Finance: Research, Policy and Anecdotes

I had the pleasure of discussing two excellent papers at the 1st Finance and productivity conference at the EBRD this week, on the role of finance in fostering or impeding entrepreneurship. Christoph Albert and Andrea Caggese use survey data from the Global Entrepreneurship Monitor for 21 OECD countries over the period 2002 to 2013 and show that GDP and financial sector shocks hurt the establishment of new enterprises, especially of high-growth enterprises, providing convincing evidence that financing constraints are especially binding for transformational, potentially high-growth entrepreneurs.   Nandini Gupta and Isaac Hamaco, on the other hand, document a drain brain from manufacturing into the financial sector in the US. Specifically, engineering graduates between 1998 and 2006 are more likely to work in financial sector if they start out in an area with a higher share (and thus higher growth) of financial sector employment or study in a state that deregulates interstate banking. This, in turn, results in relatively fewer start-ups founded by engineering graduates that go into finance, as well as less innovation and less VC funding by such start-ups.

 

Together, these papers add evidence to two strands of the macro-finance literature that have developed somewhat parallel – on the one hand, the importance of alleviating financing constraints to foster entrepreneurship and thus ultimately improve resource allocation and increase productivity growth; on the other hand, the unhealthy growth of the financial sector, extracting rents from the real economy and drawing talent away from the manufacturing sector. Both papers thus relate to the decline in start-ups (as documented for the US in this Economic Policy paper, which also shows that it is not related to higher federal regulation) and the slow-down in productivity growth. But what to make of the seeming contradiction – financing constraints vs. brain drain?  Well, these findings are consistent with an important role of financial intermediation for economic growth (which works through productivity growth and thus entrepreneurship), but also with a growth-impeding effect of an oversized financial system that does not necessarily focus on intermediation anymore. It is thus consistent with tentative results that Hans Degryse, Christiane Kneer and I documented  - financial intermediation helps growth in the long-run, while an indicator gauging the size of the financial sector (e.g., employment share) results in higher short-term growth, but higher growth volatility in the long-term. These findings are also consistent with work by Christiane Kneer who documented a brain drain, looking specifically at the US – industries with higher financing needs benefit from a larger financial sector, while industries with a higher share of R&D and skilled workers actually loose. In summary, efficient financial services are important for the real sector, while an oversized financial system is not necessarily and might even be damaging for the real sector.

The future of banking in light of technological disruption has been high on the agenda of banking sector analysts, policy makers and researchers.  The Libra announcement by Facebook has raised the urgency of the topic of digital currencies in central bank corridors around the world. As most banking/corporate finance researchers, I have somewhat contributed to this literature by (i) looking at the effects of financial innovation in banking more generally (finding both a stability-reducing and growth-enhancing effect) and (ii) analysing the real sector effects of mobile money in Kenya. While both studies are (by their empirical nature) backward-looking, I am also getting involved in more conceptual discussions, both on the inclusion as on the stability side. So, in the next few months, I will publish some thoughts on the future of banking and technological disruption on my blog – all of this purely my own thoughts, but often based on other people’s research.

 

Financial innovation has been around for centuries and often has had disruptive effects. The introduction of the ATM in the 1970s allowed US banks facing geographical constraints to undermine them and ultimately contributed to the liberalisation of branching restrictions in the US. Financial innovation often comes in the form of new types of intermediaries. As discussed by Laeven, Levine and Michalopoulos (2015), specialized investment banks emerged to facilitate the construction of vast railroad networks in the 19th and 20th centuries across North America and Europe, screening and monitoring borrowers on behalf of disperse and distant investors. In the second half of the 20th century, venture capital funds arose to finance IT start-ups, characterized by limited if any tangible assets that could be used as collateral and thus requiring patient investment capital and close screening and monitoring as well as technical advice.  Today’s disrupters are FinTech and BigTech companies, although there is a big difference between the two. FinTech refers to technology-enabled innovation in financial services with associated new business models, applications, processes or products, all of which have a material effect on the provision of financial services.  While often undertaken by independent start-ups they do not really compete against banks – to the contrary, banks encourage experimentation in this space and often take over successful companies.   BigTech companies, on the other hand, are large existing companies whose primary activity is in the provision of digital (platform) services, rather than financial services; for these companies financial services is thus an add-on service. A critical difference between BigTech companies and other large companies that (want to) branch out into financial services (e,.g, Banco Azteca in Mexico, Walmart in the US) can be summarised with the acronym DNA, an expression coined by the BIS – data, network and artificial intelligence.  Banks have always relied on their ability to collect and process hard and soft information about borrowers; BigTech firms have such data readily available from their non-financial business with customers; artificial intelligence allows them to also convert soft information into hard information. Several papers have shown that information collected this way is better in predicting default than information shared between banks in credit registries (e.g., here and here). In addition, given their platform character, BigTechs enjoy network economies, helping to reduce transaction costs and allowing better diversification.  This provides the chance for BigTech companies to enter areas so far dominated by banks, including retail banking.

 

The increasing accumulation of data raises important questions on the use of such data but also the ownership of data. The Open Banking initiative in the EU allows customers to share data across different banking institutions. The question is whether this should be expanded to BigTech companies, especially when they move into financial service provision. It also raises concerns on new risk sources, such as cyber risk, and might require a stronger focus of regulators on consumer protection.

 

The possibility to use an increasing amount of data also raises question on how they are being used. The financing constraint view has argued that more data allows more efficient provision of financial services and allows reaching households and small enterprises that so far have been excluded due to their lack of collateral and audited accounts. Credit registries are typically seen as critical component of the institutional infrastructure underpinning financial deepening, as they allow clients to build up reputation collateral. On the other hand, there is increasing evidence that such data can also be used for client-specific targeting. More data allow price discrimination and targeted shrouding, where the latter is more consequential in finance, given intertemporal nature of contracts. I recently had the honour of discussing a paper by Antoinette Schoar showing exactly that for credit card offers in the US: Less educated consumers receive more back-loaded terms (low teaser interest rate but high late-payment fees), and more shrouded offers, exploiting behavioural biases.

 

In summary, the financialisation of the modern economy and society seems to give way to the digitalisation of finance. This offers great opportunities for innovation and increased competition in the financial sector, but also lots of public policy challenges. In a future blog entry, I will focus more on the stability challenges.

There have been quite some events – some more peaceful than others – over the past weeks that have put different outspoken economists in conflict.  Take Chile where a price rise in public transport was the spark that set off week-long violent protests against the government, with wide spread destruction of public infrastructure (most notably the Santiago metro, which I fondly remember from past visits) as well as police violence. These protests came as a big surprise to many; after all, Chile has been regarded as a Latin American success story having reached high-income status and being a healthy democracy.  Obviously, not everything has been as good as it looks from the outside.  Some regard this as the ultimate proof that “neo-liberal” reforms have failed, achieving growth only for the 1% and not the 99% (to borrow one of Jeremy Corbyn’s slogans). Top of the list of “failed reforms” are pension and health insurance. What these critics seem to ignore is that income inequality has actually reduced over the past years, even though from a very high level. Throwing the baby out with the bathwater (as Jeremy would also love to do in the UK) does not seem the right answer. But two things seem problematic in Chile (and I am NOT talking as a Chile expert, simply from outside observation and drawing on broad experience in Latin American economies) – a very limited civil society and democratic participation (especially in comparison with other – European – high-income countries), with voter turnout dropping below 50% after voting stopped being mandatory, and the problem of a small market. A small economy easily allows the establishment of monopolies, especially if you have a small political and business elite and if the two are closely interlinked – so, in addition to the market not being able to maintain to many players, there is a political and thus regulatory bias in favour of incumbents. Again, I am not trying to undertake a comprehensive analysis of Chile, but this crisis certainly drives home one point (and here I am in synch with the above mentioned critics): per capita growth is not enough – income and wealth distribution is critical (where economists have moved to analyse the former, there is still limited analysis of the latter). And we also have to move beyond material achievements! In the short-run, I am most concerned about the well-being of my Chilean co-authors and friend; in the long-run, this crisis has given us lots of food for thought (and research).

 

Take next Bolivia – a coup or a public uprising? While working for the World Bank in the early 2000s, I was struck by the enormous contrast between the rich (and white) neighbourhoods (e.g., Zona Sur in La Paz) and the indigenous neighbourhoods (large parts of La Paz but especially El Alto). The early 2000s was a time of crisis and I still remember an intensive discussion with students and social activists during one of my World Bank missions – the conclusion was that much more was needed to address the underlying socio-economic problems than the technocratic solutions we were offering.  I also remember a conversation with the representative of the chamber of commerce who saw us out at the end of the meeting on bank and corporate restructuring, opened the door and said: “Well, we have had a very nice and interesting discussions, but out there – that is the real Bolivia,”, referring to the informal economy so predominant in Bolivia.  Evo Morales has brought enormous change to his country, addressing an important historic injustice by giving voice and power to the indigenous population. He managed the natural resource wave somewhat smarter than other “leftists” in the region (especially Argentina). But as so often, entrenchment in power leads to hubris and arrogance. It was pretty clear that there was cheating at the last election, which triggered the protests.  Ideally, he would have stayed on as caretaker president with a commitment not to run again (as per the referendum result in 2016), but unfortunately, the tension had raised to a point where this no longer seemed possible. One can only hope that the Bolivian political system is capable of managing the transition to peaceful elections and a new government. As in Chile, the situation in Bolivia does not lend itself to the neo-liberalism vs. socialism contrast,  but has many more facets.

 

And to round this up, there was a row about libertarianism, Marxism and the Doing Business indicators. Simeon Djankov, a former World Bank colleague of mine (and who returned to the World Bank a few months ago) dismissed criticism by economists of the Center for Global Development by referring to them as Marxists. He did make a valid point that Doing Business gauges the business environment and not economic and societal success; I disagree with him when he implies that there is no philosophy or (at a minimum) hypothesis behind the data collection - whenever you collect data, there is always some idea in the background, in the case of Simeon, one only has to consult the multiple publications that use the data. More generally, the labelling of critics with historic ideologies is not conducive at all to a fruitful debate. I have written on Doing Business before and will not warm up old debates, but we have to get back to a point where we can discuss theories, empirical findings, policies, and – most importantly – recent events without referring to silly labels and point scoring.

Financial inclusion has been at the top of the agenda for financial development researchers and policy makers over the past decade. There has been enormous progress in data collection, financial innovation and policy formulation in this area. Another important area of finance, however, has been long-term finance, the provision of long-term savings and credit services for households, enterprises and governments. It is a challenge in advanced and developing countries alike. In Europe, the objective of creating a capital market union is partly driven by the objective of more long-term financing. In developing countries, there is a remarkable long-term finance gap, with underdeveloped capital markets and contractual savings institutions and banks focusing mostly on short-term transactions. 

 

But how much long-term finance is there actually? And what are the bottlenecks to increasing the provision of long-term finance?  I have worked on this challenge across two continents - in Latin America for the Inter-American Development Bank, developing a scoreboard and undertaking country diagnostics in Colombia and Paraguay (unfortunately, only the former has been published) and in Africa for a consortium of donors, helping to develop a long-term finance scoreboard.

 

This long-term finance scoreboard was finally launched today, providing an array of data on long-term finance in Africa. Some of the data were compiled from readily available cross-country databases, other through survey work, undertaken with the invaluable help of the African Development Bank’s Statistics Department.  The result is a website which allows users to compare different countries or focus on one specific country. It presents indicators across different dimensions - the depth of long-term financial markets, access to these markets, different sources of funding and policies and institutions supporting long-term finance. Critically, it also provides the results of a benchmarking exercise, which compares countries’ indicators of long-term finance with a synthetic benchmark that takes into account the socio-economic characteristics of each country.

 

One critical factor for the financial inclusion revolution was the availability of data, which allowed benchmarking countries and progress over time and the success of policy reforms.  We hope that this long-term finance scoreboard will be the first step in a similar revolution - it starts with measuring, it continues with policy reform and it (hopefully) ends with progress.

It is always insightful to look at Brexit from a safe distance, such as Santorini where I spent the last few days relaxing. As the Brexit soap opera races towards its next season finale, many of the same themes that have become so familiar over the past 3.5 years are being revisited. And from the outside, the Westminster debate looks as ridiculous as they have over the past years, with politicians seeing Brexit as the response to a question they have forgotten. 

 

First, the Brexit trilemma is alive and kicking, with the UK wide backstop negotiated by Theresa May replaced with a Northern Ireland front-stop, taking NI effectively out of the UK customs union and internal single market. As repeated ad nauseam by many observers, only two out the following three can be achieved: no border in Ireland, UK leaving the European customs union and Single Market, and no border in the Irish Sea.  The last one had to give under Johnson’s deal, resulting in a rude awakening for the DUP who felt themselves let down not only by the Tory government but especially by the Brexiters in the ERG. 

 

Second, the utter incompetence of Tory ministers has been proven again, such as when not being able to respond whether or not there would be customs control between Great Britain and Northern Ireland (yes, there will be and they will not go away with a Free Trade Agreement between the UK and the EU as some suggested). Also, the idea that this FTA can be negotiated within the next 14 months of the transition period is on the same level as the prediction that it will be the easiest trade deal negotiated in human history. 

 

Third, the idea that Brexit will help take back control. Once Article 50 was triggered, all control was with the EU, including the option to avoid no-Deal (better described as Crash) Brexit. The same will repeat itself at the end of 2020 when the extension of the transition period has to be agreed on. And this daunting cliff will also put the UK in a weaker position during the trade negotiations. But, yes, the UK has had enough of experts who have pointed this out for the past 3.5 years!

 

Fourth, the idea that once Brexit has been “achieved”, it will all be done, the nation can find again together and the government can turn its attention to more pressing issues. The simple fact that post-Brexit the relationship of the UK not only with the EU has to be redefined, but also trade negotiations with many other countries will be informed by the future UK-EU deal tells us otherwise.  The anger on the Remainers’ side if and after Brexit happens will not go away.  Add to this the anger of Brexiters who will not get to see the blooming landscapes promised in 2016. And the continuous negotiations with the EU will give lot of opportunities to Brexiter politicians to grand-stand, threaten with the Royal Navy, appeal to the German car industry etc.

 

Can Brexit still be avoided?   Johnson has certainly been poorly advised over the past months.  He could have gotten his deal through Parliament, if not by Halloween, then by mid-November or so. But he certainly behaves like a spoiled toddler who keeps throwing his toys out of the sandbox if things do not go exactly his way. The opposition is as hopeless, I should add!  Yes, they got together to prevent a Crash Brexit. But the obvious consequence - link the new deal with a confirmatory referendum - seems not to be part of their agenda; Remainers obviously want a referendum as a last chance to reverse Brexit before it happens, but sensible Leavers (i.e., politicians who originally were in favour of Remain, but feel obliged to implement the result of the 2016 referendum) should clearly see that only a referendum will be able to settle the issue in a democratic manner, much more than a general election. 

 

As so often before, it is hard to predict what will happen next. It is unlikely that there will be Brexit next Thursday, but apart from that, many things can happen, including a General Election. And even as the EU and its member countries’ governments are losing patience with the Westminster chaos, they are unlikely to pull the plug!  Although the arguments stay the same, there is lots of new excitement to be expected in the last two months of 2019.