The financial crisis manifested a failure of bank governance and risk management. It has triggered a government response reflected in the Volcker Rule to prevent another crisis.
The rule is directed at visible symptoms of the collapse to impose a top-down solution by curtailing risky activities and expansion. Most likely, it will merely substitute "too many to fail" for "too big to fail."
A failure by bank directors and not size or risky activities caused the crisis. Directors failed to appreciate and contain the risks inherent in managements' unsustainable growth strategies based on leveraged high-risk credits.
The key for the industry is to correct the governance breakdown before Congress adopts potentially counterproductive legislation like the Volcker Rule. This can only be accomplished through a bottom-up improvement in risk management and governance.
Managers need supervision to contain themselves in overheated markets. They are tempted to follow high return-high risk competitors to maintain their market share and stock price. Research shows that banks enjoying the biggest returns in 2006 suffered the largest losses during the crisis.
How such a breakdown could have occurred despite strong governance provisions in recent reforms like Sarbanes-Oxley needs to be answered. Much of what passes for governance is check-the-box legal compliance. The law becomes a substitute for, instead of a complement to, good governance.
Several factors underlie board ineffectiveness. Director capture is the most important. This occurs when directors become dominated by management. Directors are beholden to CEOs for their nomination, compensation and information. Over time, directors lose their watchdog role and become management team members, losing their ability to think critically. Next, the average outside director spends less than 200 hours per year on bank-related matters.
Furthermore, many directors lack financial industry experience. Thus, they fail to understand the risk implications of complex management business models. Finally, director motivation is frequently lacking because their financial interest in the institution is small.
Banks and their shareholders can, however, improve governance by restoring the balance between senior management and the board. This would involve the following changes:
Independence: Remove management influence over the recruitment, retention or remuneration of directors. An independent corporate governance committee should handle these functions. Also, the board chairman and CEO roles should be split.
Experience: Directors must be knowledgeable and experienced in financial services. Bank boards before the crisis suffered from a lack of experienced directors in the crucial risk function. A director's competence exam and continuing education should be considered.
Empower risk management: The chief risk officer should report to an independent board member. His compensation also should focus on long-term stability measures like ratings, not short-term stock prices.
Motivation: Bank directors need to increase their financial commitment either through increased investment or limited personal liability. Otherwise, serving becomes a part-time job.
Weak bank governance is nothing new. It has, however, risen in importance since the industry's deregulation. Historically, bank regulators, not directors, provided the discipline.Thus, there was little need for strong governance. Once effectively deregulated in the 1990s, banks were operating without effective supervision as they entered the dangerous late stage of the financial bubble.
Increased regulation is not the answer. Regulators also suffer from capture and are subject to intense industry lobbying. Finally, regulators, as outsiders, lack the insider information needed to be proactive.
Failure of the industry to heal itself will lead to a return of heavy regulation. Banking, though ungoverned, is not ungovernable.