EUROPE’SZOMBIEMEGABANKSANDTHEDEFERENTIALREGULATORYARRANGEMENTS THATKEEP
THEMINPLAY
EdwardJ.KaneBostonCollege
2017INETPlenaryConferenceSessiononDoublingDownonFailure:SubsidizingMoreOne-WayBets
Edinburgh,ScotlandOctober23,2017
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TALKINGPOINTS1. FinancialcrisesarethelaststagesofgamesofChickeninitiatedby
megabankers.Theyknoworoughttoknowtheycanbenefitpersonally fromaggressivelyriskingtheruinoftheirfirmsandthefinancialindustryasawholeinwaysthatharmtaxpayersandthe nationaleconomy.
2. Tochangeindividual-bankerincentives,itmakessensetoidentifyandpunish crimesofrecklessbankinginmoreorlessthesamewayswepunishrecklessdriving.
3. WhatisNew:Myresearchprovidescomprehensivestatisticalevidenceconsistentwiththischicken-gamemodelofendogenousfinancialcrises.Itsupportsthemodelbyofferinganewwayofmeasuringtheparticularsubsidiesthat flowthroughbondmarkets.Themethodtracksandcomparesthechangesinbondyieldsformegabankswithchangesintheirshort-termandlong-termprobabilitiesofdefault. Unlikecreditspreadsfornonfinancialfirms,Megabankcreditspreads respondhardlyatalltosurgesintheirprobabilityofdefault.
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HOWZOMBIEMEGABANKERSPLAYCHICKENWITHCRISISMANAGERS
Aroundtheworld,megabankers havelearnedthatcapturingregulatorspoliticallyallowsthemtoholdthemacroeconomy hostageincrisestoextractsubsidiesfromthesafetynet.Zombiebanksarekeptalivebyguaranteestheirmanagersextractandexpandviarepeatedgamesofchicken.Zombiemanagerscosmeticallymisrepresenttheireconomicconditionandpursueprofit-makingopportunitiesthatexploitcounterparties’andregulators’informationaldisadvantage.TheFed’sdemonstratedpropensityforrescuingforeignbanksmakesUStaxpayersserveastheworld’sdefactoguarantorsoflastresort.
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Asinthelastcrisis,theFed(i.e.,theUStaxpayer)isthefinalandbyfarthesturdiestelement oftheglobalfinancialsafetynetand
deservestobebetterprotected.
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ContinuingFedpost-crisissupport(whichincludescurrencyswaps andinterestonforeign-bankdepositsattheFed)allowscountryregulatorstogivezombieinstitutionsthebenefitofthedoubtandbackthemupbyimplicitlybyexpandingconnectionsbetweentheirownsafetynetsandtheUSFed.
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POSTCRISISARRANGEMENTSFORRESOLVINGBANKSINCRISESSOUNDGOOD,BUTARELARGELYABLUFF
1. MandatoryBail-InFrameworkforEUcountries(Loophole-Ridden)2. RestrictionsontheFed’sabilitytolendselectivelytoindividual
distressedinstitutions.3. ExpandedDepositInsuranceCoverageandReserves4. LivingWillsandenhancedresolutionauthority5. EUandFedassurancesofsupervisionandliquiditysupportfor
centralcounterparties(i.e.,securitiesandswapsexchanges)6. CocoBonds:vonFurstenbergestimates$460Bissuedworldwide
(myguessis60%inEurope)between2009andyearend2016.7. Fedcross-bordercurrencyswapsthatinformallybackupforeign
banksandcentralbanks
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PROBLEMISTHAT,NOMATTERHOWMUCHSUPERVISORYANDRESOLUTIONAUTHORITY EXPANDS,THEUNSPOKENNORMS (LESNON-DITS)THATGOVERNTHEEXERCISE OF
THISAUTHORITYREMAINMUCHTHESAME1. Central-bankcommitmenttoprotectingandexpanding
agencyandclienteleturf2. Industry-Centerednormsofclientservice,protection,and
partialacceptanceofblamewhencrisesoccur.3. Loss-concealmentnorms(e.g.,effortstounderstatetheir
toleranceofnonperformingloans)4. Mercyandbenefit-of-the-doubtnormsthatdelayresolution
ofinsolvency5. Normsofindividualcareermanagement
a. Blame-avoidancenorms(rockingtheboatorchallenginghigher-upsisseenascareersuicide)
b. Anunderstandingthatisoktonurtureone’spost-governmentemploymentandspeakingopportunities.
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THESENORMSLEADTOWHATICALLTHECULTURE-DRIVENMEGABANK-BAILOUTMODELOFCENTRAL-BANKBEHAVIOR.THISMODELISROOTEDIN:(1)TOP-MANAGERINCENTIVESTOPURSUETAILSRISKSATMEGABANKS;(2)THEDURABILITYOFCONCEALMENTANDBENEFIT-OF-THE-DOUBTNORMSAT
REGULATORSANDCENTRALBANKS;AND(3)THEHIGHCORRELATIONOFSTAND-ALONEDEFAULTPROBABILITIESACROSSMAJORBANKSINUSANDEU
BankPair CorrelationCoefficient inKRISdata
BACandC .95
BACandJPM .92
BACandGS .94
BACandMS .94
BAC andDBK .74
BACandBBVA .85
BACandUBS .78
BACandCSGN .83
KRISpostedthesefigureson10-10-17.Thesehighcorrelationsdestroythecredibilityofstrictbail-inpromises.Theytellusthat,whenoneofthesebanksisinDistress,theothersaremoreapttoneedhelpthantobeabletoassistthem. 9
EVIDENCEOFBAILOUTEXPECTATIONSThemodelofdefaultprobabilityusedtogeneratetheprobabilitiesisKamakuraRiskInformationServicesversion6.0Jarrow-Chava reducedformdefaultprobabilitymodel (abbreviatedontheKRISsiteasKDP-jc6)• ThismodelwasdevelopedforDonvanDeventer.Donhas
generouslymadethesedataavailabletome.• Themodelusesasophisticatedcombinationoffinancialratios,
stockpricehistory,andmacro-economicfactors.Theversion6.0modelwasestimatedovertheperiodfrom1990to2014,andincludestheinsightsoftherecentcreditcrisis.Kamakuradefaultprobabilitiesarebasedon2.2millionobservationsandmorethan2,700defaults.Atermstructureofdefaultoverdifferenthorizons isconstructedbyusingarelatedseriesofeconometricrelationshipsestimatedonthisdatabase.KRIScovers35,000firmsin61countries,updateddaily.
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Inthisslide,westudythe11weakestbanks operatingintheUnitedStates(regardlessofheadquarterslocation)thatweresubjecttotheFederalReserve'sCCARstresstestingin2016.Banksarerankedinthistablebythesizeoftheirthree-year
cumulativedefaultprobabilitieson3-9-17:
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Ticker Company Country S&PRating
1 yr 3yr 10yr 10yr(10-7-17)
DBK DEUTSCHEBANKAG DEU BBB+ 2.06 6.49 22.90 18.37
SAN BANCOSANTANDERSA ESP A- 0.86 4.11 20.83 21.11
BBVA BBVA ESP BBB+ 1.01 4.05 19.75 20.35
8306 MITSUBISHIUFJFINANCIALGRP JPN A 0.49 3.43 19.79 21.18
ALLY ALLYFINANCIALINC USA BB+ 0.63 3.17 19.35 17.73
601988
BANKOFCHINALTD CHN A 0.82 2.83 15.28 17.26
HSBA HSBCHLDGSPLC GBR A 0.22 2.34 17.69 13.79
RF REGIONSFINANCIALCORP USA BBB 0.14 1.71 14.61 14.86
HBAN HUNTINGTONBANCSHARES USA BBB 0.14 1.63 14.13 15.31
TPB BNPPARIBAS FRA A 0.11 1.57 15.27 14.79
HowaFirm’sCreditSpreadMovesinDistressDependsonHowFullyItsCreditorsFeel TheyareCoveredbytheSafetyNet
• Thenextfewslideswillusegraphstoillustratedefault-swaporcredit-spreadbehaviorinandoutofcrisisfor:GE(asabaseline)andseveralUSandEuropeanmegabanks.
• Bluedots:Creditspread,basedonactualtradesandcalculatedusingmatched-maturityTreasury(differentfromtheconventionwhichusesthenearestshorter USTreasuryon-the-runyield)
• LightBluelinesshowvolume oftradingintheselectedbond
• Orangeline:1year KamakuraRiskInformationServicesreduced-formdefaultprobability(KDP),version6.0
• Greenline:10year (unlessotherwisenoted)KRISreducedformdefaultprobability,version6.0
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• FinanceisonlyasmallpartofGEoperations.• Bluedotsmovesharplywithsurgesinorangelineandstayhighevenafter
1yearKDPbottomsoutslowlyasproblemsareworkedout.• Problemsslowlyresolved.Matures12-6-17.
citigroup
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• Matures8-17.
FAILURETOPRICESURGESINKRISDEFAULTPROBABILITIESINDICATESTHATUNACKNOWLEDGED
IMPLICITGUARANTEES DELAYTHEWRITE-OFFOFWAVESOFNONPERFORMINGLOANS
• Nonstandardbehaviorindistressofcreditspreads on“unguaranteed”megabankbondsbacksupmyrejectionofofficialassessmentsofEuropeanBankresilience.Yieldsondebtsecuritiesofdistressedmegabanksactasifestimatedsurgesintheirdefaultprobabilitiesarelargelyirrelevant.
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• Matures12-1-17.
Evidencethatexpectationsoffederalrescueexistedandwereletdown.Debtpricecrashed.WeseethisforBancoPopularaswellduringitslastweek.
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UsingUScrisisexperienceasatouchstone,Iwillsummarizeevidence(presentedinmyconferencepaper)thatindicatesthatseveralmajorEuropeanMegabankswerealsoTBTFduringtheGreatFinancialCrisis.MostofthelargestbanksinEuropeshowedthispattern. Somefailed,othersmerelylimpedalongduringtheaftermath,andappeartobemovingtowardbecomingasfragileastheywereduringtheGFC.
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• SurgeinOrangeprecededGFC.Creditspreadmovedmuchlessthansurgesinotherlines.EvidenceofTBTF,butsomeuncertainty.
• Bondstudiedherematures9-1-17.19
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UBSANDBACSHOWASIMILARPATTERNINRECENTYEARS
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TWORECENTGAMESOFCHICKEN:DEFERENTIALTREATMENTOFDISTRESSATDBKANDATSANTANDERANDBANCOPOPULAR(BPM)
Mypaperpresentsevidencethat:1. MajorDBKcreditorsappeartohavereceivedcredible TBTFback-
doorassuranceslastSeptember2. BancoPopularwasfifthorsixthlargestinSpain.Itsresolutionis,at
best,abungledrun-inducedpartialbail-in:WhileBPMstockholders,COCOSandsomenonsenior creditorswereeventuallywipedout,affectedcreditorsweregrantedtimetogetoutorcollateralizetheirpositionsasthegovernmentburnedthroughalmost$4Bin“EmergencyLiquidityAssistance”inthebank’sfinaldays. Positionsofdepositorsandseniorcreditorswereassumedbythenowregulator-approvedandmonopoly-strengthenedzombieSantanderBank.ResolutionstrategyresemblesFSLIC’ssquanderingtaxpayervaluebymergingseveralsmallerzombieS&Lsintolargerzombieinstitutionstokeepfrompayingthefullcostsofresolvingtheirinsolvencyintimelyfashion.
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What“news”didDB releaseonitsstockprice’sturnarounddate?- fromTheBrief– 9.27.16
postedbyMichaelReif and RobinsKaplanLLP
DeutscheBankofficialsare denyingreports accusingthebankinggiantofaskingGermanytoprovideitwithaidtohelpitfacetheDOJ’s[opening]$14billionsettlementoffer—afigure morethan$8billion aboveDB’s allegedlegalreserves – NYTimes
TheTimesstoryincludedthisexcerpt:
"ADeutscheBankspokesmansaid onMonday thatJohnCryan,itschiefexecutive,had“atnopoint”askedChancellor AngelaMerkel tointerveneintheissuewiththeJusticeDepartment.[doesnotexcludeotherpathsforrequestingbailouts]Thespokesmansaidthatagovernmentbailoutwas“notonouragenda”[mightbeonsomeoneelse’sagendathough]andadded,“DeutscheBankisdeterminedtomeetthechallengesonitsown.”Despitethedenial,speculationaboundsthatDeutscheBankwillonceagainbeforcedtoaskinvestorsformorecashatamomentofextremeweakness.“
Note:TheDOJeventuallyreduceditsfineto$7.2billionandeaseditsterms.DBKlauncheda$8.6billionrightsissuethatshoredupitsnetworthanddilutedexistingstockholders.
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THESEQUOTESILLUSTRATEHOWBANKSANDGOVERNMENTSUSESLIPPERYDENIALS ANDHIDDENTRANSFERSOFLOSSESANDLOSSEXPOSURESTO
SUPPRESSCREDITORRUNS• INCOMPLETEFRAMINGOFISSUESANDACTIONSATSTAKE
• DIVERSION(OFFERASERIESOFHALFTRUTHS)• DEFLECTION(ATTACKCRITICSRATHERTHANISSUES)
• TRIALBALLOONS(SEEWHATLINESOFHALF-TRUTHMIGHTPROVEEFFECTIVE)
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WELL-KNOWNEFFECTSONAFIRM’SSTOCKPRICEOFRECEIVINGANEXPLICITORIMPLICITGUARANTEESUGGESTTHATMAJORDBKCOUNTERPARTIES
RECEIVEDASSURANCESLASTFALL• Inacceptinganoutsideguarantee,abankenterstwo contracts:
1) Aputoption thatallowslosses beyonditsshareholderequitytobecometheresponsibilityoftheguarantor.
2) Acalloption onitsassets thatallowstheguarantortostoplossesandtakeovertheupside ofthefirmataspecifiedlevelofnear-insolvency.
• ForToo-Big-to-Failbanks,MercyandClient-Protectionmotives,apropensityofmanagersandregulatorstomischaracterizebanklossexposure,andauthorities’“propensitynottoexercisetheircall,”increasefirmstockpricewhenitstailriskishigh.IncreasedconfidenceinthenegationofthecalltransfersvaluefromtaxpayerstostockholdersandmanagersofTBTFbanksacrossallstagesofthefinancialcycle.
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WhytheRevolvingDoorDoesSoMuchBusiness:SalariesofTopRegulatorsComparedwithIncomesEarnedby
TopManagersinthePrivateSectorOverTime
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Source:FergusonandJohnson,“WhenWolvesCryWolf,’”INETPaper,King’sCollege,CambridgeUniversity,2010https://www.ineteconomics.org/uploads/papers/[email protected]
