11.01  Corporate governance is ‘the system by which companies are directed and controlled.’³ This is the classical succinct definition for the corporate governance of companies as developed by the Cadbury Report in the United Kingdom in 1992 for the sake of company and code reform. A more economic and widely used definition holds that corporate governance ‘deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment’.⁴ In corporate law and in the legal discussion about corporate governance, the focus is on the shareholders as members of the company. The interests (p. 338) of other stakeholders—such as creditors/debtholders, the general public, and the government with its different social, environmental, and other policies—are either left to other parts of the law (classical shareholder orientation) or only very generally included in the orientation for the board when directing and controlling the company (enlightened shareholder orientation). In contrast, many economists use a broader definition of corporate governance that includes the stakeholders (stakeholder orientation).⁵

11.02  What is special about banks and bank governance? The first question was answered long ago in bank supervisory law and bank practice, and there is no need here to summarize the special functions and risks of banking. There is vast practical experience and economic literature describing the special case of banks and the consequences for the regulation and supervision of banks as a regulated sector in contrast to normal firms. In a nutshell: What is unique for banks is the liquidity risk since they are involved in borrowing short and lending long (maturity transformation), combined with other risks arising from this, such as reputational risk and, finally, systemic risk.⁶ Public trust and confidence are the very essence of banking.

11.03  But what is special about the corporate governance of banks? There is a very different focus. According to some, ‘banks are not fundamentally different from other companies in respect to corporate governance, even though there are important differences of degree and failures will have economy-wide ramifications’.⁷ It then follows that ‘[t]he general policy needs are similar for financial and non-financial companies’.⁸ This was the implicit majority view before the financial crisis, but the special case for the corporate governance of banks was not made until more recently.⁹ Since the financial crisis, the insight that banks have special corporate governance problems has gained momentum rather quickly. For the bank (p. 339) supervisory authorities, it has long been obvious that they should consider corporate governance as part of depositor protection (internal governance).¹⁰

11.04  One of the first institutions to codify minimum requirements for bank governance under the heading ‘corporate governance’ was the Basel Committee on Banking Supervision at the Bank for International Settlements (BIS) in 1999.¹¹ A newer version was published in 2006 and received wide attention.¹² It set up eight principles of good corporate governance of banks and six recommendations for bank supervision: seven of the principles concerned the board (two of these focused on the board and senior management) and one the bank (governance in a transparent manner). All six principles for bank supervision concerned corporate governance by the bank expressly or in substance.

11.05  After the financial crisis, vast amounts of reports and research on corporate governance of banks sprang up. One of the most important contributions is the new report of the Basel Committee of October 2010,¹³ which was preceded by a Consultative Document of March 2010 and will be dealt with in detail in this chapter. The 2010 report overhauled the 2006 report fundamentally. It contains 14 principles (instead of eight): four for board practices, one for senior management, four for risk management and internal control, two concerning compensation, two for bank structure, and one for disclosure and transparency. All five principles for the role of supervisors expressly address corporate governance of the bank. The recommendations provide guidance only and are not intended to establish a new regulatory framework on top of the law, regulations, and codes.¹⁴ They are principle-based rather than rule-based and address all banks, though the implementation should be proportionate to size, complexity, structure, economic significance, and risk profile of the bank or the group.¹⁵

(p. 340) 11.06  There were many other important reports, only three of which will be mentioned here: the OCED report of 2009 on ‘Corporate Governance and the Financial Crisis’¹⁶ with conclusions and emerging good practices in 2010¹⁷ and a general policy brief for boards;¹⁸ the Walker Review on corporate governance in UK banks of 2009;¹⁹ and, on the basis of earlier measures (directives and recommendations),²⁰ the European Commission’s Green Paper on corporate governance in financial institutions and remuneration policies, June 2010.²¹ A great many reports, law reforms, bank supervisory authorities’ instructions and recommendations, and codes regarding the corporate governance of banks have been spread all over the EU Member States and beyond, including the United Kingdom with the just-mentioned Walker Review as well as Germany²² and Switzerland,²³ for example. This is not surprising: the Basel recommendations, which are drawn up by delegates from many countries, are usually the international forerunners and are taken up by the EU. They are implemented in the Member States either directly or via EU directives and recommendations.

11.07  In economic research, the first contributions sprang up in the 1980s with a contribution by Fama,²⁴ followed in 2000 by Ciancanelli and Reyes Gonzales²⁵ and in 2003 by Macey and O’Hara.²⁶ Many others followed, in particular around the financial market crises.²⁷ Since 2004 the literature in Europe arose especially in (p. 341) Germany, Switzerland, and Austria.²⁸ But only after the Green Paper on corporate governance of banks in 2010 and the responses to it—some of them critical—did other contributions start to abound. In the same year, the first separate volume on the corporate governance of banks in Germany was published.²⁹

11.08  The two major principal-agent conflicts in the corporation are between the shareholders and the directors in the case of dispersed ownership and between the minority and majority, namely the controlling shareholder in groups of companies or family enterprises. In principle, this is the same for firms and for banks.

11.09  But differences may arise if there is a mandatory different orientation for the board of directors of a bank—namely, to manage the bank not only or primarily in the interest of the bank’s shareholders, but evenly or even primarily in the interest of the debtholders. This is particularly true if the stakeholder/debtholder orientation is not a matter for the board to decide (as is usually the case under those corporate laws that follow the enlightened shareholder approach), but if bank regulation and supervision interfere in the internal life of the bank corporation by establishing mandatory standards for the quality of the board and the management, setting up requirements for the organization of the bank, and prescribing certain internal procedures.

11.10  Besides internal corporate governance, there is external corporate governance—ie control from the outside, eg by disclosure to the market and control by the auditors, (p. 342) rating agencies, the market of corporate control, et al. While these forces are principally the same for all firms, there are again differences for banks.³⁰ There are many special disclosure requirements and balance sheet regimes for banks that differ considerably from those for general firms.³¹

11.11  There are special auditors for banks with particular information duties towards the bank supervisory authority. The bank supervisory authority may ask for special inquiries and have them undertaken by special bank auditors.³²

11.12  The influence of the rating agencies on banks became a source of concern during the financial crisis, especially the legal rules in various national laws which prescribed that the ratings of the rating agencies had to be taken into consideration or could even be relied on more or less automatically. Reforms are under way.³³

11.13  In a market economy, control on the firm from the outside is exercised by the markets, in particular the market for corporate control, but also other markets like the market for managers and indirectly also the product market. In theory, the market for corporate control is the most important external control mechanism that disciplines management. Bad performance will result in lower share price and make takeovers cheaper and more probable, with the result that the old management risks are replaced if the takeover is successful. Yet the takeover markets are not well developed in many European countries. The takeover market for banks is especially weak and cannot be trusted to be a major disciplining force in bank corporate governance.³⁴

11.14  The most obvious difference between firms and banks is that banking is a regulated sector with a vast number of legal, supervisory, and informal rules that cannot be treated here in any detail. According to some voices, regulators and supervisors are also stakeholders and their role should be analysed in principal-agent terms. However, it will be argued here that regulation and supervision of banks should not be considered external corporate governance, but as regulatory intervention into the corporate governance of the bank.³⁵

11.15  The conclusion of these introductory remarks is that banks and their corporate governance are special compared with general corporate governance of firms. This is in line with the development corporate governance has taken in recent years. There is a clear trend towards sector-specific corporate governance and governance codes. Examples are special corporate governances for non-listed companies,³⁶ close corporations and partnerships,³⁷ family enterprises,³⁸ state-owned enterprises,³⁹ and non-profit organizations.⁴⁰ For some of these sectors, special corporate governance codes exist. Such a code would also be appropriate for banks.⁴¹ The corporate governance principles should basically be the same for all banks,⁴² although modifications in the details may be appropriate for different kinds of banks (eg investment banks, deposit banks, universal banks, state-owned banks, and unlisted banks).

11.16  A controversial discussion has concerned whether the deficits in the corporate governance of banks were (co-) responsible for the financial crisis, or whether they have instead been irrelevant. Before going into this, it would be helpful to have a quick look at the major deficits of corporate governance of banks as they are evidenced by the financial crisis. It may be that this perspective will help to dissipate the controversy. The corporate governance failures in banks can be pinpointed in five main (p. 344) areas.⁴³ Some of these failures appeared fully only during the financial crisis that began in mid-2007.⁴⁴

11.17  Banking is an inherently risky business, and the risks both credit banks and investment banks face are many and multi-faceted. Traditional banking lives from the so-called transformation of risks (short-term into long-term), and investment banking is about finding and financing investments in enterprises and products. Key risks include credit, market, operational, compliance, and reputational, among others.⁴⁵ This is a truism and has been the cause for bank regulation and supervision for more than a century. Yet during the financial crisis it came to light that many of these risks had been neglected, underestimated, or—particularly in the case of systemic risks—not understood and taken into consideration. It is telling that in the Basel Committee’s eight principles for good corporate governance of banks in 2006, the word ‘risk’ does not appear at all, while in its 14 principles of 2010 it appears in nine of the 14 principles—in fact, in principle 11 it even appears five times.⁴⁶ In addition, terms such as risk strategy, risk tolerance, and risk appetite also became popular.⁴⁷ According to the Nestor study,⁴⁸ in the years before the financial crisis three key board failings concerning risk were found: the focus on the risk measurement at the expense of risk identification, the failure to check excessive leverage, and the gross underestimation of liquidity risks. The OECD holds that perhaps one of the greatest shocks from the financial crisis has been the widespread failure of risk management.⁴⁹ The lesson to be learned is not that risk should be eliminated—it never can. Nor should it be eliminated as far as possible—risk is the very business of banking. Instead, the lesson is this: the risk(s) must be known, understood, managed, and—when appropriate—communicated.

11.18  During the financial crisis, many deficiencies concerning boards in general and the bank board in particular appeared in a new light, though most of them had been observed (p. 345) and criticized long before. During the years before the crisis, the academic and reform discussion concentrated primarily on the conflict of interest of the board and board members, and on independent directors as the remedy or, according to many at that time, even a panacea. While this has also remained a topic after the crisis, the attention has rightly shifted to qualification. Many bank board members were just not qualified enough to know, understand, and deal with the complexities and risks of modern banking. This led to failures, even in firms and banks where the board was composed according to all good corporate governance standards that were valid at the time. Most dramatic was the failure of the boards of public banks as shown by a recent empirical study by Harald Hau and Marcel P. Thum.⁵⁰ In their profile of the 29 largest German banks during the financial crisis, they found that the public banks—in particular the banks of the German Länder (states)—had losses between the first quarter of 2007 until the third quarter of 2008 that were three times as high as other privately owned banks. In addition, Hau and Thum analysed the biographies of 593 supervisory board members of these public banks and found that the management and finance experience of the board members in the other banks was systematically higher than that in the public banks. The correlation between the losses of the banks and the qualification and experience of the bank directors was statistically highly significant and indicated causality between the two.

11.19  Such structures have been shown to be a major impediment to good corporate governance of banks. Banks have failed to create clear responsibility lines throughout the whole bank, and in particular throughout the bank group. Banks belonging to non-bank groups failed to act in the market as far as possible as stand-alone unities and therefore shared the fate of the group as a whole. In bank groups, the contradiction between the interest and the group policy of the parent and the individual interest of the subsidiaries was aggravated by the separate entity principle prescribed by the law. As a consequence, a general corporate governance policy throughout the group was difficult to achieve, since under group law there is no direct order line between the parent and the subsidiary. But there is also the flip-side. While the subsidiary bank must follow its own interest for the sake of its own shareholders and creditors, there is always the danger that the parent will impose measures, transactions, or systems of organization that are not in the interest of the subsidiary or, particularly in multinational banks, that are even illegal. These problems arise not only in normal bank group structures, but in a particular way in banks in which matrix and business line organizations are practised, and if important functions like IT are outsourced (p. 346) either within the group or fully outside.⁵¹ Both concerns—the effectuation of an appropriate group-wide risk policy and bank governance and the avoidance of conflicts of interest and inappropriate and even illegal interventions of major shareholders, especially if this is the state or even a foreign state—are intensified if the structure of the bank is complex or opaque.

11.20  Bankers’ remuneration has become a major concern during recent years. While this was also the case with excessive directors’ remuneration in general firms, the case of bankers’ remuneration was special insofar as the equity-based remuneration systems there led to very concrete wrong incentives. In particular, investment banking remuneration structures provided an inherent temptation for directors and senior management to generate short-term revenues while taking on high long-term risk. This perverse incentive was even stronger for senior investment bank managers who often earned much more than even the CEO, and it was aggravated by the fact that whole teams competed with each other and the board feared to lose them when tackling the remuneration system. The latter danger was appreciated relatively late, since the discussion on ‘pay without performance’ concentrated for a long time on directors’ pay only.

11.21  Disclosure and transparency is an overall goal, but it is seldom achieved in a fully satisfactory way unless enforced by law. Particularly if the bank structures are complex or opaque, the market discipline does not function. In multinational banking groups, the information flow between the bank that is seated in one country and the subsidiary with its seat in another country and vice versa may be impeded not only in practice, but also by national laws that prohibit information sharing or make it difficult or slow. This not only affects the parent of the group, but also the supervisory agencies of the parent and of the subsidiary. But disclosure and transparency is not only dampened in multinational settings. If new risks are not even adequately seen and understood by the bank board itself, it is difficult for the supervisory agency to grasp them and practically impossible for the shareholders and the debtholders to react to them. In sum, adequate disclosure and transparency was badly lacking, in the first instance for the board itself within the bank and bank group, then for the supervisory agency/agencies, and in the end for the shareholders and the public.

11.22  In the discussion of the financial crisis, opinions differ sharply on the contribution of failures in the corporate governance of banks. According to some, the undisputed failures of corporate governance of banks is of minor relevance or even irrelevant for the crisis.⁵² According to others, corporate governance in banks—and (p. 347) in particular ill-designed incentive structures—played a ‘significant role in the genesis of the current financial crisis’.⁵³ This is also a widely held conviction among politicians⁵⁴ and the general public. The Walker Review states that ‘the need is now to bring corporate governance issues close to centre stage’.⁵⁵

11.23  But in view of the obvious failures in the corporate governance of banks as evidenced in the financial crisis, this is a rather futile discussion. The failures must be corrected, though they seem to have been just one piece in the puzzle. Many other more important causes for the crisis are evident. This is the reason why the regulatory and supervisory reforms, which have already been enacted or are under way on the national, European, and international levels,⁵⁶ rightly extend far beyond corporate governance to capital, liquidity, systemic risk, more competences for the banking supervisory agencies, restrictions on certain transactions and products, and last but not least rescue and insolvency, among others.⁵⁷ In this chapter, the focus is on the corporate governance of banks insofar as it goes beyond general corporate governance of firms.

11.24  Instead of trying to explain why banks and bank governance are special based on the three general theories mentioned above (ie macro-economics, lack of transparency of the bank business, and regulation),⁵⁸ the special case of banks and bank governance is best shown by looking at the interests and incentives of the actors (ie of the management and the board, the shareholders, the debtholders, and the supervisors) to undertake risks.⁵⁹

11.25  The key actors in firms and banks are the directors. This is particularly true in corporations with dispersed shareholdings, though it is less true if there is a controlling shareholder who can have his or her way, at least in the end. The directors—ie the board members, or in the two-tier system, primarily the members of the management board—are the ones who run the bank and undertake risks.⁶⁰ The interests and incentives of directors in undertaking risk are mixed depending on the circumstances. In theory, directors are less prone to undertaking high risks since they are not diversified like shareholders. But this is true only for such high risks that would endanger their position as directors and only if they understand and evaluate these risks as such. Normally, undertaking risks opens chances of profit, growth, and reputation, both for the bank and the director. The financial crisis has shown how underdeveloped risk analysis and risk management were and how difficult it is to recognize systemic risks in advance. From behavioral economics we also understand the factor of over-optimism, which is particularly relevant for managers. Equity-based remuneration is a factor that adds to such over-optimism since the pay may be short term while the risk may materialize only in the long term. The prospect of certain short-term revenue may then lead to undertaking much higher risk in the longer term.⁶¹ There are also situations in which directors may be tempted to undertake high risks even if they recognize them fully. This is so in end games, for example—ie when the director knows that he or she will have left the bank, either by retirement or by taking a new position elsewhere, before the risk materializes. The financial crisis provided many examples of this type of exaggerated risk-taking by bank directors, sometimes with disastrous results.

11.26  In terms of the principal-agent analysis, the shareholders should be expected to check director risk-taking since they are the ultimate risk-bearers. Yet the situation is very different depending on the shareholder structure. In a dispersed shareholding structure, the normal shareholders are interested in the share price and the dividends (rational apathy); they do not understand the risks in play and cannot be a counterbalance to the risk-taking of the directors. Quite the contrary, they will push for more bank profit and higher dividends. This is even more the case if they are diversified. So these shareholders cannot be expected to take into consideration (p. 349) the interests of debtholders; in reality, they may actually be risk-prone in the hope that if the risk materializes they will lose only their share while the real losses will be borne by the debtholders.

11.27  The upsurge of institutional shareholders does not change this picture. Usually these shareholders hold only relatively small stakes in the bank and are not interested in internal corporate governance. If they do not like the management, they sell (the Wall Street rule). It is true that more recently much hope has been placed on them as possibly active shareholders, and regulators and legislators have pushed them to engage themselves more actively in the internal corporate governance of the firm and the bank.⁶² But there is justified scepticism.⁶³

11.28  If there is a controlling shareholder or a major blockholder in the bank, the interest and incentives differ. These shareholders may be better qualified to understand the risk and motivated to oppose excessive risk-taking since they have a clear stake in the firm or bank. Yet this is not necessarily the case. Controlling shareholders have their own agenda, in particular in the case of bank groups and multinational groups. Risks taken and borne by one member of the group may benefit the parent or another member of the group. In addition, controlling shareholders are subject to over-optimism and the temptation of empire-building.

11.29  For the corporate governance of banks, it follows that equity governance is insufficient, even if the model of shareholder profit maximization is discarded in favour of the enlightened shareholder approach.⁶⁴ It must be complemented by some sort of debt governance that is more geared towards avoiding excessive risk-taking by the bank. The debtholders are interested not in the profit of the bank as such—which stays in the bank or goes to the shareholders—but in being paid. They are therefore risk-averse, especially to ex post risk extension. Yet as in the case of shareholders, the interest and incentives of the debtholders differ widely. The employees of the bank are usually interested only in their pay and are not in a position to understand and evaluate risks taken, which, if they were to materialize, might endanger their job. Labour codetermination in the board does not change this diagnosis substantially.⁶⁵ The same is true for small bondholders and other creditors. They are usually diversified and, in any case, they are not in a position to understand and evaluate excessive risk-taking, quite apart from lacking the legal standing and rights to oppose this.

(p. 350) 11.30  These interests and incentives are different for large debtholders.⁶⁶ Like major shareholders, they may be better qualified to understand the risk and motivated to oppose excessive risk-taking. Yet again, they may not be the ones to whom debt governance could be entrusted. Large creditors such as banks are usually secured creditors. As such, excessive risk-taking does not affect them directly as long as the secured credit is not affected. Therefore, the final losses are often borne by the dispersed and other non-secured creditors. Indeed, they may even be tempted to extend new secured credit for higher risk-taking by the bank at the expense of the non-secured creditors who may not even know about this dangerous prolongation of the crisis until it is too late for rescue.⁶⁷ Nevertheless, it is true that if the bank gets into financial difficulties, the banks and other large debtholders become more active and try to influence the management. Yet this may come at too late a stage or, if the bank gets too involved in the management, there is even the risk that the bank could be treated by law as a de facto director and/or shareholder and as such held liable for the losses.⁶⁸

11.31  From the foregoing analysis, it has become clear that the actors mentioned above—directors, shareholders, and debtholders—are not solely in a position or cannot be expected to look after an appropriate level of the special corporate governance needed in banking. Regulation and supervision must step in also for the corporate governance of banks. Sometimes the supervisors and even governments are counted among the protected stakeholders.⁶⁹ This is in line with a very broad concept of stakeholders and stakeholder orientation for the board in some countries. Yet the experience with the latter is mixed. As long as the stakeholders do not have their own standing to enforce this orientation, such an orientation leaves the balancing of the interests and the final decision-making to the board—and rightly so, since this is necessary for acting and reacting in a competitive market.

11.32  For the regulators and supervisors this is different. Their very task is to intervene, but to intervene only on the basis of legitimization by law and only insofar as interference in the play of the market is necessary. Therefore, it is not a question of interests and incentives of the supervisors, but rather of the maintenance of financial stability of the banking system (not by maintaining individual banks) and, more specifically, of corporate governance of banks insofar as this contributes, though only indirectly, to such stability.⁷⁰ As far as corporate governance and (p. 351) debt governance are concerned, the intervention of regulation and supervision can therefore be considered as the necessary reaction to the failure of shareholders and debtholders to achieve appropriate corporate governance of the bank. As far as the functional relationship between corporate governance of the bank and banking regulation and supervision is concerned,⁷¹ it is a rather obvious insight that bank regulation and supervision are more on the side of the debtholders than of the shareholders.

11.33  The financial crisis has given new impetus to the old discussion on deposit insurance and bail-out systems. The pros and cons of these instruments are well known in theory and practice and need not be taken up here again. While both seem unavoidable in real life—the first for consumer protection reasons and the second under the slogan ‘too big to fail’—it is undisputable that they have severe drawbacks for the interests and incentives of the debtholders. The negative side-effect of deposit insurance is the danger of increasing risk-taking on the side of the bank directors and of less prudence and free-riding on the side of the depositors.⁷² Similarly, the negative side-effect of bail-out is the temptation of undertaking higher risks for more profit at the expense of the taxpayer, of less care of the bank creditors, and of falsifying competition.⁷³ The point in the context of this chapter is that these two instruments reduce the interests and incentives of the above-mentioned actors in the corporate governance of the banks even more. The task of the regulators and supervisors is then to try to make up for these negative effects by a reform of the deposit insurance system⁷⁴ and by bank insolvency regulation,⁷⁵ both preferably not only in disparate ways at the national level but harmonized to the necessary degree on a European or even international level.

11.34  We have seen in the first two parts of this chapter that banks are special and that the corporate governance problems of banks differ from those of general firms. Corporate governance of banks cannot be restrained to equity governance but must be broadened to debt governance. The analysis of the interests and incentives (p. 352) of the actors in the corporate governance of banks has shown that debt governance cannot be entrusted to debtholders alone, but that supervisory and regulatory intervention is needed. The legal and regulatory problem is then the measure by which an appropriate level of debt governance can be reached. The proposals in academia as well as the reforms and reform agendas in practice show a bewildering multitude of interventions into the free play of banking business. The object of the third part of this chapter is to take stock of this armory and to evaluate it. The focus is on internal corporate governance of banks—ie on corporate and supervisory law reform measures—rather than general bank regulation such as stiffer requirements on banks regarding equity, structure, products, and transactions. A number of less-suited corporate law reforms will first be dealt with rather succinctly, since mere corporate law intervention without being bolstered by supervision is less promising. Then internal corporate governance requirements under the shadow of bank supervision will be analysed in some detail and divided into supervisory law requirements for board and bank structure and internal procedures and for people (board, management, major shareholders).

11.35  The debtors who are nearest to the corporation are the workforce. Under most countries’ corporate law, labour does not participate in the corporation like the shareholders but is a special group of debtor, though as such it is privileged in many ways. This privilege is usually granted by labour law, like collective bargaining and codetermination by a work council, but in EU Member States often also by up to one-third labour codetermination on the board, and in Germany even by a quasi-paritary codetermination. Since the workers have an interest in stable work places while debtors in general are only interested in getting paid, one might expect that labour codetermination in banks would serve as an ideal means of debtor governance. Unfortunately, practice shows that this is not the case. The workforce is very often interested only in maintaining and improving their salaries and working conditions, and the trade union representatives may pursue general, sometimes ideological working-class purposes. A real interest in and control of risk-taking in the firm or in the bank at the expense of profit and better wages is not recognizable.⁷⁶

11.36  Another proposal is to have the debtors represented in the board of the bank by one or more representatives of the deposit insurer⁷⁷ or of the bank supervisor.⁷⁸ (p. 353) The former would be expected to caution against risk-taking, which might affect the deposit insurer. The latter should bring the concerns of bank supervision right into the decision-making of the supervisory board. But quite apart from the concern of the already too big German supervisory boards (for larger enterprises usually 20 members), this would fractionize the supervisory board even more. The bank supervisory agency already has the right to participate in board meetings if it deems it necessary. Having permanent representation there would mingle supervision and decision-making too much and risk making supervision co-responsible for bad decisions. Furthermore, the experience with state representatives is bad, indeed, as shown in cases of state-owned or state-controlled banks, especially the German Landesbanken and their disastrous involvement in the financial crisis.⁷⁹ Political appointees and political influence have been and are costly for the banks and debtholders.⁸⁰

11.37  Constituency clauses for labour can be found in many countries. They impose on the board the duty to act in the interest of labour as well, ie to find an adequate balance of shareholder and labour interests in the firm. The proposal of also having a constituency clause for the debtholders is not new. In German corporate law, for example, the management board has to act in the interests of the firm, including the interest of the debtholders. Yet this proved not to make a difference for the risk-taking of the banks before the financial crisis. Constituency clauses leave it to the discretion of the board how to weigh the interests and let the board act under the business judgment rule. Some cynics have observed that such clauses serve labour (and the debtholders) only if and as far as their interest coincides with the interest of the management.⁸¹

11.38  In the United States, an early proposal to foster debtholder interest extends the fiduciary duties of the directors towards the debtholders.⁸² This proposal refers explicitly to the constituency clause of the Franco-German corporate governance model. It is submitted that it would be more successful in the United States because of the well-developed private enforcement system there. The proposal is coupled with the right of creditors, including the Federal Deposit Insurance Corporation, to sue bank (p. 354) directors for damages, and with other measures tightening up bank directors’ liability. Since the financial crisis, similar ideas have spread to other countries; one of the proponents of tight liability for bank directors in Germany is Marcus Lutter.⁸³ Yet a special liability regime for bank directors is problematic, and unless the concept and requirement of civil (or even criminal) liability is curbed (such as fault, business judgment rule,⁸⁴ causation), there is little hope to make real progress.⁸⁵ Imitating the American private enforcement system with its blatant abuse possibilities would hardly be welcome under the European tradition. On the other hand, the remark that ‘even nominal liability’ might be useful⁸⁶ is rather cynical. This is not to say that directors should not be held liable if the legal requirements are fulfilled. Indeed, directors’ liability cases have sharply increased since the financial crisis, and the former under-enforcement status quo seems to be changing.⁸⁷

11.39  Looking back at the history of Wall Street, it is interesting to remember that in earlier times bankers used to be partners who were personally liable for losses. One might even consider forcing banks into a legal form of partnership that would make the directors personally liable. Yet limited liability has been a response to the needs of industrialization and modern risk-taking, and it would be utterly ahistorical to deny it to a special class of business.⁸⁸ Another still rather sketchy idea is to look for a kind of product liability for risky financial products together with the general far-reaching personal liability of directors in case of damages by financial products. This would go far beyond the traditional liability of banks for wrong or inappropriate advice and omission of warning, a liability with which the courts have long and good experience and which they have considerably stiffened after the financial crisis.⁸⁹

11.40  One short note on hybrid capital must suffice here. The idea of a mandatory subordinated debt policy and of contingent convertible bonds is an interesting (p. 355) contribution to solve the bank insolvency problem and may indeed help to broaden the financial base of banks in case of financial difficulties. The side-effect of this measure—ie broadening the debtholder group and expecting better risk control from them—would be welcome, but in practice it may be overestimated, quite apart from political and practical difficulties of implementation.⁹⁰

11.41  The board is the key organ of the firm and the bank and has the overall responsibility. According to the Basel Committee, this is the very first principle; in the case of banks in particular, it includes the responsibility for ‘approving and overseeing the implementation of the bank’s strategic objectives, risk strategy, corporate governance and corporate values’ and includes oversight of senior management.⁹¹ The overall most important responsibility concerns the strategic objectives and the risk strategy.⁹² The special responsibilities for corporate governance⁹³ and oversight of senior management⁹⁴ are spelled out by the Basel Committee in special principles. Therefore, the focus must be in the following on the board, and in particular on board and bank structure and internal procedures and on the board profile.⁹⁵

11.42  The most far-reaching requirement for the structure of the bank board is the mandatory separation of the board into a management board and a supervisory board. While this is the normal structure in all corporations in the two-tier board countries such as Germany and Austria, this is required specifically for banks even in some one-tier board countries such as Switzerland and Belgium.⁹⁶ These countries have had good experiences with this separation, especially in risky businesses such (p. 356) as banks. But it must be recognized that in many other one-tier board countries, the risk and control problems of banks can also be dealt with without such a mandatory separation, since the one-tier board is flexible by nature and can be adapted to various demands.⁹⁷

11.43  Today most banks belong in some way or another to a group, very often an international group. While legal theory upholds the principle of separate entities, the risks undertaken within the group—either by the parent bank or by the subsidiary bank—may affect the whole group. While this is also the case for general groups, it is even more so for financial groups since they depend much more on confidence and reputation. Therefore, the board of the parent company has the overall responsibility for adequate corporate governance across the group.⁹⁸ This group-wide responsibility of the board for corporate governance is complemented by a group-wide responsibility for risk management.⁹⁹ Yet it must be seen that this postulate, as sound and indispensible as it is, is faced with many technical legal problems due to the entity principle, which separates the rights and duties of each legally independent entity. The Basel Committee acknowledges this by this prudent formulation: ‘[T]he board of the parent company should:…have appropriate means to monitor that each subsidiary complies with all applicable governance requirements’.¹⁰⁰ These difficulties concern the realization of a group-wide internal corporate governance¹⁰¹ as well as the group-wide audit¹⁰² and the group-wide supervision.¹⁰³ These difficulties are mirrored by the responsibility of the board of a bank subsidiary. While this board should follow the group-wide corporate governance standards, it has its own responsibility to the subsidiary for the legality of the measures and the management and financial health of the subsidiary.

11.44  The monitoring task of the board is made more difficult if the bank structure is complex and opaque. This concern is acute as quite a number of bank failures before and during the financial crisis have evidenced. While it seems to be a truism to require the board to know the bank structure, there is unfortunately good (p. 357) reason for the Basel Committee to lay this down in a separate principle: ‘Know your structure’.¹⁰⁴ Streamlining the structure of the bank would certainly be better, but as the Basel Committee acknowledges, in multinational banking in particular there are many legal, tax, economic, and political reasons for complex structures, such as special purpose vehicles, for example. The Basel Committee therefore requires only that the board be aware of all the complexity: ‘Understand your structure’.¹⁰⁵ This should go together with disclosure and transparency.¹⁰⁶

11.45  Risk responsibility is the board’s main task, and it implies risk management and internal control.¹⁰⁷ This has consequences for the organization of the board, the organization of management, and the risk management and internal control as such.

11.46  For the board, the question is whether—apart from the normal three committees—a special risk committee should be created. By the end of 2008, 52 per cent of the 25 largest European banks possessed a stand-alone risk committee—ie not just a combined audit and risk committee—but no correlation was found between such a committee and crisis avoidance.¹⁰⁸ Sometimes in addition to the board risk committee, a separate risk management committee is created with members from across the firm.¹⁰⁹ The Walker Review holds that the FTSE 100 listed bank or life insurance companies should establish a board risk committee that is separate from the audit committee.¹¹⁰ The Basel Committee is more careful, stating that for many banks, especially those that are large and internationally active, a board risk committee is ‘appropriate’.¹¹¹

11.47  In addition, there seems to be a consensus that an independent risk management function should be created within the management of banks.¹¹² The best (p. 358) solution is a chief risk officer (CRO),¹¹³ ie a central risk management function that is responsible for all the bank’s principal risks. As late as 2007, a CRO was on the board of only one of the 25 largest European banks.¹¹⁴ Independence of the CRO is key. This means that the CRO should be an executive officer who is embedded but independent of the line businesses, specifically the profit centres; therefore, the CRO is to a considerable extent also independent of the CEO.¹¹⁵ In principle, there should not be dual-hatting, ie the COR, CFO, chief auditor, and other senior management should not simultaneously fulfil the function of the CRO.¹¹⁶ There should also be special safeguards concerning the removal of the CRO, ie consent of the board and public disclosure in general.¹¹⁷ Quick and direct information flow is essential.¹¹⁸ The CRO should have a direct reporting line not only to the CEO or CFO, but also to the board or the board risk or audit committee with direct access to the chairman of the committee if needed.¹¹⁹ The Basel Committee also recommends that the non-executive directors have the right to regular meetings with the CRO in the absence of senior management.¹²⁰ Since the board normally gets its information from the CEO and, with the CEO’s help, from other management, in order to avoid distrust it is recommended that the contacts of the CRO with the board be documented.¹²¹

11.48  Regarding risk management and internal control as such, there are detailed descriptions and recommendations in the various codes, reports, and comments.¹²² This is not the place to get into this here. Engaging in new risks as well as not paying attention to creeping risks is particularly dangerous. There is also the timely warning against excessive reliance on risk models without adequately questioning the assumptions and neglecting other scenarios, in particular embedded assumptions, (p. 359) and against the danger of credit ratings and externally purchased risk models.¹²³ Overconfidence in ‘star employees’¹²⁴ is rightly mentioned, too. New products may involve new risks, and the risk structure of the clients may also present a danger to the bank.¹²⁵ The complex or opaque structures mentioned previously also contribute to this, in particular those in bank groups and multinational banks. Risks must be identified and monitored on an ongoing, firm-wide, and individual entity basis, and there must be no ‘organizational silos’.¹²⁶

11.49  At the end, what counts is the development of a culture of risk awareness that comprises the internal pricing of the risk, defines the risk appetite, and implements this through well-established risk management throughout the whole bank and bank group in an integrated effort of the different functions of risk management, internal control, and compliance.¹²⁷ Whether all this really works depends to a considerable degree on the ‘tone at the top’, and this leads us back to the beginning: risk responsibility is a main task for the board.

11.50  In the preceding section, supervisory law requirements for board and bank structure and internal procedures were examined. Many of them were particular to banks and financial institutions. In the following section, the supervisory law requirements for people are analysed, primarily concerning the board but also the management, the blockholders, and, at least regarding remuneration, particular groups of employees even underneath the top management. While most of these requirements are not relevant only for banks, their specific feature in the context of banks is that they do not only result from general corporate law but are taken up and implemented by bank supervisory law. Legally speaking, this gives them not only the character of public law rules with consequences for the competent courts in the case of dispute and law suits, but it adds a most important enforcement dimension that is lacking for the corporate governance of firms generally.

11.51  Since the board is the key organ with the overall responsibility for the bank’s corporate governance,¹²⁸ the profile and practices of the bank board are paramount. While the election of the board of the firm is a matter only for the shareholders (with the exception of labour representatives in case of labour codetermination), for bank board members the banking supervisory agency has the right to approve the (p. 360) election or, under certain circumstances, to relieve them of office. The supervisory agency screens bank directors under a fit and proper test,¹²⁹ and it takes this much more seriously now than before the financial crisis.

11.52  Conflicts of interest and independence of board members of the firm have been considered particularly important in recent years, not only for firms but also for banks.¹³⁰ Apart from independence requirements for certain board members and for board members of the three key committees (nomination, remuneration, and audit, with at least a majority of independent directors in the latter) in many states’ company law, stock exchange rules, and corporate governance codes, such principles also exist specifically for bank boards. According to the Basel Committee, the board should have a formal written conflict-of-interest policy and an objective compliance process for implementing this policy.¹³¹ In the Green Paper of the European Commission on corporate governance of financial institutions, the question of conflicts of interest is mentioned prominently with the obvious intention of going beyond the existing European rules, such as in the MiFID and other directives.¹³² The Swiss Banking Authority requires that at least one-third of the bank board members must be independent.¹³³ The audit committee should be composed exclusively of non-executive or supervisory directors, and at least a majority of its members should be independent.¹³⁴ Yet national and international rules differ widely on the meaning of independence.¹³⁵ There are particular differences of opinion as to whether representatives of a controlling shareholder or of labour under labour codetermination may be considered independent. With the two-tier board system, it must be kept in mind that the incompatibility of seats both in the management and the supervisory board is not the same as independence.

11.53  A special concern that first arose in the United Kingdom is the separation of the positions of CEO and chair of the board. In some countries, such as Germany, there is even a mandatory two-year waiting period before the chair of the board or another board member may be elected to the supervisory board, unless the election is on the application of more than 25 per cent of the shareholders.¹³⁶ The Basel Committee expresses a similar concern, though it is rightly more flexible than (p. 361) the German mandatory solution.¹³⁷ Empirical studies have found that when the former CEO held the position of board chair, performance was better.¹³⁸

11.54  The qualification of board members, and particularly bank board members, has always been on the agenda. Yet after the financial crisis and the bad experiences with bank boards, the pendulum has swung towards more qualification. The primordial relevance of qualification is underlined by Principle 2 of the Basel Committee and the following requirement: ‘The board should possess, both as individual board members and collectively, appropriate experience, competencies and personal qualities, including professionalism and personal integrity’.¹³⁹ While there is no necessary trade-off between independence and competence,¹⁴⁰ it may well be that there are cases in which qualification may be more important than independence, since independent directors lack information.¹⁴¹ During the financial crisis, banks receiving bail-out money had boards that were more independent.¹⁴² Particular problems arose at state-owned banks such as the German Landesbanken, where in general the directors were less qualified than their colleagues in non-state-owned banks. Empirical studies found a clear correlation between less qualification and more financial difficulties.¹⁴³ According to the former chairman of the CEBS, independent directors should not only be independent but first and foremost knowledgeable; more insiders on the board (including the former CEO) might also contribute to better performance, as empirical evidence suggests; and fully independent boards may even be dangerous.¹⁴⁴ At least the chair should be reserved for financial industry experts since there is a clear positive relationship between the financial industry expertise of the chair and bank performance.¹⁴⁵

(p. 362) 11.55  This shows a need for better qualification¹⁴⁶ and more professionalization of bank non-executive directors,¹⁴⁷ according to some even for more full-time non-executive board members for bank boards, and for more training of directors for the job and continuing training, especially in banks.¹⁴⁸ More and better evaluation is also needed. In this context, a shift from internal self-evaluation to external, independent evaluation can be observed more generally.¹⁴⁹ As the Basel Committee put down in its Principle 2: ‘Board members should be and remain qualified, including through training, for their positions’.¹⁵⁰

11.56  In the discussion, the appropriate profile and practices of the bank board are at the forefront. But it should not be overlooked that the profile of the bank management is most important as well. In the two-tier board system, this concerns the management board; in the one tier-board systems it concerns the top managers and senior management. The latter are explicitly mentioned in many of the reports. The Basel Committee, for example, holds in its Principle 5 that ‘[u]nder the direction of the board, senior management should ensure that the bank’s activities are consistent with the business strategy, risk tolerance/appetite and policies approved by the board’.¹⁵¹ Accordingly, senior management should have the necessary experience, competencies, and integrity for their job.¹⁵² Particular functions embedded in the management—such as the chief risk officer, the chief compliance officer, the head of internal control and of internal auditing, and others—have been treated above as parts of good corporate governance of banks. The board has a particular responsibility for the selection, control, and succession planning concerning bank management.¹⁵³

11.57  Controlling shareholders and blockholders must not be forgotten.¹⁵⁴ It is already part of supervisory law in banking¹⁵⁵ and insurance supervision that they must (p. 363) be fit and proper or—in the words of the EU banking law directive—suitable; in addition, the supervisory agency has to examine their suitability and, if the case warrants, may refuse to grant authorization to the bank and block the transaction. They are important actors in the corporate governance of firms and banks.¹⁵⁶

11.58  Selecting the right persons as directors and imposing duties and liabilities on them is the traditional way of the law. But finding the right incentives, or at least eliminating bad incentives, may be more effective in the end. Remuneration is one example of this. Remuneration of directors has become one of the major topics of corporate governance of firms in many countries, and it is a concern and an area of its own well beyond corporate governance. This has been partly driven by a corporate governance concern, but also by more distant motivations such as envy and the (legitimate) fear that too great disparities between management and labour may endanger peaceful co-existence in modern, transparent societies.¹⁵⁷ There are a host of new rules on the national and European levels on remuneration in banks concerning, for example, the ratio of fixed to variable pay, deferral, potential clawback of annual bonuses, and more generally the need for risk-adjusted performance measures.¹⁵⁸ The Guidelines on Remuneration by the Committee of European Banking Supervisors of 2010 comprise 86 pages.¹⁵⁹ There is also important theoretical and empirical research.¹⁶⁰ This is not the place to get into this discussion. Instead, the point here is simply to underline that remuneration systems contribute to bank performance and risk-taking. In addition, remuneration of the board—as in the general discussion of corporate governance of the firm—but also and especially of senior bank employees and particularly in investment banking of the (p. 364) lower rank as well can set wrong incentives and should be aligned with risk. The Basel Committee has condensed this concern into two principles for board and employee remuneration: remuneration must be aligned with the risk, and there must not be a remuneration incentive to generate short-term revenues while taking on high long-term risk.¹⁶¹

11.59  The conclusion of this stocktaking is sobering but not outright disappointing. The hope to avoid bank crises is futile, as the ever-recurring bank failures and scandals throughout history have amply shown. But good bank governance may contribute to reducing the danger of bank crises. Unfortunately, it is not only uncertain how strong the inverse correlation of good corporate governance for banks and bank crises is; there is also no single safe way to ensure good corporate governance of banks. Instead, what we have found is a toolbox of measures from which a selection must be made. What matters is the combination. While UK-style ‘light touch regulation’ rightly gained a negative meaning during the financial crisis, in the aftermath of the financial crisis there is a danger of applying too many of these tools. Any of these tools, applied cumulatively and too strongly, could lead to the danger of overregulation. What is needed is a careful mix of mandatory and fall-back rules and soft law under the shadow of supervisory law. The old wisdom that disclosure and transparency is the least intrusive and nevertheless often very effective regulatory measure is still true,¹⁶² and even though reregulation as compared to the status before the financial crisis is unavoidable, the best way of regulation is co-regulation.¹⁶³

11.60  While after the financial crisis there is a certain tendency to overregulation in banking, there is another even more serious danger—namely, the spillover of banking regulation and bank governance to the general corporate governance of firms.¹⁶⁴ Many recent reforms and reform proposals for corporations and general corporate governance have their origin in bank and financial regulation. Examples are the requirement of risk management, the need of having at least one independent director in the supervisory board with special knowledge of accounting or (p. 365) auditing, increased demands for the qualification of directors, remuneration, and conflicts of interest. This is not to say that corporate law reform in these examples is ill-taken, but it must be remembered that banks (as well as insurance and other regulated industries) are special and that their corporate governance is also unique. It is dangerous if the financial crisis is taken as the basis for statements claiming that ‘[b]oth financial and non-financial companies face a similar range of risks…’¹⁶⁵ and for the establishment of principles, recommendations, and requirements for corporate governance reform without distinguishing clearly between the two. The UK Financial Reporting Council was fully right in not taking up all the recommendations of the Walker Review, which were developed for the financial industry entities.¹⁶⁶ ‘Invisible hands’ is not a stale concept, and this remains true even after the financial crisis. The state is not better than the markets in forecasting and discovering. Its task is and should remain to set the rules of the game and to interfere only where there are market failures. Corporate governance of banks must remain part of the special rule-setting for the game on the financial markets.¹⁶⁷

11.61  Corporate governance is the system by which companies are directed and controlled (Cadbury). This concept is also appropriate for banks. Yet for banks, the scope of corporate governance goes beyond the shareholders (equity governance) to include debtholders (debt governance).

11.62  For firms, both internal and external corporate governance are relevant. From the perspective of bank supervision, internal governance of banks is at the centre stage. External corporate governance, in particular by the market of corporate control, is more important for firms than for banks, at least under continental European practice.

11.63  Not only banks are special. Sector-specific corporate governance and governance codes also exist for family enterprises, public enterprises, and non-profit organizations. Specific corporate governance needs exist not only for banks, but also for insurance companies and other financial institutions. All players in the financial (p. 366) markets must be supervised, though not necessarily regulated. For some, mere disclosure may suffice, at least initially.

11.64  Whether failures in the corporate governance of banks were a major cause of the financial crisis is highly controversial. The fact is that there were wrong incentives inspired by compensation practices, deficiencies in board profile and practices (especially but not exclusively in state-owned banks), and risk management and internal control failures. This was exacerbated by complex and opaque bank structures. While these deficiencies did play a certain role, there were many other and more important causes that led to the financial crisis.

11.65  Equity governance and debt governance face partly parallel and partly divergent interests of management, shareholders, debtholders, and supervisors. Management tends to be risk-averse for lack of diversification, but may be more risk-prone because of equity-based compensation, in end games and under similar circumstances. Shareholders are risk-prone and interested in corporate governance. Debtholders are risk-averse and interested in debt governance. Supervisors are risk-averse and interested in maintaining financial stability and in particular in preventing systemic crises.

11.66  Deposit insurance and bail-out have an ambiguous role. Both encourage undue risk-taking and free-riding, but they are indispensible for depositor protection and mastering systemic crises. This trade-off requires careful balancing. Whether this succeeds depends on the details and the concrete situation.

11.67  Corporate law reforms are less suited for bank governance. Labour codetermination in the board does not benefit debtholders. Representation of the debtholders or of the deposit insurers in the board is also of doubtful use. Particular problems exist in state-owned banks. Directors of firms and banks already have far-reaching duties and liabilities under the present law. The problem is rather enforcement. Enforcement is being stepped up in the wake of the financial crisis.

11.68  Strengthening supervisory law requirements is more promising. Regarding board and bank structure, prominent proposals include the following: clearer separation of the management and control function by a two-tier board, as in Switzerland and Belgium; establishment of a separate risk committee of the board or an independent CRO; dealing with the problem of complex or opaque bank structure; and group-wide corporate governance in single entities as well as in the bank group.

11.69  Appropriate supervisory law requirements are needed for bank-internal procedures, specifically for risk management, internal control and compliance, and internal (p. 367) and external auditing. Facilitating the exercise of shareholder rights can be left to the corporate governance of the firm.

11.70  In the end, everything depends on the people. Supervisory law requirements need to address foremost the profile and practices of the board. The traditional wisdom of corporate governance of the firm is to have independent non-executive directors (NEDs). Yet the experience of the financial crises and recent empirical studies show that qualification and experience of bank board members is at least as important, if not more important. This has been demonstrated particularly in the failures of state-owned banks. Professionalization, continuous formation, and external evaluation are therefore important desiderata to be monitored and enforced by bank supervision.

11.71  In addition, fit and proper tests for the management and major shareholders of banks are useful. So are appropriate incentives and the elimination of negative incentives, in particular as far as compensation of the board, the management, and key personnel is concerned. Among them are more long-term orientation and share-holders’ say on pay. Numerical limits for compensation may—or may not—save taxpayers’ money in the case of state-assisted banks.

11.72  There is growing concern that the severe requirements of bank regulation and bank supervision will spill over to the corporate governance of the firm. It is true that there is such a phenomenon in relation to risk-prevention standards, requirements on the profile and practices of the board and compensation. Yet general supervision of corporations is out of question, apart from the already-existing securities markets supervision, and a more general spilling over of bank governance requirements to the general firm would lead to overregulation and impair the fair play of the market.