Bank Governance and Capital Regulation – What is at the Root of Perverse Incentives?

The global financial crisis arguably revealed systemic flaws in the reward structures of the financial sector. Yet this was not merely the result of executive greed as we might have been led to believe. Bank corporate governance is different. The traditional disciplining power of debt in corporate finance theory is reversed in banking and this dimension was much neglected amid the clamour of quasi-religious beliefs in traditional corporate governance doctrines and the disciplining power of the markets.

Arguably, the fundamental question permeating all bank regulations is why banks are not able to regulate themselves, or, in the presence of a statutory framework, supervise themselves with the regulated ‘voluntarily’ subscribing to the objectives of statutory regulation. The most convincing answer to this question is that public interest concerns (eg, institutional safety and financial stability) and private goals/incentives (profitability, compensation) in the banking sector differ sufficiently, due to the existence of intrinsic information asymmetries and inherent reliance on high levels of leverage, to make self-regulation impossible. For example, why is it that in good times, when excessive debt accumulation in society is not yet a concern, banks do not voluntarily build up adequate buffer stocks of excess capital, so that when bad times come they can absorb the losses without having to either shrink assets or raise new capital under duress? The most plausible answer is that if short-term debt is a cheaper form of finance than equity, banks will tend to take on more debt than a social planner would like them to and do not fully internalize their costs. Therefore, reliance on internal governance controls and market discipline is not enough to restrain bank risk-seeking and shareholder search for ever higher rents.

In a series of publications we have examined each of these governance dysfunctions to shed light on the root causes of the bank governance malaise. One of us explored in a 2014 book the ‘greedy bankers’ narrative, which holds that bankers took reckless risks for their personal short-term gain. He considered whether bankers would have been so free to adopt and pursue risky business strategies if their ability to excessively leverage bank balance sheets had been restricted by regulation. Overall our research points out that the principal source of those gains – and the financial fragility that accompanied them – was increased leverage.

Certainly, there appears to be some truth in the view that short-term financial rewards encouraged excessive leverage. Moreover, leverage levels did increase rapidly in the run-up to 2008. Yet, according to our 2015 paper, drivers of excessive leverage in the banking sector are not confined to weak governance, compensation incentives or banker greed. Instead, the building of leverage in the context of governance is motivated by a number of independent and powerful individual incentives. Principal drivers include reputational, job retention and promotion concerns, given shareholder capital structure preferences. Ignorance of emerging risks and the dangers of excessive borrowing, thanks to bounded rationality and complexity in financial markets, complete the picture.

Accordingly, whilst the role of compensation incentives in generating short-termism should not be overlooked, the causes of excessive leverage in banking from a governance standpoint are more plural than the standard narrative would suggest. While not explicitly stated, unlike requisite micro- and macroprudential benefits, one reason to welcome the restrictions on leverage introduced by the various regulatory authorities since 2008 is an expected improvement in bank governance. As well as avoiding some of the weaknesses of risk-weighting and internal modelling of risks, a strict leverage ratio has the potential to address many of the incentive conflicts that afflict these institutions. Restricting under-capitalization is one way to ensure that senior bankers cannot over-reach for returns, no matter their motivation for doing so. By stripping managers of the capacity to chase returns under a severely weakened capital structure, the leverage ratio has the potential to solve a number of the governance problems identified in the literature on corporate governance and banking crises.

Viewed in context the findings of our research also highlight the adverse governance impact of the FSB’s Total Loss Absorption Capacity (‘TLAC’) standard and EU's Minimum Requirement of Eligible Liabilities (‘MREL’) which incorporate various versions of debt into a notion of loss absorption capacity in resolution. Unless shareholders are reined in to the point that banks no longer look like privately run institutions - an undesirable development - the governance impact of bank loss absorption capacity in resolution should be further considered.

Emilios Avgouleas is the Chair in International Banking and Finance at the University of Edinburgh, and a Member of the EBA Stakeholder Group.

Jay Cullen is a Lecturer in Banking and Finance at the University of Sheffield.