German Financial Market Stable in International Comparison

The American and British financial markets are closely intertwined, whereas the German financial market is generally less affected by fluctuations in the USA. Dr. Christian Proaño, professor of Empirical Economics at the University of Bamberg, was able to establish these correlations in a new study. Together with Privatdozent Dr. Till Strohsal and Prof. Jürgen Wolters of the Freie Universität Berlin, he published his findings in the “Journal of Banking and Finance” in September 2019. In their study, the three economists employed statistical methods to measure how the duration and scale of the financial cycle change over time. The financial cycle is considered one of the most reliable crisis indicators and presents a model of macroeconomic lending and the growth of real estate prices over decades. Using credit growth and housing and share prices as variables, the economists were able to compare the USA, Great Britain and Germany.

First, the researchers looked at the fundamental ways in which financial cycles develop over longer periods. “In an ideal world, the financial cycle would be extremely boring, because it shows the very predictable way that budget savings are transferred to companies,” says Proaño. In the 1980s, the worldwide banking and finance sector was in fact still quite stable and predictable. But since then, the sector’s role in political economics has grown and incentives like bonuses for particularly large earnings have been introduced.

Emotions determine financial markets

“This leads to price tendencies being determined not by actual circumstances, but by emotional factors like over-optimism,” explains Proaño. Stock shares reflect a company’s expected earnings, but there’s a catch: “Nowadays, decisions are less rational. Greater macroeconomic instability arises, and in the worst case, this can lead to a financial crisis.” Proaño offers this example: In a country with a gross domestic product of two percent, you can’t expect a ten percent return. Overly optimistic shareholders create larger upturns and subsequently deeper recessions. “If interest rates in the USA are low, American shareholders become more willing to take risks,” explains Proaño. “As a result, the financial cycle in the Great Britain also changes. Germany, on the other hand, feels the effects to a significantly lesser degree because the role of the stock market is smaller here.”

In order to stabilise the worldwide financial sector, the European Central Bank and the Bank for International Settlements have introduced regulations like the countercyclical capital buffer. The buffer means that banks should possess more capital in hard times than in good ones so that they do not go bankrupt as quickly in the event of a crisis. In the coming years, Proaño and his team will study the effects of the countercyclical capital buffer on the banking sector.

Christian Proaño has been a professor of Empirical Economics at the University of Bamberg since May 2015. He studies correlations between financial markets and macroeconomics. The native Ecuadorian has co-authored more than 40 journal articles and three books on macroeconomic theory. In the 2019 Handelsblatt economics rankings, he is listed among the top 100 German economics researchers under the age of 40 worldwide.

Publication:
Till Strohsal, Christian Proaño und Jürgen Wolters. 2019. Characterizing the financial cycle: Evidence from a frequency domain analysis. Journal of Banking & Finance. DOI: 10.1016/j.jbankfin.2019.06.010

This News was translated by Ben Wilson.