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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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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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 19^th 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 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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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 (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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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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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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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 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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Thank you for the invitation to participate in the 2020 IIF Annual Membership Meeting. I am pleased to share my perspective regarding the current regulatory and policy initiatives in the area of sustainable finance. My remarks are being made in my capacity as co-chair of the Task Force on Climate-related Financial Risks (TFCR), which is part of the work of the Basel Committee on Banking Supervision. I should note that my prepared remarks and subsequent comments made as part of the panel discussion may not necessarily reflect the views of the Basel Committee or its members, or those of the Federal Reserve System or the Federal Reserve Bank of New York.

The Basel Committee’s mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. It is the primary global standard setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. As part of its work, the Committee exchanges information on developments in the banking sector and financial markets to help identify current or emerging risks for the global financial system.

The Committee noted that climate change may result in physical and transition risks that could potentially impact the safety and soundness of individual financial institutions and have broader financial stability implications for the banking system.

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Institutional investors increasingly play a central role in US stock markets, with institutional ownership rising from below 40% in 1980 to over 75% nowadays. In Glossner, Matos, Ramelli, and Wagner (2020), we examine the outbreak of the novel coronavirus (COVID-19) pandemic—a truly exogenous shock—as a powerful setting to learn more about their behavior. Did institutional investors run for the exits and sell equities, given the heightened level of uncertainty, or instead took a contrarian approach (buying when other market participants were selling, potentially seeing through the temporary nature of the pandemic)? Did institutions sell stocks indiscriminately or rebalance their equity portfolios in a “flight to quality”, favoring stocks perceived to be more “resilient”? And who took the other side of their trades?

We first looked at whether institutional ownership (IO) was a key explanatory variable for stock returns in the COVID-19 crash. Figure 1 shows that the IO level at the end of 2019 was associated with a significant stock underperformance during the COVID-19 market crash, net of the combined effects of other firm and industry characteristics. How did this vary across types of institutions? We find that stocks held more by active investors (vs. passive) investors, short-term investors (vs long-term), or those institutions that had previously experienced higher outflows during the Great Financial Crisis of 2007/2008 performed worse in the COVID-19 “Fever period” (from February 24 through March 20 of 2020, as defined by Ramelli and Wagner, 2020).

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Insurance is the tried-and-true strategy for protecting against infrequent but potentially devastating losses. In theory, governments could protect against the potential economic devastation of future pandemics by requiring businesses to insure against pandemic-related risks. In practice, however, insurers do not currently offer pandemic insurance. Insurers fear their industry does not have the capacity to provide coverage.

In Catastrophe Bonds, Pandemics, and Risk Securitization, I focus on using risk securitization—a relatively recent and innovative private-sector means of insuring otherwise “uninsurable” risks—to insure pandemic-related risks. Risk securitization depends on investor demand to purchase catastrophe (“CAT”) bonds. Capital market investors have shown high demand, for two reasons. First, CAT bonds provide a diversified return because natural catastrophes occur randomly and are not correlated with standard economic risks; therefore, CAT-bond returns are largely uncorrelated to the returns of equity securities and conventional corporate bonds. Second, CAT bonds have provided strong returns to investors.

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On September 9, 2020, the Climate-Related Market Risk Subcommittee of the U.S. Commodity Futures Trading Commission published a report, Managing Climate Risk in the U.S. Financial System, describing the links between climate change and the U.S. financial system. The Report was largely the product of efforts from its sponsor, CFTC Commissioner Rostin Benham, but was prepared with input from the Subcommittee, comprised of over 30 stakeholders, including banks; investment firms and advisors; oil and gas companies; and public interest and non-profit organizations.

The Report makes two key arguments. First, climate change poses major risks to the stability of the U.S. financial system and its institutions. Second, U.S. financial regulators must move swiftly to understand, measure and address those risks. To that end, the Report makes 53 recommendations for federal and state regulators, legislators, and financial and business leaders to manage climate change and mitigate its impacts.

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Letting workers elect some percentage of corporate directors, an approach known as codetermination, has long been viewed as a historical quirk primarily confined to the social-democratic societies of Western Europe. By and large, U.S. corporate law scholars assume that the traditional U.S. model, under which shareholders are the sole masters of the corporation, is bound to prevail. Nations that had already introduced codetermination might fail to abolish it, because of path dependence or inertia, but other countries would not follow suit. Even scholars who argued that corporate boards ought to take into account the interests of constituents other than shareholders typically did not envision allowing anyone but shareholders to elect a corporation’s directors.

More recently, however, the broad consensus supporting this shareholder-centric model of corporate governance has begun to fray. Two prominent senators and contenders for the 2020 Democratic presidential nomination, Elizabeth Warren and Bernie Sanders, advocate giving the employees of large corporations a voice in corporate governance.

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Context

In the last few years, expectations on whether—and how—companies should engage on climate change have evolved. Companies and investors now largely understand that climate change poses clear financial and even material risks to companies and industries across the economy. Additionally, climate change is now widely recognized as posing a systemic threat to financial markets writ large, with significant potential for disruptive impacts on overall economic stability and the lives and livelihoods of tens of millions of people across the U.S. and globally.

Recognizing the need to address the climate crisis, a growing number of companies are taking increasingly ambitious steps to address climate change across their performance and strategies. However, these efforts could be undermined if their lobbying on climate change, whether directly or through their trade associations, is not aligned with climate science. In fact, such misalignment could lead to inefficient corporate spending and reputational and financial risk. Companies that establish robust governance systems to address climate change as a systemic risk and align their lobbying efforts to support science-based climate policies will drive the creation of a regulatory environment that best positions them for resilient growth.

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To Whom It May Concern:

We are writing in opposition to proposed rule RIN 1210-AB95. We believe the rule is not only unnecessary, but

1. Is based on a woefully incorrect understanding of the current state of investing knowledge and theory,
2. Endangers the retirement security of Americans rather than protects it,
3. Is Internally inconsistent,
4. Applies an inadequate analysis of ERISA fiduciary duties by ignoring the duty of impartiality, and
5. Would violate Federal cost-benefit regulations.

The proposed rule is based on a woefully incorrect understanding of the current state of investing knowledge and theory: An “eye singular” towards retirement security is not the same as encouraging willful blindness.

The major goal of investing for retirement is to create a desirable risk/return portfolio over time, so as to offset retirement expenses. As the Department of Labor wrote in the background to the rule, “Courts have interpreted the exclusive purpose rule of ERISA Section 404(a)(i)(A) to require fiduciaries to act with “complete and undivided loyalty to the beneficiaries,” The Supreme Court as recently as 2014 unanimously held in the context of ERISA retirement plans that such interests must be understood to refer to “financial” rather than “nonpecuniary” benefits… plan fiduciaries when making decisions on investments and investment courses of action must be focused solely on the plan’s financial returns and the interests of plan participants and beneficiaries in their plan benefits must be paramount.”

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In the paper The Effect of Managers on Systematic Risk, we ask whether top manager-specific differences account for part of the unexplained variation in traditional asset pricing models. A key principle in asset pricing theory is that investors are compensated for bearing systematic risk, but not idiosyncratic risk. Drawing on this insight, empirical asset pricing models decompose stock return variability into systematic and idiosyncratic components. The systematic risk of a stock is determined by its beta, which measures the sensitivity of the stock’s return to common risk factors such as the market factor. A large literature investigates the determinants of beta, but a general conclusion from these studies is that a large amount of variation in systematic risk cannot be explained by firm-, industry-, or market-level variables.

Tracking the movement of top managers across firms, we document the importance of manager-specific fixed effects in explaining heterogeneity in firm exposures to systematic risk. We show that these differences in systematic risk are partially explained by managers’ corporate strategies, such as their preferences for internal growth and financial conservatism. We follow the approach of Bertrand and Schoar (2003) to document that such person-specific styles explain a significant amount of variation in firms’ capital structures, investment decisions, and organizational structures. The notion that CEOs differ in their styles is reinforced by Bennedsen, Pérez-González, and Wolfenzon (2020) who exploit hospitalizations to examine variation in firms’ exposures to their CEOs. Similarly, a vibrant literature suggests that managers’ personal traits play a role in shaping their management approach. Our results suggest that managerial style explains a substantial fraction of the variation in both idiosyncratic risk and systematic risk.

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Ms. Vanessa Countryman, Secretary
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549

June 10, 2020

Dear Secretary Countryman,

On behalf Impax Asset Management LLC, Investment Adviser to Pax World Funds, we submit this rulemaking proposal to require that companies identify the specific locations of their significant assets, so that investors, analysts and financial markets can do a better job assessing the physical risks companies face related to climate change.

Scientific research is increasingly showing that severe precipitation, floods, fires, droughts, sea level rise, extreme heat, and the spread of tropical diseases and pests to temperate zones are often not random and or impossible to anticipate, but are linked to a warming climate. These changes pose risks not only to companies, but their investors, financial markets and the global economy.

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The coronavirus pandemic has produced a public health debacle of the first-order. But, the virus has also propagated the kind of exogenous shock that can precipitate—and to a certain degree has precipitated—a systemic event for our financial system. This still unfolding systemic shock comes a little more than a decade after the last financial crisis. In a recently posted essay, Protecting Financial Stability: Lessons from the Coronavirus Pandemic, we contrast the current pandemic with the last financial crisis and then examine the steps that financial authorities have taken to safeguard financial stability against the effects of COVID-19. Our essay also explores the extent to which financial regulation might be reformed and supplemented in the future to address the emerging lessons of the pandemic crisis.

The last financial crisis is most vividly remembered as a top-down crisis starting with the failure of a series of major financial firms in 2008, culminating in a capital market meltdown in September following the bankruptcy of Lehman Brothers. The coronavirus pandemic, as yet, has not precipitated any similar financial failures, although capital markets did react dramatically in March of this year as the pathology of the virus and its potential implications on global economic activity started to come into focus. This new information produced an exogenous shock, prompting in many quarters a rush to cash and the evaporation of liquidity for many asset classes. The Federal Reserve Board, along with other central banks and financial regulators, responded promptly, drawing self-consciously on the emergency toolkit developed in the last financial crisis, as well as a number of counter-cyclical levers made available as part of regulatory reforms adopted in response to that last crisis. This intervention to stabilize capital markets (and financial firms) appears to have been successful, at least so far.

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