Finance: Research, Policy and Anecdotes

I have meant to write for a long time about papers I have been reading (and some recently published or accepted in the JBF), so here we go:


The effect of bank failures on small business loans and income inequality, by Salvador Contreras, Amit Ghosh and Iftekhar Hasan, relates to and combines three literatures: bank failures and its negative effects on real economy, SME finance and income inequality, a challenge that economists increasingly care about.  Using variation in the timing and location of branches of failed banks across the U.S. the authors analyse the effect of these failures on income inequality. Employing a difference-in-differences specification they find that bank failures increased the Gini coefficient by 0.3 units (or 0.7%). This rise in inequality is due to a decrease in the incomes of the poor that outpaces declines of the rest of the population. Further, individuals with lower levels of education exhibit a relatively greater decline in real wages and weekly hours worked. One important channel seems to be a general decline in small business loans following bank failures. This in turn reduces net new small business formation and their job creation capacity, a sector that hires a substantial share of low-income earners.


Bob Cull and co-authors study how one specific type of social capital, private social networks, affects access to credit and its implications for consumption, using a sample of Chinese households. They find a strong and likely causal link between private social networks (as measured by the number of siblings of both spouses), households’ use of informal credit, and household consumption. Facing a health shocks, households with private social networks can rely on informal credit via private social networks to maintain household consumption. This is especially relevant for households that do not have access to formal finance, and these effects are more pronounced in poorer regions and in rural areas. An interesting study that points to the importance of informal finance in the absence of formal finance and the role of social networks as underpinning informal finance.


A lot of Covid paper and the impact on and the role of the banking sector have been written over the past three years. Andrea Bellucci and co-authors add an interesting angle, focusing on reallocation effects of the pandemic on venture capital (VC) investments. Specifically, they construct a sample of VC deals that took place in 126 countries around the world from January 2018 till the end of July 2020. They find that with the onset of the pandemic, VCs invest up to 44% more capital in pandemic-related fields (including biology, chemistry and pharmaceuticals, health, healthcare supply chain, and medical science), while the number of deals increases by up to 5.8%. One could argue that these findings speak to the efficiency of the venture capital market, given that this market exists primarily of informed investors with longer time-horizons.

One of my oldest working papers has finally found a home in the Journal of International Money and Finance. In Follow the money: Does the financial sector intermediate natural resource windfalls?, with Steven Poelhekke, we explore why financial sectors in resource-rich economies are underdeveloped.


A priori, theory provides contrasting hypotheses: On the one hand, the resource absorption hypothesis argues that natural resource wealth, through financial deepening, provides a broader funding basis for financial institutions and markets and increases demand for financial services. On the other hand, the financial resource curse hypothesis argues that natural resource abundance undermines financial sector development if resource-related wealth is shifted out of the domestic financial system, either into foreign investment conduits and offshore sovereign wealth funds or into non-financial wealth, such as real estate. Finally, the modified financial resource curse hypothesis posits that the capacity of financial systems to absorb and intermediate natural resource windfall gains depends on the ability of banks to easily set interest rates and compete with each other, the ability of new entrants – both domestic and foreign – to enter the market and sufficient liquidity in capital market to support the banking system in allocating resources to their best uses and to more sectors of the economy.


Using a panel dataset of over 100 countries over the period 1970 to 2017, we test the short-run relationship between exogenous (as driven by world prices) natural resource price shocks and financial development indicators to control for reverse causation and omitted variable bias. We find that compared to countries with a similar increase in GDP, countries that experience resource windfalls and thus higher GDP see relatively slower growth in both financial sector deposits and private sector lending.  This smaller role for the financial sector is accompanied by a stronger role of governments in channeling financial capital into the economy and a relative increase in foreign asset holdings of banks.  Importantly, our findings are driven by countries that repress their financial systems.


Overall, our findings are consistent with the modified financial resource curse hypothesis. And while our results relate short-term changes in resource windfalls and financial development indicators, this lack of financial deepening adds over the years to less developed financial systems in resource-rich economies compared to non-resource countries at similar income levels.  Our findings also speak to the literature on natural resource curse and shows the importance of the financial sector as mechanism through which natural resource rents can impede the development of a country.

I have written extensively about the banking union (e.g., here and here) and about the need to complete it. Originally framing its incompleteness as glass half-full vs. glass half-empty, it has become clear that the political appetite for completing the banking union is not there.  Nevertheless, in a recent Policy Insight and as part of a larger group of economists and legal scholars, I argue that the banking union has not really achieved its objectives and make a strong case for further reform, offering a menu of three different approaches.


One can identify three objectives of the post-2008 regulatory reform, including the banking union: (i) sever the vicious link between bank and sovereign fragility, (ii) restore private liability in banking and thus avoid future bailouts, and (iii) reinforce the basis for a European single market in banking services. If one considers the last few years, these objectives have not really been achieved.


Institutionally, some progress has been made: the Single Supervisory Mechanism (SSM) has been established, shifting the supervision of the largest banks in the euro area (80% of assets) to a large extent to the supranational level. But while a Single Resolution Mechanism has been established, resolution authorities are still fragmented: resolution decisions taken by the Single Resolution Board may need the consent of other authorities, including the European Commission’s DG Competition and the Council of the EU. At the implementation stage, input from national resolution authorities is needed. There has been no progress on a supranational deposit insurance.


The result: the supranational resolution framework has been barely applied, with most cases being resolved at the national level and with taxpayer support. The sovereign-bank link has not been addressed at all and more generally, national political interests still seem to dominate regulatory and supervisory decisions.


In our Policy Insight, we provide three ways forward, which we name the ‘incremental deal’, the ‘real deal’ and the ‘cosmic deal’.  The ‘incremental deal’ is the politically least sensitive package of reforms, including extension of resolution tools to mid-sized and smaller banks, tighten state aid rules and provide more powers to the SRB. None of the proposals requires treaty change, although most would require changes in secondary law.


The ‘real deal’ goes a step further and aims at a more comprehensive reform, including addressing the sovereign-bank link by introducing sovereign concentration charges. Further, bank resolution and crisis management powers should be consolidated under the SRB and a common fiscal backstop created. Finally, a European deposit insurance is needed that complements existing national or industry-based schemes. New secondary legislation would obviously be needed to implement these proposals. In our analysis, a treaty change is not required, but may be desirable, given the uncertainty about the Meroni doctrine, which restricts the exercise of discretionary powers by a European agency (e.g., SRB) not originally established in the founding treaties. Whether such a reform is politically feasible or might have to wait until the next financial crisis is a different question.


Completing the banking union is a necessary but not sufficient condition to create a truly single market in banking, in which national banking champions are replaced by European large banks, while smaller, regionally, if not locally focused, financial institutions are maintained. For such a single market to emerge, further conditions would have to be met in what we refer to as ‘cosmic deal’, including: (i) a single system of bank taxation, (ii) a single system for corporate and personal insolvency and (iii) a single framework for housing finance and mortgages.  Such harmonisation would enable easy cross-border provision of financial services within the euro area.  While radical, these reforms may not require treaty change. The EU can harmonise tax laws under TFEU Article 114 insofar as this serves “the establishment and functioning of the internal market”, though treaty change may be prudent, to avoid overstretching Article 114.


In addition to the policy insight, this VoxEU column summarises our analysis and views.

I am certainly not the only observer who has described the UK as having become an international laughing stock.  I have been wondering what the superlative of ‘international laughing stock’ is.  When the remaining time in office of a Prime Minister is measured with the time that a lettuce can keep fresh and when the whole political class becomes the butt of a joke in US comedy central, you know the country is no longer taken seriously by anyone.  And so it happened these past two weeks with the UK.


At a conference dinner in mid-September I made the strong claim that Liz Truss would certainly be an even worse Prime Minister than Boris Johnson.  This was before the mini-budget and the reason for my claim was the fact that she owed her ‘election’ to the extreme Brexit wing of the Tories and that she was the instigator of legalisation to break the Northern Ireland Protocol, thus possibly triggering a trade conflict with the EU. Well, she did not have sufficient time in office to blow up relations with the EU and was simply too busy tanking the British economy with the 2020s version of Laffer’s curve and pseudo-supply-side reforms.


It is certainly ironic that on the one hand, one prominent part of these ‘supply-side reforms’ was the removal of bankers’ bonus as share of overall compensation, while on the other hand, it were these same bankers standing to benefit from the removal (as well as from the removal of the 45% income tax band) that triggered the run on the pound and UK government bonds following the mini-budget. Well, if you focus on an international financial centre as core component of your growth strategy you better watch out what these financial markets think about your macroeconomic policies!


Many observers in the UK link the disastrous but short-lived prime ministership of Liz Truss to the adoption of policies promoted by right-wing think tanks in the UK (often with dubious funding sources).  What people in the UK (though most people outside) do not want to discuss is that this is ultimately the Brexit chickens coming home to roost. Brexit has reduced the potential GDP in the UK substantially (which explains the higher inflation in the UK than other advanced countries and the higher labour scarcity).  The UK is now in a situation, where everyone talks about growth and productivity, but few dare to talk about the elephant in the room – the decision to cut the British economy off the Single Market. At a minimum, honesty would be called for, but few in the media seem capable of even that.


As of Monday, there is a new Prime Minister. For the first time in many years, I would argue that Rishi Sunak might not be worse than his predecessor, though this is really a low barrier. And among all the political turmoil, it is important to note that he is the first Indian-British Prime Minister, which reflects the openness of British society; I can think of few other European countries where this would be possible! This is also one of the few elements that still give me hope for the UK.


Having said this, the new Prime Minister faces the same two major constraints as his predecessors – the reality of Brexit and the myth of Brexit. First, on the Brexit myth, which implies that he has to keep feeding the trolls of the extremist Brexit wing of his party – as became obvious by reappointing the despicable Suella Braverman as Home Secretary who dreams of refugee flights to Rwanda on Christmas Day and resigned just a few days before because of security breaches.  This also means that he has limited political capital to come to an agreement with the EU on the Northern Ireland Protocol. Second, on the reality of Brexit: fiscal space will be even scarcer than before and he has already all but announced another austerity drive – how this squares with improving health and other public services remains a puzzle! The downward spiral of politics and economics in Brexit UK continues.

This is a topic I don’t enjoy writing about at all, actually I rather hate it.  But ignoring it is not an option!


Outsiders (or economists not on social media) might have missed the storm last week, triggered (as far as I can see) by a female behavioural economist in Germany raising serious accusations of sexual abuse against a more senior male economist. Not knowing any of the three people involved, I will certainly refrain from commenting on this case. However, it became quickly clear that this had hit a raw nerve, with more female academic economists coming out with ‘j’accuse’ against specific male economists. It quickly developed into a storm and has triggered an important debate.


First of all, I am disgusted by the idea that senior academic economists abuse their position for sexual favours. Having been approached by young economists of both genders for advice and offering of research assistance to get a head-start in the profession, my stomach turns thinking that other economists might abuse such situations. And no degree of academic excellence should serve as shield for such people. This is not only about creating an inclusive community, it is about basic decency!


I have mixed feelings on the social media campaign accusing specific individuals of misbehaviour: bad or even criminal behaviour should be addressed through either administrative or legal channels!  BUT: I understand the frustration of many victims who have seen perpetrators walk away free.  There are clearly senior members of our profession who have abused their position and have gotten away for far too long. Calling them out publicly as last resort, everything else having failed, can be justified. And this is also on the background that there is clearly a limitation of what any system to judge and penalise sexual harassment can achieve: too often, there are “he says, she says” situations, reference to different cultures, misunderstandings etc. Yes, there are clear-cut cases, but there are also many cases that non-observing outsiders might perceive as borderline (even though they are not!).  As pointed out here, the problem of publicly accusing people is that it might make male economists more reluctant to work with female economists. And unfortunately, there is the risk that innocent bystanders are pulled into this, simply by being co-authors or friends of perpetrators (which also happened this weekend). So, having missed the chance to address the problems in due time has resulted in a very bad situation!


If we cannot completely rely on administrative procedures against sexual harassment, where does this leave us?  As pointed out by some economists (of both genders), we have to start on a much more basic level, long before it ever comes to such mis-behaviour.  Most of these challenges are for us male economists, though some also for our female colleagues (I am arguing purely in terms of heterosexual people for simplicity, but this also extends to gay and lesbian economists): First, call out bad behaviour when you see it (I have done so in a ‘borderline case’ though have never been in a really serious situation).  Second, no locker room talk among academic economists (if you really urge to have such conversations, get a separate group of friends). Third, young economists should be explicitly encouraged to speak out, both privately if they perceive certain words or behaviour as crossing a line, and publicly if it clearly has gone too far. I sincerely hope that I will be told clearly if my behaviour has crossed a line even though I have no intention of doing so. These are some initial thoughts; there is certainly much more to say and to do and I hope that the social media storm of the past weeks will lead to a serious conversation and continuous improvements.


Finally, I saw one tweet this weekend which encouraged victims of sexual harassment to ask editors to not send a submitted paper to this specific person as reviewer.  Being an editor, I fully concur with this!  If you feel that there is a person that should be ineligible as a reviewer for your paper for such (or other) reasons, say so!


In a nutshell, there will always be bad apples – calling them to order early on or forcefully going against them is important.  As important is the overall work environment.  We will not change the world overnight, but we can (and have to) take small steps. Let’s hope we can channel the justified anger into a better work environment, for everyone's benefit!