Financial Institutions Are On Notice That Weak Governance Can Lead To Ratings Downgrades And Significant Fines

Maybe, just maybe, financial institutions’ stakeholders are finally fed up with the bad behavior of the bad apples in banking. According to ‘Governance and Credit Ratings,’ a report published today by Fitch Ratings, the firms’ ratings analysts expect that “idiosyncratic governance weaknesses to weigh on ratings more often than previously as the tolerance of governance failures from a wide range of stakeholders (e.g. authorities, investors, creditors, customers and employees) declines.” Better late than never. As someone who has worked in banking and with bankers since the 1990s, I have never understood investors’ and regulators’ endless ‘patience’ with rule breakers.

Maybe now that Fitch is putting financial institutions on notice, executives and Boards of Directors will take ethics and rules much more seriously. A downgrade, or even the threat thereof, for any bank means that their cost of borrowing goes up and that counterparties can ask for an increase in quality and quantity of collateral in a wide range of financial transactions such as loans and derivatives. Bank regulators already can demand that banks increase capital for the operational risk component of Basel III when their corporate governance and any type of controls are weak or breached.

Without a doubt that global financial crisis of 2007-2009 was incredibly influential in changing attitudes about financial institutions’ governance failures. Banks, which are far more regulated than other financial institutions (OFIs), also known as non-banks or shadow banks, have seen a significant increase in fines and other requirements so that they can remediate their governance weaknesses. No doubt many consumer advocates feel that the regulators and lawmakers have not gone far enough otherwise there would not be such a high level of recidivism in some banks such as HSBC and Deutsche Bank.  

Fitch’s report highlighted just a few of the cases that should be a warning to all financial institutions.

·      Credit Suisse’s recent Outlook revision by Fitch to Negative due to recent events that revealed weaknesses in the bank's risk governance.

·      Another notable example is Wells Fargo WFC , who’s exceptionally high profitability was linked to malpractice, signaling poor governance.

·      The matters of Goldman Sachs GS and 1MDB as fraud, however, were not emblematic of a systematic breakdown in the firm's risk management infrastructure or corporate governance framework, which led to Fitch affirming the ratings on the bank.

·      A notable example on the insurance side is AIG, which had inadequate loss reserves between 2008-2016 and had a material weakness in internal controls per its independent auditors.

You would think that by now, bank executives would take governance more seriously. Failures in controls or looking the other way is expensive for financial institutions. According to Fenergo, “monetary fines alone cost the affected banks USD47 billion between 2008 and 2020 for anti-money laundering breaches, non-compliance with know-your-customer requirements and sanctions violations. In addition, noteworthy changes to executive management and costly adaptations to risk and control systems were required. In some instances, credit ratings were affected.”

And beware to anyone who assumes stereotypically that weak governance is something that happens only in emerging markets. In fact, since the financial crisis the banks that are all too often in the news for governance problems are indeed the Globally Systemically Important Banks (GSIBs) from developed markets.

The Fitch Report found that the increase in fines levied on financial institutions “has been most notable in jurisdictions with more developed regulatory frameworks.” This is perhaps a sign that bank regulators in developed markets have more resources or political will to take enforcement seriously.

Fitch Ratings’ Environmental, Social, and Corporate Governance (ESG) Relevance Scores demonstrate that governance factors remained the most relevant of all of the ESG factors for credit ratings “across all analytical groups, with factors tied to the issuer and broader group structure most prominent for the corporates and financial institutions sectors.”

Importantly, Fitch Ratings analysts assess corporate governance when they rate financial institutions. They take into account both the jurisdiction and the issuer. “Jurisdiction-specific considerations often overlap with the operating environment. Issuer-specific considerations include broader factors, such as the effectiveness and composition of the board of directors, transparency, related-party transactions and know-your-customer processes and enforcement.” Most governance events at financial institutions have gone beyond these features. “Broader risk control shortcomings, which often have a root cause governance failure, have significantly contributed to the most recent string of cases.”