Finance: Research, Policy and Anecdotes

Today  a year ago I published my first blog entry on Finance in the Time of COVID-19, chapter of a VoxEU eBook. Time to look back and to look forward. A year ago, not much attention was paid to the impact of COVID-19 on the financial sector and rightly so – the immediate focus was on public health. Next came the fiscal policy reaction, supporting households and enterprises during the Great Lockdown(s).  However, here the banking system already took an important role as transmission channel for fiscal support measures (loan moratoria and guarantees but also direct support payments). At the same time, there was the justified fear that ‘banks and financial markets might be catching COVID’, resulting in a swift monetary and regulatory policy reaction.  It was clear already last year that any fragility in the form of non-performing loans would not show up immediately on banks’ balance sheets, but with a delay – though my original estimate of this possibly happening in the second half of 2020 was clearly – in hindsight – naïve (then again, I was also counting to being back on the road by late May)!  Where I was clearly wrong was to call for continued standard loan classification and provisioning standards to be applied – given the high degree of uncertainty, the only wise response was to ease these requirements until more clarity emerged on viability of borrowers. A second source of fragility has not emerged so far: the shift to working from home has worked well for banks and the disruption in public life has not resulted in operational problems for banks. In the long-term, however, the shift to further digitalisation will result in new risks. A third source of risks I pointed to were market disruptions – they happened indeed, with investors chasing liquidity and safety. The central banks as market makers of last resort played a critical role in calming the markets. Regulatory authorities also acted quickly, with capital relief but also imposing profit distribution restrictions, delaying stress tests and an overall accommodative approach.

 

A journalist recently asked me: “Are banks really suffering – or are they actually doing ok or maybe even making profits?” The answer to this is ambiguous. Banks have been affected by loan moratoria and an increase in general (rather than specific) provisions. Loan losses have been limited (because of the easing of classification standards discussed above) and investment banks have been able to profit from a higher volume of market transactions (including larger firms raising funding on public capital markets).  However, it is also clear that the pain is still to come; there is hidden fragility, to surface after the end of support programmes.

 

One additional source of risk that was on many people’s mind a year ago was the re-emergence of sovereign fragility, as countries with limited fiscal space saw a drop in tax revenues and increase in expenditures due to COVID support measures. Early on, many European economists called for a EU-level fiscal response, e.g., in the form of Coronabonds – well, these might be gone, but we got the European Recovery Fund, and thus an entry into common fiscal policy.

 

Where do we go from here? Attention has shifted from support measures for households and enterprises (and thus indirectly for banks) to exit strategies.  As vaccines hold the promise of a return to some kind of new normal, the attention will shift from helping households and enterprises to survive through the pandemic to helping them to adjust to the new reality. There is clearly a need for reallocation at I outlined earlier.  I will come back to this in a later blog entry. It is also clear, however, that while this moment of normalisation might not be here yet, it is important to prepare for it – for widespread overindebtedness in the corporate sector as for banking sector fragility. It is also clear that this does not only require careful coordination and cooperation between governments, central banks and bank regulators, but that many of these steps and possible interventions have to be coordinated if not undertaken on the European level (or at a minimum at the euro area level).

 

Never let a crisis go to waste. There is a lot of talk that the economic recovery should be a green one. There are also opportunities from crisis and recovery in the banking sector. One, the crisis has been a test of the post-GFC regulatory framework and will certainly lead to a debate on lessons learned and possible future reforms. Two, even more after than before the pandemic, the European banking system needs restructuring and consolidation; the crisis can give an impetus for that. Three, the banking union needs completion, this crisis can provide the necessary impetus.

 

Today, my worst-case scenario for the next five years is still the Great Lockdown recession being followed by a financial (and possibly sovereign debt) crisis if the economic exit from the pandemic is mis-handled. But there are lots of positive scenarios – yes, there will be losses, there will be a need for restructuring, but ultimately, the European banking sector (and broader financial system) might emerge stronger. May the experience of the last decade allow policymakers to make the right choices!

We are now over a month into the UK being outside the EU, Single Market and Customs Union and project fear has turned into project reality. While some of this might be transitional teething problems, others are not and will certainly lead to sectoral shifts in the UK. There is the fishery industry, which discovered that being able to fish more does not imply selling more. There are many smaller export-oriented businesses in the UK, focused on the EU market so far, finding out that the costs on either side (UK exporter and EU importer) are simply too large for business being profitable.  Social media are full now of former Brexit-fans that feel conned. One of the main frictions on the retail level has been the exit of the UK from the EU VAT system – it is important to note that this was one of the earliest decisions of the UK Parliament to force Theresa May towards as hard a Brexit as possible.  While annoying for individuals (like my family and me), it has turned into a major headache for small businesses.  And this is just on the goods-side.  The service sector has been all but ignored; the performing arts profession has been outspoken about the failure of the UK government to agree to visa-free travel for performing artists. Similarly, the fashion industry has started to complain. It is important to note, however, that this does NOT imply that there will not be winners from Brexit – yes, there will be: most obviously, customs agent has become an attractive career perspective for young people. In the medium- to long-term, firms offering substitutes for imports from the EU will emerge.  On balance, however, it has become clear that Brexit will cost the UK economy and society dearly, something that even Michael Gove – though unintentionally – acknowledged when he – correctly – claimed that Scottish independence and a trade border between England and Scotland would be even more costly than Brexit.

 

Then there is the issue of the Northern Ireland protocol, which introduces border controls between Great Britain and Northern Ireland in order to prevent such controls to happen between Northern Ireland and the Republic of Ireland.  The European Commission committed a grave mistake a week ago invoking the emergency provisions in Article 16 of this protocol to prevent COVID vaccines from crossing the invisible border between Ireland (EU) and Northern Ireland (UK).  This decision was taken on a Friday late afternoon (someone in Brussels might have started with these weekend drinks just a bit too early), without any coordination with Ireland. The immediate outcry led to a quick turn-around.  This mistake was not only grave but surprising, given the critical role that solidarity with Ireland and the Irish peace process has played over the past four years of Brexit negotiations. But it was certainly interesting to see that DUP’s Arlene Foster suddenly discovered the benefits of Northern Ireland staying in the Single Market, something that she and her party had so much fought against.

 

The main problem is that this mistake gives the UK government yet another excuse in undermining the Northern Ireland protocol – to remind everyone, it was the UK government that first tried to undermine this protocol last year with the Internal Market Bill, which included powers for the UK government contrary to its obligations under the protocol. Back then, it declared that its intention was to put pressure on the EU to get a zero-tariff, zero-quota trade deal.  Well, they got this one, though a rather thin agreement. Ultimately the border controls in the Irish Sea are the result of the Brexit  Trilemma and the Brexit choices of the UK government – exit from Customs Union and Single Market and you have to put a border either on the Irish Island or in the Irish Sea.

 

It is interesting to see the reaction of Brexiters to the new reality, ranging from the ridiculous to the bizarre. On the one hand, there is the one academic economist speaking out in favour of Brexit who pronounced that the new trade frictions are illegal under WTO rules (well, they are not).  Then there is the call for Britons to go back and plant their own food. At the same time, the government has been busy handing out money to sectors that are most affected and scream loudest and keeps referring to transitional issues. And while the government refused for a long time to acknowledge that there are customs control between Great Britain and Northern Ireland, it has now changed course and is again threatening the EU with defaulting on the Northern Ireland protocol.  One minor point that they have been ignoring, however, is that the current trade deal is being applied provisionally as it still has to be approved by the European Parliament (EP), which – unlike the very sovereign mother of all parliaments – has been studying the deal for more than the 24 hours that has been given to the British parliament. A final vote won’t happen until the end of this month.  And I am not convinced that the EP will look kindly at the constant threats by the UK to walk away from its obligations under the Northern Ireland protocol.

 

As I wrote before, the Brexit soap opera is far from over, we are simply in a new season! Old themes are brought up again and again; expect this to continue for many years to come!

 

The FDIC, which institutionally combines deposit insurance, supervision and resolution in the US, was established in 1933, but has undergone multiple reforms and changes over the past 88 years.  So, it is not surprising that the EU reforms in bank resolution over the past decade, including BRRD and SRM are not the final word.  On Friday, I participated in an important and timely workshop, organised by the Banca d’Italia, focusing specifically on how to deal with failing small and medium-sized banks. I was asked to discuss three papers focusing on the gaps in the current framework and possible solutions (two of them are here and here). 

 

One major gap is that currently resolution options are only available for banks where such resolution is in the public interest (focusing mostly on financial stability concerns). All other banks have to be sent into national insolvency proceedings, which vary quite a lot across member countries, some of them court-based and others of administrative nature. This, however, is not only inefficient but also leaves gaps, such as when the regulator declares a bank failing or likely to fail, but the court finds the bank still solvent and it can thus not enter insolvency proceedings (one example was the Latvian ABLV bank where the ECB’s declaration that it was failing was followed by the assessment of the Single Resolution Board that a resolution procedure was not in the public interest. While the Latvian parent shareholders decided to liquidate the bank voluntarily, the Luxembourg subsidiary was initially not declared insolvent). Further, such loopholes give space for political inference into the process, pressure for taxpayer support on the national level, thus leading us back to the bank-sovereign linkage that the banking union was supposed to eliminate.  

 

Second, and as Andrea Enria also pointed out in his keynote speech, “significant differences in national legal regimes for the liquidation of banks imply divergences from the European supervisory framework; they generate level playing field concerns that might impair banking market integration and they may stand in the way of a smooth exit from the market for the weakest players.”

 

A third issue is that there are restrictions on the extent to which deposit insurance schemes can contribute to such a liquidation. Experiences in Germany and Italy have shown that a strong involvement of deposit insurance schemes in resolution frameworks (either formally or informally) can be helpful for quick and efficient intervention and resolution of failing banks. On a broader level, Luc Laeven and I documented in a cross-country study, published in 2008, higher bank stability in countries where deposit insurers are in charge of bank resolution and lower bank stability in countries with court-led bank insolvency frameworks. A stronger role for deposit insurers in the resolution process can thus be useful.

 

Different solutions have been suggested. One, would be to get completely rid of the public interest assessment and allow resolution tools for any bank. While dropping the public interest assessment might be a step too far, it could be used for a different purpose, such as determining whether or not state aid is allowed. In any case, extending the possibility to use resolution tools such as purchase and assumption (P&A) to most if not all banks, is certainly an important proposal.  The experience of the US in the use of such tools has been promising, especially for smaller banks.

 

One controversial issue is whether the resolution framework should be further centralised to the Euro area level. On the one hand, this would allow reducing political interference in banking further and it would allow for more effective resolution as there are more good bank candidates for a P&A operation in the Euro area than in any given country. On the other hand, there are still significant cross-country differences in legal frameworks and market structure across countries that might make a completely supra-national approach inefficient and slow.  Industry-based deposit insurance schemes and institutional protection schemes (as, for example, in Germany) complicate things further in terms of funding and resolution. A SSM-like solution, where resolution (i.e., tools beyond insolvency) for most banks is on the national level, but under the umbrella of the SSM, and with the largest and cross-border banks directly subject to SRB resolution, might thus be preferable to a completely centralised solution, at least in the medium-term.  Further legal convergence on bank insolvency is needed, however, for such a step.

 

A final institutional question concerns the structure of a future European Deposit Insurance Scheme (EDIS), which by now almost all observers see as necessity for the completion of the banking union.  One idea would be to go all the way towards the US/Canadian model of a European Deposit Insurance Corporation (EDIC), which combines resolution and deposit insurance and maybe even a role in bank supervision. Such a centralised approach, however, might shock with the cross-country differences mentioned above. It might also require treaty changes (to my understanding and I am happy to be contradicted, the decision to house the SSM at the ECB was to avoid such treaty changes), which is politically always tricky. 

 

In summary, short-term reforms must focus on making the system, especially for mid-sized banks, more efficient. As laid out in one of the three papers, this involves further harmonisation of bank resolution/insolvency frameworks across the EU and facilitating  adequate liquidation funding, including through deposit insurance schemes  This is critically important on the background of Covid-related bank fragility, to be expected later this year and in 2022, but also on the background of the need for restructuring and consolidation of the European banking system. While industry observers and insiders often dismiss the calls by regulators and academics alike for more cross-border mergers, only these will ultimately result in a true European banking market. A truly European financial safety net is a necessary though not sufficient condition for this.

As already announced on Twitter, I will be leaving The Business School (formerly Cass) at the end of this academic year and join the Robert Schuman Centre for Advanced Studies at the EUI in Florence as Chair in Financial Stability. Even before that I will take on the role of director of the Florence School of Banking and Finance (FBF) on a part-time basis from 1 March. The FBF has been built up by an amazing team under the leadership of Elena Carletti over the past few years and I am absolutely thrilled to join this great team.  The FBF has been very active with training programmes and seminars and has smoothly transitioned to an on-line format for both in 2020.  For the second semester of 2021, we hope to return to a mix of on-line and residential courses, conferences and seminars. Having a European research and training centre on financial sector issues is more important than ever, as the challenges in this area have only increased over the past years – starting from the fall-out of COVID-19 (where we will see more this and in coming years) over challenges of green finance to digitalisation and the rise of fintech. And while it is still early days, I also hope to broaden the geographic focus beyond Europe to other regions of the world, including emerging and developing countries; as well as build up research capacity.  The interdisciplinary nature of the Robert Schuman Centre will support a similarly broad approach for the FBF. And obviously, this will also be reflected in my blog entries – less on Brexit, more on academic fields and disciplines beyond finance. Stay tuned!

Among the many details of the FTA between the EU and the UK that was supposed to smooth the exit of the UK from Single Market and Customs Union was that the UK declined to continue participating in the student exchange programme Erasmus (there are other components to Erasmus that I will not focus on).  Rather, in the spirit of sovereignty and independence, the UK will set up its own programme that will support UK students who want to study abroad for a term or two, though with very limited resources per student. While this might save indeed money (especially, as the UK is more attractive as destination than as sending country of students), there are clear negative repercussions for Higher Education in the UK. Exchange students who spend part of their undergraduate students in the UK might return as post-graduate (highly paying) students; while I did not participate myself in the Erasmus programme, I spent a seminar in the US during my undergraduate studies, which ultimately informed my decision to apply for PhD programmes in the US. Penny-wise, but pound-fool!  Of course, there are other, non-monetary benefits – a more international student body makes UK universities more attractive for domestic students and for international academics; it fuels the intellectual environment and debate etc., as eloquently discussed in this article.

 

The replacement scheme (Turing) has little to speak for it – it is one-sided, i.e., focused on outbound UK students only rather than on two-way partnerships with non-UK universities; even so, building up new partnership is costly and takes time (as mentioned in the above article, but also squaring with my own experience of three years working in the international study office in Tübingen).  And with cooperation shifting from department/school to university level, there will be less ownership in UK universities for such a scheme.

 

All in all, I see this decision as another negative shock for the UK Higher Education sector, which has been under pressure in recent years and even more so during the COVID-19 crisis, as it depends to a large extent on (international and post-graduate) student fees. Brexit has made UK universities less attractive for both European students who have to pay more and non-European students who might see fewer job perspectives in the UK after their study.  Brexit makes UK universities less attractive for academics who face more red tape than before (if they come from the EU), a less international student body, and cost pressures due to COVID-19 (and lower student fee revenues).   While I have no doubt that the UK university sector will recover in the long-run (let’s say 20 to 30 years), the short- to medium-term perspectives are not positive.  One important challenge will be the funding model with its extensive reliance on student fees, even though I do not see any political appetite to address this, given other more urgent political priorities. But I would expect more turmoil and decline before things will turn eventually to the better.