The 2007-09 financial crisis exposed numerous vulnerabilities of the financial system stemming from unprecedented (idiosyncratic) failures within individual financial institutions that collectively led to heightened systemic risk. The ‘black box’ of systemic risk was thus exposed as not being entirely exogenous, but rather an aggregation of failures at a few large institutions where much of the risk of the financial system was concentrated. Many have argued that these bank-level failures had their roots in corporate governance weaknesses in banking. To what extent are these corporate governance weaknesses linked to the ‘softer’ aspects of governance in banking like corporate culture, in addition to the more familiar aspects of corporate governance like executive compensation, board independence and so on? This is the question that US and European financial services regulators have been keen to find the answer to. Consequently, a robust discussion has emerged on how to define bank culture, how to measure it and how to change it, as well as the impact it has on a host of the bank’s measurable economic outcomes. These are all exciting new issues in research as well as in evolving regulatory policy, so their relationships and potential for shaping banking in the years to come are issues deserving of further reflection and research.
In a recent paper, I examine the roles of ethics, culture, and organizational higher purpose in the conduct of corporate governance in banking. Developments in these related but distinct areas since the 2007-09 financial crisis are discussed, including the substantial fines that major banks have paid for alleged transgressions related to the financial crisis. An analytical framework for gaining a tangible view of bank culture and measuring it is discussed. The roles of executive compensation and improved market discipline from bank equity are examined in the context of bank corporate governance. The principal conclusion of the paper is that we need to strengthen capital ratios and equity governance in banking to improve ethics and culture, and de-emphasize liquidity regulation. Another conclusion is that the embrace of authentic organizational higher purpose in banking—through dialogue between regulators and banks rather than regulation—should enhance the effectiveness of corporate governance in banks, increase employee commitment and refurbish the reputations of banks. Further, it will work in concert with prudential regulation to achieve greater financial stability and economic growth in banking. In other words, authentic higher purpose can elevate the effectiveness of other aspects of corporate governance in banking. Because the concept of authentic organizational higher purpose in banking is not familiar to many, it is defined and discussed in the paper.
This paper has important implications for both the management of banks as well as the regulation of banks. Bank managers need to focus compensation to de-emphasize dependence of executive bonuses on Return on Equity (ROE), strengthen their culture through a rigorous diagnostic and change process (the paper discusses a formal tool to do this), and embrace an authentic higher purpose that drives culture and employee engagement, thereby driving behavior that reflects a deeper commitment to the organization. Regulators can focus their attention on strengthening capital regulation and de-emphasizing liquidity requirements.
Anjan Thakor is the John E. Simon Professor of Finance at Washington University in St. Louis.