Finance: Research, Policy and Anecdotes

What a year it has been! In terms of politics, 2016 was the year of shocks (Brexit vote and Trump election) and 2017 the year of hope (Macron election). 2018 can be referred to as the year of the new normal, with populists-authoritarian parties now firmly in charge in several European countries, Macron running into trouble in France and Trump continuing his attacks on international trade. On a personal level, it has been an exciting and intellectually stimulating year, working with my outstanding PhD students Andre and Mikael, continuing as Economic Policy editor and helping to push forward the long-term finance agenda in Africa.


2019 will bring new challenges for me, including on the professional level. It will be my last year as managing co-editor of Economic Policy and my first year as managing co-editor of the Journal of Banking and Finance.  I have joined the Advisory Scientific Committee of the ESRB and have been working as academic advisor for the FSB on the evaluation of the effects of Basel III on SME finance.  And as important background noise, the comedy show “Brexit” has been just renewed for another season (my bet is that it will be extended for several more seasons).  In any case, if anyone thought 2018 was a crazy year in British politics, wait for 2019 you ain’t seen nothing yet! 


Happy holidays!

Meghana Ayyagari, Sole Martinez Peria and I have finally published a working paper version of our study on the effect of macroprudential policies on firms’ funding and investment/sales growth. An early version of this paper was supported by the Hong Kong office of the BIS and presented at the BNM-BIS conference on financial systems and the real economy in Kuala Lumpur two years ago. The new version, however, has added quite some additional results. Here is in a nutshell what we find: the implementation of macroprudential tools aimed at borrowers (such as loan-value and income-debt limits) have a statistically and economically significant association with small and young firms’ funding growth, especially those firms that are financially less healthy. These relationships are statistically and economically stronger for long-term (more than one year) funding growth. There is a similar relationships for firms’ sales and investment growth, suggesting that macroprudential tools have implications not just for the financial but also the real economy. The results do not seem that surprising as smaller and younger firms are also more affected by other types of macro policies, such as monetary policy and  capital controls.  On the other hand, the results are reassuring as it is the financially weakest firms that are affected, thus mitigating concerns on financial inclusion.


For a short, non-technical version of the paper, see the Vox column here.

This week, the Eurogroup (Ministers of Finance of all Eurozone countries) agreed on some reforms for the banking union and Eurozone governance.  As always, it is two steps forward and one step back.  There has been an important step towards creating a backstop for the Single Resolution Fund (in the form of a revolving credit line from the ESM), which will strengthen the resolution component of the banking union. Having access to the necessary funding (even if only for transitional needs) provides supervisory and resolution authorities more options and stronger incentives to intervene in time.  Moving towards a Eurozone-level deposit insurance, on the other hand, has been referred to yet another High-level Working Group, which is supposed to report back by June 2019 – typical can kicking.  While one might see backstop and Eurozone deposit insurance as substitutes, creating a common backstop specifically for depositors in the form of a Eurozone deposit insurance can help create stronger confidence in the banking system in some periphery countries where the national backstop to the deposit insurance is not trusted and might also help to move the Eurozone towards a Single Market in banking.  


Beyond the rather slow progress towards a complete banking union, one major gap is the refusal to address the stock problems in the Eurozone, most notably the large share of NPLs in Italy and other countries.   I know I sound like a broken record (here, here and here), but the refusal to address these stock problems will also prevent further progress towards a full-fledged banking union that allows for full risk-sharing and is the regulatory fundament for a Single Banking market in the Eurozone.  As long as creditor countries in the North of Europe are afraid of having to foot an open bill for legacy problems in the South, they will be reluctant to move to complete risk sharing.  Simply waiting for these problems to disappear (also known as flow solution) or national governments to address them (after they have dragged their feet for the past ten years), however, seems somewhat disingenuous.


This constraint is also reflected in the discussion on sovereign restructuring mechanisms and the role of the ESM, given the sovereign fragility of Italy.  The idea of allowing for a restructuring mechanism for sovereign debt (similar to the bail-in regime for banks) has not been adopted and the aim is now to rather introduce single limb collective action clauses (allowing for one resolution decision to cover all bonds) by 2022 and enable the ESM to facilitate a dialogue between debtholders and Eurozone governments in times of crises. In addition, precautionary credit lines from ESM for countries are planned, with conditionality imposed and monitored by the European Commission. While this might strengthen market discipline to a certain extent, the introduction of risk sharing mechanisms in the form of common fiscal policy has been left for future discussions.


As always, the question is whether the glass is half full or half empty. Maybe a different question is whether the glass will break with the next earthquake – will the necessary reforms only be undertaken when there is an acute need or will the Eurozone and its banking system enter the next crisis better prepared?


On a somewhat different, but related note, the appointment of Jakob of Weizsaecker as chief economist in the German Ministry of Finance is an incredibly good and important signal that the German government might finally move away from an exclusive focus on market discipline to a more holistic view on the Eurozone governance structure. Jakob has actively participated on the discussion on Eurozone reforms over the past ten years, with innovative proposals, so we might see a shift in the role of the German government in these discussions (where his appointment already signals a possible shift in thinking).

Last week, I participated in a conference on the dynamics of inclusive prosperity in Rotterdam, an interdisciplinary meeting bringing together economists, lawyers, sociologists and philosophers.  Participating in the opening panel session, I was asked to give a short presentation on reinventing finance – a continuous challenge. My main message: an extensive literature has shown the transformative role that a thriving and effective financial system has on economies and societies.  But in order to fulfil this role, the financial system has to continuously transform itself, partly based on the lessons from recent crises but also to confront new social and environmental challenges. In this context, the challenge of green finance has become more and more important.  Green finance, however, is a rather broad topic, encompassing lots of different questions under the broad umbrella of how financial markets react to environmental risks and challenges and how the financial system (and its stakeholders) can contribute to a sustainable environment.  One of my favourite papers in this new strand of the literature is a recent paper by Ralph de Haas and Alex Popov on the relationship between financial structure and industrial pollution.  We know from an expansive literature that banks are more conservative in their funding decisions, going for established industries and firms, while markets are more likely to fund innovative sectors and projects (where the outcome is more uncertain). Ralph and Alex show that this also holds for pollution: banking sector development is associated with faster growth in “dirty” sectors, while capital market development is associated with growth in “clean” sectors. But even within dirty sectors, stock market development (but not credit market development) is associated with cleaner production processes, as these industries also produce more green patents when stock markets expand.

But can depositors also force banks to internalise the environmental costs they impose on society through their lending decisions? This is a question my PhD student Mikael Homanen has addressed in his job market paper Depositors Disciplining Banks: The Impact of Scandals.  Specifically, he shows that  protests against the Dakota Access Pipeline that targeted banks caused significant decreases in deposit growth of banks that funded this pipeline (some of which later withdrew from this project). And the economic effect was also large: Depositors withdrew as much as $8-20 billion from the affected banks. On average, branches lost approximately 2% deposit growth, compared to the annual average of 8%. The depositor reaction was larger in areas closer to the planned pipeline and in areas where households express stronger beliefs in climate change and local readiness for tackling societal challenges.  Mikael then uses global data on bank-specific scandals and shows that this new form of depositor discipline is a much more general phenomenon. Combining scandals on tax evasion (e.g., Panama Papers), corruption (e.g., Libor-rigging scandals), and environmental scandals (e.g., the Carmichael coal mine project in Australia) with a global, quarterly bank-level dataset, he shows that total deposit growth decreases after scandals. The Dakota Access Pipeline was not a one-off!

These are only two examples of papers in this new strand of literature.  There are many important topics to be covered, including very policy relevant ones.  Environmental risks should form part of bank stress tests and in the context of Quantitative Easing the question arises to which extent asset purchases should be titled towards sectors with lower carbon footprint. On the one hand, our planet is too important to ignore the question; on the other hand, questions on central bank independence and mission drift arise. In a nutshell, the area of green finance is a critical issue that requires substantial research but also engagement with other academic disciplines and a multitude of stakeholders.


This year saw the end of a five-year project on Productivity in Low-Income Countries, funded by DFID, and in which I have been extensively involved, together with several former colleagues from Tilburg University.  The goal was to undertake empirical studies in a number of low- and middle-income countries to understand the constraints that micro- and small enterprises face for productivity and growth and instruments/tools and policies to overcome them.  The project thus comprised independent teams across a number of countries in Sub-Saharan Africa and South Asia asking different but related questions and using a variety of different methodologies, but in most cases using data collected specifically for this project. In some cases, randomised control trials (RCTs) give us confidence that we have discovered causal relationships, in other cases, cross-sectional regressions limit our interpretation to partial correlations that we relate back to existing theories or – in one case – to our own model. Some of the papers have now been published or are under review.  Herewith a short summary of the different papers – as you can see while a large share of papers focus on financing constraints, other look beyond finance to other important growth constraints:


One of the focus countries has been Kenya. Using a calibrated general equilibrium model, Haki Pamuk, Ravi Ramrattan, Burak Uras, and I show that the availability of mobile money increases supply of trade credit and reduces its price, thus expanding external finance for entrepreneurs and ultimately economic growth (see here for a longer summary).  This shows the importance of payment technologies for the financial inclusion debate.  In a follow-up paper, Patricio, Dalton, Haki, Ravi, Daan van Soest and Burak report on an RCT that tries to identify the barriers to the adoption of the mobile money technology. There is quite some unmet demand as take-up is quite high when businesses are helped to overcome information, registration and technological barriers.   The authors also find that 16 months after adoption, businesses using mobile money were more likely to feel safe and have access to mobile loans from the mobile money provider.


In a paper using firm-level survey data for Uganda, Mikael Homanen, Burak Uras and I show that access to external (bank) finance is associated with firms’ being more likely to hire skilled workers as they increase sales and profits, while the hiring of casual or family workers is not. This result links to an expanding literature on the importance of financing constraints not just for firms’ investment, but also for hiring and training.


In a paper using firm-level survey data from Ethiopia, Mohamad Hoseini, Burak Uras and I show that trade credit and bank credit can be substitutes on the aggregate level (regions with more limited access to bank credit see higher provision of trade credit), while complements on the firm-level – i.e., having access to supplier credit helps a firm signal creditworthiness and thus gain access to bank credit.  These findings relate back to different theories on the role of trade finance – as substitute for more formal sources of funding, but also as signalling tool.


In a paper using Indian data, Mohamad and I focus on the relationship between financial development and formality. We distinguish between two different dimensions of financial deepening – banking sector outreach and credit deepening.  We find that bank outreach has a stronger effect on reducing the incidence of informality by cutting barriers to entering the formal economy, especially for smaller firms, and thus diminishing opportunistic informality. In comparison, financial deepening increases the productivity of formal sector firms (important note: this paper is currently being revised, so expect new version soon).


In a paper using firm-level survey data from Tanzania, Haki, Burak and I focus on internal finance constraints, i.e., micro-entrepreneurs not being able to reinvest their savings into their business if they save within the household. Specifically, we find that there is a significantly lower association of saving within the household with the likelihood of reinvesting profits than other savings form, most importantly, formal saving forms. These results clearly point to the importance of looking beyond micro-credit to micro-savings products.


Looking beyond financing constraints, one important question is whether micro-business owners are only life-style entrepreneurs, being self-employed in the absence of salaried opportunities, or have growth aspirations.  Among a representative sample of retail shop owners in Jakarta, Patricio, Julius Rueschenpoehler and Bilal Zia find that the average business has strong short- and long-term aspirations for growth in shop size, number of employees customers, and sales. Yet, there is also pronounced heterogeneity, with more than half of the businesses reporting no aspirations for growth in the next 12 months, and 16 percent failing to imagine an ideal business over the long-term.   However, there might be opportunities for such micro-entrepreneurs to learn from successful peers. Patricio, Julius, Burak and Bilal test such opportunities with an RCT among the same group of retail shop owners in Jakarta.  They identify local best practices and disseminate the information through a handbook tailored to their business culture. Eighteen months after the intervention, they find that the handbook alone does not lead to significant performance gains, while documentary videos and individualised help from peers  significantly improve sales and profits, up to about 35% compared to the control group. These findings show that business growth can be achieved through disseminating local knowledge in ways that are simple, cost effective and scalable.


In a complementary paper, Patricio, Julius and Bilal test whether the exposure to successful peers can change retailers’ aspirations. They find that that business growth aspirations respond strongly to these interventions, measured up to eighteen months afterwards though the direction depends on the initial aspirations. Entrepreneurs with initially high business aspirations respond positively to the treatments and increase business aspirations, sales, and profits, while those with initially low aspirations respond negatively.


An even simpler method to increase productivity (at least in agriculture) might be production measurement and goal setting. Patricio and Kim Cole train a random sample of small informal Ghanaian cassava processors on these two simple business practices and find that firms trained in goal-setting increase their productivity by 50% relative to those trained in production measurement only. Goal setting can thus be an inexpensive tool to increase productivity amongst small informal enterprises.


Finally, Patricio, Nguyen Nhung, and Julius, use a sample of small low-income retailers in Vietnam to test with experiments whether financial worries affects their risk attitudes. They find that entrepreneurs exposed to financial worries are more likely to seek financial risks than those assigned to a placebo treatment. This effect is stronger for owners of shops which are smaller and less exposed to large income shocks in their everyday business. They further show that the effect of financial worries on risk attitudes is not explained by changes in the cognitive functioning of the treated.


In a nutshell, micro- and small entrepreneurs face a variety of growth constraints that might also reinforce each other. And it is not necessarily bank or micro-credit loans that are the best solution to overcoming their productivity and growth constraints, but rather an array of different financial products and management tools, but also entrepreneurial networks. Critically, different entrepreneurs have different growth aspirations and the tools and instruments have to be tailored to their respective needs.