Take home exam 4
Student No.: 2007160720 ／ 3035203297
Course Code & Course Name: LLAW/JDOC 6093 Regulation of Financial Markets
Research Title (if applicable):
Word Count (if applicable): 6993 words
2 Student number: 2007160720 / 3035203297
RFM Take‐home examination
Question 1
Word count: 3495
Student number: 2007160720 / 3035203297 3
RFM Take‐home examination
Part (i)
In this part, we aim to scrutinize the genesis of the global financial crisis. In this way, we will
derive the rationale of implementing Basel III, which involves a theoretical, practical and
empirical discussion on the main issues and problems this set of reform measures targets to
solve.
The genesis of the financial tsunami
Briefly speaking, prior to the 2008 crisis, a period of cheap credit created a flood of liquidity
in the economy. The easy-credit-environment led to overlending and overinvestment in US,
particularly in the mortgage-lending market. While qualified mortgagors were limited, banks
saw subprime mortgages as another gold mine. Subprime mortgages are loans granted to
people with poor repayment abilities. In other words, borrowers with no income or no assets
could be qualified. Shifting to the originate-and-distribute model, commercial banks sought
help from investment bankers, who then utilized their financial magic and repackaged these
loans into collateralized-debt-obligations (CDOs). Thus creating a big secondary market for
subprime mortgages. Empirical data has evidenced that Goldman Sachs, Merrill Lynch and
Lehman Brothers had leveraged up to 30-40 times of their initial investments to support these
activities; while Bank of England (2009) recorded that the subprime mortgages market has
grown, shockingly, from US$50 billion in 1997 to US$600 billion in 2005 (table (i)).1
table (i)
Nevertheless, when homeownership had reached a peak at 70% and the interest rate rose to
5.25%, it came to the turning point – Home prices started to fall, subprime borrowers could
1
Francesco Cannata and Mario Quagliariello, ‘Basel III and Beyond – A guide to Banking Regulation after the
Crisis’, 1st ed, Risk Books, 2011, page 16.
4 Student number: 2007160720 / 3035203297
RFM Take‐home examination
not afford the high interest payment and started defaulting. Investors are economically
sensitive. Flight to quality occurred and those CDOs were no longer welcomed. This marked
the beginning of the credit crisis, which ultimately evolved to become a financial crisis. In
2007, HSBC has reported severe write-downs of US$10.5 billion in its subprime-mortgage
portfolio.2 And by mid-2008, ten of the worlds’ largest financial institutions have shown a
subprime loss of US$490 billion.3 Without sufficient liquidity and by relying heavily on
leverage tricks, Northern Rock approached the Bank of England for assistance.
Issues and Problems:
Based on the above, we have broadly summarized the issues and problems Basel III tries to
tackle into 4 categories – (1) Deficiencies of the capital requirements; (2) excessive leverage;
(3) inadequate liquidity requirements and (4) systemic risks posed by certain financial
intermediaries.
Basel II required banks to maintain 8% total capital against its risk-weighted assets. To
illustrate, we hypothetically compare home mortgages to mortgage-backed-securities (MBS),
which the former is given a 50% risk-weight and the latter is given a 20% risk-weight. For
every US$1000 home mortgages, banks are required to put $40 aside ($1000x8%x50%),
while for every US$1000 MBS, banks are only required to hold $16 capital
($1000x8%x20%). Consequently, smart bankers tried to circumvent the capital requirements
by utilizing risk-transfer mechanisms such as securitisations, which is how they repacked the
subprime mortgages into CDOs. In doing so, banks were able to reduce their capital charges
by moving risky assets into the trading book and the capital freed up could be used to make
additional loans. This is probably why the trading book was criticised as one of the most
powerful devices for regulatory arbitrage. The significance of these activities can be proven
by recent empirical researches – Haldane, Brenna and Madouros (2010) reveals that the total
trading assets (the size of trading book) has grown from 20% in 2000 to approximately 45%
in 2008 (table (ii));4 the IMF (2009) also echoed this by suggesting that the yearly issuances
of securitisations have evolved from 1.5 trillion to 4.7 trillion US dollars in 2000 and 2006
2
Ibid, page 22.
3
Ibid, page 23.
4
Ibid, page 11.
Student number: 2007160720 / 3035203297 5
RFM Take‐home examination
respectively (table (iii)).5 In recent years, big banks are even allowed to determine riskweights themselves by adopting internal ratings-based models. This may further incentivize
them to attribute lower risk-weights and thus generate more profit. By underestimating the
true risk and falling below the intended capital requirements, banks may not be capable to
withstand shocks during recession.
table (ii)
table (iii)
Secondly, excessive leverage by banks is one of the key issues that might have contributed to
the financial crisis. In essence, leverage is the amount of debt used to finance the assets and is
at the heart of banking (investment) business. To elucidate, a potential homeowner with
US$100 may persuade a finance institution to loan him 9-times his original amount, making a
sum of US$1000 ($100+$900) to invest in properties. This happens not only to homebuyers,
but also to financial intermediaries. The problem of over-leveraging is caused by various
factors – As stated in the genesis part, firstly, the decline of the interest rates enhanced the
affordability of debts; secondly, companies prefer debt financing when compared to equity
financing because the interest expenses arose are tax-deductible; finally, as banks granted
more and more subprime mortgages, the market has sent out a wrong message – increased
indebtedness was no-worries. Thereupon, it is suggested statistically by Sevcan Yesiltas
5
Ibid, page 10.
6 Student number: 2007160720 / 3035203297
RFM Take‐home examination
(2011) that most investments banks were leveraged up to 30x to 50x.6 Therefore, during
recession, highly leverage companies find it hard to pay their debts with no additional
financing available.
The third issue that immediately catches our eyes is liquidity. Liquidity is the degree of
readiness to which an asset could be converted into cash without losing value. It comes as no
surprise that investors commonly favour highly liquid assets as they can easily sell them in
case of emergency. From what we have discussed so far, the bursting of the housing-bubble
in conjunction with the leverage problem may significantly reduce banks’ access to funding,
resulting in a credit crunch. Bear Stearns’s decision of closing two hedge funds, which
revealed a huge loss on MBS, in some way demonstrated this situation. Investors became
alert and they questioned to what extent the financial institutions knew the true value of their
books. Becoming more risk averse, investors began to avoid mortgage-related investments
altogether. The hard-to-value securities soon spread over and the investors are unwilling to
provide further liquidity in the marketplace. Having relied too much on short-term
borrowings, banks have put the maturity transformation practice into an extreme. Without
any loss-absorbing capital for redemptions, banks can only conduct quick sales. The
substantial reduction of asset values put banks into great financial difficulties. As a result, in
September 2007, Northern Rock (UK) and Countrywide (US), with no other resort, required
rapid assistance from Bank of England and the Fed respectively.7
Last but not least, systemic risk is another major contributory factor to the financial crisis.
There are some intermediaries in the financial market that are ‘too-big-to-fail’.8 For instance,
the American International Group (AIG), as the world’s biggest conventional insurance
6
Sevcan Yesiltas, ‘Leverage Across Firms, Bank and Countries’, Johns Hopkins University, 2011, available at
https://www.google.com.hk/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CB0QFjAA&url=https%3
A%2F%2Fwww.aeaweb.org%2Faea%2F2012conference%2Fprogram%2Fretrieve.php%3Fpdfid%3D93&ei=S
pB9VPLqJMa7mgWbqYCICA&usg=AFQjCNFlCLFD6rDM4WqCR2Ncl_4Hv2wv5g&sig2=UPfUBkikl_NE
Y5loyRWh6Q. page 40.
7
Francesco Cannata and Mario Quagliariello, ‘Basel III and Beyond – A guide to Banking Regulation after the
Crisis’, 1st ed, Risk Books, 2011, page 24.
8
Ben S. Bernake, ‘Causes of the Recent Financial and Economic Crisis’, the Financial Crisis Inquiry
Commission, Washington, 2010, available at:
http://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm.
Student number: 2007160720 / 3035203297 7
RFM Take‐home examination
provider and has made up a substantial part of the economy, sold many credit-default-swap
(CDS) during the financial crisis. A CDS works as an insurance bond which guarantees buyer
for the lender’s default. As a result, AIG built a close tie with other financial institutions
including a lot of banks. When the house bubbles burst, the close linkage of the interbank
system, so-called the ‘domino effect’ spreads the systemic risk out to other banks.9 This left
AIG with only half of the total assets and was in nowhere near the full CDS amount owed
(table (iv)). Eventually, the U.S government decided to bail AIG out with $180 million in
order to prevent AIG from bankruptcy, which if happens would cause other financial
institutions to collapse too.
table (iv)
9
Ibid.
8 Student number: 2007160720 / 3035203297
RFM Take‐home examination
Part (ii)
As a result, Basel III is introduced so as to tackle the issues we raised above. The key
elements of Basel III are – (1) Capital requirements; (2) Leverage ratio, and (3) Liquidity
requirements.
Capital requirements:
In principle, regulatory capital should be the first shield against losses, as they ensure banks
to be able to withstand negative shocks. Ideally, the ratio of capital to risk-weighted assets
must be correctly designed – capital should be able to absorb losses and risk-weights should
truly reflect the riskiness of the underlying assets. However, financial engineering techniques
were adopted by banks to disguise the public with sufficient capital standards that turned out
to be untrue. Therefore, after the Lehman crisis, a new round of negotiation of capital
adequacy has started and more stringent requirements are being introduced.
equation (i)
Basically, Basel III aims to increase the amount of capital that should be set aside. While
Basel II required banks to hold 2% of their common equity in reserve, Basel III raised it to
4.5%.10 In addition to that is the new requirement of capital conversation buffer of 2.5%.11
This measure aims to minimize procyclicality, which means slowing down the credit growth
during a boom, and at the same time provides banks the capacity to recover during a
10
DavisPolk, ‘U.S. Basel III Final Rule: Visual Memorandum’, Davis Polk & Wandell LLP, 2013, available at:
http://www.google.com.hk/url?sa=t&rct=j&q=&esrc=s&source=web&cd=20&cad=rja&uact=8&ved=0CFMQF
jAJOAo&url=http%3A%2F%2Fwww.davispolk.com%2Fdownload.php%3Ffile%3Dsites%2Fdefault%2Ffiles
%2Ffiles%2FPublication%2F3e28c060-fd34-42c0-9b75003fe1c4ea5c%2FPreview%2FPublicationAttachment%2F937e4d31-4e86-4a00-a48b00629c05ca4f%2FU.S.Basel.III.Final.Rule.Visual.Memo.pdf&ei=7CCPVI7EH8TKmwXB1IL4BA&usg=AFQj
CNEjsU-na3FXGf7Ta0r71FDcUTdFPQ&sig2=B6uU5-8DsanWQ5xNlo3UvA.
11
Ibid.
Student number: 2007160720 / 3035203297 9
RFM Take‐home examination
downturn. Overall, this brings the total common equity requirement to 7% (4.5%+2.5%).12 It
has also been suggested that the total capital requirement for bank should be increased from
the original 8% to 10.5%.13
Besides raising the minimum capital requirement, the capital ratio can be increased indirectly
by increasing the quality of capital. In this regard, the Basel III has defined the Common
Equity Tier 1 (CET1) comprehensively in order to ensure loss absorbency, flexibility of
payments and permanence by setting 14 criteria.14 Core equity capital with no loss-absorption
capacity will not be taken into account. This includes minority interests or Deferred Tax
Assets. Hybrid Tier 1 component, for instance, innovative/SPV-issued Tier 1 instruments are
gradually phase-out.15 With more stringent criteria on the sources of fund, this new definition
of regulatory capital is composed of elements that can fully reveal the solvency status of the
financial institutions. These microprudential measures aim to encourage banks to be more
alert when they allocate equity to support risky business. Other than revising firm-specific
requirements, Basel III also aims to mitigate systemic risks. As such, banks that are
designated by Financial Stability Board as systematically important are subject to a surcharge
as high as 2.5%.
Leverage ratio:
From the above, we have explored that banks may still be vulnerable even if they adhere to
the capital ratio. For instance, holdings of sovereign debt in some countries, for instance, the
Italian banks, might not be bound by capital requirements and liquidity limitations, but still
they represent a huge portion of risks. In this case, even the banks can satisfy the capital
adequacy ratios, this does not guarantee the banks’ balance sheet are sufficiently liquid and
can meet outstanding short-term and long-term obligations. Therefore, leverage ratio is
designed as a metric to limit the size of the balance sheet.
12
Ibid.
13
Ibid.
14
Ibid.
15
Ibid.
10 Student number: 2007160720 / 3035203297
RFM Take‐home examination
equation (ii)
The Basel III introduced a ‘simple, transparent, non-risk based leverage ratio’ to act as a
supplementary measure to the ‘risk-based capital requirements’.16 It aims to restrict the buildup of leverage in the broader financial system and provides a non-risk-based ‘back-stop’,17
irrespective of the assets’ quality. The leverage ratio is likely to be 3%.18 It means that a bank
would not be allowed to hold assets representing more than 33 times of its equity. Going to
the left side of the equation (ii), Tier 1 capital is now specified – It consists of Common
Equity Tier 1 and Additional Tier 1.19 To be a Tier 1 capital, it has to be perpetual in nature,
able to bear loss and fully paid up without any funding.20 Examples include common stock
and retained earning. On the denominator part, the credible leverage ratio introduced by
Basel III adequately captures both on and off balance sheet leverage of banks. Under the old
Basel rules, the capital ratio applies only to risk-weighted assets but not to total assets.
Further, big banks have been permitted to rely on their own calculation models to assess the
‘risk-weights’. Consequently, they are often tempted to attribute very low risk weights to the
assets so as to increase leverage and generate more profit. Basel III tries to introduce this
leverage cap that takes ‘the total quantity of asset as its capital’. Thus, despite the capital
ratios is largely criticized as ‘easy-to-manipulate’, the leverage ratio, which takes into
account all kind of assets, is much more difficult to manipulate.
Liquidity:
As we have seen in part (i), where Bear Stearns performed badly in the two hedge funds and
the money markets froze, banks sought assistance from the central banks or government for
liquidity support. Likewise, in the 2012 European sovereign crisis, banks obtained term
16
Georges Ugeux, ‘International Finance Regulation’, 1st edn, John Wiley & Sons Inc, 2014, page 82.
17
Ibid.
18
Ibid.
19
Ibid.
20
Ibid.
Student number: 2007160720 / 3035203297 11
RFM Take‐home examination
funding from the European Central Bank. In order to prevent the repetition of liquidityshortage, Basel III announced two new liquidity ratios to enhance liquidity and selfsufficiency of banks. They are the Liquidity Coverage Ratio (LCR) and the Net Stable
Funding Ratio. It is evidential that the funding of assets by deposits has dropped sharply
while other forms of funding have replaced this traditional liability.21 Consequently, one of
the overarching aims of Basel III is to turn the track back to relationship-based retail deposit
funding from short-term wholesale market funding.
equation (iii)
The LCR ensures that banks keep adequate stocks of ‘unencumbered high-quality liquid
assets’ that can be turned into cash immediately to meet their liquidity needs ‘for a 30
calendar day liquidity stress scenario’.22 The aim of this measure is to reduce banks’ reliance
on short-term and fragile sources, for instance, ‘unsecured inter-bank deposits with tenors
below 30 days’.23 Banks have to maintain the ratio at or above 100%. In other words, banks
can still manage to take liquidity risk, but if they choose to do so, they should have ensured
themselves with ‘sufficient liquidity risk bearing capacity to weather short-term liquidity
shocks’.24 Thereupon, high quality liquid assets on the numerator demonstrate assets with
high credit quality and high market liquidity. These may include central bank money,
government bonds or covered bonds.
equation (iv)
21
Ashok Vir Bhatia, ‘New Landscape, New Challenges: Structural Change and Regulation in the U.S. Financial
Sector’, IMF working paper, 2007, available at: https://www.imf.org/external/pubs/ft/wp/2007/wp07195.pdf,
page 3.
22
Georges Ugeux, ‘International Finance Regulation’, 1st edn, John Wiley & Sons Inc, 2014, page 81.
23
Stephan W. Schmitz, ‘The Impact of the Liquidity Coverage Ratio (LCR) on the Implementation of Monetary
Policy’, in Economic Notes, Vol 42, Issue 2, 2013, page 135.
24
Ibid.
12 Student number: 2007160720 / 3035203297
RFM Take‐home examination
For long term holding, the banks will then be required to hold ‘a net stable funding ratio’ to
meet its liquidity requirement ‘over a period of 12 months’.25 Similar to the LCR mechanism,
the gist for this measure is simply to impose a cushion by using long-term debt to cover some
of the long-term assets in the banks’ portfolio.
25
Ibid.
Student number: 2007160720 / 3035203297 13
RFM Take‐home examination
Part (iii)
Regulatory arbitrage
As we know, nothing is ever completely one-sided. Basel III, on one hand, may enhance
financial stability and bank liquidity by adopting a tight money conservative approach, on the
other hand, it may lead to severe impacts and freeze the growth of the societies – This is
particularly obvious for banks in developing countries. With the new liquidity and leverage
ratios, banks will be forced to reduce credit since maintaining additional capital significantly
reduces the amount of money available to be lent out. Derivatively, low supply raises lending
cost and banks will be less generous to extend loans to individuals. For instance, traditional
mode of financing, say, Letter of Credit, will be more expensive. Ultimately, it comes back to
the society again – individuals or corporates will then find it hard to advance their families or
businesses economically. Nevertheless, Basel III itself opens up a loophole – it has omitted to
bring non-banking financing companies under their ambit.
Shadow bank is described as a bank-like institution with activities structure outside the
regular-banking system. From the above scenario we can observe that when most of the
banks are still under the deleveraging process, shadow-banking system can act as a ‘bank-like’
credit intermediation that are not subject to the same regulatory constraints as banks. Thus,
banks themselves may rely on the shadow banking entities to build up leverage and bypass
the capital or liquidity requirements. This can be seen where banks often substitute assetbacked financing for regular lending facilities since the capital requirements for the former is
much lower. From the experiences of the financial crisis, it can generally be inferred that the
higher the capital/leverage/liquidity ratio, the more likely that regulatory arbitrage will be
exploited. They are directly proportionate. Thus, Basel III itself aggravates this problem.
How should the shadow banking system be regulated
From the above inference we can see that regulatory arbitrage increased when traditional
banks are subjected to stringent regulations. Since the end of the 2008 crisis, perhaps, the best
way is to regulate shadow-banking systems more, especially when there is no sound reason to
lessen the requirement imposed on traditional bank by Basel III. In this section, we will
14 Student number: 2007160720 / 3035203297
RFM Take‐home examination
explain how shadow banks can be regulated by direct and indirect regulatory framework and
critically analyse whether these are effective.
Indirect regulation forbids the counterparty to deal with the entities without complying with
certain rules. For instance, the Dodd-Frank Act (DFA), similar to Basel III, imposes
regulations on non-bank institutions. In order to enhance better screening and transparency
from the shadow banks, the DFA imposes an improved disclosure framework and introduces
the ‘skin in the game’ regime – by retaining a substantial share of the asset, it incentivise both
the originators or the SPVs to conduct better risk assessments. Nonetheless, we should be
cautious against these indirect regulations since a more stringent requirement for banks, again,
increases the tendency of exploiting regulatory arbitrage. Where there are two different
regulatory regimes (traditional and shadow banks) with no switching costs, it is foreseeable
that more activities will be diverted to the shadow banking system. Therefore, it has been
suggested that direct interventions are more preferred.
Direct regulation addresses risks that stem from shadow banking entities/ instruments. For
instance, the DFA has introduced a new calculation method for the capital, leverage and
liquidity ratio so managers are now easier to monitor the securities lending. Besides, hedge
funds must now register with the Securities and Exchange Commission (SEC), while all
‘systematically important institutions’ are caught under the new regime set up by Federal
Reserve. This aims to break the linkage between traditional banks and shadow banks, block
the transmission of risks and limit the impact of failures. The Solvency II Framework
Directive (2009) requires insurances to take into account credit risks. If Basel III or the
indirect regulation in a roundabout way brings back the systemic risk, a stricter and direct
regulation is necessary to reduce regulatory arbitrage or systemic risk. Nevertheless, given
that different non-bank entities may carry out different functions, it is not possible for
regulators to easily spot out non-bank entities that should be subject to regulations. One may
argue that imposing requirements to all the non-bank entities can solve the problem, but we
would contend that this burden outweighed the costs of implementation. Thus, despite direct
regulation may be more favourable than the indirect one, without an efficient enforcement
regime it is still yet to say that this is the key.
Student number: 2007160720 / 3035203297 15
RFM Take‐home examination
Overall, as shadow banking involves various activities and entities, it may not be possible for
a single regulatory approach to deal with all circumstances. Provided that shadow banking
has a fundamental role in the whole financial system by providing sources of funding and
diverting risks, the best regulation we would hereby suggest is a balancing test in minimizing
their risks but at the same time preserving their efficiencies. Accordingly, the regulatory
framework should include a case-by-case balance to deal with all potential costs and benefits
of the interventions. Alternatively, one may try to regulate the systemic risk by utilizing
insurance. Long-term insurance policies can arguably pacify the fluctuations faced by the
shadow bankers. However, we would contend that this simply moves the systemic risk
between two different sectors. Thus, regulations only help, but not heal. Ultimately, a good
regulation framework should imply flexibility and adaptability that may take into account any
adjustment the financial institutions may have made after the enactment of the Basel III (as
what they did after Basel I & II). This will now all fall to the Financial Stability Oversight
Council, who is given the discretion to recommend any necessary regulatory changes in order
to maintain financial stability. After all, there is no fast-route and we still have to admit none
of the above solution is a panacea.
16 Student number: 2007160720 / 3035203297
RFM Take‐home examination
Question 2
Word count: 3498
Student number: 2007160720 / 3035203297 17
RFM Take‐home examination
Part (i)
A security firm is a financial intermediary that conducts activities such as dealing and
advising on securities and futures, and assisting in mergers and acquisitions. Briefly
speaking, securities firms can perform several functions. For example, with the help of
securities firms like investment banks, companies can issue securities to public or to private
investors through placements to obtain extra financing. On the other hand, firms like
securities brokers and dealers provide channels for investors to trade shares in the secondary
market.
To outline the importance of an effective internal system in a securities firm, we will, in this
part, identify three main governance issues (i.e. separation of ownership and control,
transparency and resources allocation) in order to explain precisely what is the corresponding
importance of an effective internal system.
Importance (1) – Separation of ownership and control
Generally speaking, shareholders can gain from entrepreneurial ventures by supplying
capital, ‘even though they lack management skills’; 26 conversely, managers earn from
‘profitable business opportunity’ despite they lack personal wealth.27 However, problem
arises as the interests of the shareholders and managers are always diverted. For instance,
while managers cannot capture all the benefits even if their decisions are extraordinarily
successful, or they do not need to bear extra loss even the venture diminishes; they tend to
consume leisure instead of dedicating to wealth maximization.28 Therefore, it is alleged that
managers, who serve as agents, have engaged in self-serving behavior that is detrimental to
26
Fischel Engle, ‘Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United
Kingdom Inflation’, Econometrica, 50, 1982, page 1262.
27
Ibid.
28
Ibid.
18 Student number: 2007160720 / 3035203297
RFM Take‐home examination
the company’s wealth maximization.29 From the perspective of shareholders, it is important
to ensure that they can get an appropriate return for their financial investments.30
Thus, it is important for an effective internal system to exist, which outlines a board of
independent directors, who occupies a central role in entrepreneurial decision-making and is
located squarely between the shareholders and managers. The enhancement of board
independence can prevent corporate controllers from diverging their attention to personal
interests and thus it is effective in protecting shareholders’ interests. To elucidate, board
independence is particularly important in high-performing securities firms. In these firms, the
CEO may have high status and power and thus gives them a high degree of entrenchment.
This may encourage the CEO to incentivize in his/her own empire building and pursuing
higher bonuses even in regression. Notably, Mitton (2002) suggested that ‘shareholder
expropriation’ was severer during financial crisis where the expected return drops
significantly.31 Oppositely, independent boards have proven to be of greater contribution to
the firm value.32 An empirical research by Musteen (2010) has shown that firms with a
greater proportion of ‘outsider directors’ (i.e. independent non-executive directors) generally
have a better reputation than firms with a high proportion of ‘insider directors’ (i.e. executive
directors)33. Following the introduction of Sarbanes-Oxley Act (SOX), the New York Stock
Exchange had proposed rules that clearly suggested that a majority of the board of directors
of a listed company should be ‘independent’.34
Importance (2) – Transparency
The problem of asymmetric information exists in all imperfect markets. Needless to say,
parties that possess more information are in a better position to make informed decisions and
29
E.F. Fama, ‘Agency problems and the theory of the firm’, Journal of Political Economy 88, 1980, page 288-
307.
30
A. Shleifer, and R. Vishny, ‘A survey of corporate governance’, Journal of Finance, 52, 1997, page 737-783.
31
T. Mitton, ‘A cross-firm analysis of the impact of corporate governance on the East Asian financial crisis’,
Journal of Financial Economics 64(2): 215-41.
32
M.Musteen, D.K. Datta and B.Kemmerer, ‘Corporate reputation: do board characteristics matter?’, British
Journal of Management 21(2): 498-510.
33
Ibid.
34
Ibid.
Student number: 2007160720 / 3035203297 19
RFM Take‐home examination
in turn, maximize their interests. When applying such concept to a large securities firm, small
shareholders, who are seldom engaged in running the business on a day-to-day basis, may not
possess sufficient information to monitor the company’s performance and assess whether the
returns received from their investments in the company are considered reasonable. Due to the
lack of access to internal information, shareholders can merely rely on publicly published
information to base their decisions. Without a proper internal system, there are possibilities
that managers will take advantage of their positions to misuse the company’s resources for
personal benefits without being noticed. Senior management may then conceal their acts by
creating fraudulent records, thereby nullifying the accuracy and usefulness of those financial
reports. Shareholders may make wrong judgments if they refer to the erroneous information.
To avoid the occurrence of such situations, a reliable financial reporting system
complemented with an independent internal audit function should be established to ensure the
entity operates in an efficient and orderly manner. It is worth mentioning that reliable
financial statements also increase investors’ confidence in the companies concerned as they
can get a clearer picture of the entities’ financial standing and future prospects, thereby
reducing the firms’ cost of capital and increase profit margin. Shareholders will then be able
to receive a higher return accordingly.
Other than shareholders, directors also benefit from the implementation of an effective
internal system as such system helps them to discharge the fiduciary duty, and duty of care
and skill owed to the company. For example, directors in Hong Kong are expected to avoid
actual and potential conflicts of interests. Owing to the nature of business, it is not surprising
that large securities firms often enter into countless deals every day. Some of those
transactions may be very complex attributable to the involvement of numerous counterparties
that are inter-linked to each other, by that causing the identification of potential conflict of
interests a daunting task. With the help of an effective internal reporting mechanism,
directors can easily avoid breaching the aforementioned duty as all business transactions are
properly recorded and monitored. Facing a complicated organizational structure with sizable
operations, it is also almost impossible for directors of large securities firms to properly
exercise the duty of care, skill and diligence unless the relevant internal frameworks are in
place to capture all risks to which the companies and their clients are exposed.
20 Student number: 2007160720 / 3035203297
RFM Take‐home examination
Importance (3) – Resources allocation
In order to maximize profit, it is crucial for managers and directors to direct limited resources
such as labour and capital to proper use and an effective internal system can help to achieve
this result. For instance, clear reporting lines as well as well-defined roles and responsibilities
can ensure employers are working in an efficient and systematic manner, thereby avoiding
duplication of effort. Comprehensive policies and procedures outlining authority and
approval limits can expedite the execution of projects or transactions, by that ensuring the
firms can secure all good business opportunities. An appropriate risk management system
makes sure the firm only engages in businesses that are both within its risk appetite and
capacity. Presence of operational controls not only assures the business to run in a smooth
way, it also helps the firm to comply with legal and regulatory requirements. This can all be
done by continuously exercising effective control, monitoring and risk assessments.
Overall
To sum up, having an effective internal system can significantly enhance the firm’s
performance. For instance, it can encourage the parties to achieve their objective in a more
structured and effective way; it can boost public confidence by preventing fraud and
providing more reliable financial disclosures; it can also avoid any damage to the company’s
reputation by making sure it complies with relevant laws and regulations.
However, there are certain loopholes that may not be remedied by an internal system no
matter how effective it is. In no doubt an effective internal system can provides clearer
information and feedbacks, which may assist in strategic planning or achieving objectives, it
has no legal enforcement regime that can guarantee the implementation. Therefore, we
should be obliged to consider the broader picture by looking further to a legislative and
regulative framework.
Student number: 2007160720 / 3035203297 21
RFM Take‐home examination
Part (ii)
While we have already seen a sound internal system could encourage efficient and orderly
market, prevent fraud and encourage law compliance, it could be argued that this is not
enough. Added to that, a sound legislative and regulatory framework can ease the public with
better understanding on the securities industry. Another gist of these regulatory regimes is to
maintain Hong Kong’s overall financial stability and to prevent market misconduct. Looking
back to histories, we can see that economic crises often stem from ineffective or inadequate
regulations of financial markets. For instance, the broke down of the under-regulated
securities market in the US devastated the economy and led to the Great Depression in 1930.
Therefore, in this part we aim to analyze how a robust legislative and regulatory framework
provides us a safe and sound financial environment.
Importance (1) – Executive remuneration and incentives
In the 1980s, executive compensation soared due to the rapid economic growth and rising
inflation rate. It was alleged that several executives received hugely excessive payouts. For
instance, Michael Eisner (Disney) received a ‘stock option’ of 920 million35 while Sandy
Weille (Citigroup) got approximately a 980 million stock option.36 By 2006, the paychecks
received by CEOs in America were approximately four-hundred-times more than average
workers. This can be evidenced by the table below, which indicated that CEOs’ remuneration
package have grown significantly in the past decades. More absurdly, the executives of
Barclays were paid million pounds albeit a significant fall in its share price; while in Scotland,
senior management in a renowned security firm earned a huge sum despite over 1000
employees lost their job.37
35
David Larcker & Brian Tayan, ‘Corporate Governance Matters’, 1st edn, Pearson Education, 2011, page 239.
36
Ibid.
37
http://www.nytimes.com/2012/01/23/business/in-britain-a-rising-outcry-over-lavish-executive-pay.html?_r=0.
22 Student number: 2007160720 / 3035203297
RFM Take‐home examination
These unreasonably high remunerations are heavily criticized by the public and are widely
discussed these days. Researchers have revealed that ‘the correlation between’ performance
and executive pay is ‘very weak’.38 P.Jacquart (2013) even suggested that high payment
renders worse performance – it demotivated the CEOs, encourages them to omit the
stakeholders and neglect to make any long-term decisions for the stakeholders. 39 To
exemplify, the excessive compensations may lead to the emergence of self-serving behavior
and thus shorten the CEOs’ long term vision; while CEOs are generally offered to purchase
stock options, they may be tempted to buy the shares at a low price and by falsely reporting
profitability, they can resell those shares at a much higher price and reap huge profit at the
expense of the investors. This can be echoed from the Enron scandal (2001), where the
executives’ remuneration was not taken out from the net profit thus representing a false
profitability statement. Furthermore, an excessive compensation demoralizes employees. As
shown above, how can an employee be satisfied if their boss (i.e. the CEO) earns fourhundred-times more than them? Even if the CEO is incredibly smart, it is the workforce who
executes and implements his or her decisions. Without those labour, the company cannot
even function properly.
As a result, in order to safeguard the interests of other stakeholders, a legislative and
regulatory framework is a must. To effectively regulated the above problem, or from a
regulatory and supervision viewpoint, the practice can include policies that govern the
38
A.J. Vogl, ‘Vexing questions. Across the Board’, ABI/INFORM Global database, 1994, page 18.
39
Philippe Jacquart and J.Scott Armstrong, ‘Are Top Executives Paid Enough? An Evidence-Based Review’,
Interfaces, Forthcoming, 2013, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2207600.
Student number: 2007160720 / 3035203297 23
RFM Take‐home examination
execution and termination of the contract, an ad hoc disclosure that includes any share
transactions, or how the remuneration-related policy is affected by the annual voting regime.
For instance, in Hong Kong, the SFC requires institutions to include a remuneration
committee in the firm’s organizational chart in order to review ‘the level and structure’ of the
remuneration scheme.40 Besides, it also lists out the CEO’s role and responsibilities,41 which
includes but not limited to regularly report the strategic objectives to the board so that it
inhibits the CEO from manipulating the business plans for personal goals. 42 In the
international aspect, for instance in the US, section 953 of the Dodd-Frank Act (DFA)
proposes that the ‘pay-for-performance’ and the ‘ratio between the CEO’s compensation’ and
‘the median of other employee’s compensation’ should be disclosed. 43 Similarly, the
Australian Securities and Investment Commission requests financial services companies to
disclose their executives’ compensation schemes.
Another issue relating to executive’s compensation is the golden parachute clause and golden
handshake clause. Golden parachute is a clause that entitles the senior executives to a
lucrative compensation if the company is being taken over and the executives loss the job as
a result of such event. On the other hand, if a golden handshake clause is included in the
employment contract, executives can get a significant severance package once he or she loses
the job. Although golden parachute and golden handshake arrangements can help to retain
high-quality CEOs, it may also bring about moral hazards. These terms may act as a catalyst
for the executives to act for their own interest but not the shareholders. Beware that anyhow
the gist of the fiduciary duties is to act for the best interest of the company,44 the reason for
an extra compensation seems to be meaningless. To ensure the investors and shareholders
have access to this piece of material information, s951 of the DFA outlines that the golden
parachutes should now be disclosed. Likewise, the Director’s Remuneration Report
Regulation 2002 requires annual accounts to show all payment details to directors. Swiss
40
SFC, ‘Code of Conduct of Persons Licensed by or Registered with the Securities and Futures Commission’
Securities and Futures Commission, 2013, available at: http://enrules.sfc.hk/net_file_store/new_rulebooks/h/k/HKSFC3527_1868_VER30.pdf.
41
Ibid.
42
Ibid.
43
Section 953, Dodd-Frank Act, available at http://www.dodd-frank-
act.us/Dodd_Frank_Act_Text_Section_953.html.
44
Bristol and West Building Society v Mothew [1998] EWCA Civ 533.
24 Student number: 2007160720 / 3035203297
RFM Take‐home examination
referendum even requires votes on executive pay to be binding and they restrict the golden
parachutes. All those legislative and regulatory frameworks somehow help to protect the
integrity of the securities market.
Arguments like executive remuneration can encourage short-term profit and risk-taking and
thus partially contributed to the financial crisis can be seen everywhere. With the above
legislative and regulatory responses, employees’ productivity may increase as they are no
longer antagonistic about the ridiculously high-paid of their leader. Except this, we would put
more concerns on whether these frameworks may effectively help the companies to stay
competitive and allocate the right amount of risk and remuneration respectively. While no
one will argue that it is extremely hard to regulate executive remuneration, at least, with the
frameworks, the remuneration scheme has moved from arbitrary to regulatory.
Importance (2) – Whistleblowing
Whistleblowing is an act of reporting any illegal, harmful, irregular, unethical or corrupt
matters. Generally, the whistle is blown on behalf of the public interest. Despite employers
are usually the party who spot those problems, they are often reluctant to expose them. The
possibilities of getting fired, harassed or even reprimanded deter employees from disclosing
the fraudulent activities. Empirical data has shown that such fear was reasonable – A recent
survey provided that among the surveyors (whistleblowers), 62% was made redundant, 18%
were transferred and 11% had a reduction in salaries.45 Consequently, without an effective
whistleblowing system, corporate fraud is covered by veil. Stakeholders’ interests are thus
jeopardized. Even with an effective internal system, this system can still be defeated by
employees’ conspiracy. For instance, in the Enron scandal, Sherron Watkins wrote an email
to the CEO addressing the misstatements in the financial reports,46 but this report was not
published until five months later.47 Similarly, Cynthia Cooper, who worked for WorldCom,
was the first one who noticed the accounting fraud but her boss delayed her findings.48
45
http://ethics.csc.ncsu.edu/old/12_00/basics/whistle/rst/wstlblo_policy.html.
46
Geoffrey Christopher Rapp, ‘Beyond Protection: Invigorating incentives for Sarbane-Oxley Corporate and
Securities Fraud Whistleblowers’, Boston University Review, Vol 87:91, 2013, available at:
http://128.197.26.34/law/central/jd/organizations/journals/bulr/volume87n1/documents/RAPPv.2.pdf.
47
Ibid.
48
Ibid.
Student number: 2007160720 / 3035203297 25
RFM Take‐home examination
Therefore, whistleblowing is important to overcome such conspiracy and bring the
information of fraud to the regulators’ attention.
Thereupon, many countries have legislative and regulatory framework to govern the
whistleblowing activities in order to suppress malpractices. For instance, in Hong Kong, the
SFC Code of Conduct now expressly commands that any licensed entities who have
suspicions on whether their clients breach the market misconduct provision in SFO are
required to report to the authority.49 From the international aspect, the Sarbanes-Oxley Act
(SOX) (2002) includes a whistle blowing section and stating, albeit indirectly, that it is
essential to maintain an effective and proper governance structure: Firstly, section 806(a) of
the SOX outlines the ‘anti-retaliation’ provision. Employees who face wrongful dismissal can
now claim for damages. Secondly, SOX suggests the establishment of a ‘standardized
channel’ to report misconduct internally within the corporation.50
These provisions aim to deter the company from reprimanding the whistleblower and
compensate the whistleblowers for any negative impact he or she may suffer at the same time
encourage employees to participate in monitoring the corporation and thus enhance good
governance practice.
Importance (3) Adequate disclosures
The major problem here arose from asymmetric information as we have already noted in part
(i) – transparency is one of the fundamental concepts that can give shareholders and investors
better access to the information required and thus assist them to make better judgments.
However, a mere effective internal system may not be enough – a good disclosure regime is
not only beneficially internally, it can aid the public to understand the structure and
operations of the company, and subsequently analyze whether they should invest in the
company.
Thus, there remains a need for legislative and regulatory framework to step in. To
demonstrate, in Hong Kong, the regulatory structure for selling investment products issued
49
Supra note 15.
50
Section 301, Sarbanes-Oxley Act 2002.
26 Student number: 2007160720 / 3035203297
RFM Take‐home examination
by SFC requires parties to disclose sufficient information in the product documents so that a
person can be free to make an informed decision. Besides, the SFC also requires the
securities firm to make sure themselves to consider whether the product is suitable before
they recommend them to any particular investors.51 Under Securities and Futures Ordinance
Part XV,52 it requires individuals or corporations who have 5% or more voting shares to
disclose any of their interests or changes in interest; Directors and chief executives that
worked in a listed corporation are also catch by the disclosure regime. Section 336 of the
same ordinance expressly requires every listed corporation keeps ‘a register of the [disclosed]
interests and short positions’.53 Analogically, same disclosure requirement applies to the
directors and executives.54 These can be echoed internationally, where in the EU, Article
19(5) of the MiFID provides that all the EU members have to ensure securities firm to
provide knowledge of investment according to their professions and give clients appropriate
advice for their specific product.55 Furthermore, the OECD in 1999 published a legislative
and regulatory framework that aims to ensure that the company makes ‘timely and accurate
disclosure’ regarding to matters like ‘financial situation, performance, ownership and