Finance: Research, Policy and Anecdotes

Last week, I participated in a conference on the dynamics of inclusive prosperity in Rotterdam, an interdisciplinary meeting bringing together economists, lawyers, sociologists and philosophers.  Participating in the opening panel session, I was asked to give a short presentation on reinventing finance – a continuous challenge. My main message: an extensive literature has shown the transformative role that a thriving and effective financial system has on economies and societies.  But in order to fulfil this role, the financial system has to continuously transform itself, partly based on the lessons from recent crises but also to confront new social and environmental challenges. In this context, the challenge of green finance has become more and more important.  Green finance, however, is a rather broad topic, encompassing lots of different questions under the broad umbrella of how financial markets react to environmental risks and challenges and how the financial system (and its stakeholders) can contribute to a sustainable environment.  One of my favourite papers in this new strand of the literature is a recent paper by Ralph de Haas and Alex Popov on the relationship between financial structure and industrial pollution.  We know from an expansive literature that banks are more conservative in their funding decisions, going for established industries and firms, while markets are more likely to fund innovative sectors and projects (where the outcome is more uncertain). Ralph and Alex show that this also holds for pollution: banking sector development is associated with faster growth in “dirty” sectors, while capital market development is associated with growth in “clean” sectors. But even within dirty sectors, stock market development (but not credit market development) is associated with cleaner production processes, as these industries also produce more green patents when stock markets expand.

But can depositors also force banks to internalise the environmental costs they impose on society through their lending decisions? This is a question my PhD student Mikael Homanen has addressed in his job market paper Depositors Disciplining Banks: The Impact of Scandals.  Specifically, he shows that  protests against the Dakota Access Pipeline that targeted banks caused significant decreases in deposit growth of banks that funded this pipeline (some of which later withdrew from this project). And the economic effect was also large: Depositors withdrew as much as $8-20 billion from the affected banks. On average, branches lost approximately 2% deposit growth, compared to the annual average of 8%. The depositor reaction was larger in areas closer to the planned pipeline and in areas where households express stronger beliefs in climate change and local readiness for tackling societal challenges.  Mikael then uses global data on bank-specific scandals and shows that this new form of depositor discipline is a much more general phenomenon. Combining scandals on tax evasion (e.g., Panama Papers), corruption (e.g., Libor-rigging scandals), and environmental scandals (e.g., the Carmichael coal mine project in Australia) with a global, quarterly bank-level dataset, he shows that total deposit growth decreases after scandals. The Dakota Access Pipeline was not a one-off!

These are only two examples of papers in this new strand of literature.  There are many important topics to be covered, including very policy relevant ones.  Environmental risks should form part of bank stress tests and in the context of Quantitative Easing the question arises to which extent asset purchases should be titled towards sectors with lower carbon footprint. On the one hand, our planet is too important to ignore the question; on the other hand, questions on central bank independence and mission drift arise. In a nutshell, the area of green finance is a critical issue that requires substantial research but also engagement with other academic disciplines and a multitude of stakeholders.


This year saw the end of a five-year project on Productivity in Low-Income Countries, funded by DFID, and in which I have been extensively involved, together with several former colleagues from Tilburg University.  The goal was to undertake empirical studies in a number of low- and middle-income countries to understand the constraints that micro- and small enterprises face for productivity and growth and instruments/tools and policies to overcome them.  The project thus comprised independent teams across a number of countries in Sub-Saharan Africa and South Asia asking different but related questions and using a variety of different methodologies, but in most cases using data collected specifically for this project. In some cases, randomised control trials (RCTs) give us confidence that we have discovered causal relationships, in other cases, cross-sectional regressions limit our interpretation to partial correlations that we relate back to existing theories or – in one case – to our own model. Some of the papers have now been published or are under review.  Herewith a short summary of the different papers – as you can see while a large share of papers focus on financing constraints, other look beyond finance to other important growth constraints:


One of the focus countries has been Kenya. Using a calibrated general equilibrium model, Haki Pamuk, Ravi Ramrattan, Burak Uras, and I show that the availability of mobile money increases supply of trade credit and reduces its price, thus expanding external finance for entrepreneurs and ultimately economic growth (see here for a longer summary).  This shows the importance of payment technologies for the financial inclusion debate.  In a follow-up paper, Patricio, Dalton, Haki, Ravi, Daan van Soest and Burak report on an RCT that tries to identify the barriers to the adoption of the mobile money technology. There is quite some unmet demand as take-up is quite high when businesses are helped to overcome information, registration and technological barriers.   The authors also find that 16 months after adoption, businesses using mobile money were more likely to feel safe and have access to mobile loans from the mobile money provider.


In a paper using firm-level survey data for Uganda, Mikael Homanen, Burak Uras and I show that access to external (bank) finance is associated with firms’ being more likely to hire skilled workers as they increase sales and profits, while the hiring of casual or family workers is not. This result links to an expanding literature on the importance of financing constraints not just for firms’ investment, but also for hiring and training.


In a paper using firm-level survey data from Ethiopia, Mohamad Hoseini, Burak Uras and I show that trade credit and bank credit can be substitutes on the aggregate level (regions with more limited access to bank credit see higher provision of trade credit), while complements on the firm-level – i.e., having access to supplier credit helps a firm signal creditworthiness and thus gain access to bank credit.  These findings relate back to different theories on the role of trade finance – as substitute for more formal sources of funding, but also as signalling tool.


In a paper using Indian data, Mohamad and I focus on the relationship between financial development and formality. We distinguish between two different dimensions of financial deepening – banking sector outreach and credit deepening.  We find that bank outreach has a stronger effect on reducing the incidence of informality by cutting barriers to entering the formal economy, especially for smaller firms, and thus diminishing opportunistic informality. In comparison, financial deepening increases the productivity of formal sector firms (important note: this paper is currently being revised, so expect new version soon).


In a paper using firm-level survey data from Tanzania, Haki, Burak and I focus on internal finance constraints, i.e., micro-entrepreneurs not being able to reinvest their savings into their business if they save within the household. Specifically, we find that there is a significantly lower association of saving within the household with the likelihood of reinvesting profits than other savings form, most importantly, formal saving forms. These results clearly point to the importance of looking beyond micro-credit to micro-savings products.


Looking beyond financing constraints, one important question is whether micro-business owners are only life-style entrepreneurs, being self-employed in the absence of salaried opportunities, or have growth aspirations.  Among a representative sample of retail shop owners in Jakarta, Patricio, Julius Rueschenpoehler and Bilal Zia find that the average business has strong short- and long-term aspirations for growth in shop size, number of employees customers, and sales. Yet, there is also pronounced heterogeneity, with more than half of the businesses reporting no aspirations for growth in the next 12 months, and 16 percent failing to imagine an ideal business over the long-term.   However, there might be opportunities for such micro-entrepreneurs to learn from successful peers. Patricio, Julius, Burak and Bilal test such opportunities with an RCT among the same group of retail shop owners in Jakarta.  They identify local best practices and disseminate the information through a handbook tailored to their business culture. Eighteen months after the intervention, they find that the handbook alone does not lead to significant performance gains, while documentary videos and individualised help from peers  significantly improve sales and profits, up to about 35% compared to the control group. These findings show that business growth can be achieved through disseminating local knowledge in ways that are simple, cost effective and scalable.


In a complementary paper, Patricio, Julius and Bilal test whether the exposure to successful peers can change retailers’ aspirations. They find that that business growth aspirations respond strongly to these interventions, measured up to eighteen months afterwards though the direction depends on the initial aspirations. Entrepreneurs with initially high business aspirations respond positively to the treatments and increase business aspirations, sales, and profits, while those with initially low aspirations respond negatively.


An even simpler method to increase productivity (at least in agriculture) might be production measurement and goal setting. Patricio and Kim Cole train a random sample of small informal Ghanaian cassava processors on these two simple business practices and find that firms trained in goal-setting increase their productivity by 50% relative to those trained in production measurement only. Goal setting can thus be an inexpensive tool to increase productivity amongst small informal enterprises.


Finally, Patricio, Nguyen Nhung, and Julius, use a sample of small low-income retailers in Vietnam to test with experiments whether financial worries affects their risk attitudes. They find that entrepreneurs exposed to financial worries are more likely to seek financial risks than those assigned to a placebo treatment. This effect is stronger for owners of shops which are smaller and less exposed to large income shocks in their everyday business. They further show that the effect of financial worries on risk attitudes is not explained by changes in the cognitive functioning of the treated.


In a nutshell, micro- and small entrepreneurs face a variety of growth constraints that might also reinforce each other. And it is not necessarily bank or micro-credit loans that are the best solution to overcoming their productivity and growth constraints, but rather an array of different financial products and management tools, but also entrepreneurial networks. Critically, different entrepreneurs have different growth aspirations and the tools and instruments have to be tailored to their respective needs.

For the past six years I served on the advisory evaluation panel of the Dutch development bank FMO, a quite unique experience as it (i) gave me insights into the other side of the evaluation process that we academics are usually on and (ii) allowed me to serve as bridge between academia and the development finance world. As background: some 7 years ago, FMO was asked by the Dutch government to evaluate the impact of projects in developing countries that were funded by the Dutch government to thus ascertain whether taxpayers’ money was actually put to good use. Being relatively new to the evaluation world, FMO got up to speed admirably quickly on how best to go about this, which included forming an advisory panel, which I joined at the beginning of 2013.


I learned quite a lot about the challenges faced by evaluation departments in development banks: One, in several instances of evaluation requests, projects were already underway, which made a pre-intervention baseline all but impossible and an evaluation thus more challenging. And even where the projects had not started yet, a rigorous evaluation that addresses selection biases and endogeneity, is often not possible. Expanding electricity networks and/or building a bridge/road is hard if not impossible to randomise, so alternative evaluation methods are asked for. Where FMO had no contact with the ultimate beneficiaries (e.g., credit line cum technical assistance to financial institutions), a proper evaluation was often not possible and an effectiveness study (assessing how the resources were used at the level of financial institutions) was more appropriate.


Two, unlike in academic work, project evaluation (actually project preparation) starts with a theory of change, with the input provided by FMO or other donors (in the form of resources, technical assistance etc.), output being envisioned at the level of local counterparts, the outcome being at the level of beneficiaries (households and enterprises) and the ultimate impact being higher growth or poverty reduction. A first important question is which parts of the theory of change can and should be evaluated.  Another important question is the value added of individual evaluations – some questions have been extensively assessed before, while others are novel but might also be harder to assess (e.g., impact of expanding external finance for SMEs rather than for micro-entrepreneurs). Ultimately, this reflects also different interests and roles for academics and development banks’ evaluation departments: academics are interested primarily in what works best, a development bank like FMO also has to care about the value added that it can provide through its funding and the effectiveness of delivering this funding to counterparts (not necessarily the same as final beneficiaries) in the receiving country.


Being a bridge between academics and the evaluation department also provided interesting insights: undertaking an evaluation study for FMO can be interesting for academics mainly (apart from some additional income) for two reasons: one, being able to publish the results of the evaluation in an academic journal, and, two, being able to access to interesting data and possible future cooperation possibilities.  However, it is also clear that the interests of academics and development banks do not always match – as much as the latter might be interested in rigorous evaluation, they face budget and time constraints, while the former might get easily frustrated by institutional constraints and the difficulty of implementing adequate research methods (often coming from the implementing institution in the developing country).  Not surprisingly, there was thus a rich mix of consultancy companies focusing more on effectiveness or “light” evaluation studies and academic teams going all the way to econometrically rigorous evaluation. 


In a nutshell, there is so much more to the world of evaluation out there than randomised control trials. Alternative methods, such as quasi-randomised, discontinuity and propensity scoring, might help. However, even these might not be feasible in some instances, so that descriptive and qualitative methods might be necessary. While the latter might not be interesting for us academic economists, they can play an important role in completing the picture on “what works best” and – as important -  “what can each player do”.

So, here we are –habemus pactum – the European Union and the government Prime Minister of the UK have agreed on a withdrawal treaty and political declaration for the future relationship. A customs union for the UK with the EU as backstop until a new trading relationship can be negotiated that prevents the need for a hard border in Ireland with the UK respecting certain minimum standards of labour rights, environment etc.; frictions between Northern Ireland and Great Britain to allow for smooth trade across the Irish land border. And a transition period until the end of 2020, but which can be expanded until the end of 2022, during which the UK is effectively a EU member without any say and any leverage for the follow-up negotiations.  Never mind that large parts of the cabinet do not seem to agree with the Prime Minister and there is currently no majority in the House of Commons nor in the population for this agreement; as with any good compromise, everyone seems to hate it and for a good reason – economically it is worse than EU membership but better than an even harder Brexit, but politically it is worse than anything else, both EU membership and a harder Brexit, as the UK has to comply with rules it won’t set. As Ian Dunt summarises it: May’s Brexit deal is a humiliation for Britain. But then again, every serious economist in the UK has predicted that there is no such thing as a good Brexit!  So, we should not be surprised. There was simply no way to make a success out of the Brexit process.  


This withdrawal agreement is probably the best outcome for the UK, given the contradictory red lines the Prime Minister established early on and which I summarised as Brexit trilemma. Ultimately, she decided to respect the need for a soft border in Ireland, accepted some divergence along the Irish Sea (between Great Britain and Northern Ireland) and all but gave up on independent trade policy, accepting a bare-bone customs union with the EU until further notice (i.e., as long as the backstop to avoid a hard border in Ireland is needed).  The problem is not so much the agreement, but the expectations she raised during the past two years in the form of red lines and which she ultimately had to ignore. Which comes back to her original sin – setting out expectations for Brexit and triggering Article 50 without a plan whatsoever and without an agreement within her government, her party, not to mention the country on what Brexit should look like.


The one advantage of Theresa May is that there is no obvious alternative plan to the Withdrawal Agreement that is acceptable to a majority in her party (though might be in the House of Commons). Most if not all of the hard Brexiters continue to be absolutely clueless and delusional.  Never mind that all of their predictions about the EU-UK negotiations have been disproved (lest we forget, see here), their ignorance if not outright lies have dominated the debate in the UK again and again over the past 2.5 years. Latest addition to this list is the written opinion by David Davis that a withdrawal agreement is not needed as the trade relationship between the UK and the EU could be negotiated during the transition period – never mind that this transition period is the result of a withdrawal agreement! Note that this is not a slip of tongue but was provided in written form.  In addition to this comes the “Greek fallacy” that if only you get strong support at home (which Theresa May never had), this does not (and should not) trump the interests of the other 27 countries of the EU.


There are a lot of voices in the UK that demand to “just get on with Brexit”, even if it implies Brexit without a deal. This is also reflected in Boris Johnson’s statement of “Fuck Business”.  This reflects both an ignorance on the side of people with such opinions but – more importantly - a failure of the political class (and maybe us social scientists!) to better explain that the “omelette of deep economic integration” cannot be unscrambled easily and without costs. Obviously, these statements are in line with Michael Gove’s statement during the campaign that the country had enough of experts. And these feelings are fuelled by mass media that make Brexit indeed look like a walk in the park. It seems that in spite of all the mistakes the Prime Minister and her political allies have made over the past 2.5 years, there is still enough common sense left in them to realise that this assessment does not quite match reality,.


It has become clear over the past 2.5 years that for the Prime Minister Brexit seems to be all about restricting freedom of movement – the UK never made the difference between immigration (people moving from outside the EU into the UK) and EU citizens exercising their rights to live and work in the UK (and vice versa) under Single Market rules. This has become clear since David Cameron came up with the nonsensical idea of reducing net immigration (including EU citizens) to below 100,000 per year and has been reinforced by Theresa May last week when she accused EU citizens like me of jumping the queue (paraphrasing a reaction on twitter: which queue – the one to help return tax revenues towards a more stable basis after the crisis  or the one for poor public services?). The government and especially the Prime Minister have actively fuelled an atmosphere of xenophobia in this country after the referendum, which made a soft Brexit (known as Norway model) all but impossible.  In line with right-wing populist parties on the Continent and the Republicans under Mr. Trump in the US, the Tories have developed from a common-sense, business oriented party into an extreme right-wing if not fascistoid party – well, who needs the UKIP anymore if their ideology has been taken on by the governing party of this country?


Unfortunately, this will not be the end of it.  I sometimes get asked by friends of the continent whether I am glad that all of this will be over by 29 March. Well, no, it will not be over, even in the “best case” scenario of the Withdrawal Agreement being accepted by a majority in the House of Commons.  Soon after the Brexit, the next round of negotiations will start – on two levels as up to now: between the EU and the UK on the future trade deal and – as if not even more important – within the UK government and the UK political class on the future relationship between the UK and EU. This debate will put its stamp on politics in the UK for the next decade if not generation. If the Withdrawal Agreement gets rejected in the House of Commons (even in a second vote), there are chaotic weeks and months ahead for Westminster and all odds are off on what could happen.  In this case, you ain’t seen nothing yet!

There is no end to conferences that take the 10th year anniversary of the Lehman Brothers’ failure as motivation to discuss financial stability and the regulatory reforms of the past decade.  One of the highlights has certainly been a conference on Managing Financial Crises: Where Do We Stand?, at the National Bank of Belgium, co-organised by the ECB, Solvay Brussels School of Economics and Management, Toulouse School of Economics , which I had the pleasure and honour to participate in.  While split into five panels, the same topics came up again and again – how to make the Eurozone and its financial system more resilient. There has been enormous progress in strengthening banking regulation after the Global Financial Crisis and the Eurocrisis, but more is needed to make the Eurozone a sustainable currency union.  The 7+7 proposal of combining more risk-sharing with more market discipline was the starting point for several discussions during the conference.  It is clear that while politically risk sharing (in the form of, e.g., a common unemployment reinsurance and a Eurozone level deposit insurance) and market discipline (help for countries in dire fiscal position only with conditionality) are seen as contrasts, in reality they complement and reinforce each other.  Market discipline can only be enforced if credible and it can be more credible with risk sharing. In this context one important consensus that came up again and again was that the banking union has to be completed, with common deposit insurance and a backstop for the resolution fund.  Similarly, fiscal and capital market risk-sharing are not substitutes but can very much complement each other.


But when will these reforms be undertaken? On the one hand, there is a reform fatigue and political stand-off related to Italy – which speaks against any political action soon. There is also nothing like a crisis to focus minds. But “we should not build a boat again in a storm” as Herman Van Rompuy (former President of the European Council) admonished   And the next crisis might not be too far away as Vitor Constancio pointed out – if it is not Italy then the next recession might hit soon, with Eurozone authorities not having enough tools available.


I participated in a panel on bail-in vs. bail-out. I have written about this before. While Europe has moved from costly bail-outs to a framework of bail-in, in reality we are still very much in between both corner solutions and the question is whether we really should get to a corner solution where only bail-ins are allowed.  For me the challenge comes down to legacy problems vs. forward-looking. State aid restrictions were temporarily lifted in 2008 to allow bank recapitalisation but not after the Eurozone crisis, resulting in bank fragility not being addressed and the can being kicked down the road.   As Mathias Dewatripont pointed out: “‘when bailout is out and bail-in is not in, denial is the only option left’ and procrastination is also very costly for growth and thus taxpayers.”. Non-performing assets continuing to depress bank lending in several periphery countries and bail-inable debt not built up yet undermines the application of the bail-in tool as clearly seen in recent instances. It also undermines the push towards a European deposit insurance and backstop to the resolution fund as creditor countries fear that they are being asked to pay the tab for legacy losses. A solution to this problem, however, is above the paygrade of regulators and has to be resolved on the political level. Without going into recent development in German politics, let me just say that this seems rather unlikely to happen soon.