Banking on Governance

Leverage and Risk in US Commercial Banking in the Light of the Current Financial Crisis (available from SSRN) by Christian C.P. Wolff and Nikolaos I. Papanikolaou examines the relationship between leverage and risk in US commercial banking market. From their abstract:

Our findings indicate reliably that both on- and off-balance-sheet leverage contributes to (systemic) risk, which implies that large banks do not maintain a level of leverage that could allow for equity capital to act fully as a buffer, absorbing losses and enabling the business to continue in case of financial distress. In a similar vein, a direct link between short-term leverage and risk is reported, showing that leverage is one of the main factors responsible for the serious bank liquidity shortages that were revealed in the current crisis. We also find that those banks that concentrate on traditional banking activities typically carry less risk exposure than those that are involved with new financial instruments. The latter finding could play a role in the current discussion about a possible revival of the Glass-Steagall Act. Overall, our results provide a better understanding of the main causes of the present crisis and contribute to the discussion on the reinforcement of the existing regulatory framework.

Reforming Governance of ‘Too Big to Fail Banks’ – The Prudent Investor Rule and Enhanced Governance Disclosures by Bank Boards of Directors (available at SSRN) by Michael Alles and John Friedland looks at the governance challenges posed at boards of large banks, since they have proven inadequate to the task of controlling risk. From the abstract:

We propose a two step procedure to improve bank governance. First, we give bank directors an explicit standard to assess the outcome of their actions: the Prudent Investor rule which is the requirement for trusts, but has been replaced in the last hundred years by the less stringent Business Judgment rule. Adopting the Prudent Investor rule would return to director’s responsibility to control the risks of banking activities. To enforce the higher standard, we propose to use disclosure as a disciplining mechanism. We base the new disclosure regime on Section 404 of the Sarbanes Oxley Act that requires managers to implement controls over the firm’s financial reporting processes and to publicly attest to their effectiveness. This section failed to prevent the credit crisis because it was too narrowly focused. We recommend that the provision be broadened to encompass governance controls in general, and that responsibility for disclosure be placed on the bank board rather than on managers.

Ah, if only academics had a bigger role in ruling the world.