The financial crisis of 2008 forced everybody to look at the bank regulations more carefully. There is one side which believes that over the period US banking industry was de-regulated which led to a lot of reckless risk taking. British banking regulator Donald Kohn, a former Fed vice chairman, told British lawmakers he had abandoned his belief that bankers’ self-interest would keep markets safe. “I placed too much confidence in the ability of the private market participants to police themselves”.
Time and again other regulators across the world have expressed similar concerns. Public opinion has also been against banks. In a March 2011 national poll conducted by Bloomberg, only 19% respondents said that banking regulations were too strict. 76% said that current rule were too soft and should be tightened.
On the other hand, some people believe that all the reaction and allegation about the role of banking companies in 2008 crisis is baseless. The newly appointed Chair of American Bankers Association, Frank Keating thinks that there were a lot of non-bank actors that contributed to the crisis. In his opinion, from pay-day lenders to Government Sponsored Entities such as Freddie Mac and Fannie Mae are all to blame for the crisis. In an interview recently he said “if you analyze the crash of 2008, most of it was the result of non-bank recklessness and the actions of the unregulated. The Consumer Financial Protection Bureau focusing in on, for example, payday lenders and mortgage brokers and the like — the non-bank sector — that’s not inappropriate and certainly jurisdictionally it’s legal. The average person doesn’t know that the banks represented around this table had zero to do with the collapse of the economy..” It is often argued that these regulations would raise the cost of credit which ultimately would hurt businesses and industry.
However, in these big debates, we are forgetting some basic issues that might have contributed to the housing bubble. Here are some issues that need to be carefully considered in this debate:
- How did banks fail to see what the true value of a real estate was? Banks are supposed to have a better sense of valuations than common bank.
- Who regulates real estate professionals, loan originators, appraisers and other input providers in a credit decision and what are their incentives? Did State Appraisal Boards ever look at inflated housing prices that form the basis of mortgage backed securities? Do these input providers face significant penalties for bad inputs? Did they help inflate home values and equity?
- Did deregulation of banking also accompanied with perverse incentive system for bank executives? For example, stock-based pay generally encourages executives to greater risk-taking. This could become more severe if these executives also have others’ money to play with. Banks enjoy a lot of this financial leverage. Did this leverage coupled with stock-based pay and low regulations encouraged them make highly investments?
What do you think? Please share your thoughts in the comment section below!
Arun Upadhyay, Ph.D.
Dr. Arun Upadhyay teaches finance courses in the College of Business at University of Nevada Reno. His primary teaching area is corporate finance. Before moving to academic world, Dr. Upadhyay worked for several years with a commercial bank in the area of credit analysis and international banking. He received Ph.D. in finance from Temple University. Dr. Upadhyay’s research focuses on corporate governance issues. He studies corporate leadership structure and executive compensation. He has published articles on board structure in high quality finance journals such as Financial Management, Journal of Corporate Finance and Journal of Business Finance and Accounting.
The financial meltdown of 2008-2009 brought the attention of both the media and regulators back to the failure of corporate governance practices in general, but specifically on executive incentive systems which encourage risky investments. One of the most controversial issues is how executives are compensated and whether that impacted their risk-taking behaviors.
The outrage about executive pay was caused by the large pay-packages of some banking firms which eventually received bailout money from the federal government in the form of TARP money. CNN money has listed 2007 pay-packages of top executives from nine such banks. For example, in 2007 the total compensation for Kenneth Lewis of Bank of America was $24.8 million.
The role of incentives in risk-taking is even greater in the banking industry where the amount of debt is larger when compared with industrial firms. This is highlighted by the following article from Financial Times:
“The problem with this is that bankers are incentivised to seek bigger and riskier bets because volatility increases upside return without affecting downside risk. They are similarly encouraged to increase balance sheet leverage since this further magnifies the pay-off. And this incentive has been greatly reinforced by bonus targets related to return on equity – a classic inducement to short-term risk-taking.” By: John Plender, Financial Times, 25th Oct., 2011.
Critics of incentivized executive pay systems have proposed many ideas to curtail executive incentives in order to control the risk-taking behaviors. Such demands recur after every major economic crisis. For example, New York Times reported on March5, 1934 that Sen. Burton Wheeler complained about “Corporations in the red paying excessive salaries.” Recently, these proposals have been discussed across many countries. For example, in June 2010, U.S. regulatory agencies jointly issued the Final Guidance on Banking Incentive Compensation, designed to ensure that incentive compensation policies do not encourage imprudent risk taking in financial institutions. In last 3-4 years, countries like Canada, Germany and Holland have seen similar proposals. However, one needs to also consider other factors which have led to the growth in executive compensation and risk taking simultaneously. For example, the role of corporate boards which decide on how much to pay in what form to pay?
Corporate scandals of the last two decades or so have pushed board structures towards more independence from the management. The enactment of Sarbanes-Oxley Act (2002) and subsequent adoption of listing requirements by the national stock exchanges have made it mandatory to have a majority of independent directors. A push towards smaller and outsider dominated boards from the proponents of corporate governance reforms have significantly reduced the managerial representation on boards. These changes might have had impacted the quality of managerial evaluation and monitoring effectiveness of boards as outside board members rely on the insider directors for valuable information about a firm and its investments. In the absence of managerial inputs, outside board members could find it difficult to evaluate the quality of managerial decision making and may not design a compensation scheme that balances growth with risk taking.
We really need to understand whether the absence of these executive directors from the board room exacerbated the CEO power and hence the CEO pay-package and excessive risk taking. Without understanding these issues, we might end up adopting yet another defective system of executive incentives which almost certainly could expose us to the risk of another financial crisis.
Dr. Arun Upadhyay teaches finance courses in the College of Business at University of Nevada Reno. His primary teaching area is corporate finance. Before moving to academic world, Dr. Upadhyay worked for several years with a commercial bank in the area of credit analysis and international banking. He received Ph.D. in finance from Temple University. Prior to moving to University of Reno, he worked at University of Alaska Anchorage where he was awarded College of Business and Public Policy Best Teacher award. Dr. Upadhyay also served on the Investment Advisory Commission of Municipality of Anchorage.
Dr. Upadhyay’s research focuses on corporate governance issues. He studies corporate leadership structure and executive compensation. He has published articles on board structure in high quality finance journals such as Financial Management, Journal of Corporate Finance and Journal of Business Finance and Accounting. His work has been presented at various national and international conferences.