Rethinking Corporate Governance in Financial Institutions

Demetra Arsalidou

• Publisher: Routledge
• Year: 2015
• Print ISBN: 9781138614574
• eBook ISBN: 9781134499267
• Edition: 1
• Topic: Law
• Subtopic: Business Ethics
• Index: Law

There are many deep-seated reasons for the current financial turmoil but a key factor has undoubtedly been the serious failings within the corporate governance practices of financial institutions. There have been shortcomings in the risk management and incentive structures; the boards' supervision was at times weak; disclosure and accounting standards were in some cases inadequate; the institutional investors' engagement with management was at times insufficient and, last but not least, the remuneration policies of many large institutions appeared inappropriate. This book will provide a critical overview and analysis of key corporate governance weaknesses, focusing primarily on three main areas: directors' failure to understand complex company transactions; the poor remuneration practices of financial institutions; and, finally, the failure of institutional investors to sufficiently engage with management. The book, while largely focused on the UK, will also consider EU and Australian developments as well as offering a comparative angle looking at the corporate governance of financial institutions in the US.

1 Sharpening bankers’ personal accountability

DOI: 10.4324/9781315890258-1

1 Introduction

‘Three great forces rule the world: stupidity, fear and greed.’

– Albert Einstein

Good corporate governance is about keeping promises. It is about convincing, inducing, compelling and otherwise encouraging directors to keep the promises they make to investors. While it is incumbent upon investors and companies (through the contracting process) to define the content of the promises themselves, the purpose of corporate governance should be to preserve the honesty and integrity of those promises.¹ Bad corporate governance, on the other hand, can be viewed as ‘promise-breaking’ behaviour.² An important lesson of 2007–08 is that without a supporting infrastructure of governance, laws and culture, markets cannot and will not function well. Corporate governance is a key part of that infrastructure, and therefore needs to be got right. Most aspects of corporate governance were put to the test during the recent crisis and found inadequate;³ weak governance and risky business models contributed to the poor performance of banks and in some cases to the banks’ failures, bailouts or nationalisation.⁴ Significantly, the problem was not the absence of foresight about the dangers of the massive credit expansion and housing price bubble, but the absence of personal accountability in the investment banking industry. In the years leading up to 2008, the breakdown in accountability resulted in reckless business decisions in the UK and global credit markets, with catastrophic consequences for the economy. Unconstrained self-interest, irresponsible decision-making and absence of professionalism characterised the behaviour of bankers and, despite the crisis and the subsequent regulatory response, some of this behaviour remains.

1 J. Macey, Corporate Governance: Promises Kept, Promises Broken, New Jersey: Princeton University Press, 2008, p. 2. 2 Ibid., p. 1. 3 C. A. E. Goodhart, The Regulatory Response to the Financial Crisis, Cheltenham_ Edward Elgar, 2009, p. 141. 4 House of Commons, Treasury Committee, Banking Crisis: Regulation and Supervision (HC 767, Fourteenth Report of Session 2008–09) – Report, Together with Formal Minutes, London: TSO, 2009, evidence 57.

Provoked by this, the Economist magazine ran a front-page headline after the crisis with the heading ‘Banksters’, implying that banking is packed with malpractice and irresponsibility. There is an obvious problem when a popular magazine, read throughout the world, characterises banking as such without reservation.⁵ Banks contribute significantly to economic growth and other social advancement and those who manage banks should not be perceived as ‘banksters’. The public’s faith and trust in banks must be restored. Personal and professional responsibility is needed to constrain self-interest and although the damage done by the current economic crisis cannot be reversed, the sharpening of bankers’ accountability can make less likely the occurrence of actions that generate serious externalities. This, as Stiglitz argues, is particularly important as markets are plagued by problems of information asymmetries and there exist incentives for market participants both to exploit and to increase these information asymmetries.⁶

5 This argument was raised by Lord Turner in a speech in 2012: Speech by Lord Turner, FSA Chairman at Bloomberg, Banking at the Cross-roads: Where do we go from here?. Available at http://www.fsa.gov.uk/library/communication/speeches/2012/0724-at.shtml. 6 J. Stiglitz, ‘Regulation and failure’, in D. Moss and J. Cisternino (eds), New Perspectives on Regulation, Cambridge MA: The Tobin Project, 2009, p. 11. Stiglitz explains that even when the markets are efficient, it may still be difficult to produce socially desirable outcomes as the powerful may take advantage of others in an ‘efficient’ manner.

The government bailout of UK banks during the latest economic crisis is generally credited with having saved the UK economy, but by doing so it may have also saved irresponsible bankers from being held accountable for their actions. In stepping in to rescue Northern Rock through nationalisation, Royal Bank of Scotland and Lloyds through share purchases, and Bradford and Bingley through loans, the government won plaudits for prompt and decisive action which saved them from collapse. The price of this rescue, however, may be more than financial. By preventing the directors involved from being held accountable, we may not learn the lessons of the credit crunch, nor be able to prevent it from being repeated in future. The injection of taxpayer money into failing firms saves their directors from liability and creates a safety net that encourages the types of excessive risks that caused the crunch. This can potentially lead to problems of moral hazard, a term generally referring to the danger that safety nets push market participants to take greater risks than normally taken. ‘The Run on the Rock’ report recognised this problem, stating that UK banks and building societies appear to view the government’s support of Northern Rock as a promise that no bank would be allowed to fail in future.⁷ With both the banks and the bankers escaping from the consequences of any reckless risk-taking, there is clearly an urgent need to tighten the law.

7 House of Commons Treasury Committee, The Run on the Rock (HC 56–I, Fifth Report of Session 2007–08) – Report, Together with Formal Minutes, London: TSO, 2008.

There have been many quick regulatory responses by global and UK officials, and since Northern Rock almost every aspect of regulation has been reviewed and strengthened in some way. All banks now have to hold more top-quality capital, making them more resilient. The United Kingdom is redesigning its regulatory structure to address the failures of the Financial Services Authority (FSA, now FCA, i.e. Financial Conduct Authority) before the crisis. There are firmer mortgage lending standards aimed at preventing loans to buyers without well-documented income and the new Prudential Regulation Authority, which became part of the Bank of England in 2013, is now the UK’s prudential regulator for deposit-takers, insurers and designated investment firms. The intention of this new body is to take a more aggressive approach and inspect bank business plans more closely. Further, the Treasury introduced a new Banking Act in 2009, which amends the law on bank insolvency and administration. It specifically includes the possibility of bank directors being disqualified to ensure that action can be taken against those of failed banks. Additionally, the government plans to put in place a ‘rebuttable presumption’ that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank.⁸ It will generally become easier to disqualify or bring enforcement actions against directors, even if they were not personally involved in wrongdoing. Further, the question of criminal liability is raised in the report as a more efficient way of deterring financial misbehaviour and incentivising directors to act without recklessness.

8 The plans are included in the consultation document: HM Treasury, Sanctions for the Directors of Failed Banks (HC 1447, HL Paper 236, 2012), para. 3.11. In the document, the government favours legislating to amend the FSMA The necessary legislation of the proposals would be included in the Financial Services Bill. Moreover, according to the Sanctions Report, the measures could be supported by complementary reforms (which the regulators could take forward) to clarify management responsibilities and change the regulatory duties of bank directors.

These tough new liquidity standards and personal liability measures might help to incentivise directors to avoid the type of risky strategies witnessed in the past few years. However, they do not go far enough. There is a general agreement that mismanagement, incompetence and reckless risk-taking significantly contributed to pushing many of our banks to the brink of collapse. Although directors can currently be disqualified for unfitness, or made personally liable to contribute financially to their institutions’ liabilities, there remain serious problems with the current system of accountability. Significantly, the loophole remains open whereby a government rescue from insolvency prevents bankers from being held fully accountable for their actions. The directors of a company brought to the brink of insolvency, but rescued by nationalisation or another form of government protection, cannot be disqualified or held accountable for the debts of their failing institutions, no matter how much wrongful or reckless trading they have engaged in. These sanctions only apply to directors of companies that have become insolvent. The new measures are unlikely to change their behaviour, particularly if bankers believe that ultimately banks will not be allowed to fail. The United Kingdom needs a special bank directors’ regime that links the wrongful trading provisions with the aims of the new Banking Act to ensure that irresponsible directors can be held accountable even when banks are rescued. Knowing they cannot evade responsibility for their actions will deter bank directors from presiding over reckless behaviour, whilst providing some redress for those who suffer losses as a result. This is also relevant in regards to the new proposals of a rebuttable presumption of unsuitability. Moreover, the criminal sanctions require serious rethinking, particularly the type of behaviour that should result in a criminal prosecution. Without these clarifications and amendments, the type of contribution that disqualification, wrongful trading and the new government proposals can make, will remain ambiguous.

This chapter primarily focuses on the law in the United Kingdom and concentrates on the question of directors’ recklessness rather than fraud. It is structured as follows: First, it is significant to understand the reasons why bankers have a tendency to take uncalculated, reckless risks. Part 1 therefore discusses two possible explanations for their behaviour. Behavioural psychology provides interesting new perspectives on this question; studies of the ‘behavioural’ move reveal that people often do not make economic decisions in agreement with the rational choice model. This is due to a host of irrationalities that characterise individuals in economic settings. The existence of cognitive biases and information asymmetries make bankers susceptible to a number of behavioural actions which impact on their ability to act rationally. Prospect theory – a behavioural economic theory – also provides some interesting insights into bankers’ behaviour. Decision-makers irrationally seek risk despite the fact that the circumstances should lead them in the opposite direction. Further, apart from behavioural biases, banks suffer because directors are unable to fully understand their institutions’ complex operations. They simply fail to comprehend the risks their institutions are involved in and do not seem to possess the level of understanding of their businesses one would expect. This reinforces the need to provide directors with appropriate behavioural incentives that can, to some degree, diminish their cognitive limitations. Numerous older and more recent cases are suggestive of this.

The current law has not shown itself to be an effective constraint against reckless behaviour. Therefore, in the final part, this chapter critically discusses the legal and regulatory ways that hold directors responsible for their actions in the United Kingdom and that are meant to incentivise them to act with care. Monetary and non-monetary measures, including disqualification, wrongful trading, criminal and strict liability, form the focus of this part, and ways to improve the current accountability regime are considered. By strengthening and refining bankers’ accountability, the negative effects of limited liability can to some extent be reduced whilst also offering a partial solution to the problem of moral hazard. Finally, the question of education and culture is considered, albeit briefly. This is significant, as education can be a cheap, cost-effective way to encourage responsible risk-taking. It could inspire those with suitable risk preferences and professional priorities to become bankers.⁹

9 Note that the terms ‘banker’ and ‘director’ will be used interchangeably in this chapter.

2 Why bankers act as they do

There are many academic and governmental studies that examine the causes of the current financial crisis. The majority show that banks failed because of financial, economic and managerial factors.¹⁰ The highly risky and unsound business models of the global credit crisis of 2008 played a significant role, resulting in the UK’s eighth largest bank, Northern Rock, to be nationalised and its largest mortgage lender, Halifax, Bank of Scotland (HBOS) to be rescued by a rival. The United Kingdom also became the majority owner of two of the country’s top four banks, the Lloyds Banking Group and Royal Bank of Scotland (RBS). In a number of cases banks faced the prospect of failure but decision-makers were comfortable to gamble and hope for resurrection whilst placing li...

Table of contents

• Cover Page
• Half Title Page
• Series Page
• Title Page
• Copyright Page
• Table of Contents
• Dedication
• Acknowledgments
• Introduction
• 1 Sharpening bankers’ personal accountability
• 2 The theoretical justification of executive remuneration as an incentive mechanism
• 3 Shareholder engagement and activism: an effective mechanism for monitoring management or a fallacious notion?
• 4 Executive remuneration and shareholders’ voice in the United States
• Epilogue
• Index