Prof. Dr. Claudia M. Buch
Vice-President of Deutsche Bundesbank
Financial Literacy and Financial Stabilityi
Speech prepared for the 5th OECD-GFLEC Global Policy Research
Symposium to Advance Financial Literacy
Paris, 18 May 2018
Seite 1 von 27
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Abstract
Financial (il)literacy is an important channel through which financial instabilities can arise. Yet financial liter-
acy is not a sufficient condition for financial stability. Even if all actors in financial markets are fully financially
literate, they may ignore the impact of their own decisions on the functioning and stability of the financial
system. This has implications for academia and central banks. Further analytical work is needed to under-
stand the link between micro-decision making and macro-economic outcomes. Academia can also contrib-
ute to designing good policy evaluation studies and improving teaching of financial stability. For central
banks, acknowledging the role of communication for financial stability is important. While policies related to
financial consumer protection and financial stability need to be delineated in order to ensure accountability
and transparency, synergies between these policy areas can be exploited. This includes developing com-
mon narratives, common data strategies, and frameworks for policy evaluation.
1 Motivation
Well-functioning financial markets can have significant positive welfare implications. For
the individual, saving and borrowing allow consumption to be smoothened over time and
across states of nature. Wealth can be accumulated over time by the power of compound
interest. Differences in financial literacy across individuals can thus be a relevant factor
behind differences in wealth across individuals (Lusardi, Michaud, Mitchell 2017). Not
least, good financial planning helps ensure financial independence. For society as a
whole, well-functioning financial markets contribute to growth, allow innovative projects to
be financed, and risks associated with these projects to be shared and diversified.
In order to reap these benefits, individual market participants must have a basic under-
standing of relevant financial concepts, and appropriate regulations must be in place in
order to prevent the build-up of risks in the financial system. The household sector is par-
ticularly important in this regard, given that credit-driven business cycles often operate
through household demand (Mian and Sufi 2018).
Financial exuberance can thus have severe negative implications, both at the individual
and at the aggregate level. Understanding the factors that prevent excessive financial risk
taking and improve financial resilience is important. So what do we know about the links
between financial literacy and financial stability? Is financial literary a precondition for fi-
nancial stability? And how do policy decisions that target micro-level incentives affect ag-
gregate outcomes?
Financial literacy is an individual trait, related to the capability of individuals to deal with fi-
nancial concepts, to take sound financial decisions, and to balance the risks and returns
of these decisions. Measures that mitigate the adverse effects of limited financial
knowledge can take various forms, ranging from educational interventions to consumer
protection legislation. Policy interventions can be justified if they correct market failures,
including externalities (i.e. effects on third parties that are not consenting), if exchanges
take place without full information or knowledge, or if market power prevails (Tirole 2017,
Chapter 6).
By contrast, analysing financial stability issues requires taking an aggregate perspective.
Risks to financial stability emerge if distress in parts of the financial system threatens the
functioning of the entire financial system. When a financial system becomes impaired,
there may be dire consequences for economic activity such as losses in output, resource
misallocation, and social costs. Hence, the ability of the financial system to perform its key
macroeconomic functions is the focus of financial stability surveillance and, ultimately,
policy.
Post-crisis, macroprudential policy has been established as a new policy field that explicit-
ly targets financial stability. Such macroprudential policies can take various forms, e.g.
bank-based instruments that internalise systemic risk externalities or borrower-based in-
struments that allow imposing minimum standards for the granting of (mortgage) loans.
In this paper, I will begin by discussing the links between financial literacy and financial
stability. I will argue that financial (il)literacy is an important channel through which finan-
cial instabilities can arise. Uninformed investors may take on excessive risk. This risk-
taking behaviour can become systemic if there are common exposures to the same risk
factor, or if risks cluster in specific institutions or market segments. In this sense, lack of
financial literacy is an important factor behind financial instabilities. Yet financial literacy is
not a sufficient condition for financial stability. Even if all actors in financial markets are
fully financially literate, they may ignore systemic risk externalities, i.e. the impact of their
own decisions on the functioning and stability of the financial system. Relatedly, financial
market participants may have full knowledge of financial concepts but may make mistakes
in forecasting future market developments.
From these observations, several conclusions for research and policy follow. For academ-
ia, these include a greater emphasis on analysing the link between micro-decision making
and macro-economic outcomes, designing good policy evaluation studies, and improving
teaching of financial literacy and financial stability. For policy-makers, I see the need to
clearly delineate different policy areas - in particular, financial consumer protection and
financial stability. This is important in order to ensure accountability and transparency. At
the same time, synergies between these policy areas can be exploited by developing
common narratives, common data strategies, and frameworks for policy evaluation. I will
use policy measures targeting the housing market as an example to illustrate my points.
2 How are Financial Literacy and Financial Stability
Related?
Financial literacy and financial stability are related to financial resilience. Financial resili-
ence ensures that risks are manageable and do not threaten individual wellbeing or socie-
tal welfare. If an adverse shock hits, financial structures and systems should be sufficient-
ly robust to buffer the shock and provide insurance against adverse events.
Micro- versus Macro-Perspectives
Yet the perspective taken by financial literacy and financial stability differs. Financial liter-
acy is a concept related to the individual. It denotes appropriate skills and knowledge that
enable individuals to make sound financial decisions. Lusardi and Mitchell (2011a, 2011b)
developed three questions measuring fundamental concepts measuring fundamental
concepts necessary to financial decision making, related to interest rates, inflation and the
benefits of investment diversification. These questions have been widely used and added
to several national surveys, including the Panel on Household Finances (PHF) in Germa-
ny (Schmidt and Tzamourani 2017). A related concept is financial capability, which in-
cludes economic behaviour such as managing day-to day spending well, looking ahead
and planning unanticipated expenditures, selecting and using available products appro-
priately.2
Financial stability is a concept related to the financial system. Financial instabilities can
arise if shocks to individual financial institutions or market segments have repercussions
throughout the financial system, thus threatening its functioning and having adverse impli-
cations for the real economy. Financial instability thus describes a situation in which the
financial system does not perform its key macroeconomic functions, including the alloca-
tion of financial resources and risks as well as the smooth functioning of the payments
systems.
Is financial literacy a necessary condition for financial stability, and can financial stability
be achieved only if financial decisions at the individual level are sound? Sound financial
decisions at the individual level are obviously conducive to financial stability. But they are
not a sufficient condition - because individuals will tend to ignore the systemic risk exter-
nalities of their decisions and actions.
The Role of Expectations
Studying the link between (financial) decision making and aggregate outcomes is not a
new field in the macroeconomic literature. Researchers have looked into investment bias-
es such as home bias or habit formation for a long time - but often without directly linking
these insights to the stability of the financial system. The behavioural finance literature
shows that departing from the assumption of full rationality can help explain many real
world phenomena. Distorted beliefs, excessive trading, insufficient diversification, or other
examples of suboptimal investment behaviour can be attributed to psychological biases
(Barberis and Thaler 2003). Implications of behavioural models for the financial system
depend on the ability of informed, rational traders to offset the induced distortions.
Recent literature has made advances by linking decision making at the individual level to
macroeconomic outcomes. Mian and Sufi (2018) argue that one major lesson of the re-
cent financial crisis is the importance of credit-driven business cycles that operate through
household demand - and that systematic mistakes in the formation of expectation are
crucial. This channel has three elements. The first is an expansion of credit supply which
fuels household demand for consumption goods and housing, thus filtering through to
economic activities. The second ingredient is an expansion in the real economy which is
driven by an increased demand of households. The third element is a bust which is ag-
gravated by nominal rigidities, distress in the banking sector, and legacies of the boom
phase such as a resource mis-allocation towards the non-tradables and housing sector.
Distorted expectations can be a particularly powerful channel for the propagation of
shocks. Dynamics of the credit cycle might be driven by agents that overestimate the
probability of good future states of the world and, thereby, neglect risks (Bordalo, Gen-
naioli, and Shleifer 2018). If investors extrapolate past trends and rely too much on past
returns to predict future returns, financial bubbles might arise (Barberis, Greenwood, Jin,
and Shleifer 2018). A number of studies find evidence for extrapolative behaviour, for in-
stance, in the stock market (Greenwod and Shleifer 2014) and the US housing market
(Case, Shiller, and Thompson 2012).
Dynamic asset pricing model can be used to link the degree of investor experience to dis-
tortions in expectations and to the probability of financial bubbles (Adam, Beutel, Marcet,
and Merkel 2015). Dynamic stochastic general equilibrium models (DSGE) with extrapola-
tive expectations can generate excessive house price booms and household debt (Gelain,
Lansing, and Mendicino 2013). Extrapolative expectations imply that credit constraints are
believed to be loose (tight) for a longer time than would be assumed under rational expec-
tations. Extrapolative expectations can act as a powerful financial accelerator which am-
plifies microeconomic frictions and has strong financial and macroeconomic effects (Win-
kler 2016). Empirical evidence shows that overly optimistic expectations fuelled house
price growth in the U.S. in the up-run to the financial crisis. This price behaviour is con-
sistent with search models in which a small fraction of overly optimistic agents push up
house prices (Piazessi and Schneider 2009).
Essentially, these theoretical models link distorted expectations to excessive asset price
bubbles and excessive household debt. Empirical studies using aggregate data support
the mechanisms stressed by these models, in particular the link running from asset price
bubbles to financial crises (Reinhart and Rogoff 2008, 2009; Brunnermeier 2009). Moreo-
ver, early warning models also link asset price and credit bubbles to financial crises (Beu-
tel, List, and von Schweinitz 2018). Also, several asset pricing anomalies can be ex-
plained by the fact that households typically do not participate in financial markets directly
but rather operate through financial intermediaries (He and Krishnamurty 2018). Hence,
the relevant marginal investor is not the individual household but the intermediaries facing
various constraints.
Financial Literacy and Expectations
Essentially, all ingredients of financial crises - balance sheet effects, runs, and network
effects - can be linked to and are potentially aggravated by limited financial knowledge.
Identifying the exact channel running from distorted micro-economic decisions to aggre-
gate outcomes is inherently more difficult. One key question is whether financial literacy
has an impact on the degree of distortions in expectations. Empirical evidence supports
that individuals with better financial education have less distorted expectations. For ex-
ample, typical households (in the U.S.) are excessively optimistic during booms and ex-
cessively pessimistic after busts (Adam, Marcet, and Beutel 2017). At the same time, bet-
ter informed professional investors do not suffer from the same systematic biases (Beutel
2017). Moreover, experience with investing in financial markets (in years) and personal
experiences (good or bad past returns) have a strong impact on households' expectations
(Malmendier and Nagel 2011; Vissing-Jorgensen 2004).
Financial experience, in turn, is related to higher financial knowledge. In surveys, half of
the respondents stated that personal financial experiences have been their most im-
portant way of "learning about financial topics", followed by learning from friends or family
(22%), and the media (13%) (Hogarth and Hilgert 2002). Only 10% stated high school or
college courses (5%), or training courses outside of school (5%) as their most important
source of financial knowledge. Similarly, financial knowledge rises with experience and
decays at older ages (Lusardi and Mitchell 2011a). Experience with financial instruments
is a more important driver of financial knowledge than college or high school education
(Peng, Bartholomae, Fox, and Cravener 2007), which could be one reason for why finan-
cial literacy is so low and remains low among large groups of the population.
Summing up, the behavioural finance literature has contributed to an improved under-
standing of the link between distorted expectations, which can stem from limited investor
experience and thus limited financial literacy, to financial bubbles or house price booms
and household debt. Improved financial literacy and education can mitigate some of these
effects but cannot alleviate systemic risk externalities. Also, financial education is targeted
at consumers, not financial intermediaries. These insights are particularly relevant for the
housing market, given that investment into housing is one of the most important financial
decisions taken by most individuals. How borrower incentives and financial knowledge af-
fect aggregate outcome on the housing market is thus an issue to which I will turn next.
3 Micro- and Macro-Perspectives of the Housing Market
Real estate assets are a significant component of the financial wealth of households and
household debt is dominated by mortgage loans. In Germany, mortgage loans account for
about 70% of household debt, and for about 50% of loans issued by banks to the non-
financial private sector.3 The Household Finance and Consumption Survey (HFCS)
shows that about 20% of households in Germany have taken out mortgage loans; this
number is slightly higher (23%) in the euro area. In Germany, the share of mortgage debt
to total household debt is 88% according to the survey.4 The corresponding figure for the
euro area is in a similar range (86%) (HFCN 2016). Financial mistakes related to housing
finance can, therefore, have important implications for individual wealth and consumption
decisions.
Risks to financial stability
Unsustainable housing market developments also play a key role for the build-up of risks
to financial stability. About two-thirds of banking crises were preceded by housing market
booms, and housing market boom-bust cycles are often followed by a crisis (Crowe,
Dell'Ariccia, Deniz and Rabanal 2011). Additionally, economic downturns that are accom-
panied by a bust in the housing market are estimated to last around 40% longer, and they
are almost three times as severe as those without housing busts (Claessens, Kose, and
Terrones 2009). In general, financial crises which are connected with a housing market
bubble tend to be more severe if the bubble was financed by excessive credit resulting in
high leverage of private households and other housing market participants (IMF 2012;
Jordà, Schularick, and Taylor 2015a).
Looking deeper into country examples allows identifying some regularities. First, at the
aggregate level, a build-up of risks from the housing market often stems from a combina-
tion of rising house prices, strong mortgage growth, and a deterioration of credit stand-
ards (Jordà, Schularick, and, Taylor 2015b; Mian and Sufi 2010). Such developments are
especially problematic if too many market participants form overly optimistic expectations
as regards their ability to service debt over the whole cycle of a mortgage loan or with re-
spect to future house price growth. Also, macroeconomic risks and system-wide reper-
cussions are often difficult to assess for individuals. Additionally, overly optimistic expec-
tations during a boom can favour a bias towards low levels of awareness of risks. This is
even more problematic if a boom is accompanied by large current account deficits or a
domestic building boom (Bunda and Ca'Zorzi 2009; Kannan, Rabanal, and Scott 2011).
The role of financial literacy
Financial literacy and, in particular, financial education can affect the probability of mort-
gage defaults. Surveys of subprime mortgage borrowers in the US who took out loans
pre-crisis show a large and statistically significant negative association between numerical
ability and mortgage default (Gerardi, Goette, and Meier 2013). This relationship is robust
to controlling for a large set of sociodemographic variables and other aspects of cognitive
ability, and it does not depend on the type of mortgage contract. Similarly, participation in
a long-term financial education and counselling programme can be related to the default
rates of mortgages (Agarwal, Amromin, Ben-David, Chomsisengphet, and Evanoff 2010).
Ex-post delinquency rates among programme graduates are significantly lower due to dif-
ferent types of mortgage contracts, the post-purchase counselling, and the budgeting and
credit management skills taught. Moreover, increases in education (years of schooling)
lead to substantial reductions in the probability of bankruptcy and foreclosure, slightly
higher credit scores, and fewer delinquent credit card payments (Cole, Paulson, and
Shastry 2014). The effect of education on foreclosure was particularly pronounced during
the recent financial crisis. Work of Brown, Collins, Schmeiser, and Urban (2014) also
shows that financial education in high schools has an effect on debt behaviour and re-
duces the probability of defaulting on debt.
The Role of Macroprudential Policies
While improved financial education can help improve the quality of financial decisions at
the individual level, additional measures may be needed in order to mitigate negative ex-
ternalities for the financial system. Macroprudential policy has thus been established in
order to contain financial stability risks arising from unsustainable financial market devel-
opments, including the housing market. Essentially, macroprudential policy fills the gap
between microprudential supervision, which focuses on the stability of individual financial
institutions, and monetary policy, which focuses on price stability.
Risks for financial stability can arise if strong increases in prices for real estate, a strong
expansion of mortgage lending, and declining credit standards coincide. Such trends are
particularly risky if a large number of market participants form overly optimistic expecta-
tions with regard to the future evolution of prices and debt sustainability, and if they do not
take sufficient account of the fact that house prices can fall and interest rates can rise.
Macroprudential measures addressing risks to financial stability aim at reducing the prob-
ability that mortgage-related risks materialise and that these risks have system-wide im-
plications because of insufficient buffers in the system. These policy measures can target
the demand or the supply-side of the market for mortgage lending. Measures targeting the
supply side are, for example, capital-based measures that aim at increasing the resilience
of lenders and their capacity to absorb losses during a market downturn.
In many instances, though, issues of debt sustainability arising from the housing market
are not a key risk for banks but for households. Macroprudential instruments targeting the
demand side thus address the probability of borrower default and the losses arising from
default. The probability of borrower default can be limited through restrictions on loan-to-
value-ratios (LTVs), that is, caps on the ratio of borrowed money relative to the value of a
residential property. Another set of instruments is related to the ability of households to
service debt, thus limiting losses. These instruments include the debt-service-to-income
ratio and the debt-to-income ratio. Amortisation requirements can provide additional safe-
guards against future deteriorations in debt sustainability.
Essentially, these macroprudential instruments related to the housing market are similar
to indicators that individual borrowers and lenders use as a basis for loan decisions. Bind-
ing targets, however, limit the contractual freedom of private market participants. Before
invoking binding macroprudential measures, softer policy interventions, including commu-
nication strategies, can thus be useful. In this context, financial education can play an im-
portant role in terms of a longer-term strategy towards financial stability.
Recent policy discussions in Germany can serve as an illustration. In the year 2015, the
German Financial Stability Committee issued a recommendation addressing potential
risks arising from the mortgage market (Financial Stability Committee 2015). The Commit-
tee argued that, while not seeing imminent risks to financial stability, a legal basis for
macroprudential instruments related to the housing market would be needed as a precau-
tionary measure. In addition, the Committee recommended the creation of a legal basis
for the collection of granular data of the housing market. Better data serve two purposes -
improved risk assessments and impact assessments of policy measures.
Subsequent policy discussions centred around the need for policy instruments, in particu-
lar in view of the parallel introduction of new guidelines related to consumer protection,5
and the costs and benefits of additional data collections. In 2017, the German parliament
passed legislation providing the legal basis for two out of four requested macroprudential
instruments, modifying consumer protection legislation related to real estate, but without
providing the legal basis for additional granular data (Bundesgesetzblatt 2017; Deutsche
Bundesbank 2017; Federal Government of Germany 2016).
To sum up, buying and financing a house is one of the most important financial decisions
taken by many households. Promoting financial literacy with respect to housing finance
can thus contribute to improved decision making. This contributes to financial stability by
reducing the probability of financial crisis linked to high indebtedness of households. Yet,
improved financial knowledge alone does not address the issue of negative externalities.
Macroprudential policies targeted at the housing market - or, more generally, other mar-
ket segments where excessive credit is an issue - are thus needed. Their effectiveness,
in turn, will depend on the degree of financial literacy at the individual level.
4 Lessons for Academia
In recent years, empirical research has focused on the identification of causal effects:
How do particular policy measures affect policy outcomes? How can environmental fac-
tors be isolated? These strands of research have brought many important new insights in-
to individual decision making and, in particular, the implications of financial literacy.
Recent empirical work has made significant contributions to tackle the issue that financial
literacy can be endogenous, using methods allowing causal impact analysis (Lusardi and
Mitchell 2014). For example, economists are more likely to hold shares in companies than
non-economists - which can be the result of economists being more financially literate, or
it can be due to some other (unobserved) factors driving financial literacy. This issue has
been addressed using the fact that universities have been established in a particular re-
gion as an (exogenous) instrument (Christiansen, Joensen, and Rangwid 2008). Other
studies use an experimental setting in which a randomly selected group is assigned to a
"treatment" such as an education programme, while another randomly selected group
acts as the control group. A study for India uses a randomised field experiment on low-
income urban households to study the effect of a financial education programme on fi-
nancial behaviour (Carpena, Cole, Shapiro, and Zia 2011). Participation in the pro-
gramme influenced awareness of and attitudes towards financial products and financial
planning tools.
In a recent study, Kaiser and Menkoff (2016) perform a meta-analysis of studies on the ef-
fects of financial education programmes. Their main finding is that financial education and
financial literacy impact financial behaviour. At the same time, the way in which financial
education is implemented matters. For example, teaching low-income participants has a
weaker impact, behaviour is difficult to influence, providing financial education at a
"teachable moment" provides the best results, and interventions in low-income countries
appear to be less successful than those in high-income countries.
Develop Evaluation Methods
Using causal identification methods to analyse the drivers of financial stability and the ef-
fects of macroprudential policies is, obviously, more difficult for a number of reasons.
First, macroprudential policy is a relatively new policy area. Hence, there is not much ex-
perience with the use of these policies across countries. Also, systematic documentation
of macroprudential policy measures started only recently. The International Monetary
Fund (IMF) has been publishing, since 2017, a regular survey on macroprudential policy
measures (IMF 2018), which can be a good starting point for empirical work.
Second, in order to assess the effects of financial education, it is sufficient to link educa-
tion received by an individual to outcomes at the individual level. Assessing the effects of
financial stability policies, in contrast, requires linking interventions that affect decisions at
the micro-level to aggregate outcomes. Focusing on the big picture and on the question of
how micro-incentives and decisions add up to aggregate behaviour is thus needed.
A related question is how frictions and biases that affect micro-level decision making ag-
gregate up and affect financial stability, and how these frictions can be identified early on.
Uninformed investors will always be present in markets. The question is how important
they are, quantitatively, for market outcomes. Vissing-Jorgensen (2004) argues that direct
evidence on investors' beliefs is needed in order to determine which aspects of behav-
ioural finance models are relevant and thus which models provide reliable input into policy
debates. In typical environments, however, information about investors' beliefs is not
available, and the question arises how to develop robust policy implications in such envi-
ronments of limited information.
Essentially, this boils down to the question of how the need for policy interventions and
the effects of policies that have been implemented can be assessed. Designing appropri-
ate strategies for impact assessments, both ex ante and ex post, can be an important
contribution of research.
Teaching Economic and Financial Knowledge
Well-designed financial education programmes can improve financial knowledge that is
relevant for day-to-day decision making. In parallel, efforts should be made to improve
teaching financial stability and to integrate this into curricula of universities. This provides
the necessary academic background for macroprudential policies and analytical work re-
lated to financial stability to both, policymakers and academics. The challenge is that
teaching financial stability requires input from many fields including micro- and macroeco-
nomics, public finance, theory of regulation, or even competition theory. Teaching needs
to cover empirical methods - as well as knowledge about institutions. In most universities,
such knowledge is spread across different departments. Possible steps forward involve
6
developing a macroprudential module for CORE, an open-access online teaching tool,
and introducing basic concepts related to financial knowledge and financial stability al-
ready in curricula of schools.
Not least, closing gaps in financial literacy as well as teaching financial stability can great-
ly enhance the success of communication strategies of central banks. Many central banks
engage in training courses related to general economic knowledge and issues related to
price stability. Broadening the focus of these activities to include aspects of financial liter-
acy and financial stability is a natural next step.
5 Lessons for Central Banks
What are the Policy Objectives?
Policy interventions in financial markets can have many different motivations. Justification
for the microprudential regulation of banks, for instance, derives from information asym-
metries and moral hazard in banking models (Dewatripont and Tirole 1994): banks fi-
nance themselves with short-term deposits and invest in longer-term assets. This expos-
es banks to a run-risk, and deposit insurance reduces the liquidity risk for depositors. In
order to prevent moral hazard on the part of banks and to delegate monitoring away from
uninformed depositors, bank capital regulation and monitoring through the deposit insurer
helps aligning incentives.
Macroprudential supervision and regulation have a different motivation (Borio 2003). They
aim at internalizing systemic risk externalities. Individual market participants do not take
sufficiently into account that their own actions might affect the stability of the entire finan-
cial system, be it through "too big to fail" issues, common exposures, or interconnections
within the financial system. Macroprudential policy measures can take many different
forms, they can apply to different types of market participants, and they can range from
relatively soft tools such as communication to more interventionist measures.
Consumer protection, in turn, aims at protecting the individual from unsound financial de-
cision making. Financial markets are subject not only to "traditional" market failures such
as externalities, information asymmetries, market power, and coordination failures, but al-
so to inefficiencies related to biases and cognitive limitations (Campbell, Jackson, Madri-
an, and Tufano 2011). The latter include the lack of basic financial literacy. When house-
holds lack the training necessary to assess their financial decisions, they may make
mistakes that lower their own welfare, and this can have broader consequences for the
economy (Campbell 2016).
Consumer protection regulation focuses on provisions for fair treatment and