Risk Management in Banking after the 2008 Financial Crisis: what we can learn from the United States

Introduction

The second most devastating challenge faced by the economy since the Great Depressions was the crisis of 2008 (Blundell-Wignall, A., Agarwal A., 2018). This financial mishap was a result of several factors. These included easy availability of mortgages and consequent unsustainable housing boom, a rapid growth of the economy, and poorly designed regulations. These factors kept piling up until reaching the zenith of the crisis in September 2008. Within a few weeks, most of the financial institutions either failed or merged to avoid insolvency. The capital markets were freezing and the availability of credit was dramatically reduced. Thus, it became very difficult for the businesses as well as the families to meet their everyday financial requirements (Aytaç, I.A., Rankin, B.H. and İbikoğlu, A., 2015). Soon, the market participants, consumers, and investors lost trust in the financial system of America. This was responded to by the federal government with an overwhelming force and determination so as to stem the panic.

The crisis of such a devastating magnitude that the banks of the nation went through, led the financial institutions to rethink their operational strategies in more than one dimension. The risk faced by a financial institution like a bank is a financial risk which means a chance of losing investment or expected return on investment. The management of risk includes taking appropriate actions so as to minimize the assessed risk which may be in the form of mortgage of assets or high rates of interest etc. The financial crisis led to the development of a post-crisis risk response system in the banks that encompassed a number of risk management initiatives:

Risk management Initiatives

Cultural Control

Shortly after the crisis, it had become a practice to involve all the employees of the organization in the formulation of organizational strategy. The CEOs of the banks used to call the employees as most of them held the view that they had nothing to do with the company strategy. The purpose of including everyone was twofold- one, that each and every employee of the company should feel valued and two, that constructive opinions gathered from a large segment of people would lead to an effective strategy formulation. This proved to be a very democratic and effective approach for the banks. This led to the definition of entirely new cultural references and enabled the employees to move on after the said crisis. The 2008 crisis had to be dealt with the reevaluation of the existing cultural controls. The hiring practices, mentoring programs, and social events were draped with values and value-based training was given more focus. The banking sector had been growing explosively before 2008, therefore finding new talents became a serious issue (Subasat, T., 2016). The modern banks aim at training the new managers and gradually exposing them to the challenges faced by the banks with a view to train and experience such managers in the focus area.

Planning

Prior to the crisis, it was believed that long term planning within a bank wherein the assets were growing by 50-100% per year was difficult. It was almost impossible to keep an overview due to which the risks within the banks could not be focused upon. However, the bank’s market position was redefined after the 2008 crisis and new mission, values, and vision were established. As the crisis settled down, and the businesses regained the normal courses of operations, the importance of long term planning within the banking sector grew. The long term planning enables the management to forecast when new capital is required or when there is too much of it.

Changes in Management Controls

The planning process had not changed much, however, the measurement of success shifted from relying solely on financial measures to including non-financial measures as well which included consumer satisfaction, risk perception, and employee satisfaction.

Cybernetic Controls

The banks did not report any significant changes in the budgeting process post-crisis. Hence it may be concluded that the budget acted as the backbone of the financial institutions that prevented them to get completely swayed away by the turbulence of the crisis. The banks, however, are resorting to practices such as ‘Beyond budgeting approach' in order to avert potential risks. This enables a bank to save time as well as the organizational resources which used to be luxuriously spent on preparing the traditional budget. The traditional budget was inflexible and suffered a risk of being obsolete over time. However, budgeting practices were not significantly changed.

Rewards and Compensation

The rewards and compensation scheme suffered a significantly increased regulatory focus after the crisis. Modern banks have significantly restructured their reward and compensation systems. A number of schemes existed for different classes of employees before the crisis. These schemes were subjected to external regulations. Presently, only 10% of the employees come under the bonus schemes and the total bonus paid to the employees cannot exceed 20% of the annual salary of the employee. In most of the cases, the bonuses are either deferred or affected by clawback clauses. The payment of bonuses and rewards in the modern scenario is based on meeting certain compliance targets. The employees might lose a substantial amount of their bonus if the targets are not met. The strategies were bent to be more customer-centric. The primary objective, as well as basis, of the bonus was linked to customer satisfaction, and not to sales as the latter might amount to inappropriate behavior. The banks had moved from a short term return objective to a long term profit goal.

Administrative Controls

The aim of the administrative control reforms was to establish such an organization that could efficiently deal with the aftermath of the crisis and formulate such written policies and procedures that might formalize the controls within the organization. After the collapse of several financial institutions in the crisis of 2008, a restructuring department was created in the banks. The function of this department was to control the task of assessing the changed operating conditions of the bank and recalculate the financial liabilities as well as assets under these circumstances. The risk management department was provided with more responsibilities and functions. The number of employees in these departments was increased. The importance of formalization of policies and procedures increased along with the training of the employees of administrative departments. It was emphasized that the administrative departments have formally documented control and policies regarding compliance are in place.

The contribution of Management Control Professionals

The role of management control professional to interpret and execute significantly changed. The responsibilities of these professionals included overseeing the entire organizational function in respect of the interpretation and assessment of potential risks. The management control professionals were also responsible to design new values and culture control systems within the organizational framework.

One of the most significant reform post-2008 financial crisis was the Dodd-Frank Wall Street reform. Studies have shown that the Dodd-Frank Act has improved financial stability. The act also protected the customers in a better way than that before the crisis. This was due to the formation of the Customer Financial Protection Bureau (CPFB) which helped in returning over 10 billion dollars to millions of customers by April 2017 (Helleiner, E., Pagliari, S. and Spagna, I. eds., 2018). One of the major reforms was to introduce transparency in the derivative market. Derivative market was one of the primary reason for the worldwide financial recessions, hence transparency was sought in order to change the system. The speculative and proprietary trading was also put under control by Volcker rule.

Since the world had plunged into a financial recession under the Basel II norms, it was necessary to upgrade the norms from Basel II to Basel III. This crisis had brought about a major credit crisis and it was required that the banks maintain more capital. The Basel III norms were aimed at ensuring that the banks are more resistant to the crisis, were transparent towards the public and implemented better risk management policies. This targeted to prevent unexpected shocks during the crisis period. In the purview, the banks’ risk management capabilities were ensured to be more effective than they had been in the past.

The financial crisis of 2008 brought forward a need to implement revised and enhanced financial regulations in several areas including derivatives, capital, liquidity, and consumer protection. Consequently, a large number of rules and regulations were formulated and hastily implemented across the globe. These reforms were aimed at restoring the trust and confidence of the general public in the banking industry. In addition, the financial regulation reforms were also aimed at coordinating the financial reforms across the world as well as harmonize the international banking community. However, it was the time when financial policies, rules, and regulations should have been deliberated upon and cautiously implemented (Aebi, V., Sabato, G. and Schmid, M., 2012).

The Wall Street Reforms and the Consumer Protection Act was attempted in order to address the systematic risk and promoting long term sustainability after having suffered from the financial crisis. However, even after years have elapsed since its adoption, it has been accused of not being able to avert the crisis. In addition, it also failed in the complete implementation of the derivatives which could have assisted in tackling the issue. For instance, one of the many aims of the Act included enhancing systematic risk management within the framework of financial institutions (Reform, F.W.S., Act, C.P. and Protection, C.C.F., 2019). The financial institutions prior to the crisis were labeled formally as investment banks, insurance companies, etc. and not as per the actual tasks undertaken by them. Consequently, it was easy for larger institutions to have their own choice of the financial regulator that would offer the least amount of restrictive supervision. It is important to note that the financial institutions were free to make a choice from a large number of regulatory bodies as the financial sector was the most heavily regulated section of the economy. This resulted in ineffective and lax supervision. The Fed, for example, in addition to acting as a regulatory body for the banks, could also supervise and regulate the financial firms whose failure would impact the financial stability of an institution. As a result, banks, as well as non-banking financial institutions had to face strict capital and liquidity requirements so as to enable them to withstand the adverse financial circumstances.

While some of the higher capital/ liquidity requirements supported growth, the others were found to negatively affect the economy. Researchers also found that the Dodd-Frank regulations resulted to be most onerous to smaller institutions and entities who might not be able to afford a team of lawyers to comply with the requirements of the regulations (Del Prete, S., Pagnini, M., Rossi, P. and Vacca, V., 2017). The researchers also found that the legislation resulted in the decline of entities such as community banks due to the aforementioned reason.

A third agreement by the Basel Committee on International Banking Supervision, Basel III, was also implemented in order to act as a countermeasure to avert the crisis. The idea was to improve the absorption of financial shocks by making effective use of liquidity coverage ratios, monitoring metrics, net stable funding ratios, and establishing the liquidity risk management supervision principles. Basel III, like the Dodd-Frank Act, was a proponent of a higher requirement of the capital, however, it also introduced additional measures under which the banks were obliged to set aside surplus capital during credit expansion and vice versa. These were termed as countercyclical measures. However, this method, too, had its own limitations. Certain researches demonstrated that the regulation increased the borrowing costs for the banks. It was estimated that the required equity to debt ratio would increase by 1.3% and the same would result in increasing the loan rates by 0.16% in such countries that had faced the crisis and 14.8% in such countries that did not face it directly (Altunbaş, Y., Thornton, J. and Zhao, T., 2019). In a similar manner, the increase in the equity requirements, as in Basel II regulations, resulted in the creation of shadow banking. Shadow banking is the term used for the practice of lending, and other financial activities by those institutions which are not authorized to do so i.e. unregulated institutions, or by regulated/ unregulated institutions under unregulated conditions.

After the crisis, the amendments in the financial regulations were meant to either reduce the intensity of the crisis or to nullify the same. This was to be done through an increased capital requirement in addition to reduced leverage ratios and carrying out stress tests at regular intervals. However, the same resulted in a decline in the measures of risk management in the financial market sooner or later. The modern banks, however, have gotten safer in terms of risk handling capabilities. While the financial information of a bank does not provide enough support to the fact whether they have gotten safer than they were before, or during, the crisis; some of the information points down to an increased risk. The same is based on several factors such as the stock price volatility, credit swaps, and stock yields of the major institutions in America and the world. Most scholars do not support further impositions of regulations for the purpose of averting the crisis or preventing a future one. They cite the decline in the franchise value as a result of the imposition of such regulations and the prospect of future impositions. It is believed that further regulations could increase the risk posed to the system in place of pacifying the same.

In light of the discussed facts, it may be concluded that the financial regulations imposed on the banks as well as other financial institutions may not yield as promising results as expected (Gulati, R. and Kumar, S., 2016). The easy money, in addition, in the past decade invites another crisis in the years to come. It is important for the legislators and the policymakers to look at the causative agents of the crisis in a more holistic manner. However, the possibility that the expectation would realize, is very less likely.

References

Aebi, V., Sabato, G. and Schmid, M., 2012. Risk management, corporate governance, and bank performance in the financial crisis. Journal of Banking & Finance, 36(12), pp.3213-3226.

Altunbaş, Y., Thornton, J. and Zhao, T., 2019. The ‘risk dividend’in banks’ internal capital markets (No. 19004).

Aytaç, I.A., Rankin, B.H. and İbikoğlu, A., 2015. The social impact of the 2008 global economic crisis on neighborhoods, households, and individuals in Turkey. Social Indicators Research, 124(1), pp.1-19.

Blundell-Wignall, A., Agarwal A., 2018. The Crisis of 2007-2009: Origins and Causes of the Crisis. In Globalisation and Finance at the Crossroads (pp. 56-109). Partridge India.

Del Prete, S., Pagnini, M., Rossi, P. and Vacca, V., 2017. Lending organization and credit supply during the 2008–2009 crisis. Economic Notes: Review of Banking, Finance and Monetary Economics, 46(2), pp.207-236.

Helleiner, E., Pagliari, S. and Spagna, I. eds., 2018. Governing the World's Biggest Market: The Politics of Derivatives Regulation After the 2008 Crisis. Oxford University Press.

Reform, F.W.S., Act, C.P. and Protection, C.C.F., 2019. Dodd-Frank Act. Pub. L, pp.111-203.

Subasat, T., 2016. The policy-based and conjunctural causes of the 2008 crisis. In The Great Financial Meltdown. Edward Elgar Publishing.

Gulati, R. and Kumar, S., 2016. Assessing the impact of the global financial crisis on the profit efficiency of Indian banks. Economic Modelling, 58, pp.167-181.