Bank Governance and Systemic Stability: The “Golden Share” Approach

Saule T. Omarova is a Professor at Cornell Law School. This post is based on her recent article, forthcoming in the Alabama Law Review.

The global financial crisis of 2008 has underscored the urgent need for deep rethinking of how financial firms ought to manage risk, and do so not only for the sake of generating good results for themselves and their clients but also for the sake of keeping the entire financial and economic system from collapse. Conceptually, this collective post-crisis “rethinking” effort seems to proceed along two basic lines. Some scholars and policy experts focus on enhanced public regulation and supervision of financial firms and markets—through higher capital standards, mandatory stress testing, greater and faster data collection, etc.—as the key method of minimizing systemic risk. Others, by contrast, see improved private ordering—through strengthening various mechanisms of corporate governance, incentivizing individual firms and their employees to behave ethically, etc.—as the ultimate solution to the same problem.

Both of these approaches, of course, run into familiar problems and criticisms. All too often, even well-meaning regulators and supervisors find themselves at least one step (if not many steps) behind financial institutions that excel at regulatory arbitrage games. At the same time, even well-meaning private firms and their insiders—directors, shareholders, managers, and employees—are inherently limited in their ability to internalize a systemic-risk perspective, both because they generally do not have a full view of the financial system and because their actions are ultimately driven by private profit-maximization motives. Thus, neither the top-down public regulation nor the bottom-up private governance seem to offer a workable solution to this structural capacity dilemma.

There is, however, a third possibility that remains largely outside of mainstream academic and policy debate: the possibility of strategically combining certain key elements of public and private ordering, to allow for a more effective and seamless incorporation of systemic stability concerns into financial firms’ internal decision-making. In a recently published paper, I explore this unorthodox but potentially promising alternative.

The paper focuses on the structure and role of the board of directors as the key decision-making body within commercial banks, the archetypal systemically important financial institutions (“SIFIs”). Instead of tweaking existing standards and procedures that determine bank board composition or guide specific board actions, however, the paper advocates a fundamental structural reconfiguration of bank governance. It proposes the creation of a special “golden share” (“SGS”) regime that would grant direct but strictly conditional corporate governance rights to a designated government representative on the board of each systemically important banking organization.

In the 1980s-1990s, golden shares were widely used by governments around the world—including the famously conservative UK government under Margaret Thatcher—to reserve exclusive rights to control key business decisions by certain private companies in strategically significant industries. The paper examines how this familiar instrument can be adapted to serve as a tool of preventing excessive generation, concentration, and externalization of risk by privately owned banks. In essence, the proposed golden share regime is envisioned as a form of conditional (as opposed to absolute), temporary (as opposed to permanent), and individually calibrated (as opposed to uniformly predetermined) government control over banks’ internal governance.

The SGS would function as a dynamic mechanism, a sliding scale of management—but not economic—rights triggered by specified events. Under normal circumstances, the SGS is meant to remain largely a passive instrument. In this “peacetime” period of dormancy, the government-appointed directors would generally refrain from active participation in the management of the bank and perform primarily representational and observational functions, essentially serving as the public’s “eyes and ears” on the bank’s board of directors. The government’s direct management rights would get “triggered” only upon the occurrence of specified events that indicate a potentially greater likelihood of increasing systemic risk or instability. Examples of triggering events include certain worrisome trends in firm-specific metrics (falling capital levels, a sudden rise or change in the tenor of the firm’s liabilities, significant shifts in the composition or riskiness of the firm’s assets, etc.), regulatory compliance record and culture (e.g., significant instances or patterns of misconduct), as well as external indicators of potentially troubling systemic imbalances or vulnerabilities (e.g., sudden acceleration of credit growth across the financial system). In response to these warning signals, the SGS mechanism would shift into an actively participatory mode. At this “emergency” stage, the government-appointed directors would take effective control of the board and cause it to take actions necessary to remedy the specific “triggering” problem(s). Once that goal is achieved and the systemic danger is dissipated, the golden share would revert to the pre-trigger, passive state.

This brief sketch of the golden share proposal leaves out many important institutional and operational details discussed at length in the paper. Naturally, a daringly experimental project of this kind is bound to raise difficult design questions and face numerous implementation challenges. Yet, these challenges are hardly insurmountable, if we are willing to move beyond the outdated stereotypes and misplaced fears. As the paper shows, the proposed golden share regime is neither a nationalization measure nor an institutionalized bank bailout. Its overarching purpose is not to put the federal government in charge of private firms but, on the contrary, to steer those firms toward self-correcting and preventative actions necessary to avoid that undesirable result.

Moreover, enabling a public instrumentality to affect directly a private firm’s substantive business decisions—without holding a controlling economic equity stake—renders the golden share a particularly promising mechanism for preventing systemic financial shocks. As a special shareholder with uniquely tailored rights, the government would acquire the new capacity to take speedy and effective action necessary to counteract socially harmful, and thus irrational, effects of pure market rationality. In that sense, the golden share regime would effectively operationalize a novel approach to bank—and, more broadly, SIFI—corporate governance as an inherently hybrid public-private process.

The complete paper is available for download here.

Both comments and trackbacks are currently closed.