How case law has helped shape the banking union
When discussing the creation and development of the banking union, one important actor has often been ignored – the courts. The General Court and the Court of Justice of the EU, however, have taken several important decisions, over the past 10 years. In a recent paper, with Christy Petit, for the ECON committee of the European Parliament, we discuss some of the most relevant cases and their implications for the development of the banking union.
The cases concerning the SSM speak to its exclusive competence: (1) in determining an institution as significant or less significant (2) in supervision of both significant and less significant institutions and (3) in leading common supervisory procedures, once again, regardless of their significance. The courts have affirmed the ECB’s exclusive competence over prudential supervision for both significant institutions (and less significant institutions, in granting and withdrawing licences and qualifying holdings procedures in several instances.
Turning from supervision to resolution, the Single Resolution Fund (SRF) ex-ante contributions have given rise to extensive litigation. Banks have challenged the Single Resolution Board (SRB)’s decisions on these contributions relatively with success. The General Court has annulled several of these decisions, particularly those from 2017, 2021, and 2022, mostly on procedural, rather than material, grounds.
A recent case seems to revive the Meroni doctrine, which constrains the delegation of powers and discretion to EU agencies. This case, alongside earlier litigation on the resolution of Banco Popular Español, addressed the complexity of resolution decision-making.. Importantly, the Court of Justice determined that the European Commission, not the SRB, is the entity responsible for endorsing the resolution scheme, reinforcing the distinction between EU institutions and agencies.
In sum, the CJEU has followed an EU integration approach as regards the systems for banking supervision and bank resolution; however, it may have also ‘revitalised’ the Meroni doctrine by identifying the decision-maker liable as an EU institution (Commission) and not an EU agency (SRB). The important role of litigation of new laws, regulations and institutions reflects the nature of Europe’s legal system, where (unlike Napoleon’s vision), legislators cannot always design brightline rules and foresee all contingencies. In this regard, well-functioning judicial review in the BU arena also reinforces the accountability of European institutions and agencies in a very furnished area of EU Law.
4. November 2024
Emerging risk and macroprudential policies – a conference report
Late September saw the 8th Annual ESRB conference, which focused on emerging risks and their implications for macroprudential authorities. One interesting panel discussion, which I had the honour of chairing, was on how to deal with heightened uncertainty within the macroprudential framework.
In discussions on systemic risk and macroprudential policies the focus has often been on endogenous risks, including credit boom and bust cycles, one of the core factors during the global financial and eurodebt crises. However, over the past five years the focus has been more on exogenous shocks, which come from outside the financial sector but affect it through a number of channels. We are living in a volatile world! At the same, there are transformational changes in the modern economy, including the financial system that create uncertainty on how the financial system will change and thus the transformation channels through which such shocks can affect the financial system.
We often focus on trends when discussing the near and farther future, but non-linearities including trend breaks, quantum jumps and tipping points are as important. Relying on past data to extrapolate to the future might thus not be possible. One such important trend is digitalisation, including artificial intelligence (AI). In her opening speech, Mme Lagarde talked about the opportunities and risks that rapidly developing digital technology presents, including AI. We also often talk about the double transition in the EU (to net zero and digital) and the demographic changes affecting Europe. But how will these trends play out and interact with each other? In addition, and as already mentioned, this still young decade has offered a number of shocks, starting with the pandemic, the economic fallout and the Russian aggression, part of larger geopolitical tensions that Claudia Buch also referred to in her keynote speech.
In sum, emerging risks are no longer what they used be. We are living in a period of polycrisis and heightened uncertainty. There are known unknowns and unknown unknowns, although one of the panelists on ‘my’ panel did predict back in 2012 that a pandemic can hit us in the following decade. And while the focus is currently on geopolitical risks, including a widening of the Russian invasion and possible conflict in Asia, it would be wrong to limit the attention to geopolitical risks. There is a certain likelihood of another pandemic or serious climate disruptions. And geopolitical tensions can result in cyber-attacks, trade wars and domestic political disruption within European countries (Germany is the best current example based on recent elections results).
Given the global nature of trends and shocks , there is a need for international governance to address these shocks, but it is more difficult to achieve such structures (or even maintain where they exist) given current geopolitical tensions; with international institutions substantially weakened and transition into a multi-polar geopolitical system, there will be stronger emphasis on regional grouping, which makes European unity even more important.
Given these circumstances, the ESRB has put uncertainty and how macroprudential authorities can react to it as one of the work programme priorities, I have the honour to co-chair a working group on heightened uncertainty and macroprudential policy, together with Edouard Vidon from the Banque de France. This work stream has opened a whole new world for me, including horizon scanning, forecasting, forethought and building scenarios that might not be probable but plausible. It is less about predicting the future but imagining possible alternative futures and how they can affect society and economy. And, more specifically, about the channels through which they can affect the financial system and financial stability. One important element of such discussion is the diversity of people involved in developing scenarios to avoid group thinking. Or as Mme. Lagarde recently said, we have to look beyond the tribe of economists.
30. October 2024
A Nobel Prize for the institutions and growth literature
A Nobel Prize for Daron Acemoglu was always a question of when, not if. I am very happy to see it given for the work by him, Simon Johnson and James Robinson on the role of institutions and economic development. And yes, there are sceptical views (nicely summarised by Dietz Vollrath) on the details of how to measure institutions, the identification strategy and even doubts on some of the data. But the conceptual and theoretical framework and the sum of different studies and historic settings is still quite overwhelming and convincing. As pointed out by others, this is not just a prize for an important line of economic research but also a strong message that democratically-based institutions protecting citizens from government expropriation and enabling and enforcing contracts between private citizens are important. An indispensable message in today’s world, where autocrats are attacking the very foundation and philosophy of democratic freedom.
The foundation of the work by Acemoglu, Johnson and Robinson (henceforth AJR) is the hypothesis that institutions governing national economies and societies are determined by national political and economic elites (often the same). Outside a few democratic societies, entrenched elites will shape the institutions in their interest to maintain their economic and political power. Changes in these power structures come about through exogenous shocks; such as colonisation, Black Death or the European discovery of the Americas. Maybe one can add technology which can radically change market structures and thus relative market power (incidentally the work by Kroszner and Strahan showing that the introduction of ATMs/cash machines undermined local market power of banks in the US and thus their willingness to fight for local branching restrictions led to branch deregulation with positive effects for financial and economic development is an earlier example of how such shocks can disturb existing power structures in finance).
AJR were not the first one to explore empirically the relationship between institutions and economic development, but they reinforced an important trend in economics in the sense that it has moved the profession away from the (now clearly naïve) thinking that the right economic policy recommendations will make countries grow faster. Rather, economic policy formulation and implementation is clearly a function of the interests of the ruling elites. This also implies that no matter the policy conditionality ‘imposed’ by World Bank and IMF, the actual institutional framework governing economies and societies will not change. I could provide many anecdotal examples for this, but will save them for a book that I hope to write eventually.
On a personal level, AJR’s work has motivated also my own research along several dimensions. The clearest link is a paper with Luc Laeven on the role of institutions in the transition process of the formerly Socialist countries of Central and Eastern Europe. In this paper we use geographic and historic variables as drivers for the speed with which transition economies can build up inclusive institutions, including the Rule of Law. Specifically, we show that countries with higher reliance on natural resources and with a longer time under Soviet dominance are slower in building up institutions and therefore also grow more slowly.
AJR’s work has also provided an important impetus for the literature on the historic determinants of financial development. While the law and finance hypothesis has focused on the legal tradition that countries inherited, either through occupation or colonisation, the endowment hypothesis argues that it is countries’ history as settler or extractive colonies in the past that determines the development of an institutional framework supporting thriving and efficient financial systems. In work with Asli Demirguc-Kunt and Ross Levine, we show that both the law and finance and the endowment hypotheses can explain cross-country variation in financial development. However, these hypotheses might also interact, as showy by by Oto-Peralis and Romero-Avila .
In a paper, published in 2013 , I contrast three different views on the determinants of financial sector development; the policy view (focusing on macroeconomic stability and an effective contractual framework), the political view (the relative power of different interest groups determines policies that underpin an efficient financial system) and the historic view described above. These three views, however, are all related to each other – historic and geographic structures determine political structures today, which in turn influence the (lack of) adoption of policies to support the development of a stable and efficient financial system.
In sum, while some might say the prize has been given too early, it recognises not only an important and influential strand of economics, but also one of the most prolific economists of our times, Daron Acemoglu. Artificial intelligence has played an important role in this year’s Nobel Prize awards, as reported by the FT. Well, Daron is also working on this. I would not be surprised if he would be the first economist to win the Nobel Prize twice (if that is possible at all).
21. October 2024
Supranational cooperation and regulatory arbitrage – now forthcoming in Review of Finance
After a long process, Consuelo, Wolf and I have published what is the fourth paper in a series of studies on cross-border supervisory cooperation. In a previous study, we show that cross-border cooperation between supervisors of parent bank and subsidiaries (home and host countries) is positively associated with banking group stability, except for the largest banks on the globe. We identify a possible reason for why this finding does not hold for the largest banks in this just accepted study: regulatory arbitrage. Specifically, banking groups allocate lending activities and risk into third-country subsidiaries when cooperation agreements cover their operations in other countries. This relationship is also economically significant: a one-standard-deviation increase in cooperation coverage between parent and other host countries increases subsidiary lending on average by 15%. Our results with loan volume data on the subsidiary level are confirmed with syndicated loan data: we find that the probability of allocating a specific syndicated loan to a particular subsidiary increases in the supervisory cooperation coverage of the rest of the banking group.
We also provide evidence suggesting that third-country risk reallocation is motivated by higher supervisory stringency induced by cooperation and internalisation of externalities from cross-border activities following cooperation. We also find that risk reallocation is more limited when the subsidiary country has stricter supervision and better market discipline relative to other countries in which the group has foreign operations.
Our findings have a simple policy message. Actual cooperation among banking supervisors, though frequent, does not sufficiently cover banks’ global operations. This undermines the global effectiveness of cooperation due to regulatory arbitrage. The latter may result in lower financial stability in non-cooperating host-countries as risk may be moved into their foreign subsidiaries (we stay quiet on whether some countries might actually want to attract such risk). For instance, some countries with a high presence of international banks, such as several Eastern European countries, are very exposed to regulatory arbitrage. By making cooperation less effective at the group level, regulatory arbitrage also imposes costs on parent countries as they may need to support foreign subsidiaries when in distress. To prevent these negative consequences, supervisory cooperation should aim at better matching the geographic perimeter of important global banks, to prevent gaps in the cooperation landscape and resulting regulatory arbitrage.
And to link back to my initial remark on why cross-border supervisory cooperation is not necessarily stability enhancing for the largest cross-border banks: these are the ones with subsidiaries in many countries and thus more possibilities to shift risk into third countries in the wake of increasing cross-border supervisory cooperation.
14. October 2024
The financial sector agenda for the next Commission
My colleagues Maria Ana Barata and Valerio Novembre and I have just published a policy paper on the priorities that European financial sector policy makers should focus on during the next five years. Specifically, we discuss the progress that has been made in several areas, including in digital finance, anti-money laundering and micro- and macroprudential regulation, as well as areas where progress has stalled; most prominently in completing the Banking Union and building a Capital Markets Union, now also known as Savings and Investment Union. Both areas area also prominently mentioned in the mission letter for the new Commissioner-designate for financial services Maria Luis Albuquerque, but it will require significant investment of political capital from the Commission and a Coalition of the Willing. I have discussed these challenges in previous blog entries.
We also note several areas where additional regulatory and supervisory efforts have to be made, including artificial intelligence, digital financial literacy and green financing. First, the opportunities and challenges arising from digitalisation more generally, and AI more specifically, are developing rapidly as the technology is progressing swiftly. There are opportunities both for market players in the financial system and regulators and supervisors (e.g., RegTech, SupTech and ResTech) , but the increasing trend towards digitalisation make the financial system more vulnerable to cyber- attacks and computing outages, which requires more active supervision. Second, the progress in digital innovation makes one think of opportunities for strengthening financial literacy and inclusion, but also of challenges, including increasing incidents linked to fraud, over-indebtedness, cyber threats and discrimination in the EU. Efforts from both regulators and the industry are needed in this area. Finally, estimates of financial needs until 2030 point to €620bn per year for the green transition and €125bn per year for the digital transition, far above the fiscal policy space in the EU. Finance for the twin transitions will thus need to be sourced mainly from financial markets, including from non-bank financial sources.
Although the financial sector is currently not necessarily at the centre of the challenges faced by European economies and societies and thus not automatically at the top of the policy agenda in Brussels, it is important to note that the financial sector can play a critical role in addressing these challenges. However, the financial sector itself has to adjust in order to be able to play this critical role; most importantly, there is the urgent need to create a truly Single Market in finance, which currently does not exist. As I have argued in several occasions, national interests loom almost too large for making true progress. While the crisis situation that led to the initial push for the banking union is missing, a clear link between Europe’s societal and economic future and a Single Market in financial services can and has to be made to overcome national interests.
7. October 2024
Supervisory culture – a conference report
Last month, I participated in a fascinating conference on supervisory culture and effectiveness at the ECB. Academic economists have focused mostly on bank regulation, although there have been several recent studies on the effect of stress tests, distance between supervisors and supervised entities, and specific supervisory decisions (see this paper for a great literature survey). But how do we define and measure supervisory culture, including the general organizational culture that can drive supervisory effectiveness? This is not just an academic question, but critical to assess the performance of supervisors and to inform the broader public interested in financial stability (and to evaluate the compliance with what one speaker called the social contract between supervisors and the general public).
To start with the most important question and conclusion: Is there a specific catch-all metric to measure and benchmark supervisory efficiency? There was general agreement that there is none. And if there were one, Goodhart’s Law would apply, which states that when a metric becomes a target, it ceases to be a good metric. Some suggested that one metric to consider would be how quickly banks comply with supervisory interventions – however, this is certainly endogenous to banks’ initial behaviour and supervisory reactions to such behaviour. Another proposal would be the Basel Core Principles (BCP), but these are qualitative assessments (and high scores are not necessarily linked to higher bank stability, as this paper by Demirguc-Kunt et al. has shown).
Part of the challenge of measuring supervisory effectiveness is that beyond bank-level indicators (especially for off-site supervision), bank supervision is to be considered a judgement-based business. As one speaker pointed out, procrastination of bank supervisors in the banking turmoil of 2023 might have been due to slow-moving accounting ratios not sending alarm signals, while a careful consideration of banks’ governance structures and business models would have. Such judgement calls also imply being close to the supervised entities (“going into the banks”), which allows intelligence gathering, including of what we economists refer to as soft (non-quantifiable) information.
One important dimension of supervisory culture and effectiveness is leadership and management within supervisory institutions (“the tone is set at the top”). Other important characteristics include courage and boldness, speed, a forward-looking approach, an integrated approach (across units within the authority) and transparency. Ingraining such characteristics in an institution, in turn, certainly requires good leadership!
It is clear that supervision can only be as good as the regulation underpinning it, but good regulation is certainly a necessary, but not sufficient condition. As pointed out in this recent IMF paper, many countries perform well on regulation, but less on supervision, with one missing component often being related parties supervision. Another important dimension in this context is the interaction of micro- and macroprudential supervision. The job is easier for microprudential authorities if the overall system is stable, as a stable system means supervisors can focus on outliers. Having an effective resolution framework in place as back-up for effective supervision (both in terms of tools and setting incentives for banks) is also important.
What about the organisational structure of supervisory authorities? Speakers pointed to the need for both strong external governance (including budget and political independence) and internal governance, including proper internal checks and balance (separate risk detection, enforcement, analysis), an internal evaluation group, an effective research and analysis group and data availability to insiders and to outsiders (such as the call reports in the US, for which there is not really an equivalent yet in the euro area)
To end with another quote by Charles Goodhart (as cited by one of the speakers): The supervisor’s job is the hardest in the world, because most successes remain private, while every failure become very much public. Which points to another important trade-off – that between type 1 and type 2 errors – supervisors have the task to prevent bank failures, but the price of bringing the probability down to zero could be a shallow and inefficient banking system.
3. October 2024
War in the Middle East
I have written before on the Israel-Hamas conflict; now, the conflict is expanding further; with the anniversary of the terrorist attacks on 7 October 2023 coming up, the voices on the conflict will become even more shrill, drowning out the desperate cries for peace and civility in the region. I am missing the words to describe my feelings and views, so I will simply refer to a recent tweet by Alexandra Hill: "...I don’t support Iran, or Hamas or Hizbollah. I don’t like Netanyahu. I abhor occupation of West Bank... Not all criticism of Israel is anti-semitism. I’m not sorry Nasrallah is dead. And round and round and round it goes, and more, churning in my head... If you’re not torqued up inside, but can just plainly see black and white, you are fortunate indeed."
2. October 2024
Farewell banking nationalism?
The move by Italian Unicredit to acquire 9% of German Commerzbank has surprised many observers; I will not judge whether or not it makes commercial sense for Unicredit to aim for a takeover of Commerzbank. Gaining scale by merging HypoVereinsbank (which Unicredit acquired some 20 years ago) with Commerzbank might be one good reason. Escaping a credit rating cap ‘imposed’ by the Italian sovereign might be another. And it has to be seen whether Unicredit will indeed follow through and how markets will react to next steps.
Beyond the specifics of this case is the importance as a first possible significant European cross-border bank merger since the establishment of the banking union. One of the objectives of the banking union was to establish a true Single Market Banking. What we have observed, however, has been a strengthening of national banking markets rather than a European market, including with regulatory ringfencing on the national level. While some might argue that an incomplete banking union reinforces national tendencies, Brunella Bruno, Elena Carletti and I argue in a recent paper for the ECON Committee of the European Parliament that banking nationalism is both behind the failure to complete the banking union and behind limited attempts at integrating national banking markets.
A notable example of this 'banking-nationalist' approach is the German government's attempt, only a few years ago, to engineer a merger between the country's first and second-largest banks, Deutsche and Commerzbank. Conversely, French President Macron recently stated that he would not oppose a major French bank being taken over by another large bank from a different European country. Such an attitude stands in contrast to the reaction by some (not all!) German politicians following the news that Unicredit might aim for a takeover of Commerzbank, referring to the interests of the German banking system. While I am not a big fan of the current Italian government I agree with the Italian foreign minister who referred to the takeover of ITA Airways by Lufthansa being ‘sold’ as part of the Single Market in Europe, while a takeover of a German by an Italian bank being branded as hostile. Certainly a very hypocritical attitude and not very pro-European by German politicians.
Ultimately, it will be a supervisory decision (by ECB Banking Supervision) whether or not to allow a further increase of Unicredit’s share in Commerzbank to go ahead. But it is also a test for Europe whether or not we can achieve a truly European Single Market in banking and financial services more generally. Overcoming national interests will be a critical part of this test! And moving towards more cross-border banking in Europe might also help give new impetus to completing the banking union.
29. September 2024
Brexit – too much repetition drives down viewers’ attention
The never-ending Brexit soap opera has entered yet another season – some of the main protagonists have changed (most prominently in London), the tone has somewhat changed, but the themes have stayed the same. The main trade-off is still the same: if you want to play a leading role in European politics, you better be part of the European Union. Staying outside, you make up your own rules at high economic costs or you adapt to European rules without being able to influence them. The latter is the reality that British business has started to adopt to (most recent example: the new bottle caps introduced by EU regulation, but as well in the UK market) and the UK government has started to follow – the previous government only slowly and by stealth, the new Labour government much more open.
At the same time, the Labour government has decided to respect the red lines it has drawn during the campaign to counter any effort by the Tories to accuse it of pushing the UK back towards the EU. So, no move towards Single Market or Customs Union and even proposals that might give the resemblance of freedom of movement (such as a youth mobility agreement proposed by Brussels) are being rejected. At the same time, the UK government seems surprised that Brussels is not immediately agreeing to London’s ideas of a closer relationship.
So, overall, some change in tone but not much change in substance in London’s approach towards the EU. And Labour is continuing in the Tory tradition of aiming to ‘make a success out of Brexit’ with new trade agreements, while at the same time refusing to take back control (as in the case of import controls). Replacing a blue Brexit by a red Brexit won’t change the bad economics of it, however! As before, there is no “having your cake and eating it”; any serious attempt at reverting the damage done by Brexit would involve crossing the red lines. More and more British (especially younger ones) are willing to push for this; it remains to be seen whether and when Labour will feel the pressure.
As in any good soap opera, there are also funny moments, such as Brexiter comments that the only reason why the French president Macron has appointed Michel Barnier (also known as the EU’s Brexit negotiator) as the new prime minister is to annoy London. This idea probably reflects as much the idea of some Brexiters that the UK is still the centre of the universe as back in the 19th century as it does Barnier’s role in showing the naiveté of Brexiters.
15. September 2024
Law and Finance revisited
Ross Levine and I were recently invited to revise our Handbook chapter on the law and finance literature and a draft of the chapter is now available as CEPR Discussion Paper. Building on our 2005 handbook chapter, we summarise research that finds that (1) in legal systems that enforce private property rights, support private contractual arrangements, and protect investors’ legal rights, savers are more willing to finance firms, and financial markets more efficiently allocate capital, and (2) the different legal traditions that emerged in Europe over previous centuries and were spread internationally through conquest, colonization, and imitation help explain cross-economy differences in investor protection, the contracting environment, and financial development.
Compared to the first version of the literature survey, more recent papers have explored interactions between alternative hypotheses to explain legal and financial system development (such as papers by Oto-Peralis and Romero-Avila on Legal Traditions and Initial Endowments in
Shaping the Path of Financial Development) as well as provided within-country and micro-level evidence on the importance of legal origin for financial development (examples include the work by Berkowitz and Clay on differences within the US, notably between former English colonies and former French and Spanish colonies/Mexican territories and a paper by Ross Levine and co-authors on differences between British and French concessions over adjacent and similar plots of land in Shanghai following the First Opium War in the 19th century).
There has also been a large number of papers over the past two decades, exploiting micro-level data (firm and loan-level) and specific policy reforms to gauge the relationship between legal institutions, including collateral reforms, court reforms and strengthening property right protection and access to and cost of external finance. For example, Love, Martinez Peria, and Singh (2016) show that collateral registries for movable assets facilitate firm financing. Berkowitz, Lin, and Ma (2015) show that China’s 2007 Property Law, which strengthened property rights for private firms and their creditors (primarily banks), had a positive effect on firms’ value, especially those with a relatively large share of tangible assets (to be used as collateral) and no political connections. Assunção et al. (2013) exploit a reform in Brazil that simplified the sale of repossessed cars used as collateral and find that strengthening the usefulness of this form of collateral expanded credit to riskier, self-employed borrowers and led to larger loans with lower spreads and longer maturities. Finally, Brown et al. (2017) exploit externally imposed differences in legal institutions across Native American reservations: The U.S. Congress assigned state courts to adjudicate contract disputes on some reservations, leaving other reservations in the hands of tribal courts. State courts resolve contract disputes more efficiently and predictably than tribal courts, and credit market development is significantly higher in reservations assigned to state courts.
We end on a forward-looking note: “New technologies (digital finance, big data and artificial intelligence) yield new financial products and new providers of financial services, challenging existing legal institutions. Which legal institutions will best adapt to these challenges to foster investment, innovation, and improvements in living standards? How will political systems shape the adaptation of legal institutions and financial development to these technological innovations? These are some of the questions that researchers and policymakers must now address.”
9. September 2024
Back to the future – the rise of pro-Russian extremists in Eastern Germany
In 1989/90 it was hard to imagine such a title only a generation and half later. But today’s state-level elections in Eastern Germany give rise to serious concerns, for the region’s society and economy, for Germany’s democratic future, and for Europe’s resistance against Russia’s aggression and thus peace. Two pro-Russian, anti-immigration and anti-European parties have won almost 50% in Thuringia and over 40% in Saxony; including the post-communist Die Linke results in over 50% in Thuringia and almost 50% in Saxony. While these parties have also gained strength in Western Germany, there is certainly a huge gap between East and West when it comes to the tendency to vote for extremist parties.
How did we get here, 35 years after the fall of the Berlin wall and the end of 40 years of communist dictatorship? Why are East Germans voting against democratic parties? Why are they voting in favour of parties that embrace the former colonial overlord Russia? The discussion about the reasons for what can only be described as dramatic reversal from the peaceful German revolution of 1989/90 has led to what I would describe as a second historian debate (the first back in the 1980s was about the uniqueness of the holocaust)
One hypothesis focuses primarily on demographic characteristics, with Eastern Germany’s population being older and more male than Western Germany’s population. Another relates back to the unification process, when Eastern Germany was incorporated into existing structure of West Germany’s constitutional structure rather than undertaking a unification of equals, the rapid post-1990 deindustrialisation of Eastern Germany and the more general feeling that the East was taken over by the West. This explains why Die Linke was so strong over the past three decades in the East, to the point where one of the state governors came from this party and it participated in several regional governments. However, now it has been pushed aside by the neofascist AfD and the Pro-Putin authoritarian party Buendniss Sahra Wagenknecht.
The historian Ilko-Sascha Kowalczuk has an interesting alternative hypothesis, as detailed in his new book Freedom Shock (admittedly, I have not read the whole book, yet!) but also in several recent articles and talk show contributions. His argument is that most East Germans correlated West German democracy and freedom with more income, higher wealth and better quality of life, not taking into account that a shift away from the paternalistic planned economy also implied higher responsibility and – possibly – also higher income inequality. To put it in economists’ term: while average income has gone up, the second moment (standard deviation) also has. The ‘losers’ (mostly in terms of jobs) quickly became disillusioned and the perceived correlation between democracy/freedom and income levels turned them into voters for anti-democratic parties.
And while many younger East Germans left for the West (Eastern Germany lost millions of people over the past 35 years), the remaining population is the more disgruntled demography. The lack of civil society organisations has further contributed to a complete disconnect between voters and democratic system. Thus an open field for extremist pied pipers who have identified the scapegoat for any (real or imagined) problems – foreigners, especially immigrants – but have few if any other policies to offer.
One cannot turn back the wheel in terms of the unification process or political education, but the question at hand is what to do with lack of support for democracy in Eastern Germany. Is a more confrontational approach needed against at least one of the two parties (AfD, which in Eastern Germany is considered extremist)? Is a more open discussion on expectations and disappointments in Eastern Germany needed?
However, beyond academic debates, analysing the reasons behind the rise of anti-democratic parties in East Germany has critical implications for European democracy and security. These three parties are pro-Putin, want to undermine the Ukrainian resistance against the Russian aggression, and are also mostly against the current European democratic order (in line with Hungary’s Orban, Donald Trump and Nigel Farage). This makes a stronger influence of these parties in Europe’s anchor country so dangerous. The next 12 months leading up to the next federal elections in Germany will be tense!
1 September 2024
Lessons from the 2023 banking turmoil – a new ASC report
At the ESRB’s Advisory Scientific Committee we just released a new report (joint with Vasso Ioannidou, Enrico Perotti, Antonio Sánchez Serrano, Javier Suarez, and Xavier Vives), titled: “Addressing banks' vulnerability to deposit runs: revisiting the facts, arguments, and policy options”. This paper is not a post-mortem of the bank failures in the US and of Credit Suisse, but – based on these episodes – a broader discussion of bank fragility and possible policy options. Herewith a short summary:
First, deposit runs are a major source of bank fragility and are almost always the result of a combination of weak fundamentals (concerns about the solvency or liquidity position of a bank or the banking system) and strategic considerations by potentially withdrawing depositors when processing the relevant information (in plain English: no one wants to be the last one to get to the cash machine). The runs in spring 2023 unfolded much more rapidly than previous runs, fuelled by the concentration of the depositor base and by the role of social media and the feasibility of making fast (instant) payments and transfers from the accounts of the affected banks, and thus forced supervisors to intervene much more rapidly than in previous crisis situations.
Second, exposure to interest rate risk (critical for the failure of Silicon Valley Bank) is a direct consequence of banks' involvement in maturity transformation. While there is evidence for a natural interest rate hedge for banks (Drechsler et al., 2021), due to the deposit franchise, individual banks or business models may fail to be effectively hedged against interest rate risk, as the bank failures witnessed in the US in early 2023 illustrate. These failures also show that the franchise and hedging value of deposit funding is vulnerable to any force that leads depositors to withdraw their funds or suddenly requires banks to pay much higher rates for them to roll over their deposits.
The optimal prudential treatment of interest rate risk might therefore interact with banks’ funding structure. If the system can guarantee the stability of a greater fraction of deposits during crises, the minimum capital that ensures that a bank stays solvent declines. Alternatively, imposing a minimum fraction of highly liquid assets provides an immediate buffer to accommodate outflows without having to sell longer term or less liquid assets, but holding more liquidity reduces banks’ expected net interest rate income and may result in a reduced capacity to accumulate loss-absorbing capacity. In sum, the existence of multiple margins along which interest rate risk interacts with banks’ funding structure calls for considering it in conjunction with the safety guarantees and the capital and liquidity positions of each bank rather than with a single dimensional tool.
Finally, we analyse a number of policy options. The first list of categories includes options that could be further considered without major structural changes in the current regulatory and supervisory framework, and might be implemented in the form of adjustments within the margins of discretion of Basel III:
The second list of categories includes those with policy options that would imply deeper structural transformations of the institutional setup or the banking industry and that either we do not promote as the most desirable or would require further analysis:
In summary, we see the first list of policy options as input into ongoing discussions at regulatory and supervisory authorities in Europe, while the second set of policy options might be the basis for further (currently more academic) discussions.
29. August 2024
2024 Ieke van den Burg Prize
Each year, the Advisory Scientific Committee of the ESRB awards a prize for research on systemic risk by young researchers. This year’s winner is Tsvetelina Nenova for her paper “Global or regional safe assets: evidence from bond substitution patterns”. A truly impressive paper!
Using a granular dataset of global government and corporate bond holdings by mutual funds domiciled in the world’s two largest currency areas (USD and euro), the author estimates heterogeneous and time- varying demand elasticities for bonds. She shows that safe assets such as US Treasuries and German Bunds face especially price-inelastic demand from investment funds compared to riskier bonds. However, there are important differences between these two safe assets, when it comes to spillover effects from them to global bond markets. Funds substitute US Treasuries with global bonds, including risky corporate and emerging market bonds, whereas German Bunds are primarily substitutable within a narrow set of euro area safe government bonds. US Treasuries are thus global, while German Bunds regional safe assets.
The paper is not only characterised by incredibly carefully collected granular data, but also by its policy relevance. Demand elasticities of safe assets are critical for monetary policy transmission. Identifying which fixed income assets are considered safe havens and by whom is critical for crisis planning. Not surprisingly, the same paper also won the 2024 Young Economist Prize at the ECB’s Forum on Central Banking in Sintra.
26. August 2024