capital (economics), Meta Intelligence

Economics-Watching: Does Monetary Policy Affect Non-Mining Business Investment in Australia?

[from the Reserve Bank of Australia, by Gulnara Nolan, Jonathan Hambur and Philip Vermeulen]

Summary

Business investment is a key driver of economic growth. When investment is strong, workers have access to more capital and equipment, making them more productive and able to contribute to stronger productivity growth. Business investment is also thought to be an important driver of economic cycles and stimulating business investment is one of the key mechanisms through which monetary policy is thought to work.

However, non-mining business investment in Australia was fairly weak over much of the 2010s, despite declines in interest rates and moderate economic growth. While several explanations have been put forward, one potential explanation is that monetary policy is not very effective at stimulating business investment or has become less effective over time.

This study examines the effect of monetary policy changes on non-mining business investment using a variety of national and firm-level investment data, exploring both the aggregate effect of monetary policy and the channels through which monetary policy affects investment.

Abstract

We provide new evidence on the effect of monetary policy on investment in Australia using firm-level data. We find that contractionary monetary policy makes firms less likely to invest and lowers the amount they invest if they do so. The effects are similar for young and old firms, indicating that the decline in the number of young firms in Australia over time is unlikely to have weakened the effect of monetary policy. The effects are also broadly similar for smaller and larger firms. This suggests that evidence that some, particularly large, firms have sticky hurdle rates does not mean that they do not respond to monetary policy. It also suggests that overseas findings that expansionary monetary policy lessens competition by supporting the largest firms likely do not apply to Australia. We find evidence that financially constrained firms, and sectors that are more dependent on external finance, are more responsive to monetary policy, highlighting the important role of cash flow and financing constraints in the transmission of monetary policy. Finally, we find evidence that monetary policy affects firms’ actual and expected investment contemporaneously, suggesting that expectations are reactive and will tend to lag over the cycle.

Read the full paper [archived PDF].

Economics-Watching: Putting Out the NBFIRE: Lessons from the UK’s Liability-Driven Investment (LDI) Crisis

[from the International Monetary Fund Working Paper 2023/210]

by Ruo Chen & Esti Kemp

Liability-Driven Investment (LDI) funds were at the center of the severe stress that emerged in the UK gilt market in the aftermath of the September 2022 UK “mini-budget.” The episode, which came on the heels of the “Dash for Cash” and “Archegos” stress episodes in the previous two years, highlights underlying vulnerabilities in the large and diverse non-bank financial institution (NBFI) sector. This paper seeks a deeper understanding of the factors that amplified the gilt market turmoil which ultimately led the Bank of England (BoE) to undertake temporary gilt purchases on financial stability grounds in late September/early October 2022 to restore orderly market conditions and enable LDI funds to build their capital positions. With the gilt market stress and the BoE’s purchases now fully unwound, this paper identifies the key reasons for the success of the BoE’s intervention. Then, drawing also on findings of the 2022 UK Financial Sector Assessment Program (FSAP), the paper discusses key gaps and policy issues related to the monitoring of financial stability risks in the broader NBFI sector for both individual jurisdictions and international standard-setting bodies.

[read the working paper (archived PDF)]

World-Watching: Small Business and Food Waste: Not a Small Problem

[from APEC News]

by Aaron Sydor

Faced with a possible food crisis, economies must work together and take action on food waste … starting at the front line with MSMEs.

Conflict, supply disruption, rising prices, and shortages are all impacting food supplies globally. Just as we are nearing some form of recovery from the pandemic, we are now facing another global challenge in the form of a food crisis – and it’s likely to get worse.

The United Nations World Food Programm e (WFP) tells us that 349 million people face acute food insecurity this year — an increase from 287 million people in 2021. It is a tragedy that when the world is “hungrier than ever,” as the WFP calls it, so much food goes to waste. One-third of food production, or 1.3 billion tons per year, goes to waste globally, according to the UN Food and Agriculture Organization. It is inconceivable, then, that we don’t make the most of the food that we have.

This is a regional problem that cannot be solved by individual economies acting on their own. It must be looked at with a wider lens, such as through bodies, like APEC, that promote regional economic cooperation. APEC members acknowledge that all areas of the agri-food value chain are interdependent and that there is a need for a whole-system approach.

Among the forum’s efforts to reduce food waste is the Food Security Roadmap Towards 2030 which aims to establish an open, fair, transparent, productive, sustainable and resilient APEC food system. This corresponds to the UN and other multilateral goals by taking action through the following avenues: digital transformation; productivity and international trade; sustainability; public-private partnerships; and inclusivity, especially in the inclusion of micro, small and medium enterprises (MSMEs) along the agri-food value chain.

For more on this topic, download “Enhancing Green MSMEs’ Competitiveness for a Sustainable and Inclusive Asia-Pacific: Food Sector Waste Reduction in Food Supply Chain.” [Archived PDF]

In my capacity as the Chair of APEC’s Small and Medium Enterprises Working Group, I’d like to stress the importance of the latter: inclusivity and small business. MSMEs account for over 97 percent of all business in APEC economies and employ over half of the workforce. Any strategy for reducing food wastage will have to involve the wholesale participation of the region’s smaller businesses.

This is easier written than done. For one thing, fit-for-purpose data is scarce. No APEC economy has food waste data that is specific to MSMEs. And while all have policies and measures to address the problem of food waste, there are no large-scale direct MSME–food waste reduction targets, policies or plans. Few have tried to reduce MSME food waste in the retail food and food service industries. Supermarkets, food storage facilities or warehouses in many APEC economies aren’t required to donate excesses.

Most entrepreneurs aren’t even aware of the problem, or underestimate its true cost. Those who do understand have limited options or capital, and are unable to find cost-effective solutions to create value out of food waste, and face problems with logistics and transportation. On top of this, there are few to no regulatory frameworks to guide them. From a technology perspective, a majority of APEC economies utilize modern technologies, including mobile applications, to reduce or manage MSME food waste/surplus food, but these modern technologies are used only by large companies in big cities.

Amid these challenges are an abundance of opportunities to help MSMEs reduce food waste. Training, policies and guidelines can aid them in improving profits by reducing costs and increasing the value added of food. They can reduce their carbon footprint, which enhances consumer demand, and divert waste to new products or bioenergy.

A November study by the APEC Small and Medium Enterprises Working Group presents case studies, identifies the best available data on food waste for MSMEs, and identifies several best practices for economies in dealing with food waste through MSME policy.

In one section, the study’s authors analyze a case study of a successful MSME, and identify four key factors contributing to its successful reduction of food waste: 1) creating a network of people — e.g., a community surrounding a farm; 2) using innovation and technology to facilitate farming and save time; 3) producing knowledge and providing it through several channels — e.g., a learning and training center, friendly guide books; and 4) considering the environment at every step of the process.

The paper, called “Enhancing Green MSMEs’ Competitiveness for a Sustainable and Inclusive Asia-Pacific: Food Sector Waste Reduction in Food Supply Chain,” [Archived PDF] is extensive and easily doubles as a handbook for anyone interested in MSME food waste, or the problem of food waste in general. It is a great example of what can be achieved when economies combine knowledge and resources in the pursuit of keeping the region inclusive, prosperous, and fed.

Aaron Sydor is the Chair of the APEC Small and Medium Enterprises Working Group.

Globalization and Its Nuances

The PBS TV program History Detectives had an episode entitled “Atocha Spanish Silver” where the wreck of the Spanish ship Atocha was described like this:

“In 1985, one of the greatest treasure discoveries was made off the Florida Keys, when the wreck of the Spanish ship Atocha was found. On board were some forty tons of silver and gold, which in 1622 had been heading from the New World to the Spanish treasury as the means to fund the Thirty Years’ War.”

Is this an obvious case of globalization? What about Marco Polo? Rome–Han dynasty China trade in silks? Silk Road and Samarkand? Colombus? Magellan? Vasco da Gama?

All of these cases constitute a kind of harmless kind of “pop globalization” based on exotic voyages and travels.

Consider another such example, perhaps more academic:

“About the middle of the sixteenth century Antwerp reached its apogee. For the first time in history there existed both a European and a world market; the economies of different parts of Europe had become interdependent and were linked through the Antwerp market, not only with each other but also with the economies of large parts of the rest of the world. Perhaps no other city has ever again played such a dominant role as did Antwerp in the second quarter of the sixteenth century.”
(Europe in the Sixteenth Century, Koenigsberger and Mosse, Holt Rinehart Publishers, 1968, page 50)

Debt repudiations in several places in the 1550s are described like this:

“This caused the first big international bank crash, for the Antwerp bankers now could not meet their own obligations.”
(Europe in the Sixteenth Century, Koenigsberger and Mosse, Holt Rinehart Publishers, 1968, page 51)

This sounds like some kind of identifiably global period.

Actually, modern historians define globalization as “price convergence” (i.e., wheat has now a unified “world price,” implying a world market). This rigorous definition is confirmed by and also shows up in the data in the 1820s and may or may not be prefigured by all the Marco Polo and Atocha silver stories, mentioned above.

These episodes in history are not there yet.

One sees wheat prices and other commodity prices converging in the 1820s and thereafter based on railroads, steamships and telegrams.

The classic in this kind of analysis is:

Globalization and History: The Evolution of a Nineteenth-Century Atlantic Economy, by Kevin O’Rourke and Jeffrey Williamson.

Kevin O’Rourke and Jeffrey Williamson present a coherent picture of In Globalization and History, Kevin O’Rourke and Jeffrey Williamson present a coherent picture of trade, migration, and international capital flows in the Atlantic economy in the century prior to 1914—the first great globalization boom, which anticipated the experience of the last fifty years. The authors estimate the extent of globalization and its impact on the participating countries, and discuss the political reactions that it provoked. The book’s originality lies in its application of the tools of open-economy economics to this critical historical period—differentiating it from most previous work, which has been based on closed-economy or single-sector models. The authors also keep a close eye on globalization debates of the 1990s, using history to inform the present and vice versa. The book brings together research conducted by the authors over the past decade—work that has profoundly influenced how economic history is now written and that has found audiences in economics and history, as well as in the popular press.
(book summary)

In everyday language, we associate the word globalization with some ever-increasing Marco Polo phenomena. While that’s not entirely wrong, globalization in the more technical sense begins to show up in the data only from the 1820s. At this point, we begin to see the convergence of worldwide wheat prices, for example. This makes the world, for the first time, a global “store” with unified prices. Here is the technical beginning of globalization. The years 1870-1914 are subsequently the first real era of modern globalization and represent a kind of “take-off” from the first stirrings of the 1820s. World Wars I & II might be seen as globalization backlash.

At this moment in world history, whether Putin’s invasion of Ukraine will constitute a new wave of deglobalization remains to be seen.

Countries and Deep Patternings: China

China’s High-Level Equilibrium Trap as a Concept

The Pattern of the Chinese Past
Mark Elvin
Paperback: 348 pages
Publisher: Stanford University Press; 1st edition (June 1, 1973)

The 1973 classic work in Sinology, Mark Elvin’s The Pattern of the Chinese Past gives the student an “exemplum” in the kind of scholarship that might be called “pattern-seeking.” Without such attempts, all of history becomes formless and shapeless and an endless parade of “routs and rallies,” and “crimes and follies and misfortunes” (in Edward Gibbon’s catchphrase).

Professor Elvin renders Chinese history through an economic perspective instead of using the common dynastic classification by attempting to answer three questions:

What contributed to the continuity of the Chinese empire?
Why was the Chinese economy the most advanced in the world from the Song dynasty (960-1279) up until the latter half of the Qing dynasty (mid-1800s)?
Why did China fail to maintain her technological advantage after the mid-fourteenth century while advancing economically?

In the first section of the book, the author elucidates the staying power of the Chinese empire was due to the following factors. The economics of defense in relation to the size of empire and the power of its neighbors never became an extreme burden that it rendered the state impotent for any consecutively long period of time. It was always able to reformulate itself after a short disunity or rule by a foreign power of the whole, which only happened twice within a two thousand year period (Mongol and Manchu rule). Two other factors that contributed to the continuity of the Chinese state include a relatively isolated existence from the rest of the Eurasian landmass and the important placed on cultural unity, beginning with the first emperor’s destruction of local records in order to quell local loyalties (pp. 21-22). Both of these factors had been built up over time through a revolution in communication and transportation.

The second section of the book analyses the causes of the economic revolution that occurred between the 8^th and 12^th centuries and the technological growth that accompanied it. The transformation of agriculture, especially in the south, was the major impetus that fueled the economic growth of this period. This revolution in agriculture had four aspects.

The preparation of soil became more effective as a result of improved or new tools and the extensive use of manure and lime as fertilizer.
Seed improvements allowed for double cropping.
Improvements in hydraulic techniques and irrigation networks.
Specialization in crops other than basic food grains (p.118).

Improvements in transportation and communications were almost as important as agriculture in growing the economy. Water transport saw big gains and led to the golden age of geographic studies and cartography, with envoys traveling as far away as Africa. Money and credit matured during this time helping to expand the economy. Paper money made its first appearance in 1024. Improvements in science, medicine, and technology also occurred during this period. However, despite all these advancements, “this period was the climax and also the end of many preceding centuries of scientific and technical progress” (p. 179). Although the Chinese economy continued to advance from the 14^th century on, albeit on a smaller scale, it was not accompanied by improvements in technology.

The last section deals with this phenomenon, describing the distinctive characteristics of this late traditional period (1300-1800), and then proceeding to point out why technological advancements did not keep pace with the growth in the economy. This period sees a rise of small market towns in the sixteenth century and a decline in contact with the non-Chinese world around the middle of the fifteenth century. Also, by the eighteenth century serfdom disappeared, aiding population growth, which had reached 400 million by the mid-1800s. Elvin interestingly points out that the highly sophisticated metaphysics that evaded Chinese intellectual thought during the Ming and Qing dynasties negated any deep scientific inquiry (p. 233). In the attempt to explain the lack of technological advancement, Elvin disputes a number of conventional explanations. Contrary to popular belief, there was enough capital during this period to finance simple technological advances, also there was minimal political obstacles to economic growth.

In short, Elvin believes “that in late traditional China economic forces developed in such a way as to make profitable invention more and more difficult. With falling surplus in agriculture, and so falling per capita income and per capita demand, with cheapening labor but increasingly expensive resources and capital, with farming and transport technologies so good that no simple improvements could be made, rational strategy for peasants and merchants alike tended in the direction not so much of labor-saving machinery as of economizing on resources and fixed capital. Huge but nearly static markets created no bottlenecks in the production system that might have prompted creativity” (p. 314). This condition is what he terms as a “high-level equilibrium trap.” The term “trap” to describe the condition of late imperial China’s technological advancement in relation to the economy is similar to Escape from Predicament, Thomas Metzger’s analysis of the “predicament” that confronted Chinese intellectual thought from the Song through to the end of the Qing dynasty. Both explanations have at their core the idea of late imperial China not being able to generate real sustainable progress internally, stating that it was the Chinese response to the Western threat in the mid to late 1800s that finally brought the needed change.

Movies As Parallel Universities: The Promised Land

The Promised Land is a Polish film masterpiece based on Nobel laureate Reymont’s 1899 novel. The novel describes the industrialization of the Polish city of Łódź in the nineteenth century and reminds one a little of Upton Sinclair’s The Jungle of 1906 but with the emphasis not on dangers and miseries for labor but on the “mad dance” of the capitalist industrial free-for-all:

“The Promised Land (Polish: Ziemia obiecana) is a 1975 Polish drama film directed by Andrzej Wajda, based on the novel by Władysław Reymont. Set in the industrial city of Łódź, The Promised Land tells the story of a Pole, a German, and a Jew struggling to build a factory in the raw world of 19^th century capitalism.”
(Wikipedia)

Wajda presents a shocking image of the city, with its dirty and dangerous factories and ostentatiously opulent residences devoid of taste and culture. The film follows in the tradition of Charles Dickens, Émile Zola and Maxim Gorky, as well as German expressionists such as Dix, Meidner and Grosz, who gave testimony of social protest. Think also of the English poet, William Blake’s metaphor describing industrial England as a world of “dark Satanic mills.”

Reymont, the author of the original novel, was in his heart a ruralist and intensely disliked the modern industrial world, which he saw as maniacal and destructive.

In the 2015 poll conducted by the Polish Museum of Cinematography in Łódź, The Promised Land was ranked first on the list of the greatest Polish films of all time.

Plot

“Karol Borowiecki (Daniel Olbrychski), a young Polish nobleman, is the managing engineer at the Bucholz textile factory. He is ruthless in his career pursuits, and unconcerned with the long tradition of his financially declined family. He plans to set up his own factory with the help of his friends Max Baum (Andrzej Seweryn), a German and heir to an old handloom factory, and Moritz Welt (Wojciech Pszoniak), an independent Jewish businessman. Borowiecki’s affair with Lucy Zucker (Kalina Jędrusik), the wife of another textile magnate, gives him advance notice of a change in cotton tariffs and helps Welt to make a killing on the Hamburg futures market. However, more money has to be found so all three characters cast aside their pride to raise the necessary capital.
On the day of the factory opening, Borowiecki has to deny his affair with Zucker’s wife to a jealous husband who, himself a Jew, makes him swear on a sacred Catholic object. Borowiecki then accompanies Lucy on her exile to Berlin. However, Zucker sends an associate to spy on his wife; he confirms the affair and informs Zucker, who takes his revenge on Borowiecki by burning down his brand new, uninsured factory. Borowiecki and his friends lose all that they had worked for.
The film fast forwards a few years. Borowiecki recovered financially by marrying Mada Müller, a rich heiress, and he owns his own factory. His factory is threatened by a workers’ strike. Borowiecki is forced to decide whether or not to open fire on the striking and demonstrating workers, who throw a rock into the room where Borowiecki and others are gathered. He is reminded by an associate that it is never too late to change his ways. Borowiecki, who has never shown human compassion toward his subordinates, authorizes the police to open fire nevertheless.”
(Wikipedia)

Notice the sentence above:

Borowiecki’s affair with Lucy Zucker (Kalina Jędrusik), the wife of another textile magnate, gives him advance notice of a change in cotton tariffs and helps Welt to make a killing on the Hamburg futures market.

Textiles and hence cotton prices and tariffs are, as elsewhere, “the name of the game” in Łódź industry.

There is a concrete basis in reality for this 19^th century version of our derivatives trading contributing to 2008 and the Great Recession:

In a discussion of futures markets, we read:

“Already in 1880 merchants were buying an idea rather than a palpable commodity, as we saw happen in the grains futures market. In that year, sixty-one million bags (coffee, in this example) were bought and sold on the Hamburg futures market, when the entire world harvest was less than seven million bags!
It was this sort of speculation that caused the German government to shut down the futures market for a while.”
(Global Markets Transformed: 1870-1945, Steven Topik & Allen Wells, Harvard University Press, 2012, page 234)

The danger with such speculative excesses is that the economy, national or global, becomes a “betting parlor” (bets on bets on bets in an infinite regress, as in the lead-up to 2008) and governments have been paralyzed and passive in the face of such “casino capitalism” (to use Susan Strange’s vocabulary) because laissez-faire neoliberal ideology has a profound hold in the West, especially in Anglo-America.

Professor Milton Friedman (died in 2006) argued in interviews going back to the 1960s and before, that speculators fulfill a valuable economic function since they “keep the system efficient.”

The current semi-dismantling and neutralizing of the Dodd-Frank financial reforms and guidelines has to do not only with lobbying but also with the hold of various strands of such “laissez-faire” ideology and market fundamentalism.

Keynes’s classic essay, “The End of Laissez-Faire” tends to yield to the countervailing force of this market fundamentalism/“laissez-faire religion.”

Essay 102: Economics—Atlanta Fed’s November Notes from the Vault

Financial System of the Future

Notes from the Vault
Larry D. Wall
November 2019

The financial services business is an information technology business that operates in an environment with substantial government involvement. The state of both technology and government intervention have evolved considerably since the financial crisis that began in 2007, with potentially large implications for the future financial system. With that in mind, the Atlanta Fed recently hosted the workshop Financial System of the Future, which was cosponsored by the Center for the Economic Analysis of Risk (CEAR) at Georgia State University.

This post reviews many of the papers and presentations from the workshop dealing with both financial regulation and innovations in financial technology. It also reviews one of the keynote speeches on the important topic of corporate governance. A companion macroblog post summarizes the workshop’s discussion of digital currencies.

Post-crisis changes in regulation

Some banks had difficulty obtaining adequate funding from private financial markets during the crisis of 2007–08, despite being well capitalized by that period’s capital standards. In part, these funding difficulties were a result of bank depositors fearing that banks had not adequately provisioned for their credit losses.

A paper by University of Michigan professors Thomas Flanagan and Amiyatosh Purnanandam examines the question “Why Do Banks Hide Losses?” [PDF] with a particular focus on the role of shareholder monitoring and management incentives. One problem in conducting such a study is that of separating bad investment decisions from deceptive accounting. This paper exploits an unexpected change in regulation in India to help provide such separation. This regulatory change forced all of the banks in that country to detail the extent of their underreporting of loan losses in 2015. The paper finds that weaker shareholder monitoring and higher-power executive compensation contracts are associated with more underreporting of loan losses.¹ This paper helps us to understand how banks exploit accounting discretion over loan losses and reinforces the importance of supervisory oversight.

The funding problems encountered by U.S. banks led to runs and ultimately the collapse of a few banks, but these problems had a significant effect on the operations of some banks that survived. One measure of the vulnerability of a bank to a funding shock was its reliance on uninsured, wholesale deposits from large institutions. Professors Sudheer Chava of Georgia Institute of Technology, Rohan Ganduri of Emory University, Linghang Zeng of Babson College, and graduate student Nikhil Paradkar of Georgia Tech examine one effect of these shocks in their paper “Shocked by Bank Funding Shocks: Evidence from 500 Million Consumer Credit Cards” [PDF]. The paper finds that banks that were more exposed to wholesale funding shocks made larger cuts in consumer credit lines than other banks. The authors further find that these cutbacks were made to the most credit-constrained customers (those with lower credit scores and higher utilization of their credit line). The results also suggest that these credit-constrained consumers responded by cutting back their consumption. Overall, these results provide additional support for regulatory policies intended to strengthen banks so that they can continue lending through future crises.

The Federal Reserve was created in 1913 in large part to provide a source of liquidity during periods of stress in bank lending markets. Yet banks proved surprisingly resistant to borrowing from the Fed’s discount window at the start of the funding problems in the fall of 2007. In an attempt to overcome this reluctance to borrow, the Fed created the Term Auction Facility (TAF) in December 2007. A paper by professors Yunzhi Hu of the University of North Carolina at Chapel Hill and Hanzhe Zhang from Michigan State University examines the TAF in a paper titled “Overcoming Borrowing Stigma: The Design of Lending-of-Last-Resort Policies” [PDF]. This paper develops a simple model in which TAF funding is preferred by stronger banks because the funds are only available with a delay (that is, the funds will not help a bank facing an immediate run) and because TAF gives stronger banks the potential to borrow at lower costs. The paper also provides evidence that when both the discount window and TAF were available, the weakest banks borrowed from the discount window and the relatively stronger banks bid for TAF funds. The results of this study may help to inform the Fed’s policies on the provision of emergency liquidity in the future.

In the post-crisis period, the bank supervisors agreed to adopt new liquidity rules and strengthen existing capital requirements at the Basel Committee on Banking Supervision. A paper by Harvard University professor Daniel Roberts and Federal Reserve Bank of New York economists Asani Sarkar and Or Shachar examines the Basel liquidity requirements in the paper “Bank Liquidity Creation, Systemic Risk, and Basel Liquidity Regulations” [PDF]. The paper finds that the new regulation has the cost of reducing bank liquidity creation in normal times but also results in more resilient banks in a crisis. The authors estimate both the costs and benefits of the regulation and find that the benefits in terms of a more stable financial system exceed the costs of the reduction in liquidity.

Josef Schroth, an economist at the Bank of Canada, analyzes the question of how regulators could use capital regulation to smooth bank lending through a recession and financial crisis in his paper “Macroprudential Policy with Capital Buffers” [PDF]. Banks in his model hold sufficient capital in most periods but have insufficient capital to retain uninsured market funding during crises, which leads to severe credit crunches. Bank regulators can smooth lending by requiring banks to hold more capital during good times, also allowing banks to operate with reduced capital during a crisis and rebuild their capital gradually after a crisis. The paper’s findings are consistent with the Basel III’s creation of a capital conservation buffer and countercyclical capital buffer.

Issues related to bank capital have been the subject of ongoing discussion among academics, bankers, and regulators since the crisis. Bank of Finland economists Gene Ambrocio and Esa Jokivuolle, along with professors Iftekhar Hasan from Fordham University and Kim Ristolainen from the University of Turku, surveyed the views of banking and finance academics and reported the results in the paper “Are Bank Capital Requirements Optimally Set? Evidence from Researchers’ Views” [PDF] (slide deck [PDF]). The survey obtained results from 149 leading academic researchers. It found that most respondents believe that higher capital ratios would reduce the likelihood of a crisis and the social costs associated with a crisis. Most respondents thought an increase of 5 percentage points in capital would increase the average cost of capital and reduce bank lending. However, a majority said that this reduction in lending would result in “minimal to no change” in economic activity.

Fintech lending

Banks have historically been important suppliers of credit to consumers and small businesses. However, since the crisis, lending by some fintech firms to these borrowers has grown rapidly. The conference addressed a variety of questions such as the sources of competitive advantage to fintech lenders; competition between fintech lenders, small banks, and large banks; and the impact of fintech lending on consumers. Additionally, the conference looked at post-crisis changes in bank securitization rules, which may have some relevance to fintech lenders’ efforts to fund their loans.

Banks, especially large banks, have long used statistical analysis to help them predict the credit riskiness of consumers and small businesses. However, fintech firms have promoted their use of machine learning techniques as resulting in better credit analysis. Economist J. Christina Wang and former research associate Charles B. Perkins from the Federal Reserve Bank of Boston explore the value added of some machine learning techniques in their paper “How Magic a Bullet Is Machine Learning for Credit Analysis? An Exploration with Fintech Lending Data” [PDF]. In particular, they examine the contribution of tree-based models using data from LendingClub, a fintech lender. Tree-based models provide easily understood decision rules that are valuable for demonstrating compliance with U.S. fair lending rules. The results indicate that tree-based machine learning improves prediction accuracy, in part by uncovering notable interactive effects. These models benefit from additional data (albeit only up to about 5,000 observations) and from the addition of more predictors. However, exactly which tree-based approach worked best varied across different subgroups of consumers.

Many large banks retreated from some types of retail and small business lending. In part, this pullback was likely to due to a combination of the increased riskiness of these loans and the tightening of bank capital requirements. However, fintech lenders have been expanding into some of the same spaces, raising the question of whether the reduced lending by big banks was due in part to competitive pressure from fintech firms. It also raises the question of whether smaller banks were also retreating due to increased competition or expanding to help fill the void left by the larger banks. Two papers examine the rise of fintechs in two different lending markets and analyze what developments in these markets tell us about big versus small banks.

Professors Taylor Begley from Washington University in St. Louis and Kandarp Srinivasan from Northeastern University focus on mortgage market lending in their paper “Small Bank Lending in the Era of Fintech and Shadow Banking: A Sideshow?” [PDF]. Their paper observes that fintech lenders rely largely on government-supported loan securitization programs such as those of Fannie Mae, Freddie Mac, and the Federal Housing Administration. However, not all mortgage loans qualify for these programs in large part due to limits on the maximum size of the loan. Thus, fintech mortgage lenders were able to take nationwide market share in government-supported loans from the large banks. Nevertheless, it was the small banks that stepped in to provide mortgage loans that did not qualify for government-supported securitization. As a result, small banks have proven more responsive to the withdrawal of bigger banks and have maintained nearly constant market share through the period from 2009 to 2013.

The paper “What Is Fueling the Fintech Lending Revolution? Local Banking Market Structure and Fintech Market Penetration” [PDF] by professor Tetyana Balyuk of Emory University and professors Allen N. Berger and John Hackney from the University of South Carolina studies the rise of fintech lenders in small business lending. The authors find that fintech lenders’ market penetration is associated with lower small bank market shares, consistent with the decline of small banks over time and helping to explain fintech lenders’ success. They also find evidence that small banks tend to make safer loans than fintech firms. Finally, looking at the contribution of different lenders to employment, the authors find that fintech matters most for the smallest businesses, small banks matter more for larger small businesses, and neither matters for large businesses.

As fintech lending has grown, the question of whether it is good for consumers has also arisen. This may be a trick question. We have long known that if people are given a choice, some will use it wisely and others will not. Last year’s CEAR–CenFIS conference provided some evidence of how consumers manage their finances after borrowing from fintech lenders (see “Winners and Losers of Marketplace Lending: Evidence From Borrower Credit Dynamics” [PDF] and “The Real Effects of Financial Technology: Marketplace Lending and Personal Bankruptcy” [PDF]). This year, Federal Reserve Board economists Traci Mach and Timothy Dore provided additional evidence in the paper “Marketplace Lending and Consumer Credit Outcomes: Evidence from Prosper” [PDF]. The authors were able to match application data from one lender to credit bureau data. They find that relative to applicants without an origination, borrowers see an increase in their credit scores and total debt, but decreases in their delinquency rates. The increase in mortgage debt balances was especially notable.

An important issue for any type of lender is its access to funding. Banks fund their loans with a combination: (a) their own liabilities in the form of deposits and other market borrowings and (b) loan sales to investors. The risk with on-balance-sheet lending is that too many loans will turn bad, the bank will suffer large loan losses, and depositors will flee the bank. Although some fintech firms fund loans with their own liabilities, most of their loans are funded by sales to investors. The advantage to the loan originator of selling loans is that, if the loan goes bad, the buyers of the loan bear the credit losses. However, such sales can lead to concerns that the bank or fintech originating a loan will not be as careful in underwriting and monitoring as they would be with the loans they retain on their own books. The result can be similar to that discussed in the Chava et al. paper, where originators have to reduce their lending volume.

One alternative that may have the effect of improving banks’ incentives and thereby mitigating investor concerns is that of having the bank retain part of the credit risk on the loans it sells. Professor Martin Hibbeln and graduate student Werner Osterkamp from the University of Duisburg-Essen study the effect of bank loan retention in their paper “The Impact of Skin in the Game on Bank Behavior in the Securitization Market” [PDF]. The authors exploit changes in European Union regulations to study loans sold by European banks in the securitization market. They find evidence that retention of part of the risk of a loan does not improve the quality of the loans being securitized.

Corporate governance

The role of shareholders in corporate governance is important for both financial and non-financial firms. The last few decades have seen shareholder governance power increasingly concentrated in institutional investors such as mutual funds and pension funds. Although a few of these institutional funds are explicitly focused on corporate governance issues, most are not. However, even the funds that are not focused on governance nevertheless have an interest in participating in governance decisions. The problem for these investors is how to keep up with the many issues requiring a shareholder vote. The answer for a large fraction of institutional investors is to seek information and advice from proxy advisory firms. The role of these advisory firms was the topic of Carnegie Mellon University professor Chester Spatt’s dinner speech titled “Proxy Advisory Firms, Governance, Market Failure, and Regulation” [PDF] (See also his related paper [PDF].)

Spatt observed that the importance of proxy advisory firms is easy to understand. All shareholders in a firm face the same questions, and there is similarity in questions across firms. However, any one shareholder obtains only a small fraction of the gains from better governance while potentially paying all of the costs of analysis. In this setting, proxy advisory firms are a predictable market solution to a potential free-riding problem. The increasing returns to scale that arise in this setting also naturally lends itself to the development of a monopoly—or in this case, a duopoly. The result can be reduced incentives for the two proxy advisory firms to avoid factual mistakes and increased power for the advisers to impose their philosophy on firms. Spatt discussed a variety of steps the Securities and Exchange Commission has taken and further actions that could mitigate these concerns. However, the problem of what to do about the role of institutions and proxy advisers in corporate governance is one that may not be totally solvable, but rather requires careful management over time.

Conclusion

The post-crisis period has seen dramatic changes in both information technology and government regulation. The papers presented recently at a workshop at the Atlanta Fed analyzed a number of these changes and contribute to our understanding of how the financial system is likely to evolve in the future.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Brian Robertson for helpful comments. The view expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

¹ For further discussion on banks’ reporting of loan losses, see Larry’s recent post on changes to U.S. accounting rules.

Essay 5: How to Sneak Up on a Field With Types of Meta-Intelligence

If you look at a typical economics book and are coming at it with no particular background (e.g., your dad was an economist at the World Bank, say, so you’ve “swum” in this water via your background and dinner table conversations), you will find it “remote” and “foreign.”

What to do? You need to “sneak up” on a field and find a door into it or a window to climb through that brings you inside.

This foreignness and remoteness is true for any field you can think of since unfamiliar fields are disorienting at first. You need a pre-understanding.

Let’s do two simple examples of how one gets a pre-understanding:

During the foreclosure crisis following the Great Recession of 2008 and thereafter, you might have asked yourself about the size in dollars of US residential housing stock to see what it might mean if values declined. You found perhaps that it was surprising difficult to come up with some “ballpark” sense of US housing as you looked through Google and other entries.

Here’s a sample of a kind of made-up workaround that points you in the right direction:

Suppose we say the population of the USA is 320 million at the time, in round figures that are convenient and approximate only. Assume, for no reason, that all Americans are members of households of four (i.e., families with two parents and two children). This is of course utterly false but serves our “guesstimating” purpose we hope.

If we divide the total population by 4, we get 80 million families. Assume all families live in single-family homes ignoring apartment buildings, multi-family homes and a zillion other forms. Make up a number like 300 thousand dollars per home at the time, based on radio news, and you will get a national housing stock value of 80 million by 300 thousand which is 24 trillion dollars.

In fact, the official value of U.S. residential housing was usually given at 24-25 trillion so our “sneaking up” guesstimating was not bad at all.

Now ask how one might have perhaps done it better, more cleverly. You have to “back into” a field by something you yourself look into and figure out before you enter the “ocean” of the textbook presentation.

It requires a kind of “sneaking up” on a field with back-of-the-envelope “meta-intelligence” in order for you to attune yourself to the field, or if you want to “parachute” in like a “knowledge spy” and get what you need. This is true for all fields. Some “homemade” familiarity you make up yourself is needed.

How to “Sneak Up” on Academic Fields With Meta-Intelligence

An accepted workhorse of economics is the Cobb-Douglas production function based on two people with the names of Cobb and Douglas.

Your economy produces, say, shirts and to do that you need machines (capital), workers (labor), energy, materials.

Think of 100 women seamstresses at one hundred tables with sewing machines plugged into 100 electrical outlets (energy) and lots of fabric (raw materials for shirt-making).

Capital (e.g., machines, equipment, structures) is denoted by the letter K (from German word Kapital), workers or labor force by L (for labor) and the whole is called KLEM. (capital, labor, energy, materials). The letter A stands for “technology level.”

We simplify and worry only about K and L just to make the math much easier. Remember capital here means machines and not money.

In Cobb-Douglas “world,” the product of your economy, shirts is called Y (we don’t have the shirt prices to keep things easier).

Then Y=A multiplied by K (to the alpha) multiplied by L (to the beta). Alpha and beta are measures of responsiveness, “elasticity,” sensitivity.

Cobb-Douglas is multiplicative (i.e., A by K by L, so the algebra goes easier). A is called “technical change” or technology.

Suppose you don’t know or don’t remember log differentiation (calculus) to easily “play with” this little equation. That’s ok.

Think of the simple identity z=xy. This could be 10=5 x 2 or 12=4 x 3. You can show that if the left side goes up by 10%, the right must grow by 10 percent so that the 5, say, becomes 5.5. 5.5 x 2 is 11 so both sides are the same again, 11=11. It’s easy to show that the percentage growth on the left side of the equation is roughly the sum of the percentage growth of each of the numbers on the right.

You can easily show that the percentage growth of Y (say 6% per year) is approximately equal to the percentage change of A plus percentage growth of K+ plus that of L with K and L modified by alpha and beta.

This is a simplified version of so-called “Growth accounting” (i.e., components of growth in Y from year to year).

You will find that once you sense how this kind of “accounting” looks and works you can proceed to other kinds of accounting in economics such as Balance of Payments accounting or National Income accounting.

These exercises are key to economics as a field with its textbooks and again you have to sneak into it, so to speak, by climbing through a door or window you made up yourself to give you some bearings.

We call all this a pre-understanding before more usual understanding through textbooks.

Pre-understanding is a deep key or prerequisite to educational mastery.

On a National Public Radio call-in talk show few years ago, there was a discussion by four economists (professors plus private sector analysts). A listener calls in and asks one of them about the growth prospect for the following year. The professor responds: about 2.88 percent. Everybody goes quiet and wonder how he figures this out.

The answer will help you “sneak in” to or “parachute” into this world.

The professor, in his mind, calls the economy Y. He realizes that Y is the same as Y/L multiplied by L, where L is labor force. In Y/L by L the l’s cancel each other out so it’s just a harmless re-write of the basic variable Y.

Y/L is average productivity (e.g., number of shirts [the economy has one product, shirts]) divided by number of workers (laborers, seamstresses making the shirts).

If Y is one hundred and L=10, then the average laborer produced 100/10=10 shirts. ie that’s the average productivity.

The professor knows that approximately the percentage growth of Y (which is what the radio show caller’s question was about) is the sum of the percentage growth of Y/L and L.

He’s familiar with the latest productivity and labor force projections from the electronic newsletters he receives and the websites he checks out (e.g., BEA and the BLS, et al).

He adds them up to get 2.88 percent, the number he mentions to the questioner and the rest of the radio audience.

Once you’re familiar with these simple elements of analysis and sources of info, you can begin to lose your fearfulness and do the same as the professor, who is not solving complex differential equations in his head to answer the question for the listeners.

As a “field outsider,” you’re unfamiliar with the “landscape” and “rules of thumb” and your mind races or wanders when confronted by such a question because you don’t have these simple techniques.

You can thus “parachute” into any field and leave with what you need.