Archive for the ‘Financial Crisis’ Category

Banking Directors Need to be at the Top of Their Game

November 10, 2012
Dr. Richard Leblanc
BoardExpert.com

There’s an old maxim that corporations don’t fail, boards do. And when banks fail, the reason is poor management, which is the fault of a poor board.

Take the case of Lehman Brothers, the financial services firm that collapsed in 2008 and played a big role in the global economic downturn. Stanford University professors David F. Larcker and Brian Tayan noted that Lehman’s board was lacking financial services experience and current business acumen. In fact, the former CEOs on the board were, on average, 12 years into their retirement. “This raises the question of whether the professional experiences of Lehman board members were relevant for understanding the increasing complexity of financial markets,” wrote Larcker and Tayan.

Well, the job of a bank board isn’t getting any easier. Following the financial downturn, banks have been placed under greater scrutiny and new regulations, both in Canada and abroad.

That’s why, more than ever, banking board directors need to be at the top of their game.

Last week, I spoke to bank directors in Dallas, Texas, about banking governance best practices as a result of a review that I had conducted for the Office of the Superintendent of Financial Institutions. (The OFSI is Canada’s banking regulator.) Specifically, I looked at Canada’s governance guidelines and board assessment criteria and compared them with international financial regulatory practices and recent developments. I provided the OFSI with suggestions for revisions.

Some proposed board reforms to Canada’s deposit-taking institutions and insurance companies sectors under the new guidelines include:

-Having directors who possess risk management and relevant industry experience;

-A risk committee that oversees enterprise risks, and a chief risk officer who reports directly to this committee and the board;

-Board approval of the internal control framework to mitigate all material risks to the financial institution, and board monitoring of internal control effectiveness;

-Expert third party reviews of the board’s effectiveness, risk management effectiveness, and effectiveness of oversight functions (such as internal audit), with results reported to the board;

-Enhanced director orientation and training, self assessment and external reviews;

-A board-approved risk management statement that translates into cascading limits and thresholds for all material business risks (e.g., credit limits, loan losses, capital levels);

-The internal audit function should report directly to the audit committee; and

-The audit committee, not management, should approve the scope of the external auditor’s engagement and fees.

When I asked for a show of hands as to how many banking directors adopted at least some of the above best practices, about half the hands went up.

However, it’s apparent that many boards aren’t prepared for a new era of banking regulations.

Remember the JPMorgan board of directors that oversaw the derivative failure that cost the bank several billion dollars? Well, here is the current board. Last I checked, not a single director other than the CEO had banking experience. This is wrong.

In 2009 and 2010, there were a total of 297 bank failures in the U.S., according to the Federal Deposit and Insurance Corporation. In the second quarter of this year, the FDIC identified 732 “problem” banks which are at risk of failing.

At the event in Dallas, one of the speakers brought up a good point. “Don’t get involved in something you don’t understand,” said Charles G. Cooper, commissioner of the Texas Department of Banking. He added: “The duties haven’t changed, but the topic is harder.”

And he’s right. That’s why it’s vital that banking boards are well-equipped with qualified directors for this increasingly complex environment.

Cash Holdings and Credit Risk  (via Social Science Electronic Publishing, Inc.)
Authors: Viral V. Acharya, New York University – Leonard N. Stern School of Business; Sergei A. Davydenko, University of Toronto – Finance Area; Ilya A. Strebulaev, Stanford University – Graduate School of Business; National Bureau of Economic Research
Date: August 1, 2012
Rock Center for Corporate Governance at Stanford University Working Paper No. 123

SSRN Abstract:  Intuition suggests that firms with higher cash holdings should be ‘safer’ and have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive. This puzzling finding can be explained by the precautionary motive for saving cash, which in our model causes riskier firms to accumulate higher cash reserves. In contrast, spreads are negatively related to the part of cash holdings that is not determined by credit risk factors. Similarly, although firms with higher cash reserves are less likely to default in the short term, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk.

Interview with Darrell Duffie
Douglas Clement - Editor, The Region Published June 15, 2012

In the increasingly vital yet bewildering world of financial economics, Darrell Duffie is both a deep-level theorist and a hands-on plumber. He marries abstruse theory with solid reality and, unlike most economists, can then lucidly explain this often awkward union to those without his intuitive grasp. Few are better suited, then, to evaluate and clarify key challenges in the aftermath of the recent financial crisis. Duffie can’t eliminate the fog, of course, but his insights are among the sharpest.  Read more here.

Link to Prof Duffie’s bio and research.  

Abstract: 
We analyze shareholders’ incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies.

Our analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the key reason that banks funding costs would be lower if they “economize” on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that “equity is expensive” are flawed.

Like reduction in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, we show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an “addiction” to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks’ borrowing costs.

Since banks’ high leverage is a source of systemic risks and imposes costs on the public, resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high leverage may be bank managers. The majority of the banks’ shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the critical importance of effective capital regulation and high equity requirements, especially for large and “systemic” financial institutions.

We analyze shareholders’ preferences when choosing among various ways leverage can be reduced. We show that, with homogeneous assets, if the firm’s security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, asset sales are the preferred way to reduce leverage. This preference for asset sales, or “deleveraging,” can persist even if such sales are inefficient and reduce the total value of the firm.

 Keywords: capital regulation, financial institutions, capital structure, “too big to fail,” systemic risk, bank equity, debt overhang, underinvestment, recapitalization, deleveraging, bankruptcy costs, Basel.

JEL Classifications: G21, G28, G32, G38, H81, K23

The Financial Crisis Inquiry Report (and Announcement of Stanford Rock Center Hosting New FCIC Website)
Date: April 4, 2011 from 5:30 pm – 7:30 pm
Click here to RSVP for this event.

featuring Phil Angelides, FCIC Chairman; John W. Thompson, FCIC Commissioner; and Joseph Grundfest, Stanford Law School

About the Event: The Financial Crisis Inquiry Commission was created to “examine the causes of the current financial and economic crisis in the United States.” The Commission presented a Report intended to provide a historical accounting of what brought the US financial system and economy to a precipice and to help policy makers and the public better understand how this calamity came to be. The independent, 10-member panel was composed of private citizens with experience in areas such as housing, economics, finance, market regulation, banking, and consumer protection. Six members of the Commission were appointed by the Democratic leadership of Congress and four members by the Republican leadership.

In the course of its research and investigation, the Commission reviewed millions of pages of documents, interviewed more than 700 witnesses, and held 19 days of public hearings in New York, Washington, D.C., and communities across the country that were hard hit by the crisis. The Commission also drew from a large body of existing work about the crisis developed by congressional committees, government agencies, academics, journalists, legal investigators, and many others.

The Report is not the sole repository of what the panel found. A website, www.fcic.gov, soon to be hosted by the Stanford Rock Center for Corporate Governance, will host a wealth of information beyond the Report. It contains a stockpile of materials—including documents and emails, video of the Commission’s public hearings, testimony, and supporting research—that can be studied for years to come.

About the Speakers:

Phil Angelides, Chairman of Financial Crisis Inquiry Commission, has earned national acclaim as an effective public and private sector leader with accomplishments and broad expertise in the fields of investor protection, finance, housing, and corporate and financial market reform. Mr. Angelides is currently President of Riverview Capital Investments which focuses on sustainable urban development and clean energy projects. From 1999 to 2007, he served as California’s State Treasurer.

John W. Thompson, Commissioner of the Financial Crisis Inquiry Commission, is Chairman of the Board at Symantec Corporation. During his 10-year tenure as CEO, he helped transform Symantec into a leader in security, storage, and systems management solutions.

Joseph Grundfest, W. A. Franke Professor of Law and Business at Stanford Law School, is a former Commissioner of the S.E.C. and a nationally prominent expert on capital markets, corporate governance, and securities litigtation. His scholarship has been published in the Harvard, Yale, and Stanford law reviews. Prof. Grundfest is a Senior Faculty of the Arthur and Toni Rembe Rock Center for Corporate Governance.

Registration Information: This event is open to the public and registration is complimentary, but required. Click here to RSVP for this event.

Anat R. Admati, Peter M. DeMarzo, Martin R. Hellwig, and Paul Pfleiderer, August 2010, Rock Center for Corporate Governance at Stanford University Working Paper No. 86, Stanford Graduate School of Business Research Paper No. 2065.

• Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (Research Paper)

• For more Related Academic Contributions see here.

Abstract

We examine the pervasive view that “equity is expensive,” which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that
subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks’ activities should be given directly and not in ways that encourage leverage. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support.

We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer
distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

Research by

Anat R. Admati
George G.C. Parker Professor of Finance and Economics
Stanford Graduate School of Business

Peter M. DeMarzo
Mizuho Financial Group Professor of Finance
Stanford Graduate School of Business

Martin F. Hellwig
Max Planck Institute for Research on Collective Goods
Department of Economics, University of Bonn

Paul Pfleiderer
C.O.G. Miller Distinguished Professor of Finance
Stanford Graduate School of Business

• How Big Banks Fail and What to Do about It
  

Stanford Business Magazine Online, July 2010; In a new book Professor Darrell Duffie describes the financial network of incentives and financial contracts that lead to run-on-the-bank calamities during the financial crisis of 2007-2009. The Stanford Graduate School of Business finance professor argues that placing the global financial system on a sounder footing depends on an understanding of how the largest and most connected banks — the major dealer banks — can make a sudden transition from weakness to failure…