Are Bank Fiduciaries Special?

A distinct current of the post-crisis financial reform literature seizes on banking institutions’ status as corporate entities, and suggests that improving the governance regimes of these institutions can help prevent a recurrence of the abuses that led us to 2008. Some contributors to this literature highlight apparent abuses of the norms already governing bank fiduciaries prior to the crisis, and propose means of strengthening the enforcement regimes that vindicate those values. Others suggest that the content of traditional fiduciary duties be altered. And still others propose analogues to optional B-Corp charters for banks, pursuant to which some might then signal their greater public-spiritedness to would-be shareholders and depositors and, by attracting the same, model a “better way” for the industry.

In a new article, I suggest that efforts of this kind, though well-intended, are not likely to assist much in preventing future dysfunction of the pre-2008 variety. Widespread adoption of the proposals would doubtless be a good thing; it might even delay, somewhat, the onset of asset price bubbles. In the end, however, such proposals would make little difference. For they treat what is essentially an inter-firm problem as though it were an intra-firm problem.

One way to show why this is so is first to focus on the nature of pro-cyclically self-worsening “bubble” dynamics in decentralized markets—the dynamics that brought us to 2008—then to focus on the nature of the fiduciary relation, with a view to what if anything connects them. This is how I proceed in the article.

To begin with the relevant market dynamic, the dysfunctions that culminate in financial crises are ultimately rooted in what I elsewhere call “recursive collective action problems,” or “recaps.” A collective action problem, of course, is a situation in which multiple individually rational decisions aggregate into a collectively irrational outcome. A recursive such problem is one in which the rational decisions in question are iterated and interactive—they respond to one another in an indefinitely repeated “back-and-forth” manner. Bank runs and arms races are classic examples. Less noted but more salient for present purposes are consumer price inflations, asset price hyperinflations, Fisher debt-deflations, and a host of other maladies that regularly afflict our financial markets.

For present purposes the key point about all of these cases is that no defect in individual rationality or morality is required for “bubble” dynamics to get underway and then grow out-of-hand. Indeed, individual rationality is (part of) the problem in these cases. In this sense they’re “tragic.” A participant in any inflation or hyperinflation contributes to the inflation if she purchases now rather than later, yet only “shoots herself in the foot” if she refuses to participate, since she cannot single-handedly short-circuit the problem and will have to pay more for her purchase later in any event. She is “damned if she does, damned if she doesn’t.” This feature of recaps places constraints upon what measures can solve them. Collective action problems are solved through exercises of collective agency, and the scope of the collectivity in question must match the scope of the problem. More on this below.

Turning to bank fiduciaries, the best way to understand fiduciary obligation is as a required limitation on the separateness of certain persons. The fiduciary must minimize the “space” that subsists between herself and the beneficiary of her obligation. In this sense, ideal fiduciaries effectively “stand-in” for their beneficiaries—they just are their beneficiaries for those purposes to which the obligation pertains. Of course, the law of fiduciary obligation is not quite as severe as this—or, what is essentially the same thing, as severe as it once was. But legal allowances for marginal departures from the original ideal—for example, in the case of corporate fiduciaries’ duties of care—are simply pragmatic accommodations we make with the fact that fiduciaries are separate persons with interests of their own. The allowances are means of ensuring that would-be fiduciaries are not made so risk-averse as either to act insufficiently entrepreneurially or to avoid becoming fiduciaries altogether.

Once these observations are in place, it grows immediately apparent that tinkering with bank fiduciaries’ obligations is at best an incomplete way to address systemic financial dysfunction. Because these dysfunctions do not stem from defects of individual judgment, it does little if anything for financial stability to bind fiduciaries more closely to such judgment by, say, tightening their duties back up. Such judgment is, again, precisely the problem where recursive collective action problems are concerned. If, on the other hand, we instead rejigger bank fiduciaries’ obligations by requiring that they take systemic financial stability into account while acting on behalf of their beneficiaries, we address the problem at the wrong “level” and muddy fiduciary waters in a manner that places fiduciaries in essentially impossible situations. For the latter are in no position to oversee, predict, or form responsible opinions about systemic stability or otherwise, let alone able to “balance” the long-term interest in such things with the shorter-term interests of their beneficiaries.

As noted above, collective action problems require exercises of collective agency for their solution. If we make bank fiduciaries the collective agents in question, we cease to treat then as bank fiduciaries, and convert them instead into public fiduciaries. That might not be a bad thing—indeed, it might even make sense to include certain forthrightly public fiduciaries on bank (and other corporate?) boards. But we should not kid ourselves that this is a matter of forcing fiduciaries to “behave better”—or to act in closer conformity to their current fiduciary obligations to their firms. That misidentifies the problem, which is structural rather than behavioral.

There is, moreover, a better and far more familiar way: we authorize a collective agent to oversee the system as a whole, and that agent then promulgates rules that render it no longer even individually rational to participate in hyperinflationary markets. This it does by raising borrowing costs, taxing-away gains, or both, with a view to closing the spread that prompts bubble participation in the first place.

We have a name for these agents and the rules that they promulgate. We call them regulators and regulations. What is needed is good macroprudential regulation by good systemic risk-regulators. If we want to place some of them on bank boards—as we now place examiners in banks—all well and good. But then they are our fiduciaries, not the banks’. And the main event will remain overhead—with the regulatory agencies for which the new public board-members work.

The full article is available for download here.