Bank's Risk-Taking Behaviour Prior to Financial Crisis - Example

Banks Risk Taking Behaviour Prior to Financial Crisis of the Contents Introduction 3 Discussion 3 Reasons behind the Crisis 3 Incentives of Bank’s Risk Taking Behaviour 5 Bank’s Financial Leverage in the Pre-2008 Era 6 Agency Theory and Banking System 8 Theory of Moral Hazard and Banking System 8 The Case of Lehman Brothers and Moral Hazard 12 Solutions to Avoid Another Financial Crisis in Future 13 Conclusion 13 References 14 Bibliography 16 Introduction The risk taking behaviour of commercial banks had played a crucial role in the occurrence of global financial crisis of 2008. In general, conflict between the interests of shareholders of commercial banks and the depositors is very prominent. Shareholders are always willing to take higher risk in order to maximize the value of the shares at the expense of the worth of deposits (Hussain & Hassan, 2012). Although flat rate deposit insurance are assumed to be an effective tool for controlling risk factor and smooth running of banking operations, many researchers are on the opinion that such deposit insurances leads to generate moral hazard problems, influencing the shareholders’ incentive to take more risk (Acharya & Viswanathan, 2011). This paper will concentrate on the reasons behind the risk taking behaviour of commercial banks and how economic theories can explain such behaviour that leads to create financial crisis. Discussion Reasons behind the Crisis After the global financial crisis in 2008, many researchers have tried to indentify the root cause of such severe economic downturn. The main reasons that ignited risk taking behaviour of commercial banks and eventually caused for financial crisis will be discussed in the next segment. Ineffective Corporate Governance Extensive research has shown that unjustified deregulation and lenient monetary policy led the banking and financial sector ignite such crisis (Valencia, 2011). For instance, in United States, the housing bubble of 2007 directed the banks to grant subprime lending to the NINJA (No Income No Job) customers. Excessive risk taking propensity of banks in terms of property lending caused the banking sector exhaust in many economies such as Ireland, Spain and many other western countries (source). Hence, faulty line of control and loose corporate governance in banking sector also counted as the source of risky attitude of commercial banks (Agur, 2012). Pro-cyclicality The boom-bust cycle experienced in banking sector is a result of pro-cyclical accessibility of cheap capital. During the boom period, easy availability of cheap funding attracted large number of individuals to obtain loans at an all time discounted rate, irrespective of their capacity to pay (Kostovetsky, 2014). Where the banking sector ideally was supposed to keep an anti-cyclical capital buffer during the period for mitigating the damage for past and future economic breakdown, banks adopted pro-cyclical lending without taking into consideration that how much credit will be required during the phase of excessive credit growth. The Basel III reforms had shown that even though banks had noticed a deviation from the trend rule in capital to loan ratio as well as credit to GDP (Gross Domestic Product) ratio mainly because of pursuing pro-cyclical capital policy, they did not take corrective measures which had driven the sector towards crisis (Desai, 2014). Transparency and Market Discipline The post crisis analysis revealed that the market discipline forces were really weak and imperfect market information transmission led to more confusion among investors. Along with that, defective representation of bank’s financial reports and biased reports from credit rating agencies heightened the scope of uncertainty in market and led the sector collapse (Ivashinaa & Scharfstein, 2010). All these reasons motivated the banks to follow aggressive risky strategy which in turn drove the financial system towards financial crisis. The main incentives of banks’ risk taking behaviour can be attributed as the compensation structure of the bank employees as well as the defective bail out approach of the financial regulators and government. In the next segment, all such incentives will be analysed in details. Incentives of Bank’s Risk Taking Behaviour Figure 1: Compensation Structure in Financial Sector (Caprio, 2012) The incentives behind bank’s risk taking behavior were spurred during pre-crisis period mainly because of the compensation structure reinforced to the banking sector and financial institutions. Distorted incentives were introduced for bank employees in terms of providing rewards in the form of volume of loans or securitized transaction, over long-term asset quality. In this way, the lender originated poor quality of loans and then sold them in secondary markets for passing the risk towards the investors. The concept of bailout also influenced the commercial banks to take excessive risks. The policy of the US government to use taxpayers’ money for providing bailout to the commercial banks and other private financial institutions also worked as an incentive to the financial institutions to take excessive risks. In the pre-crisis era, the commercial banks initiated to adopt aggressive growth strategy and took un-calculated risks based on the belief that the government will support them if the things don’t go wrong (Agur, 2012). Bank’s Financial Leverage in the Pre-2008 Era Financial leverage indicates composition of capital structure i.e. the debt to equity ratio maintained by the particular company (Adriana and Shin, 2010). A high financial ratio indicates more amount of debt component in the bank’s capital structure that requires high level of interest payments, due to which the profitability of the firm gets affected (Acharya and Viswanathan, 2011). In the pre- recession era, high leverage of the commercial banks drove the banks towards rapid expansion and asset maximization. As a result of incorporating more debt in capital structure, banks noticed that most of its profits were getting exhausted through interest payment. Hence, the banks had to adopt an aggressive business strategy with a expectation of high return so that the loss from high interest payment can be compensated. In this way, high degree of leverage motivated the risk taking behavior of the bank managers. At the same time, high borrowing reduced the liquidity ratio of the commercial banks. Therefore, during recession, the banks failed to meet the short term cash requirement due to presence in long term borrowings in the capital structure which in turn pushed the banks towards bankruptcy (Adriana & Shin, 2010). Figure 2: Leverage Ratio of Selected US and European Banks (2001-2007) (Koudstaal and Wijnbergen, 2012) In the next segment of the paper the banks risk taking behaviour and how such behaviour caused for financial crisis will be evaluated through various economic theories such as Agency theory and Moral Hazard Problem. Agency Theory and Banking System Agency theory is based on resolving the delinquent between the principals such as shareholders and the agent of the principals like company executives. Agency theory leads to address the conflict between interests of the involved agents and the differences towards risk taking outlook of both the parties. The defective business strategy of banks that led to ignite financial crisis in 2008 was heavily based on the foundation of agency theory. According to the shareholders, the main objective of every agent such as Chairperson of the commercial banks should be to maximize the shareholders’ wealth. Hence, the conflict arises during that period mainly due to shift in attention of the Chairman and CEOs of commercial banks from maximizing the shareholders’ wealth to recovering of the bank’ net worth in order to maintain their subsistence. Conflict also arises when the banks decided to utilize the bailout to recover its internal structure whereas shareholders wanted the banks to invest in business expansion in order to maximize their wealth. Such divergence in agent and principals’ interests as reflected by agency theory created financial crisis in 2008 (Palia & Porter, 2007). Theory of Moral Hazard and Banking System The theory of moral hazard in economics defines that a person tends to take more risk when the burden of the risk is borne by some other person. In case of financial transaction, action of one party may lead to create moral hazard when the detrimental consequences of such transaction leads to affect the other party involved in the transaction. Moral hazard mainly arises due to information asymmetry as the magnitude of risk is better known to the risk taking party as compared to the other party who is having less information about it. Risk taking behaviour of commercial bank which led to instigate subprime crisis in 2008 was based on the moral hazard theory. Although it was suspected well in advance that in long run it will not be possible for the borrowers to continue payment of the loans, sudden rush of borrowers let the banks neglect the probable long term adverse consequences of such loans. Hence, huge demand of loans drove the banks to make available of cheap loans without concerning the repayment capability of the borrowers. As a result the banks were fully exposed to risk, the risk which was apparently borne by the mortgagors (Boyd, 2013). Figure 3: Moral Hazard and Investment Profile (Myerson, 2012) The problem of moral hazard became more prominent as the mass investors had to rely on the large chunk capacitors for identifying investment opportunities. Bankers and other financial intermediaries borrowed beyond their capacity of investment but their motivations to invest depended on their having a stake in the profits of their investments. This had created Moral-hazard credit cycle and pushed the economy towards recession. When the banks failed, the economy experienced massive retrenchment of mid career bankers. In order to ensure social security, the regulatory authority called for bail out which had created a new avenue of moral hazard (Marcoa & Fernández, 2008). Solutions to Moral Hazard during Pre-Crisis Period In general, the problem of moral hazard can be solved by letting the individual investors pay a share of the cost of risky attitude. For example, in auto insurance industry, as the car-owner is liable to pay full of a partial payment of the damage made by him and the insurance company is not liable to pay the full amount of the damage as per the contract, the owner is expected to be more conscious and avoid taking risk while driving. In financial market, though the principle is similar, the mechanism for avoiding moral hazard is different to some extent. In financial market including banking sector, the firms who are responsible for investing the individuals’ money, are supposed to face the consequences, if the decision made by them are defective in nature. In such circumstances, if the government decides to provide bailout support to the banks, the individuals tends to safeguard themselves from experiencing severe consequences arising out of such faulty behaviour of financial institutions. Hence, according to Boyd (2013), the problem of moral hazard in financial sector can be solved by appointing the financial regulators as “resolution authority” and channelize support in a systematic way according to the size and requirement of bailout to the commercial banks. However, during the financial crisis of 2008, this process of solving moral hazard did not proved to be fruitful due to a number of reasons. First, the commercial banks needed the money for ensuring their purpose of survival. However, defective decisions of bailout system decided that as the bailout would be provided from the taxpayers’ money, it would be handed out only to the viable banks. Moreover, the approved amount of $700 billion, which was decided upon buying up the toxic mortgages, in reality the money was infused to increase the bank’s capital rather than putting effort for eliminating the toxics. Such activity helped the shareholders to maximize their wealth which in turn created disputes among investors and shareholders as per the agency theory. Moreover, under Capital Purchase Program, more that $125 billion of the approved bailout was funded to the nine largest commercial banks of America including Citi Bank, Goldman, and Bank of America etc. Hence, many other financial institutions were deprived to receive the benefits of such bailouts. Hence, the notion on the basis of which banks took aggressive expansion policy, failed to satisfy the disrupted condition of commercial banks and accordingly, the general solutions to moral hazard could not control the financial institutions from collapsing (Myerson, 2012). In the next segment, the incident with Lehman Brothers will be exemplified to evaluate how the solutions of moral hazard could not serve the firm’s purpose and let the firm collapsed overtime. The Case of Lehman Brothers and Moral Hazard Knowing that the government will safeguard the banks in case anything wrong occurs, the banks got an incentive to take excessive risk. Moral hazard arises when the governing authorities decided not to save such private entities by using the money of general taxpayers. Hence, decision of Obama administration to let Lehman Brothers and other private financial institution crash could not resist the global economy from experiencing financial crisis (Koudstaal & Wijnbergen, 2012). The expectations from creditors also created moral hazard which in turn paved the way for Lehman Brother’s collapse. The aggressive expansion plans of Lehman Brothers were supported by the creditors who sourced high interests on the loans paid to the highly levered financial institutions such as Lehman Brothers. Such attitude of creditors also based on the expectation that world’s fifth largest financial institution would not be allowed to collapse at any circumstances. Such beliefs also created moral hazard for creditors and indirectly for Lehman Brothers as well. Though adoption of aggressive growth module of Lehman Brothers in the pre- crisis period was based on the consideration that the government would provide support, the plan backfired as the government planned to protect almost every financial instruments of credit market from money market funds. In fact, when the government connoted their vague expectation that many financial institutions such as Lehman Brothers are too big to fail (Kostovetsky, 2014), such expectation strengthened the source of moral hazard for Lehman Brothers’ eventual collapse. Solutions to Avoid Another Financial Crisis in Future The shocking effect of 2008 financial crisis on the global economy has influenced the policymakers to review the existing financial postulates and introduce corrective reforms in order to safeguard the world economy from another financial crisis in future. According to Forbes (2012), various reform measures should be incorporated in this regard. Reckless deficit spending and borrowing that leads to shrink the real income should be mitigated by incorporating more government controls. In money and credit systems of United States, only a partial private ownership exists that largely creates government monopolies. However, in a central economic system, such concentration should be liberalized and moreover, the risk taking behavior and asset expansion capacity should be timely monitored in order to restrict the banking systems from driving towards the financial crisis. Conclusion After the comprehensive study of risk taking behavior of global banks it is evident that inefficiency in corporate governance, incomplete information available to the investors as well as incidents of pro-cyclicality and lack of transparency in market discipline largely contributed towards the banking sector collapse and financial crisis in 2008. Coupled with those, the adverse effect of moral hazard and leverage cycle accelerated the possibility of such downturn. If the commercial banking system would have taken corrective measures well in advance, the economy might be safeguarded from the severe crisis in 2008. References Acharya, V. V. & Viswanathan, S. (2011). Leverage, Moral Hazard, and Liquidity. The Journal of Finance, 66(1), 99-138. Adriana, T. & Shin, H. S. (2010). Liquidity and leverage. Journal of Financial Intermediation, 19(3), 418-437. Agur, I. (2012). Excessive Bank Risk Taking And Monetary Policy. 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