A 1999 OECD report defined corporate governance as "the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”
In the WSJ, Holman Jenkins refutes claims that corporate governance caused the financial crisis. Instead, he explains that the system worked as expected:
The first thing to notice is that CEO pay works as advertised, incentivizing bank executives to take on risk to please their investors. So much for a steady rivulet of journalism that maintains that towering CEO compensation is always and everywhere evidence of theft and self-dealing. ...
"High-powered incentives . . . are simply the carrot needed to get the firm to take risks desired by institutional investors," write Ing-Haw Cheng, Harrison Hong and Jose Scheinkman, in one of several papers recently presented at a conference at Columbia University. ... Pounding home the point, the authors add that the "poor outcomes [recently experienced by banks] are not evidence of CEOs acting in their own interest at the expense of shareholder wealth." Rather, they are evidence (our words) of how the collective hunt for competitive returns is distorted by the availability of taxpayer-guaranteed leverage.
The problem thus was not that the mechanisms of corporate governance were flawed, but rather that the ends to which those mechanisms were directed were wrong.
In other words, the core problem was "not the incentive of managements to produce competitive returns, but the incentive of bank creditors to oversupply leverage because they believe government will make them whole whether or not a bank's bets pay off." Explicit government guarantees such as deposit insurance and implicit guarantees such as the beliefs that the government would not let Fannie or Freddie fail and that some banks were to big to be allowed to fail meant that key actors could externalize risk to the taxpayer. The fact that CEOs and boards did so is not evidence that corporate governance failed; to the contrary, it is evidence that corporate governance worked.
It's a question of means and ends. If a gun is used to kill someone, we don't say the gun failed. We say it was used improperly. We don't try to fix the gun, we try to give people incentives to use it properly.
Corporate governance is a tool just like the gun. Efforts to "fix it" are fundamentally misguided. Instead, we should be focusing on regulating the ends to which the system is directed, as Jenkins suggests:
Example: If depositors want no-risk, government-guaranteed deposits, why not require banks to back them up 100% with Treasury bills? Why subsidize banks to borrow with a government guarantee to invest in riskier assets?Note: Stefan Padfield has an interesting problem/solution dialogue prompted by the Jenkins column.
Perhaps the best idea, though, is to require financial firms to fund themselves partly with a special kind of debt that would automatically be converted to equity when a bank's capital or liquidity are imperiled. These debtholders then would have an incentive to monitor not just the amount of leverage, but the quality of the risks a bank is pursuing.
