Corporate Governance and Prudential Regulation of Banks: Is There Any Connection?

Abstract

One "narrative" of the financial crisis of 2007-2009 is that poor corporate governance at financial institutions was a major cause of the crisis. An immediate implication of this narrative is that better corporate governance-a better alignment of the interests of senior management with the interests of their shareholders-would have prevented (or at least ameliorated) the crisis. This chapter argues that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory. Because of the protections of limited liability, it is in the interests of diversified shareholders of a corporation (including financial institutions) to encourage senior managers to undertake greater risks than is in the interests of the corporation's creditors (or of regulators who may represent depositorcreditors or the interests of society more generally). Consequently, public policy should look to improved prudential regulation, rather than improved corporate governance, for restraining the excessively risky activities of systemically important financial institutions.