Governance, Regulation and Bank Stability

The financial crisis revealed severe weaknesses in the governance, regulation and stability of banks. The considerable economic impact of the crisis on the businesses of many individual banks is today well documented and so is its effect on systemic risk and the increased threat to the stability of the financial system as a whole. The content of this book is mainly driven by the challenges banks and other financial institutions are facing in the aftermath of the financial crisis. A number of governance related topics, and responsibilities within and outside the financial system have been, and are, discussed alongside the re-regulation of the banking industry through a gradual implementation of the proposed and continuously updated Basel III standards. The institutions that constitute the financial system infrastructure are not only preparing for possible worst-case scenarios but also for a stable, healthy and sustainable banking industry. The title of this book — Governance, Regulation and Bank Stability — intends to capture the important challenges that lie ahead, in the search for a sounder banking industry: challenges that not only comprise the probability of default for systemically important financial institutions (SIFIs), but also promote efficiency in everyday banking operations.

The subprime crisis of 2007–2009 was the most devastating financial crisis since the Great Depression, cost the US economy trillions of dollars (see Atkinson, Luttrell and Rosenblum, 2013) and caused significant economic stress worldwide.¹ In response, new financial-market regulations were adopted in many countries, including the Dodd-Frank Act in the US, which is a massively complex piece of legislation that touches most financial intermediaries in significant ways and imposes a host of new proscriptions and requirements on all sorts of intermediaries. Moreover, the crisis also required unprecedented government intervention in the financial market and the real economy, with the issuance of ex post guarantees against failure to a multitude of a priori uninsured investors and institutions, in order to stave off a complete collapse of the financial system. While there is much debate over whether the regulatory interventions were the appropriate ones (see Lo (2012), and Thakor (2013b) for detailed discussions), these interventions raise concerns about potential moral hazard insofar as expectations of future bailouts may influence present behaviour, and greater political involvement in the functioning of credit markets (see Song and Thakor, 2012).

Recent initiatives by banking supervisors, central banks and other authorities have emphasized the importance of corporate governance practices in banking sectors (see, e.g., Basel Committee on Banking Supervision, 2010; Board of Governors of the Federal Reserve System, 2010; OECD, Organization for Economic Cooperation and Development, 2010). The policy makers constantly — and with considerable effort since the subprime crisis broke out — try to improve current legislation to enable better monitoring of bank activities, including their risk-taking. It is widely recognized that the recent financial crisis is to a large extent attributable to excessive risk-taking by banks and that shortcomings in bank corporate governance may have had a central role in the development of the crisis. An OECD report argues that, ‘the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements’ (Kirkpatrick, 2009). Moreover, the crisis revealed the potential, underestimated consequences of unregulated systemic risk-taking by banks. As suggested by de Andres and Vallelado (2008), the main aim of regulators, which is to reduce systemic risk, might come into conflict with the main purpose of shareholders, which is to improve the share value by increasing their risk-taking. More recently, the National Commission on the Causes of the Financial and Economic Crisis in the United States concluded that, ‘dramatic failures of corporate governance…at many systematically important financial institutions were a key cause of this crisis’ (Beltratti and Stulz, 2011).

The recent financial crisis demonstrated the crucial importance of corporate governance for the safety and stability of financial systems. The introduction of very complex and sophisticated prudential rules — Basel II above all — in the years before the crisis was unable to prevent the fact that banks could assume a volume of risks that they were incapable of managing in conditions of stability.

The global financial crisis has brought a large number of banks to the brink of collapse, including several European banks¹, stressing the importance of detecting early signals of bank distress in order to activate prompt corrective actions. Indeed, identifying weak banks early is crucial, especially when problems are identified late, as solving them is much more costly. So in light of this, it becomes critically important to make use of data and indicators that can help supervisors and investors to discover which financial institutions are at risk of distress.

The post-crisis reform period in Asia has been characterized by an emphasis on the prudential regulation of banks, concomitant with an increased liberalization of the banking systems. More specifically while large-scale bank restructuring programmes and tighter prudential rules were put in place in those countries most affected by the 1997 crisis (e.g., Thailand, Indonesia and the Philippines), other countries, such as China, India and Vietnam, saw an acceleration of financial liberalization over the same time period. This process resulted in substantial changes in market structure, deriving both from greater foreign presence and from increased privatization across the region.

Before the 2008 crisis, financial deregulation and market efficiency were considered to be the regulatory pillars, particularly within the Basel II framework. The 2008 crisis resulted in the adoption of a new regulatory philosophy: that of strengthening and tightening regulatory supervision (Beck, 2010). Basel III focused on strengthening prudential regulations, mostly by requiring more, and better, capital and better loss-absorption capacities by large banks (BIS, 2010). EU and US authorities have supplemented Basel III by instituting complex supervisory infrastructures, based on a number of newly created institutions together with a redefinition of the objectives and prerogatives of those already in existence. In many cases, these new regulatory structures are diamond-shaped, rather than ladder-shaped (Masciandaro, Nieto and Quintyn, 2011). The complexity of banking regulations, plus overlapping prerogatives on newly created institutions, have considerably increased regulatory costs and are thus a burden on banks (KPMG, 2013). Moreover, in the EU, the new institutional safety net has not been implemented consistently and has been more of a case of constant rearrangement according to changes in macroeconomic priorities: from financial stability (European Banking Authority-based framework) to financial growth (European Central Bank-based framework), which has led to increased organizational uncertainty and chaos.

This chapter sets out to analyse the impact of the financial crisis, in particular since the start of the sovereign debt phase, on Italian banks and their intermediation model. The Italian banking and financial system showed more resilience than other national systems in the first wave of the global financial crisis, the so-called subprime phase (2007–2008), but the impact was much more severe in the second, sovereign debt and redenomination risk phase (2010–2012), and the system continues to show major signs of difficulty in the current phase of deep economic recession.

This chapter addresses the subject of diversification in the Italian banking sector. The Italian banking system represents an ideal experimental setting since it is characterized by a heterogeneous range of banks. The processes of deregulation, innovation and consolidation during the 1990s prompted a new competitive contest within the banking system, which forced new managerial strategies to emerge from attempts to find new opportunities in terms of increased profits.

The global financial crisis started in 2007, the economic downturn which followed and, the effects of the sovereign debt crisis, caused a relevant slowdown in banks’ lending in Italy. As reported by the Bank of Italy (2008, 2009, 2010, 2011) banks’ lending to customers slowed down consistently between 2008 and 2011, in spite of a slight recovery registered in 2010. Although basically widespread, this phenomenon was more intense for the larger banks than for the smaller ones, mainly reflecting different funding constraints. In particular, large intermediaries generally faced more difficulties in wholesale funding on the interbank market, especially after the start of the global financial crisis in 2007 (Bank of Italy, 2008) and cause of the effects of the sovereign debt crisis (Bank of Italy, 2011; Albertazzi et al., 2012).

The amount of literature and the research produced about reputa-tional risk in banking has grown rapidly (some of the contributions are: Fiordelisi, Soana and Schwizer, 2012; Gillet, Hubner and Plunus, 2010; Sturm, 2013) due to the obvious responsibilities of the banking and financial industry in the economic crises that have emerged since 2007. In banking studies attention has been paid to reputational damage stemming from operational risk events and losses: as often, when debating risks in banking, more effort has been dedicated to measuring effect rather than understanding the real determinants of risks and losses, and offering suggestions about how to manage risks and their causes. Having noticed a lack of or insufficient information on corporate reputation (CR) and reputational risk (RR) in the banking industry in the mainstream literature, we try to go back to basics and justify, both theoretically and practically, the need for new approaches and practices. We think that it can be useful to pick up information on how stakeholders observe and exchange opinions about reputational facts and events connected with decision-making processes and actions inside the banks.