Bank Leverage, Welfare and Regulations

Anat Admati Graduate School of Business Stanford University

Riksbank

October 16, 2018 1

1 My daughter came home from school one day and said, ‘daddy, what’s a financial crisis?’

And without trying to be funny, I said, ‘it’s the type of thing that happens every five, seven, ten years.’

Jamie Dimon, January 2010 (to Financial Crisis Inquiry Commission)

2 “The Sequel to the Financial Crisis is Here” Frank Partnoy, Financial Times, July 31, 2017

“The Next Financial Crisis is Closer than You Think,” Tim Lee, Washington Post, October 10, 2018

Italy political crisis hits financial markets BBC News, May 29, 2018

To Spot the Next Financial Crisis, Look Who Was Spared by the Last One James Mackintosh, Wall Street Journal, April 26, 2018

Leading the list are Australia, Canada and Sweden. Sweden offers a case study in financial crises. Private debt in general and mortgage debt in particular is one of the most reliable indicators of trouble ahead. Sweden’s indicator of financial vulnerability is higher than ahead of its 1992 crisis. Riksbank, Sweden’s central bank, has been warning about the risks from the housing market, and worrying in public about the strength of its banks.

3 [These events] present a challenge to standard economic theory…. policies to prevent future financial crises will depend on a deeper understanding of the processes at work. Asymmetric information is key, precisely in the complex securities that [the standard theory] called for.

Kenneth Arrow, “Risky business,” Guardian, October 15, 2008 Kenneth Arrow, 1921-2017

A Liquidity Problem? “A Classic Bank Run?”

4 Natural Disaster? Sudden “Shock” to Beliefs or Valuations?

5 The financial crisis was avoidable Widespread failures in financial regulation Breakdown in corporate governance Explosive and excessive borrowing. Lack of transparency Government was ill-prepared and responded inconsistently Widespread breaches in accountability at all Delivered January 27, 2011 levels.

The crisis reflected distorted incentives and failure of rules and governance.

6 This essay argues that “free markets” lead to inefficient fragility in banking. The problem: banks are unable to commit to maintaining efficient liquidity and safety because additional borrowing benefits their shareholders at existing lenders’ expense. Leverage regulation in banking is beneficial even without systemic risk considerations.

Historical Equity/Asset Ratios in US and UK

30

25 Mid 19th century: 50% equity, United States unlimited liability 20 After 1940s, limited liability 15 everywhere in US

10 “Safety nets” expand Percentage (%) United Kingdom 5 Equity ratios decline

0 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Year

Alesandri and Haldane, 2009; US: Berger, A, Herring, R and Szegö, G (1995). UK: Sheppard, D.K (1971), BBA, published accounts and Bank of England calculations.

7 Total Liabilities and Equity of Barclays 1992-07

1.4 Customer Total MMF Other Equity Deposits Funding Liabilities 1.2

1

0.8

0.6 Trillion pounds 0.4

0.2

0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Hyun Song Shin, “Global Banking Glut and Loan Risk Premium,” IMF Annual Research Conference, November 10-11, 2011; Figure 22.

JPMorgan Chase Balance Sheet Dec. 31, 2011 Cash

Loans Deposits Loans = $700B less than Deposits = $1.1T Other debt (GAAP): $1T Cash Other debt (IFRS): $1.8T Loans Other Debt Deposits Trading and (mostly short term) Equity (book): $184B Other Assets Equity (market): $126B

Other Debt Significant off-balance-sheet Trading and (mostly short term) commitments Other Assets Long-Term Debt Long-Term Debt “Bank Holding Company:” Equity Equity A conglomerate. GAAP Total IFRS Total $2.26Trillion $4.06 Trillion

8 JP Morgan Chase: “Fortress?” Dec. 31, 2011 (in Billions of dollars)

4,500 4,060 4,000

3,500

3,000

2,500 2,260

2,000

1,500

1,000 500 126 0 GAAP Book Assets IFRS Book Assets Market Equity

9 The Mantra in Banking: “Equity is Expensive”

Expensive to whom? Why? Are banks so special and different that none of what we know about the economics of corporate funding applies?

Bank Debt is Special by Providing “Liquidity”

Does it follow that it is efficient for banks to have little equity? NO!!! + Bank equity is subject to the same economic forces as other corporations + Default destroys liquidity benefits + Safer banks have fewer runs.

10 Central Banks: Very Special

Do Banks “Create” Money by Lending?

The liquidity benefits of deposit and other debt affect their valuation by lenders Interest rate and trust in the bank safety (or in safety nets) also affect lenders’ valuation Permitting banks to “create” deposits by lending or calling some liabilities “money” does not change the fact that they are legal obligations of the banks.

11 Economics has replaced the naïve fallacy of composition of the banker with other half truths, perhaps equally misleading. These have their root in the mystique of “money” --- the tradition of distinguishing sharply between those assets which are and those assets which are not “money,” and accordingly between those institutions that emit “money” and those whose liabilities are not “money”

“Commercial Banks as Creators of ‘Money’” James Tobin, 1967

Modigliani and Miller (M&M) and Banking A Five Decade Long Debate

The main message of Modigliani and Miller (1958) is NOT that the funding mix (capital structure) of banks, or of any firm, is irrelevant. The assumptions for “irrelevancy” are not true in reality. The key conclusion is that rearranging how risk is allocated does not by itself change the cost of funding. The impact of any change in funding mix must be examined through its effect on the total cash available to investors when frictions (such as taxes and bankruptcy costs) are taken into account

12 The banker sitting next to me was lamenting the profitable lending opportunities being passed up by capital constrained banks, when I broke in to ask: “Then, why don’t they raise more capital?” . . . “They can’t,” he said. “It’s too expensive. Their stock is selling for only 50 percent of book value.” “Book values have nothing to do with the cost of equity capital,” I replied. “That’s just the market’s way of saying: We gave those guys a dollar and they managed to turn it into 50 cents.”

Merton Miller, “Do the M&M Propositions Apply to Banks?” Journal of Banking and Finance,1995

Government (Taxpayers)

Shareholders

Other lenders (TLAC, Co-Cos, Bail-in Debt)

Short-term secured lenders

Depositors (unsecured, insured)

13 Capital Structure: The Static “Mindset”

Modigliani “Dynamic We know Agency conflict and Miller’s models” often that with debt also affects approach and assume “reset” in place, funding “Tradeoff to maximize shareholders decisions once Theory” total value. may debt is in place assume capital ... take negative NPV Critical insight for structure is projects (shift risk to understanding set once, to creditors) economics of high leverage maximize total ... pass up positive firm value NPV projects (Myers 1977)

Banks vs Non Bank Corporations Leverage

Non Banks Banks or BHC (without regulation) (with “Capital Regulation”) Have risky, long term, illiquid assets Ditto Can use retained earnings (or new Ditto shares) to invest and grow Rarely maintain less than 30% Rarely have more than 6% equity/assets, often much more equity/assets, sometimes less Sometimes don’t make payouts to Make payouts to shareholders if pass shareholders for extended periods “stress tests” (unless indebted to (Google, Berkshire Hathaway). government)

14 Borrowing and Downside Risk

Heavily Indebted Non Banks Heavily Indebted Banks (no safety net) (many supports) May become distressed/insolvent Ditto Inefficient decisions Ditto May default or file for May remain insolvent bankruptcy  Depositors maintain balances  Shareholders are wiped out  Secured lenders are protected  Access to Fed, Bailouts in crisis  Lenders are paid by seniority  Assets are depleted Lenders try to protect themselves when Can keep finding lenders despite lending, hard to borrow. opacity, risk, and extreme debt.

Zombie (Insolvent) Borrowers: Opaque and Dysfunctional

15 Zombie (Insolvent) Borrowers: Opaque and Dysfunctional

Unable to raise equity

“Gamble for resurrection”

Anxious to take cash out

Avoid equity

Sell assets, even at fire-sale prices

Underinvest in worthy “boring” assets

Try to hide insolvency in disclosures

Lobby policymakers for supports

The Leverage Ratchet Effect

(Journal of Finance, 2018)

Anat Admati, Stanford Peter DeMarzo, Stanford Martin Hellwig, Max Planck Institute Paul Pfleiderer, Stanford

Asymmetric forces in leverage adjustments cause equilibrium leverage outcomes to be history-dependent.

16 Static “Tradeoff Theory” and Leverage Adjustments

Firm Value

Leverage

Some Leverage Ratchet Effect Observations

» “Optimal” static debt level (maximizing total firm value) is unstable;

With debt in place, shareholders resist leverage reduction, yet choose to » increase leverage/indebtedness even if high.

Leverage levels are history-dependent and agency conflicts reinforce » distortions and inefficiencies on both sides of balance sheet.

» Responses to ratio-based requirements in covenants or regulations may be inefficient (e.g., bias to asset sales); other tools may be better.

17 Leverage Ratchet Example With (non-negotiable) debt in place, shareholders want to increase leverage – even if new debt is junior. Tradeoff-optimal level unstable.

Firm Value 100 VF(D)=VE(D)+VD(D) =VE(0)+G(0,D) Value of Senior Debt 75 VE(D*)+G(D*,D)

50 Value of Junior Debt Market ValueMarket

25 Value of Equity VE(D) Senior Debt Junior D* Debt D*(D*(0)) 0 0 25 50 75 100 125 150 175 200 Debt Face Value D

Leverage Reduction with Asset Transactions

Three ways to reduce leverage ratio. Which way will shareholders choose (if forced)?

Initial Balance Sheet Balance Sheets with Reduced Leverage (lower debt to assets) Debt/Assets = 0.9 Debt/Assets = 0.8 Equity: 22.5 Equity: 10 Equity: 20 Assets:Assets 12.5

Assets Assets Liabilities Equity: 10 Assets Liabilities Assets100 Assets: Liabilities Assets:100 90 100 90 100 Liabilities: 100 Liabilities:80 100 Liabilities: 90 Assets 80 90 Assets: Liabilities 50 Liabilities: 50 40 40

A: Asset Liquidation B: Pure Recapitalization C: Asset Expansion

18 Shareholders’ Preferences For Leverage Reduction

Debt Type Bought Asset Liquidation Pure Recapitalization Asset Expansion (A and B) Homogeneous Senior Debt Junior Debt

Initial Balance Sheet Balance Sheets with Reduced Leverage (lower debt to assets) Debt/Assets = 0.9 Debt/Assets = 0.8 Equity: 22.5 Equity: 10 Equity: 20 Assets:Assets 12.5

Assets Assets Liabilities Equity: 10 Assets Liabilities Assets100 Assets: Liabilities Assets:100 90 100 90 100 Liabilities: 100 Liabilities:80 100 Liabilities: 90 Assets 80 90 Assets: Liabilities 50 Liabilities: 50 40 40

A: Asset Liquidation B: Pure Recapitalization C: Asset Expansion

Bias towards Asset Sales to Reduce Leverage

If assets are identical but distinct, shareholders’ preferences for leverage reduction are

1 Asset sales 2 Pure 3 Asset purchases recapitalization

If assets have different riskiness, shareholders prefer to reduce leverage by selling safer assets first.

Basic intuition: desire to shift more risk to existing creditors.

19 Shareholders’ Preference over Buying/Selling Assets/Securities Relevant for Covenants or Regulation to Control Leverage Figure 7, “The Leverage Ratchet Effect”

Proposition 9 Indifference (Prop. 7)

Shareholder Preference E\D Leverage over Sell\Buy: A\D E\D A\D E\D A\D Decreasing J  J   S  S  Shareholder Gain E\A in Perfect Market: +/- - - - -

Shareholder Preference D\E Leverage over Sell\Buy: D \A D \ED\A D \E D \A Increasing S  S   J  J  Shareholder Gain A\E in Perfect Market: +++ 0 -

Indifference (Prop. 7) Classic Debt Overhang (Myers 1977)

A = Assets, Ds = Senior Debt, DJ = Junior Debt

“The Maturity Rat Race” Markus Brunnermeier and Martin Oehmke, Journal of Finance, 2013

20 Free Markets Do Not Produce Efficient Outcome

Fragmented lenders. Bank Costly (or impossible) coordination Free rider problems Contracts work poorly to create Depositors and effective commitments and trust other counterparties Banks have always been fragile but it does not follow that they have ever been efficient. Safety nets exacerbated conflicts of interest and inefficiencies, unless regulation is effective.

Relevance and Implications for Banking

Guarantees eliminate creditor » discipline; insured depositors Effective regulation is beneficial; are unsecured yet passive. » a form of commitment; replaces missing market forces. Benefits Expanding safety net and are larger given negative » providing more safe collateral externalities of distress or failure would exacerbate distortions. To avoid inefficient adjustment “Safe harbor” exemptions for » (fire sales, credit crunch), » repos and derivatives are too regulators must manage strong and counterproductive. adjustments rather than give ratios Key tools: mandate retention, equity Tax subsidies of debt are issuance » highly distortive and Inability to respond = failure of “market counterproductive. stress test”

21 The Great Distortion: Senseless Debt Subsidies! The Economist, May 16, 2015 U.S. tax revenues forfeited as a result of interest deductibility as % of GDP

Financial Firms Non-Financial Firms Mortgages

Sweden's tax loss for mortgage tax relief amounted to around SEK 20 billion in 2016. This sum is expected to Source: Federal Reserve; Bureau of Economic Analysis; The Economist increase when interest rates rise

Riksbank Financial Stability Report, 2018

Basel Capital Regulation (No Science, highly complex)

Basel II Basel III

“Common equity Tier 1 capital” to “Common Equity Tier 1 Capital” to risk-weighted assets: 2% risk-weighted assets (RWA): 4.5% » Plus 2.5% conservation buffer » Plus 1.5% “Tier 1” to RWA Leverage Ratio: “Tier 1” to total » Basel III: 3% » US: BHC: 5%, insured banks: 6%

“Tier 2” (loss-absorbing debt) “Tier 2”/TLAC (loss-absorbing debt).

22 Tripling almost nothing does not give one very much.

Martin Wolf, “Basel III: The Mouse that Didn’t Roar,” Financial Times, Sep 13, 2010

If at least 15% of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any. If handled properly, the transition to much higher equity requirements can be implemented quickly and would not have adverse effects on the economy. Temporarily restricting bank dividends is an obvious place to start.

Anat R. Admati, Franklin Allen, Richard Brealey, Michael Brennan, Markus K. Brunnermeier, Arnoud Boot, John H. Cochrane, Peter M. DeMarzo, Eugene F. Fama, Michael Fishman, Charles Goodhart , Martin F. Hellwig, Hayne Leland, Stewart C. Myers, Paul Pfleiderer, Jean Charles Rochet, Stephen A. Ross, William F. Sharpe, Chester S. Spatt, Anjan Thakor

23 Banks Remain Extremely Heavily Indebted

Source: Financial Stability Report, Riksbank 2018

Risk Weights Undermine the Purpose of Regulation

Complex; illusion Manipulable, Low equity levels, of “science,” distortive, and intensify distorted ignore interest political incentives, risk rate risk, and » E.g., Favor weights used to correlation of “tail government and “economize” on equity events.” traded assets over » Add fragility, business lending interconnectedness, systemic risk

24 Bad Regulations Matter The Awful Case of Greece French banks owned 40% of Greek Swiss banks retreat government debt in 2010. 350 Regulations (still) assume such 300 loans are riskless (0 risk weight). Germany 250

st st France 1 Bailout 2 Bailout 200 Greek debt restructuring Italy 150 Spain Netherlands Belgium 100 UK

Swiss 50

Other 0 2007 2008 2009 2010 2011 2012 2013 2014

BIS (2014), Company Data, EBA (For 2010-11 Greece Exposure Data), German Bankers Association, Morgan Stanley Research

Who Owned Greek Government Debt, July 2015 Leading creditors (in euros): Risk shifted to “authorities” i.e., the public EU bailout loans Private banks Other

Germany 68.2bn France 43.8bn Italy 38.4bn Spain 25bn IMF 21.4bn ECB 18.1bn Netherlands 13.4bn US 11.4bn UK 10.8bn Belgium 7.5bn Austria 5.9bn Finland 3.7bn

Source: Open Europe, BIS, IMF, ECB

25 Regulatory Measures are Uninformative “Tier 1” capital ratios:

0.1 What crisis?

0.09 0.08 Between summer 2007 and end 0.07 of 2008, the largest 19 US 0.06 institutions paid out nearly $80B 0.05 to shareholders. 0.04

0.03 'No crisis' banks 0.02 'Crisis' banks 2006 was a great year in 8% threshold 0.01 banking Lehman failure 15 Sep 08 0 May Nov May Nov May Nov May Nov May Nov May Nov May Nov 02 02 03 03 04 04 05 05 06 06 07 07 08 08

From: Andrew Haldane, “Capital Discipline,” January 2011)

Regulatory Measures are Uninformative “Tier 1” capital ratios:

0.1 What crisis? Largest 19 institutions received

0.09 ≈$160B under TARP (bailouts).

0.08

0.07 Fed committed $7.7 trillions in

0.06 below-market loans to 407 banks.

0.05

0.04 “Tier 2 capital” proved useless to 0.03 absorb losses (except Lehman). 'No crisis' banks 0.02 'Crisis' banks 0.01 8% threshold Lehman failure 15 Sep 08 0 May Nov May Nov May Nov May Nov May Nov May Nov May Nov 02 02 03 03 04 04 05 05 06 06 07 07 08 08

From: Andrew Haldane, “Capital Discipline,” January 2011)

26 Regulatory Measures are Uninformative “Tier 1” capital ratios: Market-based measures

0.1 What crisis? 0.14

0.09 0.12 0.08

0.07 0.1

0.06 0.08 0.05 0.06 0.04

0.03 'No crisis' banks 0.04 'No crisis' banks 0.02 'Crisis' banks 'Crisis' banks 0.02 5% threshold 0.01 8% threshold Lehman failure 15 Sep 08 Lehman failure 15 Sep 08 0 0 May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov May Nov 02 02 03 03 04 04 05 05 06 06 07 07 08 08 02 02 03 03 04 04 05 05 06 06 07 07 08 08

From: Andrew Haldane, “Capital Discipline,” January 2011)

“Anything but Equity” Why?

Equity EquityEquity Equity Bailout Equity Bailout?? Co-co, Tier 2 , Equity TLAC

“Straight” Assets Assets Assets Debt “Straight” “Straight” Before Before Before Assets Assets Debt Assets Debt After After After

Too Little Equity Much Safer Will it Work? Why do we need it?

27 Making Equity Regulations Work

» Safe target, e.g., 30% » Sign that regulation is allowed down to 20% working: fewer zombie symptoms

Prompt corrective action Also: better disclosure and » based also on market signals » tracking, coordination, simpler structures, better governance.

Avoid ratios, focus on » amount, but asset sales More equity: Not a silver bullet might be useful. but best bargain in regulation: numerous benefits, no social cost.

“Shadow Banking” Bugbear

Crisis exposed ineffective enforcement. + Rules are meaningless unless enforced + Regulated banks sponsor entities in the shadow banking system.

Enforcement challenge is invalid argument against regulation: + Allow robbery? + Give up tax collection?

28 Invalid “Level Playing Field” Argument

Banks can endanger the entire economy Banks compete with other industries for inputs (including talent); subsidies distort markets. It is not a national priority that “our” banks are successful at the expense of society Argument creates “race to the bottom”

29 Confusion and Politics: A Toxic Mix

“More equity might increase the stability of banks. At the same time, however, it would restrict their ability to provide loans to the rest of the economy. This reduces growth and has negative effects for all.”

Josef Ackermann, Deutsche Bank CEO, November 20, 2009 interview)

30 Just about whatever anyone proposes… the banks will claim that it will restrict credit and harm the economy…. It’s all bullshit Paul Volcker, January 2010 (From Payoff: Why Wall Street Always Wins, Jeff Connaughton, 2012)

Because we have substantial self- funding with consumer deposits, we don’t have a lot of debt…

John Stumpf, Wells Fargo Bank CEO, 2013

31 Because we have substantial self- funding with consumer deposits, we don’t have a lot of debt…

John Stumpf, Wells Fargo Bank CEO, 2013

US banks forced to hold $68 billion in extra capital. Financial Times, April 8, 2014

32 US banks forced to hold $68

billion in extra cashcapital.. FinancialTelegraph. Times, April 8, 2014

US banks forced to hold $68

billion in extra cashcapital.. FinancialTelegraph. Times, April 8, 2014

33 Every dollar of capital is one less dollar working in the economy.

Steve Bartlett, Financial Services Roundtable, Sept 2010

Every dollar of capital is one less dollar working in the economy.

Steve Bartlett, Financial Services Roundtable, Sept 2010

34 This rule will keep billions out of the Economy

Tim Pawlenty, Financial Services Roundtable, July 2015

This rule will keep billions out of the Economy

Tim Pawlenty, Financial Services Roundtable, July 2015

35 Banks are forced to hoard money and they can’t take any risks. Dodd Frank prohibits them from lending.

Gary Cohn, National Economic Council Director, February 3, 2017

Banks are forced to hoard money and they can’t take any risks. Dodd Frank prohibits them from lending.

Gary Cohn, National Economic Council Director, February 3, 2017

36 From Banking Textbook

Bank capital is costly because, the higher it is, the lower will be the return on equity for a given return on assets.

Frederic S. Mishkin, 2013, The Economics of Money, Banking and Financial Markets, 3rd Edition, p. 227

From Banking Textbook

Bank capital is costly because, the higher it is, the lower will be the return on equity for a given return on assets.

Frederic S. Mishkin, 2013, The Economics of Money, Banking and Financial Markets, 3rd Edition, p. 227

37 Equity, Risk, and Return on Equity (ROE)

 More equity: 25% ROE

. Higher ROE on upside 20% 10% equity . Lower ROE in downside 15%

. Less risk for equity 10% 20% equity . Lower required ROE. 5%

0%  Chasing returns by taking risk 3% 4% 5% 6% 7%

or excessive leverage may -5% Return on Assets harm shareholders! -10% (before interest expenses)

-15%

Good or Bad?

Meaningless distinctions Proper questions

Are worthy investments funded? Is more credit always good?

Credit Debt  Wasteful investments in boom  Booms are key predictors of bust/crisis

 Debt overhangs exacerbate recession

Why subsidies debt over other funding?

 Debt subsidies create unnecessary distortions and risk

 Find better delivery for desirable subsidies!

38 Politics of Banking Symbiosis and “bargains” banks-governments

» “Banks are where the money is” » “National champions”

Guarantees appear free, invisible Central banks support governments » social cost, willful blindness » and private banks

Banks seem sources of funding, not » risk Private banks get away with inefficient recklessness.

Willful Blindness: Excuses, Diversions and Spin

Much has been done It’s very complicated “ There will be “unintended consequences” There are tradeoffs We must maintain level playing field We must fear the “shadow banking system” We need cost-benefit estimates etc., etc......

“The Parade of Bankers New Clothes Continues: 31 Flawed Claims Debunked,” Admati and Hellwig, last revised 2015

39 Many Enablers of a Dangerous and Distorted System

Bankers and other financial Central bankers sector employees

Institutional investors The media

Executives and boards of Politicians financial firms

Auditors and rating Academics/Economists agencies

Supervisors and regulators

With such friends [as academics], who needs lobbyists? Risk manager in a major systemic institution, 2016

“It Takes a Village to Maintain a Dangerous Financial System,” Anat Admati, 2017.

40 I’ve explained it!!

Set of Different Set of Different Set of Assumptions: Assumptions: Assumptions: Observed Configuration A1, A2, A3, …, AN B1, B2, B3, …, BN C1, C2, C3, …, CN

I’ve explained it!!

I’ve explained it!!

Science is what we have learned about how to keep from fooling ourselves.

Richard Feynman

“Chameleons: The Misuse of Theoretical Models in Finance and Economics,” Paul Pfleiderer, 2014 (forthcoming, Economica, 2018)

41 The size, complexity, and opacity of institutions and the system are alarming

Too complex to Resolve? Dexia's structure, 2011

Associated Dexia Dexia SA (DSA) Technology Services DBNL (ADTS)

100% Belgium 100% Belgium 100% Netherlands DCL Paris Deniz Bank DHI DCL London Branch

DCL Global Dexia Holdings Inc Dexia Banque CBX IA1 SARL, Banque, Dexia FP (FP) Dexia Bank Belgium Dexia Credit Local (DCL) Funding (GF) (DHI) Internationale a DenizBank (DzB) (DBB) Luxembourg (BIL) CBX IA2 SARL, Banque, 100% Belgium 100% US 100% Belgium 100% France 99.8% Belgium 99.8% Luxembourg 99.8% Turkey DCL France

Dexia Crediop Dexia Sabedell Dexia Kommunalbank Dexia Municipal Dexia Insurance Dexia Asset RBC Dexia Investor Other subsidiaries DenizEmeklilik (DzE) (Crediop) (Sabadell) Deutschland (DKD) Agency (DMA) Belgium (DIB) Management (DAM) Services (RBCD)

100% Turkey 70% Italy 60% Spain 100% Germany 100% France 100% Various 99.8% Belgium 100% Belgium 50% Belgium

International subsidiaries DCL France - Dublin French Small Subsidiaries DCL East DCL France 100% Various DCL America 100% France

Dexia Real Estate DKB Polska (DCL DCL Dublin branch Chuo Mitsui SPV Capital Markets DCL NY branch DCL Canada branch Varsovie) Dexia Locatoin (DRECM) Sofaxis Domiserve SA Domiserve + Exterimmo longue duree, (LLD-JV) Dexia CAD Funding Dexia Credit Local Asia DCL Grand Cayman Dexia Kommunalkredit DCL Tokyo Pacific Pty (Dexia LLC (Dexia US branch Bank AG (DCL Vienne) Dexia Regions Pacific / China) Securities) SISL Dexia Flobail Dexial Bail CLF Immobilier Bail Dexia Credit Local Dexia Delaware LLC Dexia Management CLF Banque Mexico SA de CV (DCL (Dexia US Services Ltd (DMS UK) DCL Israel Mexico) Securities)

42 Shadow Banking Pozsar, Adrian, Ashcraft, and Boesky, Federal Reserve Bank of New York, July 2010: revised February 2012

43 Source: Collateral and Financial Plumbing, Manmohan Singh, 2014 “Leverage: A Broader View,” Manmohan Singh and Zohair Alam

In “Normal Times” Bank Holding Company Regulated Bank

Shadow Bank Vehicle Sponsored by Bank Assets Holding Company Insured Deposits

Assets Uninsured Deposit- like Claims

44 In “Troubled Times” Bank Holding Company Regulated Bank

Shadow Bank Vehicle Sponsored by Bank Assets Holding Company Insured Deposits

Uninsure Assets Assets taken d Back New Deposit- on Insured like Balance Deposits Claims sheet

Investors can’t understand the “nature and quality of the assets and liabilities... The disclosure obfuscates more than it informs. Kevin Warsh, Jan. 2013

The unfathomable nature of banks’ accounts make it impossible to know which are sound. Derivatives positions, in particular, are difficult for outside investors to parse. Paul Singer, Elliot Management, Jan. 2014

Wells Fargo: Quaint? “What’s Inside America’s Banks?” Eisinger and Partnoy, Atlantic, Jan 2013 ”

45 The omission of off-balance sheet items in the standard measures [of leverage] implies a substantial underestimation of bank leverage

Off-balance sheet funding is higher now than in 2007.

“Leverage, a Broader View,” Singh and Alam, IMF, March 2018

Governance appears broken Misconduct and fraud are pervasive

46 “Banks have paid $321 billion in fines since the crisis (but they’ve made almost $1 trillion)” CNBC, March 17, 2017

Danske’s €200bn ‘dirty money’ scandal October, 2018

47 “Wells Fargo Leaders Reaped Lavish Pay Even as Account Scandal Unfolded” New York Times, March 16, 2017 “Wells Fargo Hit With $1 Billion in Fines Over Home And Auto Loan Abuses” NPR, April 20, 2018

“We deeply regret and apologize for the conduct and compliance failures, which were in contravention of our own policies ...” - Douglas Flint, HSBC Chair

“Can I know what every one of 257,000 people is doing? Clearly I can’t.” -Stuart Gulliver, HSBC CEO

48 “Wells Fargo Hit with $1 Billion Fines Over Home and Auto Loan Abuses” NPR, April 20, 2018

Is the justice system working in the corporate context?

Thank You!

For more see: https://admati.people.stanford.edu/advocacy http://bankersnewclothes.com/ https://www.gsb.stanford.edu/faculty-research/excessive-leverage

49