April 7, 2015

Bank Shareholders and Customers Take Backseat to Regulators

Hester Peirce

Former Senior Research Fellow
Summary

Last week, the Wall Street Journal reported that bank regulators are spending lots of quality time with bank boards of directors. Bank supervisors engage in extended chats with independent directors, drop in on board meetings, and otherwise size up bank boards. As John Carney pointed out in a follow-up piece this week, the result of these activities is that shareholders are no longer boards' priority.

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Last week, the Wall Street Journal reported that bank regulators are spending lots of quality time with bank boards of directors. Bank supervisors engage in extended chats with independent directors, drop in on board meetings, and otherwise size up bank boards. As John Carney pointed out in a follow-up piece this week, the result of these activities is that shareholders are no longer boards' priority. Although disturbing to the sensibilities of those of us who believe that boards ought to answer to shareholders, bureaucrats in the boardroom are simply a tangible manifestation of the blurry line between banks and their regulators.

In recent guidance, the Office of the Comptroller of the Currency states that it assesses whether board members are "adequately objective and independent" and considers "the degree to which the member's other responsibilities conflict with his or her ability to act in the covered bank's interest." Ironically, too often responsibilities imposed by bank regulators give rise to such conflicts. Regulators want directors to stop being parochial and make decisions based on what is good for the financial system as a whole, rather than for their institution. 

Increasingly, banks are making decisions for regulatory-not business-reasons. Through stress testing, resolution planning, risk-based capital requirements, the Volcker Rule, the Durbin Amendment, new mortgage rules, Operation Choke Point, and many other regulatory and supervisory avenues, the government is reshaping how banks are structured and funded and who they serve. The notion that banks would be free to chart their own course within sensible regulatory parameters is fading away in the face of prescriptive rules and intrusive examinations.

A dangerous precedent was set during the crisis, when the government inaugurated the Troubled Asset Relief Program by gathering the country's biggest banks' CEOs in a room at Treasury and instructing them to take billions of dollars of taxpayer money for the good of the financial system. That's the kind of decision that a bank's board of directors typically would have a say in, but-as Wells Fargo CEO Richard Kovacevich told Frontline-when he dared to suggest that, government officials said he had to sign the documents within the hour. Convening a board meeting in an hour is a bit difficult, but why bother if the government has displaced the board as decision-maker anyway?

Putting regulators in board rooms is a natural next step. But it is a risky one for regulators, who may be just as likely as others in the room not to notice problems building up right under their noses. Reflecting on the last crisis, the Office of the Comptroller of the Currency wrote:

"During the financial crisis, the OCC observed that some members of the board of directors at certain institutions had an incomplete understanding of their institution's risk exposures. The OCC believes that this evidences both a failure to exercise adequate oversight of management and critically evaluate management's recommendations and decisions during the years preceding the financial crisis."

After the next financial crisis hits, the OCC's analysis might be a little more self-critical. The tighter the partnership between banks and boards on the one hand and regulators on the other, the worse regulators will look when something goes wrong.

On the bright side for banks (but not for taxpayers), it will be even easier for big financial institutions to get bailouts in the next crisis. When bad decisions come home to roost, all directors will have to do is swivel their board room chairs to plead with the regulator sitting next to them. Having been in the room when the decisions were made, the regulators will be hard pressed to say no to bailout pleas.

To avoid this scenario, let's set broad regulatory parameters and then allow boards to figure out how to incentivize managers to operate within them to serve the needs of customers and to generate income for shareholders.