Non-Shareholder Voice in Bank Governance: Board Composition, Performance and Liability

In the welter of financial sector reforms which followed the financial crisis—enhanced capital and liquidity rules, resolution mechanisms based on bail-in debt, new macro-prudential powers for regulators—the governance of banks received only non-star billing. In one sense this was surprising since the empirical data showed that banks with the “best” corporate governance, assessed on the conventional shareholder-centric basis, performed worse on average in the crisis than banks with “sub-optimal” governance structures. In other words, there seemed to be a tension between conventional good corporate governance and financial stability goals. Restructuring bank governance so as to be less shareholder focused might therefore be a useful reform. In our paper, Non-Shareholder Voice in Bank Governance: Board Composition, Performance and Liability, we analyse what has, could and should be done to move bank governance in the proposed direction.

Since we focus on the tension between governance arrangements and financial stability, we take as our non-shareholder candidates for board influence the groups which bore most of the costs of the last financial crisis or which are proposed to be the main cost-bearers in future crises. This means concentration on the “public interest” (a short-hand for taxpayers who bailed out the banks, households and entrepreneurs who suffered from the post-crisis contraction of credit, and citizens generally who experienced a reduction in job opportunities and social welfare support) and creditors, who did surprisingly well in the last crisis but who are slated to carry the main burden in any future one through bail-in.

We look at three areas: non-shareholder influence short of board representation; non-shareholder representation on the board; and finally at enhanced liability for directors as a protection for non-shareholder interests. The rules to which we devote most attention are those of the EU, the UK and Germany.

We find that public interest influence, short of board representation, has been put in place to a substantial extent through enhanced supervisory input at the time of appointment of bank directors and other senior bank officials and continuing supervision thereafter. Although “fit and proper person” tests for director appointments are not a new feature of banking regulation, pre-crisis testing focussed predominantly on honesty. Post-crisis, competence has move centre-stage in supervisory assessments. Those assessment have been extended in scope to embrace important non-director post-holders and in time to include post-appointment assessments. And the process of approval has been used to provide a basis for holding appointees potentially liable for regulatory breaches by those they supervise.

As for board influence for creditors (short of representation) we think this could be achieved by contract. Traditionally, publicly traded bonds have not contained extensive covenants, a situation usually explained by reference to the coordination costs of public bondholders. We argue that there are circumstances in which the holders of bail-in bonds might think it worthwhile to expend resources to overcome the coordination costs, in exchange for greater protection against failure, and banks to offer such covenants in exchange for a reduced cost of debt.

Alternatively, supervisors might push for a greater reflection of creditor metrics in the construction of performance-related pay schemes for directors and senior post-holders, as proposed by Bebchuk and Spamann in Regulating Bankers’ Pay (discussed on the Forum here). There is some evidence of this development at the end of the reward process (i.e. in defining what may be provided by way of an award) but, oddly, not at the beginning (i.e., when defining the criteria against which performance is to be assessed).

As for direct representation on the board, we are sceptical that this could be made to work effectively. The most obvious candidate for a seat on the board to represent the public interest is the regulator, but this would create an obvious conflict of interest between the regulator’s supervisory role and its duties to the company. In so far as the regulator’s supervisory role would be enhanced by inside information, that information is probably already available to regulators via their supervisory powers, including the power to attend board meetings in a non-voting capacity. Beyond the supervisor, it is difficult to identify an appropriate guardian of the public interest. Nevertheless, we acknowledge the evidence that banks with independent directors on the remuneration and risk committees did better in the crisis than those without, but independence requirements for these committees are now widespread.

Bond-holders, as well, are not likely to seek board representation, this time for fear of potential liabilities and to prefer influence on the board short of representation. The same goes for short-term wholesale creditor, though their contractual protections take a different form, whilst there seems no need to represent retail depositors covered by insurance.

Other reform proposals for dealing with bank governance focus on the civil law liability of directors as distinguished from regulatory duties. They appear in three different forms: first, it is postulated that there should be another, much stricter level of negligence for them; second, it is recommended to do away with the business judgment rule for bank directors; and third, it is suggested to change the burden of proof, which should be placed on them and not on the bank or the creditors. Yet in the end, all three proposals are unconvincing. Especially we doubt the benefits of enhanced criminal liability, but think that more enforcement effort, especially in the regulatory field, but also as to civil liability, would yield positive results.

But what remains is the proposal to give regulators a role in enforcing civil liability. There are different ways to do this. Regulators could make it easier for private plaintiffs to prove their liability claims by making available their own findings on directors’ violations of regulatory duties. A more far-reaching reform would be to give bank regulators standing for enforcing the civil liability of directors. This has been done, for example, in Australia and has occasionally been proposed also in Europe. Yet the German Lawyers’ Association has discussed this proposal and rejected it for a number of reasons. The main reason being that that regulators have other more direct means of enforcing the obedience of the regulatory duties of bank directors and should devote their limited personnel and financial resources to direct enforcement, leaving civil liability to the corporation, shareholders and, as the case may be, private creditors. As to the incentive structure of the directors, it is doubtful whether the additional threat of financial liability enforced by regulators may add very much to the threat of being censured or even dismissed by a regulator. In the end, such a reform would be motivated more by the social policy argument of securing compensation for damaged persons than by the need to cope with the incentive structure as to bank specific systemic risk.

The complete paper is available for download here.