Abstract
Banks, particularly those considered ‘too big to fail’, pose a particular governance challenge, especially for taxpayers who face an undiversifiable risk of being the final backstop of the financial system. The nexus of bank governance is the board of directors, but they have proven inadequate in controlling the riskiness of bank activities, an outcome due both of the complexity of modern banks, and because boards are uncertain about what is expected of them. Using an interdisciplinary approach from law and accounting, we propose a two-step procedure to improve bank governance. First, we give bank directors an explicit standard to assess the outcome of their actions: the Prudent Investor rule which is the requirement for trusts. Adopting the Prudent Investor rule would return to director's responsibility to control the risks of banking activities. To enforce the higher standard, we propose to use disclosure as a disciplining mechanism. We base the new disclosure regime on Section 404 of the Sarbanes–Oxley Act that requires managers to implement controls over the firm's financial reporting processes and to publicly attest to their effectiveness. This section failed to prevent the credit crisis because it was too narrowly focused. We recommend that the provision be broadened to encompass governance controls in general, and that responsibility for disclosure be placed on the bank board rather than on managers.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
REFERENCES AND NOTES
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.
On the final item, the bill fails completely. After President Obama signs it into law, the nation's financial industry will still be dominated by a handful of institutions that are too large, too interconnected and too politically powerful to be allowed to go bankrupt if they make unwise decisions or make huge wrong-way bets. New York Times, 26 June 2010. Rick Perry, the governor of Texas, has also called for the repeal of Dodd–Frank. ‘We have to end it right now,’ he said, on the same weekend in the same state as Mr Romney. Newt Gingrich said it is ‘a devastatingly bad bill’ that is ‘killing small banks, killing small business, killing the housing industry.’ Representative Michele Bachmann regularly reminds voters that she introduced the first Dodd–Frank repeal bill this year. New York Times, 20 September 2011.
Erkens, D., Hung, M. and Matos, P.P. (2010) Corporate Governance in the 2007–2008 Financial Crisis: Evidence from Financial Institutions Worldwide. ECGI – Finance Working Paper no. 249/2009; CELS 2009 4th Annual Conference on Empirical Legal Studies Paper. Available at SSRN: http://ssrn.com/abstract=1397685, accessed 27 November 2010.
Beltratti, A. and Stulz, R.M. (2009) Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation. Fisher College of Business Working Paper no. 2009-03-012. Available at SSRN: http://ssrn.com/abstract=1433502, accessed 27 November 2010.
Adams, R.B. (2009) Governance and the Financial Crisis. ECGI – Finance Working Paper no. 248/2009. Available at SSRN: http://ssrn.com/abstract=1398583, accessed 27 November 2010.
Schumpeter, J.A . (2010) Corporate constitutions. The world knows less about what makes for good corporate governance than it likes to think, 28 October. The Economist, http://www.economist.com/node/17359354?story_id=17359354, accessed 27 November 2010.
While it is true that banks self-fund the deposit insurance schemes, such as that administered by the FDIC in the United States, that covers only small deposits, and in the event of a major banking crisis the level of support needed dwarfs those guarantees. Indeed, in late 2009 the FDIC reserves are virtually exhausted.
Miller, R. (2010) Oversight liability for risk management failures at financial firms. Southern California Law Review 84 (47): 47–123.
Yeoh, P (2009) Causes of the global financial crisis: Learning from the competing insights. International Journal of Disclosure and Governance 7: 42–69.
‘With few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks,’ http://www.washingtonpost.com/wp-dyn/content/article/2009/02/19/AR2009021903172_pf.html.
Lorsch, J. (2009) Perspectives from the boardroom – 2009. Harvard Business School online publication, http://www.people.hbs.edu/jlorsch/BoardroomIssues.pdf, accessed 8 January 2010.
http://www.people.hbs.edu/jlorsch/BoardroomIssues.pdf‘Directors expressed strong consensus that the key to improving boards’ performance is not government action, but action on the part of each board … ineffective boards have contributed to the corporate failings that have recently been far too conspicuous on the landscape of the American economy.’
Emphasis added.
The Delaware statutes, for example, under which many US firms are incorporated, states simply that The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, but there is no further elaboration as to what this means or what level of care the directors should exercise, and no specific requirements on either risk management or indeed, for governance systems in general, http://delcode.delaware.gov/title8/c001/sc04/index.shtmlSimilar ambiguities exist in the UK Companies Act of 2006.
The Enduring Legacy of Smith v. Van Gorkom, p. 303.
Order and Final Judgment MDL no. 1222 (S.D.N.Y 12 June 2003).
No.01 CV-4080 (D. Kansas) cited in Weiss, L. and Weiss, M. (2006) Be careful what you wish for: The unintended consequences of the private securities litigation relief act. The International Journal of Disclosure and Governance 3: 115–131, note 11.
Smith v. Van Gorkom 488 A2d.858 (Del 1985).
Aronson 472 A2d 608 (Del. 1984).
Smith v. Van Gorkom at 872 quoting Aronson at 812.
Smith v. Van Gorkom at 874.
Sharfman, B. (2008) The enduring legacy of Smith v. Van Gorkom. Delaware Journal of Corporate Law 33 (2): 287–309.
In Re Walt Disney Derivative Litigation 907 A2d. 693,707–708 (Del Chan. 2005).
Brehm v. Eisner 746 A 2d 244, 263 (2000)c.
Aronson 473 A2d 805, 812 (Del 1984).
Eisenberg, M. (1993) The divergence of standards of conduct and standards of review in corporate law. Fordham Law Review 62: 437–443.
Easterbrook, F. and Fischel, D. (1991) The Economic Structure of Corporate Law. Cambridge, MA: Harvard University Press.
Private communication with the authors.
Caremark International Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch 1996), 967.
Stone v. Ridder 911 A.2d 362 (Del. 2006).
Jones, R. (2011) The Role of Good Faith in Delaware: How Open-Ended Standards Help Delaware Preserve its Edge. Boston College Law School Research Paper No. 224.
In Re American International Group Consolidated Litigation 965 A. 2d 763 (De. Chancery 2009).
In Re Citigroup Derivative Litigation 964 A.2d 106 (Del. Chancery 2009).
Alces, K. (2009) Debunking the corporate fiduciary myth. 9 Journal of Corporation Law 35 (2): 240.
Citigroup at 123.
Citigroup at 131.
Schooner, H. (1995) Fiduciary duties demanding cousin: Bank directors liability for unsafe or unsound banking practices. George Washington Law Review 63 (175): 180–127.
Briggs v. Spaulding 141 U.S. 132 (1891).
Atherton v. Federal Deposit Insurance Corporation 519 U.S 213 (1997).
McCulloch v. Maryland 17 U.S. 316 (1819).
Eerie v. Tompkins 304 U.S. 64 (1938).
Sitkoff, R. (2003) Trust Law, Corporate Law and Capital Market Efficiency. University of Michigan John Olin Center Working Paper 03-014.
Schanzenbach, M. and Sitkoff, R. (2008) Did reform of the prudent trust investment change portfolio trust allocation?. Harvard Center for Law and Economics. Discussion Paper no. 580.
26 Mass 446, 449 (1830).
Bebchuk, L.A. and Spamann, H. (2009) Regulating bankers’ pay. Georgetown Law Journal 98 (2): 247–287, 2010; Harvard Law and Economics. Discussion Paper no. 641. Available at SSRN: http://ssrn.com/abstract=1410072, accessed 27 November 2010.
http://www.nytimes.com/2010/01/03/magazine/03Compensation-t.html?ref=magazine.
Alles and Friedland48 (see note 60 below) state that: Three forces have resulted in a need to rethink how the board of directors carries out its governance responsibilities:1. The increasing complexity of the firm.2. The increasing complexity of transactions.3. The increasing complexity of the director's control problem. Similarly, Lorsch11 states: As we reflected on how and why boards had fallen short, we came to a tentative conclusion. The problems that surfaced in 2008 and 2009 largely differed, we believed, from those that had prevailed in 2002, when boards failed to identify and stop management malfeasance and fraud. By contrast, the more recent boardroom failures were primarily attributable to the growing complexity of the companies that boards are charged with governing.
Alles, M. and Friedland, J. (2007) Responsibility with authority: Using the power of the purse to leverage the effectiveness of the board of directors. International Journal of Disclosure and Governance 4 (2): 79–95.
Lorne, S. (2008) Economics, regulation and governance. International Journal of Disclosure and Governance 5 (4): 287–293.
http://www.econlib.org/library/Smith/smWN1.html#B.IChapter2, Of the Principle which gives Occasion to the Division of Labor: It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Lorne49 states (emphasis in original): We need to recognize that when we inject an independence requirement into the decision making process (as opposed to the monitoring process), we are replacing interested decision making with disinterested decision making, and moving significantly away from the moorings of an economic system that has served us very well. There may be – no doubt are – times to make that sort of move, but we should not do it lightly and we should certainly not do it reflexively. Too often, already, we have decision makers removed from the consequences of their decisions. We have failed CEO's who get paid not just millions but hundreds of millions of dollars for their failures, as they are forced out of office. That's usually the consequence of large, bureaucratic corporations that have evolved away from the system in which they operate. You don’t see those pay-offs to failed executives in family corporations, for example. But all of the big pay-off companies have independent directors, who approve those payments in part, no doubt, because they are disinterested. It isn’t their money they’re giving away, but it is their embarrassment they hope to avoid by ensuring that the CEO has no reason to litigate about his or her dismissal.
Bebchuk, L. and Fried, J. (2003) Executive compensation as an agency problem. Journal of Economic Perspectives 17 (3): 71–92.
http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf.
Alles, M., Kogan, A. and Vasarhelyi, M. (2008) Putting continuous auditing theory into practice: Lessons from two pilot implementations. Journal of Information Systems 22 (2): 195–214.
Continuous auditing is the application of information technology to automate the audit process and reduce the time between the transaction and the provision of assurance. This is in contrast to the standard financial statements audit that takes place only once a year.
Alles, M., Datar, S. and Friedland, J. (2005) Governance linked D&O coverage: Leveraging the audit committee to manage governance risk. International Journal of Disclosure and Governance 2 (2): 114–129.
Alles, M., Datar, S. and Friedland, J. (2006) Market based governance: Leveraging D&O insurance to drive corporate governance. International Journal of Disclosure and Governance 3 (2): 1–15.
De Andres, P. and Vallelado, E. (2008) Corporate governance in banking: The role of the board of directors. Journal of Banking & Finance 32 (12): 2570–2580.
In 2007 average bank director compensation is lower than average non-financial director compensation by $62 866.00. Since average director compensation in non-financials is $193 931, bank director compensation is roughly 32 per cent lower. Adams5 (p. 11).
http://www.bankdirector.com/issues/articles.pl?article_id=11981.
http://www.theracetothebottom.org/executive-comp/2009/5/6/the-director-compensation-project-bank-of-america-corporatio.htmlAnd over the last 5 years the stock price of Bank of America has gone from a high of over $50 share to a low of under $3, a reduction in stockholder wealth that puts all the compensation received by directors and officers into perspective.
Klein, A. (2002) Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics 33 (3): 375–400.
Calomiris, C. and Hitscherich, D. (2007) Banker fees and acquisition premia for targets in cash tender offers: Challenges to the popular wisdom on banker conflicts. Journal of Empirical Legal Studies 4 (4): 909–938.
‘The revolution within’, 14 May 2009, From the Economist print edition.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Alles, M., Friedland, J. Reforming governance of ‘too big to fail’ banks: The prudent investor RULE and enhanced governance disclosures by bank boards of directors. J Bank Regul 13, 189–210 (2012). https://doi.org/10.1057/jbr.2011.25
Published:
Issue Date:
DOI: https://doi.org/10.1057/jbr.2011.25