The compliance units in financial institutions have experienced explosive growth since the financial crisis. This is not surprising given the equally rapid growth in regulations governing the financial sector. For example, the Dodd-Frank Act—the US federal act which reformed financial regulation in the aftermath of the financial crisis, contains 2300 pages of detailed rules, tightly regulating the environment within which financial institutions operate. In its global regulatory outlook, the professional services firm Duff & Phelps estimates that the compliance costs among asset managers, brokers, banks and other financial institutions are up to 4% of revenue. By 2022, the costs could rise up to 10%.
The key driver behind the tightening of the regulatory landscape is the systemic risk concerns that surfaced in the aftermath of the financial crisis. Systemic risk is the risk that local losses will spread through the financial system and badly affect the financial system and the real economy. The recent financial crisis made clear that systemic risk not only arises through contagion from one distressed bank to another, as traditionally assumed, but also from the interconnections between a wide range of non-bank financial institutions and markets more broadly.
Regulators worldwide heavily rely on prescriptive prudential regulation to curb systemic risk. Prescriptive prudential regulation is regulation that controls the risks associated with the activities of financial institutions by preventing financial institutions from taking certain decisions (for example, structural regulation prevents banks from engaging in proprietary trading) and requiring financial institutions to take certain precautionary measures (for example, bank capital and liquidity requirements). The prescriptive rules are operationalised through prudential supervision, which is the set of tools (such as data collection, on-site inspections, and sector-wide reviews) regulators use to monitor the activities of financial institutions. Prudential supervision aims to ensure that financial institutions comply with the prescriptive rules and adequately manage the risks associated with their activities. In line with the change in the systemic risk paradigm since the financial crisis, regulators have complemented regulation and supervision focused on ensuring the safety and soundness of individual financial institutions—banks in particular—(“microprudential” measures), with regulation and supervision focused on ensuring the stability of the financial system as a “whole” (“macroprudential” measures).
Before the financial crisis, prescriptive prudential regulation and supervision of financial institutions—particularly banks—was deemed sufficient to control systemic risk generated by their activities. The goal of corporate governance—that is, the system by which firms are directed and controlled—with respect to financial institutions was therefore not thought to be any different than with respect to non-financial firms. However, the financial crisis has focused attention on the problems with the corporate governance of financial institutions. More specifically, studies showed that banks that adhered to “good” corporate governance practices, as defined pre-crisis, also encountered the most losses during the crisis. This is because prudential regulation and supervision are incomplete and leave discretion on behalf of banks to increase or decrease systemic risk.
Thus far, the debate on the relationship between firm governance and systemic risk has focused on the peculiarities of the governance of banks compared to non-financial firms. However, by focusing on the peculiarities of banks, the governance debate fails to appreciate the new macroprudential reality in which prudential regulators operate. This Essay connects the dots and argues that—in line with the expansion of traditional prudential regulation and supervision beyond banks—the corporate governance debate should consider the interaction between systemic risk and the governance of non-bank financial institutions. Although it is now widely acknowledged that non-bank financial institutions can contribute to systemic risk, it is less clear what the implications are of their systemic importance from a governance perspective.
To be clear, regulators did intervene—post-crisis—in the governance of non-bank financial institutions. However, in order to reach their full potential, governance interventions should go beyond transplanting bank governance measures to non-bank financial institutions. This is because the special treatment in the governance literature of systemically important banks is justified with reference to the peculiarities of the bank finance structure. Systemic risk in non-bank financial institutions, however, may arise in different ways. Therefore, it is unclear whether the prescriptions of the bank governance literature may be extrapolated to non-bank systemically important financial institutions. This essay will illustrate this claim through a case study of hedge funds.
This essay first discusses the changed paradigm for the analysis of systemic risk, followed by a discussion of the prudential framework in place to address system risk. It will then consider the role of bank governance in a microprudential framework, before analyzing the role of governance in a macroprudential framework, through the example of hedge funds.
I. A Changed Systemic Risk Paradigm
Systemic risk is the risk that local losses spread through the financial system, destabilize and disrupt its operations, and badly affect the real economy. Traditionally, regulators took a microprudential approach to systemic risk. Generally speaking, regulation was based on the idea that systemic risk is caused by a bank failure causing losses to the bank’s creditors and triggering runs by depositors on similar banks. Government-sponsored deposit insurance can prevent bank runs, but also creates incentives for banks to take excessive risk, as losses are borne by the deposit insurer rather than the bank’s shareholders. As a result, regulation focused on preventing excessive risk-taking by banks, for example, through minimum bank capital requirements, regardless of the impact of such measures on the stability of the system as a whole.
However, the crisis made clear that systemic risk also exists outside the banking sector and that the channels through which financial institutions can cause damage go beyond the failure of deposit-taking banks. Indeed, systemic risk originates from the interconnections between financial institutions and markets more broadly. For example, the run on short-term wholesale funding—where repurchase agreement and commercial paper creditors refused to roll over the loans—was a key trigger for the demise of Lehman Brothers, Bear Stearns, and Northern Rock, among others. Another example is the derivatives market and the interconnections it created, which turned out to be a catalyst for systemic contagion across market participants. More generally, the crisis showed that systemic problems do not necessarily arise from the collapse of large financial institutions, but also from the collapse of an entire asset market, such as the mortgage-backed securities market.
II. Controlling Systemic Risk Through Prescriptive Prudential Regulation and Supervision: Towards a More Macroprudential Approach
After the financial crisis, financial regulators worldwide adopted systemic risk mitigation as the main goal of the reform agenda. This resulted in a strengthening of the traditional microprudential framework for banks. In particular, regulators adopted revised capital requirements and new liquidity and leverage requirements for banks based on the “Basel III Accord”—the third installment of the internationally agreed Basel Accords regarding prudential rules in banking. These measures improve the resilience of individual banks.
Acknowledging the changed systemic risk paradigm, regulators have complemented the improved traditional microprudential measures with macroprudential ones. From a macroprudential perspective, regulators can take a cross-sectional or a time-series perspective on the manifestations of systemic risk. Time-series or “cyclical” measures focus on the build-up of risk over time and address the amount of risk in the system at a point in time relative to the capital and liquidity resources. Cross-sectional or “structural” measures focus on the structural features of a financial system that make it more vulnerable to shocks, given a certain amount of time-varying risk.
Macroprudential policy is in its infancy, and the exact impact and scope of the new instruments has yet to be determined. Basel III introduced changes to its traditionally microprudential framework in order to consider the stability of the financial system as a whole. For example, it introduced a counter-cyclical capital buffer, which requires banks to add capital in times of credit growth to be available in a downturn, addressing time-varying risk. Another example is the adoption of additional capital requirements for Global Systemically Important Banks (G-SIBs), which considers the impact of a bank on the financial system.
Moreover, macroprudential measures also expand beyond the banking industry. In the US, for example, the Financial Stability Oversight Council (FSOC) has authority to designate non-bank financial institutions as “systemically important,” resulting in higher prudential standards under the supervision of the Federal Reserve. Recent policy changes, however, prioritize an activities-based or industry-wide approach over individual designation to addressing risks to US financial stability.
Other macroprudential tools focus on market structure. For example, regulators worldwide have introduced the mandatory use of central counterparties (CCPs) for certain derivatives in order to address contagion between financial institutions through the derivatives market. A CCP is a financial institution that interposes itself between the contract parties of a trade and becomes the buyer to every seller and the seller to every buyer. CCPs—which essentially guarantee trades—should reduce counterparty risk in the derivatives market by ensuring that the failure of one counterparty does not affect the payments to the other counterparty of the trade.
Prudential supervision then monitors the compliance of financial institutions with the new prescriptive prudential rules. Again, post-crisis, regulators worldwide have introduced macroprudential supervision in addition to microprudential supervision. In the US, for example, the newly established FSOC is responsible for identifying and responding to financial stability threats in general. In the EU, the new European Systemic Risk Board (ESRB) is responsible for macroprudential oversight within the EU.
III. The New Role of Bank Governance in a Microprudential Framework
This Section discusses the new corporate governance paradigm for banks that has emerged since the financial crisis. More specifically, it explains how—post-crisis—bank governance has become an integral part of the prudential framework managing risks generated by banks in addition to prescriptive prudential regulation and supervision. First, the Section explains that the traditional prudential framework is incomplete, before discussing how the pre-crisis governance paradigm created perverse incentives for banks to exploit such incompleteness. Finally, it discusses the post-crisis response to the identified issues.
1. An incomplete prudential framework for banks
Prior to the crisis, microprudential regulation and supervision were considered sufficient to prevent banks from taking excessive risk. “Good” corporate governance of banks was, therefore, not considered any different from good corporate governance of non-financial firms. Corporate governance is the system through which companies are directed and controlled. To the extent that microprudential regulation and supervision exclude any discretion on behalf of banks to increase or decrease systemic risk, bank governance is indeed irrelevant to the systemic risk debate. However, prescriptive regulation is inevitably incomplete, as it is impossible—ex ante—to unambiguously specify for all future contingencies. In the context of systemic risk, this problem is especially pertinent, as the fast pace of innovation leaves regulators always one step behind market developments. Financial innovations can create systemic problems in a short period of time, which ex-ante rules are unable to anticipate.
Supervision by the prudential authorities can—to some extent—fill in the gaps left by incomplete prescriptive rules. This is especially the case when supervision entails the discretionary assessment by the supervisor regarding the bank’s risk management and quality of its assets, rather than compliance with specific rules. Supervision based on a conversation between supervisors and the firm can provide supervisors with the ability to adjust the behavior of banks—ex post—in the case it is deemed necessary for financial stability.
However, supervision—as a solution to the incompleteness of prescriptive rules—has significant flaws, if only because financial innovation and complexity create an information asymmetry between market participants and supervisors. Moreover, even in the presence of complete information, the limited public resources put significant constraints on the ability of prudential supervisors to understand the functioning of the market and timely identify risks.
2. Perverse incentives under the general corporate governance paradigm
Given the incompleteness of the prudential framework, bank managers are left with discretion to make decisions affecting systemic risk. As a result, the system through which such decisions are made becomes an essential part of managing systemic risk. Under the predominant view in the Anglo-American corporate governance scholarship, a firm should be run in the interests of its shareholders, within the boundaries of the applicable law and prior agreements with other stakeholders. It is argued that—as residual claimants—shareholders receive most of the upside and downside of the performance of the corporation and, as a result, have appropriate incentives to make discretionary decisions. A typical corporate governance mechanism used to align the interests of managers and shareholders is executive compensation. For example, executives often receive stock-based compensation in order to align their interests with those of the shareholders. In sum, under the general corporate governance paradigm, the corporate governance structure of banks should be designed to maximise the returns for the shareholders and not to safeguard systemic stability beyond the bank’s private interests.
This is problematic as the private interests of banks—and more specifically of their shareholders—and those of the prudential regulator are unlikely to align. Take the example of liquidity risk, that is, the risk that a business will not be able to meet its short-term liabilities by converting its assets into cash. In deposit-taking banks, the business model inevitably leads to banks holding illiquid loans funded by liquid deposits. This creates liquidity problems in the case of a sudden increase in the demand for liquid assets, for example in the case of bank runs. However, holding a substantial amount of cash (or equivalent liquid assets) as liquidity buffer instead of profit-generating illiquid loans, will push profits down.
As a result, since the financial crisis, the emerging consensus is that bank governance focused on shareholder value maximization can lead to excessive risk-taking from a prudential perspective. The argument is that shareholders have an asymmetric option: their limited liability as shareholders protects against the losses suffered due to risky behavior beyond their capital input, while profits are uncapped. In other words, the potential systemic losses stemming from insufficient levels of liquid funds to meet short-term obligations can be partly externalized onto the financial system, while unlimited profits can be enjoyed. In addition, bank creditors have reduced incentives compared to creditors of regular firms to curtail such risky behavior. This is in part because the systemic importance of banks has induced the government to provide deposit insurance in order to prevent bank runs, as well as to engage in ad-hoc bail-outs of troubled systemically important banks in order to prevent bankruptcy. Creditors might assume this could happen again in the future. This reduces their incentives to increase the price of credit, include restrictive covenants, or monitor the bank to prevent excessive risk-taking that could lead to bankruptcy.
To be clear, the current prescriptive prudential framework addresses liquidity risks in banks. Indeed, as mentioned above, Basel III introduces strengthened minimum capital ratios and new liquidity standards for banks, which led to a revision of the prescriptive prudential rules applicable to banks worldwide. In the EU, for example, the Capital Requirements Regulation (“CRR”) and the Capital Requirements Directive IV (“CRD IV”) lay down new prudential rules in the banking sector. However, like the previous Basel Accords, Basel III leaves ample of discretion to banks in implementing the capital and liquidity requirements. For example, large banking groups can rely on their own internal models for the calculation of their credit, market, and operational risks, which then forms the basis for the calculation of the amount of capital they must hold against those risks. Such discretion is inevitable, as uniform prescriptive rules leaving no discretion to the banks would conflict with the diversity of institutions subject to the rules.
3. A new paradigm for the governance of banks
Given these perverse incentives, thought-through bank governance becomes an essential part of systemic risk mitigation. In this context, the literature argues for a retreat from the shareholder maximization model in banks. For example, some authors advocate tying executive compensation to a broader basket of securities than stock and stock options. Basel III, moreover, acknowledges the importance of governance by complementing the minimum capital and liquidity requirements with an enhanced supervisory review of the bank’s governance structures and risk management practices from a prudential perspective. For example, under the CRD IV, remuneration of people working in control functions (risk management, compliance, and internal audit) cannot be linked to performance of the unit they oversee. This intervention decouples remuneration from the performance of the business and, therefore, decouples the profit maximization incentives from shareholders, in line with the new wave in the bank governance literature.
IV. The Role of Corporate Governance in a Macroprudential Framework: A Case Study of Hedge Funds
Thus far, the debate on the relationship between firm governance and systemic risk has focused on the peculiarities of the governance of banks compared to non-financial firms. By failing to distinguish between the different types of systemically important (bank and non-bank) financial institutions, however, the governance debate ignores the new macroprudential reality in which prudential regulators operate. However, corporate governance has a critical role to play within the new macroprudential framework as well. The Essay argues that the activities of some non-bank financial institutions are likely to generate similar “systemic externalities”—individually or as a herd—that distort decision-making in non-bank financial institutions with a negative impact on the stability of the financial system as a whole. Although regulators have intervened in the governance of non-bank financial institutions, these measures are heavily criticized for merely extending the rules applicable to banks. However, to be effective, governance interventions need to be based on a proper analysis of the specific source of systemic risk and the related governance problems in the relevant institutions. In this Section, a case study of hedge funds illustrates the importance of thought-through governance interventions based on the specific characteristics of the relevant institution.
1. Systemic risk and hedge funds
The systemic importance of hedge funds has been subject to extensive debate. The extent to which the activities of hedge funds will present risks to the financial stability depends on the specific characteristics of each fund. Without taking a stance in this debate, it is plausible that highly leveraged hedge funds with significant connections to other systemically important financial institutions or markets cause financial instability. For example, in stressed times, asset prices of collateral may decline, leading to margin calls (calls to deposit further cash or securities to cover possible losses) that force funds to sell off assets to meet those margin calls. If these sales are significant, relative to the market the fund is selling into, or when there is correlated selling among market participants, this could lead to fire sales, that is, sales of assets significantly below true value. This might result in spill-over effects through declining asset prices and increased margin calls for other market participants.
2. Perverse incentives under the current governance framework
In the standard structure, hedge funds are managed by asset managers. Broadly speaking, asset managers provide investment services to clients to help manage the clients’ savings based on specific investment objectives. As part of this business, some asset managers establish collective investment funds (such as hedge funds) and advertise those funds to investors to attract capital. Investors receive shares or “units” in the fund in return for their investment. Asset managers appoint a portfolio manager who will manage the fund’s investment portfolio on behalf of the investors. As asset managers are companies themselves, they have their own governance structure—separate from the fund—with their own shareholders, managers, and employees.
In hedge funds, the managerial discretion of the asset manager—and ultimately of the portfolio manager, as the asset manager’s agent—to make portfolio decisions tends to be high. In order to align the interests of the asset manager and the investors, asset managers receive performance fees based on the fund’s profits. These are expressed as a percentage of the returns made above a benchmark level. Although performance fees have come under pressure in recent years, hedge funds typically charged around 2 percent management fees and 20 percent performance fees for profits over its high-water mark (“HWM”), the historically highest level of a fund’s assets under management upon which performance fees have previously been calculated. The HWM ensures that the fund managers will only receive performance fees when previous losses are recovered.
While performance fees might align the incentives in the investor–asset manager relationship, they can create perverse incentives from a systemic stability perspective. More specifically, performance fees charged by the fund create an asymmetric pay-off structure for managers. Fund managers receive an unlimited share of the upside of risky investments (for example, 20 percent of all the profits above the HWM), while the 2 percent management fees function as a floor on the downside, allowing asset managers to cover (at least part of) their costs even in the case of severe losses. The closer to its HWM, the greater the incentive of the fund manager to increase risk to trigger the performance fees, for example through increased use of leverage.
This asymmetric structure shows similarities with the heavily criticized pay-off structure in banking prior to the crisis. Bebchuk, Cohen, and Spamann find that bank executives—even though they suffered significant losses on their bank holdings during the crisis—were able to cash out significant amounts of performance-based compensation before their firm collapsed, leaving their bottom-line pay-offs significantly positive. They argue that such compensation structure generated incentives to increase short-term profits in order to receive large amounts of performance compensation, even though this increased the probability of large losses over the longer period. In hedge funds the payment structure could provide similar benefits for managers. In the good years, the managers can cash in on the entire upside of profits above the HWM. In bad years, the losses are not borne by the managers, but by the investors. Moreover, the management fees provide—to some extent—a floor to the losses, ensuring that the costs of the asset management business are covered.
3. The need for a new paradigm
In the EU, the Alternative Investment Fund Managers Directive (“AIFMD”) regulates remuneration issues. More specifically, the remuneration of those categories of staff whose professional activities materially impact the risk profile of the asset manager or of the funds they manage, should be consistent with and promote sound and effective risk management. The rules are, to a great extent, copied and pasted from the remuneration rules in banking and are limited to the key employees of the asset manager. However, where a bank contributes to systemic risk through strategies involving the investment of their own assets, asset managers manage assets for the benefit of the fund’s investors, which adds an additional layer to the governance structure. As a result, in order to manage decision-making in the asset management industry, the interaction between the asset manager and its investors must be considered in addition to the governance structure of the asset manager and its employees. As the analysis above makes clear, the 2/20-kind of compensation of the asset manager creates perverse incentives from a systemic risk perspective, namely in the relationship asset-manager-fund/investors. The AIFMD, however, only tackles payments to the extent that they benefit the identified categories of staff of the asset manager. Given the incompleteness of the prudential framework, further research should determine how both governance layers interact in order to identify perverse incentives in the governance structure of funds. In sum, as this case study illustrates, thought-through governance interventions based on the specific characteristics of the relevant institution are essential for ensuring the stability of the financial system.
Given the incompleteness of the prudential framework, the challenge for regulators lies in ensuring that systemically important financial institutions—including banks and non-banks—exercise their discretion in line with prudential goals. Through the example of hedge funds, the essay aims to highlight the importance of research on the impact of governance rules applicable to various types of financial institutions from a prudential perspective. Only by aligning the incentives of decision-makers with prudential goals, the compliance efforts by financial institutions will further a stable financial system.
Katrien Morbee is a Lecturer in Banking and Finance Law at the Centre for Commercial Law Studies, Queen Mary University of London; PhD Candidate in Law and Finance, Balliol College, University of Oxford. The author would like to thank John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey Gordon, Andromachi Georgosouli, Allison Lantero, Joris Morbee, Robert Richardson, Veronica Root, Thom Wetzer, and the participants in the Notre Dame Law School Conference on “Investigating Intersections of Corporate Governance & Compliance” for their valuable comments as well as the Economic and Social Research Council [ES/J500112/1], the Oxford-Man Institute of Quantitative Finance, and the Scatcherd European Scholarship for their financial support. The usual disclaimers apply.