Finance: Research, Policy and Anecdotes

Now accepted by the Journal of Corporate Finance, a paper by Ilkay Sendeniz-Yuncu, Steven Ongena and yours truly. “Keep Walking? Geographical Proximity, Religion, and Relationship Banking” has nothing to do with my love for Blended Whiskey and all with the distance between borrowers and lenders across conventional and Islamic banks in Turkey. Combining data on borrower-bank relationships from Kompass and branch location data of all Turkish banks, we find that Islamic banks are geographically more distant from to their borrowers. We also find that the probability for a firm to connect to a bank substantially decreases in distance, but that if the bank in the vicinity is an Islamic bank, distance plays a more muted role.  The higher distance between borrower and bank in the case of Islamic banks is stronger in cities with a higher conservative party vote and higher trust in religious institutions.  As we control for many other firm characteristics and also control for within-firm variation (for firms with both conventional and Islamic lenders), this difference seems to be driven more by demand than supply-side differences.

 

What do we learn from these findings? Distance is far from dead and matters for which bank a borrowers links up with. Second, Islamic financial products are sufficiently attractive for certain borrowers that they are willing to take into account longer distances to access these banking products.

Fresh off the print – the Handbook of Finance and Development, co-edited by Ross Levine and yours truly!.  It has been 25 years since Bob King and Ross published the two seminal papers that kicked off the empirical finance and growth literature, so a good moment to take stock.  While these two papers established partial correlations between financial and economic development using cross-country regressions, the literature has subsequently focused on controlling for different endogeneity concerns, including reverse causation, omitted variable bias and measurement bias and has used an array of different data sources.  More recently, non-linearities in the finance-growth literature have been explored as well as the trade-off between growth and stability. At the same time, economic historians have explored the development of financial systems in major economies and how they have interacted with economic development.  Over the past decade or so, financial inclusion and microfinance have become more important, with new data sources opening up, as well as randomized control trials being used.

 

This handbook includes 20 chapters by leading economists and historians in the field, who give an overview of different aspects (theory, empirics, growth vs. stability, historical accounts, political economy of finance, financial inclusion, SME finance etc) and look forward to future research.   The handbook has been in the making for quite some time, but Ross and I are very happy with the outcome and think that this can be a major reference for anyone interested in this area.

Before heading off into my summer holiday, some interesting papers I recently read:

 

My PhD student Mikael Homanen has gained quite some media attention with his paper on the Dakota Access Pipeline. He shows that protests against the banks funding this project ultimately resulted in deposit outflows for these banks, a powerful role for depositors in forcing banks to internalise the negative externalities (in this case of environmental nature) of their lending decisions. Among many others, the FT picked up on his paper.

 

Ahmed Tahoun and Laurence van Lent have an interesting paper on the role of personal wealth of politicians in bail-out decisions, now forthcoming in the Review of Finance. Controlling for many other factors, they find that Representatives with financial wealth interests in the banking system were more likely to vote in favour of the 2008 Emergency Economic Stabilization Act, even controlling for political beliefs and lobbying.  

 

Also forthcoming in the Review of Finance, a recent paper by Marcel Fratzscher and Malte Rieth, documenting the two-way spill-over between bank and sovereign risk in the Eurozone. The recent non-standard monetary policy by the ECB, on the other hand, has contributed to lowering both risks.

I recently attended a very interesting roundtable in Kuala Lumpur on the lessons from the Global Financial Crisis.  Lots of interesting topics were touched upon, but it was one issue that really caught my attention: have the US been generous to the rest of the world by committing itself as leader of the Free World, with corresponding high military expenses, and is this generosity now going away under Donald Trump?  This is not only the narrative of Donald Trump, but many other observers who point to the costs of the leadership role the U.S. have been taking over the past 75 years. What is sometimes forgotten, however, is that this leadership role also comes with privileges, most prominently, the ability to issue the reserve currency of the world.  A recent paper by Barry Eichengreen, Arnaud Mehl and Livia Chitu, which will be presented at the next Economic Policy panel meeting in Vienna in October, shows that to a certain extent it is military alliances and support that explain why a country’s currency is used by other countries as reserve currency (thus providing it with the equivalent of seigniorage gains).  The fact that the U.S. has a leadership role in the West can thus explain why the US dollar is so popular as reserve currency and guarantees lower interest costs for the US government.   A back-of-the-envelope calculation by the authors shows that the benefit of issuing the reserve currency of the world is larger than the costs of military alliances and support the US provides to its allies.

 

By the way, these findings might also explain why the Euro has not become a major reserve currency around the world – contrary to the hopes and expectations of Europeans. As the Eurozone and the European Union are primarily economic unions and have no military ambitions, the findings of Eichengreen et al. suggest that the Euro will not be able to convert itself into a major reserve currency.

 

One might be able to make a similar argument about privileges vs. generosity about Germany within the Eurozone, though less in military and more in political terms. The Euro is effectively a foreign currency for most Eurozone countries, with the notable exception of Germany. Political or economic uncertainty in periphery countries resulting in an increase in sovereign bond yields pushes down the German Bund yield as the result of a run into safety. And it is Germany, which benefits more than from that than any other core country (e.g., Netherlands), given the size and liquidity of the German sovereign bond market. This also relates to the scarcity of safe assets in the Eurozone, which again puts Germany in a privileged position.  These benefits if not privileges from being the core country of the Eurozone make a strong economic but also political argument for taking more financial responsibilities within the Eurozone (aka as “generosity”), ultimately sharing the benefits of this privileged position with the rest of the Eurozone. While some in Germany might have recognised this point, there is no broad consensus on this yet and it might take another generation or so to get there, hopefully before the Eurozone breaks apart.  But even if there were such a consensus, we have learned from the Trump presidency that a generation-long consensus can be questioned in a rather powerful way.

When the Brexit referendum was called, I was struggling to understand why anyone would advocate or even vote for Brexit: after all, economic self-interest would force to UK to stay inside Custom Union and Single Market without being able to influence the rules.  Well, I was obviously very wrong, although I agree with many observers that the vote was actually not about EU membership but long-run frustrations built up in parts of the British electorate, which could not be voiced in General Elections.

 

The last couple of days and weeks have seen quite some developments in the Brexit debate and process. Unlike more professional bloggers (among my favourites: Simon Wren-Lewis and Ian Dunt), I cannot follow up on a high-frequency basis.  But here are some more general thoughts about Brexit now that Theresa May is no longer trying to kick the can down the road and has come up with a plan and thus a basis for negotiations with Brussels.

 

1. Leave proponents and Brexiters keep on spreading lies no matter what.  While most sensible people were cheering that Boris had finally left the Foreign Office, some people took a closer look at his resignation letter.  In this letter, he claimed that the EU had been delaying the implementation of new safety rules for truck drivers to reduce the likelihood they hit bikers, against the will of the British government, citing this as an example where closely tying the UK to regulatory rules of the EU damages the UK.  Well, it turns out, the truth is the other way around - the UK government had delayed attempts by the European Commission to introduce exactly these standards!  As Joseph Welch would have said: "have you left no sense of decency?" 

 

2.  The main problem of the Brexiters is that they do not have a sensible plan on how to execute Brexit, beyond magical thinking (also referred to as cake-ism). They keep coming back to two options: (i) take the negotiations to the brink and rely on the European Commission to blink first (which Ian Dunt referred to as using a "bicycle to play chicken with a lorry"), or (ii) crashing out of the European Union without any agreement (also known as the "f** business, f*** reality" option).   The first plan has been shown to not work - to put it simply, the European Union is too invested in the inseparability of the four freedoms than to blink in the Brexit negotiations and just give in.  The second plan can be dubbed Plan Chaos but might also be the outcome of the first plan.  Put differently: there never was a plan and there is no plan!  Reality is finally catching up with the Brexiters.

 

3. David Cameron called the referendum to settle a long-standing dispute within the Conservative Party on EU membership. The result: the dispute has turned into open civil war within the Conservative Party and across the political system. The vote in favour of Brexit was also a symptom for the loss of credibility of Britain’s political class, as the majority of MPs was and is in favour of continued EU membership.   The result of the Brexit process, however it will turn out, will be a further loss of political credibility.  Theresa May promised (and still keeps promising) a Brexit divided that does not exist.  After she became PM, she started out as a hard Brexiter (“taking back control of borders, laws and money”).  Over the following two years, she realized that such a Brexit would simply not be feasible, and she had to break these promises. Any attempt to explain this away is clearly seen as what it is: political spinning. Obviously, this is not a good way to create trust in the political class.  If there will be a soft Brexit somewhere between what the cabinet agreed in Chequers and what Brussels is willing to give, one can very much envision a revitalized UKIP with a dozen or more Tory MPs joining them. If Theresa May falls and a new PM leads the UK towards a crash out of the EU, the corresponding socio-economic damage will similarly lead to political turmoil, with possibly even wider repercussions for the electoral landscape.  

 

4. As it stands right now, it is still almost impossible to predict the outcome of the Brexit process, with one exception - the first UK draft for the future relationship between the UK and the EU (aka Chequers agreement) will NOT be the final outcome, as it involves too much cherry picking, is unwieldy and incomplete. The possible outcomes include the Chaos outcome in the form of crashing out (which would involve a meltdown not only in the negotiations between UK government and UK but also a meltdown in UK politics) but also the softest solutions of all - UK as EEA member. What is relatively easy to predict is that - in the absence of the crashing out option - the "transition period" (better described as stand-still period as the UK will have to follow all EU rules without being a member) will be extended as the future relationship will most likely not be negotiated before the end of 2020 and even less implementable by then.  But then again, the EU has not necessarily any firm interest in resolving the future relationship now, but rather to focus on the Irish backstop. Once the UK has left the EU with the Irish backstop signed, the EU will be in an even stronger negotiating position vis-à-vis the UK.  The preferred solution for many Remainers - a second referendum leading to a reversal of the Brexit process and the continuing UK membership in the EU seems still rather unlikely, though might be the result if there is no majority in the House of Commons for any of available Brexit options.

 

5. There is an important media angle to the Brexit referendum, as pointed out by Simon Wren-Lewis in several blog entries.  The hatred and lies spread by the right-wing press against Brussels and anything that has to with the European Union has certainly contributed to the referendum result, but also to the positioning of Labour against remaining in the EU. And the BBC, trying to present a neutral picture, indirectly supports the snake-oil sellers by giving them equal air time as the people who actually know what they are talking about. I think the discussion on who is actually behind the snake-oils and how it is funded is just beginning and will be an important topic for economists and political scientists alike.

 

So, coming back to my introductory remark, the economically ideal solution for the Brexit process will leave the UK in almost the same economic position as now, but with reduced political power.  The politically preferred solution for many Brexiters sees the UK economically worse off as well as politically.  Which makes one wonder yet again: why Brexit in the first place?