Finance: Research, Policy and Anecdotes

As already announced on Twitter, I will be leaving The Business School (formerly Cass) at the end of this academic year and join the Robert Schuman Centre for Advanced Studies at the EUI in Florence as Chair in Financial Stability. Even before that I will take on the role of director of the Florence School of Banking and Finance (FBF) on a part-time basis from 1 March. The FBF has been built up by an amazing team under the leadership of Elena Carletti over the past few years and I am absolutely thrilled to join this great team.  The FBF has been very active with training programmes and seminars and has smoothly transitioned to an on-line format for both in 2020.  For the second semester of 2021, we hope to return to a mix of on-line and residential courses, conferences and seminars. Having a European research and training centre on financial sector issues is more important than ever, as the challenges in this area have only increased over the past years – starting from the fall-out of COVID-19 (where we will see more this and in coming years) over challenges of green finance to digitalisation and the rise of fintech. And while it is still early days, I also hope to broaden the geographic focus beyond Europe to other regions of the world, including emerging and developing countries; as well as build up research capacity.  The interdisciplinary nature of the Robert Schuman Centre will support a similarly broad approach for the FBF. And obviously, this will also be reflected in my blog entries – less on Brexit, more on academic fields and disciplines beyond finance. Stay tuned!

Among the many details of the FTA between the EU and the UK that was supposed to smooth the exit of the UK from Single Market and Customs Union was that the UK declined to continue participating in the student exchange programme Erasmus (there are other components to Erasmus that I will not focus on).  Rather, in the spirit of sovereignty and independence, the UK will set up its own programme that will support UK students who want to study abroad for a term or two, though with very limited resources per student. While this might save indeed money (especially, as the UK is more attractive as destination than as sending country of students), there are clear negative repercussions for Higher Education in the UK. Exchange students who spend part of their undergraduate students in the UK might return as post-graduate (highly paying) students; while I did not participate myself in the Erasmus programme, I spent a seminar in the US during my undergraduate studies, which ultimately informed my decision to apply for PhD programmes in the US. Penny-wise, but pound-fool!  Of course, there are other, non-monetary benefits – a more international student body makes UK universities more attractive for domestic students and for international academics; it fuels the intellectual environment and debate etc., as eloquently discussed in this article.


The replacement scheme (Turing) has little to speak for it – it is one-sided, i.e., focused on outbound UK students only rather than on two-way partnerships with non-UK universities; even so, building up new partnership is costly and takes time (as mentioned in the above article, but also squaring with my own experience of three years working in the international study office in Tübingen).  And with cooperation shifting from department/school to university level, there will be less ownership in UK universities for such a scheme.


All in all, I see this decision as another negative shock for the UK Higher Education sector, which has been under pressure in recent years and even more so during the COVID-19 crisis, as it depends to a large extent on (international and post-graduate) student fees. Brexit has made UK universities less attractive for both European students who have to pay more and non-European students who might see fewer job perspectives in the UK after their study.  Brexit makes UK universities less attractive for academics who face more red tape than before (if they come from the EU), a less international student body, and cost pressures due to COVID-19 (and lower student fee revenues).   While I have no doubt that the UK university sector will recover in the long-run (let’s say 20 to 30 years), the short- to medium-term perspectives are not positive.  One important challenge will be the funding model with its extensive reliance on student fees, even though I do not see any political appetite to address this, given other more urgent political priorities. But I would expect more turmoil and decline before things will turn eventually to the better.

2020 promised to be an interesting year, full of new projects and interesting policy work.  It started with great trips to Barbados and Nairobi.  Then, as for most people, in March, my world split into two parallel universes: in one, I was scheduled to travel to Albania, Japan, Korea, Myanmar, Tanzania and Uganda with lots of shorter trips within Europe – and that was before the summer. In the other – real – universe, all travel got cancelled and then the first lockdown started. Teaching had to be transferred online within a few days and I learned quite a lot of new communication tools. My initial plan was to use the lockdown to do what I had been wishing to do for years – read up on lots of interesting papers and books that had been piling up in my office and on my computer. Again, reality had different plans. On the one hand, I became part of a swift trend among economists to use the COVID-19 shock for research purposes, not just to increase the number of papers with my name on it, but also to contribute to the policy debate in the current crises. Some of my existing research also took on renewed urgency, such as my paper on bank resolution frameworks. On the other hand, I was asked to chair a Task Force at the European Systemic Risk Board on pay-out restrictions for financial institutions, which resulted in an ESRB Recommendation in June. There is a lot to be said and written about the policy making process, which I will leave for another day, but seeing economic policy discussions feeding directly into actual policy making is certainly fascinating. And as discussed in my previous post, I was asked to co-chair a second task force in late September to prepare a potential extension or amendment of this recommendation, which now has also concluded.


If 2020 was ‘interesting’, I very hope much hope that 2021 will be both more boring and more interesting. More boring in the sense of bringing more certainty.  However, it will certainly be also more interesting, as it will bring professional changes for me and exciting new challenges (more on this in the New Year).


On a final note, we economists often describe ourselves as introvert. When talking on Skype before COVID-19 I would normally not have turned on the camera.  The pandemic has taught us the importance of personal contact – seeing people on the screen is certainly better than just hearing them.  Neither substitutes for face-to-face and so, like most in our profession and in our world, I hope we are back to traveling and in-person meetings soon.

Here we are.  While negotiators in Brussels are hunkering down to discuss the fishy details of a possible deal and we still do not know whether or not there will be a deal, the UK press keeps itself busy with a xenophobic hate campaign against German chancellor Merkel.  This simply repeats a well-known scheme of Brexiters: always blame someone else if things do not turn out as they promised and, if in doubt, blame foreigners. And if it is not Angela Merkel, anti-Macron pamphlets are waiting in the drawers to be published.  As disgusting as it is, as predictable it is. One interesting observation is that while under Teresa May, it was the Prime Minister herself and her ministers who used Nazi language to drive home the point that the EU was the enemy and EU citizens are no longer welcome in the UK, under Boris Johnson this is being outsourced again to the Tory press.


Independent of the trade deal, the implications of the de facto Brexit (after de jure Brexit on 31 January) are slowly sinking in: British citizens are now being treated like citizens from any non-EU country in terms of travel to and stay in the EU – while some anti-EU hate-campaigning newspapers refer to these as new rules and revenge, these rules have always been there and are now simply being implemented to UK citizens, as the UK exits the transition period and thus Single Market. There will be many more of these – small changes here and there – that will affect daily life of UK citizens (and residents as my family and me); more important will be the long-term negative changes for businesses on both sides. While there has been a strong focus on immediate disruptions in early January, it will be the long-term economic damage that will be more important.  While the Tories hope that this additional loss in economic growth and welfare will not be noted among the COVID-19 fall-out, the COVID economic crisis and Brexit might actually exacerbate each other. Nevertheless, I do not think it will be until the end of this decade that it will become clear even for non-experts what long-term damage Brexit has brought to the UK.


As the last episode of this Brexit season seems to be never-ending, there is lots to ‘look forward’ to in the next season, independent on how this season will end.  With a barebones deal, there will be calls on both sides (but especially on this side of the channel) to extend cooperation to other areas. At the same time, there will be lots of areas of “interpretation” of the agreement, especially when it comes to the implementation of the Northern Ireland protocol. There will infighting on the UK side of whether a better deal was there to be had but also on the EU side on the fishing deal.  If there is no deal, expect even more “action”: British gunboats attacking French fishing boats; French fishing boats blockading Calais; serious transportation delays and traffic jams, not for a few days, but for weeks, especially on the British sides. Suggestions that the British government will not return to the negotiating table are as credible as Boris Johnson’s announcement a few weeks ago that “Christmas will not (I repeat: WILL NOT) be cancelled”.


Finally, what are the long-term perspective for the Brexit soap opera? This being increasingly one of the least popular political shows ever, expect it to go on for years if not decades. But one idea can be discarded easily – a quick return of the UK into the EU: this will not only require both major parties in the UK to agree (i.e., Labour and the English Nationalist Party) but – even more of a constraint I would argue – 27 EU member states to agree. And if anyone thought that the current free trade negotiations were difficult, the EU membership negotiators later this century on the UK side will simply laugh about the naivete of our generation.

Important disclaimer: I am a member of the Advisory Scientific Committee of the ESRB and was co-chair of the ESRB task force on restrictions of distributions that helped draft this recommendation. However, the views expressed below are exclusively mine and do not necessarily reflect the official stance of the ESRB or its member institutions.


The ESRB issued a recommendation today extending and amending the existing Recommendation on pay-out restrictions, after the discussion at the General Board meeting on Tuesday (the same day the ECB’s Supervisory Board issued its recommendation on pay-out restrictions). It amends the previous recommendation from 27 May, which would have lapsed on 31 December.    This recommendation comes at the end of an intensive consultation process and among a lively debate between bankers, regulators and academics on the usefulness of such restrictions.  


There are valid and important arguments on both sides: on the one hand, the COVID-19 crisis is still ongoing, and uncertainty remains about the future impact on the economy and financial institutions, with a risk of further worsening of health and economic conditions. Markets and authorities lack information on the long-term impact of the crisis on the financial sector and credit markets. Financial institutions also remain strongly dependent on public policy support. This calls for an approach that aims at maintaining a sufficiently high level of capital to mitigate systemic risk and contribute to economic recovery. On the other hand, the uncertainty has a different character now than it had in the spring: we have moved from unknown unknowns to known unknowns. Further, regulators are aware of the importance of distributions in enabling financial institutions to raise capital externally, as rewarding investors for their investment is critical for the long-term sustainability of financial institutions and markets.  Extending the pay-out restriction with an expectation that it will be lifted in a few quarters could result in perverse incentives in that banks will hold back on lending and risk-taking to save capital space to pay out later, the opposite to what is the intention. Finally, restricting proper market functioning to allow for reallocation of capital across sectors and within the banking sector is certainly not in line with the need for further restructuring and consolidation in the sector. So, there is a clear trade-off or – in line with a long-standing tradition in the dismal science – good arguments on both sides. And beyond the economic arguments, there is the issue that the recommendation is not legally binding, so a degree of moral suasion is needed, which might carry only so far.


This trade-off if not tension has resulted in an amended recommendation by the ESRB, with the following highlights:


First, it is recommended that relevant authorities request financial institutions under their supervisory remit  to refrain until 30 September 2021 from (i) dividend payments, (ii) buy-back ordinary shares and (iii) creating an obligation to pay variable remuneration to a material risk takers, which has the effect of reducing the quantity or quality of own funds.  So, far this is in line with the previous recommendation.


Second, if, however, financial institutions decide to distribute profits, they are asked to apply extreme caution and that the resulting reduction in own funds does not exceed the conservative threshold set by their competent (i.e., supervisory) authority.


Third, the recommendation offers three criteria to competent authorities when setting this threshold: one, ensuring that financial institutions maintain a sufficiently high level of capital - including taking into account their capital trajectory - in order to mitigate systemic risk and to contribute to economic recovery; two, ensuring that the overall level of distributions of financial institutions under their supervisory remit is significantly lower than in the recent years prior to the COVID-19 crisis; three, an appropriate and possibly differentiated approach across the different sectors, banks, insurers and investment firms.


Fourth, CCPs are no longer included in the recommendation, as the stress test exercise regarding CCPs in the Union conducted by the European Securities and Markets Authority following the outbreak of the COVID-19 pandemic confirmed the overall operational resilience of Union CCPs to common shocks and multiple defaults for credit, liquidity and concentration stress risks.


So, here we are.  I am sure the debate on the merits and risks of such pay-out restrictions will not end.  While a rigorous analysis of the effects of these regulatory measures might be a far way off (and might not include all the different dimensions of this multi-faceted challenge), I am sure such analysis will be forthcoming at some point in the future.


The initial restrictions on profit distribution in the spring has already led to some analyses.  Here are two papers I find worth mentioning.  Leonardo Gambacorta, Tommaso Oliviero and Hyun Shin show in a recent BIS working paper that banks with a low price-to-book ratio have a greater propensity to pay out dividends, a correlation that is especially strong for banks with price-book ratios below 0.7.  This also explains why the ratio of cumulated dividends to retained earnings is particularly large for banks in the euro area, reaching 60% over 2007–19, against about 30% for banks in other advanced economies. Using data on dividend payments of previous years and based on capital-lending elasticities from the literature, the authors then show that a complete suspension of bank dividends in 2020 during the Covid-19 pandemic would have added, under different scenarios, an additional US$ 0.8–1.1 trillion of bank lending capacity in their sample, equivalent to 1.1–1.6% of total GDP across 30 advanced economies.  Obviously, this estimate is based on certain assumptions on the elasticity of lending to capital buffers and does not take into account bank reactions to dividend restrictions, so is certainly an upper limit.


My former colleague Steven Ongena co-authored an article for the European Parliament, assessing the potential increase in lending in the EU following different regulatory measures, including relaxing capital and liquidity requirements and restricting pay-outs. They document an overall reduction in capital requirements by 1.7 percentage points, which would translate into a 2.0–2.6% increase in lending to the real economy (as the previous paper these are based on capital-lending elasticities from the literature). Interestingly, the actual increase in lending was even stronger, driven by drawdowns of pre-committed credit lines and government loan guarantee schemes. The article argues for either a lifting of the pay-out restriction or a clear exit strategy from these restrictions as the policy uncertainty created by it might counter the positive effects of the other policies on lending.