Finance: Research, Policy and Anecdotes

I just attended a very interesting conference on Islamic finance in Dhahran, Saudi Arabia. For me the highlights were the paper I discussed as well as a discussion on the future of research in Islamic finance.


The paper I discussed, by Nicola Limodio, identifies the effect of deposit volatility on loan maturity using a natural experiment in Pakistan, where volatility of silver prices influences the outflow of deposits around the date of Zakat (religious donation, similar to the Christian tithe).   The author shows a dampening effect of deposit volatility on long-term lending, which results in less fixed asset investment by firms.   While one can see this as Islamic finance paper, one can also simply regard the exogeneity of the liquidity withdrawal as helpful identification strategy and the results as being applicable beyond the specific setting.  A great paper addressing an important question across the developing world (lack of long-term finance), with rather unique data (credit and corporate registry, branching map and religious composition map).


There were many other interesting papers in the conference on different aspects of Islamic finance – banking, corporate finance, household finance and regulation.   Which brings me to a more general point – the basic laws of finance – asymmetric information resulting in agency problems – hold in Islamic as much as in conventional finance.  There are some innovative solutions to the problems in Islamic finance, though also a lot of more nominal adjustment to standard financial contracts to thus make them compatible with Sharia law.  Most importantly, there is an astounding variation in Islamic finance across countries.  Many papers in the conference referred back to my 2013 paper with Asli and Ouarda on Islamic banking, but the most interesting result in this paper was for me the enormous cross-country difference in efficiency and stability indicators of Islamic vs. conventional banks across countries. To put it simply, the difference between Islamic banks in Sudan and Malaysia seems larger than the differences between conventional and Islamic banks in Malaysia. This is also consistent with other work. In recent research (with Zamir Iqbal and Rasim Mutlu) we gauged whether a higher share of Islamic banking is associated with higher consumption smoothing.  Our finding – no significant results. However, there are some weak results that a higher share of risk-sharing products within Islamic banking is associated with higher consumption smoothing. This certainly calls for a much more differentiated view on Islamic banking, going from the bank- down to the product level.


Where does the future of research in Islamic finance lie? There has been a general trend to move away from cross-country work across finance research and I think this is even more needed for Islamic finance, given the cross-country differences mentioned above.  There is a need to go down to micro-level data, for example from credit registries (such as used by Nicola, but also by Lieven Baele, Moazzam Farooq and Steven Ongena in this paper). Similarly, data from individual banks (possible one with both conventional and Islamic financial products) might be useful.  Survey data from firms and households could be explored.  Finally, randomized control trials focusing on the role of religion might be useful, as for example in this paper by Martin Kanz and co-authors.  Of course, there are still big questions to be answered – to which extent can Islamic finance contribute to financial inclusion and development and to real sector outcomes, but the future seems to be really in micro data to explore these questions.


Islamic finance is often seen as marginal field, which makes publishing papers in this area rather difficult.  However, one can see Islamic finance also in the broader context of non-profit maximizing banking across the globe.  Profit-maximizing banking is not as widespread as finance academics often assume; in Germany, for example, more than 60 percent of the banking system are either state-owned or cooperatives.  Similarly, there has been an increasing trend towards double or triple bottom-line banking around the world, taking into account both social and environmental sustainability as objectives. Behavioural constraints and effects are increasingly being recognized as important also in finance.  If one sees Islamic banking in the same vein, research on Islamic finance also moves into the mainstream of finance research rather than staying on the margins.


The coalition negotiations between Christian Democrats, Greens and Liberals have broken down.  There is talk of reviving the “grand” Coalition (grand as in comprising the largest two parties, but with a very small g, as far from having a dominating majority, just 56%, compared to over 90% in the first edition in the 1960s).   Having yet another grand coalition (after both parties lost 14% between the two), does not just send the wrong signal to voters, it makes the right-wing AfD the biggest opposition party. A look south of the border to Austria shows the danger of such an arrangement.


Protracted coalition talks are common in other European countries (e.g., Netherlands and Belgium).  In both countries, public administration continues as normal with little change noted for citizens and residents of these countries (except that painful budget cuts might be delayed).  Germany does have a special role in the Eurozone and European Union, however, so that a full-functioning German government would indeed be important.


Unlike the Economist, I do not think that new elections are the right way forward. Rather a minority government of CDU/CSU is called for, with varying support by other parties (as also recommended by the FT).  This would help overcome one big weakness of 12 years Angela Merkel – limiting decisions to a small circle and selling them as without alternative. It might slow down decision making, but might make for more discussion among parties, in the Bundestag and in the public. The other centrist parties will certainly be happy to play ball. While minority governments have a bad reputation in Germany (given the experience during the interwar Weimar Republic), it is a much safer option than in other countries, as the chancellor can only be replaced by an absolute majority (which would involve cooperation of the three other centrist parties with either left or right extremists to elect a different chancellor, rather unlikely).  So, once Merkel is re-elected as chancellor with simple majority, the only way to terminate the minority government early would be if the CDU/CSU can pass little or none of its programme and/or cannot pass a budget. It might then force new elections.  Certainly, an experiment worth undertaking. 

Whenever in conversations on the Eurozone crisis people refer to my nationality, I always state that I am German and an economist but not a German economist. This is not to downplay or ignore my many links with German economists, professional and even personal, but more a clear indication that I work in a different conceptual framework than my Germany-based colleagues. There have been many occasions where I have been reminded of that; most prominently at a CEPR workshop some five years ago, where one (non-German) European economist working in the US openly asked: what’s wrong with German economists?  


Fresh of the press, Hans-Helmut Kotz (Frankfurt and formerly Bundesbank) and I have edited a Vox eBook, which tries to explain what is different (though not necessarily wrong)  about German economics.  Starting from the premise that markets know best, but that competition has to be protected by a strong state, a strong focus on rules, on ordo follows.   Ordoliberalism’s origin were founded in strong opposition to the interventionist and cartelist economic policies of the Nazis but also the macroeconomic chaos of the Weimar Republic.  This implies a strong focus on monetary stability and macroeconomic rules but also on supply- more than demand-side economics.  There is little space for aggregate demand-side policies in ordoliberalism.


The strong focus on rule has led critics to accuse ordoliberals of focusing more on principled rules than caring about the ultimate outcome.  And contracts (as much as they are to be followed) are necessarily incomplete, so that discretion is necessary.  While this can easily turn into a slippery road towards moral hazard and kicking the can down the road, a degree of sustainable flexibility is required and rules that can actually be enforced. 


The eBook combines short chapters by both academics and (former) policy makers on both sides of the debate.  Across the chapters, one can sense a certain urge to bridge the gap, critical not only to address global imbalances and help defeat the rise of populism, authoritarianism and economic nationalism, but even more critical within a monetary union where one important adjustment tool –exchanges rates – has fallen away. 


Recent elections and referendums have been casted as a choice between establishment and populism.  As more and more evidence suggests, these contests have been partly influenced by outside forces interested in undermining democracy through social networks and fake news.  But there is another problem with these contests and that is what populists do with their wins.  Strong democracies are characterized by amicable change in power; today’s winner can be tomorrow’s loser.  Looking at the reaction of some of the successful populist politicians (which includes the Leave campaign) one wonders whether they play by the same rules.  The governments of Hungary and Poland have shown clear authoritarian tendencies, trying to undermine the independence of institutions such as the Central Bank and the judiciary, but also waging a more general war against non-conformist civil society, including the academic world.  Exhibit A: The Orban regime closing the Central European University, under the pretence that it was funded from abroad, as they dislike its main funder, George Soros.


And the most recent exhibit in the UK:  MP Chris Heaton-Harris writing to universities asking for names of academics teaching on Brexit and asking for the course material.   While one might think of this as innocent inquiry, the fact that the MP did not just ask for course material but in the first instance for the names of the academics makes this a rather chilling request!   And this comes on top of a campaign by the Morduch press against anyone critical about the consequences of Brexit (e.g., Bank of England governor Mark Carney) branding them as Enemy of the Brexit (or if they dare to hold up the constitutional framework, as the Supreme Court did, Enemies of the People) and calls by Tories for more patriotic reporting by the BBC. 


I have a strong belief in the strength of democratic institutionality of the UK (and definitely more than in the case of some Central European countries). However, these are scary trends.  It also puts the idea in perspective to let the populists show their incompetence by having them win elections and forcing them to govern.  We have to be careful what we wish for.  The spectacle from the other side of the Atlantic where the president is trying everything possible to undermine 200 years of democratic institutionality should be a warning sign.  Democracy has not only to be achieved, it has to be defended. 

After a long and rather exhausting review process, the Sex and Credit paper has been finally accepted for publication at the Journal of Banking and Finance.  The paper and its findings fit relatively well with the recent prominence given to behavioural economics and finance (best illustrated by the Noble Prize for Richard Thaler). Using a large loan-level dataset from an microfinance bank in Albania we gauge whether the assignment of a first-time borrower to a loan officer of the same or the opposite gender has repercussion for loan conditionality and, ultimately, for the likelihood of the borrower to return for a second loan.  We find that borrowers that are assigned to a loan officer of the opposite gender (where the assignment is a random process) are less likely to return for a second loan than first-time borrowers that are assigned to a same-gender loan officer, with one possible reason being that they have to pay higher interest rates and receive shorter-maturity and smaller loans. Is this statistical discrimination, i.e. do opposite-gender loan officer impose more stringent loan conditionality because of higher risks in lending relationship between borrowers and loan officers of different genders? We find that no, as there is no significant difference in the performance of such loans.   So it is taste-based discrimination?  Yes and no!  We find that the gender effect comes exclusively from loan officers with limited experience with opposite-gender loan officers (for all loan-officers it is the first job after college). Once loan officers gain sufficient experience with opposite gender borrowers, they overcome this initial bias.  But it is not only the experience, but also the incentive structure.  The bias comes from loan officers with limited opposite-gender experience in districts where the bank faces limited competition from other financial institutions and where branches are small, i.e. where internal competition is limited and discretion for loan officers larger. Our results are consistent with the existence of an initial gender bias and learning effects that lead to the disappearance of the bias, but also stress the importance of competition in limiting the effects of such bias.  Finally, does the bias come from male or female loan officers?   While our identification strategy does not allow us to answer this question conclusively, additional estimations suggest that the bias comes from both genders towards the respective other gender.


What do we learn from these results for the functioning of the credit market? First, identity should affect firms’ human-resource practices as loan officers’ opposite-gender experience has repercussions for the size of the effects. Second, from a policy perspective, our findings point to the possibility that financial market competition can be a powerful tool in dampening such discriminatory effects. 

For the Vox column on the paper: 

For a video interview: