My plan is to maintain high standards and make our business in this small segment sustainable by steadily growing our business and establish an enterprise-wide risk management architecture. Aggressive selling could increase our market share in a short-term yet at the cost of long-term value. As the CEO, I must have a long-term vision for growth and take corporate social responsibility seriously, and focus on not only what goals we achieved, but how we achieved them.
Maintaining high standards creates long-term value in our company. An important lesson I learned from the Wells Fargo scandal is that businesses shouldn’t sacrifice quality at the expense of quantity. Evidence shows that companies that have long-term vision grow faster, have higher profitability and contributes more to society by creating more jobs. Although maintaining high standards usually results in falling short of market share objective in the short term, it benefits our firm in the long term. As the CEO of our firm, I have the responsibility to act in accordance with the board’s best interests – adding long-term value.
Maintaining high standards is an effective method of risk control. Since our company has historically been a minor player in this market, we lack understanding about risks associated with rapid expansion. Risk management failure in this business is likely to impact our main business. Here is a real-life example. GE Capital was initially established to facilitate the financing of GE aviation business and to provide aircraft financing and leasing solutions to GE’s clients. Because of its aggressive expansion in derivative markets and real estate markets, GE Capital not only heavily impacted GE but posed a significant systematic risk to the market during the financial crisis. Maintaining high standards is also important for maintaining a low-risk credit profile and lower cost of debt.
Maintaining high standards boosts the corporate reputation and improve public relations. The most valuable asset for our firm is our good name and our brand. To maximize our brand reputational value, we need to demonstrate our firm takes corporate social responsibility seriously and create a robust risk culture as a guide to employee behaviors. Having a good reputation benefits our company. We’ll be more likely to build long-term relationships with partnered businesses, and our customers will be more loyal because of our services that give them positive experiences. With a good reputation, our firm will deliver sustained earnings and stable future growth and therefore attract better people.
Maintaining high standards is an effective way to lower our legal risk profiles, maintain a healthy relationship with regulators, and therefore reduce compliance costs over a long term. Regulators take risks seriously. Even though we could get a faster result by aggressive selling our products, costs of financial penalties from regulators could easily outweigh the benefits we receive from taking high risks. Given that having a strong culture of compliance is key to avoiding penalties, it’s my duty to educate shareholders and senior management about potential compliance concerns.
One could argue that lowering standards could make out firm competitive and increase market share rapidly, and a lot of investors demand more short-term results or even quarterly results. As the CEO, I have the responsibility to educate investors about the downside risk we’ll be facing and to find support from long-term investors.
To sum up, maintaining high standards benefits our firm because it creates long-term value for shareholders, it a more effective method risk control, boost reputation and public relationship, and reduce compliance costs over a long term. Therefore, I made the decision to maintain high standards.
a) Which factor in your opinion was most responsible for the financial crisis
b) Why you thought it was the most important among the five
c) How the risk of this factor could be controlled
d) What the effect would be on the mortgage finance system and the housing market of controlling this factor
In my opinion, the shadow banking system was most responsible for the financial crisis of 2008 among the five factors. The other four factors were indeed the main causes of the financial crisis; however, none of them were the underlying cause; instead, they were partly the results of inadequate or flawed financial sector regulation and supervision. The underlying cause was the biggest flaw in the shadow banking system that financial institutions borrow short and lend long. The risks in the shadow banking system have always been underestimated.
The financial crisis of 2008 was essentially a credit crisis, which followed a mortgage crisis and a banking crisis. From my perspective, banks including shadow banks are dangerous institutions and loan lending carries a tremendous amount of risk. According to Paul Krugman, a Nobel Memorial Prize-winning economist, the underlying reason why banking system is fragile is that banks invest money in risky and illiquid assets while promising ready access to cash for short-term investors and depositors. Normally, funding liquidity assets with short-term liabilities work well in market upturn; however, usually at the peak of an economic expansion, bad news regarding assets overpricing leads to withdrawal of funds from depository institutions. Consequently, confidence in banking system disappears quickly, and widespread withdrawal makes it vulnerable to a destructive banking run.
Shadow banks are even more dangerous than traditional banks are. Traditional banks have the access to Federate Funds and the Deposit Guarantee Scheme (DGS) can protect depositors in the event of a bank run. On the contrary, there are no guarantees for investors of shadow banks to liquidate their investments in economic downturns. Moreover, shadow banks were largely unregulated before the credit crisis of 2008, even though they performed the same kind of maturity transformation by providing borrowers with cheaper long-term funding and offering investors higher rates than bank deposits.
Shadow banks had grown significantly for decades before the credit crisis given that balance sheet size and high leverage were the keys to get access to cheap funding. Shadow banking system encouraged the expansion of the funding of long-term assets in short-term wholesale markets such as the ABCP and repo market. Shadow banks used Treasury securities as repo collateral and used the funds they borrowed to finance a wide range of risky activities, creating the conditions for a banking crisis. As the size of the repo market increased, the demand for collateral increased significantly. When Treasury securities couldn’t satisfy the demand, asset-backed securities, especially MBS, started to play an important role in the repo market. What’s worse, to avoid increasing regulatory capital requirements, shadow banks set up SPVs to hide risky assets from their balance sheet. Shadow banks were designed to facilitate transactions but ended up posing significant risks to the market. To sum up, shadow banking system is fragile and subject to panics. The crisis in the shadow banking system has also played a significant role in deepening recession and the slow recovery.
Shadow banks were also the main writers and buyer of OTC derivatives, particularly CDOs and CDS, which played a key role in the meltdown. Before the Credit Crisis of 2008, the riskiness of derivatives created with financial engineering was underestimated, and multi-trillion-dollar OTC CDS market was unregulated. It is widely recognized now that CDS market stirred up the mortgage crisis, which transformed to a credit crisis. CDS encouraged subprime investments. Naked CDS and “synthetic” CDOs encouraged widespread betting on the subprime market. Underwriters of CDs such as AIG didn’t have adequate capital to pay off guarantees, therefore posed a significant amount of risk to the market. CDS also increased the interconnectedness in the market.
Another cause of the financial crisis was the Community Reinvestment Act. Although CRA might encourage banks to “help meet the credit needs” of their communities, particularly low-income neighborhoods, it was not the most important role in the subprime boom. Some may argue that the CRA evaluations primarily focused on the number and dollar volume of lending to low-income neighborhoods; however, they didn’t provide targets or goals for bank lending standards. 2005- 2006 Mortgage origination data from the Home Mortgage Disclosure Act shows that only 6% of all higher-priced loans were originated to low-income borrowers or low-income neighborhoods. In other words, the CRA could have motivated banks to originate risky mortgages but it wasn’t most responsible for the financial crisis of 2008. because CRA-related loans were only a small fraction of the subprime market.
The failure of credit rating agencies was another key in the Credit Crisis. Since private-label mortgage-backed securities were not guaranteed by government agencies, investors had to rely on rating agencies such as Moody’s, S&P, and Fitch to get the risk profile of those products.
However, methodologies used by rating agencies for rating financial products were proved to be flawed, and rating agencies were wildly criticized also due to their conflicts of interest. The majority of these products was rated AAA, the highest and safest investment rating, dwarfed only by government-issued MBS. However, the mortgages making up these products carried a significantly greater risk than those backed by the government. To increase profits and market share, rating agencies gave inaccurately strong ratings to underperforming assets. Moreover, the system rating agencies used to assess the risk of financial products was also flawed. The system of two methods – “issuer pays” and “subscriber pays” led to a biased analysis and inaccurate ratings.
Although shadow banking system is extremely complex and hard to fix, there are some ways that could control the risks of shadow banking system. The ultimate solution to solve shadow banking system is to eliminate bank runs. Although Dodd-Frank Act has taken some meaningful steps in the regulation of shadow banking system, there are some important aspects it doesn’t cover.
One proposal is to improve the regulation of the liquidity of banks and shadow banks. The most striking feature of the pre-crisis regulatory system was the absence of any effective regulation of liquidity. Flooding the system with money market liquidity didn’t solve the problem in the Credit Crisis because money market liquidity didn’t get into the capital markets. Additionally, regulation should aim to be simple and robust, and avoid overly complex measures.
The second proposal to control risks in shadow banking system should aim at fixing the repo market. Shadow banks have been using repos to finance and hide risky assets off balance sheet. The best problem in the repo market in the Credit Crisis was the lack of high-quality collateral such as Treasury securities. This proposal should aim at creating a sufficient amount of high-quality collateral to be safely used in repo transactions.
The third issue is the Fed’s monetary policy. Open market operations should be modified. U.S. Treasury securities are extensively rehypothecated (Krishnamurthy and Vissing-Jorgensen 2010) and therefore should be viewed as money; in other words, open market operations are simply exchanging one kind of money to another.
Controlling risks in shadow banking system would have positive effects on the mortgage finance system and the housing market because the U.S. pre-crisis housing bubble was fueled by shadow banking and private-label mortgage securitization.
Before the Credit Crisis of 2008, the U.S experienced a long period of the loose monetary policy. Following the dot-com bubble burst, the U.S. Federal Reserve cut interest rates from over 6% in 2001 to below 2% within a year to make credit available at low-interest rates. Meanwhile, Emerging market countries such as China were running a savings surplus. The imbalances between savings and channels for investing those savings led to substantial capital inflows from emerging markets as well as European countries to the U.S.. Taking advantage of historically low-interest rates and historically large money supply, investors in the U.S. flooded money into the housing market and demanded high yield investment channels. The growth of the dollar volume in private-label mortgage-backed securities accelerated.
As the main originators of private-label MBS, shadow banks encouraged brokers to write loans to borrowers with low or no income and poor credit to access cheap money. In the case of the infamous liar loans, borrowers were only asked to state their income without any verification. Affordable mortgages such as adjustable rate mortgages, interest-only mortgages, and so-called “Alt-A” loans were widely misused.
To sum up, controlling risks in shadow banking system could help prevent lax lending standards, reduce frauds and bad incentives in mortgage writings; therefore, it could help stabilize the housing market and prevent the next housing bubble.