Quack Corporate Governance, Round III?

Like in the US, European policy-makers have taken a number of measures as a reaction to the financial crisis, some of which address corporate governance issues of credit institutions and investment firms (hereafter collectively referred to as “banks”). Other than in the U.S., however, and more consistently with the financial origins of the crisis, very little has made its way into legislation that applies to non-financial corporations.

In this paper, Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive, that was recently made publicly available on SSRN, we question the theoretical and empirical basis for the bank boards provisions contained in the most recent overhaul of European banking law (Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, commonly known as the “CRD IV”).

With CRD IV, the European Union has directly intervened in the composition and functioning of banks’ boards, going much beyond the recommendations of the banking regulators’ co-ordination body at the international level. The CRD IV, inter alia:

• 1. requires separation of chairman and chief executive officer (CEO) functions in banks with a one-tier board structure, unless competent authorities authorize CEO duality;
• 2. legislates on board composition, requiring the board as a whole to reflect “a broad range of experiences” and to “possess adequate collective knowledge, skills and experience to be able to understand the institution’s activities, including the main risks”;
• 3. requires banks to “devote adequate human and financial resources to the induction and training of members of the management body” and to engage in self-evaluation;
• 4. sets a precise limit to directorships, allowing supervisory authorities to grant a specific authorization to hold one additional board position;
• 5. gears up on individual board members’ responsibilities, by requiring that they possess at all times “sufficient knowledge, skills and experience to perform their duties” and that they act “with honesty, integrity and independence of mind to effectively assess and challenge the decisions of the senior management where necessary and to effectively oversee and monitor management and decision-making”;
• 6. harmonizes administrative sanctions for violations of CRD IV provisions, requiring member states to impose them also on individuals for violations of provisions outlined under 5. above;
• 7. promotes diversity within boards (CRD IV Art. 91(10) and (11)).

We argue that these rules are meritless or even counterproductive for the governance of European banks. First, we show that the diversity requirements and the newly spelt-out director duties, which are intended to overcome the problems of CEO-dominated boards and groupthink, may introduce problems of their own in the way boards perform their oversight and advisory functions. Second, the provisions on Chairman/CEO separation and limits on directorships petrify existing corporate governance best practices, and in so doing impose costs on banks that would be better off adopting (or maintaining) a different solution (such as a chairman/CEO or a board in which also a busy professional director with the right expertise keeps his seat). And finally, making induction and training and self-assessment exercises mandatory may easily lead to expensive and standardized box-ticking exercises, to the detriment of more customized solutions at the level of individual banks (and at the sizeable benefit of governance consultants).

In sum, there is neither any sound theoretical basis nor any sufficient empirical evidence to argue that, on average, the banking sector will be better governed/safer as an outcome of implementation of the new bank board provisions.

Looking for an explanation of why the European legislature has adopted superfluous, sometimes even harmful rules we acknowledge that in a post-financial crisis lawmakers act in haste and, in order to restore trust (and withstand the burgeoning popular outrage), sometimes use a heavier hand than needed. In mastering a financial crisis, regulators face enormous challenges: exceptional circumstances may, at least in the short run, justify unorthodox solutions.

In the case of CRD IV, policymakers appear to have deployed the corporate governance measures, together with the many others that have been taken during and after the crisis, to demonstrate their political commitment to do “whatever it takes” to restore trust in banks. We admit that this trust restoration effect may have been crucial in dealing with the crisis; in fact, we are not aware of any acceptable method to falsify the claim. Taking this trade-off into account, instead of recommending a repeal of the various provisions we criticize, we argue that implementing legislation should avoid further ratcheting up the new board rules’ intensity and that banking supervisors should refrain from prioritizing enforcement of the new governance rules in their day to day supervisory activity.

The full paper is available for download here.