Looking back at the causes of the financial crisis, it is often assumed that managers’ accountability vis-à-vis the shareholders was the major factor contributing to the excessive risk- taking that could be observed. Whilst this implication holds true, applying undifferentiated solutions to complex structures runs the danger of replacing one problem with another. Therefore, the regulatory response should account for the differences in the corporate governance of banks and companies in the real economy.
I will analyse the underlying problem regulation has to face. I will show that it was not directors’ accountability vis-à-vis shareholders as such that caused excessive risk-taking but managers’ behaving as undiversified shareholders (I). Against this background, I will comment on recent regulatory approaches in the corporate governance of banks (II). Finally, I will draw a conclusion (III).
I. The Misconception of the Alignment of Shareholders and Management
After the crisis, bank exceptionalism [1] developed, according to which the corporate governance of banks has to deviate from standard governance theory because shareholders do not account for systemic risk. Thus, aligning managers to their interests would impose negative externalities onto society. It is true that aligning managers and shareholders’ incentives (e.g., via equity-based compensation) leads to higher risk-taking since diversified shareholders prefer high-risk projects compared to managers who by default favour low-risk projects due to their undiversified human capital investment. But high-risk incentives are not necessarily bad. First, limited liability is designed to facilitate risky and innovative projects. Second, shareholders’ risk preferences are normally cancelled out by creditors’ risk aversion, which translates into management’s decision-making via covenants.
The danger of banking does not follow from risk-taking itself but from the externalities banking imposes onto society due to the interconnectedness of banks, contagion, and loss multiplication. It is for these externalities that the costs of bank failures are borne by society. The standard argument posits that shareholders push for incurring greater risks because they will earn the entire surplus if a project is successful but only bear parts of the losses in case it fails. Consequently, banks adopt a higher risk profile than is socially desirable.
Having said this, it only holds true for undiversified shareholders. Diversified shareholders, on whom the corporate governance model is based (diversified = venturesome), do suffer from the negative externalities as loss multiplication impacts on their entire portfolio, which cannot be cancelled out by any benefit derived from excessive risk-taking on a single company level. Therefore, managers’ excessive risk-taking is not attributable to their general accountability towards shareholders but constitutes the result of a different problem, namely managers acting in their own interest. Managers generally receive high equity-based remunerations. Yet, due to the very nature of this compensation, managers become undiversified investors since their financial assets are bound in a single company. The combination of high equity stakes and control is dangerous and leads to higher risk-taking. This is particularly problematic in the US, where systemically important banks are organised in holding structures with outside shareholders only investing at holding level. This means that managers on the subsidiary level are only accountable to the holding, but not to outside shareholders. In other words, the subsidiary is directly accountable to an undiversified holding company and only indirectly accountable to any form of dispersed shareholder. Moreover, this problem is exacerbated by diminishing incentives for creditors to engage in monitoring; after all, they can be sure of the indirect state guarantee associated with the lender of last resort and the deposit guarantee scheme. The combination of the two leads to what Mr. Walker identifies as the unlimited liability of the taxpayers[2], who have to bail out the institutions that are too big to fail.
In short, the failure in the corporate governance of banks was not due to aligning managers’ interests to the interests of (diversified) shareholders who represent the society but was caused by making managers act like undiversified shareholders topped with insurance coverage.
II. What to do now?
Having identified the problem, the logical response is clear: managers must act in the interests of diversified shareholders, that is, taking as much risk as possible without imposing externalities onto society or the diversified investor for that matter. In order to achieve this, managers’ incentives to behave like undiversified investors must be removed, their accountability towards diversified shareholders restored and creditor monitoring encouraged in an effort to check and counterbalance the risk preferences of the diversified shareholders. The devil however is in the details: Simply replacing managers’ equity-based compensation does not do the trick. Instead, it will bring back the default possession of too little risk-taking. Though one could argue that less risk does not do any harm, risk in manageable portions leads to financial growth and should not be discouraged. Academics propose alternative compensation schemes based on senior debt [3] or convertibles [4]. But even then, some incentives remain as equity would retain a vital function in the compensation scheme, either in the form of a benchmark or for the simple fact that more equity is converted into more debt. Instead, the way forward should be to promote diversification in managers’ portfolios. One possible approach would be to replace variable equity payment with variable cash and to require managers to invest it in diversified portfolios.
As soon as managers stop focussing on the interests of undiversified investors, alignment with diversified investors must be restored. Common tools include board structure, liability rules, and shareholder rights. The latter seems inadequate, at least in the US where shareholder rights have traditionally been very limited and bank holding structures’ swallow all that remains of the controlling function of shareholders. In any case, the rise of activist shareholders in the US makes more extensive shareholder rights – at least in the context of financial institutions – counterproductive. This is because hedge funds are not only active and venturesome but also highly concentrated. Increasing shareholder influence would thus run the danger of replacing one undiversified decision-maker with another.
Regulation with regard to board composition and structure, i.e., the increase in the number of independent directors, is a double-edged sword. On the one hand, independent directors are not captured by the insider perspective of the company [5] and do not receive equity compensation. On the other hand, their main benchmark is the share price, which again does not take systemic risk into account. Furthermore, independence comes at a trade-off. Many independent directors serve on various boards and therefore invest less time on complex business decisions than their executive counterparts. Banking, and especially risk management, is highly complex and demands full attention and a large time investment. Independent directors may indeed add value to the company but given the downsides associated with the trade-off between independence and time, more independence does not seem to be the right way forward.
Moreover, derivative suits can serve as a means of aligning directors’ interests with those of diversified shareholders. In order to be effective, derivative suits require a sophisticated litigation culture since diversified shareholders have no incentives to sue at their own expense/risk. A professional litigation culture, such as in the US, shifts the litigation risk from the plaintiff to the attorney by way of contingency fees. Whilst this creates a whole range of new problems, it results in a high case load that managers cannot ignore. At the same time, such a system also calls for highly specialised courts that have the economic proficiency to deal with complex financial cases. A specialised banking court (e.g., one based on the US Bankruptcy Court) could accomplish that. With sufficient proficiency, the review standards could be tougher than those we observe with regard to general corporate matters in Delaware, where managers are de facto isolated from liability for decisions taken in good faith [6]. Nevertheless, it has often been argued that a system that is too rigid would disincentivise qualified people to become managers in the first place or make them relocate to other jurisdictions. Having said that, we currently do not observe any greater emigration from the US even though it holds a high liability rate for security litigation. In any case, creating a baseline for the amount of liability can remedy this problem [7] since the cause of action is not compensation but the alignment of interests. This will reduce managers’ risk-taking while leaving them some air to breath. On a different note, D&O insurance regulation has to be revised. Those insurances typically insolate managers from almost all liability and thus pose a major obstacle to litigation as a constraining corporate governance tool.
Lastly, a major reason for the crisis was the lack creditors’ incentive to engage in corporate governance. Part of the solution could be a bail-in framework that converges long-term debt to equity (whose holders are most likely to monitor) when a bail-in is triggered, thereby giving these creditors an ex ante incentive to monitor. In addition, other creditors could be incentivised to monitor (as far as feasible) by making the deposit guarantee subject to some minor monitoring efforts, resulting in the deposit insurance (plus ex ante monitoring) being the cheaper option than running.
III. Conclusion
The major corporate governance problem of banks lies in the misalignment of interests: managers’ interests are aligned with those of undiversified as opposed to diversified shareholders and therefore impose high externalities onto society. Changing managers’ remuneration packages can remove their incentive to behave like undiversified shareholders. Similarly, a minority of independent directors and stronger enforcement can help achieve this alignment.
Catharina graduated from Oxford University (MJur) and University of Hannover (First State Examination). She is currently a PhD candidate at University of Hannover and trainee judge at the Higher Regional Court Frankfurt.
[1] J Armour et al, Principles of Financial Regulation, Oxford University Press 2016, p. 370 pp.
[2] D Walker, A Review of Corporate Governance of UK Banks and Other Financial Institutions, Final Recommendations (Walker Report) 2009, p. 12
[3] L Bebchuk & H Spamann, Regulating Bankers’ Pay (2010) 98 Georgetown Law Journal 247
[4] J Gordon, ‘Executive Compensation and Corporate Governance in Financial Firms, The Case for Convertible Equity-Based Pay’ (2012) Columbia Business Law Review 833
[5] J Gordon, ‘The Rise of Independent Directors in the United States 1950-2005: Of Shareholder Value and Stock Market Prices’ (2007) 59 Stanford Law Review 1465, p. 1471
[6] DGCL, § 102(b)(7); Stone v. Ritter, 911 A.2d 362, 370 (Del Sup 2006)
[7] J Armour & J Gordon, ‘Systemic Harms and Shareholder Value’ (2014) 6 Journal of Legal Analysis 35, p. 69
REGULATION-Y 