Banking regulation is first and foremost preoccupied with the problem of excessive risk-taking by banks and other leveraged financial institutions, which can lead to bank runs and panics and their resulting high economic costs. In recent decades, regulators have sought to curb bank risk-taking almost exclusively through external “safety and soundness” regulations, emphasizing capital requirements, disclosure, and an intensive examination process. Modern banking regulation, both in the United States and abroad, has largely ignored the internal governance of banks and other financial institutions. Surprisingly, this is true even in the aftermath of the financial crisis, which seemed to illustrate the shortcomings of relying exclusively on external regulatory restrictions. To the extent that policymakers have considered financial institution governance, they have primarily done so through the lens of the corporate governance literature, which focuses on shareholder agency costs and generally promotes solutions that best align manager and shareholder interests.
The synchronization of corporate governance and financial institution governance is largely the result of historical happenstance, rather than an intentional policy decision. Beginning in the late 19th century and accelerating over time, more and more banks became part of bank holding companies (which are typically structured as corporations). And in recent decades, much of the economic activity of banking moved off of the balance sheets of banks (or bank holding companies) as part of the development of the so-called “shadow banking system.” Because of this historical evolution of U.S. banking, the governance of financial institutions as a topic independent of and unique from the governance of other types of business structures such as corporations—has been largely neglected over time, as most scholars have chosen to focus instead on corporate governance.
The Dodd-Frank Act of 2010 provides a good example of this phenomenon. Dodd-Frank makes a number of important and sweeping changes to safety and soundness regulation, but contemplates only a small handful of minor changes to bank governance, including provisions calling for increased disclosures related to executive compensation (including “golden parachute” payments), non-binding shareholder votes on executive compensation, increased proxy access, and “clawback” mandates requiring corporations to develop and enforce policies that would take back incentive-based compensation from executives in the event of an accounting restatement. These measures all focus on the problem of managerial wrongdoing and aim to more closely align the incentives of the executives and shareholders of financial firms. In this regard, the reforms proposed by Dodd-Frank are consistent with the corporate governance literature, which generally focuses on shareholder-manager agency conflicts and plays up the importance of shareholder interests.
However, there are several features unique to financial institutions that may make the shareholder primacy norm inapt for financial institution governance. First, financial institutions are highly leveraged, and this leverage heightens the creditor-shareholder conflicts in bank governance and suggests that more weight should be given to creditor interests. Second, the government insures (either explicitly as in the case of deposit insurance or implicitly as with “too big to fail” guarantees) the vast majority of financial institution debt liabilities, which transforms these creditor-shareholder conflicts into taxpayer-shareholder conflicts. Finally, because bank failures can lead to financial crises, which create huge costs not borne by bank stakeholders, the logic of shareholder primacy may be inapt for financial institution governance, insofar as this logic ignores the large negative externalities of bank failures that are not borne by bank stakeholders.
The potential misalignment of shareholder interests with public policy goals has not gone wholly unnoticed in the academy. A small but growing number of academics have proposed different mechanisms for trying to address this problem. There are three different types of solutions being offered. First, there are proposals to realign the interests of managers by creating incentives for them to act in the best interests of creditors and/or regulators. These can be either carrots or sticks. Examples of the former approach include Lucian Bebchuk & Holger Spamann’s proposal for bank executive pay to be tied to a portfolio based on the overall mix of equity and debt issued by the company, Frederick Tung’s proposal to pay bank executives at least in part with subordinated debt-based compensation, or a proposal offered by a group of leading economists calling for a portion of bank executive pay to be deferred and only to be paid if the bank has not declared bankruptcy or received a government bailout. Examples of the latter approach include Claire Hill and Richard Painter’s suggestion that executives be made personally liable in the event of a bank insolvency, as well as Dodd-Frank’s § 954, which requires financial institutions to develop and implement “claw backs” that take back compensation from their executives in the event of an accounting restatement. The basic idea behind this type of approach is to incentivize the managers of financial institutions to act holistically in the interests of all of the stakeholders of the firm, and not just represent the more narrow interests of shareholders.
The second type of approach looks to change the incentives of financial institution shareholders by increasing their liability. In the pre-Depression era, shareholders of depository institutions in most states were subject to double liability, where in the event of insolvency, they would owe an amount equal to the par value of the shares they had purchased. Some, such as Jonathan Macey & Geoffrey Miller, Richard Grossman, or more recently, Richard Ridyard and Peter Conti-Brown, have argued for returning to such a regime, in which financial institution shareholders are opened to greater liability in the event of insolvency. The goal of these proposals is to incentivize financial firm shareholders—and the significant influence they wield upon firm behavior—to rein in risk-taking.
The third type of approach, proposed by Steven Schwarcz, is for a change in the fiduciary duties owed by directors of systemically important financial institutions, such that they would owe a “public governance duty” in addition to their existing fiduciary duties. The aim of this solution is to try to align the behavior of financial firm directors with public policy priorities, while giving them broad flexibility to implement different types of mechanisms to control risk-taking.
All of these proposals are promising, but as I discuss in greater detail in my Berle paper, they may be too narrow, vague, and/or impracticable to address the problems posed by the shareholder wealth maximization norm in the context of financial institution governance. A more holistic, clearly defined approach may be necessary. I am examining one such approach in a more detailed treatment of this issue that I expect to complete later this year, in which I explore the idea of potentially utilizing some of the legal doctrines and rules that have long existed for the governance of depository institutions and adopting them more broadly for the governance of financial institutions that are structured as corporations.