Finance: Research, Policy and Anecdotes

We had two events at the Florence School of Banking and Finance over the past two weeks on financial and sovereign debt stability. Joint with Georgetown University, Graduate Institute of Geneva and the Sovereign Debt Fund, we held the 5th edition of DebtCon last week in Florence, a fascinating interdisciplinary event with economists, lawyers, historians and political scientists, academics, practitioners and policymakers.  As the world has been emerging from the pandemic, corporate and sovereign overindebtedness as consequence of the pandemic, lockdowns and government support measures has been of increasing concerns. With monetary policy in the US tightening (and at least a normalisation on the horizon in the euro area) and thus the global financial cycle tightening even more rapidly after the Russian invasion of the Ukraine, the threat of sovereign distress becomes more acute and is already happening in some countries, such as Sri Lanka.  However, we were reminded that the current (corporate and sovereign) debt wave actually started in 2010, with global sovereign debt/GDP now higher than global corporate debt/GDP.  If the fear of a global recession materialises, there might be further sovereign distress such as in some countries of the former Soviet Union and Central America and Caribbean.


Certainly a scary backdrop for the academic and policy discussions at the conference, but also an important impetus for research in this area, including studies of historical sovereign distress situations (or situations where default was prevented, such as Colombia in the 1980s), studies of the domestic and international politics of sovereign debt restructuring and attempts to improve data availability on sovereign debt and increasing transparency.


There are also new issues arising; most importantly, as my new colleague Sony Kapoor pointed out, the moral debt of advanced countries not only vis-à-vis their own future generations but also vis-à-vis developing countries having used up environmental space. At the same time, developed countries are encouraging their developing peers to go for high-initial-cost investment in green energy, which might not be feasible given limited access to international capital market. Given the nature of a stable climate as global public good, there is certainly a global deal to be made; given the current geopolitical situation, however, the likelihood of such a deal seems depressingly low.    


Similar themes last Thursday, when we had an exciting online roundtable (jointly organised with the Center for Global Development) on Sovereign Debt and Financial Stability in Europe and Latin America. Several important messages came out of the discussion: first, there has been an increasing divergence in access to financing markets by sovereigns; the ability of countries to respond to the pandemic differed dramatically by their access to international capital markets. This, in turn, will also affect post-pandemic growth paths  and whether or not countries can go back to pre-covid growth paths. This divergence might be further exacerbated with the current geopolitical disruption and the monetary tightening in the US. Interestingly, this can also be seen in Europe, where countries outside the euro area (but within the EU) have seen a faster increase in sovereign bond yields than countries inside the euro area. Second, there was a general agreement that price stability is a necessary (though not sufficient) condition for returning to a sustainable growth path. And even though supply-side induced inflation (as it might be primarily the case in the euro area) might not be influenced by monetary policy, inflation expectations will, which reinforces the argument for normalisation if not tightening of monetary policy in the euro area. Third, there is a clear difference between commodity exporters and importers in the economic effects from the dramatic recent increase in commodity prices; not surprising but important to keep in mind! Fourth, as interest rates increase, bank-sovereign fragility links will again gain prominence, including in emerging markets.

One nice benefit of being able to travel again to conferences and seminars is that one meets interesting people with interesting papers.  Here a small selection


Oliver Rehbein and Simon Rother make an important contribution to the literature on the role of social connections and distance in lending in The Role of Social Networks in Bank Lending. The authors use data from Facebook to construct indicators of social ties within the U.S. population across counties. Controlling for physical and cultural distances, social connectedness increases cross-county lending. On average, a standard-deviation increase in social connectedness increases cross-county lending by 24.5%, which offsets the lending barrier posed by 600 miles between borrower and lender. This effect is stronger for SME lending (where screening and monitoring is more difficult) than for mortgage lending, in line with theory. And social connectedness between counties is not associated with riskier cross-county lending. Further, borrowers’ counties tend to profit from their social proximity to bank lending, as GDP growth and employment increase with social proximity.  Overall, social networks can thus help to overcome information frictions and improve bank lending, effects that are orthogonal to other measures of distance and can partly offset physical distance between borrowers and lenders.


Sebastian Doerr , Thomas Drechsel and Donggyu Lee show that rising income inequality can reduce job creation at small firms in Income Inequality, Financial Intermediation, and Small Firms. A lot has been written about the determinants of increasing income inequality in the U.S. and its consequences. Sebastian and co-authors focus on one specific negative effect of this rise in income inequality: as high-income households save relatively less in the form of bank deposits, a higher share of income accruing to top earners therefore undermines banks’ deposits base and their lending capacity for small businesses, thus reducing job creation. Exploiting variation in top incomes across US states and over time, they find that a 10 percentage point increase in the income share of the top 10% reduces the net job creation rate of small firms by 1.5–2 percentage points, relative to large firms. The effects are stronger at smaller firms and in bank-dependent industries, thus providing evidence on the mechanism mentioned above. Rising top incomes also reduce bank deposits and increase deposit rates, in line with a reduction in the supply of household deposits. While the political debate on income inequality often focuses on fairness and the rise of populism, this paper shows the important economic costs of rising income inequality.


Rainer Haselmann, Christian Leuz and Sebastian Schreiber provide evidence that German banks use knowledge acquired in lending relationships for trading purposes in Know Your Customer: Relationship Lending and Bank Trading. Universal banks combine lending business with investment banking and brokerage services, which might raise conflict of interests.  However, it is difficult to find a smoking gun for information exchange between different parts of an universal banks. The authors do so, by combining detailed German data on banks’ proprietary trading and market making with lending information from the credit register. They then examine how banks trade stocks of their borrowers around important corporate events and find that banks trade more frequently and also profitably ahead of events when they are the main lender (or relationship bank) for the borrower. Specifically, relationship banks are more likely to build up positive (negative) trading positions in the two weeks before positive (negative) news events, and they unwind these positions shortly after the event. This trading pattern is more pronounced for unscheduled earnings events, M&A transactions, and after borrower obtain new bank loans. A back of the envelope calculation shows that on average, relationship banks earn an additional trading profit of €3,890 per event. These results suggest that lending relationships endow banks with important information, highlighting the potential for conflicts of interest in banking, which has been a prominent concern in the regulatory debate.

Boris Johnson has a problem – he just lost local elections, his attempt to divert attention from his Covid lockdown parties by smearing the leader of the opposition with having a beer during a work meeting are failing, and his approval rates are going the opposite direction as inflation rates. What to do – oh well, why not start another conflict with the European Union to pander to the right-wing in his own party and unionists (by now minority) in Northern Ireland.  The vast majority of Northern Ireland voted against Brexit in 2016 and voted for parties in favour of keeping the Northern Ireland Protocol a few weeks ago. Supply-chain problems are fewer in Northern Ireland than in Great Britain and most of Northern Irish businesses want certainty, including the protocol, even though they might not like all parts of it. But this certainly does not prevent Boris Johnson to use the opposition of unionists in Northern Ireland (again: a minority of the electorate and in the assembly) to start a new conflict with the European Union. When the economy is in dire straits and popularity sinks, identify an outside enemy and declare a conflict. This is what the Argentine military junta did in 1982 when starting a war over the Falkland Islands – it did not end well.


Just to remind ourselves, the Northern Ireland Protocol is the result of the Northern Ireland trilemma. Theresa May wanted to solve this by keeping the whole of the United Kingdom in the customs union (as backstop, though it would probably have turned into a permanent arrangement) to prevent an Irish sea border between Great Britain and Northern Ireland. Boris Johnson dropped this idea in favour of the Protocol, which established the Irish Sea Border while preventing a border between Northern Ireland and the Republic of Ireland. What was acclaimed as great success and a great deal in late 2019 and used by Johnson to win the General Elections (the Tory manifesto clearly states: ‘no renegotiation’) is now described by the same people as having been signed under duress and imposed by the EU and should therefore be renegotiated. Other lies put forward by Brexiters include the idea that the Protocol was meant to be temporary until a trade agreement was signed (false) or that it violated the Good Friday Agreement (by avoiding a land border on the Irish island, it does the opposite).


Her Majesty’s Government has also announced (using its media outlets) that there will be a Brexit bonfire of regulations to jumpstart growth in the UK – in translation: take powers away from Parliament and allow the government to change law without parliamentary approval; certainly an interesting way to reclaim sovereignty. In the meantime, the minister for Brexit opportunities is still busy searching for such opportunities.  Early successes include importing possibly radioactive meat, dumping shit into rivers (pardon my language) and allowing teenagers to drive HGVs.


In summary, the UK has moved to a phase of exclusively performative government. It very much resembles the double-speak in 1984: foster peace in Northern Ireland by taking the side of a party that just lost the elections, effectively creating space for new conflict and declaring the views of the majority irrelevant; a  bonfire of regulations to jumpstart the economy that makes trade with Europe even more difficult and will further depress growth; taking back control of borders by allowing without controls the import of food even if this risks more diseases and animal and food safety.  Given how miserably Tories have failed over the past 12 years in government in improving the economy, rather damaging it wherever they could, first with austerity and then with Brexit, they have turned to simplistic populist ‘solutions’ – send refugees to Rwanda, force civil servants back to the office instead of working from home, criminalise peaceful but noisy protests and classify anyone who questions them as ‘Remoaners’ or EU agents. Supported by the press that has been bought off with taxpayer money during the pandemic and having cowed BBC into not report anything too critical about the government, the Orbanisation of the UK is in full process. Political ideas and arguments replaced by slogans and smears!  A sad decline for a proud and once strong European democracy!

Why do so many Russians support the Putin’s war against Ukraine? While it is hard to get a clear picture given the oppressive nature of the Putin regime, available data and anecdotal evidence suggest there is reasonably strong support for the invasion of Ukraine, with many even supporting aggression further West.  A lot of reasons for this support have been given.  One important point I would like to make in this context is the complete lack of Russia to address its 20th century history, large parts of which have been rather dark, very different from Germany after World War II, which did – as I will discuss in the following – address its very dark past, even if imperfectly. There is even a very German word for this process:“bewaeltigen”, translated as “to deal with or cope with”, but it has a much deeper meaning.


It is important to note that coping with genocide, war aggression and totalitarianism of the Nazis was not a linear process in Germany.  After initial attempts by the Allied Powers in West Germany at denazification and confronting the German people with the Nazi crimes, the topic was not really openly discussed for two decades.  My mother told me that the Nazi regime was not discussed in school and that history lessons (which in German curriculums start in Stone Age and then slowly proceed to 20th century over a couple of years of high school education) always stopped in 1914; ‘somehow the teacher always ran out of time to discuss 20th century history’, she told me. That certainly changed after 1968 and definitely in my generation. Starting high school in 1978, our classroom teacher made it his personal mission to teach us the horrors of the Nazi regime. Later during my high school years, the Nazi past was not only discussed in history lessons, but in political science, German, religious education etc.  Part of my reserve officer training near Munich (in the late 1980s) was a visit to the concentration camp Dachau.


On the political level, it wasn’t until 1985 that the then Federal President Richard von Weizsäcker remarked on the occasion of the 40th anniversary of the end of World War II that this day was to be celebrated as day of liberation rather than defeat for Germany, but also that “there can be no reconciliation without remembrance”. While he also made clear that the young generation had no personal guilt for the Nazi crimes, there was thus an obligation for Germans to never forget. It is striking that it was von Weizsäcker giving this speech since as a young man he defended his father (a high-level diplomat during the Nazi regime) in a Nuremberg follow-up trial.  One can argue that the fact that right-wing parties have not been successful until 2017 in federal German elections is this confrontation with its own history. It is also very different from the approach in East Germany, where the Nazi history was declared the responsibility of the capitalist West Germany, or Austria, which declared itself as victim of Nazi Germany, without properly confronting its own role during World War II (with Kurt Waldheim in spite of his Nazi past being elected as federal president in 1986), a tendency heavily criticised by the Austrian author Thomas Bernhard in his writings.


One might argue that by now Germany has again become a normal European country, at least to the extent that the largest country in the middle of Europe can be a normal country, and is not a military threat whatsoever to its neighbours (obviously, European integration and French-German reconciliation played a big role but went hand-in-hand with this process of Germany confronting its past. And that is the crucial difference to Russia, which has never addressed the brutality of the Communist regime, more generally, and the wide-spread violence if not genocide under Stalin, more specifically, as well as its history of aggression against its neighbours. The way World War II (when the Soviet Union was both aggressor and victim) is being used as rallying cry for the current aggression shows this lack of confronting history, as does the way Lenin and Stalin are being again acclaimed as national heroes.


After World War I, Germans did not cope well with their defeat, with one of the factors of the rise of the Nazi part being the denial of military defeat and a sense of victimhood (unfortunately being also fuelled by massive and unreasonably high reparation demands by the Western Allies).  Similarly, after Russia and the Soviet Union lost the Cold War and following the economic decline and socio-political chaos of the 1990s, there was certainly a sense of victimhood and unjust loss in Russia, tendencies that Putin benefitted from to strengthen his powerbase. What was missing both in Germany post-War World I and Russia post-Cold War was a clear confrontation of the societies with the dark chapters of their respective past. Germany past-Word War II took a long time but did go through the process (and I hope it has become clear by now that I do not claim that the process has been perfect or complete).


Will Russia be able to accomplish something similar? I am rather pessimistic. It took Germany two generations to go through the process and only after a complete societal and political collapse and military occupation. Not something that one would want to wish for Russia!  Which also means that even if and when Russia loses this latest confrontation with its European neighbours, there will be no easy path forward domestically and globally for Russian society and political system.

How can technology allow the smallest of the small firms gain access to external finance? High risk (due to information asymmetries and lack of collateralizable assets) and high costs makes lending to the smallest firms prohibitively expensive for most banks. And unlike consumer lending (which might also entail small amounts), it might be harder to automatise the screening and monitoring process. Enters fintech!  In a new paper with Leonardo Gambacorta,Yiping Huang, Zhenhua Li and Han Qiu, we gauge the effect of introducing the QR code as payment technology and how this allowed small traders to gain access to external funding. Specifically, we look at the example of Ant Group, which started providing payment services through QR codes, thus allowing offline merchants to access digital payment services. Ant Group uses the information collected through these services to decide on credit provision to merchants.


Based on a dataset of around half a million Chinese firm, we find that: (i) the creation of a digital payment footprint allows firms to access credit provided by the same big tech company, Ant Financial; (ii) transaction data generated via QR codes generate spillover effects on access to bank credit; and (iii) there are positive effects of access to big tech credit on sales, including during the Covid-19 shock. Gaining access to a more efficient payment technology thus allows these traders to signal credit worthiness and ultimately gain access to credit. Which also implies that the focus that we typically have in the financial inclusion literature on different financial services (payment, savings, credit, insurance) might not be always relevant, as they might actually hang together; in this case, payment and credit services from the same company – in other cases (as in my Kenya-focused paper on mobile money) from different providers.