Finance: Research, Policy and Anecdotes
The Ieke van den Burg Prize, an annual prize to recognise outstanding research conducted by young scholars on a topic related
to the ESRB’s mission, awarded by the Advisory Scientific Committee, was this year given to two papers, both of which address very timely topics.
The first one – especially close to my own interest - studies the effects of bank payout restrictions, imposed during the COVID-crisis in 2020 on banks’ risk-shifting incentives.
Thomas Kroen uses the fact that only Fed-supervised bank holding companies were subject to the ban on share buy-backs and restrictions on dividend payments in the US. He finds that both equity prices and CDS spreads and bond yields declined for these banks,
suggesting that that payout restrictions shift risk from debt towards equity holders. After restrictions were lifted, both effects reverted. Overall, this suggests that pay-out restrictions reduced risk-shifting incentives of banks, in line with the intention
of supervisors. Thomas also provides micro-evidence for this effect by considering syndicated lending data and shows that banks increase their non-investment grade lending by 32 % relative to investment-grade lending when the payout restrictions are removed,
while the average interest rate spread declines. Finally, he provides back-of-the envelope calculations that the financial safety net guarantee by the government also reduced in the value during the period of payout restrictions, i.e., the amount of bailout
resources the government would have to provide in case of bank failure times failure probability. Overall, quite powerful evidence in favour of payout restrictions during extreme crisis situations such as in 2020.
Antonio Coppola shows the importance of investor base composition for the performance of firms during financial
crises. Fire sales by investors might put pressure on firms and their access to external funding. This has raised the focus on long-term investors as safe hands, in contrast to weak- hand investors who are prone to quickly liquidate their investments in times
of market-wide distress. Antonio focuses on two investor sectors, insurance companies and mutual funds, which are the most important participants in the corporate bond market. Given that mutual fund clients can redeem capital easily unlike insurance policy
holders, mutual funds have a higher propensity to engage in fire sales than insurers. He finds that this matters for firms. Specifically, firms whose bonds are owned by mutual fund investors and who are thus less prone to fire sales face relatively
better credit conditions: they maintain higher levels of borrowing, pay a lower cost of capital, and have higher real investment rates. He uses large-scale security-level holdings data and introduces issuer fixed effects, i.e., comparing a firm’s bond
held by either an insurance company or a mutual fund, to control for endogeneity. The economic effects are also strong: All else equal, increasing insurance holdings in a bond by 50 percentage points leads to price declines during downturns that are
20 percent shallower; further, firms at the 90th percentile of the distribution of bonds held by insurers have capital expenditure rates higher by 1.5 percentage points than firms at the 10th percentile, are 25 percentage points more likely to issue
new bonds in each of the crisis years, and pay offering yields lower by 120 basis points when doing so. These findings are important for ongoing macroprudential policy discussions, such as on gating provisions for mutual funds during crisis periods
but also the need for a diverse institutional investor base (with mutual funds being able to provide liquidity during normal times but insurers reducing the risk of wide-spread fire sales during crisis situations).
Together with my colleagues Maria del Carmen Sandoval Velasco and Pierre Schlosser I wrote a short policy note on the impact of the Ukraine invasion on European integration.
Well known to political scientists, Monnet’s method posits that reforms and new European structures and powers are driven by adverse events and crises that cannot be solved with existing policy tools and on the national level. The eurodebt crisis has
brought us the (incomplete) banking union and the Covid crisis the Next Generation EU, a joint fiscal response which I referred to earlier as Hamiltonian glimpse
at what might be feasible in a fiscal union. Similarly, the Ukraine crisis will have repercussions for actors, instruments and rules, as we discuss in our note. Concerning actors, the European Commission seems again in the position of taking on new crisis
management responsibilities, even though security is not its area of expertise; the ECB will, on the one hand, be struggling with higher inflation, while at the same time, becoming again pre-occupied with sovereign yield divergence in the euro area. For the
first time, the SSM will have to take geopolitical risks clearly into account in its risk monitoring, while the still to be created Anti-Money Laundering Agency will take on an even more important role. Concerning instruments, while the EU has played second
violin to NATO, a total of €1.5 billion of military assistance has been agreed at the European level to support the Ukrainian army, which constitutes a new policy area for the EU. While the cohesion funds might take on a stronger role (with necessary
flexibility to reallocate funds approved by the Commission) as economies across Europe are differently exposed to the conflict and rising energy prices, there is still discussion on an NGEU 2 to help with the reconstruction of Ukraine. Finally, concerning
rules, the conflict has made clear that the Stability and Growth Pact – suspended since spring 2020 – needs an urgent revamp and redefinition although politics might only allow for further suspensions. Similarly, the suspension of state aid rules
might have to be extended, at least for some sectors in light of a looing energy crisis.
In summary, this crisis will have important implications for the European
Union on different levels and we will certainly see more actions and reforms in the coming months.
As Europe suffers from a heat wave that has been predicted
for 2050 rather than 2022, the politics across Europe has taken again a shift for the worse.
In Italy, the populist parties have put an end to Draghi’s
technocratic government. Early elections and a stop to pass the necessary reform legislation might hold back further funding from NGEU and the economic recovery. The perspective of a right-wing government, led by a formerly fascist party does not exactly raise
confidence either. At the same time, the ECB faces further pressure to fight inflation and sovereign fragility at the same time; as before, Italy will provide the proof to which extent this can work. The new programme (Transmission Protection Instrument,
also known as To Protect Italy) has the potential to reopen the political tensions between North and South. At the same time, a new conflict has been opened, between countries that have created energy dependence on Russia over the past decade (most prominently
Germany) and others (such as Spain). In the other main European countries, things do not look much better. President Macron lost his parliamentary majority (on the upside, this increase in checks and balances might make reforms more sustainable). In Germany,
Olaf Scholz is still struggling with the Putin-friendly wing of his own social democratic party. At the same time, Hungary’s regime is going a step further and trying to cosy up to Putin as much as possible.
In the UK, Liz Truss is seen as favourite to become the next Prime Minister – as a late convert to Brexit (she strongly supported Remain) she is even more extreme than others in the Tory party
(also known as English Nationalist Party), a similar trajectory as Lord Frost. The two candidates Rishi Sunak and her are currently engaged in an arms race of who can be nastier to refugees, who can give more money away to billionaires while cutting
public services even further and who will take a stronger stand against the EU. As pointed out by numerous observers, most elegantly Chris Grey, this will only end in more tears as either of them
will try to convert these promises into actual policy, which will again prove impossible. And all of this on the background of more Brexit disruptions, as British tourists trying to cross into France in Dover discover yet again how Brexit has not made
their life better, with hour-long waiting queues. Obviously, the British have to blame the French for this (French immigration is done in Dover and on one specific morning, French officials were delayed by a total of 1.5 hours); ignoring the fact that
the British government refused to expand immigration facilities in Dover ahead of Brexit – so, the usual patterns: Brits refusing to take responsibility for the consequences of Brexit and their refusal to properly prepare and blaming others – no
wonder no one takes the UK serious anymore.
A good moment to take a few weeks off and getting ready for a rather hectic autumn. On the upside, I have just
discovered a great restaurant in Bogota – Leo – which – if the Michelin guide were to cover Colombia – certainly would qualify for a Michelin star.
The Russian aggression against Ukraine has further fuelled an already high energy price inflation. There is an intensive debate on how to mitigate the impact on households, especially lower-income households. One politically
popular suggestion to mitigate the impact are price caps, which would benefit all consumers; however, this would not entice them to reduce energy consumption and – in the worst case scenario – might result in rationing. To avoid such rationing,
one could impose a more limited use of energy (such as car-free weekends in the 1970s during the first Oil Price Crisis– one of my first memories as child growing up in Hamburg). At my university, we are told to use air conditioning only between 10 and
3; however, this is not being monitored, which raises the general challenge of monitoring caps of energy usages. That’s why economists prefer the power of market pricing. But what if energy use is price-inelastic for certain ranges of consumption?
To off-set rising energy costs for consumer, transfers have been proposed. However, such transfers would have to be targeted at low-income households and involve an administrative burden (can all low-income households easily be reached, especially if
they do not pay income tax?); in addition, there might be a time gap between energy bills and transfer payments, which poses problems for liquidity-constrained consumers.
One intriguing suggestion comes from Isabella Weber and has been picked up by others: a price cap up to a threshold and market prices above. This threshold
could be set such that the energy consumption covered by the price cap corresponds to the basic needs of a household. While all households would benefit from this price cap, the administrative burden of proper targeting or transfer payments would not be incurred.
And incentives for energy savings would still be in place above the threshold where market prices would rule. Taxpayers would have to compensate energy companies for what is effectively a social transfer. . And finally, such a price cap has the positive
macroeconomic side effect of mitigating pressure on a price-wage inflation spiral. On a broader note, one can see such a quantity-limited price cap also as a tool for the transition towards net zero.
Overall, an adequate policy for extraordinary times, combining social and market into a policy tool.
When Boris goes, Brexit goes, some observers have noted. But fear not, the Brexit soap
opera will continue for many more seasons. I even would bet that one of the main protagonist, BJ, will continue to feature heavily, possibly as newspaper columnist spreading stab-in-the-back conspiracy theories and explaining to the world who prevented him
from implementing the true Brexit. But if anyone thinks that the Tories would turn sensible and real world oriented, they will most likely be in for a ride, as after all the Tories are heavily invested in this soap opera as is the sycophantic
press that supports them. To the contrary, we might see a further hardening of the Brexit stance under the next Prime Minister, with a passing of the NI Protocol Bill (which breaks NI Protocol, part of the UK Withdrawal Agreement, and thus international
law) leading to a trade conflict between the UK and the EU.
There has been a clear downward trend in the quality of Prime Ministers since Gordon Brown left office
in 2010. David Cameroon embarked on the ill-advised austerity drive (which helped the Leave campaign win in 2016 by promising to recover public services with money ‘saved’ from EU contributions) and gambled the future of the UK with a Referendum
that had only one objective: resolve an intra-Tory conflict that not many people cared about. While he had little of an ideology, his successor Theresa May did: an explicit hatred of anything foreign, ‘nicely’ summarised in her Citizens of Nowhere
speech, copied from no other than the Master of fascist hatred, Adolf Hitler. Her attempt to schmooze with ultra-Brexiteers by drawing red lines (control over laws, border and money ) without any plan on how to go about it forced her later to back-pedal and
led to her downfall, as hers was not the true Brexit. A failure on all dimensions, ‘pissing off’ everyone, including remain voters, EU citizens in the UK, ultra-Brexiters and the EU, without achieving anything
Enter Boris Johnson, the worst Prime Minister of the three and possibly in UK history, an incompetent liar, cheater and gambler with no beliefs but narcissistic self-confidence. Signing an international
treaty that he never intended to honour, breaking the laws and rules he announces on TV and lying about it afterwards. I do not want to waste any more virtual ink on this despicable human being, but just note that there is no guarantee that the next PM will
be any better and there might be a chance she will be worse; just think of Suella Braverman. In any case, as in any good soap opera, we will now see a repeat of the 2019 Tory competition, where candidates will outbid each other on who is the most radical
Brexiter in the country. More broadly, we will see the political conversation yet again turn completely inward, as it was between 2017 and 2019 during the Brexit negotiations, where the UK was so busy negotiating with itself that there was little space to
actually negotiate with the EU.
As Janan Ganesh points out, the UK has become a tragicomic
country. The best-case scenario is that it will economically (and politically) become a Mediterranean per capita income with northern European weather, as Janan argues. I would add that the worst-case scenario is that it follows the example of Argentina, the
only country that went from being a high-income country to a middle-income country in the 20th century. While this is certainly a rather long way off and might sound a bit too pessimistic, the damage done by the Conservative Party over the
past 12 years will be hard to reverse. A UK return to Single Market and/or Customs Union seems off a couple of decades and not just because Labour does not want to open the debate on it, but also because it is hard to imagine that the EU will accept such an
entry any time soon.
The UK is truly on a downward trend and it is hard to see when it will hit bottom. In the meantime for those of us who have left the UK, we
continue to watch the soap operate with amazement.