Sustainable Architecture for Finance in Europe (SAFE)
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Despite the increasing use of cashless payment instruments, the notion that cash loses importance over time can be unambiguously refuted. In contrast, the authors show that cash demand increased steeply over the past 30 years. This is not only true on a global scale, but also for the most important currencies in advanced countries (USD, EUR, CHF, GBP and JPY). In this paper, they focus especially on the role of different crises (technological crises, financial market crises, natural disasters) and analyse the demand for small and large banknote denominations since the 1990s in an international perspective. It is evident that cash demand always increases in times of crises, independent of the nature of the crisis itself. However, largely unaffected from crises we observe a trend increase in global cash aligned with a shift from transaction balances towards more hoarding, especially in the form of large denomination banknotes.
Occasionally binding constraints have become an important part of economic modelling, especially since western central banks see themselves (again) constraint by the so-called zero lower bound (ZLB) of the nominal interest rate. A binding ZLB constraint poses a major problem for a quantitative-structural analysis: Linear solution methods do no work in the presence of a non-linearity such as the ZLB and existing alternatives tend to be computationally demanding. The urge to study macroeconomic questions related to the Great Recession and the Covid-19 crisis in a quantitative-structural framework requires algorithms that are not only accurate, but that are also robust, fast, and computationally efficient.
A particularly important application where efficient and fast methods for occasionally binding constraints (OBCs) are needed is the Bayesian estimation of macroeconomic models. This paper shows that a linear dynamic rational expectations system with OBCs, depending on the expected duration of the constraint, can be represented in closed form. Combined with a set of simple equilibrium conditions, this can be exploited to avoid matrix inversions and simulations at runtime for signifcant gains in computational speed.
High-frequency changes in interest rates around FOMC announcements are a standard method of measuring monetary policy shocks. However, some recent studies have documented puzzling effects of these shocks on private-sector forecasts of GDP, unemployment, or inflation that are opposite in sign to what standard macroeconomic models would predict. This evidence has been viewed as supportive of a „Fed information effect“ channel of monetary policy, whereby an FOMC tightening (easing) communicates that the economy is stronger (weaker) than the public had expected.
The authors show that these empirical results are also consistent with a „Fed response to news“ channel, in which incoming, publicly available economic news causes both the Fed to change monetary policy and the private sector to revise its forecasts. They provide substantial new evidence that distinguishes between these two channels and strongly favors the latter; for example, regressions that include the previously omitted public macroeconomic news, high-frequency stock market responses to Fed announcements, and a new survey that they conduct of individual Blue Chip forecasters all indicate that the Fed and private sector are simply responding to the same public news, and that there is little if any role for a „Fed information effect“.
The authors examine the effectiveness of labor cost reductions as a means to stimulate economic activity and assesses the differences which may occur with the prevailing exchange rate regime. They develop a medium-scale three-region DSGE model and show that the impact of a cut in the employers’ social security contributions rate does not vary significantly under different exchange rate regimes. They find that both the interest rate and the exchange rate channel matters. Furthermore, the measure appears to be effective even if it comes along with a consumption tax increase to preserve long-term fiscal sustainability.
Finally, they assess whether obtained theoretical results hold up empirically by applying the local projection method. Regression results suggest that changes in employers’ social security contributions rates have statistically significant real effects – a one percentage point reduction leads to an average cumulative rise in output of around 1.3 percent in the medium term. Moreover, the outcome does not differ significantly across the different exchange rate regimes.
The recently observed disconnect between inflation and economic activity can be explained by the interplay between the zero lower bound (ZLB) and the costs of external financing. In normal times, credit spreads and the nominal interest rate balance out; factor costs dominate firms' marginal costs. When nominal rates are constrained, larger spreads can more than offset the effect of lower factor costs and induce only moderate inflation responses. The Phillips curve is hence flat at the ZLB, but features a positive slope in normal times and thus a hockey stick shape. Via this mechanism, forward guidance may induce deflationary effects.
Can boundedly rational agents survive competition with fully rational agents? The authors develop a highly nonlinear heterogeneous agents model with rational forward looking versus boundedly rational backward looking agents and evolving market shares depending on their relative performance. Their novel numerical solution method detects equilibrium paths characterized by complex bubble and crash dynamics. Boundedly rational trend-extrapolators amplify small deviations from fundamentals, while rational agents anticipate market crashes after large bubbles and drive prices back close to fundamental value. Overall rational and non-rational beliefs co-evolve over time, with time-varying impact, and their interaction produces complex endogenous bubble and crashes, without any exogenous shocks.
On the accuracy of linear DSGE solution methods and the consequences for log-normal asset pricing
(2021)
This paper demonstrates a failure of standard, generalized Schur (or QZ) decomposition based solutions methods for linear dynamic stochastic general equilibrium (DSGE) models when there is insufficient eigenvalue separation about the unit circle. The significance of this is demonstrated in a simple production-based asset pricing model with external habit formation. While the exact solution afforded by the simplicity of the model matches post-war US consumption growth and the equity premium, QZ-based numerical solutions miss the later by many annualized percentage points.
The crisis management and deposit insurance (CMDI) framework in the euro area requires a reset. Although its policy objectives remain valid, the means of achieving them do not. As the euro area comes the end of the long transition period taken to implement the BRRD/SRMR, it should take the opportunity to reset expectations about resolution.
Above all, resolution should be for the many, not just the few. There should be a single presumptive path for dealing with failed banks: the use of bail-in to facilitate orderly liquidation under a solvent-wind down strategy. This will protect deposits and set the stage – together with the backstop that the European Stability Mechanism provides to the Single Resolution Fund (SRF) -- for the transformation of the SRF into the Single Deposit Guarantee Scheme (SDGS). To avoid forbearance, responsibility for emergency liquidity assistance (ELA) should rest, not with national central banks, but with the ECB as a single lender of last resort. Finally, national deposit guarantee schemes should function as institutional protection schemes and become investors of last resort in their member banks. Together, these measures would complete Banking Union, promote market discipline, avoid imposing additional burdens on taxpayers, help untie the doom loop between weak banks and weak governments, strengthen the euro and enhance financial stability.
This in-depth analysis provides evidence on differences in the practice of supervising large banks in the UK and in the euro area. It identifies the diverging institutional architecture (partially supranationalised vs. national oversight) as a pivotal determinant for a higher effectiveness of supervisory decision making in the UK. The ECB is likely to take a more stringent stance in prudential supervision than UK authorities. The setting of risk weights and the design of macroprudential stress test scenarios document this hypothesis. This document was provided by the Economic Governance Support Unit at the request of the ECON Committee.
This document was requested by the European Parliament's Committee on Economic and Monetary Affairs. It was originally published on the European Parliament’s webpage: www.europarl.europa.eu/RegData/etudes/IDAN/2021/689443/IPOL_IDA(2021)689443_EN.pdf
This in-depth analysis proposes ways to retract from supervisory COVID-19 support measures without perils for financial stability. It simulates the likely impact of the corona crisis on euro area banks’ capital and predicts a significant capital shortfall. We recommend to end accounting practices that conceal loan losses and sustain capital relief measures. Our in-depth analysis also proposes how to address the impending capital shortfall in resolution/liquidation and a supranational recapitalisation.
Rising temperatures, falling ratings: the effect of climate change on sovereign creditworthiness
(2021)
How will a changing climate impact the creditworthiness of governments over the very long term? Financial markets need credible, digestible information on how climate change translates into material risks. To bridge the gap between climate science and real-world financial indicators, the authors simulate the effect of climate change on sovereign credit ratings for 108 countries, creating the world’s first climate-adjusted sovereign credit rating. The study offers a first methodological approach to extend the long-term rating to an ultra-long-term reality, aiming at long-term investors, but also regulators and rating agencies.
Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. The authors show how such features in a central bank’s collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This can potentially induce sovereign debt crises and defaults that would not otherwise arise.
We raise some critical points against a naïve interpretation of “green finance” products and strategies. These critical insights are the background against which we take a closer look at instruments and policies that might allow green finance to become more impactful. In particular, we focus on the role of a taxonomy and investor activism. We also describe the interaction of government policies with green finance practice – an aspect, which has been mostly neglected in policy debates but needs to be taken into account. Finally, the special case of green government bonds is discussed.
We show that financial advisors recommend more costly products to female clients, based on minutes from about 27,000 real-world advisory meetings and client portfolio data. Funds recommended to women have higher expense ratios controlling for risk, and women less often receive rebates on upfront fees for any given fund. We develop a model relating these findings to client stereotyping, and empirically verify an additional prediction: Women (but not men) with higher financial aptitude reject recommendations more frequently. Women state a preference for delegating financial decisions, but appear unaware of associated higher costs. Evidence of stereotyping is stronger for male advisors.
The pricing of an ambiguous asset, whose cash flow stream is uncertain, may be affected by three factors: the belief regarding the realization likelihood of cash flows, the subjective attitude towards risk, and the attitude towards ambiguity. While previous literature looks at the total price discount under ambiguity, this paper investigates with laboratory experiments how much effect each factor can induce. We apply both non-parametric and parametric methods to cleanly separate the belief effects, the risk premiums, and the ambiguity premiums from each other. Both methods lead to similar results: Overall, subjects have substantial ambiguity aversion, and ambiguity premiums account for the largest price deviation component when the degree of ambiguity is high. As information accumulates, ambiguity premiums decrease. We also find that beliefs do influence prices under ambiguity. This is not because beliefs are biased towards either good or bad scenarios per se, but because subjects display sticky belief updating as new information becomes available. The clear separation performed in this paper between belief and attitude also enables a more accurate estimation of the parameter of ambiguity aversion compared to previous studies, since the effect of beliefs is partialled out. Overall, we find empirically that both factors, belief and attitude towards ambiguity, are important factors in pricing under ambiguity.
The salience of ESG ratings for stock pricing: evidence from (potentially) confused investors
(2021)
We exploit the a modification to Sustainanlytics’ environmental, social, and governance (ESG) rating methodology, which is subsequently adopted by Morningstar, to study whether ESG ratings are salient for stock pricing. We show that the inversion of the rating scale but not new information leads some investors to make incorrect assessments about the meaning of the change in ESG ratings. They buy (sell) stocks they misconceive as ESG upgraded (downgraded) even when the opposite is true. This trading behavior exerts transitory price pressure on affected stocks. Our paper highlights the importance of ESG ratings for investors and consequently for asset prices.
We conducted a large-scale household survey in November 2020 to study how altering the time frame of a message (temporal framing) regarding an imminent positive income shock affects consumption plans. The income shock derives from the abolishment of the German solidarity surcharge on personal income taxes, effective in January 2021. We randomize across survey participants whether their extra disposable income is presented in Euros per month, Euros per year, or Euros per ten year-period. Our main findings are as follows: In General, we find our respondents’ intended Marginal Propensity to Consume (MPC) is 28.2%. Across all three treatments, the MPC is a positive function of age and being female while it is a negative function of the income increase’s size, self- control, and being unemployed. Temporal framing effects are statistically and economically highly significant as we find the monthly treatment groups’ average MPC 5.6 and 8.7 percentage points higher compared to the yearly and 10-yearly treatment groups. We will be able to analyze the real consumption behavior of households throughout 2021 based on re-surveying the participants as well as by using transaction-based bank data.
Nach der Bundestagswahl am 26. September 2021 wird sich die künftige Bundesregierung mit einer Reihe drängender Herausforderungen befassen müssen. Aus Sicht des Leibniz-Instituts für Finanzmarktforschung SAFE haben die folgenden, miteinander verbundenen Einzelpunkte dabei Priorität:
1. Schaffung eines ordnungspolitischen Pakets zur Sicherung globaler Gemeinschaftsgüter, wie etwa des Klimas
2. Initiative zum Aufbau notwendiger Datensätze und Standards für eine zielgenaue Nachhaltigkeitsgestaltung an den Finanzmärkten
3. regulatorischer Fahrplan zur Erfassung, Ermöglichung und Einhegung einer digitalen Transformation des Finanzsystems
4. Vollendung der Bankenunion, insbesondere durch einen „europäischen Schlussstein“: der Schaffung einer einheitlichen Aufsicht und Letztabsicherung
5. Durchbrechung des „Doom-Loop“ zwischen Staaten und Banken in Europa, insbesondere durch Begrenzung des Umfangs, in dem eigene Staatsanleihen im Portfolio von Banken liegen dürfen
6. ernsthafter Versuch zur Schaffung eines einheitlichen und integren europäischen Kapitalmarkts mit einer Aufsicht nach US-Vorbild
7. Banken- und Kapitalmarktunion als wesentliche Bausteine für eine grundlegende Reform der Altersversorgung mit mehr Teilhabe aller Bürger:innen an der Leistungsentwicklung der Volkswirtschaft
This policy white paper shows, using data on European Commission (EC) lobby meetings, that financial institutions and finance trade associations have substantial access to EC policymakers. While lobbying could transfer policy-relevant information and expertise to policymakers, it could also result in the capture of policymakers by the industry, which could harm consumers and taxpayers. How could policymakers prevent regulatory capture, but retain the benefits of the sector expertise in policy decisions? Awareness of regulatory capture by policymakers is one of the most important remedies. This paper provides an overview of the origins of the regulatory capture theory and recent academic evidence. The paper shows that regulatory capture could emerge in a variety of institutions and policy areas but is not ubiquitous and depends on the incentives of policymakers and the policy environment. Subsequently, the paper discusses various measures to prevent regulatory capture, such as more transparency, diverse expert groups, and cooling-off periods.
With the second wave of the Covid-19 pandemic in full swing, banks face a challenging environment. They will need to address disappointing results and adverse balance sheet restatements, the intensity of which depends on the evolution of the euro area economies. At the same time, vulnerable banks reinforce real economy deficiencies. The contribution of this paper is to provide a comparative assessment of the various policy responses to address a looming banking crisis. Such a crisis will fully materialize when non-performing assets drag down banks simultaneously, raising the specter of a full-blown systemic crisis. The policy responses available range from forbearance, recapitalization (with public or private resources), asset separation (bad banks, at national or EU level), to debt conversion schemes. We evaluate these responses according to a set of five criteria that define the efficacy of each. These responses are not mutually exclusive, in practice, as they have never been. They may also go hand in hand with other restructuring initiatives, including potential consolidation in the banking sector. Although we do not make a specific recommendation, we provide a framework for policymakers to guide them in their decision making.