Tag: Systemic risk

Why Do Bank Boards Have Risk Committees?

Posted by René M. Stulz (The Ohio State University), on
Monday, August 30, 2021
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René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University. This post is based on a recent paper by Mr. Stulz; James Tompkins, Professor of Finance at Kennesaw State University; Rohan Williamson, Professor of Finance at Georgetown University McDonough School of Business; and Zhongxia (Shelly) Ye, Associate Professor of Accounting at the University of Texas at San Antonio Carlos Alvarez College of Business.

Though the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) passed in July 2010 required bank holding companies with more than $10 billion of assets to have a board risk committee, a majority of the banks required to have a risk committee had one before the legislation. The presumption of the legislators apparently was that having a board risk committee would reduce bank risk-taking. As far as we know, there was no scientific evidence at the time suggesting that requiring the establishment of a risk committee for banks that did not have one would be valuable either for the banks’ owners or for the financial system. We develop a model of whether a bank should have a risk committee and show that for a bank that maximizes shareholder wealth there is no expectation that a board risk committee causes bank risk-taking to decrease. Our empirical analysis finds no support for the proposition that the existence of a board risk committee decreases bank risk-taking. We use unique interview data to assess how bank risk committees work and whether they act as expected with our theory. We find that risk committees play a role that is consistent with our theory except that they also seem to be a way for regulators to monitor and influence risk-taking within banks. Though a well-functioning risk committee can be valuable to a bank’s shareholders, it is also possible for the risk committee to worsen the communication and engagement of a bank’s board. Therefore, having a risk committee only makes sense for banks where risk-taking is sufficiently complex that risk metrics have to be monitored by a specialized committee.

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Business Groups: Panics, Runs, Organ Banks and Zombie Firms

Posted by Asli M. Colpan (Kyoto University) and Randall Morck (University of Alberta), on
Monday, August 16, 2021
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Asli M. Colpan is Professor at Kyoto University Graduate School of Management, and Randall Morck is Jarislowsky Distinguished Chair and Distinguished University Professor at the University of Alberta. This post is based on their recent paper.

Unlike in the US, large firms in many foreign stock markets come in business groups: sets of seemingly distinct firms—each with its own stock price, annual reports, public shareholders, board of directors and CEO—but all effectively controlled by on apex firm, often itself controlled by a tycoon of wealthy family. Business groups were commonplace in the economic histories of most of today’s developed economies and in today’s emerging market economies. Adolf Berle and Gardiner Means, members of Franklin Delano Roosevelt’s “brain trust” deemed large business groups undue concentrations of power and successive New Deal reforms largely expunged this mode of corporate governance from the US. Institutional reforms later marginalized business groups in in Australia, Britain and Canada.

Investors and boards of directors contemplating investments elsewhere must factor in the non-independence of firms in each business group. This is especially important where banks, near-banks and other financial firms such as pension fund portfolio managers, belong to business groups. How this plays out depends on where agency lies within the business group. This is because the apex controlling party often has a larger real investment in some group firms and a minor real stake in others, yet controls them all via super-voting shares, board appointment rights, or (most commonly) control pyramids.

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Shareholder Liability and Bank Failure

Posted by Felipe Aldunate (Pontifical Catholic University of Chile), on
Tuesday, July 6, 2021
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Felipe Aldunate is Assistant Professor of Finance at the Pontifical Catholic University of Chile. This post is based on a recent paper authored by Mr. Aldunate; Dirk Jenter, Associate Professor of Finance at the London School of Economics; Arthur G. Korteweg, Associate Professor of Finance and Business Economics at the University of Southern California Marshall School of Business; and Peter Koudijs, Professor of Finance and History at Erasmus University Rotterdam.

Because of limited liability, bank shareholders often prefer banks to take high risk, to the detriment of depositors and the stability of the banking system. Using data on the performance of U.S. banks during the Great Depression, we find strong evidence that increasing shareholder liability can be an effective tool to reduce bank risk taking and distress. Our results are relevant for current initiatives to increase bank stability.

Since the beginning of modern banking in the early 19th century, policy makers and regulators have tried to rein in bank risk. One often-used tool was to force bank shareholders to face some form of additional liability. From 1817 onwards, shareholders in most U.S. banks had so-called “double liability.” Double liability stipulates that, in case of bank failure, the banking supervisor levies a penalty on shareholders (up to the par or paid-in value of their shares) that is used to satisfy the bank’s depositors and other creditors. This system remained the norm until 1933, when the American banking system was restructured. All else equal, double liability should reduce shareholders’ risk taking preferences, potentially reducing bank failures.

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The False Hope of Stewardship in the Context of Controlling Shareholders: Making Sense Out of the Global Transplant of a Legal Misfit

Posted by Dan W. Puchniak (National University of Singapore), on
Friday, July 2, 2021
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Dan W. Puchniak is associate professor of law at the National University of Singapore. This post is based on his recent paper, forthcoming in the American Journal of Comparative Law. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

The 2008 Global Financial Crisis (GFC) rocked the foundation of the United Kingdom’s financial system. As the dust settled, the UK tried to figure out what went wrong. An autopsy of UK corporate governance revealed that it had developed an acute problem. Institutional investors had come to collectively own a substantial majority of the shares of listed companies, but often lacked the incentive to use their collective ownership rights to monitor them. The failure of these rationally passive institutional investors to act as engaged shareholders—or, as is now the popular vernacular, to be “good stewards”—allowed corporate management to engage in excessive risk taking and short-termism, which were primary contributors to the GFC.

In 2010, the UK enacted the world’s first stewardship code (UK Code) to solve this problem. The goal of the UK Code was to incentivize passive institutional investors to become actively engaged shareholder stewards. After a decade, there are still divergent views on whether the UK Code will ever be able to achieve this goal.

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President Biden Signs Executive Order on Addressing Climate Change Risk through Financial Regulation

Posted by Andrew Olmem, J. Paul Forrester, and Thomas J. Delaney, Mayer Brown LLP, on
Friday, June 11, 2021
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Andrew Olmem, J. Paul Forrester, and Thomas J. Delaney are partners at Mayer Brown LLP. This post is based on their Mayer Brown memorandum.

On Thursday, May 20, 2021, US President Biden signed an Executive Order, entitled “Climate-Related Financial Risk” (Climate Risk EO), that sets the stage for the US federal government, including its financial regulatory agencies, to begin to incorporate climate-risk and other environmental, social and governance (ESG) issues into financial regulation. The Climate Risk EO further demonstrates the priority the Biden administration is giving to addressing climate change and will likely accelerate ongoing efforts by federal financial regulators to adopt new, climate risk-related regulations. Of particular note, the executive order directs Treasury Secretary Janet Yellen to utilize the Financial Stability Oversight Council (FSOC) to coordinate the adoption of regulatory measures to address climate change on the part of the federal financial regulatory agencies. The US Securities and Exchange Commission (SEC) is already actively preparing a proposal to revise public company disclosure requirements to cover a range of ESG issues, [1] and the Federal Reserve Board has established two working committees to examine the climate-related risks to financial stability and to the safety and soundness of financial institutions. [2]

From the scope of the Climate Risk EO, it is evident that the administration believes that improved corporate disclosures on ESG are an important initial response to the risks posed by climate change, but that far broader regulatory reforms are likely over the next several years. The Climate Risk EO provides the policy framework for federal agencies to adopt new supervisory and regulatory measures with respect to not only insured depository institutions, but also insurers and other nonbank financial institutions, ERISA plans, the Federal Thrift Savings Plan (TSP), federal lending programs (US Department of Agriculture (USDA), US Department of Veterans Affairs (VA), Federal Housing Administration (FHA), and Ginnie Mae) and federal contractors. In addition, Secretary Yellen stated in her remarks on the signing of the Climate Risk EO that “[a]ssessments of climate-related financial risks may require new perspectives and new tools.” [3] She did no go on to elaborate what additional tools may be under consideration.

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Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis

Posted by Emily Johnston-Ross (FDIC), Song Ma (Yale University), and Manju Puri (Duke University), on
Wednesday, May 26, 2021
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Emily Johnston Ross is a Senior Financial Economist at the FDIC Center for Financial Research in the Division of Insurance and Research; Song Ma is Assistant Professor of Finance at Yale School of Management; and Manju Puri is J. B. Fuqua Professor of Finance at Duke University Fuqua School of Business. This post is based on their recent paper.

Private equity (PE) has become an important component in the financial system. An extensive literature explores the effects of private equity buyouts on firm-level outcomes, with some papers arguing that such buyouts positively affect the operations of target companies. At the same time, the private equity industry generates much controversy. Critics often argue that private equity transactions involve heavy financial engineering schemes that introduce a substantial debt burden on the target companies and default risks to the banking sector (Andrade and Kaplan, 1998; Kaplan and Strömberg, 2009). This concern could be exacerbated during an economic downturn due to the cyclicality of private equity investment (Bernstein, Lerner, and Mezzanotti, 2019).

How does private equity interact with and affect the stability of the financial system, especially during periods of crisis? In a recent paper titled Private Equity and Financial Stability: Evidence from Failed Bank Resolution in the Crisis, we investigate this question by examining private equity investors’ engagement in the failed bank resolution process in the aftermath of the 2008 crisis. This is a novel setting in which to study private equity and financial stability. Bank failures and resolutions are a salient feature of financial crises, and have a significant real effect on the economy (Bernanke, 1983; Granja, Matvos, and Seru, 2017). Indeed, banks are central to the functioning of financial markets and have important externalities (Gorton and Winton, 2003). Our setting allows us to examine private equity investors’ role in one of the most crucial steps in stabilizing the financial system in a crisis.

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Using Household Balance Sheets to Promote Consumer Welfare and Define the Necessary Role of the Welfare State

Posted by Jonathan R. Macey (Yale), on
Wednesday, April 7, 2021
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Jonathan R. Macey is Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School. This post is based on his recent paper, forthcoming in the Texas Law Review.

In a recent paper, I point out that access to credit sometimes provides a provide a path out of poverty and even a gateway to real prosperity for those who use the funds to start a business, but when credit is granted improvidently it can lead to financial ruin for the borrower up to and including homelessness and food insecurity. In light of the extreme range of consequences from the granting of consumer credit, it is peculiar that the various extant regulatory approaches to consumer lending do not distinguish between these two wildly disparate effects of the lending process. Rather current approaches to regulation focus almost exclusively on disclosure of certain features of the loan and the annual percentage rate (“APR”) associated with the loan.

A better regulatory approach would be to utilize the analytic framework developed in this paper, which utilizes the effects of borrowing on the balance sheet of the household taking on consumer debt. The key to this framework is based on the fact that it is easy to determine how the proceeds from a particular loan will be allocated, because borrowers must generally inform lenders about how the proceeds of a loan will be deployed. With this basic, non-technical, yet critical item of information, it is possible to determine whether, ex ante (which in this context means at the moment the loan is made), the immediate effects of the loan on the borrower’s balance sheet.

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Observations About the March 2020 Market Turmoil and Regulated Funds

Posted by Eric J. Pan, Investment Company Institute, on
Monday, April 5, 2021
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Eric J. Pan is President & Chief Executive Officer of the Investment Company Institute. This post is based on his remarks at the 2021 ICI Mutual Funds and Investment Management Conference.

Please let me express my sincere gratitude to everyone who has been part of putting this conference together, as well as everyone in attendance today. This conference is the premier event in the United States for legal and compliance professionals working in the regulated fund industry, and it is an honor to speak before you today as the Investment Company Institute’s new president and chief executive officer.

Since I came onboard four months ago, I have met with our Board of Governors as well as numerous other leaders of member firms to identify their priorities and concerns amid the challenges posed by this pandemic. It is abundantly clear that ICI must always be a strong and productive voice for the regulated fund industry with respect to the development of the rules, regulations, and policies that govern our financial system. All of you are key partners with ICI in carrying out our mission to promote and protect the interests of fund investors.

In that context, I would like to speak with you today about the discussions US and international policymakers are having about the March 2020 market turmoil and their work to make the financial markets more resilient in the face of a similar liquidity shock. Such work is taking place in international bodies like the Financial Stability Board (FSB) and International Organization of Securities Commissions with the active participation of US financial regulators.

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House of Representatives Testimony on Climate Change and Social Responsibility

Posted by Veena Ramani, Ceres, on
Tuesday, March 9, 2021
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Veena Ramani is Senior Program Director of Capital Market Systems at Ceres. This post is based on her testimony before the U.S. House of Representatives Subcommittee on Investor Protection, Entrepreneurship and Capital Markets Hearing on Climate Change and Social Responsibility.

Thank you for the invitation and opportunity to appear before you today. I represent Ceres, a nonprofit organization working with investors and companies to build sustainability leadership within their own enterprises and to drive sector and policy solutions throughout the economy. Through our membership networks of more than 100 companies and almost 200 investors with over $30 trillion of assets under management, we work with private sector leaders to tackle the world’s biggest sustainability challenges, including climate change, water scarcity and pollution, and deforestation.

I am Senior Program Director for Capital Market Systems in the Ceres Accelerator for Sustainable Capital Markets. The Accelerator works to transform the practices and policies that govern capital markets in order to reduce the worst financial impacts of the climate crisis. It spurs capital market influencers to act on climate change as a systemic financial risk—driving the large-scale behavior and systems change needed to achieve a just and sustainable future and a net-zero emissions economy. Ceres has a 30 year history of working on climate change and ESG disclosures. This includes founding the Global Reporting Initiative, which is currently the de facto sustainability reporting standard used by over 13,000 companies worldwide.

In 2019, our President and CEO Mindy Lubber testified before this committee on this topic. My testimony will update and complement the evidence she provided, which I have submitted by reference into the record. My testimony today also draws from past and current Ceres research and engagement with companies, investors and policymakers on climate change. It also draws from a report I authored last year entitled “Addressing Climate as a Systemic Risk: A call to action for U.S. financial regulators,” which outlines how and why U.S. financial regulators, who are responsible for protecting the stability and competitiveness of the U.S. economy, need to recognize and act on climate change as a systemic risk.

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The Fear and the Bright Side of Financial Fragility

Posted by Massimo Massa (INSEAD), David Schumacher (McGill University), and Yan Wang (McMaster University), on
Thursday, December 10, 2020
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Massimo Massa is the Rothschild Professor of Banking and a Professor of Finance at INSEAD; David Schumacher is an Assistant Professor of Finance at the Desautels Faculty of Management at McGill University; and Yan Wang is an Assistant Professor of Finance at the DeGroote School of Business at McMaster University. This post is based on their recent paper, forthcoming in the Review of Financial Studies, and their recent working paper.

The global asset management industry continues to consolidate and a small number of very large asset managers play an increasingly dominant role. At the same time, one of the main folk theorems in finance posits that asset managers do not pose a risk to financial market stability because they are not levered. This lack of leverage could make concentrated stock ownership in the hands of big asset management families a source of stock price stability.

In our research, we investigate if the rise of large asset managers like BlackRock and others raises concerns about financial market stability. We ask the following questions: Does the rise of such large asset management firms induce “fear of financial fragility” in other market participants? If so, how do these other market participants respond to such fear and how does the market overall adjust as a result? Moreover, what are the corporate implications for firms with “fragile” stocks?

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