Periodic Reporting for period 4 - COMPLEXITY (Understanding the Complexity of Modern Financial Systems)
Berichtszeitraum: 2020-10-01 bis 2021-03-31
The project focused on two intertwined areas of research: 1) Organisation of Credit: The Changing Nature of Finance, and 2) Financial regulation in a complex environment. The project employed a set of innovative research methodologies, as well as several uniquely assembled micro-level datasets covering state- and privately-owned financial institutions in Germany, Argentina, Egypt, and India to investigate this question.
Our results suggest that the trend toward more globalized and hierarchical banks may adversely affect the ability of banks to produce soft information on borrowers. To the extent that the soft information borrowers are also low-income borrowers, the results have implications for inequality in the society. This may not be an issue in a frictionless world, where new intermediaries would enter to fill this gap. Our research, however, cautions against the “Coasian” view of the world. Markets may be slow to adapt, and low-income borrowers may be thrown into a vicious poverty trap. Hierarchical structures also have benefits. We find that in environments subjected to more rent seeking behavior, hierarchical and more centralized structure fairs better than a decentralized structure. We examine the role of social or cultural proximity and find that while proximity may help mitigate some of these informational problems, it is also prone to favoritism and capture. Our results caution against complex regulation and suggest that simplifying rules would make it more effective. Finally, our results suggests that the advent of IT and financial regulation may at least partly explain the trend toward larger globalized banks.
Our results suggest that the trend toward more globalized and hierarchical banks may adversely affect the ability of banks to produce soft information on borrowers. To the extent that the soft information borrowers are also low-income borrowers, the results have implications for inequality in the society. This may not be an issue in a frictionless world, where new intermediaries would enter to fill this gap. Our research, however, cautions against the “Coasian” view of the world. Markets may be slow to adapt, and low-income borrowers may be thrown into a vicious poverty trap. Hierarchical structures also have benefits. We find that in environments subjected to more rent seeking behavior, hierarchical and more centralized structure fairs better than a decentralized structure. We examine the role of social or cultural proximity and find that while proximity may help mitigate some of these informational problems, it is also prone to favoritism and capture. Our results caution against complex regulation and suggest that simplifying rules would make it more effective. Finally, our results suggests that the advent of IT and financial regulation may at least partly explain the trend toward larger globalized banks.
We approach the issue of organizational design this two distinct ways. In a research paper titled “How Organizational Hierarchy Affects Information Production”, we exploit a variation in organizational hierarchy induced by a reorganization plan implemented in roughly 2,000 bank branches in India. We find that increased hierarchization of a branch induces credit rationing, reduces loan performance, and generates standardization in loan contracts. Additionally, we find that hierarchical structures perform better in environments characterized by a high degree of corruption, highlighting the benefits of centralization in restraining rent-seeking activities and discrimination. In our research on an Argentinian bank, we approach the question in a different manner. Specifically, we investigate the effect of a change in informational environment of borrowers, brought about by the introduction of a credit registry (an information-sharing mechanism across banks), on the organizational design of the bank. Banks responded by changing their organizational structure – banks managers significantly delegated more decision-making to loan officers inside the bank. In a series of papers, we examine the role of social/cultural proximity in addressing information frictions and find that proximity is a double-edged sword. While it can mitigate information frictions and improve the allocation of resources, it is also susceptible to favoritism.
We take insights from our research on India and Argentina to examine how the organizational design of bailout institutions in Germany affected the outcome of bank bailout decisions. We document those decisions taken by the politicians at the decentralized level are distorted by personal considerations. These bailed-out banks perform more poorly and provision credit less efficiently when compared with more centralized bailouts. We also observe a significantly worse real sector performance of localities that have undergone decentralized bailouts. Overall, our results highlight the political economy of decentralization - local politicians derive private benefits from controlling the bank at the expense of citizens at large.
Under this theme of Financial Regulation in a Complex Environment, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement and level of financial institutions' credit risk. We exploit the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, and find that counter to the stated objectives, the introduction of model-based regulation adversely affected financial institutions' credit risk as defined in the Basel framework. We further document that larger banks benefited from the “complex” reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks. Overall, our results indicate that simpler rules may dominate more complex regulation.
Under the broader theme of Financial Regulation, we carried out additional research on financial distress and bankruptcy. The globalization of banks has generated increased calls for harmonization of laws, often implemented through the establishment of centralized regulatory institutions. We examine the question of harmonization of laws through the lens of the shipping industry, where the resolution of distress is largely distanced from sovereign bankruptcy procedures. In the shipping industry, the rule of law has emerged largely though a market driven system without international coordination. We find that significant institutional and contractual innovations have strengthened the rights of creditors thereby reducing the direct cost of financial distress, for example by lowering coordination failures and reducing fire sale discounts. However, the market driven innovations may have come at a cost to other stakeholders, including crew, port authorities, and the environment, leading to oil spills and the abandonment of under-maintained low valued ships. We also examine fire sale discount in the airline industry and find that traditional fire sale discount might be exaggerated as it includes a large quality element in the discount. Importantly, fire sale discounts are not driven by misallocation to lower quality borrowers. We document that talent dependence being associated with higher labour costs of financial distress and consequently more conservative capital structures.
We take insights from our research on India and Argentina to examine how the organizational design of bailout institutions in Germany affected the outcome of bank bailout decisions. We document those decisions taken by the politicians at the decentralized level are distorted by personal considerations. These bailed-out banks perform more poorly and provision credit less efficiently when compared with more centralized bailouts. We also observe a significantly worse real sector performance of localities that have undergone decentralized bailouts. Overall, our results highlight the political economy of decentralization - local politicians derive private benefits from controlling the bank at the expense of citizens at large.
Under this theme of Financial Regulation in a Complex Environment, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement and level of financial institutions' credit risk. We exploit the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, and find that counter to the stated objectives, the introduction of model-based regulation adversely affected financial institutions' credit risk as defined in the Basel framework. We further document that larger banks benefited from the “complex” reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks. Overall, our results indicate that simpler rules may dominate more complex regulation.
Under the broader theme of Financial Regulation, we carried out additional research on financial distress and bankruptcy. The globalization of banks has generated increased calls for harmonization of laws, often implemented through the establishment of centralized regulatory institutions. We examine the question of harmonization of laws through the lens of the shipping industry, where the resolution of distress is largely distanced from sovereign bankruptcy procedures. In the shipping industry, the rule of law has emerged largely though a market driven system without international coordination. We find that significant institutional and contractual innovations have strengthened the rights of creditors thereby reducing the direct cost of financial distress, for example by lowering coordination failures and reducing fire sale discounts. However, the market driven innovations may have come at a cost to other stakeholders, including crew, port authorities, and the environment, leading to oil spills and the abandonment of under-maintained low valued ships. We also examine fire sale discount in the airline industry and find that traditional fire sale discount might be exaggerated as it includes a large quality element in the discount. Importantly, fire sale discounts are not driven by misallocation to lower quality borrowers. We document that talent dependence being associated with higher labour costs of financial distress and consequently more conservative capital structures.
Two obstacles have hindered any empirical research in this area: 1) paucity of good micro-level data and 2) organizational design related variables tend to be quite sticky. This makes causal inference incredibly hard. Our research design overcomes these challenges by employing advances research designs as well as uniquely assembled datasets covering state- and privately-owned financial institutions in Germany, Argentina, Egypt and Sweden.
Innovative instruments and quasi-natural experiments for causal inference. For example, in our research on India we exploit changes in organizational structure of bank branches and in Germany we use electoral cycle as an instrument to establish causality. Similarly, we used introduction of model-based regulation in Germany to examine the limits of complex regulation.
Our research on the shipping and airline industry proposes a novel methodology to back out the unobserved quality of ships and aircrafts and can be applied in other settings.
Adopting a multi-disciplinary approach: The research papers span several areas such as Law and Economics, Organizational Economics, Political Economy and Regulation.
Innovative instruments and quasi-natural experiments for causal inference. For example, in our research on India we exploit changes in organizational structure of bank branches and in Germany we use electoral cycle as an instrument to establish causality. Similarly, we used introduction of model-based regulation in Germany to examine the limits of complex regulation.
Our research on the shipping and airline industry proposes a novel methodology to back out the unobserved quality of ships and aircrafts and can be applied in other settings.
Adopting a multi-disciplinary approach: The research papers span several areas such as Law and Economics, Organizational Economics, Political Economy and Regulation.