META-CONTRACTS, CORPORATE
GOVERNANCE, AND BANK REGULATION
Alan D. Morrison∗
May 2012
The financial crisis of 2007-09 was interpreted by many as evidence that unregulated markets do not stabilise themselves. As a result, there are widespread calls
for more intrusive rule-making to reform the governance of banking firms. But the
contractarian model of the firm, which remains the workhorse of corporate analysis
in the law-and-economics tradition, does not identify a purposive role for the State in
the corporate governance. We therefore lack a consistent theoretical framework within
which to justify and to analyse regulatory proposals. Without such a framework it
will be difficult to frame a coherent regulatory response to the financial crisis.
This Article refines the nexus-of-contracts model of the firm to provide a framework within which regulatory interference in corporate governance can be legitimised,
and against which policy suggestions can be analysed. It characterises the agreements that investors have with firms as “meta-contracts,” comprising a black-letter
agreement about the division of the firm’s returns, and also an understanding as to
the nexus-of-contracts that the firm will create. The Article characterises “corporate
governance” as the set of formal and informal arrangements that ensure compliance
with the meta-contract. In industries that have a reasonable expectation of State
support, such as banking, the State has a legitimate role in the negotiation of the
meta-contract, and, hence, in the design of governance structures.
The Article uses the meta-contractual framework to perform a careful analysis of
existing governance structures in the financial sector. Precisely because the possibility of State support for the financial sector is reflected in security prices, managers
and shareholders have a common interest in assuming risks at the expense of the
tax payer. Governance rules that strengthen shareholder power cannot address this
problem; nor can risk management technologies designed for shareholder reporting.
Hence, new initiatives in financial sector governance should either reduce the likelihood of State support, or should slightly alter managerial incentives so as better to
reflect taxpayer interests. The Article concludes that this could be done most effectively through legislation on the size of banks, through changes to capital regulation,
and possibly via compensation policies.
Table of Contents
I.
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
II.
Meta-Contracting and Corporate Governance
A. Meta-Contracts and the Real Nexus . . . . . . . . .
B. Meta-Contracting and the State . . . . . . . . . . .
C. Traditional Modes of Corporate Governance . . . .
∗
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
2
5
5
8
11
Saïd Business School and Merton College, University of Oxford. Earlier drafts of this Article were
presented at the University of Oxford Centre for Socio-Legal Studies, the Bank of England, and an Economic
& Social Research Council/Knowledge Transfer Network/National Institute of Economic and Social Research
seminar in London, UK. I am grateful for comments from seminar participants, and in particular from
Laurence Lustgarten.
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
III. Corporate Governance in Financial Firms . . . . . . . . . . . . . . . .
12
.
.
.
.
.
.
.
.
.
.
.
.
15
15
16
18
20
21
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
23
24
26
28
32
33
35
37
VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
39
IV. Structural Problems With the Governance of Financial Firms
A. Fiduciary Responsibilities in Banking . . . . . . . . . . . . . . . . . . .
B. Compenation Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. Bank Scale and Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. Bank Complexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
E. Epistemological Misconceptions . . . . . . . . . . . . . . . . . . . . . . .
V.
Re-Thinking the Governance of Financial Firms
A. Moral Codes and Fiduciary Responsibilities . . . . . .
B. Managerial Compensation . . . . . . . . . . . . . . .
C. Shareholder Liability . . . . . . . . . . . . . . . . . .
D. Scope Restrictions in Banking . . . . . . . . . . . . .
E. Scale Restrictions in Banking . . . . . . . . . . . . .
F. Resolution Processes . . . . . . . . . . . . . . . . . .
G. Capital Adequacy and Corporate Taxation . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
I. Introduction
The financial crisis that began in 2007 exposed failings in the regulatory and governance
mechanisms that underpin financial markets around the world.1 Despite a large and complex body of international capital adequacy regulations,2 founded upon a set of apparently
sophisticated models of risk,3 it seems clear that supervisors failed adequately to measure
the systemic component of bank risks. At the same time, bankers had strong incentives to
manage their businesses so as to create those risks.4
Policy-makers and regulatory agencies responded to the information revealed by the
crisis by calling for an overhaul of bank governance and of bank regulation.5 But much of
the recent rhetoric on these subjects misses the point. For example, the Basel Committee
1
See, e.g., The Financial Crisis and the Role of Federal Regulators: Hearing Before the H. Comm. on
Oversight and Gov’t Reform, 110th Cong. 12 (2008) (statement of Alan Greenspan, former Chairman, Bd.
Governors of Fed. Reserve System) (testifying that “ those of us who have looked to the self-interest of lending
institutions to protect shareholders equity, myself especially, are in a state of shocked disbelief.”), and Grant
Kirkpatrick, Org. for Econ. Co-Op’n and Dev., The Corporate Governance Lessons From
the Financial Crisis 2 (2009), available at http://www.oecd.org/dataoecd/32/1/42229620.pdf (arguing
that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate
governance arrangements.”).
2
See infra notes 88-93.
3
See infra notes 94-101.
4
See infra text accompanying note 59.
5
See, e.g., Int’l Monetary Fund, The Recent Financial Turmoil – Initial Assessment, Policy Lessons, and Implications for Fund Surveillance 4 (Apr. 2008), available at http://www.imf.
org/external/np/pp/eng/2008/040908.pdf (stating that “supervisors have an important role in pressing for
higher quality of risk management and governance in regulated firms”) and Working Grp. on Corp. Gov.,
Grp. of Thirty, Toward Effective Governance of Financial Institutions 11 (Apr. 2012), available at http://www.group30.org/images/PDF/TowardEffGov.pdf (arguing that an excessive reliance upon
self-governance in financial firms was a contributory factor in the financial crisis).
2
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
on Banking Supervision recently opened its Principles for Enhancing Corporate Governance
by citing the OECD’s statement that “Good corporate governance should provide proper
incentives for the board and management to pursue objectives that are in the interests of
the company and its shareholders and should facilitate effective monitoring.” 6 But, if this
is all that corporate governance entails, one can rely upon market participants to provide it
without the intervention of a third party. A serious discussion of rule-making in corporate
governance should rest upon firmer foundations than the OECD’s statement.
It is hard to create a useful framework within which to evaluate rules for the governance
and regulation of financial firms, not least because the meaning and purpose of “corporate
governance” are contested. Some argue that corporate governance is concerned solely with
the maximisation of shareholder value; others take a broader perspective, and argue that
corporate governance should serve the needs of a broader set of constituencies, extending
beyond the formal boundaries of the firm into the broader community. As a result, arguments
about policy and law in this field are sometimes reflect disagreements as to the subject matter
under discussion. It is impossible to make progress in this field without a clear conceptual
analysis of corporate governance that is founded upon clearly stated normative assumptions.
This Article attempts to provide such an analysis, and to build upon it a framework for
analysing and formulating corporate governance policy as it relates to banks.
The analytic framework employed in this Article is contractarian. This approach builds
upon clear normative assumptions. In particular, the arguments that I deploy start from the
position that individuals are free to determine their own conception of the social good, and
that contractual commitments into which they enter of their own volition define that good.
In line with the contractarian tradition in the economics and law of the firm, I view the firm
as a device for creating complex contractual commitments, some of which could not be made
using black-letter corporate law.7 Hence, I analyse the firm as a nexus-of-contracts. Provided
participation in the corporate nexus is willing, I argue that the law has a facilitative role in
creating the nexus, rather than a purposive role in shaping its activities.
I argue that the corporate nexus-of-contracts can be viewed as comprising two elements:
a real nexus, comprising the relations that the firm facilitates between the participants in
the real economy, and a meta-contract, which is the agreement that investors have with
the agents who will run the real nexus. The meta-contract comprises a black-letter legal
statement about the investors’ claims upon the returns generated by the real nexus, and also
a statement about which real nexus the firm will operate. The latter statement is critically
6
Basel Comm. on Banking Supervision, Principles for Enhancing Corporate Governance
1 (Oct. 2010), available at http://www.bis.org/publ/bcbs176.pdf (citing Org. for Econ. Co-Op’n and
Dev. (OECD), Principles of Corporate Governance 11 (2004), available at www.oecd.org/dataoecd/
32/18/31557724.pdf)
7
That many of the contract-like agreements in corporations are tacit in nature, and are unenforceable
in court, is now well-understood. Stewart Macaulay’s landmark study of contractual relations between
Wisconsin companies provided an early demonstration of the importance of non-legally binding commitments
in business life: see Stewart Macaulay, Non-Contractual Relations in Business: A Preliminary Study, 28
American Sociological Review 55 (1963). For example, Wisconsin companies frequently committed
themselves to legally unenforceable requirements contracts; none of the people he quizzed believed that the
lack of legal sanctions was important. Id., at 60. The subsequent literature on this topic is vast: see, e.g.,
Lisa Bernstein, Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry,
21 J. Legal Std. 115 (1992) (demonstrating that most exchange in the diamond industry relies upon extralegal commitments); Lisa Bernstein, Provate Commercial Law in the Cotton Industry: Creating Cooperation
Through Rules, Norms, and Institutions, 99 Mich. L. Rev. 1724 (2001) (exhibiting the importance of tacit
agreements in the cotton industry).
3
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
important, as it is the primary determinant of the returns that will accrue to investors, but it
is impossible to codify it in a black-letter contract. Hence, investors and the firm’s managers
rely upon a collection of formal an informal procedures, some supported by the formal law
and some entirely tacit, to create and enforce the meta-contract. It is these procedures to
which this Article refers when it discusses “corporate governance.”
The contractarian framework is generally regarded as sympathetic to the free market.
Nevertheless, a formal role for State intervention in the corporate governance of financial
firms emerges naturally from the analysis of this Article. This role arises because, as witnessed by the events of 2007-2009, large financial firms receive State support at times of
general financial stress. The reasons for this support are partly political and partly economic. But, so long as the State is believed to stand ready to support fragile financial firms,
it is a de facto investor in large financial firms. The contract that it supports is therefore
valid in a contractarian framework only if the State’s participation is willing. It follows
immediately that the State has a legitimate voice in the financial firm’s meta-contractual
negotiations; in other words, in its corporate governance.
This argument gives a new rationale for formal rule-making in corporate governance.
Under this rationale, rules prescribing corporate governance arrangements are legitimate
precisely when they resolve at the lowest cost the inefficiencies that would arise absent the
State’s participation in meta-contracting. Hence, this theory may justify scale or scope restrictions in banking, but it does not legitimise corporate governance rules created in pursuit
of an industrial policy or a programme of wealth redistribution; I argue that arguments for
such rules lie outside the ambit of the law and economics approach to corporate governance.
The most important corporate governance problem in the banking sector is the lack of
voice for the State in meta-contracting. The consequence of this silence is that investors and
managers are free to collude (possibly tacitly, and perhaps even unconsciously) to maximise
the present value of State support. This problem appears largely to have been ignored
in recent corporate governance policy statements, which sometimes go so far as to make
the misguided claim that increasing shareholder control over banks will reduce corporate
governance problems. Increasing control rights in this fashion will serve only to render
collusion against the State.
This Article identifies two broad approaches to governance problems in the financial
sector. One is to find a credible way to withdraw State support from banks. In practice,
this is probably close-to-impossible for large and complex banks. The natural conclusion is
therefore that banks should be smaller and less complex. At the least, investors should be
more exposed to losses through higher capital requirements. Adopting any of these policies
would serve to reduce the State’s support for the banking sector. It is therefore unsurprising
that the banking lobby has expressed strong opposition to all of them.
The second approach to governance problems is to force bankers to bear more of the costs
of failure, and for the State to exercise some measure of control over the actions of bankers,
precisely as shareholders and other investors do in all firms, both financial and non-financial.
The former approach is complex and may be administratively impossible; the latter, at least,
is politically feasible. But it is subject to capture by special interest groups; for this reason,
any changes to the prudential supervision regime should be carefully evaluated against the
meta-contractarian framework introduced in this Article.
The rest of the Article is laid out as follows. In Part II, I present a discussion of the
contractarian theory of the firm, and I explain the the special role of financial contracts in
4
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
that theory. This provides a framework within which I define corporate governance, and
I discuss traditional approaches to corporate governance and the role of corporate law in
light of that definition. In Part III, I discuss the special features of corporate governance
in financial firms; I show that these justify the micro-regulation of banks, which I argue is
synonymous with the regulation of bank corporate governance. Part IV presents a discussion
of problems with current approaches to the corporate governance of financial firms in light
of the foundations developed in Parts II and III. Part V discusses reforms to financial firm
governance, and Part VI concludes.
II. Meta-Contracting and Corporate Governance
A. Meta-Contracts and the Real Nexus
The economic theory of the firm is a large and nuanced literature. A common thread in the
literature is a vision of the firm as a nexus-of-contracts . This term is widely used in the
law and economics literatures, and has more than one interpretation.8 I therefore begin by
outlining the conception of the nexus-of-contracts theory that I employ in this Article.
Consider an entrepreneur who wishes to raise financial capital in order to pursue a perceived opportunity in, for the sake of argument, a commodities business. The entrepreneur
has in mind arrangements by which raw commodities will be sourced and by which their
quality will be assessed. Hence, she envisages a set of complex relationships with a variety
of commodity producers, and she expects to create relationships with commodity buyers in
a particular geographical area, and in specific market segments. She understands the regulatory implications of her business idea; she knows the types of employees she will need,
and the business relationship that she will have with those employees. The combination of
these and other relationships comprise the nexus-of-contracts that will be her business. Of
course, the constituents of the nexus-of-contracts need not be formal contracts under the
black-letter law.9 For example, she may plan to make commitments concerning the quality
8
The contractual tradition in the theory of the firm builds upon the insights of Ronald H. Coase, The
Nature of the Firm, (n.s.) 386 Economica (1937), noting the distinction between the arm’s-length interactions of the broader marketplace, and those of the firm, which are not intermediated by price. In later,
seminal, work, Professor Coase again stressed the importance of bilateral negotiation and bargaining in the
institutions that support a market economy: see Ronald H. Coase, The Problem of Social Cost, 3 J. L. &
Econ. 1 (1960). The importance of the corporation as a basis for such bargaining was identified in Armen
A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62 Am. Econ.
Rev. 777 (1972); the phrase “nexus-of-contracts” is due to Michael C. Jensen & William H. Meckling, Theory
of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. Fin. Econ. 305 (1976).
The economic and legal literature inspired by these developments is too vast comprehensively to cite here.
For a careful review of the impact of Coase and subsequent thinkers upon the theory of the firm, see Thomas
S. Ulen, The Coasean Firm in Law and Economics, 18 J. Corp. L. 301 (1992-1993). William W. Bratton, Jr., The “Nexus of Contracts” Corporation: A Critical Approach, 74 Cornell L. Rev. 407, 417, 420
(1988-1989) distinguishes between a “neoclassical” version of the nexus-of-contracts theory, characterised
by rational self-interested actors who engage in bilateral contracts through the firm, which thus emerges
as a spontaneous order (id., at 440) as propounded by 1 Freidrich A. Hayek, Law, Legislation and
Liberty: Rules and Order 11 (1973), and an “institutional” version, due to Oliver Williamson, The
Economic Institutions of Capitalism: Firms, Markets, Relational Contracting 294-297 (1985),
which recognises limitations to the cognitive abilities of economic actors, and which stresses the importance
of relationships and institutions. The latter approach is closer to the one adopted in this Article, which relies
upon contractual incompleteness to explain the institutional content of corporation governance, although it
does not require that economic actors be boundedly rational.
9
See note 7, supra.
5
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
of the service she provides and the working conditions of her employees; equally, the moral
stance she adopts in managing her supply chain may be a critical attraction for her customers. Tacit commitments of this type cannot be enforced through the formal law, and yet
one could argue that a primary rationale for the corporate nexus-of-contracts is in creating
and enforcing tacit commitments.10
The nexus-of-contracts that I have described deliberately excludes the entrepreneur’s
sources of financial capital. As presented here, the nexus describes only the entrepreneur’s
relationship to the real economy and, for convenience, I will refer to it as the entrepreneur’s
real nexus. The real nexus is the means by which the entrepreneur generates social value and,
hence, is the firm’s rationale. But it cannot exist without the willing ex ante participation of
a financier. The entrepreneur achieves this by writing a financial contract under which she
promises to execute the real nexus, and to pay to investors a share of the financial returns
that the real nexus will generate if it succeeds.11
The financial contract between the entrepreneur and the investor therefore has two components. First, it requires an explicit exchange of investment funds now for a stream of
well-defined but uncertain future cash flows. Second, it incorporates an understanding as
to which real nexus the entrepreneur will run. That is, it includes an agreement over the
contractual relationships into which the entrepreneur will enter after financing has occurred.
The financial contract is antecedent to all of the other contracts, none of which can be written
without the willing participation of a financier. Hence, one can think of the financial contract
as a meta-contract, whose most important stipulations are not the formal ones concerning
cash flow division, but the ones that sanction the entrepreneur’s creation of other contractual
relationships, both formal and tacit. The textbook nexus-of-contracts is the combination of
the meta-contract and the real nexus.
In a world without contracting frictions, the entrepreneur would simply write a blackletter meta-contract promising to execute a particular real nexus. Her business plan would
succeed or fail for reasons outside her control, and the investors would be paid accordingly.
But, in practice, a formal and court-enforceable meta-contract is an impossibility. First, as I
indicated at the start of this Part, the agreements that form the contractual nexus are often
tacit, reputational, and cultural, precisely because it is impossible to document and enforce
them. For the same reasons, it is impossible to document every element of the contractual
nexus in the financial contract. Second, many aspects of economic life are discovered, not
planned.12 The entrepreneur may learn through experience that some types of business
10
See, e.g., Edward B. Rock & Michael L. Wachter, Islands of Conscious Power: Law, Norms, and the
Self-Governing Corporartion, 148 U. Pa. L. Rev. 1919, 1622 (2000-2001) (arguing that “the raison d’être of
firms is to replace legal governance of relations with nonlegally enforceable governance mechanisms”); Alan
D. Morrison & William J. Wilhelm, Jr., Reputation and Trust in Financial Contracts (2012) (unpublished
manuscript) (on file with author) (discussing the role of reputation in sustaining tacit agreements in the
banking sector).
11
Hence, for example, a debt contract promises to make fixed payments on given dates from the cash
flows generated by the real nexus, while an equity contract promises those residual cashflows that have not
been sold to another investor.
12
The fact that there are limitations to planned economic activity is a central tenet of the Austrian School
of economics: see, e.g., Friedrich A. Hayek, The Use of Knowledge in Society, 35 Am. Econ. Rev. 519 (1945);
see also Friedrich A. Hayek, Competition as a Discovery Procedure, in New Studies in Philosophy,
Politics, Economics and the History of Ideas 179 (1978). This idea has been widely deployed in the
management literature: see Henry Mintzberg, Crafting Strategy, Harv. Bus. Rev. (arguing that business
strategy emerges from market experience and is not planned); Richard T. Pascale, Perspectives on Strategy:
6
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
arrangements are more effective than others, and her real nexus, once created, may generate
business opportunities that neither she nor any of her competitors could possibly anticipate.
Similarly, she may learn that some of the contracts that she expected to execute have little
or no practical value. It is clearly in the best interests of the entrepreneur and her investors
that she respond to new information and to changes in the business environment, but the
relevant contingencies are too complex to document a the black-letter financial contract, and
may even be unknowable ex ante. In other words, the meta-contract is incomplete.13
Given the incompleteness of the meta-contract, any attempt to rely upon an arm’s length
meta-contract must leave the financier exposed to opportunistic entrepreneurial behaviour.
The threat of such behaviour undermines the entrepreneur’s access to finance and, hence,
serves as a drag on economic activity. It is therefore in the mutual best interests of the
entrepreneur and the financier that they find mechanisms that render the meta-contract
credible. I use the phrase corporate governance to refer to the collection of formal and
informal mechanisms that they use. In this Article, corporate governance is synonymous
with meta-contracting. It is relevant precisely because it is impossible to use the formal law
to commit to a black-letter meta-contract.
Some of the techniques of corporate governance use the formal law. Others rest upon
institutional structure, trust, or tacit understanding.14 For example, rather than attempting to create a complete inventory of what the entrepreneur should do, and what contracts
she should write, in every state of the world, corporate governance arrangements frequently
devolve control rights to the agent who has the strongest ex post incentives to ensure that
the ex ante terms of the meta-contract are adhered to. Hence, while managers, who are
better-informed about the firm’s markets, have day-to-day control over the firm’s assets,
shareholders, as residual claimants, have the right to intercede if they believe that managers
are following a private agenda rather than executing the meta-contract. Similarly, bond market investors receive control rights when the firm is financially fragile, because shareholders
and managers have a strong incentive in this situation to gamble for resurrection with the
firm’s assets.15
The discussion thus far has focused exclusively upon the de novo entrepreneur. In this
case both the existence of the meta-contract as the antecedent to everything else the entrepreneur does, and the difficulty of creating and enforcing that contract, are particularly
clear. But the meta-contract can also be used to understand investment in large corporations with a long track record and multiple, dispersed, investors.16 When reasoning about
The Real Story Behind Honda’s Success, 26 Cal. Mgmt. Rev. 47 (1984) (providing a detailed case study
of emergent strategy in the context of Honda’s entry to the US markets).
13
In economics, an incomplete contract is one that is not fully state-contingent. When complete contracts
are impossible to write, the allocation of residual control rights is critical. This observation has been used in
the economics literature to explain the optimal allocation of property rights and the boundaries of the firm:
see Oliver Hart, Firms, Contracts, and Financial Structure (1995), and references therein.
14
For a wide-ranging survey of corporate governance, see Jonathan R. Macey, Corporate Governance: Promises Kept, Promises Broken (2008). For a recent survey of the literature on the corporate
governance of banks, see Hamid Mehran, Alan D. Morrison & Joel D. Shapiro, Corporate Governance
and Banks: What Have We Learned From the Financial Crisis? (Fed. Res. Bank N.Y., Staff Report No.
502, 2011).
15
See Jensen & Meckling, supra note 8 (presenting a theory of excessive risk-taking by shareholders in
fragile firms); Assaf Eisdorfer, Empirical Evidence of Risk Shifting in Financially Distressed Firms, 63 J.
Fin. 609 (2008) (providing evidence that financially distressed firms engage in risk-shifting).
16
The logical step from closely-held firms to joint stock corporations is non-trivial, and is the basis of some
7
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
such a firm we can no longer consider a negotiation between an identifiable entrepreneur
and a single investor. Nevertheless, a larger firm raises funds against a planned nexus-ofcontracts, and the creation of that nexus is impossible without investor agreement, so that
large firm finance still creates a meta-contract. However, in contrast to the entrepreneurial
start-up, the large firm has an observable existing contractual nexus. Moreover, by virtue
of its longer track record and its reputational capital, the larger firm’s actions in undocumented states of the world are easier to anticipate.17 Observability and track-record both
render the meta-contract easier to understand and, hence, easier to create using standardform equity and debt contracts. However, we must weigh two observations against this fact.
First, precisely because they can sustain a more extensive nexus-of-contracts that extends
across multiple counterparties, industries, and jurisdictions, large firms have a far more complex meta-contract than do entrepreneurial start-ups. Second, publicly-quoted companies,
particularly in the UK and the US, do not in general have a dominant investor. As a result,
investor incentives to monitor the execution of the meta-contract are attenuated in public
companies by a free-rider problem.
B. Meta-Contracting and the State
I now turn to the relationship between the firm and the state. This question arises in
two contexts. First, I briefly examine the role of corporate law in the nexus-of-contracts.
Second, I examine the legitimacy of regulation intended to alter the composition of the
nexus-of-contracts.
In identifying corporate governance as a collection of formal and informal mechanisms
for enforcing the meta-contract, I make no judgement as to the appropriate terms of the
meta-contract. If he can find a willing investor, a social entrepreneur is at liberty to create
a real nexus whose goal is to reduce youth unemployment, say, rather than to maximise
shareholder profits.18 In other words, it is incorrect to think of corporate governance merely
as the set of arrangements by which shareholders ensure that the company maximises the
return to their investment,19 although most for-profit companies adopt this as a primary
goal in the meta-contract, and so are held responsible for their ability to meet it. Corporate
goals, as expressed in the meta-contract, vary; the corporate governance procedures that
best enforce the meta-contract are therefore likely to vary, too.
If corporate governance is an enforcement mechanism, rather than a statement-of-purpose,
then the role of corporate law is to facilitate it, rather than to impose a particular normative vision of the corporation.20 That is not to say that the corporation is trivial, or that
criticism of the contractarian view of the corporation. See, e.g., Bratton, supra note 8, at note 219 (stating
that “Close corporations involve private rights based on consensual agreements. On the other hand, the
managers of public corporations do not act on this sort of contractual basis. The certificate of incorporation
here more closely resembles a national constitution.”) This point is important, but I do not address it in this
Article.
17
See, e.g., Morrison & Wilhelm, supra note 10.
18
This remark is subject to the caveat that the real nexus satisfies the legitimate demands of the state,
as outlined infra, text accompanying notes 31-32.
19
For this perspective, see, e.g., Andrei Shleifer & Robert W. Vishny, A Survey of Corporate Governance,
52 J. Fin. 737, 737 (1997) (stating that “Corporate governance deals with the ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment.”)
20
Subject to the legitimate demands of the State: see note 18, supra. A similar argument is advanced
by Rock & Wachter, supra note 10. Professors Rock and Wachter adopt the position that, under the
nexus-of-contracts theory of the firm, “the owner/manager’s contract with the shareholders is assumed to be
8
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
the nexus-of-contracts could exist without the support of corporate law. Moreover, nothing
in the contractarian position I advance requires corporate law to be coterminous with contract law: corporate law can erect the institutional plumbing necessary to a well-functioning
nexus-of-contracts.21
The distinction between meta-contract and real nexus is useful in this context. Corporate
law, as opposed to (say) employment law, is concerned with the creation of a functional metacontract. The meta-contract is not itself codifiable,22 so corporate law creates institutional
structures that facilitate extra-legal agreements over the meta-contract. In particular, it
enables entrepreneurs to package some of the returns from their real nexus with a variety of
control rights in such a way as to render the combination saleable, and tradeable.
For example, corporate law can facilitate meta-contracting by enabling the entrepreneur
clearly to delineate the boundary of the real nexus. This is most obviously achieved via
limited liability, which some authors argue to be non-contractual:23 with limited liability, an
investors’ purchase of future returns has in common with his more mundane purchases (say,
of socks) that the terms of payment are clear and unchanging.24 Several authorities argue
that limited liability is the most important feature of the corporation.25 But limited liability
per se is not the purpose of the corporation, which exists to support complex contractual
and quasi-contractual relationships: rather, limited liability is valuable because it expands
the set of meta-contracts that entrepreneurs and investors can write.
Corporate law also assists meta-contracting by enabling investors to establish property
rights over the bundle of cash flows and control rights that they purchase. That is, as
complete.” Id., at 1629. This is analogous to the neoclassical contractarian position identified by Bratton,
supra note 8, at 417; if this view were empirically correct then there would be no place for meta-contracting.
Rock and Wachter distinguish their position from the neoclassical one in their conclusion that the firm’s
boundary separates legal contracts from “nonlegally enforceable rules and standards” (NLERS); this is similar
to the position of this Article, that the firm exists to support a mixture of legal and extra-legal contractual
agreements. Rock and Wachter do not discuss the privileged position in the nexus of the initial meta-contract,
but their argument that corporate law exists to enable the establishment of NLERS relationships (Rock &
Wachter, supra note 10, at 1653) is close to my contention that corporate law facilitates meta-contracting.
21
Some criticism of the contractarian approach rests upon the apparent belief that it is invalidated by
any non-contractual feature of the corporate form. See, e.g., Grant M. Hayden & Matthew T. Bodie, The
Uncorporation and the Unraveling of “Nexus of Contracts” Theory, 109 Mich. L. Rev. 1127, 1137 (2011)
(claiming that “The role of limited liability has long been a bête noire for contractarians, since it is clearly
an aspect of the corporation that is not contractual.”). One might as well claim that a the necessity of bricks
and mortar to the construction of a library invalidates the position that literature is appreciated in the mind.
22
See supra text accompanying notes 12-13.
23
See id., at 1137. For a dissenting argument, see John Armour & Michael J Whincop, The Proprietary
Foundations of Corporate Law, 27 Oxford J. Legal Stud. 429, 453 (2007) (stating that limited liability is
“best analysed as part of the ‘contractual superstructure’,” and noting that English insurance firms formed in
the first half of the nineteenth century achieved limited liability by inserting standard clauses into contracts).
24
Of course, alternative levels of liability can be wired into the contractual nexus: I discuss some possibilities infra, text accompanying notes 128-151.
25
See, e.g., Roger E. Meiners, James S. Mofsky & Robert D. Tollison, Piercing the Veil of Limited
Liability, 4 Del. J. Corp. L 351, 352 (1978-1979), and references therein. Meiners et. al. argue from the
Coase Theorem (Coase, The Problem of Social Cost, supra note 8) that if limited liability were withdrawn,
creditors would alter their terms of trade accordingly, and that there would be no interruption to the supply
of credit, so that “credit terms are invariant to the legal definition of the firm” (Meiners et al. , supra note 25,
at 361). But this argument assumes that it is easy and cheap for creditors to alter their terms of trade. Coase
argues that institutions matter precisely because such alteration is costly and complex. Hence, if limited
liability is difficult to create through bilateral negotiation, it can be usefully provided through the agency of
the State.
9
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
John Armour and Michael J. Whincop demonstrate, while the content of meta-contractual
entitlements may be established contractually, their scope is established through property
law.26 Closely related to Armour and Whincop’s insight is work by Henry Hansmann, Reinier
Kraakman, and Richard Squire,27 who characterise as “entity shielding” the property of the
corporation that prevents a bankrupt investor’s creditors from reaching through the corporation in which he invested to seize other investors’ assets. This feature is non-contractual,
but it is clearly a necessary precondition for meta-contracting.
Within the contractarian framework of this Article, the State’s involvement in corporate
law does not require the State to take a position on the appropriate content of either the real
nexus or the meta-contract. Indeed, under contractarian theories of the firm, the agents who
deal with one another in a firm have no special State-conferred rights; they simply assert
their individual right to contract, and they need make no contractual commitment to which
they do not consent.28 This is a normative and liberal position, which I have reached from
a starting presumption in favour of freedom of contract, and it is the basis of criticism of
nexus-of-contracts theory that is expertly surveyed by William W. Bratton, Jr.29
However, I shall argue30 that, in fact, the liberal free-market foundations of nexus-ofcontracts theory are not inconsistent with State involvement in corporate governance, although the theory does place clear limits upon the State’s role. The logical route to that
conclusion lies in the distinction between the meta-contract and the real nexus. The entrepreneur is entitled to write into the real nexus whatever contracts are ratified by the
meta-contract. Hence, if the state is to regulate the formation of the nexus-of-contracts,
it must do so by modifying the meta-contract, either on a case-by-case basis, or generally,
through restrictive legislation. The meta-contract reflects a compromise between the demands of the firm’s financiers, without whom it cannot exist,31 and those of the entrepreneur,
who creates and manages the real nexus. All of the corporation’s investors have a legitimate
place at the bargaining table when the meta-contract is formed. Hence, when the state is a
de facto investor in the firm, it has a legitimate role in forming the meta-contract: contrac-
26
See Armour & Whincop, supra note 23, at 443, 444 (arguing that investor entitlements are rights in
rem).
27
Henry Hansmann, Reinier Kraakman & Richard Squire, Law and the Rise of the Firm, 119 Harv. L.
Rev. 1333 (2006).
28
See, e.g., Bratton, supra note 8, at 433.
29
For example, some commentators have argued that the nexus-of-contracts claim is empirically flawed:
See id., at 419 (arguing that the economics of contractarianism “is not the kind that survives successful
testing of falsifiable propositions.”); some claim that corporate contracts rely at least to some extent upon
the state’s agency and the state’s acquiescence: See id., at 462 (stating that “corporate ‘contracts’ are in
large measure positive law constructs”) and id., at 445 (claiming that “the state clearly reserves the right to
rewrite the ground rules and to constrain the freedom of corporate actors.”); Professor Bratton also argues
that the nexus-of-contracts assertion is at variance with corporate doctrine: See id., at 460 (stating that “To
the extent corporate law is contractual, it is contractual only metaphorically, like the philosophical social
contract.”) These criticisms are important, but they are beyond the scope of this Article.
30
Infra text accompanying notes 47-57.
31
That is, it is the firm’s investors who “breath life” into the corporation by providing it with capital.
This is at variance with theories of concession and delegation of sovereignty, under which the state gives life
to the firm, and, hence, is justified in making reciprocal demands of the firm: See id., at 437, 438, 442, 445.
10
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
tarian theories of the firm afford it a role in no other situation.32 I argue below33 that this
argument, combined with the possibility of State support for the banking system, justifies
some regulation of the governance of financial firms.
C. Traditional Modes of Corporate Governance
If one accepts the liberal contractarian arguments that I have advanced, there is no obvious
a priori reason to compel firms to adopt any particular legal framework.34 Nevertheless,
lessons from the accumulated experience and experimentation of past corporations have
coalesced into a set of standard practises, and corporate law has evolved a set of terms for
supporting these practices. While corporations under many jurisdictions are free to write
bespoke corporate governance rules into their charters, most adopt the standard terms. This
might reflect the costs to corporations and investors of creating new rules,35 or the fact the
charter innovations are public goods for which entrepreneurs are under-rewarded;36 it could
reflect the State’s comparative advantage in renegotiating charter provisions in response to
technological, legal, or political change;37 or it might reflect network benefits arising from
standardisation38 . Whatever the reason, there are clear common tendencies in corporate
governance.
The standard terms of corporate governance are the subject of a vast literature.39 In
most companies a Board of Directors serves both to monitor managers on behalf of outside
investors, and also to advise managers on the creation and prosecution of corporate strategy.
In most countries a market for corporate control has evolved as a way of transferring control
rights to the agent who can most efficiently exercise them, and as a way of disciplining
ineffective managers.40 The relatively new markets for private equity41 and activist hedge
funds42 can be viewed as new ways of enabling investors to use control rights more effectively
to keep managers on the straight-and-narrow. A large economic and legal literature examines
32
Hence, the theory of regulation that I advance here relies upon the procedural notions of justice upon
which contractarian visions of corporations and of social orders rest, rather than upon an extrinsic theory of
distributive justice: See Michel Rosenfeld, Contract and Justice: The Relation Between Classical Contract
Law and Social Contract Theory, 70 Iowa L. Rev. 769, 780, 782, 790-798 (1984-1985)
33
See infra text accompanying note 56.
34
The case for mandatory corporate law is discussed in Jeffrey N. Gordon, The Mandatory Structure
of Corporate Law, 89 Colum. L. Rev. 1549 (1989). Professor Gordon argues that a mixture of optional
and mandatory rules might best serve the combined interests of investors and managers, most importantly
because mandatory rules are difficult for managers to change ex post so as to transfer wealth away from
investors. Id., at 1554.
35
Frank H. Easterbrook & Daniel R. Fischel, The Corporate Contract, 89 Colum. L. Rev. 1416, 1444
(1989).
36
Id., at 1445.
37
Henry Hansmann, Corporation and Contract, 8 Am. L. & Econ. Rev. 1 (2006).
38
Michael Klausner, Corporations, Corporate Law, and Networks of Contract, 81 Va. L. Rev. 757 (1995).
39
See, e.g., Macey, Corporate Governance, supra note 14, and references therein.
40
For a recent review of the market for corporate control in the US, see Bengt Holmström & Steven N.
Kaplan, Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and
1990s, 15 J. Econ. Persp. 121 (2001).
41
See Steven N. Kaplan & Per Strömberg, Leveraged Buyouts and Private Equity, 23 J. Econ. Persp.
121 (2009) (reviewing the private equity industry).
42
See Alon P. Brav et al. , Hedge Fund Activism, Corporate Governance, and Firm Performance, 63
J. Fin. 1729 (2008) (reviewing the governance role of activist hedge funds and the performance of their
investments).
11
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
the most effective ways to compensate managers so as to ensure that they execute the
promised contractual nexus.43
All of the standard governance mechanisms of the previous paragraph have a common feature. While their implementation and their emphasis varies between corporations and across
jurisdictions, all are concerned primarily with the resolution of ex post conflict between investors and managers, or between classes of investors.44 Hence, for example, managers are
exposed to personally costly risk through incentive contracts because it is believed that,
without such contracts, they will make the wrong choices. Activist investors and corporate
raiders frequently force managers to make hard but uncomfortable choices in favour of shareholders. Bond covenants protect bondholders from a shareholder propensity to gamble for
resurrection.45 And, to the extent that the corporation successfully erects barriers to this
type of intervention, it resolves conflict in favour of the managers.46 What is critical for the
argument of this Article is that standard modes of corporate governance pass in silence over
situations where the corporation’s investors and managers have aligned interests.
III. Corporate Governance in Financial Firms
Economic discourse about the special nature of the banking sector focuses upon two features
of banks. First, banks have long-term and illiquid loan assets and very short-term demand
deposit liabilities. As a result, banks are prone to destabilising runs, which occur when
many depositors simultaneously withdraw their funds, and so force the bank into damaging
early liquidation of its loan assets.47 Second, banks have an important role as delegated
monitors of entrepreneurial borrowers.48 That is, banks provide enforcement services for
the meta-contract signed by their borrowers. Without these enforcement services many
entrepreneurs would struggle to raise funds. Moreover, one bank’s monitoring services do
not readily substitute for another’s.49 Consequently, the failure of a bank entails the loss
43
See, e.g., Kevin J. Murphy, Executive Compensation, in Handbook of Labor Economics 2485
(Orley C. Ashenfelter & David Card eds., 1999).
44
Ex ante there should be no lasting disagreement: Frank H. Easterbrook and Daniel R. Fischel argue
that “Investors and other participants agree on the stakes: money. They would therefore agree unanimously
to whatever role maximizes the total value of the firm.” See Easterbrook & Fischel, supra note 351434-1435.
More generally, both parties to the meta-contract can agree ex ante even when it refers to a different stake
(a drug-free inner city, say, or effective medical provision in the Horn of Africa).
45
See supra note 15.
46
Holmström & Kaplan, supra note 40, at 122.
47
See Douglas W. Diamond & Philip H. Dynbvig, Bank Runs, Deposit Insurance, and Liquidity, 91 J.
Pol. Econ. 401 (1983) (showing that demand deposits can be used to provide depositors with insurance
against unexpected cash needs, and arguing that such insurance could not be provided through a traditional
insurance contract, because liquidity needs are not contractible).
48
See Douglas W. Diamond, Financial Intermediation and Delegated Monitoring, 51 Rev. Econ. Stud.
393 (1984) (showing that, faced with the problem of managerial theft, a bank with a diversified portfolio can
reduce aggregate monitoring costs and resolve a monitoring free-rider problem amongst multiple dispersed
lenders); Bengt Holmström & Jean Tirole, Financial Intermediation, Loanable Funds, and the Real Sector,
112 Q. J. Econ. 663 (1997) (identifying a more active role for banks in ensuring that managers run investment funds in a particular way). For empirical evidence in support of the monitoring hypothesis, see, e.g.,
Mitchell A. Petersen & Raghuram G. Rajan, The Benefits of Lending Relationships: Evidence from Small
Business Data, 49 J. Fin. 3 (1994); Steven N. Kaplan & Per Strömberg, Financial Contracting Meets the
Real World: An Empirical Analysis of Venture Capital Contracts, 70 Rev. Econ. Stud. 281 (2003).
49
See, e.g., Chitru S. Fernando, Anthony D. May & William L. Megginson, The Value of Investment
Banking Relationships: Evidence from the Collapse of Lehman Brothers, 67 J. Fin. 235 (2012) (demonstrating
that Lehman’s clients suffered significant losses as a result of its failure).
12
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
of its monitoring capability, and so restricts the supply of entrepreneurial credit. This fact
appears to reflect the degree of tacit, relationship-specific, knowledge that is deployed when
loans are extended and monitored, and the difficulty of recreating that knowledge in a new
bank. Hence, the withdrawal of a bank from the economy has long-term ramifications for
real output.50
The susceptibility of banks to runs and the essential monitoring role of banks together
render bank failure socially very costly. Ben Bernanke, Chairman of the Board of Governors
of the Federal Reserve, emphasised these costs when explaining the Fed’s rescue of Bear
Stearns in testimony to the Joint Economic Committee:
Normally, the market sorts out which companies survive and which fail, and that
is as it should be. However, the issues raised here extended well beyond the fate of
one company. Our financial system is extremely complex and interconnected, and
Bear Stearns participated extensively in a range of critical markets. With financial
conditions fragile, the sudden failure of Bear Stearns likely would have led to a
chaotic unwinding of positions in those markets and could have severely shaken
confidence. The company’s failure could also have cast doubt on the financial
positions of some of Bear Stearns thousands of counterparties and perhaps of
companies with similar businesses. Given the current exceptional pressures on the
global economy and the financial system, the damage caused by a default by Bear
Stearns would have been severe and extremely difficult to contain. Moreover, the
adverse effects would not have been confined to the financial system but would
have been felt broadly in the real economy through its effects on asset values and
credit availability.51
Rather than bear the costs identified by Dr Bernanke,52 governments around the world
elected to support their banking systems. Bailing out bankers who were widely perceived to
be the architects of their own misfortune was politically unpopular,53 but the consequences
of allowing them to fail were regarded as unthinkable.54 In the US, for example, the Troubled
Asset Relief Program (TARP) provided support for weak financial firms, creating obligations
amounting to $649 bn. In the UK, the State acquired exposures to the Royal Bank of
Scotland and the Lloyds Banking Group, as well as to a variety of smaller firms.55 While
50
See Adam D. Ashcraft, Are Banks Really Special?, 95 Am. Econ. Rev. 1712 (2005) (presenting evidence
that bank closures cause a long-term reduction in economic output).
51
The Economic Outlook: Hearing Before the J. Econ. Comm., 110th Cong. 64 (Apr. 2, 2008) (statement
of Ben S. Bernanke, Chairman, Bd. Governors of Fed. Reserve System).
52
On the contagion effects identified by Dr Bernanke, see V.V. Chari & Ravi Jagannathan, Banking
Panics, Information and Rational Expectations, 43 J. Fin. 749 (1988) and Yehning Chen, Banking panics:
The role of the first-come, first-served rule and information externalities, 107 J. Pol. Econ. 946 (1999)
(arguing that a bank’s failure might trigger runs on similar institutions) and Franklin Allen & Douglas
Gale, Financial Contagion, 108 J. Pol. Econ. 1 (2001) (noting that bank’s failure could trigger the failure
of other institutions that rely upon it for funding).
53
The first TARP legislation was rejected by the House of Representative, and the Bush administration
ran up against Congressional opposition throughout the disbursement of the TARP funds. See Morrison,
supra note 53.
54
See Financial Crisis Inquiry Commission, Financial Crisis Inquiry Report 21-2 (2011) (stating
that “if you bail out AIG and you’re wrong you will have wasted taxpayer money and provoked public outrage.
If you don’t bail out AIG and you’re wrong, the whole financial system collapses”).
55
On TARP, see Office of the Special Inspector General for the Troubled Asset Relief
Program, Extraordinary financial assistance provided to Citigroup, Inc. (Jan. 13, 2011); Of-
13
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
State support for the financial sector reflects the special economic properties of banks, a
focus upon these properties may obscure the unique problems that arise in the context of
bank governance. These problems arise precisely because of the role that the State plays in
the banking sector.
Meta-contracts are agreed between a firm’s managers and its investors. The contract
is designed to maximise the combined values of the managerial and investor stakes. Metacontracting is complicated in the special case of banking by the presence of the State. In
certain states of the world, the State provides investment capital in the form of bailout funds
to the bank. These investments occur ex post, and they are performed in exchange for the
social goods that banks provide, but they are, nevertheless, investments. And, if the State
invests in a bank, its representatives clearly have a legitimate place at the negotiating table
when the meta-contract is agreed.
It follows that the meta-contract for banks that may receive State support should reflect
the combined interests of equity and bond investors, the State, and the bank’s management.
Agreement on this contract is arrived at through a process that is qualitatively different to
the two-way negotiation that occurs when a non-financial firm raises investment capital. If
the non-financial firm’s managers believe an investor demand to be unreasonable, they can
walk away from the negotiation, and try to find a more acceptable investor. In contrast,
bankers are unable to refuse State support; it is provided in the interests of third parties
not involved in the contractual nexus, and the bankers’ wish to refuse it will be ignored by
the regulator if their institution proves systemically important. For the same reasons, the
State cannot commit ex ante never to rescue a bank ex post; such a commitment will be
jettisoned whenever the bank’s failure threatens the financial system. In short, one cannot
have a banking licence without also accepting the State’s (state-contingent) investment.
The non-negotiability of the State’s involvement in the banking meta-contract changes
the role of formal law in the corporate governance of financial firms. In non-financial firms
the meta-contract reflects a voluntary bilateral agreement, and, hence, the law’s role in
corporate governance is an enabling one. In contrast, because the State is compelled to
participate in the meta-contract for financial firms, it has a legitimate right to use the law to
impose conditions upon that meta-contract. For the same reasons, the corporate governance
provisions that enforce the financial firm’s meta-contract can legitimately be prescribed by
the law.
The formal laws that protect the State’s interest in a financial firm’s meta-contract are
what we mean when we refer to micro-regulation.56 Most of the time, we can refer to these
laws without loss of clarity as regulation, and I shall do so in this Article.
This argument demonstrates that micro-regulation is best thought of as that part of the
fice of the Special Inspector General for the Troubled Asset Relief Program, Quarterly
report to Congress (Jan. 26, 2011). On the UK government’s bank investments, see Comptroller
and Auditor Gen., Nat’l Audit Office, Maintaining financial stability across the United
Kingdom’s banking system (4 Dec., 2009); Comptroller and Auditor General, Nat’l Audit
Office, Maintaining the financial stability of UK banks: update on the support schemes
(15 Dec. 2010). For an outline of State support for banking sectors during the crisis and a summary of the
economics of the “Too-Big-To-Fail” problem, see Morrison, supra note 53.
56
This term is used to distinguish the regulation of the properties and actions of specific banks from
the regulation of the properties of the banking sector as a whole, which is often referred to as macroprudential regulation. See generally Brunnermeier et al., The Fundamental Principles of Financial Regulation
(International Center for Monetary and Banking Studies, Geneva Reports on the World Economy 11, Jan.
2009).
14
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
corporate governance of financial firms that relates to the creation and enforcement of those
elements of the meta-contract that protect the State’s interests. Explaining regulation in
these terms helps us to understand its social purpose: good regulation resolves contractual
incompleteness in the meta-contract at the lowest possible overall cost. At the same time,
the contractual perspective on financial regulation helps us to identify the legitimate bounds
of regulation. This is a concern because, in contrast to other forms of corporate governance,
regulation is imposed by fiat. But under the contractarian paradigm, it is legitimate precisely
because it allows the State to participate in the negotiation of the meta-contract. Regulations
imposed for another reason, such as the pursuit of social justice or the imposition of an
industrial policy, are not justified on contractarian grounds, as they are not agreed ex ante
by the investor and entrepreneurial parties to the meta-contract.57 Hence, if these goals
are adopted for some reason outside the scope of this Article, they are not the concern of
micro-regulation.
IV. Structural Problems With the Governance of Financial Firms
A. Fiduciary Responsibilities in Banking
Modern corporate governance frameworks have a presumption in favour of shareholder value
maximisation.58 This presumption is logical when shareholders and managers are conflicted
ex post, since it provides the residual claimants with the power and the incentives to monitor
managerial behaviour. But it is less effective for banks, because in some circumstances the
State is the bank’s residual claimant. And, given this fact, shareholders and managers can
agree that the rational choice is to maximise the value of the State’s investment; that is, to
maximise the value of the State subsidy to their bank.
Investors and bank managers need not elect consciously to pursue State support; indeed,
it seems unlikely that they do so. However, the compensation that lenders demand in
exchange for high risks is reduced if some of the adverse consequences of those risks are
likely to be absorbed by the State. Hence, managers who take high risks experience positive
market feedback; the same market metrics reflect unfavourably upon managers who do not
assume such risks. In short, the managers of financial firms and their investors are guided
by Adam Smith’s Invisible Hand59 to collude against the State by assuming high levels of
systemic risk.
Corporate governance is concerned with the enforcement of the meta-contract that is
agreed between the corporation’s various investors and its managers. Many problems in
financial sector corporate governance stem from a failure to appreciate that the State is a de
facto investor in financial firms, and, hence, that corporate governance mechanisms should
also enforce its rights. The traditional emphasis in corporate governance upon shareholder
57
See note 32, supra. Justice in the contractarian paradigm is coextensive with contract enforcement. A
contractarian justification for regulation of the meta-contract on grounds other than efficiency would rely
upon a social contract theory of justice. Not every such theory justifies such interference. This important
and fascinating subject is outside the scope of this Article: for a general discussion, although not related to
the nexus-of-contracts, see Rosenfeld, supra note 32.
58
In the US this presumption is a central feature of corporate law: see Dodge v. Ford Motor Co., 170
N.W. 668, 684 (Mich. 1919) (finding that “A business corporation is organized and carried on primarily for
the profit of the stockholders.”)
59
Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations ¶ IV.2.9
(5th ed. Methuen & Co. 1904) (1776)
15
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
value maximisation fails to respect the State’s rights, and cannot check subsidy-seeking
behaviour. Indeed, the costs of State support reflect the misallocation that results from this
behaviour, rather from the direct costs of support; at the time it is extended, State support
is much cheaper than the alternatives.
This line of reasoning dooms some recent policy initiatives to failure. For example, some
commentators recommended post-Crisis that the shareholders and the directors of banks be
given more formal powers to intercede in the running of the bank.60 But this misses the
point. A bank’s investors are very unlikely to use their power to prevent it from profiting
from State subsidies, because both parties can agree that this strategy is optimal.
We can see evidence in support of the hypothesis of this Part in the choices that banks
made in the last decade to expand their scale, scope, and complexity; the regulatory failure
to understand the special nature of bank corporate governance is exemplified by the types
of data used in supervision in the last decade. It is to these examples that I now turn.
B. Compenation Policy
Financial sector pay has been the subject of vigorous public debate. Commentators have discussed the effectiveness of compensation policy in creating the right incentives for bankers;61
they have also questioned the fairness and justice of a system that provides an extremely
high level of pay to senior financiers, apparently without penalising them very much when
they fail.62 The latter questions are a reasonable focus for public discourse. However, I argue
in this Article that bank regulation attempts to find the lowest cost way of altering the metacontract so as to prevent value destruction by a subsidy-seeking coalition of bank executives
and managers. This goal is orthogonal to questions of equity or fairness in executive pay;
within the contractarian framework of this Article the latter questions are therefore outside
the proper scope of corporate governance regulations, and, hence, are also outside the scope
of this Article.
Executive pay policies in every country reflect the belief, most famously promulgated by
Michael C. Jensen and Kevin J. Murphy, that executive pay must be closely tied to company
value if executives are to maximise investor wealth.63 However, in the special case of banking,
60
See Sir David Walker, A Review of Corporate Governance in UK Banks and Other
Financial Industry Entities 12 (Nov. 2009), available at http://www.hm-treasury.gov.uk/d/walker_
review_261109.pdf.
61
See, e.g., Nassim Nicholas Taleb, How Bank Bonuses Let us all Down, Fin. Times, Feb. 25, 2009, at 9
(arguing that annual bonuses encourage risk-taking that creates “blow up” over a 5-20 year period).
62
See, e.g., Eric Dash & Vikas Bajaj, Few Ways to Recover Bonuses to Bankers, N.Y. Times, Jan.
30, 2009, at B1 (quoting President Obama’s remark of the level of bonuses in 2009 that “It is shameful,
and part of what we’re going to need is for the folks on Wall Street who are asking for help to show
some restraint and show some discipline and show some sense of responsibility”); Paul Krugman, Money for
Nothing, N.Y. Times, Apr. 27, 2009, at A23 (arguing that “there’s no longer any reason to believe that
the wizards of Wall Street actually contribute anything positive to society, let along enough to justify those
humungous paychecks”). See generally Charlotte Villiers, Controlling Executive Pay: Institutional Investors
or Distributive Justice?, 10 J. Corp. L. Stud. 309 (2010) (surveying social attitudes to high executive pay,
highlighting increasing pay inequality around the world, and arguing against shareholder primacy and in
favour of a distributive justice framework for deciding executive pay).
63
See Michael C. Jensen & Kevin J. Murphy, CEO Incentives – It’s Not How Much You Pay, But
How, Harv. Bus. Rev., May-June 1990, at 138, 138, claiming that “In most publicly held companies, the
compensation of top executives is virtually independent of performance. On average, corporate America
pays its most important leaders like bureaucrats.” This statement was inspired by Michael C. Jensen &
Kevin J. Murphy, Performance Pay and Top-Management Incentives, 98 J. Pol. Econ. 225 (1990), finding
16
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
Jensen & Murphy’s emphasis upon the share price sensitivity of senior executive pay may be
misplaced. As Jensen himself notes in his seminal 1976 article with William H. Meckling,64 a
sole focus upon shareholder maximisation can induce excessive risk taking in highly levered
firms, because shareholders are protected by limited liability from the full extent of losses,
and so consider only the potential upside of new investments. Bank leverage,65 always high,
increased significantly prior to the crisis.66 As a result, bank shareholders had an incentive
to assume risks that did not create wealth, but merely transferred it from bondholders to
shareholders.67 A complete meta-contract would rule this type of risk-taking out ex ante, so
an effective corporate governance system should ensure that it does not occur ex post.
In theory, this could be accomplished by attaching covenants to debt that restrict managers’ freedom to make capital investments when the firm’s leverage is high. Such covenants
are less effective in banking than in other industrial sectors for two reasons. First, banks
are opaque, so that it is hard for their bondholders to monitor compliance with covenants.
Following a proposal by Jeffrey Gordon, one could attempt to address this problem by paying managers in stock that converted to subordinated debt upon a trigger event that would
normally invoke restrictive bond covenants.68 After the trigger event managers would work
for bond holders, and so in theory there would be no need of covenants. This approach would
go some way to resolving the risk-shifting problem, although it might induce gambling by
managers who feared conversion, and it would rely upon the existence of a verifiable trigger
that could not be obfuscated by managers. The second problem with bond covenants as a
way of controlling excessive bank risk taking arises because State support insulates bondholders from the full costs of risk-taking, so lowering their sensitivity to risks, and weakening
their monitoring incentives.
A purely stock-based incentive scheme is inappropriate for a bank (or, indeed, for any
other highly levered firm whose managers are able to take high levels of risk without lender
oversight). Nevertheless, banker pay was closely tied to share prices prior to the financial
that, on average, CEOs are paid $3.25 for every $1000 increase in shareholder wealth, and arguing that this
figure was too low. In fact, Jensen and Murphy’s figures have been contested: see Brian J. Hall & Jeffrey
B. Liebman, Are CEOs Really Paid Like Bureaucrats?, 113 Q.J. Econ. 653 (1998), finding that, when the
value of CEO holdings of stock and stock options are correctly accounted for, CEO compensation in the US
is actually very closely tied to firm performance.
64
Jensen & Meckling, supra note 8.
65
Leverage is defined to be the ratio of the bank’s total assets to its common equity. In contrast, the
capital adequacy ratios upon which regulatory capital requirements are based have a broader definition of
capital (the denominator in the leverage ratio), and use a risk-weighted measure of assets. As a result,
regulatory capital ratios (infra notes 88-93 and accompanying text) are lower than leverage ratios, which
give a more accurate picture of managerial incentive effects.
66
See Viral V. Acharya, Irvind Gujral, Nirupama Kulkarni & Hyun Song Shin, Dividends and Bank Capital
in the Financial Crisis of 2007-2009 11 (Nat’l Bureau of Econ. Research, Working Paper No. 16896, Mar.
2011) (documenting increased average leverage between 2000 to 2007 for 25 large financial forms. The average
leverage ratio increased from 15.0 to 22.51 for commercial banks, and from 26.90 to 35.85 for investment
banks.)
67
To understand the wealth transfer effect, consider a firm with equity capital of $2 and leverage ratio
30. A gamble that makes or loses $5 with equal likelihood risks 16% of the firm’s capital and has no value;
however, shareholders experience an expected income of 0.5 × $5 + 0.5 × (−$2) = $1.5 from the gamble,
while bondholders experience an equal and opposite expected loss. Zero value gambles are not hard to find;
as this example demonstrates, shareholders in highly levered firms have a strong incentive to take them, or
even to take negative value gambles, whose costs will likewise be absorbed by bondholders.
68
Jeffrey Gordon, Executive Compensation and Corporate Governance in Financial Firms: The Case for
Convertible Equity-Based Pay (Colum., L. & Econ. Working Paper No. 373, 2010).
17
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
crisis. Moreover, banker incentive pay before the crisis had a substantial option component.69
Options have a lopsided payoff, with substantial rewards for profit and no losses upon failure.
Managerial option grants therefore create stronger risk-taking incentives that straight stock
grants, which come with a downside as well as an upside. Although this type of compensation
does not induce the behaviour that a complete meta-contract would stipulate, it reflects the
joint interest of shareholders and executives. In the presence of State subsidies shareholders
and executives can agree an ex ante side contract under which managers work to maximise
State support; one can think of stock and stock option-based compensation as an ex post
enforcement mechanism for that side contract. In the US, the incentive to write this side
contract is enhanced by Section 162(m) of the tax code, which limits corporate tax deductions
for employee pay to $1 mn in public companies, unless the pay is linked to performance.70
In short, stock and stock option-based compensation in banks serves to enforce a collusive
side contract between executives and investors at the expense of the State. Such a contract
concentrates losses at times of systemic stress, when State bailouts are most likely to occur.
In line with this reasoning, banks with more concentrated institutional investors, who were
therefore better able to exercise control, had high-powered incentive contracts prior to the
crisis, and experienced higher losses during the crisis.71
C. Bank Scale and Scope
The State supports financial institutions when the consequences of their failure for the supply
of entrepreneurial credit, and for the stability of the financial system, are too severe to bear.
It follows immediately that it is most likely to extend support to very large institutions.
Market players believe that some banks are Too Big To Fail (TBTF).
The TBTF phrase entered the banking lexicon in the wake of the 1984 $3.4 bn bailout
of the money centre bank Continental Illinois, when Congressman McKinney remarked in
response to Congressional testimony from the C.T. Conover, US Comptroller of the Currency
that “[w]e have a new kind of bank. It is called Too-Big-to-Fail.TBTF, and it is a wonderful
bank.” 72 Eleven banks were subsequently identified by the Wall Street Journal as TBTF;73
investors responded to this information by boosting their share prices by 1.3 percent.74
Subsequent years brought further evidence that markets reward banks for being TBTF
and, hence, that it is in the interest of both shareholders and managers that their bank
should achieve TBTF status. In the wake of the Continental Illinois bailout the cost of bank
borrowing, as witnessed by bond market interest rates, became less risk-sensitive.75 Hence,
69
See, e.g., Lucian A. Bebchuk & Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 265
(2010) (documenting large CEO option positions at Bank of America and Citigroup).
70
26 U.S.C. § 162 (a) (2006).
71
Rüdiger Fahlenbrach & René M. Stulz, Bank CEO Incentives and the Credit Crisis J. Fin. Econ.
(forthcoming, 2012).
72
Inquiry Into Continental Illinois Corp. and Continental Illinois National Bank: Hearing Before the
Subcomm. on Fin. Inst. Supervision, Regulation and Ins. of the H. Comm. on Banking, Fin. and Urban
Affairs, 98th Cong. 300 (1984). For a discussion of the TBTF problem, see Morrison, supra note 53.
73
Tim Carrington, US Won’t Let 11 Biggest Banks in Nation Fail, Wall St. J., Sept. 20, 1984, at 2.
74
Maureen O’Hara & Wayne Shaw, Deposit Insurance and Wealth Effects: The Value of Being “Too-Bigto-Fail”, 74 J. Fin. 149 (2004). See also Donald P. Morgan & Kevin J. Stiroh, Too Big to Fail after All
These Years (Fed. Res. Bank N.Y., Staff Report No. 220, Sept. 2005) (documenting improved credit ratings
for banks revealed to be TBTF by Carrington, supra note 73).
75
Robert B. Avery, Terrence M. Belton & Michael A. Goldberg, Market discipline in regulating bank risk:
New evidence from the capital markets, 20 J. of Money, Credit, and Banking 597 (1988).
18
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
as noted already,76 bankers were guided by the Invisible Hand to assume more risks.
Markets have also rewarded banks for achieving TBTF status. When two banks merge to
form an entity that is regarded as TBTF, both experience a positive share price reaction.77
Such a reaction is very unusual for the acquiring firm in merger deals. It is likely to be the
reason that acquiring firms have habitually paid over the odds for takeovers that achieve
TBTF status.78
In line with these observations, bank scale has increased dramatically in recent years;79
it seems hard to justify this expansion purely on the basis of economies of scale.80
The rapid expansion of bank scale was coincidental with an expansion of scope. Universal
banks, that combined commercial banking with securities activities started to emerge in the
United States after the Gramm-Leach-Bliley Act of 199981 dismantled legal barriers to their
creation that were erected by the Glass-Steagall Act of 1933.82
The Glass-Steagall Act was inspired by the contemporary belief that universal banks
were underwriting the securities of bad borrowers, so as to ensure that their own loans
were repaid. Although recent academic work indicates that there was no substance to this
belief,83 the Act had the unanticipated consequence of separating commercial banks, whose
depositors acquired State protection shortly after the passage of the Act, from investment
banks. This made it easier to refuse State aid to firms engaged in the securities business.
Recent events suggest that the re-emergence of universal banks has served, despite the best
76
Supra, text accompanying note 59.
Maía F. Penas & Haluk Ünal, Gains in Bank Mergers: Evidence from the Bond Markets, 74 J. Fin.
Econ. 149 (2004).
78
See Elijah Brewer, III & Julapa Jagtiani, How Much Did Banks Pay to Become Too-Big-to-Fail and
to Become Systemically Important? (Fed. Res. Bank Phila., Working Paper No. 09-34, 2009) (showing that
bankers were prepared to pay a premium for mergers that would create a combined entity with total size
over $100 bn, and estimating that at least $14 bn of additional premia were paid in such mergers).
79
See Robert DeYoung, Banking in the United States, in The Oxford Handbook of Banking 777
(Allen N. Berger, Philip Molyneux & John O.S. Wilson eds., 2010) (reporting that all of the ten largest US
banks had (nominal) assets of more than $100 bn in 2007, while only Citicorp exceeded this figure in 1988);
John Goddard, Philip Molyneux & John O.S. Wilson, Banking in the European Union, in The Oxford
Handbook of Banking 844 (Allen N. Berger, Philip Molyneux & John O.S. Wilson eds., 2010) (presenting
evidence that European banks have also become much larger in the last decade).
80
See Allen N. Berger & Loretta J. Mester, Inside the Box: What Explains Differences in the Efficiencies
of Financial Institutions?, 21 J. Banking & Fin. 895 (1997) (arguing that the technologically optimal
size of a bank in the US is about $25bn). Although Robert DeYoung, The Performance of Internet-Based
Business Models: Evidence From the Banking Industry, 78 J. Bus. 893 (2005) suggests that increasing use
of the internet has since increased this figure somewhat, banks are an order of magnitude greater than the
figure identified by Berger & Mester: see Asli Demirgüc & Harry Huizinga, Are Banks Too Big to Fail or Too
Big to Save? International Evidence from Equity Prices and CDS Spreads (World Bank, Policy Research
Paper No. 5360, 2010) (identifying thirty listed banks whose liabilities exceed thirty times their country’s
GDP, and twelve that have liabilities in excess of $1 trn.).
81
Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, Pub. L. No. 106-02, 113
Stat. 1338 (codified as amended in scattered sections of 12 and 15 U.S.C.).
82
Banking (Glass-Steagall) Act of 1933, Pub. L. No. 73-66, 48 Stat. 162 (codified as amended in scattered
sections of 12 U.S.C.).
83
See Randall S. Kroszner & Raghuram G. Rajan, Is the Glass-Steagall Act Justified? A Study of the US
Experience with Universal Banking Before 1933, 84 Am. Econ. Rev. 810 (1994) (finding no evidence from
the relative performance of securities issued by commercial and investment banks that commercial bank
securities affiliates fooled the public). For a survey of the literature on universal banks and a discussion of
the repeal of the Glass-Steagall Act, see Alan D. Morrison, Universal Banking, in The Oxford Handbook
of Banking 171 (Allen N. Berger, Philip Molyneux & John O.S. Wilson eds., 2010).
77
19
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
efforts of regulators and legislators, to extend State subsidies into non-depository businesses.
If this is so then, of course, rational managers and investors may have been guided to scope
expansion by impersonal market forces.
D. Bank Complexity
Bankers may have expanded the scale and scope of their activities in the (possibly unconscious) pursuit of State subsidy. They might equally have embraced organisational complexity for the same reasons. Casual empiricism indicates that banks have become much harder
to understand in recent years. For example, Citigroup has nearly 2,500 subsidiaries in 84
countries.84 Commenting upon this fact to a UK House of Lords Inquiry, Michael Foot,
formerly head of banking supervision at the Bank of England, remarked that some banks
were now “too complex to manage,” and said that “I used to look at Citibank and I wondered
how any group of human beings could actually run that entity.” 85
Citigroup’s complexity is partly a result of its immense scale, its broad scope, and its
extreme geographical reach. It also reflects the increasing sophistication of the over-thecounter securitization and credit derivatives markets in which modern financial firms operate.
These markets have served first to render it far harder for anyone inside or outside a financial
firm to understand its positions, and second to enable banks rapidly to alter their exposures,
so that any risk analysis of their position is soon out-of-date. These developments have been
identified by many commentators as evidence of governance failures, in that they rendered
independent Boardroom monitors ineffective. But one could make a reasonable case that
financial firms elect to be opaque and complex in the rational pursuit of State support. If a
deal’s catastrophic failure is an extremely unlikely event whose ramifications are so complex
as to guarantee State support then shareholders do not need to understand it. Indeed, they
will receive positive market feedback for taking the risk of such failure.
The Crisis experience of American Insurance Group (AIG) appears to support this argument. AIG sat at the centre of a complex network of credit default swaps (CDSs), on many
of which it sold protection.86 CDS traders are not recorded centrally, and when AIG experienced severe short-term funding and collateral problems in September 2008, the supervisory
authorities were unable to ascertain the likely consequences of its failure. Faced with the
possibility of a generalised market panic, the Federal Reserve supported AIG, lending $85
bn to the firm; ultimately, $185 bn of taxpayer funds were committed to AIG.87 AIG and,
by extension, its creditors, received State support precisely because its CDS book was so
complex. While AIG’s shareholders doubtless regret the losses that it experienced, it is hard
to argue that, ex ante, it was irrational from their perspective for AIG to assume the risks
that gave rise to those losses.
84
See Richard Herring & Jacopo Carmassi, The Corporate Structure of International Financial Conglomerates: Complexity and its Implications for Safety and Soundness, in The Oxford Handbook of Banking
195 (Allen N. Berger, Philip Molyneux & John O.S. Wilson eds., 2010)
85
Select Committee on Economic Affairs, Banking Supervision and Regulation, 200809, H.L. 101-I, ¶¶ 43, 231 (U.K.).
86
A credit default swap (CDS) is a transaction under which one party, the protection buyer, pays a
premium to another party, the protection seller, for indemnification against default losses experienced by
the lender on a particular loan, the reference credit. The protection seller therefore assumes the risk of the
reference credit; the protection buyer need not have an insurable interest in the reference asset and, as a
result, CDS trades are often used to speculate on the creditworthiness of the reference credit.
87
See Financial Crisis Inquiry Commission, supra note 54, at chapter 18
20
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
E. Epistemological Misconceptions
Capital adequacy regulation has been the central focus of international coordination on
regulation since the Basel Committee on Banking Supervision88 published its first Accord in
1988.89 The Basel Accords90 have no formal legal status, but they are the basis of local rulemaking in most countries.91 . In brief, capital regulations stipulate the acceptable sources of
funds (“liabilities”) that banks can use to finance a particular risk position. Under a welldesigned bank insolvency law, investors in a fragile bank should lose their investment if they
have no access to the deposit insurance fund. Such investors are said to supply “capital”,
and capital regulation requires banks to use higher levels of capital for riskier investments,
so as to dampen investors’ preference for banks to assume socially damaging levels of risk.92
This effect is particularly pronounced when the bank is forced to rely upon common equity,
because shareholders bear the first losses upon bank failure, and they exercise control rights.
88
See Basel Comm. on Banking Supervision, History of the Basel Committee and its Membership 1 (Aug. 2009), available at www.bis.org/bcbs/history.pdf. The Basel Committee on Banking Supervision was established by the central bank governors of the G10 countries at the end of 1974 in the wake of
the failure of Bankhaus Herstatt in West Germany. It meets three of four times per year; its members are representatives of the central banks and prudential regulators of Argentina, Australia, Belgium, Brazil, Canada,
China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the
Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United
Kingdom and the United States.
89
Basel Comm. on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (July 1988), available at http://www.bis.org/publ/bcbsc111.pdf [hereinafter Basel Comm., Basel I]
90
The first Accord was followed after a length consultation period by a second Accord in 2004, which
was published with all supporting materials as Basel Comm. on Banking Supervision, Basel II:
International Convergence of Capital Measurement and Capital Standards: A Revised
Framework – Comprehensive Version (June 2006), available at http://www.bis.org/publ/bcbs128.pdf.
The second Accord presented agreed policy on three “Pillars” of regulation: capital regulation, supervisory review, and market discipline. Id., at 2 Modifications to the second Accord were agreed in July
2009 in light of the Financial Crisis, and are referred to collectively as “Basel 2.5:” See Basel Comm.
on Banking Supervision, Enhancements to the Basel II Framework (Jul. 2009), available at
http://www.bis.org/publ/bcbs157.pdf (altering capital requirements for securitisation exposures); Basel
Comm. on Banking Supervision, Revisions to the Basel II Market Risk Framework (Jul.
2009), available at http://www.bis.org/publ/bcbs158.pdf (altering the model used to quantify the risk of
trading positions); Basel Comm. on Banking Supervision, Guidelines for Computing Capital for
Incremental Risk in the Trading Book (Jul. 2009), available at http://www.bis.org/publ/bcbs159.pdf
(introducing an incremental risk charge that raises capital requirements against default risk not captured in standard Value at Risk models). Further changes were published in December 2010, and revised in June 2011: See Basel Comm. on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (June 2011), available at
http://www.bis.org/publ/bcbs189.pdf. Together with the Basel 2.5 changes, these constitute “Basel III.”
Basel III further strengthens capital requirements, and introduces a liquidity requirement.
91
For a discussion of the interaction between local rule-making authorities and the Basel Committee, see
Michael S. Barr & Geoffrey P. Miller, Global Administrative Law: The View from Basel, 17 Eur. J. Int’l L.
15, 28-41 (2006). The implementation as of March 2011 of the Basel III Accord (supra note 90) is surveyed
in Basel Comm. on Banking Supervision, Progress Report on Basel III Implementation (Apr.
2012), available at www.bis.org/publ/bcbs215.pdf.
92
See, e.g., Daesik Kim & Anthony M. Santomero, Risk in Banking and Capital Regulation, 43 J. Fin.
1219 (1988) (showing that minimum capital ratios can reduce banker bias towards risk in the presence of
deposit insurance; Alan D. Morrison & Lucy White, Crises and Capital Requirements in Banking, 95 Am.
Econ. Rev. 1548 (2005) (showing that minimum capital ratios increase the care with which bankers manage
existing investments).
21
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
For this reason, the Basel Accords stress “Tier 1 capital,” which comprises common equity
capital and retained earnings (which accrue to common equity holders).93
Successive iterations of the Basel Accords have been characterised by increasing complexity. The first Basel Accord was communicated in a twenty six page document; the
comprehensive documentation of Basel II ran to 347 pages; Basel 2.5 added a further 89
pages; and the Basel III document increased the total by 77 pages more.94 This complexity reflects in part the exponential growth of complex derivatives markets, and of securities
markets based upon them, and the concomitant increase in the complexity of banking organisations.95 Bank risk positions became correspondingly hard-to-evaluate after the publication
of the First Accord and, faced with the growing complexity of bank risk positions, supervisors chose to fall back upon risk data generated by the bankers who had evaluated the
positions and, hence, appeared to be in the best position to evaluate them. As a result, the
Basel Accords rely increasingly upon complex mathematical risk models created by banks.
For example, under the “Internal Ratings Based Approach” (IRB) of Basel II,96 bank capital
requirements are based upon banks’ in-house technical Value-at Risk (VaR) models.97
The VaR systems used in the IRB approach attempt to compute a loss that the bank
has a one percent chance of exceeding in any 10 day interval.98 They are calibrated using
a combination of past price histories and historic experience of own-portfolio losses, for example in untraded loan books. The mathematical models upon which they rest are complex
and sophisticated. Nevertheless, their use in regulation is founded upon a number of epistemological misconceptions: that is, upon failures to understand the limitations of knowledge
in financial markets.
VaR models borrow extensively from the methods and techniques of the physical sciences.
But while it is meaningful to speak of the melting point of ice, or the rate at which a smoke
particle makes its way through the air, and to attempt to measure those constants, it is
difficult to translate this type of measurement to the social world. VaR systems rely upon
such parameters as the volatility of stock price movements, and the probability that two loans
default simultaneously. Such parameters reflect the expectations of market participants,
which, in turn, are formed by engagement with other participants and government actors.
There is no reason to believe that the parameters that work in VaR systems when markets
are stable and orderly will continue to work when they are not. Indeed, one could argue
that founding an entire science of risk management upon the estimation of such parameters
reflects a basic category error, which is captured in the “financial engineering” soubriquet used
to describe it. The type of detailed understanding of wing stresses that an aircraft engineer
can achieve is not simply not attainable for the stresses in complex financial systems at times
of systemic fragility.
The decision to substitute bad science for good economics in regulation has profound
93
The first Basel Accord stipulated that capital amount to eight percent of risk-weighted assets, of which
at least a half had to be Tier 1 capital: See Basel Comm., Basel I, supra note 89, at 13. This ratio was
retained in the second Accord Basel Comm., Basel II, supra note 90, at 12; Basel III increases common
equity requirements to 4.5 percent of risk-weighted assets, and introduces additional common equity capital
charges for globally systemically important financial institutions (SIFIs).
94
See note 90, supra.
95
See supra text accompanying notes 84-87.
96
Id., at 52.
97
Id., at 80
98
Id., at 195.
22
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
implications. In particular, micro-regulation based upon detailed contracts that are founded
in turn upon the results of complex financial engineering cannot succeed. To be sure, the
clauses of such contracts can be codified and enforced. For that reason they can be the
basis of very detailed regulatory rules. But the impression of precision and accuracy that
such agreements convey is misleading. Even in the relatively quantifiable field of financial
asset pricing, it is hard for financial engineers to agree even the value of a complex financial instrument, let alone its risk.99 To take a more egregious example, regulations have
attempted to capture “operational risk,” or, in plain terms, the risk of settlement error and
fraud, formulaically.100 A moment’s introspection suggests that no simple formula could
hope to capture that risk accurately. Nor can we hope to progress like natural scientists to
ever-better formulae; the claim in the wake of the crisis that risk models failed because they
were incorrectly parameterised is another category error.
Even if VaR systems could achieve a meaningful degree of accuracy, they would still be
designed to capture the risks that bankers and their shareholders care about. But if these
were the only risks that mattered there would be no need for bank micro-regulation. Hence,
relying upon the data that bankers generate for their own purposes inevitably fails to capture
the residual risks that are the primary concern of the State. If this reliance arises because
those risks are too complex for the State’s representatives to comprehend then it is hard to
see why they should agree to a meta-contract that ratifies them.
In summary, it is impossible to write nuanced contracts over something as blunt and
difficult-to-quantify as systemic failure. And yet regulators have been seduced by the apparent precision of quasi-scientific risk management systems into attempting to write such
contracts. Huge increases in the complexity of financial institutions have resulted in corresponding increases in the complexity of financial risk measurement and management systems.
These systems have in turn legitimised complexity that, as discussed already,101 cannot the
basis of a workable micro-regulatory contract.
V. Re-Thinking the Governance of Financial Firms
The State is an investor in banks and other financial firms, in that it provides support funds in
situations of general financial fragility. Micro-regulation for those firms is therefore a form of
corporate governance that serves to enforce the interests of the State in their meta-contract.
To the extent that there is a corporate governance malaise in the financial sector, it arises
because the standard norms of corporate governance fail to account for the State’s interests.
As a result, investors and managers are free to take actions that maximise the value of the
State’s investment, without providing the State with a commensurate return. Bankers need
not consciously elect to seek State subsidies; they are guided to do so by market prices that
rationally reflect the existence of these subsidies.102 Hence, banks have become very big,
entered into businesses far removed from deposit-taking, and are now exceedingly complex.
The State’s response to these developments has been to write complex regulatory contracts
based upon pseudo-scientific analysis of risks that cannot capture, and are not designed to
99
See, e.g., Fin. Serv. Auth., The Prudential Regime for Trading Activities 45 (FSA, Discussion Paper
No. 10/4, Aug. 2010) (finding “severe discrepancies” between the valuations reported by six large UK banks
for similar risk positions as of 30 June 2009).
100
See Basel Comm., Basel II, supra note 90, at 147.
101
Supra text accompanying notes 84-87.
102
See supra text accompanying note 59.
23
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
capture, the exposures that the State ought to care about.
Standard modes of governance would be more appropriate in the financial sector if the
State were to withdraw its support from financial firms. But, ceteris paribus, a simple statement of intent will not suffice, because it would not be credible. At the time when support
is provided, it is far cheaper than the cost of not providing it; refusing support would be politically difficult, and probably socially catastrophic. Hence, fixing the corporate governance
of financial firms will require institutional changes that either reduce the likelihood of State
intervention, or that assign some control rights to the State, precisely as control rights are
assigned to shareholders in most governance systems.
In this Part, I examine a variety of institutional changes that could improve the governance of financial firms. The State’s ability to alter governance arrangements by imposing
regulatory rules is a potential focus for rent-seeking behaviour. It is therefore particularly
important that the costs imposed upon managers and investors by any change to the legal
regime for corporate governance in the financial sector be carefully justified in terms of the
gains realised from better enforcement of the State’s interests in a meta-contract.
A. Moral Codes and Fiduciary Responsibilities
When discussing problems with the UK’s approach to financial regulation prior to the Crisis,
Hector Sants, Chief Executive of the UK’s Financial Services Authority, remarked that “[a]
principles-based approach [to regulation] does not work with people who have no principles.” 103 If by this he meant that moral suasion is a poor basis for regulation, he was right:
if financial market success was dependent upon moral laxity then the morally lax would rise
to the top. But one can make a reasonable case that managers with a fiduciary responsibility to maximise shareholder value would perceive actions that did not serve this end as
immoral. If so, managers who take their fiduciary responsibilities seriously should be guided
by their moral compass to the pursuit of State support. Some commentators have argued
that reformed moral standards are a necessary precursor to a reformed financial sector; a
more coherent demand might be for reformed fiduciary duties.
As long as the State stands ready to support troubled institutions, shareholders will
have a pronounced preference for risk-taking. In line with this statement, recent evidence
indicates that institutional ownership of a bank is correlated with the riskiness of that bank’s
portfolio.104 It is therefore implausible that, ceteris paribus, governance problems in banks
could be resolved by granting shareholders increased powers of intervention. One could even
argue that financial stability would be better served by a partial withdrawal of shareholders
from the active governance of financial firms. Indeed, at least one distinguished commentator
has gone so far as to suggest that managers should be left entirely to their own devices.105
Excluding shareholders entirely from the governance of financial firms is a bad idea. It
103
Hector Sants, CEO, Fin. Serv. Auth., Delivering Intensive Supervision and Credible Deterrence, Address
at The Reuters Newsmakers Event, London, UK (12 Mar. 2009), available at http://www.fsa.gov.uk/library/
communication/speeches/2009/0312_hs.shtml. Mr. Sants acknowledged in his speech that “the majority of
market participants are decent people.”
104
See Ing-Haw Cheng, Harrison G. Hong & José A. Scheinkman, Yesterday’s Heroes: Compensation and
Creative Risk-Taking (Eur. Corp. GovernanceInst., Working Paper No. 285/2010, 2010); Luc Laeven & Ross
Levine, Bank Governance, Regulation, and Risk Taking, 93 J. Fin. Econ. 259 (2009).
105
See Martin Wolf, Seeds of its Own Destruction, Fin. Times, 9 Mar. 2009, at 7 (claiming that “It is
better, many will conclude, to let managers determine the direction of their companies than let financial
players or markets override them.”)
24
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
would re-introduce all of the classic agency problems that justify shareholder control rights,
and would therefore serve substantially to raise the cost of funds for banks and, by extension, the entrepreneurial sector. But one could attempt to move partially in that direction
by enshrining in law a broader basis for bank corporate governance than shareholder value
maximisation. This approach is advocated by Jonathan R. Macey and Maureen O’Hara,
who contend that banker fiduciary duties should be extended beyond the usual shareholder
maximization objective to include an obligation for the safety-and-soundness of their institutions.106
When standard corporate governance techniques fail in financial firms it is because they
fail to enforce the State’s interests in the meta-contract. Devolving the enforcement of those
interests to the managers of financial institutions is therefore a reasonable suggestion. But
it seems unrealistic on two grounds. First, banks are complex and opaque institutions. It
would therefore be extremely difficult for the State to monitor in real time the managers’
performance on a governance contract that incorporated a safety-and-soundness clause. It
would equally be very hard for the State to determine in the wake of a financial crisis that a
manager had failed to consider safety-and-soundness, rather than that he or she had simply
been unlucky. The State might in this situation follow the politically expedient path, and
punish the manager anyway. Equally, it would be politically and technologically very difficult
to enforce this broader fiduciary duty against managers who gambled successfully with their
institutions’ financial stability.
The second problem with an altered governance remit is that it would place obligations
upon managers that they might be unable to fulfil. Managers operate with limited information about financial sector linkages and broad system-wide stresses. They cannot rely upon
market prices to explain these factors, because prices frequently respond positively to actions
that generate complexity and increase stresses. An altered fiduciary role for financial firm
managers therefore seems very hard to fulfil, and almost impossible to police. It is unlikely
to resolve governance problems in the financial sector.
Notwithstanding this argument, there is a case for altering managerial responsibilities
so as to dampen market incentives to chase surpluses, provided those responsibilities are
verifiable, and do not generate excessive social costs elsewhere in the bank. One way to
accomplish this would be formally to contract over bank reporting lines. For example, it is
reasonable that risk policy should form part of a bank’s meta-contract, and that the State
should have a voice in determining that policy. This could be achieved by establishing a
clearly-defined risk policy, and assigning responsibility for compliance to an independent senior executive, who thus serves as a check on excessive risk-taking. Recent evidence suggests
that this approach is effective.107
106
Jonathan R. Macey & Maureen O’Hara, The Corporate Governance of Banks, 9 Fed. Res. Bank
N.Y.Econ. Policy Rev. 91 (2003).
107
In practice, responsibility for adherence to the risk policy is assigned to a Chief Risk Officer, or CRO.
Bank investments appear less risky when the CRO is independent of profit lines and has sufficient seniority
to force changes: see Andrew Ellul & Yerramilli, Stronger Risk Controls, Lower Risk: Evidence from US
Bank Holding Companies (May 2010) (unpublished manuscript), available at http://papers.ssrn.com/sol3/
Delivery.cfm/SSRN_ID1633621_code328687.pdf?abstractid=1550361 and Walker Review, supra note 60.
25
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
B. Managerial Compensation
Managers respond to incentives. When those incentives are designed by bank shareholders,
they will reward behaviour that capitalises upon the State’s implicit guarantee. A natural
response is the regulation of pay so as to enforce a meta-contract that maximises the joint
surplus of the State, managers, and investors.108 The most obvious first step in this direction
would be to require that incentive pay be indexed to the total value of all of the bank’s
investors, rather than just to the value of its shareholders. This approach would remove
managerial incentives to transfer wealth from bondholders to shareholders; it is advocated
in a recent article by Lucian A. Bebchuck and Holger Spamann.109 Their approach might
be difficult to write into regulations, however, because many non-stock bank liabilities are
not actively traded, so that it would be difficult to determine the total value of the firm.110
Moreover, a manager who maximises the combined value of the bank’s liabilities will still be
guided by market prices to take risks designed to transfer funds from the State to the bank’s
investors.
An alternative approach would be to base executive compensation on a quantifiable measure of default risk, such as the bank’s credit default swap spread.111 By aligning managerial
and credit interests, this approach would reduce the risk-taking propensity of managers, who
would no longer receive a reward for share price appreciation. But this approach would likely
tilt the playing field too far against shareholders and in favour of creditors and the State:
managers are hired to assume risks, and preventing them from doing so would restrict the
supply of credit. Hence, executive compensation contracts incorporating share prices as well
as a measure of default risk would be a better solution.112
Basing executive pay upon an appropriate metric would go some way to implementing
the optimal meta-contract. But this is not enough if bankers are able to assume massive
risks that realise with low probability long after bonus payment occurs. It is important to
appreciate that bankers do not necessarily profit from such transactions simply because the
risks that they assume are hidden from the market. Such risks increase the likelihood of
State support, and so increase the value of the bank when they are taken; if they realise
then they destroy firm value, but they do so after the banker has lost any economic interest
108
See also Kose John, Anthony Saunders & Lemma W. Senbet, A Theory of Bank Regulation and Management Compensation, 13 Rev. Fin. Stud. 95 (2000), arguing for regulation to make deposit insurance
premia contingent upon compensation policy. John et al. argue that this policy would induce investors to
write the socially optimal compensation contract. However, this argument relies upon the FDIC’s ability
to determine the effects of a particular compensation policy; if it has this ability, it is hard to see why
regulations should not simply constrain compensation directly.
109
Bebchuk & Spamann, supra note 69
110
For a discussion of this point, see Simone M.Sepe, Making Sense of Executive Compensation, 36 Del. J.
Corp. L. 189, 211 (2011), and Gordon, supra note 68, at 9 (arguing that it is difficult to measure enterprise
value, and arguing that the components of capital structure to be used in executive compensation should
not be left to the regulator’s case-by-case discretion).
111
For a definition of credit default swaps, see note 86, supra. The credit default swap spread is the price
that the protection buyer pays for CDS protection, expressed as a margin over the yield on government
securities. It is therefore a measure of the reference asset’s default risk.
112
See Patrick Bolton, Hamid Mehran & Joel Shapiro, Executive Compensation and Risk Taking (Fed. Res.
Bank N.Y., Staff Rep. No. 456, June 2010) (arguing that banker compensation contracts should reflect default
risk as well as share price appreciation, and presenting evidence that debt-like compensation is believed by
market players to reduce default risk), Frederick Tung, Pay for Banker Performance: Structuring Executive
Compensation for Risk Resolution, forthcoming, 105 Nw. U.L. Rev (2011) (arguing for payment contracts
based on the prices of shares and subordinated debt).
26
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
in their outcome. This type of problem is behind calls for bonus deferrals and clawback
arrangements.113 Both serve to give the manager an interest in the long-term survival of the
firm. An alternative approach, advocated by Simone M. Sepe, would be to give senior executives high fixed compensation payments, while reducing the power of performance-related
payments.114 The rents associated with continued employment would thus induce managerial concern for corporate survival. But neither standard clawback mechanisms nor the novel
suggestion of Sepe is without problems. The latter would be effective only if executives expected to remain in post for the long term, and it would require a very subtle and difficult
calibration to ensure that that senior executives’ entrepreneurial zeal was not destroyed by a
bureaucratic employment contract of the type discussed by Jensen and Murphy.115 Similarly,
it is hard to codify the precise basis on which clawback should occur: clawbacks are clearly
justified when managers are proved to have behaved dishonestly,116 but tying them to stock
price performance leaves managers exposed to factors over which they have no control, and
so might serve to undermine, rather than to enhance, managerial incentives.117
Left to their own devices, bankers and shareholders will not write compensation contracts
to enforce the optimal ex ante meta-contract. There is therefore a legitimate argument for
the regulation of compensation.118 I have argued that this argument is for legislation to
increase the efficiency of the meta-contract,119 and that any case for legislation to resolve
apparent inequities or injustices in executive compensation should be made separately.
Regrettably, recent legislation on executive pay does not resolve the problems that legit113
See, e.g., Lucian A. Bebchuk, Alma Cohen & Holger Spaman, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, 27 Yale J. on Reg. 257 (2010) (arguing that employees
should be compensated in shares that they are required to hold until retirement); Erica Beecher-Monas, The
Risks of Reward: The Role of Executive Compensation in Financial Crisis, 6 Va. L. & Bus. Rev. 101
(2011) (arguing for more deferred banker pay), Guido Ferrarini & Maria Cristina Ungureanu, Economics,
Politics, and the International Principles for Sound Compensation Practices: An Analysis of Executive Pay
at European Banks, 64 Vand. L. Rev. 431, 472 (2011) (stating that “deferment of variable compensation
is critical to controlling risk-taking incentives”); Sanjai Bhagat & Roberta Romano, Reforming Executive
Compensation: Focusing and Committing to the Long-Term, 26 Yale J. on Reg. 359 (2009) (arguing that
equity-based compensation should not be realised through sale or option exercise until two to four years after
the executive leaves the firm).
114
Sepe, supra note 110.
115
Jensen & Murphy, supra note 63, and accompanying text.
116
See, e.g., Sharlene Goff, Lloyds to Claw Back Bonuses over PPI, Fin. Times, Feb. 19, 2012, at 17
(stating that the UK state-owned bank Lloyds announced that it would strip Eric Daniels, its former chief
executive, and a number of other directors of a portion of their 2010 bonuses as punishment for their role in
the mis-selling of loan insurance)
117
See, e.g., Jeffrey Gordon, “Say on Pay”: Cautionary Notes on the U.K. Experience and the Case for
Shareholder Opt-In, 46 Harv. J. on Legis. 323, 334 (2009) (discussing the problem of measuring performance for clawback purposes with reference to airline managers who successfully hedged against rising oil
prices in 2007).
118
Contra Ferrarini & Ungureanu, supra note 113, at 431, arguing that “compensation structures at banks
before the financial crisis were not necessarily flawed, and that recent reforms in this area reflect already
existing best practices,” and Id., at 451, stating that “the case for regulating bankers’ pay is weak, especially
since it is far from proven that pay structures widely contributed to excessive risk taking before the recent
crisis.” Professors Ferrarini & Ungureanu argue that the FSF’s (now FSB’s) Principles on Pay are welldeigned, and note that, while they have been only partially implemented through national reforms in Europe,
European law and practice are converging towards FSB Principles and Standards (Id., at 494). I argue infra
that the FSB’s standards are excessively biased towards traditional governance modes, and, hence, towards
shareholder interests.
119
Note 62 supra, and accompanying text.
27
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
imise intervention. The Dodd-Frank Wall Street Reform and Consumer Protection Act120
(“Dodd-Frank”) contains a number of provisions on executive pay, which apply to any firm
listed on a national US exchange. The Act calls for revamped disclosure rules,121 advisory
“say-on-pay” votes to be held at least once every three years,122 independent compensation
committees,123 and for clawbacks in narrowly-defined circumstances.124 These measures all
serve to improve shareholder oversight of managers, and to ensure better alignment of shareholder and manager interests. But the fundamental problem of bank corporate governance
is the need to enforce the State’s economic interests in the meta-contract; it is impossible to
achieve this simply by granting shareholders additional control rights. Doing so will serve
only to improve the ability of shareholders and managers to create and enforce a side-deal
that enriches them collectively at the expense of the State. Governance reform requires
explicit intervention to prevent this from happening. In line with earlier remarks,125 this
will involve mandatory changes to the performance metrics used in compensation contracts,
along with changes to the horizon over which payments are made. The recent legislative
focus upon shareholder monitoring is a fundamental mistake.126
C. Shareholder Liability
Bank shareholders throughout the world are protected by limited liability. I have argued that
limited liability is important because it facilitates meta-contracting by reducing contracting
costs and clearly delineating the object over which investors and managers contract.127 Nevertheless, there is no conceptual or legal impediment to other forms of investor liability. And,
indeed, limited liability in the financial sector is a relatively recent innovation: between the
1863 passage of the National Banking Act128 and 1935 a system of “double liability” operated
for commercial banks in the US, with the shareholders in all national banks and most statechartered banks liable to the par value of their shares in addition to their investment.129
120
Wall Street Reform and Consumer Protection (Dodd-Frank) Act of 2010, Pub. L. No. 111-203, 124
Stat. 1376 .
121
Id., at 1903-04 (codified at U.S.C.§ 78n) (requiring annual disclosure of information showing the relationship between executive compensation and financial performance, as well as the median compensation of
employees other than the CEO, the CEO’s compensation, and the ratio of the two).
122
Id., at 1899-1900 (to be codified at U.S.C. § 78n-1) (requiring advisory “say-on-pay” votes to be held at
least every three years, with shareholders given the right to vote every six years on whether the vote should
be every one, two, or three years).
123
Id., at 1900-03 (amending the Securities Exchange Act by inserting § 10C) (mandating independent
compensation committees, defining independence; requiring compensation committees to report the use of
consultants, and requiring disclosure of any conflicts of interest identified by the consultant.
124
Id., at 1904 (amending the Securities Exchange Act by inserting § 10D) (providing for clawbacks of
compensation awarded due to accounting restatements resulting from material non-compliance with financial
reporting standards).
125
See supra notes 109-117.
126
See also Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151,
1155 (2009-2010) (arguing that “at least at the biggest bailout recipients, the evidence suggests that the
more serious problem was conflict between the interests of creditors on the one hand, and the interests of
shareholders, as advanced by managers, on the other. And the administration’s pay approach, by further
aligning manager and shareholder interests, only exacerbates this conflict.”).
127
See supra notes 23-25 and accompanying text.
128
National Banking Act of 1863, ch. 58, 12 Stat. 665
129
See Jonathan R. Macey & Geoffrey P. Miller, Double Liability of Bank Shareholders: History and
Implications, 27 Wake Forest L. Rev. 31 (1992). Congress repealed double liability for newly issued bank
28
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
Likewise, banks in the UK imposed additional liability upon their shareholders through the
late 19th and early 20th century by selling new “partly paid” shares for less than their nominal value; shareholders were liable for the remaining “uncalled capital” at the discretion of
managers.130 And until the 1970s investment banks were organised as partnerships or as
private companies closely held by their managers,131 who were therefore jointly personally
liable for their losses.
Some commentators have suggested that social welfare would be well-served if the limited
liability form in banking were jettisoned, for example via a total or partial return to the
partnership form.132 It is easy to make a meta-contractual case for such a policy shift.
Recall that corporate governance in banking is complex precisely because shareholders and
managers fail to account for the interests of the State when they agree their meta-contract.
A liability regime that imposes additional costs upon shareholders in those states of the
world where State support is provided should have two mitigating consequences: first, it
should provide shareholders with strong incentives to design a meta-contract that reduces
the likelihood of State investment; second, double shareholder liability should reduce the
State’s exposure by providing a cushion against losses.
Evidence from nineteenth and early twentieth century banks in the US and the UK
supports these hypotheses. Between 1863 and 1935 double liability national banks assumed
more risks that limited liability state-chartered banks.133 Moreover, double liability national
banks had lower failure rates, higher capital ratios, and higher liquidity ratios.134 In the
pre-deposit insurance era, double liability in the US and uncalled capital in the UK appear
to have protected depositors against loss upon bank failure: between 1865 and 1934, the
average annual loss to depositors of failed national banks was 44 cents per 1,000 dollars.135
There appears to be a strong logical and empirical prima facie case against limited
liability in banks. Relaxation of limited liability rules would surely resolve some corporate
governance problems. But it is an appropriate policy only if its benefits seem likely to
outweigh its costs. On this point, the evidence is rather murky.
Double liability in the United States succeeded in controlling risks, and Jonathan R.
shares, and abolished the requirement for national banks that gave six months’ termination notice. By 1953,
all but twenty five of the almost 5,000 national banks had opted out of double liability (id., at 38).
130
See Richard S. Grossman & Masami Imai, Contingent Capital and Bank Risk-Taking Among British
Banks Before World War Economic History Review (fortcoming, 2012) (outlining the history of contingent liability in UK commercial banks).
131
See Alan D. Morrison & William J. Wilhelm, Jr., Investment Banking: Institutions,
Politics, and Law 267-276 (2007) (discussing the special properties of partnerships in investment banks),
and see generally id., at 97-223 (tracing the history of investment banking partnerships).
132
See, e.g., Steven M. Davidoff, A Partnership Solution for Investment Banks?, N.Y.
Times DealBook (Aug. 20, 2008), available at
http://dealbook.nytimes.com/2008/08/20/
a-partnership-solution-for-investment-banks/; Christine Harper, Wall Street Shareholders Suffer Losses
Partners Never Imagined, Bloomberg (Feb. 11, 2011), available at http://www.bloomberg.com/apps/news?
pid=newsarchive&sid=a8wXme0GUnco (making the case for partnerships) and Claire Hill & Richard
Painter, Berle’s Vision Beyond Shareholder Interests: Why Investment Bankers Should Have (Some) Personal Liability, 33 Seattle U. L. Rev. 1173, 1188 (2010) (arguing for either mandatory partnership/joint
venture agreements between highly compensated bankers and their firms, or for any compensation over $1
mn to be paid in assessable stock).
133
Benjamin C. Esty, The Impact of Contingent Liability on Commercial Bank Risk Taking, 47 J. Fin.
Econ. 189, 215 (1998).
134
Richard S. Grossman, Double Liability and Bank Risk Taking, 33 J. Money, Credit & Bank. 143
(2001).
135
Macey & Miller, supra note 129, at 34.
29
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
Macey and Geoffrey P. Miller argue that it was expertly administered by the courts.136 But
enforcement was nevertheless costly: the courts had to deal with the opportunistic transfer
of shares from wealthy to impecunious investors who could not pay assessments,137 and it
was difficult to enforce assessments against investors in remote jurisdictions.138
It is very difficult to argue that the problems faced by nineteenth century bankruptcy
courts would be easier to resolve today. Enforcement of double liability would surely be
more complex in a world of multi-national bank and geographically dispersed shareholders.
Moreover, a smart financial engineer should be able to arrange for bank stock to be held
by a special purpose company that could frustrate any call for funds by failing. Graeme
G. Acheson and John D. Turner suggest a possible solution to this problem, in the form of
large and wealthy investors that vet all share transfers and whose liability persists after they
sell shares.139 But, while this would avoid an equilibrium of barely solvent special purpose
shareholders, it would also reduce the marketability of shares and, hence, could raise the
cost of bank capital.140
Limited liability serves clearly to delineate the boundaries of the firm, and, hence, to
clarify meta-contracting between investors and managers. Extending investor liability would
sacrifice that clarity. This would have a technological cost, in that investors would incur
higher screening and monitoring expenses. It would also require institutional changes,141
with a concomitant loss of investor liquidity. Both effects would increase the cost of metacontracting, restrict the universe of potential investors, and raise the cost of funds.
The technological effects identified in the previous paragraph were arguably behind the
flotation decision for the former investment banking partnerships. Investment banks started
to float after the New York Stock Exchange (NYSE) relaxed its rules to admit joint-stock
corporate members in 1970; sixteen retail oriented investment banks floated in short order,
and the more wholesale-oriented banks floated in a second wave, from 1978 to 1999, when
Goldman Sachs went public.142 The impetus for flotation was technological. From the early
1960s, investment banks were increasingly able to use computers to expand the scale and the
scope of their activities; at the same time, they were able to use new information technology and financial engineering techniques to codify much practice that, previously, had been
entirely dependent upon tacit knowledge and reputationally intermediated commitments.143
They therefore faced a trade-off between the benefits derived from the strong reputational
incentives of the partnership on the one hand, and the need for financial capital and organizational scale that partnerships could not support on the other. Technology increasingly
resolved this tradeoff in favour of scale and financial capital, so that flotation became un136
Id., at 40.
Id., at 46.
138
Id., at 50.
139
Graeme G. Acheson & John D. Turner, The Death Blow to Unlimited Liability in Victorian Britain:
The City of Glasgow Failure, 45 Explorations in Econ. Hist. 235, 238 (2008).
140
An increase in the cost of bank capital that reflected a more accurate pricing of the wider social costs
would ensure that all of the consequences of a manager’s actions were incorporated into his economic calculus,
and thus would be welfare enhancing. But the institutional change suggested by Professors Acheson and
Turner would achieve this only by incurring an additional, deadweight, cost from lower share liquidity. That
cost is worth incurring only if there are no cheaper ways to improve bank governance.
141
See note 140 supra
142
Morrison & Wilhelm, supra note 131, at 278-279.
143
Alan D. Morrison & William J. Wilhelm, Jr., The Demise of Investment Banking Partnerships: Theory
and Evidence, 63 J. Fin. 311 (2008).
137
30
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
avoidable.144 Large investment banks have since moved progressively towards transactional
business and away from reputationally intermediated business.145 Hence, a return to the
partnership form would certainly improve reputational incentives in investment banking,
but these incentives are less effective and less important than they once were, and their
reintroduction would be costly.
Changes to the liability structure of modern banks would also reintroduce political problems that the society of the nineteenth century was arguably better able to deal with than
today’s. These problems were manifest when the City of Glasgow bank, then the third
largest of any British bank, failed in October 1878. Double shareholder liability was effective in this instance, in that none of the City of Glasgow’s depositors experienced a loss.
However, the failure caused enormous hardship amongst its 1,819 shareholders, of whom
only 254 were solvent after the bank’s liquidation.146 The Economist commented upon the
social effects of double liability in this case as follows: “In hundreds and thousands of cases
homes have been broken up, health and life destroyed, dismay and ruin spread over towns
and parishes, sons and daughters left penniless by the wickedness and folly which perverted
a public trust in so infamous a manner.” 147 Acheson & Turner comment upon the “general
hysteria” that gripped politicians as a result of such losses, many of which were absorbed by
non-professional investors.148 The consequence in nineteenth century Britain was the 1879
passage of the Companies Act,149 which facilitated bank conversion to limited liability.150
It is hard to believe that today’s politicians would be as willing to allow widows and
orphans to be bankrupted by double liability as those of 1879. In the recent crisis, for
example, the British government yielded to political pressure to extend protection to UK
depositors in the failed Icelandic bank Icesave, despite the fact that those depositors had no
claim upon the British State.151 It is surely a realistic prospect that, when push came to
shove, a modern State would protect retail investors from the costs of double liability. An
informationally efficient capital market would reflect this in securities prices, so that all of the
technological costs of double liability would be incurred with little beneficial countervailing
impact upon shareholder and managerial incentives.
In summary, the case for relaxing limited liability in the banking sector is far from cutand-dried. Doing so would incur unavoidable technological costs, and it could be effective
only if politicians could be relied upon not to grant last-minute exceptions to vocal voter
coalitions. Recent evidence suggests that they could not.
144
Id..
See Steven M. Davidoff, Alan D. Morrison & William J. Wilhelm, Jr., The SEC v. Goldman Sachs:
Reputation, Trust, and Finduciary Duties in Investment Banking J. Corp. L. (forthcoming, 2012) (discussing the trend towards transactional investment banking in the context of a large securitization deal);
see generally Morrison & Wilhelm, supra note 10 (discussing the evolution of trading norms in investment
banking).
146
Acheson & Turner, supra note 139, at 236.
147
City of Glasgow Bank – Progress and Details of the Liquidation, 1879 The Economist 1480 (cited by
Acheson & Turner, supra note 139, at 239).
148
Id., at 252.
149
Companies Act, 1879, 33 & 34 Vict., c.104 (U.K.).
150
See Grossman & Imai, supra note 130.
151
See Matthew Vincent, Savers ‘Can Now Relax’ After Pledges Calm Fears, Fin. Times, 9 Oct., 2008,
at 6
145
31
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
D. Scope Restrictions in Banking
Lord Turner, Chairman of the UK’s Financial Services Authority, remarked in a widely-cited
2009 round-table discussion that some financial innovation was “socially useless,” 152 and remarked in a speech shortly afterwards that he believed that “some parts of the system were
swollen beyond their optimal size.” 153 An neutral observer, confused by modern finance and
appalled at the cost of State support to the banking sector, might use Turner’s remarks as
justification for legislation that restricts the scope of banking activity. But it is impossible
to make this inference in the contractarian framework upon which this Article rests. Contractarian arguments make no judgement as to the nature of the good, and, hence, cannot
make an extrinsic comment judgement as to the social utility of a particular activity. In a
contractarian world, an action is useful precisely because the parties to it wish to perform
it.154
A better way to interpret Lord Turner’s argument would be with reference to the State’s
absence from the meta-contractual bargaining in banks. If banks and shareholders agree to
engage in activities that impose uncompensated costs upon the State then those activities
are contrary to the contractarian precepts of this Article. If it would be impossible to
agree through a process of bargaining between investors, bank managers, and the State’s
representatives upon a meta-contract that sanctioned those activities then they should not
be performed. But this conclusion is some way from the extrinsic value judgement that Lord
Turner and like-minded commentators appear to deploy.
In practice, of course, the type of three-way meta-contractual bargaining envisioned in
the preceding paragraph is not possible. If so, it might be better to prevent institutions with
likely access to State support from undertaking risky and complex activities, and thereby
to resolve the distortive effect of State support from business entry decisions in the banking
sector. This idea is behind recent demands by several commentators that deposit-taking
institutions be separated from other financial institutions to create “narrow banks.” 155 Proponents of narrow banking argue that it would enable the State to commit not to rescue
non-deposit taking institutions, and so restore market discipline to their activities.156
A partial separation between deposit taking and securities businesses was advanced by
the former Federal Reserve Chairman Paul Volcker, who proposed the so-called “Volker
Rule,” preventing deposit-taking institutions from engaging in proprietary trading. The
152
Adair Turner, How to Tame Global Finance, Prospect (Aug. 27, 2009), available at http://www.
prospectmagazine.co.uk/2009/08/how-to-tame-global-finance/.
153
Adair Turner, Chairman, FSA, Speech at the City Banquet, Mansion House, London, UK (Sep. 22,
2009), available at http://www.fsa.gov.uk/library/communication/speeches/2009/0922_at.shtml.
154
Contractarianism adopts an individualist position. It therefore proceeds from the assumption that
individuals are their own arbiters of morality, and, hence, is “bound to reject as illegitimate any social
organization that aims to impose a particular vision of the good above all others.” Rosenfeld, supra note 32,
at 779. Individuals compromise and arrive at value through the process of bargaining from which contracts
emerge: See id., at 793 (arguing that contractual values are just precisely “because they are the product of
a contract.”).
155
See, e.g., John Kay, Narrow Banking: The Reform of Bank Regulation (Ctr. Study Fin. Innovation, Report No. 88, 2009).
156
Examining the Impact of the Volcker Rule on Markets, Businesses, Investors and Job Creation: Hearing
Before the Subcomm. on Capital Mkt. and Gov’t Sponsored Enter. & Subcomm. on Fin. Inst. and Consumer
Credit of the H. Comm. on Fin. Serv., 112th Cong. (Jan. 18, 2012) (opening statement of Chairman Scott
Garrett).
32
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
Volcker Rule is implemented by Section 619 of the Dodd-Frank Act.157 But the reasoning
behind the Volcker rule is unconvincing. First, proprietary trading does not appear to have
been a primary factor in the genesis of the financial crisis. Second, the Volcker rule and
related policy initiatives all rest upon the assumption that a commitment not to support
non-deposit taking institutions is credible. I have already argued that it is not.158 Recent
history provides ample evidence in support of my assertion. Three of the largest recipients
of State support during the Financial Crisis were the insurance company AIG and the US
Government-supported agencies Fannie Mae and Freddie Mac (Fannie and Freddie), none of
which was regulated as a bank. Nevertheless, the Financial Crisis Inquiry Commission notes
the widely-held market perception that Fannie and Freddie had “the implicit full faith and
credit of the government.” 159
Third, the case for narrow banks is further undermined by the ability of market participants to innovate around scope restrictions. Once again, recent experience provides us
with a good example, in the “shadow-banking sector.” 160 The shadow banking sector compriseds financial vehicles financed with short-term funds that invested in illiquid, long-term
assets. The liability structure of shadow banks exposed them to the same financial stresses
as commercial banks161 but, because they did not formally take deposits, they were subject
to none of the regulatory strictures of the commercial banks. When the crisis came, some
shadow banks received State support.162 If market participants were sufficiently far-sighted
to anticipate this support it is perhaps unsurprising that, immediately prior to the crisis, the
shadow banking sector was larger by assets than the banking sector.163 The Volcker Rule,
if rigorously enforced, will serve further to shift potentially destabilising risk-taking outside
the regulated banking sector, so that the prudential authorities are less able to prepare for
and to respond to systemic fragility.164
E. Scale Restrictions in Banking
If the State cannot credibly avoid supporting a large distressed financial firm, perhaps it
should pass laws that restrict the size of those firms. As noted in Part III supra, the
contractarian approach of this Article gives us a yardstick against which to evaluate this
approach. I have argued165 that the very large scale of financial firms might be a collusive
Wall Street Reform and Consumer Protection (Dodd-Frank) Act of 2010, Pub. L. No. 111-203, § 619,
124 Stat. 1376 . The Volcker Rule prohibits banks from engaging in proprietary trading, as well as from
retaining any ownership interest in a private equity or hedge fund.
158
See supra note 54 and accompanying text.
159
Financial Crisis Inquiry Commission, supra note 54, at 316.
160
The evolution of the shadow banking sector is analysed by Gary Gorton, Slapped by the Invisible
Hand (2010).
161
See note 47 supra.
162
See, e.g., Marcin Kacperczyk & Philipp Schnabl, When Safe Proved Risky: Commercial Paper During
the Financial Crisis of 2007-2009, 24 J. Econ. Persp. 29 (2009) (documenting that the US Department
for the Treasury responded to a run on the money market mutual fund sector by making an announcing
temporary deposit insurance protection for the sector).
163
Tobias Adrian & Hyun-Song Shin, The Shadow Banking System: Implications for Financial Regulation
(Fed. Res. Bank N.Y., Staff Rep. No. 382, July 2009).
164
For a careful discussion of this point, see Charles K. Whitehead, The Volcker Rule and Evolving Financial Markets, 1 Harv. Bus. L. Rev. 39 (2011). Whitehead suggests that “the [Volcker] Rule’s ultimate
intention was less to cure a particular cause of the financial crisis and more to champion the populist view
that commercial banking should be separated from investment banking” Id., at 41
165
Supra text accompanying notes 74-80.
157
33
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
response by managers and investors to the State subsidy that large firms attract. If this is
the case, in restricting the scale of banks the State would merely be enforcing its legitimate
bargaining rights in the meta-contract: a size restriction would be an assertion of the free
market, rather than an impediment to its operation. Hence, a policy of forcibly shrinking
banks is valid if its benefits in the form of better incentives would outweigh any efficiency
costs.
The prima facie case for smaller bank policy appears reasonable. I have already cited
evidence that appears to suggest that banks are much larger than any reasonable estimate
of their efficient scale.166 They are also extremely complex, so that neither the regulator
nor the other parties to the meta-contract can accurately evaluate their risks. At the same
time, small-to-medium sized banks are less likely to receive government bailouts, and their
investors appear more likely to dismiss managers who assume risks, incur losses, or cut
dividends.167
A world with more, smaller, banks would also be a world with a more competitive banking sector. In most walks of life, this is an unambiguously desirable outcome. But there
is a school of thought that competition may be undesirable in banking, because bank managers are more likely to assume socially costly risks when they do not expect to be rewarded
for long-term survival by a long-term stream of control rents, or “charter value.” 168 One
might argue that this effect could undermine the positive effects of heightened competition.
However, recent theoretical and empirical works cast doubt upon the causal link between
competition and risk-taking in banking.169 Moreover, evidence that heightened bank competition causes financial fragility is presented on a ceteris paribus basis; it is the thesis of
this Article that bank governance mechanisms need to be changed to reflect more accurately
the State’s role as an investor in banks. In other words, changes to the competitive landscape should be accompanied by changes to the regulatory landscape to resolve some of the
incentive problems that charter value may have addressed historically.
166
See supra note 80.
Martin Cihák, Andrea Michaela Maechler, Klaus Schaeck & Stéphanie Stolz, Who Disciplines Bank
Managers?, 16 Rev. Fin. 197 (2012).
168
See, e.g., Michael C. Keeley, Deposit Insurance, Risk, and Market Power in Banking, 80 Am. Econ.
Rev. 1183 (1990) (arguing that a decline in charter value during the 1980s caused banks to take risk and
reduce their capital levels); Thomas F. Hellmann, Kevin C. Murdock and Joseph E. Stiglitz, Liberalization,
Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?, 90 Am. Econ.
Rev. 147 (2000) (arguing that higher capital requirements might increase risk-taking incentives by lowering
charter value); Sepe, supra note 110 (arguing that managers will take fewer risks with the bank when their
pay is structured to give them long-term incumbency rents).
169
See John H. Boyd & Gianni De Nicoló, The Theory of Bank Risk Taking and Competition Revisited, 60
J. Fin. 1329 (2005) (presenting a model in which heightened bank competition serves to lower risk-taking
incentives); Thorsten Beck, Bank Competition and Financial Stability: Friends or Foes? (World Bank, Policy Research Working Paper No. 4656, June 2008) (presenting evidence that suggests that the association
between competition and fragility is caused by regulatory and supervisory failures, and concluding that regulation should concern itself directly with incentives rather than fine-tuning the competitive environment);
John H. Boyd, Gianni Do Nicoló & Abu M. Jalal, Bank Risk-Taking and Competition Revisited: New Theory
and New Evidence (Int’l Monetary Fund, Working Paper No. 06/297, Dec. 2006) and Gianni De Nicoló
& Elena Loukoianova, Bank Ownership, Market Structure and Risk (Int’l Monetary Fund, Working Paper
No. 07/215, Sep. 2007) (exhibiting evidence from large datasets that finding that failure probability is positively associated with bank concentration); Elena Carletti & Agnese Leonello, Credit Market Competition
and Liquidity Crises (Dec. 2011) (unpublished manuscript) (on file with Author) (arguing that competitive
banking systems are better able to withstand real liquidity shocks, because the opportunity cost of liquidity
reserves is lower, and hence the volume of such reserves is higher, in such markets).
167
34
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
A further objection to the argument that banks should be smaller is that, if financial
crises arise in response to system-wide shocks, they will affect every small bank in the same
way that they affected a few very large banks in the recent Crisis. The State would then be
forced to support multiple small banks simultaneously, and this may be a harder task than
supporting one big bank. This is a harder criticism to counter. Moreover, shrinking bank
sizes may induce herding amongst bankers who appreciate this effect: if the only way that
small banks can access State funds is by exposing themselves to a system-wide shock, they
could attempt to create such an exposure by ensuring that they all have the same position.
Breaking up larger banks may indeed generate herding effects. But, given the State’s
inability to walk away from a large distressed bank, it does not seem that we lose a great
deal by exchanging the current situation for one in which banks compete, but are subject to
herding incentives. Moreover, the State can make a credible commitment to bail out only
a half (say) of the failing institutions when multiple small banks experience simultaneous
problems; such a commitment would serve to improve banker incentives, and it is impossible
in a world with only very large banks. Finally, in moving from a world with a few very
large banks to one with many smaller banks, we would exchange the extreme complexity of
the large banks for a more complex network of simpler banks. The latter would, arguably,
be easier for supervisors to assess: smaller banks are easier to understand, and, when State
support is reduced, market signals derived from the contractual network between the banks
would be more accurate.
In short, there appears to be a strong case for shrinking the banks. This policy would be
politically challenging, and it would take a long time to implement, but it should nevertheless
be a central focus of future policy work.
F. Resolution Processes
Very large banks will be systemically important for as long as they are permitted to exist; the
State will continue to provide such institutions with support at times of financial fragility.
And, in the contractarian model of this paper, this support justifies State intervention in
bank corporate governance. The cost of such support is diminished when the State is able
to reduce its financial exposure to weak and failing banks through early intervention in their
affairs. That is, to some extent, the State can substitute to some extent for governance
legislation by assuming extraordinary powers of intervention in distressed banks. This is a
very large topic, and is addressed in this Article only insofar as it affects bank governance.
The Federal Deposit Insurance Corporation Act of 1991 (FDICIA)170 was a response to
the TBTF problem that attempted to achieve the substitution identified in the preceding
paragraph. It requires regulators to intervene rapidly in financially distressed firms through a
system known as Prompt Corrective Action (PCA),171 and limits their discretion to support
troubled banks.172 There is some evidence that the FDICIA went some way towards restoring
market discipline.173 The UK came later to this type of legislation with the passage of the
170
Federal Deposit Insurance Corporation Act of 1991, Pub. L. No. 102-242, 105 Stat. 2236 .
Id., at § 205.
172
Id., at § 142.
173
See, e.g., Mark J. Flannery & Soring M. Sorescu, Evidence of bank market discipline in subordinated
debenture yields, 51 J. Fin. 1347 (1996) (finding greater risk sensitivity of bank funding costs in the wake
of FDCIA).
171
35
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
Banking Act 2009,174 prior to which there were no special procedures for banks under British
insolvency law. The Banking Act institutes a Special Resolution Regime for failing banks,
allowing the regulator to use its judgement to force banks into a formal resolution process.
The Dodd-Frank Act of 2010175 attempts further to improve US resolution processes.
It provides for the creation of the Financial Stability Oversight Council (FSOC),176 with
responsibility for assessing the systemic significance of financial institutions, and it creates
an early intervention system (Early Remediation),177 and a new liquidation regime (Orderly
Liquidation Authority) for those institutions.178 In his remarks at the signing of the DoddFrank Act, President Obama stated that “because of this law, the American people will never
again be asked to foot the bill for Wall Street’s mistakes. There will be no more tax-funded
bailouts – period.” 179 But, notwithstanding these remarks, some commentators have argued
that Dodd-Frank has numerous lacunae, as a result of which the Too Big to Fail problem
remains serious.180 Moreover, in the medium term, it is reasonable to question whether the
political will to intervene aggressively in weak institutions will persist far into any economic
recovery.181 Furthermore, one could reasonably argue that it is inevitable in an advanced
economy that some banks will be systemically important.182 If so, it is inevitable that banks
will retain some measure of State support. For as long as this remains the case, the corporate
governance of banks must involve the State.
Faster and better winding-up procedures should reduce, if not remove, the deleterious
incentive effects of State support in the banking sector. But they are not a panacea. In
particular, they give regulators a good deal of power to dismantle financial structure by
administrative fiat. Such powers should of course be subject to adequate oversight, but in
practice, the danger that regulators would be insufficiently willing to pull the trigger on a
troubled bank seems greater than the risk that they would be excessively willing to do so.
This forbearance might occur because the regulator is concerned that its own reputation
might be impaired if a bank for which it is responsible is revealed to be weak.183 If so,
174
Banking Act, 2009, c.1 (U.K.).
Wall Street Reform and Consumer Protection (Dodd-Frank) Act of 2010, Pub. L. No. 111-203, 124
Stat. 1376 .
176
Id., at §§ 111-123.
177
Id., at § 166.
178
Id., at §§ 201-217.
179
President Barack Obama, Remarks by the President at Signing of Dodd-Frank Wall Street Reform
and Consumer Protection Act (Jul. 21, 2010), available at http://www.whitehouse.gov/the-press-office/
remarks-president-signing-dodd-frank-wall-street-reform-and-consumer-protection-act.
180
In a comprehensive analysis of the Act, Arthur E. Wilmarth, Jr., argues that the Act leaves significant
scope for systemically important institutions to expand, that it allows the FDIC to protect favoured creditors
of those institutions, that the Act’s prudential supervision provisions are inadequate, and that it does not
prevent the exploitation of the deposit insurance safety net by financial holding companies. See Arthur E.
Wilmarth, Jr., The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-to-Fail Problem, 89
Or. L. Rev 951 (2011).
181
See John C. Coffee, Jr., Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory
Strategies Beyond Oversight, 111 Colum. L. Rev. 795, 818-822 (2011) (arguing that regulation is intensified
after a crisis, but that it is then steadily relaxed for political reasons).
182
This will certainly be the case for as political and economic considerations continue to favour the
existence of large and complex banking organizations. See supra text following note 169.
183
See, e.g., Alan D. Morrison & Lucy White, Reputational Contagion and Optimal Regulatory Forbearance
(Eur. Cent. Bank, Working Paper 1196, 2010) (arguing that damage to regulator reputation has systemic
consequences, and, hence, that the regulator could legitimately manage its reputation); see also Arnoud
W. A. Boot & Anjan V. Thakor, Self-Interested Bank Regulation, 83 Am. Econ. Rev. (Papers and
175
36
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
there is a case for separating the supervisory responsibility from responsibility for closure.
Forbearance might also reflect regulatory capture by the financial sector.184 If so, the case for
regulatory discretion is reduced: the system may be better served by clear rules delineating
the supervisor’s responsibilities for intervening.185
G. Capital Adequacy and Corporate Taxation
Bank capital requirements should serve to ameliorate investor incentives to collude with
managers in order to maximise the value of the State’s support.186 In line with this hypothesis, bankers with more capital and a higher fraction of equity capital fared better during
the crisis,187 and, hence, attracted less State investment.
Notwithstanding these observations, the extreme complexity of the Basel Accord’s capital
requirements188 appears to have opened the door to regulatory arbitrage: that is, to actions
that reduce the severity of regulations without affecting the phenomena that the regulations
are intended to control. The capital requirements promulgated by the various Basel Accords
allow for various forms of non-equity capital,189 and assign a lower capital requirement to
bank assets that are deemed to be less risky.190 Regulators have made some rather questionable decisions about risk-weighting. For example, and notwithstanding multiple episodes
of sovereign default, sovereign debt attracted a very low risk weighting under the first and
second Basel Accords.191
Bankers managed prior to the Crisis to turn this complexity to their advantage. For
example, they managed to use the securitization market to reduce their capital requirements
significantly while scarcely altering their risk positions. 192 They also performed trades
that lowered their equity capital levels and increased their leverage to unprecedented levels,
without violating the letter of the Basel Accords.193 Clearly, the meta-contract as it relates
to capital requirements is mis-specified.
On capital requirements, the negotiating position of bank shareholders and their managers is clear. Both argue that common equity is a more costly source of investment funds
than debt, so that heightened capital requirements would reduce their ability to extend
Proceedings of the Hundred and Fifth Annual Meeting of the Am. Econ. Assoc.) 206 (1993)
(arguing that regulators might elect to manager their reputations for private gain, and at some social cost).
184
See Coffee, supra note 181.
185
See, e.g., Jonanthan M. Edwards, FDICIA v. Dodd-Frank: Unlearned Lessons About Regulatory Forebearance, 1 Harv. Bus. L. Rev. 279 (2011).
186
See supra notes 88-93 and accompanying text.
187
See, e.g., Asil Demirgüc-Kunt, Enrica Detragiache & Ouarda Merrouche, Bank Capital: Lessons From
the Financial Crisis (World Bank, Policy Research Paper No. 5473, Nov. 2010); Andrea Beltratti & René
M. Stulz, Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the
Impact of Governance and Regulation (Nat’l Bureau of Econ. Research, Working Paper No. 15180, July
2009)
188
See supra text accompanying note 94
189
See supra text accompanying note 93
190
See supra text accompanying note 97
191
The effect was stronger under the first Basel Accord than the second. See Basel Comm., Basel I, supra
note 89, at 17 (assigning a blanket zero capital requirement to claims upon any OECD central government)
and Basel Comm., Basel II, supra note 90, at 19,23 (assigning a lower capital requirement to sovereigns than
to corporate borrowers with the same credit rating).
192
See Viral V. Acharya, Philipp Schnabl & Gustavo Suarez, Securitization Without Risk Transfer (Nat’l
Bureau of Econ. Research, Working Paper 15730, Feb. 2010)
193
Acharya et al. , supra note 66.
37
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
credit.194 But a large body of economic theory and evidence supports the hypothesis, due to
Nobel Laureates Franco Modigliani and Merton Miller, that the social cost of funds relates
to the use to which they are put, and not to their source.195 The bankers’ preference for debt
over equity reflects two facts, both of which are incorporated in the market prices that they
face. First, debt financing is tax-advantageous, in that interest payments are deducted from
corporate profits before tax is calculated.196 Second, debt financing increases the likelihood
of State support. While these effects are real enough from the perspective of the banker,
both represent a transfer from the taxpayer to the bank. Hence, as I have argued repeatedly,
both have highly deleterious incentive effects.
In short, higher capital requirements would, indeed, result in a higher experienced funding
cost for the bank.197 But this cost would arise simply because investors were bearing some
of the true costs of its investment decisions that previously were absorbed in expectation by
State bodies. In other words, banker demands for lower capital requirements, and for risksensitive capital requirements, essentially boil down to a demand that State subsidies to the
banking sector be maintained. But these subsidies have damaging incentive consequences,
which, I have argued, are the root cause of governance problems in the banking sector.
Clearly, the State, in the guise of the banking regulator, should not accede to the bankers’
demands for lighter capital regulation.
And yet bankers appear to be winning the argument on capital regulation. The Basel III
Accord continues to embrace the epistemological misconceptions of the Basel II Accord,198
and introduces further complexity to an already opaque set of rules. It retains a central role
for banker-generated risk data, and, hence, hard-wires the misapprehensions of bankers into
regulation.199
It is not obvious that any of this complexity is necessary. It generates asset misallocation
both because it provides bankers with an incentive to take positions that maximise the
value of their subsidy, and also because talented people spend their careers finding ways of
turning this complexity to their own advantage, rather than in generating a social surplus.
In exchange, it delivers false precision and detailed but ineffective meta-contracts.
194
See, e.g., Francesco Guerrera & Daniel Pimlott, Pandit and King Clash Over Basel III, Fin. Times,
Oct. 25, 2010 (reporting a claim by the Chief Executive of Citigroup that equity capital is a more expensive
source of loanable funds than debt).
195
Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance, and the Theory of
Investment, 48 Am. Econ. Rev. 261 (1958); Franco Modigliani & Merton H. Miller, Corporate Income
Taxes and the Cost of Capital: A Correction, 53 Am. Econ. Rev. 433 (1963). For discussion of this point
in the banking context, see Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig & Paul C. Pfleiderer,
Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not
Expensive (Rock Ctr. Corp. Governanceat Stan. Univ., Working Paper No. 86, 2011)
196
See, e.g., John R. Graham, How Big Are the Tax Benefits of Debt?, 55 J. Fin. 1901 (2000) (presenting
evidence that, on average, the value of the tax benefit to debt equals 9.7 percent of firm value in the United
States).
197
Nevertheless, recent work from the Bank of England’s Monetary Policy Committee suggests that the
effect on the cost of borrowing from banks would be slight. See David Miles, Jing Yang & Gilberto Marcheggiano, Optimal Bank Capital (Bank of England, External MPC Unit Discussion Paper No. 31, Apr. 2011)
(concluding from a study of UK banks that a doubling of bank capital levels would cause the cost of borrowing to increase by 0.1-0.4 percent). See also Samuel G. Hanson, Anil K. Kashyap & Jeremy C. Stein, A
Macroprudential Approach to Financial Regulation, 25 J. Econ. Persp. 3 (2011) (using US data to argue
that, aside from tax considerations, changes to bank leverage have little effect upon the cost of bank funding).
198
See supra text accompanying notes 88-101.
199
See supra text following note 100.
38
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
There are two simple solutions to this problem. The first is to remove the tax advantage
that debt currently enjoys. This would resolve many of the incentive problems in banks
at a stroke. However, all of the available evidence indicates that this move is politically
impossible. Some commentators argue that it would have little effect upon leverage choices
in the largest banks, anyway.200 The second solution is significantly to simplify capital
regulation, and greatly to increase common equity capital requirements for banks. This
would involve some one-off adjustment costs, and some one-off wealth transfers between the
various bank investors.201 For this reason, it may be necessary to use administrative fiat to
force a recapitalisation.202
VI. Conclusion
The nexus-of-contracts theory of the firm is one of the central pillars of the law-and-economics
approach to corporate law. An important tenet of the theory is that individuals are free to
express their own notion of the good through the contracts they write. If one accepts
this position, corporate law appears to have a largely enabling, rather than a purposive,
role. This is an uncomfortable conclusion in light of the Financial Crisis of 2007-09, which
appeared to reveal flaws in market processes that were previously viewed in may quarters
as self-correcting. Nevertheless, we lack a consistent theoretical foundations to replace the
contractarian framework and, as a result, calls in the wake of the Crisis for better regulation
of governance processes in financial firms have been fragmented and sometimes confused.
Real progress will rest upon a theory that rationalises State-imposed rules in a contractarian
framework.
This Article presents a refinement of the nexus-of-contracts theory that lays bare the
role of corporate governance, and justifies a limited level of State intervention in corporate
governance. I argue that the firm’s nexus-of-contracts can usefully be viewed as comprising a
real nexus of contracts with agents in the real economy, and a meta-contract with investors.
The real nexus generates economic value, and throws off the surplus that is paid to investors,
200
See, e.g., Michael Keen & Ruud de Mooij, Debt, Taxes, and Banks (Int’l Monetary Fund, Working
Paper WP/12/48, Feb., 2012) (presenting evidence from 14,000 commercial banks in eighty two countries over
nine years that large bank debt choices are little affected by changes to tax codes). One obvious explanation
for Keen and de Ruud’s results is that the largest banks are so secure in their State support that they would
retain debt to profit from that even if the tax benefits of debt financing were lower.
201
When a bank has little equity capital, large losses are mostly experienced by the State and by its
debt-holders, while profits accrue largely to its shareholders. Hence, recapitalisation of fragile banks transfers wealth from shareholders to debtholders and, because the State subsidy is reduced, to taxpayers. It
is therefore rationale for bank shareholders to resist recapitalisation. See Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig & Paul C. Pfleiderer, Debt Overhand and Capital Regulation (Rock Ctr. Corp.
Governanceat Stan. Univ., Working Paper No. 114, Mar. 2012)
202
A forced recapitalisation is not the same as a higher minimum capital ratio. Banks can achieve the
latter without issuing equity by reducing their lending. While this might maximise the value of bank
equity, it undermines economic activity. Commentators have expressed concern that the failure of European
authorities to require banks to issue fresh equity may indeed have reduced lending in the Eurozone: See,
e.g., Patrick Jenkins, Draghi Must Tackle This Halfhearted Remedial Work, Fin. Times, Nov. 1, 2011, at
15 (stating that “by shrinking their way out of the capital shortfalls, . . . [banks] will have less capacity to
lend,” and arguing that Mario Draghi, the incoming president of the European Central Bank, should push
for compulsory recapitalisation of European banks). In line with the predictions of Admati et al. , supra
note 201, European bankers are resisting any call for compulsory recapitalisation. See Quentin Peel & Chris
Bryant, German bankers resist capital plans, Fin.Times, Oct. 14, 2011, at 6 (stating that “Germany’s entire
banking industry has joined forces to resist any compulsory recapitalisation of banks.”).
39
META-CONTRACTS, CORPORATE GOVERNANCE, AND BANK REGULATION
while the meta-contract comprises, first, a promise to run a particular real nexus, and, second,
a statement of how the real nexus’ surplus is to be divided amongst investors. While the
first part of the meta-contract can be written using black-letter contract law, the second part
cannot, and therefore rests upon a mixture of formal and informal devices that are designed
to commit corporate officers to certain actions. It is to this mixture of devices that I refer
in this Article when I talk about corporate governance.
If corporate governance is concerned with the creation and enforcement of corporate
meta-contracts, all of the firm’s investors should be involved in the creation of corporate
governance structures. This observation gives us a rationale for rule-making in the corporate
governance of industries that receive State support. The State is a de facto investor in those
industries and, hence, should play a part in their meta-contracting. That role is expressed
through the regulation of corporate governance.
That the State is an investor in the financial sector, and, hence, that the State has a
legitimate role in the governance of banks, was graphically demonstrated by the events of
2007-09. Policy can respond to this demonstration in two ways. First, it can substantially
reduce the level of State support to financial firms, and, thus, reduce the justification for
State involvement in governance processes. I have argued in this Article that, while it is a
desirable, for a number of economic and political reasons this goal is probably an unrealistic
one in the short run, although there is a strong case for shrinking bank sizes. This leaves
us with the second valid policy response: rule-making in bank corporate governance, or
micro-regulation of financial firms. Micro-regulation is difficult, because banks are extremely
complex and have strong incentives, often transmitted through the price mechanism, to
abuse State support. Moreover, policy in this field has arguably been excessively influenced
by quasi-scientific techniques that purport to resolve the complexity of modern financial
instruments and the firms that trade them. Nevertheless, I have presented some realistic
micro-regulatory proposals in this field, related in particular to capital requirements and
compensation.
This Article provides a rationale for State rule-making in the corporate governance of
banks. Accepting this point would represent a significant concession for some corporate
scholars, but, in making this concession, they need not accept any State activity beyond the
cost-effective correction of failures in meta-contracting. The institutions by which corporate
governance rules are created and promulgated need to be designed to ensure that they do not
exceed that limitation without a clearly enunciated mandate. The study of such institutions
is a topic for later work.
40