Finance: Research, Policy and Anecdotes

For the past six years I served on the advisory evaluation panel of the Dutch development bank FMO, a quite unique experience as it (i) gave me insights into the other side of the evaluation process that we academics are usually on and (ii) allowed me to serve as bridge between academia and the development finance world. As background: some 7 years ago, FMO was asked by the Dutch government to evaluate the impact of projects in developing countries that were funded by the Dutch government to thus ascertain whether taxpayers’ money was actually put to good use. Being relatively new to the evaluation world, FMO got up to speed admirably quickly on how best to go about this, which included forming an advisory panel, which I joined at the beginning of 2013.


I learned quite a lot about the challenges faced by evaluation departments in development banks: One, in several instances of evaluation requests, projects were already underway, which made a pre-intervention baseline all but impossible and an evaluation thus more challenging. And even where the projects had not started yet, a rigorous evaluation that addresses selection biases and endogeneity, is often not possible. Expanding electricity networks and/or building a bridge/road is hard if not impossible to randomise, so alternative evaluation methods are asked for. Where FMO had no contact with the ultimate beneficiaries (e.g., credit line cum technical assistance to financial institutions), a proper evaluation was often not possible and an effectiveness study (assessing how the resources were used at the level of financial institutions) was more appropriate.


Two, unlike in academic work, project evaluation (actually project preparation) starts with a theory of change, with the input provided by FMO or other donors (in the form of resources, technical assistance etc.), output being envisioned at the level of local counterparts, the outcome being at the level of beneficiaries (households and enterprises) and the ultimate impact being higher growth or poverty reduction. A first important question is which parts of the theory of change can and should be evaluated.  Another important question is the value added of individual evaluations – some questions have been extensively assessed before, while others are novel but might also be harder to assess (e.g., impact of expanding external finance for SMEs rather than for micro-entrepreneurs). Ultimately, this reflects also different interests and roles for academics and development banks’ evaluation departments: academics are interested primarily in what works best, a development bank like FMO also has to care about the value added that it can provide through its funding and the effectiveness of delivering this funding to counterparts (not necessarily the same as final beneficiaries) in the receiving country.


Being a bridge between academics and the evaluation department also provided interesting insights: undertaking an evaluation study for FMO can be interesting for academics mainly (apart from some additional income) for two reasons: one, being able to publish the results of the evaluation in an academic journal, and, two, being able to access to interesting data and possible future cooperation possibilities.  However, it is also clear that the interests of academics and development banks do not always match – as much as the latter might be interested in rigorous evaluation, they face budget and time constraints, while the former might get easily frustrated by institutional constraints and the difficulty of implementing adequate research methods (often coming from the implementing institution in the developing country).  Not surprisingly, there was thus a rich mix of consultancy companies focusing more on effectiveness or “light” evaluation studies and academic teams going all the way to econometrically rigorous evaluation. 


In a nutshell, there is so much more to the world of evaluation out there than randomised control trials. Alternative methods, such as quasi-randomised, discontinuity and propensity scoring, might help. However, even these might not be feasible in some instances, so that descriptive and qualitative methods might be necessary. While the latter might not be interesting for us academic economists, they can play an important role in completing the picture on “what works best” and – as important -  “what can each player do”.

So, here we are –habemus pactum – the European Union and the government Prime Minister of the UK have agreed on a withdrawal treaty and political declaration for the future relationship. A customs union for the UK with the EU as backstop until a new trading relationship can be negotiated that prevents the need for a hard border in Ireland with the UK respecting certain minimum standards of labour rights, environment etc.; frictions between Northern Ireland and Great Britain to allow for smooth trade across the Irish land border. And a transition period until the end of 2020, but which can be expanded until the end of 2022, during which the UK is effectively a EU member without any say and any leverage for the follow-up negotiations.  Never mind that large parts of the cabinet do not seem to agree with the Prime Minister and there is currently no majority in the House of Commons nor in the population for this agreement; as with any good compromise, everyone seems to hate it and for a good reason – economically it is worse than EU membership but better than an even harder Brexit, but politically it is worse than anything else, both EU membership and a harder Brexit, as the UK has to comply with rules it won’t set. As Ian Dunt summarises it: May’s Brexit deal is a humiliation for Britain. But then again, every serious economist in the UK has predicted that there is no such thing as a good Brexit!  So, we should not be surprised. There was simply no way to make a success out of the Brexit process.  


This withdrawal agreement is probably the best outcome for the UK, given the contradictory red lines the Prime Minister established early on and which I summarised as Brexit trilemma. Ultimately, she decided to respect the need for a soft border in Ireland, accepted some divergence along the Irish Sea (between Great Britain and Northern Ireland) and all but gave up on independent trade policy, accepting a bare-bone customs union with the EU until further notice (i.e., as long as the backstop to avoid a hard border in Ireland is needed).  The problem is not so much the agreement, but the expectations she raised during the past two years in the form of red lines and which she ultimately had to ignore. Which comes back to her original sin – setting out expectations for Brexit and triggering Article 50 without a plan whatsoever and without an agreement within her government, her party, not to mention the country on what Brexit should look like.


The one advantage of Theresa May is that there is no obvious alternative plan to the Withdrawal Agreement that is acceptable to a majority in her party (though might be in the House of Commons). Most if not all of the hard Brexiters continue to be absolutely clueless and delusional.  Never mind that all of their predictions about the EU-UK negotiations have been disproved (lest we forget, see here), their ignorance if not outright lies have dominated the debate in the UK again and again over the past 2.5 years. Latest addition to this list is the written opinion by David Davis that a withdrawal agreement is not needed as the trade relationship between the UK and the EU could be negotiated during the transition period – never mind that this transition period is the result of a withdrawal agreement! Note that this is not a slip of tongue but was provided in written form.  In addition to this comes the “Greek fallacy” that if only you get strong support at home (which Theresa May never had), this does not (and should not) trump the interests of the other 27 countries of the EU.


There are a lot of voices in the UK that demand to “just get on with Brexit”, even if it implies Brexit without a deal. This is also reflected in Boris Johnson’s statement of “Fuck Business”.  This reflects both an ignorance on the side of people with such opinions but – more importantly - a failure of the political class (and maybe us social scientists!) to better explain that the “omelette of deep economic integration” cannot be unscrambled easily and without costs. Obviously, these statements are in line with Michael Gove’s statement during the campaign that the country had enough of experts. And these feelings are fuelled by mass media that make Brexit indeed look like a walk in the park. It seems that in spite of all the mistakes the Prime Minister and her political allies have made over the past 2.5 years, there is still enough common sense left in them to realise that this assessment does not quite match reality,.


It has become clear over the past 2.5 years that for the Prime Minister Brexit seems to be all about restricting freedom of movement – the UK never made the difference between immigration (people moving from outside the EU into the UK) and EU citizens exercising their rights to live and work in the UK (and vice versa) under Single Market rules. This has become clear since David Cameron came up with the nonsensical idea of reducing net immigration (including EU citizens) to below 100,000 per year and has been reinforced by Theresa May last week when she accused EU citizens like me of jumping the queue (paraphrasing a reaction on twitter: which queue – the one to help return tax revenues towards a more stable basis after the crisis  or the one for poor public services?). The government and especially the Prime Minister have actively fuelled an atmosphere of xenophobia in this country after the referendum, which made a soft Brexit (known as Norway model) all but impossible.  In line with right-wing populist parties on the Continent and the Republicans under Mr. Trump in the US, the Tories have developed from a common-sense, business oriented party into an extreme right-wing if not fascistoid party – well, who needs the UKIP anymore if their ideology has been taken on by the governing party of this country?


Unfortunately, this will not be the end of it.  I sometimes get asked by friends of the continent whether I am glad that all of this will be over by 29 March. Well, no, it will not be over, even in the “best case” scenario of the Withdrawal Agreement being accepted by a majority in the House of Commons.  Soon after the Brexit, the next round of negotiations will start – on two levels as up to now: between the EU and the UK on the future trade deal and – as if not even more important – within the UK government and the UK political class on the future relationship between the UK and EU. This debate will put its stamp on politics in the UK for the next decade if not generation. If the Withdrawal Agreement gets rejected in the House of Commons (even in a second vote), there are chaotic weeks and months ahead for Westminster and all odds are off on what could happen.  In this case, you ain’t seen nothing yet!

There is no end to conferences that take the 10th year anniversary of the Lehman Brothers’ failure as motivation to discuss financial stability and the regulatory reforms of the past decade.  One of the highlights has certainly been a conference on Managing Financial Crises: Where Do We Stand?, at the National Bank of Belgium, co-organised by the ECB, Solvay Brussels School of Economics and Management, Toulouse School of Economics , which I had the pleasure and honour to participate in.  While split into five panels, the same topics came up again and again – how to make the Eurozone and its financial system more resilient. There has been enormous progress in strengthening banking regulation after the Global Financial Crisis and the Eurocrisis, but more is needed to make the Eurozone a sustainable currency union.  The 7+7 proposal of combining more risk-sharing with more market discipline was the starting point for several discussions during the conference.  It is clear that while politically risk sharing (in the form of, e.g., a common unemployment reinsurance and a Eurozone level deposit insurance) and market discipline (help for countries in dire fiscal position only with conditionality) are seen as contrasts, in reality they complement and reinforce each other.  Market discipline can only be enforced if credible and it can be more credible with risk sharing. In this context one important consensus that came up again and again was that the banking union has to be completed, with common deposit insurance and a backstop for the resolution fund.  Similarly, fiscal and capital market risk-sharing are not substitutes but can very much complement each other.


But when will these reforms be undertaken? On the one hand, there is a reform fatigue and political stand-off related to Italy – which speaks against any political action soon. There is also nothing like a crisis to focus minds. But “we should not build a boat again in a storm” as Herman Van Rompuy (former President of the European Council) admonished   And the next crisis might not be too far away as Vitor Constancio pointed out – if it is not Italy then the next recession might hit soon, with Eurozone authorities not having enough tools available.


I participated in a panel on bail-in vs. bail-out. I have written about this before. While Europe has moved from costly bail-outs to a framework of bail-in, in reality we are still very much in between both corner solutions and the question is whether we really should get to a corner solution where only bail-ins are allowed.  For me the challenge comes down to legacy problems vs. forward-looking. State aid restrictions were temporarily lifted in 2008 to allow bank recapitalisation but not after the Eurozone crisis, resulting in bank fragility not being addressed and the can being kicked down the road.   As Mathias Dewatripont pointed out: “‘when bailout is out and bail-in is not in, denial is the only option left’ and procrastination is also very costly for growth and thus taxpayers.”. Non-performing assets continuing to depress bank lending in several periphery countries and bail-inable debt not built up yet undermines the application of the bail-in tool as clearly seen in recent instances. It also undermines the push towards a European deposit insurance and backstop to the resolution fund as creditor countries fear that they are being asked to pay the tab for legacy losses. A solution to this problem, however, is above the paygrade of regulators and has to be resolved on the political level. Without going into recent development in German politics, let me just say that this seems rather unlikely to happen soon.


I am off to a week-long trip – first Washington DC where I will participate in the second meeting of the Taskforce on Basel III in Emerging and Developing Markets. While in the first part of this project we discussed challenges in the Basel III adoption and implementation for emerging and developing economies, this time we will discuss policy recommendations.  A report, however, won’t be ready until early next year.  


On Thursday/Friday then, I will be at the  68th Economic Policy panel at the Austrian National Bank in Vienna (where excellent research will be combined with delicious coffee!).  A very interesting set of papers awaits us, including two papers on the Gig economy, one of them on Uber drivers in London.  Also, Barry Eichengreen et al. on Mercury vs. Mars – what explains which currency countries hold their foreign exchange reserves in – economic or political reasons; with some interesting policy implications for both the US dollar and the Euro.  Atish Ghosh et al. discuss how policy makers have or have not adopted capital account restrictions in line with the reputation of such policies.  I will try to tweet from the panel meeting.

A lot has been written about the Global Financial Crisis, what we have learned, what we have not learned, how we can avoid future crises, etc.  Instead of adding yet another view, which might not look too different from others, let me offer some personal observations – admittedly, in many instances it took some time to put some sense to these observations, but in hindsight we are always smarter.


During my nine years post-PhD at the World Bank I had primarily worked on developing country issues – ranging from more developed systems such as Brazil, over transition economies, such as Russia, to low-income countries, such as Bolivia, Kenya and Uganda. I had worked on development and stability issues and among the latter, the design of deposit insurance and bank resolution regimes always featured prominently (you will see the relevance of this below).


My first encounter with the Global Financial Crisis was in summer 2007, which I spent with my family vacationing in Germany.  Reading German newspapers, I could not avoid the impression that the crisis had started in Germany rather than in the US.   Repackaged US subprime mortgages had shown up in the balance sheets of several German banks, including IKB, which was bailed out by other banks and the governments.    As we found out later, a sign of worse things to come. It also showed the global nature of the crisis to come.


I arrived in the Netherlands to take up my position at Tilburg University in late summer 2008, just in time to witness the onset of the Global Financial Crisis. What Lehman Brothers was for the US (and the global financial system) was the Fortis/ABN Amro failure for the Netherlands (and neighbouring Belgium). My first question for my new colleagues was: how does the bank resolution work in the Netherlands – I got rather funny looks; as I found out quickly, none of the European countries had a bank resolution framework, leaving regulators and governments with a choice between long-winded corporate insolvency proceedings (and the turmoil this causes as shown by Lehman Brothers) and bail-out – the path chosen by almost all governments for almost all banks in 2008/9.


The European Commission allowed the bail-outs of banks across the European Union in spite of the prohibition of state aid for fear of a financial melt-down. In 2009/10 I worked with Diane Coyle, Matias Dewatripont, Xavier Freixas, and Paul Seabright on a report for DG Competition assessing the state aid provided during the Global Financial Crisis across Europe, later published as CEPR book.  Our conclusion was that the carrot and stick approach advocated by many European policy makers (allow bail-out first, punish banks later) did not make much sense as punishing bailed-out banks would reduce competition and not help European banking systems support economic recovery.  We recommended to rather focus on regulatory reform to avoid that bail-out would have to happen again, including putting more burden on junior bondholders and expanding the regulatory perimeter to bank-like financial intermediaries.  As always, our recommendations were partially implemented (I think even that could be celebrated as success) – there was a somewhat less aggressive approach by the European Commission towards post-bail-out conditions and there was an overhaul of the resolution framework towards bail-in (of course we were far from the only ones to advocate that!).


This leads me to two of the immediate lessons from the failure of (cross-border) banks in Europe: the need to create bank resolution frameworks and the need to create institutional frameworks to coordinate supervision and resolution in the EU.  In the following few years, I actively participated in the policy discussion of what later was named banking union.    In 2011, Franklin Allen, Elena Carletti, Philip Lane, Dirk Schoenmaker, Wolf Wagner and I published a policy report on the future of cross-border banking in Europe – among others, we recommended EU policy makers to create a European-level deposit insurance fund and resolution framework.


I still remember a conference at the BIS in Basel in 2009 where I suggested that the Eurozone would eventually have to move towards a European version of the FDIC, i.e., a supranational financial safety net.  A Fed economist in the audience burst into laughter, declaring that European governments would never agree to this. Lawyers explained to us economists that a treaty change would be necessary to construct such a supranational framework. A few years and zero treaty changes later, the Single Supervisory Mechanism and the Single Resolution Mechanism were established, a strong entry into the banking union and thus a Eurozone-wide financial safety net. It is far from complete as many of us economists have reminded policy makers over and over again and one can argue that the glass is half empty – looking back to 2008/9, however, the glass is certainly half full.


Another important and justified question after the crisis was what the role of the financial sector should be, going forward? Was the crisis really proof that financial development does not help growth and that the finance-growth literature had just been proven wrong, as academics and policy makers alike kept telling me? Or was it rather the definition of financial development that causes this discordance?  There was certainly a realisation after the GFC that the financial centre approach to the financial sector policies might give some growth benefits but also sharper drops during the crisis. Several countries, including the Netherlands, Cyprus and Iceland had tried this approach, though in different ways, but all with other negative outcomes.  This was confirmed in a research paper by Hans Degryse, Christiane Kneer and myself even for a cross-country sample before the crisis – short-term growth benefits, longer-term high volatility costs of large financial centres. The positive role of the financial sector in the growth process comes from the intermediation and risk management role, not necessarily from having large balance sheet and employing lots of people.


So, how far have we come?  Martin Wolf recently wrote that little has changed. And even though many statistics indicate indeed that the world has gone back to business as usual, I still beg to differ.  Yes, there was no revolution. We did not hang the bankers from the lamp posts and the financial sector has not been completely transformed.  But there have been critical changes in the regulatory framework – a much tighter regime of capital requirement, augmented by liquidity requirements (with capital requirements not sufficiently high, as many economists, including this one, would argue, though I am not convinced we should move to 25%); introduction of macro-prudential tools; introduction of bank resolution frameworks in Europe; a start on the banking union; ring-fencing in the UK (maybe a good example for other countries); etc.  However, there are challenges for regulators, as Elena Carletti, Itay Goldstein and I wrote in this survey – the tension between complexity and simplicity of regulation, where the former allows for better pricing of risks, while the latter avoids regulatory arbitrage; the need for an even stronger focus on systemic risk and macroprudential tools; the need to further finetune resolution frameworks; and the need to adjust the regulatory perimeter as financial service providers might try to take intermediation business out of the costly regulated sector into the unregulated sphere of finance, an ongoing challenge given the rising importance of lending platforms and bigtech companies, such as Alibaba and Paypal moving into financial service provision.   


Does this regulatory progress mean that the financial system safe? Yes and no! It is safer than it was in 2007 and if a similar shock hit today, everyone would be better prepared. The problem with regulatory reform, however, is that it is always designed to address the previous but not the next crisis – future fragility will come from other areas, which are – as of now – unknown. Will it be fintech and cybercrime? Will it be different asset classes (student loans in the US, car loans in the UK)? Will it be in emerging markets and triggered by exchange rate movements and rising interest rates in the US? Will it be political shocks to sovereign debt in the Eurozone? There are lots of possible sources of fragility across the globe.  Economists have not a good track record in forecasting, so I will not participate in this guessing game.


In summary, the past ten years have seen lots of progress in regulatory reforms.  What is missing is a more fundamental rethink of the role of the financial sector, especially in high-income countries, at least among policy makers.  And while there has been deleveraging in some countries and some sectors, there has been more leveraging in others (partly driven by very loose monetary policies for almost a decade). So, while we might be better prepared for the next financial hurricane, the damage will still be significant!   And it is important to not pretend the impossible – the new bail-in framework will not avoid government support in all circumstances.  Yes, there will be systemic crises in the future and there will have to be government support.