Bridge over ocean
1 January 2015 CFA Institute Journal Review

Systemic Risk, Governance and Global Financial Stability (Digest Summary)

  1. Sandra Krueger, CFA

Systemic risk can result in severe negative consequences for the real economy. Too-big-to-fail institutions have historically been subject to various government reforms; however, governance has not been properly addressed by regulators, despite the link between governance and risk taking. Some possible solutions to strengthen bank governance include increasing the capital base, reforming the compensation of managers, implementing resolution regimes, and reforming the structure of company law.

What’s Inside?

The authors analyze key issues with systemic risk and global financial stability. The Financial Stability Board’s (FSB’s) goal is to ensure that standards are globally accepted and implemented through the sharing of firm-level data. As the financial markets become increasingly interconnected, the goal of achieving regional and international cooperation is crucial. If some banks are held to a lower standard, an uneven playing field is created that results in regulatory arbitrage. The authors believe that because of the diversity of the financial system, no single measurement of systemic risk will be universally applicable. Additionally, managers should pay more attention to the role of bank governance and systemic risk.

How Is This Research Useful to Practitioners?

The difficulties in developing appropriate regulation for financial institutions should be of interest to practitioners. Although the interconnected nature of the global financial system can increase systemic risk, encouraging firms to take a position of financial self-sufficiency is unrealistic.

Out of the 29 global systemically important banks (G-SIB) identified by the Basel Committee, there are a significant number of investment banks that have different balance sheet structures. Investment banks have counterparty risks that can cross borders, and they may engage in regulatory arbitrage to pursue value-destroying activities in the form of excessive risk taking—for example, by acquiring targets in countries with lax regulations and weak supervisors. This form of regulatory arbitrage could have adverse consequences for the banking system as a whole.

The FSB has developed tools to address financial stability risks and amplification mechanisms of systemic risk, such as leverage and maturity mismatches. But risks are diverse, and it cannot be assumed that the appropriate capitalization is constant across all risks. A single measurement of systemic risk (e.g., the leverage ratio) is not universally applicable. Additional tools have been created to limit spillover effects from the failure of systemically important financial institutions by improving global recovery and resolution frameworks.

The FSB has also tried to create a mechanism for the international sharing of firm-level data on systemically important financial institutions. This mechanism attempts to keep the global financial system more informed about the state of large financial institutions and their risk taking.

How Did the Authors Conduct This Research?

The authors extend previous industry research by adding their own ideas with respect to systemic risk, governance, and financial stability. In particular, they examine governance reform that has the ability to reduce the chances of regulators chasing risk around a global system. The authors offer solutions for strengthening governance.

They note that the limited liability structure gives rise to a principal–agent problem between shareholders and debtholders. Risk is a deliberate choice resulting from the choice of assets. In addition, greater leverage increases balance sheet risk and payoff asymmetry. Bank debtholders’ sense of risk tends to be dulled by insurance in the case of bank depositors. In the case of bond debtholders, the implicit insurance of bank debt by the state effectively shifts the burden of risk onto taxpayers. The authors suggest that efforts could be made to encourage debtor discipline both by reducing the probability of government intervention and by including the “bail in” of depositors/creditors.

The authors discuss the compensation structure of managers, which results in issues arising when managers put their own objectives above those of shareholders. But the alignment of managerial incentives with shareholders is not a clear answer because it can exacerbate risk shifting. For example, it could incentivize managers to gamble for resurrection when nearing insolvency.

The authors suggest that the regulatory capital base of banks could be increased, which would reduce the incentives to generate leveraged-induced risk in equity returns. Additionally, they mention a solution to reform the structure of company law by extending control rights beyond shareholders. For banks, in which the imbalance between shareholder controls (100% of balance sheet) and their stake (less than 5% of balance sheet) is significant, there is a strong case for this type of reform.

Abstractor’s Viewpoint

I agree with the authors that more attention should be paid to governance. Potential future research on governance could expand on the role of fraud in creating banking crises. Although significant research has documented the fraud and corruption that resulted in the most recent financial crisis, it would be interesting to examine whether current regulations have strengthened fraud prevention measures. For example, do current regulations include whistleblower provisions that actually encourage reporting?

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