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When markets are incomplete, social security can partially insure against idiosyncratic and aggregate risks. We incorporate both risks into an analytically tractable model with two overlapping generations and demonstrate that they interact over the life-cycle. The interactions appear even though the two risks are orthogonal and they amplify the welfare consequences of introducing social security. On the one hand, the interactions increase the welfare benefits from insurance. On the other hand, they can in- or decrease the welfare costs from crowding out of capital formation. This ambiguous effect on crowding out means that the net effect of these two channels is positive, hence the interactions of risks increase the total welfare benefits of social security.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.
This paper studies the effect of graduating from college on lifetime earnings. We develop a quantitative model of college choice with uncertain graduation. Departing from much of the literature, we model in detail how students progress through college. This allows us to parameterize the model using transcript data. College transcripts reveal substantial and persistent heterogeneity in students’ credit accumulation rates that are strongly related to graduation outcomes. From this data, the model infers a large ability gap between college graduates and high school graduates that accounts for 54% of the college lifetime earnings premium.
his paper distils three lessons for bank regulation from the experience of the 2009-12 euro-area financial crisis. First, it highlights the key role that sovereign debt exposures of banks have played in the feedback loop between bank and fiscal distress, and inquires how the regulation of banks’ sovereign exposures in the euro area should be changed to mitigate this feedback loop in the future. Second, it explores the relationship between the forbearance of non-performing loans by European banks and the tendency of EU regulators to rescue rather than resolving distressed banks, and asks to what extent the new regulatory framework of the euro-area “banking union” can be expected to mitigate excessive forbearance and facilitate resolution of insolvent banks. Finally, the paper highlights that capital requirements based on the ratio of Tier-1 capital to banks’ risk-weighted assets were massively gamed by large banks, which engaged in various forms of regulatory arbitrage to minimize their capital charges while expanding leverage. This argues in favor of relying on a set of simpler and more robust indicators to determine banks’ capital shortfall, such as book and market leverage ratios.
We study a model where some investors ("hedgers") are bad at information processing, while others ("speculators") have superior information-processing ability and trade purely to exploit it. The disclosure of financial information induces a trade externality: if speculators refrain from trading, hedgers do the same, depressing the asset price. Market transparency reinforces this mechanism, by making speculators' trades more visible to hedgers. As a consequence, issuers will oppose both the disclosure of fundamentals and trading transparency. Issuers may either under- or over-provide information compared to the socially efficient level if speculators have more bargaining power than hedgers, while they never under-provide it otherwise. When hedgers have low financial literacy, forbidding their access to the market may be socially efficient.
Most simulated micro-founded macro models use solely consumer-demand aggregates in order to estimate deep economy-wide preference parameters, which are useful for policy evaluation. The underlying demand-aggregation properties that this approach requires, should be easy to empirically disprove: since household-consumption choices differ for households with more members, aggregation can be rejected if appropriate data violate an affine equation regarding how much individuals benefit from within-household sharing of goods. We develop a survey method that tests the validity of this equation, without utility-estimation restrictions via models. Surprisingly, in six countries, this equation is not rejected, lending support to using consumer-demand aggregates.
Riley (1979)'s reactive equilibrium concept addresses problems of equilibrium existence in competitive markets with adverse selection. The game-theoretic interpretation of the reactive equilibrium concept in Engers and Fernandez (1987) yields the Rothschild-Stiglitz (1976)/Riley (1979) allocation as an equilibrium allocation, however multiplicity of equilibrium emerges. In this note we imbed the reactive equilibrium's logic in a dynamic market context with active consumers. We show that the Riley/Rothschild-Stiglitz contracts constitute the unique equilibrium allocation in any pure strategy subgame perfect Nash equilibrium.
We examine the relationship between household wealth and self-control. Although self-control has been linked to consumption and financial behavior, its measurement remains an open issue. We employ a definition of self-control failure that follows literature in psychology, suggesting that three factors can render self-control defective: lack of planning, lack of monitoring, and lack of commitment to pre-set plans. Our measure combines those three ingredients and can be computed using a standard representative survey. We find that self-control failure is strongly associated with different household net wealth measures and with self-assessed financial distress.
How special are they? - Targeting systemic risk by regulating shadow banking : (October 5, 2014)
(2014)
This essay argues that at least some of the financial stability concerns associated with shadow banking can be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules. It shows that the general policy goals of prudential banking regulation remain constant over time despite dramatic transformations in the financial and technological landscape. Moreover, these overarching policy goals also legitimize intervention in the shadow banking sector. On these grounds, this essay encourages a more normative construction of available rules that potentially limits both the scope for regulatory arbitrage and the need for ever more rapid updates and a constant increase in the complexity of the regulatory framework. By tying the regulatory treatment of financial innovation closely to existing prudential rules and their underlying policy rationales, the proposed approach potentially ends the socially wasteful race between hare and tortoise that signifies the relation between regulators and a highly dynamic industry. In doing so it does not generally hamper market participants’ efficient discoveries where disintermediation proves socially beneficial. Instead, it only weeds-out rent-seeking circumventions of existing rules and standards.
Previous research has documented strong peer effects in risk taking, but little is known about how such social influences affect market outcomes. The consequences of social interactions are hard to isolate in financial data, and theoretically it is not clear whether peer effects should increase or decrease risk sharing. We design an experimental asset market with multiple risky assets and study how exogenous variation in real-time information about the portfolios of peer group members affects aggregate and individual risk taking. We find that peer information ameliorates under-diversification that occurs in a market without such information. One reason is that peer information increases risk aversion and induces a concern for relative income position that may reduce or amplify risk taking, depending on whether the context highlights the most or least successful trader. Thus, contrary to conventional wisdom, we show that social interactions may help to reduce earnings volatility in financial markets, and we discuss implications for institutional design.
This paper contrasts the recent European initiatives on regulating corporate groups with alternative approaches to the phenomenon. In doing so it pays particular regard to the German codified law on corporate groups as the polar opposite to the piecemeal approach favored by E.U. legislation.
It finds that the European Commission’s proposal to submit (significant) related party transactions to enhanced transparency, outside fairness review, and ex ante shareholder approval is both flawed in its design and based on contestable assumptions on informed voting of institutional investors. In particular, the contemplated exemption for transactions with wholly owned subsidiaries allows controlling shareholders to circumvent the rule extensively. Moreover, vesting voting rights with (institutional) investors will not lead to the informed assessment that is hoped for, because these investors will rationally abstain from active monitoring and rely on proxy advisory firms instead whose competency to analyze non-routine significant related party transactions is questionable.
The paper further delineates that the proposed recognition of an overriding interest of the group requires strong counterbalances to adequately protect minority shareholders and creditors. Hence, if the Commission choses to go down this route it might end up with a comprehensive regulation that is akin to the unpopular Ninth Company Law Directive in spirit, though not in content. The latter prediction is corroborated by the pertinent parts of the proposal for a European Model Company Act.
Research results confirm the existence of various forms of international tax planning by multinational firms. Prominent examples for firms employing tax avoidance strategies are Amazon, Google and Starbucks. Increasing availability of administrative data for Europe has enabled researchers to study behavioural responses of European multinationals to taxation. The present paper summarizes what we can learn from these recent studies in general and about German multinationals in particular.
SAFE Professor Michalis Haliassos was a member of the National Council for Research and Technology (ESET) established by the Government of Greece for the period 2010-2013. The council, consisting of eleven scientists from a range of disciplines, has now published their communiqué "National Strategic Framework for Research and Innovation 2014 -2020".
To promote the advancement of research, technology and innovation in Greece, the strategic plan proposed by the authors seeks to identify areas of existing research strength and excellence that can be further advanced to become engines for progress and growth in Greece, as well as flaws inherent to the present system. The authors stress the need to address current constraints to growth, which include the declining education system; the confusion and weaknesses of R&D governance and management; the discontinuities and inefficiencies of resource allocation and investment; the lack of adaptation to clearly-defined national priorities; and the inadequate opportunities and funding for high-quality research and development to flourish. They stress the need for prioritisation and efficient allocation; stability of the policy frame; predictability of planning; provision of opportunity; recognition of excellence; and responsiveness to current and future needs.
9.01 This chapter outlines the development of Contingent Convertible Securities (CoCos) for financial institutions from their theoretical origins to their current form under the European Union’s Fourth Capital Requirements Directive framework and its Bank Recovery and Resolution Directive and examines the effect the framework and the directive have had on their design and ability to fulfill the ends for which they were initially conceived. It examines this from two viewpoints: the policy goals CoCos are meant to achieve and the corporate law issues raised by the requirements of CRD IV. On the policy side we conclude that CRD IV and the RRD have significantly limited the amount of CoCos a financial institution is likely to issue, but expanded their possible forms by including write-down as well as convertible structures and narrowed the differences between them and pure regulatory bail-in structures, thus calling into question whether they are truly ‘going concern’ rather than ‘gone concern’ capital. On the company law side we conclude that a number of issues, in particular the limits on an authorization of management to issue CoCos and shares, the scope of the shareholders’ right of pre-emption, the concept of dilution and the distinction between contributions in cash and in kind merit closer attention than they appear to have received in the current discussion on CoCos.
How special are they? - Targeting systemic risk by regulating shadow banking : (October 5, 2014)
(2014)
This essay argues that at least some of the financial stability concerns associated with shadow banking can be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules. It shows that the general policy goals of prudential banking regulation remain constant over time despite dramatic transformations in the financial and technological landscape. Moreover, these overarching policy goals also legitimize intervention in the shadow banking sector. On these grounds, this essay encourages a more normative construction of available rules that potentially limits both the scope for regulatory arbitrage and the need for ever more rapid updates and a constant increase in the complexity of the regulatory framework. By tying the regulatory treatment of financial innovation closely to existing prudential rules and their underlying policy rationales, the proposed approach potentially ends the socially wasteful race between hare and tortoise that signifies the relation between regulators and a highly dynamic industry. In doing so it does not generally hamper market participants’ efficient discoveries where disintermediation proves socially beneficial. Instead, it only weeds-out rent-seeking circumventions of existing rules and standards.
Advertising arbitrage
(2014)
Speculators often advertise arbitrage opportunities in order to persuade other investors and thus accelerate the correction of mispricing. We show that in order to minimize the risk and the cost of arbitrage an investor who identifies several mispriced assets optimally advertises only one of them, and overweights it in his portfolio; a risk-neutral arbitrageur invests only in this asset. The choice of the asset to be advertised depends not only on mispricing but also on its "advertisability" and accuracy of future news about it. When several arbitrageurs identify the same arbitrage opportunities, their decisions are strategic complements: they invest in the same asset and advertise it. Then, multiple equilibria may arise, some of which inefficient: arbitrageurs may correct small mispricings while failing to eliminate large ones. Finally, prices react more strongly to the ads of arbitrageurs with a successful track record, and reputation-building induces high-skill arbitrageurs to advertise more than others.
Has economic research been helpful in dealing with the financial crises of the early 2000s? On the whole, the answer is negative, although there are bright spots. Economists have largely failed to predict both crises, largely because most of them were not analytically equipped to understand them, in spite of their recurrence in the last 25 years. In the pre-crisis period, however, there have been important exceptions – theoretical and empirical strands of research that largely laid out the basis for our current thinking about financial crises. Since 2008, a flurry of new studies offered several different interpretations of the US crisis: to some extent, they point to potentially complementary factors, but disagree on their relative importance, and therefore on policy recommendations. Research on the euro debt crisis has so far been much more limited: even Europe-based researchers – including CEPR ones – have often directed their attention more to the US crisis than to that occurring on their doorstep. In terms of impact on policy and regulatory reform, the record is uneven. On the one hand, the swift and massive liquidity provision by central banks in the wake of both crises is, at least partly, to be credited to previous research on the role of central banks as lenders of last resort in crises and on the real effects of bank lending and monetary policy. On the other hand, economists have had limited impact on the reform of prudential and security market regulation. In part, this is due to their neglect of important regulatory choices, which policy-makers are therefore left to take without the guidance of academic research-based analysis.
Consumption-based asset pricing with rare disaster risk : a simulated method of moments approach
(2014)
The rare disaster hypothesis suggests that the extraordinarily high postwar U.S. equity premium resulted because investors ex ante demanded compensation for unlikely but calamitous risks that they happened not to incur. Although convincing in theory, empirical tests of the rare disaster explanation are scarce. We estimate a disaster-including consumption-based asset pricing model (CBM) using a combination of the simulated method of moments and bootstrapping. We consider several methodological alternatives that differ in the moment matches and the way to account for disasters in the simulated consumption growth and return series. Whichever specification is used, the estimated preference parameters are of an economically plausible size, and the estimation precision is much higher than in previous studies that use the canonical CBM. Our results thus provide empirical support for the rare disaster hypothesis, and help reconcile the nexus between real economy and financial markets implied by the consumption-based asset pricing paradigm.
The long-run consumption risk (LRR) model is a promising approach to resolve prominent asset pricing puzzles. The simulated method of moments (SMM) provides a natural framework to estimate its deep parameters, but caveats concern model solubility and weak identification. We propose a two-step estimation strategy that combines GMM and SMM, and for which we elicit informative macroeconomic and financial moment matches from the LRR model structure. In particular, we exploit the persistent serial correlation of consumption and dividend growth and the equilibrium conditions for market return and risk-free rate, as well as the model-implied predictability of the risk-free rate. We match analytical moments when possible and simulated moments when necessary and determine the crucial factors required for both identification and reasonable estimation precision. A simulation study – the first in the context of long-run risk modeling – delineates the pitfalls associated with SMM estimation of a non-linear dynamic asset pricing model. Our study provides a blueprint for successful estimation of the LRR model.
he predictive likelihood is of particular relevance in a Bayesian setting when the purpose is to rank models in a forecast comparison exercise. This paper discusses how the predictive likelihood can be estimated for any subset of the observable variables in linear Gaussian state-space models with Bayesian methods, and proposes to utilize a missing observations consistent Kalman filter in the process of achieving this objective. As an empirical application, we analyze euro area data and compare the density forecast performance of a DSGE model to DSGE-VARs and reduced-form linear Gaussian models.
We propose a new estimator for the spot covariance matrix of a multi-dimensional continuous semi-martingale log asset price process which is subject to noise and non-synchronous observations. The estimator is constructed based on a local average of block-wise parametric spectral covariance estimates. The latter originate from a local method of moments (LMM) which recently has been introduced by Bibinger et al. (2014). We extend the LMM estimator to allow for autocorrelated noise and propose a method to adaptively infer the autocorrelations from the data. We prove the consistency and asymptotic normality of the proposed spot covariance estimator. Based on extensive simulations we provide empirical guidance on the optimal implementation of the estimator and apply it to high-frequency data of a cross-section of NASDAQ blue chip stocks. Employing the estimator to estimate spot covariances, correlations and betas in normal but also extreme-event periods yields novel insights into intraday covariance and correlation dynamics. We show that intraday (co-)variations (i) follow underlying periodicity patterns, (ii) reveal substantial intraday variability associated with (co-)variation risk, (iii) are strongly serially correlated, and (iv) can increase strongly and nearly instantaneously if new information arrives.
This paper studies the use of performance pricing (PP) provisions in debt contracts and compares accounting-based with rating-based pricing designs. We find that rating-based provisions are used by volatile-growth borrowers and allow for stronger spread increases over the credit period. Accounting-based provisions are employed by opaque-growth borrowers and stipulate stronger spread reductions. Further, a higher spread-increase potential in rating-based contracts lowers the spread at the loan’s inception and improves the borrower’s performance later on. In contrast, a higher spread-decrease potential in accounting-based contracts lowers the initial spread and raises the borrower’s leverage afterwards. The evidence indicates that rating-based contracts are indeed employed for different reasons than accounting-based contracts: the former to signal a borrower’s quality, the latter to mitigate investment inefficiencies.
This paper examines the effect of imperfect labor market competition on the efficiency of compensation schemes in a setting with moral hazard, private information and risk-averse agents. Two vertically differentiated firrms compete for agents by offering contracts with fixed and variable payments. Vertical differentiation between firms leads to endogenous, type-dependent exit options for agents. In contrast to screening models with perfect competition, we find that existence of equilibria does not depend on whether the least-cost separating allocation is interim efficient. Rather, vertical differentiation allows the inferior firm to offer (cross-)subsidizing fixed payments even above the interim efficient level. We further show that the efficiency of variable pay depends on the degree of competition for agents: For small degrees of competition, low-ability agents are under-incentivized and exert too little effort. For large degrees of competition, high-ability agents are over-incentivized and bear too much risk. For intermediate degrees of competition, however, contracts are second-best despite private information.
We analyze the differential impact of domestic and foreign monetary policy on the local supply of bank credit in domestic and foreign currencies. We analyze a novel, supervisory dataset from Hungary that records all bank lending to firms including its currency denomination. Accounting for time-varying firm-specific heterogeneity in loan demand, we find that a lower domestic interest rate expands the supply of credit in the domestic but not in the foreign currency. A lower foreign interest rate on the other hand expands lending by lowly versus highly capitalized banks relatively more in the foreign than in the domestic currency.
In this paper we argue that very high marginal labor income tax rates are an effective tool for social insurance even when households have preferences with high labor supply elasticity, make dynamic savings decisions, and policies have general equilibrium effects. To make this point we construct a large scale Overlapping Generations Model with uninsurable labor productivity risk, show that it has a wealth distribution that matches the data well, and then use it to characterize fiscal policies that achieve a desired degree of redistribution in society. We find that marginal tax rates on the top 1% of the earnings distribution of close to 90% are optimal. We document that this result is robust to plausible variation in the labor supply elasticity and holds regardless of whether social welfare is measured at the steady state only or includes transitional generations.
What would be the economic effects of the UK leaving the European Union on living standards of British people? We focus on the effects of trade on welfare net of lower fiscal transfers to the EU. We use a standard quantitative static general equilibrium trade model with multiple sectors, countries and intermediates, as in Costinot and Rodriguez-Clare (2013). Static losses range between 1.13% and 3.09% of GDP, depending on the assumptions used in our counterfactual scenarios. Including dynamic effects could more than double such losses.
We use data from the 2009 Internet Survey of the Health and Retirement Study to examine the consumption impact of wealth shocks and unemployment during the Great Recession in the US. We find that many households experienced large capital losses in housing and in their financial portfolios, and that a non-trivial fraction of respondents have lost their job. As a consequence of these shocks, many households reduced substantially their expenditures. We estimate that the marginal propensities to consume with respect to housing and financial wealth are 1 and 3.3 percentage points, respectively. In addition, those who became unemployed reduced spending by 10 percent. We also distinguish the effect of perceived transitory and permanent wealth shocks, splitting the sample between households who think that the stock market is likely to recover in a year’s time, and those who do not. In line with the predictions of standard models of intertemporal choice, we find that the latter group adjusted much more than the former its spending in response to financial wealth shocks.
This chapter discusses whether and how 'new quantitative trade models' (NQTMs) can be fruitfully applied to quantify the welfare effects of trade liberalization, thus shedding light on the trade-related effects of further European integration. On the one hand, it argues that NQTMs have indeed the potential of being used to supplement traditional 'computable general equilibrium' (CGE) analysis thanks to their tight connection between theory and data, appealing micro-theoretical foundations, and enhanced attention to the estimation of structural parameters. On the other hand, further work is still needed in order to fully exploit such potential.
Especially in developing countries credit constraints are often perceived as one of the most important market frictions constraining firm innovation and growth. Huge amounts of public money are being devoted to the removal of such constraints but their effectiveness is still subject to an intense policy debate. This paper contributes to this debate by analysing the effects of the Brazilian Development Bank (BNDES) loans. It finds that, before receiving BNDES support, granted firms are indeed more credit constrained than comparable non-granted firms. It also finds that BNDES support allows granted firms to achieve the same level of performance as similar non-granted firms that are not credit constrained. However, it does not allow granted firms to outperform similar non-granted ones.
We develop a model of an order-driven exchange competing for order flow with off-exchange trading mechanisms. Liquidity suppliers face a trade-off between benefits and costs of order exposure. If they display trading intentions, they attract additional trade demand. We show, in equilibrium, hiding trade intentions can induce mis-coordination between liquidity supply and demand, generate excess price fluctuations and harm price efficiency. Econometric high-frequency analysis based on unique data on hidden orders from NASDAQ reveals strong empirical support for these predictions: We find abnormal reactions in prices and order flow after periods of high excess-supply of hidden liquidity.
We propose a framework for estimating network-driven time-varying systemic risk contributions that is applicable to a high-dimensional financial system. Tail risk dependencies and contributions are estimated based on a penalized two-stage fixed-effects quantile approach, which explicitly links bank interconnectedness to systemic risk contributions. The framework is applied to a system of 51 large European banks and 17 sovereigns through the period 2006 to 2013, utilizing both equity and CDS prices. We provide new evidence on how banking sector fragmentation and sovereign-bank linkages evolved over the European sovereign debt crisis and how it is reflected in network statistics and systemic risk measures. Illustrating the usefulness of the framework as a monitoring tool, we provide indication for the fragmentation of the European financial system having peaked and that recovery has started.
Futures markets are a potentially valuable source of information about market expectations. Exploiting this information has proved difficult in practice, because the presence of a time-varying risk premium often renders the futures price a poor measure of the market expectation of the price of the underlying asset. Even though the expectation in principle may be recovered by adjusting the futures price by the estimated risk premium, a common problem in applied work is that there are as many measures of market expectations as there are estimates of the risk premium. We propose a general solution to this problem that allows us to uniquely pin down the best possible estimate of the market expectation for any set of risk premium estimates. We illustrate this approach by solving the long-standing problem of how to recover the market expectation of the price of crude oil. We provide a new measure of oil price expectations that is considerably more accurate than the alternatives and more economically plausible. We discuss implications of our analysis for the estimation of economic models of energy-intensive durables, for the debate on speculation in oil markets, and for oil price forecasting.
While distribution conflicts over natural resources were central to the debates on a New International Economic Order, during the last decades the specific distribution conflicts surrounding natural resource exploitation no longer have been at the core of international law. In this paper I trace the developments in the relationship between international law and resource distribution conflicts. I first argue that the New International Economic Order favored the political resolution of distribution conflicts over natural resources and envisaged international distribution conflicts to be addressed by the political organs of international institutions within legal procedures Second, I show how the NIEO was surpassed by a different order that relied largely on the market as a distribution mechanism for raw materials and how international institutions and international law played a crucial role in the establishment of this order by promoting the privatization of natural resource exploitation and protecting foreign direct investment and trade. With reference to the copper industry in Zambia I thirdly illustrate how international investment law, and more broadly international economic law, is shaping (and affecting the resolution of) not only distribution conflicts between, but also within States. I conclude with a call for a renewed focus on an international law of resource conflicts to allow for their political resolution given the countermoves we can observe with respect to international investment law and the persistence of (violent) conflicts over natural resource exploitation within States.
In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.
The recent decline in euro area inflation has triggered new calls for additional monetary stimulus by the ECB in order to counter the threat of a self‐reinforcing deflation and recession spiral. This note reviews the available evidence on inflation expectations, output gaps and other factors driving current inflation through the lens of the Phillips curve. It also draws a comparison to the Japanese experience with deflation in the late 1990s and the evidence from Japan concerning the outputinflation nexus at low trend inflation. The note concludes from this evidence that the risk of a selfreinforcing deflation remains very small. Thus, the ECB best await the impact of the long‐term refinancing operations decided in June that have the potential to induce substantial monetary accommodation once implemented for the first time in September.
This essay reviews a cornerstone of the European Banking Union project, the resolution of systemically important banks. The focus is on the inherent conflict between a possible intervention by resolution authorities, conditional on a crisis situation, and effective prevention prior to a crisis. Moreover, the paper discusses the rules for bail-in debt and conversion rules for different layers of debt. Finally, some organizational requirements to achieve effective resolution results will be analyzed.
Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers' balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to relatively high cumulative probability of default for less capitalized companies.
This paper analyzes how on-the-job search (OJS) by an agent impacts the moral hazard problem in a repeated principal-agent relationship. OJS is found to constitute a source of agency costs because efficient search incentives require that the agent receives all gains from trade. Further, the optimal incentive contract with OJS matches the design of empirically observed compensation contracts more accurately than models that ignore OJS. In particular, the optimal contract entails excessive performance pay plus efficiency wages. Efficiency wages reduce the opportunity costs of work effort and hence serve as a complement to bonuses. Thus, the model offers a novel explanation for the use of efficiency wages. When allowing for renegotiation, the model generates wage and turnover dynamics that are consistent with empirical evidence. I argue that the model contributes to explaining the concomitant rise in the use of performance pay and in competition for high-skill workers during the last three decades.
We document and study international differences in both ownership and holdings of stocks, private businesses, homes, and mortgages among households aged fifty or more in thirteen countries, using new and comparable survey data. We employ counterfactual techniques to decompose observed differences across the Atlantic, within the US, and within Europe into those arising from differences in population characteristics and differences in economic environments. We then correlate the latter differences to country-level indicators. Ownership across the range of the assets considered tends to be more widespread among US households. We document that shortly prior to the current crisis, US households tended to invest larger amounts in stocks and smaller ones in homes, and to have larger mortgages in older age, even controlling for characteristics. This is consistent with the high prevalence of negative equity associated with the current crisis. More generally, we find that differences in household characteristics often play a small role, while differences in economic environments tend to explain most of the observed differences in ownership rates and in amounts held. The latter differences are much more pronounced among European countries than among US regions, suggesting further potential for harmonization of policies and institutions.
Regulation of investor access to financial products is often based on product familiarity indicated by previous use. The underlying premise that lack of familiarity with a product class causes unwarranted participation is difficult to test. This paper uses household-level data from the ‘experiment’ of German reunification that (exogenously) offered to East Germans access to capitalist products (exogenously) unfamiliar to them. We compare the evolution of post-unification participation of former East and West Germans in financial products, controlling for relevant household characteristics. We vary familiarity differentials by considering (i) both unfamiliar ‘capitalist’ products (stocks, bonds, and consumer credit) and ones available in the East (savings accounts and life insurance); and (ii) cohorts with different exposure to capitalism. We find that East Germans participated immediately in unfamiliar risky securities, at rates comparable to West Germans of similar characteristics. They phased out disproportionate participation in previously familiar assets as familiarity with capitalist products grew. They were more likely to use consumer debt, partly to catch up with richer new peers. We find no signs of abrupt participation drops that could suggest mistakes or regret related to lack of familiarity.
In this paper we investigate the implications of providing loan officers with a compensation structure that rewards loan volume and penalizes poor performance versus a fixed wage unrelated to performance. We study detailed transaction information for more than 45,000 loans issued by 240 loan officers of a large commercial bank in Europe. We examine the three main activities that loan officers perform: monitoring, originating, and screening. We find that when the performance of their portfolio deteriorates, loan officers increase their effort to monitor existing borrowers, reduce loan origination, and approve a higher fraction of loan applications. These loans, however, are of above-average quality. Consistent with the theoretical literature on multitasking in incomplete contracts, we show that loan officers neglect activities that are not directly rewarded under the contract, but are in the interest of the bank. In addition, while the response by loan officers constitutes a rational response to a time allocation problem, their reaction to incentives appears myopic in other dimensions.
This paper explains why the collection of panel (reinterview) data on a comprehensive measure of household expenditures is of great value both for measuring budget shares (the core mission of a Consumer Expenditure survey) and for the most important research and public policy uses to which CE data can be applied, including construction of spending-based measures of poverty and inequality and estimating the effects of fiscal policy.
The Great Recession confirmed a bedrock principle of modern consumption theory: It is impossible to explain aggregate spending behavior without knowledge of the underlying microeconomic distribution of circumstances and choices across households. National accounting frameworks therefore need to be augmented by “bottom up” measures that both (a) capture the microeconomic heterogeneity (in expenditures, income, assets, debt, and beliefs) in the population and (b) sum up to statistics that have a recognizable relationship to the aggregate totals that are already reasonably well measured.
We develop a methodology to identify and rank “systemically important financial institutions” (SIFIs). Our approach is consistent with that followed by the Financial Stability Board (FSB) but, unlike the latter, it is free of judgment and it is based entirely on publicly available data, thus filling the gap between the official views of the regulator and those that market participants can form with their own information set. We apply the methodology to annual data on three samples of banks (global, EU and euro area) for the years 2007-2012. We examine the evolution of the SIFIs over time and document the shifs in the relative weights of the major geographic areas. We also discuss the implication of the 2013 update of the identification methodology proposed by the FSB.
We examine the effects of credit default swaps (CDS), a major type of over-the-counter derivative, on the corporate liquidity management of the reference firms. CDS help firms to access the credit market since the lenders can hedge their credit risk more easily using these contracts. However, CDS-protected creditors can be tougher in debt renegotiations and less willing to support distressed borrowers, causing some firms to become more cautious. Consequently, we find that firms hold significantly more cash after the inception of CDS trading on their debt. The increase in cash holdings by CDS firms is more pronounced for financially constrained firms and firms facing higher refinancing risk. Moreover, bank relationships and outstanding credit facilities intensify the CDS effect on cash holding. Finally, firms with greater financial expertise hold more cash when their debt is referenced by CDS. These findings suggest that CDS, which are primarily a risk management tool for lenders, induce firms to adopt more conservative liquidity policies.
We use a unique data set from the Trade Reporting and Compliance Engine (TRACE) to study liquidity effects in the US structured product market. Our main contribution is the analysis of the relation between the accuracy in measuring liquidity and the potential degree of disclosure. Having access to all relevant trading information, we provide evidence that transaction cost measures that use dealer specific information such as trader identity and trade direction can be efficiently proxied by measures that use less detailed information. This finding is important for all market participants in the context of OTC markets, as it fosters our understanding of the information contained in transaction data. Thus, our results provide guidance for improving transparency while maintaining trader confidentiality. In addition, we analyze liquidity in the structured product market in general and show that securities that are mainly institutionally traded, guaranteed by a federal authority, or have low credit risk, tend to be more liquid.
Expressivist theories of punishment, according to which a penal sanction articulates or expresses a certain meaning to the offender, to the victim and to society, become more and more prominent among the traditional theories of punishment as retribution or deterrence. What these theories have in common is the idea that the conveyance of the meaning is in need of a communicative action, and that the penal sanction is such a communicative act. This article argues that pure communicative theories of punishment face great difficulties in generating any justification for hard treatment. One challenge is that certain types of sanctions – in particularly, hard treatment – restrict the communicative opportunities of the incarcerated individual; which generates a paradox, in that it turns punishment into a communicative action of non-communication. Beyond that, moreover, all practices of hard treatment potentially become unnecessary, if expressing the moral message of censure constitutes a kind of action in itself, and as such, itself a treatment of the offender, embedded in a communicative relationship between offender, victim and society; such that we may be able to think of the history of punishment as a development where hard treatment becomes more and more unnecessary for the conveyance of the message.
In this study prepared for the ECON Committee of the European Parliament, Gellings, Jungbluth and Langenbucher present a graphic overview on core legislation in the area of economic and financial services in Europe. The mapping overview can serve as background for further deliberations. The study covers legislation in force, proposals and other relevant provisions in fourteen policy areas, i.e. banking, securities markets and investment firms, market infrastructure, insurance and occupational pensions, payment services, consumer protection in financial services, the European System of Financial Supervision, European Monetary Union, Euro bills and Coins and statistics, competition, taxation, commerce and company law, accounting and auditing.
This paper contributes to the ongoing debate on the relationship between austerity measures and economic growth. We propose a general equilibrium model where (i) agents have recursive preferences; (ii) economic growth is endogenously driven by investments in R&D; (iii) the government is committed to a zero-deficit policy and finances public expenditures by means of a combination of labor taxes and R&D taxes. We find that austerity measures that rely on reducing resources available to the R&D sector depress economic growth both in the short- and long-run. High debt EU members are currently implementing austerity measures based on higher taxes and/or lower investments in the R&D sector. This casts some doubts on the real ability of these countries to grow over the next years.
The implications of delegating fiscal decision making power to sub-national governments has become an area of significant interest over the past two decades, in the expectation that these reforms will lead to better and more efficient provision of public goods and services. The move towards decentralization has, however, not been homogeneously implemented on the revenue and expenditure side: decentralization has materialized more substantially on the latter than on the former, creating "vertical fiscal imbalances". These imbalances measure the extent to which sub-national governments’ expenditures are financed through their own revenues. This mismatch between own revenues and expenditures may have negative consequences for public finances performance, for example by softening the budget constraint of sub-national governments. Using a large sample of countries covering a long time period from the IMF’s Government Finance Statistics Yearbook, this paper is the first to examine the effects of vertical fiscal imbalances on fiscal performance through the accumulation of government debt. Our findings suggest that vertical fiscal imbalances are indeed relevant in explaining government debt accumulation, and call for a degree of caution when promoting fiscal decentralization.
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
The Eurozone fiscal crisis has created pressure for institutional harmonization, but skeptics argue that cultural predispositions can prevent convergence in behavior. Our paper derives a robust cultural classification of European countries and utilizes unique data on natives and immigrants to Sweden. Classification based on genetic distance or on Hofstede’s cultural dimensions fails to identify a single ‘southern’ culture but points to a ‘northern’ culture. Significant differences in financial behavior are found across cultural groups, controlling for household characteristics. Financial behavior tends to converge with longer exposure to common institutions, but is slowed down by longer exposure to original institutions.
This is a chapter for a forthcoming volume Oxford Handbook of Financial Regulation (Oxford University Press 2014) (eds. Eilís Ferran, Niamh Moloney, and Jennifer Payne). It provides an overview of EU financial regulation from the first banking directive up until its most recent developments in the aftermath of the financial crisis, focusing on the multiple layers of multi-level governance and their characteristic conceptual difficulties. Therefore the paper discusses the need to accommodate cross-border capital flows following from the EU internal market and the resulting regulatory strategies. This includes a brief overview of the principle of home country control and the ensuing Financial Services Action Plan. Dealing with the accommodation of cross-border capital flows and their regulation necessarily require an orchestration of the underlying supervisory structures, which is therefore also discussed. In the aftermath of the financial crisis of 2007-09 an additional aspect of necessary orchestration has emerged, that is the need to control systemic risk. Specific attention is paid to microprudential supervision by the newly established European Supervisory Authorities and macroprudential supervision in the European Banking Union, the latter’s underlying drivers and the accompanying Single Supervisory Mechanism, including the SSM’s institutional framework as well as the consideration of its rationales and the Single Resolution Mechanism closely linked to it.
What happened in Cyprus? The economic consequences of the last communist government in Europe
(2014)
This paper reviews developments in the Cypriot economy following the introduction of the euro on 1 January 2008 and leading to the economic collapse of the island five years later. The main cause of the collapse is identified with the election of a communist government in February 2008, within two months of the introduction of the euro, and its subsequent choices for action and inaction on economic policy matters. The government allowed a rapid deterioration of public finances, and despite repeated warnings, damaged the country's creditworthiness and lost market access in May 2011. The destruction of the island's largest power station in July 2011 subsequently threw the economy into recession. Together with the intensification of the euro area crisis in the summer and fall of 2011, these events weakened the banking system which was vulnerable due to its exposure in Greece. Rather than deal with its fiscal crisis, the government secured a loan from the Russian government that allowed it to postpone action until after the February 2013 election. Rather than protect the banking system, losses were imposed on banks and a campaign against them was coordinated and used as a platform by the communist party for the February 2013 election. The strategy succeeded in delaying resolution of the crisis and avoiding short-term political cost for the communist party before the election, but also in precipitating a catastrophe right after the election.
Panel Sample Selection ModelsThe empirical evidence currently available in the literature regarding the effects of a country's IMF program participation on its output growth is rather inconclusive. In this paper we propose and estimate a panel data sample selection model featuring state dependence. As in this model the output growth effects of program participation can be conditional on the realization of a state variable (conditional pooling), our framework may reconcile previous empirical evidence based on models without state-dependent effects. We find that the effects of IMF program participation on output growth vary systematically with an index reflecting a country's institutional record, and that output growth effects of program participation are significantly positive only if the program participation is coupled with sufficient improvement of the institutional record.
Although oil price shocks have long been viewed as one of the leading candidates for explaining U.S. recessions, surprisingly little is known about the extent to which oil price shocks explain recessions. We provide the first formal analysis of this question with special attention to the possible role of net oil price increases in amplifying the transmission of oil price shocks. We quantify the conditional recessionary effect of oil price shocks in the net oil price increase model for all episodes of net oil price increases since the mid-1970s. Compared to the linear model, the cumulative effect of oil price shocks over course of the next two years is much larger in the net oil price increase model. For example, oil price shocks explain a 3% cumulative reduction in U.S. real GDP in the late 1970s and early 1980s and a 5% cumulative reduction during the financial crisis. An obvious concern is that some of these estimates are an artifact of net oil price increases being correlated with other variables that explain recessions. We show that the explanatory power of oil price shocks largely persists even after augmenting the nonlinear model with a measure of credit supply conditions, of the monetary policy stance and of consumer confidence. There is evidence, however, that the conditional fit of the net oil price increase model is worse on average than the fit of the corresponding linear model, suggesting much smaller cumulative effects of oil price shocks for these episodes of at most 1%.
Efforts to control bank risk address the wrong problem in the wrong way. They presume that the financial crisis was caused by CEOs who failed to supervise risk-taking employees. The responses focus on executive pay, believing that executives will bring non-executives into line—using incentives to manage risk-taking—once their own pay is regulated. What they overlook is the effect on non-executive pay of the competition for talent. Even if executive pay is regulated, and executives act in the bank’s best interests, they will still be trapped into providing incentives that encourage risk-taking by non-executives due to the negative externality that arises from that competition. Greater risk-taking can increase short-term profits and, in turn, the amount a non-executive receives, potentially at the expense of long-term bank value. Non-executives, therefore, have an incentive to incur significant risk upfront so long as they can depart for a new employer before any losses materialize. The result is an upward spiral in compensation—reducing an executive’s ability to set non-executive pay and the ability of any one bank to adjust compensation to reflect risk-taking and long-term outcomes. New regulation must address the tension between compensation and competition. Regulators should take account of the effect of competition on market-wide levels of pay, including by non-banks who compete for talent. The ability of non-executives to jump from a bank employer to another financial firm should also be limited. In addition, banks should be required to include a long-term equity component in non-executive pay, with subsequent employers being restricted from compensating a new employee for any losses she incurs related to her prior work.
We examine trust and trustworthiness of individuals with varying professional preferences and experiences. Our subjects study business and economics in Frankfurt, the financial center of Germany and continental Europe. In the trust game, subjects with a high interest in working in the financial industry return 25 percent less than subjects with a low interest. We find no evidence that the extent of professional experience in the financial industry has a negative impact on trustworthiness. We also do not find any evidence that the financial industry screens out less trustworthy individuals in the hiring process. In a prediction game that is strategically equivalent to the trust game, the amount sent by first-movers was significantly smaller when the second-mover indicated a high interest in working in finance. These results suggest that the financial industry attracts less trustworthy individuals, which may contribute to the current lack of trust in its employees.
In the wake of the Global Financial Crisis that started in 2007, policymakers were forced to respond quickly and forcefully to a recession caused not by short-term factors, but rather by an over-accumulation of debt by sovereigns, banks, and households: a so-called “balance sheet recession.” Though the nature of the crisis was understood relatively early on, policy prescriptions for how to deal with its consequences have continued to diverge. This paper gives a short overview of the prescriptions, the remaining challenges and key lessons for monetary policy.
n a contribution prepared for the Athens Symposium on “Banking Union, Monetary Policy and Economic Growth”, Otmar Issing describes forward guidance by central banks as the culmination of the idea of guiding expectations by pure communication. In practice, he argues, forward guidance has proved a misguided idea. What is presented as state of the art monetary policy is an example of pretence of knowledge. Forward guidance tries to give the impression of a kind of rule-based monetary policy. De facto, however, it is an overambitious discretionary approach which, to be successful, would need much more (or rather better) information than is currently available. In Issing's view, communication must be clear and honest about the limits of monetary policy in a world of uncertainty.
We investigate the relationship between anchoring and the emergence of bubbles in experimental asset markets. We show that setting a visual anchor at the fundamental value (FV) in the first period only is sufficient to eliminate or to significantly reduce bubbles in laboratory asset markets. If no FV-anchor is set, bubble-crash patterns emerge. Our results indicate that bubbles in laboratory environments are primarily sparked in the first period. If prices are initiated around the FV, they stay close to the FV over the entire trading horizon. Our insights can be related to initial public offerings and the interaction between prices set on pre-opening markets and subsequent intra-day price dynamics.
he observed hump-shaped life-cycle pattern in individuals' consumption cannot be explained by the classical consumption-savings model. We explicitly solve a model with utility of both consumption and leisure and with educational decisions affecting future wages. We show optimal consumption is hump shaped and determine the peak age. The hump results from consumption and leisure being substitutes and from the implicit price of leisure being decreasing over time; more leisure means less education, which lowers future wages, and the present value of foregone wages decreases with age. Consumption is hump shaped whether the wage is hump shaped or increasing over life.
This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis allows to capture individual behavior across various levels of ambiguity, ranging from low to high. Attitudes towards risk and attitudes towards ambiguity are disentangled, providing pure measures of ambiguity aversion. Ambiguity aversion is captured in several ways, i.e. as a discount factor net of a risk premium, and as an estimated parameter in a generalized utility function. We find that ambiguity aversion varies across individuals, and with the level of ambiguity, being most prominent for intermediate levels. Around one third of subjects show no aversion, one third show maximum aversion, and one third show intermediate levels of ambiguity aversion, while there is almost no ambiguity seeking. While most theoretical work on ambiguity builds on maxmin expected utility, our results provide evidence that MEU does not adequately capture individual attitudes towards ambiguity for the majority of individuals. Instead, our results support models that allow for intermediate levels of ambiguity aversion. Moreover, we find risk aversion to be statistically unrelated to ambiguity aversion on average. Taken together, the results support the view that ambiguity is an important and distinct argument in decision making under uncertainty.
Motivated by the question whether sound and expressive applicative similarities for program calculi with should-convergence exist, this paper investigates expressive applicative similarities for the untyped call-by-value lambda-calculus extended with McCarthy's ambiguous choice operator amb. Soundness of the applicative similarities w.r.t. contextual equivalence based on may-and should-convergence is proved by adapting Howe's method to should-convergence. As usual for nondeterministic calculi, similarity is not complete w.r.t. contextual equivalence which requires a rather complex counter example as a witness. Also the call-by-value lambda-calculus with the weaker nondeterministic construct erratic choice is analyzed and sound applicative similarities are provided. This justifies the expectation that also for more expressive and call-by-need higher-order calculi there are sound and powerful similarities for should-convergence.
The pi-calculus is a well-analyzed model for mobile processes and mobile computations.
While a lot of other process and lambda calculi that are core languages of higher-order concurrent and/or functional programming languages use a contextual semantics observing the termination behavior of programs in all program contexts, traditional program equivalences in the pi-calculus are bisimulations and barbed testing equivalences, which observe the communication capabilities of processes under reduction and in contexts.
There is a distance between these two approaches to program equivalence which makes it hard to compare the pi-calculus with other languages. In this paper we contribute to bridging this gap by investigating a contextual semantics of the synchronous pi-calculus with replication and without sums.
To transfer contextual equivalence to the pi-calculus we add a process Stop as constant which indicates success and is used as the base to define and analyze the contextual equivalence which observes may- and should-convergence of processes.
We show as a main result that contextual equivalence in the pi-calculus with Stop conservatively extends barbed testing equivalence in the (Stop-free) pi-calculus. This implies that results on contextual equivalence can be directly transferred to the (Stop-free) pi-calculus with barbed testing equivalence.
We analyze the contextual ordering, prove some nontrivial process equivalences, and provide proof tools for showing contextual equivalences. Among them are a context lemma, and new notions of sound applicative similarities for may- and should-convergence.
We study consumption-portfolio and asset pricing frameworks with recursive preferences and unspanned risk. We show that in both cases, portfolio choice and asset pricing, the value function of the investor/representative agent can be characterized by a specific semilinear partial differential equation. To date, the solution to this equation has mostly been approximated by Campbell-Shiller techniques, without addressing general issues of existence and uniqueness. We develop a novel approach that rigorously constructs the solution by a fixed point argument. We prove that under regularity conditions a solution exists and establish a fast and accurate numerical method to solve consumption-portfolio and asset pricing problems with recursive preferences and unspanned risk. Our setting is not restricted to affine asset price dynamics. Numerical examples illustrate our approach.
We study self- and cross-excitation of shocks in the Eurozone sovereign CDS market. We adopt a multivariate setting with credit default intensities driven by mutually exciting jump processes, to capture the salient features observed in the data, in particular, the clustering of high default probabilities both in time (over days) and in space (across countries). The feedback between jump events and the intensity of these jumps is the key element of the model. We derive closed-form formulae for CDS prices, and estimate the model by matching theoretical prices to their empirical counterparts. We find evidence of self-excitation and asymmetric cross-excitation. Using impulse-response analysis, we assess the impact of shocks and a potential policy intervention not just on a single country under scrutiny but also, through the effect on cross-excitation risk which generates systemic sovereign risk, on other interconnected countries.
Exit strategies
(2014)
We study alternative scenarios for exiting the post-crisis fiscal and monetary accommodation using a macromodel where banks choose their capital structure and are subject to runs. Under a Taylor rule, the post-crisis interest rate hits the zero lower bound (ZLB) and remains there for several years. In that condition, pre-announced and fast fiscal consolidations dominate - based on output and inflation performance and bank stability - alternative strategies incorporating various degrees of gradualism and surprise. We also examine an alternative monetary strategy in which the interest rate does not reach the ZLB; the benefits from fiscal consolidation persist, but are more nuanced.
We study the behavioral underpinnings of adopting cash versus electronic payments in retail transactions. A novel theoretical and experimental framework is developed to primarily assess the impact of sellers’ service fees and buyers’ rewards from using electronic payments. Buyers and sellers face a coordination problem, independently choosing a payment method before trading. In the experiment, sellers readily adopt electronic payments but buyers do not. Eliminating service fees or introducing rewards significantly boosts the adoption of electronic payments. Hence, buyers’ incentives play a pivotal role in the diffusion of electronic payments but monetary incentives cannot fully explain their adoption choices. Findings from this experiment complement empirical findings based on surveys and field data.
Securities transaction tax in France: impact on market quality and inter-market price coordination
(2014)
The general concept of a Securities Transaction Tax is controversial among academics and politicians. While theoretical research is quite advanced, the empirical guidance in a fragmented market context is still scarce. Possible negative effects for market liquidity and market efficiency are theoretically predicted, but have not been empirically tested yet. In light of the agreement of eleven European member states to implement an STT, this study aims to give a comprehensive overview of the effects of the STT, introduced in France in 2012, on liquidity demand, liquidity supply, volatility and inter-market information transmission. The results show that the STT has led to a decline in liquidity demand, has had a detrimental effect on liquidity supply and negatively influences the inter-market information transmission efficiency. However, no effect on volatility can be observed.
In the United States, on April 1, 2014, the set of rules commonly known as the "Volcker Rule", prohibiting proprietary trading activities in banks, became effective. The implementation of this rule took more than three years, as “proprietary trading” is an inherently vague concept, overlapping strongly with genuinely economically useful activities such as market-making. As a result, the final Rule is a complex and lengthy combination of prohibitions and exemptions.
In January 2014, the European Commission put forward its proposal on banking structural reform. The proposal includes a Volcker-like provision, prohibiting large, systemically relevant financial institutions from engaging in proprietary trading or hedge fund-related business. This paper offers lessons to be learned from the implementation process for the Volcker rule in the US for the European regulatory process.
Financial innovation is, as usual, faster than regulation. New forms of speculation and intermediation are rapidly emerging. Largely as a result of the evaporation of trust in financial intermediation, an exponentially increasing role is being played by the so-called peer to peer intermediation. The most prominent example at the moment is Bitcoin.
If one expects that shocks in these markets could destabilize also traditional financial markets, then it will be necessary to extend regulatory measures also to these innovations.
This article discusses the recent proposal for debt restructuring in the euro zone by Pierre Paris and Charles Wyplosz. It argues that the plan cannot realize the promised debt relief without producing moral hazard. Ester Faia revisits the Redemption Fund proposed in November 2011 by the German Council of Economic Experts and argues that this plan, up to date, still remains the most promising path towards succesful debt restructuring in Europe.
On November 8, 2013, several members of the British House of Lords’ Subcommittee A conducted a hearing at the ECB in Frankfurt, Germany, on “Genuine Economic and Monetary Union and its Implications for the UK”. Professors Otmar Issing and Jan Pieter Krahnen were called as expert witnesses.
The testimony began with a general discussion on the elements considered necessary for a functioning internal market. Do economic union and monetary union require a fiscal union or even a political union, beyond the elements of the banking union currently being prepared? In this context, also the critique of the German current account surplus and the international expectations that Germany stimulate internal demand to support growth in crisis countries, were discussed.
With regard to the monetary union, the members of the subcommittee asked for an assessment of how European nations and the banking industry would have fared in the banking crisis that followed the Lehman collapse, had there not been a common currency. Given the important role that the ECB has played in the course of the crisis management, the members further asked for an evaluation of the OMT-program of the ECB and also if the monetary union is in need of common debt instruments, in order to provide the ECB with the possibility of buying EU liabilities, comparable to the Fed buying US Treasury bonds. Finally, the dual role of the ECB for monetary policy and banking supervision was an issue touched on by several questions.
In many cases, the dire situation of public finances calls into question the very soundness of sovereigns and prompts corrective actions with far-reaching consequences. In this context, European authorities responded with several measures on different fronts, for instance by passing the "Fiscal Compact", which entered into force on January 1, 2013. Of critical importance in this framework is the assessment of a country’s situation by way of statistical measures, in order to take corrective actions when called for according to the letter of the law. If these statistics are not correct, there is a risk of imposing draconian measures on countries that do not really need it.
Before the 2007–09 crisis, standard risk measurement methods substantially underestimated the threat to the financial system. One reason was that these methods didn’t account for how closely commercial banks, investment banks, hedge funds, and insurance companies were linked. As financial conditions worsened in one type of institution, the effects spread to others. A new method that more accurately accounts for these spillover effects suggests that hedge funds may have been central in generating systemic risk during the crisis.
Social impact bonds are a special type of bond whose purpose is to provide long term funds to projects with a social impact. Especially in the UK and in the US these bonds are increasingly being used to raise funds to finance government projects. Their return depends on the social improvements achieved. Especially in times of crisis, governments lack funds to prevent the social consequences of recessions. Faia argues that the European Union should develop an equivalent to the British Social Finance Ltd. to finance projects for social improvement.
Neither Northerners are willing to invest in a South they perceive as unwilling to undertake necessary structural reforms, nor are Southerners willing to invest in their countries in a climate of austerity and policy uncertainty imposed, in their view, by the North. This results in a vicious cycle of mistrust. However, as the author argues, big steps in the direction of reforms may provide just enough thrust to break out of this vicious cycle, propel southern countries – and especially Greece – to a much happier future, and promote the chances for more balanced economic performance in North and South.
Social Security rules that determine retirement, spousal, and survivor benefits, along with benefit adjustments according to the age at which these are claimed, open up a complex set of financial options for household decisions. These rules influence optimal household asset allocation, insurance, and work decisions, subject to life cycle demographic shocks, such as marriage, divorce, and children. Our model-based research generates a wealth profile and a low and stable equity fraction consistent with empirical evidence. We confirm predictions that wives will claim retirement benefits earlier than husbands, while life insurance is mainly purchased by younger men. Our policy simulations imply that eliminating survivor benefits would sharply reduce claiming differences by sex while dramatically increasing men’s life insurance purchases.
One of the motivations for establishing a European banking union was the desire to break the ties with between national regulators and domestic financial institutions in order to prevent regulatory capture. However, supervisory authority over the financial sector at the national level can also have valuable public benefits. The aim of this policy letter is to detail these public benefits in order to counter discussions that focus only on conflicts of interest. It is informed by an analysis of how financial institutions interacted with policy-makers in the design of national bank rescue schemes in response to the banking crisis of 2008. Using this information, it discusses the possible benefits of close cooperation between financial institutions and regulators and analyzes these in the wake of a European banking union.
This paper makes a conceptual contribution to the effect of monetary policy on financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the beneficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We find that central bank supply of liquidity quite generally increases systemic risk.
This paper explores consequences of consumer education on prices and welfare in retail financial markets when some consumers are naive about shrouded add-on prices and firms try to exploit it. Allowing for different information and pricing strategies we show that education is unlikely to push firms to disclose prices towards all consumers, which would be socially efficient. Instead, price discrimination emerges as a new equilibrium. Further, due to a feedback on prices, education that is good for consumers who become sophisticated may be bad for consumers who stay naive and even for the group of all consumers as a whole
This paper makes a conceptual contribution to the effect of monetary policy on financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the beneficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We find that central bank supply of liquidity quite generally increases systemic risk.
This paper investigates the role of monetary policy in the collapse in the long-term real interest rates in the decade before the onset of the financial crisis using a sample of five advanced economies (United States, United Kingdom, the euro area, Sweden and Canada). The results from an estimated panel VAR with monthly data show that, while monetary policy shocks had negligible effects on long-term real interest rates, shocks to the long-term real interest rates had a one-to-one effect on the short nominal rate.
This paper empirically tests the role of bank lending tightening on non-financial corporate (NFC) bond issuance in the eurozone. By utilizing a unique data set provided by the ECB Bank Lending Survey, we capture the "pure" credit supply effect on corporate external financing. We find that tightened credit standards positively affect the NFC bond issuance: A 1pp increase in banks reporting considerable tightening on loans leads to around a 7% increase in firms' bond issuance in the eurozone. Focusing on a spectrum of aspects contributing to bank credit tightening, we document that banks' balance sheet constraints, as well as the perception of risk lead to significantly higher NFC bond issuance. In addition, we show that stricter lending conditions, such as wider margins, higher collateral requirements and covenants significantly increase NFC bond issuance volumes too. Furthermore, the impact of bank credit tightening on firms' bond issuance is particularly observable in core eurozone countries and not in peripheral countries. This is partially due to the underdeveloped of debt capital markets in the peripheral countries.
This paper investigates the determinants of value and growth investing in a large administrative panel of Swedish residents over the 1999-2007 period. We document strong relationships between a household’s portfolio tilt and the household’s financial and demographic characteristics. Value investors have higher financial and real estate wealth, lower leverage, lower income risk, lower human capital, and are more likely to be female than the average growth investor. Households actively migrate to value stocks over the life-cycle and, at higher frequencies, dynamically offset the passive variations in the value tilt induced by market movements. We verify that these results are not driven by cohort effects, financial sophistication, biases toward popular or professionally close stocks, or unobserved heterogeneity in preferences. We relate these household-level results to some of the leading explanations of the value premium.
We analyze the risk premium on bank bonds at origination with a special focus on the role of implicit and explicit public guarantees and the systemic relevance of the issuing institutions. By looking at the asset swap spread on 5,500 bonds, we find that explicit guarantees and sovereign creditworthiness have a substantial effect on the risk premium. In addition, while large institutions still enjoy lower issuance costs linked to the TBTF framework, we find evidence of enhanced market disciple for systemically important banks which face, since the onset of the financial crisis, an increased premium on bond placements.
We examine the impact of so-called "Crisis Contracts" on bank managers' risk-taking incentives and on the probability of banking crises. Under a Crisis Contract, managers are required to contribute a pre-specified share of their past earnings to finance public rescue funds when a crisis occurs. This can be viewed as a retroactive tax that is levied only when a crisis occurs and that leads to a form of collective liability for bank managers. We develop a game-theoretic model of a banking sector whose shareholders have limited liability, so that society at large will suffer losses if a crisis occurs. Without Crisis Contracts, the managers' and shareholders' interests are aligned, and managers take more than the socially optimal level of risk. We investigate how the introduction of Crisis Contracts changes the equilibrium level of risk-taking and the remuneration of bank managers. We establish conditions under which the introduction of Crisis Contracts will reduce the probability of a banking crisis and improve social welfare. We explore how Crisis Contracts and capital requirements can supplement each other and we show that the efficacy of Crisis Contracts is not undermined by attempts to hedge.
Banks can deal with their liquidity risk by holding liquid assets (self-insurance), by participating in interbank markets (coinsurance), or by using flexible financing instruments, such as bank capital (risk-sharing). We use a simple model to show that undiversifiable liquidity risk, i.e. the liquidity risk that banks are unable to coinsure on interbank markets, represents an important risk factor affecting their capital structures. Banks facing higher undiversifiable liquidity risk hold more capital. We posit that empirically banks that are more exposed to undiversifiable liquidity risk are less active on interbank markets. Therefore, we test for the existence of a negative relationship between bank capital and interbank market activity and find support in a large sample of U.S. commercial banks.
From the late middle ages to early modern times (ca. 1200-1600) the Lübeck City Council was the most important courthouse in the Baltic. About 100 cities and towns on its shores lived according to the law of Lübeck. The paper deals with the old theory that Imperial law, i.e. mainly the learned Ius commune, was generally rejected by the council on the grounds of its foreign nature. The paper rejects this view with the help of 8 case studies. There exist rather spectacular statements against Imperial Law, but a closer look reveals that they have to be seen in the light of a specific practical context. They must not be confounded with general statements in which the council had no interest. Its attitude towards Learned Law was flexible and purely pragmatic.
I analyze a critical illness insurance in a consumption-investment model over the life cycle. I solve a model with stochastic mortality risk and health shock risk numerically. These shocks are interpreted as critical illness and can negatively affect the expected remaining lifetime, the health expenses, and the income. In order to hedge the health expense effect of a shock, the agent has the possibility to contract a critical illness insurance. My results highlight that the critical illness insurance is strongly desired by the agents. With an insurance profit of 20%, nearly all agents contract the insurance in the working stage of the life cycle and more than 50% of the agents contract the insurance during retirement. With an insurance profit of 200%, still nearly all working agents contract the insurance, whereas there is little demand in the retirement stage.
I numerically solve realistically calibrated life cycle consumption-investment problems in continuous time featuring stochastic mortality risk driven by jumps, unspanned labor income as well as short-sale and liquidity constraints and a simple insurance. I compare models with deterministic and stochastic hazard rate of death to a model without mortality risk. Mortality risk has only minor effects on the optimal controls early in the life cycle but it becomes crucial in later years. A diffusive component in the hazard rate of death has no significant impact, whereas a jump component is desired by the agent and influences optimal controls and wealth evolution. The insurance is used to ensure optimal bequest such that there is no accidental bequest. In the absence of the insurance, the biggest part of bequest is accidental.
We explore the sources of household balance sheet adjustment following the collapse of the housing market in 2006. First, we use microdata from the Federal Reserve Board’s Senior Loan Officer Opinion Survey to document that banks cumulatively tightened consumer lending standards more in counties that experienced a house price boom in the mid-2000s than in non-boom counties. We then use the idea that renters, unlike homeowners, did not experience an adverse wealth shock when the housing market collapsed to examine the relative importance of two explanations for the observed deleveraging and the sluggish pickup in consumption after 2008. First, households may have optimally adjusted to lower wealth by reducing their demand for debt and implicitly, their demand for consumption. Alternatively, banks may have been more reluctant to lend in areas with pronounced real estate declines. Our evidence is consistent with the second explanation. Renters with low risk scores, compared to homeowners in the same markets, reduced their levels of nonmortgage debt and credit card debt more in counties where house prices fell more. The contrast suggests that the observed reductions in aggregate borrowing were more driven by cutbacks in the provision of credit than by a demand-based response to lower housing wealth.
This paper solves a dynamic model of households' mortgage decisions incorporating labor income, house price, inflation, and interest rate risk. It uses a zero-profit condition for mortgage lenders to solve for equilibrium mortgage rates given borrower characteristics and optimal decisions. The model quantifies the effects of adjustable vs. fixed mortgage rates, loan-to-value ratios, and mortgage affordability measures on mortgage premia and default. Heterogeneity in borrowers' labor income risk is important for explaining the higher default rates on adjustable-rate mortgages during the recent US housing downturn, and the variation in mortgage premia with the level of interest rates.
In ‘Strafe für fremde Schuld’ Harald Maihold uncovered how a doctrine of surrogate punishment in the legal treatises of the Salamanca school gradually gave way to the principle of guilt. This meant that punishment eventually could only be inflicted upon a culprit and no longer upon an innocent. We will use René Girard’s philosophy of (the disruption of) scapegoat mechanisms and sacrifice to develop a coherent interpretation not only of how this institution of surrogate punishment functioned, how it selected its victims and the way it was legitimated, but also of the theology that formed its background. We argue that most of what surrogate punishment is about can be grasped in two words: sacrificial logic. The elimination of surrogation from criminal law would then correspond to the rejection of this logic, an evolution which could be interpreted as a desacralisation or secularisation of criminal law under the influence of the upcoming principle of guilt.
Noumenal Power
(2014)
In political or social philosophy, we speak about power all the time. Yet the meaning of this important concept is rarely made explicit, especially in the context of normative discussions. But as with many other concepts, once one considers it more closely, fundamental problems arise, such as whether a power relation is necessarily a relation of subordination and domination. In the following, I suggest a novel understanding of what power is and what it means to exercise it.
Francisco Suárez (1548-1617) and Rodrigo Arriaga (1592-1667) on the state of innocence and community
(2014)
Recent scholarship on late-scholastic thought has stressed a Jesuit discontinuity from Thomism. While Aquinas’ Aristotelian thesis located the political sphere in the state of innocence, Jesuit thought on community formation is said to have referred to ‘fallen’ and ‘pure’ nature. In this piece, I trace one particular narrative: In the hypothetical, lasting state of innocence (if original sin had not occurred), Aquinas identified the political community, but not the institution of the sacraments. Two celebrated Jesuit scholastics, Francisco Suárez and Rodrigo Arriaga, challenged the latter claim and defended the naturalness of spiritual alongside temporal power. This effectively allowed them to connect ‘nature’ to ‘utility’ and ‘necessity’ without tying their claims to the supernatural teleology. To them, the state of innocence remained relevant for politics, albeit in a way that challenged the Thomist account.
In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium.
This paper studies the life cycle consumption-investment-insurance problem of a family. The wage earner faces the risk of a health shock that significantly increases his probability of dying. The family can buy term life insurance with realistic features. In particular, the available contracts are long term so that decisions are sticky and can only be revised at significant costs. Furthermore, a revision is only possible as long as the insured person is healthy. A second important and realistic feature of our model is that the labor income of
the wage earner is unspanned. We document that the combination of unspanned labor income and the stickiness of insurance decisions reduces the insurance demand significantly. This is because an income shock induces the need to reduce the insurance coverage, since premia become less affordable. Since such a reduction is costly and families anticipate these potential costs, they buy less protection at all ages. In particular, young families stay away from life insurance markets altogether.