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A stochastic forward-looking model to assess the profitability and solvency of European insurers
(2016)
In this paper, we develop an analytical framework for conducting forward-looking assessments of profitability and solvency of the main euro area insurance sectors. We model the balance sheet of an insurance company encompassing both life and non-life business and we calibrate it using country level data to make it representative of the major euro area insurance markets. Then, we project this representative balance sheet forward under stochastic capital markets, stochastic mortality developments and stochastic claims. The model highlights the potential threats to insurers solvency and profitability stemming from a sustained period of low interest rates particularly in those markets which are largely exposed to reinvestment risks due to the relatively high guarantees and generous profit participation schemes. The model also proves how the resilience of insurers to adverse financial developments heavily depends on the diversification of their business mix. Finally, the model identifies potential negative spillovers between life and non-life business thorugh the redistribution of capital within groups.
Households buy life insurance as part of their liquidity management. The option to surrender such a policy can serve as a buffer when a household faces a liquidity need. In this study, we investigate empirically which individual and household specific sociodemographic factors influence the surrender behavior of life insurance policyholders. Based on the Socio-Economic Panel (SOEP), an ongoing wide-ranging representative longitudinal study of around 11,000 private households in Germany, we construct a proxy to identify life insurance surrender in the data. We use this proxy to conduct fixed effect regressions and support the results with survival analyses. We find that life events that possibly impose a liquidity shock to the household, such as birth of a child and divorce increase the likelihood to surrender an existing life insurance policy for an average household in the panel. The acquisition of a dwelling and unemployment are further aspects that can foster life insurance surrender. Our results are robust with respect to different models and hold conditioning on region specific trends; they vary however for different age groups. Our analyses contribute to the existing literature supporting the emergency fund hypothesis. The findings obtained in this study can help life insurers and regulators to detect and understand industry specific challenges of the demographic change.
In this paper I assess the effect of interest rate risk and longevity risk on the solvency position of a life insurer selling policies with minimum guaranteed rate of return, profit participation and annuitization option at maturity. The life insurer is assumed to be based in Germany and therefore subject to German regulation as well as to Solvency II regulation. The model features an existing back book of policies and an existing asset allocation calibrated on observed data, which are then projected forward under stochastic financial markets and stochastic mortality developments. Different scenarios are proposed, with particular focus on a prolonged period of low interest rates and strong reduction in mortality rates. Results suggest that interest rate risk is by far the greatest threat for life insurers, whereas longevity risk can be more easily mitigated and thereby is less detrimental. Introducing a dynamic demand for new policies, i.e. assuming that lower offered guarantees are less attractive to savers, show that a decreasing demand may even be beneficial for the insurer in a protracted period of low interest rates. Introducing stochastic annuitization rates, i.e. allowing for deviations from the expected annuitization rate, the solvency position of the life insurer worsen substantially. Also profitability strongly declines over time, casting doubts on the sustainability of traditional life business going forward with the low interest rate environment. In general, in the proposed framework it is possible to study the evolution over time of an existing book of policies when underlying financial market conditions and mortality developments drastically change. This feature could be of particular interest for regulatory and supervisory authorities within their financial stability mandate, who could better evaluate micro- and macro-prudential policy interventions in light of the persistent low interest rate environment.
The modern tontine: an innovative instrument for longevity risk management in an aging society
(2016)
The changing social, financial and regulatory frameworks, such as an increasingly aging society, the current low interest rate environment, as well as the implementation of Solvency II, lead to the search for new product forms for private pension provision. In order to address the various issues, these product forms should reduce or avoid investment guarantees and risks stemming from longevity, still provide reliable insurance benefits and simultaneously take account of the increasing financial resources required for very high ages. In this context, we examine whether a historical concept of insurance, the tontine, entails enough innovative potential to extend and improve the prevailing privately funded pension solutions in a modern way. The tontine basically generates an age-increasing cash flow, which can help to match the increasing financing needs at old ages. However, the tontine generates volatile cash flows, so that - especially in the context of an aging society - the insurance character of the tontine cannot be guaranteed in every situation. We show that partial tontinization of retirement wealth can serve as a reliable supplement to existing pension products.
Common systemic risk measures focus on the instantaneous occurrence of triggering and systemic events. However, systemic events may also occur with a time-lag to the triggering event. To study this contagion period and the resulting persistence of institutions' systemic risk we develop and employ the Conditional Shortfall Probability (CoSP), which is the likelihood that a systemic market event occurs with a specific time-lag to the triggering event. Based on CoSP we propose two aggregate systemic risk measures, namely the Aggregate Excess CoSP and the CoSP-weighted time-lag, that reflect the systemic risk aggregated over time and average time-lag of an institution's triggering event, respectively. Our empirical results show that 15% of the financial companies in our sample are significantly systemically important with respect to the financial sector, while 27% of the financial companies are significantly systemically important with respect to the American non-financial sector. Still, the aggregate systemic risk of systemically important institutions is larger with respect to the financial market than with respect to non-financial markets. Moreover, the aggregate systemic risk of insurance companies is similar to the systemic risk of banks, while insurers are also exposed to the largest aggregate systemic risk among the financial sector.
We designed and fielded an experimental module in the 2014 HRS which seeks to measure older persons’ willingness to voluntarily defer claiming of Social Security benefits. In addition we evaluate the stated willingness of older individuals to work longer, depending on the Social Security incentives offered to delay claiming their benefits. Our project extends previous work by analyzing the results from our HRS module and comparing findings from other data sources, which included very much smaller samples of older persons. We show that half of the respondents would delay claiming if no work requirement were in place under the status quo, and only slightly fewer, 46 percent, with a work requirement. We also asked respondents how large a lump sum they would need with or without a work requirement. In the former case, the average amount needed to induce delayed claiming was about $60,400, while when part-time work was required, the average was $66,700. This implies a low utility value of leisure foregone of only $6,300, or about 10 percent of older households’ income.
In the wake of the recent financial crisis, significant regulatory actions have been taken aimed at limiting risks emanating from banks’ trading activities. The goal of this paper is to look at the alternative reforms in the US, the UK and the EU, specifically with respect to the role of proprietary trading. Our conclusions can be summarized as follows: First, the focus on a prohibition of proprietary trading, as reflected in the Volcker Rule in the US and in the current proposal of the European Commission (Barnier proposal), is inadequate. It does not necessarily reduce risk-taking and it is likely to crowd out desired trading activities, thereby possibly affecting financial stability negatively. Second, trading separation into legally distinct or ring-fenced entities within the existing banking organizations, as suggested under the Vickers Report for the UK and the Liikanen proposal for the EU, is a more effective solution. Separation limits cross-subsidies between banking and proprietary trading and diminishes contagion risk, while still allowing for synergies and risk management across banking, non-proprietary trading and proprietary trading.
We provide an assessment of the Basel Committee on Banking Supervision (BCBS) proposal to restrict the internal ratings-based approach on bank risk and to introduce risk-weighted asset floors. If well enforced, risk-sensitive capital regulation results in a more efficient credit allocation compared to the standard approach. Thus, the internal ratings-based approach should be maintained. Further, the use of internal ratings-based output floors potentially results in unintended negative side effects. Input floors are likely a valuable tool to achieve risk-weighted assets comparability. Finally, the proposed measures have a potential detrimental impact for European banks as compared to others.
I show that disruptions to personal sources of financing, aside from commercial lending supply shocks, impair the survival and growth of small businesses. Entrepreneurs holding deposit accounts at retail banking institutions that defaulted following the financial crisis reduce personal borrowing and are consequently more likely to exit their firm. Exposure to the corresponding investment losses from delisted publicly traded bank stocks strongly reduces the rate of firm survival, particularly for early-stage ventures. At the intensive margin, owners who remain in business reduce employees after personal wealth losses. My results suggest that personal finance is an important component of firm financing.
We develop a model that endogenizes the manager's choice of firm risk and of inside debt investment strategy. Our model delivers two predictions. First, managers have an incentive to reduce the correlation between inside debt and company stock in bad times. Second, managers that reduce such a correlation take on more risk in bad times. Using a sample of U.S. public firms, we provide evidence consistent with the model's predictions. Our results suggest that the weaker link between inside debt and company stock in bad times does not translate into a mitigation of debt-equity conflicts.
This paper compares the dynamics of the financial integration process as described by different empirical approaches. To this end, a wide range of measures accounting for several dimensions of integration is employed. In addition, we evaluate the performance of each measure by relying on an established international finance result, i.e., increasing financial integration leads to declining international portfolio diversification benefits. Using monthly equity market data for three different country groups (i.e., developed markets, emerging markets, developed plus emerging markets) and a dynamic indicator of international portfolio diversification benefits, we find that (i) all measures give rise to a very similar long-run integration pattern; (ii) the standard correlation explains variations in diversification benefits as well or better than more sophisticated measures. These Findings are robust to a battery of robustness checks.
his paper examines whether investor mood, driven by World Health Organization (WHO) alerts and media news on globally dangerous diseases, is priced in pharmaceutical companies' stocks in the United States. We concentrate on irrational investors who buy and sell pharmaceutical companies' stocks guided by beliefs as opposed to rational expectations. We argue that disease-related news (DRNs) should not trigger rational trading. We find that DRNs have a positive and significant sentiment effect among investors (on Wall Street). The effect is stronger (weaker) for small (large) companies, who are less (more) likely to engage in the development of new vaccines in the wake of DRNs. A potential negative mood (on Main Street) – induced by disease related fear – does not alter the positive sentiment effect. Our findings give rise to profitable trading strategies leading to significantly positive performances. Overall, this unparalleled research shows that large events of devastating nature to the economy can be considered as good news to some groups of interest, such as stock market traders.
In a field study with more than 1.500 customers of an online-broker we test what happens when investors receive repeated feedback on their investment success in a monthly securities account report. The reports show investors’ last year’s returns, costs, their current level of risk and their portfolio diversification. We find that receiving a report results in investors trading less, diversifying more and having higher risk-adjusted returns. Results are robust to controlling for potential play money accounts and changes in report designs. We also find that investors who are less likely to subscribe equally benefit from the report.
We study the impact of higher capital requirements on banks’ balance sheets and its transmission to the real economy. The 2011 EBA capital exercise provides an almost ideal quasi-natural experiment, which allows us to identify the effect of higher capital requirements using a difference-in-differences matching estimator. We find that treated banks increase their capital ratios not by raising their levels of equity, but by reducing their credit supply. We also show that this reduction in credit supply results in lower firm-, investment-, and sales growth for firms which obtain a larger share of their bank credit from the treated banks.
This paper studies the role of the Community Reinvestment Act (CRA) in the recent US housing boom-bust cycle. Using a difference-in-differences matching estimation, I find that the enhancement of CRA enforcement in 1998 caused a 7.7 percentage points increase in annual growth rate of mortgage lending by CRA-regulated banks to CRA-eligible census tracts relative to a group of similar-income CRA-ineligible census tracts within the same state. Financial institutions which are not subject to the CRA, however, do not show any change in their mortgage supply between these two types of census tracts after 1998. I take advantage of this exogenous shift in mortgage supply within an instrumental variable framework to identify the causal effect of mortgage supply on housing prices. I find that every 1 percentage point higher annual growth rate of mortgage supply leads to 0.3 percentage points higher annual growth rate of housing prices. Reduced form regressions show that CRA-eligible neighborhoods experienced higher house price growth during the boom and sharper decline during the bust period. I use placebo tests to confirm that this effect is in fact channeled through the shift in mortgage supply by CRA-regulated banks and not by unobserved demand factors. Furthermore, my results indicate that CRA-induced mortgages went to borrowers with lower FICO scores, carried higher interest rates, and encountered more frequent delinquencies.
In order to better differentiate the drivers of corporations’ actions, in particular shareholder wealth and stakeholder interests, the paper explores the significance of the comply or explain-principle and its underlying enforcement mechanisms more generally. Against this background, compliance rates with specific provisions may shed a light on companies’ reasons for following the code. An analysis of these rates at the example of distinct provisions of the German Corporate Governance Code is therefore entered into. In light of the current corporate governance debate and the legitimacy problems that are raised, among the code provisions that exemplify these questions very well are those regulating incentive pay, severance pay caps, and age limits for supervisory board members. Their analysis will lay a basis for an answer to the question about what motivates companies to comply with the code. The motivation then paves the way to arrive at a further specification of the determinants of the regulatory evolution of the Code and the range of stakeholders and their concerns that enter into it.
Little evidence exists on the financing decisions of newly founded firms or on the financing dynamics of these firms over their life cycle. We aim to help filling this gap by investigating the financing dynamics of 2,456 French manufacturing firms founded between 2004 and 2006 through their legally required and reported financial statements. Because we observe significant heterogeneity in the financing decision in the firms' founding year, we focus on analyzing whether these differences widen, persist, or converge by using different convergence concepts. We identify a persistence-cum-convergence pattern. We find the existence of ß-convergence (implying that e.g. firms with lower initial levels of debt accumulate more debt over time) but not of σ-convergence (i.e. we observe an increase in the cross-sectional dispersion of the financing structure). We also show that the dynamics of financing matter for the growth path of the firms.
The ECB’s Outright Monetary Transactions (OMT) program, launched in summer 2012, indirectly recapitalized periphery country banks through its positive impact on the value of sovereign bonds. However, the regained stability of the European banking sector has not fully transferred into economic growth. We show that zombie lending behavior of banks that still remained undercapitalized after the OMT announcement is an important reason for this development. As a result, there was no positive impact on real economic activity like employment or investment. Instead, firms mainly used the newly acquired funds to build up cash reserves. Finally, we document that creditworthy firms in industries with a high prevalence of zombie firms suffered significantly from the credit misallocation, which slowed down the economic recovery.
The global financial crisis and the ensuing criticism of macroeconomics have inspired researchers to explore new modeling approaches. There are many new models that deliver improved estimates of the transmission of macroeconomic policies and aim to better integrate the financial sector in business cycle analysis. Policy making institutions need to compare available models of policy transmission and evaluate the impact and interaction of policy instruments in order to design effective policy strategies. This paper reviews the literature on model comparison and presents a new approach for comparative analysis. Its computational implementation enables individual researchers to conduct systematic model comparisons and policy evaluations easily and at low cost. This approach also contributes to improving reproducibility of computational research in macroeconomic modeling. Several applications serve to illustrate the usefulness of model comparison and the new tools in the area of monetary and fiscal policy. They include an analysis of the impact of parameter shifts on the effects of fiscal policy, a comparison of monetary policy transmission across model generations and a cross-country comparison of the impact of changes in central bank rates in the United States and the euro area. Furthermore, the paper includes a large-scale comparison of the dynamics and policy implications of different macro-financial models. The models considered account for financial accelerator effects in investment financing, credit and house price booms and a role for bank capital. A final exercise illustrates how these models can be used to assess the benefits of leaning against credit growth in monetary policy.
Amid increasing regulation, structural changes of the market and Quantitative Easing as well as extremely low yields, concerns about the market liquidity of the Eurozone sovereign debt markets have been raised. We aim to quantify illiquidity risks, especially such related to liquidity dry-ups, and illiquidity spillover across maturities by examining the reaction to illiquidity shocks at high frequencies in two ways:
a) the regular response to shocks using a variance decomposition and,
b) the response to shocks in the extremes by detecting illiquidity shocks and modeling those as ultivariate Hawkes processes.
We find that:
a) market liquidity is more fragile and less predictable when an asset is very illiquid and,
b) the response to shocks in the extremes is structurally different from the regular response.
In 2015 long-term bonds are less liquid and the medium-term bonds are liquid, although we observe that in the extremes the medium-term bonds are increasingly driven by illiquidity spillover from the long-term titles.
Most defined contribution pension plans pay benefits as lump sums, yet the US Treasury has recently encouraged firms to protect retirees from outliving their assets by converting a portion of their plan balances into longevity income annuities (LIA). These are deferred annuities which initiate payouts not later than age 85 and continue for life, and they provide an effective way to hedge systematic (individual) longevity risk for a relatively low price. Using a life cycle portfolio framework, we measure the welfare improvements from including LIAs in the menu of plan payout choices, accounting for mortality heterogeneity by education and sex. We find that introducing a longevity income annuity to the plan menu is attractive for most DC plan participants who optimally commit 8-15% of their plan balances at age 65 to a LIA that starts paying out at age 85. Optimal annuitization boosts welfare by 5-20% of average retirement plan accruals at age 66 (assuming average mortality rates), compared to not having access to the LIA. We also compare the optimal LIA allocation versus two default options that plan sponsors could implement. We conclude that an approach where a fixed fraction over a dollar threshold is invested in LIAs will be preferred by most to the status quo, while enhancing welfare for the majority of workers.
Systemic co-jumps
(2016)
The simultaneous occurrence of jumps in several stocks can be associated with major financial news, triggers short-term predictability in stock returns, is correlated with sudden spikes of the variance risk premium, and determines a persistent increase (decrease) of stock variances and correlations when they come along with bad (good) news. These systemic events and their implications can be easily overlooked by traditional univariate jump statistics applied to stock indices. They are instead revealed in a clearly cut way by using a novel test procedure applied to individual assets, which is particularly effective on high-volume stocks.
This paper addresses whether and to what extent econometric methods used in experimental studies can be adapted and applied to financial data to detect the best-fitting preference model. To address the research question, we implement a frequently used nonlinear probit model in the style of Hey and Orme (1994) and base our analysis on a simulation stud. In detail, we simulate trading sequences for a set of utility models and try to identify the underlying utility model and its parameterization used to generate these sequences by maximum likelihood. We find that for a very broad classification of utility models, this method provides acceptable outcomes. Yet, a closer look at the preference parameters reveals several caveats that come along with typical issues attached to financial data, and that some of these issues seems to drive our results. In particular, deviations are attributable to effects stemming from multicollinearity and coherent under-identification problems, where some of these detrimental effects can be captured up to a certain degree by adjusting the error term specification. Furthermore, additional uncertainty stemming from changing market parameter estimates affects the precision of our estimates for risk preferences and cannot be simply remedied by using a higher standard deviation of the error term or a different assumption regarding its stochastic process. Particularly, if the variance of the error term becomes large, we detect a tendency to identify SPT as utility model providing the best fit to simulated trading sequences. We also find that a frequent issue, namely serial correlation of the residuals, does not seem to be significant. However, we detected a tendency to prefer nesting models over nested utility models, which is particularly prevalent if RDU and EXPO utility models are estimated along with EUT and CRRA utility models.
Microeconomic modeling of investors behavior in financial markets and its results crucially depends on assumptions about the mathematical shape of the underlying preference functions as well as their parameterizations. With the purpose to shed some light on the question, which preferences towards risky financial outcomes prevail in stock markets, we adopted and applied a maximum likelihood approach from the field of experimental economics on a randomly selected dataset of 656 private investors of a large German discount brokerage firm. According to our analysis we find evidence that the majority of these clients follow trading pattern in accordance with Prospect Theory (Kahneman and Tversky (1979)). We also find that observable sociodemographic and personal characteristics such as gender or age don't seem to correlate with specific preference types. With respect to the overall impact of preferences on trading behavior, we find a moderate impact of preferences on trading decisions of individual investors. A classification of investors according to various utility types reveals that the strength of the impact of preferences on an investors' rading behavior is not connected to most personal characteristics, but seems to be related to round-trip length.
Shortcomings revealed by experimental and theoretical researchers such as Allais (1953), Rabin (2000) and Rabin and Thaler (2001) that put the classical expected utility paradigm von Neumann and Morgenstern (1947) into question, led to the proposition of alternative and generalized utility functions, that intend to improve descriptive accuracy. The perhaps best known among those alternative preference theories, that has attracted much popularity among economists, is the so called Prospect Theory by Kahneman and Tversky (1979) and Tversky and Kahneman (1992). Its distinctive features, governed by its set of risk parameters such as risk sensitivity, loss aversion and decision weights, stimulated a series of economic and financial models that build on the previously estimated parameter values by Tversky and Kahneman (1992) to analyze and explain various empirical phenomena for which expected utility doesn't seem to offer a satisfying rationale. In this paper, after providing a brief overview of the relevant literature, we take a closer look at one of those papers, the trading model of Vlcek and Hens (2011) and analyze its implications on Prospect Theory parameters using an adopted maximum likelihood approach for a dataset of 656 individual investors from a large German discount brokerage firm. We find evidence that investors in our dataset are moderately averse to large losses and display high risk sensitivity, supporting the main assumptions of Prospect Theory.
Ongoing demographic change will lead to a relative scarcity of raw labor to the effect that output growth will be decreasing in the next decades, a secular stagnation. As physical capital will be relatively abundant, this decrease of output will be accompanied by reductions of asset returns. We quantify these effects for the US economy by developing an overlapping generations model with risky and risk-free assets. Without adjustments of human capital, risky returns decrease until 2035 by about 0.7 percentage point, and the risk-free rate by about one percentage point, leading to substantial welfare losses for asset rich households. Per capita output is reduced by 6%. Endogenous human capital adjustments strongly mitigate these effects. We conclude that human capital policies will be crucial in the context of labor shortages.
We study whether the presence of low-latency traders (including high-frequency traders (HFTs)) in the pre-opening period contributes to market quality, defined by price discovery and liquidity provision, in the opening auction. We use a unique dataset from the Tokyo Stock Exchange (TSE) based on server-IDs and find that HFTs dynamically alter their presence in different stocks and on different days. In spite of the lack of immediate execution, about one quarter of HFTs participate in the pre-opening period, and contribute significantly to market quality in the pre-opening period, the opening auction that ensues and the continuous trading period. Their contribution is largely different from that of the other HFTs during the continuous period.
The equity trading landscape all over the world has changed dramatically in recent years. We have witnessed the advent of new trading venues and significant changes in the market shares of existing ones. We use an extensive panel dataset from the European equity markets to analyze the market shares of five categories of lit and dark trading mechanisms. Market design features, such as minimum tick size, immediacy and anonymity; market conditions, such as liquidity and volatility; and the informational environment have distinct implications for order routing decisions and trading venues' resulting market shares. Furthermore, these implications differ distinctly for small and large trades, probably because traders jointly optimize their trade size and venue choice. Our results both confirm and go beyond current theoretical predictions on trading in fragmented markets.
Using two datasets containing demographically representative samples of the Dutch population, I study how lifetime experiences of aggregate labor market conditions affect personality. Three sets of findings are reported. First, experienced aggregate unemployment is negatively correlated with the levels of all Big Five personality traits, except for conscientiousness (no significant correlation). Second, in panel data models with individual fixed effects I find that changes in experienced aggregate unemployment cause changes in emotional stability and agreeableness for men, and conscientiousness for women. The correlation is positive, and effects are economically large. Thirdly, I report suggestive evidence that the main driver is experienced aggregate unemployment, instead of other macroeconomic variables as experienced GDP, stock market returns or inflation. Taken together, these findings suggest that changes in Big Five personality traits are systematically related to experienced aggregate labor market conditions.
This paper is the outcome of a related broader project, exploring the explanatory power of the Legal Theory of Finance, which proposes a new institution-based analytical framework for the analysis of phenomena of financial markets. One of its most important theoretical assumptions, the legal construction of financial markets, is highlighted by the example of the private creation of money by structured finance products in this paper. Further implications can then be shown referring to pari passu clauses and collective action clauses, which are both exhibit a differential application of these legal rules according to the hierarchical status of the respective market participant, and can therefore endanger sovereign debt restructurings. Legal instruments to avoid this are briefly explored. An example of another key role of the law in crisis that is the task to resolve the tension between market discipline and financial stability is exemplified by the regulation of the OTC derivatives market and proposals of effective loss-sharing among CCPs. Related questions about the significance of legal rules to ensure financial stability are raised in the analysis of minimum capital requirements under Basel III.
“Institutional Overburdening” to a large extent was a consequence of the “Great Moderation”. This term indicates that it was a period in which inflation had come down from rather high levels. Growth and employment were at least satisfying and variability of output had substantially declined. It was almost unavoidable that as a consequence expectations on future actions of central banks and their ability to control the economy reached an unprecedented peak which was hardly sustainable. Institutional overburdening has two dimensions. One is coming from exaggerated expectations on what central banks can achieve (“expectational overburdening”). The other dimension is “operational overburdening” i.e. overloading the central bank with more and more responsibilities and competences.
This note discusses the basic economics of central clearing for derivatives and the need for a proper regulation, supervision and resolution of central counterparty clearing houses (CCPs). New regulation in the U.S. and in Europe renders the involvement of a central counterparty mandatory for standardized OTC derivatives’ trading and sets higher capital and collateral requirements for non-centrally cleared derivatives.
From a macrofinance perspective, CCPs provide a trade-off between reduced contagion risk in the financial industry and the creation of a significant systemic risk. However, so far, regulation and supervision of CCPs is very fragmented, limited and ignores two important aspects: the risk of consolidation of CCPs on the one side and the competition among CCPs on the other side. i) As the economies of scale of CCP operations in risk and cost reduction can be large, they provide an argument in favor of consolidation, leading at the extreme to a monopoly CCP that poses the ultimate default risk – a systemic risk for the entire financial sector. As a systemic risk event requires a government bailout, there is a public policy issue here. ii) As long as no monopoly CCP exists, there is competition for market share among existing CCPs. Such competition may undermine the stability of the entire financial system because it induces “predatory margining”: a reduction of margin requirements to increase market share.
The policy lesson from our consideration emphasizes the importance of a single authority supervising all competing CCPs as well as of a specific regulation and resolution framework for CCPs. Our general recommendations can be applied to the current situation in Europe, and the proposed merger between Deutsche Börse and London Stock Exchange.
Mis-selling by banks has occurred repeatedly in many nations over the last decade. While clients may benefit from competition – enabling them to choose financial services at lowest costs – economic frictions between banks and clients may give rise to mis-selling. Examples of mis-selling are mis-representation of information, overly complex product design and non-customized advice. European regulators address the problem of mis-selling in the "Markets in Financial Instruments Directive" (MiFID) I and II and the "Markets in Financial Instruments Regulation" (MiFIR), by setting behavioral requirements for banks, regulating the compensation of employees, and imposing re-quirements on offered financial products and disclosure rules.
This paper argues that MiFID II protects clients but is not as effective as it could be. (1) It does not differentiate between client groups with different levels of financial literacy. Effective advice requires different advice for different client groups. (2) MiFID II uses too many rules and too many instruments to achieve identical goals and thereby generates excessive compliance costs. High compliance costs and low revenues would drive banks out of some segments of retail business.
Under ordinary circumstances, the fiscal implications of central bank policies tend to be seen as relatively minor and escape close scrutiny. The global financial crisis of 2008, however, demanded an extraordinary response by central banks which brought to light the immense power of central bank balance sheet policies as well as their major fiscal implications. Once the zero lower bound on interest rates is reached, expanding a central bank’s balance sheet becomes the central instrument for providing additional monetary policy accommodation. However, with interest rates near zero, the line separating fiscal and monetary policy is blurred. Furthermore, discretionary decisions associated with asset purchases and liquidity provision, as well as with lender-of-last-resort operations benefiting private entities, can have major distributional effects that are ordinarily associated with fiscal policy. In the euro area, discretionary central bank decisions can have immense distributional effects across member states. However, decisions of this nature are incompatible with the role of unelected officials in democratic societies. Drawing on the response to the crisis by the Federal Reserve and the ECB, this paper explores the tensions arising from central bank balance sheet policies and addresses pertinent questions about the governance and accountability of independent central banks in a democratic society.
We consider an infinitely repeated game in which a privately informed, long-lived manager raises funds from short-lived investors in order to finance a project. The manager can signal project quality to investors by making a (possibly costly) forward-looking disclosure about her project’s potential for success. We find that if the manager’s disclosures are costly, she will never release forward-looking statements that do not convey information to external investors. Furthermore, managers of firms that are transparent and face significant disclosure-related costs will refrain from forward-looking disclosures. In contrast, managers of opaque and profitable firms will follow a policy of accurate disclosures. To test our findings empirically, we devise an index that captures the quantity of forward-looking disclosures in public firms’ 10-K reports, and relate it to multiple firm characteristics. For opaque firms, our index is positively correlated with a firm’s profitability and financing needs. For transparent firms, there is only a weak relation between our index and firm fundamentals. Furthermore, the overall level of forward-looking disclosures declined significantly between 2001 and 2009, possibly as a result of the 2002 Sarbanes-Oxley Act.
We show that the net corporate payout yield predicts both the stock market index and house prices and that the log home rent-price ratio predicts both house prices and labor income growth. We incorporate the predictability in a rich life-cycle model of household decisions involving consumption of both perishable goods and housing services, stochastic and unspanned labor income, stochastic house prices, home renting and owning, stock investments, and portfolio constraints. We find that households can significantly improve their welfare by optimally conditioning decisions on the predictors. For a modestly risk-averse agent with a 35-year working period and a 15-year retirement period, the present value of the higher average life-time consumption amounts to roughly $179,000 (assuming both an initial wealth and an initial annual income of $20,000), and the certainty equivalent gain is around 5.5% of total wealth (financial wealth plus human capital). Furthermore, every cohort of agents in our model would have benefited from applying predictor-conditional strategies along the realized time series over our 1960-2010 data period.
Since the outbreak of the financial crisis, the macro-prudential policy paradigm has gained increasing prominence (Bank of England, 2009; Bernanke, 2011). The dynamics of this shift in the economic discourse, and the reasons this shift has not taken place prior to the crisis have not been addressed systemically. This paper investigates the evolution of the economic discourse on systemic risk and banking regulation to better understand these changes and their timing. Further, we use our sample to inquire whether, and if so, why the economic regulatory studies failed to recommend a reliable banking regulation prior to the crisis. By following a discourse analysis, we establish that the economic discourse on banking regulation has not been suitable for providing the knowledge basis required for a dynamically reliable banking regulation, and we identify the underlying reasons for such failure. These reasons include the obsession of economic discourse with optimization and particular forms of formalism, particularly, partial equilibrium analysis. Further, the economic discourse on banking regulation excludes historical and practitioners’ discourses and ignores weak signals. We point out that post-crisis, these epistemological failures of the economic discourse on banking regulation were not sufficiently recognized and that recent attempts to conceptualize systemic risk as a negative externality and to thus price it point to the persistence of formalism, equilibrium thinking and optimization, with their attending dangers.
A stochastic forward-looking model to assess the profitability and solvency of european insurers
(2016)
In this paper, we develop an analytical framework for conducting forward-looking assessments of profitability and solvency of the main euro area insurance sectors. We model the balance sheet of an insurance company encompassing both life and non-life business and we calibrate it using country level data to make it representative of the major euro area insurance markets. Then, we project this representative balance sheet forward under stochastic capital markets, stochastic mortality developments and stochastic claims. The model highlights the potential threats to insurers solvency and profitability stemming from a sustained period of low interest rates particularly in those markets which are largely exposed to reinvestment risks due to the relatively high guarantees and generous profit participation schemes. The model also proves how the resilience of insurers to adverse financial developments heavily depends on the diversification of their business mix. Finally, the model identifies potential negative spillovers between life and non-life business thorugh the redistribution of capital within groups.
Recently there has been an explosion of research on whether the equilibrium real interest rate has declined, an issue with significant implications for monetary policy. A common finding is that the rate has declined. In this paper we provide evidence that contradicts this finding. We show that the perceived decline may well be due to shifts in regulatory policy and monetary policy that have been omitted from the research. In developing the monetary policy implications, it is promising that much of the research approaches the policy problem through the framework of monetary policy rules, as uncertainty in the equilibrium real rate is not a reason to abandon rules in favor of discretion. But the results are still inconclusive and too uncertain to incorporate into policy rules in the ways that have been suggested.
Understanding the shift from micro to macro-prudential thinking: a discursive network analysis
(2016)
While some economists argued for macro-prudential regulation pre-crisis, the macro-prudential approach and its emphasis on endogenously created systemic risk have only gained prominence post-crisis. Employing discourse and network analysis on samples of the most cited scholarly works on banking regulation as well as on systemic risk (60 sources each) from 1985 to 2014, we analyze the shift from micro to macro-prudential thinking in the shift to the post crisis period. Our analysis demonstrates that the predominance of formalism, particularly, partial equilibrium analysis along with the exclusion of historical and practitioners’ styles of reasoning from banking regulatory studies impeded economists from engaging seriously with the endogenous sources of systemic risk prior to the crisis. Post-crisis, these topics became important in this discourse, but the epistemological failures of banking regulatory studies pre-crisis were not sufficiently recognized. Recent attempts to conceptualize and price systemic risk as a negative externality point to the persistence of formalism and equilibrium thinking, with its attending dangers of incremental innovation due to epistemological barriers constrains theoretical progress, by excluding observed phenomena, which cannot yet be accommodated in mathematical models.
We argue two alternative routes that lead entrepreneurial start-ups to acquisition outcomes instead of liquidation. On one hand, acquisitions can come about through the control route with external financers such as venture capitalists (VCs). VCs take control through their board seats along with other contractual rights that can bring about changes in a start-up necessary to successfully attract a strategic acquirer. Consistent with this view, we show that VCs often replace the founding entrepreneur as CEO long before an acquisition exit. On the other hand, acquisitions can come about through advice and support provided to the start-up, such as that provided by an incubator or technology park. Based on a sample of 251 Crunchbase companies in the U.S. over the years 2007 to 2014, we present evidence that is strongly consistent with these propositions. Further, we show that the data indicate a tension between VC-backing of start-ups resident in technology parks insofar as such start-ups are slower to become, and less likely to be, acquired.
Intrinsic motivation for honesty is perceived as an important determinant of large and persistent variation in cheating behavior. However, little is known about its actual role due to challenges in obtaining precise measures of motivation for honesty, as well as field outcomes on cheating. We fill these gaps using a unique setting of informal milk markets in India. A novel behavioral experiment, which combines a standard die roll task with Bluetooth technology, is used to measure motivation for honesty of milkmen at both extensive and intensive margins. We then buy milk from the same milkmen and show that cheating in the field, measured by the amount of water added to milk, widens significantly with a milkman’s degree of dishonesty. Additional analyses show that conventional binary measure of motivation for honesty suffers from measurement errors, resulting in underestimation of this association.
In this paper, we examine how the institutional design affects the outcome of bank bailout decisions. In the German savings bank sector, distress events can be resolved by local politicians or a state-level association. We show that decisions by local politicians with close links to the bank are distorted by personal considerations: While distress events per se are not related to the electoral cycle, the probability of local politicians injecting taxpayers’ money into a bank in distress is 30 percent lower in the year directly preceding an election. Using the electoral cycle as an instrument, we show that banks that are bailed out by local politicians experience less restructuring and perform considerably worse than banks that are supported by the savings bank association. Our findings illustrate that larger distance between banks and decision makers reduces distortions in the decision making process, which has implications for the design of bank regulation and supervision.
We employ a unique dataset on members of an elite service club in Germany to investigate how elite networks affect the allocation of resources. Specifically, we investigate credit allocation decisions of banks to firms inside the network. Using a quasi-experimental research design, we document misallocation of bank credit inside the network, with state-owned banks engaging most actively in crony lending. The aggregate cost of credit misallocation amounts to 0.13 percent of annual GDP. Our findings, thus, resonate with existing theories of elite networks as rent extractive coalitions that stifle economic prosperity.
The term 'financialization' describes the phenomenon that commodity contracts are traded for purely financial reasons and not for motives rooted in the real economy. Recently, financialization has been made responsible for causing adverse welfare effects especially for low-income and low-wealth agents, who have to spend a large share of their income for commodity consumption and cannot participate in financial markets. In this paper we study the effect of financial speculation on commodity prices in a heterogeneous agent production economy with an agricultural and an industrial producer, a financial speculator, and a commodity consumer. While access to financial markets is always beneficial for the participating agents, since it allows them to reduce their consumption volatility, it has a decisive effect with respect to overall welfare effects who can trade with whom (but not so much what types of instruments can be traded).
The eurozone remains in a deep, largely macro-economic crisis. A robust global economy and falling oil prices have supported Europe’s economy for some time, but by now it is clear that the eurozone will only be able to pull itself out of this crisis by means of more decisive action. One response, the recent easing of monetary policy by the European Central Bank (ECB), has, for the most part, been sharply and one-sidedly criticised in Germany. Monetary policy inaction seems to be the preferred option of many in Germany.
The authors discuss the following question: What would happen if the ECB failed to respond to the excessively low inflation and the weak economy? And what economic policy would be suitable under the current circumstances, if not monetary policy?
Euro area shadow banking activities in a low-interest-rate environment: a flow-of-funds perspective
(2016)
Very low policy rates as well as the substantial redesign of rules and supervisory institutions have changed background conditions for the Euro Area’s financial intermediary sector substantially. Both policy initiatives have been targeted at improving societal welfare. And their potential side effects (or costs) have been discussed intensively, in academic as well as policy circles. Very low policy rates (and correspondingly low market rates) are likely to whet investors’ risk taking incentives. Concurrently, the tightened regulatory framework, in particular for banks, increases the comparative attractiveness of the less regulated, so-called shadow banking sector. Employing flow-of-funds data for the Euro Area’s non-bank banking sector we take stock of recent developments in this part of the financial sector. In addition, we examine to which extent low interest rates have had an impact on investment behavior. Our results reveal a declining role of banks (and, simultaneously, an increase in non-bank banking). Overall intermediation activity, hence, has remained roughly at the same level. Moreover, our findings also suggest that non-bank banks have tended to take positions in riskier assets (particularly in equities). In line with this observation, balance-sheet based risk measures indicate a rise in sector-specific risks in the non-bank banking sector (when narrowly defined).
Non-bank (-balance sheet) based financial intermediation has become considerably more important over the last couple of decades. For the U.S., this trend has been discussed ever since the mid-1990s. As a consequence, traditional monetary transmission mechanisms, mainly operating through bank balance sheets, have apparently become less relevant. This in particular applies to the bank lending channel. Concurrently, recent theoretical and empirical work uncovered a "risk-taking channel" of monetary policy. This mechanism is not confined to traditional banks but has been found to operate also across the spectrum of financial intermediaries and intermediation devices, including securitization and collateralized lending/borrowing. In addition, recent empirical evidence suggests that the increasing importance of shadow-banking activities might have given rise to a so-called "waterbed effect". This is a mediating mechanisms, dampening or counteracting typically to be expected reactions to monetary policy impulses. Employing flow-of-funds data, we can document also for the Euro Area that a trend towards non-bank (not necessarily more 'market'-based) intermediation has occurred. This is, however, a fairly recent development, substantially weaker than in the U.S. Nonetheless, analyzing the response of Euro Area bank and nonbank financial intermediaries to monetary policy impulses, we find some notable behavioral differences between mainly deposit-funded and more 'market'-based financial intermediaries. We also detect, inter alia, the existence of a (still) fairly weak, but potentially policyrelevant, "waterbed" effect.
his paper analyses the consumption-investment problem of a loss averse investor equipped with s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descend to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and rebalanced more aggressively toward stocks in bad times. This consumption-investment strategy contrasts with customary portfolio theory and is consistent with several recent stylized facts about investors' behaviour. I also analyse the joint effect of loss aversion and persistence of the reference level on optimal choices. Finally, the strategy of the loss averse investor outperforms the conventional Merton-style strategies in bad times, but tend to be dominated by the conventional strategies in good times.
We introduce long-run investment productivity risk in a two-sector production economy to explain the joint behavior of macroeconomic quantities and asset prices. Long-run productivity risk in both sectors, for which we provide economic and empirical justification, acts as a substitute for shocks to the marginal efficiency of investments in explaining the equity premium and the stock return volatility differential between the consumption and the investment sector. Moreover, adding moderate wage rigidities allows the model to reproduce the empirically observed positive co-movement between consumption and investment growth.
This paper introduces endogenous preference evolution into a Lucas-type economy and explores its consequences for investors' trading strategy and the dynamics of asset prices. In equilibrium, investors herd and hold the same portfolio of risky assets which is biased toward stocks of sectors that produce a socially preferred good. Price-dividend ratios, expected returns and return volatility are all time varying. In this way, preference evolution helps rationalize the observed under-performance and local biases of investors' portfolios and many empirical regularities of stock returns such a time variation, the value-growth effect and stochastic volatility.
Keywords: Asset pricing, general equilibrium, heterogeneous investors, interdependent preferences, portfolio choice
JEL Classification: D51, D91, E20, G12
We investigate the role of competition on the outcome of Austrian Treasury auctions. Austria's EU accession led to an increase in the number of banks participating in treasury auctions. We use structural estimates of bidders' private values to examine the effect of increased competition on auction performance: We find that increased competition reduced bidder surplus substantially, but less than reduced form estimates would suggest. A significant component of the surplus reduction is due to more aggressive bidding. Counterfactuals establish that as competition increases, concerns regarding auction format play a smaller role.
Private equity fund managers are typically required to invest their own money alongside the fund. We examine how this coinvestment affects the acquisition strategy of leveraged buyout funds. In a simple model, where the investment and capital structure decisions are made simultaneously, we show that a higher coinvestment induces managers to chose less risky firms and use more leverage. We test these predictions in a unique sample of private equity investments in Norway, where the fund manager's taxable wealth is publicly available. Consistent with the model, portfolio company risk decreases and leverage ratios increase with the coinvestment fraction of the manager's wealth. Moreover, funds requiring a relatively high coinvestment tend to spread its capital over a larger number of portfolio firms, consistent with a more conservative investment policy.
This paper describes cash equity markets in Germany and their evolution against the background of technological and regulatory transformation. The development of these secondary markets in the largest economy in Europe is first briefly outlined from a historical perspective. This serves as the basis for the description of the most important trading system for German equities, the Xetra trading system of Deutsche Börse AG. Then, the most important regulatory change for European and German equity markets in the last ten years is illustrated: the introduction of the Markets in Financial Instruments Directive (MiFID) in 2007. Its implications on equity trading in Germany are analyzed against the background of the current status of competition in Europe. Recent developments in European equity markets like the emergence of dark pools and algorithmic / high frequency trading are portrayed, before an outlook on new regulations (MiFID II, MiFIR) that will likely come into force in early 2018 will close the paper.
In the wake of the recent financial crisis, significant regulatory actions have been taken aimed at limiting risks emanating from trading in bank business models. Prominent reform proposals are the Volcker Rule in the U.S., the Vickers Report in the UK, and, based on the Liikanen proposal, the Barnier proposal in the EU. A major element of these reforms is to separate “classical” commercial banking activities from securities trading activities, notably from proprietary trading. While the reforms are at different stages of implementation, there is a strong ongoing discussion on what possible economic consequences are to be expected. The goal of this paper is to look at the alternative approaches of these reform proposals and to assess their likely consequences for bank business models, risk-taking and financial stability. Our conclusions can be summarized as follows: First, the focus on a prohibition of only proprietary trading, as envisaged in the current EU proposal, is inadequate. It does not necessarily reduce risk-taking and it likely crowds out desired trading activities, thereby negatively affecting financial stability. Second, there is potentially a better solution to limit excessive trading risk at banks in terms of potential welfare consequences: Trading separation into legally distinct or ring-fenced entities within the existing banking organizations. This kind of separation limits cross-subsidies between banking and proprietary trading and diminishes contagion risk, while still allowing for synergies across banking, non-proprietary trading and proprietary trading.
An important prerequisite for the efficiency of bail-in as a regulatory tool is that debt holders are able to bear the cost of a bail-in. Examining European banks’ subordinated debt we caution that households may be investors in bail-in able bonds. Since households do not fulfil the aforementioned prerequisite, we argue that European bank supervisors need to ensure that banks’ bail-in bonds are held by sophisticated investors. Existing EU market regulation insufficiently addresses mis-selling of bail-in instruments.
A number of contributions to research on monetary policy have suggested that policy should be asymmetric near the lower bound on nominal interest rates. As inflation and economic activity decline, policy should ease more aggressively than it would in the absence of the lower bound. As activity recovers and inflation picks up, the central bank should act to keep interest rates lower for longer than without the bound. In this note, we investigate to what extent the policy easing implemented by the ECB since summer 2013 mirrors the rate recommendations of a simple policy rule or deviates from it in a way that indicates a “lower for longer” approach to policy near zero interest rates.
This paper investigates the potential implications of say on pay on management remuneration in Germany. We try to shed light on some key aspects by presenting quantitative data that allows us to gauge the pertinent effects of the German natural experiment that originates with the 2009 amendments to the Stock Corporation Act of 1965. In order to do this, we deploy a hand-collected data set for Germany's major firms (i.e. DAX 30), for the years 2006-2012. Rather than focusing exclusively on CEO remuneration we collected data for all members of the management board for the whole period under investigation. We observe that the compensation packages of management board members of Germany's DAX30-firms are quite closely linked to key performance measures. In addition, we find that salaries increase with the size of the company and that ownership concentration has no significant effect on compensation. Also, our findings suggest that the two-tier system seems to matter a lot when it comes to compensation. However, it would be misleading to state that we see no significant impact of the introduction of the German say on pay-regime. Our findings suggest that supervisory boards anticipate shareholder-behavior.
In a production economy with trade in financial markets motivated by the desire to share labor-income risk and to speculate, we show that speculation increases volatility of asset returns and investment growth, increases the equity risk premium, and reduces welfare. Regulatory measures, such as constraints on stock positions, borrowing constraints, and the Tobin tax have similar effects on financial and macroeconomic variables. Borrowing limits and a financial transaction tax improve welfare because they substantially reduce speculative trading without impairing excessively risk-sharing trades.
The old boy network: the impact of professional networks on remuneration in top executive jobs
(2016)
We investigate the impact of social networks on earnings using a dataset of over 20,000 senior executives of European and US firms. The size of an individual's network of influential former colleagues has a large positive association with current remuneration. An individual at the 75th percentile in the distribution of connections could expect to have a salary nearly 20 per cent higher than an otherwise identical individual at the median. We use a placebo technique to show that our estimates reflect the causal impact of connections and not merely unobserved individual characteristics. Networks are more weakly associated with women's remuneration than with men's. This mainly reflects an interaction between unobserved individual characteristics and firm recruitment policies. The kinds of firm that best identify and advance talented women are less likely to give them access to influential networks than are firms that do the same for the most talented men.
The dynamics of entrepreneurial careers in high-tech ventures: experience, education, and exit
(2016)
We investigate the career dynamics of high-tech entrepreneurs by analyzing the exit choice of entrepreneurs: to found another firm, to become dependently employed, or to act as a business angel. Our detailed data resting on the CrunchBase online database indicate that founders stick with entrepreneurship as a serial entrepreneur or as an angel investor only in cases where the founder (1) had experience either in founding other startups or working for a startup, (2) had a ‘jack-of-all-trades’ education, or (3) achieved substantial financial success upon a venture capital exit transaction.