Forecasting Currency Crises

Macroeconomic master project by Ivana Ganeva and Rana Mohie ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Introduction

The question of whether a currency crisis can be predicted beforehand has been discussed in the literature for decades. Economists and econometricians have been trying to develop different prediction models that can work as an Early Warning System (EWS) for a currency crisis. The significance of such systems is that they provide policy makers with a valuable tool to aid them in tackling economic issues or speculation pressure, and in taking decisions that would prevent that from turning into a crisis. This topic is especially relevant to Emerging Markets Economies due to the presence of a greater number of fluctuations in their exchange rate translating to a bigger currency crisis risk.

In this paper, we propose an Early Warning System for predicting currency crises that is based on an Artificial Neural Networks (ANN) algorithm. The performance of this EWS is then evaluated both in-sample and out-of-sample using a data set of 17 developed and developing countries over the period of 1980-2019. The performance of this Neural-Network-based EWS is then compared to two other models that are widely used in the literature. The first one is the Probit model dependent variable which is considered the standard model in predicting currency crises, and is based on Berg and Patillo, 1999. The second model under consideration is a regime switching prediction model based on that proposed by Abiad, 2006.

Artificial Neural Networks

Artificial Neural Networks (ANN-s) is a Machine Learning technique which drives its inspiration from biological nervous systems and the (human) brain structure. With recent advancement in the computing technologies, computer scientists were able to mimic the brain functionality using artificial algorithms. This has motivated researchers to use the same brain functionality to design algorithms that can solve complex and non-linear problems. As a result, ANN-s have become a source of inspiration for a large number of techniques across a vast variety of fields. The main financial areas where ANN-s are utilized include credit authorisation and screening, financial and economic forecasting, fixed income investments, and prediction of default and bankruptcy and credit card manipulations (Öztemel, 2003).

Main Contributions

1. Machine Learning Techniques:

(a) Using an Artificial Neural Network predictive model based on the multi-layered feed forward neural network (MLFN), also known as the “Back-propagation Network” which is one of the most widely used architectures in the financial series neural network literature (Aydin and Savdar 2015). To the best of our knowledge, this is the first study that used a purely neural network model in forecasting currency crises.

(b) Improving the forecast performance of the Neural Network model by allowing the model to be trained (learn) from the data of other countries in the cluster; i.e countries with similar traits and nominal exchange rate depreciation properties. The idea behind this model extension is mainly adopted from the “Transferred Learning” technique that is used in image recognition applications.

2. The Data Set: Comparing models across a large data set of 17 countries in 5 continents, and including both developing and developed economies.

3. Crisis Definition: Adding an extra step to the Early Warning System design by clustering the set of countries into 6 clusters based on their economy’s traits, and the behavior of their nominal exchange rate depreciation fluctuations. This allows for having a crisis definition that is uniquely based on each set of countries properties – we call it the ’middle-ground’ definition. Moreover, this allowed to test for the potential of improving the forecasting performance of the neural network by training the model on data sets of other countries within the same cluster. 4. Reproducible Research: Downloading and Cleaning Data has been automated, so that the results can be easily updated or extended.

Conclusions

We compare between models based on two main measures. The Good Signals measure captures the percentage of currency crises predicted out of the total crises that actually occurred in the data set. The second measure used for comparing across models is the False Alarms measure. That is, the percentage of false signals that the EWS gives out of the total number of crises it predicts. In other words, that is the percentage of times when the EWS predicts a crisis that never happens.

The tables presented below show our findings and how the models perform against each other on our data set of 17 countries. We also provide the relevant findings from literature as a benchmark for our research.

The results in Table 1 show that Berg & Patillo’s clustering of all countries together generally works worse than our way of clustering data. Therefore, we can confirm that the choice of a ’middle-ground’ crisis definition has indeed helped us preserve any potential important country- or cluster-specific traits. In brief, we get comparable results to the ones found in the literature when using conventional methods, as highlighted by the table to follow.

After introducing the ANN model and its extension, we observe their Out-of-Sample models performance and obtain some of the key results to our research.

Summary of the key results

  • The proposed Artificial Neural Network model crisis predictability is shown to be comparable to the standard currency crisis forecasting model across both measures of Good Signals and less False Alarms. However, the modified Neural Network model on the special clustering data set has shown superior performance to the standard forecasting model.
  • The performance of the Artificial Neural Network model observed a tangible improvement when introducing our method of clustering the data. That is, data from similar countries as part of the training set of the network could indeed serve as an advantage rather than a distortion. To the contrary, using the standard Probit model with the panels of clustered data resulted in lower performance as compared to the respective country-by-country measures.

Authors: Ivana Ganeva and Rana Mohie

About the Barcelona GSE Master’s Program in Macroeconomic Policy and Financial Markets

On the evolution of altruistic and cooperative behaviour due to schooling system in Spain

Economics master project by Shaily Bahuguna, Diego Loras Gimeno, Davina Heer, Manuel E. Lago, and Chiara Toietta ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

This paper aims to find a pattern in the evolution of altruistic and cooperative behaviour whilst distinguishing across different types of schools in Spain. In specific, we design a controlled laboratory experiment by running the standard dictator game and a public goods game in a public and private (“concertada”) high school. Using a sample of 180 students, we compare 12 and 16 year old children to distinguish the evolutionary pattern and test if there is a significant change by the type of schooling system. Alongside, we control for variants such as parental wealth status, religious views and ethical opinions. Interestingly, evidence from our data highlights that altruism levels rise throughout public school education whilst it falls in private schools. On the contrary, cooperation levels are relatively stable in public schools but rise in private schools. The results from this paper can be exploited to understand how education may influence selfish and individualistic behaviour in our society. 

Key results

Diff-in-Diff (Altruism (L) & Cooperation (R))

Our results show that at the initial stage, i.e. for the first year students, the level of altruism is higher in public schools and this prevails throughout the students’ education in a public school. On the other hand, we observe an opposite trend for students attending private school, as over the four years of education, the average level of altruism declines. In regards to cooperation, we find some surprising results. Although students attending a public school initially show higher levels of cooperation than private schools, over the course of their education, this gap is not only reduced but it is also surpassed by the private school. Our results are in line with previous research which state that females are more likely to donate and cooperate than males but contradict the popular view in literature that income has a positive correlation with both dependent variables.

Authors: Shaily Bahuguna, Diego Loras Gimeno, Davina Heer, Manuel E. Lago, and Chiara Toietta

About the Barcelona GSE Master’s Program in Economics

Women’s Status in Rural Bangladesh: Exploitation and Empowerment

Economics of Public Policy master project by Agrima Sahore, Ah Young Jang, and Marjorie Pang ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

Using household survey data from rural Bangladesh, we explore determinants of domestic violence. We propose two hypotheses: first, women suffer more domestic abuse as a result of marrying young; and second, women who are empowered suffer less gender-based violence. We isolate the causal effect of marriage timing using age at first menstruation and extreme weather as instruments; and the effect of empowerment using the number of types of informal credit sources as instrument. We find robust evidence contrary to our hypotheses. Our findings highlight that mere empowerment or increasing age at first marriage are insufficient mediums to combat gender-based violence and can in fact be counterproductive to reducing domestic violence against women, if the socio-economic context is not carefully considered.

Conclusion

Interestingly, we find a positive relationship between age at first marriage and domestic violence; and empowerment and domestic violence. This highlights the complexity of the nature of domestic violence against women in a highly conservative setting like rural Bangladesh.

Violence against women continues to be a social and economic problem Bangladesh struggles with. Although the government had aimed to eliminate gender based violence in the country by 2015, their efforts have not achieved the desired results. However, if the empowerment of women (an improvement in their economic and social status) and violence against them follows an inverted U-shaped curve, it is possible that Bangladesh is still adjusting to egalitarian gender norms and expectations and is stationed somewhere on the positive slope of the curve, wherein increase in empowerment initially would increase violence against women, before reducing it.

In order to design successful policies to combat violence against women, our study highlights the importance of understanding traditional cultural norms – especially prevailing gender norms – economic conditions, and how the interplay of various socio-economic factors contribute to domestic violence against women. Ultimately, actions and practices aimed at improving women’s condition in societies should work towards confronting existing circumstances and environments that underlie women’s risk of experiencing domestic violence.

Authors: Agrima Sahore, Ah Young Jang , and Marjorie Pang

About the Barcelona GSE Master’s Program in Economics of Public Policy

An Empirical Framework: Financial Globalization and Threshold Effects

Economics master project by Eimear Flynn, Florencia Saravia, Josefina Cenzon, Nimisha Gupta, and Selena Tezel ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

Is financial globalization beneficial to economies at all levels of development? Or are there certain “threshold” levels of financial, institutional and economic development a country must first attain in order to realize the growth benefits of globalization? Kose, Prasad and Taylor (2009) develop a unified empirical framework to answer this question. The debate on the literature is ongoing. Yet few studies have explored these questions in a post-crisis context. In this paper, we replicate and extend their work, paying close attention to the period 2005-2014. Our analysis yields three key results. First, the financial depth threshold above which countries can benefit from financial globalization increases from 66% to 81% when we consider the extended period. Second, the proportion of countries with depth levels above this threshold declines over time. Finally, the coefficients are smaller in absolute value over the period 1975-2014. Taken together, these results imply a breakdown in the relationship between financial depth, openness and growth since the Great Recession. Financial deepening on its own can no longer ensure positive growth effects of financial integration.

Conclusion

In the paper, we examine two periods 1975-2004 and 1975-2014 and test for threshold effects in three variables, financial depth, institutional quality and trade openness. This paper is unique in its inclusion of the years immediately before and following the Great Recession. Following a surge in international financial integration between 2005 and 2007, financial openness plummeted with the onset of the crisis in 2007. This effect was most pronounced in advanced economies. As economic growth rates declined, countries turned their backs on financial globalization. Financial flows have since rebounded, albeit not to their pre-crisis levels. The effect of this volatility on the relationship between financial openness and economic growth however is not well understood.

thresh_FD_Graph
Overall Financial Openness Coefficient and Financial Depth in 1975-2014 vs 1975-2004

We analyze changes in the financial depth threshold over time as well as changes in the proportion of countries with depth levels above this threshold over time. We present three key findings. We first document an increase in the threshold level of financial depth from 66% to 81% when we extend the period to 2014. It follows that the proportion of countries with levels of depth above this threshold decreases over time. Our estimate of 66% for the period 1975-2004 is remarkably close to that of Kose et al. Secondly, the coefficient estimates are smaller and less significant which points to a breakdown in the relationship between financial openness and growth in the post-crisis period. Finally, we identify significant threshold effects of institutional quality.

Together these results point to a weaker relationship between financial openness and growth in the post-crisis period. Our estimates suggest that once a country reaches the threshold level of financial depth, further improvements in depth stop being important quite rapidly. It is now more difficult for countries to attain the benefits of financial integration, not just because the threshold of financial depth is higher but because financial depth alone may no longer be sufficient to ensure growth. The trade-off that further financial deepening can generate between higher growth and a higher risk of crisis needs to be addressed. The Great Recession was a reminder that financial depth and financial stability need not go hand in hand. The risks of financial deepening are more evident than before. Focusing only on the long run growth view overlooks this trade-off. In order to conduct policy relevant research, a new approach that realistically accounts for both the growth and crisis effects of financial deepening is required.

Authors: Eimear Flynn, Florencia Saravia, Josefina Cenzon, Nimisha Gupta, and Selena Tezel

About the Barcelona GSE Master’s Program in Economics

Bank Interconnectedness and Monetary Policy Transmission: Evidence from the Euro Area

ITFD master project by Sofia Alvarez, Michael Barczay, Guadalupe Galambos, Ina Sandler, and Rasmus Herløw Schmidt ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

Whereas monetary policy in the euro area is conducted by one single authority, the European Central Bank (ECB), the real effects of these decisions provoke different reactions among the set of targeted countries. One common explanation for this finding is structural heterogeneity across the members of the eurozone. The paper assesses how commercial bank interconnectedness – as a specific source of structural heterogeneity – affects the propagation of common monetary policy shocks across the euro countries between 2003 and 2018. While recent research has found that bank interconnectedness can counteract the contraction in loans resulting from a monetary policy tightening in the US, evidence on the effects in the euro area is scarce. The paper tests this hypothesis empirically by constructing a panel data set for the original euro area countries, creating a measure for country-specific bank interconnectedness, and by identifying an exogenous monetary policy shocks based on high-frequency data. Employing local projections we find evidence that – in accordance with the theoretical model we discuss – a contractionary monetary policy surprise leads to a reduction in the supply of corporate and household loans in countries with a low degree of interconnectedness. Conversely, when the banking sector is highly interconnected, the impact of monetary policy is reduced or even counteracted. This implies that a common monetary policy shock can have heterogeneous effects among countries of the euro area, depending on the degree of interconnectedness of their banking industries. These results are robust to the inclusion of a wide set of controls and alternative shock specifications.

Conclusions and Key Results

Standard theory, assuming that the balance sheet transmission channel is at play, suggests that an increase in the interest rate reduces the value of pledgeable assets held by firms and households. This reduction in the borrowers’ creditworthiness consequently induces banks to constrain their amount of lending. A higher degree of interconnectedness of the banking sector, however, makes banks less sensitive to changes in the value of the collateral posted by borrowers since loan portfolios can be traded among banks with different risk exposures. Thus, when banks are highly interconnected, the reduction of the loans supply after contractionary monetary policy is expected to be smaller and the effects of monetary policy are likely to be less pronounced.

The paper tests this hypothesis for the eurozone using local projections and a panel dataset of 12 euro-area countries in the period between 2003 and 2018. The eurozone constitutes an excellent subject to study: It exhibits significant variation of bank interconnectedness – both across time and countries – which makes the hypothesis of bank interconnectedness as a determinant of heterogeneous reactions to monetary policy particularly relevant.

The key findings of the paper are that interconnectedness is in fact an important driver of heterogeneity in the transmission of monetary policy in the eurozone. More precisely, the analysis shows that when bank interconnectedness is low, contractionary monetary policy leads to a reduction in lending. In countries with highly interconnected banking sectors, however, the paper documents that the impact of monetary policy on loans may be offset. Even more so, our findings suggest that the effect of monetary policy may even be reversed at certain points in time after a monetary policy shock (see Figure 1). More generally, these effects seem to persist for approximately 15 months and hold for both household and corporate loans. A potential conjecture for the observed increase in loans, when bank interconnectedness is high, could be that contractionary shocks induce lending from highly interconnected core countries to countries with low bank interconnectedness in the European periphery.

Additionally, higher interest rates may induce banks to increase the loan supply due to higher potential returns in a context of efficient risk-sharing. The analysis also suggests that cross-country variation of bank interconnectedness, in particular, plays an important role in explaining heterogeneous responses to monetary policy. Muting the cross-country variation, by contrast, delivers effects that are  still in line with the theory but which turn out to be statistically insignificant. In other words, accounting for cross-country heterogeneity is essential. Moreover, employing alternative specifications, the results are found to be robust to using alternative shock measures, including additional controls, and excluding outliers.

Figure_1
Figure 1: Impulse response of total loans to a one basis point increase in the monetary policy shock variable (Red: Low bank interconnectedness, blue: high bank interconnectedness)

Using our estimates to predict the country specific responses to a monetary policy shock, we show that countries are expected to react very heterogeneously. While Greece, for instance, is predicted to experience a contraction of loans after an interest rate hike at its 10th, 50th, and 75th percentile of bank interconnectedness, the effect of  monetary policy is almost completely offset in Germany or Austria (see Figure 2).

Figure 2
Figure 2: Implied heterogeneous responses after 6 months to a common monetary policy shock of 1 basis point by each country’s degrees of interconnectedness

In sum, the analysis contributes to the understanding of how monetary policy is transmitted across countries in the euro area. The paper shows how heterogeneous responses can be explained by the variation in countries’ individual levels of bank interconnectedness. Furthermore, it provides a potential explanation for why recent research has found rather modest responses of the loan supply to monetary policy. Such observations appear inevitable given that many countries display levels of interconnectedness at which the reaction of loans to monetary policy is predicted to be only small or even nonexistent. Only by incorporating interbank lending into the analysis, sizable effects of monetary policy become apparent again. 

Authors: Sofia Alvarez, Michael Barczay, Guadalupe Galambos, Ina Sandler, and Rasmus Herløw Schmidt

About the Barcelona GSE Master’s Program in International Trade, Finance, and Development

Estimating Time-Varying Network Effects with Application to Portfolio Allocation

Finance master project by Daniel A. Landau and Gabriel L. Ramos ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

In this paper, we characterize a variety of international financial markets as partially correlated networks of stock returns via the implementation of the joint sparse regression estimation techniques of Peng et al. (2009). We explore a number of mean-variance portfolios, with the aim of enhancing out-of-sample portfolio performance by uncovering the hidden network dynamics of optimal portfolio allocation. We find that Markowitz portfolios generally dissuade the inclusion of central stocks in the network, yet the interaction of a stock’s individual and systemic performance is more complex. This motivates us to explore the time-varying correlation of these topological features, which we find are highly market dependent. Building on the work of Peralta & Zareei (2016), we implement a number of investment strategies aimed at simplifying the portfolio selection process by allocating wealth to a targeted subset of stocks, contingent on the time-varying network dynamics. We find that applying mean-variance allocation to a restricted sample of stocks with daily portfolio re-balancing can statistically significantly enhance out-of-sample portfolio performance in comparison to a market benchmark. We also find evidence that such portfolios are more resilient during periods of major macroeconomic instability, with the results applicable to both developed and emerging markets.

Conclusion and Future Research

In our work, we represent 4 international exchanges as individual networks of partially correlated stock returns. To do so, we build a Graph, comprised of a set of Vertices and Edges, via the implementation of the joint sparse regression estimation techniques of Peng et. al (2009). This approach allows us to uncover some of the hidden topological features of a series of Markowitz tangency portfolios. We generally find that investing according to MPT dissuades the inclusion of highly central stocks in an optimally designed portfolio, hence keeping portfolio variances under control. We find that this result is market-dependent and more prevalent for certain countries than for others. From this cross-sectional network analysis, we learn that the interaction between a stock’s individual performance (Sharpe ratio) and systemic performance (eigenvector centrality) can be complex. This motivates us to explore the time-varying correlation ρ between Sharpe ratio and eigencentrality.

Optimal_Weights_for_Tangency_Portfolio_Strategy
Optimal Weights for Tangency Portfolio Strategy.

Overall, we show that in considering the time-varying nature of partially correlated networks, we can enhance out-of-sample performance by simplifying the portfolio selection process and investing in a targeted subset of stocks. We also find that our work proposes a number of future research questions. Although we implement short-sale constraints, it would also be wise to introduce limits on the amount of wealth that can go into purchasing stocks, as this would help to avoid large portfolio variances. Furthermore, our work paves the way for future research into the ability of ρ-dependent investment strategies to enhance portfolio performance in times of macroeconomic distress and major financial crises.

Authors: Daniel A. Landau and Gabriel L. Ramos

About the Barcelona GSE Master’s Program in Finance

Certain uncertainty? The response of Venezuelan banks to a political dilemma

Economics of Public Policy master project by Mary Armijos and Guillem Cuberta ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Introduction

Our work focuses on the analysis of the Venezuelan banks, which have become more vulnerable. The leading causes of this vulnerability have been oil price shocks, political instability, pro-cyclical monetary conditions (i.e., interest rates), low level of financial intermediation, changing structure (e.g., consolidation, closure or nationalization), non-traditional bank transactions, high exposure to the public sector, and government intervention in their operations.  (Blavy R., 2014) Hence, studying the response of banks to policy uncertainty becomes relevant. However, even more critical, in Venezuela’s context, would be to ask: do banks respond differently to uncertainty if they are politically connected?

To address this question, we construct two indices: the policy uncertainty index and political connection index. Our uncertainty index is in a monthly basis and bank-invariant; it is developed following the work previously done by Baker, Bloom, and David, on the Economic Policy Uncertainty Index (EPU Index) and by Ahir, Bloom, and Furceri, on the World Uncertainty Index (an extension of the EPU).  Similar to Xu and Zhou (2008), for the case of the political connection index, we define the dummy variable connected bank equal one based on whether it is a state-owned bank. Alternatively, in case it is a private one if at least one of the board members has any connection with someone from the government. We adapt these criteria to the information there is available from Venezuela. We also look if one of the members is part of the ‘bolibourgeoisie’ ( a combination of the words Bolivarian and bourgeoisie, a term used to classify the businessmen and public officials linked to the government). For our dependent and micro-control variables (i.e., bank characteristics), we use monthly data from 2006 to 2018 obtained from SUDEBAN (Venezuela’s Superintendence of Banks). Moreover, for the macro-control variables, we obtain monthly data from the International Financial Statistics of the International Monetary Fund (IMF).  The variables we choose for our specifications are based on the works done by Vera et al. (2019) and Bordo et al. (2016).

Our central hypothesis is that when there is high policy uncertainty, political connections may allow connected banks to smooth the effects of uncertainty. We believe that connected banks might respond differently to uncertainty because they have privileged information or preferential treatment from the government, which grants them a competitive advantage over non-connected banks. To test the response of banks, we look at their behavior respect to credit supply and provisions, and we also investigate banks’ profitability in periods of uncertainty through the ROA. Our identification strategy to investigate the causal effect of policy uncertainty and political connection considers the fact that the uncertainty index is a high-frequency time series, which makes it be almost an exogenous variable. Also, the political connection index is not endogenous as it does not vary over time.

In addition to that, we control for bank-invariant and time-specific factors that affect both the right-hand side and left-hand-side variables by adding bank and time fixed effects. Furthermore, to separate the impact of our primary explanatory variable (interaction) from other confounding factors, we control for a block of bank-specific covariates. We also consider different specifications with and without lags of these controls to mitigate the potential reverse-causality concern. Even though we know that all of these adjustments might not entirely correct for omitted variable bias, we consider it adjusts well enough to investigate this relationship. We consider that one of the significant sources of potential bias comes from monthly macro changes (i.e., exogenous shocks like oil prices or U.S. sanctions, and government decisions) that are accounted by including time fixed-effects.

Figure 1: Monthly Economic Policy Uncertainty Index for Venezuela (EPUV)

Results

In our main results, we find that politically connected banks acquire more risks when there is higher uncertainty as an increase of 10 percent in our uncertainty measure leads them to give on average, 0.0262 percent more credits than non-politically connected banks. This result corroborates similar results from the literature that establishes a positive value from being politically connected (Kostovetsky 2015).  Also, we observe that an increase in the uncertainty index induces politically connected banks to hold more loss provisions in their portfolio than non-politically connected banks. A 10 percent increase in our uncertainty index prompts politically connected banks to hold 0.0192 percent more loss provisions than non-politically connected banks. Lastly, the effect of economic policy uncertainty for politically connected banks on ROA has a positive sign. A 10 percent increase in uncertainty increases the average returns on assets of politically connected banks by almost 11 percent compared to non-politically connected banks.

Summing up, connected banks can give more credit to the public in periods of higher uncertainty, at the same time that they hold more loss provisions. The first result is consistent with the ones shown by Cheng et al. (2017), where they find that banks supply much more credit when there is high uncertainty. However, our result of provisions does not coincide with theirs. Contrarily, they find that under higher uncertainty, connected banks reserve lower provisions than unconnected banks. In the case of the profitability analysis, connected banks have lower profits when there is high uncertainty. These results go along with the ones found by Dicko (2016).

We consider that this study presents new relevant findings regarding the literature of political connection and policy uncertainty, and for the Venezuelan economy overall. The political connection matters in periods of high uncertainty but until one point. From our results, we find that politically connected banks seem pro-risk as they give more credit when there is more policy uncertainty. However, on another level, it appears that they do receive privilege information form the government (bad news about the future) that makes them risk-averse at the same time as they also reserve more provisions. Additionally, the result of the relationship between uncertainty and profitability indicators, like ROA, indicates that being politically connected might not be extremely helpful to banks if they only benefit from having more information and do not receive any tangible benefit from the government. For further studies, it would be interesting to analyze how economic agents respond to policy uncertainty depending on the type of benefit they receive from being politically connected to some institutions.

About the Barcelona GSE Master’s Program in Economics of Public Policy

Effective competition in non-workplace pensions

FCA publication with contributions by Lorenzo Migliaccio ’14 (Competition and Market Regulation)

FS19/5 in the context of FCA work across the pension saving value chain . Source: FS19/5

The Financial Conduct Authority has published three pensions papers covering advising on pension transfers, the retirement outcome review, and effective competition in non-workplace pensions. The last one – which I’ve contributed to – outlines a number of proposals to improve competition in the non-workplace pensions market in the UK.

To share my Head of Department’s words, ‘this has been one of the most challenging data gathering exercises I have been involved in’, with more than 100 firms providing input for our analysis.

We found similar weaknesses to those the OFT identified in the DC workplace pension market in 2013, ie demand-side weaknesses and reduced competition on charges.

We now invite stakeholders’ views and welcome alternative suggestions for the way we and the industry can address the issues identified. Here you can find more information and download the feedback statement (pdf).

author

Lorenzo Migliaccio ’14 is Senior Associate Economist at the Financial Conduct Authority. He is an alum of the Barcelona GSE Master’s in Competition and Market Regulation.

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Quantification of Instruments’ Strength

Economics master project by Oriol González, Marko Irisarri, Santiago Iglesias, Asier Beristain and Manuel Cabado ’19

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects. The project is a required component of all Master’s programs at the Barcelona GSE.

Abstract

Weak identification is known to yield unreliable standard instrumental variables (IV) inference. A large literature has focused on addressing this issue by proposing methods to detect weak instruments, mainly through the first-stage F-statistic. Our paper evaluates the weak identification in two leading empirical analyses by using the novel alternative approach developed by Ganics, Inoue and Rossi (2018), who base their tests on confidence intervals for the bias of the two-stage least squares estimator, and the size distortion of the associated Wald test. We illustrate the behavior of the tests in empirical settings, and compare how the conclusions differ to those using the standard tests. Our findings suggest that, in our empirical application, the results obtained using this approach are in line with those using previous tests in the literature, confirming it to be a robust alternative. An R package to directly compute these novel tests is also presented.

Main conclusions

The contribution of our paper is mainly twofold. On the one hand, we aim at motivating the usefulness of the novel approach developed by Ganics et al. (2018) to evaluate the robustness of empirical analyses to the potential presence of weak instruments. On the other hand, we make these tests accessible to researchers via the proposed R function. The paper shows how recent tests applied to previous literature unveil new interesting information about the results obtained and hence the conclusions drawn from them. We highlight the consequences of IV estimates displaying both high sampling uncertainty and high specification uncertainty, as minor specification changes can lead to very different estimates, which is in line with current findings in the IV literature (see Yogo, 2004; Kleibergen and Mavroeidis, 2009; Mavroeidis, 2010; Mavroeidis et al., 2014; Ganics, 2017; or Barnichon and Mesters, 2019). Another remarkable issue that arises, mirroring the recent findings in Young (2019), is the importance of the baseline assumptions on the structure of the error variance to correctly interpret the estimation results.

girtest
Output retrieved by the proposed girtest function in R

References

  • Barnichon, R. and Mesters, G. (2019), ‘Identifying modern macro equations with old shocks’, Barcelona GSE Working Paper Series (Working Paper n◦1097).
  • Ganics, G. (2017), Essays in macroeconometrics, PhD thesis, Universitat Pompeu Fabra.
  • Ganics, G., Inoue, A. and Rossi, B. (2018), ‘Confidence intervals for bias and size distortion in IV and local projections-IV models’, Banco de España Working Paper.
  • Kleibergen, F. and Mavroeidis, S. (2009), ‘Weak instrument robust tests in gmm and the new keynesian phillips curve’, Journal of Business & Economic Statistics 27(3), 293-311.
  • Mavroeidis, S. (2010), ‘Monetary policy rules and macroeconomic stability: some new evidence’, American Economic Review 100(1), 491-503.
  • Mavroeidis, S., Plagborg-Møller, M. and Stock, J. H. (2014), ‘Empirical evidence on inflation expectations in the new keynesian phillips curve’, Journal of Economic Literature 52(1), 124-88.
  • Yogo, M. (2004), ‘Estimating the elasticity of intertemporal substitution when instru- ments are weak’, Review of Economics and Statistics 86(3), 797-810.
  • Young, A. (2019), ‘Consistency without inference: Instrumental variables in practical application’, Unpublished manuscript.

About the Barcelona GSE Master’s Program in Economics

Bank Assets, Liquidity and Credit Cycles

Forthcoming publication by Federico Lubello ’12 (Economics)

My paper, “Bank Assets, Liquidity and Credit Cycles” with Ivan Petrella (Warwick and CEPR) and Emiliano Santoro (University of Copenhagen) has been accepted at the Journal of Economic Dynamics and Control. In the paper, we uncover a close connection between the collateralization of bank loans, macroeconomic amplification and the degree of procyclicality of bank leverage.

Abstract

We study how bank collateral assets and their pledgeability affect the amplitude of credit cycles. To this end, we develop a tractable model where bankers intermediate funds between savers and borrowers. If bankers default, savers acquire the right to liquidate bankers’ assets. However, due to the vertically integrated structure of our credit economy, savers anticipate that liquidating financial assets (i.e., loans) is conditional on borrowers being solvent on their debt obligations. This friction limits the collateralization of bankers’ financial assets beyond that of real assets (i.e., capital). In this context, increasing the pledgeability of financial assets eases more credit and reduces the spread between the loan and the deposit rate, thus attenuating capital misallocation as it typically emerges in credit economies à la Kiyotaki and Moore (1997). We uncover a close connection between the collateralization of bank loans, macroeconomic amplification and the degree of procyclicality of bank leverage.

Federico Lubello ’12 is a Research Economist at Banque centrale du Luxembourg. He is an alum of the Barcelona GSE Master’s in Economics.

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