Corporate governance reform in a time of crisis.

• Author: Bruner, Christopher M.

1. INTRODUCTION II. CORPORATE GOVERNANCE DIMENSIONS OF THE CRISIS A. Moral Hazard, Risk, and the Financial Crisis B. The Role of Equity-Based Compensation C. Curbing Risk-Taking in Financial Institutions III. SHAREHOLDERS AND CORPORATE GOVERNANCE A. Shareholder Power in the United States and the United Kingdom B. Culture, Politics, and Corporate Governance IV. THE POLITICAL ROOTS OF SHAREHOLDER-CENTRIC REFORM EFFORTS A. Shareholders as Stewards B. Shareholders as Spectators V. CONCLUSIONS I. INTRODUCTION

   The financial and economic crisis that emerged in 2007 wrought havoc on banking systems around the world, and leading global financial centers in the United States and the united Kingdom were hardly spared. To the contrary, New York and London found themselves at the very heart of the crisis, their banks similarly crippled by extraordinary levels of debt and losses on complex mortgage-backed securities. In the wake of the crisis, both countries have engaged in wide-ranging regulatory efforts to contain the damage and prevent such a catastrophe from occurring again, and these efforts have included corporate governance reform proposals intended to curb risk-taking. on both sides of the Atlantic these proposals have sought to empower shareholders--not only in financial firms, but in all public companies--evidently in the belief that this would permit the shareholders to constrain reckless managers of banks and other types of entities in the future.

   In light of the historical, cultural, and financial ties between the United States and the United Kingdom, it is perhaps unsurprising that the two countries would pursue broadly similar strategies in response to the crisis. What is certainly surprising, however, is that policymakers in both countries would seek to empower the very stakeholder group whose incentives are most skewed toward the kind of excessive risk-taking that led to the crisis in the first place. All the more baffling is the tendency to conflate financial and non-financial firms in these reform efforts, when risk incentives and associated regulatory problems differ substantially between the two domains.

   This Article explains why U.S. and U.K. policymakers have reacted to the crisis as they have. The matter is far less straightforward than it might appear at first blush, because although broadly similar by global terms, the U.S. and U.K. corporate governance systems in fact differ considerably on some fundamental matters--the U.K. system proving to be far more shareholder-centric than the U.S. system. This means that shareholder-oriented reforms are more in keeping with the status quo in the United Kingdom than in the United States, where managers have traditionally possessed greater autonomy. This in turn suggests that the political dynamics motivating shareholder-oriented reforms in each country must differ in fundamental respects.

   The Article proceeds as follows. Part II describes the risk incentives of shareholders and managers in financial firms, examines how excessive leverage and risk-taking in each country's financial system led to the crisis, and summarizes corporate governance reforms proposed to remedy these problems. Part III outlines core distinctions between the U.S. and U.K. corporate governance systems. It examines the far greater power and centrality that U.K. shareholders have historically possessed relative to their U.S. counterparts, and highlights three factors explaining this distinction: the earlier rise to power of U.K. institutional investors, the relative proximity and homogeneity of U.K. market actors, and broader differences in how each country's corporate governance system relates to external regulatory structures conditioning relationships among stakeholders in the firm. Critically, the more robust U.K. welfare state has tended to deflect political pressure to accommodate non-shareholders' interests within the corporate governance system, whereas weaker social welfare policies in the United States have brought about the opposite result, diminishing the emphasis on shareholders. Part IV argues that such dynamics loom large in the crisis responses observed in each country--the U.K. initiatives reflecting reinforcement of the more shareholder-centric status quo, and the U.S. initiatives reflecting a populist backlash against managers fueled by middle class anger and fear in a far less stable social welfare environment.

   Part V offers conclusions. Ultimately this Article suggests that the principal challenge facing U.K. policymakers will likely be the need to re-conceptualize the more shareholder-centric U.K. corporation in the financial setting as a means of curbing risk-taking in banks. In the United States, on the other hand, the principal challenge facing policymakers will likely be resisting populist pressure to empower shareholders further in financial and non-financial settings alike. In the financial sector, such a move would not only fail to remedy the problem, but in fact would likely exacerbate risk-taking. And in the non-financial sector, where the case for reform remains weak in any event, the intrinsic relationship of corporate governance to social welfare goals in the United States would ultimately render this a considerably more comprehensive and complex regulatory undertaking than policymakers appear to recognize.

2. CORPORATE GOVERNANCE DIMENSIONS OF THE CRISIS

   The causes and consequences of the crisis have been broadly similar in the United States and the United Kingdom, and the role of corporate governance practices and executive compensation structures in the financial sector has been hotly debated in each country. (1) This Part outlines the peculiar risk incentives of investors and managers in financial firms, describes how excessive leverage and risk-taking in each country's financial system caused the crisis, and summarizes corporate governance reforms proposed in each country to address these problems.

   1. Moral Hazard, Risk, and the Financial Crisis

      Modern banking regulation aims, first and foremost, to manage the moral hazard problem arising from deposit insurance. (2) Banks are in the business of maturity transformation--that is, rendering short-term capital (in the form of deposits) useful for long-term purposes (in the form of loans). This mismatch between long-term assets and short-term liabilities naturally leaves them vulnerable to "bank runs," in which depositors losing faith in the institution seek to withdraw their deposits en masse. (3) Having lent out most of the money, even solvent banks cannot repay all depositors at once, giving rise to a prisoners' dilemma--while depositors as a group may be better off leaving their money with the bank, each depositor as an individual fears receiving nothing if limited reserves are exhausted. Deposit insurance systems--like those administered through the Federal Deposit Insurance Corporation in the United States and the Financial Services Compensation Scheme in the United Kingdom--aim to resolve this collective action problem by guaranteeing deposits up to some specified amount. (4)

      Deposit insurance itself, however, gives rise to an equal and opposite problem-insufficient incentive to monitor risk exposure. Unlike typical corporate creditors, depositors secure in the knowledge that deposits are guaranteed by the government have little reason to concern themselves with how the bank is managed. Bank shareholders, for their part, strongly prefer risk-taking because, due to limited liability and deposit insurance, they can capture the entire upside while avoiding much of the downside. (5) Governments, as the principal creditors of insured banks, would seem to have ample incentive to monitor, and have indeed imposed supervisory regimes and regulatory capital requirements to address the moral hazard problem created by deposit insurance. (6) As Frederick Tung observes, however, the regulators' incentives may not be so "finely honed" as private lenders' would be, given that regulatory agencies' efforts are to some degree "politically determined" and susceptible to capture. (7) Lucian Bebchuk and Holger Spamann further note that "regulators are bound to be at an information disadvantage vis-a-vis bank executives"--particularly given the increasing complexity of modern financial products and firms. (8)

      Commercial banks, as William Bratton and Michael Wachter explain, "historically have been low-beta stocks," profiting simply by lending at higher rates than they pay to depositors--making them "steady earners with high dividends." (9) Over the last few decades, however, regulations constraining the size, geographic markets, and activities of U.S. commercial banks have been steadily dismantled. Beginning in the 1970s, restrictions on branching and interstate banking were lifted, greatly facilitating the growth of banks and enhancing competition through the 1980s. The 1999 Gramm-Leach-Bliley Act went substantially further, permitting the creation of full-service financial firms with investment and commercial banking activities under the same roof. These developments "pushed commercial banks further out of their cozy protected markets, forcing them not only to compete with one another ... but also to compete with diversified financial firms with insurance and securities businesses." (10) This led to what Bratton and Wachter call "management to the market"--that is, prioritizing maximization of the stock price. (11)

      While a full explanation of the crisis lies well beyond the scope of this Article--and likely far in the future--it is patently clear that excessive risk-taking to boost financial firm stock prices must figure prominently in any account of the financial and economic crisis emerging in 2007. Lord Adair Turner, in his review of the crisis, describes the dangerous build-up of leverage and risk in the U.S. and U.K. financial systems over the last decade. Turner observes that the "reduction in real...