Finance: Research, Policy and Anecdotes

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.

What a nice quiet week the Easter week was!  No action in the House of Commons, only few if any new crazy Brexit proposals. And at least here in London, attention has been drawn to the real future problems of our planet! Just before the Brexit craziness starts again tomorrow and the campaign for the European Parliamentary Elections will turn ugly, a few notes on the longer-term perspectives on Brexit.


First, Northern Ireland: the murder of journalist Lyra McKee has shown yet again the fragility of the peace process in Northern Ireland. While no one would accuse Brexiters of any direct responsibility, the uncertainty on the future of the border in Northern Ireland caused by Brexit plays directly into the hands of extremists! It is sad to see that 21 years after the Good Friday Agreement peace cannot be taken as granted anymore! And it reminds us what damage nationalism can do in Europe!


Second, the future of banking in London. My colleagues Barbara Casu and Angela Gallo found in a recent report that London continues to have competitive advantages as financial centre, even as banks shift some staff and activities to the continent. Different corporate forms are discussed to continue providing financial services into the EU after Brexit, but the bigger picture prediction is certainly that in the near future, London will not lose its status as global financial centre. This is also consistent with recent research by Sascha Steffen and co-authors that the reduction in syndicated lending after Brexit is mostly due to reduced lending to domestic firms and by domestic banks.


This brings me to the broader point of the future economic structure of UK after Brexit.  I really enjoyed this insightful piece by Martin Sandbu on Brexit and the Future of UK Capitalism. One of the main messages is that “both in high‐value manufacturing and services, the best performers are successful precisely because their activities pool resources from all of Europe and sell to all of Europe. They are not good British jobs as much as good European jobs located in Britain.” I think this last sentence really drives home the point how the four freedoms hang together and are hard to disentangle even on the economic level.  The harder Brexit, the more likely are these jobs to disappear. However, a Brexit from the Single Market will hit manufacturing more than services (which are already oriented more toward non-Europe), so that “a hard Brexit will not only ensure the most loss of growth in aggregate, but stands to exacerbate the polarising characteristics of the UK's existing economic model and harshen the social tensions to which it has given rise.” Scary thoughts!


On a final note, and before we all get drawn back into the daily Brexit chaos, I really enjoyed this film about the Barnier team – it shows a human side to the negotiating team. And without rubbing it too much to the British side, it makes clear that the EU team went about the negotiations in a systematic and rational way.


Now, let me get the popcorn and get ready for tomorrow’s first episode of the new season of Brexit – the soap opera.

I am escaping the Brexit craziness for a few days.  First, for the April version of the Economic Policy Panel in Tallinn. As always, exciting set of papers, including one on the European Deposit Insurance, showing that such a scheme does not necessarily lead to cross-subsidisation as often feared in Germany.   We also have a special issue coming on the economics of automation and jobs, with exciting papers, discussing if and under which circumstances labour-saving technology can boost employment; how technology has changed the composition of labour demand toward more skilled, older and male employees; how competition from China pushes investment into automation; and how technology drives the falling labour share of income. We will also have a public session together with the Bank of Estonia on automation, with short presentations and a panel discussion later today.  More to come…

I am just coming back from Mumbai from an exciting conference on financial intermediation in emerging markets, jointly organised with Franklin Allen, Manju Puri and Co-Pierre Georg and co-sponsored by the Brevan Howard Centre at Imperial College and CAFRAL at the Reserve Bank of India.  This was the third in a series of BRICS conferences, which started with a conference in Rio de Janeiro in 2015, followed by a conference in Cape Town in 2016.  We hope for a repeat event in China, Russia or another major emerging market in the next few years.


India is certainly an appropriate place to host such a conference, given the rich and varied history of financial sector policies the country has gone through. As deputy governor N.S. Vishwanathan discussed in his policy keynote, there was an ongoing learning process, which resulted in policy experimentation over the decades and which has also been used as identification strategy  by researchers in research papers, such as myself in this paper (currently under revision). And there is now also exciting research work going on in CAFRAL in banking and finance.  


Tarun Ramadorai gave a keynote address on household finance in emerging markets and presented fascinating statistics based on detailed household surveys across different emerging markets on households’ balance sheets.  The most striking findings were that households hold much more real estate assets (rather than financial assets) in emerging markets than in advanced countries, while at the same time they have less secured (mortgage) debt. Estimates also show that shifting from such a rather inefficient balance sheet to more financialisation could bring quite a boost in income growth. Not surprisingly, Tarun’s finding match with my own work on financial sector structure in develolping countries (limited mortgage loans, focus on short-term lending) and to work showing that more efficient financial markets have an important growth benefit for developing and emerging markets. An interesting challenge that arises out of this work is for researcher to focus more on middle classes (20th to 80th percentiles of income distribution, in statistical terms) and a fuller set of financial services than we often do when focusing on the bottom of the pyramid. 


There was an exciting set of papers covering countries as diverse as Bolivia, China, Greece and Rwanda.  In the following I will only point to a few that looked especially interesting to me.


Mrinal Mishra and co-authors use the Bolivian credit registry to test the impact of the entry of new arms-length consumer lenders on credit access by costumers of relationship-focused microfinance institutions (MFIs).  They find that loans disbursed by new entrants to borrowers who switch from incumbents turn out to be riskier driven primarily by adverse selection. The incumbent MFIs, in turn, react with an “arms race”, offering better loan terms to these customers, ultimately resulting in overindebtedness.


Ioannis Spyridopoulos and co-author identify strategic default by mortgage borrowers in Greece, using  the introduction of a foreclosure moratorium and a new personal bankruptcy process in 2010 as identification strategy.  Specifically, borrowers that took advantage of the foreclosure moratorium but did not declare personal bankruptcy (which would have implied giving up other assets) are identified as strategic defaulters. Ioannis shows that 28% of all defaulters were strategic, contributing three percentage points to the NPL stock in Greek banks.  Strategic defaulters are more likely to be self-employed, to have higher educational levels and to work in finance or law.  What these findings show is that loan modification programmes – often an important component of crisis resolution strategies - have to be better targeted.


My former PhD student Andre Silva and co-authors examine the impact of a large-scale microcredit expansion program in Rwanda. Not surprisingly, a higher share of previously unbanked people gain access to credit. The more interesting part is that a large share of first-time borrowers subsequently switch from these microfinance institutions to commercial banks, which cream-skim low-risk borrowers and grant them larger, cheaper, and longer-term loans.  Powerful evidence how a credit registry including information on loans from all financial institutions can allow borrower to climb up the ladder of financial institutions.


Finally, Tianyue Ruan sheds light on entrusted loans in China, inter-firm loans arranged by banks. She finds that such loans are more prevalent and more profitable in cities with a tighter supply of bank loans than in other cities (due to a loan-deposit ratio cap introduced by regulators).  And it is banks with excess cash that function as lenders, suggesting that this type of lending might pose fewer financial stability risks (than if these firms raised money to on-lend).


What these four papers (and others in the conference) have in common is that they use unique data – either credit registry data, loan-level data from a specific bank or hand-collected data. This is clearly the future of research in finance and development – micro-data on transactions or survey-based. I am very much looking forward to the next edition of this conference… stay tuned….

What a week! The week when Theresa May declared that no deal is better than a bad deal, just not on 29 March 2019, allowed her party members to vote in favour of taking no deal off the table for 29 March, but then changed course and told them that no deal is still supposed to be a viable option (just not at the end of this month), just to be defied by large numbers of her own party (including government ministers). Confused? No worries, this soap opera has a rather sophisticated plot.


The week where we finally found out who will be thrown under the train in the case of a no-deal Brexit (b/c in this populist soap operate someone has to “die” after all) – the Northern Irish farmers. The week where we found out how a no-deal Brexit will solve the Brexit Trilemma – by giving up on all red lines ever drawn by Theresa May. Eventually, border controls will be necessary between Northern Ireland and the Republic of Ireland; given differential tariff regimes between the Irish border and all other UK borders, controls have to be imposed in the Irish Channel and the new tariff regime will undermine UK’s ability to get any new free trade deals (complete loss of trustworthiness being the top reason). A very odd way of taking back control!


The week where the government got finally downgraded to the status of caretaker government as it has lost its majority in parliament. The week where the leader of the opposition finally looked more prime ministerial than the prime minister (never thought I would write this about Jeremy Corbyn). The week where we are closer to the season finale, but still have no clue how this season will end (just that there are many more seasons to come).


As in any good soap opera, there was lots of excitement and “action”, but little substantive change in the underlying plot and no sign of resolution. Theresa May is still trying to push through her deal and her chances might have actually increased as the alternatives have been reduced.  The playing field has tilted even more against the UK as the EU has to agree unanimously to extend Article 50. If there will be any more negotiations in Brussels it will be no longer about backstops but about the terms of extension. 


In case you cannot wait until the next week’s episode, I can promise you replays over the weekend. Well informed sources have told me that Brexiteers will insist that no deal should still be part of the British negotiating position (even though there is no one left to negotiate with – Brussels has made that clear). There are also rumours that Brexiteers might have identified yet another obscure GATT or WTO article they can mis-interpret in their favour.  And we will hear yet again, ad nauseam, to “just get on with it…” – Brexiteers have promised that the moon is made of cheese, so we have to get on with it….