The Corporate Governance Movement, Banks and the Financial Crisis

Brian Cheffins is a Professor of Corporate Law at the University of Cambridge.

The primary function of corporate governance in the United States has been to address the managerial agency cost problem that afflicts publicly traded companies with dispersed share ownership. Berle and Means threw the spotlight on this type of agency cost problem—using different nomenclature—in their famous 1932 book The Modern Corporation and Private Property. Nevertheless, it was only in the 1970s that the now ubiquitous corporate governance movement began. Why did the corporate governance movement gain momentum in the U.S. when it did? And given its belated arrival, why did it flourish during ensuing decades?

These important questions have gone largely unaddressed thus far in the corporate governance literature. The Corporate Governance Movement, Banks and the Financial Crisis offers conjectures on why the corporate governance movement gained momentum when it did and proved robust thereafter. This is done primarily to offer insights concerning the inter-relationship between the corporate governance of U.S. banks and the financial crisis.

“The Corporate Governance Movement, Banks and the Financial Crisis” explains the staying power of the corporate governance movement by reference to changing market conditions and a pronounced deregulation trend that provided executives with unprecedented managerial latitude. Since this expanded managerial discretion could potentially be exercised in a manner prejudicial to the interests of shareholders, corporate governance could plausibly function as a highly beneficial corrective. It correspondingly would not be a mere 1970s fad.

With banking the historical pattern paralleled general trends in large measure but also varied from the basic narrative in an important way. Due to a combination of deregulation, technological change and financial innovation banking was transformed between the 1970s and the mid-2000s from a “boring” business to a business that was anything but. Given the trends affecting banking, to the extent that corporate governance can and does provide a salutary check on executives operating with substantial latitude, a marked strengthening in the corporate governance in banks would have been anticipated. There was movement in this direction but in the wake of corporate governance scandals occurring during the early 2000s and the enactment of the Sarbanes-Oxley Act of 2002 the banking sector received a de facto governance “free pass” denied to other firms due to delivering strong shareholder returns. Complacency about risks senior bank executives were running arguably put their firms in jeopardy as the financial crisis loomed and plausibly contributed to the market turmoil of 2008.

“The Corporate Governance Movement, Banks and the Financial Crisis” brings the story up-to-date by discussing how the banks’ corporate governance “free pass” ended abruptly with the onset of the financial crisis and by describing how in recent years regulatory trends have forced the banking sector to revert at least partially to “boring” mode. Corporate governance reforms the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act introduced are also put into context. Empowering shareholders was the pre-dominant theme in the Dodd-Frank Act provisions dealing with corporate governance, which is ironic given that shareholders have incentives to pressure bank executives to pursue high-risk strategies that post-financial crisis regulators seem to oppose.

The full paper is available for download here.

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