Creditor or debtholder governance is more important than shareholder governance

The special governance of banks and other financial institutions is firmly embedded in bank supervisory law and regulation. Most recently there has been intense discussion on the purpose of non-bank corporations. For banks stakeholder governance and, more particularly, creditor or debtholder governance is more important than shareholder governance. Even though reform are still uncertain. Banks are special, and so is the corporate governance of banks and other financial institutions. Empirical evidence, mostly gathered after the financial crisis, 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. The key problem is the composition and qualification of the board. The legislative task is to enhance independent as well as qualified control. The proposal of giving creditors and even supervisors a special seat in the board is not convincing. Other important special issues of bank governance are 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. Much depends on enforcement, an understudied topic.

Effective corporate governance is critical to the proper functioning of the banking sector and the economy as a whole.  The corporate governance of banks and other financial institutions has gained much attention after the financial crisis. The financial crisis certainly contributed to this, yet whether the financial crisis can really be attributed mainly to financial institutions’ shortcomings in corporate governance, as some authors assert, is doubtful. Their uniqueness is reflected in frequently recurring banking crises and the structural flaw whereby banks are seen as ‘too big to fail’ and ‘too interconnected to fail’, such that state rescue is needed whenever a bail-in is either not an option or proves ineffective. One cannot dispute that these unique characteristics are of course of particular importance for systemically important banks. But they are not limited to such entities. Instead these attributes are of more general relevance, even if they are naturally more consequential and visible. It is hardly astonishing that these special characteristics of banks demand, in turn, a special variety of corporate governance. Yet what is surprising is that particular attention to this has traditionally been absent and that economic exploration as to the special governance of banks has commenced relatively late. Principal-Agent dilemma and were oriented on the conflict between directors and shareholders, this corresponding to shareholder structure mostly dispersed shareholdings and relatively few major block-holdings.

To the good extent banks that are controlled by shareholders saw higher profits before the crisis as compared to banks that are controlled by directors. In general, the shareholder structure of a bank correlated strongly to the bank’s insolvency, particularly where low-level management was significantly involved in the decision-making process. It is erroneous that traditional even if empirically established approaches to the corporate governance can be seamlessly applied to the corporate governance of banks; in fact, exactly the opposite may be true. This is the case, for example, as regards director independence, which according to recent studies can carry negative effects. Whereas expertise and experience are of much greater value, at least when obvious conflicts of interest are avoided. Still, it bears emphasis that sound judgment is called for when evaluating empirical results. Often, warranting a differentiated assessment are held up against one another despite their embodying nuanced differences that may reflect a dissimilar time horizon in the lessons, an inadequate account of the interdependence of certain factors and, above all, country and path dependent differences resulting from legal regulation and cultural circumstances.

The purpose of an organization is to make profit for the shareholders. On the other side of the spectrum stands. There, the board is responsible to promote the interests of all stakeholders, i.e. the shareholders, employees and the public good. While the shareholder-oriented approach had gained some attention, the traditional stakeholder concept is still generally agreed upon. So called enlightened shareholder approach, a shareholder orientation that also looks at the interests of other stakeholders in view of preserving a long term profitability. But this concept is increasingly criticized as too vague and hardly effective. In any case, in times and terms of financial rescue and insolvency proceedings, it has been recognized that risk together with governance (‘ownership’) is transferred from the owners to the creditors.  In regard to banks corporations and financial institutions, the case is clearly different. Realistically, the experience of the financial crisis, and economic and legal conclusions have produced a change in perspective that amounts to a concept of creditor i.e. debtholders’ and depositors’ governance. The primary objective of corporate governance should be safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis. Among stakeholders, particularly with respect to retail banks, shareholders’ interest would be secondary to depositors’ interest. This corresponds to the standing supervisory practice of other national and international banking agencies too.

This position is a clear rejection of the shareholder primacy view, but it differs also from the only slightly tempered view held, since banks are expected to consider creditor interest not only when this is in the long-term interest of the corporation. Creditor governance is not just a question of the purpose of banks, instead having consequences in many other areas regarding the corporate governance of banks. In particular, this view reduces also the relative importance of controlling shareholders, institutional investors and shareholder control in general, as is presently the center of attention in the corporate governance. Much depends on enforcement, an under considerable topic. 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 exploration on corporate governance in banks and financial institutions is needed, and it could also help pave the way forward.

As liquidity increased, banks began to manage credit risk through purchases and sales of loans and other credit exposure, lowering capital costs, but potentially weakening their incentives and ability to monitor and enforce covenant protections. During financial crisis and recognition that shareholder oversight, without the offsetting discipline provided by creditors, could cause financial firms to incur socially suboptimal levels of risk re-focused attention on the importance of debt governance.

There is relatively little law in the law and economics of debt governance beyond the legal infrastructure necessary to implement debt’s oversight function including contract law, enforcement of contract rights, and bankruptcy law and a greater reliance on debt with shorter maturities in countries with higher levels of corruption. There is relatively little “law” in the law and economics of debt governance beyond the legal infrastructure necessary to implement debt’s oversight function (including contract law, enforcement of contract rights, and bankruptcy law) and a greater reliance on debt (with shorter maturities) in countries with higher levels of corruption. It may, therefore, be useful to consider the extent to which financial regulation beyond its traditional focus on market integrity, customer protection, and systemic risk may increasingly affect how firms are governed. It should always keep in mind that shareholders are the residual claimants on the assets of a company even of banks/financial institutions. Creditors are fixed claimants whose interest lies in the solvency of the borrower. Consequently, shareholders are usually thought to have optimal incentives to maximise the value of the company. It demonstrates how bail in able creditors can correct for shareholders’ perverse incentives and make debt governance work in banking. The policy proposal advanced in the paper would complement substantive regulation and prudential oversight. The governance role of creditors has the potential to be particularly helpful in preventing disproportionate risk taking decisions in good times, when regulatory and supervisory standards are lax and systemic risk piles-up.