The conflict is upon us
The following contains strong political opinions. Reader discretion advised!
February 2022 will be marked in the history books as the start of a new conflict, or at least as the start of a new phase in a conflict. But, make no mistake – this is NOT a conflict between Russia and Ukraine, between Russia and NATO or between East and West – it is a conflict between democracy and authoritarianism. NATO did not expand to Eastern Europe to threaten Russia, but was joined by Central and Eastern European countries whose democratically elected government decided to join a defence alliance. NATO does not threaten Russia - or any other country for this matter. The hope that Russia will turn into a normal country has turned into realisation that it has rather turned into an authoritarian kleptocracy. It is Vladimir Putin who is afraid of democratically elected governments in neighbouring countries showcasing to Russian people that democratic societies are better off. That’s why he attacked Georgia in 2008 and Ukraine in 2014. And that is why he has supported authoritarian politicians and movements across the globe – the Leave campaign in the UK, Donald Trump in the US and Jean Marie Le Pen in France.
The best evidence that this is not about East vs. West are the people in Europe and the US who speak up in favour of Putin and his thugs. They are both on the left and the right of the political spectrum, on the extremes or beyond the extremes of the democratic groupings. In Germany, politicians of right-wing AfD and left-wing Die Linke have joined forces in defending Putin’s aggression. In the UK, it is both the Corbyn-wing of Labour and Nigel Farage who speak up for Putin. What ties them together is their hatred of democratic and transparent politics that has underpinned peace and prosperity in Europe over the past 75 years.
In hindsight it is easy to say that the West has been asleep with the threat becoming stronger and stronger over the past 15 years. The US has receded from its role as superpower, starting with President Obama leaving Syria to Russia and ending with President Biden withdrawing from Afghanistan. In between a US president who admired Putin and other strongmen and who often gave the impression that he somehow was on the payroll of Putin.
In hindsight it is easy to conclude that the line in the sand should have been drawn earlier; the more important it is to stand up now – the decision of the German government to suspend Nord Stream 2 is a first important step. One can only hope that the British government follows up and turns off the London money-laundering machine for Russian oligarchs – though given the deep penetration of the Tory party with Russian money, I am somewhat sceptical.
As in the 1980s, there are those who call for appeasement. They were wrong then and they are wrong now. As in 1938 one cannot appease dictators; one has to stand up to them! Democratic societies need dissent and I respect anyone’s right to disagree with me on the right strategy towards Putin. But strong democracies also need to defend themselves from being undermined by authoritarians. Putin has been successful in getting Trump elected and the UK leaving the European Union. He has infiltrated the political establishment across Europe, ranging from the former German chancellor Schroeder to former Italian prime minister Silvio Berlusconi. Cutting off the Russian money stream into European politics and societies will be critical to counter this new threat. Cutting off Russian money will be costly for the West but it is a price we have to pay to defend democracy!
22. February 2022
Bank business models – another JBF special issue
Differentiating between different types of banks (domestic vs. foreign, government vs. private, retail vs. wholesale, commercial vs. investment) has a long-standing tradition in banking research, but what are the implications for performance over the business and financial cycles and banks’ reaction to monetary policy and other shocks? A new special issue of the JBF includes six papers on the Americas, with some of the papers part of the BIS Consultative Council for the Americas (CCA) research project on “Changes in banks’ business models and their impact on bank lending: an empirical analysis using credit registry data” implemented by a Working Group of the CCA Consultative Group of Directors of Financial Stability (CGDFS). Herewith a quick run-down of the six papers, with more details in this editorial.
Using loan-level data from five credit registries in a meta-study, Carlos Cantú, Stijn Claessens, and Leonardo Gambacorta find that large and well-capitalized banks with low risk indicators, stable sources of funding and a commercial business model generally supply more credit. Focusing on one of these five countries, Mexico, Carlos Cantu, Roberto Lobato, Calixto Lopez and Fabrizio Lopez-Gallo find that higher capital, liquidity, profitability, long-term funding and deposit fund- ing mitigate the impact of shocks, while credit risk and foreign funding amplifies the impact. Using bank-firm loan level data for Colombia between 2006 and 2017, Paola Morales, Daniel Osorio, Juan Lemus, and Miguel Sarmiento find that loan growth and loan rates from banks with international presence respond less to monetary policy changes than those of domestic banks and that internationalisation partially mitigates the risk-taking channel of monetary policy.
The other three papers looks at regulatory changes and tools, including capital requirements, stress tests and internal vs. standardised models. Using quarterly bank-level data over 2009 to 2016 for Peru and exploiting the adoption of bank-specific capital buffers Xiang Fang, David Jutsra, Soledad Martinez Peria, Andrea Presbitero and Lev Ratnovski they find that higher capital requirements are associated with lower credit growth, but only in the short-run, while the effect becomes insignificant in about half a year. Exploiting the cut-off of $50 billion in assets for stress test requirements under the Comprehensive Capital Analysis and Review in the US, and using data between 2011 and 2016, Raffi Garcia and Suzanne Steele find that stress tested banks shift out of high-risk asset classes and into traditional lending, resulting in lower aggregate risk weights. Using data for Mexico, Mariela Dal Borgo finds that the probability of adopting an internal model for demand deposits rather than the standard approach is higher for banks with longer term deposits and for banks with higher capital requirements for credit and operational risks, while there is no evidence of capital constraints affecting the probability of adoption. Using an internal rather than standard approach also has implications for repricing of mortgages.
Together, these six papers show the wealth of questions that one can address with granular data available in most central banks and supervisory authorities, but also the multi-dimensionality of business models and the heterogeneous effect of changes in regulatory frameworks.
11. February 2022
Supranational cooperation and regulatory arbitrage
Fresh of the press, another paper in my long-standing research programme on cross-border supervisory cooperation and jointly with my long-standing co-authors Consuelo Silva-Buston and Wolf Wagner. Our previous paper showed that cross-border supervisory cooperation can help improve the stability of cross-border banking groups, but this relationship turns insignificant for very large cross-border groups. This new paper provides one possible explanation for that, but also answers to other questions. Specifically, we gauge the effects of supervisory cooperation between the parent bank supervisor and host country supervisor A on the banking group’s behaviour in subsidiary B. Considering the effect of supervisory cooperation on third parties also allows us to mitigate endogeneity concerns arising from addressing the effect of supervisory cooperation in the affected subsidiary.
Using data on 364 subsidiaries belonging to 113 banking groups across 116 host countries and 40 home countries from 1995 to 2013, we find that banking groups increase lending in a foreign subsidiary when the degree to which their other (foreign) subsidiaries are covered by cooperation agreements increases. The increase in lending is funded by debt and does not lead to higher profitability, suggesting higher risk-taking in the subsidiary. We show that the magnitude of the lending effect is higher when supervisory oversight and market discipline in the subsidiary country are weak relative to the other countries a bank group is operating in. We confirm our findings with syndicated loan data: loans are more likely to be given at third party subsidiaries if supervisory cooperation with parent bank and other host country supervisors increases, especially in the case of risky loans and risky borrowers. Taken together, our results indicate that supervisory cooperation agreements have negative externalities on third countries, as banks shift risks, undermining their overall effectiveness and suggesting a need to “cooperate on cooperation” across all parent and host country supervisors. And coming back to our previous paper, as regulatory arbitrage is easier done across larger banking groups with more subsidiaries across more host countries, this can explain why (incomplete) supervisory cooperation does not necessarily lead to stability gains.
Here is the VoxEU column discussing our paper.
9. February 2022
Bank complexity – a JBF special issue
Complexity of banks poses governance and regulatory challenges – the more complex, the harder to govern and monitor and the harder to supervise and resolve in case of failure. And especially global banks are mind-bogglingly complex, as first documented by Nicola Cetorelli and Linda Goldberg. But what are the implications of this complexity for performance and stability, both on the bank and the system level? And what drives complexity? The International Banking Research Network (IBRN), under the leadership of Claudia Buch and Linda Goldberg, used micro data and analytical advances to generate rich cross-country insights on the complexity and riskiness of banking organizations, with a selection of the consequent papers published in a recent special issue in the Journal of Banking and Finance and summarised in this article by Claudia and Linda. The special issue contains papers on banks in Colombia, Germany, Hong Kong, Italy, Norway and Spain, as well as a cross-country paper and a fascinating paper on the links between banks and shadow banking entities in Europe. The papers cover many different aspects of complexity, including geographic, organisational and business complexity.
Claudia and Linda point to four key findings of the research project: “First, the largest banks in countries tend to be the more complex ones. Yet, even controlling for size, there is substantial diversity across banking organizations in terms of complexity choices. Second, over the past decade, banking organizations have tended to reduce complexity by limiting the number of affiliates in both domestic and foreign locations. Generally, however, complexity patterns are fairly persistent. Third, regulatory changes can alter both banking organization complexity and the associated risk profiles. Fourth, the link between complexity and risks involves trade-offs: diversification benefits and reductions in liquidity risk may weigh against agency problems, monitoring costs, and systemic risk contributions arising from higher complexity.” Overall, a fascinating set of papers on a topic which will continue to pose challenges for academic and policymakers alike.
26. January 2022
The Russian Threat – Back to the 1980s?
I don’t write that often about foreign policy, but the current situation in Ukraine worries me and brings back memories from 40 years ago. I grew up during the height of the Cold War and many of my early political views were formed during the early 1980s. In 1979, NATO reacted to the military build-up of Warsaw Pact countries with the Double-Track Decision, which ultimately resulted in the deployment of Pershing II missiles in Germany in the 1980s (including close to my hometown). This in turn led to massive protests by the Peace Movement and bitter political conflicts (and also helped the rise of the Green party), but one can argue (as I do) that the tough position by the West ultimately contributed to the subsequent positive developments: disarmament talks between the US and the Soviet Union, the fall of the Communist bloc in Central and Eastern Europe and the Soviet Union, and the end of the Cold War. The European members of the Warsaw Pact as well as the Baltic states (previously part of the Soviet Union) are now members of the EU and NATO. The fear of mutual destruction, very much on the mind of many during the 1980s, has given place to peace, though possibly also a certain laxness about threats to Europe’s security.
Fast forward to 2022 and it seems that the Russian president Putin is not happy with the status quo and is pushing to create a two-class NATO by demanding withdrawal of NATO troops from any country that used to be part of the Warsaw Pact or the Soviet Union. It would undermine sovereignty of these countries that barely won their true independence 30 years ago. Mr. Putin argues that Russia feels threatened by NATO; it rather seems that he dislikes democratically elected governments in countries surrounding Russia, as this might provide a positive contrast to his own repressive regime. It is clear that none of the demands and actions by Mr. Putin is about Russia’s security, they are all about the security of his own autocratic regime. His aggressions against Ukraine mirror those against other neighbouring countries such as against Georgia in 2008.
It is clear that there is no immediate threat of war against Central and Western Europe; Putin’s regime is not interested in putting troops across Europe, as there are less costly (in human lives) ways to undermine democratically elected governments. The interference by Russia in the 2016 US elections and its (still opaque) role in the Brexit referendum point to a new modus operandi. Smaller states are being bullied, while in larger states, political influence is being bought and democratic institutions undermined. Cyber-attacks as recently against Ukraine and targeted terrorist attacks, such as in Salisbury, complement the toolbox.
One can also argue that Putin has been encouraged by changes in US foreign policy and the US-European relationships. As much as Trump stands out with his boot-licking of Putin and other strongmen, the slow withdrawal of the US as global superpower has started under Obama and his refusal to follow up on the red lines vis-à-vis the Assad regime in Syria when it used chemical weapons against its own people, effectively leaving this part of the world to Russia. The shift of US attention from Europe to Asia has also played a role. And it is clear that foreign policy is the one area, where Biden is not that different from Trump in approach (though very different in tone): he has made it clear again and again that he does not believe in foreign military interventions.
However, the weakest link in all of this seems to be Germany. The remarks by the navy inspector Kay-Achim Schönbach in a conference in India (“Putin just wants respect, let’s give it to him”) simply mirrors the thinking by many of Berlin’s political class who do not really see Russia as any threat; surprisingly, the Green party, 40 years ago at the core of the Peace Movement, is now among the more hawkish voices. The Nord Stream 2 pipeline is at the core of this ambivalent relationship between Germany and Russia, which focuses on economic interlinkages between both countries, with the former chancellor Schröder being chairman of Nord Stream 1’s shareholder committee. However, compromising the security of Europe for ‘economic’ gains, which ultimately will give the Russian regime another tool for blackmail, seems not only wrong but dangerous.
Unlike in the 1980s, there is no immediate threat of war in Europe beyond Ukraine. But, unless the ‘West’ draws a line in the sand and reacts strongly to any aggression by Russia, as minor as the incursion into Ukraine’s territory might be, this will only encourage further provocations and aggressions. Appeasement did not work in the late 1930s, the opposite of appeasement worked in the 1980s, and appeasement will not work in the 2020s! Those who do not learn history are doomed to repeat it!
23. January 2022
Will Video Kill the Radio Star?
Financial innovation tends to be disruptive; while bringing many benefits for consumers, it can also bring new sources of fragility, both related to new products and providers and to the retrenchment of incumbent providers. I have written on both aspects before, both on the growth and fragility effects of financial innovation as on one specific innovation. With several colleagues at the Advisory Scientific Committee and the Secretariat of the ESRB I have been working on a report that gauge the possible impact of digitalisation and the financial innovations it has brought with it on banking in Europe.
Given the entry of new providers, incumbent banks face competition across different business lines, and disintermediation may result in losses of scale and/or scope economies. Banks typically expect fintechs not to threaten their incumbency, albeit with some need to buy out innovators to sustain this position. With bigtechs, however, incumbent banks could react in different ways, depending on how big techs go about expanding into financial service provision: by establishing subsidiaries or cooperating with incumbent banks. The former approach would constitute a direct challenge for incumbent banks, which might react by increasing their risk profile to defend their position. Cooperation seems less disruptive, although it would also likely erode the rents that incumbent banks have enjoyed until recently, potentially rendering many of them unviable in their current business model.
New providers entering with bank-like intermediation models would be exposed to the known risks in banking (liquidity risk, credit risk, market risk, etc.), affecting, in turn, system-wide risk. While more competition could enhance stability over the long term, concentration (particularly with big techs) could result in new too-big-to-fail institutions, and a stronger focus on transaction-based intermediation could make the system more procyclical. Furthermore, incumbent banks may take greater risks to compete with new providers. Cooperation between big techs and incumbent banks might lengthen intermediation chains, moving them towards the originate-and-distribute model, which raises concerns about incentives and risk distribution.
In addition to financial risk, digitalisation also poses significant non-financial risks, both for banks and for fintech and big tech companies. These risks stem from (i) greater concentration on providing basic services, such as cloud computing; (ii) broader use of artificial intelligence (AI) in finance; (iii) overly automated or IT-oriented services that may be more prone to cyberattacks; (iv) trust in a leading technology that might suddenly turn obsolete; and (v) a false sense of security from overleveraging insights from AI.
The report then presents three scenarios for the EU banking system in 2030 as a basis for discussing the appropriate macroprudential policy responses: (i) incumbent banks continue to dominate and maintain their central role in money creation and financial intermediation, (ii) incumbent banks retrench, while bigtechs offer financial services through regulated subsidiaries and capture the hard data, transaction-based lending market, (iii) the issuance of retail central bank digital currencies can lead to a very different structure of the financial system, with incumbent banks facing higher funding costs and a more volatile funding base, as the traditionally stable retail deposit clientele might switch to the digital currency.
The analysis and three scenarios give risk to a number of macroprudential policy recommendations:
Here is the Vox column that summarises the main messages.
19. January 2022
Have banks caught Corona?
One of the papers I co-authored during the Covid crisis was just accepted at the Journal of Corporate Finance. In this paper, with Jan Keil, we exploit geographic variation in the exposure of US banks to COVID-19 and lockdown policies using branch network and branch-level deposit data to gauge the effect of the pandemic on bank stability and lending. First, we find that banks geographically more exposed to lockdown measures experience an increase in loss provisions and nonperforming loans. Exposures to the pandemic itself have a similar, but slightly weaker effect. Second, we observe an increase in small business lending driven by government-guaranteed loans which seem to replace regular loans. Interestingly, lenders more exposed to lockdown measures rely more on government-guaranteed loans – even when controlling for borrower exposure. Finally, we observe a reduction in the number and average amount of syndicated loans for banks more affected by the pandemic, as well as an increase in interest spreads. Overall, these findings point to a negative impact of the pandemic on the supply side of finance, to previously unknown side effects of government support, and to the critical role of banks in channeling government support measures to small firms. On a final note, while the original title of the paper was: Are Banks Catching Corona?, we decided to change it to: Have Banks Caught Corona? to reflect that the initial effect of the pandemic has certainly turned into longer-term effects on the banking system, a challenge I have written extensively about in other context.
13. January 2022
Brexit – a new season with the same themes
The last season of the Brexit soap opera ended with David Frost resigning from his position as provocateur-in-chief of the UK government vis-à-vis Brussels. The new season has started with Liz Truss taking on the role and repeating the same mantra again: “Brussels, give us what we did not get two years ago or else we trigger Article 16.” Over the past year or so, triggering Article 16 of the Northern Ireland has taken on the role of some golden-calf for the Brexit movement, similar to what used to be No-Deal Brexit and the WTO option.
As I have written many times before, Brexit will never quite be done and we can expect many more seasons to come. There are three main reasons for that: one, the European Union continues to be the biggest geographic and economic neighbour of the UK (I know this sounds like a trivial statement but sitting in London one has to remind oneself of this constantly) and for any UK government, the relationship with Brussels thus has to top the policy agenda. Two, given the obsession of part of the Tory party and right-wing media complex with Europe, this will thus not go away. And even though the Economist reports that frictions within the broader population are starting to heal, the political usefulness of using Brussels as scapegoat for anything going wrong in the UK is still there. Three, the situation in Northern Ireland is far from settled; while the Northern Ireland Protocol is a useful compromise and its overall structure is finding more and more support in Northern Ireland itself, it is far from completely defined and will constantly provide a basis for new arguments between London and Brussels. This tension is further fuelled by the political interests of the unionist movement in the province and the Brexiter movement in London, neither of whom seem to be interested in the practical workings of the protocol, but rather in political symbolism. These tensions will certainly increase further in the run-up to the next elections in the province in May 2022 and beyond.
I can only see two ways out of the Northern Ireland tension: one, a unification of the province with the Republic of Ireland (certainly not an easy process) or, two, the UK moving considerably closer to the EU, becoming a member of the Single Market in goods in all but law. In the short-term, however, neither seems on the horizon, so further tensions are to be expected. Triggering Article 16 will certainly not bring the resolution that Brexiters are hoping for and will certainly not get rid of the Northern Ireland Protocol. On the other hand, Brussels has clearly indicated that any actions by the UK government that go beyond any immediate concerns or needs might trigger quite some strong response by the European Union.
Which brings us back to the vicious cycle that the UK finds itself in. As the damage that Brexit has brought on the UK economy is becoming clearer, the incentives to trigger yet another conflict with Brussels as dead cat strategy are rising; this in turn, however, can make the situation even worse (most recent exhibit: U.S. steel tariffs have been lifted for the EU but not the UK, most likely related to the ongoing uncertainty about Northern Ireland the UK government’s plans). In sum, Brexit has not only made the country poorer, but through an ongoing process of grandstanding and victimhood, Brexiters keeping digging the hole deeper and deeper.
11. January 2022
Macro-financial policy in the UK
Some time ago I was asked to contribute a paper to the Asian Monetary Policy Forum 2021 Special Edition and MAS-BIS Conference on "Macro-financial stability policy in a globalised world: lessons from international experience”, held virtually last May. Joint with three co-authors from the Bank of England – Simon Lloyd, Dennis Reinhardt, and Rhiannon Sowerbutts- we contributed a paper that combines a description of the post-GFC supervisory structure in the UK, a discussion on the UK’s position as an international financial centre, and the implications for inward and outward spillover effects of monetary and prudential policy actions and an empirical analysis of the effect of monetary policy surprises in the UK on cross-border lending towards other countries. The Global Financial Crisis led to a restructuring of the monetary and prudential policy architecture in the UK, with bank supervision returning into the fold of the Bank of England. The monetary policy committee is responsible for monetary policy, the prudential regulation committee for microprudential regulation and the financial policy committee for macroprudential regulation; while separate committees, there is a heavy overlap in terms of members. Such overlap can be helpful in crisis situation, as the coordinated policy response in March 2020 showed.
The special role of London as international financial centre means that it is highly connected with the rest of the world. These connections alsogo beyond service trade linkages. The UK is host to over 200 international banks, and UK-based banks – spanning foreign branches and subsidiaries – have over $5 trillion in cross-border claims. This has implications for the policy making of the FPC and its stress testing framework. About half of the possible GDP stress in the FPC’s Annual Cyclical Scenario are due to external factors.
In a final part of the paper, we combine panel data on UK-based banks’ cross-border lending with UK monetary policy shocks and macroprudential policy actions based on data from the IMF’s Integrated Macroprudential Policy (iMaPP) Database. We find that a surprise UK monetary policy tightening significantly reduces UK-based banks’ external lending growth, but ab additional prudential policy tightening action in the recipient country, in advance of a surprise UK monetary policy tightening, can partly offset spillovers to lending growth. We also find that these effects are primarily driven by foreign-owned branches and subsidiaries. Differentiating between different types of macroprudential policies, we find that cyclical prudential policies affecting particular loans and in particular housing loans can act to significantly offset the effect of UK monetary policy shocks, while other policies, including counter-cyclical capital requirements, are not effective. In sum, and in line with other papers, we find support for the thesis that (macro)prudential policies can help insulate countries from the global capital flows cycles.
7. January 2022
Price controls and inflation
Microeconomic theory tells us that price controls, be they price ceiling or price floors, might have the intended effect on pricing, but can lead to adverse reactions in supply and demand, leading to pernicious short- and long-term consequences. We have also learned, however, that what the simple theory tells us does not necessarily hold in a more complex setting. Best example are minimum wages, where a large share of economists have moved away from a clear stance that minimum wage reduce employment (especially among less skilled workers) to a more nuanced position, based on theory (e.g., monopsony position of employers) and empirical evidence (here one recent paper on Germany). By now, many (though not all) economists agree that minimum wages can have beneficial effects up to a certain level. Can a similar argument be made about price ceilings? Isabella Weber recently put the case forward for strategic price controls to fight inflation, pointing to an explosion in corporate profits based on windfall gains from supply chain problems. The proposal has met with rather strong if not dismissive opposition. As so often in economics, the reality is much more complicated!
The question of price controls came also up during the early days of the pandemic, as the supply of toilet paper turned out to be limited. I remember a heated discussion in my April 2020 MBA class on whether a shortage of toilet paper justifies price controls, given the nature of toilet paper as necessity (as it turned out, the shortage was a temporary one, as companies had to switch production from toilet paper rolls used at offices to toilet paper rolls used at home). There are market arguments for simply allowing the demand and (constrained) supply determine the market price, but given the social importance of toilet paper, also arguments for some rationing and price controls.
The argument put forward by Isabella is obviously a different one: using price controls for strategic goods that drive the current inflation until the supply-chain problems have been sorted. Unlike the classical microeconomic arguments on price caps (nicely illustrated in the well-intentioned recent rent cap in Berlin that might have solved rental problems for some but exacerbated them for others), Isabella’s argument uses a microeconomic tool for macroeconomic purposes. Even though there might be good arguments and some historical parallels for that, I am sceptical. First, it is not clear that corporate profits drive the high prices (as opposed to being simply a consequence of them) and price controls will therefore simply reduce prices at the same supply or rather might reduce supply even further. Further, price controls might undermine incentives for addressing supply chain problems and prevent new entry into markets. Second, who decides which prices to cap and which not – a purely technocratic decision or a political one? The problem with ‘strategic’ is that different actors have a very different understanding of it and politics is hard if not impossible to separate from economics. Third, the current situation is characterised not only by pent-up demand but also the need for reallocation of resources and thus relative price changes – as the experience of the transition economies has taught us, this requires higher inflation than usual. There are other arguments, nicely summarised by Noah Smith.
Where does this leave us? I would not exclude price controls in extraordinary and very time-limited circumstances, but it seems as economic policy tool it is rather risky if not outright dangerous. If the problem is really monopolistic market structures and supply-chain problem, addressing these would certainly lead to a more sustainable solution, both on the micro- and the macro-level. As already argued above, price controls might actually reduce pressure and incentives to achieve sustainable solutions.
5. January 2022
To a Better 2022!
I had plans for several blog entries in December, but as so often, this last month of the year turned out a bit more hectic than expected. But there is so much to write about in the new year, including about two forthcoming special issues in the Journal of Banking and Finance and about several new papers that my co-authors and I are about to finish. Then there is the sad story of the British polity, with its corruption, rule-breaking, and failing state, while there are high (maybe too high) expectations for the new German government. As we enter the third full year of Covid-19, all the optimism from a year ago is gone, with omicron spreading quickly and country after country going into another lockdown. But on a positive note, I have been lucky to have been able to work again in a regular office over the past four months, interacting daily with my colleagues in the beautiful Tuscan hills. I also count myself lucky to have attended two conferences in person this fall and meeting again friends and colleagues.
Hope springs eternal: to a better 2022 and a more stable new normal!
22. December 2021
Bank crisis management – what next?
Last week saw the virtual conference on Bank Crisis Management – What Next?, jointly organised by the Florence School of Banking and Finance, SAFE Frankfurt and the Single Resolution Board, with seven papers covering a wide range of topics related to the title of the conference and a keynote lecture by Manju Puri who – among many other jobs and honours – was at some point Chief Economist of the FDIC. A short summary of the papers, with some (maybe provocative) policy conclusions.
Diana Bonfim and João Santos show the importance of deposit insurance credibility, i.e., the importance of a credible sovereign backstop, using data from Portugal and exploiting the fact that some foreign banks changed their status in Portugal from subsidiary to branch status during the European sovereign debt crisis, which implies that their Portuguese deposits became subject to the deposit insurance scheme of countries with lower sovereign risk. They show an increase in deposits after the shift in status, suggesting that depositors do care about the credibility of their deposit insurance and thus sovereign backstop. An argument for European deposit insurance to break the link between banks and sovereign and move towards a truly European market in banking.
Christian Muecke and co-authors gauge the effect of a disciplining tool in the US to 'convince' bailed-out banks during the Global Financial Crisis to pay dividends to Treasury on its capital injection: pay up or accept Treasury-appointed board members; specifically, if a bailed-out bank missed six quarterly dividend payments, the US government had the right to appoint independent board members. The incentive was effective as many banks missed no more than five dividend payments (maximum before the appointment of board members) but also the stick helped, as board appointments by the Treasury helped improve bank performance and reduce risks. Results clearly show that incentives can work in crisis resolution and that bailout funds should not be given without conditions.
Mathias Dewatripont and co-authors discuss to which extent the resolution model of Single Point of Entry (SPE) (where losses are upstreamed to the parent bank, while capital is downstreamed to subsidiaries if needed) can counter regulatory incentives of host authorities to ringfence a subsidiary during times of crisis. They argue that an SPE model is not sufficient, as the regulatory authorities of subsidiaries have a legitimate incentive to maintain measures to safeguard the corporate interest of subsidiaries as long as the support to be expected by the parent company remains uncertain. What is needed is (i) the formalisation of the nature of the parent support through a burden sharing agreement and (ii) the introduction of a hierarchy of creditors within groups, which would be aligned on the implicit hierarchy of creditors prevailing under the SPE strategy. Another strong argument illustrating that the European banking union is far from complete.
Alessandro Scopelliti and co-authors focus on the introduction of bailinable bonds, an important component of regulatory reforms in the last decade aimed at reducing the likelihood of future bailouts. Exploiting granular data on banks’ securities holdings they find that banks hold more bailinable bonds issued by other banks and issued by other parts of same group. In addition, there is a clear home bias, as banks hold primarily bailinable bonds by other banks in the same country. Clearly not what was intended and an indication of an incomplete reform!
The paper by Orkun Saka and co-authors explores governments’ financial sector policies after crises. They show that financial crises can lead to more government intervention and a process of re-regulation in financial markets. However, some of these interventions might not necessarily be in the public interest, as democratic leaders who do not have re-election concerns are substantially more likely to intervene in financial markets after crises, in ways that promote their private interests, with pay-offs in the form of financial sector jobs after their government tenure. Lesson: Post-crisis reforms are important, but it is crucial to consider the incentives of those who propose and implement them.
Sascha Steffen and co-authors explain the heavy decline in banks’ stock prices during the early part of the pandemic. They show that the decline in banks' stock return during Covid-19 is primarily driven by liquidity risk. Specifically, stock prices of banks with large ex-ante exposures to undrawn credit lines and large ex-post gross drawdowns declined more, especially of banks with weaker capital buffers. This also had consequences for banks’ behaviour as these banks reduced new lending, even after stabilization policies and even if drawdowns were accompanied by deposit inflows. Clearly a justification for the increasing focus on liquidity in addition to solvency risk in banks.
Miguel Faria and co-authors show the macroeconomic consequences of evergreening of bad loans by banks, using both theory and empirical evidence with loan-level data from the US: low-capitalized banks systematically distort their risk assessments of firms to window-dress their balance sheets and extend relatively more credit to underreported borrowers, with negative economic consequences, in the form of lower firm entry and lower aggregate productivity. Clear evidence of distortive incentives provided by low bank capital and the negative consequences of zombie lending!
Finally, in the keynote lecture, Manju Puri discussed the role of private equity (PE) investors after the 2008 crisis. Using proprietary failed bank acquisition data from the FDIC combined with data on PE investors, she and her co-authors find that PE investors made substantial investments in underperforming and riskier failed banks and where there are few healthy banks as alternative acquirers. They find a positive impact of PE acquisition on bank performance and local economic recovery. While the results are for the US, an interesting and important lesson for Europe, where we still have a steep learning curve ahead of us in terms of bank resolution.
Note: this blog entry was also published on the FBF website.
26. November 2021
The new German government
The mood was very different yesterday when the negotiators of the future German coalition (referred to as traffic light coalition, in line with the parties’ colours red, yellow and green) presented their coalition agreement than in early 2018 when the last government presented its programme. Back then, the renewal of the ‘grand coalition’ of Christian and Social Democrats was seen as second-best solution, after a Jamaica coalition (black, yellow and green) failed in negotiations. Lots of novelties this time around: a social democratic chancellor after 16 years of Angela Merkel (Christian Democrat) and one who few gave any chances just half a year ago; a female foreign minister for the first time in German history and a FDP minister of finance (for the first time in almost 60 years). It is the latter that has been of most concern for many economists inside and outside Germany and rightly so, even though given a social democratic chancellor and a green ‘super-minister’ of economy and climate change, one wonders how powerful Christian Lindner will be. The FDP (I try to avoid calling them liberals, as this description is too generic for a rather small party, with lots of liberals across the German party spectrum) wants to return to the fiscal policy rules and constitutional debt brake as soon as possible, which would imply a strong fiscal brake on the German (and ultimately European) recovery process; it is more, one can easily envision a scenario where such fiscal tightening will lead to a similar situation as in the early 2010s, not exactly the most glorious hour of economic policy making in Europe (to put it mildly). It certainly is not in line with the new government’s investment plans, which implies some playing around with the rules (through trust funds and special budgets); it will certainly be interesting to see the 2022 budget and the actual squaring of the circle. At the same time, there are signals of flexibility with European fiscal rules. And there is an explicit recognition that the ECB can only fulfil its mandate of price stability if fiscal policy plays its rule; this phrase can obviously be interpreted in many different ways but if clearly shows recognition that fiscal and monetary policy can no longer be regarded as completely independent from each other. And the establishment of some form of European deposit insurance (at least through a reinsurance scheme) is mentioned. So, positive signals even though a government without the FDP would have sent even stronger ones, one can assume. A sidenote for Brexit observers: clear support for the Northern Ireland Protocol and the principle that pacta sunt servanda; on the other hand, no mentioning of the German car industry in this specific circumstance to ride to the UK’s support, as has been awaited for so long by Brexiters 😀).
One final interesting note is that the SPD will get to nominate the next president of the Bundesbank, which suggests not only a simple change of guards in Frankfurt, but maybe also a new style and new role for the Bundesbank president within the ECB governing council. Given that the FDP secured the Ministry of Finance, this development is no surprise.
25,. November 2021
Covid-19 and Banking – Special JBF issue
There has been an explosion of papers gauging the effect of the pandemic on the financial sector and assessing different policy responses. Some of them have now been published in a special issue of the Journal of Banking and Finance, under the guidance of four outstanding guest editors (Allen Berger, Asli Demirguc-Kunt, Fariborz Moshirian and Anthony Saunders).
As pointed out by the guest editors in their editorial, the pandemic has resulted in the most significant global disruption since the Second World War. While it did not start in the financial system (unlike the Global Financial Crisis), financial sectors across the globe were as much affected as other sectors; at the same time they played an important role as transmission channel for government support programmes.
While the editorial gives a nice overview of the different papers, let me point to some highlights. First, many papers have been written about the US, some about Europe, but the special issue contains several interesting cross-country studies: Gönül Ҫolak and Özde Öztekin show that bank lending is weaker in countries that are more affected by the health crisis, but that there are important interactions with market structure and regulatory framework. Yuejiao Duan and co-authors find that the pandemic has increased systemic risk across countries, but is moderated by bank regulation and higher trust. Iftekhar Hasan and co-authors use global syndicated loan data and find that loan spreads rise by over 11 basis points in response to a one standard deviation increase in the lender's exposure to COVID-19 and over 5 basis points for an equivalent increase in the borrower's exposure.
Second, Erik Feyen and co-authors introduce a new global database (still updated on a regular basis) and a policy classification framework that records the financial sector policy response to the COVID-19 pandemic across 155 jurisdictions and over time and explore what drives cross-country differences in policy implementation.
Third, what has been the role of different types of banks during the crisis? Chris James and co-authors show for the US that small banks responded faster to Paycheck Protection Program (PPP) loan requests and lent more intensively to small businesses than larger banks, which suggest that community banks remain an important conduit for small business credit particularly during crises when a rapid response is required; a clear indication that relationship lending can be helpful in crisis situations, as shown in my own work for the Global Financial Crisis. And interestingly, Mustafa Karakaplan finds that these loans were not substitutes but rather complements to regular small business lending, with a multiplier effect of one dollar of PPP credit on conventional loans to the smallest firms of about an extra dollar.
I am sure that this will not be the end of the research programme on the effect of the pandemic. There are lots of more issues to explore, including the exit from the different support programmes and the effect of asset reallocation in a post-Covid world and corporate overindebtedness on banks. I am sure we will see some of these papers in the JBF!
14. November 2021