Finance: Research, Policy and Anecdotes

The past two days saw our first London Political Finance workshop, co-organised by Orkun Saka, Paolo Volpin and I – on-line rather than in person. We had nine excellent papers plus a keynote speech by Sir Tim Besley on the political economy implication of the COVID-19 crisis responses.  I will not discuss all the papers in this blog entry but focus on a few that were especially interesting for me.


The first session featured two interesting papers on the rise of right-wing populist parties in the wake of bank failures.  First, Hans Joachim Voth and co-authors use micro-level data to relate a banking crisis in 1931 and the electoral rise of the Nazi Party in Germany. Two large banks were at the core of the crisis, Danatbank and Dresdner Bank. Cities with a higher share of firms connected to either bank saw larger income declines, and unemployment rose more. However, only towns and cities affected by the failure of Danatbank (which had a Jewish CEO) show evidence of voting for the Nazis above and beyond economic factors.  This can be directly linked to Nazi propaganda blaming the economic and financial crisis on the Jewish population.  The second paper in the same session by Emil Verner links borrower fragility post-2008 in Hungary to the rise of the right-wing Jobbik. Before 2008, a mortgage credit boom in Hungary was driven by Swiss-Franc loans (lower interest rates), with both lenders and borrowers counting on the Hungarian Forint to appreciate vis-à-vis the Swiss Franc over time (in line with the Samuelson-Balassa effect). When in the wake of the Global Financial Crisis the Forint depreciated, Swiss Franc borrowers suffered. Using exogenous variation in the attractiveness of Swiss Franc loans, the authors then show how the post-2008 fragility is correlated with the geographic variation in the rise of the right-wing Jobbik party.


Travers Barclay Child and c-authors use the surprise of Donald Trump’s election in 2016 to identify the value of sudden connectedness to the US President among S&P 500 firms with pre-existing ties to the businessman Trump. They show that Trump-connected firms (though only business- and not socially related) had significantly higher abnormal stock returns around the 2016 election than their nonconnected counterparts, which translates to $1.2 and $2.4 billion in wealth creation for shareholders. Since Trump’s inauguration, connected firms showed better performance, were more likely to receive government procurement contracts, and were less subject to unfavourable regulatory actions.


Two interesting papers focused on the role of the media. April Knill and co-authors show that partisanship in television coverage influences corporate decisions. Specifically, Fox News has a clear bias in favour of Republican presidents. Exploiting the fact that the Fox News channel was not available across all of the US, they show that during George W. Bush’ presidency,  firms led by Republican-leaning managers headquartered in regions into which Fox was introduced shift upward their total investment expenditures, R&D expenditures, and leverage, compared to firms led by Republican-leaning managers headquartered elsewhere.  Ruben Durante and co-authors consider media capture by banks. Specifically, considering a sample of top European newspapers and linking them to their creditor banks, they shows that newspapers’ coverage of bank earnings announcements of their lender banks, relative to other banks, are significantly more likely to be the case in case of profits than in case of losses. This pro-lender bias is stronger for newspapers that are highly leveraged. This bias also carries over to the Eurozone crisis, when newspapers connected to banks more heavily exposed to stressed sovereign bonds are less likely to portrait banks as being responsible for the crisis and to support debt-restructuring measures detrimental to creditors.

I have meant to write this blog post for quite some time, but as the events over the past weeks have accelerated, there seemed to be more and more dimensions to this problem. I will therefore focus only on a few here.


First and foremost is the police brutality against (not only but especially) African-Americans in the US (a problem which exists to a lesser degree also in many European countries, though even less often with homicidal consequences).  Academic economists have been accused that – unlike in the COVID-19 crisis – we have been silent and do not really have anything to contribute to this societal challenge. I would strongly argue against that. There is an extensive literature on discrimination (of all types) and one major insight has been that technologically-enhanced monitoring (shown for example, here) can help as well as competition – as shown for example here - (one minor contribution by Patrick Behr, Andreas Madestam and I refers to own-gender preferences by loan officers, showing that experience with the other gender as well as intra- and inter-bank competition is a powerful tool against it). And a quick look at employment conditions for police officers in the US shows clear incentive problems, including qualified immunity and the power of unions. Both of these allow “bad apples” to continue to thrive in many police forces across the US. However, beyond the microeconomic incentives, there are important social elements, such as the glorification of police officers, including when they go beyond reasonable force, in Hollywood movies, and historic elements – the police force was used for decades to suppress African-Americans in the South.  There is also a historic literature on the long-term effects of slavery on socio-economic and political outcomes in the US, such as by Ken Sokoloff and Stan Engerman as well as work by Lisa Cook, showing the persistence of institutional arrangements created during pre- and post-Civil War periods for socio-economic outcomes today.  There is certainly more that I am not aware of, but it is important to stress that there are many different research approaches and different literatures that speak to the issue at hand. This also means that simple policy solutions as suggested by the incentive literature might not be easy to implement given socio-political constraints.


A second theme I want to touch on is the Causa Harald Uhlig whose blog and twitter rants have made quite an impact and not exactly a positive one, leading to calls for him to resign as lead editor of the Journal of Political Economy. I have meet Harald in several occasions while in Tilburg, as he was part-time research professor there. He is certainly one of the smartest macroeconomists I have met, but he is also academic through and through.  Reading his blog and recent twitter rants, I was not only disappointed but disgusted! He might not be a racist, but his comments and name calling are a sign of incredible lack of sensitivity and common sense. While I originally did not sign the letter calling for his resignation as JPE lead editor, the allegations of discriminatory remarks in the class room made me think again. And if someone like Harald is not able to adjust his ivory tower discussion style when leaving the seminar room it might be better if he did not participate in the public discussion at all. Of course, this does not address the allegations of discriminatory behaviour in the class room and is certainly something to be addressed by his department.


However, there is a broader lesson here for economists and social scientists. It is important for us academics to step outside the ivory tower and take part in the societal conversation (even more so during the time of populism); however, we have to learn how to participate in a sensible and sensitive way. While doing my PhD in the late 1990s, there was often reference to the rather aggressive Chicago seminar style, certainly something to be avoided in settings outside the seminar room (and maybe even inside, see below). As much as we have to learn the difference between academic writing style and translating our research for non-academics and even non-economists, we have to learn how to participate in the public discourse in a style that is respectful if not humble!


Which brings me to a third theme – the lack of diversity within the economics and finance academia. For many years, we have discussed the gender problem in economics – before I joined academia, I never faced this issue as the group at the World Bank where I spent my first nine post-PhD years was very balanced in gender terms. The fact that many international financial institutions and organisations (IMF, World Bank, OECD and EBRD) have female chief economists, is certainly an important signal. Yes, economics (and finance) academia still has a gender problem, as the discussion about clearly shows, but we have started to address it.  However, the problem of diversity is a broader one.  The lack of African (American) economists in the US (and similarly limited minority representation in other countries) is certainly alarming. However, it is important to understand that this is not a problem we can solve overnight. Unless I am mistaken, there seems to be a lack of African (-American) students in economics and finance in both undergraduate and (post) graduate courses. Addressing the diversity problem has to start at the undergraduate level and strong mentoring programmes and a change in culture and style will hopefully get us where we need to be, eventually.


Being a male middle-aged white economist, I realise that I have been in a very privileged position during my whole professional life. And I realise that I have a responsibility to do my small part of changing the culture in our profession.  I hope I can live up to it – it won’t be easy, as much of our behaviour is so ingrained that we might not even realise where and when we go wrong!

I had the honour of co-editing a special issue of the Journal of Financial Intermediation, just published, comprising five papers that use granular data to assess the effectiveness of different macro-prudential tools. While macro-prudential regulation has become very prominent over the past decade, following the experience of the Global Financial Crisis, there is still limited empirical evidence on what works and what does not. Assessing the effect of macroprudential policies is made difficult by two challenges: endogeneity of policy decisions and difficulty of differentiating between demand and supply-side reactions. Using bank- or loan-level data allows to address these challenges to a certain extent and that is what these five papers are doing. Doing so, however, limits the analysis typically to one country at a time and thus limits the external validity of each study. In the first paper, however, my special issue co-editor Leonardo Gambacorta and Andres Murcia undertake a meta-analysis of studies by five central banks in Latin America countries (Argentina, Brazil, Colombia, Mexico and Peru) to evaluate the effectiveness of macroprudential tools and their interaction with monetary policy; they find that macroprudential policies in these five countries have been quite successful in stabilising credit cycles and macroprudential tools have a greater effect on credit growth when reinforced by the use of monetary policy. Thus interaction of macro-pru and monetary policies is a first important key insight.


A paper on the impact of macroprudential housing tools in Canada combines loan-level administrative data with household-level survey data on first-time homebuyers and finds that policies targeting the loan to value (LTV) ratio have a larger impact than policies targeting the debt service-to-income (DSTI) ratio, such as amortisation. A paper focusing on the US finds that the initiation of the Comprehensive Capital Analysis and Review (CCAR) stress tests in 2011 had a negative effect on the share of jumbo mortgage originations and approval rates at stress-tested banks – banks with worse capital positions were impacted more negatively. Macro-pru can thus be effective in reducing the cyclicality of housing (credit) cycles. And as a study on Brazil shows, it can also reduce defaults. Specifically, the authors study the impact of the introduction of LTV limits in Brazil against the back drop of a housing price boom in 2013. Borrowers that were constrained by the LTV limit have a significantly lower chance of being in arrears, which ultimately limits the build-up of risk, showing the effectiveness of LTV caps.


Finally, a study on Colombia evaluates the effects of the introduction of:(i) a dynamic provisioning scheme for commercial loans; and ii) a countercyclical reserve requirement implemented in 2007 to control for excessive credit growth. Results suggest that both policies and an aggregate measure of the macroprudential policy stance had a negative effect on credit growth, with the effect varying with bank and debtor-specific characteristics. The effects are intensified for riskier debtors, thus suggesting that the aggregate policy stance in Colombia has worked effectively to stabilise credit cycles and reduce risk-taking.


The number of papers using loan-level data has exponentially increased over the past years and so has the number of papers assessing macro-prudential policies.  There will be lots more to be learned, both on the country-level but also comparing across countries.

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.


Over the past two months, I chaired a workstream at the European Systemic Risk Board on pay-out restrictions, with the General Board adopting a Recommendation on 27 May to this effect. This recommendation was published on 8 June. The bottom line is to restrict voluntary payments by banks, insurers and CCPs that reduce own funds, including dividends, buy-back of shares and variable compensation to material risk-takers. The ultimate aim is to have sufficient levels of capital and loss absorbing capacity remaining in the financial institutions to mitigate the impact of the current crisis and thereby contribute to a smoother recovery for the pan-European economy as a whole. As the recommended actions fall under the jurisdictions of many different authorities, the Recommendation is addressed to relevant competent or supervisory authorities and, designated or macroprudential authorities.


While such restrictions intervene in ownership and management rights, there are strong arguments for such restrictions in times of crisis. First, banks constitute a critical sector for economic recovery and therefore there is the need to maintain sufficiently high capitalisation. Second, governments have provided capital relief to banks (e.g., EUR120 billion for significant institutions under direct ECB supervision) and have indirectly supported them through support payments to enterprises and households (who otherwise might have defaulted on loans) and credit guarantees; voluntary pay-outs would partly off-set the effect of these measures. Third, banks behave in a procyclical manner in their lending, showing a propensity to build reserves against credit losses and reduce lending during recessions. High capital buffers can to a degree mitigate this tendency towards deleveraging, which in turn calls for suspension of pay-outs to not off-set the effect of high capital buffers. Finally, if banks use dividend payments as a signal of strength to the market then any bank not doing so will fear being stigmatised, which speaks in favour of coordinated and mandatory action to restrict pay-outs.


There are certainly arguments against imposing such restrictions: charities, foundations, pension funds and retail investors often depend on steady dividend income; the prohibition of pay-outs might limit resource reallocation that might be needed during the recovery stage; and banning dividend payments can undermine banks’ relationships with investors and thus potentially restrict future access to market funding. These arguments certainly speak for only temporary restrictions.


The ESRB Recommendation comes after several recommendations issued by EBA, SSM and EIOPA in late March/early April, but there are several notable developments since then. First, this recommendation is a broader one, across several segments of the financial system, including banks, investment firms, insurance companies (which will certainly get under similar stress as banks and play a critical role in financial markets) and CCPs (while they are not directly involved in real sector funding, their critical role in financial market transactions makes their reliance important for banks’ and insurance companies’ hedging activities). 


Second, the recommendation refers to all voluntary pay-outs that have the effect of reducing the quality or quantity of own funds, including dividends, share buy-backs and variable remuneration to material risk-takers (staff members whose professional activities have material impact on the institutions' risk profile) and thus goes beyond previous recommendations. There is a proportionality clause in the recommendation and – obviously – where financial institutions have a legal obligation to pay, they have to do so.


Third, the restrictions apply until the end of 2020, rather than 1 October 2020, as under the SSM recommendation. It can be extended.


While the recommendation primarily targets pay-out restrictions on the consolidated level, one tricky issue has been restrictions on the sub-consolidated level. On the one hand, the recommendation calls for restrictions on the consolidated level, but on the sub-consolidated level if the parent bank is outside the EU. While ideally there would be cooperation on the global level, this has not happened, so we need to primarily take care of the European financial system.  On the other hand, several Central and Eastern European countries have imposed restrictions on subsidiaries of EU cross-border banks for financial stability concerns. There are strong arguments on either side. On the one hand, regulatory risk-sharing is incomplete in the EU (including within the euro area) and the financial stability mandate of national macro-prudential authorities focuses on local financial systems and economies. On the other hand, the Single Market principle of free movement capital speaks against imposing restrictions on the subsidiary level. The Recommendation therefore advocates that the relevant authorities enter a dialogue when considering imposing pay-out restrictions on subsidiaries of EU financial institutions. Compared to the last crisis, there are quite some fora available for this dialogue, including colleges, the Vienna Initiative and the Nordic-Baltic Macroprudential Forum.


It is important to stress that this recomendation constitutes “soft law”. The ESRB has no legal powers to enforce compliance; rather ESRB Recommendations are ‘comply or explain’. This means that an addressee could decide to explain in case it had good reasons for not complying. I am aware that there will be indeed some authorities who will decide to not comply, but I think it is still important to send this broad message in favour of capital preservation at times of very high uncertainty and possibly future distress!


In a survey, published  in October 2019, the US and the UK were rated as the two countries best prepared for a global pandemic; as it is well known now, these two countries now head a different ranking – that of total excess deaths during the pandemic so far. Why is this?  Is it populism?  Structural reasons? And how can a recent survey go so wrong?


Let’s first take the US – yes, it is certain that political leadership plays a role and that Hillary Clinton, Bernie Sanders, Marco Rubio, Jeff Bush, Mitt Romney or actually any functioning adult would have been better than the current president, but beyond the political leadership (well, the lack thereof), this pandemic has shown the failure of the federal government in the US. Starved of funding over the past 20 years, ridiculed and insulted by one of the two parties over the past 40 years and lacking a consensus that public health should be a common good, not a club good, the federal government is not up to the job. There is a lot more to be said about the current situation in the US (which has been hit by a combination of 1918, 1929 and 1968 shocks), but I will leave it for another day.


Let’s now take the UK (which is personal for me as I am currently living here). Being an island, the country had the advantage of being exposed several weeks later to the virus than other countries. The reaction: “well, we are so much better than everyone else, especially than Italians, so let’s go and watch horse races in Cheltenham.” One might forgive the government for changing their advice and policies as more evidence became available, but: too late in securing PPE, too late in quarantining travellers from abroad (they might implement it next week, when it is all but useless), too late in starting to test, too late in securing enough ventilators, with the consequence of sending older people from hospitals back to care home, where they were left to transmit the virus to others and die – how much more disgraceful can a democratically elected government become – well, too late in everything! But as the Prime Minister declared yesterday: he is proud of his record! And when the data contradict the government’s assertion, they are being either not published (such as testing data over the past days) or they are being manipulated (such as counting mailed test kits as undertaken tests). I am sure there is still a receptive audience for Johnson’s nationalist idiotic bluster, but in the not too far future, there will be a reckoning for this failure.  And I am not even mentioning the threat of yet another Brexit no-deal cliff edge.


There is one more thing I have noticed in the UK over the past years: politicians love slogans. From “take back control” over “Brexit means Brexit” and “get Brexit done” to “following scientific advice”, British politicians love hiding behind slogans. It shows how empty of quality the political class in this country has become. Having a government minister on the radio or TV often turns into PR disasters as their lack of competence shows when they are forced to go beyond their carefully prepared notes and when interviewers question their silly slogans. Changing ministerial briefs every few months does not help either. But it is clear that something is deeply broken in the governmental system of the UK. Brexit is damaging but not necessarily deadly; bungling the COVID-19 response kills people!  And their families will note!


This brings me to a broader point. The legal origin theory is often interpreted as implying that everything is better in Common Law (such as US and UK) than in Civil Law countries (and yes, I have several papers showing that legal origin can explain some variation between countries in financial development). The effectiveness of government might certainly be an important exception to that! Having spent my adult life in two Common Law (US and UK) and two Civil Law countries (Germany and the Netherlands), my own personal and professional (as economist and academic) experience with government services has been much better in Continental Europe than in the Anglo-American world, but then again, the plural of anecdotes (of which I have plenty) is not data. I think this crisis has shown more than any other evidence that (controlling for the level of GDP per capita), government quality is certainly not higher in the UK or US than most (Civil Law) countries in Continental Europe. However, this also means that we have to become much more cautious with institutional indicators based on expert surveys, such as the one I quote at the beginning.