The Return of the Rogue

The “rogue trader”—a famed figure of the 1990s—recently has returned to prominence due largely to two phenomena. First, recent U.S. mortgage market volatility spilled over into stock, commodity, and derivative markets worldwide, causing large financial institution losses and revealing previously hidden unauthorized positions. Second, the rogue trader has gained importance as banks around the world have focused more attention on operational risk in response to regulatory changes prompted by the Basel II Capital Accord. This Article contends that of the many regulatory options available to the Basel Committee for addressing operational risk it arguably chose the worst: an enforced selfregulatory regime unlikely to substantially alter financial institutions’ ability to successfully manage operational risk. That regime also poses the danger of high costs, a false sense of security, and perverse incentives. Particularly with respect to the low-frequency, high-impact events—including rogue trading—that may be the greatest threat to bank stability and soundness, attempts at enforced self-regulation are unlikely to significantly reduce operational risk, because those financial institutions with the highest operational risk are the least likely to credibly assess that risk and set aside adequate capital under a regime of enforced self-regulation

Bank institutional setting and risk-taking: The missing role of directors’ education and turnover

Purpose: This paper aims to analyze the relationship between bank institutional setting and risk-taking by exploring whether board education and turnover are drivers of the risk propensity of cooperative banks compared to jointstock banks. Design/methodology/approach: Based on a comprehensive dataset of Italian banks over the 2011-2017 period, we examine whether these board characteristics affect the risk propensity of cooperative and joint-stock banks. Bank risk is measured by the Zindex, profit volatility and the ratio of non-performing loans to total gross loans. Findings: The findings show that cooperatives take less risk than joint-stock banks and have lower board turnover and education. Furthermore, we find that while board education mediates the relationship between the cooperative model and bank risk-taking, we do not find evidence of board turnover. Thus, the lower educational level of cooperative directors contributes to explaining the lower risk-taking of cooperative banks. Implications: The findings have several implications. In terms of the more general policy debate, our results point to the need to strengthen the governance model for both joint-stock and cooperative banks while supporting the view that a more ad hoc perspective on the best models and practices for each type of institutional setting would be preferable. In particular, the study reveals how board education’s effects on bank risk-taking should be carefully monitored. Originality/value: Through a mediation framework, this study provides empirical evidence on the relationship between bankinstitutional setting (by distinguishing between cooperative and joint-stock banks) and risk-taking behavior by exploring the underlying mechanisms at the board level, which is novel in the literature

Capture Nuances in the Contest for Financial Regulation

Applying capture analysis in the hotly contested arena of financial regulation is difficult. Numerous regulators with widely differing missions and widely diverse stakeholders are involved. Regulators operate under widely differing authorizing legislation. They even function at different levels of government. Agencies are often at odds with each other when it comes to determining optimal public policy. Unlike policy disputes in many other areas of regulation, which can be settled by reference to scientific data, public policy in financial regulation rests profoundly on essentially contested economic ideologies. This makes financial policy doubly difficult: one the one hand, it requires deep expertise—and therefore agency, as opposed to legislative—determination; on the other, this expertise must be informed by prevailing perceptions of which economic principles are most plausible, even though these principles are seldom actually verifiable. It is also often overlooked that financial institutions—banks in particular—perform quasigovernmental roles, such that close cooperation between the regulators and the regulated is not only inevitable but also indispensable. “Capture” is therefore often just a confusing term of regulatory analysis because it rests on shallow perceptions of the regulatory process. Stakeholders and even the agencies themselves inevitably “contest” for the policies they deem most desirable. What is important is to prevent, as far as possible, undue influence by certain stakeholders at the expense of others, and the adequate representation of alternative views in the combative arena of policy competition. The principles of democratic participation remain the important guiding light for financial regulatory reform. This article reviews the fragmented nature of the regulatory process in finance, the close relationship between banks and government, and the emerging forces that might help to make the policy contest more balanced

The Consumer Financial Protection Agency

Examines the current regulatory structures for consumer financial services protection, its limitations, and concerns about the proposal to consolidate consumer protection functions under one agency with research, rule-making, and enforcement authority

The determinants of debt and (private-) equity financing in young innovative SMEs: evidence from Germany

Financial theory creates a puzzle. Some authors argue that high-risk entrepreneurs choose debt contracts instead of equity contracts since risky but high returns are of relatively more value for a loan-financed firm. On the contrary, authors who focus explicitly on start-up finance predict that entrepreneurs are the more likely to seek equity-like venture capital contracts, the more risky their projects are. Our paper makes a first step to resolve this puzzle empirically. We present microeconometric evidence on the determinants of debt and equity financing in young and innovative SMEs. We pay special attention to the role of risk for the choice of the financing method. Since risk is not directly observable we use different indicators for financial and project risk. It turns out that our data generally confirms the hypothesis that the probability that a young high-tech firm receives equity financing is an increasing function of the financial risk. With regard to the intrinsic project risk, our results are less conclusive, as some of our indicators of a risky project are found to have a negative effect on the likelihood to be financed by private equity

Financial Intermediation

The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years' of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Revenue diversification in emerging market banks: implications for financial performance

Shaped by structural forces of change, banking in emerging markets has recently experienced a decline in its traditional activities, leading banks to diversify into new business strategies. This paper examines whether the observed shift into non-interest based activities improves financial performance. Using a sample of 714 banks across 14 East-Asian and Latin-American countries over the post 1997-crisis changing structure, we find that diversification gains are more than offset by the cost of increased exposure to the non-interest income, specifically by the trading income volatility. But this diversification performance's effect is found to be no linear with risk, and significantly not uniform among banks and across business lines. An implication of these findings is that banking institutions can reap diversification benefits as long as they well-studied it depending on their specific characteristics, competences and risk levels, and as they choose the right niche

CDS Zombies

This paper examines the contract interpretation strategies adopted by the International Swaps and Derivatives Association (ISDA) for its credit derivatives contracts in the Greek sovereign debt crisis. The authors argue that the economic function of sovereign credit default swaps (CDS) after Greece is limited and uncertain, partly thanks to ISDA’s insistence on textualist interpretation. Contract theory explanations for textualist preferences emphasise either transactional efficiency or relational factors, which do not fit ISDA or the derivatives market. The authors pose an alternative explanation: the embrace of textualism in this case may be a means for ISDA to reconcile the competing political demands from state regulators and its market constituents. They describe categories of contracts susceptible to such political demands, and consider when and why textualism might be the preferred response