Bank Corporate Governance: A Proposal for the Post-Crisis World

TLDR: In this paper, a new paradigm for bank corporate governance in the post-crisis era was proposed, which would mandate a higher level of competence for bank directors, consistent with the greater knowledge required to understand and to oversee today's more complex financial institutions.

Abstract: 1. INTRODUCTION Legislation and regulation, particularly laws and regulations related to corporate finance and financial markets, tend to follow crisis. The myriad corporate scandals in the previous decade led to a heightened awareness of the role played by corporate governance, so it is hardly surprising that corporate governance has been the focus of regulation for some time now. In the wake of Enron, Tyco, and other high-profile failures, the Sarbanes-Oxley Act of 2002 focused on the internal controls of firms and the risks that poor governance imposed on the market. In the aftermath of the recent financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act unleashed a plethora of changes for markets that involved restrictions on what banks can do, who can regulate them, and how they should be liquidated, as well as mortgage and insurance reform and consumer protection initiatives. Surprisingly, the duties required of bank directors per se were not a focus of specific attention in either act. We believe the role that bank corporate governance issues played in the financial crisis is not inconsequential and that, as suggested by the recent JP Morgan Chase London Whale fiasco, these bank corporate governance issues pose an ongoing risk to the financial markets. Hence, bank corporate governance in the post-crisis era warrants careful review. That governance problems can arise in banks is well understood (Levine 2004; Bebchuk and Spamann 2010; de Haan and Vlahu 2013; Adams and Mehran 2008, revised 2011; Calomiris and Carlson 2014). What may not be appreciated, however, is the degree to which the unique features of banking complicate both the role of the board and its governance effectiveness. In an earlier paper (Macey and O'Hara 2003), we reviewed the different models of corporate governance, with a particular focus on the duties that board members owe to different constituencies. We argued that these unique features of banks dictated a heightened "duty of care" for bank directors. (1) We discussed the various legal cases defining the duty of care for directors, and how the courts have vacillated in their application of these duties owed by directors. Since then, a lot has changed with respect to banking structure and practice, but little has changed with respect to the duties and obligations of bank directors. This inertia with respect to bank directors is all the more puzzling given that Dodd-Frank explicitly addressed the externalities imposed by individual banks on the financial system yet imposed no additional requirements on bank directors to make them responsible for limiting such risks. (2) In this article, we propose a new paradigm for bank corporate governance in the post-crisis world. We argue that bank directors should face heightened requirements owing to the increased risk that individual banks pose for the financial system. Our thesis is that the greater complexity and opacity of banks, and the increased challenges in monitoring these complex institutions, require greater expertise on the part of bank directors. We propose new "banking expert" and "banking literacy" requirements for bank directors akin to the "financial expert" requirements imposed on audit committees by Sarbanes-Oxley As we argue, these requirements would mandate a higher level of competence for bank directors, consistent with the greater knowledge required to understand and to oversee today's more complex financial institutions. It has been argued that large, complex financial institutions are now simply too large to govern--that "too big to fail" is "too big to exist." This may be true, but before we throw in the towel on the corporate form of bank organization in favor of some regulator-based form of control, we think it makes sense to try to craft a more relevant corporate governance standard for banks. Similarly, it has been argued that mendacity is to blame for the myriad scandals in banking--that bank management, and presumably bank directors, are somehow not sufficiently motivated to "do the right thing. …