After the 2008 financial crisis, a substantial part of the blame for the numerous bank failures that occurred as a result of the crisis has been put on corporate governance. Consequently, regulation and supervision have been enhanced both as a complement to the corporate governance of financial institutions and as a substitute for the same in areas where governance failures appear more evident. In a recent paper, I argue that the swinging of the pendulum between corporate governance and financial regulation may have gone too far, as a result of the ‘nirvana fallacy’ that often affects reformers. I suggest, therefore, that corporate governance should recover some of the lost ground, possibly through spontaneous enhancement of the role of boards by financial institutions and cautious deregulation of the governance mechanisms by supervisory authorities. I also suggest that proposals to reform corporate law for financial institutions, for instance by restricting the scope of the business judgement rule, should be rejected, as this would adversely affect entrepreneurship and stifle innovation in the financial sector.
The financial crisis has led to a restatement of the global principles concerning the corporate governance of financial institutions in the belief that governance failures contributed to these institutions’ failures in the crisis. Similarly, international principles and standards on sound compensation practices were adopted. Both sets of principles emphasize the relationship between governance and compensation, on one side, and risk management by financial institutions, on the other.
Indeed, governments and regulators rely on corporate governance as a complement to financial supervision, which explains why regulation is on the rise in this area. In brief, regulation requires boards of directors and their risk committees to oversee the undertaking and management of risks by financial institutions. Corporate governance therefore serves the purposes of supervisors, to the extent that it should prevent the undertaking of excessive risk by financial institutions. No doubt, the interests of shareholders are also protected. However, wealth maximization by financial institutions is constrained whenever regulation or supervision foreclose the assumption of risk which would be in the interest of shareholders to assume, but could endanger creditors or even threaten systemic stability.
Moreover, post-crisis reforms have extended prudential regulation to areas which reinforce the idea of financial regulation as a substitute for corporate governance, such as incentive compensation. The FSB principles and standards interfere with the structure of compensation in ways that restrict the autonomy of boards. The principles also tackle concerns relative to bonuses, which famously emerged during the recent crisis.
An important question for policy research is to what extent and under what conditions regulation should work either as a complement or a substitute for corporate governance. While an answer can only be given in specific circumstances, I suggest three general criteria. First, the autonomy of boards should be protected, for they represent the main governance mechanism in today’s enterprises. Second, prudential regulation should abstain from setting too detailed requirements as to the organization and functioning of boards. Third, we should distinguish between a regulatory approach and a supervisory approach to the corporate governance of financial institutions. To the extent that the latter approach is followed, flexibility can be maintained particularly in the implementation of international principles. If a regulatory approach is followed, the risk of too detailed rules being issued is relevant and supervisors loose discretion as a result.
Another question for policy research is whether corporate law should be different for financial institutions. The differences between corporate law and financial regulation are reflected in the distinction between fiduciary duties and regulatory duties. The former respond to the interests of shareholders and creditors, while the latter are dictated mainly from a public interest perspective and respond to financial stability concerns. Some scholars argue that the business judgement rule protection leads to excessive risk-taking in a systemically important firm. They suggest a standard of liability that is negligence-based, arguing that the business judgement rule is inappropriate when systemic risks are concerned.
The arguments advanced in my paper point in a different direction. Indeed, financial institutions are enterprises and the business judgement rule protects entrepreneurship in risk-taking, which is essential for firms’ development and sustainability. If the rule were removed or limited in its scope, financial entrepreneurship and innovation would be negatively affected. Moreover, regulatory duties complement fiduciary duties by requiring a greater effort in risk management and oversight. There is no need for corporate law to enhance the duty of care and increase the potential for directors’ civil liability, given that financial regulation already provides enforcement mechanisms to this effect.
To conclude, my paper indicates a research agenda for further work on the topic. Corporate governance effectiveness does not only depend on rules and their enforcement, but also on ethics and culture within the firm. This explains the emphasis put on culture in the post-crisis corporate governance discussion, which underlines the roles that ethics and the relevant monitoring play in the financial services sector. Therefore, future research on the governance of financial institutions should not be limited to legal and economic analysis, but extend to the role and impact of culture and ethics in financial firms from a broad social sciences perspective. In this way, sociology, psychology and anthropology will help us understand the “informal constraints” which determine financial institutions’ behaviour and complement their regulation and supervision.
Guido Ferrarini is Emeritus Professor of Business Law, University of Genoa, and Chair in Governance of Financial Institutions, Radboud University of Nijmegen.