Finance: Research, Policy and Anecdotes

I cannot help but comment on the latest episode of “Brexit – The Never-ending Soap Opera”.  It is true, ratings of the series might have come down (Brexit is boring), as people cannot really follow the plot anymore (neither in the UK nor in Brussels nor anywhere in the world, it seems). The British government, however, is trying its best to bring back up its rating by choosing an ever shriller tone. The Prime Minister has now decided that it is really the EU’s fault that she has not been able to solve the Brexit Trilemma. In the meantime, ministers of her government are competing on who can make the most stupid comment.   And the clock is ticking….


Next week will (supposedly) see votes in the House of Commons on (i) Theresa May’s deal, (ii) a no-deal and (iii) and the request for a possible extension of the Article 50 process. I will not join in any predictions, except that next week’s episode of the soap opera might actually be quite interesting.  And we might actually find out whether and for how many more seasons it will be extended (rumours have it that the name will change to: “Brexeternity – The Sequel”).  In the meantime, I will get myself some popcorn and a nice drink and relax for the weekend.  Cheers!

I just returned from Stockholm where I participated in a workshop on the Banking Union from a Nordic-Baltic Perspective.  The banking union was established as reaction to the Eurozone crisis and so far only Euro countries have been participating in the SSM and SRM. However, non-Euro EU member countries also have the option to join (once the ECB has vetted the regulatory and supervisory quality of the applicant).  Sweden is currently undertaking a public inquiry into whether or not it should join the banking union and in this context I was asked to prepare a report that I now presented, followed by discussions from Professor Lars Calmfors and Steen Lohmann Poulsen from the Danish government (who is also considering joining the banking union).  This was followed by a fascinating discussion among Nordic-Baltic supervisors on the banking union, the special situation of Nordea and – not surprisingly – money laundering problems and how to address them.


The establishment of SSM and SRM has had an important impact not only in the participating countries but also repercussions for non-Euro EU member countries. Rather than dealing with national supervisors they deal with the SSM in the case of significant institutions (118 banks in the Eurozone). Their rights as host country supervisors, however, have been strengthened, especially in the cases of significant branches and with the European Banking Authority taking an important mediation role between supervisors (binding as long as it does not infringe on fiscal policy).  This is especially important since Nordea decided to move its headquarters from Stockholm to Helsinki last October and thus from Swedish supervision into the SSM perimeter, leaving its operations in Sweden in the form of a branch (and not a self-standing subsidiary)


Sweden’s banking system is closely interconnected with the rest of the Nordic-Baltic region. Four (since October three) of the six largest Nordic banks are headquartered in Sweden. Most of the cross-border banking activity in the Nordic region is done by Nordic banks and banks from outside the region generally have low market shares.   The four largest Swedish banks have presence – in the form of either branches or subsidiaries – in most neighbouring countries.  In line with my work with Wolf Wagner it is thus not surprising that the Nordic-Baltic countries have taken the lead in developing more intense forms of cross-border supervisory cooperation, starting with the establishment of a supervisory college for Nordea, which emerged from a cross-border merger in 2001.  This was followed by Memorandum of Understanding (MoU) on the "Management of a financial crisis with cross-border establishments" in 2003, thus well before the Global Financial Crisis that saw the failure of several large cross-border banks in Europe. A Crisis Management Group for Nordea was established in 2012 after its designation as G-SIB (which also effectively replaces the resolution college, mandated under the BRRD). Finally, in 2011, the Nordic-Baltic countries established the Nordic-Baltic Macroprudential Forum (NBMF) to complement bank-level supervisory cooperation with systemic stability cooperation, an informal forum with no formal decision powers.  Finally, there are arrangements between the central banks of Denmark, Norway and Sweden on utilisation of central bank deposits at one of the central banks as collateral for intraday liquidity lending in another of the three central banks (Scandinavian Cash Pool).


Given this rather close cooperation within the region, would it make sense for Sweden to join the banking union? Four of the other countries are already in it – Finland and the Baltics – and Denmark is considering it, too (as non-EU country, Norway will not be able to join). There are some arguments in favour. Sweden would gain a seat at the table and would benefit from scale and scope economies of the SSM and its enormous expertise. Joining the banking union would also help avoid supervisory divergence from the Eurozone and would allow Sweden to more easily participate in the Single Market in banking, benefitting from its efficiency and competition.


However, there are also arguments against it. There will certainly be a loss of independence, as rather than being part of the supervisory and resolution colleges for its main banks, Swedish supervisors would supervise these banks together with SSM staff in Joint Supervisory Teams. The major banks would also become part of a Single Point of Entry resolution procedure in the case of failure, another bite into independent regulation.  A second major argument is that while Sweden might have a seat at the table, its influence might not be as large as that of larger and more important banking systems. Finally, it would never be a full-fledged member of the banking union: it would not have a vote in the Governing Council of the ECB that – in case of disagreement – can overrule decisions of the Supervisory Board where Sweden would be a member. Sweden would also not be part of the lender of last resort component of the Eurozone financial safety net and it is not clear to which extent it would benefit from a backstop for the Single Resolution Fund from the ESM.


Most important for my final conclusion, however, is the fact that the banking union is still under construction. The insurance component, which might make the banking union attractive for smaller non-Euro countries has not been fully developed yet, in the absence of deposit insurance.  There is also the issue of legacy losses in Southern Europe still haunting the banking union and ultimately limiting a push towards full mutualisation of risks. Overall, there are lots of questions to be answered that I assume would be part of a negotiation process if Sweden (perhaps together with Denmark) decides to explore more formally entering the banking union.  Ultimately, my conclusion is that having the option to join the banking union is valuable; it is less clear whether now is the optimal time to exercise this option, especially given the incomplete structure of the banking union. A wait-and-see approach might be preferable at this stage. Interestingly, this conclusion was support by Lars Calmfors (who in the 1990s led a task force on the possible participation of Sweden in the Eurozone).


There was an interesting additional perspective from Denmark – on the one hand, the Danish financial system shows quite some particularities that the Danish authorities fear might not be completely compatible with current banking union rules; on the other hand, there is an important political economy argument that – after Brexit – the club of non-Euro countries will lose influence and it might be more helpful to be part of the club, even if only as a part-time member.  A final complication is that possibly a Danish banking union participation might have to be approved in a referendum (which brings rather unpleasant memories to this resident of the UK).  Which brings me to the final point – one cannot ignore the political economy dimensions. Delegating the financial safety net to a supranational authority is an important step that requires proper democratic vetting and backing.

I just came back from Abidjan where I gave a keynote at an event co-organised by the Alliance for Financial Inclusion, BCEAO and the Ivorian Ministry of Economy and Finance on “Reshaping the Future for Financial Inclusion”.


It is quite interesting to note how the discussion on access to financial services has changed over the past 15 years. In the early to mid-2000s, the focus was on microcredit, branch expansion and NGOs offering financial services to the bottom of the pyramid.  Now the discussion is on digital finance, the role of telcos and a broad suite of financial services for previously unbanked population segments.  Most importantly, while we had few if any data in the early 2000s, we have an abundance of data now, with the main important sources being the Financial Access Survey and the Global Findex.  The Alliance for Financial Inclusion has also been collecting data from its member countries on different policy actions in the area of financial inclusion. In on-going work, we are trying to explore correlations between these policy actions and changes in financial inclusion, to be published later this year.  


As always at these conferences with lots of practitioners I learned a lot and gained new insights. With all the (justified) excitement about digital finance overcoming geographic barriers to access to financial services, the access to mobile technology in rural areas still depends on physical infrastructure, a challenge we might easily forget.  One important topic that came up again and again is the persistent gender gap.  As I wrote in an earlier blog entry, this might be partly driven by persistent gender norms across the globe. But do we have to take these norms for given or can specific financial products actually influence such gender norms? There is evidence that access to financial services can result in female empowerment, but can this in turn help reducing societal gender biases? Or is it rather part of a broader educational and cultural agenda? More questions for research!


One (still) important barrier is the lack of identification.  Large population shares in many developing countries do not have the necessary documentation (passports, driver licence etc.) to allow them to easily access formal financial services but also build up a financial history that can be used across financial institutions. Technology has helped in the identification challenge and – partly through social media, mobile phone use etc. – has allowed to compile lots of information on (potential) clients. Countries as diverse as India and Uganda have taken on this challenge successfully, with positive repercussions for financial inclusion.  But where it is easy to collect and use data, Big Brother is not far.   So it is not just about portability of data, but also sovereignty – it is the individual who owns his/her data and should have corresponding rights on their use by third parties.  A clear tension and challenges for market participants and regulators.


A relatively new topic is that of green financial inclusion - how can financial services contribute to climate change mitigation and adaptation at the bottom of the pyramid?  As often with new topics there is quite some definitional confusion on products and services, different players and their roles and the extent to which regulators and central banks should get involved.  More concerning for me is the idea that prudential regulatory tools are being used for non-prudential purposes. Freely based on the Tinbergen principle (“achieving the desired values of a certain number of targets requires the policy maker to control an equal number of instruments”), non-prudential policy tools might be better positioned to target more directly green objectives without compromising financial stability! Further, while it is impossible to understate the importance of addressing the environmental externalities and the public good character of fighting climate change, we should not forget the lessons from decades of failed financial repression in the form of directed and subsidised credit, tools that might look attractive in the area of green finance. However, there are also positive lessons from development banks acting as second-tier institutions to help expand financial inclusion – maybe a similar role can be envisioned in the area of green financial inclusion. I have not formulated my thoughts completely in this area, but this seems one of the big challenges going forward- how to address an important market friction and challenge for humanity, while taking into account lessons learned.

Let me first say that I have enormous respect for Paul Romer’s contribution to modern growth theory. I first encountered his work as undergraduate student in Germany when I had to write a term paper about one of his papers. Many theoretical models that underpin the empirical finance-growth literature build on endogenous growth theory, so his contribution cannot be underestimated and he is well deserving of the Nobel Prize in Economics.  I have somewhat less respect for him when it comes to his excursion into the policy world, most recently as Chief Economist of the World Bank, a position which he had to leave early due to his rigidity and due to wrong claims he publicly made about the Doing Business methodology and which did cause a minor diplomatic incident between Chile and the World Bank.


In a recent op-ed for the Financial Times, Paul Romer gives the still-to-be-elected new president of the World Bank two recommendations, one of which drew my attention. “First, outsource the bank’s research upon which it depends for identifying problems and proposing solutions.”  His main argument: “When complex political sensitivities are allowed to influence research by stifling open disagreement, it ceases to be scientific.” He is certainly not the first to make such a case; others have argued for leaving academic research to universities rather than international financial institutions (IFIs) such as the World Bank or the IMF. I think such a recommendation is wrong, for several reasons (this might be a good point to mention that I am still working as consultant for both World Bank and IMF, so, yes, my views are biased by personal experience and – possibly – personal interest).


First, combining policy work with research can be fruitful, both in terms of policy questions/challenges giving rise to research questions and in terms of research feeding back into policy debates. A lot of my early work on financial inclusion (together with Asli Demirguc-Kunt and Sole Martinez) was motivated and informed by policy discussions in the developing world (I still remember the Kenyan Finance Minister asking us in 2003 why bank account fees were so high in his country, a question we somewhat answered in a subsequent paper).  Could such work been undertaken in academia?  Yes, but collecting information from banks and regulators is hard to undertake by academics without the backing of a large IFI such as the World Bank. Further, being challenged on an almost daily basis by operational colleagues can be very helpful in taking a sufficiently granular view in such research (e.g., when designing questionnaires, exploring alternative explanations or understanding the political economy of financial system structures).


Second, research done within multinational institutions can result in a dialogue within the institution, much more than research done outside.  Best example is the research undertaken by my former colleague and boss Asli Demirguc-Kunt on deposit insurance in developing countries. While the standard recommendation by IMF and World Bank previously had been to introduce deposit insurance wherever it had not existed before, Asli with several colleagues (some in academia) showed the moral hazard risk, with too generous a deposit insurance raising bail-out expectations and ultimately resulting in the systemic banking crisis it was designed to prevent in the first place.     Yes, such research can be undertaken and had been undertaken in academia before, but mostly if not exclusively focused on US and other advanced countries.  With a publication bias towards US data still very prominent, researchers in multinational institutions have a critical role to play in research on developing countries.


But why can such cross-country data not be collected by multinational institutions and then primarily used by academic researchers? Data to be used by researchers is best collected by researchers who can link specific research questions to data and information to be collected. One good example is the Banking Environment and Performance Survey undertaken by the EBRD across Central and Eastern Europe and Central Asia (with data collection facilitated by the relationship the EBRD has with many of these banks), a first round in the early 2000s but with the questionnaire primarily designed by operational staff, while a second round was undertaken in 2011, with the questionnaire designed jointly by EBRD research staff and academics (like yours truly) with very specific research questions in mind, subsequently resulting in several top publications.


But what about political sensitivities? Yes, they exist, though in both IFIs and academia. Several years ago I was involved in a research project sponsored by the European Fund for South Eastern Europe and while ultimately everything turned out just fine, there were quite some (sometimes tense) negotiations with the funder and with the banks providing us with data during the process. So, it is not only research undertaken in IFIs where political sensitivities can play a possible role. Where (empirical) research depends on micro-data provided by financial institutions or government agencies, one can never completely ignore political or institutional sensitivities.


Where does this leave us? I would argue it leaves us exactly where we are right now – close cooperation between researchers in IFIs and academia, where either side can take the initiative and where cooperation will ultimately result in policy-relevant research with important policy implications. So to come back to Paul’s recommendation: what we need is not outsourcing of research, but increased cooperation and strengthening the independence cum accountability of the research department within the World Bank.

The topic of bank resolution in the Eurozone is again in the headlines, with possible controversial actions in two countries that often find themselves at opposite sides of the argument – Italy and Germany. Both threaten to undermine the progress that the Eurozone has made over the past years to a Single Market in banking and thus a more sustainable currency union.


In Italy, there are – not surprisingly -  more bank failures. On January 2, the ECB appointed temporary administrators at Banca Carige, based in Genoa, after shareholders were unable to secure additional equity. The problems in Banca Carige are not new, but the can had been kicked down the road until late last year.  The Italian government seems to stand ready to pour money into Banca Carige via the instrument of  precautionary recapitalization (as also applied to Monte dei Paschi in Siena in 2017) even though this bank cannot really be considered a systemically important financial institution. Also, guarantees of Carige’s bondholders go through the Italian deposit insurance scheme, thus transferring contingent liabilities to the rest of the Italian banking system. However, the bail-out goes beyond this specific case. According to news reports, Italy’s government has set up a 1.6 billion euro fund to compensate investors who have lost their money in a string of recent bank liquidations. This will pay junior bondholders up to 95 percent of the original value of the investment and shareholders up to 30 percent. While this arrangement is almost exclusively for retail investors, it certainly extends the financial safety net far beyond what has been agreed under the new European bail-in rules. And even if one can make the case for compensation for retail investors that were mis-sold junior securities in banks, there is no case to be made to compensate equity holders!


Ultimately, the Italian-style bank resolution over the past two/three years is a big step backwards to the era of bail-outs. It is also a reflection of the failed politics of kicking the can down the road when it comes to bank resolution – the Italian government had ample opportunities to clean up its banking system before the BRRD came into force; however, it is also a failure on the European level that new rules come into place for a continuously weak banking system whose structural deficiencies have not been addressed yet.  


While Italy thus undermines the bail-in principle of the banking union, the German government is going even a step further, trying to “renationalise” banking sector policies, thus actively undermining the Single Market in Banking.  In the spirit of industrial policy and creating national champions, there seem to be government efforts under way to facilitate a possible merger of Deutsche Bank and Commerzbank, the two largest privately-owned banks in the fragmented German market. While the argument of consolidation and reducing overbanking might make sense, the creation of a national champion as explicitly aimed at by the Minister of Finance seems mistaken if not dangerous. Such a bank would be considered German and with active political involvement in its creation would immediately raise further bail-out expectations in case things do not work out as planned. It also undermines level playing field within the Eurozone - fiscally strong countries such as Germany can support their banking systems, while others cannot. This also shows the hypocrisy of German commentators when criticising bail-outs in Italy (as politely pointed out by Isabel Schnabel in this German commentary).


Both the Italian and the German actions counter the enormous progress made over the past years towards a single regulatory framework for the Eurozone. Let’s remind ourselves – the most immediate reason for the banking union was to cut the link between sovereign and bank fragility (a target which has not really been achieved, but this is for another day); however, the broader objective is that of creating a Single Market in Banking without which the Eurozone would not be a sustainable currency union. However, this implies a move away from national champions and purely national actions.


The Eurozone has made big strides towards a Single Market in Banking with the establishment of the Single Supervisory Mechanism and the Single Resolution Mechanism. Important elements (most notably a European Deposit Insurance Scheme) are still missing. However, a Single Market in Banking is not only about the legal framework but political actions. Both the Italian and the German governments have shown over the past weeks that they are not willing to “walk the talk”. Not only have the lessons of the Global Financial Crisis been forgotten, but also the lesson of the Eurozone crisis that national financial safety net and national banking sector policies undermine the Eurozone!