles of income distribution, in statistical terms) and a fuller set of financial services than we often do when focusing on the bottom of the pyramid.
There was an exciting set of papers covering countries as diverse as Bolivia, China, Greece and Rwanda. In the following I will only point to a few that looked especially interesting to me.
Mrinal Mishra and co-authors use the Bolivian credit registry to test the impact of the entry of new arms-length consumer lenders on credit access by costumers of relationship-focused microfinance institutions (MFIs). They find that loans disbursed by new entrants to borrowers who switch from incumbents turn out to be riskier driven primarily by adverse selection. The incumbent MFIs, in turn, react with an “arms race”, offering better loan terms to these customers, ultimately resulting in overindebtedness.
Ioannis Spyridopoulos and co-author identify strategic default by mortgage borrowers in Greece, using the introduction of a foreclosure moratorium and a new personal bankruptcy process in 2010 as identification strategy. Specifically, borrowers that took advantage of the foreclosure moratorium but did not declare personal bankruptcy (which would have implied giving up other assets) are identified as strategic defaulters. Ioannis shows that 28% of all defaulters were strategic, contributing three percentage points to the NPL stock in Greek banks. Strategic defaulters are more likely to be self-employed, to have higher educational levels and to work in finance or law. What these findings show is that loan modification programmes – often an important component of crisis resolution strategies - have to be better targeted.
My former PhD student Andre Silva and co-authors examine the impact of a large-scale microcredit expansion program in Rwanda. Not surprisingly, a higher share of previously unbanked people gain access to credit. The more interesting part is that a large share of first-time borrowers subsequently switch from these microfinance institutions to commercial banks, which cream-skim low-risk borrowers and grant them larger, cheaper, and longer-term loans. Powerful evidence how a credit registry including information on loans from all financial institutions can allow borrower to climb up the ladder of financial institutions.
Finally, Tianyue Ruan sheds light on entrusted loans in China, inter-firm loans arranged by banks. She finds that such loans are more prevalent and more profitable in cities with a tighter supply of bank loans than in other cities (due to a loan-deposit ratio cap introduced by regulators). And it is banks with excess cash that function as lenders, suggesting that this type of lending might pose fewer financial stability risks (than if these firms raised money to on-lend).
What these four papers (and others in the conference) have in common is that they use unique data – either credit registry data, loan-level data from a specific bank or hand-collected data. This is clearly the future of research in finance and development – micro-data on transactions or survey-based. I am very much looking forward to the next edition of this conference… stay tuned….
24. March 2019
Brexit – what a week!
What a week! The week when Theresa May declared that no deal is better than a bad deal, just not on 29 March 2019, allowed her party members to vote in favour of taking no deal off the table for 29 March, but then changed course and told them that no deal is still supposed to be a viable option (just not at the end of this month), just to be defied by large numbers of her own party (including government ministers). Confused? No worries, this soap opera has a rather sophisticated plot.
The week where we finally found out who will be thrown under the train in the case of a no-deal Brexit (b/c in this populist soap operate someone has to “die” after all) – the Northern Irish farmers. The week where we found out how a no-deal Brexit will solve the Brexit Trilemma – by giving up on all red lines ever drawn by Theresa May. Eventually, border controls will be necessary between Northern Ireland and the Republic of Ireland; given differential tariff regimes between the Irish border and all other UK borders, controls have to be imposed in the Irish Channel and the new tariff regime will undermine UK’s ability to get any new free trade deals (complete loss of trustworthiness being the top reason). A very odd way of taking back control!
The week where the government got finally downgraded to the status of caretaker government as it has lost its majority in parliament. The week where the leader of the opposition finally looked more prime ministerial than the prime minister (never thought I would write this about Jeremy Corbyn). The week where we are closer to the season finale, but still have no clue how this season will end (just that there are many more seasons to come).
As in any good soap opera, there was lots of excitement and “action”, but little substantive change in the underlying plot and no sign of resolution. Theresa May is still trying to push through her deal and her chances might have actually increased as the alternatives have been reduced. The playing field has tilted even more against the UK as the EU has to agree unanimously to extend Article 50. If there will be any more negotiations in Brussels it will be no longer about backstops but about the terms of extension.
In case you cannot wait until the next week’s episode, I can promise you replays over the weekend. Well informed sources have told me that Brexiteers will insist that no deal should still be part of the British negotiating position (even though there is no one left to negotiate with – Brussels has made that clear). There are also rumours that Brexiteers might have identified yet another obscure GATT or WTO article they can mis-interpret in their favour. And we will hear yet again, ad nauseam, to “just get on with it…” – Brexiteers have promised that the moon is made of cheese, so we have to get on with it….
15. March 2019
Brexit – this week’s episode
I cannot help but comment on the latest episode of “Brexit – The Never-ending Soap Opera”. It is true, ratings of the series might have come down (Brexit is boring), as people cannot really follow the plot anymore (neither in the UK nor in Brussels nor anywhere in the world, it seems). The British government, however, is trying its best to bring back up its rating by choosing an ever shriller tone. The Prime Minister has now decided that it is really the EU’s fault that she has not been able to solve the Brexit Trilemma. In the meantime, ministers of her government are competing on who can make the most stupid comment. And the clock is ticking….
Next week will (supposedly) see votes in the House of Commons on (i) Theresa May’s deal, (ii) a no-deal and (iii) and the request for a possible extension of the Article 50 process. I will not join in any predictions, except that next week’s episode of the soap opera might actually be quite interesting. And we might actually find out whether and for how many more seasons it will be extended (rumours have it that the name will change to: “Brexeternity – The Sequel”). In the meantime, I will get myself some popcorn and a nice drink and relax for the weekend. Cheers!
8. March 2019
Better in or better out? Sweden and the banking union
I just returned from Stockholm where I participated in a workshop on the Banking Union from a Nordic-Baltic Perspective. The banking union was established as reaction to the Eurozone crisis and so far only Euro countries have been participating in the SSM and SRM. However, non-Euro EU member countries also have the option to join (once the ECB has vetted the regulatory and supervisory quality of the applicant). Sweden is currently undertaking a public inquiry into whether or not it should join the banking union and in this context I was asked to prepare a report that I now presented, followed by discussions from Professor Lars Calmfors and Steen Lohmann Poulsen from the Danish government (who is also considering joining the banking union). This was followed by a fascinating discussion among Nordic-Baltic supervisors on the banking union, the special situation of Nordea and – not surprisingly – money laundering problems and how to address them.
The establishment of SSM and SRM has had an important impact not only in the participating countries but also repercussions for non-Euro EU member countries. Rather than dealing with national supervisors they deal with the SSM in the case of significant institutions (118 banks in the Eurozone). Their rights as host country supervisors, however, have been strengthened, especially in the cases of significant branches and with the European Banking Authority taking an important mediation role between supervisors (binding as long as it does not infringe on fiscal policy). This is especially important since Nordea decided to move its headquarters from Stockholm to Helsinki last October and thus from Swedish supervision into the SSM perimeter, leaving its operations in Sweden in the form of a branch (and not a self-standing subsidiary)
Sweden’s banking system is closely interconnected with the rest of the Nordic-Baltic region. Four (since October three) of the six largest Nordic banks are headquartered in Sweden. Most of the cross-border banking activity in the Nordic region is done by Nordic banks and banks from outside the region generally have low market shares. The four largest Swedish banks have presence – in the form of either branches or subsidiaries – in most neighbouring countries. In line with my work with Wolf Wagner it is thus not surprising that the Nordic-Baltic countries have taken the lead in developing more intense forms of cross-border supervisory cooperation, starting with the establishment of a supervisory college for Nordea, which emerged from a cross-border merger in 2001. This was followed by Memorandum of Understanding (MoU) on the "Management of a financial crisis with cross-border establishments" in 2003, thus well before the Global Financial Crisis that saw the failure of several large cross-border banks in Europe. A Crisis Management Group for Nordea was established in 2012 after its designation as G-SIB (which also effectively replaces the resolution college, mandated under the BRRD). Finally, in 2011, the Nordic-Baltic countries established the Nordic-Baltic Macroprudential Forum (NBMF) to complement bank-level supervisory cooperation with systemic stability cooperation, an informal forum with no formal decision powers. Finally, there are arrangements between the central banks of Denmark, Norway and Sweden on utilisation of central bank deposits at one of the central banks as collateral for intraday liquidity lending in another of the three central banks (Scandinavian Cash Pool).
Given this rather close cooperation within the region, would it make sense for Sweden to join the banking union? Four of the other countries are already in it – Finland and the Baltics – and Denmark is considering it, too (as non-EU country, Norway will not be able to join). There are some arguments in favour. Sweden would gain a seat at the table and would benefit from scale and scope economies of the SSM and its enormous expertise. Joining the banking union would also help avoid supervisory divergence from the Eurozone and would allow Sweden to more easily participate in the Single Market in banking, benefitting from its efficiency and competition.
However, there are also arguments against it. There will certainly be a loss of independence, as rather than being part of the supervisory and resolution colleges for its main banks, Swedish supervisors would supervise these banks together with SSM staff in Joint Supervisory Teams. The major banks would also become part of a Single Point of Entry resolution procedure in the case of failure, another bite into independent regulation. A second major argument is that while Sweden might have a seat at the table, its influence might not be as large as that of larger and more important banking systems. Finally, it would never be a full-fledged member of the banking union: it would not have a vote in the Governing Council of the ECB that – in case of disagreement – can overrule decisions of the Supervisory Board where Sweden would be a member. Sweden would also not be part of the lender of last resort component of the Eurozone financial safety net and it is not clear to which extent it would benefit from a backstop for the Single Resolution Fund from the ESM.
Most important for my final conclusion, however, is the fact that the banking union is still under construction. The insurance component, which might make the banking union attractive for smaller non-Euro countries has not been fully developed yet, in the absence of deposit insurance. There is also the issue of legacy losses in Southern Europe still haunting the banking union and ultimately limiting a push towards full mutualisation of risks. Overall, there are lots of questions to be answered that I assume would be part of a negotiation process if Sweden (perhaps together with Denmark) decides to explore more formally entering the banking union. Ultimately, my conclusion is that having the option to join the banking union is valuable; it is less clear whether now is the optimal time to exercise this option, especially given the incomplete structure of the banking union. A wait-and-see approach might be preferable at this stage. Interestingly, this conclusion was support by Lars Calmfors (who in the 1990s led a task force on the possible participation of Sweden in the Eurozone).
There was an interesting additional perspective from Denmark – on the one hand, the Danish financial system shows quite some particularities that the Danish authorities fear might not be completely compatible with current banking union rules; on the other hand, there is an important political economy argument that – after Brexit – the club of non-Euro countries will lose influence and it might be more helpful to be part of the club, even if only as a part-time member. A final complication is that possibly a Danish banking union participation might have to be approved in a referendum (which brings rather unpleasant memories to this resident of the UK). Which brings me to the final point – one cannot ignore the political economy dimensions. Delegating the financial safety net to a supranational authority is an important step that requires proper democratic vetting and backing.
8. March 2019
Reshaping the Future for Financial Inclusion
I just came back from Abidjan where I gave a keynote at an event co-organised by the Alliance for Financial Inclusion, BCEAO and the Ivorian Ministry of Economy and Finance on “Reshaping the Future for Financial Inclusion”.
It is quite interesting to note how the discussion on access to financial services has changed over the past 15 years. In the early to mid-2000s, the focus was on microcredit, branch expansion and NGOs offering financial services to the bottom of the pyramid. Now the discussion is on digital finance, the role of telcos and a broad suite of financial services for previously unbanked population segments. Most importantly, while we had few if any data in the early 2000s, we have an abundance of data now, with the main important sources being the Financial Access Survey and the Global Findex. The Alliance for Financial Inclusion has also been collecting data from its member countries on different policy actions in the area of financial inclusion. In on-going work, we are trying to explore correlations between these policy actions and changes in financial inclusion, to be published later this year.
As always at these conferences with lots of practitioners I learned a lot and gained new insights. With all the (justified) excitement about digital finance overcoming geographic barriers to access to financial services, the access to mobile technology in rural areas still depends on physical infrastructure, a challenge we might easily forget. One important topic that came up again and again is the persistent gender gap. As I wrote in an earlier blog entry, this might be partly driven by persistent gender norms across the globe. But do we have to take these norms for given or can specific financial products actually influence such gender norms? There is evidence that access to financial services can result in female empowerment, but can this in turn help reducing societal gender biases? Or is it rather part of a broader educational and cultural agenda? More questions for research!
One (still) important barrier is the lack of identification. Large population shares in many developing countries do not have the necessary documentation (passports, driver licence etc.) to allow them to easily access formal financial services but also build up a financial history that can be used across financial institutions. Technology has helped in the identification challenge and – partly through social media, mobile phone use etc. – has allowed to compile lots of information on (potential) clients. Countries as diverse as India and Uganda have taken on this challenge successfully, with positive repercussions for financial inclusion. But where it is easy to collect and use data, Big Brother is not far. So it is not just about portability of data, but also sovereignty – it is the individual who owns his/her data and should have corresponding rights on their use by third parties. A clear tension and challenges for market participants and regulators.
A relatively new topic is that of green financial inclusion - how can financial services contribute to climate change mitigation and adaptation at the bottom of the pyramid? As often with new topics there is quite some definitional confusion on products and services, different players and their roles and the extent to which regulators and central banks should get involved. More concerning for me is the idea that prudential regulatory tools are being used for non-prudential purposes. Freely based on the Tinbergen principle (“achieving the desired values of a certain number of targets requires the policy maker to control an equal number of instruments”), non-prudential policy tools might be better positioned to target more directly green objectives without compromising financial stability! Further, while it is impossible to understate the importance of addressing the environmental externalities and the public good character of fighting climate change, we should not forget the lessons from decades of failed financial repression in the form of directed and subsidised credit, tools that might look attractive in the area of green finance. However, there are also positive lessons from development banks acting as second-tier institutions to help expand financial inclusion – maybe a similar role can be envisioned in the area of green financial inclusion. I have not formulated my thoughts completely in this area, but this seems one of the big challenges going forward- how to address an important market friction and challenge for humanity, while taking into account lessons learned.
2. March 2019
Why Paul Romer is wrong (again)!
Let me first say that I have enormous respect for Paul Romer’s contribution to modern growth theory. I first encountered his work as undergraduate student in Germany when I had to write a term paper about one of his papers. Many theoretical models that underpin the empirical finance-growth literature build on endogenous growth theory, so his contribution cannot be underestimated and he is well deserving of the Nobel Prize in Economics. I have somewhat less respect for him when it comes to his excursion into the policy world, most recently as Chief Economist of the World Bank, a position which he had to leave early due to his rigidity and due to wrong claims he publicly made about the Doing Business methodology and which did cause a minor diplomatic incident between Chile and the World Bank.
In a recent op-ed for the Financial Times, Paul Romer gives the still-to-be-elected new president of the World Bank two recommendations, one of which drew my attention. “First, outsource the bank’s research upon which it depends for identifying problems and proposing solutions.” His main argument: “When complex political sensitivities are allowed to influence research by stifling open disagreement, it ceases to be scientific.” He is certainly not the first to make such a case; others have argued for leaving academic research to universities rather than international financial institutions (IFIs) such as the World Bank or the IMF. I think such a recommendation is wrong, for several reasons (this might be a good point to mention that I am still working as consultant for both World Bank and IMF, so, yes, my views are biased by personal experience and – possibly – personal interest).
First, combining policy work with research can be fruitful, both in terms of policy questions/challenges giving rise to research questions and in terms of research feeding back into policy debates. A lot of my early work on financial inclusion (together with Asli Demirguc-Kunt and Sole Martinez) was motivated and informed by policy discussions in the developing world (I still remember the Kenyan Finance Minister asking us in 2003 why bank account fees were so high in his country, a question we somewhat answered in a subsequent paper). Could such work been undertaken in academia? Yes, but collecting information from banks and regulators is hard to undertake by academics without the backing of a large IFI such as the World Bank. Further, being challenged on an almost daily basis by operational colleagues can be very helpful in taking a sufficiently granular view in such research (e.g., when designing questionnaires, exploring alternative explanations or understanding the political economy of financial system structures).
Second, research done within multinational institutions can result in a dialogue within the institution, much more than research done outside. Best example is the research undertaken by my former colleague and boss Asli Demirguc-Kunt on deposit insurance in developing countries. While the standard recommendation by IMF and World Bank previously had been to introduce deposit insurance wherever it had not existed before, Asli with several colleagues (some in academia) showed the moral hazard risk, with too generous a deposit insurance raising bail-out expectations and ultimately resulting in the systemic banking crisis it was designed to prevent in the first place. Yes, such research can be undertaken and had been undertaken in academia before, but mostly if not exclusively focused on US and other advanced countries. With a publication bias towards US data still very prominent, researchers in multinational institutions have a critical role to play in research on developing countries.
But why can such cross-country data not be collected by multinational institutions and then primarily used by academic researchers? Data to be used by researchers is best collected by researchers who can link specific research questions to data and information to be collected. One good example is the Banking Environment and Performance Survey undertaken by the EBRD across Central and Eastern Europe and Central Asia (with data collection facilitated by the relationship the EBRD has with many of these banks), a first round in the early 2000s but with the questionnaire primarily designed by operational staff, while a second round was undertaken in 2011, with the questionnaire designed jointly by EBRD research staff and academics (like yours truly) with very specific research questions in mind, subsequently resulting in several top publications.
But what about political sensitivities? Yes, they exist, though in both IFIs and academia. Several years ago I was involved in a research project sponsored by the European Fund for South Eastern Europe and while ultimately everything turned out just fine, there were quite some (sometimes tense) negotiations with the funder and with the banks providing us with data during the process. So, it is not only research undertaken in IFIs where political sensitivities can play a possible role. Where (empirical) research depends on micro-data provided by financial institutions or government agencies, one can never completely ignore political or institutional sensitivities.
Where does this leave us? I would argue it leaves us exactly where we are right now – close cooperation between researchers in IFIs and academia, where either side can take the initiative and where cooperation will ultimately result in policy-relevant research with important policy implications. So to come back to Paul’s recommendation: what we need is not outsourcing of research, but increased cooperation and strengthening the independence cum accountability of the research department within the World Bank.
25. February 2019
Europe’s banking union – two steps backwards
The topic of bank resolution in the Eurozone is again in the headlines, with possible controversial actions in two countries that often find themselves at opposite sides of the argument – Italy and Germany. Both threaten to undermine the progress that the Eurozone has made over the past years to a Single Market in banking and thus a more sustainable currency union.
In Italy, there are – not surprisingly - more bank failures. On January 2, the ECB appointed temporary administrators at Banca Carige, based in Genoa, after shareholders were unable to secure additional equity. The problems in Banca Carige are not new, but the can had been kicked down the road until late last year. The Italian government seems to stand ready to pour money into Banca Carige via the instrument of precautionary recapitalization (as also applied to Monte dei Paschi in Siena in 2017) even though this bank cannot really be considered a systemically important financial institution. Also, guarantees of Carige’s bondholders go through the Italian deposit insurance scheme, thus transferring contingent liabilities to the rest of the Italian banking system. However, the bail-out goes beyond this specific case. According to news reports, Italy’s government has set up a 1.6 billion euro fund to compensate investors who have lost their money in a string of recent bank liquidations. This will pay junior bondholders up to 95 percent of the original value of the investment and shareholders up to 30 percent. While this arrangement is almost exclusively for retail investors, it certainly extends the financial safety net far beyond what has been agreed under the new European bail-in rules. And even if one can make the case for compensation for retail investors that were mis-sold junior securities in banks, there is no case to be made to compensate equity holders!
Ultimately, the Italian-style bank resolution over the past two/three years is a big step backwards to the era of bail-outs. It is also a reflection of the failed politics of kicking the can down the road when it comes to bank resolution – the Italian government had ample opportunities to clean up its banking system before the BRRD came into force; however, it is also a failure on the European level that new rules come into place for a continuously weak banking system whose structural deficiencies have not been addressed yet.
While Italy thus undermines the bail-in principle of the banking union, the German government is going even a step further, trying to “renationalise” banking sector policies, thus actively undermining the Single Market in Banking. In the spirit of industrial policy and creating national champions, there seem to be government efforts under way to facilitate a possible merger of Deutsche Bank and Commerzbank, the two largest privately-owned banks in the fragmented German market. While the argument of consolidation and reducing overbanking might make sense, the creation of a national champion as explicitly aimed at by the Minister of Finance seems mistaken if not dangerous. Such a bank would be considered German and with active political involvement in its creation would immediately raise further bail-out expectations in case things do not work out as planned. It also undermines level playing field within the Eurozone - fiscally strong countries such as Germany can support their banking systems, while others cannot. This also shows the hypocrisy of German commentators when criticising bail-outs in Italy (as politely pointed out by Isabel Schnabel in this German commentary).
Both the Italian and the German actions counter the enormous progress made over the past years towards a single regulatory framework for the Eurozone. Let’s remind ourselves – the most immediate reason for the banking union was to cut the link between sovereign and bank fragility (a target which has not really been achieved, but this is for another day); however, the broader objective is that of creating a Single Market in Banking without which the Eurozone would not be a sustainable currency union. However, this implies a move away from national champions and purely national actions.
The Eurozone has made big strides towards a Single Market in Banking with the establishment of the Single Supervisory Mechanism and the Single Resolution Mechanism. Important elements (most notably a European Deposit Insurance Scheme) are still missing. However, a Single Market in Banking is not only about the legal framework but political actions. Both the Italian and the German governments have shown over the past weeks that they are not willing to “walk the talk”. Not only have the lessons of the Global Financial Crisis been forgotten, but also the lesson of the Eurozone crisis that national financial safety net and national banking sector policies undermine the Eurozone!
27. January 2018
Brexit soap opera – ready for the next season?
If Brexit were a soap opera, yesterday’s historic defeat of Theresa May would have been the season finale. But the new season is starting almost immediately and – maybe, just maybe – might become quite innovative and original. Two quick observations.
First, on popular (populist) vs. representative democracy. The referendum of 2016 was odd in many aspects, as not really in line with the parliamentary tradition of the UK. And unlike many previous referenda on EU issues across Europe, it did not offer a choice between status quo and further integration but between status quo and something unknown (aka unicorns) – where the unknown won. The Prime Minister took it on herself to interpret the findings without any consultation or consensus-seeking within government, party or country – so not really surprising that she failed! Step by step, over the past two years parliamentary democracy has fought back, first gaining the right to a meaningful vote (which took place yesterday) and by forcing the government to show its cards (and thus calling its bluff). Now, that the referendum politics has failed and Theresa May is in the weakest position of any prime minister over the past generations, it might be the moment when parliament finally takes back power and does what it is supposed to do in a representative democracy like the UK: legislate – in this case, legislate the future relationship between the UK and the EU. It would be ironic if after two years of everyone being fixated by the referendum result, parliament comes out stronger than before!
Second, Brexit has been mainly and predominantly an intra-Tory discussion. David Cameron triggered the referendum to settle an intra-Tory conflict; Theresa May initially tried to mollify hard-line Brexiteers in her own party, and even now the tendency is to first look for a consensus on Brexit within the party rather than within the House of Commons and the country. This “party before country” approach has brought the Prime Minister and the Tories to the brink of complete failure (and has allowed Jeremy Corbyn a home run by not forcing him to take any realistic position). Maybe, just maybe, it is time to put country first! This relates directly to my first point – maybe it is time for some sensible people in the House of Commons from all sides of the political spectrum to take charge of the process and come to a solution! Make the whole political class and the whole country own its future, not the kitchen cabinet in 10 Downing Street!
16. January 2019