Finance: Research, Policy and Anecdotes

As most of my generation, I have a very ambiguous relationship to Helmut Kohl; on the one hand, he was not considered to be on the same intellectual level as his predecessor Helmut Schmidt, he was seen as opportunist who relied on relationships rather than principles. On the other hand, he is rightly considered as the father of the German unification – where others hesitated, he saw the unique window of opportunity (which might have closed only a year later with the disintegration of the Soviet Union) to push ahead and achieve what few had considered feasible a few years earlier: a unified, stable and democratic Germany.  Politically the right move, it came with some doubtful economic policy decisions – one of the major decisions was a conversion rate of East and West German marks of one-to-one, which turned East German companies completely uncompetitive and is one of the reason why Eastern Germany was not converted into “blooming landscapes” as he promised in 1990.  It was one of several economic policy mistakes (nicely documented by HW Sinn in his book “Kaltstart”), which came back to haunt the unified Germany in the early years of the 21st century   The second important decision taken in 1990 was that of the introduction of the euro – concession to the French president Mitterand for given his approval for the German unification. While praised as success story for the first 10 years, the governance structure of the Eurozone has been a major cause of the prolonged Eurozone crisis for the following ten years.

 

How ever one might evaluate Helmut Kohl’s policies and politics, he will enter the history book as the last chancellor of Western Germany and the first chancellor of the unified Germany (for the first time a unified and stable democratic Germany); he helped close a chapter of German and European history and push open a new one. For better or worse, he helped shape the political and economic ground on which today’s European policy makers have to play. A European giant!

Two interesting papers from a recent conference in Frankfurt, showing the importance of too rapid expansion for both bank-level and systemic fragility and shedding doubt on whether the focus on higher capital standards should really be a first-order regulatory priority.

 

Moritz Schularick from Bonn likes to go for big questions – so in a recent paper with Oscar Jorda, Bjoern Richter and Alan Taylor, he asks whether bank capitalization can predict systemic fragility?  Using data for almost 150 years, the answer is: NO. Banks’ solvency has no value as a crisis predictor; liquidity indicators, such as the loan-to-deposit ratio and the share of non-deposit funding, have some predictive power, but the most robust and clearest crisis predictor is loan growth.  One consolation prize for the higher-capital-buffer-lobby: recoveries from financial crisis recessions are much quicker with higher bank capital (consistent with the recent experiences in U.S., Japan and Eurozone, I would add).

 

And to complement these macro findings with some micro-evidence, Rudiger Fahlenbrach, in joint work with Robert Prilmeier and Rene Stulz, uses bank-level from the U.S. over 40 years and shows that stocks of banks with high loan growth significantly underperform banks with low loan growth over the following three years, mostly due to higher loan losses stemming from riskier lending associated with rapid loan portfolio expansion. It is interesting that neither markets nor analysts pick up this phenomenon in time.

 

So, yes, capital buffers are important, but so is macro-prudential trying to affect the credit cycle! 

The British voter has spoken and has left everybody confused.  The promise of “strong and stable leadership” did not seem sufficient to sway voters towards a Tory landslide as predicted just a few weeks ago. It seems that British voters do want to have details and where they got them (e.g., dementia tax) they did not like them. They also do not seem to like kitchen cabinets (e.g., government by unelected Fiona and Nick), but rather more inclusive and transparent governments (which also implies showing up for TV debates). Instead of getting a strong mandate for Brexit negotiations, Theresa May enters these talks now very much weakened and with a certain degree of uncertainty whether she will still be in Downing Street in March 2019, when the process is scheduled to end.  I agree with Martin Sandbu, that this can either end in the UK crashing out of the EU in March 2019 or (if cool heads prevail) in a much softer Brexit than Theresa May promised.

 

How to interpret the rise of Labour under Jeremy Corbyn, fueled, as early indications suggest, by young voters finally turning out (where were you last year in the referendum???).  Are these the Remain voters finally standing up? Unlikely, as they should have voted Lib-Dem! Or is it rather that they see that Labour better understands the message that the 52% sent last year, expressing their social and economic frustrations with a vote against the EU?   Jeremy Corbyn promised a free lunch, with the tab being handed down to future generations – but it seems Labour better understands the underlying fears and hopes of many people outside the Westminster/Brussels bubble: for many voters, it is primarily not about the European Court of Justice, Single Market or Customs Union, but about education, NHS, income and the future.

The banking union has passed its first test – the take-over of Banco Popular by Santander, combined with a bail-in of equity and junior bond holders at Banco Popular was done swiftly and efficiently, without rocking the markets or depositors. Certainly, a success for the new resolution framework in the Eurozone, including in terms of cooperation between SSM and SRM. And judging from the impact of the bail-in at Banco Espirito Santo on the real economy, we can expect some but limited negative fall-out for Banco Popular’s borrowers.

 

As academics, we are not supposed to simply praise, but point to challenges.  So, let me point to two!  First, no funding was required (to a large extent, it seems, courtesy of supervisors in Frankfurt and Madrid being alert and reacting in time), which made the operation simpler. The resolution of Italian banks might not be as easy! Second, it was a bank failure in a large country where another bank stood ready to take over the failing bank.  We might not always be as lucky; more importantly, if we want a truly European banking system, we should cheer for cross-border resolutions of such bank failures!  

 

I spent the last two days at a workshop on the adoption of Basel standards in banking systems of low-income countries.    Economists typically discuss regulatory standards under the perspective of maintaining stability and reducing the risk of fragility.    Many of the international standards (such as the Basel capital standards) were developed by and for developed financial systems, without taking into account the needs of developing countries.  Nonetheless, many developing countries have decided to adopt international standards even where they do not seem fit for purpose.  In an ESRC-DFID funded research project with Ngaire Woods and Emily Jones from the Blavatnik School of Governance in Oxford, we are trying to understand what factors drive these decisions, in terms of policy objectives, influence of domestic and foreign banks, internal political power struggles and influence of international financial institutions. Ten country case studies form the core of the project, ranging from Vietnam over several African countries to Bolivia, from non-adopters and closed financial systems, such as Ethiopia, to adopters with open and competitive financial systems, such as Kenya. It seems that in many (though not all) cases, adopting international standards was used as signaling device to international investors, but there is quite a network effect as well, across regulators and with the influence of international financial institutions.

 

As economist, it is always fascinating to participate in workshops and conversations dominated by political scientists who have different concepts, theory and perspectives on the same important issues that we economists grapple with. Quite interesting their view of the financial system, either in the context of the developmental state (known to us economists as financial repression) or in the context of financialisation (off-shore centre or financial hub). Trying to impress on my colleagues that the financial sector can also serve the rest of the economy (at least in theory)….