Finance: Research, Policy and Anecdotes

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.

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.

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.

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:


  • a designated resolution authority, which can intervene and resolve failing banks without having to wait for court decisions;
  • wide-spread powers for this resolution authority, including to remove and replace bank management and override shareholder rights;
  • a wide range of resolution tools, including a transfer or sale of assets and liabilities, the establishment of a bridge institution or of an asset management company;
  • the possibility to bail in junior bondholders and a restriction on taxpayer support before such a bail-in.


While we see a general trend of countries adopting more comprehensive resolution frameworks over time, there are some noteworthy observations:

  • There is substantial variation in the implementation of resolution features across countries.
  • The US had an already comprehensive bank resolution framework in the early 2000s, mostly due to the reforms implemented after the S&L crisis of the late 1980s and early 1990s. Further reforms were introduced under the Dodd-Frank Act in 2010.
  • European countries were lagging behind, with major reforms only introduced in the wake of the Global Financial Crisis. The Bank Recovery and Resolution Directive (BRRD) of 2014 subsequently harmonised the frameworks across the EU.


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:


  • Systemic risk increases more after negative system-wide shocks in countries with more comprehensive resolution frameworks, while it decreases more after positive shocks, suggesting that more comprehensive resolution regimes amplify rather than mitigate shocks during crisis times.
  • This result is robust to excluding global systemically important banks (G-SIBs), weighing regressions by the number of banks per country, controlling for the initial level of systemic risk contribution of banks, and controlling for the endogeneity of resolution reforms.
  • Disentangling the effect of different components, we find that it is primarily driven by the bail-in framework and resolution authorities’ ability to manage losses and operate banks. Given that no country had a bail-in framework in place during the early events of our study and few during the last events, we interpret the results as suggesting that the absence of a bail-in framework does not exacerbate system-wide shocks
  • Having a designated resolution authority seems to be a mitigating factor of systemic risk during negative system-wide shocks.
  • We do not find an exacerbating effect during times of bank-specific shocks, such as the trading losses of Société Générale in 2008, the resolution of the Portuguese Banco Espírito Santo in 2014, or the announcement of losses at Deutsche Bank in 2016.



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.

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.