The Market Revolution in Bank and Insurance Firm Governance: Its Logic and Limits

Abstract

This article addresses the question whether the recent changes in bank and insurance firm governance suggest that U.S. financial firm governance will soon replicate the governance of nonfinancial firms. In addressing this question, the Article starts from the assumption that we must consider both corporate governance and the background insolvency procedures to fully appreciate the overall governance framework. In particular, the relationship between corporate governance and insolvency tends to be complementary. The governance of nonfinancial U.S. firms, for instance, relies on ex post correctives such as takeovers to address the conflicts of interest between managers and widely scattered shareholders; and if the firm fails, offers a manager-driven reorganization option. In other nations, such as Germany and Japan, banks and other large investors actively participate in corporate governance; bankruptcy is characterized by immediate displacement of managers and liquidation of the firm. I describe U.S. governance as an "ex post" framework, and the German and Japanese alternative as an "ex ante" approach.

Unlike nonfinancial firms, the governance of U.S. banks and insurance companies has long been ex ante in character. Takeovers and other ex post correctives have been rare, and insolvency means immediate removal of the managers and liquidation of the firm. Although the principal overseer of bank and insurance managers is a governmental regulator, rather than a private investor, the overall governance framework functions very much like the approach used by nonfinancial firms in Germany and Japan.

The recent changes in bank and insurance firm governance have introduced a significantly greater market component, but the regulatory framework puts real limits on how far the transition can or will go. Despite the changes, bank and insurance governance has retained much of its traditional character. As the discussion thus far suggests, much of the analysis is descriptive rather than normative in character. In discussing the treatment of insolvent banks and insurers, however, the article offers several prescriptions for improving the governance framework. In order to reduce managers' current incentive to avoid insolvency proceedings at all costs, and to harness managers' superior information about the firm, the article calls for changes to both bank and insurance insolvency law. In banking, managers should be permitted to propose a "prepackaged" purchase and assumption transferring the banks assets and liabilities to another bank; and a traditional reorganization option should be added to insurance insolvency. The article also argues that lawmakers should add insurance insolvency (though not bank insolvency) to the Bankruptcy Code.

Note: This article formerly was University of Pennsylvania Law School, Institute for Law and Economics, Working Paper No. 268, July 1999.

JEL Classification: G34