ECB should look out the window more often

On June 14th ECB Vice President Vitorio Constancio gave a speech at Utrecht University School of Economics on the ECB’s negative interest rate experiment. It was a most interesting lecture in which he argued the equilibrium real interest rate (the rate at which demand and supply for capital equalize) in Europe and much of the West may in fact be negative. Secular stagnation due to low productivity growth, labor replacing technological change and sluggish demand may have pushed demand below capacity and the real interest rate at which Western economies achieve full employment at stable inflation rates could then be negative. A most interesting proposition.

But to me that was not the most interesting thing this monetary policy maker said. In passing mr. Constancio said something that was far more intriguing and perhaps scary. There is a lot of criticism on the ECB policy of massive purchases of investment grade assets in the Eurozone. This so called Quantitative Easing is claimed to be unsuccessful because in a balance sheet recession there is no demand for additional credit and making it cheaper for banks to lend out money will simply not lead to more investment, more real expenditure, employment, wage pressure and inflation. That issue is fundamental and has been discussed elsewhere. SFL member prof. Harald Benink and prof. Wim Boonstra, chief economist for Dutch Rabobank, for example suggested channeling the new liquidity through the European Investment Bank (read more here) and others have suggested monetary finance of government expenditure or even outright giving newly created liquidity to consumers directly (helicopter money). All to ensure the extra liquidity actually translates into actual real expenditure. But according to mr. Constancio that was not necessary, illegal and impractical, respectively. Because the current policies work.

On the question how the ECB could be so sure its policies worked, mr. Constancio gave the audience an interesting view into policy evaluation at the ECB. First he dismissed the above criticism that the policy does not result in real expenditure as unfair and based on “just looking out the window”. His argument was that one can not criticize the ECB policies for not creating growth and investment without controlling for shocks that also affected the economy in the past 18 months. Fair enough. That is what we teach all students in econometrics 101. You have to control for all relevant variables if you want to identify the effect of a treatment.

But mr. Constancio’s alternative for “looking out the window”, as far as I understood it from his response, is not much better. According to him the ECB evaluates the success of its policies by simulating complicated models. In these models they create a counter factual to compute the economic outcomes with and without the policy. He stressed the fact that they use multiple models to be sure the measured impacts are robust across these models. It sounded very convincing.

But if you consider how the ECB came up with the idea to implement this policy in the first place, you should wake up and smell the coffee. I did not ask, but I would hope that the ECB ran simulations in these same models to get an idea of the effects of this policy before it decided to spend 80 billion a month. And I would hope they did so in a range of models and for a range of possible scenarios for key exogenous variables like oil price and world trade. But then it should come as no surprise that comparing observed data to a counter factual that is constructed with the same models leads you to conclude that your policy worked. Ok, you will have introduced the true data for exogenous variables (oil price, world trade etc.) in the ex post run, but if these fall in the scenarios you used ex ante, the result is a mere tautology. If you implement policies that work in your models under a wide range of key input variables, you can be sure that excluding those same policies in a counterfactual simulation gives you the same result. All such an evaluation then proves is that the policy works in theory and the models have not changed much in the last 18 months. But what if theory is misguided and the models are misspecified? Should that not be a concern, particularly when you are pushing the economy into unchartered territory with negative real interest rates.

As an economist I love models. And every disproven theory spells another decade of fun for academics. But as a policy maker perhaps occasionally looking out of the window is not such a bad idea after all.

Mark Sanders

Investors can learn a thing or two from the natural world

While humans have been learning from nature for thousands of years, a formal concept “biomimicry” – which seeks inspiration from nature to solve complex human problems – is more recent. Nature constitutes the source of inspiration for many new products and processes among diverse fields, for example, Tokyo’s rail system inspired by slime molds, Shinkansen bullet train inspired by the kingfisher’s beak and wind turbine blades designed based on humpback whales. These nature-based innovations will play an important role in the transformation towards our vision of a sustainable future.

Investors can also learn a thing or two from the natural world, according to Katherine Collins, the founder and CEO of Honeybee Capital and author of the book “The Nature of Investing: Resilient Investment Strategies through Biomimicry”. On May 9 Collins gave a lecture on “Finance & Biomimicry” in Amsterdam. The SFL co-hosted this event jointly with Triodos Bank, the VBA, the IUCN and biomimicryNL, Ministry of Economic Affairs and the RVO. More than 100 professionals from the financial industry, governmental agency and academia attended her lecture. With more than 20 years of experience in the commercial world of investing, she talked in depth about the biggest challenges the financial industry faces and showed how investors can think ‘outside the box’ by applying the principles of biomimicry to create an optimal and regenerative investment framework that is truly different from the mechanized one widely employed in practice.

At its core biomimicry revolves around a simple open question: WWND? What would nature do? Nature has sustained for 3.8 billions years. Natural systems provide the most proven and sustainable models. She urged us to reconnect to nature and draw upon the wisdom of nature for making investment, and in fact any decisions.

Risk vs. Uncertainty

The main challenge in investing is managing risk and preparing for uncertainty. Risk is a situation where the outcome is unknown, but the range of possible outcomes is known. Therefore, risk can be managed in a way that is predictable, rational and responsible. On the contrary, uncertainly, which may look like risk on the surface is a situation when we face “unknown unknowns”. The dilemma is that the protocol we relied on for risk management – automated algorithms, standardization and predetermined processes – are exact the opposite of what is required to handle uncertainly. In time of uncertainly we need to build a resilient, adaptive and flexible system which nature has 3.8 billion years of wisdom to offer. The guiding principle is to define the function we have to perform and think how nature would perform this function in this context.

Diversity, Redundancy & Resilience  

Diversity, which refers to the mix of forms and processes that exist to perform a particular function, is proven to be a key component of a resilient system. Diversification, or in other words “Don’t put all of your eggs in one basket” is one of the basic building blocks of modern portfolio management. However, Collins asserts that we live in a world with more baskets than eggs. There are more funds than securities in the US. The possibility of diversity has gone down dramatically. How to bring back diversity is something we need to learn from the natural system. Her idea is in line with the SFL project on the diversity of the financial system.

Redundancy is another vital element of a resilient and adaptive system. For example, sea slugs eat toxic substances around them. Instead of being poisoned, they released those toxins to protect themselves from the predators. This type of adaption allows sea slugs to thrive in threatening conditions. Following a similar reasoning, Collins points out that in time of crises, those financial assets that protect us from big loses are not those we pay much attention to during normal times.

To an investment world obsessed with complexity, obscurity and opacity, Collins has offered us an elegant path inspired by nature. As appealing as it seems, how to integrate biomimicry into actual investment practices in a systematic manner remains a promising, yet elusive endeavor for investors. Collins does not have all the answers yet, at least she has invited us to think through with her on the question – what would nature do?

Lu Zhang

Why this Capital Markets Union is a bad idea

In a few months European Parliament will take a vote on the European Commission’s proposal known as the European Capital Markets Union. This proposal aims to create a single European market for capital and eliminate all remaining barriers to cross border investments in the EU. As with the single markets for goods, services, energy and labor, this is, in principle, a good idea. A single market allows for a more efficient use of our limited resources and benefits investors as well as those looking for funding. Moreover, Eurogroup chairman Dijsselbloem has said (e.g. such a Single European Capital Market can help stabilize the Eurozone. It allows surplus countries to invest their excess savings in deficit countries, thus diversifying risk and synchronizing the European business cycle. The Capital Market Union thus aims to mobilize more investment and allocate it better across the EU to help stabilize the Monetary Union.

It is a good thing the European Commission has set these goals. Europe is facing quite serious investment challenges. The crisis has starved our businesses of much needed capital and investment across the Union has grinded to a halt. This could not have come at a worse time as the urgent transition to a more sustainable energy system requires massive innovation and an updating of a lot of private and public infrastructure and outdated technology. Moreover, in the crisis the financial sector across Europe retreated back to national markets, causing cracks and fault lines in the Eurozone that still have not been healed. In short, our capital markets failed when we needed them the most. It is time to act.

But the currently proposed Capital Market Union does not address any of these major challenges, nor prevent such crises from happening again. Instead it proposes to introduce, this time at a European scale, a regulatory framework for securitization. Securitization is the bundling of existing, non-tradable loans into a package that can be traded. Typically one takes a big number of existing loans, puts these on the balance sheet of a new company and then sells equity and debt in that new company to investors. The idea is that such securitization will allow European banks to give more credit to business and thus channel more savings to productive, innovative investment. Unfortunately this is not likely to be the effect and in fact this will give us less, not more of the type of finance we now need.

The first observation that leads to this negative conclusion is the fact that before and after the crisis, securitization requires large numbers of relatively standardized and, more importantly, quantifiable debt contracts. You cannot securitize murky, risky and heterogeneous SME loans, let alone equity. What can be securitized are long term debt contracts, especially morgages. Making securitization easier, cheaper and more profitable will thus stimulate a further trend towards a financial monoculture of tradable debt finance. Not the innovative and risk carrying equity type of finance we so desperately need.

Moreover, securitization will increase the leverage in our financial system and reduces role of bank (and other intermediaries) equity. When we require less ‘skin in the game’ we indeed will stimulate the creation of more credit, but also more systemic risk. This is risk of the ‘heads I win, tails you lose’-variety that we promised European tax payers we would eliminate. We all agreed the originate-to-sell model was to be eliminated because of its perverse incentives. The CMU now does the exact opposite. Investing in innovative, experimental SMEs and startups, especially in other countries, is risky. And European savers and investors are more than willing to take on such risk for the right return. But they will not do so if our financial sector offers them safe bets with higher returns at the risk of whoever ends up with the worthless assets, not rarely the taxpayer.

Finally, no benefits are to be expected in terms of stabilizing the Eurozone either. With more securitization, European banks can channel their depositors’ savings into (deficit) countries, but given the preference for mortgage loans, most of these funds will flow into those countries’ real estate markets. A smart deficit country will then use the freed up national savings to finance innovative SMEs with equity, but chances are the deficit country banks and investors will also want a piece of the securitization-pie. If European banks fund European businesses with long term equity, the CMU could stabilize the Monetary Union. If they inflate housing and real estate bubbles instead, the tradability of the securitized debt instruments adds to the instability. A country in boom will attract cheap savings from all over Europe, fueling the boom and most probably a real estate bubble. When the tables turn and crisis hits, the same tradability implies a quick withdrawal as we saw so many times before in developing countries, starving the already struggling economies of liquidity and deepening the bust. It is unlikely the Eurozone can sustain another round of the core fueling real estate bubbles in the periphery, but the irony of the CMU is that now also periphery savers can join in, depositing their savings in the core only to see them reinvested in periphery mortgage backed securities.If we summarize the above:

  • CMU will not channel more finance to productive and innovative SMEs
  • CMU will not make banking more stable
  • CMU will not stimulate diversity in EU financial markets
  • CMU will cause more of our investment to be diverted into unproductive, speculative real estate and asset bubbles.
  • CMU will destabilize the Eurozone forcing surplus countries to bail out either their TBTF banks or the deficit countries they lent to.

CMU should stimulate real, productive, long term equity cross border investments. Instead it now promotes on financial, speculative, short term debt investment. Securitization under the CMU creates an accident waiting to happen at an unprecedented scale. Banks have lobbied hard for this result. One can only wonder why…

Mark Sanders

Friend or Foe? Securitization and the Dutch mortgage boom

The revival of the securitization market lies at the heart of the European Commission’s initiative to launch a pan-European capital market union (CMU). Securitization, as an additional source of funding for banks are considered as the solution of unlocking more investments for all companies, especially small and medium enterprises (SMEs) in the EU.[1] However, questionably as securitization in recent history has been mainly used for funding residential mortgages. This note explores the role of securitization in financing Dutch mortgage boom over the last decade.

In 2013, total Dutch mortgages stood at 111% of GDP in 2013, up from 50% in 1995. The substantial increase in mortgage lending by Dutch banks could not be fully funded with deposits held by households and corporations. This is owing to the fact that large parts of Dutch private savings are in the form of compulsory pension savings schemes. As Dutch pension funds predominantly invest abroad,  the resulting deposit funding gap has forced Dutch banks to increasingly rely on external funding from the international capital markets, for example through securitization.

Securitization involve the bundling of illiquid loan assets, such as residential mortgages, credit card loans, car loans or SMEs loans, and through financial restructuring, transforming them into marketable securities (liquid assets). These asset backed securities (ABS), in particular residential mortgage backed securities (RMBS) can be then sold to investors. This is so called “external” securitization. Due to its complex and opaque nature, securitization has been seen as the culprit in the 2007/2008 global financial crisis.

If we look to the Netherlands, we see that Dutch banks are heavily relying on securitization in comparison to other countries.[2] Prior to the crisis, over one quarter of all Dutch mortgages outstanding were financed by means of “external” securitization.[3] However, banks’ costs of financing through securitizations are not found to be systematically higher in the Netherlands than other countries, according to a report of CPB.[4]

Following the outbreak of the crisis (in the mid-2007), securitization in the Netherlands took place mainly for liquidity purposes (Chart  1 and 2). Such “internal” securitization is not sold on the market but held by the originators for use as collateral in obtaining liquidity from central banks and other financial institutions. The significant increase in securitization totaled a record amount of 137 billion EUR in 2010, including 78 billion in restructured securitizations, in which old securitizations were terminated and the underlying loans were resecuritized. Following the strong dip in 2008 and 2009, “external” securitizations have recovered to some extent. In 2010, investors purchased 22 billion EUR of RMBS originated by Dutch financial institutions.

Chart 1 New securitisations, by type



Chart 2 Outstanding securitisations, by type



The enormous increase in mortgages has made Dutch households the most debt-burdened ones in the Eurozone. In 2013, household debts in the Netherlands stood at 288% of net disposal income, which is higher than Portugal, Ireland, Greece or Spain. The figure was 148% in 1995. Therefore, the danger of reviving securitization may lead to the restart another mortgage and housing boom.



[3] Author’s own calculations based on the statistics retrieved from DNB,


Lu Zhang

Finance in a Circular Economy

The concept of a circular economy is starting to gain traction in the financial community. The concept is an appealing alternative to our current linear economy in which finite resources are being used for the manufacturing of products, which get disposed of and thus wasting a lot of value. This process often produces negative externalities such as pollution of air, soil and water, but also exploitation of people and (unnecessary) poverty.

In a circular economy, all components within that economy have their own niche. All in- and outflows are being used and produced in unique combinations, without waste and with positive total net revenue. Such a circular system is inspired by eco systems and is essentially different from our current linear system.

The need of a transition towards a circular economy is broadly recognized, as we are looking towards depletion of resources and being more and more aware of the finiteness of our planet. At the same time, circularity provides a way to do business within our planetary boundaries, while taking away the risks related to price volatility and limited availability of raw materials.

Financial institutions now face an important choice. They can be a major catalyst of the transition by funding circular businesses and engaging with their clients. However, to play this role well, the financial sector needs to adapt to the changes that are rapidly evolving.

Funding new business models
The circular economy comes with a number of new business models to increase the use of renewable energy sources, reduce dependency of (scarce) resources, extend product life and increase social capital through sharing systems. One of the upcoming business models is providing clients with access to a product or service rather than selling it. This way profitability is decoupled from selling products. For example, Rolls Royce does not sell engines, but flying hours, and Philips is leasing light instead of selling lighting equipment, stimulating them to take good care of their product and reuse components and materials after use. Consequently, the increased lifetime of products demands for longer term financing.

This also means that the products will remain on the companies’ balance sheet for a long time, which impacts its leverage ratio. For this reason they will be looking for ways to manage their assets off-balance, for example by putting a Special Purpose Vehicle in place. Additionally, they have to depreciate the assets smartly and calculate the residual value of its products, which is difficult for many companies because data about this is lacking, which in turn scares off investors. In short, financial institutions are willing to serve the circular economy, as economic opportunities are evident, but need to adapt their financial services to these new business models.

True risk
Circular businesses require risk assessments that go beyond their company profile. Currently risks are mainly based on past results rather than future oriented and systemic analysis of global impacts. The fact that many companies are in a risky position by depending on finite resources with fluctuating prices is often overlooked, and circular companies that are not depending on raw materials are often misunderstood instead of favoured.

Systems thinking
In the discussions around financing the circular economy assumed is that money is neutral and infinitely available. This assumption deserves more attention. Our money system that is supposed to facilitate our communal household is confronted with various problems. Money flows are not circular, but money flows from people that have little money to people that have a lot of it[1]. Although the government is trying to, artificially, reverse this flow (e.g. through taxes) its impact is marginal. Additionally, through compound interest short-termism is induced, as long-term debt is exponentially discouraged. Circularity requires a long-term vision beyond generations, but if needed to be financed through debt, economically unsustainable.

Our economy is a complex system where many stakeholders interact and influence behaviour that affects the flows of money, material, energy and information. Therefore it is essential to have the right incentives in place. If, for example, linear risk (i.e. the risk of continuing in the linear economy) is not explicitly priced, there is no incentive for the financial sector to move. Therefore, collaboration with the whole system is required.

SFL and Circle Economy are working with the sector to get ready for the transition towards a circular economy, and seek synergies between all actors to overcome barriers through systems thinking.





Elisa Achterberg

The banker and his grandchildren

President Obama has summarized nicely the conclusions of the hundreds of scientists from the Intergovernmental Panel on Climate Change: “We are the first generation to experience the effects of climate change, and the last who can still do something about it.”

In this, the financial sector will play a decisive role. It will accelerate the development towards a sustainable energy system or slow it down. The question that ING director Koos Timmermans recently received by a popular Dutch radio programme (“What can you tell your grandkids? Did grandfather made every effort to save the world? “),is one which all financial professionals should ask themselves.

Timmermans’ answer may not get his grandchildren wildly enthusiastic, but it was spot on. Timmermans indicated to believe that we can through cooperation of all financial institutions and the government do better than we do now.

That same conclusion has recently been drawn by a UN commission, known as the UNEP Inquiry. After searching the planet for inspiring examples of sustainable finance their final report contains over 100 of those coming from 40 countries. The Inquiry called on each country to formulate the most effective approach for their specific context.

Countries such as Switzerland and China have picked up the gauntlet. The Chinese Communist Party has set itself in its 13th Five-Year Plan ‘ecological civilization’ as the goal. No luxury in a country where in 90% of the large cities the air is unhealthy and 75% of drinking water unsafe. To find the required $ 320 billion per year, a detailed roadmap has been developed towards a green financial sector.

In the Netherlands there are numerous initiatives to make the sector more sustainable. The question is whether these, if executed well and added together, would bring us where we should be. I think the answer can only be ‘no’. More and more solid action is required. It is up to this generation of financial professionals to do that, or they will end up with a mouth full of teeth in front of their grandchildren.

Rens van Tilburg