Finance: Research, Policy and Anecdotes

One of the most useful classes during my PhD course was on growth economics.  Not so much because of the content (which was fascinating!), but rather because our professor (who later became my PhD supervisor and co-author) had one important objective for this course – teach us how to write a paper!   He even provided us with an outline for how to write up the Introduction of a paper – something I still use and happily pass on to my own PhD students (with full acknowledgements!). 

 

Last weekend I spent Friday and Saturday at a workshop in Bonn (organized by Ruediger Fahlenbrach and Henrik Hakenes) taking this approach one step further; an intensive and interactive meeting of junior researchers (post-doc and assistant professor level) and more senior researchers (always relative, obviously!), where the latter shared with the former their experience with the publication process.  This included not only discussions on how to have appropriate expectations (50% desk reject at top journals, and a Revise and Resubmit almost as rare as a black swan) and to deal with frustrations, but also very practical consideration, such as how to package best your message.  The four most important messages (motivation, research question, methodology and contribution) have to be clearly presented in the Introduction, be mentioned on the first page of the paper and summarized in the abstract (where you often face a space constraint). A challenge, but a feasible one!  And a skill that can be acquired with practice.  Finally, the elevator pitch: how to bring across the main ideas of your research in two minutes (or less if the other person gets off on the third floor!).   Bottom line: original, innovative and frontier research is necessary but not sufficient for success in the academic world!  The good news: packaging can be learned! 

Olivier De Jonghe, Klaas Mulier and I just finished a new version of our sectoral specialization paper and also just published a Vox column on it.

 

Although the importance of sectoral concentration for bank performance and stability has been discussed by economists and regulators alike, there is little empirical evidence, mostly due to lack of data. Olivier, Klaas and I take a new and broader approach to measuring sectoral specialization: a factor-based model, where we gauge whether banks’ stock returns react to sectoral stock indices after controlling for global and domestic stock indices, a financial sector index and the Fama-French factors. Using a return-based approach allows us to take into account that banks are over (or under) exposed to specific economic sectors not only through lending, but also through derivative positions, taken to hedge lending positions or create sectoral exposures without lending. 

 

Our results for over 1,500 banks across 24 countries show that: (i) more sectorally specialized banks experience lower volatility and lower exposure to systemic banking distress and (ii) banks that have more similar sectoral exposures to their peers in the same country and year also experience lower volatility and lower exposure to systemic banking distress, though the last results is driven by the 2008/9 crisis years. These findings are not consistent with the traditional portfolio theory that focuses on diversification benefits, but they are consistent with theories focusing on information asymmetries between lenders and borrowers that can be reduced if lenders specialize. On the first look these findings are not consistent with theories focusing on similarity of banks resulting in higher banking distress; however, we argue that the discount for being different from your peers might stem from information problems in the case of systemic banking distress and from the too-many-to-fail bailout bonus. 

Some interesting papers from recent conferences.

There is no such thing as finance without politics!   In Politicizing Consumer Credit, Pat Akey and co-authors show how exogenous “promotions” of senators to committee chairman in the U.S. Senate result in more regulatory leniency in the senators’ home states vis-à-vis consumer lending by banks. Specifically, lending to disadvantaged groups (supposedly protected by the Community Reinvestment and Equal Credit Opportunity Acts) decreases significantly, an effect independent of the senator being Republican or Democrat.  One wonders though whether this only benefitted the banks in questions or also had a dampening effect on the overindebtedness of risky borrowers.

 

Everyone talks about the geographically concentrated effect of Chinese imports into the U.S. on manufacturing employment. Import Competition and Household Debt shows that areas that were more hit by Chinese imports and thus job losses in manufacturing saw a more rapid increase in household debt.   Is this consumption smoothing or too slow adjustments to permanent income shocks? Does consumer credit serve as opium of the 21st century?  It certainly shows the powerful role of consumer credit and household debt in the socio-economic development of the US over the past two decades.  

               

Ugo Panizza and co-author document in a recent paper that the post-2008 expansion in city-level government debt across China has not only led to fragility concerns (see this recent report) but has also crowded out lending by banks to private sector firms.  Interestingly, state-owned and foreign-owned companies have not been significantly affected. So, short-term crisis stimulus results in long-term lower growth perspectives!        

 

And to prove that I do (sometimes!) look beyond finance, here is an interesting paper by Alex Trew and co-authors (“East Side Story: Historical Pollution and Persistent Neighborhood Sorting”) who gauge why the East sides of former industrial cities like London or New York are poorer and more deprived?  It seems to be pollution going back to the Industrial revolution that made richer people settle on the side of industrial chimneys where they were less exposed to the pollution.  And as so often in history, these neighborhood differences are persistent, as these patterns continue to hold today!  

At the end the results were clearer than predicted and feared.  65% for the candidate of the liberal and democratic centre. As much as this looks like a win, there was not really a democratic choice, as the main opposition party is a nationalistic, backward-looking, anti-European movement. If there is no choice between two democratic opponents, we cannot call it a democratic choice! 

So, as much as we are supposed to celebrate Macron’s win tonight, this is the clearest warning signal yet that we cannot take the progress Europe has made over the past seven decades for granted.  A wake-up call to make the gains from globalization and European integration accessible to all. A wake-up call to more fairly distribute the benefits and losses from globalization and technological change. Certainly, a wake-up call for France whose socio-economic model has been broken for a long time.  But also a wake-up call for Europe, for a more inclusive Europe, a more solidary Europe, a Europe not beholden by the legacy of past crises but future opportunities.

There are many parts of the U.S. regulatory framework under attack (or: under review, in the more bureaucratic language), even though there is no evidence that the slow-down of entrepreneurship in the U.S. is related to federal regulation.  One of the many aspects of the regulatory framework is the resolution framework for large systemically financial institutions in the Dodd-Frank Act.

 

The suggestion to throw out the resolution mechanism, which allows the use of taxpayer money, to thus minimize moral hazard risk and foster market discipline sounds intellectually honest and logical.  After all, if there is a chance to be bailed out if things go wrong, this provides incentives for aggressive risk-taking, an effect that is stronger the larger the bank – commonly known as too-big-to-fail effect  - and the lower the capital buffer of the bank – known as betting the bank effect.  So, increasing capital buffers further and getting rid of potential bail-outs should firmly consolidate market discipline.

 

However, that is where economic theory meets economic reality and political economy. In 2008, none of the European countries had a proper bank resolution framework.  The U.S. had such a regime (successfully used by the FDIC) for commercial banks, but not for investment banks and bank holding companies.  As U.S. and European supervisors and governments looked into the abyss of not only a systemic banking crisis but a complete melt-down of the financial system, they found themselves empty-handed when considering how to resolve the failing banks.  Using the regular corporate insolvency framework was not an option, as the Lehman Brothers bankruptcy had just shown.  So, the only option was a tax-payer funded bail-out of these banks.  Over the past nine years, governments have reacted, introducing bank resolution regimes that combine bail-in rules (i.e., making sure that shareholders and junior bond holders lose their shirts) with ensuring that the financial system and thus ultimately, the real economy, does not offer.  To ensure the latter, options for government support have to exist, though as last resort, not as first resort, as in 2008.  Not having such a clause would make it non-credible and result in creditor run and contagion effects at the slightest sign of trouble.

 

But wouldn’t scrapping any possibility for government support strengthen market discipline?  Only if it were credible, i.e., nothing short of a constitutional restriction would do, given a history of government responses to previous crises.  And it would certainly reduce the flexibility of policy makers in the eye of a crisis.  Ultimately, effective bank resolution is about a trade-off between enforcing market discipline on stakeholders in failing banks and protecting the rest of the financial system and the real economy. While tying your hands might reduce the number of bank failures by strengthening market discipline, it will not eliminate them and will make their negative effects for the real economy even worse.

 

But wouldn’t very high capital buffers reduce the need for a resolution regime? While capital requirements under Basel III might still not be at the level where they should be, increasing capital buffers to a level where bank failure is all but esxcluded would ultimately drive banks towards narrow banking, with the consequence that risk taking would move away from the regulated into currently less or even non-regulated segments of the financial system.  As more and more households are excluded from fixed-return passive long-term investment strategies, such as relying on a defined-benefit pension, active management of their investment portfolio, which includes maximizing a risk-adjusted return, would ultimately increase pressure on regulators to extend the financial safety net beyond narrow banking if households are pushed away by minimal interest rates in a narrow banking system.

 

In summary, governments have a comparative advantage in providing certainty and they are most asked to do so during systemic banking crises. Tying their hands by pretending there will never be a bail-out will leave governments with the choice between a melt-down of the financial system with terrible repercussions for the real economy or violating the no-bail-out rules, no matter how binding they were meant to be.  It is clear what a democratically elected government will do!  

 

So beware of easy solutions, as economic reality does not always comply with good intentions!