Finance: Research, Policy and Anecdotes

I am off to Zurich for the next Economic Policy Panel meeting.  As always an exciting programme. One important highlight will be four papers on populism, a critical issue for policy makers and social scientists on both sides of the North Atlantic (and increasingly in Latin America as well).   To better understand the challenges, several papers by political scientists are included in the programme.  And one interesting paper, which has already made headlines, is by Patrick Kennedy and Andrea Prat on where people get their news, especially relevant in the current political environment.   Also on the programme two papers that look at the effect of zombie enterprises and misallocation of resources – one cross-country and one on Italy. The final three papers will focus on the extent to which the expansion of education can make up for negative consequences of an aging population on growth; the effect of monetary policy on banks’ profits at the zero lower bound; and the effects of national borders and thus secession on trade. An exciting and diverse set of papers!    I will be tweeting from the panel meeting!

Last week, I had the honour and pleasure of co-organising a conference on financial inclusion at the IMF with Andrea Presbitero and my former colleague Sole Martinez Peria. Nine papers, mostly work in progress, were presented and together gave nice insights on where the financial inclusion literature stands.  Together, these papers also show how the literature has matured over the past ten years, with big questions no longer receiving simple, but rather qualified answers, and new questions arising.


While evidence from multiple randomized control trials across the world have shown “a consistent pattern of modestly positive, but not transformative, effects” and aggregate evidence points more to distributional rather than growth-enhancing effect, a new paper presented by Cynthia Kinnan shows that when considering the impact of microcredit, heterogeneity is key.  One of the differentiating factors is whether borrowers are entrepreneurial and thus use the loan receipts for investment rather than consumption. As so often in economics, one size does not fit all and targeting of broad population groups with credit will certainly not give the expected return in investment and growth.  The uptake of microcredit might also be constrained by religious beliefs and a paper by Dean Karlan and co-authors shows that offering a Sharia-compliant lending product increased the application rate by religious people in Jordan and that such borrowers are also less “interest rate” sensitive. Interestingly, the uptake does not seem to depend on who the entity authorizing the Islamic product is.  This might show the tolerance of religious Muslims for different authorities or the importance of labelling a lending product as Sharia-compliant.


Several papers used observational data to explore the impact of financial inclusion programmes.  Sumit Agarwal and co-author  study the Pradhan Mantri Jan Dhan Yojna (“JDY”) programme launched in India in 2014, the world’s largest financial inclusion program so far, resulting in 225 million new accounts. While usage of these account increased only slowly after account opening, the authors document a shift away from informal sources of finance and provide indications of more consumption smoothing and savings.  Claire Celerier and Adrien Matray show that branch expansion following deregulation between 1994 and 2010 in the US resulted in higher wealth accumulation by low-income people, suggesting that geographic access matters.  Finally, another paper by Sumit Agarwal and (other) co-authors shows that a financial inclusion program establishing saving and credit associations (SACCOs) across Rwanda resulted in a high take-up of new loans and positive real effects.  More importantly, however, it also led to making some of these new SACCO borrowers bankable, allowing them to switch to banks an initial loan with the SACCOs.  Given the frequently lamented fragmentation of African banking systems, such “integration” of different segments of the financial system, supported by the credit registry, is welcome.  


There were also two papers on mobile money in Kenya. In one, my former Tilburg colleagues show that sometimes small (administrative or monetary) barriers can prevent the uptake of more efficient payment tools by small businesses; once they adopt these tools, however, they seem to use them frequently. In a second paper,  Billy Jack and co-author show that encouraging parents to use formal savings accounts via mobile phone increases savings for high school tuition and makes it more likely that kids are sent to high school.


While none of these findings might seem ground breaking, they help us make progress in understanding the barriers to the use of financial services and the impact of using them. Personally, I have three take-aways from these papers.  First, the distinction between credit, savings and payment services has become fluid and the fear that the improvement in access to simple mobile money-based transaction services will not lead to the use of other financial services might not be overstated. Second, interventions to increase access to financial services have to go beyond monetary and geographic barriers and also address behavioural constraints (including nudges). Finally, a methodological point – I think we are beyond the point where one methodology can be declared the gold standard in this literature.  Only a combination of randomised control trials, use of observational data combined with natural or policy experiments, and theory-motivated structural models can provide us the necessary insights and policy recommendations to push the financial inclusion agenda forward. Plus data – and as so many, I am looking forward to the next round of the Global Findex, to be released in a few weeks. 

The UK and the European Commission have agreed on a transition period for the UK after March 2019.  However, this “agreement” still has many open points, most notably the question of Norther Ireland.  The conundrum Theresa May finds herself in right now can be framed with the concept of a policy trilemma.  Three political objectives are at the top of the agenda: (i) take back control (of money, border, laws), (ii) prevent a hard border to arise in Ireland (and thus honouring the Good Friday Agreement) and (iii) keep the UK together as political and economic unit.  Only two of these objectives can be met as I illustrate below.  Taking back control and maintaining the Good Friday Agreement would require Northern Ireland to effectively stay in Customs Union and Single Market, imply a border in the Irish Sea and thus undermine the unity of the UK.  One might see this not only as constitutionally questionable, but also politically infeasible as the DUP (currently in a confidence and supply agreement with the Tory government) would not agree to this.  However, if the UK wants to avoid a border in the Irish Sea and take back control (i.e., leave Custom Union and Single Market), this would imply constructing a hard border in Ireland and thus violating the Good Friday Agreement.  Any alternative plan focused on technological solution is currently in the realm of dreams and visions.  Finally, maintaining the unity of the UK and avoiding any hard border in Ireland would require the whole UK to stay in the Customs Union and Single Market, a solution also known as Soft Brexit to some and as Brexit in Name Only to others. The UK would stay closely linked to the EU, with no option to do independent trade deals, having to accept free movement and having to pay, BUT: without any formal say.   Which raises the question: what does Brexit mean in this case? 


So, far the British government has fudged with this trilemma, mostly with platitudes (Brexit means Brexit, taking back control, red lines etc.) and the firm intention to keep the peace within the conservative party.  However, the trilemma cannot be talked away: something has to give.  Which will it be?  And when will the decision be taken?  And by which Prime Minister? 

At some point in the future, historians might look back in surprise at the 2010s in the UK and the rather convoluted Brexit process. In the back-and-forth between Commission and the British government one really wonders whether the British government simply does not know better or whether they have reached the point where they realized that the envisioned Brexit strategy is simply not feasible and are looking for an organized retreat.  The hostile reaction of politicians and right-wing press to the EU draft of the Brexit treaty was surprising, as all it did was to put into legal language the political agreement from December. More realistic Theresa’s May latest speech last Friday where she finally acknowledged that the UK might after all not have its cake and eat it.


The main tension between London and Brussels seems to stem from a fundamentally different approach: for the UK government, Brexit is a political process, for the European Commission a legal-administrative process. One might also think that the difference between principle-based Common Law and bright-line based Civil Law/Continental European approach shines a bit through, but I would put more weight on the political explanation. From the viewpoint of the EU, it is very simple: the EU cares primarily about the interest of its remaining 27 countries and their people (important if you think about the issue of the Irish border).  The EU has no business to solve internal policy conundrums in the UK or help the UK government to resolve problems stemming from Theresa May’s mistake of drawing red lines for Brexit before thinking through the implications.   For the UK government, on the other hand, this process is as much about managing expectations with its electorate and internal Tory critics on both sides as it is about negotiating with Brussels. It is more, the UK government seems to negotiate more with itself than with the European Commission. Therefore it is not surprising that even though it was the UK government that started the divorce process, it is the European Commission that has produced a first draft of a divorce document.


The best example is the stand-off on the border between Republic of Ireland and Northern Ireland.  The EU’s suggestion of leaving Northern Ireland within the Single Market and Customs Union is a fall-back position to prevent a hard border from have to emerge after Brexit; it is up to the UK to come up with an alternative if they insist on the UK leaving the customs union and not having a border in the Irish Sea.  The technological solution so much advertised by Boris and Co. has so far been nothing but an ambition and a slogan.  And since the final trade agreement between the UK and the EU will not be agreed upon before Brexit, a fall-back position to avoid a hard border and thus endanger the Good Friday Agreement is necessary. Again, this is the logical consequence of a legal approach to Brexit.


So far, nothing has gone according to the Brexiters’ plan.  Instead of a leisurely afternoon tea in Berlin to agree on a new EU-UK deal, long negotiations with Eurocrats in Brussels have awaited the British government. Ignorance on how the EU works and the utter lack of preparation has not helped.  It was not until this past week, that the British and Irish governments have agreed on a study how to avoid a hard border in Ireland after Brexit, one year after triggering Article 50 and almost two years after the Brexit referendum.


Again, historians will look back at these years in surprise and/or despair.  Having lived and worked in this country for over four years and being an anglophile by upbringing, education and conviction, I can only hope the best for the UK. But I am no longer optimistic. The political class in the UK has failed its population miserably!  

Consuelo, Wolf and I have been working on this paper for quite some time, but finally have a version that we feel comfortable with to publish as CEPR Discussion Paper. It is the third (but not last!) of a series of papers that Wolf and I have co-authored on the tension between national bank supervision and cross-border banking, a tension that comes out especially during the failure and resolution of banks, as we show in our 2013 paper with Radomir Todorov, published in Economic Policy. Does that imply that supranational supervision is a better solution – not so fast, we argue in our theory paper, published in the International Journal of Central Banking, where we formalize the trade-off between cross-border externalities from bank failure and heterogeneity in the cost of bank failure, where the former makes cooperation if not supervisory integration welfare improving and the latter welfare reducing. 


In the latest paper with Consuelo we take this model to the data.  We first hand-collected data on supervisory cooperation among a global sample of countries over the period 1995 and 2013. The information is at the country-pair level and was gathered from the supervisory bodies' websites and official documents available online. Supervisory cooperation can take many different forms and degrees of intensity. In our work we distinguish between four (and increasingly intense) forms of cooperation: a Memorandum of Understanding for information sharing and onsite inspection, a College of Supervisors, a Memorandum of Understanding on crisis management and resolution and a supranational supervisor. We then regress these gauges of supervisory cooperation on measures of cross-border externalities (including foreign bank share, financial market integration and currency unions or peg) and heterogeneities (structure and level of financial development, political structure, historic links, geographic proximity etc.).  


Consistent with theory, we find that higher cross-border externalities between two countries increases both the likelihood of cooperation and the intensity. Distinguishing between different dimensions, we find that it is all three – cross-border externalities through bank ownership links, spill-over effects through financial markets and linkages within a currency union – that increase the probability and intensity of cooperation. We also find that higher heterogeneity between countries decreases the likelihood and intensity of cooperation, again consistent with theory, though the economic effect of heterogeneity is less prominent than that of externalities. In summary, economics matters! Countries are not only driven by politics and history when agreeing to cooperate among regulators, but also by the net benefits of doing so. 


We can also use the exercise to predict which countries are likely to cooperate with each other.  Take the European Union. The banking union is currently limited to Eurozone countries, but is – in principle – open to non-euro countries of the EU.  Using our model to consider externalities and heterogeneity of non-euro EU countries vis-à-vis the banking union countries, we would predict most of them not to join the banking union, maybe with the exception of Bulgaria and Denmark, countries with a currency board and a peg to the euro, respectively.