Principles of Financial Regulation: Bank Governance

According to a common narrative, in addition to inadequate capital and liquidity, the failure of banks in the financial crisis also reflected their poor governance. By ‘governance’, I mean broadly the oversight that comes from banks’ own shareholders and other stakeholders of the way in which they are run. The problem of bank governance stems from the way in which banks are financed and regulated, from the externalities bank failures produce, and from the nature of their assets. These challenges, and the regulatory responses, are considered in ‘Bank Governance’, a chapter from Principles of Financial Regulation, a new book written by Dan Awrey, Paul Davies, Luca Enriques, Jeff Gordon, Colin Mayer, Jenny Payne and myself.

As banks are highly levered institutions, shareholders may gain at creditors’ expense from an increase in risk and associated returns. If things go well, shareholders keep the higher returns; if things go badly, the creditors suffer. Moreover, bank failure has the ability to impose large costs on society at large, far greater than those borne by bank investors.

If banks were companies like any other, depositors and other creditors would take notice of the risk of shareholder opportunism and either charge a higher interest rate (making financing through debt more expensive and therefore less predominant) or insist on having stronger governance and control rights. Yet, various factors stand in the way of creditors themselves playing an important part in disciplining shareholder opportunism. First, a bank’s assets (its loans) are particularly opaque and difficult for creditors to monitor. Second, many creditors of banks lack strong incentives to monitor. Depositors are dispersed and they are protected by deposit insurance; moreover, creditors of larger banks might reasonably expect a state bailout that will soak up their losses should the bank become insolvent.

In the period leading up to the financial crisis, the peculiarities of banks’ balance sheets, their regulation, and the externalities they can create were thought not to necessitate any difference in the structure of bank governance from that of non-financial firms. Regulators, it was believed, would cause banks to internalize the costs of their activities, meaning that what maximized bank shareholders’ returns would also be in the interests of society. Consequently, large banks used the same governance tools as non-financial companies to minimize shareholder-management agency costs, namely independent boards, shareholder rights, the shareholder primacy norm, the threat of takeovers, and equity-based executive compensation.

Unfortunately, such tools had the adverse effect of encouraging bank managers to take excessive risks. The banks that had the most ‘pro-shareholder’ boards and the closest alignment between executive returns and the stock price were those that took the most risks prior to, and suffered the greatest losses during, the crisis.

As a result, a significant rethink about the way in which banks are governed is required. The structure and function of bank boards, the compensation of bank executives, and the function of risk management within organizations needs careful crafting if governance reforms are to address not exacerbate bank failures. At the same time, just as the design of capital ratios and liquidity requirements is far from a fail-proof endeavour, getting bank governance reforms right is far from granted.

Reforms since the financial crisis have gone some way to address these problems. Two particularly beneficial steps have been the push towards greater resources being deployed in risk management and internal monitoring functions, and an attempt to better calibrate incentives in relation to executive pay. The latter task will be extremely challenging for regulators to get right, but the former seems more promising. 

John Armour is the Hogan Lovells Professor of Law and Finance at the University of Oxford.