Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy

Klaus J. Hopt is former director at the Max Planck Institute for Comparative and International Private Law, Hamburg, Germany. This post is based on his recent paper, forthcoming in the European Business Organization Law Review.

Corporate governance was first developed as a concept and field of research for private listed corporations. The idea of developing corporate governance standards spread quickly to other sectors, in particular to banks, insurance companies and other financial institutions. Yet after the financial crisis it turned out that not only banks are special, but so is the corporate governance of banks and other financial institutions as compared with the general corporate governance of non-banks. The corporate governance of banks and other financial institutions has gained much attention after the financial crisis. From 270 economic and legal submissions from 2012 to 2016 in the ECGI Working Paper Series of the European Corporate Governance Institute (ECGI), roughly half address corporate governance questions, and more than a quarter of these look at the regulation and corporate governance of banks (in the broad sense). Empirical evidence confirms this. Banks practicing good corporate governance in the traditional, shareholder-oriented style fared less well than banks having less shareholder-prone boards and less shareholder influence. Apparently bank boards charted a course more aligned with the preferences of shareholders, who—if sufficiently diversified in their holdings—embrace risk more readily than, for instance, a bank’s creditors. Banks that were controlled by shareholders saw higher profits before the crisis as compared to banks that were controlled by directors. Enterprises in which institutional investors held stocks correspondingly fared worse. Banks with independent boards were run more poorly. At least for banks, director independence can carry negative effects whereas expertise and experience are of much greater value, at least when obvious conflicts of interest are avoided.

The special governance of banks and other financial institutions is firmly embedded in bank supervisory law and regulation. Starting with the recommendations of the Basel Committee on Banking Supervision (revised version in July 2015), many other supervisory institutions have followed the lead with their own principles and guidelines for good governance of banks. In the European Union, this has led to legislation on bank governance under the so-called CRD IV (Capital Requirements Directive), which has been transformed into the law of the Member States. Yet the legal literature dealing with this transformation is mostly doctrinal and concerned with the national bank supervisory law. But there are also more functional legal as well as economic contributions, these addressing primarily, but not exclusively, systemically important financial institutions. The latter are under a special regime that needs separate treatment.

Most recently there has been intense discussion on the purpose of (non-bank) corporations. Shareholder governance and stakeholder governance have been and still are the two different prevailing regimes, the first in the United States (despite some critique most recently) and the second in Europe, particularly in Germany. Yet for banks this difference has given way to stakeholder and, more particularly, creditor or debtholder governance, certainly in bank supervision and regulation. Yet the implications of this for research and reform are still uncertain and controversial. For banks, self-regulation, if at all, must give way to co-regulation or cooperative regulation between the banks and the state. Mandatory transparency is indispensable. For banks this transparency has the additional function of informing the regulators and supervisors in order to facilitate their task of creditor and debtholder protection and more generally the protection of the economy. Particular qualification and independence problems arise for state-owned banks.

The regulatory core issues for the corporate governance of banks are manifold. A key problem is the composition and qualification of the (one tier or two tier) board. The legislative task is to enhance independent as well as qualified control. Yet the proposal of giving creditors a special seat in the board may be disruptive, and in Germany at least, it disregards the reality of labor codetermination at parity. Giving bank supervisors a permanent seat in the board would create serious conflicts of interest since they would have to supervise themselves. There are many other important special issues of bank governance, for example the duties and liabilities of bank directors in particular as far as risk and compliance are concerned, but also the remuneration paid to bank directors and senior managers or key function holders. Claw-back provisions, either imposed by law or introduced by banks themselves, exist already in certain countries and are beneficial, but here more could be done.

As always much depends on enforcement. This corresponds to an increased orientation in literature and research not merely on substantive company and banking law questions, but also on problems related to procedural law and insolvency law insofar as corporations are concerned. In the area of banking law, one even speaks of a shift from banking contract law to bank supervisory law and bank regulation. Yet based on the above-mentioned empirical findings, this simply does not correspond to more enforcement by shareholders (specifically by large shareholders, institutional investors and hedge funds all of which are currently at the center of the corporate governance discussion). But also a conclusion to impose legal obligations on the creditors—in the place of investors—would be inadequate since that would mean merely shifting the problem from one group of stakeholders onto another. Small creditors like small investors have a rational disinterest, particularly when they are protected by deposit guarantees. Bond creditors as well have only a limited potential and interest in influencing and monitoring the corporate governance of issuers. It follows that rather a mix of civil, penal and administrative sanctions, possibly coupled with private enforcement, may have advantages.

The corporate governance of banks is an ongoing task for supervisors, regulators and legislators, but also one for the banks themselves. In banking, ethics is indispensable, and the tone from the top matters. For all of these issues, more economic, legal and interdisciplinary research on corporate governance in banks and financial institutions is needed, and it could also help pave the way forward. In addition to this, there might also be a role for banks’ own codes of conduct—whether internal or applicable for the entire sector—as is shown, for instance, by the Dutch Banking Code and as is highly recommended by institutions such as the Basel Committee, the European Banking Authority, the European Central Bank and the Financial Stability Board. Internationally, there are successful experiences with the implementation of soft law by the National Contact Points (NCP) under the OECD proposals on corporate social responsibility that could offer orientation to the banking sector too. In the end, however, it inevitably boils down to the ethical standards prevailing among companies and business leaders, who must set the tone from the top. This applies generally to the corporate governance of companies, and it is especially true in respect of banks and financial institutions. Some have rightly observed that a European bank corporation law is gradually developing in its own right, and these authors ask what effect the European banking union will have on the governance of credit institutions. Corporate governance of banks may even pave the way to a self-contained law covering financial intermediaries and their corporate governance.

The complete paper is available for download here.

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