Lawyering Up.

• Author: Guernsey, Scott B.

1. INTRODUCTION 279 II. BANK RISK AND REGULATION 283 A. Risky Business 283 B. Risk-taking Incentives 286 C. Dynamic Risk, Static Regulation 287 III.ENTER THE LAWYERS 290 A. Data and Data Sources 291 B. Lawyer-Directors on the Rise 293 C. What Predicts a Lawyer-Director? 296 D. Lawyers, Bank Risk, and Bank Value 299 1. Bank Risk 300 2. Bank Value 304 IV. THE VALUE OF THINKING LIKE A LAWYER 307 A. Advocates 308 B. Mediators 309 C. Legal Experts 313 V. RETHINKING BOARDS 315 A. Beyond Compliance 316 B. Beyond the Black Box 317 C. Beyond Banks 320 VI. CONCLUSION 321 VII. APPENDIX 323 I. INTRODUCTION

   Economic crises resemble Tolstoy's unhappy families--each crisis exists in its own unhappy way. (1) The financial crisis of 2008 arose out of flaws in the subprime mortgage market and the instruments used to finance it. (2) Now, just 13 years later, a second financial crisis is tied to a global pandemic and its effects on the real economy. From these crises, two lessons are already clear: first, if it ever was true, the statement that a global financial crisis is "once in a lifetime" is no longer true today. The decades-long period of financial calm leading up to the 2008 crisis may have been the aberration rather than the tumult of the last 13 years. (3) Second, it is a fool's errand to attempt to predict how the next crisis will arise. The two recent crises had very different causes and affected the financial sector in very different ways. (4) Regardless of how well changes in regulation responded to the 2008 crisis, (5) the nature and scale of the current pandemic-induced crisis was never even considered. (6) Regulating for the next financial crisis, based on the conditions of the last, (7) is simply misplaced.

   In this Article, we demonstrate that banks (8) have come to realize the value of efficiently responding in real-time to changes in risk. As obvious as this sounds, it contradicts the standard framing of bank regulation. That framing presupposes that a bank's managers are largely unable or unwilling to optimize the risks to which banks are exposed, principally due to the risk-taking incentives of the banks' diversified shareholders. The result, within the traditional framing, is a need for new or stricter regulation to circumscribe the greater risk to which banks are exposed. (9)

   Our findings draw that framing into question. Rather than bank managers who incur too much risk, our study uncovered a sea change--unprompted by new regulation--in bank governance that is aimed to more effectively manage bank risk. (10) Increasingly, bank boards are "lawyering up" to address the new and significant risks to which banks are exposed. In 1999, only about 40% of banks had a lawyer on the board. (11) Today, that level has risen to more than 70%, a staggering 73% increase. (12) The rise is too precipitous to be a coincidence. Using a matching methodology to mitigate endogeneity concerns, (13) our results show that when a lawyer is on the board, a bank assumes more risk in ordinary (non-crisis) times and less risk when a crisis arises--braking and accelerating risk-taking in valuable ways. (14) During a financial crisis, it is natural to focus on the "bad risk" that can harm bank value. (15) However, effective risk management also addresses "good risk," in which uncertain opportunities that are likely to be profitable are identified and pursued. (16) As a result, our data show that bank value (as measured by Tobin's Q) (17) increased by 5.7% in the year immediately after a lawyer joined a bank's board and continued to increase in the following years. (18)

   These findings suggest that what goes on inside the board and who the directors are is as important, if not more important, than current regulation, whether in the form of higher capital requirements or rules requiring directors to be independent or financially literate. (19) While our study underscores the value of director expertise, it more broadly suggests that the current approach is too narrow and too static. other types of expertise may be as relevant--perhaps more relevant--for today's banks, including legal expertise. Moreover, rather than compliance with static regulation, we find that effective risk management requires striking a balance between curbing bad risk, on the one hand, and leaving bank managers the flexibility to pursue good risk, on the other. (20)

   This need to flexibly manage risk is greatest as banks begin to consider the "new normal" that will follow the COVID-19 pandemic. For example, due to the pandemic's economic impact, models that banks have used to assess the likelihood a borrower will default must now be reconsidered. (21) Banks must also begin to assess the legal and regulatory issues involved in monitoring employees who continue to work from home. (22) How quickly the economy will return to pre-crisis growth levels, and what will happen if there are later pandemics, must also be weighed. Finally, banks must consider the likelihood that the post-crisis world will provide business opportunities that did not exist before. New technology-based businesses may make banking easier in a world where social distancing and cashless transactions have become the norm in how banks interact with customers. (23)

   These changes, and the risks and opportunities they entail, cannot be addressed through fixed regulation. Instead, they require directors who can fluidly respond to changes in risk as they evolve. in other words, if there is a change in the risk affecting a bank, the bank benefits by having managers who can efficiently respond to that risk as it arises. To that end, we find empirical evidence that lawyers are more likely to be elected to a bank's board when the bank is underperforming, including, in particular, during a financial crisis. (24) We interpret this evidence to indicate that lawyer-directors are elected with the expectation they will help improve bank value. Moreover, the rise of lawyer-directors when the bank is underperforming suggests they are particularly valuable when effective risk management--the ability to enhance value by fluidly responding to changes in risk as they evolve--has become critical. (25)

   But why are lawyers--and not other experts (26)--so well-positioned to manage a bank's risks, including those arising from COVID-19? (27) Our answer, supported by further empirical evidence, is that there is value in "thinking like a lawyer." Drawing on information economics, (28) we suggest that a lawyer's training as an advocate--to question assumptions and consider different viewpoints--promotes the gathering of more information and the reduction of "group thinking" among directors. (29) We see evidence of this in the increased likelihood of having a lawyer-director when the CEO is on the board. (30) As advocates, we expect lawyer-directors to be less inclined to defer to the CEO (or any other single source of information). Thus, banks are more likely to benefit from a lawyer-director's ability to mitigate the risk of a CEO-director's excessive influence over the board.

   By facilitating consensus, a lawyer's negotiation and mediation skills can also assist a board's decision-making. (31) Lawyers are trained to find a common ground on which to resolve disputes. Consequently, lawyer-directors can help mediate different points of view, for example, between directors who are "banking literate" and those who are non-experts, as one way to encourage effective interaction among board members. in support, we find that the value of having a lawyer-director is greater in banks whose directors have diverse educational and professional backgrounds (32)--that is, banks with expert and non-expert directors may benefit by having a lawyer-director who can bridge multiple perspectives.

   Of course, a lawyer's value also springs from a substantive knowledge of the law. In particular, lawyers are experts at assessing litigation and regulatory risks, which have grown significantly as banks have come to face greater litigation and regulation in the aftermath of the 2008 crisis. (33) Not surprisingly, we find that banks with more exposure to these risks especially benefit from having a lawyer on the board. (34)

   To date, the literature on boards and risk management has been fairly coarse--often conceiving of the board as a "black box," with only a limited account of the directors "inside" the box and how they fulfill their risk management duties. (35) As a result, regulators and academics lack a clear understanding of how directors interact and the effect of that interaction on how risks are managed. What is clear from our findings is that the standard framing of the board is outdated and must be revisited. This Article begins to penetrate the black box, beyond lawyer-directors on bank boards, to emphasize the importance of an individual director's characteristics to effective corporate governance and board leadership.

   We proceed as follows. In Part II, we explain why risk management is challenging and, at the same time, valuable for banks. We also discuss the complexities that bank risk creates for regulation. In Part III, we introduce data on the increasingly frequent election of lawyers to bank boards and the value to a bank of a lawyer-director's ability to manage risk. With this evidence, in Part IV, we explain and support with further empirical evidence the value of having a bank director who "thinks like a lawyer." Specifically, we identify three skill sets that are likely to assist lawyers in their board service and, in particular, in identifying, assessing, and managing risk. Part V then discusses certain of the normative implications of our analysis, offering an alternative to the current regulatory approach to effective risk management and corporate governance.

2. BANK RISK AND REGULATION

   1. Risky Business

      Managing risk is at the heart of a bank's business. one sees this, for example, in the basic business model for commercial...