Agency Problems Highlighting Risk Culture and Unethical Behavior in the Banks - Essay Example

Finance and accounting Table of Contents Introduction 3 Concept of Risk taking culture in banks 4 Agency problems highlighting risk culture and unethical behavior in the banks 4 Interest of the creditors 6 Solution: Risk culture and management 8 Conclusion 8 Introduction The global financial crisis of 2007 was the worst one for the economy after the Great Depression of 1930. The main cause of the crisis was related to shortfall in liquidity in banking sector of the US. Apart from that, the collapse of real estate market was also a major reason for the crisis. The tax policies and bailouts had led to decline of financial industry in the society. However, the role of the banks was under spotlight as it failed to keep its commitments with the customers and investors. The banks took unethical means to increase their benefits, which latter created problem for them as the economy experienced downturn. Moreover, the financial institutions practiced excessive risk taking, which became the part of their culture; hence, these risks led to creation of systemic problems and many individual banks failed to generate revenue from the financial services and products (Ashbaugh, LaFond and Mayhew, 2003). The risk taking culture appeared to be severe fort are complicated and numerous in number; however, it was observed the financial institutions and the root cause of this culture related to the general agreement regarding incentive structure in public sector and financial industry has played a significant role. The integrity of the banks was hampered as their executive was questioned. It not only damaged the reputation of the banks but also decreased the assets considerably. In order to solve the issue of extreme risk taking, financial reform agenda was developed. An attempt was made to improve the regulation associated with the corporate governance in the banks (Hodgdon, et al, 2009; Carmichael, 2004). It also included regulations to govern the pay of the executives. The report aims at highlighting the different consequences experienced by the economy during 2007-2008 because of the excessive risk taking culture and unethical behavior practiced in the financial institutions. This risk taking also contributed towards the financial crisis. Concept of Risk taking culture in banks (Risk culture and unethical behavior is elaborated in this section by highlighting agency problem and how the interest of the bondholders were hampered due to the unethical means adopted by the financial institution; this section depicts the answers of the statement with the help of conventional theories) The section gives emphasis on the conventional theories, related to the tension between the shareholders and the managers. This tension was severe for the banks during the period 2007-2008. It also concentrated on maximizing value of the shareholders, which was not liked by the creditors as they did not get any preference from the banks. The systemic risks are also depicted in this section, which created conflicting interest among the people in the society (Acharya and Hassan, 2012). This people were affected by the decisions of management as it only focused on the manager’s personal benefits (Humphrey, et al., 2011). Agency problems highlighting risk culture and unethical behavior in the banks Modern compensation system did not consider insufficient risk taking. Agency theory indicated conflict between managers of a company and its owner. In this theory, it is identified that the managers does not always takes into account the shareholder’s interest, which leads to conflict of interest (Acharya and Hassan, 2012). The managers do not give their full effort for supervising their employees, whether they are able to meet the needs of the shareholders and customers. They even fail to instruct their employees to choose the best supplier, which will assist the company to reduce their cost (Sikka, 2009). Hence, the attitude of the management towards risk taking is not at all optimal from the view point of the shareholders (Humphrey, et al., 2011; Chesney, Stromberg and Wagner, 2012; Beltratti and Stulz, 2012). The management provides incentives to the managers when the company is performing well (Carmichael, 2004). They do so in order to retain the managers and make them satisfied with the compensation plan. The incentives and corporate governance structure assured the management regarding the fact that employees and the managers perform their job with full effort; it also aimed at maximizing the shareholders wealth, by earning profit in the market by undertaking risky projects, which will yield higher benefit. The performance of the managers are not only supervised by the management but also monitored by the debt holders, credit rating agencies and large shareholders, who own maximum share in the company (Hodgdon, et al, 2009; Carmichael, 2004). This monitoring is costly and may not become effective enough to bring any change to any deteriorating situation. The success of the method is solely dependent on the skills and ability of the managers (Carmichael, 2004). Hence in order to avoid the conflicting interest of the shareholders, the company aims at aligning the incentives of the shareholders with that of the managers through a number of schemes such as performance-based compensation plan. This plan makes the managers more sensitive towards the changes in shareholder’s value (Chesney, Stromberg and Wagner, 2012). The same agency problems are very common in banks because of risk management. These agency problems in the banks were prominent during the financial crisis of 2007-2008. The managers and bank owners failed to manage the risks that are prevalent in the bank during that period of time. Hence, the banks owners had to align the risk incentives between their business and managers as risk taking is in their business model (Acharya and Hassan, 2012). The bank managers during this period failed to delegate the decision makings regarding any risk to the lower level managers. Hence, the monitoring and controlling of the banks are ineffective and even difficult to implement (Hodgdon, et al, 2009). The payment structure of the employees and managers are based on their performance. This acts as the limited substitute for the direct controlling and monitoring of their performance (Hodgdon, et al, 2009; Carmichael, 2004). It is difficult to gauge the performance of the managers and employees; however, the incentives may boost the employees to a great extent to give their full effort (Chesney, Stromberg and Wagner, 2012). This is done with the help of risk taking by the managers and employees, which is encouraged from the shareholder’s point of view. During 2007, the mangers and employees of leading banks took loans, which are profitable for the bank in short run and long run risks are hidden from the customers. In this manner, the bankers can increase their pay by concentrating on the risks and does not think about the long rum affect (Chesney, Stromberg and Wagner, 2012). The main complication for the bank is that it does not look at the amount of risk that the financial institution can encounter in the long run. This had also added fuel to the events that took place during 2007-2008. The bank staffs took such loans, which have a chance to get defaulted because of inability of the loan holders (Chesney, Stromberg and Wagner, 2012). During the economic downturn, the individual across the globe experienced reduction in pay structure, which affected their financial condition. This had direct impact on their loan payment, which got defaulted as they could not pay it. Hence, the banks failed to retrieve the amounts that are paid to the debtors and thus their assets got depleted. This incident contributed towards financial crisis during the period (Chesney, Stromberg and Wagner, 2012; Beltratti and Stulz, 2012). Interest of the creditors Even if the banks are successful in aligning the employee incentives with the shareholders’ interest; it is not necessary that the stakeholders are satisfied. The stakeholders include shareholders, creditors, investors and the employees. In this context, the bondholders or shareholders’ value is not maximized (Chesney, Stromberg and Wagner, 2012). The shareholders possess limited liability, which indicates the fact that there is limited downside on their investments; however, they are liable to receive the benefits if the value of the company increases. This provides an opportunity to transfer wealth of the creditors to the banks by undertaking risky projects and gain maximum benefit. The risk-shifting is observed to have increased as the companies are close to encounter default risk (Vincent, Sabato and Schmid, 2012; Beltratti and Stulz, 2012). The managers actually tend to gamble with the shareholders’ wealth on a hope that they will receive higher benefit in future. In this case, it is noteworthy to mention that because of this risk taking behavior of the managers, the shareholder’s lose the maximum, if the project fails in future. Here, the managers does not lose much from the failure however, if the project is successful they are bound to get the maximum benefit from the success (Vincent, Sabato and Schmid, 2012; Beltratti and Stulz, 2012). With respect to banks, the conflict between the debt holders and shareholders are severe. This is one of the reasons why the failure of the banks affected the global economic condition (Beltratti and Stulz, 2012). Small depositors of several banks receive negligible incentives and as result they do not monitor the performance of the banks very minutely. These depositors are protected by deposit insurance, which gives them a definite return. Moreover, the banks have more leverages as compared to other companies as they provide loans to the customers. This have added risk of losing asset of the banks, which actually led to the financial crisis (Beltratti and Stulz, 2012). Solution: Risk culture and management (This section highlights the sustainable measures that should be adopted by the financial institutions for creating appropriate risk culture) Risk management will assist the management of the banks to make solution related to any problem (Forssbaeck, 2011). The bank managers should study the financial condition of the customers before providing any loan amount. The details regarding the financial condition will assist the bankers to understand whether the customers will be able to pay back the loan in future along with the interest. There is always a possibility that the customers are not able to pay back the loan and the interest after few period of time; in that case the banks experience the loss. Hence, it is very important for the bank managers to evaluate the financial ability of the companies or customers to whom the loan is offered. This reduces the possibility of losing excessive amount of money and risk taking. Conclusion Risk culture in banks had brought severe consequences during the period 2007-2008. This added to the reasons, which were responsible for the financial crisis during that period of time. The risk taking culture not only affected the operation of the banks but also the investors and customers who lost big amount of investment that they had made in the banks. However, the loss of the managers and employees are less as compared to that of the shareholders and customers. Hence, shareholders are observed to lose the highest amount of money, which affected their financial condition. Nevertheless, it is worth mentioning that during that period of time, the debt holders could not pay the interest as a result the banks were affected severely. It can be concluded that role of the financial institution had negative impact on the global economy during 2007-2008. Reference List Acharya, V., and Hassan, N., 2012. The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle. Journal of Financial Economics 106 (2), pp. 349–66. Ashbaugh, H., LaFond, R. and Mayhew, B.W., 2003. Do Non-audit Services Compromise Auditor Independence? Further Evidence. The Accounting Review, 78(3), pp. 611-639. Beltratti, A. and Stulz, R., 2012. The Credit Crisis around the Globe: Why Did Some Banks Perform Better? 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