Finance: Research, Policy and Anecdotes

As part of a revision of my recent paper with Consuelo Silva-Buston and Wolf Wagner, we have explored whether stronger cooperation between supervisors is associated with higher stability.  This is summarized in this Vox column.  Herewith the one-paragraph version: Banks where the parent supervisor has cooperation agreements with a larger number of host supervisors (weighted by share of each subsidiary’s assets in total foreign assets of the parent bank), have higher z-scores and a lower marginal expected shortfall (so both a book and a market-based stability measure).  However, these findings are driven by the “smaller” cross-border banks – the larger one might be simply too big or too complex. This relationship is as strong during normal and during crisis times. Obviously, this relationship could be a spurious one – confirming our results with political affinity between countries as instrument for cooperation and the fact that we exploit within-bank variation rather than cross-bank or cross-country variation makes this less likely, however.

I am on my way back from Dhaka, where I attended a workshop on Institutional Diagnostics in Bangladesh, commenting on a paper on the “Political Economy of Private Bank Governance in Bangladesh”.   Bangladesh’s financial system is very much in line with its status as a lower-middle income country, dominated by banks, with a large share of government-owned banks. Non-performing loans are high and one can argue that it not quite fulfilling its role in pushing the economic development and transformation (including export diversification) of Bangladesh further. But what holds financial sector development back. If one considers the policies that international experience has shown to be conducive for financial sector development – macro-stability, contractual framework – one sees there is volatility and there are many gaps in the institutional framework. But what are the political constraints to addressing these gaps.

 

It was my third visit to Dhaka; the first time was in 2006, while at the World Bank, when I was asked to write a background paper for the Country Economic Memorandum on the challenges facing the financial sector.   Some readers might not be surprised, but the challenges to which I pointed in 2006 are still around. In addition to the ones mentioned above, the regulatory framework has been anything but conducive for the development of a thriving banking system – heavy-handed regulation, on the one hand, though often not enforced; bank licenses awarded as political favours and regulatory forbearance resulting in fragile private banks never going out of business.  What has changed over the past 13 years is that the independence of the central bank and thus supervision has been further undermined, increasing political and regulatory capture. The political background to this is a shift from a competitive political system (where the main two parties alternated in power) to a political system dominated by one party.

 

What are the solutions? The literature tells us what to do, but these reforms might encounter strong political constraints! Privatization of state-owned banks – politically difficult and not necessarily a solution as regulatory forbearance vis-à-vis private banks and the political “sale” of bank licenses show. Strengthening the independence of the central bank; this has worked in many countries but given the record of political appointees at Bangladesh Bank, it might be difficult to turn de jure into de facto independence.

 

There are no panaceas but the need to think outside the box.  Two suggestion I have made are: first, a stronger role for foreign banks. Foreign banks are more immune to political pressure and can help break the link between politicians, bankers and borrowers. The experience of Central and Eastern Europe has shown the transformational role foreign banks can have. Yes, there are worries that foreign banks might ignore the low-end of the market (as shown by Atif Mian in his paper on Pakistan), but this might be somewhat less of a concern in Bangladesh given a thriving microfinance industry that is eager to move up-market. It is important to note, however, that the benefits of foreign bank entry for host economies can only be reaped when the institutional infrastructure surpasses a minimum quality threshold. Second, strengthening private monitors. Accounting and auditing companies seem to be struggling; given regulatory forbearance, market discipline is very limited. However, it seems that the print media still have an important role to play, but more players would be better. Establishing an independent FCA-style institution might be useful. Strengthening banks’ disclosure requirements (and making CEOs liable for complying with them) might help as well. 

 

Ultimately, it is difficult to address financial sector and institutional reforms outside the political space.  Increasing the share of people with a stake in such reforms and creating coalitions that benefit from such reforms can help.

Today 80 year ago, German troops attacked Poland, starting World War II, the most horrific slaughter and genocide in European history  (I will not be drawn into comparisons with Stalin – “we dealt” with this comparison in the late 1980s during the German “Historikerstreit”). Growing up as German in Germany, I was confronted early on with this horrific legacy. We had furious debates in high school whether Germany lost the war or was liberated from the Nazis by the Allies.  I have never had any doubt that it was the latter and that we should be grateful for having lost the war (watching “The Man in the High Castle” these days, it is hard for me understand why anyone in my generation can think otherwise).  In later years, I started confronting my personal history, finding out that both my grandfathers had been members of the Nazi party, even though not involved in any of the atrocities of the holocaust or war.  There have been vigorous discussions whether Germany is “allowed" to move on from its history, whether it can change the conversation, given the historic distance. And from abroad I could clearly see that German society has taken on a new attitude towards the flag and national anthem. Healthy or risky?  In spite of the rise of the AfD, I am generally optimistic. One cannot be careful enough about early dangerous trends, but given how German society has dealt with the recent migration wave, there is not just reason for optimism but even pride! There is a striking difference to what we can see in the US and the UK and what we can see in Germany; an unfortunate reversal of roles.

 

And one important reason for this optimism is the European Union. No, the European Community and later Union was NEVER a purely economic project.  The reason why the European Coal and Steel Community was founded in 1951 was to avoid a future war by regulating and integrating heavy industries across the six founding countries (especially France and Germany). The following trend towards further integration, of which the Single Market is the biggest achievement (more than the euro, I would argue), has created one social, political and economic space, which cherishes national and regional differences and fosters exchange along all possible dimensions. Most importantly, the free movement of people, for travel, study and work, has changed life in Europe.  I am part of the Interrail Generation and more than happy to see that it is still around (and would support the proposal to give every young European a free Interrail pass). As Kevin Hjortshøj O'Rourke recently pointed out, part of the success of the EU and the Single Market is that a life without borders is seen as normal (I have personally seen the opposite, traveling from Costa Rica to Guatemala by bus in 1992, crossing through Nicaragua, Honduras and El Salvador, with one hour wait at each border and Nicaraguan citizens being accompanied on the bus by Honduran soldiers on the two hour trip through Honduras before arriving in El Salvador)!  There are many good things about European integration, but if there is something I definitely hope we can pass on to the next generations, then it is this absence of borders!

 

So, on this historic day, we shall not just remember the crimes of the past (and we Germans DO have an obligation to teach future generations across the globe about these events), but I think we can also express gratitude for what came afterwards.

One of the most insightful bloggers on Brexit, Chris Grey, titled his last blog entry “The August serious season before the September crisis”. His timing was off by only one week, as the crisis started this week, before the end of August, with Boris Johnson’s decision to prorogue parliament for five weeks.  The reaction was furious, to put it mildly, though observers should not have been surprised by this move.  It is clear now that this unelected government, made up to a large extent of opportunists (who previously came out strongly against proroguing parliament), is dead-set on delivering Brexit by any means possible, most likely by a Crash-Brexit on Halloween day. It seems that they are even willing to undermine the long democratic tradition in this country.

 

Will taking the initiative away from parliament to prevent a Crash Brexit make it more likely that the EU gives in to the demands of Boris Johnson to drop the backstop?  I simply cannot see this!  Even if they did, there is no guarantee that there won’t be enough ERG members that would vote still against a new deal. And if the EU gave up on the backstop, it would basically agree to putting up a border in Ireland, once the UK leaves the Single Market and the Customs Union. But wouldn’t they have to do it anyway after a Crash Brexit?  Yes, but in this case the EU would not be complicit in violating the Good Friday Agreement and in stoking a new wave of conflict in Northern Ireland. And a Crash Brexit would force the UK back to the negotiating table at some point and the three preconditions for a free trade agreement are obvious – money, citizen rights and backstop.  One future possible compromise, which could be included in the political declaration now, but in case of a Crash Brexit will certainly come up later, is a referendum in Northern Ireland on whether the backstop and thus avoiding a border on the Irish island would be acceptable (as also suggested in this letter to the editor in the FT).  Polls suggest that there is currently a clear majority for the backstop in Northern Ireland.  Given that NI has voted clearly in 2016 to stay in the EU and given that the majority of elected representatives in NI are in favour of the backstop, this would be the most democratic solution.

 

But back to Westminster: There are some options left for the majority in parliament that wants to prevent this Crash Brexit though the legislative path seems more and more difficult. A vote of no confidence can also succeed if there is a clear majority for a new prime minister, but Jeremy Corbyn certainly does not have it – and in this case Boris Johnson could just hold on and run the clock down. One of the remaining options that Tory rebels have is to cross the aisle and sit with one of the opposition parties (be it Lib Dems or be it Change UK) or as independent, making it clear that the Tories plus DUP have no longer a majority.   But this is only necessary not sufficient, as the opposition parties would have to agree on a PM candidate who is not Jeremy Corbyn.  But there seems a small hope and the more radical the government gets in its actions, the more it might push the opposition within the Tory party towards radical solutions.

 

It is sad to consider how far the Brexit debate has pushed the UK towards a constitutional crisis. And while everyone seems to have marked Halloween day as the decisive end day, it is clear that it will be just the starting point of the next season of the Brexit tragedy.

Before taking a week off for summer holidays, quick note on two recently accepted papers at the Review of Finance. While my tenure at the RF ended more than 18 months ago, I am still handling papers originally submitted and invited for resubmission during this period.  And it is always a pleasure to see papers finally make it to the acceptance stage, significantly improved and with important conclusions.  And as the coincidence has it, both papers concern banks’ risk-taking behaviour in the securitization market.

 

In Arbitraging the Basel Securitization Framework: Evidence from German ABS Investment, Mattias Efing shows how German banks use regulatory arbitrage for additional risk-taking.  Specifically, he uses data on ABS investments on the balance sheets of German financial institutions between 2007 to 2012 and shows that banks go for higher-yielding (but therefore also higher risk) securities within the same credit rating (and thus capital risk weight) class.  This effect is especially strong for more capital-constrained banks (not quite betting the bank behaviour, but along the same lines).

 

In Revenge of the Steamroller: ABCP as a Window on Risk Choices, Carlos Arteta, Mark Carey, Ricardo Correa and Jason Kotter explore banks’ incentives to upload on tail risk through bank-sponsored asset-backed-commercial papers. These securities offer relatively low but safe returns during normal times, but large negative returns during distress times due to maturity mis-match and reliance on wholesale funding. The authors find an interesting interaction between governance and government-provided financial safety net (also known as bail-out expectations). On the one hand, banks with managers that had better aligned incentives with shareholder returns were on average less likely to become sponsors. However, for such banks, which also operated with very high implicit government guarantees, this relationship reverses and such banks are more likely to sponsor such vehicles. Another important reminder that assessing the governance of banks is incomplete without considering the role of government (guarantees).