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The issuance of sustainability-linked loans (SLLs) has grown exponentially in recent years. Using a scoring methodology, we examine the underlying key performance indicators of a large sample of SLLs and analyze whether their design creates effective incentives for improving corporate sustainability performance. We demonstrate that the majority of loans fails to meet key requirements that would make them credible instruments for generating effective sustainability incentives. These findings call into question the actual sustainability impact that may be achieved through the issuance of ESG-linked debt.
This study looks at potential windfall profits for the four banking acquisitions in 2023. Based on accounting figures, an FT article states that a total of USD 44bn was left on the table. We see accounting figures as a misleading analysis. By estimating marked-based cumulative abnormal returns (CAR), we find positive abnormal returns in all four cases which when made quantifiable, are around half of the FT’s accounting figures. Furthermore, we argue that transparent auctions with enough bidders should be preferred to negotiated bank sales.
This document was provided/prepared by the Economic Governance and EMU Scrutiny Unit at the request of the ECON Committee.
Shallow meritocracy
(2023)
Meritocracies aspire to reward hard work and promise not to judge individuals by the circumstances into which they were born. However, circumstances often shape the choice to work hard. I show that people's merit judgments are "shallow" and insensitive to this effect. They hold others responsible for their choices, even if these choices have been shaped by unequal circumstances. In an experiment, US participants judge how much money workers deserve for the effort they exert. Unequal circumstances disadvantage some workers and discourage them from working hard. Nonetheless, participants reward the effort of disadvantaged and advantaged workers identically, regardless of the circumstances under which choices are made. For some participants, this reflects their fundamental view regarding fair rewards. For others, the neglect results from the uncertain counterfactual. They understand that circumstances shape choices but do not correct for this because the counterfactual—what would have happened under equal circumstances—remains uncertain.
Investors' return expectations are pivotal in stock markets, but the reasoning behind these expectations remains a black box for economists. This paper sheds light on economic agents' mental models -- their subjective understanding -- of the stock market, drawing on surveys with the US general population, US retail investors, US financial professionals, and academic experts. Respondents make return forecasts in scenarios describing stale news about the future earnings streams of companies, and we collect rich data on respondents' reasoning. We document three main results. First, inference from stale news is rare among academic experts but common among households and financial professionals, who believe that stale good news lead to persistently higher expected returns in the future. Second, while experts refer to the notion of market efficiency to explain their forecasts, households and financial professionals reveal a neglect of equilibrium forces. They naively equate higher future earnings with higher future returns, neglecting the offsetting effect of endogenous price adjustments. Third, a series of experimental interventions demonstrate that these naive forecasts do not result from inattention to trading or price responses but reflect a gap in respondents' mental models -- a fundamental unfamiliarity with the concept of equilibrium.
The financial sector plays an important role in financing the green transformation. Various regulatory initiatives in the EU aim to improve transparency in relation to the sustainability of financial products and the sustainability of economic activities of non-financial and financial undertakings. For credit institutions, the Green Asset Ratio (GAR) has been established by the European regulatory authorities as a key performance indicator (KPI) for measuring the proportion of Taxonomy-aligned on-balance-sheet exposure in relation to the total assets. The breakdown of the total GAR by type of counterparty, environmental objective and type of asset provides in-depth information about the sustainability profile of a credit institution. This information, which has not been available to date, may also initiate discussions between management and shareholders or other stakeholders regarding the future sustainability strategy of credit institutions. This paper provides an overview of the regulatory background and the method of calculating the GAR along different dimensions. Finally, the potential benefits and limitations of the GAR are discussed.
The Federal Reserve has been publishing federal funds rate prescriptions from Taylor rules in its Monetary Policy Report since 2017. The signals from the rules aligned with Fed action on many occasions, but in some cases the Fed opted for a different route. This paper reviews the implications of the rules during the coronavirus pandemic and the subsequent inflation surge and derives projections for the future.
In 2020, the Fed took the negative prescribed rates, which were far below the effective lower bound on the nominal interest rate, as support for extensive and long-lasting quantitative easing. Yet, the calculations overstate the extent of the constraint, because they neglect the supply side effects of the pandemic.
The paper proposes a simple model-based adjustment to the resource gap used by the rules for 2020. In 2021, the rules clearly signaled the need for tightening because of the rise of inflation, yet the Fed waited until spring 2022 to raise the federal funds rate. With the decline of inflation over the course of 2023, the rules’ prescriptions have also come down. They fall below the actual federal funds rate target range in 2024. Several caveats concerning the projections of the interest rate prescriptions are discussed.
The economic rise of China has changed the global economy. The authors explore China’s transformation from a low-cost manufacturing hub to an increasingly innovation- and service-driven economy. Major growth drivers for the period 2010-2025 are analysed, including the paradigms of “Made in China” and the “Dual Circulation Strategy”. The export intensity of China’s economy is declining overall, with a tendency towards greater regional diversification and a gradual decoupling from North America and the European Union. At the same time, trade and investment activities are increasingly geared to the Belt and Road Initiative. Furthermore, labour and energy cost advantages for manufacturing operations in China are likely to diminish in the coming years, calling into question China’s attractiveness as a global manufacturing hub. In this regard, the further development of regional and industrial clusters is pivotal for China to enhance its global competitiveness and remain an attractive destination for foreign direct investment (FDI) in the medium term. On the other hand, high productivity in science and technology and rich deposits of critical minerals put China in a favourable position in advanced industries. Important challenges include the still wide development gap between rural and urban areas, the structural mismatch in the labour market, with persistently high youth unemployment, and the race to achieve carbon neutrality by 2060.
We document the individual willingness to act against climate change and study the role of social norms in a large sample of US adults. Individual beliefs about social norms positively predict pro-climate donations, comparable in strength to universal moral values and economic preferences such as patience and reciprocity. However, we document systematic misperceptions of social norms. Respondents vastly underestimate the prevalence of climate-friendly behaviors and norms. Correcting these misperceptions in an experiment causally raises individual willingness to act against climate change as well as individual support for climate policies. The effects are strongest for individuals who are skeptical about the existence and threat of global warming.
Looking beyond ESG preferences: The role of sustainable finance literacy in sustainable investing
(2024)
We assess how sustainable finance literacy affects people’s sustainable investment behavior, using a pre-registered experiment. We find that an increase in sustainable finance literacy leads to a 4 to 5% increase in the probability of investing sustainably. This effect is moderated by sustainability preferences. In the absence of moderate sustainability preferences, any additional increase in sustainable finance literacy is at minimum irrelevant, and we find some evidence that it might even reduce sustainable investments. Our findings underscore the role of knowledge in shaping sustainable investment decisions, highlighting the importance of factors beyond sustainability preferences.
This paper studies whether Eurosystem collateral eligibility played a role in the portfolio choices of euro area asset managers during the “dash-for-cash” episode of 2020. We find that asset managers reduced their allocation to ECB-eligible corporate bonds, selling them in order to finance redemptions, while simultaneously increasing their cash holdings. These findings add nuance to previous studies of liquidity strains and price dislocations in the corporate bond market during the onset of the Covid-19 pandemic, indicating a greater willingness of dealers to increase their inventories of corporate bonds pledgeable with the ECB. Analysing the price impact of these portfolio choices, we also find evidence pointing to price pressure for both ECB-eligible and ineligible corporate bonds. Bonds that were held to a larger extent by investment funds in our sample experienced higher price pressure, although the impact was lower for ECB-eligible bonds. We also discuss broader implications for the related policy debate about how central banks could mitigate similar types of liquidity shocks.
Despite a number of helpful changes, including the adoption of an inflation target, the Fed’s monetary policy strategy proved insufficiently resilient in recent years. While the Fed eased policy appropriately during the pandemic, it fell behind the curve during the post-pandemic recovery. During 2021, the Fed kept easing policy while the inflation outlook was deteriorating and the economy was growing considerably faster than the economy’s natural growth rate—the sum of the Fed’s 2% inflation goal and the growth rate of potential output.
The resilience of the Fed’s monetary policy strategy could be enhanced, and such errors be avoided with guidance from a simple natural growth targeting rule that prescribes that the federal funds rate during each quarter be raised (cut) when projected nominal income growth exceeds (falls short) of the economy’s natural growth rate. An illustration with real-time data and forecasts since the early 1990s shows that Fed policy has not persistently deviated from this simple rule with the notable exception of the period coinciding with the Fed’s post-pandemic policy error.
What are the aggregate and distributional consequences of the relationship be-tween an individual’s social network and financial decisions? Motivated by several well-documented facts about the influence of social connections on financial decisions, we build and calibrate a model of stock market participation with a social network that emphasizes the interplay between connectivity and network structure. Since connections to informed agents help spread information, there is a pivotal role for factors that determine sorting among agents. An increase in the average number of connections raises the average participation rate, mostly due to richer agents. A higher degree of sorting benefits richer agents by creating clusters where information spreads more efficiently. We show empirical evidence consistent with the importance of connectivity and sorting. We discuss several new avenues for future research into the aggregate impact of peer effects in finance.
Central banks sowing the seeds for a green financial sector? NGFS membership and market reactions
(2024)
In December 2017, during the One Planet Summit in Paris, a group of eight central banks and supervisory authorities launched the “Network for Greening the Financial Sector” (NGFS) to address challenges and risks posed by climate change to the global financial system. Until 06/2023 an additional 69 central banks from all around the world have joined the network. We find that the propensity to join the network can be described as a function in the country’s economic development (e.g., GDP per capita), national institutions (e.g., central bank independence), and performance of the central bank on its mandates (e.g., price stability and output gap). Using an event study design to examine consequences of network expansions in capital markets, we document that a difference portfolio that is long in clean energy stocks and short in fossil fuel stocks benefits from an enlargement of the NGFS. Overall, our results suggest that an increasing number of central banks and supervisory authorities are concerned about climate change and willing to go beyond their traditional objectives, and that the capital market believes they will do so.
In this study, we unpack the ESG ratings of four prominent agencies in Europe and find that (i) each single E, S, G pillar explains the overall ESG score differently,(ii) there is a low co-movement between the three E, S, G pillars and (iii) there are specific ESG Key Performance Indicators (KPIs) that are driving these ratings more than others. We argue that such discrepancies might mislead firms about their actual ESG status, potentially leading to cherry-picking areas for improvement, thus raising questions about the accuracy and effectiveness of ESG evaluations in both explaining sustainability and driving capital toward sustainable companies.
We create an alternative version of the present utility value formula to explicitly show that every store-of-value in the economy bears utility-interest (non-pecuniary income) for ist holder regardless of possible interest earnings from financial markets. In addition, we generalize the well-known welfare measures of consumer and producer surplus as present value concepts and apply them not only for the production and usage of consumer goods and durables but also for money and other financial assets. This helps us, inter alia, to formalize the circumstances under which even a producer of legal tender might become insolvent. We also develop a new measure of seigniorage and demonstrate why the well-established concept of monetary seigniorage is flawed. Our framework also allows us to formulate the conditions for liability-issued money such as inside money and financial instruments such as debt certificates to become – somewhat paradoxically – net wealth of the society.
In its first ten years (2014-2023), the banking union was successful in its prudential agenda but failed spectacularly in its underlying objective: establishing a single banking market in the euro area. This goal is now more important than ever, and easier to attain than at any time in the last decade. To make progress, cross-border banks should receive a specific treatment within general banking union legislation. Suggestions are made on how to make such regulatory carve-out effective and legally sound.
This paper addresses the need for transparent sustainability disclosure in the European Auto Asset-Backed Securities (ABS) market, a crucial element in achieving the EU's climate goals. It proposes the use of existing vehicle identifiers, the Type Approval Number (TAN) and the Type-Variant-Version Code (TVV), to integrate loan-level data with sustainability-related vehicle information from ancillary sources. While acknowledging certain challenges, the combined use of TAN and TVV is the optimal solution to allow all stakeholders to comprehensively assess the environmental characteristics of securitised exposure pools in terms of data protection, matching accuracy, and cost-effectiveness.
This study analyses potential consequences of exiting the Targeted Long-Term Refinancing Operations (TLTRO) of the European Central Bank (ECB). Thanks to its asset purchase programs, the Eurosystem still holds plenty of reserves even with a full exit from the TLTROs. This explains why voluntary and mandatory repayments of TLTRO III borrowing went smoothly. Nevertheless, the more liquidity is drained from the banking system, the more important becomes interbank market borrowing and lending, ideally between euro area member states. Right now, the usual fault lines of the euro area show up. The German banking system has plenty of reserves while there are first signs of aggregate scarcity in the Italian banking system. This does not need to be a source of concern if the interbank market can be sufficiently reactivated. Moreover, the ECB has several tools to address possible future liquidity shortages.
This document was provided/prepared by the Economic Governance and EMU scrutiny Unit at the request of the ECON Committee.
Almost ten years after the European Commission action plan on building a capital markets union (CMU) and despite incremental progress, e.g. in the form of the EU Listing Act, the picture looks dire. Stock exchanges, securities markets, and supervisory authorities remain largely national, and, in many cases, European companies have decided to exclusively list overseas. Notwithstanding the economic and financial benefits of market integration, CMU has become a geopolitical necessity. A unified capital market can bolster resilience, strategic autonomy, and economic sovereignty, reduce dependence on external funding, and may foster economic cooperation between member states.
The reason for the persistent stand-still in Europe’s CMU development is not so much the conflict between market- and state-based integration, but rather the hesitancy of national regulatory and supervisory bodies to relinquish powers. If EU member states wanted to get real about CMU (as they say, and as they should), they need to openly accept the loss of sovereignty that follows from a true unified capital market. Building on economic as well as historical evidence, the paper offers viable proposals on how to design competent institutions within the current European framework.
This note outlines the case for speedy capital market integration and for the adoption of a common regulatory framework and single supervisory authority from a political economy perspective. We also show the alternative case for harmonization and centralization via regulatory competition, elaborating how competition between EU jurisdictions by way of full mutual recognition may lead to a (cost-)efficient and standardized legal framework for capital markets. Lastly, the note addresses the political economy conflict that underpins the implementation of both models for integrating capital markets. We point out that, in both cases, national authorities experience a loss of legislative and jurisdictional competence at the national level. We predict that any plan to foster a stronger capital market union, following an institution based or a market-based strategy, will face opposition from powerful national stakeholders.
In recent decades, biodiversity has declined significantly, threatening ecosystem services that are vital to society and the economy. Despite the growing recognition of biodiversity risks, the private sector response remains limited, leaving a significant financing gap. The paper therefore describes market-based solutions to bridge the financing gap, which can follow a risk assessment approach and an impact-oriented perspective. Key obstacles to mobilising private capital for biodiversity conservation are related to pricing biodiversity due to its local dimension, the lack of standardized metrics for valuation and still insufficient data reporting by companies hindering informed investment decisions. Financing biodiversity projects poses another challenge, mainly due to a mismatch between investor needs and available projects, for example in terms of project timeframes and their additionality.
This paper shows that support for climate action is high across survey participants from all EU countries in three dimensions: (1) Participants are willing to contribute personally to combating climate change, (2) they approve of pro-climate social norms, and (3) they demand government action. In addition, there is a significant perception gap where individuals underestimate others' willingness to contribute to climate action by over 10 percentage points, influencing their own willingness to act. Policymakers should recognize the broad support for climate action among European citizens and communicate this effectively to counteract the vocal minority opposed to it.
Inflation and trading
(2024)
We study how investors respond to inflation combining a customized survey experiment with trading data at a time of historically high inflation. Investors' beliefs about the stock return-inflation relation are very heterogeneous in the cross section and on average too optimistic. Moreover, many investors appear unaware of inflation-hedging strategies despite being otherwise well-informed about inflation and asset returns. Consequently, whereas exogenous shifts in inflation expectations do not impact return expectations, information on past returns during periods of high inflation leads to negative updating about the perceived stock-return impact of inflation, which feeds into return expectations and subsequent actual trading behavior.
We educate investors with significant dividend holdings about the benefits of dividend reinvestment and the costs of misperceiving dividends as additional, free income. The intervention increases planned dividend reinvestment in survey responses. Using trading records, we observe a corresponding causal increase in dividend reinvestment in the field of roughly 50 cents for every euro received. This holds relative to their prior behavior and a placebo sample. Investors who learned the most from the intervention update their trading by the largest extent. The results suggest the free dividends fallacy is a significant source of dividend demand. Our study demonstrates that simple, targeted, and focused educational interventions can affect investment behavior.
How does the design of debt repayment schedules affect household borrowing? To answer this question, we exploit a Swedish policy reform that eliminated interest-only mortgages for loan-to-value ratios above 50%. We document substantial bunching at the threshold, leading to 5% lower borrowing. Wealthy borrowers drive the results, challenging credit constraints as the primary explanation. We develop a model to evaluate the mechanisms driving household behavior and find that much of the effect comes from households experiencing ongoing flow disutility to amortization payments. Our results indicate that mortgage contracts with low initial payments substantially increase household borrowing and lifetime interest costs.
This paper contributes a multivariate forecasting comparison between structural models and Machine-Learning-based tools. Specifically, a fully connected feed forward non-linear autoregressive neural network (ANN) is contrasted to a well established dynamic stochastic general equilibrium (DSGE) model, a Bayesian vector autoregression (BVAR) using optimized priors as well as Greenbook and SPF forecasts. Model estimation and forecasting is based on an expanding window scheme using quarterly U.S. real-time data (1964Q2:2020Q3) for 8 macroeconomic time series (GDP, inflation, federal funds rate, spread, consumption, investment, wage, hours worked), allowing for up to 8 quarter ahead forecasts. The results show that the BVAR improves forecasts compared to the DSGE model, however there is evidence for an overall improvement of predictions when relying on ANN, or including them in a weighted average. Especially, ANN-based inflation forecasts improve other predictions by up to 50%. These results indicate that nonlinear data-driven ANNs are a useful method when it comes to macroeconomic forecasting.
Central bank intervention in the form of quantitative easing (QE) during times of low interest rates is a controversial topic. The author introduces a novel approach to study the effectiveness of such unconventional measures. Using U.S. data on six key financial and macroeconomic variables between 1990 and 2015, the economy is estimated by artificial neural networks. Historical counterfactual analyses show that real effects are less pronounced than yield effects.
Disentangling the effects of the individual asset purchase programs, impulse response functions provide evidence for QE being less effective the more the crisis is overcome. The peak effects of all QE interventions during the Financial Crisis only amounts to 1.3 pp for GDP growth and 0.6 pp for inflation respectively. Hence, the time as well as the volume of the interventions should be deliberated.
Experiments are an important tool in economic research. However, it is unclear to which extent the control of experiments extends to the perceptions subjects form of such experimental decision situations. This paper is the first to explicitly elicit perceptions of the dictator and trust game and shows that there is substantial heterogeneity in how subjects perceive the same game. Moreover, game perceptions depend not only on the game itself but also on the order of games (i.e., the broader experimental context in which the game is embedded) and the subject herself. This highlights that the control of experiments does not necessarily extend to game perceptions. The paper also demonstrates that perceptions are correlated with game behavior and moderate the relationship between game behavior and field behavior, thereby underscoring the importance and relevance of game perceptions for economic research.
The development of China’s exports – is there a decoupling from the EU and the United States?
(2024)
Some observers warn that a high level of economic dependence on China could negatively affect the economic resilience of Western economies and therefore recommend reducing such dependence by gradually decoupling from China. On the other hand, industry leaders emphasise the economic importance of China and warn against any kind of trade conflicts.
Against this background, we briefly analyse the development of China’s export strategy. We find that the export intensity of the Chinese economy is diminishing and that exports are becoming more diversified overall. In addition, the relative importance of the United States and the European Union as export markets has been reduced, indicating a gradual decoupling of China from Western economies. Conversely, we find that exports to China have become more important, both for the EU and the United States. Although the figures remain at a non-critical level, Europe’s export activities could be more diversified as well.
We use a structural VAR model to study the German natural gas market and investigate the impact of the 2022 Russian supply stop on the German economy. Combining conventional and narrative sign restrictions, we find that gas supply and demand shocks have large and persistent price effects, while output effects tend to be moderate. The 2022 natural gas price spike was driven by adverse supply
shocks and positive storage demand shocks, as Germany filled its inventories before the winter. Counterfactual simulations of an embargo on natural gas imports from Russia indicate similar positive price and negative output effects compared to what we observe in the data.
Why do banks issue contingent convertible debt? To answer this question we study comprehensive data covering all issues by publicly traded banks in Europe of contingent convertible bonds (CoCos) that count as additional tier 1 capital (AT1). We find that banks with lower asset volatility are more likely to issue AT1 CoCos than their riskier counterparts, but that CDS spreads do not react following issue announcements. Our estimates therefore suggest that agency costs play a crucial role in banks' ability to successfully issue CoCos. The agency costs may be higher for CoCos than for equity explaining why we observe riskier or lowly capitalized banks to issue equity rather than CoCos.