Bank Governance PDF 2016

Bank Governance Law Working Paper N° 316/2016 John Armour University of Oxford and ECGI June 2016 Dan Awrey University of Oxford Paul...

Bank Governance Law Working Paper N° 316/2016 John Armour University of Oxford and ECGI June 2016 Dan Awrey University of Oxford Paul L. Davies University of Oxford and ECGI Luca Enriques University of Oxford and ECGI Jeffrey N. Gordon Columbia University and ECGI Colin Mayer University of Oxford, CEPR and ECGI Jennifer Payne University of Oxford © John Armour, Dan Awrey, Paul L. Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer and Jennifer Payne 2016. All rights reserved. Short sec- tions of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. This paper can be downloaded without charge from: http://ssrn.com/abstract=2793112 www.ecgi.org/wp  ECGI Working Paper Series in Law Bank Governance Working Paper N°. 316/2016 June 2016 John Armour Dan Awrey Paul L. Davies Luca Enriques Jeffrey N. Gordon Colin Mayer Jennifer Payne © John Armour, Dan Awrey, Paul L. Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer and Jennifer Payne 2016. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.  Abstract According to a common narrative, in addition to inadequate capital and liquidity, the failure of banks in the financial crisis also reflected their poor governance. By governance we mean broadly the oversight that comes from banks’ own shareholders and other stakeholders of the way in which they are run. The problem of bank governance stems from the way in which banks are financed and regulated, from the externalities bank failures produce, and from the nature of their assets. In the period leading up to the financial crisis, it was believed that regulation would cause banks to internalize the costs of their activities, meaning that what maximized bank shareholders’ returns would also be in the interests of society. Consequently large banks used the same governance tools as non-financial companies to minimize shareholder-management agency costs, namely independent boards, shareholder rights, the shareholder primacy norm, the threat of takeovers, and equity-based executive compensation. Unfortunately, such tools had the adverse effect of encouraging bank managers to take excessive risks: as we describe in this chapter, banks that had the most ‘pro-shareholder’ boards and the closest alignment between executive returns and the stock price were those which took the most risks prior to, and suffered the greatest losses during, the crisis. Consequently, a significant rethink about the way in which banks are governed is required. The structure and function of bank boards, the compensation of bank executives and the function of risk management within organizations needs careful crafting if governance reforms are to address not exacerbate bank failures. Keywords: Financial regulation, bank governance, executive compensation, financial sec- tor pay, independent directors, board structure JEL Classifications: G21, G28, G32, G38, K22 John Armour * University of Oxford, Faculty of Law e-mail: [email protected] Dan Awrey University of Oxford, Faculty of Law e-mail: [email protected] Paul L. Davies University of Oxford, Faculty of Law e-mail: [email protected] Luca Enriques University of Oxford, Faculty of Law e-mail: [email protected] Jeffrey N. Gordon Columbia University, Columbia Law School e-mail: [email protected] Colin Mayer University of Oxford, Said Business School e-mail: [email protected] Jennifer Payne University of Oxford, Faculty of Law e-mail: [email protected] *Corresponding Author Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717937 Date:12/5/16 Time:16:22:22 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717937.3d Dictionary : OUP_UKdictionary 3 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Principles of Financial Regulation JOHN ARMOUR, DAN AWREY, PAUL DAVIES, L U C A E N R I Q U E S , J E F F R E Y N. G O R DO N , COLIN MAYER, AND JENNIFER PAYNE 1 Electronic copy available at: http://ssrn.com/abstract=2793112 Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717937 Date:12/5/16 Time:16:22:23 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717937.3d Dictionary : OUP_UKdictionary 4 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 3 Great Clarendon Street, Oxford OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © J. Armour, D. Awrey, P. Davies, L. Enriques, J. Gordon, C. Mayer, and J. Payne 2016 The moral rights of the authors have been asserted First Edition published in 2016 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number ISBN 978-0-19-878647-4 (hbk.) 978–0–19–878648–1 (pbk.) Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work. Electronic copy available at: http://ssrn.com/abstract=2793112 Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717937 Date:12/5/16 Time:16:22:30 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717937.3d Dictionary : OUP_UKdictionary 11 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Contents Preface v Acknowledgements ix List of Abbreviations xiii Table of Cases xix Table of Legislation xxi P A R T A FO U N D A T IO N S 1. Introduction 3 2. The Financial System 22 3. The Goals and Strategies of Financial Regulation 51 4. The Limits of Financial Regulation 80 PART B FINANCIAL MARKETS 5. Theory of Financial Markets 101 6. Information Intermediaries 118 7. Market Structure 143 8. Issuer Disclosure Regulation 160 9. Trading and Market Integrity 181 PART C CONSUMERS A ND THE FINANCIA L SYSTEM 10. Regulating Consumer Finance 205 11. Financial Advice 226 12. Financial Products 245 PART D BANKS 13. Theory of Banking 275 14. Capital Regulation 290 15. Liquidity Regulation 316 16. Bank Resolution 340 17. Bank Governance 370 18. Payment and Settlement Systems 391 19. The Macroprudential Approach 409 PART E MARKE TS AND B ANKS 20. Market-Based Credit Intermediation: Shadow Banks and Systemic Risk 433 21. Making Markets 449 Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717937 Date:12/5/16 Time:16:22:31 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717937.3d Dictionary : OUP_UKdictionary 12 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi xii Contents 22. Asset Managers and Stability 478 23. Structural Regulation 505 P A R T F T H E M I X O F I N S TI T U TI O N S 24. From Principles to Practice 533 25. The Political Economy of Financial Regulation 553 26. Supervision and Enforcement of Financial Regulation 577 27. Regulatory Architecture: What Matters? 597 28. International Regulatory Coordination 616 29. Conclusion—Designing Tomorrow’s Financial System Today 644 Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:03 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 370 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 17 Bank Governance 17.1 Introduction So far, our analysis of the regulation of banks has focused on the imposition of rules relating to their capital structure and liquidity to reduce risks of failure and on resolution processes in the event of failure. According to a common narrative, however, in addition to inadequate capital and liquidity, the failure of banks in the financial crisis also reflected their poor corporate governance.1 By ‘corporate govern- ance’, commentators mean the mechanisms by which managers are selected, motiv- ated, and rendered accountable to shareholders, as well as those by which managers oversee the activities of other employees. Yet empirical studies report that the banks with the ‘best’ corporate governance practices, as measured by ordinary standards, were the ones that did worst during the financial crisis. The weakness in pre-crisis bank governance was not that banks had ignored ‘best practices’ in corporate governance. Rather, it was a failure to appreciate that the ways in which banks differ from non-financial firms imply that ‘best practice’ for bank governance should also be different. Banks are materially different in their financing, business model, and balance sheets from most non-financial firms. First, banks are highly leveraged institutions: share- holders may gain at creditors’ expense from an increase in risk and associated returns. If things go well, shareholders keep the higher returns; if things go badly, the creditors suffer. If banks were companies like any other, depositors and other creditors would take notice of the risk of shareholder opportunism and either charge a higher interest rate (making financing through debt more expensive and therefore less predominant) or insist on having stronger governance and control rights.2 Yet various factors stand in the way of creditors themselves playing an important part in disciplining shareholder opportunism. Depositors have no oversight rights, are dispersed, and are protected by deposit insurance. Banking regulation and supervision are there precisely to prevent shareholder opportunism of this kind, so that (at least unsophisticated) market participants may over-rely on their effectiveness. And perhaps most importantly, as we have seen in Chapter 16, creditors of larger banks could (and perhaps still can) reasonably expect a state bail-out that will avoid them any losses should the bank become insolvent. 1 See eg OECD, Corporate Governance and the Financial Crisis: Key Findings and Main Messages 41 (2009); European Banking Authority, EBA Guidelines on Internal Governance 3 (2011). 2 On the important role of creditors in the governance of listed companies even in a highly shareholder-focused corporate governance system such as the US, see DG Baird and RK Rasmussen, ‘Private Debt and the Missing Lever of Corporate Governance’ (2006) 154 University of Pennsylvania Law Review 1209. Principles of Financial Regulation. First Edition. John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer, and Jennifer Payne. © John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer, and Jennifer Payne 2016. Published 2016 by Oxford University Press. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:05 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 371 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 371 In addition, as Chapter 16 also illustrated, bank failures have the ability to impose large costs on society at large—externalities—which are not borne by bank shareholders. Finally, a bank’s assets (its loans) are hard to monitor for any outsider, which makes any external monitoring mechanism less effective. In the period leading up to the financial crisis, the peculiarities of banks’ balance sheets, their regulation, and the externalities they can create were thought not to necessitate any difference in the structure of bank governance from that of non- financial firms. Regulators, it was believed, would cause banks to internalize the costs of their activities, meaning that what maximized bank shareholders’ returns would also be in the interests of society. On this view, which we might call the ‘assimilation’ theory of bank governance, it was thought appropriate for banks to use the same governance tools as non-financial companies to minimize shareholder-management agency costs, namely independent boards, shareholder rights, the threat of takeovers, and equity- based executive compensation. Unfortunately, tightening the linkage between shareholders and managers in banks had the adverse effect of encouraging bank managers to test the limits of regulatory controls and take excessive risks. As we describe in this chapter, the banks that had the most ‘pro-shareholder’ boards and the closest alignment between executive returns and the stock price were those that took the greatest risks prior to, and suffered the greatest losses during, the crisis. As a result, a significant rethink about the way in which banks are governed is required. The revised perspective might be termed a ‘bank exceptionalism’ theory of governance.3 The structure and function of bank boards, the compensation of bank employees, and the function of risk management within banks need careful crafting if governance reforms are to address, and not exacerbate, bank failures. In the last few years, a plethora of special ‘bank governance’ rules have been introduced. While these initiatives recognize that assimilation was an error, we shall see that it remains unclear how effectively the new measures get to grips with the exceptional challenges of bank governance. The rest of this chapter is structured as follows. Section 17.2 reviews the goals and mechanisms of ‘ordinary’ corporate governance, and explains their limitations when applied to banks. Sections 17.3–17.6 then consider, respectively, the operation of boards of directors, executive pay, shareholder rights, and directors’ duties in relation to banks, reviewing empirical evidence and describing regulatory initiatives. By the end of this chapter, you should have a good understanding of why the corporate governance tools that have prevailed for listed companies generally in the last thirty years may have led to undesired consequences when applied to banks. In addition, you should have an idea of which bank governance reforms have been implemented on each side of the Atlantic and how they may support the goal of a more resilient banking system. 3 To the extent that the factors differentiating banks are also relevant for other, non-bank, financial firms, then this ‘bank exceptionalism’ theory of governance should also extend mutatis mutandis. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:07 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 372 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 372 Principles of Financial Regulation 17.2 Corporate Governance: How are Banks Different? 17.2.1 The conventional approach to corporate governance The standard approach to corporate governance exhorts managers to run their firm in the interests of shareholders. This is because shareholders are ‘residual claimants’: that is, they receive what is left after all fixed claimants have been paid. Focusing on maximizing the residual surplus gives incentives to maximize the overall value of the firm: that is, to run it as efficiently as possible. Moreover, amongst those who contract with the firm—investors, creditors, employees, customers, and suppliers—the share- holders have the most homogeneous interests in the financial performance of the firm.4 Their interests relate simply to the maximization of the value of their claims, which, in the context of a publicly traded firm, is reflected in the firm’s stock price. Consequently, maximizing the stock price should be management’s objective. To implement this, shareholders are given the right to appoint directors, who in turn select the managers.5 The significance of the directors derives from the fact that ownership of shares in large public corporations is typically widely dispersed. As a consequence, shareholders face high coordination costs in exercising their rights. A number of mechanisms are relied upon to overcome this problem. First, the board of directors has increasingly come to be viewed as performing the function of monitoring managerial performance on behalf of the shareholders. If the shareholders are too dispersed to be able to engage in effective monitoring themselves, then the elected board of directors can do so in their stead. The problem here is that the shareholders’ very lack of coordination may undermine the process of election of effective monitors. The managers may influence the list of candidates and ensure that only their friends and associates are represented on the board. In response to this concern, directors are increasingly expected to be ‘independent’ of the firm: that is, they should have no family, financial, or employment ties to the firm or its managers. Independent directors, it is thought, will make better delegated monitors on behalf of shareholders. The problem remains that in the absence of effective shareholder input, the ‘independence’ of directors means simply the absence of a conflict of interest; it does nothing to ensure the presence of the necessary qualities to be an effective monitor. Executive pay comprises a second mechanism, which has in recent years become the most important focus of governance activity in the US. Tying managerial compensa- tion to the stock performance gives very direct incentives. A drawback with condition- ing pay on financial performance is that it requires managers to bear the risk of the firm’s underperformance, even for reasons beyond their control. This may result in managers adopting an unduly risk-averse approach to decision-making, passing up valuable but risky opportunities in favour of safer, more conservative, strategies. One way to encourage managerial risk-taking and stock price maximization at the same 4 H Hansmann, The Ownership of Enterprise (Cambridge, MA: Belknap Press, 1996). 5 R Kraakman, J Armour, P Davies, L Enriques, H Hansmann, G Hertig, K Hopt, H Kanda, M Pargendler, G Ringe, and E Rock, The Anatomy of Corporate Law, 3rd ed (Oxford: OUP, 2016), s 1.2.5. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:09 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 373 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 373 time is to pay managers by way of options. These have the potential to offer managers rewards for increasing the stock price, but with no associated loss if the share price falls. However, the incentives associated with options are highly sensitive to the way in which the strike price is set. These contracts are normally negotiated by the compensation committee of the board of directors. Their success, therefore, is a function of the quality of the board. Because of this, some influential scholars argue that the rise in option-based compensation is not so much a function of improved corporate governance, but of a combination of changes to the US tax code that made it cheaper for firms to grant options than cash compensation, and of thinly veiled managerial self-interest.6 Third, shareholder rights provide channels through which shareholders may exer- cise control, for example by voting on major business decisions or more generally by removing directors. The exercise of shareholder rights requires some concentration of ownership, so as to overcome coordination problems. It is sometimes suggested that takeovers are a mechanism by which external discipline is brought to bear on man- agement even in the presence of dispersed shareholdings. Poorly performing manage- ment faces the threat of acquisition by another company, and the mere threat of this occurring may be sufficient to encourage management to pursue the interests of their shareholders vigorously. Recently, we have witnessed the emergence of a second mechanism by which external discipline is brought to bear on management in the presence of dispersed shareholders. Activist shareholders, and in particular hedge funds, have acquired significant but not necessarily controlling shareholdings in firms to effect changes in corporate policy and management. They frequently act in conjunction with other institutional investors in promoting change. The rise of institutional activists has had a profound impact on the conduct of management in dispersed ownership systems in the UK and US particularly. Fourth, directors and officers are subject to legal duties to avoid conflicts of interest and to take appropriate care in the running of their company. These may be enforced by shareholders through derivative or class actions, which enable a single shareholder or group of shareholders to represent the rest in claims against errant directors. However, it is unlikely that the shareholders who initiate such an action, or the judges called upon to adjudicate them, will know as much about the business as the incumbent managers. This makes litigation a blunt instrument. To avoid overzealous enforcement, there are typically checks on shareholder litigation in relation to good faith business decisions that grant considerable discretion to management in the running of their businesses, leaving shareholder plaintiffs to focus on more egregious cases of conflicts of interest. 6 See L Bebchuk and J Fried, Pay Without Performance. The Unfulfilled Promise of Executive Compen- sation (Cambridge, MA: Harvard University Press, 2004); JC Coffee, ‘A Theory of Corporate Scandals: Why the USA and Europe Differ’ (2005) Oxford Review of Economic Policy 198, 202. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:11 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 374 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 374 Principles of Financial Regulation 17.2.2 How are banks different? As anticipated in the introduction, governance problems and mechanisms may play out differently in banks than in ordinary firms, reflecting how banks differ from non- financial firms in three important respects. The first difference is that banks are highly leveraged. The core of a bank’s business model is to transform short-term deposits into long-term loans, implying that most of its capital is raised through debt. In addition to deposits, banks raise money via short-term and long-term debt which, together with deposits, typically make up most of the liability side of their balance sheets. As a result, shareholders may stand to benefit at creditors’ expense from changes in the bank’s investment projects that increase risk and associated returns. If things go well, the shareholders keep the increased returns, whereas if things go badly, the creditors suffer losses. Perversely, mechanisms that succeed in tying executives to the interests of shareholders may actually exacerbate these financial agency costs. Creditors should therefore satisfy themselves that there are strong checks in place to ensure that the riskiness of the bank’s activities is kept within acceptable limits. However, depositors usually have only modest amounts at stake and are widely dispersed, so they do not wish to, or feel able to, monitor bank lending effectively. The second difference is that bank failure imposes greater costs on society. A bank failure can trigger contagion in other parts of the financial system, and, by impeding the operation of the financial system, can harm the ability of businesses to obtain finance. Since losses are purely economic, they are not generally susceptible to com- pensation through the tort system.7 Moreover, as the source of contagion is usually the failure of a financial firm, governments have incentives to throw money at troubled firms to avert such failure.8 The more systemically important the bank, the more likely it will be able to rely on government support should it get into difficulties. This gives banks a perverse incentive to structure their operations such that they are systemically important and, in the eyes of policymakers, ‘too big to fail’.9 The implicit government guarantee means that such firms enjoy a lower cost of credit,10 and that creditors’ incentives to monitor the firms’ performance is undermined. What this does is to morph the creditors’ problem described in the previous paragraph into a problem for society more generally, through the implicit subsidy that creditors receive. 7 This is ordinarily justified on the basis that economic harms to one party often represent opportun- ities to someone else: a power outage closing firm A’s factory for a week (and resulting in lost profits) represents an opportunity for A’s competitors to earn extra profits by selling more products instead. However, if contagion is systemic in the sense that it affects the entire financial sector, competitors will not profit from a bank’s difficulties, nor will competitors of manufacturing firms who are unable to raise finance be readily able to profit from their circumstances. And even if the economic losses caused by contagion were in principle recoverable, the way in which they are triggered ensures they will not be visited on share- holders. Banks trigger contagion through their financial distress and there would consequently be no assets to pay tort liabilities. 8 This is distinct from other cases of catastrophic industrial accidents, where governments intervene to ameliorate the consequences but nevertheless are content to bankrupt the firm in the process. 9 See M Roe, ‘Structural Corporate Degradation Due to Too-Big-To-Fail Finance’ (2014) 162 University of Pennsylvania Law Review 1419. 10 See VV Acharya, D Anginer, and AJ Warburton, ‘The End of Market Discipline? Investor Expect- ations of Implicit Government Guarantees’, Working Paper (2016).  Text Text Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:12 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 375 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 375 ‘IBG–YBG’ To be sure, bank shareholders will lose money if their bank fails, but, because of limited liability, the shareholders’ maximum loss is set by the initial value of their shares. Conse- quently, other than the extent to which it affects creditors’ willingness to lend, shareholders have no incentive to take precautions that might reduce the total losses consequent upon failure: as far as the shareholders are concerned, they have lost everything anyway by that point. There is even a Wall Street acronym, used by market participants to reassure themselves they need not worry about marginal losses consequent upon failure: ‘IBG– YBG’—‘I’ll be gone, You’ll be gone’: I’ll have taken my commission, you’ll have sold out to the next guy.11 Yet the costs to society from bank failure can greatly exceed the losses to shareholders, given the risk of domino effects that may bring down the entire financial system and freeze loan markets across the economy. The third difference is that certain types of financial assets are hard to observe and measure. The rationale for bank lending, as previously described in Chapter 13 is that banks may be able to collect information on borrowers that is not available to others. Hence, the value of their loan portfolio may not readily be subject to external scrutiny by shareholders as well as potential hostile bidders and creditors themselves.12 As a result of the first and second of these differences, regulators—in lieu of creditors—are tasked with monitoring and controlling bank risk-taking. However, the very difficulty of monitoring financial assets—the third of the differences described above—makes it particularly challenging for regulators, as well as investors, to perform this task effectively.13 And the efficacy of regulatory control is further compromised by very intense managerial incentives to maximize the share price. Managers may, therefore, seek to avoid regulation and to minimize the costs of regulation by influen- cing regulators, rather than taking desired actions and precautions to minimize risks of failure. 17.2.3 Bank governance before the crisis For much of the postwar period, banks were treated as utilities subject to a form of rate regulation: both entry to the sector, and profits, were restricted. This gave shareholders a steady stream of returns, and no great incentive to push managers. Managers in turn had no great incentive to push to increase the firm’s performance. From the 1980s onwards, there was significant deregulation in banking in the US, the UK, and many Deregulation other countries. This introduced greater competition to the sector and volatility to shareholder returns. Bank governance, therefore, became more intensely focused on 11 See eg E Dash, ‘What’s Really Wrong with Wall Street Pay’, New York Times Economix Blog, 18 September 2009 (http://economix.blogs.nytimes.com/2009/09/18/whats-really-wrong-with-wall-street-pay/). 12 Banking supervisors control over banks’ ownership structure also makes hostile bids more difficult. See JC Coates IV, ‘Takeover Defenses in the Shadow of the Pill: A Critique of the Scientific Evidence’ (2000) 79 Texas Law Review 271, 290. 13 See Chapter 4, section 4.2 and Chapter 24, section 24.2.  Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:14 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 376 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 376 Principles of Financial Regulation share price maximization. To the extent that banks were different, it was thought that financial regulation could be relied upon to correct any problems. Consequently, policymakers and industry participants sought to apply ordinary ‘best practice’ in corporate governance to banking firms. For example, guidance by the Basel Committee concerning corporate governance in banks emphasized the monitoring role of the board of directors.14 Of the governance mechanisms described in section 17.1, incentive pay was perhaps the most heavily relied upon to control bank executives. This tracked the rise of executive compensation as a governance mechanism generally. Moreover, variable pay has long been a feature of employment in the investment banking sector. When the major investment banks converted from partnerships to corporations in the 1990s, profit-sharing that had previously been effected through partnership status came to be managed through variable pay for risk-takers instead. As investment banks merged with commercial banks, these pay practices were rationalized as promoting shareholder Incentive Pay/ value and extended to the commercial banking divisions of the resulting financial Compensation conglomerates. However, reliance on incentive compensation has a serious drawback in the context of financial institutions. Correctly calibrating incentive pay depends on assessments of the state of financial assets, which by definition are hard to observe. For example, consider a loan officer, who agrees to loans on the bank’s behalf. The number of loans she writes, and the interest charged, are easy to observe. But the quality of the borrowers she lends to is not. If the bank were to offer her ‘incentive’ compensation, this should condition amongst other things on the quality of borrow- ers, but because borrower quality is hard to observe, the bank may only be able to make the contract conditional on loan size and interest rates, which will lead to predictably problematic results. The failure to appreciate that the differences between banks and non-financial firms “Best” had implications for governance, and that these could not readily be solved by regulators, had unfortunate consequences. An emerging body of literature reports Governance that the bank executives subject to the strongest incentives to maximize the value of Practice as their shares—as reflected in stock-based compensation, oversight by independent understood directors, and shareholder power—worked at banks that took the greatest risks and suffered the greatest losses.15 In other words, financial firms that had the ‘best’ ~ governance mechanisms, as conventionally understood before the crisis, actually did worst hit in crisis worst during the crisis. We now review the application to financial institutions of each of the corporate governance mechanisms described in section 17.1. We begin with boards of directors, then consider compensation practices, then shareholder rights, and conclude with a discussion of legal duties. In each case, we consider first what we have learned from pre-crisis practices, and then review critically recent regulatory initiatives. 14 BCBS, Enhancing Corporate Governance for Banking Organisations (1999), 6–7; ibid (2006), 6–15. 15 See section 17.3.1 for references. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:15 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 377 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 377 17.3 Bank Boards of Directors 17.3.1 Before the crisis Historically, bank boards in the UK and the US were typically larger, and had more independent directors, than non-financial firms.16 However, the size of bank boards around the world had been shrinking during the decade prior to the financial crisis, making these boards look more like those in non-financial firms.17 Yet banks’ compli- ance with general norms of ‘good’ corporate governance was associated with their failure during the financial crisis.18 Two studies of banks around the world report that those with more ‘shareholder-oriented’ boards had greater levels of risk prior to the crisis and experienced greater losses subsequently.19 There are at least two, likely complementary, explanations for these results. The first is that independent directors in banks may have assumed that regulators were exercising appropriate risk controls and consequently became less intensive in their own scrutiny. The second is that, because of the externalities associated with bank risk-taking, shareholders would have wanted banks to take greater risks. In other words, since financial gains benefit shareholders and losses that are so large as to put banks into bankruptcy are borne by creditors, shareholders benefit from the firm’s pursuit of more risky investments. 17.3.2 Bank internal controls An important role of the board of directors is to oversee internal controls within a firm. In most firms, these are primarily concerned with ensuring operational decisions are actually made in accordance with the firm’s strategy. However, the business of financial institutions is principally concerned with the allocation of risk. As a result, these firms need to engage in risk management: that is, ensuring that the financial risks assumed by the organization are consistent with its objectives.20 At the core of this is the need to 16 RB Adams and H Mehran, ‘Bank Board Structure and Performance: Evidence for Large Bank Holding Companies’ (2012) 21 Journal of Financial Intermediation 243 (study of thirty-five bank holding companies over 1964–99, reporting a positive relationship between board size and shareholder returns, and no link between number of independent directors and shareholder returns); cf D Walker, A Review of Corporate Governance in UK Banks and other Financial Industry Entities (2009) 41; RB Adams, ‘Governance and the Financial Crisis’ (2012) 12 International Review of Finance 7, 27. 17 M Becht, P Bolton, and A Röell, ‘Why Bank Governance is Different’ (2012) 27 Oxford Review of Economic Policy 437, 448. In contrast to non-financial companies, some studies report a positive association between bank board size and shareholder returns: see Adams and Mehran, n 16. 18 For reviews, see Becht, Bolton, and Röell, n 17. 19 A Beltratti and RM Stulz, ‘The Credit Crisis Around the Globe: Why Did Some Banks Perform Better? (2012) 105 Journal of Financial Economics 1, 10–11, 14–15 (sample of 503 deposit-taking banks around the world; reporting positive association between index of ‘shareholder-friendliness’ compiled from twenty-five ISS board variables and pre-crisis default risk, and a negative association with post-crisis performance); DH Erkens, M Hung, and P Matos, ‘Corporate Governance in the 2007–2008 Financial Crisis: Evidence from Financial Institutions Worldwide’ (2012) 18 Journal of Corporate Finance 389 (panel of 296 financial firms worldwide; reporting positive association between proportion of independent directors and pre-crisis risk- taking, and negative association with post-crisis performance). 20 AM Santomero, ‘Commercial Bank Risk Management: An Analysis of the Process’ (1997) 12 Journal of Financial Services Research 83, 89–90; DH Pyle, ‘Bank Risk Management: Theory’, in D Galai, D Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:17 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 378 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 378 Principles of Financial Regulation assess whether (a) the risks are justified by the returns associated (for particular contracts), and whether (b) the portfolio of risks taken on by the firm as a whole is appropriately constructed. Banks’ risk management systems can be subdivided into four components:21 (i) the assimilation and communication of information about exposures, in the form of standards and reports; (ii) the application of rules governing limits on positions that employees with a given level of authority may enter into on the firm’s behalf; (iii) the development of strategies and guidelines governing investment; and (iv) the design of employee compensation so as to generate appropriate incentives. Each component needs to be monitored and reviewed on a continuing basis, as does its relationship with the others. A number of aspects of bank risk management are particularly problematic. First is the gross level of complexity. In addition to the inherent difficulty of observing financial assets, noted in section 17.2, bank risk management systems have evolved gradually over time, following different trajectories in relation to different categories of risk. Credit risk management differs from interest rate risk or liquidity risk, for example. The level of complexity involved in the management of each of these has evolved in accordance with the limit of the competence of the most highly skilled teams of experts. This makes it extremely difficult for senior management to synthesize and assess overall risks to the firm.22 Second, there is a particular conflict between risk management and high-powered financial incentives for employees. Employees with strongly incentive-based compen- sation will seek to maximize whatever performance benchmark has been set for them. The more intense the incentive to maximize a particular benchmark, the more single- minded the focus on that measure will be, which may be to the detriment of other business objectives. Worse still, intense incentives can lead employees to seek to ‘game’ the performance benchmark through steps that are positively harmful to the business as a whole, or even fraudulent. Given the great difficulties in monitoring financial assets, the appropriate calibration of employee compensation schemes and the policing of the way in which employees meet their performance targets are extremely important for the successful operation of the business. They therefore demand significant levels of internal oversight. This needs to be effected not just at the level of individual compen- sation targets and behaviour, but also at group- and firm-wide levels, ensuring that individual (group) targets are set in a way that are mutually consistent at the level of the firm as a whole. Consistent with intuition, there is evidence that the level of resources devoted to risk management has a meaningful impact on bank overall returns. Ellul and Yerramilli constructed an index of risk management intended to capture the strength and independence of risk management functions at US bank holding companies. They Ruthenberg, M Sarnat, and BZ Schreiber, Risk Management and Regulation in Banking (New York, NY: Kluwer, 1999), 7, 8. 21 22 Santomero, ibid, 86. Ibid, 110–12. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:19 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 379 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 379 report that bank holding companies with higher scores in this index were less risky prior to the crisis and enjoyed better returns during the crisis.23 EU= Prescriptive 17.3.3 EU Regulation of bank board structure and risk management rules on board + risk The EU has, under the aegis of the Capital Requirements Directive IV (‘CRD IV’) and the accompanying Capital Requirements Regulation (‘CRR’),24 introduced a wide- ranging and prescriptive set of guidelines for bank governance, dealing inter alia with board structure and risk management. In contrast, the US has steered clear of imposing prescriptive rules on bank boards, save as respects compensation committees (discussed in section 17.4) and for risk management, for which a board committee with oversight over risk management policies is required under Dodd-Frank and the implementing regulations, with heightened requirements for the largest firms.24a CRD IV, which applies to credit institutions and investment firms, emphasizes the obligations of the board to monitor the performance, risk controls, compensation strategy, and integrity of disclosures of the firm.25 It imposes regulatory duties of care and loyalty on board members.26 It does not impose any minimum requirements for the proportion of independent directors, or the extent of their ‘independence’, save for separation of Chair and Chief Executive and the composition of the nomination, remuneration, and risk committees.27 However, it does require that board members ‘commit sufficient time to perform their functions in the institution’, and to encourage this, mandates that not more than two non-executive roles at other organizations may be combined with one executive role, and not more than four non-executive roles in total may be held by any individual director.28 It also requires firms to promote diversity in the boardroom, on the theory that this will assist in ‘recruiting a broad set of qualities and competences’.29 To this end, nomination committees must specifically introduce targets for representation of women on the boards, although not as regards ethnicity.30 CRD IV also imposes both procedural and substantive requirements regarding risk management. Procedurally, it emphasizes the importance of overall risk management functions that are proportionate to the nature, scale, and complexity of the risks inherent in the firm’s business model.31 It also requires boards to ‘devote sufficient time to consideration of risks’, and for large firms to establish a risk committee of the board comprised of non-executive directors.32 Firms are also required to ensure that they have a ‘risk management function’, which is independent of the operational 23 A Ellul and V Yarramilli, ‘Stronger Risk Controls, Lower Risk: Evidence from US Bank Holding Companies’ (2013) 68 Journal of Finance 1757. 24 Directive 2013/36/EU of the European Parliament and of the Council on Access to the Activity of Credit Institutions and the Prudential Supervision of Credit Institutions and Investment Firms, Amending Directive 2002/87/EC and Repealing Directives 2006/48/EC and 2006/49/EC OJ L176/338; Regula- tion (EU) No 575/2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 OJ L176/1. 24a Dodd-Frank Act sec. 165(h); 12 CFR 252.22, 252.33. 25 26 27 CRD IV, Art 88(1). Ibid, Art 91(7)–(8). Ibid, Arts 88(2) and 95. 28 29 Ibid, Art 91. Ibid, Art 91(10). 30 Ibid, Arts 88(2)(a) and 91(10). For a critical overview of the measures described in this paragraph see L Enriques and D Zetzsche, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’ (2015) 16 Theoretical Inquiries in Law 211. 31 32 CRD IV, Art 74(2). Ibid, Art 76(2)–(3). Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:21 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 380 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 380 Principles of Financial Regulation decision-makers, reports to the board, has sufficient stature and resources to ensure that ‘all material risks are identified, measured, and properly reported’, and is capable of delivering a ‘complete view of the whole range of risks of the institution’.33 Turning to substantive requirements, the Directive requires regulators to specify guidelines regarding the management of various types of risk run by financial institutions.34 Ironically, however, to the extent that these detailed guidelines adopt different meas- urement technologies for different types of risk, they may actually make it harder for boards and risk committees to comply with their procedural obligations.35 Institutions must also disclose their recruitment and diversity policies for the board and its members’ relevant knowledge and expertise, whether or not the firm has a risk committee, and if so, how frequently it meets, and a description of the information flow on risk to the management body.36 17.4 Executive Pay in Banks 17.4.1 History and problems Prior to the crisis, the financial sector made enthusiastic use of performance-related pay.37 In keeping with the pattern for non-financial firms, CEOs of US banks typically received far more variable pay than base salary.38 For example, Fahlenbrach and Stulz (‘F&S’), studying compensation of US bank CEOs in 2006, report a mean base salary of $760,000, which is less than a sixth of the mean variable pay (comprising cash bonus and equity compensation) of $5.3 million.39 This heavy weighting towards variable pay—characterized as ‘performance-related’—was relatively recent. Historically, US bank executives received a greater fraction of fixed pay than was the norm in non- financial firms.40 Following the deregulation of banking in the 1990s, the use of equity- based pay rose sharply in the sector, such that by the turn of the century, bank executive pay looked very similar to other sectors.41 Just as before the crisis no one questioned the application to banks of ordinary governance standards, it has now become an article of faith that high levels of variable pay for bank executives tend to encourage ‘excessive’ risk-taking. Yet such a 33 34 35 36 Ibid, Art 76(5). Ibid, Arts 77–87. See nn 21–2. CRR, Art 435(2). 37 Most is known about the compensation of US CEOs and ‘top five’ executives, because US disclosure rules require the most detailed information to be made public about their compensation. 38 Nevertheless, in comparison to non-financial firms, when controlling for firm characteristics (espe- cially size), banks typically have less CEO total and incentive compensation, and less director compensa- tion: Adams, n 16, 27. 39 R Fahlenbrach and RM Stulz, ‘Bank CEO Incentives and the Credit Crisis’ (2011) 99 Journal of Financial Economics 11, 16. 40 See JF Houston and C James, ‘CEO Compensation and Bank Risk: Is Compensation in Banking Structured to Promote Risk Taking?’ (1995) 36 Journal of Monetary Economics 405; L Angbazo and R Narayanan, ‘Top Management Compensation and the Structure of the Board of Directors in Commercial Banks’ (1997) 1 European Finance Review 239. 41 DA Becher, TL Campbell II, and MB Frye, ‘Incentive Compensation for Bank Directors: The Impact of Deregulation’ (2005) 78 Journal of Business 1753; V Cuñat and M Guadalupe, ‘Executive Compensation and Competition in the Banking and Financial Sectors’ (2009) 33 Journal of Banking and Finance 495; R DeYoung, EY Peng, and M Yan, ‘Executive Compensation and Business Policy Choices at US Commercial Banks’ (2013) Journal of Financial and Quantitative Analysis 1. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:23 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 381 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 381 generalization might be just as misleading as the pre-crisis complacency. We need to look carefully at the details in order to understand the mechanisms in play. Did having ‘skin in the game’ restrain risk-taking? First, we should note that bank executives typically held significant holdings of stock in their firms. In F&S’ sample, the mean value of the stock CEOs held in their own firm was $87.5 million, approximately 0.4 per cent of the outstanding stock.42 In part this would have been because stock awards were often ‘restricted’ for five years, meaning that the CEO could not sell until five years after grant. However, these very large holdings also reflected a significant degree of voluntary exposure by executives: that is, not selling their stock holdings even when they were no longer restricted. As a result, bank CEOs suffered huge losses— averaging $31.5 million—over the period 2006–8.43 Should we conclude that because managers had such a substantial amount of ‘skin in the game’, they did not have incentives to indulge in ‘excessive’ risk-taking? Apparently not. While managers clearly had significant downside exposure, looking solely at their holdings of stock does not take account of cash already received from bonuses and stock sales. Bebchuk, Cohen, and Spamann report that the top five executives in Bear Stearns and Lehman Brothers received aggregate cash flows of $2.4 billion over the period 2000–8.44 Although these executives suffered losses of approximately $1.4 billion through their holdings of stock in their firms, taking cash flows into account showed they were still ahead by approximately $1 billion over these eight years.45 In other words, even for the financial firms that failed outright, managers’ payouts from good years had greatly exceeded their eventual losses when the firms failed. This asymmetry—upside returns exceeding downside—seems to generalize. Thus F&S report that, taking into account options and cash bonuses, the mean CEO in their sample would receive 2.4 per cent of the value of any increase in the stock price.46 However, their downside losses would only be 0.4 per cent of any decrease, tracking their holdings of the firm’s stock. In short, incentives on the upside were five times as strong as on the downside. Moreover, this asymmetry of incentives appears linked to underperformance during the financial crisis. F&S report that the greater the managers’ incentives to increase the stock price—as measured by the proportion of the increase in value they captured—the worse were bank shareholders’ returns during the financial crisis.47 This suggests that powerfully asymmetric financial incentives encouraged managers to pursue strategies 42 Fahlenbrach and Stulz, n 39. 43 Ibid, 23. Note that the median was only $5.1m, however. 44 LA Bebchuk, A Cohen, and H Spamann, ‘The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008’ (2010) 27 Yale Journal on Regulation 257. 45 Similarly, Bhagat and Bolton look at CEO payoffs in the largest fourteen crisis institutions, and find that they took $1.77bn in net stock sales plus $0.89bn in cash compensation during the period 2000–8, a total cash flow of $2.66bn. In 2008, their equity holdings suffered an aggregate loss of $2.01bn. Nevertheless, they were better off, on net, over the period by $0.65bn: S Bhagat and P Bolton, ‘Financial Crisis and Bank Executive Compensation’ (2014) 25 Journal of Corporate Finance 313, 319–23. 46 Fahlenbrach and Stulz, n 39, 17. 47 F&S gauge the incentive effect for managers by measuring the dollar value CEOs earn from a 1 per cent increase in stock price. Ibid. This measure—the change in managerial pay associated with a change in the stock price—is known as the ‘delta’ of the compensation package. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:25 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 382 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 382 Principles of Financial Regulation that, at least ex post, turned out to be harmful to shareholders. We need to understand why this may have been the case. One answer may be that stock options gave incentives to take risks in excess of what was optimal even from the shareholders’ perspective. The basic rationale for using options is that—assuming they are correctly priced (that is, ‘out-of-the-money’)—they provide a powerful upside incentive to take actions that will increase the stock price. But might managers be pushed too far? Could options encourage them to pursue risky projects simply for the sake of it? An increase in the volatility of a firm’s stock price will increase the value of an out-of-the-money option on that stock48 and if the incentive is sufficiently powerful, then managers may be induced to select projects with lower net present values simply because they are more risky. F&S did not find any evidence of a link between the risk-sensitivity of managers’ portfolios and shareholder returns.49 In other words, they found no evidence that option compensation led managers to select projects with lower expected values—thus harming even shareholders—simply because they are more risky. However, this does not imply that option contracts do not encourage a degree of risk-taking that is detrimental to creditors. Were the risks excessive from a societal perspective? The costs of financial firm failure are not borne entirely by shareholders. Implicit or explicit government guarantees of creditors mean that these costs are only partially priced into credit agreements. As a result, shareholders as a group may stand to benefit from strategies that increase default risk but generate more positive cash flows in other states of the world. Consistently with this, Balachandran et al report a positive relationship between managerial equity com- pensation and default risk.50 That is, firms whose managers had the strongest incentives to maximize share price were also those most likely to fail. However, this cynical perspective fails to explain why managers did not reduce their holdings of shares in anticipation of the financial crisis. Had managers simply been ramping up risk in order to transfer losses to the state, it would make no sense for them to remain holding shares at the time the losses crystallized. Moreover, this perspective also overlooks the fact that—in the US and the UK at least—most bank shareholders are diversified, meaning that they incur significant losses through their other portfolio firms should systemic harms materialize.51 Such shareholders would not want bank managers to take socially exces- sive risks.52 48 This is because the increase in volatility implies an increase in the states of the world in which the option will be in-the-money. The extent to which an increase in the volatility of the share price results in an increase in the value of managerial compensation is known as the ‘vega’ of the latter. 49 Ibid, 18–19. But see Bhagat and Bolton, n 45. 50 S Balachandran, B Kogut, and H Harnal, ‘Did Executive Compensation Encourage Extreme Risk- Taking in Financial Institutions?’, Working Paper (2011). 51 J Armour and JN Gordon, ‘Systemic Harms and Shareholder Value’ (2014) 6 Journal of Legal Analysis 35. 52 On the other hand, the private incentives of asset managers who control institutional portfolios may have led financial firms to engage in excessive risk taking. Recent theoretical and empirical work suggests that the riskiest firms, which generally outperformed in the pre-financial crisis period, gave the highest levels of variable pay, to compensate executives for the extra risk-taking: see I-H Chang, H Gong, and JA Scheinkman, ‘Yesterday’s Heroes: Compensation and Risk at Financial Firms’ (2015) 70 Journal of Finance 839. Asset managers, who are evaluated on relative performance, would encourage risk-taking by portfolio companies that would lead to outperformance. On the corporate governance issue, see section 17.5 and Armour and Gordon, n 51, 56, 60–1. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:26 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 383 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 383 What about more junior employees? We have so far focused on the compensation of senior managers, primarily because these are the only group for whom detailed compensation information must be disclosed. Consequently, far less is known about the compensation of less senior employees. However, such literature as exists suggests that incentive problems stemming from miscalibrated ‘performance’ pay may have been most egregious at the level of trading and sales staff, rather than senior executives. Shortly after the onset of the financial crisis, the FSA carried out a study of bank employee compensation practices in the UK.53 They found that cash bonuses accounted for a large proportion of employees’ pay. However, these bonuses were typically not linked to the stock price, but to net revenues in that financial year. Conditioning bonuses on revenues, rather than stock price, means that not even the market’s (perhaps imperfect) assessment of the downside risk for shareholders of the firm’s strategies was priced-in. In fact, it seems an astonishingly poor way to motivate employees, as the box text explains. ‘Performance Pay’ and Insurance Contracts Where a financial firm takes on a risk under a contract, it is functionally—albeit not legally— providing insurance to the counterparty in respect of that risk. We would expect the premium for providing this insurance to be reflected in the price of the contract. It is clearly a mistake to reward people for writing insurance based only on the size of the premium they earn, without taking into account the risks insured. This simply gives them incentives to commit their firm to the biggest risks they can find, because these will attract the highest premiums. But this is precisely the effect of rewarding employees in a financial firm on the basis of revenues, without any adjustment for risk. This disturbing picture is reinforced by Acharya et al’s innovative study of the impact of employee incentive compensation.54 These authors identify the aggregate compensation for sub-board-level employees by subtracting the (disclosed) compen- sation for ‘top five’ executives from the (disclosed) aggregate total compensation paid by financial firms, and then determine how sensitive this total compensation is to the firm’s revenues (not stock price). This gives a measure of the extent to which employees are incentivized to maximize revenues in a given year. The authors go on to report that greater revenue-sensitivity of aggregate employee cash pay was associated with greater default risk for the firm. This implies that incentive contracts of the type the FSA reported—linking pay to revenues—were associated with greater default risk. In light of our discussion in section 17.4 about the deficiencies of internal monitor- ing, we can offer a conjecture about the ways in which senior management may have made mistakes about risk-taking. Management with strong incentives to increase the stock price may have been more inclined to focus simply on revenues generated by 53 FSA, ‘Reforming Remuneration Practices in Financial Services’, Consultation Paper 09/10 (2009). 54 V Acharya, LP Litov, and SM Sepe, ‘Seeking Alpha, Taking Risks: Evidence from Non-Executive Pay in US Bank Holding Companies ’, Working Paper NYU/University of Arizona (2014); see also SM Sepe and CK Whitehead, ‘Paying for Risk: Bankers, Competition and Compensation’ (2015) 100 Cornell Law Review 655. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:28 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 384 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi 384 Principles of Financial Regulation employees and (mistakenly) reflected in the stock price, paying insufficient attention to appropriate risk-adjustment of returns. That is, there was likely a negative synergy between the extent to which managers were encouraged to ‘manage the stock price’ and the extent to which the stock price failed—owing to opacity—to take into account the true downside costs of firms’ strategies. 17.4.2 The new regulation of executive compensation in banks Bank executive compensation became an early target for regulatory reform. At the G20 summit in Pittsburgh in September 2009, member countries circulated a Statement of Principles regarding executive pay in the financial services sector.55 This encompassed a programme of reform with the following three pillars: first, internal governance mechanisms were to be strengthened as regards the process of setting compensation; second, the substance of compensation packages should be more closely aligned with ‘prudent risk-taking’; and third, there should be more disclosure, and effective super- visory oversight, of both the process and substance of compensation arrangements. These principles were first implemented in Europe through CRD III,56 and subse- quently tightened considerably in CRD IV,57 which goes significantly beyond what is envisaged by the FSB’s Statement of Principles. In the US, the Dodd–Frank Act requires the appropriate Federal regulators to introduce rules in relation to internal govern- ance,58 disclosure of executive pay, and substantive regulation of compensation con- tracts.59 Rules regarding internal governance, in particular the role of compensation committees, have been implemented by the Securities and Exchange Commission (‘SEC’), and in 2016 there was a revised interagency rule proposal regarding enhanced disclosure of compensation in financial firms and substantive standards on compen- sation contracts.60 Table 17.1 sets out the firms and executives to which the regulations apply in the EU and the US, respectively. We now turn to consider specific details of the rules that have emerged. The Process of Setting Compensation. The FSB’s first pillar proposed more active internal oversight of the setting of compensation.61 At the centre is the idea of a remuneration committee of the board with sufficient independence and expertise to exercise appropriate judgement on remuneration policies. The remuneration commit- tee should work with the firm’s risk committee to evaluate the incentives created by the 55 Financial Stability Forum, FSF Principles for Sound Compensation Practices, 2 April 2009. 56 Directive 2010/76/EU OJ L329/3. In the UK specifically, this was implemented under the Financial Services Act 2010, ss 4–6, and amendments to the FSA’s (now FCA’s) Remuneration Code: FSA, Revising the Remuneration Code, Consultation Paper 10/19 (2010). 57 Directive 2013/36/EU OJ L176/338. 58 §952, inserting new §10C into the Securities Exchange Act of 1934. 59 §956 (enhanced disclosure and reporting of compensation arrangements at financial institutions and provision for prohibition of ‘types of incentive-based compensation arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions’). 60 US Department of the Treasury et al, ‘Notice of Proposed Rulemaking and Request for Commen: Incentive-Based Compensation Arrangements’ 21 April 2016. 61 FSB, FSB Principles for Sound Compensation Practices: Implementation Standards, 25 September 2009, 2. Comp. by: Sivakumar Stage : Revises1 ChapterID: 0002717923 Date:12/5/16 Time:16:19:30 Filepath://ppdys1122/BgPr/OUP_CAP/IN/Process/0002717923.3d Dictionary : OUP_UKdictionary 385 OUP UNCORRECTED PROOF – REVISES, 12/5/2016, SPi Bank Governance 385 Table 17.1 To which financial firms does the regulation of executive compensation apply? EU US Which CRD IV Art 3, CRR Art 4(1). Dodd–Frank Act of 2010, §956 firms? ‘Credit institutions’ (firms both taking deposits ‘Covered financial institutions’ (firms and granting credit); taking deposits or their holding ‘Investment firms’ (firms providing investment companies, registered broker-dealers, services or engaging in investment activities, credit unions, investment advisors, Fannie including brokers, dealers, investment Mae and Freddie Mac, and any other managers, underwriters, and market operators). financial institution that Federal regulators jointly determine should be treated as such) with assets > $1 billion. Which CRD IV Art 92(2) and Delegated Regulation Dodd–Frank Act of 2010, §956 and employees? (EU) No 604/2014. proposed Rule ‘Material risk-takers’ (categories of employee ‘Senior executive officers and significant whose professional activities have a material risk-takers’: senior executive officers, and impact on [the firm’s] risk profile). any other executive officer or employee Identification based on both internal criteria who received total compensation in top developed by the firm and qualitative (functions 5% (for firms with assets >$250bn) or 2% performed) and quantitative (compensation (for firms with assets >$50bn) of payroll or value) criteria applied by supervisors. who can expose 0.5% or more of the firm’s net worth. Qualitative criteria: Board and senior management; staff with the authority to commit significant credit risk exposures. Quantitative criteria: (i) Total gross remuneration > €500,000; or (ii) among firm’s 0.3 per cent most highly paid staff; or (iii) remuneration equal to senior managers; or (iv) variable pay could exceed €75,000 and 75 per cent of fixed pay. firm’s compensation arrangements so as to ensure that these are consistent with the risk committee’s assessment of the firm’s financial condition and prospects, and with regulatory guidelines. It should also oversee an annual review of compensation prac- tices which should be produced for regulator