Finance: Research, Policy and Anecdotes

So here we are. More than 3.5 years after the referendum the UK finally leaves the EU. The cliff-edge of a no-deal Brexit has been avoided, to be replaced with the fear of a no-trade deal cliff-edge at the end of 2020 when the transition period ends.


Before leaving, the public was again exposed to the rather confused approach of the UK to the EU and Brexit.   A few days ago, even the Brexit MEPs noticed that Brexit implies loss of influence in Brussels.   And last weekend the FT exposed us to the confusion that many British intellectuals have about the EU and the role of the UK in Europe as well the Little England philosophy. And while the EU has clearly set out its negotiation strategy, the UK government keeps sending confusing signals (one day it is complete divergence in regulatory standards, the next day no divergence at any price).  If this looks like deja-vu from the withdrawal treaty negotiations, then yes, welcome to the next season of the Brexit soap opera.


As Tony Connelly pointed out, the negotiations will not result in a Canada plus/minus agreement, but rather in a Swiss-type approach, especially given the time pressure, a patchwork of different agreements, with permanent negotiations for the next decade.  So, the end of the transition period will be dominated by Swiss cheese – a new framework of EU-UK relationships with lots of holes. In addition to negotiations on the future relationship between the UK and the EU, the practical arrangements for the customs border between Great Britain and Northern Ireland will offer ample space for conflicts in the future. And the more the UK diverges from the EU, the harder the Irish Sea customs border turns.


Boris Johnson has declared that Brexit is done and that the word is not to be used after 11 pm tonight. Some observers predict that trade negotiations are technical so will not attract headlines. But how will he (and government, Tories, Brexit media etc.) refer to the negotiations with the EU, especially once they turn nasty and affect the future of manufacturing companies in the UK? What about the future of the fishery industry? Will they claim that the EU is taking revenge against the “independent UK” after Brexit by not allowing the UK to have its cake and eat it? Will they blame again the civil servants for caving in? And what if the dream of a US and an EU trade agreement before the end of the year is not achieved? It will be hard to disentangle the next phase from the previous one, even in the mind of the most-convinced Brexit voters.


There is more and more evidence on the high price that the UK has already paid for Brexit over the past year, with the weekly bill now even exceeding the fake 350 millions Brexiters claimed the UK pays to the EU every week. There are now clear indications that the manufacturing sector will decline if the Johnson government follows its approach of divergence from the EU (and even under a zero-tariffs, zero quota regime). But will Brexiters ever acknowledge that there were wrong in their predictions? Certainly not; it will always be someone else’s fault.  And assuming there will be no cliff-edge at the end of the transition period (either because it gets extended or there will be a bare-bone agreement in place with lots of additional temporary measures unilaterally introduced by the EU), the decline will be a slow one. In addition, the economic predictions of lower growth and GDP loss are under ceteris paribus assumptions (with lots of other things moving, e.g., increasing government deficits to cushion any economic hit), so simple comparisons undertaken in ten years might not give necessarily the same picture as a hypothetical counterfactual of the UK having stayed in the EU.


There are those who hope that the UK will rejoin the EU quickly.  I think this is a rather naïve hope. It would require a much broader political and societal consensus than 52-48 to do so and the UK is far away from that. And there is the “minor” issue that leavers and remainers keep forgetting – joining the EU is based on negotiations between the UK and the EU!  The best that remainers (after 11 pm aka rejoiners) can hope for and should work towards is a closer alignment of the UK with the EU in the future, the Norway model, which in turn might eventually lead to a rejoining in the second half of this century.  


Today is a sad day. Brexit makes the UK poorer and the EU smaller and possibly weaker. Unfortunately, it is not the end of a sad story, but just the beginning of what will be a fraught cross-channel relationship, with lots of potential for future conflicts.

My last conference of the year (and even decade) was on Funding Stability and Financial Regulation and organised by ACPR and ANR in Paris. Yet, another financial stability workshop, I thought, but it turned out to include a number of very interesting and policy-relevant papers, some of whom I will mention in the following. I will not discuss my own paper, as I will dedicate a separate blog entry to it next year, when a presentable working paper version will be finally ready.


Helene Rey presented work on Machine Learning and the Financial Crisis. Using a general framework that draws on different crisis prediction models in a type of meta-analysis, it improves on standard crisis prediction models (which typically have a relatively poor out-of-sample prediction power) and is able to predict systemic financial crises 12 quarters ahead in quasi-real time with very high signal to noise ratio.  Melina Papoutsi shows the importance of lending relationship for borrowers that fall in distress. Using data from Greece, she shows that firms that experience an exogenous interruption in their loan officer relationship are less likely to renegotiate their loans and, if they manage to renegotiate, they are given relatively tougher loan terms, compared to firms whose loan officer relationships were not interrupted. Relating this to my own work, yet again, more evidence that personal lending relationships are far from dead. My former colleague Max Bruche presented fascinating work on leveraged loan syndication (a better description would be: junk loan syndication), making a strong case that supervisors better pay more attention to retention risk in this market segment. Neeltje van Horen presented a paper that is effectively an impact evaluation of Basel III on the repo market. Specifically, she shows that the adoption of the leverage ratio (which should have a dampening effect on low-margin business such as repo transactions) had transitory effects on the access to the repo markets by smaller clients. Thibault Libert shows that large borrowers can have an impact on aggregate lending, in work that uses credit registry data from France and builds on an expanding literature that looks at the importance of firm-specific shocks for macro-aggregates. Laura Blattner uses Portuguese credit registry data to show that increased capital requirement can have perverse consequences as affected banks respond by not only cutting lending but also by reallocating credit to distressed firms with underreported loan losses. Finally, Eva Schliephake presented some very interesting theory work on how informed and uninformed depositors interact in bank runs, showing that more information can actually result in a higher likelihood of panic runs.

The voters have spoken and the uncertainty is over.  Unless something unexpected happens in the next few weeks, the UK will finally leave the EU on 31 January. There must be quite a feeling of relief in Brussels and across the EU that the naughty kid has finally decided to leave. But the show will go on – far from getting Brexit done, in February the new season of the Brexit show will start, this time negotiating the future relationship between the EU and UK. It will then become clear that Boris Johnson has fooled his voters yet again – after lies about 350m extra for the NHS and about no controls in the Irish Sea. There will be a rather long drawn-out negotiation with the EU on the future trade relationship. Of course, this can be done within three months, if the UK accepts everything (EVERYTHING) the EU proposes (including in such sensitive areas as fishing and the UK following EU rules). And even that would have to imply that there are no contrasting interests among the 27 member countries of the EU in these negotiations – unlike in the withdrawal negotiations, where little conflict could be expected among EU member states on money (more is better), EU citizen rights (as water tight guarantees as possible) and avoiding a border across Ireland.  All three objectives are achieved with the withdrawal treaty, but the interests among EU member states might very well diverge when it comes to the new relationship with the UK. And let’s not forget that unlike the withdrawal agreement, a comprehensive free trade agreement between the EU and the UK has to be approved by all national parliaments as well as some regional ones.


So, here is the new Brexit trilemma – there are three objectives for the Johnson government– (i) exit from transition phase by end-2020, (ii) get as good a deal as possible for the UK economy and the Conservative Party, and (iii) avoid another no-deal cliff edge at the end of the transition period -  and at most two can be achieved. To achieve (i) and (iii), (ii) has to give, i.e., the UK has to accept everything the EU proposes. To achieve (ii) and (iii), (i) has to give, i.e., at a minimum a two-year extension of the transition period has to be accepted by the UK government. Objectives (i) and (ii) are not compatible from the start.


What will happen? What will Boris Johnson do? He threw the DUP over board when it was convenient in order to get a deal with Brussels that ensures no border in Ireland but a border in the Irish Sea. Will the ultra-Brexiteers among the Tories also just roll over when he defaults on all his promises to them?  If he gets the big majority the exit polls predict, he might not care. He can then either agree to an extension of the transition period (more likely) or give in to all of the EU’s proposals (less likely). In any case, I would argue that the new deadline is now 2024, i.e., the Conservatives will aim to get all new relationship with EU defined before the next elevations.  It does promise many more seasons of the Brexit soap opera then.


These landslide results also indicate that the opposition has failed. It has failed to successfully make the case for a second referendum. It has failed to combine forces to translate a large voting share into actual seats at parliament. It has failed to stop the populist nationalist English wave. We will see a lot of infighting in the Labour Party over the next year or so and a lot of soul-searching among the Liberal Democrats.


My comments so far have been somewhat removed, without personal touch – it does help that I am in Sydney right now, far away from the Brexit mess.  But on a personal level, there is a degree of sadness, somewhat similar to the morning of 24 June 2016, a feeling of loss and finality.  It is sad to see a country close itself off the world and embark on a long path to long-term decline. It is scary to see its governing party appeal to people’s lowest instincts of xenophobia and attack the media at every feasible point.  If this sounds familiar – yes, there are clear parallels now between the transformation of the Republican party in the US and the Tories in the UK – though there is hope of a post-Trump era for the US and the Republican party, whereas it seems harder to revert the populist trends in the UK.  As an economist and observer, the next years promise to be as interesting as the last three, as UK resident, it is dispiriting and sad.

Yesterday, I participated in an exciting panel discussion on infrastructure finance at the IFABS conference in Medellin, together with Eduardo Cavallo (IDB) and Alejandro Sanchez (Corficolombiana), thus combining practitioner, policy and academic viewpoints.  There are lots of things to be noted on this topic, so here just some highlights – linking also to some projects I have done in this area over the past years. First, on a theoretical and practical level, infrastructure finance (or project finance more broadly) shows several characteristics that increase cost and risk profile – large size (requiring syndicates), long maturities, a lack of collateralizable assets in the early stages of funding and repayment flows only feasible after the construction phase. There are also higher skill and capacity requirements in infrastructure compared to other financing modes. These challenges have been around for many decades and it is an on-going area of learning, both for practitioners and policymakers. This also implies that one segment of the financial sector might not be positioned well to take on this challenge by itself, nor the private or public sector independently. It also implies that there are many policy and regulatory challenges in this space and a close connection with the larger challenge of financial sector development.


Second, as pointed out by Eduardo, most of infrastructure financing in Latin America is undertaken by banks, rather than non-bank financial institutions, which would be much better positioned to do so. Specifically, pension and mutual funds are in a better position (especially the former due to long-term liabilities and the latter due to risk profile) to invest in infrastructure. My own case study for Colombia (undertaken a few years ago for the IDB) shows that pension funds are relatively well developed in Colombia, though mutual funds focus mostly on low-risk, low-return securities (also referred to as “AAA-itis”). So, infrastructure is still supported mainly by banks rather than by non-banks. On the upside, the Financiera de Desarrollo Nacional,  set up in 2011 by the government, with support from IFC and CAF, as well as – at a later stage – by the IDB, has evolved into a best practice example of public-private partnership taking on a critical role in structuring financing arrangements using a mix of instruments. It has successfully provided not only direct finance, but also been a catalyst in bringing in domestic and foreign private funding for infrastructure. However, broader challenges in long-term finance continue: how to bring a larger share of the active population into the pension fund system – mainly a problem of informality -, how to address the high concentration in the pension fund industry  and how to lower entry barriers. The ultimate challenge, however, is: how to increase the risk appetite of non-bank financial institutions?


Third, has regulatory tightening under Basel III resulted in banks moving even further away from infrastructure financing, given the recent regulatory focus on reducing maturity mis-matches? This FSB evaluation suggests that no,  but some caveats are due with such an assessment, including that the impact on infrastructure finance is likely to be slower moving than that on other segments because infrastructure finance involves fewer larger transactions, typically with longer maturities. In this taskforce report with Liliana Rojas Suarez, we point to several potential adverse effects that Basel III can have on infrastructure finance (through liquidity requirements, output floor, exposure limits etc.). Most important, however, seems the lack of infrastructure as asset class. If projects can be developed in a more standardized fashion, and if there is agreement on the different dimensions of risk and how they should be quantified, it may become easier to issue securities backed by infrastructure projects, potentially also resulting in lower risk weights. This could allow banks to finance infrastructure projects in the early stage before selling them off. It also makes investment by non-bank financial institutions in such projects more likely!


Finally, infrastructure finance is part of the larger long-term finance landscape. While the focus of researchers and policymakers has been on financial inclusion over the past decade, it is important to focus again more prominently on the challenges of long-term finance. I have earlier written about an effort to get data on long-term finance for Africa. The strong needs in infrastructure funding as well as long-term funding needs by firms and households calls for a comprehensive approach to strengthen the intermediation and maturity transformation capacity of banks and non-banks alike, taking into account their critical linkages and synergy effects.


I had the pleasure of discussing two excellent papers at the 1st Finance and productivity conference at the EBRD this week, on the role of finance in fostering or impeding entrepreneurship. Christoph Albert and Andrea Caggese use survey data from the Global Entrepreneurship Monitor for 21 OECD countries over the period 2002 to 2013 and show that GDP and financial sector shocks hurt the establishment of new enterprises, especially of high-growth enterprises, providing convincing evidence that financing constraints are especially binding for transformational, potentially high-growth entrepreneurs.   Nandini Gupta and Isaac Hamaco, on the other hand, document a drain brain from manufacturing into the financial sector in the US. Specifically, engineering graduates between 1998 and 2006 are more likely to work in financial sector if they start out in an area with a higher share (and thus higher growth) of financial sector employment or study in a state that deregulates interstate banking. This, in turn, results in relatively fewer start-ups founded by engineering graduates that go into finance, as well as less innovation and less VC funding by such start-ups.


Together, these papers add evidence to two strands of the macro-finance literature that have developed somewhat parallel – on the one hand, the importance of alleviating financing constraints to foster entrepreneurship and thus ultimately improve resource allocation and increase productivity growth; on the other hand, the unhealthy growth of the financial sector, extracting rents from the real economy and drawing talent away from the manufacturing sector. Both papers thus relate to the decline in start-ups (as documented for the US in this Economic Policy paper, which also shows that it is not related to higher federal regulation) and the slow-down in productivity growth. But what to make of the seeming contradiction – financing constraints vs. brain drain?  Well, these findings are consistent with an important role of financial intermediation for economic growth (which works through productivity growth and thus entrepreneurship), but also with a growth-impeding effect of an oversized financial system that does not necessarily focus on intermediation anymore. It is thus consistent with tentative results that Hans Degryse, Christiane Kneer and I documented  - financial intermediation helps growth in the long-run, while an indicator gauging the size of the financial sector (e.g., employment share) results in higher short-term growth, but higher growth volatility in the long-term. These findings are also consistent with work by Christiane Kneer who documented a brain drain, looking specifically at the US – industries with higher financing needs benefit from a larger financial sector, while industries with a higher share of R&D and skilled workers actually loose. In summary, efficient financial services are important for the real sector, while an oversized financial system is not necessarily and might even be damaging for the real sector.