Manual Governance, Regulation and Bank Stability

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Governance, Regulation and Bank Stability (Palgrave Macmillan Studies in Banking and Financial Institutions): Economics Books.
Table of contents

Various reforms have been enacted to ameliorate Governance standards, notably risk management and incentive systems; but the key driver remains the improvement of shareholders rights, with a view to ensuring sustainable value creation. Instead, in this paper it is argued that, to strive for a structural advance in the risk appetite framework of the banking firm, the fundamental assumption behind corporate governance — i. To start with, it is recalled that, according to the options enterprise model, the effective owners of a corporation can be identified with its debt holders.

Summary: 1. Introduction: a holistic view of new banking rules in Europe — 2. The corporate governance in enterprises and in banking-firms: similarities and differences. Corporate governance new parameters in the latest orientations of legal scholars. Continued … and case law. This work examines the issue related to the Corporate Governance CG of banks with specific reference to the implications of the new regulation system and the resolution mechanism introduced by the EU,and recent experiences in Italy.

The considerations-both economic and legal-have general implications which could be extended on a global scale. The financial crisis of had its beginnings in the United States and culminated in the failure of Lehman and the rescue and bail-out of big banks and insurance companies, but then it spread with disruptive and long lasting effects also into Europe.

These recommendations lie at the heart of the new system of European financial supervision. In particular, the Report has introduced new macro-prudential regulatory policies in order to prevent systemic crisis and has underlined the need to put macro-prudential objectives before the micro-prudential ones; moreover, it has suggested the creation of three separated authorities to micro-manage banks, insurance companies and markets [1].

Also the techno-financing developments, especially in the derivatives market, were implemented with disregard for the rules [2] , with the aim of creating short-term profits which caused severe economic and social problems in the medium term, instead of being able to reduce the costs of the intermediaries, and therefore improve the efficient levels of economic production. The priority of macro-prudential issues above the micro ones is analytically clear, even if the real centres of economic, monetary and political power are actually interested in implementing the specific policies under their control.

This fragmentation is particularly significant in the Eurozone, due to the absence of a fiscal and political union. Here it is not possible to deeper analyse the processes of re-regulation in Europe and USA. In this respect, we are substantially making reference to the USA supports for national banks and economic markets, which — beyond bailouts — has been obtained through the introduction of Quantitative Easing starting from on Federal securities and bonds, and the acquisition by the Fed — in accordance with the Treasury and public guarantees — of deteriorating bank credits, as well as the securitization of performing credits and the acquisitions implemented by national agencies [4].

The BU has also completed the so-called Single Rulebook, i. The BU can be specifically analysed in the Fig. The analysis of the European resolution mechanism and its implications for Italian banks, especially for the smaller ones, appears complex. If it were so, a cardinal rule of the macro-prudential regulation would be violated, i.

It will be replenished by the national contributions of the Member States collected from the banking industry and it will be progressively mutualised, with a capital supposed to reach some 55 billion euros between and The capital strengthening of banks, under a unitary regulation for all Eurozone countries, was a right target. Nevertheless, it is legitimate to ask ourselves whether the trade-off between regulation and growth has been properly treated with regard to its micro- and macro-prudential dimension.

In particular, since rules have been tightened and multiplied in their number, the expansive action of monetary policy had to be increased: on the one hand, as far as the monetary base is concerned, the throttle was opened; on the other hand, with regard to the credit and money multiplier [5] , the brakes have been applied. Vice versa , we should prevent the rules about capital, liquidity and banking resolution from neutralising the expansionary impulses of QE, whose distortive side effects might be exacerbated.

These arguments have been supported and explained by several economists and professionals in the financial field [6] , even inside monetary authorities; in spite of this, across Europe, they have been heard little so far. The International Monetary Fund itself has largely documented, in recent Global Financial Stability Reviews , that — beyond certain limits — the attempt to pursue the objective of a banking system apparently safer, through higher and higher capital ratios, might result in smaller growth and negatively feedback on the stability of intermediaries itself.

As shown in the charts above, the set of rules involving banks in Europe is impressive.

The Governance of Monetary and Financial Stability Policy | The Clearing House

To sum up, along with capital requirements stemming from Basel, the changes related to the creation of the Banking Union have been enacted, thus implying new constraints on banks in any case. Rules about capital have been tightened much more than in the United States, following the principle of a wrong, indiscriminate application, having regard neither to size nor to business models [7]. As indicated, no mechanisms of securitisation, provided with public guarantees, have been established, neither on problem loans nor on the ones in bonis ; rules on banking resolution have added complexity and constraints to the system, to the point where, according to the Italian economic authorities, they should be revised.

Moreover, it is necessary to highlight that practically all banks have been directly or indirectly subject to a set of new provisions regarding the financial system as a whole, having an impact — in terms of compliance — on the activities of credit institutions, too, as shown in Figure 6. Figure 6 — The new regulations of the EU financial system.

Governance, Regulation and Bank Stability

Repeated amendments to primary and secondary rules, along with their tightening and increasing number, legitimise the basic issue of the need to estimate the costs and benefits of such rules, their interaction with economic policies and, ultimately, the connection between banking regulation, growth and financial stability itself. Changes in regulation have directly affected the issue of CG Figure 5 , trying to control the excessive risk appetite shown by the shareholders, the Board of Directors and the top management of banks. At the same time, new and tighter rules have been introduced about capital, liquidity and the maturity transformation aimed at internalising possible losses suffered by the credit institution, moving from a bail-out system to a bail-in one.

However, it has not been realized that such a problem would have required a different paradigm with regard to CG, that had played a pivotal role in the excessive risk shown by several credit institutions. In particular, as argued in this work, in order to tackle the root causes of the issue, one should consider an active voting role in general meetings and a position in the Board of Directors for subordinated bondholders.

As we are trying to demonstrate, such a reform would be consistent with both the new charges on a relevant segment of bondholders and — above all — the need for changing from inside the risk profile and the strategy of the banking-firms, thus helping to pursue the creation of sustainable value in the medium term. Since the Eighties, characterised by banking de-regulation, the axiom that the bank is a firm has gained ground.

This approach had some good points; however, it ended up with neglecting that the banking company has nevertheless some features that are special with respect to other corporations. Credit institutions represent a key element of the implementation of monetary policy, basically — but not exclusively — because deposits are an essential component of money. The relevance of financing decisions in order to determine the value of a bank arises from the specific characteristics of their assets, liabilities and associated risks.

In fact, as highlighted by DeAngelo and Stulz , credit institutions play a crucial role in the production of liquidity in the economic and financial system; moreover, as long as there is a risk premium a reduction in the cost of funding for liquid securities, then a high leverage is optimal for banks, becoming a source of value-creation itself. As highlighted by Adams and Rudolf , credit institutions generate profits both on their assets loans and liabilities deposits. In particular, their ability to receive deposits at lower rates than the market creates an extra-profit that grows with leverage.

This means that Modigliani-Miller theorem, along with corporate finance models based upon it, should be properly modified in order to take this peculiarity into account.

In the light of these specificities, too, the issue related to the need of revising the CG of enterprises — in particular, as far as the relationship between shareholders and bondholders is concerned — nowadays arises, as we shall see, especially for banking companies. However, we cannot neglect that traditional CG structures require, anyway, a general critical revisiting.

We should nevertheless underline that even such a model, assuming the validity of the abovementioned Modigliani-Miller theorem, should be properly amended or adjusted in order to consider the peculiarities of the banking company as indicated above. They hold equity capital and receive rights, on the income and the assets of the firm, that are subordinated with respect to creditors the latter holding claims on debt capital. Shareholders are in a riskier position and are compensated through dividends if the company can afford them and capital gains, that do not have any predetermined bounds.

Debtholders of a firm, as a priority with respect to any payment to shareholders, receive the interest due; in the event of the liquidation of the company, all debts must be satisfied before any distribution to shareholders. It is important to notice that, under a fiscal standpoint, both dividends and interest are subject to levies on the income of recipients; however, for a corporation, interest is fiscally deductible, whereas dividends contribute to taxable income.

Hence, for the company, this gives rise to an evident advantage to finance itself through debt rather than equity. Ceteris paribus , this is increasing the potential instability of the economic and financial system. Furthermore, shareholders have an additional incentive to increase the leverage and the risks faced by the banking firm, to the extent that — as argued before — a higher leverage brings to the creation of value that ends up with them being the main beneficiaries.

Both shareholders and bondholders have a common interest in preserving and increasing the value of the company they invested in. Shareholders are remunerated only after bondholders are paid off.

  1. How the corporate governance mechanisms affect bank risk taking!
  2. The corporate governance of banks.
  3. Corporate Governance.

As a consequence, only shareholders have voting rights at general meetings as well as the chance to directly or indirectly appoint the top management of the firm [8]. Shareholders and bondholders are characterized by partially different objective functions. Shareholders, given their power to appoint board members and managers, have different control tools which make their objective functions even more complex and exacerbate agency problems.

In sum, according to the traditional approach above mentioned, the enterprise value V can be calculated as the sum of claims from both equity-holders E and debt-holders B :. Figure A. Conversely, shareholders can collect potentially unlimited returns while creditors have just the chance to get their investment back. Moreover, the overall scenario is even more complex for banks given the fact that their enterprise value increases with leverage. This, even though we must recognize that the interests of the shareholders can impose costs on other stakeholders and, in particular, on creditors and ultimately on the company itself because of the existence of conflicts of interests.

Literature has highlighted the specifically relevant debt-equity conflicts, in particular those of the debt overhang Myers, and those of risk shifting Jensen and Meckling, The assumption of relevant risks can represent a benefit in the short term for the share value, at the expense of the sustainable value of the debt of the same company. Compliance and risk management represent essential components to foster a good CG and, namely they have to concur in controlling and avoiding conflicts of interest, particularly between shareholders and creditors.

In conclusion, the conventional wisdom, according to which bondholders are only creditors instead shareholders are the sole owners of the company, must be re-discussed. These considerations become particularly relevant and mandatory in the current context of bank resolution mechanisms Figure 4 , aiming at favouring the bail-in to overcome the schemes that resorted to the taxpayer in case of default of a large bank. The aforementioned considerations are significant in order to understand the essential purposes and the security system behind the interplay operating between risk and debt capital.

Before going into the details of the convoluted structure that the EU legislator adopted in recent years, it is though necessary to briefly explore one of the main rationale behind the peculiar essence of the banking governance phenomenon, which is the regulation of financial intermediaries. Financial intermediaries accomplish a peculiar task within the market, and they deeply influence its development through their actions Visco, c : such a circumstance lays the ground for the banking governance regulation. Economic literature has widely shown how the interplay between savings and investments, and incomes, rests on the brokerage activity in order to reallocate resources from those entities focused on the accumulation of savings; this activity affects the efficiency of the market, and has been the basis of the constant relationship between productivity and economic growth experienced since the English industrial revolution Abel and Bernanke, ; Sylos Labini, ; Ehnts, The impact of banks — in accordance with instructions coming from European Union institutions — on markets is the ultimate reason for which public supervisory authorities are appointed to monitor their risk activity in order to guarantee their solvency.

Following these regulations, the supervision of the credit system refers to an entrepreneurial benchmark characterized by a prudential corporate governance Minto, ; Ferro-Luzzi, Regulating the banking governance shall — in order to properly accomplish an unavoidable supervision activity — shape the banking activity to sound and prudential rules, so as to guarantee the general stability, the efficiency and the competitiveness of the financial system Mottura, Financial intermediaries are therefore compelled to comply with those standards that supervisory authorities appoint through their analysis Goodhart, The principle of sound and prudent managements preserves a general we might say, macroeconomic objective of banking regulation, which is nonetheless addressed by regulating individual entities through an individual we might say, microeconomic approach towards a specific market condition.

It must be further considered that a strict connection exists between substantive goals and regulatory powers that must be assigned to supervisory authorities: in order to properly accomplish their tasks, authorities must consider the specific characteristics of each entity operating in the banking sector, and evaluate their capacity of implementing sound and prudent management on the basis of the concrete situation addressed.


The overlaps between banking regulation and general enterprise governance are mostly related to their conducts, rather than to their substance Masera, On the basis of this consideration, it is clear how the corporate governance of banks is a pivotal requirement to ensure the stability of financial entities, since the criteria that regulate the management and control of credit institutions are strictly connected with the functioning of the credit organizational system, and with the equilibrium of the financial sector as a whole.

Such an aim is pursued through the provision of corporate rules aiming at implementing risk-control systems against those conducts that might compromise the objectivity and the impartiality of strategic decisions operated by banks i. All these aspects lead to one, first, conclusion: the architecture of corporate governance in the credit sector is instrumental to the proper development of banking activity. The responsibility of corporate bodies should assure a well-balanced exercise of their duties and powers: their choices must reconcile the profit-seeking purposes with a responsible assumption of the risks implied, and this equilibrium is programmed by way of given management choices rectius , operational structures.

If corporate bodies can accomplish these tasks with success, the banking company will satisfy both private and public interests that constitutes the basis of its real essence. Rules must promote a management structure able to guarantee the adequacy of decision-making processes and to avoid a laissez fair approaches. Such a mechanism is necessary considering that the market is not always able to properly use the freedom granted by laws and regulators.

The normative framework arranged at EU level moves from the abovementioned bedrock in order deal with the criticalities in the banking European system caused by the crisis and by its development. Also, this intervention should be read in accordance with the law regulating the sanctions system and the administrative procedure regarding their application, which is pivotal in order to overcome the uncertainties related to the efficacy and the dissuasive attitude of the intervention Council of the European Union, The main consequence of this approach is that EU interventions do not take into account their impact on the shareholding structures as they currently are in the financial structure of banks.

A significant aspect is also the fact that the introduction of crisis management mechanisms for banks involves — in terms of corporate liability — subjects other than the shareholders, traditional owners of the capital risk. In particular, this happens in those crisis management procedures where the aim of preventing hazardous conducts by banking authorities as well as the concern to protect taxpayers from the economic burdens arising from these operations led the legislator to increase capital ratios and implement bail-in rules in order to include bonds and other credits — except for deposits within a determined amount, that are granted with specific guarantees — in the resolution procedure.

More in particular it has to be underlined that such a choice was consistent with the idea that every reallocation of resources amongst sectors and enterprises should be considered as a potential alteration of market equilibrium, therefore conflicting with the rules stated by Treaties of the European Union.

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These members have a significant interest in assessing the profits arising from a proper balance between risks and returns: therefore, assigning them the accomplishment of this activity — that was traditionally conducted by shareholders — seems to guarantee a consistent awareness to company risk. The roots on which bank governance is built up need to be re-shaped in order to enhance the aspect of the congruence between risk and liability, which characterizes the essence of such roots.

This stems from the obligation to respect — in the application of the bail-in — the principle of proportionality as a fundamental parameter in the regulation of the European financial sector. As a consequence, this principle must be further specified into the constant pursuit of a behavioural conformity amongst market operators, that stands as the basis for a fair competition amongst peers in a market free from disparities Montedoro, In other words, it must be ascertained that — in any hypothesis of bail-in — the result achieved would be the same that would have been reached through liquidation procedures: the bail-in must be, though, a neutral intervention.

The very same logic behind the bail-in procedures can be found in the EU law on State aids: within this regulatory framework, of particular interest is the analysis of the provisions on the so-called burden sharing , which is a rule of solidarity between shareholders and other subordinated creditors. This novelty, as far as the Italian scenario is concerned, encourages to mull over some aspects of a regulatory nature concerned with that legal system that may ultimately affect the consistency of the legislative amendments more recently introduced by the EU legislation.

Thus, there is a decrease in the hiatus existing between the rights pertaining to the holders of the risk-capital equity and the those vested with mere claims vis-a-vis the bank i.