13 What Has Changed: How Little Has Changed in Terms of Complexity, Producer Managers and Absent Management in Banking

CHAPTER 13

What Has Changed: How Little Has Changed in Terms of Complexity, Producer Managers and Absent Management in Banking

Having mentioned plagues in relation to the Florentine bankers in the fourteenth century, it is illuminating to compare the historical ability to manage major global crisis of health and finance. The Plague killed over a third of Europe’s population in the fourteenth century, and as a side effect caused the failure of the Medici predecessor banks in Florence. The influenza epidemic in 1918–1919 may have killed between 50 and 100 million people worldwide or between 3 and 5 per cent of the world’s population. Since then there has thankfully been a considerable improvement in the containment of medical epidemics. More recent outbreaks of plague, such as the Ebola tragedy in Western Africa in 2013 that caused the loss of over 11,000 lives, were contained mainly to the unfortunate countries of Guinea, Liberia and Sierra Leone and eradicated within three years from its outbreak. This is a remarkable, historical improvement in containing medical crisis.

Compare this to the 2008 financial crisis. Importantly this probably caused mainly material losses rather than human life. However this financial crisis was not contained to a few countries but went global and spread from individual country’s banking crises to become an international sovereign crisis affecting dozens of countries. There had been no improvement in containing financial crisis such as the Great Recession to one country compared to the Great Depression nearly 80 years earlier. The Great Recession is still widely felt in many countries through personal and

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_13 245

corporate financial loss, continued political and economic austerity and significantly tightened financial regulation and fines of banks. In the days of the Medici, there was little ability to geographically control either medical epidemics or financial crises. Since then we have improved our capabilities to contain medical but not financial crisis.

And perhaps the recent financial crisis did not just cause material loss and misery. How long we can expect to live in has increased fairly steadily since the end of the Second World War in most countries, but this increase has almost stalled in the Western World since 2009. This reduced increase in life expectancy in the Western World (Campbell 2017), for example in the United Kingdom, may have been influenced by government austerity and reduced social spending, in turn caused by the recent banking crises. If this is correct, and the evidence is not conclusive, banking crises may have significant health implications. So while we are much better at controlling medical crises from spreading geographically, financial crises still spread very rapidly globally and may even have health implications in addition to the devastating costs and stress.

Absent management in banks is caused by a combination of complexity and the producer manager approach. Absent management can cause a bank to fail, as we have seen many examples. Bank failure is bad enough in itself, but it also has the ability to cause a crisis, to make another type of crisis much worse or both. This chapter will look at what has changed in terms of complexity and the producer manager approach since the 2008 financial crisis. It will finish with three recent yet to be historical examples of possible absent management in banks.

The loosening of bank regulation was widely perceived to have been a cause of the bank failures and the 2008 financial crisis. In this book the argument is that it is the management of banks that matters most in terms of bank failure. Regulation provides rules. And these rules are applicable to all banks. But all banks do not fail in a crisis and nor did all banks fail in the 2008 financial crisis. It is not logical to argue that loose regulation caused some banks to fail. So management is the determinant of failure, not the rules and regulations.

A loosening of rules allows banks to do things that may make failure more likely. But it is the management of banks that decides what the bank does. So it was not the loosening of regulation that caused banks to fail. Loosening of rules allowed the management of some banks to take actions that caused them to fail. A former Lehman Brothers executive, who still works in Wall Street, was quoted as saying in 2017: “At the end of the day,

the crisis was the banks’ fault. You can’t blame the regulator - just because a gun is left sitting on the counter, it doesn’t mean you have to pick it up and shoot someone” (Jenkins 2017).

And almost whatever the rules, if there is absent management the risk of failure is greater. So regulation should ensure that banks are managed. But changes in regulations in the last three years have not significantly addressed two of the causes of absent management in banking, namely complexity and the producer manager approach. In some ways regulation has made absent management more likely, which will be described later. So as far as regulation is concerned the absent management in banks continues, as will be seen at the end of this chapter.

After the financial crisis the primary aim of regulation was to stabilise the financial system and then to stimulate demand by restoring the ability of banks to provide credit. As seen in the previous chapter on the cost of the financial crisis, stabilising the financial system was achieved by injecting taxpayers’ money into banks, primarily paid for by increasing government borrowing and taxation and reducing other government expenditure. Restoring demand in the economy was firstly done by dramatically reducing interest rates and keeping them low. Secondly central banks, particularly the Federal Reserve and the European Central Bank (ECB), both of which are ultimately backed by taxpayers, dramatically increased their balance sheets by buying astronomical amounts of bonds, particularly corporate bonds. The Federal Reserve balance sheet increased more than four times to over $4 trillion from 2008 to 2014 and has only very recently begun to descend from this plateau. The European Central Bank balance sheet more than doubled to over €4 trillion and has shown no signs of reducing yet. This bond buying became known as quantitative easing. Once the banking and financial crisis had become a sovereign crisis in Europe, the head of the European Central Bank said that, in order to secure the European Currency: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” (Draghi 2012).

In 2009 the United States introduced stress test for banks to determine how much capital they would need in various crisis situations. This information was then made public and did much to restore confidence on many of the banks’ financial solidity. Stress tests were also seen as superior to the banks’ internal, risk-based capital models that had not prevented their failure. Stress tests are parameters, in this case decided by the regulator, that banks have to model in order to understand what their capital

strength will be after the occurrence of specific negative events, for example, a fall in the value of real estate. The Federal Reserve then required the banks that had received support to raise capital to be able to pay the support back to the government (Tarullo 2016).

These regulatory measures and interventions prevented another Great Depression, but not a Great Recession. However, important historical lessons had been learnt and, crucially, the economic collapse of the 1930s was prevented (Wolf 2018).

These measures contrasted sharply with the actions of central banks after the Great Depression. Then banks were allowed to fail in their thousands culminating in the shutdown of the United States banking system on the Bank Holiday in March 1933. And the Federal Reserve did not expand the money supply. When a central bank buys government bonds, this increases the amount of money or cash in circulation. When a central bank reduces the rate at which commercial banks can borrow, the discount rate, this also increases the money supply. It was this historical lack of action in not expanding the money supply, as was done by quantitative easing, that the Governor of the Federal Reserve apologised for when he said in 2002 that “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again” (Bernanke 2002).

The second aim of regulation after the 2008 financial crisis was to prevent a recurrence. Here a possible historic mistake was made. Regulators accepted the status quo of banks and decided to regulate banks as they were rather than change the banks. In particular regulation did not make banks less complex and therefore more manageable or at least possible to manage. This was also in contrast with regulatory changes after the Great Depression and the Glass-Steagall Act of 1933 which separated commercial and investment banks. This Act was the most important regulatory measure ever to make banks less complex. And this simplification of banks by regulatory measures made the banks easier to manage, even for producer managers. This regulatory simplification in turn made absent management less likely, thereby making bank failure less likely. And less bank failures made financial crisis less likely and less severe.

So while the United States did not repeat the mistake of not expanding the money supply, the regulatory success of simplifying banks after the Great Recession was not repeated.

Because no single capital measure can capture all possible sources of loss, United States banking regulation had for three decades required both a leverage ratio and a risk-based capital requirement. In responding to the

crisis, regulation applied a higher leverage ratio and stronger risk-based capital requirements, including a stress testing programme, to larger banks.

To some extent the United States regulatory response after the 2008 financial crisis was more of the same. In response to the crisis regulators requested a lower leverage ratio and stronger risk-based capital requirements than had been in place for three decades (Tarullo 2016). This did not question the regulatory approach that had allowed the 2008 financial crisis, merely that the approach had not required low enough leverage ratios and high enough levels of capital. But stricter leverage and capital rules did not address absent management of in banks.

Implementing complex regulation after the 2008 financial crisis meant that the battle against future bank failure and crisis may have been lost before it was begun. There are several reasons for this. The more complex the regulation the more difficult it will be to implement and supervise. Firstly large banks will always have greater resources than regulators. When the teams of highly paid bankers arrive to discuss regulation with their regulatory supervisors, these supervisors will have the power of the law behind them. But the bankers will have the most skilled and highly paid specialists, sometimes including former regulatory supervisors, now much higher paid. Within the framework of the law, the bankers will win. And the bankers will be highly, sometimes very highly, incentivised to take advantage of any complexities within the new regulation. And the more complex the regulation the more possibilities for taking advantage.

When a large amount of the regulation is focused on capital, this gives the banks another, second advantage. Capital is what bankers do. Capital is one thing bankers do know how to manage. In the game of capital management regulators are there to enforce the rules, but bankers are the experts at playing the game.

A third reason why complex regulation may defeat the objective of preventing future bank failure is that the more complex the regulation the more it drives consolidation of banks. The larger banks are able to dedicate significantly greater resources to regulation than smaller banks. This gives them a competitive advantage in being able to understand regulatory complexity and to extract any available advantages. So the complexity of the postcrisis regulation is likely to have made banks larger and more complex and therefore more difficult, or less possible, to manage. This may contribute to, rather than prevent, future bank failure.

One possible approach would now be to go through the very extensive and highly complex regulations implemented since the 2008 financial

crisis to prevent it happening again. Others have done this, in both expert and sometimes excruciating detail. A simpler, different and hopefully additive and helpful approach is to consider what has not been addressed by regulation, what is absent from regulatory change. It is also worth considering why regulation in some cases has made things worse, but mainly why regulation has not addressed the causes of absent management in banking.

Banks are now subject to regulation by more authorities compared to before 2008. In the United States nine federal agencies and several state agencies regulate the financial sector (Bruner 2018). In the United Kingdom the Financial Services Authority was abolished in 2012 and replaced by the Prudential Regulatory Authority and the Financial Conduct Authority. Both regulators were returned to come under the Bank of England. Previously, the Bank of England had been the regulator of banks but lost this role in 1997 when it was given its independence from the Government. This was when the Financial Services Authority had been established to regulate the financial sector together with the Treasury and the Bank of England, partly in response to criticism of a failure of the Bank of England to do this adequately on its own.

More than one regulator is obviously more complex for banks than being subject to a single regulator. Conversely the management of a single regulator would be a highly complex task for those taking on this challenge. However risks exist that with more than one regulator gaps may occur between them. An important conclusion is that banks remain significantly too complex to be regulated by one entity in the United States and the United Kingdom. This is strong evidence that bank remains complex and perhaps increasingly so.

The United States Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 is a comprehensive set of new regulations having the aim of making the United States financial system sustainable. It was signed into law on 21 July 2010 and is the most significant national regulation enacted in response to the financial crisis encompassing 2300 pages and some 400 rules. Amongst the many rules it introduced is a resolution regime to allow the orderly winding down of failed banks including authorising the Federal Reserve to extend credit in “unusual or exigent circumstances” (Minor and Persic 2012). The Act also aims to monitor bankers’ compensation.

The Act did contain some rules reducing the complexity of banks, including the so-called Volcker Rule. Under this rule, “large, systemically important banking institutions should be restricted in undertaking

proprietary activities that present particularly high risks” (Group of Thirty 2009). This means that banks would be restricted from trading for their own book. Commercial banks would also be prohibited from owning hedge funds and private equity firms.

Regulators would now be able to identify both banks and non-banks as ‘Systemically important’ and subject to additional supervision. A systemically important firm is one that could pose a threat to the financial stability of the United States if it failed or engaged in risky activities. Any firm designated a systemically important firm is subject to stricter oversight from the Federal Reserve, including stress tests, writing bankruptcy plans known as living wills and meeting stricter capital requirements.

By early 2017, 275 of the 400 rules had become law, while some 125 had not or not yet. In February 2017 the president of the United States signed an executive order to review the Act.

The Dodd-Frank Act did not include recommendations on capital adequacy. This was to be enacted under international rules with Basel III providing this complement to the act (Blaylock and Conklin 2010).

In 1974, following the abolition of the international Bretton Woods currency management system in 1971, the Group of Ten central bank countries, later to grow to the Group of Thirty, established the Basel Committee on Banking Supervision at the Bank for International Settlements. The aim was to promote cooperation in international global banking regulation with a primary focus on ensuring that banks have enough capital. The committee has no power to impose its rules on member countries or to regulate banks. The publishing of the so-called Basel I in 1988 was a response to deteriorating capital in many banks in the early 1980s. This was later replaced by Basel II in 2004. In December 2009 the Committee published what became known as Basel III consisting of the International Framework for Liquidity Risk Measurement, Standards and Monitoring and the Strengthening the Resilience of the Banking Sector in response to the 2008 financial crisis (Basel Committee 2010). Basel III recommends a more sophisticated and also more complex approach to capital held by banks. This involves increasing the quality, consistency and transparency of the capital held by banks while reducing the required capital ratio to 7 per cent (Basel Committee 2010).

Designing global bank regulation is obviously a complex task not least because of the global aspect. However the more complex the approach the less able the system may be to accommodate local requirements, often based on tradition and culture, even path dependencies. A completely

consistent global regulatory system is highly unlikely to be achieved for these reasons, but also because some countries are keen to attract banks with less stringent regulation. This may make such countries more prone to future bank failures and crisis (Blaylock and Conklin 2010).

Countries have taken different approaches to the adoption of the Basel III rules. Canadian regulators support a principle-based regulatory system rather than one based on rules. A principle-based approach uses general frameworks to guide banks’ compliance without establishing specific rules. This principle-based regulation requires banks to establish their own risk management with the regulator focused on the quality of controls and stress testing to anticipate problems and crisis. Canada has never had a banking crisis (Arjanil and Paulin 2013). That is worthy of attention as not many developed countries can say the same. Following the failure of two small banks Canadian Commercial Bank and the Northland Bank of Canada in 1985, which did not result in a crisis, regulation was improved. This included the establishment of the Office of the Superintendent of Financial Institutions in 1987, consolidating various supervisory activities. The Financial Institutions Supervisory Committee was also established to coordinate activities by the Superintendent of Financial Institutions and the Governor of the Bank of Canada, the Deputy Minister of Finance and the President of the Canadian Deposit Insurance Corporation (Arjanil and Paulin 2013).

Compared to many other countries Canadian banks were more resilient to the 2008 financial crisis. The largest Canadian losses from subprime were Canadian Imperial Bank of Commerce with $3 billion and Royal Bank of Canada with $1 billion ranked 24 and 37 amongst world banks’ subprime losses respectively (Wikipedia 2010).

A principles-based supervisory approach puts the onus on banks to prove that they are compliant with the principles laid out by the regulation. The Canadian regulator evaluates each bank according to its approach and has extensive authority to provide guidance for improvements backed up by extensive legal powers to enforce compliance with the guidance. Risk management has been a strongly emphasised principle since the establishment of this supervisory approach.

Canadian regulation also has rules and these were earlier and stricter in terms of quality of capital and leverage than in the United States and the United Kingdom. However a greater emphasis on banks having to prove their adherence to principles to the regulator may have created a stronger culture of management. This means that the banks have to show that they manage their risks, not just that they follow regulatory rules.

The relatively benign crisis may have been because Canadian banks were responsible for their own risk management (Blaylock and Conklin 2010) and, as should always be the most important requirement of any bank, to manage themselves.

A principle-based, rather than a rules-based, system of regulation may also have advantage in terms of dealing with financial innovation. A rulesbased system will never do better than playing catch up with innovation. It is not possible to make rules for an activity that has not been fully thought of yet. The onus is on bank management to prove it can manage the new activity. This may but does not guarantee better management than following regulatory rules.

Principle-based regulation will require that regulators become much more focused on regulating management rather than balance sheets. Many current regulators have highly numerical capabilities but are perhaps less experienced and skilled in assessing management. Principle-based regulation would require at least significant training of existing regulators and probably changes to recruitment of differently skilled people, with experience of management rather than numbers.

However a principle-based approach utterly failed in the United Kingdom including in the case of Northern Rock. This was probably partly due to the lack of rigour in the supervision as this was remote and intermittent rather than close and continuous as had been the regulatory intention (Black 2010).

Principle-based regulation may encourage banks to be managed rather than just complying with rules. It does however require a significant regulatory effort, not just in terms of sustained diligence but also in having the resources to understand the complexities of banks and whether they are being managed. This effort may be so great that it is beyond regulators and one reason why rules-based regulation remains the dominant approach in developed countries.

In the United Kingdom, there is now much increased focus on the senior executives who occupy ‘significant influence functions’. Banks have to produce an organisation chart naming a range of senior executives and their responsibilities. Those holding the positions can be subject to interviews by the regulators and to receiving a regulatory ‘no objection’ before they can take up the post. There is also a greater responsibility on board of directors, including those who are not executives and expected to be independent (Black 2010). This Senior Manager and Certification Regime has the potential to make a positive difference in reducing absent manage-

ment in banking. By making individuals personally responsible for specific activities it can be expected that these individuals will pay greater attention to manage these responsibilities. However the activities have to have a level of complexity that is manageable and incentive structures have to be aligned with the responsibilities. Only time will tell if this new regime will reduce absent management.

Banks in most major economies are now backed by an estimated ten times the equity capital than before the financial crises (Editorial Board 2018). There is no doubt that a larger amount of capital provides a greater cushion against bank failure. However much larger levels of capital put greater pressure on banks to achieve what many and perhaps all of them still consider their primary objective, which is making an attractive return to shareholders. This increased pressure could incentivise banks to take greater risks in search of greater returns. It will certainly make banks explore every avenue in their most expert domain of capital to extract every possible advantage from the regulations.

Significantly important banks have submitted a ‘living will’ to regulators that can be implemented in a crisis and assist in an orderly winding down (Editorial Board 2018). This rule is a central pillar of the DoddFrank Act and has been replicated in other countries including the United Kingdom. While a plan for an orderly wind down appears to be a sensible precaution to mitigate the need for taxpayers to bail out banks, the functioning has yet to be tested. It is possible to imagine it working for a single bank that has overextended itself. It is perhaps less credible in a full blown banking crisis where several major banks fail.

Another increase in the complexity of banks’ capital is the introduction of ‘bail-in bonds’. These bonds are intended to assist in an orderly wind down of a failing bank, by converting from a bond into equity. The bank would no longer be obliged to pay back the principle of the bond and investors could no longer expect to receive back the money invested. Bond investors receive a higher premium for these bonds than for more traditional bonds due to this risk of becoming an equity rather than a bond investor (Editorial Board 2018). Making bond investors take more risk in banks provides an additional cushion, but it also adds significant complexity to the composition of the capital of banks.

Basel III also recommends a leverage ratio that includes monitoring leverage outside the banks’ balance sheet. This should overcome the expansion of leverage both on and off balance sheet seen before the financial crisis.

On liquidity the Basel III recommendations seek to improve banks’ resilience to periods of low liquidity with both short- and long-term liquidity ratios. Stress testing is recommended including such stresses as a downgrade of the bank’s public credit rating, a partial loss of deposits, a loss of unsecured wholesale funding and an increase in call for collateral under derivative contracts, all of which were experienced in bank failures in 2008 as we have seen.

Implementing Basel III rules is a decision of national governments and their regulators. By the end of 2017, all 24 of the countries had adopted core elements of the capital and liquidity rules. All countries with globally systemically important banks have enforced final rules on higher loss absorption. This often means banks issuing bail-in bonds. Final rules on higher loss absorbency requirements for domestic systemically important banks have been implemented in 23 countries. However, rules on leverage and funding are only in force in 15 and 11 countries respectively. The aim is for all rules to be implemented by 2022 and phased in over five years. That is 20 years after the beginning of the financial crisis in 2007 (FSB 2018). This would create comparable regulation in the major countries but taking more than two decades to be implemented. The complexity of the rules and regulations is one reason why implementing will take so long. There is also a danger that the time to implement such complex global rules will cause individual countries to adopt different rules because they are unwilling to wait for the implementation. Finally, some countries may delay implementation because they are concerned about losing competitive advantages for their banks compared to other countries that delay implementation.

Consistent global rules have the attractions of reducing competition between regulators to attract banks to locate in their country. However concerns have been raised that consistent rules, globally as well as within countries, can result in banks behaving uniformly in a crisis. Such behaviour might make a crisis worse, such as when many banks seek to sell the same type of assets because regulation makes these assets onerous to own, for example due to a downgrade of the credit rating of this type of asset (Plender 2017). However, without such regulation banks could easily all decide to divest certain assets by simply acting according to market movements and without consistent regulatory rules.

Increased regulation has caused consolidation as it nearly always does. It has also meant increased complexity. It is a dangerous irony that regulations that were concerned about banks that were too big to fail have

caused banks to become larger and therefore more complex. J.P.Morgan’s investment bank chief acknowledged this irony in 2018 when he said that “When you think about the amount of capital, liquidity, the increase in the control environment, compliance, risk - all the things we have to do - [then] the more you put through the pipes, the [cheaper] it is” (Weber 2018).

The 2008 financial crisis made some very large banks bigger. Increased regulation, particularly significantly increased and complex regulation, has the effect of consolidating the banks being regulated. The first regulatory measures were the government-supported takeover of Bear Stearns and later Washington Mutual by J.P.Morgan. These actions were instrumental in making J.P.Morgan first the largest investment bank in the world and then the largest universal bank in 2008. After the acquisitions introduced by the crises, and a decade of growth since then, if one of the largest banks in the world was to fail, in spite of its increased capital and more restrictive leverage and funding, the consequences might be unprecedented (Editorial Board 2018).

Some banks were too big and complex to be manageable before the crisis. The regulatory interventions have done little to reduce this risk but have increased the size and complexities of banks. As one experienced commentator said in 2017:“Many are simply too big to be manageable. J.P.Morgan Chase is widely regarded as the best managed international bank. But when a group of traders lost $6bn in 2012 in the so-called London Whale scandal it was clear that top management in New York had absolutely no clue as to what was going on” (Plender 2017). We will return to the London Whale at the end of this chapter.

As has been the case historically, and particularly since the 1970s, as banks grow, they become more difficult to manage. HSBC was supposedly surprised by the more recent problems in its Swiss private banking operation. Problems more than a decade old emerged in 2015 at which time the chief executive officer said, “Can I know what every one of 257,000 people is doing? Clearly I can’t” (Hill 2015). The statement is literally correct, but it is also an admission of potential absent management.

While some regulation has yet to be implemented other regulation is being loosened ten years after the 2008 financial crisis. In 2009 the Federal Reserve introduced regulation that required a deep regulatory probe of any bank merger exceeding $25 billion. In the period 2010 to 2017, the total value of banks merging in the United States has been below $50 billion per year. In the previous period from 2005 to 2009 it was only below $50 billion in one year. The threshold for mergers requiring deep regula-

tory probe has been lifted to $100 billion from 2017, loosening regulation for bank mergers below this level. Additionally, the Federal Reserve would grade management teams from one to five with four or five being required to achieve regulatory approval for a merger. From 2017 this scale will lose a grade and be reduced to one from four. This will probably result in more management teams being acceptable to merge banks. Finally the level at which the strictest on-going regulation is required has been increased five times from banks with $50 billion of asset to only apply to banks with assets above $250 billion (McLannahan 2018b). The result is that more smaller- and medium-sized banks can merge into large banks that will be more complex and therefore more difficult to manage.

In February 2019, the two banks, bb&t and SunTrust, announced a $66 billion merger, by far the largest since the 2008 financial crisis. The new bank, Truist Financial Corp. will be the United States sixth largest commercial retail bank and the fifth largest deposit holder with $332 billion. Citi holds around $500 billion of deposits while the three largest, Bank of America, JPMorgan Chase and Wells Fargo all hold over $1 trillion in deposits (Economist 2019).

Perhaps the largest gap in regulation has been the lack of any restrictions on what lines of business banks can operate in. The Glass-Stiegel Act of 1933 separated commercial and investment banks. British banks were prevented from stock market activities until the Big Bang in 1986. The loosening of regulations of what types of activities any one bank can undertake made banks more complex to manage and contributed to absent management. But little regulation has been introduced to simplify banks activities and thereby make absent management less likely. This may be the single greatest error in regulation, an absence of regulation that does nothing about absent management in banking.

The Vickers rule in the United Kingdom came into force on 1 January 2019, more than ten years after the 2008 financial crisis, as part of the Financial Services (Banking Reform) Act 2013. Under this rule banks can operate as both commercial and investment banks but must ring fence the deposits of core retail banking. The intention of the Act is that it will make banks safer because if one part of the bank fails, it will not affect the other part (HM Treasury 2017). That may have some validity, although the examples of some universal banks during the 2008 financial crisis appear to have been forgotten. Banks such as UBS saw significant outflows from its wealth management business, where clients’ assets were completely separate or ring fenced, due to problems in the investment bank. Whatever

regulatory ring fencing the Vickers rule will introduce, it cannot prevent depositors from withdrawing their deposits if they have concerns about problems in the investment banking part of a universal bank. Ring fencing may not persuade depositors that their deposits are safe.

This also questions the aim of the Vickers rule that the government will not be required to bail out the bank. If problems in the investment bank cause it to fail, the government may allow it to do so. If the failure causes depositors to withdraw their deposits, however ring fenced they may be, the government may find itself in the situation that the retail bank has to be rescued to stop the bank run, and avoid possible contagion spreading to other banks.

Another aim of the Vickers rule is that the ring fencing will make the bank simpler. This is hard to credit given that the top management will still have to manage both investment and commercial banking activities. Ring fencing does not necessarily make this simpler and could in fact make it more complicated, particularly in a crisis. Only divestment of one of the activities would truly make a bank simpler to manage.

Regulators have made some specific requirements for banks to reduce their activities. They have however been so limited as to make little impact on the size of the bank and therefore, most likely, in reducing complexity. In the United Kingdom Lloyds was forced to divest the TSB retail operation. This is estimated to have cost Lloyds £2.5 billion to carry out, but importantly the divestment reduced Lloyds’ asset by less than 3 per cent. Similarly, RBS was requested to divest Williams & Glyn with its 300 branches, which also amounted to less than 3 per cent of RBS’ assets. After eight years, regulators abandoned the request as RBS argued that no suitable buyer could be found. The process still cost RBS more than £1.5 billion (Samuels 2016).

There has been no regulation to reduce banks geographically. Operations outside a bank’s home country add significantly to the complexity of managing the bank, but this has remained unchanged. International operations also dramatically increase the complexity of regulating a bank, both for the regulator in the home country and where the bank has subsidiaries. Coordination between head office and subsidiary regulators is complex, particularly where the supervisory rules differ significantly. Such differences offer opportunity for banks to exploit to achieve the most favourable regulatory treatment for its activities.

Some banks decided to reduce some of their activities themselves. Regulatory pressure may have played a part in these decisions. UBS has

reduced the capital employed in its investment bank by one-third to SFR8 billion to focus more on wealth management. Other banks may reduce their involvement in a sector or geographically, such as Deutsche Bank’s announcement that it will reduce investment banking outside Europe (Deutsche Bank 2018).

In the United States, all investment banks were made to become commercial banks from a regulatory point of view as part of the initial regulatory intervention in 2008. One of the reasons was to allow them to access the Federal Reserve discount window for liquidity assistance as this was previously only available to commercial banks. With Bear Stearns and Lehman Brothers having failed and Merrill Lynch being taken over by Bank of America, only Morgan Stanley and Goldman Sachs remained as major, pure investment banks, which had to become commercial banks from a regulatory point of view. Both confirmed they would make this conversion on 21 September 2008. Goldman Sachs became the fourth largest bank in the United States.

Somewhat surprisingly Goldman Sachs have since expanded into retail banking at the end of 2016 through an entity named Marcus, after its founder Marcus Goldman. Marcus has subsequently expanded into the British retail market. Given the existing and long-term complexity of Goldman Sachs, this expansion may not add much in terms of additional complexity. However it is noteworthy that the largest pure investment bank, which survived the 2008 financial crisis better than most, is taking on more complexity. This is also a sharp contrast to the simplification of regulation after the Great Depression that has been almost completely absent after the Great Recession.

A further increase in complexity in European banking would have been likely if a merger between Deutsche Bank and Commerzbank had gone ahead. It would have been possible to devote more attention to Deutsche Bank in this book in addition to the fines it incurred for alleged missselling of mortgage-backed securities of $7 billion and the largest LIBOR fine of any bank of $2.5 billion. The merger that was explored with Commerzbank was supposedly partly driven by the German regulator and government who would like to reverse the poor performance of the country’s two largest banks and would like to create a national champion to support German industry to expand internationally (Storbeck and Chazan 2019). The combination would have created Europe’s third largest and the Eurozone’s second largest bank with €1.9 trillion of assets (Storbeck 2019). Interestingly, when the merger was abandoned in 2019 ‘execution

risk’ was given by both parties as one of the reasons for abandonment. No one mentioned that the complexities of managing a combined entity might have been too much for management teams that have struggled to manage either bank.

Subprime mortgage lending in the United States is no longer called that, with other terms such as ‘no prime’ and ‘non-qualifying’ mortgages being mentioned. Non-qualifying means that these mortgages are not qualified to be bought from the lender by Fannie Mae or Freddie Mac. The market for securitisation of these loans has remerged although from a low base. Mortgages included in securitisation have to conform by eight ‘ability to pay’ parameters for the original lender to avoid future liability from investors in the securitisation. Also the sponsors or arrangers of the mortgage-backed securities cannot sell all of the issue but must retain at least one-twentieth on its own balance sheet. The year 2017 saw the issuing of $4 billion of what would have been called subprime mortgagebacked securities before the crisis (McLannahan 2017). About $29 billion was issued in 2018, almost doubling the previous year (NAIC 2019).

Before 2008 rating agencies were largely unregulated. The Dodd-Frank and European regulations introduced significant new rules to improve the quality and methodology of rating agencies. This regulation addressed requirements for board approval of procedures and methodologies, record keeping of decisions and analysts’ training. Rating decisions remain under the control of the agencies, although the Securities & Exchange Control can bring action for fraudulent ratings. The European Securities and Market Authority now regulates the European credit rating agencies on a similar basis to the United States. Both regulators have sought to separate the credit analysis activity from both advice on how to achieve a desired level of rating and the commercial aspects of selling rating services. Analysts are now prohibited from guiding the rated issuer. The position where the rated issuers pay for the ratings, much criticised after the 2008 financial crisis, has not changed. But the analysis and payment are now handled by two separated parts of the rating agencies.

However credit ratings remain as embedded in regulation as ever and probably more. Regulators take a strong lead from the agencies’ ratings when assessing the capital models, stress tests and so on of banks. And banks continue to rely heavily on rating agencies. Rating processes are now regulated and the processed probably of a higher quality, less conflicted and more transparent. Whether banks do more of their own credit

analytical work or continue to rely on rating agencies at the continued request of bank regulators will probably not be known until the next crisis.

If little has been done to reduce the complexity of banks neither has there been much change to the producer manager approach. The path dependency remains whereby many senior bankers remain involved with clients and production, even as they reach the very top of management. Many senior managers have had to spend a great deal of their time, sometimes the majority, dealing with the fallout from the crisis and the resulting regulation. But they have remained producer managers. Specialist managers, who are trained in management and have no other role, have not emerged as dominant in banking, particularly in the large combined commercial and investment banks, the most complex of all with the most demand for specialist management.

One area of management addressed by regulation has been incentives. The much criticised bankers’ bonuses, reviled by the public that suffered the consequences of the 2008 financial crisis, have been checked, at least partly. The Dodd-Frank Act ensured that shareholders of United States banks have the right to vote on remuneration of senior managers in banks at least every three years, or more frequently, should shareholders so desire. Banks are also required to provide details of any ‘golden parachute’ arrangements, being provisions for senior executives who leave the bank, and shareholders must approve these (SEC 2011).

In Europe, a limitation of bonuses was introduced at one time fixed salary or two times with shareholders’ approval in 2014. This applied to all those who have a potential impact on the risks of the banks, amounting to some 60,000 individuals in Europe. Banks responded by significantly increasing the fixed salaries. The corresponding provisions for deferral of payment of bonuses have been implemented inconsistently across Europe affected by local regulation (EBA 2016). Provisions have also been made for bonuses to be ‘clawed back’ where losses emerge from business conducted during the period where the bonuses were awarded.

There is now a link between the level of capital, under the new Basil III rules, whereby banks face restrictions on bonuses to employees, and dividends to shareholders if the bank’s capital is below a 7 per cent ratio (Plender 2017).

Incentives have been restricted but are still large. Bankers have been paid more than other industries for many years but this accelerated. In 1980 remuneration in the United States financial securities industry was twice the average of the private sector. By 2000 it was five times higher. In

spite of the financial crisis it is now again more than five times the average and approaching the peak of six times seen just before the financial crisis. In 2017 Wall Street bonuses were up close to one-fifth to over $180,000 compared to 2016 and not far below the 2006 record of just over $190,000 (McLannahan 26 March 2018a). Some have said that this represents a disturbing failure of regulatory policy.

Lobbying by banks is perhaps the main reason why so little has changed. In the United States, President Obama observed in 2010 that “What we’ve seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people. So if these folks want a fight, it’s a fight I’m ready to have” (Obama 2010). The fight more specifically meant that by mid-2009, the financial sector had deployed three or four lobbyists for each member of Congress and was spending an estimated $1.4 million a day lobbying against the financial reform legislation. They succeeded in blocking legislation to break up the largest banks (Johnson 2010).

One of the large banks’ key arguments was a repeat of the argument made by the chief executive officer of Chemical Bank, when previously merging with Manufacturers Hannover Bank in 1991 that “If it’s important for the United States to have large, globally competitive automobile companies, globally competitive chemical companies, globally competitive computer companies, it’s important to have large globally competitive banks as well” (Gilson and Escalle 1998). Splitting up the banks was thereby linked to reducing the power of the United States. This argument was largely self-serving. Western non-financial conglomerates have been in a decade-long process of splitting themselves up to focus on their core businesses and core management competencies. An important example was General Electric’s divestment of its finance division in GE Capital in 2015. Banks were, as usual, decades behind the management developments of corporates. Secondly, the 2008 financial crisis, partly caused by large complex banks, damaged the standing of the Western countries it affected.

The banks won the fight, and the president lost. While there was a great deal of talk about breaking up the big banks, which would have made them simpler to manage, reduced the possibility of absent management and therefore of failure, perhaps more than any other measure could have done, it never became part of the Dodd-Frank Act.

One of the most extraordinary arguments put forward by the big banks is that they are simply too complicated to break up. Their capital, funding,

information technology and legal structures have been argued to be so intricate that breaking up is impossible (Samuels 2016). In making such an argument there seems to be no self-awareness on the part of the managers of the largest banks that if they are too complicated to break up, they may be too complicated to manage.

Domestic United States banks were also opposed to the implementation of the Volcker Rule that would limit banks’ ability to trade for their own account and the associated revenue (Minor and Persic 2012). The Volcker Rule, as part of the Dodd-Franck Act was another highly complex piece of regulation. It was finally implemented in 2013 having been jointly agreed by five regulatory entities being the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (FED 2016). The latest development is that the rule will now be lifted for smaller banks, having only been in place for four years. Further amendments to the rule are being considered by regulators, and the direction appears to be towards a loosening of the restriction on banks to trade for their own account. It is hard to imagine a loosening of regulation with more potential for increasing risks and complexity in banks. This is a sad development as we mourn the passing of Paul Volcker in 2019, a giant of prudent governance.

More generally the current United States administration is reviewing all the regulation put in place by the Obama administration after the 2018 financial crisis. Further loosening of regulation may result.

In spite of the extensive and complicated regulations enacted since the 2008 financial crisis, absent management in banks is still having a highly detrimental impact.

JPMorgan Chase, including the merged Banc One, was considered to have had a less bad 2008 Financial Crises than many large peers. However, the complexity of this mammoth bank still resulted in an occurrence of absent management a few years later. An incident initially described as a tempest in a teapot by the chief executive officer in relation to the 2012 first quarter results, involved losses on credit derivatives from trading the bank’s own capital that eventually amounted to $6 billion. The losses emanated from the chief investment officer entity whose mandate was to manage the bank’s liquidity and conservatively invest those funds that were in excess of what the bank could lend. The trader responsible became known as the London Whale, due to the size of the positions taken by the chief investment officer’s London operation. A task force was established to investigate the losses. One of the observations was that the bank had

not made sure that the controls and oversight had evolved commensurately with the increased complexity and risks of chief investment officer’s activities. The chief executive officer was later quoted as saying that “If I’d asked some basic questions earlier, I would have caught it but I didn’t”. Even for this largest of all producer managers, perhaps the most highly regarded banker and the only one still in place from the 2008 financial crisis, this was in instance of absent management (Weber 2018).

Complexity had grown beyond management’s capability, leading to absent management. In frankly admitting to the loss and the bank’s errors the chief executive officer described the strategy as flawed, complex, poorly reviewed, poorly executed and poorly monitored. One would never expect one of the world’s most senior financial managers to use words such as absent management, but his description is fairly close (J.P.Morgan 2013).

As I was writing the last chapter of this book, I received a letter from Danske Bank. It was assuring me that the bank was doing everything to sort out an issue in its Estonian branch that would have no impact on my personal account. It is too early to say if what has been termed the largest money laundering scandal in history is about absent management, but the signs are there. In 2007 Danske Bank, Denmark’s largest bank, took over Sampo Bank from a Finnish insurer including a branch in Estonia. During the next ten years, some €200 billion of money from residents outside Estonia would flow through the branch. In 2011, the Estonian nonresident activity generated over one-tenth of Danske Bank’s profits. There were many warnings including as early as just after the takeover in 2007. The Estonian regulator warned over non-compliance and problems with know-your-customer rules to detect money laundering. The Russian Central Bank warned about the Estonian branch being used for tax evasion and money laundering of billions of roubles per month. The Danish regulator requested information from Danske Bank in 2012 regarding complaints from the Estonian regulator about serious money laundering issues. The head of the Estonia branch between 2007 and 2014 reported his concerns in 2013, using the whistleblowing route with several emails. When resigning in 2014, he blamed the lack of response to his whistleblowing. An internal audit was conducted in 2014, after the whistleblowing, and confirming many of the allegations. Only in 2017 after several newspaper publications did Danske Bank have an investigation conducted by an external lawyer that brought the extent of the non-resident money flow to light. This was followed by the dismissal of Danske Bank’s chief executive, later followed by the chairman and most of the board (Milne and Winter 2018). The whistleblower has become central to the case and

in November 2018 testified to the Danish Parliament. Other banks including Bank of America, J.P.Morgan and Deutsche Bank had been correspondents to Danske Bank’s Estonian branch. The United States Department of Justice is conducting an investigation. Danske Bank has announced a provision of close to €3 billion against possible fines. In one case of money laundering the United States Treasury suspended the licence to clear United States dollars under the Patriot Act of the largest Latvian bank ABLV, an action that contributed to ABLV’s complete failure (Ford 2018). A similar action against Danske Bank may seem unlikely now but would have serious consequences.

It is difficult to imagine that Danske Bank’s management did manage the Estonian business, however badly. There are strong indications of absent of management. The statement “We overlooked the suspicious circumstances because we had too little focus on and knowledge about the part of the business and the risk that followed” (Danske Bank 2018) is close to an admittance of absent management. Danske Bank did not respond to early warnings and whistleblowing. It had no person responsible for money laundering for the whole group in the first 11 months of 2013, in contravention of regulation. Danske Bank did not reduce the non-resident business until 2015. Perhaps most remarkably is that Danske Bank had a very difficult 2008 financial crisis, partly due to another acquisition of Irish banks, and received significant support of DKR26 billion in loans from the Danish government and taxpayer. Danske Bank only had to extend its operations as far as Estonia for an apparent occurrence of absent management to cause unprecedented damage to its reputation and possibly to its balance sheets, once the full impact of one of the historical largest cases of money laundering is known.

So many of the signs of absent management are there. Growth by acquisition, increased complexity by geography and new lines of business and management that did not appear to manage. If absent management was the case in what has been considered one of the most respected financial institutions in the world, in a country that makes claims of superior regulation and cultural transparency and even after extensive state support, the chance is that management will also be absent in other large banks now and in the future. None of the extensive regulatory changes since the 2008 financial crisis appear to have had any effect on this scandal.

A similar lack of effect of the financial crisis appears to be the case for Goldman Sachs and the 1MBD scandal. On 1 February 2019, Goldman Sachs said that it was deferring decisions on long-term incentives for three former executives “until more information is available” about the “ongoing

government and regulatory investigations” into the 1MDB scandal (Noonan 1 February 2019). One of the executives is believed to be the former chief executive officer since 2006 who retired in 2018. The incentives had been granted to in 2011 and had been due to vest in 2018, presumably meaning that the executives could then have been able to turn them into cash. Deferral of incentives and possible claw backs is new and related to the changes in regulations, employment contracts and attitudes since the 2008 financial crisis. What is not new is a scandal with the indications of an occurrence of absent management.

In 2012 and 2013 Goldman Sachs was the sole underwriter of a $6.5 billion bond issue for the Malaysian government-owned fund 1 Malaysia Development Berhad or 1MBD and received a $600 million fee. Close to $3 billion of the issue was allegedly used by a Malaysian financier on lavish spending and bribes to government officials including a former prime minister. In November 2018 a former Goldman Sachs partner pleaded guilty to bribery, conspiracy and money laundering charges in connection with what appears to be a significant case of fraud in 1MBD. The bank is being investigated by the United States Department of Justice and has had criminal charges filed against it by the Malaysian Attorney General. Goldman Sachs has seen a significant fall in its share price at the end of 2018 of about two-fifths, although the latter had recovered about half of that at the beginning of 2019. Goldman Sachs has said that it knew nothing of the alleged role of its former partner in fraudulent use of funds in the 1MBD scandal (Crow and Noonan 23 December 2019).

It is too early to say what Goldman Sachs’ role was. Given the fall in the share price and the damage caused to the bank’s reputation, it does not seem likely that the otherwise strong management would have made such bad decisions. Perhaps the complexities of operating in a different country and culture were too great to manage. Given the timing following the 2008 financial crisis, including the $500 million fine imposed for missselling mortgage-backed securities in 2010, and the extensive internal compliance supposedly in place perhaps there was absent management.

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CHAPTER 14

Conclusion

It has been the intention and hope of this book to have added something to the causation of bank failure and financial crisis by a combined approach of economic history, management consultancy and banking experience. This approach has led to understanding absent management in banking as a reason for bank failure and a cause of financial crisis.

There have been banks for at least 600 years in the Western World and probably much longer. Something as potentially impactful and dangerous as absent management in banks would surely have been noticed at some stage over this long period. Considering this apparent omission was one reason for taking a long-term historical approach to write about absent management in banks. The other reason was to try and understand how and why we ended up in a situation where some banks are not managed.

Management is a determining factor in bank failure. It is possible for all banks to fail in a crisis, such as the Plague in Europe in the fourteenth century. All major banks can be nationalised such as happened in France in 1982, including the Rothschild, BNP, Paribas and Société Générale banks. In nearly all other bank failures it is management that is the determining factor. Sometimes it is management that has put the bank in harm’s way over a period of time by the choice of business lines, location or both. In other cases the management makes the wrong decision when external factors threaten the future of the bank.

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_14 271