Sustainable Architecture for Finance in Europe (SAFE)
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Socially responsible investing (SRI) continues to gain momentum in the financial market space for various reasons, starting with the looming effect of climate change and the drive toward a net-zero economy. Existing SRI approaches have included environmental, social, and governance (ESG) criteria as a further dimension to portfolio selection, but these approaches focus on classical investors and do not account for specific aspects of insurance companies. In this paper, we consider the stock selection problem of life insurance companies. In addition to stock risk, our model set-up includes other important market risk categories of insurers, namely interest rate risk and credit risk. In line with common standards in insurance solvency regulation, such as Solvency II, we measure risk using the solvency ratio, i.e. the ratio of the insurer’s market-based equity capital to the Value-at-Risk of all modeled risk categories. As a consequence, we employ a modification of Markowitz’s Portfolio Selection Theory by choosing the “solvency ratio” as a downside risk measure to obtain a feasible set of optimal portfolios in a three-dimensional (risk, return, and ESG) capital allocation plane. We find that for a given solvency ratio, stock portfolios with a moderate ESG level can lead to a higher expected return than those with a low ESG level. A highly ambitious ESG level, however, reduces the expected return. Because of the specific nature of a life insurer’s business model, the impact of the ESG level on the expected return of life insurers can substantially differ from the corresponding impact for classical investors.
Lack of privacy due to surveillance of personal data, which is becoming ubiquitous around the world, induces persistent conformity to the norms prevalent under the surveillance regime. We document this channel in a unique laboratory---the widespread surveillance of private citizens in East Germany. Exploiting localized variation in the intensity of surveillance before the fall of the Berlin Wall, we show that, at the present day, individuals who lived in high-surveillance counties are more likely to recall they were spied upon, display more conformist beliefs about society and individual interactions, and are hesitant about institutional and social change. Social conformity is accompanied by conformist economic choices: individuals in high-surveillance counties save more and are less likely to take out credit, consistent with norms of frugality. The lack of differences in risk aversion and binding financial constraints by exposure to surveillance helps to support a beliefs channel.
Supranational supervision
(2022)
We exploit the establishment of a supranational supervisor in Europe (the Single Supervisory Mechanism) to learn how the organizational design of supervisory institutions impacts the enforcement of financial regulation. Banks under supranational supervision are required to increase regulatory capital for exposures to the same firm compared to banks under the local supervisor. Local supervisors provide preferential treatment to larger institutes. The central supervisor removes such biases, which results in an overall standardized behavior. While the central supervisor treats banks more equally, we document a loss in information in banks’ risk models associated with central supervision. The tighter supervision of larger banks results in a shift of particularly risky lending activities to smaller banks. We document lower sales and employment for firms receiving most of their funding from banks that receive a tighter supervisory treatment. Overall, the central supervisor treats banks more equally but has less information about them than the local supervisor.
Resolving financial distress where property rights are not clearly defined: the case of China
(2022)
We use data on financially distressed Chinese companies in order to study a debt market where property rights are crudely defined and poorly enforced. To help with identification we use an event where a business-friendly province published new guidelines regarding the administration and enforcement of assets pledged as collateral. Although by no means a comprehensive reform of bankruptcy law or property rights, by instructing courts to enforce existing, albeit rudimentary, contractual rights the new guidelines virtually eliminated creditors runs and produced a sharp increase in the survival rate of financially-distressed companies. These changes illustrate how piecemeal reforms of property rights and their enforcement may have a significant impact on economic outcomes. Our analysis and results challenge the view that a fully fledged system of private property is a precondition for economic development.
The loan impairment rules recently introduced by IFRS 9 require banks to estimate their future credit losses by using forward-looking information. We use supervisory loan-level data from Germany to investigate how banks apply their reporting discretion and adjust their lending upon the announcement of the new rules. Our identification strategy exploits a cut-off for the level of provisions at the investment grade threshold based on banks’ internal rating of a borrower. We find that banks required to adopt the new rules assign better internal ratings to exactly the same borrowers compared to banks that do not apply IFRS 9 around this cut-off. This pattern is consistent with a strategic use of the increased reporting discretion that is inherent to rules requiring forward-looking loss estimation. At the same time, banks also reduce their lending exposure to exactly those borrowers at the highest risk of experiencing a rating downgrade below the cutoff. These loans would be associated with additional provisions in future periods, both in the intensive and extensive margin. The lending change thus mitigates some of the negative effects of increased reporting opportunism on banks’ crisis resilience. However, when these firms with internal ratings around the investment grade cut-off obtain less external funding through banks, the introduction of IFRS 9 will likely also be associated with real economic effects
The great financial crisis and the euro area crisis led to a substantial reform of financial safety nets across Europe and – critically – to the introduction of supranational elements. Specifically, a supranational supervisor was established for the euro area, with discrete arrangements for supervisory competences and tasks depending on the systemic relevance of supervised credit institutions. A resolution mechanism was created to allow the frictionless resolution of large financial institutions. This resolution mechanism has been now complemented with a funding instrument.
While much more progress has been achieved than most observers could imagine 12 years ago, the banking union remains unfinished with important gaps and deficiencies. The experience over the past years, especially in the area of crisis management and resolution, has provided impetus for reform discussions, as reflected most lately in the Eurogroup statement of 16 June 2022.
This Policy Insight looks primarily at the current and the desired state of the banking union project. The key underlying question, and the focus here, is the level of ambition and how it is matched with effective legal and regulatory tools. Specifically, two questions will structure the discussions:
What would be a reasonable definition and rationale for a ‘complete’ banking union? And what legal reforms would be required to achieve it?
Banking union is a case of a new remit of EU-level policy that so far has been established on the basis of long pre-existing treaty stipulations, namely, Article 127(6) TFEU (for banking supervision) and Article 114 TFEU (for crisis management and deposit insurance). Could its completion be similarly carried out through secondary law? Or would a more comprehensive overhaul of the legal architecture be required to ensure legal certainty and legitimacy?
Using the negotiation process of the Basel Committee on Banking Supervision (BCBS), this paper studies the way regulators form their positions on regulatory issues in the process of international standard-setting and the consequences on the resultant harmonized framework. Leveraging on leaked voting records and corroborating them using machine learning techniques on publicly available speeches, we construct a unique dataset containing the positions of banks and national regulators on the regulatory initiatives of Basel II and III. We document that the probability of a regulator opposing a specific initiative increases by 30% if their domestic national champion opposes the new rule, particularly when the proposed rule disproportionately affects them. We find the effect is driven by regulators who had prior experience of working in large banks – lending support to the private-interest theories of regulation. Meanwhile smaller banks, even when they collectively have a higher share in the domestic market, do not have any impact on regulators’ stand – providing little support to public-interest theories of regulation. Finally, we show this decision-making process manifests into significant watering down of proposed rules, thereby limiting the potential gains from harmonization of international financial regulation.
The author proposes a Differential-Independence Mixture Ensemble (DIME) sampler for the Bayesian estimation of macroeconomic models.It allows sampling from particularly challenging, high-dimensional black-box posterior distributions which may also be computationally expensive to evaluate. DIME is a “Swiss Army knife”, combining the advantages of a broad class of gradient-free global multi-start optimizers with the properties of a Monte Carlo Markov chain (MCMC). This includes fast burn-in and convergence absent any prior numerical optimization or initial guesses, good performance for multimodal distributions, a large number of chains (the “ensemble”) running in parallel, an endogenous proposal density generated from the state of the full ensemble, which respects the bounds of the prior distribution. The author shows that the number of parallel chains scales well with the number of necessary ensemble iterations.
DIME is used to estimate the medium-scale heterogeneous agent New Keynesian (“HANK”) model with liquid and illiquid assets, thereby for the first time allowing to also include the households’ preference parameters. The results mildly point towards a less accentuated role of household heterogeneity for the empirical macroeconomic dynamics.
The authors estimate perceptions about the Fed's monetary policy rule from panel data on professional forecasts of interest rates and macroeconomic conditions. The perceived dependence of the federal funds rate on economic conditions is time-varying and cyclical: high during tightening episodes but low during easings. Forecasters update their perceptions about the policy rule in response to monetary policy actions, measured by high-frequency interest rate surprises, suggesting that forecasters have imperfect information about the rule. The perceived rule impacts asset prices crucial for monetary policy transmission, driving how interest rates respond to macroeconomic news and explaining term premia in long-term interest rates.
We employ a proprietary transaction-level dataset in Germany to examine how capital requirements affect the liquidity of corporate bonds. Using the 2011 European Banking Authority capital exercise that mandated certain banks to increase regulatory capital, we find that affected banks reduce their inventory holdings, pre-arrange more trades, and have smaller average trade size. While non-bank affiliated dealers increase their market-making activity, they are unable to bridge this gap - aggregate liquidity declines. Our results are stronger for banks with a higher capital shortfall, for non-investment grade bonds, and for bonds where the affected banks were the dominant market-maker.