Corporate Governance Reform in Post-Crisis Financial Firms: Two Fundamental Tensions

The manner in which financial firms are governed directly affects the stability and sustainability of both the financial sector and the “real” economy, as the financial crisis and associated regulatory reform efforts have tragically demonstrated.  However, two fundamental tensions continue to complicate efforts to reform corporate governance in post-crisis financial firms.

The first relates to reliance on increased equity capital as a buffer against shocks and a means of limiting leverage.  The tension here arises from the fact that no corporate constituency desires risk more than equity does—and that risk preference only tends to be stronger in banks, and at times of financial distress.  This places a premium on evaluating who these capital providers are, and what their risk incentives look like.

The second tension relates to reliance on increased board independence as a buffer between the risk management function and senior corporate management.  The tension here arises from the fact that a growing empirical literature increasingly associates board independence with increased risk-taking and worse performance in the wake of the crisis, in addition to the more general concern that independent directors may lack industry-relevant expertise.  This once again places a premium on evaluating who these outside voices in the boardroom are and the governance capacities they bring to the table in the financial context.  In a recent paper, I explore these tensions in the context of financial firm governance and assess the intellectual groundwork that remains to be done before identifying a coherent way forward.

The appropriate role of shareholders in corporate governance, and the ideal composition of the board of directors, represent two of the most fundamental—and hotly contested—issues in corporate governance generally.  However, several unique features of banking render these issues even more fraught and complex in the financial sector.  Banks perform (quasi-)public functions relating to the creation and distribution of money, and they have heightened systemic significance to the broader economy—a reason they are widely said to involve a broader range of core stakeholders than typical corporations do.

At the same time, banking and finance involve forms and degrees of risk that differ fundamentally from other sectors.  Bank’s central function of maturity transformation—using short-term deposits to finance long-term lending—creates a mismatch that raises the specter of destabilizing runs, yet at the same time their reliance on leverage naturally leads their shareholders to prefer greater risk-taking.  Deposit insurance, coupled with the perception that certain financial institutions may be “too big to fail,” may substantially allay the former concern, yet only at the cost of exacerbating the latter.  In addition to such dynamics, financial firm governance is rendered even more challenging by the complexity and opacity of financial assets, which are inherently difficult to assess and monitor—particularly as financial firms and their services grow more sprawling.  Such idiosyncrasies have prompted regulatory efforts to contain and manage risk-taking in banking and finance, yet the challenges remain daunting—not least due to the staggering size and systemic significance of the largest financial firms.

Given their magnitude, their systemic significance, and the potential threats they pose to financial and economic stability, one might have expected post-crisis regulatory reforms to have focused on how these entities are governed.  However, for all the energy and resources devoted to post-crisis reforms, these fundamental governance matters have largely gone unaddressed or moved in the wrong direction.  The ramifications of the critical governance distinction between financial and non-financial firms have largely gone unrecognized in debates regarding post-crisis financial reform, and my paper explores two of the resulting regulatory tensions.

The first arises from our increasing reliance on heightened equity capital as a buffer against shocks and a means of mitigating risks associated with excessive leverage on financial firm balance sheets—a strategy reflected in post-crisis reform packages on both sides of the Atlantic, including the Basel III framework and the Dodd-Frank Act.  Yet, it is widely understood that equity holders—more so than any other constituency in a financial firm—prefer greater risk-taking, and that equity holders’ risk preference only becomes stronger as a firm approaches insolvency.

While increasing the capital buffer does not intrinsically alter the total voting power or governance authority of shareholders as a matter of corporate law, it may alter how that power is used to the extent that additional equity requires new, and qualitatively different, equity capital providers.  This inherent tension has received insufficient public attention, and our knowledge of who is providing the increased capital cushion in post-crisis financial firms remains limited, meaning that we know little of their preferences and incentives and cannot coherently assess whether the benefits of their involvement exceed the costs.  Yesha Yadav’s recent work documents a rise in blockholding since 2010 among systemically significant U.S. banks, with mega-asset managers including Vanguard, BlackRock, and State Street looming particularly large.  However, it remains uncertain to what degree these institutions will impose themselves upon financial firm governance and unclear what time horizons and risk incentives would guide their engagement strategies.  Simply put, there can be no assurance that equity capital providers will play a productive role in reducing financial firm risk-taking, short of imposing real curbs on the generalized preference for risk that prevails among all financial firm shareholders.

The second tension relates to the role of independent directors in financial firms.  We are increasingly relying on greater board-level independence as a buffer between risk management and senior corporate management to focus more attention on overall risk in these increasingly far-flung firms—a strategy likewise reflected in the Basel and Dodd-Frank reforms.  Yet, there is a growing post-crisis empirical literature that tends to associate greater reliance on independent directors (and other shareholder-centric governance structures) with excessive risk-taking in the run-up to the crisis and bad outcomes in its aftermath.  Meanwhile, there is mounting evidence in the broader corporate governance literature that whatever performance benefits independent directors might offer for relatively simple businesses, they may do harm in highly complex settings, where outsiders generally lack the technical knowledge to advise and monitor effectively.  For example, Ran Duchin, John Matsusaka, and Oguzhan Ozbas have found that “adding outside directors to the board does not help or hurt performance on average, consistent with the previous literature,” but that “outsiders significantly improve performance when their information cost is low, and hurt performance when their information cost is high,” findings suggesting that “outsiders are less effective when it is difficult for them to understand the firm’s business.”

There is certainly reason to suspect that financial firms have been negatively affected by such dynamics—that is, by high degrees of board independence without requisite expertise in a high information-cost environment.  However, this inherent tension has likewise received insufficient public attention, and little thought has been devoted to how well (or badly) such widely embraced reforms might translate to the unique context of financial firm governance.  While backing away from independence requirements appears politically implausible, I argue that board independence rules across the universe of public companies, and particularly for financial firms, ought to require that at least some of the independent directors have experience in broadly related industries (a requirement that should prove straightforward and realistic, given the availability of classification systems already widely used in a variety of public and private contexts).

The need for relevant experience would seem to be particularly acute in financial firms, yet the potential loss of expertise and capacity to understand the business that often accompany independence requirements have received little attention, suggesting that we can expect problems of this sort to persist.  Much like our reliance on equity capital providers to serve as a buffer against shocks and a means of limiting leverage, the wisdom of reliance on independent directors to serve as a risk management buffer turns principally on who the people performing this role are.  Until we develop a clearer sense of who director independence rules tend to place in financial firm boardrooms and take steps to ensure sufficient expertise and understanding of the business, we should remain skeptical that greater independence in this context will make us better off.

Shareholder wealth maximization and risk management stand in fundamental tension, and regulatory supervision and corporate governance can manage that tension.  How to strike such balances remains hotly contested, but the emphasis on corporate governance in post-crisis reforms implies imperfect confidence in the ability of external supervision to contain risk-taking.  This places a premium on a clear-eyed understanding of risk incentives, interests, and governance capacities among various internal corporate constituencies in systemically significant financial firms.

This post comes to us from Christopher M. Bruner, the Stembler Family Distinguished Professor in Business Law at the University of Georgia School of Law.  It is based on his recent paper, “Corporate Governance Reform in Post-Crisis Financial Firms: Two Fundamental Tensions” (forthcoming, Arizona Law Review), available here.