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/INET-C@K-Paper-Session-8-Ferguson-Rob-Johnson.pdf