Finance: Research, Policy and Anecdotes

We seem only a few days away from Boris Johnson becoming Prime Minister, with the firm pledge to take the UK out of the EU by 31 October, “do or die”.  Not that anything has changed in the situation or will change before the end of October. Though the tone of the debate has fallen back into war talk – references to a war cabinet, appeals to the Dunkirk spirit, and one of the Brexit MEPs wanting to use the navy to chase out non-British fishing boats from British waters, appealing to the Falklands War spirit. At the same time, the revolution keeps eating its children with Liam Fox, one of the original Brexiteers shedding doubt on a “WTO-Gatt 24” strategy and promptly being disowned by the “true Brexiteers”.


As it currently stands, there seem to be only three options left: try to pass Theresa May’s deal with a few twists and tweaks in the Political Declaration on the future relationship; revoke Article 50 and remain; or crash out. The first option would require quite some political manoeuvring by Boris Johnson; the second seems quite impossible, which leaves the last option. However, there is an increasing opposition to this option even among Conservative MPs and it might come to a constitutional stand-off between a Prime Minister who insists on the default option in the absence of other legislative action and a Parliament insisting that a no-deal Brexit cannot take place. Something that future constitutional scholars will have a field day in discussing and interpreting; in the current time, however, something that will take the British economy and people as hostage. But then again, we seem to be a stage where large part of the Conservative party and a certain part of the country are so obsessed with Brexit that nothing but nothing can stop them, not even the break-up of the United Kingdom, another economic crisis or even the destruction of the Conservative party.


What is the likelihood of each of these options? I get asked repeatedly but will not participate in the betting game.  Many far more qualified people come to different conclusions.  One thing we can do is to outline the different scenarios that might play out in the different cases.  If – against all odds – a slightly revised withdrawal agreement makes it through Parliament, a very long transition period would follow until the relationship between the UK and EU is sorted out; we can expect quite some more political upheaval in the UK during this time. A no-deal or Crash-Brexit would not be that much different but come with significantly higher economic costs. We can expect lots of recriminations against the EU and within the UK, possibly a general election with a very uncertain outcome and a very long period, during which the UK has to sort out its position vis-à-vis the EU and the rest of the world (but from a significantly weakened position).  We might also see Irish unification and Scottish independence (ok, that is very speculative, I admit). Common denominator to both options: there is no such thing as a clean Brexit; it is rather the starting point for a decade-long self-finding-cum-difficult-international-negotiations process for the UK.


But what about the UK-US trade agreement and Donald Trump riding in with the cavalry to save the British economy? Right, I will not even consider these ridiculous ideas, as they are so far out there in dream land, that it is not worth wasting anyone’s time. Suffice to say that Donald Trump does NOT care about the UK, but just about weakening the EU; that Congress (where the house is under Democratic control) has to approve such a deal; and that by the time such a trade deal could be ready (think 2024) the whole political landscape might look very different on both sides of the Atlantic.


So, as we are getting ready for the next season of the Brexit soap opera: there will be lots of common themes from previous seasons (as in most soap operas), but with different actors. The autumn promises to be quite action- and emotion-filled; now if only this were a TV show only and not politicians playing with people’s lives.

The Financial Stability Report has just published a draft report for public consultation on the effects of Basel III on SME Finance. My former colleague and co-author Hans Degryse and I have served as academic advisors on this project. This report is part of a larger evaluation programme that also include an evaluation of the effect of Basel III on infrastructure finance (already published) and an evaluation on Too-Big-To-Fail (just starting).


Here is the summary of the findings of the consultative report: “…the analysis thus far does not identify material and persistent negative effects on SME financing in general, although there is some differentiation across jurisdictions. There is some evidence that the more stringent risk-based capital (RBC) requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at the most ‘affected’ banks (i.e. those least capitalised ex ante) relative to other banks. These effects are not homogeneous across jurisdictions and they are generally found to be temporary.” These results are not that surprising for many observers. They come on the background that regulatory subsidies such as the SME supporting factor in the EU have not really helped SME lending as well as previous findings that higher capital requirements negatively affect private second lending at most in the transition period if at all.  One important caveat to keep in mind is the heterogeneity across the different FSB jurisdictions, some of which recovered relatively quickly from the Global Financial Crisis, while others took much longer or went back into recession, while introducing regulatory reforms.  There are also significant differences in banking sector structures across banks, in terms of ownership and market structures.


While the main text might not give it away, an enormous amount of data and estimation work went into this exercise, undertaken by different teams across jurisdictions and setting an important precedent for future evaluations of regulatory reforms. Different exercises using cross-country data on the bank- or firm-level were accompanied by country-specific exercises using regulatory data for banks and credit registry data.  The latter allows for the most rigorous disentanglement of supply and demand-side effects by linking banks to firms and assess changes in lending (conditionality) over time.  While this evaluation might not satisfy the much higher causality standards adopted in the development field, it clearly shows the way forward in terms of evaluations of regulatory reforms. And important next step would be to extend the assessment of such reforms to non-FSB member jurisdiction, especially emerging markets and developing economies, as we call for in this recent task force report on Making Basel III work for the EMDEs.

The decade since the Global Financial Crisis has seen changes in the architecture of supervision across Europe.  On the one hand, the tendency to separate the responsibility for monetary and financial stability into two different authorities has been reversed in many countries.  One prominent example is the UK where the Financial Supervisory Authority was dissolved and responsibility for bank supervision returned to the Bank of England.  On the other hand, there has been a move towards more cross-border cooperation between supervisors, which in the case of the Eurozone culminated in the creation of a Single Supervisory Mechanism and the ECB and a Single Resolution Mechanism.


I have co-authored a discussion paper with several academic and ECB colleagues on an early evaluation of these trends, just published.  Unlike a regular paper, this discussion paper takes a broader look at the literature,  complemented with some new theoretical and empirical analysis. Herewith a quick summary:


There are theoretical and empirical arguments for combining or separating the responsibility for monetary and financial stability. The recent crises and past decade, however, have shown that monetary and financial stability cannot be separated and that possible tensions between these objectives do not get more easily resolved if assigned to two different authorities.   Assessing different hypotheses on supervisory architecture is difficult in a cross-country settings, given endogeneity concerns.  However,  we offer some tentative evidence that having an integrated supervisory architecture is not associated with higher inflation or lower growth and there is some tentative evidence that it might help reduce the probability of a credit boom turning nasty.


A lot has been written on the advantages of centralised supervision in the Eurozone, including avoiding supervisory arbitrage, economies of scale in supervision and matching the geographic footprint of banks with the supervisory perimeter.  There are also shortcomings, however, including an increase in distance between supervisors and supervised institutions.  It is certainly too early to come to a clear conclusion on these trade-offs, though it is important to stress that the SSM model is not one of complete but rather partial centralisation, focusing centralised supervision on systemically important institutions and even here combining national and supranational expertise. The next years will certainly see more research in terms of banks’ reaction to these changes in supervisory architecture and its implications for stability.

As Theresa May announced her resignation, the airwaves and Twitter were full of praise for her sense of duty!  As German very conscient of Germany’s dark chapter in the 20th century I am always sceptical of people claiming to do their duty! Though her duty she did – bully and harass legal residents (remember Windrush generation) and foreign university students as Home Secretary – all to draw attention away from the social consequences of Tory austerity. It is telling and noteworthy that before her resignation, newspaper headlines in the UK were dominated by the disenfranchisement of EU citizen in the European Parliamentary Elections.  She claimed to have done her duty by trying to implement Brexit – maybe so, but was it her duty to go into the negotiations without any plan and without properly understanding how the EU works and what the constraints of Brexit are?  Was it her duty to draw red lines that cannot be respected at the same time (also known as Brexit trilemma)? Was it her duty to pander to the wet dreams of Brexiteers rather than searching for a national consensus? I will spare the reader an answer to these questions! Most telling in recent political obituaries is the statement that she did not realise the consequences of agreeing to the Northern Irish backstop in December 2017!  Really?!?!


Exit the Dancing Queen – enter the clown?  As Tories (and in a rare political consensus) most of UK’s and Europe’s political class breathe a sigh of relief that she will be gone soon, it is important to stress that nothing but nothing has changed in the Brexit constellation! Will 27 elected heads of EU governments and a recently democratically elected European Parliament get rid of the Northern Ireland backstop and endanger peace in Ireland just because another unelected British prime minister asks them to do so?  No need for an answer here!  Risk a “clean Brexit” and negotiate from outside with the EU?  Sure, the EU will negotiate, with a few preconditions, though, one of which starts with “back” and ends with “stop”. Will it be easier to negotiate for the UK government under the pressure of economic chaos after a Crash-Brexit?  I guess some hard questions that the next unelected Prime Minister of the UK should ask him/herself before taking decisions. 


In her resignation speech she cited Nicholas Winton who had saved the lives of hundreds of children from Hitler’s death camps.    Less than three years after she paraphrased Adolf Hitler in her Citizen of Nowhere speech, this is not just cynical, it is simply disgraceful!  In short: Good Riddance.

I am just coming back from the 2nd young writers workshop in Bonn; an intensive and interactive meeting of junior researchers (post-doc and assistant professor level) and more senior researchers (always relative, obviously!), where the latter shared with the former their experience with the publication process.  

I have discussed some issues in a blog entry two years ago, but have some additional points, partly coming out of discussions with other participants at the workshop.  Over the past six years, I have been editor at three different journals, each one with their different approaches and procedures. In the following, I will discuss some important points on the procedures (mainly referring to the JBF) but also more generally on the editorial process.  


First, where and when should you submit? Perfect is the enemy of the good; so, there is a point in not waiting too long for submission. Also, some topics are rather hot and there might be other people working on it (as happened to me in my job market paper, though I was lucky and published first). On the other hand, do not submit a paper before you have presented it at conferences, seminars etc. Get as much feedback as possible, before submitting.  As pointed out ad nauseam by editors across the profession – editors and referees are not here to help you improve and polish your paper, there are here to judge it and possibly push you the extra step needed. Choosing a journal is always tricky – one school of thought is to always start at the top, as lower-ranked journals are not worth your time (especially with a tenure clock ticking); my approach has been that sometimes I have very interesting projects and papers that might still be worthwhile publishing even if not in a top journal.


Second, what is the process?  For the following, I speak mainly for myself, though I assume that my co-editors at the JBF follow similar approaches.  There are three options for papers that come into my editorial inbox at the JBF: first, desk rejects (mainly because of limited contribution or being too specialised for the JBF; in some cases where the paper is in my own area and there are clear methodological deficiencies, I also desk-reject); second, papers I handle myself and send out to reviewers; third, papers I assign to an associate editor.  Associate editors again have two options; recommend desk-reject or send out to reviewers.  Even though managing editors have the final word, it would be rare for me not to follow the advice of the associate editor. In cases of split reviewer decisions, however, I take another close look at the paper and the reports.


Third, when reading for the first time as editor at a paper, what am I looking for?  As for most people in our profession, my time is scarce and I expect to get an overview of the paper after having read the introduction, with a first impression at the end of the first page. As I wrote in my earlier blog entry, the four most important messages (motivation, research question, methodology and contribution) have to be clearly presented in the introduction, (ideally) mentioned on the first page, and summarised in the abstract. How important are title and letter to the editor – the former can whet the appetite (but do not ask a question in the title that you then do not answer), the latter is rather unimportant, unless you have something important to tell the editor (conflict with other papers/authors/possible reviewers).


Fourth, how important is a proper identification and has our profession gone too far in focusing on identification rather than stressing research questions and policy implications? It is a question we often discuss also among the managing editors at Economic Policy (who come from different fields of economics). Proper policy advice should be based on proper identification, but there is also the issue of internal vs. external validity (best example is experimental field evidence vs. broad cross-country evidence). One important aspect in this debate is the novelty of the question (where even documenting correlation might be interesting); in more established if not saturated literature it is much less attractive to have yet another paper with half-baked identification.  However, confirming a well-established result by a just slightly refined identification strategy might not be as exciting either.  But as always, the devil is in the details, so there is no clear answer here.


Fifth, appeals! The first reaction after any rejection is “how stupid are these referees and how could the editor have followed their advice.” Take a deep breath! If you feel like writing a nasty email, write it, save it, read it the next morning, and delete it!  Is it worth appealing a decision?  I have appealed myself four times over the past 10 years or so, and was successful twice. Do not argue with an editor or referee over lack of contribution or (even worse) poor writing. There are very limited circumstances where such an appeal makes sense, including obvious and critical mistakes of the referees – but these have to be critical for the decision of the editor to reject the paper. Finance journals have tightened the process for appeals quite a lot recently, including that the paper will go to a different editor and a new reviewer, so the hurdle is quite high.  In almost all cases, it is best to move on; after carefully considering the comments of the reviewers, as they might be very valid and they might also be your reviewer at the next journal.


Finally, a word of encouragement.  There are many reasons why our profession has trended towards co-authored papers, one might be that it is easier to share the frustration of rejections.