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«UK CORPORATE GOVERNANCE AND BANKING REGULATION: THE REGULATOR’S ROLE AS STAKEHOLDER Kern Alexander* The role of financial regulation in influencing ...»

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Kern Alexander*

The role of financial regulation in influencing the development of corporate governance principles in the United Kingdom

(UK) and throughout Europe has become an important policy issue that has received little attention in the literature. To date,

most research on corporate governance has addressed issues affecting companies and firms in the nonfinancial sector. Corporate governance regulation in the financial sector traditionally has been regarded as a specialty area with standards and rules fashioned to achieve the overriding objectives of financial regulation— safety and soundness of the financial system, and consumer and investor protection. In the case of banking regulation, the traditional principal–agent model used to analyze the relationship between shareholders, directors, and managers has given way to broader policy concerns to maintain financial stability and to ensure that banks operate in a way that promotes broader economic growth and enhances shareholder value.

Recent research suggests that corporate governance reforms in the nonfinancial sector may not be appropriate for banks and other financial sector firms.1 This is based on the view that no * © 2004, Kern Alexander. All rights reserved. Senior Research Fellow, Cambridge Endowment for Research in Finance, The Judge Institute of Management, University of Cambridge, and Tutor in Economics and Law, Queens’ College, Cambridge. This Article was presented at the Comparative Corporate Governance Symposium at the Annual Meeting of the American Society of Comparative Law.

I would like to thank Dr. Rahul Dhumale and Professor John Eatwell for their comments and insights. Special thanks to the Stetson Law Review and, in particular, to Cheryl L. Smith and Meredith A. Phipps for their careful editorial attention. Many thanks also to the participants of the Annual Meeting of the American Society of Comparative Law and to the organizers of the Comparative Corporate Governance Symposium. Much of the research and writing took place at the Cambridge Endowment for Research in Finance and the ESRC Centre for Business Research, Cambridge University. All errors remain mine.

1. See e.g. Renée Adams & Hamid Mehran, Is Corporate Governance Different for Bank Holding Companies? 9 Fed. Reserve Bank of N.Y. Econ. Policy Rev. 123 (2003) (explaining why governance may differ for bank holding companies).

992 Stetson Law Review [Vol. XXXIII single corporate governance structure is appropriate for all industry sectors and that the application of governance models to particular industry sectors should take account of the institutional dynamics of the specific industry. Corporate governance in the banking and financial sector differs from that in the nonfinancial sectors because of the broader risk that banks and financial firms pose to the economy.2 As a result, the regulator plays a more active role in establishing standards and rules to make banking management practices more accountable and efficient.

Unlike firms in the nonfinancial sector, a mismanaged bank may lead to a bank run or a collapse. This can cause the bank to fail on its various counterparty obligations to other financial institutions and to fail to provide liquidity to other sectors of the economy.3 The role of the board of directors therefore becomes crucial in balancing the interests of shareholders and other stakeholders, such as creditors and depositors. Consequently, bank regulators place additional responsibilities on bank boards that often result in detailed regulations regarding the boards’ decision-making practices and strategic aims. These additional regulatory responsibilities for management have led some experts to observe that banking regulation is a substitute for corporate governance.4 According to this view, the regulator represents the public interest, including stakeholders’ interests, and can act more efficiently than most stakeholder groups to ensure the bank’s adherence to regulatory and legal responsibilities.

By contrast, other scholars argue that private remedies should be strengthened to enforce corporate governance standards at banks.5 Many propose improving banks’ accountability and efficiency of operations by increasing the legal duties that bank directors and senior management owe to depositors and

2. See John Eatwell & Lance Taylor, Global Finance at Risk: The Case for International Regulation 21–27 (The New Press 2000) (discussing the pricing of risk by banks and how systemic risk can arise and undermine financial stability).

3. The mispricing of risk by banks creates the negative externality of systemic risk.

See id. at 40–43 (discussing systemic risk and risk management techniques in the financial sector). For a discussion of how the negative effects of bank insolvency can be transmitted through the economy, see E. Philip Davis, Debt, Financial Fragility, and Systemic Risk 109–116 (Clarendon Press Oxford 1995).

4. Adams & Mehran, supra n. 1, at 124.

5. See e.g. Jonathan R. Macey & Maureen O’Hara, The Corporate Governance of Banks, 9 Fed. Reserve Bank of N.Y. Econ. Policy Rev. 91, 103 (2003) (proposing expanded fiduciary duties for bank directors).

2004] Regulator’s Role as Stakeholder 993 other creditors.6 This would involve expanding the scope of fiduciary duties beyond shareholders to include depositors and creditors. Under this approach, depositors and other creditors could sue the board of directors for breach of fiduciary duties and the standard of care, in addition to whatever contractual claims they may have. This would increase bank managers’ and directors’ incentive to pay more regard to solvency risk and would thereby protect the broader economy from excessive risk-taking.

The traditional approach of corporate governance in the financial sector often involved the regulator or bank supervisor relying on statutory authority to devise governance standards promoting the interests of shareholders, depositors, and other stakeholders. In the UK, banking regulation has traditionally involved government regulators adopting standards and rules that applied externally to regulated financial institutions.7 Regulatory powers were derived, in part, from the informal customary practices of the Bank of England and other bodies that exercised discretionary authority in their oversight of the UK banking industry.8 Bank regulation involved, inter alia, capital requirements, ownership limitations, and restrictions on connected lending.9 These regulatory standards and rules composed the core elements of corporate governance for banking and credit institutions.

As deregulation and liberalization led to the emergence of global financial markets, banks expanded their international operations and moved into multiple lines of financial business. They developed complex risk-management strategies that allow them to price financial products and hedge their risk exposures in a manner that improves expected profits, but which may generate more risk and increase liquidity problems in certain circumstances.10 The limited liability structure of most banks and financial firms, combined with the premium placed on shareholder profits, provides incentives for bank officers to undertake increasE.g. id. at 92.

7. See Maximilian J.B. Hall, Handbook of Banking Regulation and Supervision in the United Kingdom 205 (3d ed., Edward Elgar 1999) (discussing the flexible supervisory approach of regulation in the UK).

8. Id.

9. Id.

10. Avinash Persaud, Liquidity Black Holes: And Why Modern Financial Regulation in Developed Countries Is Making Short-Term Capital Flows to Developing Countries Even More Volatile 1 (UNU/WIDER 2002).

994 Stetson Law Review [Vol. XXXIII ingly risky behavior to achieve higher profits without a corresponding concern for the downside losses of risk. Regulators and supervisors find it increasingly difficult to monitor the complicated, internal operating systems of banks and financial firms.

This has made the external model of regulation less effective as a supervisory technique in addressing the increasing problems that financial firms’ excessive risk-taking poses to the broader economy.

Increasingly, regulators are devising frameworks that require financial firms to adopt internal, self-monitoring systems and processes to comply with statutory and regulatory standards. This Article analyzes the new financial regulatory framework under the UK Financial Services and Markets Act of 200011 (FSMA), which requires banks and other authorized financial firms to establish internal systems of control, compliance, and reporting for senior management and other key personnel.12 Under FSMA, the Financial Services Authority (FSA) has the power to review and sanction banks and financial firms regarding the types of internal control and compliance systems they adopt.13 These systems must be based on recognized principles and standards of good governance in the financial sector. These regulatory standards place responsibility on the senior management of firms to establish and to maintain proper systems and controls, to oversee effectively the different aspects of the business, and to show that they have done so.14 The FSA will take disciplinary action if an approved person—director, senior manager, or key personnel—deliberately violates regulatory standards or if his or her behavior falls below a standard that the FSA could reasonably expect him or her to observe.15 The broader objective of the FSA’s regulatory approach is to balance the competing interests of shareholder wealth maximization and the interests of other stakeholders.16 The FSA’s balancing 11. 2000, c. 8 (Eng.).

12. Id.

13. Id. at § 66.

14. Id. at § 1.

15. Fin. Servs. Auth., Consultation Paper 17: Financial Services Regulation: Enforcing the New Regime 33, http://www.fsa.gov.uk/pubs/cp/cp17.pdf (Dec. 1998).

16. See id. at 5 (explaining that the FSA seeks to “[maintain] confidence in the financial system, promot[e] public awareness of the financial system, [and] secur[e] the appropriate degree of protection for consumers”).

2004] Regulator’s Role as Stakeholder 995 exercise relies less on the strict application of external statutory codes and regulatory standards, and more on the design of flexible, internal compliance programs that fit the particular risk level and nature of the bank’s business. To accomplish this, the FSA plays an active role with bank management in designing internal control systems and risk-management practices that seek to achieve an optimal level of protection for shareholders, creditors, customers, and the broader economy.17 The regulator essentially steps into the shoes of these various stakeholder groups to assert stakeholder interests while ensuring that the bank’s governance practices do not undermine the broader goals of macroeconomic growth and financial stability. The proactive role of the regulator is considered necessary because of the special risk that banks and financial firms pose to the broader economy. This Article raises the broader question, for future research, of whether regulation should play as proactive a role in the governance practices of other large companies in the nonfinancial sector.18 Part I of this Article reviews recent developments in UK corporate governance and discusses the relevant aspects of UK company law. Unlike United States corporation law, company law in the UK has traditionally provided that directors owe a duty to the company, not to the shareholders.19 This legal principle provides a point of departure for analyzing the regulator’s role in devising corporate governance standards that seek to balance the various interests of shareholders, creditors, and stakeholders. Part II considers “governance” within the context of the principal–agent framework and how this would apply to financial-sector firms.

Part III reviews some of the major international standards of corporate governance as they relate to banking and financial firms.

This involves a general discussion of the international norms of corporate governance for banking and financial institutions, as set forth by the Organisation for Economic Cooperation and Development and the Basel Committee on Banking Supervision.

Part IV analyzes the FSMA regulatory regime for banking regulation and suggests that its requirements for banks and fiSee infra nn. 166–176 and accompany text (discussing senior management arrangements, systems, and controls).

18. However, this Article does not specifically address the question.

19. See infra nn. 57–89 and accompanying text (discussing directors’ duties under English company law).

996 Stetson Law Review [Vol. XXXIII nancial firms to establish internal systems of control and compliance programs represent a significant change in UK banking supervisory techniques and establishes a new corporate governance framework for UK banks and financial firms. This new regulatory framework departs from traditional UK company law by establishing an objective reasonable person standard to assess whether senior managers and directors have complied with regulatory requirements, with the threat of substantial civil and criminal sanctions for breach.20 Part V argues that this new regulatory framework for the corporate governance of banks promotes some of the core values in the corporate governance debate over transparency in governance structure and information flow, and the supervisor’s external, monitoring function. This Section also suggests that the governance framework of UK banking regulation might serve as a model for corporate governance reform for companies in the nonfinancial sector.



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