Governance and the Financial Crisis

In the aftermath of the global financial crisis of 2008-2009, investors, analysts, legislators, and pundits have spotlighted "good" or "improved" corporate gove
ance as a remedy for all that presently ails us. It is one remedy in a long wish list that includes tougher requirements for risk capital, liquidity, and leverage; compensation and bonus reform; reimposition of the Glass-Steagall-like separation of bank "utility" and "casino" functions; the downsizing or breakup of institutions deemed "too big to fail;" enhanced consumer protection; securities law liability for secondary violators; direct taxation of proprietary trading; "macro-prudential" regulation; and new transparency requirements for derivatives trading and clearance.
This time, the proposed objects of corporate gove
ance reform are not Michael Eisner's personal "magic kingdom" at the Walt Disney Company or Andy Fastow's self-dealing and ultimately self-deceiving Enron Corporation, but the global financial institutions that saw their balance sheets degraded-and the global credit markets put at risk-by proprietary trading in so-called "toxic" assets and other high-risk, high-reward, "casino" activities. The renewed focus on good corporate gove
ance pertains not only to the perceived asymmetry between the outlandish compensation dished out at now bankrupt or massively bailed-out firms, but also to the traditional, broader roster of corporate gove
ance mechanisms designed to enhance director-manager accountability to firm "owners"-the shareholders.
In this case, however, more effective corporate gove
ance may not be a serious part of the solution; instead, "good" (or effectively functioning) corporate gove
ance may have been one of the major factors that contributed to the global financial meltdown. This insight highlights the existence of unalterable constraints on any corporate gove
ance system, and emphasizes the need for even more robust gove
ment regulation of private businesses-especially firms...

The financial crisis revealed severe shortcomings in corporate gove
ance. When most needed, existing standards failed to provide the checks and balances that companies need in order to cultivate sound business practices.
Bank capitalisation determines the probability of a bank failure. This column discusses how bank’s corporate gove
ance affects its capitalisation. Corporate gove
ance, in which the bank acts in the interest of its shareholders, is defined as a good one. Such gove
ance, however, can lead to lower bank capitalisation. It also has possibly negative implications for financial stability.
Value-maximising shareholders are likely to favour relatively low bank capitalisation, as this increases a bank’s prospects of receiving generous bailouts in the event of a future bank failure. Consistent with this, our main finding is that ‘good’ corporate gove
ance – or corporate gove
ance that makes the bank act in the interest of bank shareholders – engenders lower bank capitalisation.
The finding that good corporate gove
ance leads to low bank capitalisation does not necessarily imply that corporate gove
ance schemes at banks should not be designed to be good. In the end, the disadvantage of good corporate gove
ance in bringing about lower bank capitalisation has to be balanced against any presumed benefits in terms of restricting management’s ability to perform badly in unrelated ways, for instance, by shirking or acquiring perks at the expense of bank shareholders.