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MACROPRUDENTIAL REGULATION:
A SUSTAINABLE APPROACH TO
REGULATING FINANCIAL MARKETS
Kristin N. Johnson
*
Following the financial crisis that began in 2007, Congress and
regulators acted to address perceived gaps in the regulation of corpo-
rate boards, including boards of large, complex financial institutions.
With the goal of improving the stability of global financial markets,
regulators have adopted reforms intended to enhance the role of
boards, particularly those of financial institutions, as gatekeepers and
systemic risk monitors. Arguing that the culture of financial institu-
tions may lead board to govern these businesses less effectively than
boards in non-financial sectors, this Article challenges assumptions
that conventional regulatory or corporate governance mechanisms
will conclusively address systemic risk concerns in the financial sec-
tor.
T ABLE OF CONTENTS
I. INTRODUCTION ....................................................................................
II. RISK-MANAGEMENT O VERSIGHT .....................................................
A. The Monitoring Board ............................................................... 888
B. Recent Reforms ........................................................................... 892
1. Board Independence .......................................................... 895
2. Risk-Management Oversight ............................................. 899
III. T HE RISE OF SHADOW BANKING .......................................................
A. Systemic Risk: Fault Lines .......................................................... 903
B. Shadow Banking: New Fault Lines Revealed ........................... 905
C. The Securitization Puzzle ........................................................... 907
D. The Systemic Risk Implications of Self-Regulated
Shadow Banking Institutions and Instruments ......................... 910
IV. A N ALTERNATIVE APPROACH ...........................................................
V. CONCLUSION .........................................................................................
- Associate Professor of Law, Seton Hall University Law School. B.S., Edmund J. Walsh School of Foreign Service, Georgetown University, with distinction ; J.D., University of Michigan Law School. For their thoughtful commentary that advanced the completion of this Article, I thank Steve Ramirez, Omari Simmons, Nicola Sharpe, Verity Winship, Jeff Schwartz, and Dre Cummings. All errors are my own.
882 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
I. INTRODUCTION
Over the last thirty years, complex derivatives contracts
1 and other
exotic, innovatively engineered financial products have captured an in-
creasingly prominent role in financial markets.
2 The notional value
3 of
over-the-counter (OTC) derivative agreements grew from $3.45 trillion
in 1990
4 to over $700 trillion by 2011.
5 Financial product engineers, also
described as “rocket scientists,”
6 carefully design these financial instru-
ments to avoid the ambit of federal and state statutes that regulate the
origination and trading of complex financial instruments.
7
In tandem with the explosive growth of complex financial products,
a new category of financial institutions emerged.
8 To avoid the legal, tax,
- Derivatives contracts are financial agreements whose value is derived from the value of a financial instrument identified in the contract. For a description of the characteristics of derivatives, the benefits and costs derivatives transactions create, and concerns regarding market participants’ use of these financial products to manage risk, see Henry T.C. Hu, Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism , 102 YALE L.J. 1457, 1463 (1993); Kristin N. Johnson, Things Fall Apart: Regulating the Credit Default Swaps Commons , 82 U. COLO. L. REV. 167, 182 (2011); Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives , 75 U. CIN. L. REV. 1019, 1021–22 (2007); Roberta Romano, A Thumbnail Sketch of Deriv- ative Securities and Their Regulation , 55 M D. L. REV. 1, 27 (1996).
- See Steven L. Schwarcz, Regulating Complexity in Financial Markets , 87 WASH. U. L. REV. 211, 220 (2009); Johnson, supra note 1, at 196–99.
- The term notional value refers to the face value of the debt securities or loans identified in a financial arrangement. See BARRON ’ S FINANCIAL GUIDES : DICTIONARY OF FINANCE AND I NVESTMENT TERMS 487–88 (8th ed. 2010).
- A LFRED S TEINHERR , DERIVATIVES : THE WILD BEAST OF FINANCE 53–60 (1998).
- See BANK FOR I NT ’ L S ETTLEMENTS OTC D ERIVATIVES MARKET A CTIVITY IN THE FIRST HALF OF 2011 (2011), available at http://www.bis.org/statistics/otcder/dt1920a.pdf; see also Mark J. Roe, The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator , 63 S TAN. L. REV. 539, 543 n.6 (2011) (discussing the nearly fortyfold growth in interest rate derivatives market from $ trillion in 1994 to $430 trillion in 2009).
- Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975– 2000: Competition, Consolidation, and Increased Risks , 2002 U. I LL. L. REV. 215, 335.
- One commentator offers a careful evaluation of market participants’ efforts to design con- tractual arrangements beyond the ambit of regulation. See Victor Fleischer, Regulatory Arbitrage , 89 TEX. L. REV. 227 (2010). For a discussion of financial products intentionally created to minimize fed- eral and state regulatory oversight, see Erik F. Gerding, Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension , 8 BERKELEY BUS. L.J. 29, 43–44 (2011); Kathryn Judge, Fragmentation Nodes: A Study in Financial Innovation, Complexity, and Systemic Risk , 64 S TAN. L. REV. 657, 679 (2012). Accounting policies, for example, include over-the-counter (OTC) derivatives among off-balance- sheet transactions. Investment in off-balance-sheet transactions are typically recorded separately from existing financial obligations. For a discussion of accounting policies related to derivatives, see Ken- neth C. Kettering, Securitization and Its Discontents: The Dynamics of Financial Product Development , 29 CARDOZO L. R EV. 1553, 1572 (2008).
- The term financial institution refers to investment banking firms, bank holding companies, and traditional depository banks or thrifts that engage in investment businesses in the financial ser- vices industry—including custodial, brokerage, lending, and underwriting services for securities and other assets, insurance companies, hedge funds, private equity funds, and mutual funds. A NTHONY S AUNDERS & MARCIA MILLON CORNETT , FINANCIAL I NSTITUTIONS MANAGEMENT : A RISK MANAGEMENT A PPROACH 97–103 (6th ed. 2008). The literature also refers to financial institutions as financial intermediaries. RICHARD S. CARNELL ET AL ., THE LAW OF BANKING AND FINANCIAL
884 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
To mitigate systemic risk concerns, or concerns that a systemically
significant financial institution or a chain of financial institutions may
fail,
16 state and federal regulators have historically relied on prudential
regulation.
17 Prudential regulation centers on identifying and mitigating
exposure to endogenous shocks (solvency crises) within individual finan-
cial institutions. Prudential regulation aims to prevent excessive risk tak-
ing by regulating leverage.
18 Examples of prudential regulation include
limits on commercial lending, banks’ leverage of deposits, and margin
and collateral requirements for securities transactions.
19 To comply with
prudential regulation, a commercial bank’s board of directors typically
introduces, implements, and enforces internal risk-management poli-
cies.
20 In the past, encouraging bank boards to dedicate significant atten-
tion to capital adequacy and other prudential concerns offered a sustain-
able approach to banking regulation. Times have changed, however, and
in order to keep pace with these changes, financial market regulators
may need more effective tools to address emerging systemic risk con-
cerns.
The rise of the shadow banking system creates concerns that unreg-
ulated financial institutions may attempt to externalize the risks associat-
ed with their activities, creating new classes of systemic risks.
21 Pruden-
tial regulation adopts several myopic assumptions about conventional
commercial banking institutions that are not consistent with shadow
banking business models.
22 For example, prudential regulation assumes
that regulated entities hold deposits for account holders who may with-
- See sources cited infra note 21.
- See Heidi Mandanis Schooner, Private Enforcement of Systemic Risk Regulation , 43 CREIGHTON L. R EV. 993, 1010 (2010); see also Gerding, supra note 7, at 61–73.
- “Such solvency regulation avoids deposit insurance payouts and systemic risk, transmitted through interbank deposit linkages, payment systems, or imitative runs. Prescription of bank capital adequacy—the amount of capital relative to assets—has become the dominant method of prudential regulation in recent decades.... A key aspect of the U.S. regulatory system is ‘prompt corrective ac- tion,’ a mandate for supervisors to intervene in banks as their capital and, occasionally, other perfor- mance factors decline, to correct course or close problem banks before their capital becomes negative and uninsured depositors are exposed to risk.” HAL S. S COTT & A NNA GELPERN , I NTERNATIONAL FINANCE: TRANSACTIONS , POLICY , AND REGULATION 237 (18th ed. 2011).
- See infra Part II.A.
- Id.
- While there is no universally adopted definition of systemic risk, scholars generally agree that systemic risk involves “(i) an economic shock such as market or institutional failure that triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or de- creases in its availability, often evidenced by substantial financial-market price volatility.” Steven L. Schwarcz, Systemic Risk , 97 GEO. L.J. 193, 198–204 (2008); see also Viral V. Acharya et al., Regulating Systemic Risk , in RESTORING FINANCIAL STABILITY : HOW TO REPAIR A FAILED S YSTEM 283, 284– (2009); E.P. DAVIS , DEBT , FINANCIAL FRAGILITY , AND S YSTEMIC RISK 117 (1992) (defining systemic risk as “a disturbance in financial markets which entails unanticipated changes in prices and quantities in credit or asset markets, which lead to a danger of failure of financial firms, and which in turn threat- ens to spread so as to disrupt the payments mechanism and capacity of the financial system to allocate capital”).
- See infra Part III.
No. 3] FINANCIAL FIRM BOARDS 885
draw their cash or assets immediately, creating short-term liabilities.
23
Commercial banks earn fees by lending these deposits to commercial and
individual borrowers, creating long-term assets.
24 A maturity mismatch
arises.
25 If depositors contemporaneously demand the return of their
cash and assets, described as a “run” on the bank, the bank may be una-
ble to recall outstanding debt obligations and satisfy depositors’ de-
mands.
26 A flood of depositors withdrawing assets may trigger a series of
events that lead to the bank’s insolvency.
27 To address such endogenous
risks, prudential regulation encourages banks to adopt corporate govern-
ance mechanisms that reduce the likelihood of depositors’ loss of confi-
dence or bank runs.
28
In their seminal article, theorists Michael Jensen and William Meck-
ling explore the separation of economic rights and decision-making au-
thority that characterizes modern corporations.
29 Physically dispersed
shareholders delegate authority over the business and affairs of the cor-
poration to professional managers whose interests may diverge from the
interests of the owners of the corporation.
Appreciating that managers may shirk, steal, or worse, shareholders
create mechanisms to prevent errant behavior.
30 The structural mecha-
nisms adopted to monitor professional managers create costs referred to
as agency costs. Jensen and Meckling’s theory assumes that dynamic,
market-based solutions emerge to address agency costs. For example,
appointing a board of directors enables shareholders to monitor execu-
tives and employees’ conduct and preserve shareholders’ capital invest-
ment in the firm. Boards facilitate firms’ oversight of the positive and
negative externalities that business activities engender.
31 The board of
directors serves as a critical gatekeeper, monitoring a corporation’s com-
pliance with state and federal regulation and employees’ risk-taking deci-
sions.
32 Thus, it is not surprising that prudential regulation relies heavily
- Steven L. Schwarcz, Regulating Shadow Banking: Inaugural Address for the Inaugural Sym- posium of the Review of Banking & Financial Law , 31 REV. BANKING & FIN. L. 619, 625 (2011–2012).
- Id. at 621 n.8.
- Id.
- Jonathan R. Macey & Geoffrey P. Miller, Bank Failures, Risk Monitoring, and the Market for Bank Control , 88 COLUM. L. REV. 1153, 1156–59 (1988); Daniel R. Fischel et al., The Regulation of Banks and Bank Holding Companies , 73 VA. L. REV. 301, 307–09 (1987).
- See Macey & Miller, supra note 26, at 1156.
- See infra Part II.B.
- Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure , 3 J. FIN. ECON. 305 (1976).
- Owners of modern corporations delegate their authority over operational decisions to pro- fessional managers. Upon delegation of authority, a problem arises. Managers’ interests and share- holders’ interests may not align. Managers may shirk or steal in pursuit of their own interests. The expenses that shareholders incur to create mechanisms to protect their economic interests in the cor- poration are referred to as agency costs. For a discussion of agency costs, see Kristin N. Johnson, Governing Financial Markets: Regulating Conflicts , 88 U. WASH. L. REV 185 (2013).
- Jensen & Meckling, supra note 29.
- See infra Part II.B.
No. 3] FINANCIAL FIRM BOARDS 887
and shadow banking instruments significantly alters the kinds of enter-
prises that constitute systemically important financial institutions.
Second, this Article rejects the notion that conventional composi-
tion and structural corporate governance mechanisms, such as requiring
boards to create specific risk-management committees or appoint inde-
pendent directors to these committees, determinatively address systemic
risk concerns. After examining the rationale for relying on corporate
governance mechanisms to mitigate systemic risk, this Article finds that
regulators’ emphasis on conventional board reforms is misplaced. Con-
centrating on preventing endogenous events that impact regulated finan-
cial institutions leaves the financial system vulnerable to exogenous
shocks created by actors and activities in the shadow banking system.
Third, this Article concludes that regulators should dedicate re-
sources to understanding and identifying exogenous events that engender
and exacerbate systemic risk concerns. This Article advocates for a
greater emphasis on macroprudential regulation, an emerging regulatory
framework. Macroprudential regulation examines the interconnected-
ness among regulated and shadow banking financial institutions, includ-
ing their relationships as counterparties, shared reliance on important
market utilities, common use of quantitative models and risk metrics, and
their correlated exposure to certain assets.
38 In the past, limited research
and analytical tools stymied regulators’ ability to adopt a macropruden-
tial approach.
39 With increasing frequency, researchers and research lit-
erature identify important benefits associated with macroprudential poli-
cy.
40 Macroprudential regulation addresses many of the weaknesses of
prudential policy by focusing on both the endogenous events that impact
individual financial institutions and the exogenous events that lead to
systemic risk concerns.
41 Because macroprudential regulation is an
emerging theory, this Article merely offers a thumbnail sketch of the
benefits and limits of this approach.
Part II of this Article explores the presumed role of corporate
boards and post-crisis corporate governance reforms designed to en-
hance financial institution boards’ execution of one of their central objec-
tives—monitoring the business’s exposure to risk. This Part examines
board independence and risk management oversight requirements. This
Part argues that financial institution boards are distinct from the boards
- Id. at 28.
- See infra Part IV.
- Id.
- A VINASH PERSAUD, THE W ORLD B ANK GRP., MACRO- PRUDENTIAL REGULATION : FIXING FUNDAMENTAL MARKET ( AND REGULATORY ) FAILURES 1 (2009), available at http://rru.world bank.org/documents/CrisisResponse/Note6.pdf (“The solution to the crisis is not more regulation, though more comprehensive regulation may be required in some areas. Instead, it is better regula- tion—in particular, regulation with a greater macroprudential orientation... .”); see also Gabriele Galati & Richhild Moessner, Macroprudential Policy—A Literature Review 7 (Bank for Int'l Settle- ments, Working Paper No. 337, 2011), available at http://www.bis.org/publ/work337.pdf.
888 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
of other types of businesses and, therefore, mitigating systemic risk con-
cerns in financial markets requires unique reforms.
Part III explores an undertheorized area of financial markets regu-
lation—the rise of the shadow banking system and argues that the finan-
cial institutions and financial instruments that comprise this sector of fi-
nancial markets create new systemic risk concerns. Part IV concludes by
offering a suggestion for a more comprehensive theoretical approach to
regulation. Part IV’s analysis, limited solely to outlining a framework for
reform, suggests adopting a macroprudential regulatory framework.
II. RISK-MANAGEMENT O VERSIGHT
A. The Monitoring Board
Two significant factors influence the decision-making processes
adopted by most U.S. corporations. First, based on the influence of the
organizational structure of English joint stock companies,
42 U.S. corpora-
tions typically vest formal decision-making authority in an elected, repre-
sentative body, a board of directors.
43 State statutes authorize the board
to make decisions on behalf of the corporation. Notwithstanding this
mandate, directors rarely, if ever, sully their hands advancing the prover-
bial corporate plow.
44 Rather, directors delegate their authority to ap-
pointed executive officers who manage the daily operations of the busi-
ness.
45
A second factor explains the evolution of reposing central decision-
making authority in a board of directors. As corporations evolved from
entrepreneurial family-owned and controlled ventures to their modern
form, a significant shift occurred in the composition of the board of di-
rectors.
46 Detailing this evolution in The Modern Corporation and Pri-
vate Property , Adolph Berle and Gardiner Means explain that in con-
temporary periods the owners of corporations are no longer the robber
- Franklin A. Gevurtz, The Historical and Political Origins of the Corporate Board of Direc- tors , 33 HOFSTRA L. REV. 89, 115–22 (2004).
- Id. at 108 (citing An Act Relative to Incorporations for Manufacturing Purposes, 1811 N.Y. Laws LXVII).
- As early as the sixteenth and seventeenth centuries, the charters of English trading compa- nies permitted passive investors to acquire transferable ownership stakes coupled with voting interests that enabled the investors to representatively govern the business. Id. at 122.
- See , e.g. , DEL. CODE A NN. tit. 8, § 141(e) (2010) (permitting directors to rely on the advice of officers and experts); id. § 141(a) (indicating that the corporation’s business and affairs shall be “man- aged by or under the direction of a board of directors” (emphasis added)).
- Elizabeth Cosenza, The Holy Grail of Corporate Governance Reform: Independence or De- mocracy? , 2007 BYU L. R EV. 1, 18 (“Whereas in the 1960s most boards had a majority of in-house, non-independent directors, most boards today have a majority of outside, independent directors.”); Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices , 59 S TAN. L. REV. 1465, 1465 (2007).
890 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
Since the 1970s, chief executive officers (CEOs) have acquired sig-
nificant authority over strategic and operational decisions.
56 The CEO’s
preferences dominate the selection processes for the appointment of
other executive officers and may even significantly influence the director
nomination process.
57 Several scholars agree that this inversion in the re-
lationship between the board and the executive officers has drastically
reduced the board’s authority.
58 The evolving roles of executive officers
and the board has led commentators to question the purpose of the
board and the standard by which shareholders, courts, and regulators
should evaluate the performance of the board.
59
Empirical studies demonstrate that directors increasingly delegate
major policy decisions and responsibilities for monitoring the firm’s op-
erations to executive officers.
60 Directors rely on managers, specifically
CEOs, to communicate vital information and frequently advise the board
regarding strategic corporate directions.
61 As a result of their increasing-
ly passive role, directors serve as mere supervisors. In light of this signif-
icant delegation of their authority, commentators have questioned the
role of the board in contemporary corporations.
Examining the effects of the changes in power dynamics between
executive officers and boards, the prevailing view among corporate
scholars is that the board merely serves an advisory role
62 and its ostensi-
ble purpose is to monitor or supervise executive managers and their deci-
sion making. If the board’s central role is limited to monitoring, hiring,
and firing executives, several commentators argue boards are patently
dysfunctional.
63 The exorbitant executive compensation packages
64 and
- See Steven A. Ramirez, The End of Corporate Governance Law: Optimizing Regulatory Structures for a Race to the Top , 24 YALE J. ON REG. 313, 329–335 (2007); Steven A. Ramirez, Re- thinking the Corporation (and Race) in America: Can Law (and Professionalization) Fix “Minor” Problems of Externalization, Internalization, and Governance? , 79 S T. JOHN ’ S L. REV. 977, 982 n. (2005) (“The CEO typically holds ultimate control over management and decisive control over the selection of directors.”).
- See Cosenza, supra note 46, at 27.
- See sources cited supra note 56.
- Kelli A. Alces, Beyond the Board of Directors , 46 W AKE FOREST L. REV. 783, 783 (2011) (explaining that the corporate board has “outlived its purpose” and proposing alternative approaches for structuring decision-making authority); see also Franklin A. Gevurtz, The Function Of “Dysfunc- tional” Boards , 77 U. CIN. L. R EV. 391 (2008).
- See MYLES L. MACE, DIRECTORS : MYTH AND REALITY 107 (1971) (study finding that direc- tors rarely challenged or monitored CEO performance, but instead often served as little more than “attractive ornaments on the corporate Christmas tree”); Myles L. Mace, Directors: Myth and Reali- ty—Ten Years Later , 32 RUTGERS L. REV. 293, 295–97 (1979) (reaffirming the results of an earlier study as to director passivity); see also ROBERT A ARON GORDON , B USINESS LEADERSHIP IN THE LARGE CORPORATION 143 (1966) (“[T]he board of directors in the typical large corporation does not actively exercise an important part of the leadership function.”).
- See DEL. CODE A NN. tit. 8, § 141(e) (2013).
- Frankel, supra note 50, at 507.
- See, e.g. , Alces, supra note 59, at 784; Jayne W. Barnard, Corporate Therapeutics at the Secu- rities and Exchange Commission , 2008 COLUM. BUS. L. REV. 793, 802; Lynne L. Dallas, Proposals for
No. 3] FINANCIAL FIRM BOARDS 891
excessive risk-taking strategies
65 that characterized most financial institu-
tions’ operations in the period precipitating the recent financial crisis
support this conclusion.
As described above, the interests of directors and executives of cor-
porations may diverge from the interests of shareholders. When direc-
tors and executives of a financial services intermediary promote their
self-interests ahead of the stability of the enterprise, the business’s losses
may engender spillover effects that impact the global economy and the
social and economic welfare of the nation.
Critics contend that financial institution boards relied too heavily on
executive officers, failed to adopt effective risk monitoring mechanisms,
and, consequently, breached their fiduciary duties to their respective
corporations during the period leading up to the recent financial crisis.
66
Evidence of executive officers’ self-interested pursuit of incentive-based
compensation coupled with directors’ reliance on executives’ reports re-
garding risk exposure and risk management created a perfect storm. Ac-
cording to critics, the boards of several large systemically significant fi-
nancial institutions failed to monitor the activities of executive officers
and senior employees.
67 Responding to public outrage and demands for
boards to accept greater accountability for the negative externalities that
financial institutions’ risk-management failures engendered,
68 Congress
adopted several federal corporate governance reforms aimed to restore
the balance between directors and executives within financial institu-
tions.
Reform of Corporate Boards of Directors: The Dual Board and Board Ombudsperson , 54 W ASH. & LEE L. REV. 91, 130 (1997).
- See Lucian A. Bebchuk & Holger Spamann, Regulating Bankers’ Pay , 98 GEO. L.J. 247 (2010); Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance , 114 YALE L.J. 1521, 1529–30 (2005).
- See Kristin N. Johnson, Addressing Gaps in the Dodd-Frank Act: Directors’ Risk Manage- ment Oversight Obligations , 45 U. M ICH. J.L. R EFORM 55, 112 (2011).
- Paul Myners, Banking Reform Must Begin in Boardroom , FIN. TIMES , Apr. 24, 2008, http:// www.ft.com/cms/82d60c06-1212-11dd-9b49-0000779fd2ac.html (“[B]oard members should never forget that the most vital part of their job is to challenge executives.”); John Schnatter, Editorial, Where Were the Boards? , WALL S T. J., Oct. 25, 2008, at A11 (“[Boards of directors] have a clear-cut fiduciary re- sponsibility to provide oversight.... Behind the CEO of every Freddie Mac, Bear Stearns or Lehman Brothers who led their company down a path toward financial ruin, there was a board of directors that sat by silently and let it happen.”); Review & Outlook, Citi's Taxpayer Parachute: Why are Robert Ru- bin and Other Directors Still Employed? , WALL S T. J., Nov. 25, 2008, at A14 [hereinafter Citi’s Tax- payer Parachute ] (“‘Citi never sleeps,’ says the bank's advertising slogan. But its directors apparently do.... Such a record of persistent failure suggests a larger—you might even call it ‘systemic’— management problem... .”).
- Citi's Taxpayer Parachute , supra note 66.
- See Johnson, supra note 65; René M. Stulz, Risk Management Failures: What Are They and When Do They Happen? , 20 J. A PPLIED CORP. FIN. 58, 58 (2008).
No. 3] FINANCIAL FIRM BOARDS 893
managers’ selfish pursuit of the kind of risk-taking strategies that threat-
en the long-term health of the firm.
75
Congress also created a say-on-pay vote giving shareholders the
ability to express views on the compensation paid—golden parachutes—
to departing executives and directors who are leaving the firm.
76 To align
managers’ incentives with shareholders’ incentives, the EESA prohibited
firms that received federal assistance from making golden parachute
payments. While this kind of arrangement—a golden parachute—is
common, contractual provisions that reward departing executives may
exacerbate the tension between shareholders’ interests and managers’
interests. The Dodd-Frank Act does not adopt the EESA’s prohibition
on golden parachutes; the recently enacted legislation does, however, re-
quire disclosure regarding golden parachutes and endows shareholders
with a nonbinding advisory vote on these arrangements.
77
In addition to say-on-pay, new obligations under Regulation S-K
require companies subject to the Act to disclose the relationship between
executives’ compensation and the firm’s performance, the mean of the
annual compensation of all employees, the total annual compensation
awarded to the CEO, and the ratio of the CEO’s compensation to the
median compensation of all employees.
78 The Dodd-Frank Act also re-
quires companies whose securities trade in public markets to include
clawback provisions in executives’ contracts. Clawbacks enable the
company to recover incentive-based compensation awarded to any cur-
rent or former executive officer in the event that the company is required
to restate its financial statements because of material noncompliance
with applicable financial reporting requirements.
79
Underscoring the significant monitoring role of the board and the
incentives that managers and inside directors may have to take excessive
risks to temporarily increase the company’s share price and enhance
their compensation, the Dodd-Frank Act requires companies subject to
the Act to appoint only independent directors to the board’s compensa-
tion committee.
80 Prior to the adoption of the Dodd-Frank Act, howev-
er, federal corporate governance reforms already required certain re-
porting companies to create audit committees composed of only
independent directors.
81 In addition, preexisting regulations require
- The Securities Exchange Act of 1934, 15 U.S.C. § 78n-1 (2006).
- Id.
- Id. §§ 78n-1(b)(1)–(2).
- Dodd-Frank Act § 953.
- Id. § 954.
- 15 U.S.C. § 78j-3(a)(2).
- See Lisa M. Fairfax, Government Governance and the Need to Reconcile Government Regula- tion with Board Fiduciary Duties , 95 MINN. L. REV. 1692, 1702 (2011) (“Indeed, corporate governance reforms under the Sarbanes-Oxley Act of 2002 (SOX) essentially required public companies to main- tain independent audit committees, which enhanced that committee's role in the corporate governance landscape.”); Usha Rodrigues, The Fetishization of Independence , 33 J. CORP. L. 447, 453 (2008)
894 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
companies whose equity securities are publicly traded to elect independ-
ent directors to a majority of the seats on the board.
82
Finally, to address concerns regarding risk taking directly, the
Dodd-Frank Act regulations require a narrative explanation of compen-
sation policies affecting employees who may have incentives to take risks
that may have a material effect on the corporation.
83 Regulations also
require disclosure regarding the board’s role in risk oversight.
84 Moreo-
ver, large systemically significant financial institutions must create a risk-
management committee of the board of directors that oversees risk man-
agement on an enterprise-wide basis.
85
The risk-management committee must have a written charter ap-
proved by the company’s board of directors.
86 At least one member of
the risk-management committee must have risk-management expertise
commensurate with the company’s capital structure, risk profile, com-
plexity, activities, size, and other appropriate risk-related factors.
87 The
chair of the committee must be independent, meaning the chair lacks
personal or financial ties to the company.
88 The risk committee must
adopt a risk-management framework that sets clear risk limitations, se-
lect processes and systems for identifying and reporting risks, and devel-
op effective and timely corrective action policies to address risk deficien-
cies.
89 To preserve the independence of the chief risk officer (CRO), the
regulations provide for the CRO to report directly to the risk committee
and the CEO.
90 In addition, if companies are subject to section 165(h),
the chair of the board’s risk-management committee must be independ-
ent.
91
Notwithstanding regulators’ enthusiasm, newly adopted reforms are
far from revolutionary. For example, despite the aggressive moniker,
say-on-pay merely grants shareholders the right to cast a nonbinding ad-
visory vote on executive compensation packages previously determined
by the compensation committee of the board of directors.
92 Critics chide
regulators for suggesting that say-on-pay mitigates managers’ incentives
(“Under SOX, the audit committee must consist entirely of independent directors, who in order to qualify cannot accept ‘any consulting, advisory, or other compensatory fee’ from the company on whose board they sit.”).
- Dodd-Frank Act § 952.
- Incentive-Based Compensation Arrangements, 76 Fed. Reg. 21,170 (proposed Mar. 2, 2011).
- Id.
- See Dodd-Frank Act § 165(h).
- Enhanced Prudential Standards and Early Remediation Requirements for Covered Compa- nies, 77 Fed. Reg. 594, 624 (Jan. 5, 2012).
- Id.
- Id. at 623–24.
- Id. at 624.
- Id. at 625.
- Id. at 623.
- David McCann, Say What? The Battle Over Executive Comp , CFO (June 4, 2008), http:// www.cfo.com/article.cfm/11485334/c_11485705?f=todayinfinance_next.
896 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
A wealth of literature describes the continuing debate about the ex-
act parameters of the definition of the term “independence.”
96 Although
there is no universally adopted understanding of independence, com-
mentators and regulators generally agree that references to independent
directors exclude “inside directors” or employees of the company serving
on the board of directors. Independent directors lack material financial
and relational ties to the company; they are described as “non-
interested,” “disinterested,” and “outside.”
97 Inside directors are typical-
ly salaried employees of the company.
98 Inside directors receive compen-
sation for their service as employees as well as their service as board
members. As a result, commentators note that inside directors’ material
dependence on the company may inhibit their ability to vote objectively
on board matters.
99 Independent directors, by contrast, are typically se-
lected from the greater business community and their relationship with
the corporation is usually limited to their service on the board.
100 In the-
ory, because they lack economic and financial ties, independent directors
can engage in decision making, operational supervision, and advisory
services free from the strictures of bias.
101
There are two significant challenges with relying on independent di-
rectors to enhance boards’ oversight of excessive risk taking: the amor-
phous contours of the definition of independence and the danger of un-
dervaluing the contributions of inside directors. First, as noted, defining
independence is difficult. State courts, federal regulators and self-
regulatory organizations have adopted a variety of definitions for inde-
pendence; and no uniform definition has emerged from existing regula-
tions or jurisprudence.
102 Failing to correctly identify the relevant attrib-
utes of independent directors undermines the benefits of appointing
- See, e.g. , Lisa M. Fairfax, The Uneasy Case for the Inside Director , 96 I OWA L. REV. 127, 131 (2010).
- Donald C. Clarke, Three Concepts of the Independent Director , 32 DEL. J. CORP. L. 73, 78 (2007) (citing Investment Company Act (ICA) (codified as amended in relevant part at 15 U.S.C. § 80a-2(a)(19) (2000)); Securities Exchange Act of 1934 (SEA), Pub. L. No. 73–291, § 10A, 48 Stat. 881 (codified as amended at 15 U.S.C. § 78j-1(i)(3)); Transactions Between an Issuer and Its Officers and Directors, 17 C.F.R. § 240.16b-3(b)(3)(i) (2005).
- Fairfax, supra note 96, at 130.
- Id. at 139.
- Rodrigues, supra note 81, at 453.
- See Clarke, supra note 97, at 78.
- Prior to the adoption of the Dodd-Frank Act, the national securities exchanges had imple- mented requirements for companies who list securities on the exchanges to appoint independent direc- tors to their boards and to certain board committees. The Sarbanes-Oxley Act introduced federal regulation mandating exchanges that require listed companies to create audit committees and to ap- point only independent directors to the audit committees. The New York Stock Exchange and the NASDAQ had already adopted rules to this effect. The definition of independence that each ex- change implemented emphasizes the absence of material financial ties but fails to consider the influ- ence of cognitive biases. For a discussion of cognitive biases, see sources cited infra note 103. One state court opinion, however, carefully details the importance of structural and cognitive biases. In re Oracle Corp. Derivative Litig., 824 A.2d 917, 938 (Del. Ch. 2003).
No. 3] FINANCIAL FIRM BOARDS 897
independent directors to the board and to critical board committees. De-
fining independence liberally permits the inclusion of directors who may
be biased or may face the kinds of conflicts that appointing independent
directors is intended to avoid.
103 Defining independence too narrowly
unduly restricts the pool of director candidates.
104
- A liberal definition of independence may, for example, emphasize a single issue, such as whether the director is interested or has a conflict of interest relating to an issue before the board. Defining independence generally in terms of a director’s interest fails to consider the influence of cog- nitive biases on directors’ decisions. While a director may not have a personal financial interest in a matter, other factors may limit the director’s ability to offer an unbiased evaluation of the issue before the board. These include relationships with other board members or biases that arise because of the cognitive limits on the director’s ability to evaluate important information in a timely manner. See Johnson, supra note 65 (exploring behavioral literature’s evaluation of the structural and cognitive biases and concluding that cognitive biases limit the benefits of decision making in cohesive peer in- groups where, similar to corporate cultural environments, the institution that is the subject of the affil- iation emphasizes cohesiveness and consensus). Corporate boards are particularly susceptible to the pressures of structural dynamics and cognitive biases. Scotland M. Duncan, The Empirics of Governance and Fraud , 70 U. PITT. L. R EV. 465, 476 (2009). There is a cultural tendency to disapprove of—or even preclude—confrontation and dissen- sion. Id. While groups may generally arrive at better conclusions through their collaborative process- es and rigorous debate, in the context of corporate boards, unspoken social and cultural cues may en- courage group members to more readily acquiesce to and agree with the dominant perspective. Id. In board meetings, a more robust deliberative process may be discouraged, and thus, the benefits of rig- orous debate severely curtailed. Id. Several cognitive biases may influence boards’ decision-making processes, including in-group bias, confirmation bias, overconfidence, and structural bias. See Michelle M. Harner, Barriers to Effective Risk Management , 40 S ETON HALL L. REV. 1323, 1352–53 (2010); Antony Page, Unconscious Bias and the Limits of Director Independence , 2009 U. ILL. L. REV. 237, 251; Julian Velasco, Structural Bias and the Need for Substantive Review , 82 W ASH. U. L. Q. 821, 855 (2004). In-group bias describes inclina- tions to evaluate the contributions or performance of one’s own group members more favorably than the contributions or performance of others who are not members of this group. Christopher L. Aberson et al., Ingroup Bias and Self-Esteem: A Meta-Analysis , 4 PERSONALITY & S OC. PSYCHOL. REV. 157, 157 (2000). Influenced by in-group bias, for example, directors may view the contributions of their fellow directors less objectively. Page, supra at 251. Directors may also be subject to confirmation bias—an inclination to look for and adopt infor- mation that confirms their intuitive beliefs. Harner, supra at 1352–53. Confirmation bias is an infor- mation processing bias; directors engage in selective information gathering. Id. Directors may inter- pret neutral information as confirming their beliefs and ignore information that challenges their instincts. See Douglas G. Baird & Robert K. Rasmussen, The Prime Directive , 75 U. CIN. L. REV. 921, 936 (2007). Moreover, confirmation bias may lead directors to defer to the opinions of executives and insiders because directors perceive the insiders as more informed and better able to evaluate strategic questions on behalf of the company. See Melanie B. Leslie, The Wisdom of Crowds? Groupthink and Nonprofit Governance , 62 FLA. L. R EV. 1179, 1201 (2010). In addition, board members may become overconfident in their judgments. See id. at 1183. Board members who are overconfident may be overly optimistic about their competence and their ability to objectively make fair, moral, unbiased, and well-informed decisions. See Donald C. Langevoort, The Human Nature of Corporate Boards: Laws, Norms, and the Unintended Consequences of Independence and Accountability , 89 GEO. L.J. 797, 803 (2001). Board members may also become overconfident about the capabilities of other board members or executives of the company. See id. ; Stephen M. Bainbridge, Why a Board? Group Decisionmaking in Corporate Governance , 55 VAND. L. REV. 1, 11 (2002). Overestimation may distort directors’ appreciation of their own cognitive limitations and prej- udices and, consequently, lead the board to make unsound business decisions. See Langevoort, supra , at 803. Structural bias also creates concerns regarding the influence of relational dynamics on the board. Id. at 811. Structural bias generally refers to a sense of empathy or collegiality created by a shared educational, professional, economic, or other social affiliation or tie. See Velasco, supra at 824; see
No. 3] FINANCIAL FIRM BOARDS 899
2. Risk-Management Oversight
Impartial oversight of risk management is critical not only to the in-
tegrity of financial institutions but also to the stability of broader finan-
cial markets. Financial institutions often adopt business models that
provide complex lending, underwriting, and securitization arrange-
ments.
110 Financial institutions may have multiple business units that
generate independent revenue streams by performing different financial
services. For example, one business unit within a financial institution
may serve as a market maker and trade securities on behalf of clients
while another unit may trade securities for the financial institution’s pro-
prietary investment portfolio.
111 Other business units may originate loans
or issue credit cards, while still another unit advises corporate clients on
mergers, acquisitions, or restructuring.
Understanding risk management is important for all businesses. Fi-
nancial institutions, however, face unique challenges as they attempt to
quantify their exposure to risk. Financial institutions and other business-
es in the financial services industry adopt policies and procedures to
measure and mitigate risk. Commentators refer to these policies and
procedures as enterprise-risk-management (ERM) programs.
112 Because
financial institutions’ business models and activities are complex, the
mechanisms that these institutions use to understand and mitigate risk
are also complex. Risk management describes the organizational pro-
cesses that financial institutions adopt to identify, measure, and mitigate
risk.
113 ERM policies attempt to comprehensively measure risks. In re-
cent years, financial institutions have heavily relied on two ERM meth-
ods that may pose a challenge for unsophisticated independent board
members—quantitative risk models and derivatives.
114
Risk modeling offers one of the most commonly adopted quantita-
tive methods. Risk modeling calculates, for example, the potential losses
that a portfolio may incur under certain stated assumptions. The Value-
at-Risk (VaR) model, introduced in the 1980s, has gained significant
popularity with financial institutions.
115 VaR measures the potential loss
- S AUNDERS & CORNETT , supra note 8, at 97–103.
- Id. “Market making can involve either agency or principal transactions,” meaning the market maker can engage in proprietary transactions or transactions on behalf of clients. Id. at 100. Financial institutions also “maintain an inventory of financial instruments or commodities in order to satisfy cli- ents orders to purchase or sell such instruments.” CARNELL ET AL ., supra note 8, at 36–38. Financial institutions purchase illiquid assets from investors and hold the assets, using their proprietary portfoli- os to create a market for illiquid assets. S AUNDERS & CORNETT , supra note 8, at 100. Serving as mar- ket makers, financial intermediaries act as investors or dealers on behalf of clients for a fee or commis- sion. Market makers offer a secondary market for illiquid assets. Id.
- Johnson, supra note 68, at 66.
- CHRISTOPHER L. CULP, T HE RISK MANAGEMENT PROCESS : BUSINESS S TRATEGY AND TACTICS 13–14 (2001).
- Johnson, supra note 65, at 67–78.
- Charles K. Whitehead, Destructive Coordination , 96 CORNELL L. REV. 323, 362 (2011).
900 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2013
in value of an asset or portfolio at a given confidence level over a speci-
fied period.
116 Through their use of VaR, financial institutions are able to
better predict future losses. While the earliest VaR models measured the
risk of loss related to an individual portfolio, later models measure the
cumulative risk of loss across a group of portfolios, multiple business di-
visions, or an entire firm.
117
While VaR enables financial institutions to better predict any risk of
loss, the model also has several limitations. First, VaR is a backward
looking simulation model that predicts future performance based on how
the market has historically performed.
118 The model requires users to
identify a historic reference point, which may be yesterday, a week ago, a
month ago, or a year ago.
119 The model assumes that the market will per-
form in the future as it has performed in the past. In reality, past per-
formance is not indicative of future results, which may vary. There may
be limited predictability as to the market’s future performance. Unprec-
edented or unanticipated events may alter the future performance of
markets. Financial institution boards that rely on VaR’s results as gospel
or who are influenced by inside directors or managers may, however, be
unable or unwilling to challenge the model’s predictions.
Moreover, the VaR model classifies potential risks as “likely;” other
risks are classified as “rare” or “infrequent” or “less likely.” The model
focuses more on the former class of risks than the latter class.
120 Other
quantitative models, such as Monte Carlo simulations
121 and stress tests,
122
- Harry Markowitz is credited with introducing one of the earliest quantitative models devel- oped to measure portfolio risk. See HARRY M. MARKOWITZ, PORTFOLIO S ELECTION : EFFICIENT DIVERSIFICATION OF I NVESTMENTS (1959) [hereinafter M ARKOWITZ, EFFICIENT DIVERSIFICATION ]; Harry Markowitz, Portfolio Selection , 7 J. FIN. 77 (1952) [hereinafter Markowitz, Portfolio Selection ]. In a seminal article published in the Journal of Finance in 1952, Markowitz offered a simple quantita- tive risk measuring model that theorists later adapted to address more complicated risk calculations. Id. ; PHILIPPE J ORION , VALUE AT RISK : THE NEW BENCHMARK FOR M ANAGING FINANCIAL RISK 159– 85 (3d ed. 2007).
- Andreas Krause, Exploring the Limitations of Value at Risk: How Good Is It in Practice? , 4 J. RISK FIN. 19, 19 (2003) (discussing how companies estimate value at risk (VaR): “Originally VaR was intended to measure the risks in derivatives markets, but it became widely applied in financial institu- tions to measure all kinds of financial risks, primarily market and credit risks.”).
- See J ORION , supra note 116, at 17–22.
- See id.
- Theorists refer to the low probability events that represent less frequent distributions and occur on the ends of the distribution curve as “tail” risks. David Einhorn & Aaron Brown, Cover Sto- ry: Point/Counterpoint: Private Profits and Socialized Risk , 42 GLOBAL ASS ’ N OF RISK PROF' LS , June- July 2008, at 11 (explaining VaR’s shortcomings).
- Monte Carlo simulations calculate the covariances, or correlations, among risks. See MICHEL CROUHY ET AL ., RISK MANAGEMENT 198 (2001).
- Id. A stress test enables financial institutions to examine their readiness or capacity to func- tion under certain adverse market conditions. See BD. OF GOVERNORS OF THE FED. RESERVE S YS ., THE S UPERVISORY CAPITAL A SSESSMENT PROGRAM: DESIGN AND I MPLEMENTATION (2009), availa- ble at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090424a1.pdf. These models rely on individuals to identify appropriate hypothetical events which means human bias may influence the efficacy of the model. If managers at financial institutions perceive massive defaults on residential
