Corporate Governance of SIFI Risk-Taking: An International Research Agenda

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law and Senior Fellow, the Centre for Corporate Governance Innovation (CIGI); and Aleaha Jones is a 2017 graduate of Duke University School of Law. This post is based on their recent paper, forthcoming as a chapter in Cross-Border Bank Resolution (Bob Wessels & Matthias Haentjens, eds., 2017-18).

In Corporate Governance of SIFI Risk-taking: An International Research Agenda, a chapter forthcoming in Cross-Border Bank Resolution (Bob Wessels & Matthias Haentjens, eds., 2017-18), we suggest a framework for examining how corporate governance regulation could help to control excessive risk-taking by systemically important financial institutions (SIFIs) and analyzing how that regulation should be evaluated. Our purpose is not to provide definitive and complete answers; instead, we offer a possible research agenda of critical issues for scholars, policymakers, and regulators around the world to consider.

Excessive risk-taking by SIFIs is widely regarded as a cause of the 2007–08 global financial crisis, and researchers are finding that SIFIs may be no safer than they were pre-crisis and might even be increasing their risk-taking. Superficially, these findings are baffling. Risk-taking is inherently a corporate governance choice. Why would rational managers want their firms to engage in excessive, instead of appropriate, risk-taking?

We explain that there are at least two possible answers: disagreement about what “excessive” risk-taking means, and flaws (market failures) in corporate governance. Both answers suggest the possibility of regulatory solutions.

For example, what constitutes excessive risk-taking may well depend on the observer. Under the universally adopted shareholder-primacy model of governance, risk-taking is excessive if it has a negative expected value to the firm and its shareholders. But a broader perspective of excessive risk-taking might also take into account societal consequences, in particular significantly harmful systemic externalities. Should corporate governance law applicable to SIFIs adopt that broader perspective?

The other reason why rational managers might want their SIFIs to engage in excessive risk-taking turns on corporate governance flaws. For example, firms sometimes pay managers for increasing share price without adequate consideration of the firm’s long-term sustainability. Some post-crisis regulation attempts to address SIFI compensation flaws, at least at the most senior managerial levels. This problem can be especially insidious, though, for secondary manager compensation. Financial complexity is increasing the information asymmetry between technically sophisticated secondary managers and the senior managers to whom they report, enabling secondary managers of SIFIs to effectively control some of their firm’s decisionmaking. Yet secondary managers are almost always paid under short-term compensation schemes.

Whether for these or other reasons, there is a widespread global consensus that the post-crisis regulatory requirements may be insufficient to control SIFI risk-taking. We discuss possible new regulatory approaches, including SIFI governance alternatives to strict shareholder primacy. We also compare several foreign laws that begin to address SIFI governance.

Finally, we explore how new regulatory approaches, including SIFI governance alternatives to shareholder primacy, could be evaluated. That raises a host of questions, including whether cost-benefit analysis is an appropriate evaluation tool; if so, how to estimate the relevant costs (e.g., potentially weakening a firm’s wealth-producing capacity) and benefits (e.g., reducing SIFI risk-taking, thereby reducing systemic risk); even assuming costs and benefits could be appropriately estimated, how they should be weighed; and how should SIFI managers be tasked with addressing these types of questions?

These questions, in turn, raise further questions. Consider, for example, how costs and benefits should be weighed. Cost-benefit analysis normally applies a standard Kaldor-Hicks efficiency weighing, under which regulation is deemed efficient if its benefits exceed its costs. But should private benefits (to the firm and its investors) have the same weight as public costs (including systemic harm)? And should systemic harm, which can sometimes have such devastating consequences as to exceed any estimate, justify applying a precautionary principle?

Again, our chapter does not purport to give final answers. We merely offer these and other questions as part of a potential international research agenda on SIFI risk-taking.

The complete chapter is available for download here.

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