Internal and External Governance of Large Banks

September 30, 2012

Who and what oversees the actions of large banks, and how are they disciplined? Economist Bill Emmons describes how both internal and external governance play a role, as well as their limitations.

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William Emmons: Okay, next topic. How, in fact, do we manage, discipline these banks? And I'll split this into internal and external forms of governance. So you can probably think of others, but here are some examples. One form of internal governance is corporate culture. I'll explain these in just a second.

One would be board oversight. Members of the board of directors. Another would be managerial self-interest. Maybe there's some sort of correlation between how individuals within the big banks operate their objectives and generating good outcomes for the banks.

In terms of external governance, product market disciplines. So these banks have to be able to sell their goods and services to survive. So that's discipline of the market. Shareholders can sell their stock if they want. That provides some discipline. There's also the possibility the depositors could take their money out. Bond holders might refuse to lend to these firms. Counterparties in various transactions might refuse to trade with a bank they don't feel is well run. And, of course, there's government supervision and regulation.

So what do we mean by corporate culture? It's—the best corporate culture is where do the right thing just comes naturally. If there's ever any doubt, you always use this as the rule of thumb. That's what I have in mind. Board oversight, what I mean by that is making sure that all of the employees are serving not only shareholders' interests but respecting other stakeholders too, creditors, employees, members of the community, etc. And by managerial self-interest, what I mean is that all the individuals inside the organization, because they're pursuing their own concerns, career concerns, trying to make money, if that leads in the right direction, in other words, somebody who doesn't believe that the bank is the right way for them to build a successful career and they leave to go somewhere else, that's a form of discipline on the organization.

So my first example of sort of discouraging evidence on corporate culture at big banks comes from a survey that was conducted recently by a British survey research firm. It was sponsored by a law firm from New York. And it asks about 500 senior employees at U.S. and U.K. financial services firms a series of questions. One of them was do you think a financial services professional must engage in unethical or illegal conduct to succeed? And 24 percent said yes.

Do you have any firsthand knowledge of wrongdoing in your workplace? Similarly, yes, about a quarter. Would you commit a trading related crime if you thought you would not be caught? 16 percent said yes. Do you think some of your competitors cheat? 39 percent said yes. Do you think your firm's compensation practices create pressure to compromise your ethical standards? 30 percent said yes.

So I don't have the evidence on how firms in other—or how employees in other companies would answer, but that's kind of discouraging.

Martin Taylor, former CEO of Barclays Bank, and most recently a member of the U.K.'s Independent Commission on Banking, said recently, "It had sometimes seemed that we had not only the wrong kind of bank but the wrong kind of banker. At some stage the customer relationship drifted from duty of care to buyer beware." So on a scoreboard of whether the big bank culture is an effective disciplining device, I'm going to say no. I don't think that, you know, this is just fragmentary evidence, but I think some of the discussion that we had at the very beginning, some of those misbehaviours, I think, also point in this direction. That the internal corporate culture at the largest banks are not an effective mechanism for keeping the banks on the straight and narrow.

I think it's also true that board oversight is lacking. I've heard from my colleagues that at smaller banks this is a perennial issue. At mid-sized banks it's a bigger issue. And at the largest, how could these non-experts coming in from other parts of the economy, how could they possibly understand and provide effective oversight on these very large, very complex organizations?

I will though give the benefit of the doubt to the fact that these are internally very competitive organizations and that there is an incentive for people working at a big bank to leave to go to some other big bank if they think this one is not operating well enough.

So against maybe an impossible benchmark I'm putting in this first column, the very best of internal governance at non-financial companies, banks don't rank very well, I think.

In terms of external governance, what about product market discipline, needing to sell your goods and services? Do shareholders, in fact, pay attention to banks' performance? Do they sell their stock when the performance is poor? What about depositors, bond holders, counterparties? Are they paying attention? Do they provide the kind of feedback and discipline that would help to keep a bank on the straight and narrow? And what about supervision and regulation? Is it effective?

Well, I won't go through lots of extended arguments, but I think that this in general is more effective. That there's more external discipline working certainly through product markets. We do have competitive financial services markets. So whether it's a small bank or a big bank, they still have to provide good products and services.

There's no question that shareholders are paying attention. These stocks are actively traded. I showed you the picture of the huge declines in bank stocks. That shows you, I think, that shareholders are paying attention. So that's providing very effective discipline on banks.

In terms of depositors, no, we don't want that because if we did have unrestrained depositor discipline that would result in bank runs. And in fact, we've made a decision, a conscious decision not to ask depositors to provide that sort of discipline. Instead we have deposit insurance and in order to keep the cost of deposit insurance reasonable, we have supervision and regulation. So that's really where the government oversight comes in, to protect the public in providing this guarantee of depositors.

So this is very, very crude. But I think, you know, the basic message is that there are some real weaknesses on the internal side, and to the extent that we can be effective as supervisors and regulators, we can probably provide fairly effective external sources of discipline. You may agree or disagree with those judgments, but my overall conclusion is that combining the internal and external forms of discipline, there are weaknesses with banks. And it's not even unique to the big banks, but it is a problem.

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