Finance: Research, Policy and Anecdotes

I am off to a week-long trip – first Washington DC where I will participate in the second meeting of the Taskforce on Basel III in Emerging and Developing Markets. While in the first part of this project we discussed challenges in the Basel III adoption and implementation for emerging and developing economies, this time we will discuss policy recommendations.  A report, however, won’t be ready until early next year.  


On Thursday/Friday then, I will be at the  68th Economic Policy panel at the Austrian National Bank in Vienna (where excellent research will be combined with delicious coffee!).  A very interesting set of papers awaits us, including two papers on the Gig economy, one of them on Uber drivers in London.  Also, Barry Eichengreen et al. on Mercury vs. Mars – what explains which currency countries hold their foreign exchange reserves in – economic or political reasons; with some interesting policy implications for both the US dollar and the Euro.  Atish Ghosh et al. discuss how policy makers have or have not adopted capital account restrictions in line with the reputation of such policies.  I will try to tweet from the panel meeting.

A lot has been written about the Global Financial Crisis, what we have learned, what we have not learned, how we can avoid future crises, etc.  Instead of adding yet another view, which might not look too different from others, let me offer some personal observations – admittedly, in many instances it took some time to put some sense to these observations, but in hindsight we are always smarter.


During my nine years post-PhD at the World Bank I had primarily worked on developing country issues – ranging from more developed systems such as Brazil, over transition economies, such as Russia, to low-income countries, such as Bolivia, Kenya and Uganda. I had worked on development and stability issues and among the latter, the design of deposit insurance and bank resolution regimes always featured prominently (you will see the relevance of this below).


My first encounter with the Global Financial Crisis was in summer 2007, which I spent with my family vacationing in Germany.  Reading German newspapers, I could not avoid the impression that the crisis had started in Germany rather than in the US.   Repackaged US subprime mortgages had shown up in the balance sheets of several German banks, including IKB, which was bailed out by other banks and the governments.    As we found out later, a sign of worse things to come. It also showed the global nature of the crisis to come.


I arrived in the Netherlands to take up my position at Tilburg University in late summer 2008, just in time to witness the onset of the Global Financial Crisis. What Lehman Brothers was for the US (and the global financial system) was the Fortis/ABN Amro failure for the Netherlands (and neighbouring Belgium). My first question for my new colleagues was: how does the bank resolution work in the Netherlands – I got rather funny looks; as I found out quickly, none of the European countries had a bank resolution framework, leaving regulators and governments with a choice between long-winded corporate insolvency proceedings (and the turmoil this causes as shown by Lehman Brothers) and bail-out – the path chosen by almost all governments for almost all banks in 2008/9.


The European Commission allowed the bail-outs of banks across the European Union in spite of the prohibition of state aid for fear of a financial melt-down. In 2009/10 I worked with Diane Coyle, Matias Dewatripont, Xavier Freixas, and Paul Seabright on a report for DG Competition assessing the state aid provided during the Global Financial Crisis across Europe, later published as CEPR book.  Our conclusion was that the carrot and stick approach advocated by many European policy makers (allow bail-out first, punish banks later) did not make much sense as punishing bailed-out banks would reduce competition and not help European banking systems support economic recovery.  We recommended to rather focus on regulatory reform to avoid that bail-out would have to happen again, including putting more burden on junior bondholders and expanding the regulatory perimeter to bank-like financial intermediaries.  As always, our recommendations were partially implemented (I think even that could be celebrated as success) – there was a somewhat less aggressive approach by the European Commission towards post-bail-out conditions and there was an overhaul of the resolution framework towards bail-in (of course we were far from the only ones to advocate that!).


This leads me to two of the immediate lessons from the failure of (cross-border) banks in Europe: the need to create bank resolution frameworks and the need to create institutional frameworks to coordinate supervision and resolution in the EU.  In the following few years, I actively participated in the policy discussion of what later was named banking union.    In 2011, Franklin Allen, Elena Carletti, Philip Lane, Dirk Schoenmaker, Wolf Wagner and I published a policy report on the future of cross-border banking in Europe – among others, we recommended EU policy makers to create a European-level deposit insurance fund and resolution framework.


I still remember a conference at the BIS in Basel in 2009 where I suggested that the Eurozone would eventually have to move towards a European version of the FDIC, i.e., a supranational financial safety net.  A Fed economist in the audience burst into laughter, declaring that European governments would never agree to this. Lawyers explained to us economists that a treaty change would be necessary to construct such a supranational framework. A few years and zero treaty changes later, the Single Supervisory Mechanism and the Single Resolution Mechanism were established, a strong entry into the banking union and thus a Eurozone-wide financial safety net. It is far from complete as many of us economists have reminded policy makers over and over again and one can argue that the glass is half empty – looking back to 2008/9, however, the glass is certainly half full.


Another important and justified question after the crisis was what the role of the financial sector should be, going forward? Was the crisis really proof that financial development does not help growth and that the finance-growth literature had just been proven wrong, as academics and policy makers alike kept telling me? Or was it rather the definition of financial development that causes this discordance?  There was certainly a realisation after the GFC that the financial centre approach to the financial sector policies might give some growth benefits but also sharper drops during the crisis. Several countries, including the Netherlands, Cyprus and Iceland had tried this approach, though in different ways, but all with other negative outcomes.  This was confirmed in a research paper by Hans Degryse, Christiane Kneer and myself even for a cross-country sample before the crisis – short-term growth benefits, longer-term high volatility costs of large financial centres. The positive role of the financial sector in the growth process comes from the intermediation and risk management role, not necessarily from having large balance sheet and employing lots of people.


So, how far have we come?  Martin Wolf recently wrote that little has changed. And even though many statistics indicate indeed that the world has gone back to business as usual, I still beg to differ.  Yes, there was no revolution. We did not hang the bankers from the lamp posts and the financial sector has not been completely transformed.  But there have been critical changes in the regulatory framework – a much tighter regime of capital requirement, augmented by liquidity requirements (with capital requirements not sufficiently high, as many economists, including this one, would argue, though I am not convinced we should move to 25%); introduction of macro-prudential tools; introduction of bank resolution frameworks in Europe; a start on the banking union; ring-fencing in the UK (maybe a good example for other countries); etc.  However, there are challenges for regulators, as Elena Carletti, Itay Goldstein and I wrote in this survey – the tension between complexity and simplicity of regulation, where the former allows for better pricing of risks, while the latter avoids regulatory arbitrage; the need for an even stronger focus on systemic risk and macroprudential tools; the need to further finetune resolution frameworks; and the need to adjust the regulatory perimeter as financial service providers might try to take intermediation business out of the costly regulated sector into the unregulated sphere of finance, an ongoing challenge given the rising importance of lending platforms and bigtech companies, such as Alibaba and Paypal moving into financial service provision.   


Does this regulatory progress mean that the financial system safe? Yes and no! It is safer than it was in 2007 and if a similar shock hit today, everyone would be better prepared. The problem with regulatory reform, however, is that it is always designed to address the previous but not the next crisis – future fragility will come from other areas, which are – as of now – unknown. Will it be fintech and cybercrime? Will it be different asset classes (student loans in the US, car loans in the UK)? Will it be in emerging markets and triggered by exchange rate movements and rising interest rates in the US? Will it be political shocks to sovereign debt in the Eurozone? There are lots of possible sources of fragility across the globe.  Economists have not a good track record in forecasting, so I will not participate in this guessing game.


In summary, the past ten years have seen lots of progress in regulatory reforms.  What is missing is a more fundamental rethink of the role of the financial sector, especially in high-income countries, at least among policy makers.  And while there has been deleveraging in some countries and some sectors, there has been more leveraging in others (partly driven by very loose monetary policies for almost a decade). So, while we might be better prepared for the next financial hurricane, the damage will still be significant!   And it is important to not pretend the impossible – the new bail-in framework will not avoid government support in all circumstances.  Yes, there will be systemic crises in the future and there will have to be government support.

I did not plan to write on Brexit any time soon, as I was under the firm impression that it won’t be until November (or even December) that there would be some kind of political fudge/compromise that would allow the UK to exit with a deal and kick the debate on the future relationship down the road, leading to what has been referred to as Blind Brexit or Neverending Brexit.  Well, EU leaders did something this week completely new, almost unheard of in European politics: rather than kicking the can down the road, they took a clear and firm stance on Brexit, the Withdrawal Agreement and the future relationship between the EU and the UK.


And here we are back at the Brexit Trilemma I discussed earlier – and the North Ireland backstop has become the stumbling block, as some have predicted before. And while the current debate is seemingly about the Withdrawal Agreement, the North Ireland backstop (to avoid border between Northern and Republic of Ireland) forces the discussion on future relationship on everyone right now.  If backstop implies that Northern Ireland stays in Single Market and Customs Union (as EU insists on), then the only way that the UK can exit Single Market and Customs Unions is to have an economic border in the Irish Sea between Northern Ireland and the rest of the UK. If this is to be avoided, the whole UK has to stay in Single Market and Customs Union.  Theresa May tried to get around this by proposing regulatory alignment of UK with EU and a version of a customs union between UK and EU.  That’s where EU leaders put down their foot and said no to separation of the four freedoms (goods, services, capital and people).  While the expectation was for some kind of fudge in a withdrawal agreement with a declaration of intent for a future relationship, Theresa May clearly overplayed her cards. As always, a lot comes down to chemistry between people, attitudes and behaviour (remember Yanis Varoufakis’ behaviour at Eurozone Group meetings?) and Theresa May does not seem to have pulled it off. There might also be other reasons – the EU has a lot on its plate and does not want the Brexit debate to drag on for the next five years or so, making the agenda on EU summits a hostage of the whims of British politics.


Brexiters promised the British a free cake, 52% of the British people voted for the free cake and now the EU is refusing to deliver it. As much as the Brexiters want to take the UK out of the EU as quickly as possible, the EU wants to close the chapter on this tragicomedy and without any cake (or cherries).  It is up to the British government and political class to explain its electorate what has gone wrong (or better: what they did wrong!).


What will happens next in London?  It is hard to predict, but for sure there will be another increase in political temperature and tempers. There seems no obvious option left for Theresa May except for accepting an economic border in the Irish Sea (effectively losing her majority in the House of Commons, as the DUP will pull its support) or accepting membership in the EEA (which might have a majority in the House of Commons, as it should fulfil the Labour Party’s red lines but would result in a coup against her among Tories); either of the two might be the end of her time in office. There might be fresh elections (could be as early as November). And there might be – still an outside option – a new referendum. In any case, the next few months promise to be interesting for Westminster politics.


When David Cameron called the referendum on British EU membership, he wanted to resolve an intra-Tory conflict; he created a political civil war in the UK! Even before the actual Brexit, there have already been economic costs! One wonders when the British will finally come to their mind and rediscover their common sense!

The recent IFWSAS conference at Casssaw a highly interesting set of papers.  Herewith just a small set


In “Can Technology Undermine Macroprudential Regulation?” Fabio Braggion, Alberto Manconi and show that peer-to-peer lending platforms can help retail borrowers get around loan-to-value caps and thus macroprudential regulations aimed at smoothing house price and credit cycles.  Using detailed borrower and funder data from one Chinese P2P platform, they show that the tightening of LTV caps in some but not all Chinese cities in 2013 resulted in an increase in P2P lending in the affected cities, consistent with borrowers tapping P2P credit to circumvent the regulation.



Jannic Cutura assesses the effect of the new bail-in rule under BRRD for market discipline in the Eurozone.  Exploiting the difference between yields of bonds maturing before 2016 and maturing later (where only the latter would be subject to the bail-in rule) before and after it became clear that the bail-in rule would be introduced he finds evidence for a higher yield differential after markets realised that the bail-in rule was for real.  I have still lots of question on specification and exact timing of different events, but clearly an interesting and highly relevant paper.    


Does access to finance help with labour market mobility and employment?  Yes, according to Bernardus Van Doornik, Armando Gomes, David Schoenherr and Janis Skrastins who exploit random variation in the allocation of motorcycles through lotteries among participants in a financial savings product in Brazil. They find that individuals exhibit higher employment, earnings, and business ownership, and commute further after obtaining a motorcycle compared to participants who did not yet win a motorcycle.  And these effects are persistent rather than temporary. 



Right after the conference I went for a seminar at Bocconi.  These visits do not only allow one to receive valuable comments on one’s own work but one also learns about other people’s work. In Milan, I met Thorsten Martin, whose job market paper looks at the introduction of steel futures. There are lots of concerns that this just enables financialisation and speculation. But Thorsten shows that the creation of future markets increased price transparency in product markets. Higher price transparency reduced producer surplus and customer material costs. This higher price transparency ultimately increased the market share of low-cost steel producers and thus aggregate productivity. This is really important work that shows that financial markets (here derivative markets) help economic growth not through investment but rather by improving resource allocation, which is very consistent with an extensive body of work in the Finance and Growth literature.

As reported earlier, I was part of a research project on the determinants of adoption of international regulatory standards in emerging and developing economies. My colleagues have now put together an excellent website with lots of important information, not just for academics, but also analysts of regulatory frameworks and policy makers wanting to look across their borders. The website shows which elements of Basel II/III have been adopted by which countries and explores the factors that explain why different countries have chosen specific adoption strategies, including several highly insightful case studies from Asia, Africa and Latin America.  Also, on the website are two policy notes, one directed at regulators in EMDEs concerning their approach to adoption of Basel II/III and one directed at international institutions (including the Basel Committee) to ensure that such international standards are more appropriate for developing countries.



But the main focus of the project has been the factors explaining of why different developing countries have chosen different paths towards the adoption of international regulatory standards. To summarise the findings

Basel II and III adoption in developing countries is widespread but selective.  While some might see this as slacking, this can also be interpreted as a signal of a cautious approach by developing countries regulators to international standards to which most had no input and which might not fit the needs of their economies.


Three key actors shape Basel standards adoption in specific countries: regulators, politicians, and domestic banks, consistent with the political economy literature on financial sector development – to understand cross-country variation in financial sector policies, in this case, regulatory frameworks, one has to understand the politics behind the adoption/implementation of such frameworks and the interests and relative powers of different groups.


You might wonder what is new – well, to my best knowledge this is the first time researchers have taken a systemic look at the adoption of international banking standards – a cross-country approach combined with a number of detailed and diverse case studies that shows different models, ranging from no adoption (Ethiopia) over mock compliance (Vietnam) to selective adoption to foster financial development and a financial centre approach (Nairobi). The different case studies helped identify very different reasons for adoption:


  • Signalling sophistication to international investors. For example, in Ghana, Rwanda, and Kenya, politicians have advocated the implementation of Basel II and III, and other international financial standards, as part of a drive to establish financial hubs in their countries.
  • Reassuring host regulators. Banks headquartered in developing countries  may endorse Basel II or III as part of an international expansion strategy, as they seek to reassure potential host regulators that they are well-regulated at home. We see this at work in Nigeria, where large domestic banks have championed Basel II/III adoption at home as they seek to expand across Africa.
  • Facilitating home-host supervision. Adopting international standards can facilitate cross-border coordination between supervisors. In Vietnam, for example, regulators were keen to adopt Basel standards as their country opened up to foreign banks, to ensure they had a ‘common language’ to facilitate the supervision of the foreign banks operating in their jurisdiction.
  • Peer learning and peer pressure. Even while acknowledging the shortcomings of Basel II and III developing country regulators often describe them as international ‘best practices’ or ‘the gold standard’ and there is strong peer pressure in international policy circles to adopt them. In the West African Economic and Monetary Union (WAEMU), for example, regulators are planning an ambitious adoption of Basel II and III with the support and encouragement of technocratic peer networks and the IMF.
  • Technical advice from the International Monetary Fund and the World Bank can play an important role in shaping the incentives for politicians and regulators in developing countries, although their recommendations vary across countries.

As I had discussed earlier, I am also co-leading (with Liliana Rojas-Suarez at the Center for Global Development) a Taskforce on Basel III adoption in emerging and developing markets, where the focus is more on identifying specific recommendations to improve the fit of such international regulatory standards for these markets. The report is not due until next year, but understanding the reasons of why or why not countries adopt Basel III can certainly help in the analysis.