Banking and Effective Capital Regulation in Practice

A Leadership Perspective

Sophia Velez

• Publisher: Routledge
• Year: 2020
• Topic: Economics
• eBook ISBN:
  9781000180121
• Subtopic: Business Ethics
• Index: Economics

Due to a historical lack of attention to the importance of modelling, measuring and managing risk, senior bank leaders are struggling to implement unified practices within their financial institutions that could address the gaps posed by risky management behaviour, rogue trading, liquidity crises, prohibited investments in mortgage-backed securities, and default risks aligned with loans. This book discusses the theories at play between bank agents (bank managers) and their principals (shareholders), a topic which has gained importance as a result of the banking crisis, and similarly, governed the need for more efficient risk management and ethical managerial practices.

The author worked with a senior bank leadership team to identify and describe effective capital regulation practices that can lead to a reduction in loss and risky management behavioural practices. The book offers consensus on a number of activities that bank managers can implement to address bank risk. It analyses the relevant factors that determine the necessity for banking regulation and the important role of regulation in managing banking crises. The author's analysis of the important regulatory aspects in developed countries such as the US, offers a useful conceptual framework for creating an adequate banking regulatory environment in developing countries.

This book offers an original contribution to the field of banking that undergraduate, masters, PhD students, academics and researchers can use to gain a deeper understanding of the constructs at play in the banking industry.

Part 1

Mega banks’ practices and their occurrence of significant losses

Chapter 1 The unanticipated losses of mega banks and the economic impact

Chapter 2 Bank managers’ practices and alignment to significant losses, insufficient capital, and increased operational risk

Chapter 3 Risky management practices incentivized by principal–agent theory

Chapter 4 Risky management practices incentivized by goal theory

Chapter 5 Designing a risk management environment using OCEG standards

Chapter 1

The unanticipated losses of mega banks and the economic impact

The financial crisis was felt on a global level, which was evident in the collapse in asset value, extreme uncertainty, fear, pessimism about future asset value, contraction in credit markets, rising unemployment, and shrinkage in economic output. This resulted in hundreds of bank failures and many relied on government bailouts. Many families lost their home, and trillions of dollars of assets were wiped out, while unemployment rates soared high. The 2007–2009 US recessions resulted in the loss of 8.8 million jobs, $19.2 trillion household wealth reduction and mortgage foreclosures, the placement of Fannie Mae and Freddie Mac into conservatorship, the collapse of Bear Stearns, and the bankruptcy of Lehman Brothers, AIG, and Indymac, along with 700 banks receiving $245 billion in Fed bailout funds (US Department of Treasury, 2012). The United States was in the middle of an economic upheaval with companies failing daily; 14 banks went bankrupt in 2009 alone (Robertson & Sullivan, 2009). The subprime mortgage bubble was exploited by senior managers who made risky investments in improperly priced mortgages, rewarded themselves with large short-term bonuses, and incentivized their subordinates to increase sales and portfolios in these products (Calomiris, 2009). This led to the 2007 subprime mortgage meltdown which caused the short selling by banks of their real estate investments, billions in write-downs of mortgage-backed securities and collateralized debt obligations, and shrinkage of credit markets (Guynn, 2010). The liquidity crisis in the credit markets caused the decline of asset-backed securities and credit derivatives (Corder, 2009). This resulted in investors shorting real estate markets as the leverage credit market dried up, and the collapse of billions of dollars in buy-out deals. Consequently, billions in mortgage-backed securities (MBS) and collateralized debt obligations (CDO) were written down. Bear Sterns and Northern Rock collapsed and were rescued by the Federal Reserve through the de-stigmatized discount window for commercial banks which makes emergency liquidity facilities available to large investment banks (Guynn, 2010). By the fall of 2008 as per Rahman (2012) the financial crisis had sent the financial sector into a disastrous state. Petersen, Senosi, Mukuddem-Petersen, Mulaudzi, and Schoeman (2009, p.2) mention that regulation and supervision are important factors in managing capital and assets.

Similarly, Calomiris (2009) contends that the subprime crisis occurred because managers of large financial institutions took risks by buying financial instruments that were improperly priced, which did not represent the shareholders’ interests. The risk was substantially underestimated in the market and signs that reflect forward-looking estimates of risk were ignored by financial institutions’ senior management. Senior management structured compensation packages which rewarded asset managers who maximized incentives to undertake these underestimated risks. An increase in regulatory capital could reduce risk undertaken, and provide a cushion from losses (Calomiris, 2009). Viljanen (2016) argues that management-based regulation engages firms to develop their own process and management system standards to achieve regulatory or corporate goals). There are ‘too big to fail’ banks such as JP Morgan. Shorter, Murphy, and Miller (2012) observe that JP Morgan had ‘lost more than $2 billion by trading financial derivatives …. The trading losses resulted from an attempt to unwind a previous hedge investment’ (p.1). The Federal Reserve structured policies to preempt large financial institutions that were too big to fail from failing.

According to the US Department of Treasury (2012), in response to the recession of 2008, the federal government Troubled Asset Relief Program (TARP) was established, which provided capital to more than 700 banks throughout the country. Shortly after, on March 3, 2009, the Term Asset-Backed Securities Loan Facility (TALF) programme was launched, which revived the credit markets (US Department of Treasury, 2012). Robertson and Sullivan (2009) refer to bailouts in the millions received by American International Group (AIG), which shortly afterwards paid its former chief executive a $5 million performance bonus and sent top performers on a half-million-dollar resort trip, all on taxpayer money. In 2002 and thereafter, the CEOs of Merrill Lynch, Countrywide, and the by-then struggling Citigroup took home combined paychecks of over $460 million, while their companies looked as if they had no one at the wheel. This all occurred while thousands of investors saw their life savings disappear along with the integrity of big business (p.1). Bass & Steidlmeier (1998) contend that ethical leadership rests on three pillars: the moral character of the leader; the ethical legitimacy of the values in the leader’s vision, as evidenced in the programnes that followers either embrace or reject; and the morality of the processes of social, ethical choice and action that leaders and followers pursue collectively.

The bailouts came with the issuance of new laws and regulations, and many companies inherited additional financial burdens while they strove to comply. The US government implemented capital regulation to prevent another financial crisis. Improved government regulations and supervision could have prevented the financial crisis and prohibited future occurrence (Guynn, 2010). The Dodd–Frank Act (2010), Section 165, permits the Fed to exercise regulation and supervision by requiring banks to hold a minimum amount of capital that is convertible to equity to cover losses in periods of financial stress (Wan, 2016). The passing of the Dodd–Frank Act under President Obama was a step in the right direction towards preventing another financial crisis. However, there were some unintended consequences for BHCs that resulted from the Fed-imposed capital requirements.

Capital regulations in the US have been a response to past financial depression, in 1929 (Mitchener, 2005) and in 2007–2009 (Tanda, 2015). The banking crisis of 1930 resulted in ten thousand commercial banks going out of business and prudential regulation reforms were passed that regulated capital and reserve requirements to prevent bank runs (Mitchener, 2005). Similarly, the financial crisis that spanned 2007–2009 highlighted the need for capital regulation to stabilize the financial sector (Tanda, 2015). A bank becomes insolvent when its liabilities are greater than its assets (Baradaran, 2014). To prevent firms from becoming insolvent in the 2007–2009 recession the US government offered financial bailouts.

The US government provided bailout funds to firms at systemic risk whose failure could jeopardize the stability of the financial markets (Miller & Rosenfeld, 2010) – JP Morgan lost more than $2 billion and was in receipt of bailout funds (Shorter et al., 2012). An organizational culture is a solution to a problem within the company (Sinclair, 1993). The reduction of systemic risk requires improving the risk culture, which is complex in a large multicultural institution (McConnell, 2012). The regulators faced several challenges which made it difficult to enforce laws and regulate the financial markets (Prasch, 2012). Similarly, secular leaders face challenges with the maintenance of a dynamic, open system where learning is highlighted as important in the organization (Andreadis, 2009). However, transformational leaders can change the outlook of those they lead and foster an environment where learning thrives (Bass & Steidlmeier, 1998). A change in risk culture involves transformational leaders working with the regulators to improve the culture, which will reduce the need for future bailouts.

The bailouts encouraged the banks’ abusive behaviour. A change in organization culture requires a learning environment that fosters the growth of the desired future culture (McConnell, 2012). Transformational leaders are persistent (Bass & Avolio, 1993), express goals, and communicate high expectations to followers (Humphreys, 2005). In addition, macro-prudential regulation is needed (Gohari & Woody, 2015) for micro finance to be effective (McNew, 2009). The abuse of bailouts can be eliminated through a transformation of culture and leadership mindset.

Dowd (2015) posits that central banking went through a transformation following the 2008 global financial crisis in its growth of regulatory stress tests for larger banks. The central bank

uses the results of the stress test to determine the ability of the banks to withstand significant losses and to determine the overall financial health of the banking system.

(Dowd, 2015)

Dowd argues that regulators stress testing of banks uses

some stress scenario(s) to which banks might be exposed and a number of models to determine how the scenario(s) will affect the banks’ capital ratio over the course of the stress period.

(Dowd, 2015)

The financial models and the stress tests to be used going forward are presented to the banks by the regulators. Models are presented and banks are asked to take their reliability on trust. As Dowd (2015) explains, bankers believe the methodologies underpinning both financial models and regulatory stress tests do not work, and the results are unreliable.

BHCs’ capital and losses reveal that their operational risk exposure is higher today than it was prior to the 2008 recession, which exposes them to insolvency (Sarin & Summers, 2016); these unanticipated losses in mega banks and the continuance of economic turmoil suggest the ineffective delivery of capital regulation (Tanda, 2015; Yeoh, 2016). BHCs that sustain significant losses without adequate capital can become insolvent and pose a systemic risk to the US economy (Berger, Curti, Mihov, and Sedunov, 2018; Crawford, 2017; Gong, Huizinga, and Laeven, 2018).

The leadership risk management approach adopted by the Fed in 2002–2005 to boost the economy was implemented through lax interest rate policies, which kept interest rates extremely low as in post-war years where interest rates were kept in the negative to promote easy credit and stimulate the economy (Calomiris, 2009). These low interest rates attracted greedy asset managers who underwrote improperly priced mortgages, drove up the overpricing of houses and promised clients profits that they could not deliver (Calomiris, 2009). Lehman underwrote 10 per cent of the mortgage market during 2007–2009, and its CEO’s unethical conduct left over 100,000 investors with more than $150 billion in bond debt which contributed to the credit crises (Robertson & Sullivan, 2009). Lehman’s company philosophy was aggressive in risk-taking and mirrored that of its CEO Richard Fuld, whose salary was over $45 million and $22 million in bonuses; he led investors to believe the company was profitable while he drove the company to bankruptcy with over $600 billion in debt (Robertson & Sullivan, 2009).

The federal government implemented subprime government housing policy as a short-term risk management leadership approach to stimulate the housing market through the affordable housing programmes, which incentivized Fannie Mae and Freddie Mac to promote investments in high-risk subprime mortgages (Calomiris, 2009). Fannie Mae and Freddie Mac mortgage companies acted as guarantors to subprime loans and held $1.5 trillion of exposure in toxic mortgages despite their in-house senior management warning of the risk involved (Calomiris, 2009). Bruce Bent of the Reserve Primary Fund purchased subprime-related securities, including $785 million in securities issued by Lehman Brothers, who held 10 per cent of the toxic mortgages, and the fund suffered significant losses when it was forced to mark its Lehman Brothers investments to zero after Lehman became bankrupt in September 2008 (Miller & Rosenfeld, 2010). The government provided insurance to companies against failure, incentivizing companies to take on excessive risk, a moral hazard that contributed to the financial crises (Miller & Rosenfeld, 2010). The government subprime programmes implemented as a risk management approach to boost the housing market incentivized Stan O’Neal, CEO of Merrill Lynch (whose earnings were $48 million in 2006), to mislead investors in 2007 that subprime defaults were contained, while the company suffered $8 billion in losses shortly thereafter related to risky investments in mortgages and credit (Robertson & Sullivan, 2009). The CEOs of Countrywide and Citigroup invested their companies’ monies in the subprime market while their companies faced bankruptcy during the subprime meltdown and thousands of investors suffered losses (Robertson & Sullivan, 2009). Some banks that were cost-efficient navigated the market failures, accessed cost advantages and continued to grow (Clark, 1996).

The liquidity crisis in the credit markets caused the decline of asset-backed securities and credit derivatives (Corder, 2009). The Federal Reserve has been criticized by the public for its response to the financial crisis and its exercise of power (Weatherford, 2013). The Fed policies incentivized company executives to make investments in risky products, encouraging some to engage in unethical practices in the pursuit of significant profits. The subprime meltdown was caused by unethical practices of CEOs and executive officers such as Richard Fuld of Lehman, Jimmy Cayne of Bear Stearns, and Bernie Madoff.

BHCs experienced significant losses that exposed them to insolvency due to inadequate capital during the 2008 financial crisis (Berger et al., 2018; Crawford, 2017; Gong et al., 2018). A financial crisis is linked to high levels of risk, lower levels of liquidity, and under-capitalization (Dandapani, Lawrence, & Patterson, 2017). In the previous few years, several factors (housing boom, aggressive lending activity, financial innovation, increased access to money) increased bank risk and contributed to them experiencing significant losses and a financial crisis (Egly, Escobari, & Johnk, 2016). BHCs experienced low levels of leverage, liquidity, and capital, and risky senior bank manager behaviour; they had significantly higher debt to equity ratios, held lower liquidity and capital adequacy ratios, engaged in greater home mortgage lending, and had a higher proportion of defaulting first and second (junior) home mortgages than unaffiliated banks (Dandapani et al., 2017). Research showed that six US BHCs’ (Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Wells Fargo) capital ratios and their losses incurred exposed them to higher operational risk today when compared to their amounts in 2008 (Sarin & Summers, 2016).

A safety net is a term used in the banking sector over the years; this is a safety net protection and prudential regulation that the Fed uses to prevent banks from experiencing insolvency and affecting the economy. This measure failed during the recent financial crisis (Aiyar, Calomiris, & Wieladek, 2015). One contributing factor to the failure of the safety net is that banks suffered a stigma that made them reluctant to go to the discount window to borrow funds during the crisis; and fear that depositors, creditors, and investors would view this as a sign of weakness, which could generate a bank run (Gorton, 2015). The magnitude of this failure was 322 banks became insolvent during the 2008 US financial crisis (Álvarez-Franco & Restrepo-Tobón, 2016). Conversely, some banks with good corporate governance structures were financially sound during the recent financial crisis; this was attributable to their reduction of risky investments on the downside of the economy when banks have larger regulatory capital and they are inclined to undertake more risky assets, loans, and OBS positions on the upside (Abou-El-Sood, 2017).

The financial regulators’ powers were increased globally to crack down on insider trading; market regulators believed that insider trading was harmful to the capital markets (Montagano, 2012). In an attempt to adopt stricter capital regulations for both domestic and international banks, BHCs and foreign banking organizations (FBOs) with large US subsidiaries are required to form international holding companies (IHCs) and are subject to minimum capital adequacy and liquidity requirements (Wall, 2017). Having sufficient capital allows banks to provide for loan losses and mitigate the effects of financial shocks during crises and recessions. The capital approach to idiosyncratic banking risk models should be complemented by market discipline that is both credible and effective (Petersen et al., 2009).

Chapter 2

Bank managers’ practices and alignment to significant losses, insufficient capital, and increased operational risk

Senior bank managers lack effective practice towards capital regulation. Capital regulation failed to reduce losses and operational risk in BHCs as enacted in the Dodd–Frank Act (2010), Section 165. Scholars theorize that bank managers sometimes pursue their own financial interest of short-term financial gains while exposing shareholders to significant losses from their risky investments, which reflects aspects of principal–agent theory (Lui, 2011). Yet, limited research exists on an effective capital regulation measure to address operational risk, significant losses, and risky management behavior in BHCs (Berger, Curti, Mihov, & Sedunov, 2018; Dowd & Hutchinson, 2016).

A contributing factor to risky management behavior is goal theory. Sepdiningtyas and Santoso (2017) argued goal theory motive...

Table of contents

• Cover
• Half Title
• Series Information
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of Tables
• List of Figures
• Preface
• Acknowledgments
• About the author
• Outline of chapters
• Part 1 Mega banks’ practices and their occurrence of significant losses
• Part 2 Government regulations and redesigning the compliance environment of banks
• Part 3 Bank leadership consensus on effective capital regulation practices
• Appendix A: First-round questionnaire
• Further appendices
• References
• Index