Challenges of financial regulation in the post crisis world

Ania ZalewskaCentre for Governance and Regulation,

School of Management, University of Bath, UK CMPO, University of Bristol, UK

9-10 June 2015, VEAM, Hanoi, Vietnam

Based on• A. Zalewska, 2015, A new look at regulating bankers’ remuneration,

WP• E.Ferrer, J.Salaber, and A. Zalewska, 2015, Consumer confidence

indices and stock markets’ meltdowns, European Journal of Finance, forthcoming

• A. Zalewska, 2014, Challenges of corporate governance: Twenty years after Cadbury, ten years after Sarbanes-Oxley, Journal of Empirical Finance 27, 1-9

• A. Zalewska, 2014, Gentlemen do not talk about money: Remuneration dispersion and firm performance relationship on British boards, Journal of Empirical Finance 27, 40-57

• Other papers are referenced when referred to

L. Laeven and F. Valencia, 2013, Systemic Banking Crisis Database, IMF Economic Review 61(2), 225-270

Understanding the causes

• Financial Crisis Inquiry Commission (FCIC)– Established: May 2009 – Published a report: January 2011

• We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets… we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it.

• We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis.

• We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets.

• We conclude there was a systemic breakdown in accountability and ethics.• We conclude collapsing mortgage-lending standards and the mortgage

securitization pipeline lit and spread the flame of contagion and crisis.• We conclude over-the-counter derivatives contributed significantly to this

crisis.• We conclude the failures of credit rating agencies were essential cogs in the

wheel of financial destruction.

FCIC report (signed by 6 out of 10 members)

Global economic forces and failures in U.S. policy and supervision

1. Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe

2. Starting in the late 1990s, there was a sustained housing bubble in the U.S

3. Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages

4. Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets

5. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk

6. Managers of many large and midsize financial institutions amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt

7. High risk of contagion .

8. A common shock

9. A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic .

10. Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy

According to them

According to Peter J. Wallison• U.S. affordable housing policies of the former government-sponsored enterprises

Fannie Mae and Freddie Mac before they fell into government conservatorship in 2008

“…the Commission’s majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions—that the crisis was caused by “deregulation” or lax regulation, greed and recklessness on Wall Street, predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to excessive risk-taking. The Commission did not seriously investigate any other cause, and did not effectively connect the factors it investigated to the financial crisis.”

“why Congress bothered to authorize it at all. Without waiting for the Commission’s insights into the causes of the financial crisis, Congress passed and the President signed the Dodd-Frank Act (DFA), far reaching and highly consequential regulatory legislation.”

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“The houses that saved the world”The Economist, 28 March 2002

USA: Remuneration in brief

• Securities Act of 1933 and 1934– Companies are generally required to describe their executive compensation

programme for most recently competed fiscal year• Internal Revenue Code of 1993: performance-based compensation is tax

exempt, while ‘fixed’ remuneration in excess of $1mln cannot be treated as company’s expense

• SOX of 2002• Prohibits personal loans to directors and executive offices (which were

commonly granted to facilitate conversions of options• Puts restrictions on stock sales during retirement plan blackout periods

• Compensation Disclosure and Analysis Act of 2006: – ‘Plain English’ statements on how much and in what form CEO and

CFO are paid– Companies provide information about remuneration of CEO, CFO, and

three most paid executive and non-executive directors

Emergency Economic Stabilisation Act/ Troubled Asset Relief Program (TARP), 2008

• Recipients of financial support provided by TARP must establish (if they had none prior to entering TARP) and maintain a compensation committee (CC) during the remainder of the TARP period

• CCs have multiple tasks relating to the form and size of remuneration offered and paid to SEOs and other employee compensation plans:– “discuss, evaluate, and review at least every six months with the TARP

recipient's senior risk officers the SEO compensation plans to ensure that the SEO compensation plans do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the TARP recipient”

– “do not encourage behaviour focused on short-term results rather than long-term value creation, the risks posed by employee compensation plans and how these risks were limited, including how these employee compensation plans do not encourage behaviour focused on short-term results rather than long-term value creation”

FSF Principles for Sound Compensation Practices, Financial Stability Forum, 2009

• “Compensation practices at large financial institutions are one factor among many that contributed to the financial crisis that began in 2007”

• “Multiple surveys find that over 80 percent of market participants believe that compensation practices played a role in promoting the accumulation of risks that let to the current crisis. Experts agree.”

• “Compensation must be adjusted for risk”

• “Compensation outcomes must be symmetric with risk outcomes”

• Compensation must be disclosed in “clear, comprehensive and timely” manner to “facilitate constructive engagement with shareholders”

,

G20 Summits• April 2009 (London):

– agreed “to endorse and implement the FSF’s tough new principles on pay and compensation”

• September 2009 (Pittsburgh):– agreed to the proposal of the FSB to “regulate compensation practices

to support financial stability”– disclosure of compensation policies and structures – limitation of “variable compensation as a percentage of total net

revenues when it is inconsistent with the maintenance of a sound capital base”

– restrictions on granting multi-year guaranteed bonuses, and defer, tie to performance, impose appropriate clawback and vest in the form of stock or stock-like instruments a significant part of variable compensation, as long as these create incentives aligned with long-term value creation and the time horizon of risk

Dodd-Frank Act, 2010• It is an amendment of the Sarbanes-Oxley Act (2002) and the Emergency

Economic Stabilisation Act (2008)– 2,319 pages contained the blueprint for 243 rule-makings along with numerous

studies and reports

• Financial institutions are in primary focus, but it has consequences for the non-financial publicly traded firms:– Role of shareholders – Board structure– Disclosure of remuneration

• Executives, the median annual total compensation of all employees, the ratio of this median to the total compensation of the CEO

• Disclosure whether any directors/employees were permitted to buy financial instruments to hedge/offset a potential decline in the value of company’s shares held as part of compensation

– Enforcement

Executive remuneration at the Dodd-Frank Act

Increased role of shareholders in determining remuneration• Publicly listed firms are required to hold a non-binding shareholder

vote: – at least every three years on the compensation of executives named in the

proxy statement– no less than once every six years on the frequency of the ‘say on pay’ vote

(should be 1, 2 or 3 years)– On remuneration arrangements (if not voted on before, as above) that may

have arisen from some corporate transactions (e.g., acquisitions)• Brokers cannot vote on behalf of their clients (unless specifically given

the authority by customers) to vote on remuneration issues, as well as appointment of directors

• Shareholders are authorised to propose their own nominees for directors and these have to be included in proxy materials distributed by firms.

Remuneration at Basel II

Adopted FSF 2009 Principles to develop Pillar 3 Disclosure Requirements for remuneration (2011)

• Remuneration disclosure (at least once a year & clearly specified in content and form)– Support effective market discipline– Allow market to assess the quality of practices

• Exceptions can be granted– Low level of risk (there is to be a threshold)– Information is not important or confidential

Corporate governance and the financial crisis: Conclusions and emerging good practices to enhance

implementation of the Principles, OECD, 2010• Executive remuneration is a responsibility of the board. • The boards set the strategic goals of the company and its associated risk

appetite. – the board needs to establish and oversee enterprise-wide risk management systems – internal control functions report directly to the audit committee or equivalent, – it is good practice for the risk management function to be able to report directly to the

board.

• Compensation structure should meet a small number of performance metrics based on these goals.

• An explicit governance process needs to be established that will also define the role and duties of compensation consultants who are increasingly important.

• “Good practice is for the process, remuneration structure and performance to be made transparent through some form of remuneration report.“

European Commission, 2013

• The European Council of Ministers approved the fourth Capital Requirement Directive (CRD-IV) which regulates bankers’ variable pay:

– “the variable component shall not exceed 100% of the fixed component of the total remuneration for each individual”

– Tougher or lighter restrictions can be imposed by individual member states, but the upper limit of the variable component had not to exceed 200% unless approved through a specific EU procedure.

Bankers’ bonusesK.J. Murphy, Regulating Banking Bonuses in the European Union: a Case Study in Unintended

Consequences, 2013, EFM 19(4), 631-657

A few quotes• “the government is not stopping RBS handing McEwan £1m a year in

“allowances” – in effect doubling his salary – as a route to sidestep the EU bonus cap”

• “one shareholder in RBS warned that the bank might now have little option but to increase salaries”

• “it is not easy to accept, but if RBS is to thrive we must do what it takes to attract and keep the people who will help us achieve the goals. We think that the right position of the business is to be commercial. (…) the ability to pay competitively is fundamental to getting RBS to where we need it to be”

Some regulatory issues• Shareholders set compensation

– Bebchuk, Cohen and Spamann (2010); Fahlenbrach and Stulz (2011); DeYoung, Peng and Yan (2013); Beltatti and Stulz (2012) , etc…

• Remuneration of material risk takers (MRTs)– Capital Requirements Directives (CDR III, 2010): clear requirements

on how much of variable pay should be equity-linked and how much deferrable, as well as the length of the deferral period.

– If supervisors of a bank feel that an MRT is following a risky strategy, then the bank will be required to hold a Pillar 2 add-on, i.e., bank specific extra capital requirement to offset the risk of the activity

• Interaction of regulation of remuneration with the new regulatory framework

Features of banks• Short term supply/long term demand for funds

– multiple equilibria

• Leverage ratios • Systemic risk• Payment systems – large interconnectivity• Asymmetry of information (particularly smaller depositors)

Significant externalities (divergence between social and private incentives) - potentially too much risk, too big to fail, etc.

Requires sector specific regulation

Capital and Leverage Framework• Basel II

– Pillar 1 - capital requirements– Pillar 2 - supervisory– Pillar 3 - market discipline

• Basel III– New capital, leverage and liquidity requirements

• Capital Requirements Directive IV (max harm)• Capital Adequacy Ratio (risk weighted)

– Standardised approach– Internal rating based approach

• Leverage Ratio

Bank Recovery and Resolution Directive

• Financial Institutions must be able to fail and restructure in orderly fashion – removing barriers to exit - proportionate

• Stabilisation tools:– private sector purchaser– bridge bank– bail-in

• Features: – MREL (minimum requirements for loss-absorbing capacity)– ‘No creditor worse off’ safeguard

Structural Reform

• Ring fenced banks requirement:– USA: Dodd Frank Act– UK: Financial Services (Banking Reform) Act, In force 2019– EU: under negotiation

• Aims to minimize impact of failure – makes banks more resolvable

• Separates core activities from trading• Applies to big banks (£25bn +, UK)

Regulatory Challenges

1. Stability v entry: competitors or bedfellows?

• Weak regulation: TBTF can be an equilibrium solution

• Competition objectives

• Better regulation provides confidence with regard to quality of entrant

Quantity

Price

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Regulatory Challenges

1. Stability v entry: competitors or bedfellows?

• Weak regulation: TBTF can be an equilibrium solution

• Competition objectives

• Better regulation provides confidence with regard to quality of entrant

Regulatory Challenges

2. Perception

• Understanding of protections and resolution systems for specific banks

• Understanding of specific and general shocks (matters for systemic risk)

• Scale or market power?

Regulatory Challenges

3. Digital Future

• Digital banks (access to accounts, etc.)

• ‘New’ digital payment systems

• New models: digital currencies, crowd funding, etc.

Open data and APIs

Digital banks

• Often standard banking products but no branches (telephone support but no telephone transactions) – aimed at millennials.

• Parallel banks• Flexible IT systems• Cost to income ratio for digital bank of 30% compared to

50% for branch based model (Anthony Thompson (Atom)). • Large banks rapidly moving transactions away from

branches.

Large scale innovation in payment systems from non-banks:

• Wrappers

Potentially large scale impact - Google Wallet, Apple Pay, Paypal – essentially uses existing infrastructure

• Mobile money

M-Pesa (Kenya)

Digital currencies - Distributed ledger technology

Crowd funding, etc.

Regulatory issues:

• Will this bring disruptive competition and innovation?• How much difference will this make to the ‘standard’ model

of regulation in the near medium term?• IT quality is critical – does this raise concerns and, if so,

what should be done?• Impact on innovation and entry (culture differences?)• How does regulation develop over time as parties grow?

How much do we learn from history?