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Lessons from a crisis: Rules alone will not suffice

  • 20Jul 17
  • Paul Lee Head of Corporate Governance

Ten years after the financial crisis, the weight of regulation is making it hard to hold banks to account.

It was becoming obvious at about this time in 2007 that something very bad was happening in America’s banks. Air was rushing out of the US housing market bubble and the country’s banks, mortgage providers and brokers were bearing the brunt of the blast.

One of the biggest sub-prime lenders in the U.S., New Century Financial, had already filed for bankruptcy. Bear Stearns would soon bail out one of its hedge funds that was exposed to the U.S. housing market to the tune of $3.2 billion. The bank would be forced to liquidate it a month later. As we now know, what started in the U.S. would spread around the world.

Part of the crisis response has been to rewrite the global bank rulebook. Much of this has been sensible. This has provided banks with additional protection from the kind of capital flight that caused so many problems during the crisis. Big capital buffers should mean that the largest banks will not need to turn to taxpayers if there is a repeat of the conditions of the financial crisis.

Regulation has also forced cultural change upon banks. Those who ran banks in the run-up to crisis were natural risk takers. Dick Fuld, who rose to the top of Lehman Brothers over nearly 40 years, typified the bank’s culture as much as he was a product of it. Now, culture is all about responsibility.

Regulation has forced cultural change upon banks.

The interests of regulators and shareholders are generally aligned: it is in everyone’s interests to avoid a repeat of the financial crisis. And it’s clear that shareholders generally did not do a great job of acting in their own best long-term interests ahead of the crisis. But what’s good for regulators – the minimization of risk at whatever cost – is not always going to be in the interests of shareholders. At the moment, the regulator’s voice seems to trump all others.

This is not an argument for less regulation. But regulation has to make sense. Take, for example, bank disclosure requirements which create mammoth amounts of work and material but not necessarily the desired results. They come from pillar three of the Basel agreements and force banks to provide extensive detail about the instruments that they hold. The idea is that putting all of this information into the public domain will improve scrutiny. Pillar three is based on the assumption that market scrutiny will help exert a discipline on bank risk-taking. Except, that’s not what seems to be happening.

These disclosures are vast data sets which can run to 150 pages, generally published alongside but separate from the annual report. The job of sifting through that data is herculean. It’s not clear who is doing this analysis. Just because the data is there, it doesn’t mean anyone is looking at it.

Banks, investors, rating agencies, regulators and central banks all pointed the finger of blame at one another during the financial crisis. This was partly because each of them thought it was the responsibility of the other to understand the risks in the system.

Whoever is or isn’t looking, the sheer weight of disclosure also makes it harder to spot problems, which can often be hidden in plain sight. Bank disclosures are now like an ever-growing library where spotting the book that is out of place is getting harder and harder to do. They also run the risk of crowding out other measures of corporate health like those on long-term business performance contained in the recent BankingFutures report.

There is also a wider issue about how stakeholders in banks get heard. In absolute terms, regulators hold much greater sway over what a bank does than shareholders do. Again, some of this is right. Banks, like all companies, need to be accountable to more than just their shareholders. But for banks, one stakeholder is now pre-eminent: the sheer pressure of regulatory adherence is driving out all other voices.

Regulators’ voices are not just heard within boardrooms. Increasingly, they are physically in boardrooms and make clear what they expect to hear when in there. They are active in dialogue at all levels of organizations, especially with all those individuals now subject to personal liability. In comparison, the shareholder voice is muffled. Yet investors in banks need to be able to have a dialogue with management too and to be able to push for change when they think it’s in their clients’ interests.

Rules can always be circumvented and generally have unintended consequences. This is partly because rules are by definition fairly static; something is deemed permissible or not. In contrast, the dialogue which shareholders have can adapt much more readily to changing conditions. Rules for an industry do not discriminate much between companies either. Shareholders will push for change in banks because of the particular characteristics of that bank. Their voice should not be crowded out.

Banks are in better shape than they were ten years ago. But the crisis was caused by a collective failing. It was a failure of banks, investors, regulators and central banks. Investors, like regulators, learned important lessons. No one party should hold a disproportionate sway over how banks are now run. Shareholders’ voices should be heard.

A version of this article first appeared in the Daily Telegraph on July 14, 2017.

ID: US-170717-37667-1