Big Bank Problems: A Culture Ratio is More Important Than a Capital One

My Comments:house and pig The financial crisis in 2008-09 could have been much worse. The Federal Reserve intervened and limited the damage. After the fact, the regulators created a major remedy, one intended to “make sure” a similar crisis wouldn’t happen again. The idea was to impose new standards regarding the amount of capital, or reserves, on the books of the banks that were deemed “too large to fail”.

This author suggests it wasn’t enough. Which in turn suggests we’ll have another crisis down the road, only for different reasons. I can hardly wait.

Simon Samuels / November 24, 2014

The focus on making banks ‘safe’ by holding more capital is unrealistic, writes Simon Samuels

Tim Geithner said he realised Merrill Lynch’s risk culture was not in great shape when John Thain, then chief executive, did not know the name of his chief risk officer – who at the time was sitting next to him. The anecdote demonstrates a truth that is in danger of being lost in the regulatory clamour for banks to hold ever more capital: that the driver of bank failure is not insufficient capital but rather a bad “risk culture”.

Think of three pairs of superficially similar banks pre-crisis: Citigroup and JPMorgan Chase; Royal Bank of Scotland and Barclays; Belgian-Dutch lender Fortis and BNP Paribas. In each case, when crisis struck, the first needed a taxpayer rescue; the second did not. Yet here is the odd thing. Entering the crisis the capital strength of each pair was near identical. The overall risk culture, and not capital levels, explained their divergent fortunes.

Today regulators are focused on requiring all banks to hold much more capital as they attempt to make banks “safe”. In practice, however, making all banks “safe” is unrealistic. While RBS was suffering losses of £30bn in the crisis, BNP Paribas was making profits of €34bn. Would it have been right to have set BNP Paribas’ capital requirements in anticipation of RBS-sized losses?

Some say yes, including Robert Jenkins, a former member of the Bank of England’s Financial Policy Committee, who in 2012 put to the industry the idea of a “deal” whereby all new regulation would be suspended in return for a 20 per cent leverage ratio on banks, many times the Basel requirement. In practice, such a measure is a hammer to crack a nut. Much better, surely, would be to demand more capital only from those banks more likely to lose money: those with poor risk cultures.

But it is hard to measure risk culture. Some weaknesses are, in retrospect, obvious. Citigroup’s board included the chief executives of a galaxy of famous US companies who between them had hardly any banking experience. However, a good risk culture is more complicated than knowing who your risk officer is or having banking experts in the boardroom. Entering the crisis, the directors of RBS included a healthy compliment of extremely experienced bankers who – at the time – regulators, investors and analysts regarded as suitably qualified. Between them the five critical boardroom lieutenants of Fred Goodwin, chief executive, had almost 150 years of relevant banking industry experience. Yet, apparently, the culture was not one that encouraged challenge.

The UK’S 2009 Walker report on corporate governance recommended fostering such a culture in boardrooms as part of a strong risk culture. And it is more important than ever today, when the risks remain long after the loan has been repaid or the trade completed, as shown by the billions of dollars banks have paid so far for misconduct in the run-up to, during and after the crisis, including by those banks that did not need a taxpayer rescue to survive the economic meltdown.

But, while much has been done by regulators and policy makers, much more is needed. First, global regulators should disclose their own assessment of a bank’s risk culture. They may well penalise those deemed weak by confidentially requiring them to hold more capital. Disclosing such information – after an appropriate delay allowing the banks time to rectify the situation – will offer banks an incentive to address the problem and provide valuable information to investors.

Second, banks could vary the way they pay directors to reflect their different relationships with risk. By all means pay the chief executive, who will be focused on the bank’s growth, in deferred stock. But it is better, surely, to pay the chief financial and risk officers – both more focused on avoiding dangers – in similarly aligned debt instruments.

Third, banks should reveal their own record at measuring risk by disclosing how their losses each year compare to the level they expected, and providing an explanation for any difference. The International Accounting Standards Board’s IFRS 9 accounting standard takes steps in this direction but does not go nearly far enough.

Finally, banks could disclose the topics discussed and voting patterns at board meetings. Giving investors such an insight may reveal how good the board is at anticipating and managing risk, and how challenging or submissive the boardroom culture is.

Just because culture is harder to measure than capital does not mean it is less important. As Albert Einstein said: “Many of the things you can count don’t count. Many of the things you can’t count really count.”

The writer is a member of the Financial Stability Board’s enhanced disclosure task force. He writes in a personal capacity.