Bank Corporate Governance, Beyond the Global Banking Crisis
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Bank Corporate Governance, Beyond the Global
Banking Crisis
BY JEAN DERMINE
Following up on the publication of the Walker Report (2009) in the United Kingdom,
international organizations such as the Basel Committee (2010), the OECD (2010), and the
European Union (2010) have proposed guidelines to improve bank corporate governance
and, more specifically, risk governance. These international reports vary widely on what the
prime objective of bank corporate governance should be, with one group recommending a
shareholder-based approach, and the other a stakeholder-based one. Moreover, the focus of
these reports is exclusively on risk avoidance, with little guidance as to how an acceptable
level of risk should be defined. Drawing on insights from economics and finance, this paper
is intended to contribute to the debate on bank corporate governance.
Our four main conclusions are as follows. Firstly, the debate on bank governance should
concern not only the boards but also the governance of banking supervision with clearly
identified accountability principles. Secondly, since biases for short-term profit maximiza-
tion are numerous in banking, boards of banks should focus on long-term value creation.
Thirdly, board members and banking supervisors should pay special attention to cognitive
biases in risk identification and measurement. Fourthly, a value-based approach to risk
taking must take into account the probability of stress scenarios and the associated costs of
financial distress. Mitigation of these costs should be addressed explicitly in the design of
bank strategy.
Keywords: Banking, bank corporate governance, banking regulation.
JEL Classification: G18, G21, G28, G32.
I. INTRODUCTION
Following up on the banking crisis and the Walker Report (2009) published in the
United Kingdom, international organizations such as the Basel Committee (2010),
the OECD (2010), and the European Union (2010) have proposed guidelines to
improve banks’ corporate governance and, more specifically, risk governance –
all with a common objective: never again!
These international reports vary widely on what the prime objective of bank
corporate governance should be, with one group recommending a shareholder-
based approach and the other a stakeholder-based one. Moreover, the focus of
these reports is exclusively on risk avoidance, with little guidance as to how boards
should define an acceptable level of risk. In this paper, we contribute to the debate
on bank corporate governance, drawing insights from economics and finance.
The paper is divided into five sections. In Section 1, we remind readers of
the significance of the banking crisis, both in terms of private and public costs.
Some ‘high level corporate governance principles’ are identified in Section 2, and
Corresponding author: Jean Dermine, INSEAD Europe Campus, Boulevard de Constance, 77305 Fontainebleau
Cedex, France, Tel: + 33 1 60 72 41 33, jean.dermine@insead.edu
C 2013 New York University Salomon Center and Wiley Periodicals, Inc.260 Jean Dermine
Table 1: Bank Size and Public Bailout Cost (Dermine and Schoenmaker,
2010)
Countries with Countries with
large banks with Bailout cost small banks with Upfront Government
Equity/GDP > 4% (% of GDP) Equity/GDP < 4% Financing (% of GDP)
Austria 5.3% France 1.5%
Belgium 4.7% Germany 3.7%
Denmark 5.93% Italy 1.3%
Ireland 5.3% USA 6.3%
Spain 4.6% Greece 5.4%
Netherlands 6.2%
Sweden 5.8%
Switzerland 1.1%
United Kingdom 19.8%
Source: IMF (2009), IMF (World Economic Outlook), Thomson One Bankers Analytics.
Public bailout costs refers to Upfront Government Financing. It includes capital injection,
purchase of assets and lending by treasury and central bank support provided with treasury
backing. For Denmark, the source is Wall Street Journal (2/7/09).
a discussion of the merits of the shareholder- and stakeholder-based approaches
follow. In the next three sections we discuss more applied issues: problems with
the identification of risk, issues in measurement of performance and design of
compensation schemes, and the identification of criteria to guide the board when
defining an acceptable level of risk. This is followed by four conclusions related
to the need for governance of financial supervision, a focus on long-term value
creation, attention to cognitive biases in risk identification and measurement, and
a value-based approach to risk taking.
II. THE FINANCIAL CRISIS AND THE CALL FOR BETTER BANK
CORPORATE GOVERNANCE
The state-led resolution of the 2007–2009 financial crisis has proven to be
costly. For the OECD as a whole, the gross government debt-to-GDP ratio has
increased by more than 20 percentage points from 2008 to 2011. To this fig-
ure, one needs to add the lost output and social costs for which the global
recession is to blame. In the fourth quarter of 2011, OECD-average youth un-
employment represented 18% of the labor force aged 15–24, an increase of 5%
over four years. And in Spain, youth unemployment had reached 49.6% (OECD,
2012).
In the OECD, countries that host both large and small banks can be affected
(Dermine and Schoenmaker, 2010). As documented in Table 1 for the time period
2007–2009, the United Kingdom which hosts large banks relative to GDP (such
as Royal Bank of Scotland), has seen up-front government financing of 20%Bank Corporate Governance 261
Table 2: Stock Performance of Private Banks 2007–2009
Share Price Trough as a% of Share
Bank Price Peak 15/06/2007–15/02/2009
Royal Bank of Scotland 5%
Citigroup 5%
Commerzbank 8%
Lloyds TSB 10%
UBS 17%
Deutsche Bank 20%
BNP Paribas 30%
Credit Suisse 34%
BBVA 35%
Santander 40%
Standard Chartered 50%
HSBC 55%
Source: Thomson One Bankers Analytics (author’s calculation).
of GDP. Greece1 and the USA, which host smaller banks relative to GDP, also
face high bailing costs of respectively 5.4% and 6.7%. The advent of a common
shock (such as a bubble in the real estate market or a currency devaluation) that
simultaneously affects many smaller banks (a case of correlated default risk or
default clustering) explains why countries with smaller banks can face large
bailout costs at a time of crisis. Good corporate governance in banking is essential
to both small and large institutions.
With regards to the private costs incurred by bank shareholders during the crisis,
the peak-to-trough evolution of bank share prices between June 2007 and February
2009 is reported in Table 2. In the disastrous case of Royal Bank of Scotland,
following its € 71 billion consortium bid for ABN AMRO in 2007, its share price
felt by 95%. Banks diversified in emerging markets did better, as illustrated by the
share price of HSBC. Although heavily exposed to the US subprime crisis with its
US consumer finance subsidiary Household International, it felt by 45%, helped
in part by diversification in Asian and Latin American markets.
The severity of the global crisis, the huge public costs of bailing out the banks,
burgeoning budget deficits, and the large losses incurred by private shareholders
have prompted a chorus of “Never Again”. Bank corporate governance had failed
in several cases, a view reinforced by the fact that banking crises seem to be
a recurrent phenomenon, as reported in Table 3, with 13 major financial crises
observed over the last 30 years. It is the succession of financial crises which has
inspired the call for a review of corporate governance in the banking sector.
1 The data for Greece do not include the 2012 capital injections from the EU-funded Hellenic Financial
Stability Facility.262 Jean Dermine
Table 3: A list of 13 Significant Financial Crises
Date Event
1982 Latin American Crisis
1982 US S&L Crisis
1987 Stock Market Crash
1991 Global Real Estate Crises
1992 Loan Losses in Japan and Scandinavia
1997 Asian Financial Crisis
1998 Russian Default
2000 End of Tech & Telecom Bubble
2001 Turkey
2002 Argentina Default
2007 Subprime Crisis in USA
2009 Banking Crisis in Nigeria
2011 EU Sovereign Crisis
III. BANK CORPORATE GOVERNANCE, THE ‘HIGH LEVEL
PRINCIPLES’
Corporate governance has been defined in the following ways. According to
the OECD Principles of Corporate Governance (OECD, 2004; Mulbert, 2010),
“Corporate governance involves a set of relationships between a company’s man-
agement, its board, its shareholders and other stakeholders. Corporate governance
also provides the structure through which the objectives of the company are set,
and the means of attaining those objectives and monitoring performance are de-
termined. Good corporate governance should provide incentives for the board and
management to pursue objectives that are in the interests of the company and its
shareholders, and should facilitate effective monitoring.” Professors Schleifer and
Vishny (1997) offer a more succinct definition: “Corporate governance deals with
ways in which suppliers of finance to corporations assure themselves of getting a
return on their investment.”
In a market-based economy, several types of corporate governance mechanisms
may exist and co-exist. For example, the board of a bank can consist exclusively
of representatives elected by shareholders. In countries such as Germany, it will
also include representatives of employees. In a cooperative structure, such as
a credit cooperative, it may include representatives of clients: borrowers and
depositors. In several countries, members of the board of savings banks are locally
elected politicians. What is striking to observe from a reading of the international
proposals for better bank corporate governance is the division between two camps,
representing a shareholder-based view of governance and a stakeholder-based
approach. According to the first view, governance should serve the shareholders,
the owners of the corporation. According to the second view, corporate governance
should serve both shareholders and stakeholders, including depositors, employees,
clients, taxpayers and society. Both views are discussed next.Bank Corporate Governance 263
The Walker Report (2009, p.23), which builds on the UK Companies Act, is
resolutely based in the shareholder-based camp: “The role of corporate governance
is to protect and advance the interest of shareholders through setting the strategic
direction of a company and appointing and monitoring capable management to
achieve this.” But it does not imply that other stakeholders are to be ignored.
Annex 3 to the Walker Report (pp 135–136) includes a list of sound principles of
management:
“To promote the success of a company, directors must have regard, amongst
other matters, to the following six factors:
- The likely consequence of any decision in the long term
- The interests of the company’s employees
- The need to foster business relationships with suppliers, customers and others
(fiduciary responsibility)
- The impact of the company on the community and environment
- The desirability to maintain a reputation (long-term franchise)
- The need to act fairly between members of the company”
However, according to the Walker Report, a single goal should be pursued by
the directors of a corporation: to promote the welfare of the shareholders, the
owners of the corporation.
In sharp contrast, the proposals for improved bank corporate governance drawn
up by the Basel Committee (2010) and the European Union (2010) favor the
stakeholder view. For instance, the Basel Committee’s Principles for Enhancing
Corporate Governance (2010, pages 5 and 10) state “ . . . how the board and senior
management:
- Set the bank’s strategy and objectives
- Determine the bank’s risk tolerance/appetite
- Operate the bank’s business on a day-to-day basis
- Protect the interest of depositors, meet shareholder obligations, and take into
account the interests of other recognized stakeholders.
- Align corporate activities and behavior with the expectation that the bank
will operate in a safe and sound manner, with integrity and in compliance
with applicable laws and regulations.”
“In discharging these responsibilities, the board should take into account the
legitimate interests of shareholders, depositors, and other relevant stakeholders.”
While the Walker Report refers to a single objective for bank corporate gover-
nance, the Basel Committee and the European Union refer to multiple objectives,
that of serving the welfare of shareholders, depositors, employees, clients, suppli-
ers and society.
As mentioned above, different forms of corporate governance can prevail in
a market-based economy. The question is which form of corporate governance
leads to the most efficient outcome for society? The proposals of both the Basel264 Jean Dermine Committee and the European Union have been greatly influenced by the global financial crisis and the cost to society. The prevailing view is that, as some banks have taken excessive risk leading to large losses, costly bailouts by taxpayers, large budget deficits and increase in unemployment, pressure should be put on the boards to take into account not only banks’ shareholders, but also depositors and society as a whole. While the public reaction and calls for changes to corporate governance are legitimate, it should not prevent a dispassionate and lucid analysis of the merits of various forms of governance mechanisms, not only at the level of banks, but also at the level of bank regulators and supervisors. Indeed, the need for efficient banking regulation and supervision was identified many years ago,2 and one mission of bank regulators and supervisors is the development of a sound and safe banking system. Our discussion starts with the governance of bank regulators and super- visors, followed by a discussion of corporate governance by the boards of banks. GOVERNANCE OF BANK SUPERVISION With regard to the solvency and stability of banking systems, what is needed, in our opinion, is independence and accountability of banking supervisors and appropriate legal mechanisms to privatize bank losses. Regulators with rules and legislation codify what is permissible. The supervisors, based on custom, practice and judgement of the rules and regulations, control what and how it should be done. The need for independence and accountability of banking supervisors was addressed in Dermine and Schoenmaker (2010). Unlike CEOs of banks, very few heads of national supervisory authorities have been asked to step down over the past five years,3 which inevitably calls into question the accountability and independence of banking supervisors. In several countries in Central and Eastern Europe (ECB, 2006, 2007a), for example, banks were allowed to lend massively in foreign currency (mostly Swiss francs, euro, and yen) on the individual mortgage market. This created a large source of systemic risk, as the devaluation of the local currency would raise the default rate across the entire banking system. Why was this source of systemic risk allowed to develop? It is not difficult to imagine that, for many ministers, a strong real estate market was helping to buoy up the economy, employment, real estate developers, and the public budget with increased tax receipts. It would require a very brave bank supervisor to put a break on foreign currency lending, slowing down the economy and hurting real-estate developers. Other examples include the Financial Sector Assessment Programs 2A discussion of public failures in banking and the need for banking regulation and supervision, national and international, is available in Baltensperger and Dermine (1987) and Dermine (2003). The traditional argument for bank regulation is the need to limit moral hazard arising out of deposit insurance and the inability of depositors to assess bank riskiness. An additional argument brought out by the crisis is the need to internalize the systemic costs resulting from financial distress. Regulatory tools include control of management and rules of conduct, such as level of capital, a list of permissible activities, and group structure (branches vs. subsidiaries). 3 Exceptions include the head of banking supervision in Ireland, or the president of the central bank in Iceland.
Bank Corporate Governance 265 (FSAP) undertaken jointly by the IMF and the World Bank or the EU stress tests. The FSAP had been undertaken since 1999, yet they did not prevent the crisis. It is striking to observe that, in the wake of the December 2010 Irish banking crisis, European bank supervisors have recognized that the European stress tests conducted in July 2010 were too lenient. Given that it is not a lack of regulations but poor enforcement by banking supervisors that contributed to the crisis (Levine, 2010), a reinforcement of banking supervisors’ accountability is a must.4 The need to evaluate bank supervisors calls for the development of measures of performance. In the case of central banking, these are simpler to identify: inflation or inflation expectations. In the case of banking supervision, they are more difficult as no single index of financial stability is available. A comparison can be drawn with the evaluation of the risk department of a bank for which no single index of bank riskiness exists. To evaluate performance, quantitative data (such as spread on banks’ CDS contract or subordinated debt, and the probability of bank default provided by external firms) will need to be combined with ‘soft’ data (such as evaluation of regulation and supervision by a panel of experts). A clear linkage between results and promotion/remuneration appear necessary to build the correct incentive structure.5 The second tool available to reinforce financial stability is to develop a legal mechanism that forces debt holders to bear bank losses. It is only when debt holders are at risk that they spend resources to analyze the risks taken by bank. Two such mechanisms have been proposed: financing by securities that can absorb losses on a going concern basis (such as equity and contingent convertible bonds), or a swift resolution mechanism that can impose a ‘haircut’ on ‘bail in’ securities. The latter would be facilitated by ‘living wills’, plans that facilitate a rapid resolution in a situation of financial distress (Avgouleas, Goodhart and Schoenmaker, 2010). In other words, appropriate mechanisms can be put in place to reduce the like- lihood of a banking crisis and the potential consequences for the public finances. If the governance of bank regulation and supervision allows for independence and accountability, the debate on bank corporate governance can focus on the efficiency of financial institutions and economic development. BANK CORPORATE GOVERNANCE Three arguments can be put forward for the shareholder-based view of corporate governance, centering on organizational efficiency, entrepreneurial innovation and economic welfare. 4 One had to wait for pressures from members of Parliament before the Financial Services Authority in the UK agreed to publish the details of its investigation on Royal Bank of Scotland (FSA, 2011). 5 The use of a panel of experts may partly solve the issue of confidentiality. Confidentiality, a principle enshrined in legislation, implies that prudential supervisors are not allowed to publish confidential information about individual banks. So, supervisors cannot publish successful actions: cases in which failure was averted because of prompt intervention by the supervisor (Dermine and Schoenmaker, 2010).
266 Jean Dermine The first refers to the efficiency of an organization. The pursuit of a single objective – the welfare of shareholders – provides a clearer goal than the pursuit of multiple objectives. To use a biblical reference, “No one can serve two masters.” (Matthew 6: 24). Or, as the old adage goes, “By pursuing multiple objectives, you will achieve none.” As it is difficult to develop an indicator of aggregated stakeholders’ welfare, there is a danger of a lack of accountability of management who might prefer to maximize their own welfare, for example with empire building (Tirole, 2006). Michael Jensen (2001, p.38) develops the notion of Enlightened Value Maxi- mization: “It is a basic principle of enlightened value maximization that we cannot maximize the long-term market value of an organization if we ignore or mistreat any important constituency. We cannot create value without good relations with customers, employees, financial backers, suppliers, regulators and communities.” Shareholder value maximization is the scorecard objective, but to achieve this, common sense tells us that proper care must be taken of stakeholders; in banking it is known as a fiduciary duty vis-à-vis depositors and clients. Moreover, the useful maturity transformation performed by banks with the financing of illiquid assets with short-term deposits (Diamond-Dybvig, 1983) creates the risk of a run on the bank by depositors. To reduce the likelihood of a costly run, a bank has an incentive to protect short-term depositors with a cushion of long-term securities such as eq- uity or subordinated debt that can absorb losses as a going concern. The protection of short-term depositors is thus compatible with shareholder value maximization. The second argument refers to economic development and risk taking. Progress in our free-market societies is due in part to private firms taking risk, in accordance with the Shumpeterian view of the role of innovations by private firms. But risk taking implies necessarily the occurrence of failure. If one of the objectives of corporate governance is to serve debtholders and banking supervisors, then one should reduce risk to a minimum, avoiding actions that can lead to failure. Ceteris paribus, a reduction of risk will increase the value of debt and reduce the liability borne by the deposit insurance system.6 Numerous innovations have occurred in the banking domain such as microfi- nance, lending to subprime borrowers, junk bonds issued by non-investment grade firms, financial derivatives, guaranteed-funds, credit derivatives, and alternative investment vehicles. In some cases, these have led to large losses and failures, but few would deny the usefulness of derivatives in hedging risks or in security design.7 6 Intheory, an increase of riskiness of an asset can be accompanied by an increase in the deposit rate or the insurance premium to compensate depositors or deposit insurers, but this might be difficult to do if terms have been fixed ex ante. 7 An example of security design is the proposal for COERC, a Call Option Enhanced Reverse Con- vertible (Pennacchi et al. 2010), a form of contingent convertible bonds that will act as efficient bail in securities in case of bank distress.
Bank Corporate Governance 267 The third strand of argument, from welfare economics, is that under certain conditions (such as competitive markets), the pursuit of shareholder value maxi- mization leads to economic welfare with the equalization of marginal revenue to marginal cost. Well-identified frictions such as imperfect competition, imperfect information or distribution of income call for public interventions. Similarly in banking, the fragile nature of the industry caused by the useful transformation of short-term deposits into illiquid assets requires public intervention (deposit insurance, central banks acting as lender-of-last-resort), but these frictions do not necessarily call for a change in corporate governance. We favor a dual governance system based on clear objectives and account- ability: the governance of banking supervision should insist upon a clear objec- tive (stability of the banking system) and accountability of supervisors, and the governance of banks should concern itself with the maximization of the wel- fare of shareholders. Devolving the responsibilities of regulators to the board of banks, as the proposals of the Basel Committee and European Union imply, could hurt economic efficiency, innovation and development, and further extend the lack of accountability of banking supervisors and ministers of finance. Un- derstandably, the global crisis has generated a vast amount of emotion. What is needed is an efficient regulatory/resolution system to promote stability and an efficient corporate governance system to promote economic development and risk taking. Having developed arguments in favor of shareholders-based governance, it is important to address concern about whether the pursuit of value maximization may lead to short-term objectives. In theory, share prices should reflect the present value of future expected cash flows. So, the monitoring of share prices would be one way to assess the expected long-term outcome of strategic decisions. However, if because of imperfect information or inefficiency, the share price is driven by short-term results, there could be an incentive to increase short- term reported profit at the expense of the long-term well-being of the firm. In banking, there are numerous ways to improve short-term reported profits. Firstly, an increase in leverage (debt/equity) can increase Return on Equity and earnings- per-share. This higher leverage could be hidden by manipulating the measure of risk-weighed assets commonly used to assess capital adequacy.8 Secondly, delaying the recognition of provisions on expected credit losses will improve reported profit. Thirdly, higher credit risks can lead to large interest rate margin in the short term, with credit losses realized subsequently. Fourth, a plain maturity mismatch (cash and carry trade) at a time of a rising yield curve can report positive profits in the short term, followed by losses later on when interest rates increase. Although the extent to which financial markets can see through remains to be proven, it appears that opacity is particularly prevalent in banking due to the 8 Under Basel 2 capital regulations, an optimistic assessment of the probability of default of a borrower or of a loss-given-default will reduce the reported weighted assets.
268 Jean Dermine
complex nature of many transactions. In Figure 1 we report the evolution of the
share price of the Irish Anglo Irish Bank, that precipitated the economic crisis
in Ireland. The bank pursued reckless growth in mortgage lending, soon to be
followed by competitors in a classical herding saga. As is apparent from the
graph, the stock market rewarded the short-term profit of Anglo Irish Bank until
the crisis broke out in the Summer 2007. Martin Taylor, former CEO of the British
bank Barclays, expressed a harsh judgment on his peers, compensation practice
and the pursuit of short-term profits:
“Innumerate bankers were ripe for a reckoning. Any industry that pays out in cash (to
employees) accounting profits that are largely imaginary will go bust quickly”.9
In a world in which financial markets reward short-term reported profits, it is
the responsibility of the bank’s board to take care of long-term value creation,
even it that means hurting reported revenue and the share price in the short term.
Executives should drive the business within regulations in accordance with the
strategy and manner (ethics/culture) set and supervised by the board.
As the Roman poet Juvenal wrote in Satires : “Quis custodiet ipsos custodies”
– Who will guard the guards? Transposed to a corporate governance context, how
does one ensure that board members fulfill their mission? Some have observed
that non-executive or independent members have been negligent in their duties,
frequently due to their lack of understanding of the businesses for which they were
responsible. The Walker Report (2009) addresses the issue with a discussion of
the stewardship of institutional investors. Since due to free-riding, it is unlikely
that individual investors will spend resources exercising control, one has to rely on
long-term institutional investors who should make public their intent to exercise
their governance rights.
Having examined the‘high level principles of governance’, we now turn to three
key issues in bank governance: the identification of risk, financial compensation,
and the balance between risk-avoidance and risk-taking.
IV. ISSUES WITH THE IDENTIFICATION OF RISKS
The case for improved bank corporate governance rests in part on the perception
that risks taken by banks were not identified properly by their boards. In this
section, we look at the measurement of risks by bankers and banking supervisors
as it refers to four issues: identification of relevant stress tests, a clear distinction
between situations of risk and those of uncertainty, psychological cognitive biases
in risk measurement, and lessons from a 20-year experience with bankers using a
bank simulation.
9 Financial Times, 11/12/ 2009.Bank Corporate Governance 269 IDENTIFICATION OF RELEVANT STRESS TESTS A necessary condition for bank soundness is that it can survive and keep the going-concern value of the franchise at a time of significant economic shock. Bank capital must able to absorb losses at a time of a stress scenario (also referred to as tail risk). During the 2007–2009 banking crisis, the United States attempted to reassure financial markets on the soundness of its banking system by submitting them to stress testing in May 2009. In July 2010, the European Union disclosed information on stress tests conducted on 91 banks (CEBS, 2010). All but seven banks passed the test of a minimum 6% Tier 1 ratio, including the two large Irish banks Allied Irish Bank and Bank of Ireland. In the case of the July 2010 European stress test, an assumption was made of a decline in house prices in Spain of 15%, at a time when The Economist indicators had reported a potential overvaluation of 35%, based on a standard rent-to-value ratio. Moreover, it is troubling that the EU stress tests evaluated the magnitude of potential losses at 1.1% of risk-weighted assets of banks (aggregate Tier 1 falling from 10.3% to 9.2%), while the Basel 2 capital regulation, which measures risk with 99.9% confidence, evaluated them at 8% of risk-weighted assets. Six months later in December 2010, the Irish government called for EU/IMF support to help bail out its banks. Proposals for producing super stress tests followed.10 In a similar manner, securitized vehicles such as Collaterized Debt Obliga- tions (CDOs) were created on a very large scale. In a securitized vehicle, as- sets such as mortgages are funded with several types of ‘waterfall’ securities. Equity and mezzanine (subordinated) tranches absorb the first loan losses, pro- tecting the senior tranches. The art in securitization design is to select the size of equity and mezzanine tranches needed to protect senior debt holders. Intu- itively, the higher the level of loan losses in cases of stress (a case of correlated defaults), the larger the equity and mezzanine tranches should be. Securitiza- tion experts and rating agencies rely heavily on mathematics of credit risk. In Figure 2, we present the loan loss probability distribution for a case of constant probability of loan default of 2%, but with default correlation varying from 0.02 to 0.1. One can see that, as correlation increases from 0.02 to 0.1, the potential for large losses increases very rapidly from 5% to 9%. Despite major empirical uncertainty with estimates of credit default correlation, there was an explosion of securitization deals. In 2005, world-leading academics had already expressed concerns with the lack of empirical knowledge on default correlation (Das et al., 2005). Both examples – the design of stress tests and the growth of the securitization market – underline the need for independence in the design of stress tests, possibly with input from external independent experts. 10 In March 2011, the European Banking Authority (EBA) announced the publication of more demand- ing stress tests in June 2011 (FT, 3 March 2011).
270 Jean Dermine
Figure 1: Share Price of Anglo Irish Bank
RISK AND UNCERTAINTY
Subprime lending, similar to the case of junk bonds with the financing of non-
investment grade corporations in the 1980s, was a great innovation. It allowed
more risky borrowers to access credit and home ownership. In a similar man-
ner, microfinance allows borrowers to finance small businesses. However, while
these are useful innovations, one must recognize that it is difficult to assess po-
tential losses on these new ventures because, being new, few historical data are
available, unlike lending to wealthier prime customers for whom a large set of his-
torical data are available to evaluate the volatility of credit losses over a business
cycle.
In such as situation, an explicit distinction between risk and uncertainty would
seem useful (Knight, 1921 and Keynes, 1921). In a situation of risk, the probability
distribution of losses can be identified with relevant data. In the case of uncertainty,
the distribution of losses cannot be measured, as the situation being new, no relevant
data are available. This is not to say that bankers should necessarily avoid situations
of uncertainty; as entrepreneurs they should look at new business opportunities.
But it would seem that cases of uncertainty should receive very special attention
by the board of banks and banking supervisors, and that, at a minimum, the scale
of exposure should be limited until more information on risk becomes available.
The fatal error of quite a few banks was not, in our opinion, their decision to enter
the subprime market: rather it was rather their inability to limit the growth of this
highly uncertain activity.Bank Corporate Governance 271
A
0 1 3 5 7 9
Loan Losses (%)
B
0 1 3 5 7 9
Loan Losses (%)
Source: Dermine (2009)
Figure 2: (A) Loan Loss Distribution (probability of default = 2% ; correlation =
0.02). (B) Loan Loss Distribution (probability of default = 2%; correlation = 0.1)
PSYCHOLOGICAL BIASES IN RISK MEASUREMENT
Experts in decision science (Hammond et al., 1998) have identified several
cognitive biases with the measurement of risks. A few of these include:
Anchoring: The brain appears to have a bias in ‘fixing’ an estimate close to a
reported value. The EU stress test offers an example. The design of stress testing
was based on two steps: it first reported the evolution of EU economies and banks
based on a current forecast designed by the European Commission, and then
estimated a stress deviation from that initial forecast. The initial forecast acted as
an anchor which might have prevented the design of tougher stress tests.
Framing formulation: This refers to the way a risk measure is expressed. For
example, a 99% maximum loss of X, or a 1% chance that a loss will be higher
than X. The first expression, the 99% maximum loss, can be interpreted by the272 Jean Dermine
bank as a maximum loss, while the second expression calls to the attention that
losses could be larger.
Availability: This looks at risk in relation to memory. Due to limited memory we
may believe that the recent past describe potential volatility, ignoring historical
cases of higher volatility. Memory is one source of availability. In general, events
are judged more likely to the extent that they are vivid or easily recalled.
As evidence of these cognitive biases mounts, it seems important for boards
of banks and banking supervisors to take these explicitly into account in mea-
suring risk. This is one more reason why the help of independent experts could
help.
LESSONS FROM 20-YEAR EXPERIENCE WITH A BANKING SIMULATION
Over the past 20 years, the author has observed senior bankers, banks’ board
members and central bankers acting as members of an Asset & Liability Committee
(ALCO) in a banking simulation setting, ALCO Challenge. Although a banking
simulation is an imperfect representation of reality, several lessons can be drawn
from these experiences (Dermine, 2008):
1. Success can bring over-confidence and complacency. If a group succeeds
with interest rate forecasts over a few quarters, confidence in their ability to
forecast increases, complacency sets in, and much large positions are taken,
leading eventually to large losses.
2. Controlling the consequences of extreme events. Related to the ‘anchoring’
bias discussed earlier, bankers have a hard time to imagine an economic
world different from the current one.
3. Over-confidence in numbers and graphs. Numbers, formulas and mathemat-
ics give a false sense of comfort and precision in measuring risk, when the
relevant questions should concern the key assumptions driving the numbers.
Board member should spend more time validating the assumptions driving
reports, rather than analyzing the results.
4. Relative positioning. In a competitive setting, the focus of bankers is more on
relative performance (how do I rank vis-à-vis competitors) than on absolute
performance. This behavior, characteristic of Western societies (Layard,
2005), can lead to excessive risk taking to outperform the competitors.
5. Group decision making as opposed to individual decision making. Group
discussion allows a better, more complete identification of risks, leading to
reduced risk taking.
6. Separate risk management function. Forcing a group to create a specific
risk management committee, separate from the trading unit, leads to more
attention paid on risk at the expense of profit opportunities, and reduced
risk-taking.Bank Corporate Governance 273
Probability
Expected Economic Profit Economic profit
Figure 3: Probability Distribution of Economic Profit
To summarize this discussion of risk measurement, board members and bank
supervisors should be very careful with cognitive biases in risk assessment and
wary of the supposed comfort given by reports, graphs and risk figures. They
should be more cautious about the underlying assumptions driving these reports.
V. MEASUREMENT OF PERFORMANCE AND COMPENSATION
All the above-mentioned international reports on bank corporate governance
devote considerable attention to the design of performance evaluation and com-
pensation schemes. A view common among the public, the press and many politi-
cians is that compensation schemes have been, in part, responsible for excessive
risk taking and the global banking crisis.11
We begin by reviewing the reasons for the difficulty in measuring performance
in banking and then discuss the compensation mechanisms proposed. For example,
in granting a loan, the end result can be positive if the economy performs well,
but negative in case of a recession. Similarly, when an asset manager invests in
shares, the results can be positive if the market goes up, and negative if the overall
market goes down. The possible outcomes resulting from taking a risky decision
are shown in Figure 3, which represents the probability distribution of economic
profit, that is, the profit of a transaction net of a cost of allocated equity. If one was
able to observe ex ante, at the time the decision is taken, the expected economic
profit, this measure could be used to evaluate performance and design a bonus
scheme. However, observation of the complete probability distribution ex ante
will often be difficult. What is observed, ex post, is the outcome, the result of the
decision. If economy is doing well (or if the stock market goes up), there will be
a profit; but if the economy goes into a recession (stock market goes down), there
will be a loss. As a consequence, the observation of a realized economic profit
does not allow us to identify whether the result is due to good luck or to good
management. Similarly, the observation of a loss does not allow to observe if it is
11 “Multiple surveys find that over 80 percent of market participants believe that compensation practices
played a role in promoting the accumulation of risks that led to the current crisis” (FSF, 2009). In their
review of the empirical literature, Ferrarini and Ungureanu (2010) report that it is far from proven that
pay structures generally contributed to excessive risk taking before the recent crisis.274 Jean Dermine
due to bad luck or bad management. Not only is it difficult to evaluate superior
performance, but a second related issue is that bonuses calculated on realized ex
post performance can create an incentive to increase the riskiness of an activity. If
the outcome is positive, a high bonus is paid, while if the outcome is negative, the
loss is borne by the bank or by tax payers in case of bailout. This is the well-known
parallel between bonus design and call options, known to increase in value with
increased volatility.
In the asset management industry, the superior realized performance of an asset
manager is evaluated against a passive benchmark (a portfolio with comparable
risk). In the same way, we have argued that a similar technique could be used in
lending, in comparing realized performance to a benchmark corporate bond with
similar risk (Dermine, 2009).12 An alternative to benchmarking in the asset man-
agement industry is to report the average performance of a fund over several years,
in the hope that the lucky and unlucky draws of nature will cancel out, revealing the
expected economic profit and true performance. The proposals for compensation
scheme designs in banking (for example, Financial Stability Board (2009), Basel
Committee (2010), Bebchuk (2010), European Union (2010)) are all inspired by
a desire to reduce incentives for risk taking and option-like compensation struc-
tures. It is hoped that linking compensation to performance evaluated over several
years will succeed in rewarding superior performance, not just luck. Leaving aside
measures taken to increase disclosure and transparency of senior executive pay,
the key measures on compensation proposed in international reports include:
- Reducing the part of the bonus paid in cash immediately and increasing the
part deferred over a minimum 3-year period.
- Including a clawback (malus) clause that allows the deferred bonus pool to
be reduced if a loss materializes later.
- Paying a significant part of the bonus in restricted shares that cannot be sold
over a certain retention period.
Let’s analyze the efficiency of this proposal. The deferral period with a claw-
back clause goes in the right direction of evaluating average performance and
avoiding the option-like payoffs discussed earlier. Indeed, it will create a symme-
try between gains and losses as the malus clause will reduce the deferred bonus
pool. However, the three-year period appears quite short in the credit area, given
that positive economic cycle lasts often much longer than 3 years. The invest-
ment in bank shares is more problematic if, due to opacity or market inefficiency
discussed above, the share price is driven by short-term reported profits. This
could in fact encourage management to focus on short-term results at the expense
of long-term value creation. To reduce this risk, a fairly long retention period
should be enforced to ensure that share prices reflect long-term value (Bebchuck,
2010).
12 Note that benchmarking can only be made if the level of riskiness of the loan can be identified ex
ante.Bank Corporate Governance 275
Beltratti and Stultz (2009) observe that banks which were operating under ‘good
governance principles’ with significant restricted equity stakes owned by manage-
ment did not perform better than other institutions. This has three interpretations:
the first is that these banks were not aware of the risk. The second is that the in-
centive scheme was not appropriate because the retention period was too short. As
shareholders, they had an incentive to take risk. The third is that motives other than
financial compensations were at work, such as a herding mentality in competing
for market share.
An alternative to payment of bonus in restricted shares is payment of bonus
in restricted bonds. One example of this is that of Barclays’s 2011 proposal to
pay bonus in contingent convertible bonds – bonds that convert automatically into
shares – if a certain level of distress (such as a minimum capital ratio) is reached.13
Like regular bond holders who receive a fixed interest payment and only fall in
value when the bank suffers, holders of contingent convertible bonds would have
an incentive to reduce the overall riskiness of the bank, aligning their interest with
those of depositors and debtholders.14
In the debate on compensation, it is implicitly assumed that behavior and risk-
taking is driven mostly by compensation incentives. However, it is the author’s
belief that, while some individuals are driven mostly by financial incentives,
sometimes other factors may be at work, such as competition among large egos,
the race to be in first position, or a tendency for conformity and herding behavior.
Ireland provides a good example when two large historically prudent banks, Bank
of Ireland and Allied Irish Bank, abandoned strict credit standards policy to
engage in market share fight with a reckless risk-taker Anglo-Irish Bank. In this
compensation discussion, one likes to quote the legendary investor Warren Buffet:”
It is only when the tide goes away that one can see who has been swimming
naked”.15
Difficulty in linking compensation to superior performance, the race for first
position, and the possible herding behavior of bank senior executives reinforce
the call for a focus of the board on long-term value creation, even if it can have a
negative effect on share price performance in the short term. A remarkable case is
that of the major Canadian banks. Although not far from Wall Street, they managed
to avoid the worst of the mortgage crisis (Freeland, 2010).
VI. RISK AVOIDANCE OR RISK-TAKING
It will always be possible to engineer a stress test, a tail risk that brings a
bank down. So is there any guidance as to how much risk is acceptable? Indeed,
international reports on bank corporate governance seem concerned with risk
13 FinancialTimes 25/01/11.
14 Note that the proposal to pay bonus in bonds defeats the objective pursued with the payment of
bonuses in shares: the alignment of management’s interest with that of shareholders.
15 FT 7 March 2005.276 Jean Dermine avoidance, providing no guidance on risk taking. Conceptually, a long-term value- based approach should provide guidance on how much risk is acceptable. Long-term value creation implies that in evaluating a risky decision, such as an investment in mortgage loans, an acquisition, or investment in shares, one should assess the discounted value of expected short- and long-term cash flows. One would evaluate the probability of positive outcomes, such as repayment of a mortgage loans or the liquidity available to finance an acquisition, with the probability of less positive outcomes, such as default payment or disappearance of liquidity. In the event of negative outcomes, one should include the additional expected costs resulting from financial distress. The concept of cost of financial distress needs to be clarified. In a recession it is normal to report low profit and to observe a fall in the share price. Costs of distress are additional costs that arise because the company is in a difficult situation. In the banking industry, the costs of financial distress can be quite significant. First, due to the nature of its activities – borrowing short to lend long – the short-term depositors may panic and run away. Second, an undervalued stock will raise the cost of external finance (earnings dilution if the bank issues stock at an undervalued price) and prevent investment such as an acquisition. A third type of cost to arise from financial distress might be the need to sell assets at fire-sale price to meet a minimum regulatory capital ratio. Finally, and specific to the European Union, government bail-out subsidies lead to remedies (various divestments) imposed by the European Union’s competition authorities. To identify the expected cash flows resulting from a risky decision it is useful to separate what are reversible decisions from irreversible ones. A reversible decision entails a risky decision that can be unwound fairly rapidly. One example would be a position in a stock or in currency traded on liquid markets. In this case the probability of a stress scenario or tail risk is likely to be small over a short-term holding horizon. However, in the case of irreversible decisions, such as holding of long positions in illiquid credit instruments or physical investment in a country, the probability of a large shock becomes much higher over a long-term holding horizon. Indeed, Table 3 shows that large shocks have occured fairly regularly over the past 30 years. In the context of irreversible investments, it seems helpful for a bank to reduce the probability of distress and the resulting costs of distress listed above. A first option could be to avoid risk, but that implies missing value-creating activities. A second possibility is to fund the bank with a significant amount of securities that can absorb losses on a going-concern basis (the bail-in securities). Equity or contingent convertible bonds would be needed. This approach is feasible, but likely to be expensive. A third option is to be diversified across products and geographies. This ensures that a shock in one market can be absorbed by the diversified group. Examples of diversified financial group that have, so far, done relatively well in the crisis are HSBC and Santander. As mentioned earlier, despite severe losses in its US consumer finance subsidiary Household Intl, HSBC’s share price fell by 45% in the crisis. In the case of Santander exposed to the major recession in Spain
Bank Corporate Governance 277
and the United Kingdom, diversification in Latin America helped to maintain a
good performance. It is worth noting that these two groups have made acquisitions
recently.
It is interesting to observe the pendulum of opinion among bank analysts.
When the economy is doing well and memories of crisis fade, praise is heaped
upon focused companies that operate in one market. When the economy falls into
a recession, the praise is reserved for diversified groups that can sustain heavy
losses. As large tail risk seems to occur at frequent interval, it is recommended to
run a diversified financial group.16 In a recent proposal on a rating methodology for
banks, Standard & Poor (2010) refer explicitly to diversification, with an analysis
of both the benefits and the capacity of management to manage complexity.
VII. CONCLUSIONS
The global economic crisis with its impact on unemployment and public debt-
to-GDP ratios has naturally generated anger and emotion. In its wake, several
proposals on bank corporate governance have been put forward by international
organizations, such as the OECD, the Basel Committee of Banking Supervision
and the European Union.
Our discussion of bank corporate governance leads to four main conclusions.
Firstly, the debate on bank governance should not only focus on their boards
but also on banking supervisors with clearly identified accountability principles.
Adequate governance of banking supervision should have as objective a sound
banking system, while adequate governance by board should focus on the welfare
of shareholders, the owners of corporation. As discussed earlier a single objective
will help to create a more efficient organization, which, to succeed, needs to
be concerned about its fiduciary duty to its customers and its relationship with
employees and suppliers. Secondly, since biases for short-term profit maximization
are numerous in banking, boards are advised to focus on long-term value creation.
Thirdly, board members and banking supervisors should pay special attention
to several cognitive biases recognized in risk identification and measurement.
Fourthly, while the governance papers focus very much on risk avoidance, little
guidance is offered to evaluate an adequate level of risk. A value-based approach
to risk taking must take into account the probability of stress scenarios and the
associated costs of financial distress, likely to be quite significant in banking. In
this respect, a useful distinction should be made between reversible and irreversible
investments, the latter being a more likely source of financial distress costs. We
have argued that diversification of risks is one way to reduce the probability of
distress and its associated costs. This will require the building up of an organization
that can manage complexity.
16 Note that this conclusion runs counter to finance wisdom according to which there is no benefits
in financial diversification as shareholders can diversify themselves. The argument is that financial
diversification is one way to avoid the expected cost of financial distress.278 Jean Dermine
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