Regulating Risk and Governance in Banks: A Contractarian Perspective

In the lead up to the 2007-2008 financial crisis, U.S. banks engaged in systemic, excessive risk taking that drove the economy to the verge of collapse. This Article makes three contributions to understanding how this pandemic of excessive bank risk taking was possible and which policy reforms are desirable to promote more prudent banking conduct.First, this Article counters the common narrative that blames the crisis on managerial moral hazard. Instead, it focuses on bank shareholders and debtholders, arguing that their distorted incentives drove banks to take excessive risks. Corporate finance theory teaches that debtholders charge higher interest rates in response to the shareholders' preferences for high-risk, high-return projects. In highly leveraged firms, this incentivizes shareholders, eager to minimize the cost of debt, to seek safe governance arrangements that can commit their firms to sound risk choices. But in the banking sector, deposit insurance and bailouts undermine this balance, causing debtholders to become less sensitive to risk taking. As a result, bank shareholders, shielded by limited liability and unconstrained by debtholder monitoring, rationally support governance arrangements that incentivize risk taking.This Article's second contribution is normative: it develops a contractarian approach to bank regulation in order to overcome the distortions that affect bank governance. Under this approach, regulators should assume the hypothetical position of bank debtholders in a world without safety nets, and they should discipline banks as debtholders would in such a world. Where debtholders would offer lower interest rates in exchange for safer governance, regulators would offer lower capital requirements and lower deposit insurance premiums while demanding the same governance concessions. By promoting more socially responsible risk taking, this policy reform would add to bank safety and overall economic stability.Finally, this Article provides a conceptual foundation for designing and implementing safe governance arrangements in banks.INTRODUCTIONThe events leading up to the banking crisis of 2007-2008 have been extensively publicized.1 Most U.S. banks made huge investments in the highly remunerative subprime market, while disregarding the enormous risks associated with these investments. When those risks finally materialized, they almost drove the U.S. banking system to collapse.2 What is still puzzling, however, is how this was possible. Which failure can explain systematic, excessive risk taking by all of the U.S. banks?One popular answer points to the failure of bank governance. On this view, rapacious bank CEOs usurped the corporate governance mechanisms that should have protected bank investors from excessive risk taking.3 This usurpation produced a system of skewed incentive schemes, complacent risk managers, and captured boards that allowed a pervasive culture of risk taking to flourish. This narrative, however, reflects an inadequate understanding of corporate governance theory and practice. It does not account for the causal relationship between external and internal governance. External governance is defined here as the pressure of oversight demands and backroom influence exercised by shareholders and debtholders.4 These interactions directly inform internal governance, which comprises the organizational rules and bodies that discipline the corporate decision-making process-features including the board of directors, compensation schemes, and internal control procedures.5 Understanding this causal relationship has more than mere theoretical implications: the interplay between external and internal governance exposes which regulatory approaches are cosmetic and which approaches can meaningfully constrain risk taking and preserve banking stability.Adopting the conceptual framework above, this Article makes two important contributions: first, providing a causal analysis of the financial crisis, and second, developing a normative case for the future regulation debate. …