Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

3 The Quality of Corporate Governance Within Financial Firms in Stressed Markets

C h a p t e r 3 The Quality of Corporate Governance Within Financial Firms in Stressed Markets Robert Mark Introduction The recent financial crisis has caused internal and external corporate stakeholders to increase their scrutiny of the quality of corporate governance within financial firms in stressed markets. This scrutiny includes examining the impact that financial models, financial products (e.g., credit default swaps), and business operating styles (e.g., the amount of financial leverage) have on managing and hedging risk.1 The financial crisis has also raised issues on how the individual objectives of firms on Wall Street are harmonized to achieve broader societal goals (e.g., increased home ownership). The risk governance objective of a chief risk officer (CRO) in financial firms is to guide management toward controlling the amount of risk through ensuring measures of risk are reasonably accurate and assigning risk limits based on a clearly articulated set of corporate objectives. The risk governance objectives of the CRO are also designed to protect the firm from excessive losses in stressed markets. The objective of a corporate treasurer is to generate gap revenue2 within interest rate risk governance limits assigned by the CRO. Financial firms rely on highly analytical financial models to guide the firm toward achieving clearly articulated risk-adjusted Corporate Governance Within Financial Firms 53 return on capital (RAROC) objectives (see the Appendix for an explanation of RAROC). A significant challenge for regulators is to tie the deployment of financial models within the firm to the amount of risk generated external to the firm. Typically the internal risk governance objective of financial firms is neither designed to enhance the health of Main Street nor harmonized to achieve societal goals in stressed markets. For example, the objective of a trader is to generate trading revenue within trading risk governance limits assigned by the CRO. Risk governance to control model risk within financial firms is typically not designed to reduce external systemic risk across the financial markets in stressed markets. Systemic risk refers to the risk of a systemwide financial crisis caused by the contemporaneous failure of a substantial number of financial markets, institutions, or both. Sophisticated financial theories are analytically elegant, but over and over again the shock of extremely volatile markets has demonstrated that the application of financial theories that either guide portfolios toward optimal solutions (e.g., making investment decisions based on using modern portfolio theory [MPT]) or link return with risk (such as based on using the capital asset pricing model [CAPM]) is a double-edged sword. Financial firms that understand the inherent risk of marketing and trading financially engineered products (e.g., interest rate caps) have implemented risk governance policies that enable them to understand the limitations of financial models. Sophisticated financial firms that deploy leading-edge risk governance practices are able to slice and dice their risk as well as append warning labels to dashboards that serve to highlight the amount of risk in stressed markets. On the other hand, if financial firms fail to implement best-practice risk governance through well-designed riskmanagement programs, then many of these firms will be in danger of experiencing dramatic losses due to model risk in the so-called highly improbable stressed markets. There has been a relentless increase in the complexity of financial models and the associated valuation theories since 1973, with the publication of the Black-Scholes and the Merton models.3 The fixed-income instrument market, and the derivatives markets more generally, provide the most striking examples. Throughout the 1970s, the market risk of bonds was assessed using a simple duration-based measure, with or without an adjustment for convexity.4 As securities increased in sophistication to include features such as embedded options, valuation came to be based on complex models. The 54 Robert Mark models work well in normal markets but tend to break down in stressed markets. The pace of model development accelerated through the 1980s and 1990s to support the rapid growth of financial innovations such as caps, floors, swaptions, spread options, and other exotic derivatives. Product innovations (e.g., credit default swaps) were themselves made possible by developments in financial theory that allowed analysts to capture many new facets of financial risk. The models could have never been implemented in practice, or have come to be so well accepted, had the growth in computing power not accelerated dramatically. Financial innovation, model development...