The recent, indeed continuing, financial crisis (that began in 2007) has prompted an enormous theoretical and policy debate. Central to this debate are the post-crisis ‘best’ corporate governance systems and business models for banks going forward. These two questions are inextricably linked and the logical starting point is corporate governance. Without an adequate system of corporate governance, no banking business model is necessarily ‘the best’ or ‘safe’.
Corporate governance is concerned fundamentally with the responsibilities and disciplining of senior managers and directors. This covers important questions like ….‘What should these responsibilities be..? How should they be evaluated..? To what stakeholders are these responsibilities owed..?
The report this week in the UK on the RBS (Royal Bank of Scotland) disastrous takeover of ABN Amro, the compensation of the exited Chief Executive and the subsequent bailout of the bank by the UK Government, and the continuing concern with RBS compensation packages within its investment baking arm have put these kinds of questions ‘centre stage’ again. Banking bonuses and compensation packages are also in the news once more, and these are also linked to questions of corporate governance. Even the veto (9 December) by David Cameron of the latest EU Treaty proposals are linked to banking corporate governance, since a major reason for the veto was apparently the protection of the UK financial services sector from Brussels-led increased regulation. The latter is not in keeping with the ‘free market model’ that characterises UK banking and financial services. Many within the EU believe that it was primarily UK/US-style banking deregulation that led to the ‘credit crunch’ that erupted with the collapse of the US Lehman Brothers.
What is Corporate Governance?
Corporate governance in popular usage is concerned with the actions available to shareholders (owners) to influence and discipline managers’ decisions. Economists use the term ‘governance’ in a wider context to cover all of the mechanisms through which managers are incentivised and controlled to act in the best interests of an organisation’s owners.
A perfect system of corporate governance would provide managers with the right incentives to make value-maximising decisions for owners. Such a system, for example, would make sure that cash was paid out to investors when the company is unable to generate positive NPV (Net Present Value) investments. It would provide managers and employees with fair compensation, but would not allow excessive managerial and employee perks of any kind.
This view of corporate governance is the modern corporate finance vision. It is consistent with the free market model, where investors ultimately determine the internal resource allocation decisions of firms. In this world, shareholders wealth (or value) maximisation (SWM) is the dominant corporate objective.
During the modern (post-1970) era of banking, deregulation has moved global banking systems along this kind of free market trajectory. The many banking and financial crises of the modern era have not deflected this deregulation policy. The latest and most severe of these crises has prompted a serious debate and much re-thinking, but the discipline of the free market is still the preferred policy context in important banking countries like the US and UK.
Corporate Governance Out of the Wings
In the past ten years or so corporate governance has moved to a much more central position in the debate on banking structures, strategy and regulation. The wider economic model of deregulation that drove the development of banking markets appeared to accept the standard corporate finance model of corporate governance. The theory is that so long as markets are provided with sufficient information, they will ultimately discipline and incentivise the required, value-maximising behaviour.
Although the recent crisis has not interred this standard model of corporate finance in banking, it has certainly raised some fundamental questions. Following the UK Walker (2009) report, international organisations like Basel (2010), OECD (2010) and the European Union (2010) have all studied and reported on corporate governance in post-crisis banking.
All of these studies have developed guidelines to improve bank corporate governance. In all of them the emphasis, not surprisingly, has been on risk governance.
However, these studies vary markedly on what they consider to be the main objective of bank corporate governance. Broadly speaking, two main schools of thought can be identified. A shareholder-dominant approach (typified by Walker, although this does not imply that other stakeholders should be ignored) and a stakeholder-based one (typified by the Basel Committee and the EU). In the latter model, multiple stakeholders and their respective objectives are more strongly emphasised.
Banking is Different
The debate has also needed to address another fundamental issue. Banks are different compared with non-banking firms since all banking systems rest ultimately on confidence. It is through the continued maintenance of this market confidence that banks are able to carry out their unique and important economic functions. So long as bank depositors remain confident that their bank can repay its deposits on any day, banks are able to borrow short and lend longer. This confidence preservation is (and always has been) the bedrock of fractional reserve banking.
Banking history and a raft of special banking regulations reflect the practical importance of this kind of depositor and overall market confidence. The central bank lender of last resort function, deposit insurance and ‘too big to fail’ regulatory interventions are reflective of this unique feature of banks compared with non-banks. The ‘costs’ of these kinds of banking-unique regulatory interventions are borne ultimately by government and taxpayers. These costs can be high (especially in a crisis), but banks are uniquely important economic institutions and their fundamential importance to economic stability and growth are widely acknowledged.
These kinds of necessary, bank-unique regulatory interventions are also examples of ‘market failures’ in applying the standard corporate finance model to banks. This means simply that the model does not necessarily work as expected in allocating banking resources unless these kinds of market failures are at least recognised and their consequences (intended and otherwise) recognised.
At the same time, these kinds of regulatory interventions, these ‘market failures’, carry with them certain privileges and responsibilities that all banks enjoy. They enable banks to operate with higher levels of leverage and risk assumption than would otherwise be possible in a completely free market (where banks are treated like any other non-bank company). There has to be a price and a required level of professional responsibility assumed for these economic responsibilities and privileges.
Towards a Post-Crisis Model of Bank Corporate Governance
Where does the preceding lead us in devising an effective, post-crisis system of corporate governance for banks? What do we want from such a new system? I believe that there are three basic requirements.
First, the special role and unique economic position of banks must be recognised. Secondly, a system is needed that enables the free market model (deregulation) to work effectively and safely in disciplining the banking system and allocating resources in the most efficient way. Thirdly and following from the last point, the most important ‘market failures’ associated with modern banking need to be recognised and addressed.
These are complex requirements and there are no easy solutions. What banking history appears to confirm is that ever more regulations in key areas like risk, capital adequacy and liquidity are not the complete answer. These new rules may be necessary, but they are not sufficient by themselves. Indeed, ever more tight and detailed regulations may ultimately be risk-producing as banks attempt to innovate around the rules. Paradoxically, deregulation and more intensive competition may help stimulate this kind of regulation-avoidance behaviour.
So where does this lead? First of all it is clear that banks are ‘different’ compared with other firms. As we saw earlier, this special nature of the banking firm leads to the proposition that the duty of care (so-called ‘fiduciary duties’ to key stakeholders) is wider for bank directors. In particular, it should encompass bank depositors, especially retail depositors who do not have the expertise (or incentive, given the implied role of the central bank and government in helping to underpin, or ‘backstop’, banking confidence) to assess banking risks.
This is not a new proposition (see, for example, Macey O’Hara, 2003). In practice it means that bank directors must be fully cognisant of any decision that might impact badly on bank capital adequacy (solvency risk) and affect the ability of the bank to repay bank depositors. Bank directors and the senior management team would have a personal liability within this proposed framework.
By itself, though, this is not enough. The reason is that bank regulators are also a key party in evaluating and ultimately determining capital adequacy.
The key role of bank regulators in determining capital adequacy comes from the function of them setting (at least broadly) the level or extent of crisis scenario (downside risk) for which bank capital has ultimately to be adequate. The free market is not able (or incentivised) to do this. Even supervisors with all the information that they have cannot be precise in setting exact downside risk needs of banks, but is they who have to have the final word on what level of bank risk cushioning is adequate.
This leads to a second proposition. Senior bank supervisors should have fiduciary duties of care to both banks and especially their customers in carrying out this important and unavoidable task. This is a more radical proposal and it has been promulgated in a recent paper by Dermine (2011) who proposed many other related features of such a system.
These proposals lead to a kind of tripartite system of bank corporate governance. Requiring fiduciary duties of bank directors and the senior management team to bank depositors is one part. The second element is the requirement that bank supervisors also have fiduciary duties to bank depositors. Together such a system would enable banks to be subject also to the shareholder-based model of corporate governance. In such a system the latter might work more effectively and, at the same time, the probability of systemic shocks and contagion risk reduced.
It cannot be pretended that these proposals are an ‘easy solution’ and that some challenging practical issues still need to be addressed. Nor could one argue that they provide a guarantee of bank safety and prudence. But they would at least address the real problem of the ‘market failures’ we have discussed that characterise banking and which compromise an unaided free market solution to bank corporate governance. At the same time these proposals would surely put a premium on the professionalism, accountability and managerial quality that should now be demanded of bank supervisors, bank directors and senior managers.
Professor Ted Gardener