Myths about the Stability and Efficiency of Global Finance Anat Admati Graduate School of Business Stanford University Fields / OECD-NAEC / Rebuilding Macroeconomics Symposium on Systemic Recovery, April 27, 2021 1 Is the financial system “sufficiently” resilient? NO, it is too fragile every day!! Is the system efficient? NO, it is bloated and distorted every day!! Is there a tradeoff between resiliency and efficiency in finance? NO, finance can be improved at no social cost!! Power in Finance: People, Institutions, and Markets Financial Institutions and Markets Central Banks Individuals Non-Financial Institutions and Markets Governments and (“Real Economy”) their Institutions Including media The Economy is a Web of Legal Promises (IOUs), People and Entities What happens if a “shock” disrupts someone’s ability to fulfill promise? ● Household debt ● Small and medium size enterprise debt ● Corporate debt ● Contingent liabilities (derivatives, insurance) ● Other contracts How Finance Can Benefit Society Payment Money Risk Guiding System Across Time Sharing Investments Cash or private beneficial exchange Insurance and Scrutiny, pricing, debt claims diversification monitoring Should be trustworthy and efficient. Making Finance Work Too Little… Too Much… ● “Unbanked” ● Huge, complex, and opaque system. ● Cumbersome payments and trade ● Highly interconnected ● Difficult to save and fund investments ● Enormous “systemic” institutions ● Exposure to downside risks ● Appears inefficient and reckless How to enable “enough” finance but avoid “too much?” Key for “Proper” Financial Development Education Effective laws, Technology (financial literacy) regulations, and (mostly for enforcement payment system) Literacy and effective rules and enforcement are key Myths about Global Finance: All are False! The financial system Reformed regulations Global financial is much safer than it are “science-based” markets allocate was before 2007 and address “TBTF” resources efficiently [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 1921-2017 “Risky business,” Guardian, October 15, 2008 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) A Liquidity Problem? “A Classic Bank Run?” Narratives Inform Policy Was the 2007-2009 Financial Crisis a Natural Disaster? A Sudden “Shock?” A “100-year flood?” 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 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 Trillion 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. Shadow Banking Pozsar, Adrian, Ashcraft, and Boesky, Federal Reserve Bank of New York, July 2010: revised February 2012 The US System IMF Financial Stability Report 10/2014, Figure 2.1.1 Deposits Banks Loans Credit & liquidity Money Loans puts Super seniors Securities SIVs & RMBSs CDOs ABCP Money Money Lenders Credit Borrowers insurance term fundingterm Credit - insurance Monoline Money insurance paper Short Commercial Money Money market mutual funds Loans Money Money Loans Nonbank mortgage originators The Safety Net of Banking Corporations is Special Deposit insurance Central bank support » “liquidity” and “lender of last resort” facilities » Subsidized borrowing » Low interest rates Government bailouts » Direct investment, e.g., TARP, to prevent default. » Guarantees, e.g., JPMorgan Chase acquisition of Bear Stearns . » Nationalization, e.g., Royal Bank of Scotland, Lloyds, Dexia. Zombie (Insolvent) Borrowers: Opaque and Dysfunctional 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 others for supports A Brief Revisit of 2007-2013 Bailouts in US Bear Stearns; TARP funding of banks, AIG, GM, Chrysler; guaranteed money market funds; trillions in “liquidity support” and massive purchases of government and mortgage securities by the Federal Reserve (QE) Propped up financial firms and markets; minimal if any help for homeowners; about 3.8 million foreclosures 2007-2010 A Brief Revisit of 2007-2017 Bailouts in Europe Numerous banks became insolvent, massive bailouts by central banks, governments; indirect bailouts (e.g., of Greek government); some nationalization (e.g., RBS, Dexia) “Doom Loop” governments/banks Dodd Frank Act, July 21, 2010: No More Bailouts. Period. (2 minute applause) Dodd Frank Act Title II: FDIC Systemic Resolution. “Let them Fail!” Loss-Absorbing Debt (a.k.a “Total Loss Absorbing Capacity,” Contingent capital, etc.): Clever “Bail-In” or Fool’s Gold? 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) % 70% Italy 60% Spain 100% Germany 100% France 100% Various 99.8% Belgium 100% Belgium 50% Belgium 100 Turkey 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) “Heroic Savior” Button JPMorgan 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 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 “The Leverage Ratchet Effect,” Anat Admati, Peter DeMarzo, Martin Hellwig, Paul Pfleiderer Journal of Finance, 2018 Asymmetric leverage adjustments create path dependence and inefficiencies in corporate investment and funding Basel II: A spectacular failure Basel III: An inadequate tweak, “a well-intended illusion” Thomas Hoenig, April 2013 “The omission of off-balance sheet items in the standard measures 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 Risk Weights Undermine the Purpose of Regulation Complex; give the Manipulable, distortive, Used by banks to illusion of “science” and political “economize” on equity yet ignore interest rate risk Favor loans to governments Add fragility, and correlation of and traded assets over interconnectedness, and “tail events” business lending; Allow systemic risk banks to use own models 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 Germany loans are riskless (0 risk weight). 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) 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