Alert June 17, 2014

FRB Governor Tarullo Makes Presentation Concerning Alignment of Bank Corporate Governance and Prudential Regulation

FRB Governor Daniel K. Tarullo made a provocative presentation concerning bank corporate governance and prudential regulation to corporate and financial law professors and other attendees at the Midyear Meeting of the Association of American Law Schools.

In his presentation, Governor Tarullo pointed out that the recent financial crisis provided support for the proposition that banks require both enhanced microprudential level (regulation at the individual bank level e.g., increased capital and liquidity requirements) and microprudential regulation (regulation designed to protect the U.S. economy as a whole and avoid a harmful contraction of credit in a significant geographic region or to an industry sector).  Because management of risk is central to the activities of banks, stated Governor Tarullo, we need to consider ways in which prudential regulation does and should influence bank risk-taking decision-making.  One example of a step already taken to influence risk management by banks is the Dodd-Frank Act’s requirement that bank holding companies with more than $10 billion in total assets establish a risk management committee comprised of independent directors.

Governor Tarullo next discussed three kinds of regulatory and supervisory measures that he believes can better align bank corporate governance with prudential regulation.

Changing Compensation Incentives for Senior Executives

Governor Tarullo observed that stock option and other equity-based compensation arrangements for senior managers do a good job of aligning the executives’ interests with those of diversified shareholders “who value the upside of risk-taking and whose limited liability makes them relatively less concerned with catastrophic downside possibilities.”  However, regulatory objectives are focused on avoiding the catastrophic downside risk and preservation of the bank.  Ways of realigning these incentives noted Governor Tarullo include: (1) having a bank’s return on debt as well as return on equity reflected in incentive compensation calculations, and (2) making a significant portion of incentive compensation deferred and subject to clawback and forfeiture.  In addition, stated Governor Tarullo, incentive realignment can be addressed by increasing capital market discipline through imposition of a requirement that a banking organization maintain specified minimum amounts of long-term debt that would be converted to equity upon the insolvency of the banking organization.  Governor Tarullo stated that requiring establishment of this class of convertible debt would indirectly influence a bank’s corporate governance because senior managers of the institution would need to understand, monitor and address the concerns of a new constituency, those of at-risk debt holders.

Requirements for Stress Testing and Capital Planning That Help to Regulate Risk-Taking Decisions

Governor Tarullo pointed out that it would be very difficult for bank supervisors to develop a rule that would require a bank to implement a risk appetite plan that matched regulatory objectives.  However, bank supervisory programs that require a bank to conduct stress tests and develop and implement a capital plan “serve as partial surrogates for such a rule.”  Stress tests allow bank regulators to evaluate at an early stage whether a bank’s risk-taking is consistent with the bank supervisor’s microprudential and macroprudential objectives.

Enhanced Board Oversight of Risk Management and Potential Change in Fiduciary Duties of Bank Directors

In discussing actions that have the effect of improving the risk assessment and risk management capacity of bank boards of directors, Governor Tarullo noted efforts to enhance management information systems that improve the quality of data and other information provided to bank boards.  He also noted the value brought to the board decision-making process by including independent board members and by having members with relevant expertise and experience.  Bank regulators, said Governor Tarullo, should expect that a banking organization board’s risk management decisions are made on an enterprise-wide basis and that the board is spending a sufficient amount of time on overseeing key risk management and control functions.

Furthermore, Governor Tarullo suggested that consideration be given to expanding the fiduciary duties of directors of banking organizations to more closely align these duties with meeting regulatory objectives.  While such changes in fiduciary duties would require amendments to state corporate laws and are beyond the powers of bank regulators, Governor Tarullo stated that such changes would be likely to make bank boards more responsive to interests beyond those of diversified shareholders i.e., to interests of regulators and society as a whole.  Governor Tarullo further noted that broadening of a bank director’s fiduciary duties would make “the courts . . . available as another route for managing the divergence between private and social interests in risk-taking,” by providing a mechanism to hold a bank director liable for an alleged breach of his or her broadened fiduciary duty.