Controlling Systemic Risk Through Corporate Governance

Steven L. Schwarcz is a Senior Fellow with the Centre for International Governance Innovation (CIGI) and the Stanley A. Star Professor of Law & Business at Duke University School of Law. This post is based on a recent paper by Professor Schwarcz.

In Policy Brief No. 99—February 2017 of the Centre for International Governance Innovation (CIGI), I explain how corporate governance could be used to help control systemic risk. Excessive risk taking by systemically important financial firms is widely seen as one of the primary causes of the 2007-2008 global financial crisis. Most of the post-crisis regulatory measures to control that risk taking are designed to reduce moral hazard and to align the interests of managers and investors. These measures may be flawed, I argue, because they are based on questionable assumptions.

For example, the assumption that systemically important firms engage in morally hazardous risk taking because they expect a bailout lacks persuasive empirical support and may also be contrary to management incentives. The assumption that a systemically important firm’s investors would oppose excessively risky business ventures is questionable because much of the harm from such a firm’s failure would be externalized onto the public, allowing it to engage in risk taking ventures that have a positive expected value to its investors but a negative expected value to the public.

Excessive corporate risk taking is, at its core, a corporate governance problem. Shareholder primacy requires managers to view the consequences of their firm’s risk taking only from the standpoint of the firm and its shareholders, ignoring harm to the public. In governing, managers of systemically important firms should also consider public harm.

This proposal engages the longstanding debate whether corporate governance law should require some duty to the public. The accepted wisdom is that corporate profit maximization provides jobs and other benefits that exceed public harm. Opponents of a public duty also argue that managers could not feasibly govern if they had to take into account the myriad small externalities that result from corporate risk taking. Those arguments are less persuasive, however, in the context of systemic economic harm. Even in that context, though, there’s uncertainty. Some believe, for example, that specific regulatory requirements—such as mandating resolution planning, contingent debt conversion, and minimum liquidity and capital—can successfully mitigate systemic externalities. Others suggest that imposing specific requirements may be inadequate or possibly even harmful.

This paper rethinks the public duty debate in that context, demonstrating that corporate governance law can usefully supplement specific regulatory requirements in controlling systemic risk, without unduly weakening wealth production. Regulating corporate governance may even have an intrinsic advantage over specific regulatory requirements. The latter depends on regulators precisely understanding the financial “architecture”—the particular design and structure of financial firms, markets and other related institutions—at the time the requirements are imposed. Because the financial architecture constantly changes, those requirements should be periodically updated. But ongoing financial monitoring and regulatory updating can be costly and is subject to political interference at each stage. As a result, financial regulation usually lags behind financial innovation, causing unanticipated consequences and allowing innovations to escape regulatory scrutiny.

Regulating corporate governance can overcome that regulatory time lag. A public governance duty would fail, however, if it unduly impairs corporate wealth production. The paper suggests two governance approaches, one subjective and the other more objective, that should minimize any impairment. The latter approach can be illustrated by the example of a systemically important firm engaging in a risky project that could be profitable. The expected private benefits would be the expected value of the project to the firm’s investors (usually the shareholders). The expected public costs would be the expected value of the project’s systemic costs.

In large part, the firm’s managers should have sufficient information, or at least much more information than third parties, about these values. Valuing the systemic costs if the firm fails, however, should be a public policy choice. The paper analyzes how that valuation could be made. It also examines how managers could pragmatically balance costs and benefits.

From a strict economic standpoint, a project would be efficient if, on balance, its expected value to investors exceeds the expected value of its systemic costs. As a policy matter, however, economic efficiency may be insufficient because the magnitude and harmful consequences of a systemic collapse, if it occurs, could be devastating. The paper therefore suggests applying a form of precautionary principle to the balancing, directing regulators to err on the side of safety.

Another critical issue is how to apply the business judgment rule as a defense to manager liability. In the traditional corporate governance context, managerial risk-taking decisions are protected to some extent by this rule, which presumes that managers should not be personally liable for harm caused by negligent decisions made in good faith and without conflicts of interest—and in some articulations of the business judgment rule, also without gross negligence. The rule attempts to balance the goal of protecting investors against losses with the goals of encouraging the best managers to serve and avoiding the exercise of inappropriate judicial discretion (as would occur if courts tried to second-guess business judgments).

The paper explains why, due to certain conflicts of interest, the business judgment rule should apply slightly differently in a public-governance-duty context. But it also shows how that rule could be conformed to a duty of process care, a standard commonly used. The paper additionally analyzes how managers could be protected under directors and officers (D&O) liability insurance, incentivizing good managers to serve without sacrificing a reasonable deterrent effect.

The complete paper is available here.

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