Book Description

The financial crisis of 2007-09 was interpreted by many as evidence that the incentives of managers were not optimally aligned with the interests of shareholders. As a result, a plethora of proposals have been put forward seeking to increase shareholder engagement. However, this shareholder engagement strategy only makes sense if the risk appetite of bank shareholders is not socially excessive. The conventional model for corporate governance presumes that the costs of failure are largely internalized by the firm and so are taken into account when shareholders determine their risk appetite. In this paper I argue, when applied to banks, this view is mistaken. Banks do not internalize the costs of failure, hence the risk appetite of bank shareholders is socially excessive. I show that shareholder pressure on their management to accept greater risk can help explain the excessive risk-taking of banks. My analysis indicates that recent corporate governance reforms that attempt to tighten the alignment of managerial and shareholder interests cannot be expected to address the problem I identify. To adequately understand what policies should be explored, we must first recognize that excessive risk-taking is also partly a product of the conventional model of governance. I therefore propose a modification to that model: a regime of double bank shareholder liability that is triggered by bank failure. I discuss how this has the potential to reduce bank shareholders' risk appetite, and, make less likely, excessive risk-taking. Welfare improvement occurs because of heightened risk awareness and enhanced risk-taking controls, decreasing the likelihood of failure. I introduce the term "the bank shareholder-orientated model" of governance to characterize this modified approach.