Reforming governance of ‘too big to fail’ banks: The prudent investor RULE and enhanced governance disclosures by bank boards of directors

Abstract

Banks, particularly those considered ‘too big to fail’, pose a particular governance challenge, especially for taxpayers who face an undiversifiable risk of being the final backstop of the financial system. The nexus of bank governance is the board of directors, but they have proven inadequate in controlling the riskiness of bank activities, an outcome due both of the complexity of modern banks, and because boards are uncertain about what is expected of them. Using an interdisciplinary approach from law and accounting, we propose a two-step procedure to improve bank governance. First, we give bank directors an explicit standard to assess the outcome of their actions: the Prudent Investor rule which is the requirement for trusts. Adopting the Prudent Investor rule would return to director's responsibility to control the risks of banking activities. To enforce the higher standard, we propose to use disclosure as a disciplining mechanism. We base the new disclosure regime on Section 404 of the Sarbanes–Oxley Act that requires managers to implement controls over the firm's financial reporting processes and to publicly attest to their effectiveness. This section failed to prevent the credit crisis because it was too narrowly focused. We recommend that the provision be broadened to encompass governance controls in general, and that responsibility for disclosure be placed on the bank board rather than on managers.