Finance: Research, Policy and Anecdotes

Last week saw the virtual conference on Bank Crisis Management – What Next?, jointly organised by the Florence School of Banking and Finance, SAFE Frankfurt and the Single Resolution Board, with seven papers covering a wide range of topics related to the title of the conference and a keynote lecture by Manju Puri who – among many other jobs and honours – was at some point Chief Economist of the FDIC. A short summary of the papers, with some (maybe provocative) policy conclusions.

 

Diana Bonfim and João Santos show the importance of deposit insurance credibility, i.e., the importance of a credible sovereign backstop, using data from Portugal and exploiting the fact that some foreign banks changed their status in Portugal from subsidiary to branch status during the European sovereign debt crisis, which implies that their Portuguese deposits became subject to the deposit insurance scheme of countries with lower sovereign risk. They show an increase in deposits after the shift in status, suggesting that depositors do care about the credibility of their deposit insurance and thus sovereign backstop. An argument for European deposit insurance to break the link between banks and sovereign and move towards a truly European market in banking.

 

Christian Muecke and co-authors gauge the effect of a disciplining tool in the US to 'convince' bailed-out banks during the Global Financial Crisis to pay dividends to Treasury on its capital injection: pay up or accept Treasury-appointed board members; specifically, if a bailed-out bank missed six quarterly dividend payments, the US government had the right to appoint independent board members. The incentive was effective as many banks missed no more than five dividend payments (maximum before the appointment of board members) but also the stick helped, as board appointments by the Treasury helped improve bank performance and reduce risks. Results clearly show that incentives can work in crisis resolution and that bailout funds should not be given without conditions.

 

Mathias Dewatripont and co-authors discuss to which extent the resolution model of Single Point of Entry (SPE) (where losses are upstreamed to the parent bank, while capital is downstreamed to subsidiaries if needed) can counter regulatory incentives of host authorities to ringfence a subsidiary during times of crisis. They argue that an SPE model is not sufficient, as the regulatory authorities of subsidiaries have a legitimate incentive to maintain measures to safeguard the corporate interest of subsidiaries as long as the support to be expected by the parent company remains uncertain.  What is needed is (i) the formalisation of the nature of the parent support through a burden sharing agreement and (ii) the introduction of a hierarchy of creditors within groups, which would be aligned on the implicit hierarchy of creditors prevailing under the SPE strategy. Another strong argument illustrating that the European banking union is far from complete.

 

Alessandro Scopelliti and co-authors focus on the introduction of bailinable bonds, an important component of regulatory reforms in the last decade aimed at reducing the likelihood of future bailouts. Exploiting granular data on banks’ securities holdings they find that banks hold more bailinable bonds issued by other banks and issued by other parts of same group. In addition, there is a clear home bias, as banks hold primarily bailinable bonds by other banks in the same country. Clearly not what was intended and an indication of an incomplete reform!

 

The paper by Orkun Saka and co-authors explores governments’ financial sector policies after crises. They show that financial crises can lead to more government intervention and a process of re-regulation in financial markets. However, some of these interventions might not necessarily be in the public interest, as democratic leaders who do not have re-election concerns are substantially more likely to intervene in financial markets after crises, in ways that promote their private interests, with pay-offs in the form of financial sector jobs after their government tenure. Lesson: Post-crisis reforms are important, but it is crucial to consider the incentives of those who propose and implement them.

 

Sascha Steffen and co-authors explain the heavy decline in banks’ stock prices during the early part of the pandemic. They show that the decline in banks' stock return during Covid-19 is primarily driven by liquidity risk. Specifically, stock prices of banks with large ex-ante exposures to undrawn credit lines and large ex-post gross drawdowns declined more, especially of banks with weaker capital buffers. This also had consequences for banks’ behaviour as these banks reduced new lending, even after stabilization policies and even if drawdowns were accompanied by deposit inflows. Clearly a justification for the increasing focus on liquidity in addition to solvency risk in banks.

 

Miguel Faria  and co-authors show the macroeconomic consequences of evergreening of bad loans by banks, using both theory and empirical evidence with loan-level data from the US: low-capitalized banks systematically distort their risk assessments of firms to window-dress their balance sheets and extend relatively more credit to underreported borrowers, with negative economic consequences, in the form of lower firm entry and lower aggregate productivity. Clear evidence of distortive incentives provided by low bank capital and the negative consequences of zombie lending!

 

Finally, in the keynote lecture, Manju Puri discussed the role of private equity (PE) investors  after the 2008 crisis. Using proprietary failed bank acquisition data from the FDIC combined with data on PE investors, she and her co-authors find that PE investors made substantial investments in underperforming and riskier failed banks and where there are few healthy banks as alternative acquirers. They find a positive impact of PE acquisition on bank performance and local economic recovery. While the results are for the US, an interesting and important lesson for Europe, where we still have a steep learning curve ahead of us in terms of bank resolution.

 

Note: this blog entry was also published on the FBF website.

The mood was very different yesterday when the negotiators of the future German coalition (referred to as traffic light coalition, in line with the parties’ colours red, yellow and green) presented their coalition agreement than in early 2018 when the last government presented its programme. Back then, the renewal of the ‘grand coalition’ of Christian and Social Democrats was seen as second-best solution, after a Jamaica coalition (black, yellow and green) failed in negotiations. Lots of novelties  this time around: a social democratic chancellor after 16 years of Angela Merkel (Christian Democrat) and one who few gave any chances just half a year ago; a female foreign minister for the first time in German history and a FDP minister of finance (for the first time in almost 60 years).  It is the latter that has been of most concern for many economists inside and outside Germany and rightly so, even though given a social democratic chancellor and a green ‘super-minister’ of economy and climate change, one wonders how powerful Christian Lindner  will be. The FDP (I try to avoid calling them liberals, as this description is too generic for a rather small party, with lots of liberals across the German party spectrum) wants to return to the fiscal policy rules and constitutional debt brake as soon as possible, which would imply a strong fiscal brake on the German (and ultimately European) recovery process; it is more, one can easily envision a scenario where such fiscal tightening will lead to a similar situation as in the early 2010s, not exactly the most glorious hour of economic policy making in Europe (to put it mildly). It certainly is not in line with the new government’s investment plans, which implies some playing around with the rules (through trust funds and special budgets); it will certainly be interesting to see the 2022 budget and the actual squaring of the circle. At the same time, there are signals of flexibility with European fiscal rules. And there is an explicit recognition that the ECB can only fulfil its mandate of price stability if fiscal policy plays its rule; this phrase can obviously be interpreted in many different ways but if clearly shows recognition that fiscal and monetary policy can no longer be regarded as completely independent from each other.  And the establishment of some form of European deposit insurance (at least through a reinsurance scheme) is mentioned. So, positive signals even though a government without the FDP would have sent even stronger ones, one can assume. A sidenote for Brexit observers: clear support for the Northern Ireland Protocol and the principle that pacta sunt servanda; on the other hand, no mentioning of the German car industry in this specific circumstance to ride to the UK’s support, as has been awaited for so long by Brexiters 😀).

 

One final interesting note is that the SPD will get to nominate the next president of the Bundesbank, which suggests not only a simple change of guards in Frankfurt, but maybe also a new style and new role for the Bundesbank president within the ECB governing council.  Given that the FDP secured the Ministry of Finance, this development is no surprise.

There has been an explosion of papers gauging the effect of the pandemic on the financial sector and assessing different policy responses. Some of them have now been published in a special issue of the Journal of Banking and Finance, under the guidance of four outstanding guest editors (Allen Berger, Asli Demirguc-Kunt, Fariborz Moshirian and Anthony Saunders).

 

As pointed out by the guest editors in their editorial, the pandemic has resulted in the most significant global disruption since the Second World War. While it did not start in the financial system (unlike the Global Financial Crisis), financial sectors across the globe were as much affected as other sectors; at the same time they played an important role as transmission channel for government support programmes.

 

While the editorial gives a nice overview of the different papers, let me point to some highlights. First, many papers have been written about the US, some about Europe, but the special issue contains several interesting cross-country studies: Gönül Ҫolak and Özde Öztekin show that bank lending is weaker in countries that are more affected by the health crisis, but that there are important interactions with market structure and regulatory framework. Yuejiao Duan and co-authors find that the pandemic has increased systemic risk across countries, but is moderated by bank regulation and higher trust. Iftekhar Hasan and co-authors use global syndicated loan data and find that loan spreads rise by over 11 basis points in response to a one standard deviation increase in the lender's exposure to COVID-19 and over 5 basis points for an equivalent increase in the borrower's exposure.

 

Second, Erik Feyen and co-authors introduce a new global database (still updated on a regular basis) and a policy classification framework that records the financial sector policy response to the COVID-19 pandemic across 155 jurisdictions and over time and explore what drives cross-country differences in policy implementation.

 

Third, what has been the role of different types of banks during the crisis?  Chris James and co-authors show for the US that small banks responded faster to Paycheck Protection Program (PPP) loan requests and lent more intensively to small businesses than larger banks, which suggest that community banks remain an important conduit for small business credit particularly during crises when a rapid response is required; a clear indication that relationship lending can be helpful in crisis situations, as shown in my own work for the Global Financial Crisis. And interestingly, Mustafa Karakaplan finds that these loans were not substitutes but rather complements to regular small business lending, with a multiplier effect of one dollar of PPP credit on conventional loans to the smallest firms of about an extra dollar.

 

I am sure that this will not be the end of the research programme on the effect of the pandemic.  There are lots of more issues to explore, including the exit from the different support programmes and the effect of asset reallocation in a post-Covid world and corporate overindebtedness on banks.  I am sure we will see some of these papers in the JBF!

As I am spending a few days in Northern Ireland during half-break term, it might be time to catch up a bit on Brexit, given that this part of the Irish island continues to be at the centre of the ongoing conflict between the UK and the EU. As widely noted, Northern Ireland has not suffered from the same food and fuel shortages as Great Britain (and yes, I can confirm this from own experience), given that it is still integrated into the Single Market. East-West trade has become more difficult and North-South trade has therefore increased significantly, a not surprising consequence of the Irish Protocol that the UK government had signed up for, as part of the Withdrawal Agreement, in 2019. The controls envisioned by the European Commission might initially have gone beyond what was strictly necessary; after extensive consultations with Northern Irish businesses, the Commission has now made proposals to ease these controls. The UK government, on the other hand, is looking for symbolic fights, such as the right to exclusively use imperial measures.  Most importantly, and impossible for the European Union to accept, the British government wants to eliminate the role of the European Court of Justice, in the name of complete sovereignty, even though this seems to have no importance for businesses on the ground in Northern Ireland. There are now indications that even if the British government will eventually back off, they do not consider this issue settled but will bring it up again in the future. Thus, a continuous conflict with the European Union, something that Brexiters promised to end after Brexit, but seemingly cannot let go.

 

In this context, the government has now all but officially confirmed that it signed the Withdrawal Agreement in bad faith, never planning on complying with its part of the Northern Ireland Protocol. Perfidious Albion is raising its ugly head!

 

And as the problems in Brexitland are mounting, the argumentation by the government that labour shortages (i) do not exist, (ii) do exist, but have nothing to do with Brexit, (iii) are actually caused by Brexit but are a benefit of Brexit is becoming more and more absurd; not sure whether to call it Orwellian or Trumpian. And the itching of some right-wing media figures for a trade war with the EU to rekindle the Blitz spirit of World War II stands in odd contrast with the fear of government to impose any Covid restrictions as the population will not be able to take it.

 

As ridiculous as Brexiters look from outside the UK, as naïve looks the ‘re-join’ the EU movement. Completely illusionary, they imply that all they need is a majority in parliament or some referendum to re-join the European Union in a few years. Well, the 27 member countries of the EU beg to differ. While careful with predictions, I would dare to predict that I will not see the UK re-joining the EU in my lifetime (and I currently have no indications nor wishes that I will pass on shortly 😊). All 27 current members of the EU have to agree and many of them will have their specific demands and objections. More importantly, the absence of the UK might have facilitated recent movements towards a fiscal union. And the looming conflict with Poland will make the EU even more reluctant to let back in a country that is not exactly known for its constructive role during the last decade of its membership. So, EU membership is off the table for the next couple of decades, at least with the current structure of the EU. The best the re-join movement can hope for is a Swiss-style alignment with the EU that re-establishes closer links between the UK and the EU in specific policy areas. Even Single Market membership is far away and not easy to achive, as explained here.

 

So, both Brexiters and the re-join movement are stuck in their respective bubbles, with one trying to divert attention from the damage Brexit is doing to the UK by fuelling constant conflict with the EU and the other blaming any problem on Brexit and promising the end to all problems once the UK re-joins the EU (sounds familiar?). Being in Northern Ireland, one is reminded where ideology and religion-like purity tests can lead to, with the two camps living in their own world; while in Northern Ireland they are also physically separated, in England, they live intellectually in their own respective bubbles. With calls that certain positions in the BBC have to be occupied by pro-Brexit journalists, the UK is moving closer and closer to the US model where the two bubbles no longer talk with but only at each other.

After 10 years of fighting the windmills of lose monetary policy, Bundesbank president Jens Weidmann leaves the stage. There are two reactions in Germany (and across Europe) towards the appointment of his successor.  Some lament the possible end to a hawkish Bundesbank that is focused primarily on inflation angst and sees any loosening of monetary policy and the slightest increase in inflation rate as the possible start of a hyperinflationary downward spiral. Others see the appointment of a new Bundesbank president as chance to finally move away from a sometimes confrontational approach towards unconventional monetary policy under Draghi and Lagarde.  Whatever side one takes, it is clear that Weidmann has been in the minority in the ECB’s Governing Council over the past decade and has had therefore limited influence.  At the same time, one can argue that his position has contributed to the increasing hostility of media and public in Germany vis-à-vis the ECB.

 

Trying to stick to orthodoxy in monetary policy when the world around one changes seems at best naïve and at worst dangerous. First, it is important to remember that one important reason for the ECB to take a much more prominent, unorthodox role under Draghi after the onset of the eurodebt crisis was the refusal of ‘creditor countries’ (led by Germany) to give fiscal policy the necessary role in crisis mitigation. Second, monetary policy frameworks have to adjust to changes not just in economic structures but also in analytical insights.  Over the past decade that I have been discussing monetary, financial stability and euro area policies more broadly with my fellow economists in Germany, I have noticed a clear shift away from orthodoxy to a more realistic approach, moving from ‘we show the rest of Europe how to do it properly’ to the recognition that Germany as anchor country of the euro has not only privileges (and big economic advantages) but also responsibilities. Third, the world has moved on from a view that money supply drives inflation and that monetary and prudential policies are independent of each other to the realisation that financial and monetary stability are inherently related with each other, which requires a much more broader central banking approach (reflected also in the fact that with one exception  - Sweden – it is the central bank governors of the EU that have voting power in the General Board of the ESRB, the macroprudential coordination mechanisms of the EU).

 

So, what does this imply for the next president of the Bundesbank? Isabel Schnabel as member of the ECB Executive Board has given an important example, being a bridge between the ECB and often hostile, inflation-averse German media and public. The new president should see him or herself as being in the centre of the euro area system, being the representative of the anchor country of the euro in the Governing Council of the ECB and actively shaping ECB policies going forward.  At the same time, (s)he should be a more active spokesman for the ECB towards the German media and public. The new president can draw on talented staff at the Bundesbank and an increasingly diverse and vibrant world-class economics and finance academic community in Germany.  That’s an incredible opportunity and much more promising than tying oneself to historic orthodoxies.