Racism and economics
I have meant to write this blog post for quite some time, but as the events over the past weeks have accelerated, there seemed to be more and more dimensions to this problem. I will therefore focus only on a few here.
First and foremost is the police brutality against (not only but especially) African-Americans in the US (a problem which exists to a lesser degree also in many European countries, though even less often with homicidal consequences). Academic economists have been accused that – unlike in the COVID-19 crisis – we have been silent and do not really have anything to contribute to this societal challenge. I would strongly argue against that. There is an extensive literature on discrimination (of all types) and one major insight has been that technologically-enhanced monitoring (shown for example, here) can help as well as competition – as shown for example here - (one minor contribution by Patrick Behr, Andreas Madestam and I refers to own-gender preferences by loan officers, showing that experience with the other gender as well as intra- and inter-bank competition is a powerful tool against it). And a quick look at employment conditions for police officers in the US shows clear incentive problems, including qualified immunity and the power of unions. Both of these allow “bad apples” to continue to thrive in many police forces across the US. However, beyond the microeconomic incentives, there are important social elements, such as the glorification of police officers, including when they go beyond reasonable force, in Hollywood movies, and historic elements – the police force was used for decades to suppress African-Americans in the South. There is also a historic literature on the long-term effects of slavery on socio-economic and political outcomes in the US, such as by Ken Sokoloff and Stan Engerman as well as work by Lisa Cook, showing the persistence of institutional arrangements created during pre- and post-Civil War periods for socio-economic outcomes today. There is certainly more that I am not aware of, but it is important to stress that there are many different research approaches and different literatures that speak to the issue at hand. This also means that simple policy solutions as suggested by the incentive literature might not be easy to implement given socio-political constraints.
A second theme I want to touch on is the Causa Harald Uhlig whose blog and twitter rants have made quite an impact and not exactly a positive one, leading to calls for him to resign as lead editor of the Journal of Political Economy. I have meet Harald in several occasions while in Tilburg, as he was part-time research professor there. He is certainly one of the smartest macroeconomists I have met, but he is also academic through and through. Reading his blog and recent twitter rants, I was not only disappointed but disgusted! He might not be a racist, but his comments and name calling are a sign of incredible lack of sensitivity and common sense. While I originally did not sign the letter calling for his resignation as JPE lead editor, the allegations of discriminatory remarks in the class room made me think again. And if someone like Harald is not able to adjust his ivory tower discussion style when leaving the seminar room it might be better if he did not participate in the public discussion at all. Of course, this does not address the allegations of discriminatory behaviour in the class room and is certainly something to be addressed by his department.
However, there is a broader lesson here for economists and social scientists. It is important for us academics to step outside the ivory tower and take part in the societal conversation (even more so during the time of populism); however, we have to learn how to participate in a sensible and sensitive way. While doing my PhD in the late 1990s, there was often reference to the rather aggressive Chicago seminar style, certainly something to be avoided in settings outside the seminar room (and maybe even inside, see below). As much as we have to learn the difference between academic writing style and translating our research for non-academics and even non-economists, we have to learn how to participate in the public discourse in a style that is respectful if not humble!
Which brings me to a third theme – the lack of diversity within the economics and finance academia. For many years, we have discussed the gender problem in economics – before I joined academia, I never faced this issue as the group at the World Bank where I spent my first nine post-PhD years was very balanced in gender terms. The fact that many international financial institutions and organisations (IMF, World Bank, OECD and EBRD) have female chief economists, is certainly an important signal. Yes, economics (and finance) academia still has a gender problem, as the discussion about www.econjobrumors.com clearly shows, but we have started to address it. However, the problem of diversity is a broader one. The lack of African (American) economists in the US (and similarly limited minority representation in other countries) is certainly alarming. However, it is important to understand that this is not a problem we can solve overnight. Unless I am mistaken, there seems to be a lack of African (-American) students in economics and finance in both undergraduate and (post) graduate courses. Addressing the diversity problem has to start at the undergraduate level and strong mentoring programmes and a change in culture and style will hopefully get us where we need to be, eventually.
Being a male middle-aged white economist, I realise that I have been in a very privileged position during my whole professional life. And I realise that I have a responsibility to do my small part of changing the culture in our profession. I hope I can live up to it – it won’t be easy, as much of our behaviour is so ingrained that we might not even realise where and when we go wrong!
23. June 2020
Effectiveness of macro-pru in the America
I had the honour of co-editing a special issue of the Journal of Financial Intermediation, just published, comprising five papers that use granular data to assess the effectiveness of different macro-prudential tools. While macro-prudential regulation has become very prominent over the past decade, following the experience of the Global Financial Crisis, there is still limited empirical evidence on what works and what does not. Assessing the effect of macroprudential policies is made difficult by two challenges: endogeneity of policy decisions and difficulty of differentiating between demand and supply-side reactions. Using bank- or loan-level data allows to address these challenges to a certain extent and that is what these five papers are doing. Doing so, however, limits the analysis typically to one country at a time and thus limits the external validity of each study. In the first paper, however, my special issue co-editor Leonardo Gambacorta and Andres Murcia undertake a meta-analysis of studies by five central banks in Latin America countries (Argentina, Brazil, Colombia, Mexico and Peru) to evaluate the effectiveness of macroprudential tools and their interaction with monetary policy; they find that macroprudential policies in these five countries have been quite successful in stabilising credit cycles and macroprudential tools have a greater effect on credit growth when reinforced by the use of monetary policy. Thus interaction of macro-pru and monetary policies is a first important key insight.
A paper on the impact of macroprudential housing tools in Canada combines loan-level administrative data with household-level survey data on first-time homebuyers and finds that policies targeting the loan to value (LTV) ratio have a larger impact than policies targeting the debt service-to-income (DSTI) ratio, such as amortisation. A paper focusing on the US finds that the initiation of the Comprehensive Capital Analysis and Review (CCAR) stress tests in 2011 had a negative effect on the share of jumbo mortgage originations and approval rates at stress-tested banks – banks with worse capital positions were impacted more negatively. Macro-pru can thus be effective in reducing the cyclicality of housing (credit) cycles. And as a study on Brazil shows, it can also reduce defaults. Specifically, the authors study the impact of the introduction of LTV limits in Brazil against the back drop of a housing price boom in 2013. Borrowers that were constrained by the LTV limit have a significantly lower chance of being in arrears, which ultimately limits the build-up of risk, showing the effectiveness of LTV caps.
Finally, a study on Colombia evaluates the effects of the introduction of:(i) a dynamic provisioning scheme for commercial loans; and ii) a countercyclical reserve requirement implemented in 2007 to control for excessive credit growth. Results suggest that both policies and an aggregate measure of the macroprudential policy stance had a negative effect on credit growth, with the effect varying with bank and debtor-specific characteristics. The effects are intensified for riskier debtors, thus suggesting that the aggregate policy stance in Colombia has worked effectively to stabilise credit cycles and reduce risk-taking.
The number of papers using loan-level data has exponentially increased over the past years and so has the number of papers assessing macro-prudential policies. There will be lots more to be learned, both on the country-level but also comparing across countries.
9. June 2020
Preserving capital – restricting pay-outs
Important disclaimer: I am a member of the Advisory Scientific Committee of the ESRB. However, the views expressed below are exclusively mine and do not necessarily reflect the official stance of the ESRB or its member institutions.
Over the past two months, I chaired a workstream at the European Systemic Risk Board on pay-out restrictions, with the General Board adopting a Recommendation on 27 May to this effect. This recommendation was published on 8 June. The bottom line is to restrict voluntary payments by banks, insurers and CCPs that reduce own funds, including dividends, buy-back of shares and variable compensation to material risk-takers. The ultimate aim is to have sufficient levels of capital and loss absorbing capacity remaining in the financial institutions to mitigate the impact of the current crisis and thereby contribute to a smoother recovery for the pan-European economy as a whole. As the recommended actions fall under the jurisdictions of many different authorities, the Recommendation is addressed to relevant competent or supervisory authorities and, designated or macroprudential authorities.
While such restrictions intervene in ownership and management rights, there are strong arguments for such restrictions in times of crisis. First, banks constitute a critical sector for economic recovery and therefore there is the need to maintain sufficiently high capitalisation. Second, governments have provided capital relief to banks (e.g., EUR120 billion for significant institutions under direct ECB supervision) and have indirectly supported them through support payments to enterprises and households (who otherwise might have defaulted on loans) and credit guarantees; voluntary pay-outs would partly off-set the effect of these measures. Third, banks behave in a procyclical manner in their lending, showing a propensity to build reserves against credit losses and reduce lending during recessions. High capital buffers can to a degree mitigate this tendency towards deleveraging, which in turn calls for suspension of pay-outs to not off-set the effect of high capital buffers. Finally, if banks use dividend payments as a signal of strength to the market then any bank not doing so will fear being stigmatised, which speaks in favour of coordinated and mandatory action to restrict pay-outs.
There are certainly arguments against imposing such restrictions: charities, foundations, pension funds and retail investors often depend on steady dividend income; the prohibition of pay-outs might limit resource reallocation that might be needed during the recovery stage; and banning dividend payments can undermine banks’ relationships with investors and thus potentially restrict future access to market funding. These arguments certainly speak for only temporary restrictions.
The ESRB Recommendation comes after several recommendations issued by EBA, SSM and EIOPA in late March/early April, but there are several notable developments since then. First, this recommendation is a broader one, across several segments of the financial system, including banks, investment firms, insurance companies (which will certainly get under similar stress as banks and play a critical role in financial markets) and CCPs (while they are not directly involved in real sector funding, their critical role in financial market transactions makes their reliance important for banks’ and insurance companies’ hedging activities).
Second, the recommendation refers to all voluntary pay-outs that have the effect of reducing the quality or quantity of own funds, including dividends, share buy-backs and variable remuneration to material risk-takers (staff members whose professional activities have material impact on the institutions' risk profile) and thus goes beyond previous recommendations. There is a proportionality clause in the recommendation and – obviously – where financial institutions have a legal obligation to pay, they have to do so.
Third, the restrictions apply until the end of 2020, rather than 1 October 2020, as under the SSM recommendation. It can be extended.
While the recommendation primarily targets pay-out restrictions on the consolidated level, one tricky issue has been restrictions on the sub-consolidated level. On the one hand, the recommendation calls for restrictions on the consolidated level, but on the sub-consolidated level if the parent bank is outside the EU. While ideally there would be cooperation on the global level, this has not happened, so we need to primarily take care of the European financial system. On the other hand, several Central and Eastern European countries have imposed restrictions on subsidiaries of EU cross-border banks for financial stability concerns. There are strong arguments on either side. On the one hand, regulatory risk-sharing is incomplete in the EU (including within the euro area) and the financial stability mandate of national macro-prudential authorities focuses on local financial systems and economies. On the other hand, the Single Market principle of free movement capital speaks against imposing restrictions on the subsidiary level. The Recommendation therefore advocates that the relevant authorities enter a dialogue when considering imposing pay-out restrictions on subsidiaries of EU financial institutions. Compared to the last crisis, there are quite some fora available for this dialogue, including colleges, the Vienna Initiative and the Nordic-Baltic Macroprudential Forum.
It is important to stress that this recomendation constitutes “soft law”. The ESRB has no legal powers to enforce compliance; rather ESRB Recommendations are ‘comply or explain’. This means that an addressee could decide to explain in case it had good reasons for not complying. I am aware that there will be indeed some authorities who will decide to not comply, but I think it is still important to send this broad message in favour of capital preservation at times of very high uncertainty and possibly future distress!
8. JUne 2020
Covid-19 response – failing governments
In a survey, published in October 2019, the US and the UK were rated as the two countries best prepared for a global pandemic; as it is well known now, these two countries now head a different ranking – that of total excess deaths during the pandemic so far. Why is this? Is it populism? Structural reasons? And how can a recent survey go so wrong?
Let’s first take the US – yes, it is certain that political leadership plays a role and that Hillary Clinton, Bernie Sanders, Marco Rubio, Jeff Bush, Mitt Romney or actually any functioning adult would have been better than the current president, but beyond the political leadership (well, the lack thereof), this pandemic has shown the failure of the federal government in the US. Starved of funding over the past 20 years, ridiculed and insulted by one of the two parties over the past 40 years and lacking a consensus that public health should be a common good, not a club good, the federal government is not up to the job. There is a lot more to be said about the current situation in the US (which has been hit by a combination of 1918, 1929 and 1968 shocks), but I will leave it for another day.
Let’s now take the UK (which is personal for me as I am currently living here). Being an island, the country had the advantage of being exposed several weeks later to the virus than other countries. The reaction: “well, we are so much better than everyone else, especially than Italians, so let’s go and watch horse races in Cheltenham.” One might forgive the government for changing their advice and policies as more evidence became available, but: too late in securing PPE, too late in quarantining travellers from abroad (they might implement it next week, when it is all but useless), too late in starting to test, too late in securing enough ventilators, with the consequence of sending older people from hospitals back to care home, where they were left to transmit the virus to others and die – how much more disgraceful can a democratically elected government become – well, too late in everything! But as the Prime Minister declared yesterday: he is proud of his record! And when the data contradict the government’s assertion, they are being either not published (such as testing data over the past days) or they are being manipulated (such as counting mailed test kits as undertaken tests). I am sure there is still a receptive audience for Johnson’s nationalist idiotic bluster, but in the not too far future, there will be a reckoning for this failure. And I am not even mentioning the threat of yet another Brexit no-deal cliff edge.
There is one more thing I have noticed in the UK over the past years: politicians love slogans. From “take back control” over “Brexit means Brexit” and “get Brexit done” to “following scientific advice”, British politicians love hiding behind slogans. It shows how empty of quality the political class in this country has become. Having a government minister on the radio or TV often turns into PR disasters as their lack of competence shows when they are forced to go beyond their carefully prepared notes and when interviewers question their silly slogans. Changing ministerial briefs every few months does not help either. But it is clear that something is deeply broken in the governmental system of the UK. Brexit is damaging but not necessarily deadly; bungling the COVID-19 response kills people! And their families will note!
This brings me to a broader point. The legal origin theory is often interpreted as implying that everything is better in Common Law (such as US and UK) than in Civil Law countries (and yes, I have several papers showing that legal origin can explain some variation between countries in financial development). The effectiveness of government might certainly be an important exception to that! Having spent my adult life in two Common Law (US and UK) and two Civil Law countries (Germany and the Netherlands), my own personal and professional (as economist and academic) experience with government services has been much better in Continental Europe than in the Anglo-American world, but then again, the plural of anecdotes (of which I have plenty) is not data. I think this crisis has shown more than any other evidence that (controlling for the level of GDP per capita), government quality is certainly not higher in the UK or US than most (Civil Law) countries in Continental Europe. However, this also means that we have to become much more cautious with institutional indicators based on expert surveys, such as the one I quote at the beginning.
4. June 2020
Finance and Covid-19 in Africa
This past Tuesday, I participated in a virtual roundtable, organised by ODI, on “Covid-19 and Africa’s financial sector”. Herewith a short summary of my own remarks and what I have learned from others: It is clear that the effect of COVID-19 on the financial sectors in Africa (as in other developing regions) will be different than in advanced countries, as well as their role in getting through the crisis and helping the recovery. First, the role of the informal economy across the region makes outreach to large part of the population much more difficult. Second, lockdown strategies such as in Europe are less realistic and effective given that a large share of the population is vulnerable to fall back into poverty and governments do not have the tools and channels to support them easily during an economic lockdown. Finally, independent of the direct impact of the COVID-19 pandemic, there will be a significant fall-out from lower global trade, (in some countries) from falling resource prices and flight to safety in global capital markets.
To assess the possible impact of COVID-19 on Africa’s financial sectors, I started with a simple SWOT analysis:
Strengths: on average, African banks are well capitalised and liquid; they have a limited exposure to the real economy; many countries have a diversified population of banks, with regional banks playing an important role and being less likely to retrench than global banks during a crisis.
Weaknesses: given the economic structure of most African countries, African banks have a concentrated asset portfolio and are thus more exposed to sector-specific shocks (e.g., natural resources, tourism etc.); there is a high dependence of many borrowers and therefore also banks on international trade finance; finally, the fact that African banks have a limited exposure to the real economy, also limits their role in helping the real economy through the crisis and beyond.
Opportunities: the increasing mobile phone and mobile money account penetration has made it easier for people to send money between friends and within families, thus have improved informal sharing risks; this also makes pushing out support payments by governments much easier.
Threats: with the crisis in advanced countries and across the globe, there is the risks of dramatically reduced capital inflows, including remittances; there is a risk of increasing and unsustainable sovereign overindebtedness and therefore a high risk of sovereign and (consequently) bank rating downgrades; finally, some countries have seen a consumer credit boom in recent years, based on mobile money accounts, which might now be followed by a bust.
Given this SWOT analyses, what are financial sector policies that can play to the strengths and use opportunities, while reducing weaknesses and addressing threats?
First, using mobile phone networks to push out support payments can be an attractive option given that tools as in advanced economies (e.g., furlough schemes, tax refunds) are not appropriate for economies with an important role for informal economies. One example where this has been done is Togo.
Second, making it easier to use mobile money for payment purposes is important. Several central banks have already lifted ceilings for such transactions and have reduced fees. This will facilitate informal risk sharing and an ease the shift away from a cash-based economy.
Third, anti-cyclical regulatory policies can be useful to prevent lending retrenchment by banks. In Europe, regulators have provided capital relief, eased loan classification rules, delayed implementation of Basel III reforms and postponed stress tests. While some of these policies might be less relevant in developing countries, they can support lending. As important as banks, however, are microfinance institutions and other bottom-of-the-pyramid financial institutions. Here, the proper approach depends critically on the regulatory framework – where these institutions are deposit-taking and thus have access to central bank liquidity, such liquidity support can be critical if their deposit base becomes volatile and credit demand increases; where such institutions are outside the financial safety net other support mechanisms have to be considered, e.g., through development banks, indirect support by the central banks through commercial banks or donor support.
Fourth, credit guarantee schemes have become popular, as I discussed in a previous blog entry. A recent analysis by my former colleague Hans Degryse for Belgium has shown the need to tailor such a scheme carefully to the needs of the real economy. And I am increasingly sceptical that more debt (even at negligible interest rates) is what most firms need right now. Grants, equity participation or some kind of mezzanine funding might be more useful.
Fifth, it is important to address the wave of loan defaults by households and firms that might not be able to repay given the economic crisis. Black marks in the credit registry will shut many of them out of credit markets for a long time; a certain degree of forbearance is called for, even though there will certainly be abuse by borrowers that can actually repay. Dealing with wide-spread insolvency of smaller will be difficult given the deficient insolvency frameworks that most countries have and using simplified crisis-specific frameworks will be critical.
Finally, many countries in Africa will see a dramatic increase in debt/GDP ratios, both because of higher debt burdens (tax revenues will decrease and expenditures increase) and because of shrinking GDP. Add adverse exchange rate movements and you will get easily to unsustainable sovereign debt levels. Unlike most advanced countries, it will be difficult for most African countries to expand fiscal policy aggressively, even in local currency markets, given limited absorption capacity. And unlike in advanced countries, where expanding money supply even through “printing money” is unlikely to lead to high inflation in the current circumstances, I would be concerned about this in many developing countries. Support from international financial institutions is thus critical! And sovereign debt restructuring is certainly back on the agenda, this time with a rather prominent role for China. (After having written this, I found this interesting piece by Rabah Arezki and Shanta Devarajan who make similar points).
So, not all is bleak, but there are a lots of worries! Africa has made a lot of progress in the past decade, including in the financial sector – now, is the time to not lose this progress.
29. May 2020
Hamilton visits Berlin
I do not think one can overestimate the importance of this week’s joint German-French initiative for a 500 billion Euro post-pandemic recovery fund for the EU. While not called Coronabonds, it is very much in their spirit: the European Commission would borrow money on the capital markets to distribute in the form of grants to countries most affected by the crisis; thus common liability for debt to address a common shock . As before (during the refugee crisis), Angela Merkel has risen to the challenge and provided leadership on a topic where there is far from an agreement within her own party and within the EU. She made a clear case that post-pandemic reconstruction is beyond the capacity of nation-states and requires a European effort, expressing in political terms, what many of us economists (including yours truly) have argued in recent weeks. The economic, political and moral case for a joint European reconstruction effort is simply too strong to be ignored. It will be for historians to disentangle how we actually got there, but the ruling of the German Constitutional Court might have put additional pressure on the German government to take this step. As I wrote last week, it has become increasingly clear that leaving the burden of crisis resolution to the ECB is no longer politically feasible. In this sense, this ruling might actually have provided a positive impetus.
Her finance minister Olaf Scholz went one step further and referred to this as the Hamiltonian moment in Europe. To remind us: Alexander Hamilton, first Secretary of the Treasury of the US secured in 1790 that the US federal government assumed the debt incurred by the US states during the War of Independence, thus laying the foundation for federal taxation and a strong federal government in the United States, effectively turning a lose political union into a fiscal union. And while it is clear that the current initiative might be the beginning of a long and slow process, one can take comfort from US history, where the process towards a stronger role of the federal vis-à-vis state governments also was a long one.
The history of European integration does not always follow a straight line, often taking a step back after two steps forward. So, it is not clear quite yet how fast and how far this Franco-German initiative will take us, but it is clear that an important step has been taken and it will be hard to close the door that has been opened. For federalist Europeans like me this is certainly an important step, to be celebrated with cautious optimism.
20. May 2020
Karlsruhe and the euro
Last week’s ruling of Germany’s Constitutional Court in Karlsruhe that the ECB’s asset purchase programme might not be proportional and thus possibly unconstitutional has sent shock waves through the euro area. I will not comment on the legal arguments of the Court’s ruling and its implication for the legal order within the EU and rather focus on its implication for economic policy going forward.
The ECB Executive Board has already made it clear that it does not see this ruling as any impediment for its monetary policy decisions going forward and that it regards this as a purely intra-German matter. It will thus have to be the Bundesbank and/or the German government that answer to the German Constitutional Court. In the worst case scenario that the Bundesbank will no longer be allowed to participate in asset purchase programmes of the ECB, even that would not be a major problem, as the ECB can simply ask other national central banks to buy German bonds.
The problem is more a political one. The Constitutional Court of the euro core country has sent a strong negative signal against ECB’s independence, giving a boost to opponents of the euro and the current move towards a more integrated policy framework not just in Germany but across the euro area. It has also opened the door to legal challenges across the euro area against future monetary policy decisions and tools of the ECB.
Most importantly, this decision might affect the space that the ECB will have in the next few years in how to deal with the increasing sovereign debt if not fragility of several euro area member countries. Future “whatever it takes” announcements might not necessarily be taken at face value anymore by markets. It sheds doubts on the idea that a rising sovereign debt burden can be dealt with a combination of ESM loans and ECB bond purchases.
On the upside, this court ruling puts the pressure back on governments across the EU and the euro area to finally rise up to the challenge of taking forward-looking decisions on how to deal with the large deficits and rapidly rising sovereign debt burdens across the euro area. As I have written earlier, such a decision should be taken by democratically elected and directly accountable governments rather than independent and indirectly accountable central banks. There is a strong case for loss sharing within the EU and/or the euro area, on economic, political and moral grounds. There are certainly different structures and mechanisms that one can think of, but burdening again the ECB with the main responsibility to deal with the fallout from the COVID-19 crisis should be avoided, even more so with this court ruling.
This ruling has also made clear that the current institutional and governance structure of the euro area is not fit for purpose, especially during crisis times. There have been important reforms in the banking area in the form of the banking union; it is also clear that it is not complete and does not provide for sufficient risk sharing yet. More risk sharing through capital markets will continue to be a high policy priority. But what the current crisis has shown us is that in these extreme tail events, it can only be the government that can provide the necessary degree of certainty. This in turn puts a stronger premium on delegating a larger share of fiscal policy responsibilities to the euro area level. Suggestions have been made: a crisis-specific recovery initiative, a reconstruction fund and unemployment reinsurance.
In summary, one can see the glass as half empty, with this decision undermining the ECB’s ability to respond to this and future crises; one can also see this as a glass half full as the ruling has again shown the deficiencies in the euro area governance and should be interpreted by governments across the euro area as a call for action.
13. May 2020
Bank resolution and systemic risk
We have been working on this paper for quite some time, but the current crisis makes it actually a very timely paper. As the global economy descends into recession, there are rising worries about the ability of banking systems across the globe to withstand the sharp, and synchronized, downturn. Over the past decade, countries across the globe have established or upgraded their legal and regulatory frameworks for resolving banks in distress. The question is whether these frameworks are also fit for purpose in a systemic banking crisis.
In recent work with Deyan Radev and Isabel Schnabel, we have compiled a database on resolution frameworks across 22 member countries of the Financial Stability Board (FSB) and assess how the systemic risk contributions of banks in these countries change if the global economy or financial system is hit by system-wide shocks.
First, based on the FSB’s 12 Key Attributes of an effective bank resolution framework, we construct an index of the comprehensiveness of bank resolution frameworks. Among the critical components of a comprehensive bank resolution regime are:
While we see a general trend of countries adopting more comprehensive resolution frameworks over time, there are some noteworthy observations:
We then compare the changes in banks’ DCoVaR across 760 banks and 22 countries with different bank resolution frameworks after system-wide shocks, including negative system-wide shocks (such as Lehman Brothers’ collapse in 2008) and positive system-wide shocks (such as Mario Draghi’s ‘whatever it takes’ speech in 2012).
Our results show:
Overall, our results lend support to theories that focus on the negative stability effects of bank resolution regimes designed for idiosyncratic bank failures during system-wide shocks. These theories posit that during systemic bank distress a rule-based system that ties regulators’ hands can result in bank runs and contagion if regulators have private information about bank performance and can destabilize the financial system in the middle of a crisis, through direct interlinkages of banks holding each other’s claims, as well as information effects and sudden reassessment of bank risk. While resolution regimes seem fit for purpose for resolution of individual banks, they may be counterproductive during systemic distress situations.
7. May 2020
Interesting papers – May 2020
More interesting papers I have had time to read. Angelo d’Andrea and Nicola Limodio gauge the relationship between “High-Speed Internet, Financial Technology and Banking” in Africa. While a lot has been written about financial innovation, including in Africa, this paper focuses on the technological condition that allows financial innovation, in this case the staggered arrival of submarine cables between 2000 and 2013 and thus high-speed internet across African coastal countries. First, having access to high-speed Internet increases the probability of moving towards real-time gross settlement (RTGS) payment systems. Gross instead of net settlement in turn reduces liquidity risk and increases size and liquidity of the interbank market. African banks hold traditionally a large share of liquid assets, the reduction of liquidity hoarding following the adoption of RTGS hence allowed for a statistically and economically significant increase in private sector lending, part of the financial sector deepening that I have documented earlier in several policy publications (Financing Africa-Through the Crisis and Beyond). While we focused more on the micro-elements of financial innovation, this paper documents very nicely how even back-office technology can help deepen financial systems. And finally, the authors use enterprise survey data to show that higher private sector lending also improved access to credit by firms and the maturity of their loans.
Bjoern Richter and Kaspar Zimmermann show in “The Profit-Credit Cycle” that an increase in banks’ return on equity predicts credit booms and subsequent busts. Part of an expanding literature on understanding credit cycles and building on a historical macro-financial literature, the authors use data for 17 advanced countries between 1870 and 2015. The increase in credit following higher bank equity comes with lower interest rates, suggesting that it is a supply- rather than demand-driven phenomenon. There are several channels through which bank profitability can influence future credit growth, but the strongest evidence seems to be for a behavioural channel – low loan losses and high profits increase the confidence of banks and results in stronger credit growth. This is confirmed by looking at more recent survey data from the US: there is a high correlation between bank profitability and bank CFO optimism. To close the circle, the authors show that increases in bank profitability predict banking crises a few years ahead. Ultimately, a lot of evidence in line with Minsky’s hypothesis that good times cause future instability.
Isaac Hacamo and Kristoph Kleiner have a fascinating paper on Forced Entrepreneurs. Research on entrepreneurship in developing countries has shown that a large part of micro-entrepreneurs are life-style or subsistence entrepreneurs, forced into self-employment due to the lack of salaried employment. Estimates for Sri Lanka has shown that 30% of informal entrepreneurs are life-style type, while Miriam Bruhn has an estimate of 50% in Mexico. In my work with Mohammad Hoseini we found that 54% in India are subsistence entrepreneurs. This paper considers such entrepreneurs in the US. Analysing the employment histories of 650,000 workers, the authors document that graduating college during a period of high local unemployment increases the likelihood of entry into entrepreneurship given poorer employment perspectives. Surprisingly, these entrepreneurs do not seem of lower quality, neither ex-ante nor ex-post in their entrepreneurial performance. Rather, based on multiple measures of success, including survival, growth, innovation, and venture capital, recession-driven entrepreneurs are equal to or even more successful than voluntary entrepreneurs. Ultimately, it seems that recession pushes more risk-averse graduates into entrepreneurship. So, it seems that it is risk aversion rather than the lack of entrepreneurial skills that holds graduates back from becoming self-employed. These are very different results from those in the developing world, which is not surprising – in this paper, the focus is on college graduates with typically good employment perspectives, though significantly varying over the business cycle.
1. May 2020
Credit guarantees in the time of Covid-19
Credit guarantees for (small) businesses have been one popular policy tool in government’s fight against the COVID-recession. At a time when revenues fall away, but many businesses still have to cover at least part of their costs, cash can run out quickly. Further, the changed economic environment and high degree of uncertainty increases the riskiness of these borrowers in the eyes of the banks, which might result in reductions of credit lines or non-renewal of loans at a time when external funding is most needed; where funding is not cut, higher risk could be reflected in higher interest rates or demands for additional collateral. Credit guarantees are supposed to counter these effects and help small businesses through these hard times, in line with the idea that the economy is to go into the freezer for some weeks or months but should roar back to life quickly once it is possible. Maintaining the productive capacity is key in this context.
Before discussing their effects, it is important to note that credit guarantees have been used for a long time by governments in the developed and developing world alike. Though their purpose has been traditionally a different one – trying to expand access to external finance among small businesses without sufficient access to bank finance. With this purposes, policy makers typically face the trade-off between additionality and sustainability, i.e., reaching firms that previously did not have access to external funding while at the same time minimising losses that arise from banks calling in guarantees. The track record is a mixed one, with problems ranging from limited take-up over administrative barriers to lack of limited additionality and unsustainable losses. However, there have also been quite some successful cases, as a growing literature has shown.
Back to credit guarantee as crisis management tool. The issue here is not additionality or sustainability, but survival. Guarantees are targeted at existing borrowers with the objective of guaranteeing their survival during the Great Lockdown and incentivising banks to extend as much financing as necessary. The challenge is one of speed – how to get cash as quickly as possible to firms affected by COVID-19. However, there are clearly still design issues and trade-offs to be considered. Underlying these trade-offs is the deeper issue whether liquidity support is really the ideal way to address what increasingly seems more like a solvency problem.
First, what should be the coverage? 100% (as in Switzerland) or rather 80% (as in the UK)? On the one hand, incentive theory tells us that banks should maintain skin in the game so that they keep monitoring borrowers. On the other hand, anything less than 100% loss coverage might make banks reluctant to lend in these uncertain times and might make them also slower in their lending decisions. The recent decision of the UK government to shift towards 100% guarantees clearly shows these problems.
Second, for how long will such guarantees last? As with containment policies, there is the question of an exit strategy. As our economies will slowly emerge from the Great Lockdown, it will become very clear that there are winners and losers (at least in relative terms). Capital reallocation to winning sectors will be important as will be to NOT keep zombie firms alive. Borrowing firms might not be able to repay loans quickly and might need additional funding during the recovery phase. There will be thus pressure to extend the guarantee scheme further. Converting many of these guaranteed loans into grants ex-post might be one way to address this challenge, which would be the ultimate recognition that the Great Lockdown implies solvency and not liquidity problems. There will be losses from these guarantee schemes, with government bearing all or large parts of them (which will bring some governments in the euro area into potential trouble).
While the ultimate reckoning can be delayed, it cannot be avoided. If we want to avoid the banking system turning into a utility channelling government funds to the private sector, it has to eventually recover its function as screener and monitor, deciding on credit allocation across sectors and firms according to expected risk-adjusted returns. There will be a clear trade-off between a quick recovery, with government continuing to be the ultimate guarantor and with an increasing contingent debt burden vs. a slower recovery with more pain but possibly returning eventually to a more sustainable growth part. Corporate restructuring programmes for small businesses, as used previously in emerging market crises, might be one valid policy option. Challenges that still seem far away but it is important to start thinking about them now.
26. April 2020