Implications of Corporate Governance framework during the Credit Crisis on 3 banks

Abstract

Financial organizations are extremely critical for a stable economy. Through efficient mobilization and allocation of funds, they lower the cost of capital to firms, boost capital formation, and stimulate productivity growth. The credit crisis revealed the fragility of corporate governance and management within several reputed financial organizations. We discuss the cases of corporate failures of 3 financial institutions, namely Bear Stearns, Lehman Brothers and The Royal Bank of Scotland. We highlight certain intangible governance traits common across the 3 organizations such as charismatic CEOs, inability to comprehend the risk and complexities of the business and delay in providing effective guidance. Further, we analyze the latest filings prior to the credit events and contrast the approach of the 3 institutions against the best practices. We recommend an urgent need for external risk consultants that assist the board in better understanding of the risks, and a regular living will filings that provides a recovery plan (for going concerns) and a resolution plan (for “gone” concerns).

Introduction

Several factors contributed with varying degrees of significance towards the buildup of the 2008 credit crisis. (Diamond & Rajan, 2009) highlight three causes: (i) the U.S. financial sector misallocated resources to real estate, financed through the issuance of exotic new financial instruments; (ii) a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; (iii) these investments were largely financed with short-term debt. Similarly, (Baily & Elliott, 2009) state three possible narratives for the crisis: (i) the government intervention in the housing market – principally through Fannie Mae and Freddie Mac – inflated a housing bubble that triggered the crisis; (ii) the Wall Street bankers’ greed, arrogance and manipulation of the financial system, and misaligned incentives, especially in compensation structures that resulted in inflated balance sheets and mispricing of risks; (iii) “Everyone was at fault”- the government, Wall Street, and wider society adopted a lax attitude towards risk-taking and leverage, creating a bubble across a wide range of investments and countries. Interestingly, even the 10-member strong Financial Crisis Inquiry Commission (FCIC) created by the U.S. Congress to investigate the causes of the financial crisis could not arrive at a consensus on the causes for the credit crisis. FCIC’s final report, (Angelides, et al., 2011), had two dissenting statements. One dissenting note from 3 members (Bill Thomas, Keith Hennessey and Douglas Holtz-Eakin) was in line with the third narrative of Elliot and Baily, which emphasizes both global economic forces and failures in U.S. policy/supervision to have contributed in equal measure. The other dissenting note by Peter Wallison endorses the first narrative that the crisis was an outcome of the U.S. government’s housing policy, which led to the creation of 27 MM subprime and other risky loans – half of all mortgages in the United States – which defaulted as soon as the massive 1997- 2007 housing bubble began to deflate

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