Financial regulation and supervision in corporate governance of banks.

• Author: Kim, Hwa-Jin

1. INTRODUCTION II. CORPORATE GOVERNANCE OF BANKS AFTER THE FINANCIAL CRISIS A. Economic and Legal Dimensions B. Comparative and International Dimensions III. STATE INTERFERENCE THROUGH FINANCIAL SUPERVISION A. Limits of Corporate Law and Financial Regulation B. The State as a Stakeholder in the Corporate Governance of Banks IV. THE CASE FOR THE CONSTRUCTIVE LEGAL APPROACH A. Bank Directors' Duties and Liabilities B. Risk Management C. Bankers' Pay V. EXCURSUS: TORT LAW LIABILITY RULES FOR BANK DIRECTORS VI. CONCLUDING REMARKS I. INTRODUCTION

   The CEO of a big bank steps down. The bank has three candidates--A, B, and C--for the available CEO position. A and B have backgrounds as former high-ranking government officials. Only C is from the private sector. Surprisingly, the bank's board of directors--whose majority consists of outside directors--elects C for approval at the shareholders' meeting. A and B withdraw their applications before this happens to save face as well as to record their discord. Then, the government launches a massive scale special audit on the bank. The audit is so intense one bank employee dies from overwork. C resigns. A rumor starts to circulate that some of the outside directors of the bank committed wrongdoings and even criminal acts within their own organizations. Criminal and tax investigations begin to press charges on those outside directors. Eventually, those outside directors step down. People in the media start to talk about the drawbacks of the outside director system and the self-entrenchment of outside directors. The government releases new guidelines for board composition and functions. The bank in question reorganizes its board with new outside directors, apparently all with government backing and endorsement, and the board elects D as the new candidate. D is known to be very close to the President. At the bank's shareholders' meeting, D wins election as the new CEO.

   This is what played out within KB Financial Group (KB) in the year 2010, (1) one of the biggest financial holding companies in Korea and once recognized internationally as having robust corporate governance. (2) The company's fate is hard to understand considering the ownership structure of the bank. KB's ownership is dispersed with majority foreign shareholders. (3) The foreign shareholders did not play any role in the bizarre process. Although the Korean Banking Act subjects domestic investors to a ceiling, (4) minority shareholders had no voice. In this scenario, it is hard to expect D to be independent from the government and to serve only the shareholders' or even public interests. Why were the shareholders silent, and what was the practical mechanism behind the story that made this happen? KB's case is not an isolated one by any means--most major Korean banks used to be owned and controlled by the government. Even though banks are now in private hands, they still operate under the heavy guidance and influence of the government for various reasons. (5) As far as the corporate governance of banks is concerned, the government quite often uses non-legal measures to exercise its power. The KB case dramatically shows the role of the government in bank corporate governance. The case also illustrates how the outside director system plays a confusing role in the process.

   Just as KB is not an isolated case in Korea, Korea may not be an isolated case in the world, particularly within emerging markets. The role of the state in corporate governance, in general, and in corporate governance of banks in particular, may be substantial in emerging economies. It is well known the state often controls corporate governance of private firms in Russia through non-legal measures. (6) Even the United States does not remain immune from the problem, as shown in Bank of America's acquisition of Merrill Lynch in the global financial crisis. (7) The German financial supervisory authority also reportedly exercises such informal measures as special audits. (8) This Article focuses on the state interference of corporate governance of banks and looks at the issue from the perspective of financial regulation and supervision as additional and non-legal determinants, respectively, of bank corporate governance.

2. CORPORATE GOVERNANCE OF BANKS AFTER THE FINANCIAL CRISIS

   The corporate governance of banks has always been treated differently than general corporate governance due to the special nature of the banks as deposit institutions. (9) Before discussing financial regulation and supervision in the corporate governance of banks, a quick look at the developments after the financial crisis is necessary. The years following the financial crisis have been characterized by a massive increase of financial regulation and tightening of financial supervision. Reform agendas all over the world address regulatory oversight of bank corporate governance and the quality of related supervision and enforcement. (10)

   1. Economic and Legal Dimensions

      Since the 1990s, corporate governance and finance scholarship have often discussed the legal origin of corporate governance. (11) The relationship between the legal origin and banking systems was also of great academic interest and, in particular, the bank-centered German economy and corporate governance received much attention. (12) The discussion, however, has not focused on corporate governance of banks but instead on the role of banks in corporate governance.

      Since the global financial crisis, bank corporate governance has become a hot issue in the United States because many claim one cause of the global financial crisis was the poor corporate governance of banks and other financial institutions. (13) Although the claim remains contested, (14) the crisis also stimulated discussions on bank corporate governance in Europe. (15) As the European countries wanted to keep the conventional universal banking system, despite witnessing problems inherent in large and complex financial institutions, (16) the corporate governance of banks--along with prudential rule and improved financial supervision--has become more important as the alternative to a structural approach to financial regulation. The corporate governance of banks is not directly related to the business structure of universal banks. However, the size and complexity of a financial institution may impact its corporate governance and vice versa. Smartly regulating the corporate governance of banks can manage the risks inherent to universal banking. In particular, discussions focus on risk management, the pay of bank managers, and the bank directors' liabilities. (17) The discussion may spill over to nonbank corporations to the extent it does not conflict with the business judgment rule.

      Although corporate law governs corporate regulation, corporate law is not oriented to protect the depositors and the economic system. Corporate law--as applied to banks--may actually work against the interests of outside entities with managers discharging their fiduciary duties to promote shareholders' interests, including taking risks. Therefore, reform after the financial crisis was largely carried out through prudential regulation directly involving corporate governance. (18) It has also been proposed that corporate governance of systemic firms, such as big banks, must be modified by relaxing shareholder value maximization mechanisms because financial regulation alone cannot solve the problems in the corporate governance of banks. (19) The argument continues by asserting that relaxing the shareholder value maximization norm would not increase agency costs because diversified shareholders have a strong interest in avoiding the managers' decisions that increase systemic risk. (20)

   2. Comparative and International Dimensions

      A substantial number of studies discuss the ownership and board structure of banks. (21) However, as the highly regulated financial industries of the world remain shielded from foreign competition and under the strong influence of path dependency, the corporate governance of banks presents a diverse picture and is subject to the political tradition of each individual jurisdiction. For instance, there may be concerns in emerging economies about state and political interference with corporate governance of banks. Comparative research may provide insight into the issue and contribute to the refinement and effective enforcement of principles and guidelines (22) for bank corporate governance articulated by international financial organizations.

      The structural approach to financial regulation largely failed to get support outside of the United States. (23) For European countries, in particular, financial regulation and supervision appeal more to the international regulatory arbitrage issue (24) than the Glass-Steagall type approach. While the United States tries to apply the Dodd-Frank Act extraterritorially, (25) the international financial organizations, including the Basel Committee and Financial Stability Board, (26) also developed international financial law to address the problem. (27) International financial law also includes corporate governance in its agenda and area of practice. (28) The importance of comparative study in bank corporate governance must be emphasized because it contributes to the developments of international law in the area. The international financial organizations will take the studies seriously and incorporate them into their legislative works to create more legitimate and effective international rules.

3. STATE INTERFERENCE THROUGH FINANCIAL SUPERVISION

   Empirically proving the link between the financial supervision (29) and the corporate governance of banks remains difficult. Therefore, this Article takes two factors into account that make the corporate governance of banks special: (1) the limits of corporate law and financial regulation; and (2) the stakeholder corporate governance model. These two factors appear to...