Balancing the Governance of Financial Institutions
22 Pages Posted: 17 Oct 2018
Date Written: February 1, 2017
Banking regulation is first and foremost preoccupied with the problem of excessive risk-taking by banks and other leveraged financial intermediaries, which can lead to bank runs and panics and their resulting high economic costs. In recent times, regulators have sought to curb bank risk-taking almost exclusively through external “safety and soundness” regulations, which emphasize, among other things, capital requirements, disclosure, and an intensive examination process. Modern banking regulation, both in the United States and abroad, has largely ignored the internal governance of banks. Surprisingly, this is true even in the aftermath of the financial crisis, which seemed to illustrate the shortcomings of external regulatory restrictions. To the extent that policymakers consider bank governance issues, they typically defer to the corporate governance literature, which focuses on shareholder agency costs and generally promotes solutions that best align manager and shareholder interests.
The Dodd-Frank Act of 2010 provides a good example of the short shrift that policymakers have paid to internal bank governance. Dodd-Frank makes a number of important changes to bank safety and soundness regulation, particularly for so-called “systemically important financial institutions” (SIFIs). Under the changes implemented by Dodd-Frank, SIFIs now face new consolidated capital and examination requirements and a newly created resolution regime called the “Orderly Liquidation Authority,” intended to end the prospect of government bailouts of uninsured investors. Dodd-Frank also implements new mortgage origination and securitization standards that banks must follow and creates a Consumer Financial Protection Bureau to promulgate and enforce consumer protection rules relating to bank loans and other financial products. Notably, almost all of these changes are external regulatory measures that outside regulators must monitor and enforce.
Dodd-Frank contemplates only a handful of minor changes to the internal corporate governance of banks, and these measures all attempt to address managerial wrongdoing and more closely align the incentives of corporate executives and shareholders. In this regard, the reforms proposed by Dodd-Frank are consistent with the corporate governance literature, which generally focuses on shareholder–manager agency conflicts and plays up the importance of shareholder interests. But as I discuss in this symposium article, banks are different from nonfinancial corporations in that there are strong reasons to believe that the prioritization of bank shareholder interests encourages greater risk-taking and thus works contrary to the purposes of banking regulators.
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