Finance: Research, Policy and Anecdotes

La Repubblica Firenze has an agreement with EUI to publish op-eds by academics and this week it was my turn – to make the direct link to my new host region, I chose the never-ending saga of Monte dei Paschi di Siena, which for me is a mirror of where Europe’s banks, regulators and politicians have gone wrong over the past 20 years: a rapid expansion before 2008, followed by mounting losses, hidden from auditors and regulators; a government bail-out in 2013, which did not help turn things around and nationalisation in 2017. At the core of this drawn-out failure of MPS has been too close a relationship between politicians and bankers, which has prevented early and effective intervention.


What I see as critical mistake and would call the original sin of the banking union was the decision in 2014 to apply the new regulatory framework to a banking system still working through the aftermath of the Global Financial and Eurodebt crises and – in the case of Italy – a triple-dip recession rather than to address legacy losses and force an effective restructuring of European banking.  Yes, supervision has been Europeanised, but banks’ connections with local and national politicians have kept the resolution effectively on the national level and bailouts are still the default solution. And while there is no immediate risk that the sovereign-bank deadly embrace will emerge again in the near future, the risk has not been eliminated because of these national and taxpayer supported resolutions.


To link back to MPS and my new host region – as there are concerns about the demise of MPS: Tuscany needs strong banks that serve the local economy and society. However, times have changed and the focus has to move from trying to conserve what is no longer sustainable to building effective and stable finance. Europe should not be seen as the enemy that robs Tuscany of its banks, but as an opportunity to create sustainable provision of financial services.

The World Bank’s decision to permanently suspend the Doing Business project is the sad end to an initially very good idea! My latest Vox column discusses how we got from a research-based data collection effort as an important impetus into policy debate to a ranking exercise that undermined the usefulness of these data. A short summary:


20 years ago, the Doing Business project filled an important gap by providing detailed indices on specific institutions (e.g. credit registries) or specific business cases (enforcement of bounced check, registering a property of specific value). Over time, Doing Business has become by far the most successful data collection exercise and report of the World Bank, but also, as former World Bank chief economist Kaushik Basu (2018) stated, the most contentious publication. Controversies over Doing Business resulted in the resignation of Kaushik’s successor Paul Romer and have resulted in numerous inquiries and reviews, ultimately resulting in the pausing of the report in August 2020 and its permanent suspension in September 2021.


In order to maximise the impact of the data collection, the Doing Business report included rankings of countries based on Doing Business data. The report and ranking became part of a broader effort of the World Bank and other donors to assess countries’ investment climate and foster private sector development and thus growth in developing countries.  Countries that moved up the most in the ranking were crowned reformer of the year, which in turn has been used by governments to attract foreign direct investment. However, governments that care about these rankings, might start gaming the system – rewriting laws with an eye on improvements in the Doing Business ranking rather than focusing on the most important constraints for private sector development.


Credit rating agencies face a conflict of interest if they rate securities while providing advisory services to the issuing companies. Similarly, the Doing Business team faces a conflict of interest if it collects data used for country ranking while at the same time offering advisory services to governments on how to improve their business environment and thus their Doing Business Ranking.  This conflict of interest is not theoretical, but has been clearly shown in the Wilmer Hale (2021) report .


However, the conflict of interest is even deeper and cannot necessarily be remedied by introducing a firewall between data collection efforts and advisory services. Ultimately, the World Bank is owned by its member countries who are represented on the Executive Board.  The (ultimately successful) attempt by certain governments to take influence on the ranking (and thus the underlying data) clearly speaks to this conflict of interest.


Beyond these conflicts of interest, there is a broader concern of whether the political targeting of the Doing Business ultimately undermines the usefulness of the index.  Charles Goodhart stated in 1975 that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”  Originally, this regularity (known nowadays as Goodhart’s Law) was used in monetary policy, but it can be applied in any economic policy area. Marilyn Strathern (1997) summaries Goodhart’s Law in a discussion on the UK evaluation framework for universities:  “When a measure becomes a target, it ceases to be a good measure”.


The events described in the World Bank report read like Goodhart’s Law in action.  As rankings were published on an annual basis and as improvements in the ranking became political targets, so did attempts at influencing ranking and thus data. The conflict of interests mentioned above facilitated such influence-taking; all that was needed were persons in place that would be open to such influences.  Beyond these conflicts of interests, however, it is hard to see how one can get around this more fundamental problem of declaring an index as policy target, without this index subsequently losing its usefulness. 


Where do we go from here?  The original idea of collecting data on the business environment in which companies across different countries (or even across different regions within countries) operate continues to be good and important – again for research purposes and to inform the policy dialogue (though not to pre-empt policy outcomes). In a previous VoxEU column in 2013, I called for moving away from rankings and to focus exclusively on data. Researchers do not need rankings, we need data.  Policy makers need data and comparisons, while questionable rankings do not only not help a constructive reform process, but narrows it down to what are not necessarily the best reforms. Finally, Doing Business data should be regarded as one of several gauges of the business environment firms face, forming part of a more broadly-based approach that draws on multiple data sources and analyses. Such an approach might not hit the headlines as often, but might be more effective in driving policy reforms.

Important disclaimer: I am a member of the Advisory Scientific Committee of the ESRB. However, the views expressed below are exclusively mine and do not necessarily reflect the official stance of the ESRB or its member institutions.


The General Board of the ESRB decided to allow the revised recommendation on payout restrictions lapse at the end of this month, maybe not a surprising decision given the earlier decision of the ECB Supervisory Board in July. This brings to an end over 16 months of such ‘restrictions’, given that these were recommendations, the restrictions were soft, though it seems that at least in the banking sector, the compliance was high.  Payout restrictions were controversial from the beginning; as discussed in this ESRB report (which was the basis for the first ESRB recommendation in June 2020) , there are good arguments on either side. Many felt that in spring 2020 the arguments in favour of such restrictions were stronger than the arguments against them: extremely high uncertainty (unknown unknowns) and an unprecedented degree of government support for the economy. The situation has certainly changed; there is a clear exit path from the pandemic; bank and corporate fragility concerns are lower than anticipated just a year ago and fiscal support is being phased out. On the other hand, the stress tests published in July have shown quite some variation across banks in terms of possible fragility and the fallout from the pandemic both in corporate and ultimately banking sector will not become clear until next year, the earliest. But importantly, profit distributions are an important part of the market process; a market-based process of bank restructuring and consolidation cannot take place, if equity holders are deprived of their property rights!


All of these arguments seem to speak clearly in favour of moving away from blanket (macroprudential) restrictions to more targeted (microprudential) approaches, in the context of the usual supervisory process. There will certainly (and hopefully) research being done in the coming years to assess the impact of these restrictions. The final word is certainly not spoken yet.


A related discussion is whether macroprudential authorities should get formal powers to impose such restrictions to distribute profits during crisis times. I am somewhat sceptical on this. Macroprudential tools are designed for the financial cycle; the situation in 2020 was certainly not a financial cycle situation. Prudential authorities have ample tools to intervene into failing banks (the fact that they are not always being used is a topic for a different conversation), formal powers to suspend property rights across the financial sector seems a rather extreme step. There is certainly an important discussion to be had on the use of such a tool outside all but the most extreme economic situations and certain safeguards for the use of such instrument might be needed.

The German elections this Sunday are a game changer, not only because they will mark the end point of the Merkel era. As pointed out by many observers, this is the first time in modern German history that there is no incumbent chancellor running for re-election (all previous seven chancellors either (were) stepped down in between elections or lost re-election. A second novel feature is that the campaign started out with three serious candidates for chancellors (before the Green candidate tumbled). Hand in hand with this, there has been a trend away from the two-camp structure that has dominated campaigns (though less so governments) since the early 1980s – SPD-Greens on the one hand and CDU/CSU-FDP on the other hand, with two ‘Volksparteien’ (big tent parties) as anchors on either side. There has been an increasing Dutchification of German party politics, with no party getting more than 30% of the votes, a number of mid-sized parties and a number of smaller parties.  This has resulted in more flexibility in government formation – so far only on the state-level, but now also at the federal level. There was already an attempt after the last election to form a government between CDU/CSU, FDP and Green party, which ultimately failed, but this time it is almost certain that there will be a coalition of three parties, with at least four different possible combinations.  However, this also means that government formation will take much longer (to retake the example of the Netherlands: elections took place in March and there is still no new government in place).


But what are the challenges that the new government will face?  Many of these coincide with challenges on the European level.  This brings me to a podcast conversation that I had with Thomas Losse-Mueller earlier this year (in German!).  This conversation was a broad tour d’horizon on topics I have thought and written about over the past decade, but several of these are directly relevant for the current political discussion in Germany and for the next German government:  First, there has been a rediscovery of the role of the government both in aggregate demand policies and as insurer of last resort, as we have clearly seen during the current pandemic. Second, this applies beyond the national level to the European level, especially the euro area level. The pandemic has opened the door towards a fiscal union, first on the expenditure side, but in future also on the revenue side. There has been also a change in the German position, both among politicians and economists, with the realisation that the privilege of Germany as anchor country of the euro area (thus reaping a euro dividend) also implies certain responsibilities. Ultimately, the European economy can only recover if all countries recover with a similar trajectory, given their close economic integration.  Third, it is critical that the heavy lifting is not left exclusively to the ECB as during the eurodebt crisis, where expansive monetary policy was offset by tightening fiscal policy in many core countries, including Germany.


One final comment on the hysterical inflation fears that are being raised during the current election campaign (minor ironic note: globally, hyperinflation is typically defined as inflation of more than 50% per month, in Germany apparently as above 2% per year). There is a narrative that Hitler’s rise to power in 1933 was driven by the hyperinflation in 1923 – you do not really have to be an economist or historian to see fallacy in this argument – Hitler’s electoral success started during the Great Depression and high unemployment it brought with it, while Germany suffered from deflation rather than inflation!


P.S.: there is one comment I made in this podcast where I certainly have changed my mind – vaccines: while the European “vaccine-union” might not have been successful initially and much slower than in the US and the UK, looking at the rollout from the current viewpoint, I think it has been a huge success, especially considering the counterfactual of purely national approaches.

Today, the CEPR and the Korea Institute for Finance published a book, which I co-edited with Prof. Yung Chul Park, with the title Fostering Fintech for Financial Transformation. The motivation behind this book was an initiative by the KIF to draw on international expertise for specific policy lessons for Korean regulators.


The first four chapters draw on international experience and comparison, discussing the impact of financial digitalisation on the future structure of the financial system, providing a literature survey on the impact of financial digitalisation on the efficiency and stability of the financial system, focusing on innovations in money and payments, specifically the combination of new forms of digital assets with new forms of payment technology, and describing the regulation of cryptocurrencies across different jurisdictions.


The final chapter (which I want to talk a bit more about) focuses on Korea, taking stock of the current situation and drawing on international expertise for specific policy recommendation for Korean regulators. Fintech services have been regulated in Korea under a specific framework established in 2006, which has turned out too narrow.  At the initial stage of fintech development, Korea's financial regulatory authorities chose to embrace a market-led approach to fostering the fintech industry in line with a general move towards financial liberalization. A decade later, however, a series of market failures and inefficiencies of the laissez-faire approach has begun to take its toll, with P2P lending platforms losing their credibility and reliability as they were shrouded in widespread fraud and deception of investors and borrowers, the number of fintech startups ballooning, but few of them being efficient, and the fintech industry developing into an oligopoly controlled mostly by financial subsidiaries of big techs.


The financial regulatory authorities have reacted to these problems with a law restricting entry and lending in the P2P sector, which has effectively driven all platform operators out of business. The FSC also plans to establish a "fintech assistance center" as part of the program arranging policy loans, business consulting, and startup support for small fintech firms. In addition, there are current discussions underway to reform the broader legislative and regulatory framework for fintech.


How can the regulatory framework support financial innovation without undermining financial stability? Based on international experience, there are no easy answers, though some general principles. One first principle is that it is not desirable to regulate the FinTech sector through legislation alone, but rather use legislation to establish general principles and then set forth regulation for details. This allows a more flexible and swifter regulatory response to developments in the rapidly changing FinTech sector. A second principle is a risk-based approach, which focuses on prudential regulation of financial intermediaries and applies a less rigorous approach to other non-intermediating financial service providers. However, this principle might ignore the critical position that some non-intermediating financial service providers have in infrastructure services (e.g. cloud services, clearance services). So, both business and market linkages have to be taken into account when deciding on a FinTech’s regulatory regime.


A third principle is to recognise that regulation of financial services has two opposing objectives. One is to enable efficiency and competition. The other is to protect investors and savers and avoid the failure of non-intermediating institutions to prevent stability risk for other institutions and segments of the financial system. Given that these two objectives can clash, it is important to define whether two different regulatory institutions should be in charge of these objectives or whether the financial regulator should obtain a secondary objective as in the Bank of England with the competition.


These opposing objectives on the FinTech industry regulation also imply that, on the one hand, a light-touch approach is called for in the case of novel products and services (in the form of a regulatory sandbox) or as long as new providers are not directly involved in intermediation and have not taken on a systemically important role in the overall financial system. On the other hand, it requires frequent review of the supervisory status of FinTech companies to see whether they have grown to a relevant size or into a systemically important role that would require including them in the standard regulatory perimeter (in return, requiring a banking license).