Dividing fiduciary attention

Posted by Marc Hodak on April 6, 2015 under Governance, History | Read the First Comment

Regulators are saying that they may want some of that fiduciary attention that boards currently, presumably owe exclusively to their shareholders. Last year, Fed Governor Daniel Tarullo broached the idea that bank boards should perhaps account for regulatory as well as shareholder interests in their governance to address the divergence between firm-level and “macro-prudential” needs. Tarullo suggested that this division of loyalty might supplement, if not somewhat obviate the need for, the other two approaches that the government has tried, i.e., increasingly constrained incentive plan structures and increasingly detailed banking regulations.

The incentive problem has been well covered here and here, as has the downsides of proposed regulatory remedies. Dodd-Frank includes a plethora of direct regulatory constraints to moderate the risk appetite of banks, among other things. Of course, that grand legislation failed to address TBTF or the GSEs with which the big banks competed, and—surprise!—a general feeling persists that regulation may not be enough.

One the one hand, we should have expected that conclusion long before Dodd-Frank was even passed. Contrary to the prevailing narrative, banks were working under a heap of government regulations in the run-up to 2008. Those regulations may have been the wrong ones, or they may have been poorly administered, but they undoubtedly contributed to market distortions that made ‘up’ look like ‘down’ in many derivatives transactions.

Rationalizing the regulations, and accounting for the complexity that they create (and their secondary effects), would have been a good start to improving bank governance. Instead we have greater regulatory complexity than ever, which means we have more potential distortions and perverse incentives built into our financial system than ever before. Given this reality, perhaps it makes sense to throw in the towel on trying to contain the externalities of our banking system via sensible regulation, and just tell the board of directors that they must begin to internalize those potential costs by accounting for regulatory interests alongside (or perhaps ahead of) shareholder interests.

Unfortunately, that approach has yet to work well in any other industry in which it has been tried. Instead, history suggests that regulatory cures beget regulation-induced problems, which beget more regulation, etc., until the whole sector becomes in essence, if not in fact, nationalized. This state of affairs continues, often for decades, until the manifest defects of this nationalization become obvious to everyone, and the sector gets substantially deregulated. And everything is better.

Until problems crop up again, and politicians feel compelled to do “something…anything.”