Corporate Governance and Double Liability: Toward a Bank Shareholder-Orientated Model

Abstract

The financial crisis of 2007-09 was interpreted by many as evidence that incentives of managers were not optimally aligned with interests of shareholders. As a result, a plethora of proposals have been put forward seeking to increase shareholder engagement. However, this shareholder engagement strategy only makes sense if risk appetite of bank shareholders is not socially excessive. The conventional for corporate governance presumes that costs of failure are largely internalized by firm and so are taken into account when shareholders determine their risk appetite. In this paper I argue, when applied to banks, this view is mistaken. Banks do not internalize costs of failure, hence risk appetite of bank shareholders is socially excessive. I show that shareholder pressure on their management to accept greater risk can help explain excessive risk-taking of banks. My analysis indicates that recent corporate governance reforms that attempt to tighten alignment of managerial and shareholder interests cannot be expected to address problem I identify. To adequately understand what policies should be explored, we must first recognize that excessive risk-taking is also partly a product of conventional of governance. I therefore propose a modification to that model: a regime of double bank shareholder liability that is triggered by bank failure. I discuss how this has potential to reduce bank shareholders’ risk appetite, and, make less likely, excessive risk-taking. Welfare improvement occurs because of heightened risk awareness and enhanced risk-taking controls, decreasing likelihood of failure. I introduce term the bank shareholder-orientated model of governance to characterize this modified approach.