Finance: Research, Policy and Anecdotes

The decade since the Global Financial Crisis has seen changes in the architecture of supervision across Europe.  On the one hand, the tendency to separate the responsibility for monetary and financial stability into two different authorities has been reversed in many countries.  One prominent example is the UK where the Financial Supervisory Authority was dissolved and responsibility for bank supervision returned to the Bank of England.  On the other hand, there has been a move towards more cross-border cooperation between supervisors, which in the case of the Eurozone culminated in the creation of a Single Supervisory Mechanism and the ECB and a Single Resolution Mechanism.


I have co-authored a discussion paper with several academic and ECB colleagues on an early evaluation of these trends, just published.  Unlike a regular paper, this discussion paper takes a broader look at the literature,  complemented with some new theoretical and empirical analysis. Herewith a quick summary:


There are theoretical and empirical arguments for combining or separating the responsibility for monetary and financial stability. The recent crises and past decade, however, have shown that monetary and financial stability cannot be separated and that possible tensions between these objectives do not get more easily resolved if assigned to two different authorities.   Assessing different hypotheses on supervisory architecture is difficult in a cross-country settings, given endogeneity concerns.  However,  we offer some tentative evidence that having an integrated supervisory architecture is not associated with higher inflation or lower growth and there is some tentative evidence that it might help reduce the probability of a credit boom turning nasty.


A lot has been written on the advantages of centralised supervision in the Eurozone, including avoiding supervisory arbitrage, economies of scale in supervision and matching the geographic footprint of banks with the supervisory perimeter.  There are also shortcomings, however, including an increase in distance between supervisors and supervised institutions.  It is certainly too early to come to a clear conclusion on these trade-offs, though it is important to stress that the SSM model is not one of complete but rather partial centralisation, focusing centralised supervision on systemically important institutions and even here combining national and supranational expertise. The next years will certainly see more research in terms of banks’ reaction to these changes in supervisory architecture and its implications for stability.

As Theresa May announced her resignation, the airwaves and Twitter were full of praise for her sense of duty!  As German very conscient of Germany’s dark chapter in the 20th century I am always sceptical of people claiming to do their duty! Though her duty she did – bully and harass legal residents (remember Windrush generation) and foreign university students as Home Secretary – all to draw attention away from the social consequences of Tory austerity. It is telling and noteworthy that before her resignation, newspaper headlines in the UK were dominated by the disenfranchisement of EU citizen in the European Parliamentary Elections.  She claimed to have done her duty by trying to implement Brexit – maybe so, but was it her duty to go into the negotiations without any plan and without properly understanding how the EU works and what the constraints of Brexit are?  Was it her duty to draw red lines that cannot be respected at the same time (also known as Brexit trilemma)? Was it her duty to pander to the wet dreams of Brexiteers rather than searching for a national consensus? I will spare the reader an answer to these questions! Most telling in recent political obituaries is the statement that she did not realise the consequences of agreeing to the Northern Irish backstop in December 2017!  Really?!?!


Exit the Dancing Queen – enter the clown?  As Tories (and in a rare political consensus) most of UK’s and Europe’s political class breathe a sigh of relief that she will be gone soon, it is important to stress that nothing but nothing has changed in the Brexit constellation! Will 27 elected heads of EU governments and a recently democratically elected European Parliament get rid of the Northern Ireland backstop and endanger peace in Ireland just because another unelected British prime minister asks them to do so?  No need for an answer here!  Risk a “clean Brexit” and negotiate from outside with the EU?  Sure, the EU will negotiate, with a few preconditions, though, one of which starts with “back” and ends with “stop”. Will it be easier to negotiate for the UK government under the pressure of economic chaos after a Crash-Brexit?  I guess some hard questions that the next unelected Prime Minister of the UK should ask him/herself before taking decisions. 


In her resignation speech she cited Nicholas Winton who had saved the lives of hundreds of children from Hitler’s death camps.    Less than three years after she paraphrased Adolf Hitler in her Citizen of Nowhere speech, this is not just cynical, it is simply disgraceful!  In short: Good Riddance.

I am just coming back from the 2nd young writers workshop in Bonn; an intensive and interactive meeting of junior researchers (post-doc and assistant professor level) and more senior researchers (always relative, obviously!), where the latter shared with the former their experience with the publication process.  

I have discussed some issues in a blog entry two years ago, but have some additional points, partly coming out of discussions with other participants at the workshop.  Over the past six years, I have been editor at three different journals, each one with their different approaches and procedures. In the following, I will discuss some important points on the procedures (mainly referring to the JBF) but also more generally on the editorial process.  


First, where and when should you submit? Perfect is the enemy of the good; so, there is a point in not waiting too long for submission. Also, some topics are rather hot and there might be other people working on it (as happened to me in my job market paper, though I was lucky and published first). On the other hand, do not submit a paper before you have presented it at conferences, seminars etc. Get as much feedback as possible, before submitting.  As pointed out ad nauseam by editors across the profession – editors and referees are not here to help you improve and polish your paper, there are here to judge it and possibly push you the extra step needed. Choosing a journal is always tricky – one school of thought is to always start at the top, as lower-ranked journals are not worth your time (especially with a tenure clock ticking); my approach has been that sometimes I have very interesting projects and papers that might still be worthwhile publishing even if not in a top journal.


Second, what is the process?  For the following, I speak mainly for myself, though I assume that my co-editors at the JBF follow similar approaches.  There are three options for papers that come into my editorial inbox at the JBF: first, desk rejects (mainly because of limited contribution or being too specialised for the JBF; in some cases where the paper is in my own area and there are clear methodological deficiencies, I also desk-reject); second, papers I handle myself and send out to reviewers; third, papers I assign to an associate editor.  Associate editors again have two options; recommend desk-reject or send out to reviewers.  Even though managing editors have the final word, it would be rare for me not to follow the advice of the associate editor. In cases of split reviewer decisions, however, I take another close look at the paper and the reports.


Third, when reading for the first time as editor at a paper, what am I looking for?  As for most people in our profession, my time is scarce and I expect to get an overview of the paper after having read the introduction, with a first impression at the end of the first page. As I wrote in my earlier blog entry, the four most important messages (motivation, research question, methodology and contribution) have to be clearly presented in the introduction, (ideally) mentioned on the first page, and summarised in the abstract. How important are title and letter to the editor – the former can whet the appetite (but do not ask a question in the title that you then do not answer), the latter is rather unimportant, unless you have something important to tell the editor (conflict with other papers/authors/possible reviewers).


Fourth, how important is a proper identification and has our profession gone too far in focusing on identification rather than stressing research questions and policy implications? It is a question we often discuss also among the managing editors at Economic Policy (who come from different fields of economics). Proper policy advice should be based on proper identification, but there is also the issue of internal vs. external validity (best example is experimental field evidence vs. broad cross-country evidence). One important aspect in this debate is the novelty of the question (where even documenting correlation might be interesting); in more established if not saturated literature it is much less attractive to have yet another paper with half-baked identification.  However, confirming a well-established result by a just slightly refined identification strategy might not be as exciting either.  But as always, the devil is in the details, so there is no clear answer here.


Fifth, appeals! The first reaction after any rejection is “how stupid are these referees and how could the editor have followed their advice.” Take a deep breath! If you feel like writing a nasty email, write it, save it, read it the next morning, and delete it!  Is it worth appealing a decision?  I have appealed myself four times over the past 10 years or so, and was successful twice. Do not argue with an editor or referee over lack of contribution or (even worse) poor writing. There are very limited circumstances where such an appeal makes sense, including obvious and critical mistakes of the referees – but these have to be critical for the decision of the editor to reject the paper. Finance journals have tightened the process for appeals quite a lot recently, including that the paper will go to a different editor and a new reviewer, so the hurdle is quite high.  In almost all cases, it is best to move on; after carefully considering the comments of the reviewers, as they might be very valid and they might also be your reviewer at the next journal.


Finally, a word of encouragement.  There are many reasons why our profession has trended towards co-authored papers, one might be that it is easier to share the frustration of rejections.

As I wrote in an earlier post, the establishment of the banking union has had not only implications for the participating countries, but also for other countries in and outside the EU with Eurozone bank presence. Over the past year, I have been participating in a World Bank project analysing the challenges for small host countries in Central, Eastern and South Eastern Europe and the report has now been published.


At the core of the report is the asymmetry between the systemic importance of the subsidiary in the host country and the irrelevance of the host country operation for the overall operation of the parent bank; therefore we refer to these countries as “small host countries”. This exacerbates an asymmetry in rights and powers that can be typically found between home and host supervisors across the globe.


While all of these countries in the region share the characteristics of being host to several Western European banks, they are also quite diverse in terms of their relationships with home country supervisors; specifically, the group includes Eurozone countries, such as Slovenia and the Slovak Republic, non-Euro EU member countries, such as Croatia and non-EU member countries (though some candidate countries) such as Albania or Serbia. This differentiation is quite important as we detail in the report.


In the Eurozone the distinction between home and host supervisors  has disappeared for significant institutions, where the SSM and the SRM are the only authority within the Eurozone left – while this implies loss of supervisory independence, small host countries gain through participation in Joint Supervisory Teams and Internal Resolution Teams, as long it is host to a subsidiary or significant branch.


Contrary to Eurozone hosts, other EU Member States retain their full competences as individual or sub-consolidated host supervisors and resolution authorities. However, they are bound by new rules on supervision and resolution on the EU level.  They have the right to participate in Supervisory and Resolution Colleges, thus gaining access to critical information on the consolidated level about the subsidiaries in their countries.  At the same time, dealing with one supranational authority as home supervisor rather than several national ones can be an advantage.


Non-EU member countries, on the other hand, have few rights vis-à-vis home supervisors within the EU. They can  be invited as observers to join supervisory and resolution colleges, but have no right to be invited and their participation is conditional on an equivalence assessment by the EBA and agreement of other college members.   Unlike EU members, non-EU hosts do not have access to the EBA mediation process and there is no basis for joint decisions as under BRRD for home and host supervisors in the EU.  This reduces the bargaining position of non-EU small hosts rather drastically and results – in our opinion – in an uneven playing field.    


What are the conclusions (and policy implications) of our report?


First, non-EU host supervisors, particularly candidate countries, should participate in all relevant EU supervisory and resolution colleges,  as well as crisis management groups as observers.


Second, EU authorities should reach out to non-EU small host countries and improve cooperation with them.


Third, Small EU host countries outside the Banking Union should make more use of the EBA mediation service when relevant to ensure their interests are properly protected when it comes to joint decision making in colleges.


Fourth, non-EU host candidate countries should adapt EU regulations to fit their national circumstances rather than adopting them blindly, while non-candidate countries should take an even more flexible approach. An approach very much in line with the one we recommend in the recent Making Basel III Work for EMDEs report.

As I have mentioned in a previous blog entry, I have been co-leading a taskforce on Making Basel III Work for Emerging Markets and Developing Economies (EMDEs).  The report was formally launched at a G-24 meeting during the Spring Meetings in Washington DC and is now available, with another blog entry by Liliana and me.


I will not repeat the blog entry or executive summary here, just point to some of the main messages:


Our conceptual framework starts from specific characteristics of EMDEs that, while not universal, have been widely documented: variable access conditions to international capital markets; high macroeconomic and financial volatility; less developed domestic financial markets; limited transparency and data availability; and capacity, institutional, and governance challenges.


These characteristics help explain why the impact of regulatory reforms, such as those under Basel III, is expected to be different in EMDEs than in advanced countries. They also imply the need for a differentiated approach to bank regulation to make Basel III work in these countries and lead us to the following principles underpinning our recommendations:

(i)            Minimize/reduce negative spillover effects of Basel III adoption in advanced countries;

(ii)           Proportionality: the application of Basel standards has to be adapted to the circumstances in EMDEs to maximize the stability benefits for their financial; 

(iii)          Minimize financial stability versus financial development trade-offs.

These principles have guided our analysis and have led us to certain recommendations, of which I will highlight a few:


Minimizing Potential Spillovers on EMDEs: One important area of concern are the significant changes in the volume and composition of cross-border financing to EMDEs since the Global Financial Crisis, including a reduction in cross-border lending from global banks, a heavier reliance by EMDEs on debt issues rather than cross-border lending, and an increasing role of South-South lending. These three developments have important policy implications, but also call for more analysis than before, undertaken by central banks and regulators in advanced countries and EMDEs as well as by international institutions.


One specific area of concern in this context is infrastructure finance. While far from clear that Basel III has been a primary factor behind the relative reduction in private infrastructure finance in EMDEs, an ongoing challenge is that infrastructure is currently not an asset class in itself. If projects can be developed in a more standardized fashion and there is agreement on the different dimensions of risk and how they should be quantified, then it may become easier to issue securities backed by infrastructure projects.


Another area of concern (that pre-dates Basel III) is the potential for spillover effects through the large presence of subsidiaries of global banks in EMDEs. Home supervisors in advanced economies require that regulations, including Basel III, be applied and enforced on a consolidated basis, that is including its foreign affiliates. But this can mean that the same sovereign exposure might get different regulatory treatment by home-country than by host-country supervisors. Currently, for example, in calculating capital requirements, most EMDE authorities assign a risk weight of zero to papers issued by their sovereign and denominated in local currency, whereas global banks largely use their own internal rating models for this purpose. Thus, it is plausible that the same sovereign paper issued by an EMDE government could be treated as a foreign currency-denominated asset, with higher risk weight requirements, if held by a local subsidiary of a global bank. This, in turn, increases the cost to the subsidiary to hold the sovereign paper and might increase the financing costs of EMDE governments. One possible solution would be to agree on threshold values for a set of easily verifiable and widely available macrofinancial indicators (including, but not limited to, international credit ratings). For host countries whose indicators surpass the thresholds, home-country supervisors and global banks would accept, at the consolidated level, the host country’s regulatory treatment of these exposures



Aiming for Proportionality: As EMDEs proceed to adopt and implement Basel III in their countries, proportionality implies adjusting capital and liquidity requirements to the capacities and needs in EMDEs. Many emerging markets “gold-plate” capital requirements, increasing them beyond international standards to reflect higher risks. It might be better to use a data-driven process to determine the riskiness of assets and thus the necessary capital buffers.  Where available, micro-data can be used to calibrate risk weights to the realities and stability needs of emerging markets.  When it comes to liquidity requirements, simpler ratios might be called for if the data requirements for the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) are not easily fulfilled. On the other hand, the typical characteristics of EMDEs, as discussed above, might make a centralized, systemic liquidity management tool necessary. Specifically, banks could be mandated to maintain a fraction of the liquid assets required to fulfil Basel III requirements with a centralized custodian such as the central bank.


Minimizing Trade-offs between Financial Stability and Development: While the financial stability goal in Basel III is necessary, the growth benefits from deeper and more efficient financial systems are larger in emerging than in advanced markets. And when banks are – correctly – subject to increasingly tighter regulatory standards, there is a bigger premium on developing non-bank segments of the financial system, such as insurance companies, pension funds, and public capital markets – segments that are still underdeveloped in most developing economies.


As happy as I am to have finalised this report, the launch of the report is not the end of the work!  I will be presenting the report at an IMF/BIS conference in May and at a conference of the Community of African Bank Supervisors in June.  Stay tuned for a follow-up.