Governance of Financial Institutions (Oxford EU Financial Regulation) 0198799977, 9780198799979

Citation preview

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GOVERNANCE OF FINANCIAL INSTITUTIONS

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OXFORD EU FINANCIAL REGULATION SERIES​ The Oxford EU Financial Regulation Series provides rigorous analysis of all aspects of EU Financial Regulation and covers the regulation of banks, capital markets, insurance undertakings, asset managers, payment institutions, and financial infrastructures. The series considers Brexit and third-​country relations. The aim of the series is to provide high-​quality dissection of and comment on EU Regulations and Directives, and the EU financial regulation framework as a whole. Titles in the series consider the elements of both theory and practice necessary for proper understanding, analysing the legal framework in the context of its practical, political, and economic background, and offering a sound basis for interpretation.

Series Editors: Danny Busch

Professor of Financial Law and Director of the Institute for Financial Law, Radboud University Nijmegen; Visiting Professor at Università Cattolica del Sacro Cuore di Milano; Visiting Professor at Università degli Studi di Genova; Visiting Professor at Université de Nice Côte d’Azur; Member of the Dutch Banking Disciplinary Committee (Tuchtcommissie Banken); Member of the Appeal Committee of the Dutch Complaint Institute Financial Services (Klachteninstituut Financiële Dienstverlening or KiFiD).

Guido Ferrarini

Emeritus Professor of Business Law, Università degli Studi di Genova; Professor of Governance of Financial Institutions, Radboud University Nijmegen; Founder and fellow of the European Corporate Governance Institute (ECGI), Brussels; Former member of the Board of Trustees, International Accounting Standards Committee (IASC), London.

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GOVERNANCE OF FINANCIAL INSTITUTIONS Edited by

Danny Busch Guido Ferrarini Gerard van Solinge

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1 Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © The editors and several contributors 2019 The moral rights of the authors have been asserted First Edition published in 2019 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2018952422 ISBN 978–​0–​19–​879997–​9 Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

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PREFACE

The 2008 financial crisis had a profound impact on the regulation of financial institutions and their governance. Massive re-​regulation occurred at the international, regional (EU), and national levels, touching upon all kinds of financial institutions, including banks, insurers, investment firms, asset managers, and financial market infrastructures. The autonomy of boards of directors in these institutions has been substantially constrained as a result of the new regulatory requirements, which cover their composition, organization, and functioning. Core managerial functions such as risk management, internal controls, and compliance have been reinforced both on supervisory grounds and in practice. Managerial incentives are now subject to extremely detailed provisions based on the belief that distorted incentives contributed to the crisis of many financial institutions, banks in particular. On the whole, corporate governance in financial institutions is regulated to an extent which was unthinkable before the crisis and would be difficult to accept in non-​financial firms. Moreover, the governance of different types of financial institutions tends to be regulated in similar ways, but differences remain which need to be analysed so as to understand whether they are justified. All this briefly explains the origins of this volume and its inclusion in a series dedicated to EU financial regulation. Indeed our focus will be on Europe, but important references will be made to US regulation and to the international principles, such as those stated by the Financial Stability Board and the Basel Committee. Moreover, our analyses will be mainly devoted to financial regulation, but corporate law will also be considered whenever necessary or useful, particularly with regard to the tensions existing between financial regulation and corporate law, and to the nature and extent of the duties of directors and managers of financial institutions. In addition, the ownership structures of banks will be analysed from a legal perspective, together with their impact on the behaviour and performance of the relevant institutions. Non-​legal issues will also be considered with special reference to the conduct of boards and managers of financial institutions either in good times or throughout a crisis. Culture will be analysed as an indispensable complement or substitute for regulation. An interdisciplinary perspective will be suggested for the study of compliance and other issues that are often examined from either a legalistic or abstract viewpoint. A reflection on the role of corporate culture is today emerging both in the law and economics literature and in the activities of supervisors. This volume

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Preface intends to contribute to the understanding of corporate culture in financial institutions and their governance and supervision also through a series of case studies considering banking and financial failures in a number of EU countries at the time of the recent crisis. The book was preceded by a meeting on 25 and 26 January 2018 of the International Working Group on Governance of Financial Institutions, established as a joint initiative of the Institute for Financial Law and the Van der Heijden Institute for Company Law within the Business & Law Research Centre of Radboud University Nijmegen, the Netherlands and the Genoa Centre for Law and Finance, University of Genoa, Italy. We thank the Business & Law Research Centre for its sponsorship. We also thank De Brauw Blackstone Westbroek in Amsterdam for hosting the meeting. We are grateful to the distinguished members of the Working Group for their dedication to the project and, in particular, for their contributions to this book as authors. We also thank the invitees to the meeting for providing the members of the Working Group with invaluable comments on their draft chapters. Last but not least, we acknowledge our gratitude to the editorial team at Oxford University Press, who successfully brought a lengthy and complex project to completion. The manuscript was completed on 1 July 2018. No account could be taken of developments since that date.

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TABLE OF CONTENTS

Table of Cases Table of Legislation List of Abbreviations List of Contributors

xv xvii xxxiii xxxvii I GENERAL

1. Governing Financial Institutions: Law and Regulation, Conduct and Culture Danny Busch, Guido Ferrarini, and Gerard van Solinge I. Introduction

1.01



II.

1.03



III. Lessons from the Financial Crisis

1.12



IV. Global Principles

1.16



V.



VI. The Role of Conduct and Culture

Basic Concepts

Corporate Governance and Prudential Regulation: Complements or Substitutes?

1.25 1.31

2. Corporate Governance of Financial Institution: In Need of Cross-Sectoral Regulation Jens-​Hinrich  Binder I. Introduction

2.01



II.

Taking Stock: Governance-​Related Regulation in EU Legislation after the Global Financial Crisis



III. The Case for Cross-​Sectoral Governance-​Regulation Re-​examined—​A Functional Approach

IV. Conclusions

2.06 2.20 2.30

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Table of Contents 3. Comparative Regulation of Corporate Governance in the Insurance Sector Arthur van den Hurk and Michele Siri I. Introduction

3.01



II.

3.08



III. Risk Management

3.41



IV. The Actuarial Function

3.54



V.

The ORSA Process

3.55



VI. Internal Control System

3.58



VII. Governance Regulation Supporting Quantitative Requirements

3.61



VIII. Conclusions

3.70

Governance-​Related Regulation in EU Insurance Legislation

4. The Governance of Banks and the Requirement of Resolvability: Fundamental Change in Perspective? Bart Bierens I. Introduction

4.01



II.

4.02



III. The EU Banking Union

Complex Banks and a Global Financial Crisis

4.05

IV. Resolvability

4.08



V.

The Resolvable Bank: A Blue Print

4.12



VI. Decision to Remove Impediments

4.28



VII. The Transition to Being Resolvable

4.34



VIII. Rethinking the Governance of Banks

4.37

IX. Conclusion

4.42

5. Corporate Law Versus Financial Regulatory Rules: The Impact on Managing Directors and Shareholders of Banks Kitty Lieverse and Claartje Bulten I. Introduction

5.01



II.

Taking Stock: The Potential Tension between Corporate Law and Financial Regulatory Rules



III. Impact on the Board

5.11



IV. Impact on Shareholders

5.38

viii

5.05

ix

Table of Contents

V.

Impact of the Single Rulebook on the Interpretation of Corporate Interest

VI. Conclusions

5.46 5.56

II  GOVERNANCE STRUCTURES AND REGULATION 6. Non-​Shareholder Voice in Bank Governance: Board Composition, Performance, and Liability Paul Davies and Klaus J Hopt

I.

Bank Governance and Corporate Governance

6.01



II.

Supervisory Approval of Bank Directors and Senior Managers

6.07



III. Debt-​Holders and Bank Governance

6.17



IV. Composition of the Boards of Banks

6.32



V.

6.52

Liability of Bank Directors and Other Key Function Holders

7. Responsibility of Directors of Financial Institutions Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan I. Introduction

7.01

II. Analysis

7.03

III. Conclusion

7.56

8. Fit and Proper Requirements in EU Financial Regulation: Towards More Cross-​Sectoral Harmonization Danny Busch and Iris Palm-​Steyerberg I. Introduction

8.01



II.

8.02



III. The Impact of the Financial Crisis

8.08



IV. Credit Institutions and Investment Firms

8.11



V.

8.22



VI. The Dutch Cross-​Sectoral Approach

8.46



VII. Recommendations

8.54



VIII. Final Remark

8.84

Scope and Definitions

Cross-​Sectoral Analysis

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Table of Contents 9. Risk, Risk Management, and Internal Controls Lodewijk van Setten

I.

The Concept of ‘Risk’

9.01



II.

Risk Management is an Intrinsic Component of the Governance Design of a Firm

9.06



III. Culture and Conduct Inform Risk Management

9.20



IV. Risk Management is Part of the Internal Controls of a Firm

9.29



V.

The Risk Management and Internal Control Provisions of CRD IV

9.36



VI. The Risk Management and Internal Control Provisions of MiFID II

9.45



VII. Risk Management and Internal Controls in the UCITS Directive and AIFMD

9.51



VIII. Specific Risk-Management Controls: Remuneration Policies

9.56



IX. Concluding Remarks

9.62

10. Financial Market Infrastructures: The Essential Role of Risk Management Paolo Saguato I. Introduction

10.01



II.

10.12



III. The Public Regulation of Risk Management: EMIR and CSDR and their Implementing Regulations

10.20



IV. The Challenges of Regulating Risk Management

10.45

FMIs and the Business of Managing Risk

V. Conclusion

10.57

11. Compensation in Financial Institutions: Systemic Risk, Regulation, and Proportionality Guido Ferrarini I. Introduction

11.01



II.

11.02



III. International Principles and Standards

11.12



IV. European Banking Regulation

11.21



V.



VI. Ways to Improve EU Regulation

Grounds for Regulation

EU Regulation of Insurers, Asset Managers, and Investment Undertakings

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11.48 11.58

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Table of Contents 12. Corporate Governance, Financial Information, and MAR Carmine Di Noia and Matteo Gargantini

I.

Inside Information and Listed Banks: An Introduction

12.01



II.

A Snapshot of the MAR Regime for Inside Information

12.06



III. Is Inside Information Relevant to Bank Governance?

12.16



IV. Internal Information Flows

12.28



V.

12.38



VI. Listed Banks and Their Shareholders

12.49



VII. Financial Reporting

12.61



VIII. Conclusion

12.67

Listed Banks and Their Subsidiaries and Associates

III  OWNERSHIP STRUCTURES 13. Engagement of Institutional Investors Maria Cristina Ungureanu

I.

Financial Institutions and Investor Activism 

13.01



II.

Active Ownership

13.13



III. Stewardship Principles

13.23



IV. Engagement and Voting

13.45



V.

13.65

Exercise of Voting Rights

VI. Conclusions

13.70

14. State-​Owned Financial Institutions Johannes Adolff, Katja Langenbucher, and Christina Skinner I. Introduction

14.01



II.

14.06



III. State-​Owned Institutions: The Practical Challenges

14.37



IV. Alternative Legal Paths to the Same Policy Goals?

14.73

A Theoretical Case for State-​Owned Institutions

15. Cooperative Banking—A Dutch Experience Martin van Olffen and Gerard van Solinge I. Introduction

15.01



II.

A Short History of Cooperative Banking

15.05



III. A Short History of Cooperative Banking in the Netherlands: Rabobank

15.13

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Table of Contents

IV. Main Characteristics of Dutch Cooperative Law

15.21



V.

15.31



VI. Rabobank Corporate Governance and Finance Structure—​The Recent Past

15.40



VII. Rabobank Corporate Governance Structure—​The Present

15.52



VIII. Regulatory Framework

15.68

Specific Features of Cooperatives: Assets or Risks?

IX. Summary

15.70

IV  CONDUCT AND CULTURE 16. Corporate Culture in the Governance of Financial Institutions: An Interdisciplinary Approach Shanshan Zhu and Guido Ferrarini

I.

Financial Institutions and Culture

16.01



II.

The Notion of Culture

16.17



III. Governing Corporate Culture: (A) Leadership

16.27



IV. Governing Corporate Culture: (B) Managerial Incentives

16.42



V.

16.53



VI. Cognitive Framing and Group Dynamics

16.61



VII. Concluding Remarks

16.67

Governing Corporate Culture: (C) Codes of Conduct

17. Public Supervision of Behaviour and Culture at Financial Institutions Wijnand Nuijts I. Introduction

17.01



II.

17.05



III. What is the Supervision of Behaviour and Culture?

Development of the Supervision of Behaviour and Culture

17.11

18. The Dutch Banker’s Oath and the Dutch Banking Disciplinary Committee Peter Laaper and Danny Busch I. Introduction

18.01



II.

18.05



III. The Dutch Banking Disciplinary Committee: Actors, Procedures, and Sanctions

The Dutch Banker’s Oath

xii

18.10

xi

Table of Contents

IV. Right to a Fair Trial

18.22



V.

18.37



VI. Anonymizing Files by Notifying Banks

18.46



VII. Demarcation of the Bank’s Acts, Professional Acts, and Private Acts

18.52



VIII. Conflicting Interests of the Notifying Bank

18.60



IX. Deviation from Internal Policies

18.65

Independence and Impartiality of the Tribunal

X. Transparency

18.70

XI. Evaluation

18.77

19. Managing Conduct Risk: From Rules to Culture Antonella Sciarrone Alibrandi and Claudio Frigeni I. Introduction

19.01



II.

19.09



III. Definitional Issues Related to ‘Conduct Risk’

19.18



IV. Conduct Risk: Between the ‘Conduct Perspective’ and the ‘Prudential Perspective’

19.31



V.

19.38

Examples of Misconduct and Analysis of the Related Costs

A New Approach: From Rules to Culture

20. Conflicts of Interest: Comparing Compliance and Culture in the United States and the United Kingdom Geneviève Helleringer and Christina Skinner I. Introduction

20.01



II.

20.06



III. Navigating the Conflicts of Interest Ahead

20.32



IV. Building Cultural Infrastructure Around Legal Frameworks

20.68

Protecting the Retail Investor: The Legal Framework

V. Conclusion

20.80

21. The Venetian Banks’ Collapse Paolo Giudici I. Introduction

21.01



II.

21.08



III. Public Enforcement

21.41



IV. Red Flags

21.52



V.

21.71

The Collapse of Banca Popolare di Vicenza

Would MiFID II have Prevented the Disaster?

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Table of Contents 22. The Spanish Banking Crisis as a Corporate Governance Problem Maribel Sáez-Lacave and María Gutiérrez-Urtiaga I. Introduction

22.01



II.

22.09



III. Recapitalization Efforts

22.17



IV. The Bankia Case: The Bank that Broke Spain

22.27



V.

22.34

The Cajas de Ahorros

The Unhappy Ending

VI. Conclusions

22.41

23. Banco Espírito Santo: Anatomy of a Banking Scandal in Portugal José Engrácia Antunes

I.

From Cradle to Grave: 150 Years of Banking History

23.01



II.

The BES’s Autopsy: On the Causes of Death

23.13

III. Epitaph

23.25

24. Governance Problems in Dutch Financial Institutions from 2007 to 2017 Bas de Jong I. Introduction

24.01



II.

24.05



III. Reflections on Governance and Supervision in the DSB Case

24.15



IV. Legislative and Policy Changes after DSB

24.27



V.

EU Rules and the DSB Case

24.31



VI. Main Lessons from the Netherlands

24.35

The Case of DSB Bank

Index

577

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TABLE OF CASES

CANADA BCE Inc v 1976 Debentureholders [2008] 2008 SCC 69 (Can) . . . . . . . . . . . . . . . . . . . 7.04, 7.07 EUROPEAN SUERVISORYAUTHORITIES (BOARD OF APPEAL) SV Capital OŰ v European Banking Authority, Decisions EBA 2013 002 and BoA 2014-​C1-​02. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.16 EUROPEAN COURT OF HUMAN RIGHTS Bendenoun v France App No 12547/86 (24 February 1994). . . . . . . . . . . . . . . . . . . . . . . . . 18.32 Benham v the United Kingdom App No 19380/92 (10 June 1996). . . . . . . . . . . . . . . . . . . . 18.32 Blum v Austria App No 33060/10 (5 April 2016) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.36 Brown v the United Kingdom App No 38644/97 (24 November 1998). . . . . . . . . . . 18.30, 18.36 Diennet v France App N0 18160/91 (26 September 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . 18.30 Engel & others v the Netherlands, judgement of 23 November 1976, Series A No 22. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.30, 18.36 H v Belgium App No 8950/80 (30 November 1987). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.30 Hurter v Switzerland App No 53146/99 (15 December 2005). . . . . . . . . . . . . . . . . . . . . . . . 18.30 Le Compte, Van Leuven & De Meyere v Belgium App No 6878/75; 7238/75 (23 June 1981). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.30 Müller-​Hartburg v Austria App No 47195/06 (19 February 2013) . . . . . . . . . 18.30–​18.31,  18.36 Öztürk v Germany App No 8544/79 (12 February 1984) . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.32 WR v Austria App No 26602/95 (21 December 1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.36 EUROPEAN UNION Crédit Agricole v ECB (T-​758/​16) 24 April 2018, EU General Court. . . . . . . . . . . . . . . 5.35–​5.36 Grøngaard and Bang (C-​384/​02) 22 November 2005, ECJ. . . . . . . . . . . . . . . . . . . . . . . . . . 12.23 Markus Geltl v Daimler AG (C-​19/​11) 28 June 2012, [2012] ECR, II 38–​40. . . . . . . . . . . . 12.09 Opinion of the Advocate General Mengozzi, 21 March 2012 [2012] ECR I-​55. . . . . . . . . . . 12.09 Sociedad de Gestión y Participación SA v De Nederlandsche Bank NV (C-​18/​14 CO) 25 June 2015, ECJ. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.40 United Kingdom of Great Britain and Northern Ireland v European Parliament, Council of the European Union (C-​507/​13) 9 December 2014. . . . . . . . . . . . . . 11.34–​11.35 GERMANY Bundesgerichtshof, Decision of 21 April 1997, Arag v Garmenbeck, Decisions of the Bundesgerichtshof, Vol 135, 244. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.63, 6.73 NETHERLANDS Breeweg v Wijnkamp, ECLI:NL:HR:2015:2745, 18 September 2015, Dutch Supreme Court (HR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.68

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Table of Cases Cancun ECLI:NL:HR:2014:797, NJ 2014/​286, 4 April 2014, para 4.3, Dutch Supreme Court (HR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.50 Fugro v Boskalis ECLI:NL:HR:2018:652, 20 April 2018, Dutch Supreme Court (HR) . . . . . 5.50 Staleman v Van de Ven, NJ 1997/​360, 10 January 1997, Dutch Supreme Court (HR) . . . . . . 5.26 VEB v Fortis NV ECLI:NL:GHAMS:2012:BW0991, JOR 2013/​41, 5 April 2012, Court of Appeals Amsterdam, Enterprise Court (Ondernemingskamer). . . . . . . . . . . . . . 5.53 VEB v Fortis NV ECLI:NL:HR:2013:1586, JOR 2014/​65, 6 December 2013, Dutch Supreme Court (HR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.53 UNITED KINGDOM Concord Trust v Law Debenture Trust Corporation plc [2005] UKHL 27. . . . . . . . . . . . . . . . 6.24 Pottage v FSA, Upper Tribunal, 2012 (FS/​2010/​33). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.13 UNITED STATES Aronson v Lewis, 473 A 2d 805, 811 (Del, 1984) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.24 Atherton v FDIC, 519 U S 213, 219, 117 S Ct 666, 671–​74 (1997). . . . . . . . . . . . . . . . 7.31–​7.32 Behrens v Aerial Comm, Inc Del Ch No 17436 (18 May 2001) . . . . . . . . . . . . . . . . . . . . . . . 7.25 Branch Banking & Trust Co v Thompson, 107 N C App 53, 418 S E 2d 694, 699 (1992). . . 7.28 Caremark Int’l Inc. Derivative Litig, In Re, 698 A 2d 959, 967 (Del Ch, 1996). . . . . . . . . . . 7.10, 7.16, 7.22, 20.77 Chamber of Commerce of the US v US Dep’t of Labor, No 17-​10238 (5th Cir, 15 March 2018). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.16 Citigroup Inc Shareholder Derivative Litigation, Re, 964 A 2d 106, 115, 123–​24 (Del Ch, 2009) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.22 Citigroup Ltd, In Re (2009) 264 A 2d 106 (Del Ch). . . . . . . . . . . . . . . . . . 6.08, 6.77, 7.22, 20.77 Dodge Ford Motor Co, 204 Mich 459, 507, 170 NW 668, 684 (1919) . . . . . . . . . . . . . . . . . 7.04 eBay Domestic Holdings, Inc v Newmark, 16 A 3d 1, 34 (Del Ch, 2010). . . . . . . . . . . . . . . . 7.05 Francis v United Jersey Bank, 87 NJ 15, 27, 432 A 2d 814, 819–​20 (1981). . . . . . . . . . . . . . . 7.16 Guth v Loft Inc, 23 Del Ch 255, 270, 5 A 2d 503, 510 (1939). . . . . . . . . . . . . . . . . . . . . . . . 7.04 Kamin v Am Exp Co, 383 NYS 2d 807, 812 (Sup Ct, 1976). . . . . . . . . . . . . . . . . . . . . . . . . . 7.15 Lamden v La Jolla Shores Condo Homeowners Assn, 21 Cal 4th 249, 257 (1999). . . . . . . . . .7.15 Lewis v Knutson, 699 F 2d 230, 237–​38 (5th Cir, 1983). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.24 Litwin v Allen, 25 NY 2d 667, 668 (Sup Ct, 1940). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.62 MuCulloch v Maryland, 17 US 316 (1819). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.38 SEC v Stoker, 865 F Supp 2d 457 (SDNY 2012). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.43 Shocking Techs, Inc v Michael, No CIV A 7164-​VCN, 2012 WL 4482838, *8 (Del Ch, 1 October 2012). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.21 Smith v Van Gorkom, 488 A 2d 858, 873 (Del, 1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.16 Stone v Ritter, 911 A 2d 362, 370 (Del, 2006). . . . . . . . . . . . . . . . . . . . . . . . . . . 7.10, 7.22, 20.77 Walt Disney Co Derivative Litigation, In Re, 907 A 2d 693 (Del Ch, 2005). . . . . . . . . . 7.16, 7.20 Wells Fargo Bank, NA v Vandorn, 2012 NCBC 6, 17 (NC Super Ct, 17 January 2012). . . . . 7.28, 16.01, 16.65, 19.35, 20.51 Wells Fargo & Company Shareholder Derivative Litig, No 3:16-​cv-​05541 (No D Cal, filed 24 February 2017). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.51, 20.77 Worldcom Inc, In Re, 323 BR 844, 850 (Bankr, SDNY, 2005). . . . . . . . . . . . . . . . . . . . . . . . 7.25

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TABLE OF LEGISLATION

INTERNATIONAL INSTRUMENTS Basel Committee on Banking Supervision (BCBS) Corporate Governance Principles for Banks (2015) ����������������17.34 Recital 3���������������������������������������������� 17.34 Recital 5���������������������������������������������� 17.34 Recital 14�������������������������������������������� 17.34 Art 22 ������������������������������������������������ 17.35 Art 23j������������������������������������������������ 17.35 Art 28 ������������������������������������������������ 17.35 Arts 30, 31������������������������������������������ 17.35 Art 33b ���������������������������������������������� 17.35 Art 33f������������������������������������������������ 17.35 Arts 34, 35������������������������������������������ 17.35 Art 98 ������������������������������������������������ 17.35 Charter of Fundamental Rights of the European Union (CFR) 2000������������ 4.30 Art 16 �������������������������������������������������� 4.30 European Convention on Human Rights (ECHR) 1950����������� 18.28–​18.29 Art 6 ���������������� 18.23–​18.24, 18.28–​18.29, 18.37, 18.77 International Association of Insurance Supervisors (IAIS) Insurance Core Principles (2015)���������������������������� 17.36 ICP 7.1 �������������������������������������������������� 17.36 ICP 7.2.3������������������������������������������������ 17.36 ICP 7.2.4������������������������������������������������ 17.36 Treaty of Lisbon 2009 ������������������������������ 4.34 Art 50 �������������������������������������������������� 4.34 EUROPEAN UNION Regulations Regulation (EC) 1606/​2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards [2002] OJ L243(IAS Regulation) ��������� 12.62–​12.63 Art 5(b)���������������������������������������������� 12.62 Regulation (EU) No 1060/​2009 Regulation of 16 September 2009

on credit rating agencies [2009] OJ L302/​1(CRA Regulation)����������� 2.09, 8.02, 8.32 Art 3(1)(n)�������������������������������������������� 8.37 Regulation (EU) No 1093/​2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), amending Decision No 716/​2009/​EC and repealing Commission Decision 2009/​78/​EC [2010] OJ L 331/​12 (EBA Regulation)��������������������� 2.01, 8.03 Art 16 �������������������������������������������������� 8.03 Regulation (EU) No 1094/​2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Insurance and Occupational Pensions Authority), amending Decision No 716/​2009/​EC and repealing Commission Decision 2009/​79/​EC [2010] OJ L 331���������� 8.03 Art 16 �������������������������������������������������� 8.03 Regulation (EU) No 1095/​2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority), amending Decision No 716/​2009/​EC and repealing Commission Decision 2009/​77/​EC [2010] OJ L 331 ��������������������������������2.09, 8.03 Art 16 �������������������������������������������������� 8.03 Regulation (EU) No 513/​2011 of the European Parliament and of the Council of 11 May 2011 amending Regulation (EC) No 1060/​2009 on credit rating agencies Text with EEA relevance [2009] OJ L 145 ������������������������������ 8.02

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Table of Legislation Commission Delegated Regulation (EU) No 449/​2012 of 21 March 2012 supplementing Regulation (EC) No 1060/​2009 of the European Parliament and of the Council with regard to regulatory technical standards on information for registration and certification of credit rating agencies (Text with EEA relevance) [2012] OJ L 140�����������8.02, 8.40 Art 15(1)(b), (c)������������������������������������ 8.40 Regulation (EU) No 648/​2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (Text with EEA relevance) [2012] OJ L 201(EMIR)����������������������2.01, 2.17, 5.02, 8.02, 8.24, 8.32, 10.09, 10.19, 10.24–​10.26, 10.33–​10.38, 10.40–​10.41, 10.47, 10.53–​10.55,  10.59 Recital 13�������������������������������������������� 10.25 Art 2(29)���������������������������������������������� 8.37 Art 3 �������������������������������������������������� 10.33 Art 4 ��������������������������������������� 10.25, 10.33 Art 4(1)���������������������������������������������� 10.25 Art 4(3)���������������������������������������������� 10.25 Arts 5, 6���������������������������������������������� 10.33 Art 7 ��������������������������������������� 10.26, 10.33 Art 9 �������������������������������������������������� 10.33 Art 9 ��������������������������������������� 10.27, 10.33 Art 9(1)���������������������������������������������� 10.25 Art 11 ������������������������������������������������ 10.41 Art 13 ������������������������������������������������ 10.33 Title III ���������������������������������������������� 10.25 Art 14 ������������������������������������� 10.25, 10.33 Art 15 ������������������������������������������������ 10.33 Art 16(1), (2)�������������������������������������� 10.41 Arts 17, 18������������������������������������������ 10.25 Arts 20–​22������������������������������������������ 10.25 Art 25 ������������������������������������������������ 10.25 Title IV ������������������������������������� 2.01, 10.28 Chap 1�������������������������������������������������� 2.01 Art 26(1)����������������������������������� 2.17, 10.29 Art 26(2), (3)�������������������������������������� 10.29 Art 27(1)�������������������������������������������� 10.29 Art 27(2)��������������������������������� 10.29, 10.31 Art 28 �������������������������������������������������� 2.17 Art 28(1)�������������������������������������������� 10.32 Art 28(3)�������������������������������������������� 10.32 Art 28(5)�������������������������������������������� 10.32 Art 30(1), (2)�������������������������������������� 10.30 Art 31 ������������������������������������������������ 10.31

Art 33 ������������������������������������������������ 10.33 Art 36(1)�������������������������������������������� 10.34 Art 37 ������������������������������������� 10.35, 10.37 Arts 38, 39������������������������������������������ 10.29 Art 40 ������������������������������������������������ 10.36 Art 42 ������������������������������������������������ 10.38 Art 42(1), (2)�������������������������������������� 10.40 Art 42(3)��������������������������������� 10.38, 10.40 Art 42(4)�������������������������������������������� 10.38 Art 45 ������������������������������������������������ 10.36 Art 45(1)�������������������������������������������� 10.37 Art 45(2)��������������������������������� 10.38–​10.39 Art 45(3), (4)�������������������������������������� 10.39 Art 46 ������������������������������������������������ 10.37 Art 48 ������������������������������������������������ 10.36 Art 49 ������������������������������������� 10.25, 10.41 Art 51 ������������������������������������������������ 10.25 Art 54 ������������������������������������������������ 10.25 Art 55 ������������������������������������������������ 10.27 Art 79 ������������������������������������������������ 10.33 Commission Delegated Regulation (EU) 149/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-​ financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP [2013] OJ L52/​11 (Delegated Regulation)��������� 10.25, 10.41 Art 5 �������������������������������������������������� 10.25 Art 7 �������������������������������������������������� 10.25 Arts 12–​20������������������������������������������ 10.41 Commission Delegated Regulation (EU) 150/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards specifying the details of the application for registration as a trade repository [2013] OJ L52/​25 (Delegated Regulation 150/​2013) �������������������� 8.02, 8.27, 10.33 Commission Delegated Regulation (EU) 152/​2013 of 19 December 2012 supplementing Regulation (EU)

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Table of Legislation No 648/​2012 of the European Parliament and of the Council with regard to regulatory technical standards on capital requirements for central counterparties [2013] OL J52/​37 (Delegated Regulation 152/​2013)�����������������������������������������10.41 Arts 2–​5���������������������������������������������� 10.41 Arts 47–​60������������������������������������������ 10.41 Commission Delegated Regulation (EU) 153/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​ 2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties [2013] OJ L52/​41 (Delegated Regulation 153/​2013) ������ 10.29, 10.37, 10.39 Art 3 �������������������������������������������������� 10.29 Arts 4–​6���������������������������������������������� 10.32 Art 7 �������������������������������������������������� 10.29 Art 8 �������������������������������������������������� 10.31 Arts 17–​31������������������������������������������ 10.37 Arts 24–​28������������������������������������������ 10.37 Arts 29–​31������������������������������������������ 10.39 Art 35, 36 ������������������������������������������ 10.39 Arts 37–​42������������������������������������������ 10.37 Annexes 1, 2���������������������������������������� 10.37 Commission Delegated Regulation (EU) No 231/​2013 of 19 December 2012 supplementing Directive 2011/​61/​EU of the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision, OJ L83/​1 (AIFMD SupR)�������������2.09, 8.02, 8.29, 9.53–​9.55, 9.59–​9.60, 19.39, 19.43 Recital 3������������������������������������������������ 8.38 Recital 34���������������������������������������������� 8.38 Art 1(3)������������������������������������������������ 8.38 Art 1(4)������������������������������������������������ 8.33 Art 16 �������������������������������������������������� 9.55 Art 21 �������������������������������������������������� 8.33 Arts 38–​45�������������������������������������������� 9.54 Art 40(2)���������������������������������������������� 9.54 Arts 46–​49�������������������������������������������� 9.55 Art 57 �������������������������������������������������� 9.53 Regulation (EU) No 345/​2013 of the European Parliament and of the Council of 17 April 2013 on European venture capital funds [2013] OJ L115/​ 1 ��������������������������������� 2.09 Art 9 ���������������������������������������������������� 2.09

Regulation (EU) No 575/​2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/​2012 (Text with EEA relevance) [2013] OJ L 176 (CRR)������������� 2.07, 2.18, 2.30, 3.17, 4.06, 4.33, 5.02, 5.42, 5.44, 5.58, 8.02, 11.30, 11.34, 11.44, 12.41, 12.68, 15.6, 21.24 Art 4(1)������������������������������������������������ 5.39 Art 4(1)(1)����������������������������������� 2.07, 5.01 Art 4(1)(2)����������������������������������� 8.02, 9.45 Art 4(1)(3)�������������������������������������������� 8.02 Arts 11–​14������������������������������������������ 12.41 Art 28 ������������������������������������������������ 21.24 Art 52 ������������������������������������������������ 11.30 Art 63 ������������������������������������������������ 11.30 Art 77 ��������������������������������������� 5.42, 21.24 Art 104(1)�������������������������������������������� 2.18 Art 191 ������������������������������������������������ 2.18 Art 221(4)(h)���������������������������������������� 2.18 Art 225(3)(d)���������������������������������������� 2.18 Art 228 ������������������������������������������������ 2.18 Art 361(1)(h)���������������������������������������� 2.18 Art 429 ������������������������������������������������ 9.43 Art 435(c)(2)���������������������������������������� 5.24 Art 450 ������������������������������������������������ 2.30 Regulation (EU) No 1024/​2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions [2013] OJ L287 (SSM) ������������������ 4.06–​4.07, 4.33, 5.02, 5.58, 6.15, 21.36 Recital 53���������������������������������������������� 8.15 Art 2 ���������������������������������������������������� 4.07 Art 6 ���������������������������������������������������� 5.24 Art 6(4)������������������������������������������������ 8.14 Art 7 ���������������������������������������������������� 4.07 Art 15 �������������������������������������������������� 8.14 Art 16(2)(m) ������������������������������� 6.15, 8.14 Regulation (EU) No 1042/​2013 of 7 October 2013 amending Implementing Regulation (EU) No 282/​2011 as regards the place of supply of services[2011] OJ L 284��������5.04 Art 4 ���������������������������������������������������� 5.04 Art 6 ���������������������������������������������������� 5.04 Regulation (EU) No 468/​2014 of the European Central Bank of 16 April 2014 establishing the framework

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Table of Legislation for cooperation within the Single Supervisory Mechanism between the European Central Bank and national competent authorities and with national designated authorities [2014] OJ L 141(SSM Framework Regulation)��������������������� 6.15 Regulation (EU) No 596/​2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/​6/​ EC of the European Parliament and of the Council and Commission Directives 2003/​124/​EC, 2003/​ 125/​EC and 2004/​72/​EC (Text with EEA relevance) [2014] OJ L 173 (MAR)��������������1.24, 1.26, 1.29, 9.48, 12.03–​12.10, 12.16, 12.18, 12.20, 12.33–​12.43, 12.47–​12.48, 12.51, 12.55, 12.66–​12.68, 18.01 Recital 3���������������������������������������������� 12.66 Recital 32�������������������������������������������� 12.59 Art 1(21)�������������������������������������������� 12.40 Art 3(1)(26)���������������������������������������� 12.48 Art 7 ���������������������������� 12.07–​12.08,  12.19 Art 7(2)������������� 12.08–​12.09, 12.20, 12.33 Art 7(3)���������������������������������������������� 12.09 Art 7(4)���������������������������������������������� 12.08 Art 8(4)���������������������������������������������� 12.21 Art 8(4)(b)������������������������������������������ 12.59 Art 9(1)���������������������������������������������� 12.35 Art 9(1)(b)������������������������������������������ 12.35 Art 10 ������������������������� 12.21–​12.34, 12.36, 12.41–​12.43, 12.50, 12.52, 12.56, 12.58, 12.60, 12.66 Art 10(1)�������������������������������������������� 12.50 Art 11 ������������������������������������������������ 12.50 Art 17 ��������������� 12.09, 12.28, 12.39, 12.41 Art 17(1)�������������������������������������������� 12.40 Art 17(4)��������������������������������� 12.13–​12.14 Art 17(5), (6)�������������������������������������� 12.15 Art 17(8)���������������������� 12.21, 12.57, 12.60 Art 19 ������������������������������������������������ 12.48 Art 19(12)������������������������������������������ 12.55 Art 30(a), (c) �������������������������������������� 18.01 Art 30(e), (f ), (i)���������������������������������� 18.01 Regulation (EU) No 600/​2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/​ 2012 (Text with EEA relevance) [2014] OJ L 173 (MiFIr)�����������1.11, 20.21

Commission Delegated Regulation (EU) No 604/​2014 of 4 March 2014, supplementing Directive 2013/​36/​EU of the European Parliament and of the Council with regard to regulatory technical standards with respect to qualitative and appropriate quantitative criteria to identify categories of staff whose professional activities have a material impact on an institution’s risk profile (Text with EEA relevance) [2014] OJ L 167������������ 11.22 Regulation (EU) No 806/​2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/​2010, [2014] OJ L225 (SRMR)�������� 4.06–​4.08, 4.10, 4.29, 4.30, 4.33, 4.39, 5.02 Art 2(2)������������������������������������������������ 4.08 Art 4 ���������������������������������������������������� 4.07 Art 8(6)������������������������������������������������ 4.10 Art 8(12)���������������������������������������������� 4.10 Art 10 �������������������������������� 4.08, 4.12, 4.37 Art 10(6)���������������������������������������������� 4.07 Art 10(7)������������������������������������� 4.10, 4.28 Art 10(9)���������������������������������������������� 4.29 Art 10(10)����������������������������������� 4.29–​4.30 Art 10(11)�������������������������������������������� 4.29 Art 10(13)�������������������������������������������� 4.30 Art 12(7), (8)���������������������������������������� 4.10 Art 15(1)(g)������������������������������������������ 4.17 Art 20 �������������������������������������������������� 4.20 Art 27 �������������������������������������������������� 4.16 Art 27(3)���������������������������������������������� 4.17 Art 30(2)���������������������������������������������� 4.28 Art 34 �������������������������������������������������� 4.11 Arts 85, 86�������������������������������������������� 4.31 Regulation (EU) No 909/​2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/​26/​EC and 2014/​65/​EU and Regulation

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Table of Legislation (EU) No 236/​2012 (Text with EEA relevance)[2014] OJ L 257 (CSDR)���������������� 2.01, 8.02, 8.24, 8.32, 8.36, 10.43, 18.01 Art 2(1)(46)��������������������������������� 8.36–​8.37 Title III ���������������������������������������������� 10.43 Chap 2, s1�������������������������������������������� 2.01 Arts 26–​28������������������������������������������ 10.43 Art 42 ������������������������������������������������ 10.43 Art 47 ������������������������������������������������ 10.43 Art 63(2)(a), (b)���������������������������������� 18.01 Art 63(2)(d), (f )���������������������������������� 18.01 Commission Delegated Regulation (EU) 2015/​35 of October 2014, supplementing Directive 2009/​138/​EC of the European Parliament and of the Council on the taking-​up and pursuit of the business of Insurance and Reinsurance [2015] OJ L12 (Solvency II)������3.11, 3.32–​3.34, 3.38–​3.40, 8.02, 8.26, 8.29. 8.31, 8.62, 11.49 Recital 29���������������������������������������������� 8.62 Art 13(29)�������������������������������������������� 8.39 Art 19 �������������������������������������������������� 3.52 Art 42(1)���������������������������������������������� 8.39 Art 259 ������������������������������������������������ 3.52 Art 259(1)�������������������������������������������� 3.50 Art 265 ������������������������������������������������ 3.52 Art 267 ������������������������������������������������ 3.52 Art 267(2), (4)�������������������������������������� 3.60 Art 274 ��������������������������������������� 3.32, 3.34 Art 274(2)�������������������������������������������� 3.36 Art 274(3)�������������������������������������������� 3.37 Art 274(5)(a), (b)���������������������������������� 3.38 Art 275 ������������������������������������� 3.38, 11.49 Regulation (EU) 2015/​760 of the European Parliament and of the Council of 29 April 2015 on European long-​term investment funds [2015] OJ L169/​8 ������������������ 2.09 Commission Delegated Regulation (EU) 2016/​522 of 17 December 2015 supplementing Regulation (EU) No 596/​2014 of the European Parliament and of the Council as regards an exemption for certain third countries public bodies and central banks, the indicators of market manipulation, the disclosure thresholds, the competent authority for notifications of delays, the permission for trading during closed periods and types of

notifiable managers’ transactions (Text with EEA relevance) C/​2015/​8943 [2016] OJ L 88�������� 12.55 Art 8 �������������������������������������������������� 12.55 Commission Delegated Regulation (EU) 2016/​778 of 2 February 2016 supplementing Directive 2014/​59/​EU of the European Parliament and of the Council with regard to the circumstances and conditions under which the payment of extraordinary ex post contributions may be partially or entirely deferred, and on the criteria for the determination of the activities, services and operations with regard to critical functions, and for the determination of the business lines and associated services with regard to core business lines (Text with EEA relevance) C/​2016/​0424 [2016] OJ L 131 ��������������������� 4.07–​4.08 Arts 6, 7������������������������������������������������ 4.08 Commission Delegated Regulation (EU) 2016/​960 of 17 May 2016 supplementing Regulation (EU) No 596/​2014 of the European Parliament and of the Council with regard to regulatory technical standards for the appropriate arrangements, systems and procedures for disclosing market participants conducting market soundings (Text with EEA relevance) [2016] C/​2016/​2859 [2016] OJ L 160 ���������������������������� 12.50 Regulation (EU) 2016/​1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/​48/​EC and 2014/​17/​EU and Regulation (EU) No 596/​2014 (Text with EEA relevance) [2016] OJ L 171 (Benchmark Regulation) ��������� 2.01, 2.17 Arts 4–​7������������������������������������������������ 2.01 Art 6(3)������������������������������������������������ 2.17 Commission Delegated Regulation (EU) 2016/​1075 of 23 March 2016 supplementing Directive

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Table of Legislation 2014/​59/​EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the content of recovery plans, resolution plans and group resolution plans, the minimum criteria that the competent authority is to assess as regards recovery plans and group recovery plans, the conditions for group financial support, the requirements for independent valuers, the contractual recognition of write-​down and conversion powers, the procedures and contents of notification requirements and of notice of suspension and the operational functioning of the resolution colleges (Text with EEA relevance) C/​2016/​1691 [2016] OJ L184 (Delegated Regulation)������������ 4.07, 4.10, 4.12–​4.13,  4.25 Recital 21���������������������������������������������� 4.10 Art 2(2), (3)������������������������������������������ 4.10 Arts 24, 25�������������������������������������������� 4.10 Arts 27–​32�������������������������������������������� 4.12 Art 27 �������������������������������������������������� 4.13 Art 29 �������������������������������������������������� 4.20 Art 30 �������������������������������������������������� 4.23 Art 31 �������������������������������������������������� 4.25 Commission Delegated Regulation (EU) 2016/​1712 of 7 June 2016 supplementing Directive 2014/​59/​ EU of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms with regard to regulatory technical standards specifying a minimum set of the information on financial contracts that should be contained in the detailed records and the circumstances in which the requirement should be imposed (Text with EEA relevance) C/​2016/​ 3356 [2016] OJ L258/​1����������� 4.07, 4.20 Annex��������������������������������������������������� 4.20 Commission Delegated Regulation (EU) 2017/​390 of 11 November 2016 supplementing Regulation (EU) 909/​2014 of the European Parliament and of the Council

with regard to regulatory technical standards on certain prudential requirements for central securities depositories and designated credit institutions offering banking-​type ancillary services [2016] OJ L65/​9������10.43 Commission Delegated Regulation (EU) 2017/​565 of 25 April 2016 supplementing Directive 2014/​65/​ EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive [2017] OJ L87/​1��������������� 2.08, 2.18, 9.45–​9.46, 9.50, 11.57 Art 16 �������������������������������������������������� 9.58 Art 21(1)(a)������������������������������������������ 9.46 Art 21(1)(c)������������������������������������������ 9.46 Art 22 �������������������������������������������������� 2.18 Art 23 �������������������������������������������������� 2.19 Art 23(1)������������������������������������� 9.46, 9.50 Art 23(2)���������������������������������������������� 9.46 Art 24 �������������������������������������������������� 2.18 Art 27 ������������������������������������������������ 11.57 Regulation (EU) 2017/​1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/​71/​EC(Text with EEA relevance) [2017] OJ L 168������12.51 Art 1(4)(j) ������������������������������������������ 12.51 Art 1(5)(i) ������������������������������������������ 12.51 Regulation (EU) 2017/​1131 of the European Parliament and of the Council of 14 June 2017 on money market funds [2017] OJ L169/​8������������������������������� 2.09, 8.02 Chap III������������������������������������������������ 2.09 Directives Directive 77/​780/​EEC of 12 December 1977 on the coordination of the laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institution [1977] OJ L 322/​30����������������� 2.08, 2.16 Directive 85/​611/​EEC of 20 December 1985 on the coordination of laws,

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Table of Legislation regulations, and administrative provisions relating to undertakings for collective investment in transferable securities [1985] OJ L375/​3(UCITS)������������� 2.08, 2.09, 2.13, 2.18, 2.30, 8.32–​8.33, 8.38, 8.57 Recital 45���������������������������������������������� 8.57 Art 5(4)(3)�������������������������������������������� 2.13 Art 51 �������������������������������������������������� 2.18 Directive 89/​592/​EEC of 13 November 1989 coordinating regulations on insider dealing [1989] OJ L 334�������12.23 Art 3a�������������������������������������������������� 12.23 Directive 89/​646/​EECof 15 December 1989 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/​780 [1989] OJ L 386/​1 (Second Banking Directive)��������������������� 2.08, 2.16 Arts 11, 12�������������������������������������������� 2.16 Art 13(2)���������������������������������������������� 2.08 Directive 93/​6/​EEC of 15 March 1993 on the capital adequacy of investments firms and credit institutions [1993] OJ L 141������������ 2.08 Directive 93/​22/​EEC of 10 May 1993 on investment services in the securities field [1993] OJ L141/​27 (ISD) �������������������������������� 2.08 Directive 2000/​12/​EC of 20 March 2000relating to the taking up and pursuit of the business of credit institutions [2000] OJ L 126/​1 �������������������������������������� 2.08 Directive 2002/​65 of 23 September 2002 concerning the distance marketing of consumer financial services [2002] OJ L271/​16�������������� 2.01 Directive 2002/​87/​EC of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives 73/​239/​EEC, 79/​267/​EEC, 92/​49/​EEC, 92/​ 96/​EEC, 93/​6/​EEC and 93/​22/​ EEC, and Directives 98/​78/​EC and 2000/​12/​EC of the European Parliament and of the Council [2002] OJ L 35/​1 �������������2.07, 5.02, 9.36

Directive 2002/​92/​EC of 9 December 2002 on insurance mediation [2002] OJ L 9/​3 (IMD)����������� 2.07, 8.02 Directive 2003/​41/​ECof the European Parliament and of the Council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision [2003] OJ L235/​10����������������� 2.09–​2.10 Directive 2003/​71/​ECof the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading [2003] OJ L345/​64 (Prospectus Directive) �������������������� 20.07 Recital 10�������������������������������������������� 20.07 Recital 12�������������������������������������������� 20.07 Recital 16�������������������������������������������� 20.07 Directive 2004/​39/​EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments [2004] OJ L 145/​1 (MiFID I)��������������������� 3.17, 8.02, 8.11, 19.39, 20.21, 21.06, 21.08, –​21.09, 21.46, 21.52, 21.66–​21.68, 21.70, 21.72 Art 9(1)������������������������������������������������ 8.11 Directive 2004/​109/​EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/​34/​EC [2004] OJ L390/​38 (Transparency Directive) ���������������� 20.07 Recital 1���������������������������������������������� 20.07 Recital 5���������������������������������������������� 20.07 Recital 7���������������������������������������������� 20.07 Directive 2005/​60/​EC of the European Parliament and of the Council of 26 October 2005 on the prevention of the use of the financial system for the purpose of money laundering and terrorist financing (Text with EEA relevance) [2005] OJ L 309/​15���������� 2.01 Directive 2006/​48/​ECof the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the

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Table of Legislation business of credit institutions (Recast Banking Directive) [2006] OJ L 177 (CRD III)���������������� 2.07–​2.08, 4.01, 5.02, 6.16, 8.02, 8.11, 9.36 Art 11(2)���������������������������������������������� 8.11 Art 22 �������������������������������������������������� 6.16 Directive 2006/​49/​ECof the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions [2006] OJ L 177/​201 (Recast Capital Adequacy Directive)������ 2.07–​2.08, 4.01, 5.02, 9.36 Directive 2006/​70/​EC of 1 August 2006 laying down implementing measures for Directive 2005/​60/​ EC of the European Parliament and of the Council as regards the definition of politically exposed person and the technical criteria for simplified customer due diligence procedures and for exemption on grounds of a financial activity conducted on an occasional or very limited basis [2006] OJ L 214/​29�������������������������� 2.01 Directive 2006/​73/​ECof 10 August 2006 implementing Directive 2004/​39 of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive[2006] OJ L24/​126 (Organisational Requirements Directive)������������������������������� 2.08, 21.68 Art 52 ������������������������������������������������ 21.68 Directive 2007/​36/​EC of the European Parliament and of the Council of 11 July 2007 on the exercise of certain rights of shareholders in listed companies, [2007] OJ L184/​ 17�������������������� 5.01, 13.23–​13.24, 16.68 Directive 2007/​64/​EC of the European Parliament and of the Council of 13 November 2007 on payment services in the internal market amending Directives 97/​7/​ EC, 2002/​65/​EC, 2005/​60/​EC and 2006/​48/​EC and repealing Directive 97/​5/​EC (Text with EEA relevance) [2007] OJ L 319/​1������������ 2.01 Art 11(4)���������������������������������������������� 2.01

Directive 2009/​14/​EC of the European Parliament and of the Council of 11 March 2009 amending Directive 94/​19/​EC on deposit-​guarantee schemes as regards the coverage level and the payout delay (Text with EEA relevance) [2009] OJ L 68�������� 5.02 Directive 2009/​65/​EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (as amended) [2009] OJ L302/​32������� 2.09, 2.30, 8.02, 9.51–​9.53, 9.55–​9.62, 11.53–​11.56 Art 1(2)������������������������������������������������ 9.52 Art 1(3)������������������������������������������������ 9.59 Art 7(1)(b)����������������������������������� 2.09, 8.38 Art 7(1)(c)�������������������������������������������� 2.09 Art 7(3)������������������������������������������������ 2.09 Art 8 ���������������������������������������������������� 2.09 Art 12 �������������������������������������������������� 2.09 Arts 13–​14b������������������������������������������ 2.09 Art 14(2)���������������������������������������������� 2.09 Art 14a��������������������� 2.09, 9.59, 9.61, 11.53 Art 14a(1) �������������������������������������������� 9.60 Art 14a(3), (4)�������������������������������������� 9.59 Art 14b ������������������� 2.09, 9.59, 9.61, 11.54 Art 14b(1)�������������������������������������������� 9.60 Art 29(1)(b), (c)������������������������������������ 2.09 Art 30 �������������������������������������������������� 2.09 Art 51 �������������������������������������������������� 9.54 Directive 2009/​110 of the European Parliament and of the Council of 16 September 2009 on the taking up, pursuit and prudential supervision of the business of electronic money institutions [2009] OJ L 267 (EMD)������2.01, 8.02, 8.26, 8.31 Directive 2009/​138/​EC of the European Parliament and of the Council of 25 November 2009 on the taking-​up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast) (as amended) [2009] OJ L335/​1 (Solvency II)���������� 2.17, 3.06, 3.11–​3.14, 3.16–​3.19, 3.22–​3.23, 3.29–​3.30, 3.32, 3.38, 3.40, 3.42–​3.48, 3.51, 3.53–​3.55, 3.57–​3.58, 3.60–​3.63, 3.69, 5.40, 6.32, 8.02 Recital 16���������������������������������������������� 3.23

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Table of Legislation Art 37 �������������������������������������������������� 3.45 Art 38 �������������������������������������������������� 3.32 Art 40 �������������������������������������������������� 3.48 Chap IV, s 2��������������������������������� 3.12, 3.58 Art 41 ����������������������������������������� 3.12, 3.22 Art 41(1)���������������������������������������������� 3.58 Art 41(3)���������������������������� 2.17–​2.18,  3.51 Arts 42, 43����������������������������������� 3.13, 3.58 Arts 44–​46�������������������������� 2.17, 3.13, 3.58 Art 44 �������������������������������������������������� 3.47 Art 44(1)������������������������������������� 3.46, 3.48 Art 44(2)���������������������������������������������� 3.51 Art 46 �������������������������������������������������� 3.58 Art 46(1)���������������������������������������������� 3.52 Art 47 ����������������������� 2.17–​2.18, 3.13, 3.58 Art 48 ����������������������������������������� 3.13, 3.58 Art 49 ����������������������������������������� 3.32, 3.58 Art 49(2)(a), (b)������������������������������������ 3.38 Art 50 �������������������������������������������������� 3.11 Art 82 �������������������������������������������������� 3.52 Art 132 ������������������������������������������������ 3.62 Art 236 ������������������������������������������������ 2.17 Art 246 ������������������������������������������������ 2.17 Art 246(1)�������������������������������������������� 3.41 Art 258 ��������������������������������������� 3.16, 3.52 Art 259 ������������������������������������������������ 3.52 Commission Directive 2010/​43/​EU of 1 July 2010 implementing Directive 2009/​65/​EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company [2010] OJ L 176/​42 (UCITS ImpD)����������������2.09, 2.30, 8.02, 8.29, 9.53 Recital 1������������������������������������������������ 2.09 Recital 10���������������������������������������������� 8.38 Recital 15���������������������������������������������� 8.38 Recital 17���������������������������������������������� 8.38 Art 3(4)–​(6)������������������������������������������ 8.38 Art 4 ���������������������������������������������������� 9.53 Arts 38–​43�������������������������������������������� 9.54 Art 38(1)���������������������������������������������� 9.54 Art 40(3), (4)���������������������������������������� 9.55 Directive 2010/​76/​EU of the European Parliament and of the Council of 24 November 2010 Amending Directives 2006/​48/​EC and 2006/​49/​EC As Regards Capital Requirements for the Trading Book and for Re-​Securitisations,

and the Supervisory Review of Remuneration Policies, [2010] OJ L329/​3 (CRD III)��������������� 11.21, 11.31 Art 23 ������������������������������������������������ 11.31 Directive 2011/​61/​EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/​41/​EC and 2009/​65/​EC and Regulations (EC) No 1060/​2009 and (EU) No 1095/​2010 Text with EEA relevance [2011] OJ L 174 (AIFMD)����������������������� 1.29, 2.07, 2.09, 2.13, 2.18, 2.30, 8.02, 8.25. 8.31, 8.33–​8.34, 8.45, 9.51–​9.54, 9.62, 11.56 Art 1 ���������������������������������������������������� 9.51 Art 4(1)(a)�������������������������������������������� 9.51 Art 8(1)������������������������������������������������ 2.13 Art 8(1)(c)�������������������������� 2.09, 8.33, 8.38 Art 8(1)(d)�������������������������������������������� 2.09 Art 8(6)(a)�������������������������������������������� 2.30 Art 13 ��������������������������������������� 9.59, 11.56 Art 13(1)���������������������������������������������� 9.61 Art 15 ����������������������������������������� 2.18, 9.54 Annex II������������������������������������������������ 9.59 para 1(a)�������������������������������������������� 9.61 Directive 2013/​36 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firmsamending Directive 2002/​87/​ EC and repealing Directives 2006/​ 48/​EC and 2006/​49/​EC [2013] |OJ L176/​338 (CRD IV)��������1.23, 1.24, 1.27, 1.29, 2.01, 2.03, 2.07–​2.08, 2.11–​2.13, 2.15, 2.18, 2.30, 3.07, 3.29, 3.39–​3.40, 3.43, 4.01, 4.06–​4.07, 4.33, 5.02, 5.05, 5.33, 5.36, 5.39, 5.43–​5.44, 6.06, 6.10, 6.15–​6.16, 6.28, 6.31–​6.32, 6.54–​6.55, 6.76, 7.36, 8.01–​8.03, 8.14, 8.16–​8.17, 8.22, 8.24–​8.25, 8.32, 8.36, 8.41, 8.44, 8.64, 8.67, 8.84, 9.36–​9.38, 9.43, 9.45–​9.47, 9.50–​9.51, 9.58, 9.62, 11.01, 11.21–​11.26, 11.29, 11.31, 11.37, 11.42–​11.44, 11.57, 11.64, 11.66–​11.69, 12.39, 13.06, 15.68, 16.52, 18.01, 24.19, 24.32 Recital 55������������������������������������� 5.05, 5.19 Recital 56���������������������������������������������� 5.05 Recital 60������������������������������������� 5.24, 8.24 Recital 65���������������������������������������������� 6.28 Recital 66�������������������������������������������� 11.24

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Table of Legislation Art 1(1)(7)����������������������������������� 5.05, 5.19 Art 2(1)������������������������������������������������ 8.02 Art 3(1)(1)�������������������������������������������� 2.07 Art 3(1)(7)�������������������������������������������� 8.14 Art 3(1)(9)�������������������������������������������� 8.36 Art 3(1)(26)���������������������������������������� 12.39 Art 13 �������������������������������������������������� 6.09 Art 13(1)���������������������������� 5.19, 5.36, 8.31 Art 14 �������������������������������������������������� 5.39 Art 23(1), (2)���������������������������������������� 5.39 Art 67(2)(a), (b)���������������������������������� 18.01 Art 67(2)(d), (f )���������������������������������� 18.01 Art 74 ������������������������������ 4.01, 6.16, 24.32 Art 74(1)������������������ 9.36–​9.37, 9.44, 9.46, 9.49, 9.57, 11.23 Art 74(2)���������������������������������������������� 9.39 Art 74(3)������������������������������������� 2.30, 9.57 Art 75(2)������������������������������������� 2.30, 9.57 Art 76–​87 ����������������������������������� 1.27, 9.37 Art 76 �������������������������������� 4.01, 6.06, 9.38 Art76(1)–​(3) ������������������������������� 2.18, 9.39 Art 76(3)���������������������������������������������� 7.36 Art 76(5)������������������������������������� 2.18, 6.50 Arts 79–​83�������������������������������������������� 9.40 Art 86 ����������������������������������������� 9.40–​9.41 Art 86(1)���������������������������������������������� 9.41 Art 86 (4), (5) �������������������������������������� 9.41 Art 87 �������������������������������������������������� 9.40 Art 87(1), (2)���������������������������������������� 9.43 Arts 88–​96�������������������������������������������� 9.44 Art 88 ���������������������� 4.01, 5.36, 6.16, 9.32, 9.47, 24.32 Art 88(1)������������������������������������� 5.52, 9.44 Art 88(1)(a)������������������������������������������ 5.28 Art 88(1)(b)������������������������������������������ 5.36 Art 88(2)���������������������������������������������� 5.24 Art 88(2)(a)������������������������������������������ 2.11 Art 90(1)(f )���������������������������������������� 11.33 Art 91 ������������ 4.01, 5.19, 8.14, 9.47, 24.32 Art 91(1)–​(10)����������������������������� 2.11, 5.19 Art 91(1)���������������������������������������������� 6.09 Art 91(2), (3)���������������������������������������� 5.06 Art 91(10)�������������������������������������������� 5.24 Arts 92–​97�������������������������������������������� 9.57 Art 92 ���������������������������� 6.29, 11.23, 24.32 Art 92(1)����������������������������������� 6.51, 11.22 Art 92(2)���� 9.57, 9.59, 11.22, 11.24, 11.26 Art 92(2)(a)������������������������������������������ 6.28 Art 92(2)(c)������������������������������������������ 5.33 Art 92(2)(g)���������������������������������������� 11.31 Art 93 ��������������������������������������� 6.50, 11.23 Art 94 �������������������������������������������������� 5.33 Art 94(1)��������������������������������� 11.27, 11.28 Art 94(1)(f )���������������������������������������� 11.32

Art 94(1)(g)������������������������������� 6.28, 11.32 Art 94(1)(g)(i) �������������������������������������� 5.33 Art 94(1)(g)(ii)��������������������������� 5.33, 11.32 Art 94(1)(g)(iii)������������������������������������ 6.51 Art 94(1)(l) ������������������������������������������ 6.30 Art 94(3)�������������������������������������������� 11.68 Art 95 �������������������������������������������������� 6.29 Arts 97–​101���������������������������������������� 24.33 Art 97 �������������������������������������������������� 1.27 Art 98(7)���������������������������������������������� 6.09 Art 102 ������������������������������������� 5.44, 24.33 Art 104 ���������������������������� 5.44, 5.46, 24.33 Art 104(1)(g)���������������������������������������� 6.28 Art 107(3)�������������������������������������������� 1.27 Art 116 ������������������������������������������������ 6.50 Art 123(2)�������������������������������������������� 2.18 Art 128(6)�������������������������������������������� 5.43 Art 141 ������������������������������������������������ 5.43 Art 141(4)�������������������������������������������� 5.43 Directive 2013/​34/​EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/​43/​EC of the European Parliament and of the Council and repealing Council Directives 78/​660/​EEC and 83/​349/​EEC (Text with EEA relevance) [2013] OJ L 182������������������ 12.38, 12.62, 12.65 Art 2(12), (13)������������������������������������ 12.38 Art 8(4)(c)������������������������������������������ 12.62 Art 27 ������������������������������������������������ 12.62 Art 27(3)�������������������������������������������� 12.65 Directive 2014/​57/​EU of the European Parliament and of the Council of 16 April 2014 on criminal sanctions for market abuse [2014] OJ L 173 (MAD)����������������� 12.03–​12.04 Directive 2014/​59/​EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms [2014] OJ L173/​90 (BRRD)�������������������� 2.01, 4.01, 4.06–​4.09, 4.11–​4.12, 4.15–​4.16, 4.20, 4.22, 4.29–​4.30, 4.39–​4.40, 5.02, 6.19, 8.58, 14.19, 14.77–​14.79, 15.68, 21.02 Recital 29���������������������������������������������� 4.30 Art 2(1)(35)������������������������������������������ 4.08 Art 2(1)(47)������������������������������������������ 4.08

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Table of Legislation Art 2(1)(100)���������������������������������������� 4.20 Art 10(2)���������������������������������������������� 4.10 Art 10(6)���������������������������������������������� 4.10 Art 11 �������������������������������������������������� 4.11 Art 15 ����������������������� 4.01, 4.08, 4.12, 4.37 Art 17(1)������������������������������������� 4.10, 4.28 Art 17(3)���������������������������������������������� 4.29 Art 17(4)������������������������������������� 4.29–​4.30 Art 17(5)���������������������������������������������� 4.29 Art 17(6)���������������������������������������������� 4.30 Art 19 �������������������������������������������������� 4.16 Art 31 �������������������������������������������������� 4.10 Art 32 ������������������������������������������������ 21.02 Art 34(1)(c)������������������������������������������ 4.40 Art 34(1)(g)��������������������������������� 4.17, 4.40 Art 36 �������������������������������������������������� 4.20 Art 37 �������������������������������������������������� 4.40 Art 37(2)���������������������������������������������� 4.08 Art 43 �������������������������������������������������� 4.16 Art 44(2)���������������������������������������������� 4.17 Art 45(6)���������������������������������������������� 4.10 Art 55 �������������������������������������������������� 4.25 Art 71 �������������������������������������������������� 4.25 Title VI ������������������������������������������������ 4.23 Art 108 ������������������������������������������������ 4.18 Chap VI������������������������������������������������ 4.08 Annex—​ s B���������������������������������������������������� 4.10 sC ������� 4.09, 4.12–​4.13, 4.16, 4.20, 4.23 Directive 2014/​65/​EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments [2014] OJ L 173/​349 (MiFIDII)���������������� 1.11, 1.24, 1.29, 2.01, 2.03, 2.07–​2.09, 2.13, 2.15, 2.18, 2.30, 3.07, 3.29, 3.43, 8.01–​8.02, 8.16, 8.24–​8.25, 8.32, 8.41, 8.44, 9.45–​9.47, 9.50–​9.51, 9.58, 9.62, 10.09, 11.57, 18.01, 19.39, 20.07, 20.21, 21.09, 21.46, 21.52, 21.66–​21.68, 21.70, 21.72–​21.75 Recital 5������������������������������������������������ 8.16 Recital 7���������������������������������������������� 20.07 Recital 39�������������������������������������������� 20.07 Recital 45�������������������������������������������� 20.07 Recital 53���������������������������������������������� 8.24 Recitals 57, 58������������������������������������ 20.07 Recital 97�������������������������������������������� 20.07 Recital 133������������������������������������������ 20.07 Art 4(1)(1), (2)�������������������������������������� 2.07 Art 4(1)(5)������������������������������������������ 21.09 Art 9 ���������������������������������������������������� 8.16 Art 9(1)������������������������������������������������ 9.47 Art 9(3)��������������������������������������� 9.32, 9.47

Art 9(3)(c)��������������������������������� 9.58, 11.57 Art 9(6)(b)�������������������������������������������� 2.13 Art 16 ��������������������������������������� 9.46, 19.41 Art 16(2)������������������������������������� 2.18, 9.48 Art 16(3)�������������������������������������������� 21.72 Art 16(5)���������������������������� 2.18, 9.46, 9.49 Art 24(1)�������������������������������������������� 20.21 Arts 45–​48�������������������������������������������� 2.01 Art 45(5)���������������������������������������������� 2.11 Art 70(6)(a), (b)���������������������������������� 18.01 Art 70(6)(d), (g)���������������������������������� 18.01 Annex 1������������������������������������������������ 2.07 s A���������������������������������������������������� 2.07 s C������������������������������������������� 2.07, 4.07 Directive 2014/​80/​EU of 20 June 2014 amending Annex II to Directive 2006/​118/​EC of the European Parliament and of the Council on the protection of groundwater against pollution and deterioration (Text with EEA relevance) [2014] OJ L 182���������������������������������������� 21.39 Art 18(1)(a)���������������������������������������� 21.39 Directive 2014/​91/​EU of the European Parliament and of the Council of 23 July 2014 amending Directive 2009/​65/​EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities as regards depositary functions, remuneration policies and sanctions [2014] OJ L 257/​ 196 (UCITS V)������������� 1.29, 8.02, 8.31, 8.34, 8.45, 9.61, 11.53, 18.01 Recital 2������������������������������������������������ 9.61 Art 1(16)(6)(a), (b)������������������������������ 18.01 Art 1(16)(6)(d), (f )������������������������������ 18.01 Directive 2014/​95/​EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/​34/​EU as regards disclosure of non-​financial and diversity information by certain large undertakings and groups (Text with EEA relevance) [2014] OJ L 330���������������������������������������� 13.68 Directive 2015/​849/​EU of the European Parliament and of the Council of 20 May 2015 on the prevention of the use of the financial system for the purposes of money laundering or terrorist

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Table of Legislation financing, amending Regulation (EU) No 648/​2012 of the European Parliament and of the Council, and repealing Directive 2005/​60/​EC of the European Parliament and of the Council and Commission Directive 2006/​70/​ EC (Text with EEA relevance) OJ L 141/​73 (AML Directive) �������� 2.01 Directive 2015/​2366/​EU of the European Parliament and of the Council of 25 November 2015 on payment services in the internal market [2015] OJ L 337/​35 (PSD II)���������������� 2.01, 8.02, 8.26, 8.31, 8.34, 8.43, 8.57 Recitals 6, 7������������������������������������������ 8.57 Art 11(4)���������������������������������������������� 2.01 Art 111(1)�������������������������������������������� 8.43 Directive 2016/​97/​EU of the European Parliament and of the Council of 20 January 2016 on insurance distribution (recast)Text with EEA relevance [2016] OJ L 26 (IDD) ��������������������������� 8.02, 19.41 Directive 2016/​2341/​EU of the European Parliament and of the Council of 14 December 2016 on the activities and supervision of institutions for occupational retirement provision [2016] OJ L 354/​37 (IORP II)������� 2.10, 2.13, 2.18, 8.02, 8.23, 8.26, 8.31, 8.33, 8.40, 8.62 Recital 5������������������������������������������������ 8.77 Recital 52���������������������������������������������� 8.62 Art 10 �������������������������������������������������� 2.10 Arts 21–​26�������������������������������������������� 2.10 Art 21(3)���������������������������������������������� 2.18 Art 22(1)���������������������������������������������� 2.13 Art 24(1)���������������������������������������������� 2.18 Art 25 �������������������������������������������������� 2.18 Directive 2017/​828/​EU of the European Parliament and of the Council of 17 May amending Directive 2007/​36/​EC as regards the encouragement of long-​term shareholder engagement [2017] OJ L132/​1���������� 5.01, 5.32, 6.29, 13.01, 13.19, 13.24, 13.51, 16.68 Art 9a���������������������������������������������������� 6.29 Directive 2017/​1132/​EU of the European Parliament and of the Council of 14 June 2017 relating to certain aspects of company law[2017] OJ L 169�������������������������� 5.01

Directive 2017/​2399/​EU of the European Parliament and of the Council of 12 December 2017 amending Directive 2014/​59/​EU as regards the ranking of unsecured debt instruments in insolvency hierarchy [2017] OJ L345/​96����������������4.18 NATIONAL LAW Australia Securities and Investments Commission (ASIC) Act 2001 (Cth) �������������������� 6.79 s 50 ������������������������������������������������������ 6.79 Bulgaria Bulgarian Code for Corporate Governance 2012������������������������������ 7.06 Canada Canada Business Corporations Act (CBCA) RSC 1985, c C-​44�������������� 7.03 § 122���������������������������������������������������� 7.03 France Code de commerce—​ Article L. 651-​2 ������������������������������������ 6.68 Law on transparency, anti-​bribery, and modernization of the economy 2016 (LOI No 2016-​1691 du 9 décembre 2016) (Sapin II) ���������� 20.56 Germany Bank Supervision Act (KWG) ������������������ 6.44 Art 44, s 4 �������������������������������������������� 6.44 Banking Law (Kreditwesengesetz) (KWG)��������������������������������������������� 2.29 Section 2 § 1 �������������������������������������� 14.67 Co-​Determination of the Workers Act 1976 (MitbestG)��������������� 5.22, 6.34 Financial Services Supervisory Act (FinDAG) 2002�������������������������������� 6.45 Art 4, s 4 ���������������������������������������������� 6.45 One-​Third Participation Act, Paragraph 4(4) (DrittelbG)���������������� 5.22 Penal Act �������������������������������������������������� 6.56 s 266 ���������������������������������������������������� 6.56 Stock Corporation Act (Aktiengesetz)������ 2.29, 5.01, 5.16, 5.26, 5.31, 6.38 Art 76 �������������������������������������������������� 6.38 Art 87 �������������������������������������������������� 5.31 Art 93 �������������������������������������������������� 6.67 Art 100 ������������������������������������������������ 5.26 Art 120(4)�������������������������������������������� 5.31

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Table of Legislation Italy Consolidated law on finance Art 114(2)������������������������������������������ 12.39 Legislative decree No 127/​1991�������������� 12.66 Art 43 ������������������������������������������������ 12.66 Legislative decree No 136/​2015�������������� 12.66 Art 38(2)�������������������������������������������� 12.66 Netherlands Civil Code (DCC)����������������� 5.01, 5.11, 7.09, 15.21, 15.30 Art 2:9�������������������������������������������������� 7.09 Art 2:37(2)������������������������������� 15.39, 15.62 Art 2:38(3)������������������������������������������ 15.26 Art 2:39���������������������������������������������� 15.23 Art 239(1)������������������������������������������ 15.59 Art 2:53(1)������������������������������� 15.21, 15.25 Art 2:53(3), (4) ���������������������������������� 15.23 Art 2:53a���������������������� 15.23, 15.39, 15.62 Art 2:56(1)������������������������������������������ 15.26 Art 2:63b�������������������������������������������� 15.28 Art 2:63c�������������������������������������������� 15.28 Art 2:63(e)������������������������������������������ 15.28 Art 2:63(f )(2)�������������������������������������� 15.29 Art 2:63(f )(4)�������������������������������������� 15.29 Art 2:63(h)������������������������������������������ 15.61 Art 2:63(j)������������������������������������������ 15.29 Art 2:63(k)������������������������������������������ 15.30 Art 2:129(5)������������������������������������������ 5.49 Art 2:129a�������������������������������������������� 5.11 Art 2:135���������������������������������������������� 5.31 Art 2:140���������������������������������������������� 5.11 Art 2:140(2)������������������������������������������ 5.49 Art 2:158���������������������������������������������� 5.17 Art 2:158(12)���������������������������������������� 5.17 Art 2:166���������������������������������������������� 5.21 Art 2:391(5)������������������������������������������ 5.01 Art 2: 391(7)���������������������������������������� 5.21 Art 7:611��������������������������������� 18.60, 18.82 Art 138 ���������������������������������������������� 24.20 Art 238 ���������������������������������������������� 24.20 Corporate Governance Code 2016����������� 4.39, 5.50, 7.06 Preamble ���������������������������������������������� 5.50 Principle 1.1������������������������������������������ 5.50 Principle 1.1.1�������������������������������������� 7.06 Art 1.1�������������������������������������������������� 4.39 Decree of 12 October 2006 concerning rules on conduct of business supervision for financial institutions (Besluit Gedragstoezicht financiële ondernemingen) (Wft) ���������������������24.30 Art 32 ������������������������������������������������ 24.30

Disciplinary Regulations (Tuchtreglement Bancaire Sector) (version 1 September 2016)����������� 18.11, 18.38, 18.39 Art 1.1������������������������������������������������ 18.39 Art 2.1.1 �������������������������������������������� 18.12 Art 2.1.3 �������������������������������������������� 18.13 Art 2.1.7 �������������������������������������������� 18.11 Arts 2.2.1–​2.2.4���������������������������������� 18.11 Art 2.2.1 �������������������������������������������� 18.13 Art 2.2.3 ��������������������������������� 18.14, 18.82 Art 2.2.4 �������������������������������������������� 18.14 Art 2.2.7 �������������������������������������������� 18.17 Art 2.2.8 ���������������������� 18.11, 18.17–​18.18 Arts 3.3.3–​3.3.6���������������������������������� 18.41 Arts 3.7.3–​3.7.5���������������������������������� 18.18 Art 3.7.9 �������������������������������������������� 18.18 Art 3.8.2 ���������������������� 18.13, 18.47, 18.63 Art 3.9.2 �������������������������������������������� 18.19 Art 3:17c(2)(b)������������������������������������ 18.37 Art 4.3.1 �������������������������������������������� 18.20 Art 4.3.2 �������������������������������������������� 18.20 Art 4.4.1 ��������������������������������� 18.11, 18.20 Art 5.2������������������������������������������������ 18.21 Art 5.4������������������������������������������������ 18.21 Art 5.5������������������������������������� 18.21, 18.72 Art 6.4������������������������������������������������ 18.39 Art 6.6.2 �������������������������������������������� 18.13 Disciplinary Register Protocol (Protocol Tuchtrechtelijk Register StichtingTuchtrechtBanken) (November 2016 version)���������������� 18.21 Art 6.2������������������������������������������������ 18.21 Financial Supervision Act 2007 (Wet op het financieeltoezicht) (Wft)������������� 5.02, 8.48–​8.51, 15.43, 18.06, 18.38, 24.27 Art 1 �������������������������������������������������� 15.68 Art 1:24������������������������������������������������ 8.48 Art 1:47c����������������������������������� 8.49, 24.27 Art 1:48������������������������������������������������ 8.49 Art 1:49������������������������������������� 8.49, 24.27 Art 1:49 (5)������������������������������������������ 8.49 Art 1:77(2)������������������������������������������ 24.27 Art 1:125���������������������������������������������� 8.48 Art 1:121���������������������������������������������� 5.02 Art 2:12����������������������������������� 24.27–​24.28 Art2:105 �������������������������������������������� 15.43 Art 2:116(1)���������������������������������������� 24.27 Art 2:120(3)���������������������������������������� 24.27 Art 2:121(3)���������������������������������������� 24.27 Art 3:8������������������������������������������������ 24.27 Art 3:8(1)��������������������������������� 18.06, 24.27 Art 3:8(2)�������������������������������������������� 18.06 Art 3:9(2)���������������������������������������������� 8.49 Art 3:10���������������������������������������������� 24.28

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Table of Legislation Art 3:17���������������������������������������������� 24.28 Art 3:17b�������������������������������������������� 24.30 Art 3:17b(1), (2) �������������������������������� 18.08 Art 3:17c���������������������� 18.08–​18.09,  24.30 Art 3:17c(2)(b)������������������������������������ 18.48 Art 3:111�������������������������������������������� 15.43 Art 4:9(1), (6) ������������������������������������ 18.06 Art 4:10(2)�������������������������������������������� 8.49 Art 4:15a�������������������������������������������� 18.08 Intervention Act 2012 ���������������������������� 24.30 Oath or Affirmation (Financial Sector) Regulation��������������������������� 18.06, 18.08 Personal Data Protection Act (Wet beschermingpersoonsgegevens)�������� 18.47 Slovakia Corporate Governance Code 2008������������ 7.06 Spain Real Decreto Ley 9/​2009������������������������ 22.17 Real Decreto Ley 2/​2011������������������������ 22.32 Real Decreto Ley 11/​2010����������� 22.20, 22.26 Real Decreto Ley 2/​2011������������������������ 22.26 Real Decreto Ley 2/​2012������������� 22.36, 22.38 Real Decreto Ley 9/​2012������������������������ 22.39 Real Decreto Ley 24/​2012���������������������� 22.39 Real decreto Ley 26/​2013������������������������ 22.40 United Kingdom Bank of England Act 1998���������������������� 14.84 s 9C���������������������������������������������������� 14.84 ss 9E, 9F �������������������������������������������� 14.84 Bank of England and Financial Services Act 2016 ������������������������������������������ 6.13 ss 25(3)(f ), (g)�������������������������������������� 6.13 Companies Act 1985�������������������������������� 7.47 Companies Act 2006����� 5.01, 5.26, 5.31, 7.40 s 172 ������������������������������������������� 5.48, 7.06 s 172(1)��������������������������������������� 7.03, 7.06 s 174(1)������������������������������������������������ 5.26 Financial Services Act 1986 �������������������� 20.13 Financial Services Act 2000 ���������������������� 6.11 s 59ZA�������������������������������������������������� 6.12 s 60(2A)������������������������������������������������ 6.12 s 62A���������������������������������������������������� 6.12 ss 63E, 63F ������������������������������������������ 6.12 s 63ZB�������������������������������������������������� 6.12 s 66B(5)������������������������������������������������ 6.12 s 66B(6)������������������������������������������������ 6.13 Financial Services (Banking Reform) Act 2013 ��������������������������������� 6.11, 6.14 s 36 ��������������������������� 6.13, 6.57, 6.69, 7.46

United States Code of Federal Regulations—​ Title 12, §§ 9.2, 9.11�������������������������� 20.12 Title 17, Chapter II, Part 230, § 501��������20.08 Community Development Act 1977 ������ 14.81 Community Reinvestment Act���������������� 14.81 Delaware Code������������������������������������������ 7.18 Title 8, § 102���������������������������������������� 7.18 Title 8, § 144 (West) ���������������������������� 7.21 Title 8, § 145 (West) ���������������������������� 7.19 Title 8,§ 145(a) and (c) ������������������������ 7.18 Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) PL 96-​221, 94 Stat 132�������������������������������������� 14.39 Dodd-​Frank Wall Street Reform and Consumer Protection Act 2010 ������� 7.35, 10.09, 11.64, 13.25, 20.20 Title II������������������������������������������������ 14.19 Title VII���������������������������������������������� 10.09 Title VIII�������������������������������������������� 10.09 § 165(h)������������������������������������������������ 7.35 § 913�������������������������������������������������� 20.20 § 956�������������������������������������������������� 11.64 Employee Retirement Income Security Act 1974 ������������������ 20.17–​20.18,  20.20 Export-​Import Bank Act 1945���������������� 14.53 Federal Housing Enterprises Finance Safety and Soundness Act���������������� 14.42 Federal Reserve Act 1913������������������������ 14.38 Financial Choice Act 2017���������������������� 14.39 Financial Institutions Supervisory Act of 1966 �������������������������������������� 7.34 s 3158 �������������������������������������������������� 7.34 s 3695 �������������������������������������������������� 7.34 General Corporation Law�������������������������� 7.16 § 102(b)(7) ������������������������������������������ 7.16 Gramm-​Leach-​Bliley Act 1999���������������� 14.39 Investment Advisers Act 1940 ��������������� 20.11, 20.20, 20.41 Investment Company Act 1940�������������� 20.41 § 3a-​4�������������������������������������������������� 20.41 Model Business Corporation Act (MBCA)�������������������������������������������� 7.12 § 8.30(b) ���������������������������������������������� 7.12 § 8.31(a)(2)(ii)(A) �������������������������������� 7.16 National Banking Act 1863���������������������� 6.71 New York Banking Law���������������������������� 4.22 § 606���������������������������������������������������� 4.22 Sarbanes-​Oxley Act �������������������������������� 16.56 § 406�������������������������������������������������� 16.56 Securities Act1933���������������������������������� 20.06 Securities Exchange Act 1934������������������ 20.06

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Table of Legislation Uniform Prudent Investor Act 1994—​ § 5������������������������������������������������������ 20.09 Uniform Trust Code—​ § 802�������������������������������������������������� 20.09 US Code of Federal Regulations—​ Title 12 ���������������������������������������������� 14.39 §§ 252.20–​22 �������������������������������������� 7.37

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§ 4501(7)�������������������������������������������� 14.42 § 635�������������������������������������������������� 14.53 § 635a(c)�������������������������������������������� 14.57 § 1821(k)���������������������������������������������� 7.32 § 1828(k)���������������������������������������������� 7.32 § 5365(h)���������������������������������������������� 7.35 Title 15 ���������������������������������������������� 14.39

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LIST OF ABBREVIATIONS

AFM AIFMD AIFMs AIFs AML AMSB APRA ASIC

Stichting Autoriteit Financiële Markten Alternative Investment Fund Manager Directive Alternative Investment Fund Managers Alternative investment funds anti-​money-​laundering regulations Administrative, management, or supervisory body Australian Prudential Regulation Authority Australian Securities and Investments Commission

BaFin BCBS BES BESCL BHB BIC Exemption BIS BNA BoA BPVI BRRD BSA

German Federal Financial Supervisory Agency Basel Committee on Banking Supervision Banco Espírito Santo Banco Espírito Santo e Comercial de Lisboa Bank Holding Companies Best Interest Contract Exemption Bank of International Settlement Bond van Nederlandse Architecten (Dutch Association of Architects) Bank of England Banca Popolare di Vicenza Bank Recovery and Resolution Directive Bank Secrecy Act

CCM CCPs CDO CDS CEBs CEBS CEO CET1 CFA CFO CFPB CFTA CoCos COSO

Caja Castilla-​La Mancha Central Clearing Counterparties collateralized debt obligation credit default swap Committee of European Banking Supervisors Committee of European Banking Supervisors Chief Executive Officer Common Equity Tier 1 Chartered Financial Analyst Chief Financial Officer Consumer Financial Protection Bureau Commodity Futures Trading Commission Contingent Convertible bonds Committee of Sponsoring Organizations of the Treadway Commission Committee on Payments and Markets Infrastructures

CPMI

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List of Abbreviations CPSS CRA CRD CRR CSDs CSR CVF

Committee on Payment and Settlement Systems Community Reinvestment Act Capital Requirements Directive Capital Requirements Regulation central securities depositories corporate social responsibility Competing Values Framework

D&O DCC DGS DNB DOL DSI D-​SIBs

Directors and Officers Dutch Civil Code Deposit Guarantee System Dutch National Bank (De Nederlandsche Bank N.V.). Department of Labor (US) Dutch Securities Institute Domestic systemically important banks

EBA EBF ECB ECHR ECJ ECJI ECtHR EEA EFAMA EFRAG EIOPA EMIR EMU ERISA ESAs ESC ESFG ESG ESI ESMA ESRB ETFs

European Banking Authority European Banking Federation European Central Bank European Convention for the Protection of Human Rights and Fundamental Freedoms European Court of Justice European Corporate Governance Institute European Court of Human Rights European Economic Area European Fund and Asset Management Association European Financial Reporting Advisory Group European Insurance and Occupational Pensions Authority European Market Infrastructures Regulation European Monetary Union Employee Retirement Income Security Act of 1974 European Supervisory Authorities Espírito Santo Control Espírito Santo Financial Group environmental, social, and corporate governance Espírito Santo International European Securities and Markets Authority European Systemic Risk Board exchange-​traded  funds

FBEE FCA FDIC FINRA FMIs FPA

Foundation for Banking Ethics Enforcement (Stichting Tuchtrecht Banken) Financial Conduct Authority Federal Deposit Insurance Corporation Financial Industry Regulatory Authority Financial market infrastructures Financial Prudential Authority

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List of Abbreviations FPC FRC FROB FSA FSB FSF FTEs

Financial Policy Committee Financial Reporting Council Fondo de Reestructuración Ordenada Bancaria Financial Services Authority Financial Stability Board Financial Stability Forum Full-​time equivalents

GES GSEs G-​SIBs G-​SIFs

Grupo Espírito Santo Government-​Sponsored Enterprises globally systemically important banks global systemically important financial institutions

HLEG

High-​Level Expert Group

IAIS IAS ICA ICAAP ICGN ICPs IFRIC IFRS IIF IMF IORP IOSCO IPO IRAs

International Association of Insurance Supervisors International Accounting Standards International Co-​operative Alliance Internal Capital Adequacy Assessment Process International Corporate Governance Network Insurance Core Principles International Financial Reporting Interpretations Committee International Financial Reporting Standards International Institute of Finance International Monetary Fund Institutions for Occupational Retirement Provision International Organization of Securities Commissions initial public offering individual retirement accounts

LER LIBOR LTIP

Legal Entity Rationalization London Interbank Offered Rate long-​term incentive plans

MAD MAR MBCA MCR MDA MiFID II MIS MoU MPE MPS MREL MTF

Market Abuse Directive Market Abuse Regulation Model Business Corporation Act Minimum Capital Requirement Maximum Distributable Amount Markets in Financial Instruments Directive Management Information Systems Memorandum of Understanding Multiple point of entry Monte dei Paschi di Siena minimum requirement for own funds and eligible liabilities Multilateral trading facility

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List of Abbreviations NCWO NRA NVB

no creditor worse off National Resolution Authorities Nederlandse Vereniging van Banken

OECD ORSA OTC

The Organisation for Economic Co-​operation and Development own risk and solvency assessment (ORSA) process over-​the-​counter

PCBS PDCA PFMI PPI PRA PRI PSPA

Parliamentary Commission on Banking Standards plan–​do–​check–​adjust Principles of Financial Market Infrastructures Payment Protection Insurance Prudential Regulatory Authority Principles for Responsible Investment Senior Preferred Stock Purchase Agreement

RAF RDR RMI RPE

Risk appetite framework Retail Distribution Review Risk Management Index Relative Performance Evaluation

SCE SDX Protocol SEC SIFIs SIP SM&CR SMEs SRB SREP SRF SRI SRI SSM

Societas Cooperativa Europaea Shareholder-​Director Exchange Protocol Securities and Exchange Commission systemically important financial institutions Sistemas Institucionales de Protección Senior Manager and Certification Regime Small to medium sized enterprise Single Resolution Board supervisory review and evaluation process Single Resolution Fund Sustainable and Responsible Investing Socially Responsible Investment Single Supervisory Mechanism

TBTF TLAC TRs

too-​big-​to-​fail’ Total loss-​absorbing capacity trade repositories

UCITS

undertakings for collective investment in transferable securities

VB

Veneto Banca

WGGF

Working Group on Governance Frameworks

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LIST OF CONTRIBUTORS

Antonella Sciarrone Alibrandi is a Professor of Banking Law at the School of Banking, Finance and Insurance at the Università Cattolica del Sacro Cuore in Milan. She is a Member of the European Commission Expert Group on Regulatory Obstacles to Financial Innovation (ROFIEG). She is also President of the Society of Italian Professors of Law and Economics (ADDE). José Augusto Quelhas Lima Engrácia Antunes is Professor of Law (Portugal). He holds a Master of Law from the Universidade Católica, Lisbon, 1988, and a PhD of Law from the European University Institute, Florence, 1992. He is the author of books and articles in the areas of commercial law, company law, financial law, and philosophy of law, published in Portuguese, American, French, German, Dutch, Spanish, Brazilian, and Italian editing houses. Bart Bierens is Legal Adviser at Rabobank and Professor of Banking Law and Financial Regulation at the Institute for Financial Law, Radboud University in Nijmegen, the Netherlands. He is the author of many articles in the field of financial law, including publications on money and payment services, public offerings, a bank’s duty of care, the EU Banking Union, and the rules on bank resolution. Jens-​Hinrich Binder is Professor of Law, University of Tübingen, Chair in private law, commercial, and corporate Law. He holds an LLM from the London School of Economics and Political Science, 2001; and a Dr iur from the University of Freiburg, 2003. He is a member of the advisory panel on financial markets regulation with the German Federal Ministry of Finance; and co-​editor of Zeitschrift für Bankrecht und Bankwirtschaft/​Journal of Banking Law and Banking. Claartje Bulten is Professor of Company Law of the Business and Law Research Centre at Radboud University in Nijmegen and Crown-​Member of the Social and Economic Council (SER). Danny Busch is full Professor (Chair) of Financial Law and Director of the Institute for Financial Law, Radboud University, Nijmegen, the Netherlands. He is also visiting professor at Université de Nice Côte d’Azur, Università Cattolica del Sacro Cuore di Milano, and Università degli studi di Genova, Member of the Dutch Banking Disciplinary Committee (Tuchtcommissie Banken), and Member of the Appeal Committee of the Dutch Complaint Institute Financial Services (Klachteninstituut Financiële Dienstverlening, KiFiD). He is extensively engaged in the provision of training to attorneys-​at-​law, financial regulators, and financial

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List of Contributors professionals. He is author of many articles in the field of financial and commercial law, and author and editor of several books, including Capital Markets Union in Europe (with E Avgouleas and G Ferrarini), Oxford University Press, 2018; Regulation of the EU Financial Markets—​MiFID II and MiFIR (with G Ferrarini), Oxford University Press, 2017; A Bank’s Duty of Care (with C C van Dam), Hart/​ Bloomsbury, 2017; Agency Law in Commercial Practice (with L J Macgregor and P Watts), Oxford University Press 2016; European Banking Union (with G Ferrarini), Oxford University Press, 2015; Alternative Investment Funds in Europe (with L D van Setten), Oxford University Press, 2014; and Liability of Asset Managers (with D A DeMott), Oxford University Press, 2012. After having graduated with highest honours in Dutch law from Utrecht University in 1997, he was awarded the degree of Magister Juris in European and Comparative Law by the University of Oxford (St John’s College) in 1998. From 1998 until 2001 he held the position of lecturer and researcher at the Molengraaff Institute of Private Law in Utrecht. In 2002, he defended his PhD in Utrecht (Indirect Representation in European Contract Law, KLI 2005). From 2002 until 2010 he was an attorney-​at-​law (advocaat) with the leading Dutch international law firm De Brauw Blackstone Westbroek in Amsterdam where he practiced banking and securities law (both the private law and regulatory aspects). Paul Davies is a Senior Research Fellow at Harris Manchester College, Oxford, United Kingdom. He was the Allen & Overy Professor of Corporate Law, University of Oxford, from 2009 to 2014; Cassel Professor of Commercial Law at the London School of Economics and Political Science from 1998 to 2009; and, before that, Professor of the Law of the Enterprise, University of Oxford. He is an honorary Queen’s Counsel and an honorary Bencher of Gray’s Inn. His main interests are in labour law, corporate law, and banking law. His most recent work on corporate boards was as an editor of and contributor to Corporate Boards in Law and Practice: A Comparative Analysis in Europe (Oxford University Press, 2014). Bas de Jong is full-​time Professor of Capital Markets Law at Radboud University in Nijmegen, with financial support from Dutch Investor Association VEB (Vereniging van Effectenbezitters). He was a visiting scholar at Columbia University and Cambridge University, and is editor of Wolters Kluwer’s Groene Series on Dutch capital markets law. Carmine Di Noia is Commissioner at Consob since February 2016. He also served at Consob between 1995 and 2000, first in the research department and then as head of the market information office. From 2001 to 2016, he was Head of the Capital Markets and Listed Companies Unit and Deputy Director General at Assonime. Guido Ferrarini is Emeritus Professor of Business Law at the University of Genoa, Italy, and Professor of Governance of Financial Institutions, University of

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List of Contributors Nijmegen, The Netherlands. He holds a J D (University of Genoa), an LLM (Yale Law School), and a Dr jur (hc, Ghent University). He is a founder and fellow of the European Corporate Governance Institute (ECGI), Brussels. He was a member of the Board of Trustees, International Accounting Standards Committee (IASC), an independent director at several Italian blue-​chip companies, and Chairman of EuroTLX (an Italian MTF). He was an adviser to the Draghi Commission on Financial Markets Law Reform, to Consob (the Italian Securities Commission), and to the Corporate Governance Committee of the Italian Stock Exchange. He has held Visiting Professor positions at several universities in Europe (Bonn, Católica Lisbon, Frankfurt, Ghent, Hamburg, LSE, UCL, Tilburg, and Duisenberg) and the United States (Columbia, NYU, and Stanford), teaching courses on comparative corporate governance and financial regulation. He is author of many articles in the fields of financial law, corporate law, and business law, and editor of several books, including Financial Regulation and Supervision: A Post-​crisis Analysis (with E Wymeersch and K J Hopt), Oxford University Press, 2012; Boards and Shareholders in European Listed Companies (with M Belcredi), Cambridge University Press, 2013; European Banking Union (with D Busch), Oxford University Press, 2015; Regulation of the EU Financial Markets: MiFID II & MiFIR (with D Busch), Oxford University Press, 2017 and Capital Markets Union in Europe (with Avgouleas and Busch), Oxford University Press, 2018. He is presently board chair of a securities firm, board member of a private bank, and adviser on corporate law and financial regulation. Claudio Frigeni is Professor of Company Law and Corporate Governance Systems at the Università Cattolica del Sacro Cuore in Piacenza, Italy. He holds a PhD (Università Cattolica del Sacro Cuore) and an LLM (University of London—​ UCL). His research focuses on corporate governance and banking regulation. Matteo Gargantini works at Consob. Before joining Consob, he was senior research fellow at the Max Planck Institute Luxembourg for procedural law. He also worked in the Capital Markets and Listed Companies Unit of Assonime. He holds a PhD in Law and Economics (University of Sienna). Paolo Giudici is Professor of Business Law at the School of Economics and Management of the University of Bozen-​Bolzano. He is an ECGI Research Associate and professorial fellow at Tilburg University. His research started with antitrust, and then he moved to capital markets law and company law, with a key interest in civil liability and private enforcement. Before starting his academic career he was a practising business lawyer for fifteen years. In the continental Europe tradition, he continues to serve as legal counsel and advocate in matters concerning his areas of academic expertise. María Gutiérrez-​Urtiaga is Associate Professor of Finance (with tenure) at Universidad Carlos III de Madrid, Department of Business Administration. She is also research

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List of Contributors associate of the ECGI. Her research interests include corporate governance, corporate finance, and law and economics. Her research examines corporate governance institutions such as boards of directors and fiduciary duties, and corporate governance problems such as minority expropriation and bankruptcy costs. She has published in prestigious international journals such as the Rand Journal of Economics; Industrial and Corporate Change; Journal of Law, Finance and Accounting; Corporate Governance: An International Review; and the Journal of Corporate Legal Studies. From 2012 until 2016 she served as a member of the Consulting Committee of the CNMV (Comisión Nacional del Mercado de Valores Español). Geneviève Helleringer is a Law Professor at ESSEC Business School, Institute of European and Comparative Law Lecturer at Oxford University, and ECGI Research Member. Geneviève is an executive editor of the Oxford Journal of Financial Regulation (Oxford University Press). Klaus J Hopt is Professor and Director (Emeritus) at the Max Planck Institute for Comparative and International Private Law, Hamburg. From 1974 to 1995 he was a professor in Tübingen, Florence, Berne, and Munich; Dr h c mult in Brussels, Louvain, Paris, Athens, and Tiflis; and visiting professor at the University of Chicago, Harvard Law School, NYU, and Columbia University, among others. From 2002 to 2008, he was vice president of the German Research Foundation. He is the author of publications in European corporate, capital market, and financial law. Peter Laaper specializes in financial law. He works at Keijser Van der Velden law firm and is an assistant professor at Utrecht University, both in The Netherlands. He wrote a dissertation on outsourcing regulations in the financial sector. Katja Langenbucher is a scholar of corporate and securities law. She has published extensively in the fields of corporate law, corporate finance, and European securities law. Her latest book Economic Transplants—​on Lawmaking for Corporations and Capital Markets broadens her focus to include problems of legal theory in law and economics. She holds a full professorship for private law, corporate, and securities law at Goethe-​University’s House of Finance in Frankfurt, Germany. She is also an Affiliated Professor at the Ecole de Droit de SciencesPo, Paris, France. She has held visiting positions at Université de Sorbonne; Wirtschaftsuniversität, Vienna; London School of Economics; and Columbia Law School; and has been awarded the Edward Mulligan Distinguished Professorship for international law by Fordham Law School, New York. She sits on the supervisory board of SciencesPo University, Paris, she is a member of the takeover panel of ‘BaFin’, and was a member of the supervisory board of Postbank. Kitty Lieverse is Professor of Financial Regulatory Law at the Business and Law Research Centre at Radboud University in Nijmegen and attorney-​ at-​ law in Amsterdam.

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List of Contributors Wijnand Nuijts is heading the governance, behavior, and culture department of De Nederlandsche Bank (DNB). Since its inception in 2010, he has been responsible for the national and international development of an innovative type of supervision that focuses on leadership styles, group dynamics, and the quality of decision making by companies. Together with a multidisciplinary team of organizational psychologists and governance experts, he is responsible for conducting numerous examinations into the effects of behaviour all patterns for the performance of Dutch financial institutions. Personally, he takes great interest in analysing human behaviour within the context of board decision-​making processes and he is convinced that a closer focus on human behaviour with organizations and their boards, will contribute to their sustainable (financial) performance. He has published various (scientific) articles about these topics and provides training to internal and external supervisors on how to integrate behaviour and culture in their work. In addition to his position with DNB, he carried out an examination on behalf of the Health and Youth Care Inspectorate into the organizational culture of a large hospital in the Netherlands in 2016. Prior to his current role, Wijnand held various management positions at DNB and before joining the Dutch Central Bank he was working as a corporate finance consultant and attorney-​at-​law. Iris Palm-​Steyerberg is Head of the Supervision and Regulation Department at the Dutch Central Bank (De Nederlandsche Bank NV or DNB). After graduating in both psychology and law (cum laude) at Utrecht University she started her career in 1997 as a corporate lawyer in Amsterdam. In 2004 she joined the Dutch Authorities for the Financial Markets (Autoriteit Financiele Markten or AFM), leading the Legal Enforcement Department. In 2012 she started working for DNB, and in 2017 she became a Fellow at the Institute for Financial Law, Radboud University Nijmegen. In this last capacity, fit and proper testing is one of her main focus areas. Maribel Sáez-​Lacave is professor of corporate and business law (Profesora Titular) at Universidad Autónoma de Madrid. Her research interests include corporate law and law and economics. She received a postdoctoral fellowship from the Alexander von Humboldt Foundation to visit Marburg University and Bonn University (2004–​2005). She has been visiting scholar at Harvard Law School (2017) and Columbia University (2012) and visiting professor of law at the Radzyner School of Law in the Interdisciplinary Center Herzliya (2013). Her work is regularly presented at prestigious conferences including the American Law and Economics Association and the European Law and Economics Association. She has published in prestigious international law and finance journals such as Journal of Law, Finance and Accounting; and Corporate Governance:  An International Review and the Journal of Corporate Legal Studies. Paolo Saguato is assistant professor at Antonin Scalia Law School, George Mason University (GMU) specializing in financial regulation. His research interests

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List of Contributors encompass the intersection of banking, securities, and derivatives regulation and the international and comparative dynamics of financial markets. His recent scholarship was published in the Yale Journal on Regulation; the Stanford Journal of Law, Business and Finance; the Journal of Corporate Law Studies; and the Oxford Handbook of Financial Regulation. Before joining GMU, he was a research fellow at Georgetown Law Center and the London School of Economics and Political Science, and a Global Hauser Fellow at New York University School of Law. He holds a LLM from Yale Law School, which he attended as a Fulbright Scholar. He graduated summa cum laude from the University of Genoa and received a PhD in Private, Business, and International Law from the same institution. Steven L Schwarcz is the Stanley A Star professor of Law and Business at Duke University and founding director of Duke’s interdisciplinary Global Financial Markets Center (see https://​law.duke.edu/​fac/​schwarcz/​). His areas of research and scholarship include insolvency and bankruptcy law, international finance, capital markets, systemic risk, corporate governance, and commercial law. He holds a bachelor’s degree in aerospace engineering (summa cum laude) and a Juris Doctor from Columbia Law School. Prior to joining Duke, he was a partner at two of the world’s leading law firms and visiting lecturer at Yale Law School. He also helped to pioneer the field of asset securitization, and his book Structured Finance: A Guide to the Principles of Asset Securitization is one of the most widely used texts in that field. Schwarcz has also been the Leverhulme visiting professor at the University of Oxford, visiting professor at the University of Geneva faculty of law, lecturer in law at Columbia Law School, distinguished visiting professor at University College London (UCL) faculty of laws, the MacCormick Fellow at The University of Edinburgh School of Law (scheduled for spring 2019), and an adviser to the United Nations. He has testified before the US Congress on topics including systemic risk, securitization, credit rating agencies, and financial regulation, and has advised several US and foreign governmental agencies on the financial crisis and shadow banking. His article ‘Systemic Risk’ (Georgetown Law Journal, 97, 1) was the second most-​cited law review article of 2008; he also has been recognized as the world’s second most-​cited scholar, 2010–​2014 and again 2013–​2017, in commercial, contract, and bankruptcy law. Schwarcz is a fellow of the American College of Bankruptcy and the American College of Commercial Finance Lawyers, a founding member of the International Insolvency Institute, former business law Adviser to the American Bar Association, a member of P.R.I.M.E. Finance’s Panel of Recognized International Market Experts in Finance, and senior fellow of the Centre for International Governance Innovation (CIGI). Co-authors Aleaha Jones and Jiazhen Yan received their Juris Doctor degrees from Duke Law School and, at the time of co-authoring the chapter, were Professor Schwarcz’s research assistants. Michele Siri is a Professor of Business Law at the University of Genoa (Italy) and holds a Jean Monnet Chair on European Union Financial and Insurance Markets

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List of Contributors Regulation awarded by the European Commission in 2017 for teaching and research activities devoted to the EU financial services law. He is also a visiting professor of financial institutions and markets law at the Bocconi University. He is an academic member of ECGI, the European Corporate Governance Institute in Brussels and an academic fellow of EBI, the European Banking Institute in Frankfurt. He has published widely in the fields of insurance and financial services law, and has served as an adviser to and participated in expert working groups initiated by public institutions, such as the Italian government and the Italian Supervisory Authorities, on financial and insurance markets regulation with a particular focus on EU policy initiatives. He was appointed in 2018 by EIOPA, the European Insurance and Occupational Pensions Authority, as a member of the Board of Appeal of the European Supervisory Authorities. Previously, in 2017, ESMA, the European Securities and Markets Authority appointed him as a member of the Consultative Working Group for Investor Protection and Intermediaries Standing Committee (IPISC). His academic publications deal with insurance, financial markets, and corporate law topics. The primary research interests concern the corporate governance of financial institutions, investor protection, and the regulation of financial and insurance intermediaries. He is a guest contributor to the Oxford Business Law Blog. Christina Skinner is an Assistant Professor of Legal Studies and Business Ethics at the Wharton School of the University of Pennsylvania. Her research focuses on financial regulation and securities regulation. Maria Cristina Ungureanu is Head of Corporate Governance at Eurizon Capital SGR, the asset management company of the Intesa Sanpaolo Bank Group, Italy. She is also member of the SRI (Social Responsible Investments) Committee of Eurizon, member of the ECGI (European Corporate Governance Institute) and fellow of the Genoa Center for Law and Finance. Cristina is responsible for Eurizon’s Corporate Governance and Stewardship activity, developing and applying Eurizon’s corporate governance policies and guidelines through active ownership, coordinating the company engagement activities globally. Before her role in Eurizon, Cristina worked in international corporate and academic environments in South Africa, United Kingdom and Italy, providing high-level corporate governance consulting and research to a diverse range of institutions. Cristina holds a Bachelor Degree in Economics and Business Administration, a Master’s Degree in International Affairs and a PhD in Finance and Banking. Arthur van den Hurk started his career as an attorney in a law firm in the Netherlands. He is currently working as senior regulatory counsel at Aegon NV He studied law at Erasmus University in Rotterdam and Università ‘La Sapienza’ in Rome and has completed postgraduate courses in mergers and acquisitions and securities law (Grotius Academy). He is a fellow of the Institute of Financial Law, part of the

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List of Contributors Research Centre for Company & Law, of the law faculty of the Radboud University in Nijmegen. He publishes regularly in the area of financial services law in general. His research and publications focus primarily on insurance regulation, in particular prudential regulation, recovery resolution, and group supervision. He is chairman of the legal and regulatory committee of the Dutch Association of Insurers and is a member of the policy committee of European Issuers. Furthermore, he is an editorial board member of the Dutch financial law journal Tijdschrift voor Financieel Recht, regular contributor to the Dutch legal journal Ars Aequi, and to other legal journals, and contributes to two commentaries to the Dutch Financial Supervision Act. Martin van Olffen is Professor of Company Law at the Business and Law Research Centre, Radboud University in Nijmegen and Civil Law Notary (partner) at De Brauw Blackstone Westbroek in Amsterdam. Lodewijk van Setten has wide ranging experience with the legal, regulatory, and operational risks of regulated investment firms, which he gained as general counsel and, subsequently, chief operating officer at Morgan Stanley Investment Management and, prior to that, State Street Global Advisors. He was appointed visiting Professor of Financial Law at King’s College London in 2005. Gerard van Solinge has been Professor of Company Law at the Radboud University Nijmegen since 1997; a co-​leader of the research programme Company Law of the Business and Law Research Centre, and the Van der Heijden Institute, the oldest research centre for company law in the Netherlands (established in 1966). Further, he is Editor-​in-​Chief of Ondernemingsrecht (the leading Dutch law journal on company law), member of the supervisory board of Rabobank Rijk van Nijmegen, advisory member of the standing advisory committee on company law of the Ministry of Justice in Curaçao (Dutch Carribean). He is the author and editor of numerous books, book entries, and articles on corporate litigation, corporate governance, M&A (cross-​border mergers, public bids, takeovers), and private international law, including one of the volumes on company law published in the Asser Series, the authoritative treatise on Dutch private law and company law (with M Nieuwe Weme); the Van der Heijden Institute book series on company law; VOC 1602-​2002. 400 Years of Company Law (with E Gepken-​Jager and L Timmerman), Kluwer Legal Publishers 2005; and Corporate Board in Law and Practice. A  Comparative Analysis in Europe (with P Davies, K J Hopt, and R Nowak), Oxford University Press, 2013. In 1993, he became a member of the Amsterdam Bar. Shortly after, he defended his PhD on cross-​border mergers at the Free University in Amsterdam (cum laude). Since 2004 he has been an attorney (advocaat) and of counsel at Allen & Overy LLP in Amsterdam. Shanshan Zhu is a junior research fellow at the Genoa Centre for Law and Finance and a PhD candidate in Company Law at the University of Genoa, Italy.

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Part I GENERAL

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1 GOVERNING FINANCIAL INSTITUTIONS Law and Regulation, Conduct and Culture Danny Busch, Guido Ferrarini, and Gerard van Solinge

I. Introduction II. Basic Concepts III. Lessons from the Financial Crisis IV. Global Principles

V. Corporate Governance and Prudential Regulation: Complements or Substitutes? 1.25 VI. The Role of Conduct and Culture 1.31

1.01 1.03 1.12 1.16

I. Introduction Compared with governance in general, the scholarly literature has paid relatively 1.01 little attention to the governance of financial institutions,1 which is however not only important, but also unique.2 This volume intends to fill this gap through original contributions offered by scholars and practitioners focussing on the law and regulation of the governance of financial institutions (Parts I–​III) and on the role played by conduct and culture in the same area (Part IV). After the 2008 financial crisis, a substantial part of the blame for the numerous 1.02 bank failures that occurred as a result of the crisis has been put on corporate governance. Consequently, regulation and supervision have been enhanced both as a complement to the governance of financial institutions and as a substitute for the same in areas where governance failures appear more evident. Against this backdrop, important questions arise. Has the swinging of the pendulum between 1 Frank Song and Li Li, ‘Bank Governance: Concepts and Measurements’, in James Barth, Chen Lin, and Clas Wihlborg (eds), Research Handbook on International Banking and Governance, Elgar, 2012, 17. 2 Ross Levine, ‘The Corporate Governance of Banks:  A Concise Discussion of Concepts and Evidence’, World Bank Policy Research Working Paper No 3404/​2004; Klaus J Hopt, ‘Better Governance of Financial Institutions’, ECGI Law Working Paper No 207/​2013.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge corporate governance and financial regulation gone too far, as a result of the ‘nirvana fallacy’3 that often affects reformers? Should corporate governance recover some of the lost ground, possibly through spontaneous enhancement of the role of boards by financial institutions and cautious deregulation of the governance mechanisms by supervisory authorities? Is corporate law for financial institutions in need of reform, for instance by restricting the scope of the business judgement rule, or should this suggestion be rejected, as this would affect entrepreneurship and stifle innovation in the financial sector? Must this reform, if any, come from national legislation or from a European source or both? These and other important questions regarding the relationship between governance of financial institutions on the one hand, and rules and regulation on the other, will be analysed and discussed in Part I of this volume.4

II.  Basic Concepts 1.03

Financial institutions are enterprises that provide financial services. They perform three main functions:  transformation of financial assets; broker–​dealer services; asset management. Three types of financial institutions are consequently identified: financial intermediaries; investment firms; asset managers.5 Financial market infrastructures are added as a special type of financial institution, whose relevance is on the rise in today’s financial markets.6

1.04

Financial intermediaries transform financial assets acquired through the market and constitute them into a different type of asset, more widely preferable, which becomes their liability. Financial intermediaries include banks of all types and credit unions, insurance companies, pension funds, investment funds, and finance companies. Their transformation function involves at least one of the following: (i) maturity intermediation; (ii) risk reduction via diversification; (iii) transaction costs reduction; and (iv) payment services.7 Banks often provide all of these functions. Insurers offer the first three, while pension funds and investment funds provide 3 See Harold Demsetz, ‘Information and Efficiency:  Another Viewpoint’, Journal of Law and Economics (1969), 12, 1, stating: ‘The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing “imperfect” institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements’. 4 See, in various directions, Jens-​Hinrich Binder, Chapter 2; Kitty Lieverse and Claartje Bulten, Chapter 5; Paul Davies and Klaus Hopt, Chapter 6; Steven Schwarcz, Aleaha Jones, and Jiazhen Yan, Chapter 7; Iris Palm-​Steyerberg and Danny Busch, Chapter 8; Guido Ferrarini, Chapter 11, all this volume. 5 Frank Fabozzi, Franco Modigliani, and Frank Jones, Foundations of Financial Markets and Institutions, Pearson, 4th ed, 2014, 23ff. 6 Guido Ferrarini and Paolo Saguato, ‘Regulating Financial Market Infrastructures’, in Niamh Moloney, Eilis Ferran, and Jennifer Payne (eds), The Oxford Handbook of Financial Regulation, Oxford University Press, 2015, 568. 7 Fabozzi, Modigliani, and Jones, n 5, 24.

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Governing Financial Institutions risk diversification and transaction costs reduction. Specialized institutions offer payment services in addition to banks. Investment firms provide broker–​dealer functions, such as exchanging financial 1.05 assets on behalf of customers and/​or for their own account, and/​or underwriting functions (i.e. they assist their clients in the creation of financial assets, which they then offer to market participants). Asset managers provide investment advice to other market participants (including financial intermediaries) and/​or manage their assets. Financial market infrastructures are established as multilateral systems among 1.06 participating institutions, including the operator of the system, for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions. They foresee a set of common rules and procedures for all participants, a technical infrastructure, and a specialized risk-​management framework. Through the centralization of specific activities, they allow participants to manage their risks more efficiently and, in some instances, eliminate certain risks.8 Financial institutions are in the business of taking risks and managing them. In 1.07 so doing, they face ‘idiosyncratic’ risks, such as credit risk, settlement risk, counterparty risk, liquidity risk, market risk, and operational risk.9 Moreover, the great financial crisis has restored the importance of systemic risk in the financial sector, as distinguished from idiosyncratic risk. A  common factor in the various definitions of systemic risk is that a trigger event, such as an economic shock or institutional failure, causes a chain of bad economic consequences, which could include a chain of financial institution and/​or market failures.10 While an idiosyncratic shock will affect only a single institution or asset, systemic risk focuses on the danger of the entire financial system collapsing, causing a major downturn in the real economy. Indeed, the consequences of a systemic financial crisis are more devastating than those of other economic crises because of the role that finance plays in the economy.11 Connected with the concept of systemic risk, is that of systemically important 1.08 financial institutions (SIFIs). SIFIs are firms whose disorderly failure, because of their size, complexity, and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.12 The Financial

8 CPSS—​IOSCO, Principles for financial market infrastructures, 2012. See Paolo Saguato, Chapter 10, this volume. 9 Fabozzi, Modigliani, and Jones, n 5, 30. 10 Steven Schwarcz, ‘Systemic Risk’, Georgetown Law Journal (2008), 97, 193. 11 See the definition offered by the Systemic Risk Centre, London School of Economics, at www. systemicrisk.ac.uk/​systemic-​risk, accessed 1 July 2018. 12 FSB, ‘Reducing the Moral Hazard Posed by Systemically Important Financial Institutions, Recommendations and Time Lines’, 20 October 2010.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge Stability Board (FSB) recommends that financial institutions that are clearly systemic in a global context (G-​SIFIs) should have higher loss-​absorbency capacity than the minimum levels agreed in Basel III. These institutions must also be subject to more intensive coordinated supervision and resolution planning to reduce the probability and impact of their failure. 1.09

Financial intermediaries in general are different from non-​financial firms for several reasons that matter from a corporate governance perspective. Firstly, they are more leveraged, with the consequence that the conflict between shareholders and fixed claimants, present in all corporations, is more acute for them.13 Secondly, banks’ liabilities are largely issued as demand deposits, while their assets (e.g. loans) often have longer maturities. The mismatch between liquid liabilities and illiquid assets may become a problem in a crisis situation, as was vividly seen in the recent financial turmoil, when bank runs took place at large institutions, threatening the stability of the whole financial system. Thirdly, despite contributing to the prevention of bank runs, deposit insurance generates moral hazard by incentivizing shareholders and managers of insured institutions to engage in excessive risk-​taking. Similarly, the expectation that governments will bailout large financial institutions without letting them fail enhances moral hazard of the managers, while reducing monitoring by creditors. Fourthly, asset substitution is relatively easier in financial firms than in non-​financial ones. This allows for more flexible and rapid risk shifting, which further increases agency costs between shareholders and stakeholders (bondholders and depositors) and moral hazard of managers. In addition, banks are more opaque, that is, it is difficult to assess their risk profile and stability. Information asymmetries, in particular for depositors, hamper market discipline and, in turn, increase moral hazard of managers.

1.10

Insurers are different from non-​financial firms for reasons that are not entirely similar to those applicable to banks. Insurance covers risk for financial and corporate undertakings, and households. Unlike most financial products, it ‘is characterised by the reversal of the production cycle insofar as premiums are collected when the contract is entered into and claims arise only if a specified event occurs. Insurers intermediate risks directly. They manage these risks through diversification and risk pooling enhanced by a range of other techniques.’14 In addition to business risks, insurers bear technical risks, which concern the liability side of their balance sheet and relate to the actuarial and/​or statistical calculations used in estimating liabilities. They also incur risks from their investments and financial operations, including those arising from asset-​liability mismatching.15 13 Jonathan Macey and Maureen O’Hara, ‘The Corporate Governance of Banks’, FRBNY Economic Policy Review, April 2003, 91. 14 See International Association of Insurance Supervisors (IAIS), Insurance core principles, updated November 2015. 15 ibid.

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Governing Financial Institutions These preliminary comments show, on one side, the importance of corporate gov- 1.11 ernance for financial institutions; and, on the other, the uniqueness of banks and insurers’ governance as a reflection of their specialness.16 Banks, in particular, are inherently fragile given the liquid nature of deposits and the illiquid nature of their assets, which makes them especially prone to crisis.17 Other institutions, like asset managers, are less fragile, to the extent that they undertake risks on behalf of investors, while their activities are more similar to other professional activities, including those of lawyers and accountants.18 The corporate governance of asset managers, albeit important, is less special than in the case of banks and is mainly focused on the quality of services offered to clients and on the prevention of conflicts of interest.19

III.  Lessons from the Financial Crisis Official policy documents issued after the 2008 crisis argued that the malfunctioning 1.12 of corporate governance at banks and other financial institutions contributed to their collapse in the financial turmoil. The de Larosière Report stated that corporate governance was one of the most important failures in the crisis.20 An Organisation for Economic Co-​operation and Development (OECD) paper and a Commission Green Paper similarly argued that boards of directors rarely comprehended either the nature or scale of the risks they were facing.21 The same documents argued that the recourse to flawed remuneration structures, including the excessive use of short-​term incentives for managers and other risk-​taking employees, contributed to the failure of many banks and other financial institutions. Similar arguments have been criticized by empirical studies showing that good gov- 1.13 ernance is not enough for bank soundness. A notable example is a paper by Andrea 16 For a critical view, see Cristoph van der Elst, ‘Corporate Governance and Banks: How Justified is the Match’, Law Working Paper No 284/​2015, who hardly finds convincing arguments for bank governance specificities. 17 Richard Dale, ‘The Regulation of Investment Firms in the European Union’, in Guido Ferrarini (ed), Prudential Regulation of Banks and Securities Firms, Kluwer, 1995, 28 (comparing the regulation of banks with that of securities firms). 18 See Jens-​Hinrich Binder, ‘Governance of Investment Firms under MiFID II’, in Danny Busch and Guido Ferrarini (eds), Regulation of the EU Financial Markets:  MiFID II & MiFIR, Oxford University Press, 2017, 49. 19 See Julian Franks, Colin Mayer, and Oxford Economic Research Associates Ltd, Risks and Regulation in European Asset Management: Is There a Role for Capital Requirements, January 2001; Julian Franks and Colin Mayer, Risk, Regulation and Investor Protection:  The Case of Investment Management, Oxford University Press, 1989. 20 See the Report by The High Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009. 21 Grant Kirkpatrick, ‘The Corporate Governance Lessons from the Financial Crisis’, OECD Journal of Financial Market Trends (2009), 1, 61; EU Commission, Green Paper: Corporate governance in financial institutions and remuneration policies, COM(2010) 284 final.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge Beltratti and René Stulz, who investigate possible determinants of bank performance measured by stock returns, for a sample of ninety-​eight large banks across the world, during the crisis.22 The authors find no evidence that failures and weaknesses in corporate governance arrangements were a primary cause of the financial crisis. In particular, they find no evidence that banks with better governance performed better during the crisis. On the contrary, banks with more pro-​shareholder boards performed worse. Another paper by Rüdiger Fahlenbrach and René Stulz on bank CEO incentives analyses a sample of ninety-​eight large banks across the world and finds ‘no evidence that banks with a better alignment of CEOs’ interests with those of their shareholders had higher returns during the crisis’.23 The authors rather identify ‘some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity’. 1.14

Almost paradoxically, therefore, ‘good’ corporate governance (i.e. aligning the interests of managers and shareholders) simply led bank managers to engage in more risky activities. However, this is explained by the fact that in financial intermediaries a major part of the losses are externalized to stakeholders, while gains are fully internalized by shareholders and managers (if properly aligned by the right incentives). It is therefore the task of prudential regulation and supervision to reduce the excessive risk propensity of shareholders and managers in order to guarantee the ‘safety and soundness’ of financial institutions.24 Capital requirements, in particular, should reduce the incentives of shareholders to undertake excessive risks, while providing a cushion for the protection of depositors and other stakeholders, including the taxpayers to the extent that the chances of a bailout are diminished.25 Another way to mitigate these problems would be to keep large financial institutions in public ownership so as to align the interests of shareholders with those of the financial system. However, this has clear downsides in terms of political interference with the management of financial institutions, as shown by those countries where public ownership of banks and other financial institutions is widespread.26

1.15

Nonetheless, there is a role for corporate governance in constraining excessive risk-​ taking by financial institutions beside prudential supervision. A study by Ellul and 22 Andrea Beltratti and René Stulz, ‘The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?’, Journal of Financial Economics (2012), 105, 1, 1. 23 Ruediger Fahlenbrach and René Stulz, ‘Bank CEO Incentives and the Credit Crisis’, Journal of Financial Economics (2010), 99, 1, 11. 24 Lawrence White, ‘Corporate Governance and Prudential Regulation of Banks: Is There Any Connection?’, in Barth, Lin, and Wihlborg (eds), n 2, 344. 25 Anat Admati and Martin Hellwig, The Bankers’ New Clothes, Princeton University Press, 2013. Other important remedies are analysed by Paul Davies and Klaus Hopt, Chapter 6, this volume. 26 See Johannes Adolff, Katja Langenbucher, and Christina Parajon Skinner, Chapter  14, this volume, with special reference to Germany and the United States; Maribel Sáez-Lacave and María Gutiérrez-Urtiaga, Chapter 22, this volume, concerning the Spanish crisis of public banks.

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Governing Financial Institutions Yerramilli shows that the organization of risk management at banks, including the role of boards overseeing the same, is important in predicting risk-​taking by the institutions concerned and their performance over time.27 The authors examined the organizational structure of risk management at Bank Holding Companies (BCH) in the United States by constructing an index (Risk Management Index = RMI) that measures the importance attached to the risk management function within each BCH and the quality of risk oversight provided by the BHC’s board of directors. Their main hypothesis is that BCHs with strong and independent risk-​ management functions should have lower tail risk, all else being equal. In fact, a strong risk-​management function correctly identifies risks and prevents excessive risk-​taking, which cannot be controlled entirely by regulatory supervision or external market discipline. They find that BCHs with higher pre-​crisis RMI had lower tail risk, a smaller fraction of nonperforming loans, and better operating performance and stock return performance during the crisis years. They also examine the association between RMI and tail risk-​taking over the 1995–​2010 period and find that BCHs with higher RMI (strong organizational risk controls) in the previous year have lower risk in the following one. On the whole, Ellul and Yerramilli highlight that weak risk management at financial institutions may have contributed to the excessive risk-​taking that brought about the financial crisis. Indeed, they show that banks with internal risk controls in place before the onset of the financial crisis were more judicious in the tail risk exposures and fared better, in terms of both operating performance and stock market performance, during the crisis years. To conclude, aligning the interests of boards, managers, and shareholders is not enough for limiting risk-​taking by financial institutions to an optimal level from a societal perspective. Indeed, the quality of risk-​management systems and effective board monitoring over these systems definitely contribute to the safety and soundness of financial institutions.28

IV.  Global Principles The financial crisis has led to a restatement of the global principles concerning the 1.16 corporate governance of financial institutions in the belief that governance failures contributed to these institutions’ failures in the crisis. However, the work of

27 Andrew Ellul and Vijay Yerramilli, ‘Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies’, Journal of Finance (2013), 68, 1757. 28 See René Stulz, ‘Risk-​Taking and Risk Management by Banks’, Journal of Applied Corporate Finance (2015), 27, 8; Andrew Ellul, ‘The Role of Risk Management in Corporate Governance’, Annual Review of Financial Economics (2015), 7, 279, who reached similar conclusions, in line with the official reports cited earlier, at least for what concerns risk management failures before and throughout the financial crisis.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge international organizations in this area started just before the end of the last century.29 In 1999, the OECD published the ‘Principles of Corporate Governance’, which focus on publicly traded companies, both financial and non-​financial. The Principles were subsequently updated and are now available in their 2015 edition, which has been issued under the auspices of G20/​OECD.30 The Basel Committee on Banking Supervision (BCBS) took the first edition of the Principles as a basis for drafting its Guidelines on corporate governance principles for banks in 1999. 1.17

Originally the BCBS Guidelines were directed to assist supervisors in the promotion of sound corporate governance practices, with the belief that ‘through sound corporate governance, bank supervisors can have a collaborative working relationship with bank management, rather than an adversarial one’. In their 2015 edition, however, the Guidelines underline that ‘effective implementation of sound corporate governance requires relevant legal, regulatory and institutional foundations’ and encourage supervisors ‘to be aware of legal and institutional impediments to sound corporate governance, and to take steps to foster effective foundations for corporate governance where it is within their legal authority to do so’. No doubt, this exhortation reflects and/​or explains the post-​crisis shift of many legal systems from a supervisory to a regulatory approach to bank governance.

1.18

One of the main goals of the 2015 BCBS Guidelines is to emphasize the role of risk governance in banks. Indeed, their main purposes are ‘to explicitly reinforce the collective oversight and risk governance responsibilities of the board’ and ‘to emphasize key components of risk governance such as risk culture, risk appetite and their relationship to a bank’s risk capacity’. Moreover, the Guidelines identify ‘the specific roles of the board, board risk committees, senior management and the control functions, including the CRO and internal audit’.

1.19

The OECD Guidelines on Insurer Governance follow a path similar to that of the BCBS Guidelines and were ‘designed in light of the overriding objective of an insurance undertaking, which is to provide benefits to the insured in accordance with the contracts concluded with them, and satisfy its shareholders (member-​policy holders in the case of mutual insurers)’. 31 Their rationale is explained accordingly: ‘( . . . ) insurers are expected to have sound governance practices and effective risk management so that they will be in a position to provide promised benefits to

29 See Jens-​Hinrich Binder, Chapter 2, and Arthur van den Hurk and Michele Siri, Chapter 3, both this volume. 30 See G20/​OECD, ‘Principles of Corporate Governance’, 2015, available at http://​www.oecd. org/​corporate/​principles-​corporate-​governance.htm, accessed 1 July 2018. 31 See OECD ‘Guidelines on Insurer Governance’, 2011, 13. The Guidelines were established as an OECD Recommendation in 2005 and were revised in 2011. They complement the OECD ‘Recommendation of the Council on Core principles of Occupational Pension Regulation’ and the OECD ‘Principles of Corporate Governance’.

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Governing Financial Institutions policy holders (and any relevant beneficiaries) and thus fulfil their insurance function in the economy’.32 The topic of financiers’ compensation is more politically charged than that of cor- 1.20 porate governance as it involves issues that are especially salient from the voters’ perspective particularly in times of crisis. However, no domestic regulatory solution can be effective without agreement at international level, which explains why international principles for sound compensation practices were adopted after the crisis at the initiative of G20 and the FSB.33 In a similar vein, the FSB adopted ‘Principles for an Effective Risk Appetite Framework’, which aim to enhance the supervision of SIFIs, but are also relevant for the supervision of financial institutions and groups more generally, including insurers, securities firms, and other non-​bank financial institutions.34 The FSB Principles set out key elements for an effective risk appetite framework, an effective risk appetite statement, risk limits, and defining the roles and responsibilities of the board of directors and senior management. For non-​SIFIs, supervisors and financial institutions may apply the Principles proportionately so that the Risk Appetite Framework is appropriate to the nature, scope, and complexity of the activities of the financial institution. The Basel Committee’s ‘Corporate Governance Principles for Banks’ clearly 1.21 enounce the overarching principle of proportionality by specifying that their implementation should be commensurate with the size, complexity, structure, economic significance, risk profile and business model of the bank and the group (if any) to which it belongs. This means making reasonable adjustments where appropriate for banks with lower risk profiles, and being alert to the higher risks that may accompany more complex and publicly listed institutions.

Proportionality, therefore, works in two directions, either weakening or reinforcing the governance requirements of the institutions concerned on the basis of their risk profile and business model. Other circumstances are also relevant, such as size and complexity, so that smaller institutions and/​or less complex ones can be treated differently in the implementation of the individual standards, which could be either displaced or applied in a different way.

32 ibid, 43, arguing that insurers ‘as financial institutions accepting funds in return for promised future payments ( . . . ) may have an incentive to engage in risky behaviour or practices that have short-​term benefits but do not properly consider policyholder interests or, more broadly, the reputation of the industry’. 33 FSF, ‘Principles for Sound Compensation Practices’, 2009, available at http://​www.fsb.org/​wp-​ content/​uploads/​r_​0904b.pdf; FSB, ‘Principles for Sound Compensation Practices: Implementation Standards’, 2009, available at http://​www.fsb.org/​wp-​content/​uploads/​r_​090925c.pdf, both accessed 1 July 2018. 34 FSB, ‘Principles for an Effective Risk Appetite Framework’, 18 November 2013.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge 1.22

Moreover, firms that qualify as systemically important financial institutions (SIFIs) are ‘expected to have in place the corporate governance structure and practices commensurate with their role in and potential impact on national and global financial stability’. Indeed, SIFIs’ distress or disorderly failure can cause significant disruption to the wider financial system and economic activity, because of their size, complexity, and systemic interconnectedness. This is why the FSB framework for reducing the moral hazard of SIFIs has been adopted.35 The objective of this framework is to address the systemic risks and the associated moral hazard problem for institutions that are seen by markets as too big to fail. Amongst the various measures foreseen, intensive and effective supervision of all SIFIs is required, including through stronger supervisory mandates, resources, and powers, and higher supervisory expectations for risk management functions, data aggregation capabilities, risk governance, and internal controls.36 Also the FSF (now FSB) ‘Principles for Sound Compensation Practices’ ‘are intended to apply to significant financial institutions, but they are especially critical for large, systemically important firms’.37

1.23

As a result, the international principles touching upon corporate governance and related issues establish a hierarchy of firms, depending on their systemic relevance (G-​SIFIs, SIFIs) or on their significance, complexity, and size. However, the implementation of the principles and the choice of how to model them with respect to such hierarchy are left to individual jurisdictions. It is known that the European Union has neglected proportionality to a large extent, particularly in the CRD IV provisions concerning the corporate governance of banks and compensation practices, which tend to follow a one-​size-​fits-​all approach that is creating problems for smaller and/​or less complex institutions.38

1.24

The international principles and the EU provisions are not uniform across financial sectors, which is often justified by the functional differences between types of firms highlighted in section II above. Nevertheless, some of the differences in regulation across sectors are less clearly grounded, as will be shown with regard to fit and proper requirements which are heavier under CRD IV and MiFID II than in other sectors.39 Moreover, divergences emerge between the regulation of financial intermediaries and capital markets regulation, as will be shown with reference to the Market Abuse Regulation and its potential clashes with the prudential regulation of intermediaries.40

35 FSB, ‘Reducing the Moral Hazard Posed’, n 12. 36 FSB, ‘Policy Measures to Address Systemically Important Financial Institutions’, 2011. 37 See n 33. 38 See Guido Ferrarini, ‘Regulating Bankers’ Pay in Europe:  The Case for Flexibility and Proportionality’, in Festschrift für Theodor Baums, 2016. 39 See Iris Palm-​Steyerberg and Danny Busch, Chapter 8, this volume. 40 See Carmine di Noia and Matteo Gargantini, Chapter 12, this volume.

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Governing Financial Institutions

V.  Corporate Governance and Prudential Regulation: Complements or Substitutes? Governments and regulators rely on corporate governance as a complement to fi- 1.25 nancial supervision, which explains why regulation is on the rise in this area to the point that some argue that a new type of European company law statute is arising for financial institutions.41 In brief, regulation requires boards of directors and their risk committees to oversee the undertaking and management of risks by financial institutions. Board members of financial institutions are subject to regulatory duties, which specify their monitoring tasks and the ways in which they should perform the same in the interest of financial stability. In the absence of regulation, financial institutions would undertake more risks than is socially optimal, for they would act exclusively in the interest of shareholders who do not internalize the social costs, but only the private costs of their firm’s failure. Corporate governance therefore serves the purposes of supervisors, to the extent 1.26 that it should prevent the undertaking of excessive risk by financial institutions. No doubt, also the interests of shareholders are protected. However, wealth maximization by financial institutions is constrained whenever regulation or supervision foreclose the assumption of risk which would be in the interest of shareholders to assume, but could endanger creditors or even threaten systemic stability. A difficult trade-​off is therefore struck between the maximization of the value of financial firms and the social interest to systemic stability.42 The case is not different for financial institutions which are constituted as cooperatives, except that they may need special tailoring of the prudential requirements. The case of Rabobank shows that even a long story of success as a banking group made of cooperatives may not prevent the involvement in financial scandals, such as those concerning LIBOR, which has determined the need for a deep governance overhaul.43 Even worse, the case of Venetian banks shows how the cooperative form may contribute to generate serious governance problems, which have led—​in the presence of fraudulent behaviour and supervisory failures—​to the crisis and resolution of these banks.44 Regulators, for their part, complement the monitoring by boards and risk com- 1.27 mittees through public supervision on governance mechanisms and risk management by financial institutions. The EBA Guidelines on common procedures and

41 See Kitty Lieverse and Claartje Bulten, Chapter 5, this volume. 42 A similar trade-​off exists between the interest to keep the confidentiality of inside information (MAR) and the need to allow the circulation of information within financial institutions and their groups for prudential reasons: Carmine di Noia and Matteo Gargantini, Chapter 12, this volume. 43 See Martin van Olffen and Gerard van Solinge, Chapter 15, this volume. 44 See Paolo Giudici, Chapter 21, this volume.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge methodologies for the supervisory review and evaluation process (SREP), drawn up pursuant to Article 107(3) of CRD IV, offer a good example. They are addressed to competent authorities and are intended to promote common procedures and methodologies for the SREP referred to in Article 97 et seq of CRD IV and for assessing the organization and treatment of risks referred to in Articles 76 to 87 of that Directive. The common SREP framework introduced in these guidelines is built around business model analysis; assessment of internal governance and institution-​wide control arrangements; assessment of risks to capital and adequacy of capital to cover these risks; and assessment of risks to liquidity and adequacy of liquidity resources to cover these risks. The specific elements of the SREP framework are assessed and scored on a scale of 1 to 4. The outcome of the assessments, both individually and considered as a whole, forms the basis for the overall SREP assessment, which represents the up-​to-​date supervisory view of the institution’s risks and viability. 1.28

The monitoring of corporate governance by bank supervisors can be usefully explained from the perspective of the ‘representation hypothesis’ developed by Dewatripont and Tirole.45 In their opinion, prudential regulation is primarily motivated by the need to ‘represent’ small depositors (and small customers of non-​ bank financial institutions) and to bring about appropriate corporate governance. The two authors see the import of corporate governance ideas as a way to enrich the financial regulation debate. In brief, they argue that financial institutions tend to be regulated under the following circumstances: First, the claimholders are somewhat unsophisticated or free-​riding (small depositors, insurance policyholders, pensioners) and/​or cannot conceivably thoroughly monitor their counterparts due to the number of such parties and to the time scale involved (interbank depositors, traders on securities markets). Second, no mechanism of private representation is (or can be?) set up that would dispense the claimholders from having to monitor, write covenants, and interfere.46

Dewatripont and Tirole argue however that ‘despite some differences, the philosophy of prudential regulation strongly resembles that of loan agreement covenants’.47 Standard loan agreements demand capital adequacy, include liquidity and early warning systems, and provide for the handling of failures. In the case of covenant violation, the creditor may face roughly the same choices as a banking regulator: ‘forbearance, liquidation, or renegotiation’. The latter results in debt forgiveness, which is the analogue of government financial assistance, or in a debt–​ equity swap, which is the analogue of government ownership.



Mathias Dewatripont and Jean Tirole, The Prudential Regulation of Banks, MIT Press, 1994. ibid, 44. 47 ibid, 88. 45 46

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Governing Financial Institutions However, post-​crisis reforms have extended prudential regulation to areas, which are 1.29 not easily reduced to the covenants analogy and reinforce the idea of financial regulation as a substitute for corporate governance. One of these areas is incentive compensation. The FSB principles and standards interfere with the structure of compensation in ways that restrict the autonomy of boards.48 Other areas are risk management and internal controls, which are intrinsic components of the design of the firm governance, but in the case of financial institutions are also subject to regulation and supervision.49 Given that corporate governance is a complement to regulation in assuring the 1.30 stability of financial institutions, an important question for policy research is to what extent and under what conditions regulation should work either as a complement or a substitute for corporate governance. Another important question is whether and to what extent bank resolution and the relevant regimes influence the corporate governance of banks by adding gone-​concern considerations to the traditional going concern-​perspective.50 Moreover, the role of institutional investors as shareholders of (listed) financial institutions needs to be considered, to the extent that their engagement puts pressure on the governance structures of the relevant institutions and may contribute to better risk management by the same, given that diversified shareholders are in any case exposed to systemic risk.51

VI.  The Role of Conduct and Culture Corporate governance effectiveness depends not only on rules and their enforce- 1.31 ment, but also on conduct and culture within the firm. As argued by Douglass North from a general perspective: . . . formal rules, in even the most developed economy, make up a small (although very important) part of the sum of constraints that shape choices; a moment’s reflection should suggest to us the pervasiveness of informal constraints. In our daily interaction with others, whether within the family, in external social relations, or in business activities, the governing structure is overwhelmingly defined by codes of conduct, norms of behaviour, and conventions.52

In a similar setting, culture plays a fundamental role for it ‘defines the way individuals process and utilize information and hence may affect the way informal constraints are specified. Conventions are culture specific, as indeed are norms’.53

48 See Guido Ferrarini, Chapter 11, this volume. 49 See Lodewijk van Setten, Chapter 9, this volume, with special reference to CRD IV, MiFID II, the UCITS Directive, and the AIFMD. 50 See Bart Bierens, Chapter 4, this volume. 51 See Maria Cristina Ungureanu, Chapter 13, this volume. 52 Douglass North, Institutions, Institutional Change and Economic Performance, Cambridge University Press, 1999, 37. 53 ibid, 42.

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Danny Busch, Guido Ferrarini, and Gerard van Solinge 1.32

This explains the emphasis put on culture in post-​crisis corporate governance discussion, which underlines the roles that conduct and the relevant monitoring play in the financial services sector: ‘With over $100 billion in fines imposed on the largest financial institutions since the financial crisis, there is now a growing suspicion that ethical lapses in banking are not just the outcome of a few bad apples—​deviant rogue traders—​but rather a reflection of systematic weaknesses in governance’.54 There is no doubt, therefore, that research on the governance of financial institutions should not be restrained to legal and economic analysis, but extend to the role and impact of culture and conduct in financial firms from a broad social sciences perspective.55 In this way, sociology, psychology, and anthropology will help understanding the ‘informal constraints’ which determine financial institutions’ behaviour and complement their regulation and supervision.56

1.33

Important questions regarding the relationship between governance of financial institutions on the one hand, and conduct and culture on the other, are analysed and discussed in the chapters included in Part IV of this volume. Indeed, ineffective rules and inadequate governance structures are not enough to explain the 2008 financial crisis, nor to justify the reiteration of misbehaviour and fraud episodes carried out during the subsequent years by banks and other financial institutions. In order to get to the roots of these problems and to build a sustainable financial system, a new approach should be followed and similar phenomena should be analysed through the lenses of other social sciences too.57

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Moreover, financial supervision needs to combine ‘structural’ perspectives with insights into the behavioural and cultural drivers of firm performance, in order to become more effective in fostering firm and financial stability. Two chapters in this volume specifically examine the case of the supervision of conduct and culture by the Dutch National Bank (DNB)58 and that of the Dutch banker’s oath and the Dutch Banking Disciplinary Committee.59 Other chapters consider the relatively new topic of conduct risk and its treatment from the perspectives of regulation, governance, and culture,60 and the traditional issue of conflicts of interest which is

54 Anjan Takor, ‘Corporate Culture in Banking’, Federal Reserve Bank of New York, Economic Policy Review (2016), 22, 1/​5. 55 Andrew Lo, ‘The Gordon Gekko Effect:  The Role of Culture in the Financial Industry’, FRBNY Economic Policy Review (August 2016), 17. 56 Alan Morrison and Joel Shapiro, ‘Governance and Culture in the Banking Sector’, Working Paper, February 2016, available at https://​papers.ssrn.com/​sol3/​papers.cfm?abstract_​id=2731357, accessed 1 July 2018. 57 See Guido Ferrarini and Shahshan Zhu, Chapter 16, this volume. 58 See Wijnand Nuijts, Chapter 17, this volume. 59 See Peter Laaper and Danny Busch, Chapter 18, this volume. 60 See Antonella Sciarrone Alibrandi and Claudio Fregeni, Chapter 19, this volume.

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Governing Financial Institutions however examined from a comparative perspective with a new emphasis on the role of culture in compliance.61 Part IV is completed by an analysis of the recent banking crises in some European 1.35 countries, such as Italy, Portugal, Spain, and the Netherlands. The relevant case studies show how weaknesses in corporate governance and culture, together with political interference and supervisory failures, contributed to the failure of either public or private institutions in the aftermath of the great financial crisis.



See Geneviève Helleringer and Christina Skinner, Chapter 20, this volume.

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2 CORPORATE GOVERNANCE OF FINANCIAL INSTITUTION In Need of Cross-Sectoral Regulation Jens-​Hinrich Binder*

I. Introduction 2.01 II. Taking Stock:  Governance-​Related Regulation in EU Legislation after the Global Financial Crisis 2.06 A. Relevant legal sources B. Board-​related requirements C. Control of shareholders and owners of qualifying holdings D. Risk governance, internal audits, and compliance E. Preliminary findings

III. The Case for Cross-​Sectoral Governance-​Regulation Re-​examined—​A Functional Approach

2.20 A. Cross-​sectoral regulation on a sectoral basis? The traditional focus on banks and its limits 2.20 B. Governance-​related regulation in the interest of systemic stability and depositor/​investor protections 2.24 IV. Conclusions 2.30

2.06 2.11 2.16 2.17 2.19

I. Introduction 2.01

Judging from European legislation adopted in the aftermath of the financial crisis, the case for cross-​sectoral regulation of governance arrangements in financial institutions, at first sight, appears almost too evident as to justify closer analysis. ‘Corporate governance’, in this sense, will be understood, for present purposes, as referring to ‘the system by which companies are directed and controlled’ (to borrow from the seminal UK Cadbury Report on the financial aspects of corporate

* The author would like to thank Guido Ferrarini and Danny Busch for the invitation to contribute to the project. For numerous insightful comments, special thanks are owed to Veerle Colaert and Marije Louisse, who kindly agreed to act as discussants within the working group, as well as to Eddy Wymeersch, Carmine di Noia, and Guido Ferrarini.

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Corporate Governance of Financial Institution governance),1 which includes, in particular, requirements for the structure and functioning of the board, risk management and internal control arrangements, organizational and procedural aspects of decision making, as well as the enforcement of relevant standards by internal (shareholders, non-​executive board members) and external (auditors, supervisory authorities) actors. In recent years, relevant requirements for intermediaries have been adopted, or rather (in many cases) reinforced, not just with regards to banks, investment firms, asset managers, and pension funds—​those types of intermediaries covered in the present chapter,2 but also to the insurance industry (covered in Chapter 3) and, to some extent, likewise to ‘payment institutions’ as defined by the revised Payment Services Directive of 2015,3 administrators of benchmarks,4 and operators of financial market infrastructures (FMI)5 (not covered in detail in this chapter).6 In addition (and also outside the 1 ‘Report of the Committee on the Financial Aspects of Corporate Governance’, chaired by Sir Adrian Cadbury, London, December 1992, available at http://​www.ecgi.org/​codes/​documents/​cadbury.pdf, para 2.5 accessed 28 September 2018. See also, for discussion of this and other definitions in the context of financial institutions, Klaus J Hopt, ‘Better Governance of Financial Institutions’, ECGI Law Working Paper No 207/​2013, available at https://​ssrn.com/​abstract=2212198, 4 accessed 28 September 2018; Klaus J Hopt, ‘Corporate Governance of Banks and Other Financial Institutions After the Financial Crisis’ (2013) Journal of Corporate Law Studies 13, 219, 222; Klaus J Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, in Eddy Wymeersch, Klaus J Hopt, and Guido Ferrarini (eds), Financial Regulation and Supervision—​A Post-​Crisis Analysis, Oxford University Press, 2012, para 11.01. 2 For a cross-​sectoral stock-​take, see Section II. 3 See Directive (EU) 2015/​2366 of the European Parliament and of the Council of 25 November 2015 on payment services in the internal market, amending Directives 2002/​65/​EC, 2009/​110/​EC, and 2013/​36/​EU and Regulation (EU) No 1093/​2010, and repealing Directive 2007/​64/​EC, OJ L337/​35, Article 11(4). 4 Within Europe, see Regulation (EU) 2016/​1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (  . . .  ), OJ L171/​1 (hereafter ‘EU Benchmark Regulation’), Articles 4 (‘governance and conflict of interest requirements’), 5 (‘oversight function requirements’), 6 (‘control framework requirements’), 7 (‘accountability framework requirements’). And see, for a general discussion of these and other governance-​related provisions in the Regulation, Jens-​Hinrich Binder, ‘Organisationsanforderungen an Marktteilnehmer und Marktinfrastruktur’, in C W Canaris, M Habersack, and C Schäfer (eds), Staub. Handelsgesetzbuch, vol. 11/​2: Bankvertragsrecht—​Investment Banking, DeGruyter, 2018, Part 7, paras 122–​134. 5 For specific regulatory requirements addressing FMI in European legislation, see, in particular, Directive 2014/​65/​EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments ( . . . ) (MiFID II), OJ L173/​349, Articles 45 (‘requirements for the management body of a market operator’), 46 (‘requirements relating to persons exercising significant influence over the management of the regulated market’), 47 (‘organisational requirements for regulated markets’), 48 (‘systems resilience, circuit breakers and electronic trading’); Regulation (EU) No 648/​2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (hereafter: EMIR), OJ L201/​1, Title IV (‘requirements for CCPs’), Chapter 1 (‘organisational requirements’); Regulation (EU) No 909/​2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories (hereafter: CSDR), OJ L257/​1, Title III (‘Central Securities Depositories’), Chapter II (‘requirements for CSDs’), Section 1 (‘organisational requirements’). 6 For introductions to the relevant issues, see, e.g. Iris Chiu, ‘Financial Benchmarks: Proposing a Governance Framework Based on Stakeholders and the Public Interest’, Law and Financial Markets

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Jens-Hinrich Binder scope of the present chapter), special governance requirements apply under Articles 45 and 46 of the Money Laundering Directive of 2015.7 Finally, the adoption of resolution frameworks for insolvent banks (and other financial intermediaries)8 also come with implications for the corporate governance of the relevant firms (outside the scope of the present chapter). Thus, although the cross-​sectoral perspective adopted in this chapter is fairly comprehensive, the focus is on parts of a broader phenomenon. 2.02

To be sure, governance-​related regulatory requirements, as such, have existed prior to the global financial crisis; in fact, some aspects can be traced back to the very origins of financial regulation in the early twentieth century.9 Yet in response to shortcomings in the governance of financial institutions identified in the run-​up to, and during, the global financial crisis, relevant regulations have been reinforced to a considerable extent, and have been expanded into sectors where relevant arrangements had previously been left to the discretion of owners and management, for example, benchmark administrators or FMI operators. As such, this development is hardly surprising, since the financial crisis has increased the awareness of academics and policymakers of the relevance of governance arrangements within intermediaries for the sustainability of their business activities and thus, ultimately, for systemic stability.10 In the post-​crisis world, formal and substantive similarities between different sectoral regimes are pervasive, as are identical provisions that can be found in relation to different sectors. This reinforces the impression that the corporate Law Review (2015), 9, 223; Iris Chiu, ‘Regulating Benchmarks by “Proprietisation”:  A Critical Discussion’, Capital Markets Law Journal (2016), 11, 191 (benchmarks), and Guido Ferrarini, ‘Exchange Governance and Regulation: An Overview’, in Guido Ferrarini (ed), European Securities Markets:  The Investment Services Directive and Beyond, Kluwer Law International, 1998, 245; Guido Ferrarini, ‘Stock Exchange Governance in the European Union, in M Balling, E Hennessy, and R O’Brien (eds), Corporate Governance, Financial Markets and Global Convergence, Springer International, 1998, 139; Guido Ferrarini and P Saguato, ‘Governance and Organization of Trading Venues’, in:  D Busch and G Ferrarini (eds), Regulation of EU Financial Markets:  MiFID II and MiFIR, Oxford University Press, 2017, 285 (on FMI governance). And see (in German), Binder, n 4, paras 141–​150. 7 Directive (EU) 2015/​849 of the European Parliament and of the Council of 20 May 2015 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, amending Regulation (EU) No 648/​2012 of the European Parliament and of the Council, and repealing Directive 2005/​60/​EC of the European Parliament and of the Council and Commission Directive 2006/​70/​EC, OJ L141/​73. 8 In particular, under the BRRD, i.e. Directive 2014/​59/​EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms ( . . . ), OJ L173/​190. See, e.g. Jens-​Hinrich Binder, ‘Resolution Planning and Structural Bank Reform within the Banking Union’, in Juan Castaneda et al (eds), European Banking Union. Prospects and Challenges, Routledge, 2015, 129. 9 See, analysing the historical development of organizational requirements for banks, insurance companies, and investment funds in Europe, Jens-​Hinrich Binder, ‘Organisationspflichten und das Finanzdienstleistungs-​ Unternehmensrecht:  Bestandsaufnahme, Probleme, Konsequenzen’, ZGR Zeitschrift für Unternehmens-​und Gesellschaftsrecht (2015), 667, 672–​701. 10 See further text and nn 25 and 90.

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Corporate Governance of Financial Institution governance of financial institutions is in need not just of sector-​specific regulation, but presents more or less the same set of problems. This reasoning has clearly inspired recent regulatory initiatives at the European level, where the governance of financial institutions generally, based on recommendations by the High Level Group on Financial Supervision in the European Union (the de Larosière Group) in 2009,11 has been addressed in a Commission Green Paper as early as 2010.12 It is less dominant among international standard setters, however, where relevant publications—​ obviously owing to restrictions in the respective institution’s mandate—​frequently follow a sector-​specific approach.13 Significant exceptions are the Financial Stability Board’s (FSB’s) ‘Principles for Sound Compensation Practices’,14 which address the remuneration of directors and managers in significant financial institutions, and, in particular, the Principles of Corporate Governance, which were first promulgated by the Organisation for Economic Co-​operation and Development (OECD) in 1999 and updated, jointly with the G20, in 2015.15 Among relevant international standards, this latter publication occupies a unique position in that it is not confined to financial intermediaries at all, but takes a much more general perspective by defining standards for ‘publicly traded companies, both financial and non-​financial’. Moreover, ‘[t]‌o the extent [the principles] are deemed applicable, they might also be a useful tool to improve corporate governance in companies whose shares are not publicly traded’.16 The G20/​OECD Principles, in other words, reflect the notion that, while financial intermediaries may present specific problems that potentially require technical deviations from general standards, their corporate governance is nonetheless sufficiently aligned with arrangements in non-​financial firms as to merit a comprehensive, generalized treatment. This, in turn, may help to explain why the Principles have not just been influential for the Basel Committee on Banking Supervision’s (BCBS) ‘Corporate Governance Principles for Banks’17 and formative for the EU Commission’s position articulated in the 2010 Green Paper,18 but 11 The High-​Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, Report, Brussels, 25 February 2009, available at https://​ec.europa.eu/​info/​system/​files/​de_​larosiere_​ report_​en.pdf, accessed 28 September 2018. 12 European Commission, Green Paper: Corporate governance in financial institutions and remuneration policies, COM(2010) 284 final. 13 e.g. BCBS, ‘Guidelines: Corporate Governance Principles for Banks’, July 2015, available at https://​www.bis.org/​bcbs/​publ/​d328.pdf, accessed 28 September 2018; Technical Committee of the International Organization of Securities Commissions, ‘Examination of Governance for Collective Investment Schemes –​Final Report’, Part I (June 2006), Part II (February 2007); IOSCO, Report on Corporate Governance—​Final Report, October 2016. 14 FSB, Principles for Sound Compensation Practices’, 2 April 2009, available at http://​www.fsb. org/​wp-​content/​uploads/​r_​0904b.pdf, accessed 28 September 2018. 15 G20/​OECD, Principles of Corporate Governance, 2015, available at http://​www.oecd.org/​ corporate/​principles-​corporate-​governance.htm, accessed 28 September 2018. See also OECD, ‘Corporate Governance and the Financial Crisis: Key Findings and Main Messages’ (2009). 16 OECD, Principles of Corporate Governance, n 15, 9. 17 See n 13, para 4. 18 See n 12, 5.

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Jens-Hinrich Binder have also been designated as one of the FSB’s ‘Key Standards for Sound Financial Systems’19 and, as such, form the basis of periodic assessments of member jurisdictions in the FSB’s thematic reviews.20 2.03

On closer inspection, however, the picture turns out to be far from clear-​cut. Despite the obvious trend towards cross-​ sectoral convergence of governance-​ related regulations, the available literature, both theoretical and empirical, focuses mainly on the corporate governance of banks.21 With the exception of a few studies on the governance of investment funds, only few analyses have been devoted to the governance of non-​bank financial intermediaries22 and operators of financial market infrastructures,23 respectively, which casts some doubt on the rationale for cross-​sectoral approaches to governance-​related regulation for different types of intermediaries (and FMI providers). In view of—​evident—​differences between business models, ownership, and group structures, and, consequently, also between the risk profiles across the different sectors, the case for a cross-​sectoral perspective appears weaker still. Indeed, in a recent proposal for the reform of the regulatory framework for investment firms, the European Commission suggests nothing less than a departure from the established cross-​sectoral framework for the corporate governance for banks and investment firms, including, in particular, substantial reductions in the applicable requirements for non-​systemically important investment firms.24

2.04

Seen against this backdrop, the recent convergence of governance-​related requirements across the different sectors should be interpreted not as a consequence of agreed lessons learned during the crisis years, but rather as a conundrum in terms of both the underlying rationale and the design of technical solutions. In view of the differences mentioned before, cross-​sectoral governance-​related regulation is, in fact, in need of justification, and the literature available so far falls short of providing it. Essentially, four fundamental questions can be distinguished: First, are corporate governance arrangements a problem for financial institutions at all? Second: If so, are the relevant problems different from non-​regulated, non-​financial companies, and 19 See http://​www.fsb.org/​what-​we-​do/​about-​the-​compendium-​of-​standards/​key_​standards, accessed 28 September 2018. 20 See, for the latest version, FSB, ‘Thematic Review on Corporate Governance. Peer Review Report’, 28 April 2017, available at http://​www.fsb.org/​2017/​04/​thematic-​review-​on-​corporate-​ governance, accessed 28 September 2018. 21 This holds true even for papers that purported to take a broader perspective, e.g. Hopt, n 1. 22 But see, e.g. Eric D Roiter, ‘Disentangling Mutual Fund Governance from Corporate Governance’, Harvard Business Law Review (2016), 6, 1 (discussing fund governance from a US perspective); Houman B Shadab, ‘Hedge Fund Governance’, Stanford Journal of Law, Business & Finance (2013), 19, 141. 23 But see, again, Ferrarini and Saguato, n 6. 24 European Commission, Proposal for a Directive of the European Parliament and of the Council on the prudential supervision of investment firms and amending Directives 2013/​36/​EU and 2014/​65/​EU, 20 December 2017, COM(2017) 791 final.

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Corporate Governance of Financial Institution why? Third: If the answer to the first two questions is in the positive—​are the relevant problems of a genuinely cross-​sectoral nature, as the convergence of applicable requirements suggest, that is, are they present, in the same or at least in a similar form, across the board of intermediaries of all types? And fourth: If that is the case, to what extent can and should regulatory responses also be cross-​sectoral in nature? Only the first two questions have been addressed comprehensively—​but with a focus on banks and, therefore, not exhaustively—​in the relevant literature so far,25 while the answer to the latter, as noted earlier, appears to have been taken for granted at least in European legislation. If the answer to the third and fourth questions were to be in the positive, one possible, and potentially far-​reaching, policy implication could be a readjustment in the structure of EU financial regulation generally. If and to the extent that the case for cross-​sectoral regulation of governance-​related issues—​as has been suggested rather forcefully also for the regulatory framework for investor protection through conduct-​of-​business and transparency requirements26—​is found to be sufficiently strong also in the area of governance-​related requirements, the rationale for sector-​specific regulation would be called into question, and at least parts of existing secondary and tertiary legislation could (and, in the interest of more transparent, streamlined regulation, perhaps should) be consolidated into a single regulatory instrument for cross-​sectoral application.27 In other words: If relevant provisions 25 For comprehensive reviews of the available evidence and current controversies in recent years, see, e.g. James R. Barth, Chen Lin, and Clas Wihlborg (eds), Research Handbook on International Banking and Governance, Edward Elgar, 2012; Kevin Davis, ‘Bank governance –​What do we know, what should we do?’, in David G Mayes and Geoffrey Wood (eds), Reforming the Governance of the Financial Sector, Routledge, 2013, 107; Jakob de Haan and Razvan Vlahu, ‘Corporate Governance of Banks: A Survey’, Journal of Economic Surveys (2016), 30, 228; Guido Ferrarini, ‘Understanding the Role of Corporate Governance in Financial Institutions: A Research Agenda’, in Ondernemingsrecht, 2017, 72; Hopt, n 1; Klaus J Hopt, ‘Corporate Governance von Finanzinstituten  –​Empirische Befunde, Theorie und Fragen in den Rechts-​und Wirtschaftswissenschaften’, ZGR Zeitschrift für Unternehmens-​und Gesellschaftsrecht (2017), 438; Peter O Mülbert, ‘Corporate Governance of Banks’, in A Jalilvand and A G Malliaris (eds), Risk Management and Corporate Governance, Routledge, 2014, 242; Peter O Mülbert and Ryan Citlau, ‘The Uncertain Role of Banks’ Corporate Governance in Systemic Risk Regulation’ in Hanne S Birkmose, Mette Neville, and Karsten E Sørensen (eds), The European Financial Market in Transition, Aalphen aan den Rijn: Kluwer, 2012, 275; see also, discussing the relevance for investment firms, Jens-​Hinrich Binder, ‘Corporate Governance of Investment Firms under MiFID II’, in Busch and Ferrarini, n 6, 49, para 3.06. And see, for an in-​depth analysis of the UK framework for the corporate governance of banks, Andreas Kokkinis, Corporate Law and Financial Instability, Routledge, 2018, 14–​39. 26 See, in particular, Veerle Colaert, ‘European Banking, Securities and Insurance Law: Cutting through Sectoral Lines’, Common Market Law Journal (2015), 52, 1579; Veerle Colaert, ‘European Banking, Securities and Insurance Law: Towards a Cross-​Sectoral Approach?’, Butterworths Journal of International Banking and Financial Law (2016), 295; Veerle Colaert, ‘Building Blocks of Investor Protection: All-​embracing Regulation Tightens its Grip’, Journal of European Consumer and Market Law (2017), 229. 27 This should not be interpreted as a novel hypothesis. See, e.g., discussing the lack of a consolidated set of general rules in European securities regulation in the German tradition of an ‘Allgemeiner Teil’ (‘General rules’ which are then amended and specified for application to more specific circumstances by subsequent parts of a statute), Rüdiger Veil, ‘Europäische Kapitalmarktunion—​Verordnungsgesetzgebung, Instrumente der europäischen Marktaufsicht und

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Jens-Hinrich Binder across different sectoral regulations are found to be converging, could their replacement by, and consolidation into, a single legislative act be advantageous and more efficient, possibly not just for the regulated firms but also in terms of enforcement and, ultimately, in the interest of clients? In view of the drastically increased level of complexity of post-​crisis financial regulation within the European Union, this could potentially facilitate a more than welcome streamlining of the existing body of regulations without losses to the substantive content. Even under the existing frameworks, evidence supporting cross-​sectoral regulatory approaches could be beneficial, in that it would support convergence of interpretation and enforcement standards, as well as cross-​references between the different regimes, and thereby enhance legal certainty for regulatees even to the extent that the wording of the different legal instruments differs. At the very least, a higher level of convergence of substantial requirements could improve the organization of cross-​sectoral groups of intermediaries and help reap efficiency gains, for example in terms of application processes and supervisory scrutiny with regard to the election of board members with mandates in different intermediaries and the composition of the respective boards. 2.05

In this light, the present chapter presents a comparative cross-​sectoral introduction to the relevant problems and literature, but also seeks to prepare the ground for future research by outlining a conceptual framework for a functional analysis of the relevant provisions and the underlying policy rationale. The remainder of the chapter is organized as follows: Section II below starts with a comparison of the existing approaches to regulating the corporate governance of relevant intermediaries. On this basis and against the backdrop of the post-​crisis literature on governance problems in the financial sector, section III then turns to a functional analysis of the underlying policy objectives. Section IV concludes.

II.  Taking Stock: Governance-​Related Regulation in EU Legislation after the Global Financial Crisis A. Relevant legal sources 2.06

Governance-​related regulation of banks, investment firms, asset managers, and pension funds in Europe, for historical reasons, has taken the form of a rather intricate—​and idiosyncratic—​mix of sectoral and cross-​sectoral approaches, which, to the present day, continues to be heavily influenced by the European approach to regulate both universal and specialized commercial and investment banks within a single legislative framework. As of today, governance-​provisions are not just laid down in the relevant Level 1 instruments for banks, investment firms, asset die Idee eines “Single Rulebook” ’, in ZGR Zeitschrift für Unternehmens-​und Gesellschaftsrecht (2014), 544, 576.

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Corporate Governance of Financial Institution managers, and pension funds, but also in Level 2 instruments (regulations and directives). To get the full picture, it is important to note that this regime has, in several respects, also been complemented by Level 3 instruments. The most comprehensive set of regulations is to be found in the CRD IV, the cur- 2.07 rent version of the prudential Capital Requirements Directive,28 which applies in relation to banks—​‘credit institutions’ engaging in the business of taking deposits and granting credits29—​as well as investment firms.30 For banks and investment firms in Europe, governance-​related regulation had assumed its present role as a cornerstone of prudential requirements, and integral part of regulation addressing both the funding structure and organizational aspects, already prior to the global financial crisis, mainly with the transposition of the Basel II capital accord of 200431 into European law by the CRD I package in 2006.32 By contrast, the Second Banking Law Directive 198933 had provided for only a few rudimentary requirements in this regard.34 Starting with the Investment Services Directive 1993,35 prudential regulation of credit institutions within Europe has been extended, path-​dependently, also to ‘investment firms’, that is, firms engaging in a list of specified securities-​related activities now set out in Annex I MiFID II,36 now including, in particular, portfolio management and the provision of investment advice, the execution of orders on behalf of clients, dealing on own account, but also underwriting of and placement services to issuers of securities and, ultimately, the operation of certain types of financial 28 Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​ 49/​EC, [2013] OJ L176/​338 (hereafter CRD IV). 29 As defined by Regulation (EU) No 575/​2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/​2012, [2013] OJ L176/​1 (hereafter CRR), Article (4)(1)(1) (referred to in Article 3(1)(1) CRD IV). 30 i.e. firms engaging in a selected list of regulated investment services, see Directive 2014/​65/​EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/​92/​EC and Directive 2011/​61/​EU, OJ L173/​349 (hereafter MiFID II), Article 4(1)(1) and 4(1)(2) in conjunction with Sections A and C of Annex I. 31 BCBS, ‘International Convergence of Capital Management and Capital Standards –​A Revised Framework’ (June 2004). 32 Directive 2006/​48/​EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions [2006] OJ L177/​1 (the ‘recast Banking Directive’); Directive 2006/​49/​EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast) [2006] OJ L177/​201 (the ‘recast Capital Adequacy Directive’). 33 Second Council Directive 89/​646/​EEC of 15 December 1989 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/​780/​EEC, OJ L386/​1. 34 ibid, Article 13(2): ‘sound administrative and accounting procedures and adequate internal control mechanisms’ as prerequisites for licensing of institutions by home authorities. 35 Council Directive 93/​22/​EEC of 10 May 1993 on investment services in the securities field, OJ L141/​7 (hereafter ‘ISD 1993’). 36 Specifically, see Article (4)(2) in conjunction with Section A of Annex I MiFID II.

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Jens-Hinrich Binder market infrastructures (‘multilateral trading facilities’, ‘organised trading facilities’). Interestingly, the equal treatment of credit institutions and investment services, from the beginning to the present date, has only to a lesser extent (if at all) been based on a cross-​sectoral analysis of the risks associated with the respective business models, and rather sought to remove anti-​competitive imbalances between the regulatory frameworks for universal banks and specialized (investment) banks following the introduction of harmonized prudential standards for credit institutions.37 Upon completion of the present manuscript, it remains to be seen to what extent this approach will be changed under the Commission proposals for greater differentiation between banks on the one hand and non-​systemically important investment firms on the other.38 2.08

At the same time, ‘investment firms’ as defined in European regulation (which may include specialized firms engaging only in the provision of investment services, but also universal banks providing investment services and simultaneously licensed as credit institutions under the CRD IV/​CRR regime) have been subject to additional sector-​ specific governance-​related regulations, which reflected US American precedents39 and were set out, first, in the Investment Services Directive 1993, subsequently in the first Markets in Financial Instruments Directive of 200440 and the implementing Organisational Requirements Directive of 2006,41 and are presently stipulated in several provisions of MiFID II, which have been specified further in in the supplementing Regulation 2017/​565.42 Thus, the governance of investment firms is effectively covered by a two-​tiered combination of general, cross-​sectoral prudential requirements (for ‘credit institutions’ and ‘investment firms’) with specialized, sectoral requirements addressing specific problems of firms qualifying as investment firms under MiFID II.

2.09

By comparison, the regulatory landscape for asset managers within the EU looks rather straightforward. To the extent that the industry is not covered (qua provision of ‘portfolio management’ services) by MiFID II, the relevant requirements are to be found mainly in the revised regime for the regulation of Undertakings for Collective Investment in Transferable Securities (UCITS). While the first version

37 See, for a more detailed analysis of the rationale and the relevant policy background, Binder, n 25, para 3.12. 38 See n 24. 39 See Binder, n 9, 688. 40 Directive 2004/​39/​EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/​611/​EEC and 93/​6/​EEC and Directive 2000/​12/​EC of the European Parliament and of the Council and repealing Council Directive 93/​22/​EEC, OJ L 145 p. 1 (hereafter ‘MiFID I’). 41 Commission Directive 2006/​73/​EC of 10 August 2006 implementing Directive 2004/​39/​EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L241/​26. See, for further details, Binder, n 25, paras 3.15 and 3.16. 42 Commission Delegated Regulation (EU) 2017/​565 of 25 April 2016 supplementing Directive 2014/​65/​EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L87/​1.

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Corporate Governance of Financial Institution of the UCITS Directive, enacted in 1985, came with rather rudimentary fit-​and-​ proper requirements for the directors of a UCITS,43 a more complex regime is now set out in the recast version of 2009,44 in conjunction with the Implementing Directive 2009/​65/​EC,45 which seeks to align the relevant requirements, ‘to the greatest possible extent’, with the corresponding standards under the MiFID II regime.46 In addition, managers of Alternative Investment Funds (AIFM) are subject to the relevant provisions of the AIFM Directive,47 in conjunction with Chapter III of Delegated Regulation (EU) 231/​2013.48 This includes also specialized AIFs subject to separate legislation (European Long-​Term Investment Funds,49 Venture Capital Funds,50 and Money Market Funds51), which broadly follow the same rules.52

43 Council Directive 85/​611/​EEC of 20 December 1985 on the coordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), OJ L375/​3. 44 See Directive 2009/​65/​EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (as amended), OJ L302/​32, in particular Articles 7(1)(b) (qualification and reputation of management of management company), 7(1)(c) (organizational structure of management company to be disclosed with application for authorization), 7(2) (assessment of ‘close links’ between management company and other natural or legal persons in the authorization process), 8 (assessment of shareholders/​members with qualifying holdings), 12 (general organizational requirements for management companies), 14(2) (organizational requirements for implementation of conduct-​of-​business standards), 14a and 14b (remuneration policies of management companies), 15 (complaints management), 29(1)(b) (qualification and reputation of directors of investment companies), 29(1)(c) (organizational structure of management company to be disclosed with application for authorization), 30 (application of Articles 13–​14b to investment companies). 45 Commission Directive 2010/​43/​EU of 1 July 2010 implementing Directive 2009/​65/​EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company, OJ L 176/​42. 46 ibid, Recital 1. 47 See Directive 2011/​61/​EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/​41/​EC and 2009/​65/​EC and Regulations (EC) No 1060/​2009 and (EU) No 1095/​2010 (as amended), OJ L174/​1, in particular Articles 8(1)(c) (qualification and reputation of controlling managers), 8(1)(d) (assessment of shareholders and owners with qualifying holdings), 8(3)(a) (close links with third parties preventing effective supervision), 12 (general operating requirements), 13 (remuneration of directors and managers), 14 (conflicts of interest, including relevant organizational requirements), 15 (risk management), 18 (general organizational requirements). 48 Commission Delegated Regulation (EU) No 231/​2013 of 19 December 2012 supplementing Directive 2011/​61/​EU of the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision, OJ L83/​1. 49 See Regulation (EU) 2015/​760 of the European Parliament and of the Council of 29 April 2015 on European long-​term investment funds, OJ L169/​8. 50 See Regulation (EU) No 345/​2013 of the European Parliament and of the Council of 17 April 2013 on European venture capital funds, OJ L115/​ 1. 51 See Regulation (EU) 2017/​1131 of the European Parliament and of the Council of 14 June 2017 on money market funds, OJ L169/​ 8. 52 But note that, in addition to the AIFM regime, specific requirements apply with regard to the management of conflicts of interests by managers of venture capital funds (Regulation (EU) No

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Jens-Hinrich Binder 2.10

Lastly, pension funds, insofar as they do not fall within the scope of any of the above legal instruments, have been regulated separately within Europe, beginning with the first Directive on the activities and supervision of institutions for occupational retirement provision in 2003,53 now—​with a substantial expansion of governance-​related provisions—​recast as Directive 2016/​2341.54 B. Board-​related requirements 1.  Board qualification and board composition

2.11

For banks as well as other intermediaries, minimum requirements for the qualification of board members have been in place long before the financial crisis, but—​at least, with regard to some sectors and particularly for banks—​have since become much more granular and multifaceted. In addition to general requirements pertaining to the reputation of office-​holders, designed so as to prevent persons with a criminal or otherwise negative record to enter the relevant positions, and standards for their qualification, both in order to enhance the safety and soundness of the relevant intermediaries’ financial position and client assets, the post-​crisis reforms have come to follow a broader approach and now address, for credit institutions and investment firms covered by CRD IV55 as well as for market operators,56 also the composition of the board as a whole, including diversity policies.57 This is fully in line with, and clearly has been inspired by, international standards,58 but is not uncontroversial especially insofar as requirements for gender diversity among board members are concerned.59 To date, the regulatory frameworks for other sectors have not followed suit in this regard. This leaves matters of board composition entirely to the discretion of the regulated firms on the one hand and the control by supervisory authorities on the other hand, but the scope for supervisory intervention is clearly limited by the absence of a statutory basis comparable to that for banks. 345/​2015, Article 9) on the one hand and risk management practices in money market funds on the other hand (Regulation (EU) 2017/​1131, Chapter III). 53 Directive 2003/​41/​EC of the European Parliament and of the Council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision, OJ L235/​10. 54 See Directive 2016/​2341/​EU of the European Parliament and of the Council of 14 December 2016 on the activities and supervision of institutions for occupational retirement provision (hereafter IORP Directive), OJ L 354/​37, in particular Articles 10 (operating requirements), 21 (general governance requirements), 22 (reputation and qualification of management), 23 (remuneration policies), 24 (key functions), 25 (risk management), 26 (internal audit). 55 Article 88(2)(a) and Article 91(1) and (10) of CRD IV. 56 Article 45(5) of MiFID II. 57 See, for a detailed analysis, Stefano Finesi, ‘Suitability of Bank Directors in Europe:  Just a Matter of Being “Fit & Proper”?’, European Company and Financial Law Review (2015), 45. 58 See, in particular, BCBS, n 13, Principle 2, paras 47–​56; see also IOSCO, ‘Report on Corporate Governance—​Final Report’, October 2016, 19–​22. 59 See, critically, e.g., Luca Enriques and Dirk Zetzsche, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’, Theoretical Enquiries in Law (2015), 16, 211, 218–​225.

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Corporate Governance of Financial Institution Irrespective of these developments, it can be observed that individual requirements for 2.12 board members differ from sector to sector, ranging from rather broad principles, which reflect general criteria also used with regard to other sectors, to detailed sector-​specific specifications included in Level 1 or Level 3 instruments. By comparison, the regulatory framework for credit institutions and investment firms set out by the CRD IV stands out in this regard. This is probably attributable to perceived governance failures specifically in banking institutions during the financial crisis,60 but the resulting cross-​ sectoral imbalances in terms of the ‘granularity’ of standards certainly prevent the emergence of clear-​cut, reliable criteria for the interpretation and enforcement of the relevant standards. This may come with significant distortions for competition in the financial industry as a whole, although probably less in terms of competitive equality between firms operating in different sectors61 than in terms of cross-​border competition between firms operating in different European jurisdictions, where the relevant standards set out in the different Level 1 instruments, in the absence of specifications at least at Level 3, may come to be interpreted very differently by the relevant competent authorities. To illustrate the above findings and considerations, Table 2.1 below compiles infor- 2.13 mation on individual requirements (reputation and qualification) for the different sectors, with the last line (‘granular’) indicating whether relevant requirements go beyond general principles (‘fit and proper’, ‘good repute’, ‘qualified’, etc.): Table 2.1 Individual requirements for directors and managers Credit institutions /​ investment firms (CRD IV regime)

Investment firms (MiFID II)

Asset managers (UCITS, AIFM)

Pension funds (IORP Dir)

Level 1

Art 91 CRD IV n/​a

Art 7(1)(b) UCITS Dir, Art 8(1)(c) n/​a

Art 22(1) IORP Dir

Level 2

Art 9(6), for market operators Art 45(1) n/​a

ESMA/​EBA Guidelines on Suitabilitya

n/​a

EBA Q&A; ECB Guide (for SSM)b yes

n/​a

n/​a

n/​a

no

yes

Level 3 Other granular

n/​a n/​a yes

 European Securities and Markets Authority (ESMA) and European Banking Authority (EBA), ‘Final Report: Joint ESMA and EBA Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders under Directive 2013/​36/​EU and Directive 2014/​65/​ EU’ (EBA/​GL/​2017/​12), 26 September 2017. b  European Central Bank (ECB), ‘Guide to Fit and Proper Assessments’, 16 May 2017. a

60 See, again, n 25 and accompanying text. 61 Note that this can cause problems only to the extent that the regulated firms actually may, and do, compete with each other, which is not the case, for example, between intermediaries subject to the CRD IV regime (credit institutions and investment firms) on the one hand and asset managers or pension funds on the other hand.

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Jens-Hinrich Binder To be sure, Table 2.1 has its limits, and should be read with caution. In order to get the full picture, a more detailed comparison would be required, which is outside the scope of the present chapter (while other chapters in this volume will explore the relevant details). It should be noted, however, that a certain degree of consistency between the different legal instruments examined above is undisputable; in all sectors covered, the reputation and qualification of board members clearly has been identified as a problem requiring regulatory intervention, resulting at least in a core set of general fit and proper requirements that have been formulated in very similar, if not identical, terms in the different Level 1 instruments. This should not be read as evidence of full convergence, however. As will be examined more closely in Chapter 8 in this volume, qualification requirements, even where formulated as a broad principle that reappears in the legal frameworks for different sectors, should not be interpreted as identical with one another, and most certainly will not be enforced as such in supervisory practice either. For even in the absence of more granular requirements (i.e., outside the CRD IV regime, where relevant Level 1 provisions have been complemented by Level 3 Guidelines), the general standard (‘sufficient experience’ or similar variations) does not stand alone, but is expressly linked to the specific duties arising with regard to the specific activities regulated under the relevant framework.62 In other words: Even if, and to the extent that, the different legal instruments employ the same language, this should not be misinterpreted as reflecting a truly cross-​sectoral standard. Thus, the qualification of directors and senior managers will inevitably (and most convincingly) be assessed not on the basis of abstract, generic criteria, but with regard to the specific duties arising out of the different business models and risk profiles for each specific sector. If, for example, a person, owing to her individual experience in the banking sector, can demonstrate adequate skills and experience as a bank director, this does not automatically qualify her for positions of similar seniority in the fund industry, and vice versa. It is perhaps in this regard that an in-​depth analysis of the rationale for greater convergence of standards—​and the removal of what could be classified as ‘unsubstantiated differentiations’ without justification in the practical differences between different sub-​sectors—​could play the most important role.63 2.  Remuneration policies 2.14

In response to concerns about remuneration standards more aligned with the self-​ interest of senior bank staff (and the short-​term interests of bank owners) than medium-​and long-​term sustainability, regulatory requirements for the design of

62 cf Article 9(6)(b) of MiFID II; Article 5(4)(3) of UCITS Directive; Article 8(1) of AIFM Directive; and see, for a particularly detailed formulation of the general principle, Article 22(1) of IORP Directive. 63 The author would like to thank Veerle Colaert for making this point.

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Corporate Governance of Financial Institution remuneration policies within intermediaries have come to be recognized as a core element of post-​crisis financial reforms. Just as with regard to board-​related requirements in general, this mirrors broader international trends.64 Specifically within Europe—​as evidenced, for example, by the European Commission’s 2010 Green Paper,65 the regulation of remuneration practices, while sector-​specific in terms of the relevant legal instruments, has been developed broadly along similar concepts, with close parallels between the different regimes. At the same time, given residual differences in business models, risk structures and, consequently, in the incentives for managers, the regulation of remuneration policies and practices presents a particularly interesting case for further research into the merits and limits of cross-​sectoral regulation. While a more detailed analysis will be presented in Chapter 11 of the present volume,66 Table 2.2 below summarizes the relevant provisions: Table 2.2 Remuneration requirements Credit institutions /​ investment firms (CRD IV regime)

Investment firms (MiFID II)

Asset managers (UCITS, AIFM)

Pension funds (IORP Dir)

Level 1

Arts 74(1), 75, 92–​95 CRD IV; Art 450 CRR

Arts 9(2)(c), 23(1), 24(10)

Art 14a and b UCITS Dir; Art 13 AIFM Dir

Art 23 IORP Dir

Level 2

COM Del Reg (EU) No 527/​2014 of 12 March 2014 (OJ L148/​,21)

COM Del. Reg. (EU) 2017/​565 of 25 April 2016 (OJ 87/​,1), Art 27

n/​a

n/​a

Level 3

EBA Guidelinesa

ESMA Guidelinesb

ESMA Guidelinesc

Other

EBA Q&A

n/​a

n/​a

granular

yes

yes

yes

no

 EBA, ‘Guidelines on Sound Remuneration Policies under Articles 74(3) and 75(2) of Directive 2013/​ 36/​EU and Disclosures under Article 450 of Regulation (EU) No 575/​2013’, 21 December 2015 (EBA/​GL/​2015/​22), and EBA, ‘Guidelines on the Remuneration Benchmarking Exercise’, 16 July 2014 (EBA/​GL/​2014/​08). b  ESMA, ‘Final Report: Guidelines on Remuneration Policies and Practices’, 11 June 2013 (ESMA/​ 2013/​606). c  ESMA, ‘Final Report: Guidelines on sound remuneration practices under the AIFMD’, 11 February 2013 (ESMA/​2013/​232); ESMA, ‘Final Report: Guidelines on sound remuneration practices under the UCITS Directive and the AIFMD’, 31 March 2016 (ESMA/​2016/​411). a

64 See, in particular, FSB (then FSF), ‘Principles for Sound Compensation Practices’, 2009, available at http://​www.fsb.org/​wp-​content/​uploads/​r_​0904b.pdf, accessed 28 September 2018; FSB, ‘Principles for Sound Compensation Practices: Implementation Standards’, 2009, available at http://​www.fsb.org/​wp-​content/​uploads/​r_​090925c.pdf, accessed 28 September 2018. 65 See n 12, 17–​18. 66 And see, generally, Tom Dijkhuizen, ‘The EU’s Regulatory Approach to Banks’ Executive Pay: From Pay Governance to Pay Design’ European Company Law (2014), 11, 30; Eilís Ferran, ‘New

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Jens-Hinrich Binder 3.  Board responsibilities, organization of the board, and performance standards 2.15

By contrast, regulatory requirements specifying the responsibilities and the organization of the board and defining performance standards have not become ubiquitous in the sub-​sectors covered by the present chapter, but continue to be restricted mainly to the regulation of credit institutions under the CRD IV package and, to a much lesser extent, in additional requirements complementing those arising under the CRD IV, under MiFID II. In view of the differences in terms of legal forms and organizational structures between the different sub-​sectors, this discrepancy is particularly illustrative of the limits to cross-​sectoral governance-​related regulation in general. Table 2.3 below summarizes the relevant provisions: Table 2.3 Requirements pertaining to board responsibilities, board organization, and board performance Credit institutions /​ investment firms (CRD IV regime) Level 1

Arts 76 (treatment of risks, including risk committee), 88(1) (responsibility of management body with regard to governance arrangements)ss, 88(2) (functions of nomination committee), 91(2) (sufficient time to be devoted to mandate), 91(8) (required standard of care of board members), 95 (remuneration committee) CRD IV Level 2 n/​a Level 3 EBA Guidelines on internal governancea Other n/​a granular yes

Investment firms (MiFID II)

Asset managers (UCITS, AIFM)

Pension funds (IORP Dir)

Art 9(3) (responsibilities of management body) MiFID II

Annex II (3) AIFMD (remuneration committees required in significant AIFMs)

n/​a

n/​a n/​a

n/​a n/​a

n/​a n/​a

n/​a no

n/​a no

n/​a n/​a

 EBA, ‘Final Report: Guidelines on Internal Governance under Directive 2013/​36/​EU’ (EBA/​GL/​2017/​11), 26 September 2018, 24 and 26–​9.

a

Regulation of Remuneration in the Financial Sector in the EU’ European Company and Financial Law Review (2012), 9, 1; Guido Ferrarini and Maria Cristina Ungureanu, ‘An Overview of the Executive Remuneration Issue Across the Crisis’ in Birkmose, Neville, and Sørensen (eds), n 25, 349; Guido Ferrarini and Maria Cristina Ungureanu, ‘Lost in Implementation: The Rise and Value of the FSB Principles for Sound Compensation Practices at Financial Institutions’ Revue Trimestrielle de Droit Financier (2011), 1–​2, 60; Andrew Johnston, ‘Preventing the Next Financial Crisis? Regulating Bankers’ Pay in Europe’ Journal of Law and Society (2014), 41, 6; for a US perspective, cf Lucian Bebchuk and Holger Spamann, ‘Regulating Bankers’ Pay’ Georgetown Law Journal (2010), 98, 247.

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Corporate Governance of Financial Institution C.  Control of shareholders and owners of qualifying holdings Restrictions for the acquisition of ‘qualifying holdings’ (i.e. holdings exceeding 2.16 certain quantitative thresholds that facilitate a special influence on the relevant institution’s management) have played an important role in the governance-​related regulation of credit institutions ever since the Second Banking Law Directive of 1989.67 Supervisory scrutiny of shareholders and owners of qualifying holdings, both as part of the authorization process and on an on-​going basis, has since also been applied with regard to other sub-​sectors, including those outside the scope of the present chapter. While both the underlying policy objectives and the relevant qualitative standards and technical procedures are similar, the requirements nonetheless provide yet another example for the limits of cross-​sectoral regulation. As summarized in Table 2.4 below, the differences between the regimes are substantial: Table 2.4 Requirements pertaining to the control of shareholders and owners of qualifying holdings Credit institutions /​ investment firms (CRD IV regime)

Investment firms (MiFID II)

Asset managers (UCITS, AIFM)

Level 1

Art 14 (authorisation process), Arts 22–​27 (acquisition of holdings) CRD IV

Arts 7(6)(c) and 8 UCITS Dir; Art (1)(d) AIFM Dir.

Level 2

Art 10 (authorisation process), Art 11 (acquisition of holdings) MiFID II n/​a

COM Implementing Reg (EU) 2017/​461 of 16 March 2017 on the consultation process btw. relevant competent authorities (OJ L72/​57) n/​a n/​a EBA Q&A n/​a yes no

Level 3 Other granular

Pension funds (IORP Dir)

n/​aa

n/​a no.

  Article 8(6)(a) of AIFM Directive envisages the development of RTS specifying the requirements for shareholders and owners of qualifying holdings, but such standards are yet to be promulgated. a

D. Risk governance, internal audits and compliance Organizational duties pertaining to the managing of risks have been a core element 2.17 of financial regulation for some time, again: well beyond the global financial crisis, 67 cf Articles 11 and 12 Second Council Directive 89/​646/​EEC of 15 December 1989 on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/​780/​EEC, OJ L386/​1.

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Jens-Hinrich Binder where risk management arrangements within banks were widely seen to be deficient.68 Just as with the reputation and qualification of board members, risk management requirements, at first sight, appear to have become a commonplace feature in European financial regulation generally (and are, again, not confined to those types of intermediaries covered by the present chapter, but have also been enacted with regard to, inter alia, insurance companies,69 administrators of benchmarks,70 and operators of central counterparties71). 2.18

On closer inspection, however, the differences between the various sectors are at least as striking as with regard to board-​related requirements. For credit institutions and investment firms covered by the CRD IV in particular, the risk management requirements are extremely complex. They include institutional provisions (on the creation of a risk committee and a risk function with a highly prescriptive set of specifications for its organization and duties72), corresponding board duties,73 and procedural aspects.74 Under MiFID II, these provisions are supplemented by even more detailed requirements addressing specific problems of risk management in the provision of regulated investment services.75 Sector-​specific, albeit less detailed risk management requirements, also apply to asset managers under Article 51 of the UCITS Directive, Article 15 of the AIFM Directive, and Article 25 of the IORP Directive. By contrast—​unlike for investment firms under the MiFID II regime,76 IORPs77 (and, e.g. insurers78)—​detailed institutional requirements for the internal audit function have not been adopted for credit institutions under CRD IV. However, specific duties for the internal audit function of credit institutions and investment firms are provided with regard to certain capital requirements.79 Finally, only investment firms covered by MiFID II80 are subject to specific organizational duties with regard to the creation of a compliance function. These differences are summarized in Table 2.5 below. 68 e.g., Iris H-​Y Chiu, Regulating (From) the Inside, Bloomsbury, 2015, 87; Grant Kirkpatrick, ‘The Corporate Governance Lessons from the Financial Crisis’, (2009) OECD Journal Financial Market Trends, 6–​12. For a comparative review of the different sectors, see, again, Binder, n 9, 680–​96. 69 See, in particular, Directive 2009/​138/​EC of the European Parliament and of the Council of 25 November 2009 on the taking-​up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast) (as amended) (‘Solvency II’), OJ L335/​1, Articles 41(3), 44–​47, 236, and 246. 70 Article 6(3) of EU Benchmark Regulation. 71 Articles 26(1) and 28 of EMIR. 72 Article 76(3) and (5) of CRD IV, respectively. 73 See, in particular, Article 76(1) and (2) of CRD IV. 74 See, in particular, Article 123(2) of CRD IV. 75 Article 16(5) of MiFID II and Article 23 of Commission Delegated Regulation (EU) 2017/​ 565 of 25 April 2016 supplementing Directive 2014/​65/​EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, OJ L87/​1. 76 Article 16(5) of MiFID II and Article 24 of Delegated Regulation 2017/​565. 77 Articles 21(3) and 24(1) 78 See Articles 41(3) and 47 of Solvency II Directive. 79 See Articles 191, 221(4)(h), 225(3)(d), 288, 361(1)(h), and 104(1) of CRR. 80 See Article 16(2) of MiFID II and Article 22 Delegated Regulation 2017/​565.

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Corporate Governance of Financial Institution Table 2.5 Requirements pertaining to risk governance, internal audit and compliance 72

Credit institutions /​ investment firms (CRD IV regime)

Investment firms (MiFID II)

Asset managers (UCITS, AIFM)

Level 1

Arts 73–​101, 123(2) CRD IV (part of SREP framework) n/​a

Art 16 MiFID II (general organisational requirements) Arts 21–​24 Del Reg 2017/​565

Art 51 UCITS Dir, Art 24(1), 25, Arts 15 and 18 26, and 28 AIFM Dir IORP Dir

n/​a yes

n/​a yes

Level 2

EBA Guidelines on internal governanceb Other n/​a granular yes

Pension funds (IORP Dir)

Arts 9–​12, 38–​45 Implementing Dir. 2010/​43a

Level 3

n/​a yes

 Commission Directive 2010/​43/​EU of 1 July 2010 implementing Directive 2009/​65/​EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a depositary and a management company, OJ L 176/​1. b  See ‘Final Report: Guidelines on Internal Governance under Directive 2013/36/EU’ (EBA/GL/2017/11), 26 September 2018, 29, 32–43. For a detailed assessment (in German), see Peter O Mülbert and Christian Wilhelm, ‘Risikomanagement und Compliance im Finanzmarktrecht –​Entwicklung der aufsichtsrechtlichen Anforderungen’, ZHR Zeitschrift für das gesamte Handelsrecht und Wirtschaftsrecht (2014), 502, 178. a

E. Preliminary findings Comparing parallels and differences between the board-​related and risk-​manage- 2.19 ment requirements examined above, the general impression of cross-​sectoral convergence of relevant standards sketched out in the introduction to this chapter gives way to a more nuanced approach. Especially with regard to what has been referred to as ‘granularity’ above, that is, the degree to which broad principles are complemented by more granular technical requirements, the differences between the regulatory requirements for the individual sectors remain considerable—​enough, in fact, as to cast doubt on the assumption that a trend for greater convergence of relevant standards—​at least below the surface created by general categories like ‘fit and proper requirements’, ‘risk management’, etc—​actually exists. At any rate, if there is a case for genuine cross-​sectoral regulation of the corporate governance at all, it does not follow from the simultaneous existence of provisions addressing broadly similar aspects of the internal governance of financial firms as such, which, at the technical level, differ markedly in many cases. If anything, this suggests that the case for or against cross-​sectoral approaches probably cannot be assessed without differentiation across the board of governance-​related regulation as a whole, but has to be evaluated on a case-​by-​case basis, with a view to the functional characteristics of each sector and, in particular, the relevant business models and risk profiles.

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Jens-Hinrich Binder Particularly risk management requirements are a case in point:  The (trivial) fact that the provision of financial services is associated with risks across the different sectors, and that such risks need to be monitored in order to ensure the financial soundness of each individual firm, does not support the conclusion that adequate arrangements could, or should, be the same or even similar across the board, as the relevant types of risks are different and therefore need a differentiated response. By contrast, the case for convergence may be more compelling with regard to institutional aspects, for example the reputation and qualification of board members and board infrastructure, but even in this regard, as has been noted above, a nuanced approach is in place in existing regulation, and justifiable in view of existing differences between business models and risk profiles.

III.  The Case for Cross-​Sectoral Governance-​Regulation Re-​examined—​A Functional Approach A. Cross-​sectoral regulation on a sectoral basis? The traditional focus on banks and its limits 2.20

The preliminary findings summarized clearly before do not support the case for cross-​sectoral governance-​related regulation for financial firms without qualifications. This impression is reinforced rather than removed by the available empirical and theoretical literature on the governance of financial institutions. To be sure, despite the differences between the sectoral frameworks observed earlier, financial regulation within the European Union, as evidenced in the Commission’s Green Paper of 2010, builds on the assumption that sectoral characteristics and resulting needs for technical adjustments of general concepts and solutions should not obscure fundamental similarities between financial firms in different sectors and that, consequently, governance problems and the resulting need for regulation should be interpreted as genuinely cross-​sectoral in nature.81 This assumption, which is also characteristic for the preparatory Commission Staff Working Document published in the same year,82 may well turn out to be rather ill-​founded, however.

2.21

To begin with, as noted before, it is all too easily forgotten that the available empirical literature on governance failures in the run-​up to the global financial crisis (understandably) focuses on banks, without even discussing whether similar problems could be expected in other sectors as well.83 Given that (i) governance failures 81 cf again, EU Commission, Green Paper, n 12, in particular 3–​4. 82 European Commission, Commission Staff Working Document:  ‘Corporate Governance in Financial Institutions:  Lessons to be drawn from the current financial crisis, best practices’, SEC(2010) 669 (2 June 2010). 83 See, e.g., Marco Becht, Patrick Bolton, and Ailsa Röell, ‘Why Bank Governance is Different’, Oxford Review of Economic Policy (2011), 3, 437 (discussing both board incompetence and

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Corporate Governance of Financial Institution were not observed in the same form across all different sectors and that (ii) business models, corporate structures, and resulting risk profiles evidently differ markedly, this would, at the very least, caution against uncritical transposition of bank-​related findings to other types of intermediaries. In order to build and substantiate the case for cross-​sectoral regulation, cross-​sectoral empirical evidence would be required, which appears to be inexistent to date, at least at the European level.84 From a more theoretical point of view, the fundamental policy rationale for 2.22 governance-​related regulation of banks and the analysis of more technical governance problems within banks do not provide a more solid rationale for cross-​sectoral regulation either. In this respect, the traditional analysis of the problems of debt governance in banks provides a particularly illustrative starting point. It is well accepted that the prudential regulation of credit institutions is warranted because, in addition to common agency problems between shareholders and management in place in public companies generally, control of management by debtholders is uniquely weak in banks as a result of the specific debt structure made up, to a substantial degree, by deposit holders with little financial sophistication and very limited bargaining power.85 The same analysis cannot, however, be applied without alterations to investment firms engaging in portfolio management, where even the full-​fledged financial failure of the firm does not automatically expose its clients to losses. Even with asset managers, the situation is not altogether clear-​cut. To be sure, fund investors (who, incidentally, are not debtholders but shareholders) may, and frequently will, fall victim to information asymmetries prima facie similar to those encountered by bank depositors, and thus do not seem to be in a strong position to exercise effective control over the management and reduce its incentives for excessive risk-​taking. As has been argued with regard to the fund industry in the United

deficient risk management); on the relationship between shareholder-​friendly governance structures and risk appetite of intermediaries, see (with mixed results) Deniz Anginer et al, ‘Corporate Governance and Bank Insolvency Risk. International Evidence’, 2014, available at http://​ssrn. com/​abstract=2491490 accessed 28 September 2018; Andrea Beltratti and René M. Stulz, ‘Why Did Some Banks Perform Better During the Credit Crisis? A Cross-​Country Study of the Impact of Governance and Regulation’, Journal of Financial Economics (2012), 105, 1; David H Erkens, Mingyi Hung, and Pedro P Matos, ‘Corporate Governance in the 2007-​2008 Financial Crisis: Evidence from Financial Institutions Worldwide’, Journal of Corporate Finance (2012), 18, 389; Luc Laeven and Ross Levine, ‘Bank Governance, Regulation and Risk Taking’, Journal of Financial Economics (2009), 93, 259. See also text and n 25. 84 It is worth noting, in this context, that the EU Commission’s Staff Working Document preparing the ground for the 2010 Green Paper, while purporting to discuss governance-​related problems of financial institutions generally, expressly focuses on banks and insurance companies, while specific governance issues relating to special types of non-​bank institutions are expressly excluded, see EU Commission, n 82, 5. 85 See, e.g., Hopt, in Wymeersch, Hopt, and Ferrarini, n 1, para 11.29; Andreas Kokkinis, ‘A primer on corporate governance in banks and financial institutions: are banks special?’, in Iris Chiu (ed), The Law on Corporate Governance of Banks, Edward Elgar, 2015, paras 1.27–​1.28 and 1.56–​ 1.59; see also Mülbert, Corporate Governance of Banks, n 25, 256–​7.

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Jens-Hinrich Binder States, however, fund governance may turn out to differ from governance structures both in unregulated public companies generally and in other types of financial intermediaries because of fund investors’ redemption rights, which allow them to withdraw their capital on short notice and thereby to effectively discipline an ill-​ performing management.86 In this context, it is important to note that another key rationale frequently cited in support of special governance-​related regulation of banks—​the opacity of banking activities and business models, which reduces debtholders’ ability to monitor, and discipline, management yet further87—​does not apply to the same extent to all types of financial companies either. 2.23

To conclude, it is worth recalling that the above considerations are directly related to differences in the corporate (and funding) structures as well as the business models that have been hinted at before. It is certainly possible to identify common economic functions in the abstract, which are performed by different types of intermediaries alike, for example, to borrow from a prominent analysis, ‘(i) maturity intermediation; (ii) reducing risk via diversification; (iii) reducing the cost of contracting and information processing; and (iv) providing a payments mechanism’.88 While this analysis has its conceptual merits, it is important to note, for present purposes, that not all types of intermediaries (and other market participants or providers of market infrastructure) do engage in all of these activities, which again weakens the case for equal regulatory treatment.89 Much the same applies to the wide range of risks incurred in the pursuit of the respective business models.90 If the risk profile of diverse types of intermediaries is entirely different, this further weakens the case for cross-​sectoral regulation from a functional approach too. Consequently, even if risk management, as such, can probably be agreed to be crucial for the safety and soundness of all types of financial intermediaries,91 the practical implications for the technical design of risk-​ management arrangements within the regulated firms as well as for the design and calibration of relevant regulations are limited, because both would still have to be tailored to the sector-​specific needs.

86 Roiter, n 22, 14. 87 e.g. Hopt, in Wymeersch, Hopt, and Ferrarini, n 1, para 11.19; Kokkinis, n 85, paras 1.39–​ 1.47; Mülbert, n 25, 249 and 254. 88 Frank Fabozzi, Franco Modigliani, and Frank Jones, Foundations of Financial Markets and Institutions, Pearson, 4th ed, 2014, 24. 89 See Ferrarini, n 25, 73. 90 ibid. 91 ibid, 75. See also, with a focus on risk management and organizational regulation in banks and investment firms, Iris H-​Y Chiu, Regulating (From) the Inside. The Legal Framework for Internal Control in Banks and Financial Institutions, Bloomsbury, 2015, 77–​119. And see, defining the crucial role of risk management regulation in post-​crisis financial regulation within the European Union, EU Commission, Green Paper, n 12, 7.

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Corporate Governance of Financial Institution B. Governance-​related regulation in the interest of systemic stability and depositor/​investor protections If, as argued above, neither the empirical nor the theoretical literature bears out a 2.24 fundamental shift from sectoral to cross-​sectoral regulation, this does not imply that no common rationale for the regulation of the corporate governance of financial firms can be identified at all. At a rather abstract level, the justification of governance-​related regulation is, in fact, rather intuitive, and it is indeed identical for each particular sub-​sector: Regulatory intervention pertaining to the internal governance is justifiable if, and to the extent that, governance failures are likely to cause negative externalities in terms of systemic stability and/​or losses to (equity or debt) investors. Seen this way, governance-​related financial regulation simply can be interpreted as an attempt to activate pre-​existing governance arrangements within the regulated firms in order to enhance the stability and soundness of these firms in the public interest, essentially as a form of ‘management based regulation’.92 In this way, governance-​related regulation, which prescribes qualitative standards for the design of internal processes in the regulated firms rather than prescribing substantive specific duties and obligations, can be perceived as a form of ‘meta-​regulation’, which activates the regulatees’ self-​interest in accomplishing socially desirable results.93 At least to some extent, this is also reflected in the regulatory agenda defined in the European Commission’s Green Paper of 2010, which has identified systemic crises and resulting problems for stakeholders (including not just depositors, investors, policyholders, and other creditors but also the taxpayers), as a direct consequence of governance failures.94 While it could be mistaken as trivial, this rationale certainly offers a coherent and 2.25 potentially even plausible justification for governance-​related regulation as such. In this sense, the regulation of financial intermediaries can certainly be described as stakeholder-​driven, be it in the form of capital adequacy, liquidity, or governance-​ related requirements. At the same time, it should be noted that the focus on systemic stability concerns on the one hand and individual stakeholder protection on the other hand could give rise to at least three misunderstandings, with potentially far-​reaching consequences on policy design. First, it is worth noting that externalities for both types of interest associated (either 2.26 directly or indirectly, as a result of domino effects) with the failure of financial institutions do not by themselves justify governance-​related regulation. As has been recalled before, the empirical link between deficiencies in governance arrangements 92 To use the concept framed by Cary Coglianese and David Lazer, see Coglianese and Lazer, ‘Management-​Based Regulation Regulation:  Prescribing Private Management to Achieve Public Goals’, Law & Society Review (2003), 37, 691. 93 See generally Chiu, n 91, 14–​18. 94 EU Commission, Green Paper, n 12, 4.

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Jens-Hinrich Binder and firm performance, with the possible exception of risk management, is rather weak even for the banking sector and, absent empirical evidence, almost non-​ existent for other sectors, which at the very least calls for further research. In other words: The case for governance-​related regulation would be convincing only if and to the extent that the underlying assessment of governance failures were to be corroborated by empirical evidence, which is presently not the case. 2.27

Secondly, as pointed out repeatedly in the present chapter, even if the case for governance-​related regulation (generally or with respect to individual) could be substantiated more forcefully than is presently possible, this would not inevitably support the need for cross-​sectoral regulation. If the protection of public interests, including, for that matter, the interests of investors and other creditors, requires regulatory intervention in the form of governance-​related requirements across the board of different types of financial intermediaries, it does not automatically follow that such regulation should be the same in form and content.

2.28

Thirdly, and perhaps most importantly, none of the findings above support the conclusion that the governance structure of financial institutions as a whole can, or should be, qualified as genuinely stakeholder-​oriented and thus as fundamentally different from non-​regulated public companies. While public regulation subjects the regulated industry to specific duties and obligations with regard to the various aspects of governance arrangements examined above, these requirements, as discussed before, generally build on general principles of company law, and thus reinforce duties that would also, in principle, apply in non-​regulated companies.

2.29

In other words:  regulatory requirements and general principles of company law can, at least to a significant extent, be said to complement, rather than conflict with, each other.95 Irrespective of the special nature of governance-​related regulation for financial institutions, which by far surpasses general company law in terms of complexity and prescriptiveness, it is therefore not incorrect to conclude that financial institutions, at least if organized in the form of public companies, ‘are not fundamentally different from other companies with respect to corporate governance, even though there are important differences of degree and failures will have economy-​wide ramifications’.96 To be sure, this statement could be criticized on the grounds that it fails to acknowledge the fundamental impact of stakeholder-​oriented regulation on corporate behaviour in general and board

95 See, e.g., discussing requirements pertaining to the supervisory board under the German Banking Act and the German Stock Corporation Act, Jens-​Hinrich Binder, ‘Der Aufsichtsrat von Kreditinstituten drei Jahre nach dem “Regulierungstsunami” ’, ZGR Zeitschrift für Unternehmens-​ und Gesellschaftsrecht (2018), 88. 96 See, with regard to banks, but in principle applicable across the board, OECD, ‘Corporate Governance and the Financial Crisis: Key Findings and Main Messages’ (June 2009), 12.

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Corporate Governance of Financial Institution decisions in particular.97 In fact, it would surely be problematic if the applicable regulations had no such effects. Nonetheless, the conclusion, prominently stated by the BCBS, that governance-​related regulation effectively results in a full-​fledged shift in paradigm compared to general company law—​from shareholder-​to stakeholder oriented governance, with board duties focusing on stakeholders’ (depositors’, investors’) best interests98—​not only overstates the relevance of stakeholder interests, but simply fails to acknowledge the limits of existing stakeholder-​oriented regulation within the general framework of company law, and the systematic relationship between these two regimes. If, as highlighted before, and to the extent that governance-​related financial regulation can be implemented without structural conflicts within the corporate constitution (as prescribed by general company law), the mere existence of such requirements certainly limits the board’s discretion with regard to design of internal procedures that would otherwise apply, but it is not in itself sufficient to remove the focus on shareholder interests altogether.99

IV.  Conclusions The prima facie assumption that governance-​related regulation has been conver- 2.30 ging for the different types of financial intermediaries is misleading. The case for a shift towards integrated cross-​sectoral regulatory strategies is thus less compelling than would appear at first sight. Yet these findings should not be interpreted as an outright dismissal of such plans. The fact that the substance of relevant requirements has been converging not just with regard to banks, investment firms, asset managers, and pension funds, but also with regard to insurance companies and FMI operators is, as such, undeniable, which indicates that, despite residual differences between the sectors, some common ground still exists. Moreover, the case for simplification of the regulatory frameworks, which has been cited as a potential rationale for enhancing cross-​sectoral consolidation above, is, as such, entirely unaffected by the findings just summarized. Specifically, surely not all differences in form and substance of the corresponding requirements across different sectoral

97 See, to that effect, Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, n 1, para 11.03. 98 See BCBS, n 13, para 2:  ‘The primary objective of corporate governance should be safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis. Among stakeholders, particularly with respect to retail banks, shareholders’ interest would be secondary to depositors’ interest.’ 99 See, reaching a similar conclusion, Ferrarini, n 25, 81. And cf, discussing possible strategies for enhancing stakeholder orientation, also Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, n 1. See also, discussing the implications for bank boards’ decisions against incoming demands by supervisory authorities under German banking regulation and company law, Jens-​Hinrich Binder, ‘Vorstandshandeln zwischen öffentlichem und Verbandsinteresse’, ZGR Zeitschrift für Unternehmens-​und Gesellschaftsrecht (2013), 760.

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Jens-Hinrich Binder regimes can be explained, and justified, by residual differences in terms of corporate structures, business models, risk profiles, etc. Procedural requirements in particular, such as general principles on board information, documentation obligations, and fundamental board obligations, seem particularly well-​suited for cross-​sectoral consolidation, and partly have been treated as such in existing regulation. As indicated above, however, the rationale, prospects, and limits to a differentiated consolidation of existing regulations can hardly be analysed without cross-​sectoral analyses of governance-​related problems, which also has to include empirical research into the parallels and differences between the various types of financial intermediaries. Effectively, the cross-​sectoral comparison carried out above thus culminates into a reframed research agenda, and calls for micro-​comparisons between the different approaches taken in existing sectoral regulation.

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3 COMPARATIVE REGULATION OF CORPORATE GOVERNANCE IN THE INSURANCE SECTOR Arthur van den Hurk and Michele Siri*

I. Introduction II. Governance-​Related Regulation in EU Insurance Legislation A. Relevant legal sources B. Board-​related requirements C. Balancing policyholder protection and other goals in insurance supervision D. Fitness and propriety E.  Key functions F.   Outsourcing G. Remuneration policies

III. Risk Management A. Introduction B. Risk-​management system

3.01

C. Strategies, policies, and reporting procedures D. Risk-​management function

3.08 3.08 3.15

IV. The Actuarial Function V. The ORSA Process VI. Internal Control System VII. Governance Regulation Supporting Quantitative Requirements

3.23 3.26 3.29 3.32 3.38 3.41 3.41 3.46

A. Introduction B. The ‘prudent person principle’ C. Own fund requirements and the system of governance

VIII. Conclusions

3.50 3.53 3.54 3.55 3.58

3.61 3.61 3.62 3.67 3.70

I. Introduction Insurers fulfil an essential role in the economy as managers of insurable risk over 3.01 potentially long periods of time. Performance may only take place when an insured event occurs. Alternatively, policyholders may not have a right to immediate or early redemption of the policy, in case premiums have been invested on their * The authors thank participants at workshop presentations held in Amsterdam organized by the Radboud University of Nijmegen in January 2018 for their valuable comments on the preliminary version of this chapter. Particular thanks go to Klaus Hopt, Mariken van Loopik, and Lodewijk van Setten, as well as to John Greenwall for his review of the final version of this chapter. The views and opinions expressed are in the personal capacity of the authors.

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Arthur van den Hurk and Michele Siri behalf. Thus, insurers are expected to have sound governance practices to support this specific role and position.1 3.02

This role requires a corporate culture and environment of shared values and respect of sound ethical principles.2 Overall, this is a system which is composed of corporate structures (board of directors, senior management, key functions) and related governing policies (by-​laws, organizational rules, committee and key functions mandates). In addition, corporate governance of insurers is closely related to the decision-​making processes and actions linked to the firm’s corporate environment and framework of structures, policies, and controls.

3.03

As financial institutions accepting private savings in return for future payments, insurers are faced with the moral hazard of acting in short-​term profitable transactions that may jeopardize their ability to meet their long-​term obligations. Accordingly, expectations with regard to governance practices of insurers in general exceed those of most other corporations.3

3.04

These expectations are reinforced by the prudential regulatory framework under which insurers operate. This emphasizes insurers’ responsibility for managing and controlling their risks and establishing appropriate policies and practices. Prudential regulation and supervision may intervene at the various levels (licensing, fit and proper management, solvency and insurer investments, policyholder protection funds, resolution regimes).

3.05

Corporate governance requirements define roles, responsibilities, and accountability.4 They define the duties and the legitimate powers to run the business and under which conditions. Corporate governance sets requirements for taking decisions and actions, in line with the business purposes and rationale of the undertaking, and for disclosure to the supervisor and other stakeholders. It should also provide for corrective action in case of non-​compliance or failure. Moreover, corporate governance requires an organizational structure with an appropriate segregation of duties. There should be a trade-​off between an efficient decision-​making process (because an insurer has to be responsive to make timely decisions), and appropriate systems, controls, and limits to ensure that business operations are driven by the best interest of policyholders and the insurer as a whole.5

1 Organisation for Economic Co-​operation and Development (OECD), ‘Guidelines on Insurer Governance 2017 Edition’, 40. 2 C Hodges, Law and Corporate Behaviour. Integrating Theories of Regulation, Enforcement, Compliance and Ethics, Hart, 2015, Ch 20. 3 OECD, ‘G20/​OECD Principles of Corporate Governance’, 2015. 4 OECD, n 2, 40. 5 International Association of Insurance Supervisors (IAIS), ‘Issues Paper on Corporate Governance’, July 2009, 11.

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Corporate Governance in the Insurance Sector In the aftermath of the crisis, as was also the case for other types of financial 3.06 institutions—​in particular banks, regulators, supervisors, investors, shareholders, and policyholders alike—​the effectiveness of the existing corporate governance system in overseeing insurance companies, and, in some cases, their excessive risk-​taking, was questioned.6 Corporate governance mechanisms can affect executives’ risk-​taking preferences—​and, as such, firm risk—​which is relevant to owners and policyholders. The regulatory importance of this analysis becomes obvious in light of Solvency II, which provides for the redefinition of capital adequacy, risk management, and disclosure requirements for insurance companies in the European Union. In the Solvency II framework, capital adequacy, risk management, and disclosure requirements are all areas that have been closely linked to corporate governance.7 Having this as a general framework, there should be adequate recognition of the 3.07 nature, scale, and complexity of the business of insurers and of the risks to which they are exposed (life, non-​life, retail, business, reinsurance, etc), as insurers have very different risk profiles, diversification, size, and business models.8 Thus, EU prudential regulation, with its sets of high-​level corporate governance principles, has to deal with the specificities of the insurance sector and needs to have sufficient flexibility to take into account the characteristics of each type of insurance activity and various forms of corporate structure (mainly stock companies, but also mutual and co-​operative). There are also expectations to shape corporate governance frameworks of financial institutions in a comparable and similar way for all types of financial institutions, often using banking regulation as the underlying template.9 Thus, the governance framework for insurers should be well-​defined and is becoming even more comparable to the framework for other financial institutions.10

6 N Boubakri, ‘Corporate Governance and Issues from the Insurance Industry’, The Journal of Risk and Insurance (2011), 78, 3, 501. See also M Eling and S D Marek, ‘Corporate Governance and Risk Taking: Evidence From the U.K. and German Insurance Markets’, Journal of Risk and Insurance (2013), 81, 3, 653–​82. 7 M Siri, ‘Corporate Governance of Insurance Firms After Solvency II’, in P Marano and M Siri (eds), Insurance Regulation in the European Union, Springer, 2017, Ch 7, 132ff. See also O Ricci, Corporate Governance in the European Insurance Industry, Palgrave, 2014. 8 OECD, n 2, 42. 9 See for a critical analysis of this topic:  Jens-​Hinrich Binder, Chapter  2, this volume; and Klaus J Hopt, ‘Corporate Governance von Finanzinstituten. Empirische Befunde, Theorie und Fragen in den Rechts-​und Wirtschaftswissenschaften’ ZGR Zeitschrift für Unternehmens-​und Gesellschaftsrecht (2017) 46(4), 438–​9. 10 Financial Stability Board (FSB), ‘Thematic Review on Corporate Governance Peer Review Report 2017’; ESA 3L3 Task Force On Internal Governance, ‘Cross-​sectoral stock-​take and analysis of internal governance requirements’, 2009, available at https://​www.eba.europa.eu, accessed 30 September 2018. For the last developments in the banking and securities sectors see: European Banking Authority (EBA), ‘Guidelines on Internal Governance’, 2017, available at https://​ www.eba.europa.eu, accessed 30 September 2018; The European Securities and Markets Authority (ESMA)/​EBA, ‘Joint ESMA and EBA Guidelines on the assessment of the suitability of members of the management body and key function holders under Directive 2013/​36/​EU and Directive 2014/​

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II.  Governance-​Related Regulation in EU Insurance Legislation A. Relevant legal sources 3.08

Governance structures for insurers differ amongst European jurisdictions. Boards may be structured in various ways depending on, among other things, jurisdictional corporate law. 11 Despite the differences, two distinctive functions commonly need to be performed: (i) setting the overall strategy and (ii) oversight, execution, and management. These functions can either be entrusted to a single body or spread over separate bodies. In many jurisdictions, the corporate body responsible for oversight and overall strategy and policy is the board of directors. The board relies on the senior management which is responsible for executing decisions made by the board and for managing the insurer on a day-​to-​day basis.

3.09

In some European jurisdictions, an insurer’s board includes executive directors, who are managers and employees of the insurer, and external directors, who are independent or disinterested board members. Outside directors are often part of the governance requirements prompted by Member States’ insurance legislation to promote the independence of the board’s decision making.

3.10

One-​tier boards typically have overall responsibility for the insurer but are allowed, by law, to delegate management of the insurer to a CEO. In other European Member States, insurers are required by general company law or other regulation to spread the board function over two formal bodies usually called a supervisory board and a management board. In a two-​tier system, the supervisory board is responsible for oversight on the overall course of business and strategy of the company while strategy setting, execution, and management are carried out by a management board whose chairman is sometimes named as CEO. The supervisory board may have, in some cases, additional tasks, including the approval of important strategic and corporate decisions.

3.11

Because of the coexistence of the two approaches, the European insurance sector requirements are based on a functional perspective to be applied consistently across Europe.12 The Directive13 comprises a considerably high level of detail concerning

65/​EU’, 2017, available at https://​www.esma.europa.eu/​, accessed 30 September 2018. Both sets of guidelines entered into force on 30 June 2018. 11 IAIS, ‘Draft Application Paper on the Composition and the Role of the Board’ 29 June 2018, available at https://​www.iaisweb.org/​page/​consultations/​current-​consultations/​application-​ paper-​on-​the-​composition-​and-​the-​role-​of-​the-​board//​file/​75305/​draft-​application-​paper-​on-​the-​ composition-​and-​the-​role-​of-​the-​board, accessed 30 September 2018. 12 Siri, n 7, 133ff. 13 Directive 2009/​138/​EC of the European Parliament and of the Council on the taking-​up and pursuit of the business of Insurance and Reinsurance (Solvency II), [2009] OJ L335.

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Corporate Governance in the Insurance Sector principles and requirements of the system of governance, especially compared to the Level I and/​or Level II texts (implementing measures) of other EU directives on financial services. The Solvency II Directive covers the most important issues to be regulated to ensure appropriate governance standards within insurance and reinsurance undertakings. Therefore, the scope of essential and extensive measures on Level II14—​with some specific exceptions, such as the Level II rules on outsourcing, remuneration, risk management, and valuation—​has been limited.15 Moreover, Article 50 of the Directive stipulates the minimum contents of the Level II implementing measures. These are the reasons why the provisions of the 2nd Pillar concerning the corporate governance of insurance undertakings also include the European Insurance and Occupational Pensions Authority (EIOPA) Guidelines supplementing the Solvency II requirements, as provided by the Directive and the Implementing Measures, to foster supervisory convergence across the EU Member States. With regards to the overall system of governance for insurance and reinsurance 3.12 undertakings, Section 2 of Chapter IV of the Directive focuses on the regulation of the following main issues: general governance requirements, fit and proper requirements, risk management, internal control, outsourcing, and the prudent person principle. The ‘general governance requirements’ (Art 41) aim at the implementation of an effective and proportionate system of governance, which provides for sound and prudent management of the business and sets out the implementation of written policies concerning the primary functions of the undertaking (i.e. risk management, internal audit, internal control, outsourcing), including the development of contingency plans. The ‘fit and proper requirements for persons who effectively run the undertaking 3.13 or have other key functions’ (Arts 42–​43) aim to ensure that all the persons that effectively manage the undertaking or perform key functions within the undertaking are fit and proper, meaning that they comply with both professional and reputational standards. The ‘risk management’ requirements (Art 44) aim to set standards for the implementation of an effective risk-​management system within the undertaking, comprising strategies, processes, and reporting procedures

14 Specifically Commission Delegated Regulation (EU) 2015/​35 of October 2014, supplementing Directive 2009/​138/​EC of the European Parliament and of the Council on the taking-​up and pursuit of the business of Insurance and Reinsurance (Solvency II) [2015] OJ L12. 15 Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), ‘Advice for Level 2 Implementing Measures on Solvency II: System of Governance’ (former Consultation Paper 33), October 2009, 3, available at https://​eiopa.europa.eu/​CEIOPS-​Archive/​, accessed 30 September 2018. The Advice, at para 1.3, remarks that ‘the Level I text already comprises a considerably high level of detail concerning principles and requirements on the system of governance, especially compared to the Level I text and/​or Level II implementing measures in other EU directives on financial services’.

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Arthur van den Hurk and Michele Siri necessary to identify and manage the main risks to which the undertaking is exposed, at both an individual and group level, including the ‘own risk and solvency assessment’ activity (Art 45). ‘Internal control’, ‘internal audit’, and ‘actuarial function’ (Arts 46–​48) aim to implement an adequate internal control system, internal audit function, and actuarial function with the undertaking. 3.14

These governance requirements are addressed and, in some cases, further developed in the Implementing Measures and the EIOPA Guidelines on the System of Governance. It is worth remembering that both the Solvency II Directive and the EIOPA Guidelines are addressed to the competent national authorities that should implement—​at the national level—​suitable measures within the specified time framework to ensure compliance with the provisions of the Solvency II Directive and the EIOPA Guidelines.16 B. Board-​related requirements

3.15

In cases of failures or near-​failures of insurers, weak governance and ineffective internal controls and risk management are often associated with the problems that arose.17 A board is responsible, more than ever, for understanding and supervising the insurer’s strategy and risk appetite. For a variety of reasons, some boards may be not well informed, or do not realize, or did not have the appropriate understanding of the financial condition and risks faced by the insurer.18 In other cases, preference could have been given to short-​term profits rather than to policyholders’ and beneficiaries’ interests. Boards often know much less about an insurer’s financial condition than management. Consequently, due consideration must be paid to the requirements of individual directors, their knowledge of the business, their continuing education needs/​requirements, the development of ethical and honest conduct and decision making, and their awareness of their personal responsibility and fairness.19

16 EIOPA, ‘Guidelines on System of Governance’, 28 January 2015, EIOPA-​BoS-​14/​253, available at https://​eiopa.europa.eu/​, accessed 30 September. The ‘General Governance requirements’ are detailed in Section 1 (Guidelines 1–​8); ‘Remuneration’ in Section 2 (Guideline 9–​10); ‘the Fit and Proper’ in Section 3 (Guidelines 11 –​16); the ‘Risk Management’ in Section 4 (Guidelines 17–​26); and the ‘Prudent Person Principle’ in Section 5 (Guidelines 27–​35). 17 Siri, n 7, 141ff. See also IAIS, n 11. 18 W McDonnell, ‘Managing Risk:  Practical lessons from recent “failures” of EU insurers’, Occasional Paper Series, FSA, December 2002, 15–​16, http://​www.fsa.gov.uk/​pubs/​occpapers/​ op20.pdf, accessed 30 September 2018. 19 De Nederlandsche Bank, ‘Supervision of Behaviour and Culture:  Foundations, practice & future developments’, 117, available at https://​www.dnb.nl/​binaries/​Supervision%20of%20 Behaviour%20and%20Culture_​tcm46-​334417.pdf , accessed 30 September 2018.. See also FSB, ‘Strengthening Governance Frameworks to Mitigate Misconduct Risk:  A Toolkit for Firms and Supervisors’, 20 April 2018, available at http://​www.fsb.org/​wp-​content/​uploads/​P200418.pdf, 22, accessed 30 September 2018.

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Corporate Governance in the Insurance Sector Following best practices at international level, the Solvency II Directive requires 3.16 all insurance and reinsurance undertakings to have in place an effective system of governance which provides for a sound and prudent management of the business.20 That system shall at least include an adequate transparent organizational structure with a clear allocation and appropriate segregation of responsibilities, as well as an effective system for ensuring the transmission of information.21 In line with corporate governance best practices, the EIOPA Guidelines put par- 3.17 ticular emphasis on the company’s organization by referring, as usual, to four main areas:  an effective system of governance (comprising risk), the internal control system, the organizational and operational structure, and the decision-​making process. Like the existing governance requirements for credit institutions and investment firms set out in the regimes laid down in the Capital Requirements Directive and the Markets in Financial Instruments Directive, under Solvency II the administrative, management, or supervisory body is at the centre of the governance system. The nature and structure of the administrative, management, or supervisory body 3.18 varies with the national company law applicable in the jurisdiction in which the insurance undertaking is incorporated. The term ‘administrative, management or supervisory body’ (hereafter, the AMSB) covers the single board in a one-​tier system and the management or the supervisory board of a two-​tier board system. According to the Directive, the responsibilities and duties of the different bodies should be seen having regard to different national laws. When transposing the Level I text, each Member State has to consider its own system and attribute each responsibility and duty to the appropriate board. The primary governance requirements focus on the duty of the AMSB to be in- 3.19 formed.22 Committees (if established), senior management and key functions are the interlocutors with whom the board has to interact, ‘proactively requesting information from them and challenging that information, when necessary’. It seems impossible to miss that the provision requires directors to behave proactively. This means that the AMSB has to carry out a rather strict duty of monitoring. Indeed, directors not only have to check the information provided but should also independently collect relevant information. This solution could affect the general 20 P Manes, ‘Corporate Governance, the Approach to Risk and the Insurance Industry under Solvency II’, in M Andenas et al (eds), Solvency II: A Dynamic Challenge for the Insurance Market, Il Mulino, 2017, Ch IV, 115ff. 21 See Article 258 of Solvency II Regulation. 22 CEIOPS, n 15, 10, para 3.4. Therefore, each undertaking’s administrative, management, or supervisory body should consider whether the structure of a committee is appropriate (e.g. forming audit, risk, investment, or remuneration committees) and, if so, what its mandate and reporting lines should be. See also K Van Hulle, ‘The challenge of Solvency II: Lecture to the faculty of actuaries’, British Actuarial Journal (2008), 14, 1, 27.

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Arthur van den Hurk and Michele Siri principle that directors can rely on officers’ information. In this case, the liability of non-​executive directors would increase dramatically. Furthermore, it is necessary to highlight that the Solvency II Directive does not make any explicit reference to a proactive behaviour, but it instead refers to, among other things, an effective system of governance and requires the implementation of appropriate segregation of responsibilities. It is questionable whether a too broad monitoring duty is compatible with effectiveness, and whether it allows the separation of executive and non-​executive  tasks. 3.20

As to the organizational and operational structure,23 a close link exists between organisation and effective operation, provided that they support each other. Both are necessary to ensure a proper flow of information among the undertaking’s different levels of hierarchy. In this regard, the organizational structure determines the tasks and assignments, while the operational structure settles the way of performing the tasks. In any case, it is ultimately the AMSB that has the responsibility for execution and it is not bound by recommendations included in the findings of the key functions. Although EIOPA in the explanatory text to Guideline 5 clearly states that the AMSB is apparently not entitled to suppress or tone down the results of the key functions,24 it is not fully clear how the AMSB can reach different conclusions without pressing the several functions to get new data capable of supporting its position.

3.21

Lastly, the organizational and operational structure is based on a cost benefit approach. This represents a fundamental change to the earlier generations of EU insurance directives, that were based on the ‘one size fits all’ principle. This new approach, on the one hand, introduces more flexibility in the corporate governance system of each undertaking and, on the other hand, increases the responsibility of the board, if compared to the previous regulatory framework. Undertakings have to review their system of governance periodically (as well as in the case of particularly significant events), under the ultimate responsibility of the AMSB.25

3.22

EIOPA does not require a mandatory organizational structure of separate units focusing on risk management, compliance, internal audit, and actuarial function.26 23 EIOPA, n 16, Guideline 2. 24 EIOPA, ‘Final Report on Public Consultation No. 14/​017 on Guidelines on the system of governance’, part 2, n 2.17: ‘The AMSB does not exert influence to suppress or tone down key function results so that there is no discrepancy between the findings of key functions and the AMSB’s actions’, available at https://​eiopa.europa.eu/​, accessed 30 September 2018. 25 EIOPA, n 16, Guideline 6. 26 According to the para. 3.11 of the CEIOPS Advice ‘The undertaking should ensure that each key function has an appropriate standing concerning organisational structure. Considering the principle of proportionality, CEIOPS believes that in large undertakings and undertakings with more complex risk profiles the key functions should generally be performed by separate units’ (CEIOPS, n 15, 12, para 3.10). An adequate interaction between the key functions has to be fostered and adequately defined by each undertaking, including the establishment of communication and reporting

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Corporate Governance in the Insurance Sector The undertaking is still permitted to combine each function based on its own specifics. However, the Solvency II regime provides a mandatory model for the written policies required by Article 41, relating to the risk management, internal control, internal audit, and, where relevant, outsourcing, and for any further policy the undertaking decides to implement.27 C. Balancing policyholder protection and other goals in insurance supervision The primary goal of Solvency II is the protection of policyholders and benefi- 3.23 ciaries.28 However, other goals should be taken into account by the insurer as well, including financial stability and fair and stable markets as long as this is not to the detriment of the primary goal of Solvency II. Besides, supervisory authorities may also take into account in their supervisory task the impact of voluntarily adopted codes of conduct and transparency codes when insurers invest in non-​regulated or alternative investment categories. The alignment between the primary goal, protection of policyholders and beneficiaries, and expectations of another nature may present additional challenges from a governance perspective. As can be observed in initiatives such as the European Capital Markets Union, as well as the European Action Plan on Sustainable Finance, there is an expectation for insurers to contribute to the goals, pursued through these initiatives, in particular through their investment behaviour.29 In these EU initiatives, certain types of investments (e.g. infrastructure, sustainable 3.24 investments) receive a specific focus within the more generic investment categories such as equities, bonds, etc.)30 These investments might benefit from a more favourable capital treatment than other types of investments in these categories. These investments are not per se less risky than other investments in the same investment category, and such investments might not necessarily be prudent from a policyholder protection perspective. Therefore, additional safeguards will be built in to justify such preferential treatment. Such measures may include qualitative requirements concerning these investments, as well as additional governance requirements procedures. In this context, all key functions should have access rights to the relevant systems and staff members, including any records, necessary to allow them to carry out their responsibilities. 27 EIOPA, n 16, Guideline 9. 28 Recital 16 of Solvency II Directive. See also Siri, n 7, 132ff. 29 See, for instance, D Focarelli, ‘Why insurance regulation is crucial for long-​term investment and economic growth’, in Marano and Siri (eds), n 7. 30 See, for instance, B Joosen and AJAD van den Hurk, ‘Prudentiële eisen voor banken en verzekeraars’, in J Barnard, D Busch, and L Silverentand (ed), Lustrumbundel 2017, Vereniging voor Financieel Recht, Een Kapitaalmarktunie voor Europa, Wolters Kluwer, Deventer, 2017; AJAD van den Hurk, ‘Het actieplan voor duurzame financiering van de Europese Commissie, mogelijkheden binnen de kaders van het prudentieel toezicht voor verzekeraars’, Tijdschrift voor Financieel Recht (2018), 5.

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Arthur van den Hurk and Michele Siri specifically aimed at these specific assets. As an example, the possibility for insurers to invest in infrastructure investments31 with a lower capital charge than other investments in the same investment categories is confined to certain types of qualifying infrastructure investments and imposes on the insurer more prescriptive due diligence requirements, checks on (potential) conflicts of interests, modelling, stress-​testing, etc. Similar mechanisms can be observed for other investment categories (such as securitizations, mortgage loans) and it can be expected that, for instance, in the context of sustainable finance, this approach might be taken as well. It should be noted that some or many of these investments might be harder to assess than other investments, for instance, because the investments are not admitted to trading on regulated markets, which might pose additional challenges concerning valuation. This requires additional safeguards concerning such assets.32 3.25

An additional safeguard for the appropriate assessment of the risks is, of course, the own risk and solvency assessment (ORSA) process, which is discussed in more detail in Section V of this chapter. As part of this process, the AMSB should challenge the assumptions behind the calculation of the solvency capital requirements to ensure these are appropriate given the assessment of the undertaking’s risks. This provides an additional safeguard that, where such goals are pursued by the insurer, in addition to policyholders’ interests, this does not go against the primary goal of policyholder protection. D. Fitness and propriety

3.26

Fitness and propriety, as part of the governance of financial institutions, are covered in detail elsewhere in this book.33 However, some short, specific remarks on fitness in the context of insurers’ governance can be made. As is clear from this chapter, the responsibility of members of the AMSB and persons responsible for other key functions, in particular concerning risk management, is very substantial. Risk management is of course (close to) the essence of insurance.

3.27

The fitness requirements concerning insurers reflect this notion by dedicating specific attention to the qualifications of members of the AMSB in this area. These requirements include a significant level of insurance-​sector specific knowledge and expertise.34 Members of the AMSB should collectively possess appropriate qualifications, experience, and knowledge about at least:  (i) insurance and financial

31 One of the initiatives that form part of the European Capital Markets Union Action Plan. 32 EIOPA, n 16, Guideline 33. 33 See Iris Palm-​Steyerberg and Danny Busch, Chapter 7, this volume, and Jens-​Hinrich Binder, Chapter 2, this volume, Section II.B.1 in particular. 34 The authors agree in this respect with Binder, who notes that ‘fitness’ should not be misinterpreted as reflecting a genuinely cross-​sectoral standard: Jens-​Hinrich Binder, Chapter 2, this volume, Section II.B.1.

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Corporate Governance in the Insurance Sector markets; (ii) business strategy and business models; (iii) systems of governance; (iv) financial and actuarial analysis; and (v) regulatory framework and requirements. ‘Insurance and financial markets knowledge’, in this context, means awareness and 3.28 understanding of the wider business, economic, and market environment in which the insurer operates and awareness of the level of knowledge and needs of policyholders. ‘System of governance knowledge’ means the awareness and understanding of the risks the insurer is facing and its capability to manage them. Furthermore, it includes the ability to assess the effectiveness of the insurers’ arrangements to deliver effective governance, oversight, and controls in the business and, if necessary, oversee changes in these areas. ‘Financial and actuarial analysis knowledge’ means the ability to interpret the insurer’s financial and actuarial information, identify key issues, put in place appropriate controls, and take measures based on the information.35 E. Key functions Earlier in this chapter, reference has been made to ‘key functions’. Apparently, 3.29 this is a more generally used concept in financial services legislation. In contrast to the current Capital Requirements Directive (CRD IV) and the current Markets in Financial Instruments Directive (MiFID II),36 Solvency II is explicit as to which functions, apart from the AMSB, should at least be considered key functions.37 The risk-​management function and the actuarial function have already been discussed. Apart from these functions, Solvency II also distinguishes the compliance function 3.30 and the internal audit function. Many, if not most, insurers have identified in their organization these four functions as the key functions, although the Solvency II Directive does not exclude the possibility of identifying more than only these four key functions. Identification of these functions is relevant for a number of reasons:  (i) persons 3.31 responsible for key functions are subject to fitness and propriety requirements; (ii) supervisory authorities should be informed of changes in respect of the persons responsible for key functions; (iii) outsourcing of key functions is subject to more stringent requirements than outsourcing of other activities or functions; and (iv) key functions are subject to specific independence requirements.

35 EIOPA, n 16, Guideline 11, explanatory text, 54–​5. 36 See also Iris Palm-Steyerberg and Danny Busch, Chapter 8, this volume, Section II. 37 In November 2018, EIOPA published a peer review report on supervisory practices and application in assessing key functions. This report provides an interesting overview of the current state of affairs with respect to the application of Solvency II key function requirements in EU member states. https://eiopa.europa.eu/Publications/Reports/Peer%20review%20Key%20Functions22-11-18.pdf

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Arthur van den Hurk and Michele Siri F. Outsourcing 3.32

The importance of outsourcing for insurers is reflected in the attention that Solvency II dedicates to this topic.38 Recently, EIOPA has reconfirmed the importance of the supervisory convergence of Solvency II requirements, including governance, risk management, and outsourcing requirements in the context of the UK’s decision to withdraw from the European Union.39 40 As a general principle, insurers are entirely responsible for discharging all of their obligations when they outsource functions or insurance or reinsurance activities, irrespective of whether the activity or function has been outsourced. Solvency II does not formally limit the activities or functions that can be outsourced by the insurer, but does provide that, when outsourcing critical or important operational functions or activities, these shall not be outsourced in such a way as to lead to either: (i) materially impairing the quality of the system of governance of the undertaking concerned; (ii) unduly increasing operational risk; (iii) impairing the ability of the supervisory authorities to monitor the compliance of the undertaking with its obligations; or (iv) undermining continuous and satisfactory service to policyholders.

3.33

In the context of outsourcing, Solvency II distinguishes between outsourcing of critical and important operational functions or activities and outsourcing of other activities. This distinction is relevant for many reasons. As referred to above, in certain circumstances, outsourcing of important operational functions or activities may not take place. Furthermore, supervisory authorities should be informed timely in advance of the outsourcing of important operational functions or activities and of subsequent material developments concerning these activities or functions.

3.34

When an insurer proposes to outsource functions or insurance or reinsurance activities, it should establish a written outsourcing policy and enter into a written agreement with the service provider that complies with many detailed requirements, set out in Article 274 of the Solvency II Delegated Regulation.41 38 In particular Articles 49 and 38 of Solvency II Directive and Article 274 of Solvency II Delegated Regulation, as well as EIOPA, n 16, Guidelines 60–​64. 39 EIOPA, 11 July 2017,’Opinion on supervisory convergence in light of the United Kingdom withdrawing from the European Union’, EIOPA-​BoS-​17/​141. 40 More generally on the impact of Brexit on insurance regulation in the UK, see J Burling, ‘The Potential Effect of Brexit on Insurance Regulation in the UK’, in Marano and Siri (eds), n 7. 41 On 22 June 2018, EBA published a consultation paper on guidelines for outsourcing, which is intended to replace the 2006 outsourcing guidelines, developed by CEBS, aimed at harmonizing the approach to all outsourcing arrangements in the scope of EBA’s action (EBA/​CP/​2018, 11). While respecting sectoral differences, one could raise the question why these guidelines have been developed by the different European Supervisory Authorities separately and if coordination, for instance through the European Supervisory Authorities (ESA)’s Joint Committee, would not lead to more cross-​sectoral consistency. Also on topics that seem less ‘sector-​specific’, the EBA Guidelines differ from the EIOPA Guidelines (e.g. on the content of an outsourcing policy and the maintenance of a register of outsourcing arrangements).

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5

Corporate Governance in the Insurance Sector The insurer should determine and document itself whether a function or activity 3.35 is critical or important. The basis for that determination is whether the function or activity is essential to the operation of the undertaking as it would be unable to deliver its services to policyholders without the function or activity.42 Not all activities performed by a service provider fall within the scope of the outsourcing requirements. In particular, occasional or one-​off provision of services to the insurer is less likely to constitute outsourcing but it might become outsourcing if the reliance on that service provider for a specific function or activity becomes more structural. While EIOPA acknowledges that it is not possible to determine a bright line of what should and need not be considered outsourcing, it does provide some guidance, as well as on which activities or functions should be considered critical or important.43 It is important to note that the outsourcing requirements apply to both external 3.36 outsourcing and outsourcing arrangements within the group. Individually for intra-​group arrangements, the insurer should consider its ability to control and influence the activities of the service provider.44 Also, at the level of the group, it should be documented which activities relate to which legal entity, to ensure continuity of the services to the individual entities in the group.45 It is clear that the AMSB is ultimately responsible for the outsourced activities 3.37 or functions. This responsibility is reflected in many specific requirements for the AMSB.46 Those responsibilities include the obligation to perform a proper due diligence on the service provider on the ability, capacity, and authorizations needed to deliver the required functions or activities, management of potential conflicts of interest, the obligation to gain a proper understanding of the terms and conditions of the outsourcing arrangement, as well as data privacy and confidentiality arrangements. Furthermore, an essential element of the requirements is that both the service provider’s risk management and internal control system are adequate to comply with Solvency II requirements.47 Moreover, the activities are also taken into account in the risk management and internal control systems of the insurer itself.48

42 EIOPA, n 16, Guideline 60. 43 ibid, explanatory text, 99–​100. 44 Article 274(2) of Solvency II Delegated Regulation. 45 EIOPA, n 16, Guideline 62. 46 Article 274(3) of Solvency II Delegated Regulation. 47 Article 274(5) (a) of Solvency II Delegated Regulation, which refers to Article 49(2)(a) and (b) of Solvency II Directive specifically. 48 Article 274(5)(b) of Solvency II Delegated Regulation.

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Arthur van den Hurk and Michele Siri G. Remuneration policies 3.38

Remuneration policies have become a core element of post-​crisis financial reforms, including in the insurance sector. While the Solvency II Directive itself, dating back to 2009, is silent on remuneration policies, the Solvency II Delegated Regulation, dating from 2015, has an elaborate provision on remuneration policies,49 largely developed along similar lines as the CRD requirements in this respect, and complemented by EIOPA guidelines on remuneration polices and remuneration committees.50

3.39

Specific requirements are set for remuneration of key function holders and other staff working in key functions. In some jurisdictions (e.g. the Netherlands), in the immediate regulatory response to the financial crisis, while the Solvency II framework was not yet in force, local remuneration rules, based on CRD requirements, were applied in a cross-​sectoral manner to insurance companies too, also incorporating guidelines, promulgated by EBA’s predecessor, CEBS,51 as the appropriate guidance for the interpretation of local requirements.

3.40

In addition, deviations from minimum CRD requirements (in particular, a more stringent bonus cap of 20 per cent) were also imposed on insurance companies. Recently, a more sectoral approach is again being followed for insurance companies, under the influence of the entry into force of Solvency II and the development of new EBA guidelines. While the bonus cap continues to be in place for insurance companies in the Netherlands, the local remuneration framework there now relies on the directly applicable Solvency II Delegated Regulation with sector-​specific guidelines (despite being developed along CRD-​lines) and any guidance under the Solvency II framework, instead of CEBS or EBA guidelines.

III.  Risk Management A. Introduction 3.41

The core business and reason for the existence of insurance companies is the assumption, pooling, and spreading of risk,52 in order to mitigate the risk of adverse financial consequences to individuals and businesses that are policyholders or beneficiaries of insurance policies.53 A  thorough understanding of risk types,

49 Article 275 of Solvency II Delegated Regulation. 50 EIOPA, n 16, Guidelines 9 and 10. 51 Committee of European Banking Supervisors. 52 IAIS, ‘Insurance Core Principles’, para 16.0.4. 53 See, for instance, on the role and specificity of insurance: C Thimann, ‘What is Insurance and how Does it Differ from General Finance?’, in F Hufeld, R S Koijen, and C Thimann (ed), The Economics, Regulation and Systemic Risk of Insurance Markets, Oxford University Press, 2017, ch 1.

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Corporate Governance in the Insurance Sector characteristics and interdependencies, sources of risks, and the potential impact on the business is key for insurers. Therefore, the risk management system, as well as capital management, plays a key role within insurance companies and in insurance groups54 (hereinafter, together referred to as ‘insurers’), and due to the nature of the insurance business, a very specific role. Both risk management and capital management aim to protect both policyholders and capital providers from adverse events. Consequently, the risk management system also plays a pivotal role in the system of governance of insurers and is closely linked to capital management. The crucial role of risk management can be observed in the Insurance Core 3.42 Principles (ICPs), developed by the International Association of Insurance Supervisors (IAIS). The ICPs provide a global framework for insurance supervision and dedicate various statements55 specifically to risk management, risk governance, internal controls, and enterprise risk management for solvency purposes.56 57 As Binder rightly observes in Chapter 2 of this volume,58 risk-​management requirements have become commonplace in European financial regulation generally, and have also been enacted concerning insurance companies. In Europe, the Solvency II framework provides a regulatory framework for in- 3.43 surance supervision that is generally considered to be consistent with the ICPs. Although the Solvency II project originates from well before the financial crisis, the influence of post-​financial crisis regulation can be observed. The Solvency II requirements and EIOPA guidelines, including in areas such as risk management, internal controls, outsourcing, and remuneration are detailed and prescriptive, which provides the insurer with a very significant and detailed basis of requirements for its internal organization and system of governance already. In terms of complexity, the detailed requirements promulgated under the Solvency II framework, compete

54 The Solvency II provisions relating to the system of governance apply mutatis mutandis at the level of the group: Article 246(1) of Solvency II Directive. 55 The ICPs follow a specific hierarchical structure, whereby ‘statements’ rank highest, and prescribe essential elements that must be present in a supervisory system. Subsequently, ‘Standards’ set out key high-​level requirements that are fundamental to the implementation of the ICP and ‘Guidance’ provides detail on how to implement an ICP statement or standard (IAIS ‘Insurance Core Principles’, update November 2015, para 6, available at https://​www.iaisweb.org, accessed 30 September 2018. 56 The most important ICPs in this context are ICP 7 (Corporate Governance); ICP 8 (Risk Management and Internal Controls); and ICP 16 (Enterprise Risk Management for Solvency Purposes). Other ICPs obviously rely as well on and further specify governance requirements, such as ICP 14 (Valuation); ICP 15 (Investments); and ICP 17 (Capital Adequacy). 57 On the development of the Insurance Core Principles and on the development of insurance regulation in the United States and the European Union, see, for instance, E F Brown, R W Klein, ‘Insurance Solvency Regulation: A New World Order?’, in D Schwarcz and P Siegelman (eds), Research Handbook on the Economics of Insurance Law, Elgar, 2015, Ch 8. 58 Jens-​Hinrich Binder, Chapter 2, this volume, Section II.D.

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Arthur van den Hurk and Michele Siri with the CRD IV and MiFID II frameworks, albeit targeted to a large extent to the particularities of insurance companies’ business models.59 3.44

Solvency II approaches risk in accordance with the so-​called economic total balance sheet approach.60 Unlike the previous regulatory EU framework for insurers, not only the insurance risks are taken into account for the calculation of capital requirements, all risks of insurers are taken into account. A holistic approach is taken in the supervision of insurers, whereby the different pillars of the Solvency II framework influence each other and both sides of the balance sheet may have an impact on the capital requirements: Investment in riskier assets by an insurance company may result in higher capital requirements and/​or more stringent governance requirements. Weaker governance may lead to capital add-​ons.61 (Risk) governance requirements for the management of assets that back technical provisions are more stringent than governance requirements for assets held to cover the minimum capital requirement and these requirements are, again, more stringent than the requirements that are held to cover the (higher) solvency capital requirement.

3.45

For insurers, subject to Solvency II, the Solvency II Directive distinguishes various elements within the risk-​management system and in the system of governance more generally that are relevant in the context of risk management within insurers. In particular, the risk-​management system, the risk-​management function, the ORSA, and the internal control system should be mentioned. B. Risk-management  system

3.46

Insurers are required to have in place an effective risk-​management system62 comprised of strategies, processes, and reporting procedures necessary to identify, measure, monitor, manage, and report, on a continuous basis, the risks, at an

59 ibid. 60 See, for instance, H Gründl et al (eds), Solvency II –​Eine Einführung, Grundlagen der neuen Versicherungsaufsicht, 2nd ed, Verlag Versicherungswirtschaft GmbH, Karlsruhe, 2016, Ch 4.1; M Andenas et al (eds), Solvency II, A Dynamic Challenge for the Insurance Market, Il Mulino, 2017, in particular Ch III, R G Avesani, ‘Objectives and evolution of the new supervisory regime’, and Ch IV, P Manes, ‘Corporate Governance, the approach to risk and the insurance industry under Solvency II’; Marano and Siri (eds), n 7; M Dreher, Treatises on Solvency II, Springer Verlag, 2015, Ch 4, para 4.2.1. 61 A  capital add-​on under Solvency II is not a proper capital requirement but is a temporary supervisory measure that can be imposed by supervisors in exceptional circumstances in a limited number of cases to remedy deficiencies that emerged as part of the supervisory review process (Article 37 of Solvency II Directive). 62 See, for instance, Gründl, n 60, Ch 5.2; Andenas et  al (eds), n 60, in particular Ch IV, P Manes, ‘Corporate Governance, the approach to risk and the insurance industry under Solvency II’, and Ch IX, Avesani, et al, ‘Pillar II, Risk Governance’; Marano and Siri (eds), n 7; and Dreher, n 60, Ch 4, para 4.2.1.

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Corporate Governance in the Insurance Sector individual and at an aggregated level, to which they are or could be exposed, and their interdependencies.63 The risk-​management system, therefore, has three main building blocks:  strat- 3.47 egies, processes, and reporting procedures.64 Furthermore, insurers are also required to have in place, as part of the risk-​management system, a risk-​management function. The risk-​management function is one of the key functions that Solvency II distinguishes. The other key functions are the compliance function, the actuarial function, and internal audit function. Solvency II explicitly links the risk-​management system to the system of govern- 3.48 ance, not only by making it clear that the risk-​management system is part of the system of governance, but also by requiring that the risk-​management system must be effective and well-​integrated into the organizational structure and in the decision-​making process of the insurer with proper consideration of the persons who effectively run the insurer or have other key functions.65 Furthermore, the AMSB is ultimately responsible for the effectiveness of the risk-​management system, setting the insurance companies’ risk appetite and overall risk tolerance limits, as well as approving the main risk-​management strategies and policies.66 The ultimate responsibility of the AMSB is emphasized by the expectation that at least one member of the AMSB is designated to oversee the risk-​management system on its behalf,67 and by the expectation that the embedding of adequate risk-​ management processes and procedures across the undertaking and the adequate consideration of the risks involved is provided for in all major decisions of the insurer.68 A number of elements can be highlighted in this context: (i) the role of the AMSB 3.49 in respect of the risk management system; (ii) the role of the ORSA in the risk-​ management system and the integration of the ORSA in decision-​making processes and in the strategy; (iii) the interaction between the quantitative requirements and qualitative requirements; and (iv) the importance of documentation and internal reporting to support the system of governance.

63 Article 44(1) of Solvency II Directive. 64 Article 44 of Solvency II Directive, see also IAIS, Insurance Core Principles, ICP 8, para 8.0.4. 65 Article 44(1) of Solvency II Directive, second para. 66 Article 40 of Solvency II Directive allocates the ultimate responsibility for compliance with laws and regulations (which include those relating to risk management) to the administrative, management or supervisory body. More explicitly, the responsibility in respect of risk management is set out in Guideline 17 of the EIOPA Guidelines. It is also in line with ICP 8. In para 8.0.1 (introductory guidance) IAIS states that the Board is ultimately responsible for ensuring that the insurer has in place effective systems of risk management and internal controls and functions to address the key risks it faces and for the key legal and regulatory obligations that apply to it. 67 EIOPA, n 16, para 2.74. 68 ibid, para 2.81.

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Arthur van den Hurk and Michele Siri C. Strategies, policies, and reporting procedures 3.50

According to the IAIS, strategies should set out an insurers’ approach for dealing with specific areas of risk and legal and regulatory obligations.69 Article 259(1) of the Solvency II Delegated Regulation requires the risk-​management strategy to be clearly defined and consistent with the insurers’ overall business strategy and requires the objectives and key principles of the strategy, the approved risk tolerance limits, and the assignment of responsibilities across all the activities of the insurer to be documented. The risk-​management strategy incorporates the risk appetite of the insurer. This is the attitude of the insurer toward the main categories of risks. This risk appetite needs to be clear and detailed enough to express and reflect the strategic high-​level objectives of the administrative, management, or supervisory body.70 The AMSB is expected to give appropriate directions concerning the definition of risk appetite. Furthermore, the risk-​management strategy should also be expressed in risk tolerance limits. These are the restrictions that the insurer imposes on itself when taking a risk. These restrictions effectively limit the capacity of the insurer to take risks. These restrictions can go beyond the Solvency II requirements. In addition, risk tolerance limits should take into account the insurers’ risk appetite as well as other relevant information, such as the risk profile of the insurer and the interrelationship between risks.71 The AMSB is also responsible for the approval of periodic revisions of the main risk strategies of the insurer.72

3.51

As part of the general Solvency II governance requirements, insurers should have in place written policies concerning at least risk management, internal control, internal audit, and, where relevant, outsourcing. Insurers shall ensure that those policies are implemented.73 The risk-​management policy shall comprise policies on specific areas, mentioned in the Directive. These areas correspond with material risk types faced by insurers, such as underwriting and reserving, asset-​liability management, investments (in particular derivatives and similar commitments), liquidity, and concentration risk management, operational risk management, reinsurance, and other risk-​mitigation techniques.74 The AMSB is responsible for the approval of the periodic revisions of central risk policies of the insurer.75

3.52

In general terms, Solvency II places much emphasis on the proper documentation and reporting of processes and procedures. This notion can be found in various places in the Solvency II framework, and in general terms in Article 258 of the



IAIS Insurance Core Principles, introductory guidance, ICP 8, para 8.0.4. EIOPA, n 16, para 2.77. 71 ibid. 72 ibid, para 2.80. 73 Article 41(3) of Solvency II Directive. 74 Article 44(2) of Solvency II Directive. 75 EIOPA, n 16, para 2.80. 69 70

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Corporate Governance in the Insurance Sector Solvency II Delegated Regulation that requires the insurer to establish, implement, and maintain effective cooperation, reporting, and communication of information at all relevant levels of the undertaking. Specifically in the context of the risk management system, Article 259 of the Solvency II Delegated Regulation requires the insurer to have in place a number of written policies of material risk categories, as well as clear definitions and categorization of risk types. Furthermore, this provision requires reporting procedures and processes to ensure that information on material risks faced by the insurer and the effectiveness of the risk-​management system are effectively monitored and analysed and appropriate modifications can be made where necessary. On top of that, the persons that effectively run the insurer or have other key functions should take into account the information reported as part of the risk management system in the decision-​making process. EIOPA complements these requirements in a number of areas, for instance by providing: (i) specific guidelines on the way policies should be structured, maintained, approved, reviewed, and documented;76 (ii) specific requirements with respect to the documentation of the valuation of technical provisions;77 and (iii) requirements with respect to data quality, in particular concerning data quality in respect of the technical provisions.78 These are reflected in the required internal controls concerning the valuation of assets and liabilities more generally.79 In addition, in respect of the internal control system, specific mention is made of appropriate (administrative and accounting) procedures, as well as appropriate reporting procedures.80 D. Risk-​management function As part of the risk-​management system, insurers are required to have in place a risk-​ 3.53 management function, as the Solvency II Directive describes it: ‘to facilitate the implementation of the risk management system’. The risk-​management function is responsible for assisting management in the effective operation of the risk-​management system, monitoring the risk-​management system, monitoring the general risk profile of the insurer as a whole, reporting on risk exposures, and advising management on risk-​management matters, including in relation to strategic affairs, such as mergers and acquisitions and major projects and investments, and identifying and assessing emerging risks. Furthermore, the risk-​management function has a number of additional tasks in case the insurer uses a partial or full internal model for the calculation of its capital requirements. In addition, the risk-​management function is required to liaise closely with the users of the outputs of the internal model and to cooperate closely with the actuarial function.

EIOPA, n 16, Guideline 7 and paras 2.23–​2.31. Article 265 Solvency II Delegated Regulation. 78 Article 82 of Solvency II Directive; Article 19 of Solvency II Delegated Regulation. 79 Article 267 of Solvency II Delegated Regulation. 80 Article 46(1) of Solvency II Directive. 76 77

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IV.  The Actuarial Function 3.54

The actuarial function is a function specific to insurers, and as such, part of the system of governance of insurers. One of the key tasks of the actuarial function is the coordination of the calculation of the technical provisions. Solvency II does not specify who should be doing the actual calculation of the technical provisions, as long as there is a clear allocation and appropriate segregation of responsibilities to ensure independent scrutiny and validation of the technical provisions.81 Furthermore, the actuarial function is responsible for the assessment of the data quality of both the internal and external data used in the calculation of the technical provisions, as well as the testing against experience of the technical provisions.82

V.  The ORSA Process 3.55

Insurers should, as part of their business strategy, regularly assess their overall solvency needs in accordance with their own risk profile. This process is referred to as the own risk and solvency assessment (ORSA).83 The ORSA process does not, however, serve to calculate a solvency requirement different from the one that the insurer calculates following Solvency II requirements. The results of the ORSA could prompt an insurer to reassess the calculation of its capital requirements but might, instead, also result in alternative measures, such as changes in the risk profile of the insurer or changes in its system of governance. It would be easy to assume that the ORSA is primarily a reporting obligation or a mere compliance exercise, but that would disregard the key position that is given to the ORSA process in the context of Solvency II.

3.56

The ORSA should be integral to the business strategy and the strategic decisions of the insurer. As such, the ORSA is a central element in the governance of an insurer. The results of the ORSA are expected to contribute to decisions regarding the risks the insurer is prepared to retain or transfer, how to optimize capital management, pricing of products, and other strategic decisions.84 The insight gained from the ORSA should also be taken into account by the AMSB in the medium and

81 EIOPA, n 16, para 2.210. 82 ibid, Guideline 49. 83 See, for instance, Gründl et al (eds), n 60, Ch 5.3; Andenas et al (eds), n 60, in particular Ch IV, P Manes, ‘Corporate Governance, the approach to risk and the insurance industry under Solvency II’, and Ch IX, Avesani et al, ‘Pillar II, Risk Governance’; Marano and Siri (eds), n 7; Dreher, n 60, Ch 5; M Dreher and M Wandt, Solvency II in der Rechtsanwendung 2014, Rechtsschütz gegenüber EIOPA, FLAOR und ORSA, 77 and further, Frankfurter Reihe, no. 30, Versicherungswissenschaften an der Universität Frankfurt am Main, Verlag Versicherungswissenschaft GmbH, Karlsruhe, 2014. 84 EIOPA, n 16.

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Corporate Governance in the Insurance Sector long-​term capital planning of the insurers, taking into consideration the business and strategy the insurer has decided upon. Given the key role the ORSA plays in the governance of the insurer, it is not sur- 3.57 prising that the role of AMSB is also expressly dealt with in the Solvency II context. In its guidelines on the ORSA, EIOPA describes the role of the AMSB as a ‘top-​down-​approach’, whereby the AMSB is supposed to take an active part in the ORSA process, should steer the ORSA process and how it is performed, and has a role in challenging the results of the ORSA. Active involvement of the AMSB in the ORSA process is therefore expected. EIOPA is fairly explicit in the importance of the ORSA process as a management tool. The ORSA is supposed to provide the AMSB with a comprehensive picture of the risks the insurer is exposed to or (forward looking) could face in the future. It should enable the AMSB to understand the risks, translate risks into capital needs or the application of risk mitigating techniques (such as reinsurance). Furthermore, using the ORSA as a starting point, it forms the basis for the AMSB for instructions on management actions if specific risks were to materialize.

VI.  Internal Control System The internal control system appears, considering the structure maintained in the 3.58 Solvency II Directive, to be distinct from the risk-​management system but is closely related to it and plays a crucial role in the system of governance of insurers.85 In fact, the requirements for the internal control system are referred to and consequently made part of the general requirements concerning the system of governance.86 The purpose of the internal control system is to ensure the insurers’ compliance with applicable laws, regulations, and administrative provisions and the effectiveness and efficiency of the insurers’ operations in light of its objectives as well as to ensure the availability and reliability of financial and non-​financial information. At least, the internal control system must include administrative and accounting procedures, an internal control framework, appropriate reporting arrangements at all levels of the insurer’s undertaking, and must include a compliance function. Conceptually it is quite odd that Article 46 of the Solvency II

85 The IAIS acknowledges that in some jurisdictions, risk management is considered a subset of internal controls, while other jurisdictions would see it the other way around. The IAIS stresses that determining where the boundaries lie between the two is less important than achieving, in practice, the objectives of each. ICP, paragraph 8.0.2. 86 Article 41(1) of Solvency II Directive requires insurance undertakings to have in place an effective system of governance which provides for the sound and prudent management of the business and must include an adequate transparent organizational structure with a clear allocation and appropriate segregation of responsibilities and an effective system for ensuring the transmission of information. It shall include compliance with the requirements laid down in Articles 42 to 49.

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Arthur van den Hurk and Michele Siri Directive identifies specifically the compliance function as part of the internal control system. The other key functions that can equally be considered to be part of the internal control system of an insurer are not explicitly mentioned in the context of the internal control system. Section 2 of Chapter IV of the Solvency II Directive dedicates a specific provision to each of the other key functions, without explicitly referencing to the internal control system. 3.59

EIOPA conceptually breaks down internal controls into various aspects:  (i) an internal control environment; (ii) internal control activities; (iii) communication; and (iv) monitoring.87 These aspects are not discussed in this chapter in detail but it should be highlighted that, in this context, EIOPA emphasizes the importance of the awareness of all personnel of the insurer of their respective roles in the internal control system, the responsibility of the insurer to promote this awareness, and the reliance of an adequate internal control system on a high level of integrity in the organization. The internal control system should be fully embedded in the insurers’ culture and any policies and practices that may provide incentives for inappropriate behaviour should be avoided.88

3.60

Solvency II devotes specific consideration to internal controls of the valuation of assets and liabilities. Insurers are expected to establish, implement, maintain, and document clearly defined policies and procedures for the process of valuation, including a description of roles and responsibilities of the personnel involved with the valuation, the relevant models, and the sources of information used.89 More detailed requirements set out the elements that should be included in internal control processes.90

VII.  Governance Regulation Supporting Quantitative Requirements A. Introduction 3.61

As indicated above, Solvency II takes a holistic approach to the regulation and supervision of insurers. Therefore, it is not surprising that in the Solvency II requirements and accompanying EIOPA guidelines, quantitative and qualitative requirements are closely linked. Capital requirements, own fund requirements, and investment requirements, which by nature are primarily quantitative requirements, are supported by qualitative requirements, including governance requirements.



EIOPA, n 16, Guideline 38, explanatory text, 81. ibid. 89 Article 267(2) of Solvency II Delegated Regulation. 90 Article 267(4) of Solvency II Delegated Regulation. 87 88

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Corporate Governance in the Insurance Sector This is in line with the general guidance supporting IAIS ICP 15.91 The IAIS considers that financial requirements are not sufficient by themselves to ensure solvency and, therefore, should be complemented with appropriate quantitative or qualitative requirements limiting/​regulating the investment risks that are taken by the insurer.92 In establishing such requirements, one of the factors that may be included is the overall quality of risk management and governance frameworks in the insurance industry in the jurisdiction.93 B. The ‘prudent person principle’ Unlike earlier generations EU insurance directives, under the Solvency II frame- 3.62 work, insurers are no longer subject to hard legal investment restrictions or requirements.94 Instead, insurers have the freedom to invest in any category of asset without prior approval of systematic notification requirements to supervisors.95 The freedom of investment is complemented by the ‘prudent person principle’, according to which insurers are required to invest their assets with prudence.96 Prudence, in this context, has various dimensions. In the first place, it means that insurers can only invest in assets and instruments whose risks it can properly identify, measure, monitor, control, and report, and can appropriately take into account in the assessment of the overall solvency needs of the insurer. Furthermore, all assets, in particular, those covering the lower and higher solvency requirement (the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR) shall be invested in such a manner as to ensure the security, quality, liquidity, and profitability of the portfolio as a whole. Besides, localization of those assets shall be such as to ensure their availability. Assets held to cover technical provisions (i.e. those assets that correspond most directly to the insurance liabilities) shall be invested in a manner appropriate to the nature and duration of the insurance liabilities. Moreover, these assets shall be invested in the best interests of all policyholders and beneficiaries, taking into account any disclosed policy objective. In case of conflicts of interest, the investments need to be done in the best interests of policyholders and beneficiaries. It is important to note that, according to EIOPA, the features of security, quality, liquidity, and profitability apply to the portfolio as a whole and not to individual investments in the portfolio, but they should, finally,

91 ICP 15 provides that the supervisor establishes requirements for solvency purposes on the investment activities of insurers to address the risk faced by insurers. 92 Para 15.1.3. 93 ibid. 94 Article 132 of Solvency II Directive. 95 ICP 15 leaves room for different approaches: rules-​based, principles-​based, or a combination of both. 96 Article 132 of Solvency II Directive.

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Arthur van den Hurk and Michele Siri contribute to the security, quality, liquidity, and profitability of the portfolio as a whole.97 3.63

Specific arrangements have been made in the Solvency II framework for assets held in respect of life insurance contracts where the investment risk is borne by policyholders, or where the benefits are linked to certain investment funds.

3.64

As follows from the above, the freedom of investment and prudent person principle emphasize the need for strong governance of the assets and instruments held by insurers. The insurer is itself responsible for setting prudent limits in its investment portfolio for specific investment categories, without prescribed regulatory limits to stay within. Moreover, the insurer should define its own risk appetite, but pursuing more risky strategies might result in stronger governance and/​or higher capital requirements.

3.65

In fact, EIOPA has developed, as part of the guidelines for the system of governance, specific guidelines on the prudent person principle and the system of governance.98 EIOPA clarifies in this context that the prudent person principle is as much a behavioural standard as an assessment of judgements and investment decisions. According to EIOPA, prudence is to be found in the process by which investment strategies are developed, adopted, implemented, and monitored in light of the purposes for which funds are managed, as well as in the outcomes. EIOPA emphasizes the importance of: (i) due diligence and process in respect of investment decisions; (ii) care, skill, and delegation; (iii) duty to monitor; (iv) duty to protect policyholders’ and beneficiaries’ interest; and (v) the principle of delegation.

3.66

The level of skills and expertise that is expected to fulfil the prudent person principle may require the insurer to obtain external advice or to delegate specific tasks to external parties with the required skills. Nevertheless, the insurer remains responsible for the delegated tasks and monitoring and reviewing these activities to ensure that they are being carried out appropriately and prudently. The insurer should also assess any conflicts of interests or misalignment of incentives that may exist or arise when delegating tasks. C. Own fund requirements and the system of governance

3.67

As part of the system of governance, insurers are required to develop a capital management policy. In addition, insurers should develop a medium-​term capital management plan. The role of the AMSB in respect of the medium-​term capital management plan is described in some detail by EIOPA.99



EIOPA, n 16, para 2.142. ibid, Guidelines 27–​36. 99 ibid, Guideline 37. 97 98

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Corporate Governance in the Insurance Sector The AMSB should monitor the medium-​term capital management plan; both its 3.68 development and maintenance. The frequency with which the AMSB needs to consider the plan depends on the specific circumstances of the insurer, including but not limited to:100 (i) the stability of the insurer’s business model and projections; (ii) the frequency of planned capital issuance, repayment, and redemptions, and other factors affecting own funds including the performance during the year; (iii) the extent to which own funds exceed the SCR and the assessment of capital needs identified when the ORSA was performed; and (iv) the extent to which available own funds exceed, or are close to, the limits applying when determining eligible own funds. In this manner, Solvency II allows for different business models and capital man- 3.69 agement strategies, but at the same time links these to governance requirements matching such business models and strategies.

VIII. Conclusions The interests of both shareholders and management may diverge from the interests 3.70 of policyholders.101 Policyholders and insurance beneficiaries are also a dispersed group, with little power to compel insurers and their management to take specific action, as they may be in a weak position to contest the settlement of claims or dormant life assurance policies. Life insurance establishes contractual relations over many years between an insurer and the life policyholder or the latter’s beneficiaries, which is similar in many respects to the ‘fiduciary’ relationships of pension funds. In the non-​life business, taking account of a shorter time horizon, the potential divergence of interests between insured and insurer originates from the discretionary power of management concerning claims settlement. This possible divergence arises from the value-​maximization objective of share- 3.71 holders and management and may take the form of inadequate technical provisions, unfair claims settlement outcomes, or inequitable profit distributions to participating policyholders. Thus, the European legislation designs and implements a system of governance of the insurance firm oriented to care for the best interests of policyholders. This combines with a supervisory expectation that firms and their corporate governance system—​including the board of directors—​take into account the interests of policyholders in their decision making.



ibid, explanatory text, 80.

100

OECD, n 2, 43ff.

101

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4 THE GOVERNANCE OF BANKS AND THE REQUIREMENT OF RESOLVABILITY Fundamental Change in Perspective? Bart Bierens*

I. Introduction II. Complex Banks and a Global Financial Crisis III. The EU Banking Union

4.01

A. Purpose and pillars B. CRD IV, BRRD, and SRMR

IV. Resolvability A. The requirement B. An iterative process C. What is and what should be: mind the gap

V. The Resolvable Bank: A Blue Print A. Structure and operations B. Financial resources

C. Information D. Cross-​border issues E. Other potential impediments F. The common thread: reducing complexity

4.02 4.05 4.05 4.07 4.08 4.08 4.10

VI. Decision to Remove Impediments A. Process and decision B. Alignment of the SREP and resolvability assessment

4.20 4.22 4.25 4.27 4.28 4.28 4.32

VII. The Transition to Being Resolvable 4.34 VIII. Rethinking the Governance of Banks 4.37 IX. Conclusion4.42

4.11 4.12 4.13 4.16

I. Introduction 4.01

The term corporate governance, though widely used, is not well defined. It involves the set of relationships among a company’s management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives

* The author would like to thank the participants of the Amsterdam International Working Group conference on 25 and 26 January 2018 for their insightful comments. This chapter is a revised, updated, and extended version of an article (in Dutch) published in Ondernemingsrecht (2017) 41.

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The Governance of Banks and Resolvability and monitoring performance are determined.1 Banks are not only subject to the general principles of good governance but also have to meet specific regulatory requirements. Banks within the European Economic Area (EEA) are subject to the Capital Requirements Directive (CRD IV), which contains provisions on the composition of the board, the quality requirements imposed on executive directors and supervisory directors, the integrity of business operations, and the structure of the group.2 Banks also have to meet the objectives of the Bank Recovery and Resolution Directive (BRRD), including the overarching requirement to become and remain ‘resolvable’.3 A bank is resolvable if its balance sheet can be restructured effectively in order to protect the continuity of critical functions, avoiding any significant adverse effect on the financial system and without the support of public funds. This objective of resolvability reflects the lessons learned during the global financial crisis. Resolvability is intended as a precautionary measure and forces banks to be prepared for a resolution as part of their going concern operation. Every bank, including banks with a solid balance sheet and healthy levels of profitability, has to meet the requirement of resolvability. This chapter analyses the resolvability requirement from an EU perspective and explores, taking into account the experiences of the eight largest banks in the United States, the impact it will have on the structure and governance of systemically important banks.4

II.  Complex Banks and a Global Financial Crisis The need for resolvability, like many other more recently introduced regulatory 4.02 requirements in the banking sector, is directly linked to the events that marked the beginning of the global financial crisis in September 2008. The bankruptcy of Lehman Brothers sent a shockwave through the global financial system. Banks in 1 G20/​OECD, ‘Principles of Corporate Governance’, 9. On the application of these principles, see Financial Stability Board (FSB), ‘Thematic Review on Corporate Governance. Peer Review Report’, April 2017. 2 Articles 74, 76, 88, and 91 of Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​49/​EC, [2013] OJ L176 (CRD IV); Basel Committee on Banking Supervision (BCBS), ‘Corporate Governance Principles for Banks’, Guidelines, July 2015; EBA, ‘Guidelines on internal governance under Directive 2013/​36/​EU (Final Report), September 2017, EBA/​CL/​2017/​ 11; See P O Mülbert, and A Wilhelm, ‘CRD IV Framework for Banks’ Corporate Governance’, in D Busch and G. Ferrarini (eds), European Banking Union, Oxford University Press, 2015, 155–​99. 3 Article 15 of Directive 2014/​59/​EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms, [2014] OJ L173 (BRRD). On the BRRD, see J-​H Binder, and D Singh (eds), Bank Resolution. The European Regime, Oxford University Press, 2016. 4 The FSB publishes annually a list of global systemically important banks (G-​SIBs). There are currently thirty G-​SIBs, including eight banks in the United States; seven in the EU euro-​zone and five currently within the European Union but outside the euro-​zone (four in the United Kingdom; in September 2017 Nordea announced that it was moving its headquarter from Sweden to Finland, entering the euro-​zone). For the purpose of this chapter, the scope of ‘systemically important banks’ is wider and includes banks that are systemically important on a domestic or regional level (D-​SIBs)

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Bart Bierens the United States and Europe were nationalized, received emergency support, or were acquired by other banks in order to avoid a total collapse of the system.5 There was at that time hardly an available alternative. The failure of international banks resulting in a melt-​down of the financial system would have a disruptive effect on all economic activities worldwide. Payment, clearing, and settlement systems would freeze and savings become inaccessible. The global financial crisis also had an impact on the financial position of countries. The nationalization of banks increased sovereign debts and resulted in a declining market confidence in countries whose levels of sovereign debt were already high. For banks for which domestic sovereign debt is a substantial part of their assets, the paradox arises that its nationalization exposes the bank to a further increased level of credit risk, creating a vicious circle, also known as sovereign-​bank nexus, or doom loop. 4.03

Decisions by governments during the global financial crisis to rescue complete banks rather than protect and continue certain of their parts or activities were based on both factual and legal considerations. With regard to the factual considerations: given the size and complexity of large international banks, it was not considered a feasible option to continue certain activities and, at the same time, liquidate other parts of the group according to the applicable bankruptcy regime. Large banking groups are built by hundreds or even thousands of closely operationally and financially interconnected legal entities, have ten-​thousands of employees and make use of hundreds or even thousands interlinked IT systems. Such banks were not only deemed too-​big-​to-​fail but also too-​complex-​to-​liquidate in an orderly manner.6 As for the legal considerations: there was no effective regulatory framework giving authorities the statutory power to intervene and to restructure the banking group. The bank rescues during the global financial crisis gave the impression of being improvised rather than following a preconceived approach, and the actions taken were sometimes legally questionable.

4.04

The rescues during the global financial crisis and the unprecedented amounts of tax-​payers money involved, placed the need to develop and adopt a legal framework for the recovery and resolution of banks on the top of the action list for politicians. During the G20 Pittsburgh Summit in September 2009, it was decided to develop resolution tools and a framework for the effective resolution of financial groups. The outcome was the ‘Key Attributes of Effective Resolution Regimes and other banks that, given their size and business, cannot be liquidated under normal insolvency proceedings. 5 For the United States: FDIC ‘Failed bank List’ (https:www.fdic.gov) with 465 failed banks from 2008 to 2012. R E van Lambalgen, State aid to banks. An analysis of the Commssion’s decisional practice, Wolters Kluwer, 2018 refers to 513 state aid decisions in respect of more than 100 EU banks. For some legal case studies on EU bank restructurings, see World Bank Group, ‘Bank Resolution and “Bail-​in” in the EU: selected case studies pre and post BRRD’, 2016. 6 R J Herring, and J Carmassi, ‘Complexity and Systemic Risk’, in:  A N Berger et  al (eds), The Oxford Handbook of Banking, Oxford University Press, 2015, 77–​112. Re Lehman Brothers International (Europe) [2012] UKSC 6 gives factual information on the complex operational structure and interconnectedness between the Lehman entities on the date of their bankruptcy.

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The Governance of Banks and Resolvability for Financial Institutions’, which were endorsed by the G20 during the Cannes Summit in November 2011. These Key Attributes have now become the benchmark for legislators and policymakers. The overarching requirement of resolvability, as discussed in this chapter, is an important element of these Key Attributes.7

III.  The EU Banking Union A. Purpose and pillars Within the European Union, the global financial crisis morphed into a sovereign-​bank 4.05 crisis, known as the euro-​crisis. In the course of 2010, the financial markets were concerned about the levels of government debt in Greece, Italy, Spain, Ireland, and Portugal. Compared to the global financial crisis, there were some additional risk factors: The EU Member States that were facing financial difficulties participated in the European Monetary Union (EMU) and shared the euro as their common currency. Financial turmoil in individual Member States easily created spillover effects to other participating Member States and, through the sovereign-​bank nexus, the European financial system.8 The structure of the EU banking supervision also proved to be a cause for concern. A weak spot in the initial design of the EMU was the continuation of banking supervision on a national level. This created national biases and supervisory fragmentation. It also caused complexity in the supervision of cross-​border banks and rescue of ailing banks across borders, evidenced by the collapse of the Dutch-​Belgian-​Luxemburg bank Fortis in 2008. Each of these three involved governments merely concentrated on the part of the group that was most important for their own respective markets.9

7 FSB, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’, 2011 (extended in 2014), para 10 and I-​Annex 3 on resolvability. See also FSB, ‘Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Identification of Critical Functions and Critical Shared Services’, July 2013; FSB, ‘Recovery and Resolution Planning for Systemically Important Financial Institutions:  Guidance on Developing Effective Resolution Strategies’, July 2013. On the tasks of the FSB, see C Brummer, Soft Law and the Global Financial System, Cambridge University Press, 2015, 69–​76. The segregation of commercial and investment banking—​also known as ring-​fencing—​became a related regulatory narrative. Rules to this effect were introduced in the United States and some European jurisdictions. The EU Proposal (COM/​ 2014/​43 final 2014/​0020/​COD) was controversial and eventually withdrawn at the end of 2017. According to the Commission, the rationale of this proposal has been addressed in the meantime by the recovery and resolution framework: J-​H Binder, ‘Ring-​Fencing: An Integrated Approach with Many Unknowns’ , European Business Organization Law Review (2015), 16, 1 97–​119; T Wetzer, ‘In Two Minds: The Governance of Ring-​Fenced Banks’ (forthcoming). 8 European Parliament resolution of 20 November 2012, ‘Towards a genuine Economic and Monetary Union’, 2012/​2151(INL), considering that ‘during the current crisis it has become self-​ evident that the bank-​sovereign link is stronger and more damaging within a monetary union, where the internal exchange rate is fixed and there exists no mechanism at Union level to alleviate the costs of bank restructuring’. 9 E Avgouleas, Governance of Global Financial Markets, 2012, Cambridge University Press, 250–​ 1; D Schoenmaker, Governance of International Banking. The Financial Trilemma, Oxford University Press, 2013.

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Bart Bierens 4.06

The EU Banking Union was conceived as a response to the euro-​crisis. The road map towards a Banking Union was presented in 2012.10 Its purpose is to complete and strengthen the EMU, to address the risks of a fragmented banking supervision and break the sovereign-​bank nexus. The Banking Union has a three-​pillar structure. The first pillar is the Single Supervisory Mechanism (SSM) and is about the shift of prudential supervision of banks to a European level. This pillar became effective as of 4 November 2014. The supervisory tasks are now performed by the European Central Bank (ECB) in cooperation with the national competent authorities in the euro-​zone. The legal basis is found in the SSM Regulation.11 The second pillar is the Single Resolution Mechanism (SRM) and is about the resolution of banks. The Single Resolution Board (SRB) has been fully operational since 1 January 2016. The SRB has the power to restructure a bank that fails or is likely to fail, using resolution tools and, if certain criteria are met, the privately financed Single Resolution Fund (SRF).12 Mirroring the SSM and the position of the ECB, the SRB is supported in its tasks by national resolution authorities (NRA). The legal basis for the SRM is the SRM Regulation (also: SRMR).13 The third pillar of the Banking Union consists of the European Deposit Insurance Scheme. This pillar is still under debate at the time of writing and will only briefly referred to at the end of this chapter. The three pillars of the Banking Union are built on the Single Rulebook. This rulebook for banks includes the—​already mentioned—​Capital Requirements Regulation and the Capital Requirements Directive (CRR/​CRD IV), the Bank Recovery and Resolution Directive (BRRD), and a large number of Level 2 Regulations based on the Level 1 CRR/​CRD IV and BRRD. B. CRD IV, BRRD, and SRMR

4.07

It is important to understand the three-​pillar structure of the Banking Union as it relates on various levels to the subject of this chapter. In the first place, it explains the structure of the relevant legislation and the diversity of rules that are applicable to the resolvability requirement as discussed here. The BRRD covers the full EU/​EEA territory while the SRM Regulation only applies within

10 On the background of the EU Banking Union and an analysis of its three-​pillar structure, see D Busch and G Ferrarini (eds), European Banking Union, Oxford University Press, 2015. 11 Council Regulation (EU) No 1024/​2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, [2013] OJ, L287. 12 The BRRD requires the establishment of national resolution funds within the European Union; the SRF is the single resolution fund covering the euro-​zone. The SRF will be gradually built up and shall reach the target level of at least 1 per cent of the amount of covered deposits of all credit institutions within the Banking Union by 2023. 13 Regulation (EU) No 806/​2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/​2010, [2014] OJ L225.

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The Governance of Banks and Resolvability the euro-​zone.14 The fact that the SRM Regulation contains cross-​references to the BRRD,15 the BRRD itself is implemented in national legislation, and parts of the BRRD are further detailed in Regulations16 and Guidelines17 makes the legislative framework massive and difficult to digest. In the second place, it shows that governance and resolution are allocated to different pillars of the Banking Union. The CRD IV contains governance related provisions, including requirements on the composition of the board, the organizational structure, and the internal control mechanisms. These requirements are part of the first pillar. The rules on resolution and resolvability are based on the BRRD and part of the second pillar. As follows from the powers granted to the ECB and SRB, this second pillar is the most dominant. What this means in practice will be discussed below. In the third place, this overview reflects the boundaries and levels of integration within and outside the European Union. The BRRD provides for harmonized rules within the European Union, including the obligation of bank supervisors and resolution authorities to cooperate within a defined framework. Within the euro-​zone, the powers to restructure a troubled bank are allocated on an EU-​level to the SRB. The intensity of the cooperation to be expected among the various resolution authorities will be an important factor for resolution plans of international banks.

IV. Resolvability A. The requirement Before a closer look at the definition of resolvability in the BRRD is taken, a caveat 4.08 lector is appropriate as this definition is captured in rather complex language. Pursuant to the BRRD,18 a bank is resolvable if it is feasible and credible for the

14 Articles 2 and 7 of SSM Regulation and Article 4 of SRM Regulation permit a voluntary participation in the Banking Union for EU Member States outside the euro-​zone. However, no EU Member State has applied for admission at the time of writing. 15 Relevant for this chapter: Article 10(6) of SRM Regulation requires that the resolvability assessment of banks in the euro-​zone includes an analysis of the matters as specified in Article C of the Annex to the BRRD. 16 Including: Commission Delegated Regulation (EU) 2016/​1075 of 23 March 2016, [2016] OJ L184 (Delegated Regulation, with sections on resolution plans); Commission Delegated Regulation (EU) 2016/​1712 of 7 June 2016, [2016] OJ L258/​1 (specifying a minimum set of the information on financial contracts that should be contained in the records); Commission Delegated Regulation (EU) 2016/​778 of 2 February 2016, [2016] OJ L131/​41 (with a section on critical functions). 17 EBA, ‘Guidelines on the specification of measures to reduce or remove impediments to resolvability and the circumstances in which each measure may be applied under Directive 2014/​59/​EU, EBA/​GL/​2014/​11 (‘EBA Guidelines to remove impediments’). 18 Article 15 of BRRD; Article 10 of SRMR. The BRRD refers to ‘institution’. The application of this provision on non-​bank institutions and third-​country banking groups operating within the European Union will not be discussed here.

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Bart Bierens resolution authority to either liquidate it under normal insolvency proceedings19 or to resolve it by applying the different resolution tools20 and powers21 to the bank while avoiding, to the maximum extent possible, any significant adverse effect on the financial system, including in circumstances of broader financial instability or system-​wide events, of the Member State in which the bank is established, or other Member States of the European Union and with a view to ensuring the continuity of critical functions22 carried out by the bank. In more condensed wording and leaving aside the details: the structure and organization of a bank must facilitate resolution authorities to effectively apply their resolution tools. The purpose is to ensure the continuity of critical functions and the ability to refinance a bank without the use of public funds. 4.09

Some preliminary observations with regard to this definition follow. Firstly, resolvability is a going concern-​requirement for banks. All European banks have to comply, and maintain compliance, with this overarching requirement while a resolution itself will most likely remain a rare event. Consequently, it is important for all banks to be aware of the potential impact of the BRRD on their ordinary course of business.23 Secondly, resolvability is not a clear-​cut rule but an objective. What actions are required to meet this objective depends on the specific features of a bank group, including its size, business model, funding model, capital structure, number of entities, and interconnectedness. The resolution authority makes an assessment of the resolvability of each banking group. Section C of the Annex to the BRRD is a non-​exhaustive list with factors the resolution authority is to consider during the assessment. B. An iterative process

4.10

The assessment of resolvability is an iterative process involving the resolution authority and the bank.24 The resolution authority is leading in this process and starts 19 As defined in Article 2(1)(47) of BRRD. 20 Article 37(2) of BRRD; Article 22(2) of SRMR. The four resolution tools are: (i) the sale of business tool; (ii) the bridge institution tool; (iii) the asset separation tool; and (iv) the bail-​in tool. 21 Chapter VI of BRRD. This includes, inter alia, the power to take control of an institution under resolution and exercise all the rights and powers conferred upon the shareholders; other owners; and the management body of the institution under resolution, and the power to remove or replace the management body and senior management of an institution under resolution. 22 As defined in Article 2(1)(35) of BRRD; Articles 6 and 7 Regulation (EU) 2016/​778 of 2 February 2016, [2016] OJ L131/​41. Obvious examples of critical functions are payment and securities clearing and settlement systems. 23 Although there is a fast growing amount of literature on the BRRD, the number of publications on its going concern-​impact is relatively small. See T F Huertas, Safe to Fail. How Resolution Will Revolutionise Banking, Palgrave Macmillan, 2014; V de Serière, ‘Recovery and Resolution Plans of Bank in the Context of the BRRD and SRM. Some Fundamental Issues’, in Busch and Ferrarini (eds), n 10; D Schoenmaker, ‘The impact of the legal and operational structures of euro-​area banks on their resolvability’, Bruegel Policy Contribution, December 2016. 24 Recital 21 of the Commission Delegated Regulation (EU) 2016/​1075; visualized as a plan-​do-​ check-​adjust cycle: SRB, ‘The Single Resolution Mechanism. Introduction to Resolution Planning’, 2016, 20.

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The Governance of Banks and Resolvability with an analysis of the data on the group structure, its organization, financials, business model, critical functions, and operating systems of the bank.25 On the basis of these data, it will be assessed whether a bank can be wound up under normal insolvency proceedings.26 If not, the resolution authority will determine the preferred resolution strategy for the bank. That is a resolution strategy capable of best achieving the resolution objectives27 given the structure and the business model of the institution or group, and the resolution regimes applicable to legal entities in a group.28 For groups, resolution authorities shall assess whether the resolution strategy requires supporting action by other authorities, in particular in third countries.29 On the basis of this preferred resolution strategy,30 the resolvability of the bank is assessed and impediments are identified.31 Impediments to resolvability could relate to any aspect of the business and have to be removed by the bank.32 The resolution authority also determines the minimum requirement for own funds and eligible liabilities (MREL) that, for the purposes of loss-​absorption and/​or recapitalization, can be converted into shares or other instruments of ownership as part of the financial restructuring during a resolution.33 Resolution plans are reviewed and updated at least annually and after any material changes to the legal or organizational structure of the bank.34 C. What is and what should be: mind the gap The fact that the EU-​legislator envisaged a process with a leading role for the au- 4.11 thorities has practical and legal implications. Banks have to respond to data requests35 and to explain the information provided. The authorities and the bank both have to find their way in a legal framework that defines an objective and a process but no readily applicable rules. It takes time and effort to develop a mature and well-​balanced bank-​specific resolution plan. In the course of this process it becomes clear what has to be done to transform and maintain the bank-​as-​is into the bank-​to-​be that, in line with the analysis and requirements of the resolution authorities, meets the required level of resolvability and that is prepared for the execution of the preferred resolution strategy. Impediments to resolvability as determined by

25 Section B of the Annex to the BRRD contains a list of information that resolution authorities may request banks to provide for the purposes of drawing up and maintaining resolution plans. 26 Article 24 of Delegated Regulation. 27 Set out in Article 31 of BRRD. 28 Defined in Article 2(2) of Delegated Regulation. 29 Article 25 of Delegated Regulation. 30 Defined in Article 2(3) of Delegated Regulation. 31 Article 10(2) of BRRD; Article 8(6) of SRMR. 32 Article 17(1) of BRRD; Article 10(7) SRMR. 33 Article 45(6) of BRRD; Article 12(7) and (8) of SRMR. 34 Article 10(6) of BRRD; Article 8(12) of SRMR. 35 Article 11 of BRRD; Article 34 of SRMR.

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Bart Bierens the authorities have to be removed by the bank, and the creation of new impediments should be prevented. In other words: ex ante measures as required by the authorities to make and keep a bank going concern resolvable. What is the likeliness that banks have to restructure their business activities in order to become resolvable? It is difficult to give a generally applicable and precise answer as it depends on the characteristics of each individual bank. Nevertheless, it is safe to assume that most of the EU banks are currently not fully and credibly resolvable to the standards of the BRRD. These standards were non-​existent before the global financial crisis in the time that many banks developed their current legal, operational, and financial structures. Other considerations were leading, like the supervisory regime, licensing requirements, tax treatment, or the level of operational, legal, and financial integration within a group after a merger or acquisition.

V.  The Resolvable Bank: A Blue Print 4.12

Despite these uncertainties, it is possible to outline the key features of a resolvable bank by combining the EU legal framework with recent experiences of US G-​SIBs. From an EU legal point of view, section C of the annex to the BRRD refers to the matters that the resolution authority has to consider. Consequently, these matters are determining factors for becoming resolvable.36 With regards to the experiences of the US G-​SIBs:  the public sections of their 2017 resolution plans provide a window into the efforts made to become resolvable.37 The US G-​SIBs are on the forefront of this transformation process and EU banks are likely to face similar measures. After all, the US and EU requirements find their common source in the global Key Attributes. A. Structure and operations

4.13

A first perspective concerns the structure and operations of the bank and the extent to which the institution is able to map core business lines and critical operations to

36 Pursuant to Article 15 of BRRD and Article 10 of SRMR, a resolution strategy should be feasible and credible. The feasibility assessment is outlined in more detail in Articles 27 to 31 of Delegated Regulation and further discussed in the following paragraphs of this chapter. The credibility assessment is detailed in Article 32 of Delegated Regulation and includes the expected impact of the selected resolution strategy on the financial markets. This assessment is not further discussed here. 37 The public parts of the resolution plans as provided by the banks are available on the websites of the FDIC at (https://​www.fdic.gov) and FED (https://​www.federalreserve.gov), accessed 29 September 2018. The feedback letters of the FDIC and FED of December 2017 signal that the banks, save for some smaller weaknesses, are considered now to be resolvable. References to plans in the footnotes in this chapter are to the public section of the 2017 resolution plan of the individual bank.

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The Governance of Banks and Resolvability legal persons.38 The legal structure of the group does not inhibit the application of the resolution tools as a result of the number of legal persons, the complexity of the group structure, or the difficulty in aligning business lines to group entities. The governance, control, and risk-​management arrangements are consistent with any changes to the structure of the institution or group as envisaged in the resolution plan. To ensure their continuity, critical operations are separated into separate legal entities, which can be transferred during a resolution. The legal group structure has become the backbone of a resolvable bank. The financial and operational structure has to be organized along the lines of this legal structure. The US G-​SIBs report to have taken various actions in this area, including the re- 4.14 duction of legal entities, simplifying the ownership chains, and the development of a Legal Entity Rationalisation (LER) process, applying LER criteria. The objectives of these criteria are to facilitate the recapitalization and liquidity support of material entities, facilitate the separation of businesses, provide continuity of services, protect insured depository institutions, minimize complexity, and reduce unnecessary entities.39 Some banks refer to the adoption of a service company model. Under this model, the support divisions, including critical services, are under the control of resolution resilient material services entities, which provide support services to other subsidiaries within the group. These shared services entities are well capitalized, hold significant resources, and are operationally independent, including own bank accounts for the payment of employees’ salaries, vendors, and other expenses.40 This shift towards a leading role for the legal structure of a bank could be the 4.15 cause of a discrepancy between the current situation of EU banks and the projected situation of resolvability according to the standards of the BRRD. Until the introduction of the resolvability criteria, banks did not generally prioritize legal structures when designing management processes or IT systems, or IT functionality when designing trade booking structures.41 Lehman was no exception to this practice: its legal structure did not always correspond with its the operational structure as understood by its employees, who adopted a more functional approach.42

38 Article 27 of Delegated Regulation, referring to items 1–​7, 16, 18, and 19 of section C of the Annex to the BRRD. 39 Bank of America, 31; Wells Fargo, 24. Other banks refer to the application of similar LER criteria. 40 Morgan Stanley, 57–​9; BNY Mellon, 67. 41 S Gleeson and R Guynn, Bank Resolution and Crisis Management, 2016, 28. 42 S J Lubben and S P Woo, ‘Reconceptualizing Lehman’, Texas International Law Journal, (2014), 49, 303–​4.

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Bart Bierens B. Financial resources 4.16

A  second perspective concerns the financial resources of a resolvable bank.43 An important aspect of resolvability deals with the availability of capital and eligible liabilities to absorb losses during a resolution and the subsequent recapitalization of the bank. One of the instruments available to the resolution authorities, known as bail-​in tool, converts debt into equity.44 This makes that investors in the bank carry the burden of absorbing the losses and recapitalization, and assume other costs related of the financial restructuring. The application of a bail-​in is linked to the overall objective of the BRRD that the bank is restructured without the support of public funds. A bail-​in will in most cases be an important part of the preferred resolution strategy.45 Consequently, a resolvable bank is prepared for the application of the bail-​in tool.

4.17

If the bail-​in tool is actually applied, no creditor shall incur greater losses than would have been incurred if the bank had been wound up under normal insolvency proceedings. This is the no creditor worse off (NCWO) principle.46 Preparing a banking group for a bail-​in that meets this NCWO principle may impact the legal structure of the group. Let us assume that the banking activities are rendered by one (single) authorized legal entity. On the liability side of the balance sheet are obligations arising from capital and debt instrument liabilities of the bank (capital liabilities) as well as obligations arising from the regular banking activities, such as client deposits and contracts with service vendors to support critical activities (operational liabilities). In case of a resolution that includes the write-​down and conversion of liabilities under capital and debt instruments, the losses are absorbed by the capital liabilities but not by the operational liabilities.47 A write-​down of debts from this last category will threaten the continuity of critical business activities and thus an objective of resolution. However, if the debts from both categories are equal in rank, such distinction conflicts with the NCWO principle.48

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These complications can be addressed by a subordination of the capital liabilities to the operational liabilities of the bank. A  change in creditor hierarchy can be statutory—​based on the law—​or an agreement between the bank and its creditor

43 Article 28 of Delegated Regulation, referring to items 13, 14, 15, and 17 of Section C of the Annex to the BRRD. An aspect not discussed here is intra group financial support in accordance with Article 19 of BRRD. 44 Article 43 of BRRD; Article 27 of SRMR. 45 Bail-​in is the Bank of England’s (BoE) preferred resolution strategy for the largest UK firms, including all the UK G-​SIBs and D-​SIBS; see The Bank of England’s approach to resolution, October 2017, 24. 46 Article 34 (1)(g) of BRRD; Article 15(1)(g) of SRMR. 47 Article 44 (2) of BRRD; Article 27(3) of SRMR mention the liabilities that are excluded from a bail-​in. See also Gleeson and Guynn, n 41, 5–​6. 48 EBA, ‘Interim Report on MREL’, July 2016, 54–​5.

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The Governance of Banks and Resolvability but can also be realized by the structure of the bank group using a holding structure. As an example:  a parent holding company without other activities issues equity and debt instruments that are eligible for write-​down or conversion in case of a resolution. This company holds the shares in a bank subsidiary. In addition to the equity and subordinated debt provided by the parent holding company, the bank subsidiary will only have operational liabilities on its balance sheet. During a resolution, the write-​down and restructuring of the capital will be effectuated at the level of the parent holding company, while the operational liabilities are isolated in the bank subsidiary and will not be affected. This structural subordination reduces the risk that the NCWO principle is breached.49 The US G-​SIBs refer to various actions supporting the absorption of risk on a 4.19 holding level and the continuation of services on an operational level. The parent holding must have enough loss-​absorbing capacity to recapitalize the operating entities but could enter bankruptcy proceedings if a resolution is triggered.50 At the same time, ‘clean funding pathways’ are designed to deliver financial resources to the operating entities during a resolution.51 Regulatory risks creating obstacles for the delivery are mitigated by avoiding passing through intermediate jurisdictions. Providing capital and liquidity support could be challenged by creditors of the bank. The US G-​SIBs have taken measures to mitigate these legal risks, including the creation of a prefunded intermediate holding company, executed support agreements between the holding and operational entities on their capital and liquidity needs, with predetermined capital and liquidity triggers, and the public disclosure of the existence of financial support agreements.52 C. Information The third perspective is about the availability of data. A resolvable bank has ad- 4.20 equate management information systems (MIS) ensuring that the resolution authorities are able to gather accurate and complete information regarding the core business lines and critical operations so as to facilitate rapid decision making.53 Before taking resolution action or exercising the power to write-​down or convert relevant capital instruments resolution authorities shall ensure that a fair, prudent, 49 ibid, 57:  For the purposes of enhancing resolvability, the United Kingdom has encouraged major banks to issue new senior unsecured debt from non-​operating holding companies, rather than from the operating legal entities which are CRR credit institutions. In other jurisdictions, insolvency laws were amended to address this matter. To reach a uniform approach, Article 108 of BRRD has been amended: Directive (EU) 2017/​2399 of 27 December 2017, [2017] OJ L345/​96 to be implemented in national laws before 29 December 2018. 50 Goldman Sachs, 22; State Street, 16. 51 Citigroup, 14; State Street, 32. 52 Citigroup, 13–​14; Goldman Sachs, 26–​32. 53 Article 29 of Delegated Regulation referring to items 8–​12 of Section C of the Annex to the BRRD.

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Bart Bierens and realistic valuation of the assets and liabilities of the bank is carried out. To facilitate such valuation, the bank has information on the assets and liabilities available.54 As liquidity support by the ECB could be necessary during a resolution, information should be available on the assets eligible as collateral and where these assets are held. All financial data should be related to the relevant legal entities. The bank is also required to maintain detailed records of various categories of agreements, including ‘financial contracts’. These are basically derivatives.55 The minimum set of readily available information on these contracts consists of forty-​three different fields, which is indicative of the required level of detail.56 4.21

The US G-​SIBs refer to upgrades of their existing management information systems and significant investments in the system architecture and data quality.57 Their systems are now able to support the information needs associated with resolution planning and execution of the resolution strategy, such as (net and gross) exposure by client, collateral position, legal entity, country, assets, services, and operational resources such as personnel, facilities, and information systems. As part of these improvements, various banks have created large contract repositories with search engines that are able to identify and extract special data fields.58 Banks have also built an infrastructure around transaction preparedness to ensure that the divestiture options in the resolution plan can be executed on short notice. This includes electronic data rooms for each potential object of sale populated with materials that would be expected to be made available to facilitate a buyer due diligence.59 D. Cross-​border  issues

4.22

Systemically important banks are international in nature and provide their services around the globe or, at least, across the borders of countries and regions. They could have business within the euro-​zone (with the SRB as common resolution authority), within EU Member States but outside the euro-​zone (operating within the common resolution framework of the BRRD) or in third country jurisdictions (with a resolution framework based on local law and authorities operating under local mandates).60 The expected level of cooperation between resolution authorities is a determining factor for the preferred resolution strategy of an international bank. If a bank has a substantial part of its activities within the euro-​zone or European Union, it is likely that a single point of entry (SPE) strategy will be applied. This

54 Article 36 of BRRD; Article 20 of SRMR. 55 As defined in Article 2(1)(100) of BRRD. 56 Annex to Regulation (EU) 2016/​1712, [2016] OJ L258/​1. 57 BNY Mellon, 55–​9. 58 Goldman Sachs, 34; Citigroup, 116. 59 BNY Mellon, 70. 60 M J Nieto, ‘Third Country Relations in the Directive Establishing a Framework for the Recovery and Resolution of Credit Institutions’, in Binder and Singh (eds), n 3, 137–​56.

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The Governance of Banks and Resolvability means that one single resolution authority exercises its powers on the level of the top holding of the bank.61 Losses are absorbed at this top level while subsidiaries, in particular the material operating entities, have sufficient capital and funding to continue their day-​to-​day services. Consequently, an SPE strategy requires a free flow of assets and liquidity within the group and across the borders of jurisdictions. It requires an in-​depth legal analysis whether this is a fair assumption, in particular with regard to activities outside the European Union. A local regulator may (or is even obliged to) restrict a local operating entity from using its excess financial resources to other operating entities. This is commonly referred to as ring-​fencing and could negatively affect the execution of an SPE strategy.62 A multiple point of entry (MPE) strategy is feasible if the bank has significant ac- 4.23 tivities in third countries and, at the time of resolution, no effective cooperation is to be expected between the resolution authorities. Indicators are the absence of cooperation agreement between authorities or the mandates that are focused on the protection of local creditors rather than international financial stability.63 In case of an MPE strategy, the resolution powers are exercised by two or more resolution authorities on regional sub-​groups.64 An MPE strategy will be reflected in the governance and legal entity structure of a resolvable bank.65 It creates regional sub-​holdings resulting in capital and liquidity ring-​fenced within the group. This comes at a price: each individual resolution authority will require reassurance that critical systems in their jurisdiction continue to operate without the support of group entities outside their jurisdiction. All aspects of the ‘resolvable bank’ are considered at the level of the local sub-​holding. This potentially causes expensive operational duplications within the group. Seven out of the eight US G-​SIBs apply an SPE strategy, supporting the absorption 4.24 of risk on a holding level under US jurisdiction.66 To reduce the risk that such US-​ lead resolution is impeded by ring-​fencing actions of foreign authorities, the US G-​SIBs haven taken various measures. The operating entities outside the United States are provided with capital and liquidity support. This creates local interests 61 EBA Guidelines to remove impediments, n 17, 9, definition of SPE. See also J Jennings-​Mares, A T Pinedo, and O Ireland, ‘The Single Point of Entry Approach to Bank Resolution’, in Binder and Singh (eds), n 2, 281; J Armour, ‘Making Bank Resolution Credible’, in N Moloney, E Ferran, and J Payne (ed), The Oxford Handbook of Financial Regulation, 2015, 470. 62 As an example: pursuant to § 606 of the New York Banking Law, a superintended may take possession of the New York branch of a non-​US bank to ensure that local creditors are paid. Other examples are transfers of financials within the group that are subject to tax deductions or prior regulatory approvals. 63 See also Title VI of BRRD on relations with third countries. 64 EBA Guidelines to remove impediments, n 17, 9, definition of MPE. 65 Article 30 of Delegated Regulation referring to item 20 of Section C of the Annex to the BRRD. See also FSB, ‘Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Developing Effective Resolution Strategies’, July 2013. 66 Wells Fargo, 9 maintains a ‘bridge bank’ strategy.

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Bart Bierens aligned with the SPE strategy: as the operations continue and remain compliant with local regulatory requirements, there are no incentives for local unilateral actions.67 The complexity of cross-​jurisdictional issues is also reduced by locating the material operating entities in a limited number of countries.68 Another action is a crisis communication plan that provides a guide to communications to key stakeholders, including non-​US regulators. Despite all these executed or anticipated actions, unconditional cross-​border cooperation does not seem to be expected yet. One bank reports to have assumed a ‘soft ring-​fencing’.69 On the European side of the Atlantic, the SRB considers it a priority to conclude cooperation agreements concerning G-​SIBs for which SRB is the host authority, including four of the US G-​SIBs.70 E. Other potential impediments 4.25

The Delegated Regulation refers to some potential legal impediments, including the risk that a resolution triggers an early termination clause in contracts. This results in a payment obligation of the troubled bank or, in case of service contracts, losing IT-​licenses or access to critical market infrastructures. An early termination could also trigger cross-​default clauses creating a cascade of terminating contracts and payment obligations accelerating the liquidity problems of the bank. Resolution authorities require resolution-​stay clauses in contracts making it clear that a resolution is no ground for an early termination as long as the bank continues to meet its obligations under the agreement.71

4.26

The US G-​SIBs refer to their adherence to the 2015 ISDA Universal Stay Resolution Protocol, which is part of a series of initiatives promoted by US and foreign regulators and the financial sector to contractually limit early termination rights with respect to certain common financial transactions, in particular derivatives.72 This protocol mitigates the risk that operational entities are subject to simultaneous liquidity outflow and disorderly liquidations of collateral as result of close-​outs of over-​the-​counter (OTC) derivatives.73 The US G-​SIBs have also initiated a review 67 Citigroup, 15; JPMorgan Chase & Co, 61; BNY Mellon, 71. 68 Goldman Sachs, 19. 69 JPMorgan Chase & Co, 62. 70 SRB, ‘Multi-​Annual Planning and Work Programme 2018’, 26. On 14 December 2017, the SRB and FDIC announced that a cooperation agreement had been signed. See also C Russo, ‘Third Country Cooperation Mechanism within the Bank Recovery and Resolution Directive: Will They Be Effective?’ in Binder and Singh (eds), n 2, 157. 71 Article 31 of Delegated Regulation. Pursuant to Article 55 BRRD, banks have to include a bail-​in recognition clause in agreements subject to the laws of a non-​EU jurisdiction. Resolution authorities may temporarily suspend the effect of early termination clauses provided that the bank continues to perform its obligations: Article 71 of BRRD. See also the proposal to amend Article 55 of BRRD, 23 November 2016, COM(2016) 852 final. 72 JPMorgan Chase & Co, 45; Wells Fargo, 28. 73 Citigroup, 109.

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The Governance of Banks and Resolvability of their vendor contracts and amended termination rights and change-​of-​control clauses that could impede resolvability. New contracts, including inter-​company service contracts, have resolution and divestiture friendly provisions.74 F. The common thread: reducing complexity Resolvability is an addition to the existing governance related requirements for 4.27 banks. The necessity for an individual bank to reorganize its business largely depends on its current legal, financial, and operational structure and to what extent it already meets the features of a resolvable bank. The common thread running through the various aspects of resolvability is the reduction of complexity. This means, in the first place, a simplification of the legal, operational, and financial structures of the group, including a reduction of the number of legal entities, rationalizing intra-​group financial relations, streamlining the IT-​structure, and the availability of management information on a legal entity level. However, the most important challenge is probably not the reduction of complexity within these separate areas but their mutual alignment across the group. As experienced and reported by US banks, it will take time and effort to map core business lines and critical operations to legal entities and to correspond operational and financial structures with this legal structure. Before the global financial crisis, such alignment was not a priority in the design of the legal, financial, and operational structure of a group. Since the global financial crisis, it has become a determining factor in becoming resolvable.

VI.  Decision to Remove Impediments A. Process and decision The resolvability assessment of a bank is not an open-​ended exercise, especially not 4.28 if the resolution authority (for large banks in the euro-​zone, the SRB) after its own assessment and in consultation with the supervisors (for large banks in the euro-​ zone, the ECB) considers that there are impediments. This will be communicated in writing to the bank, the ECB or national competent authorities, and the authorities in the jurisdictions where significant branches are located.75 It is interesting to note that the ECB and the national competent authorities are consulted as part of the process and informed on the outcome, but have no decision rights or voting power on the significance of the impediments or the required actions to remove these impediments.76 This allocation of powers shows the priorities of the European 74 Citigroup, 26; Morgan Stanley, 60. 75 Article 17(1) of BRRD; Article 10(7) of SRMR. 76 Article 30(2) of SRMR concerns the exchange of information; see also the Memorandum of Understanding (MoU) of 22 December 2015 between the SRB and the ECB.

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Bart Bierens legislator after the global financial crisis and euro-​crisis:  resolution prevails over prudential supervision. 4.29

After the bank has been informed on the identified impediments, it is required to propose, within a period of four months, actions to address or remove these impediments. The resolution authority will assess, in consultation with the ECB or national competent authorities, the adequacy of the measures proposed.77 Where the resolution authority concludes that the measures proposed by the bank do not effectively reduce or remove the impediments, it requires the bank to take alternative measures that may achieve the objective, and notify those measures to the bank, which shall propose, within one month, a plan to comply.78 The BRRD and SRMR empower the resolution authorities to take various measures, such as changes to legal or operational structures of the bank or any group entity to reduce complexity, require a bank to set up a parent financial holding company in an EU Member State, and restrictions on the development of new or existing business lines or sale of new or existing products.79 These powers underscore the importance of resolvability within the post-​crisis framework for banking supervision.

4.30

The decision of the resolution authority to remove impediments explains the reasons for the assessment, substantiates why the required actions are proportionate, and refers to the right of appeal.80 The decision should be limited to what is necessary in order to simplify the structure and operations solely to improve the banks’ resolvability and should be consistent with Union law. Measures should be neither directly nor indirectly discriminatory on the grounds of nationality, and should be justified by the overriding reason of being conducted in the public interest in financial stability. Furthermore, action should not go beyond the minimum necessary to attain the objectives sought.81

4.31

At the time of writing, the SRB as leading resolution authority in the euro-​zone, seems reluctant to use formal decrees and prefers a more informal style of communication. It approaches the transition towards a resolvable bank as a plan-​do-​ check-​adjust (PDCA) cycle. This method of transformation works with dialogues, guidance, and expectations rather than formal decisions. The avoidance of formal decisions also relates to the early stage of the SRM and existing differences across the euro-​zone Member States with regard to resolution preparation.82 However,

77 Article 17(3) of BRRD; Article 10(9) of SRMR. 78 Article 17(4) of BRRD; Article 10(10) of SRMR. 79 Article 17(5) of BRRD; Article 10(11) of SRMR. 80 Article 17(4), second paragraph, and (6) of BRRD; Article 10(10), second paragraph, and (13) of SRMV. 81 Article 16 of the Charter of Fundamental Rights of the EU and Recital 29 of BRRD. 82 According to the ‘SRB Multi-​Annual Planning and Work Programme 2018’, 20, measures to remove impediments are intended to be taken from 2019 onwards.

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The Governance of Banks and Resolvability on-​going communications as part of a PDCA cycle entails the risk that expectations are poorly substantiated and do not explain why a resolvability enhancing measure, according to the resolution authorities, meets the requirement of proportionality. Moreover, informal communications and feedback letters are not subject to the right of appeal.83 B. Alignment of the SREP and resolvability assessment The process of resolvability assessment may develop in the forthcoming years to- 4.32 wards a more mature process that could resemble the supervisory review and evaluation process (SREP). The SREP is performed annually by the ECB or national competent authorities and is the core of on-​going prudential bank supervision. Based on the risk profile of the bank and the shortcomings assessed during this process, the ECB or the competent authorities may require the bank to hold risk-​ absorbing capital on top of the general applicable minimum requirements or take actions to address any shortcomings. This is communicated to the bank in a SREP decision explaining the reasons for the required actions. This SREP decision is subject to the right of appeal. Actions to enhance the resolvability of a bank are interrelated with the SREP and, 4.33 more generally, the capital requirements of the CRR/​CRD IV. Under the BRRD, the MREL needs to ensure that, if the bail-​in tool is to be applied, the losses of the bank could be absorbed and the capital ratio of the bank could be restored to a level necessary for continued authorization and to sustain sufficient market confidence post resolution. The quantum of the loss-​absorbing amount as part of the MREL requirement includes the quantum of the SREP requirements. The costs of becoming resolvable will also have effects on the financial position and the going-​concern priorities of a bank. The costs of compliance could affect the overall profitability of the bank and hamper the increase of capital buffers by retained earnings. A US bank has spent two billion dollars after six years of resolution planning.84 Moreover, EU banks have to contribute to resolution funds.85 Whether a prudential risk reducing measure is proportionate, including the actions necessary to remove any impediments to resolvability, should be balanced against the costs of all other risk-​reducing measures imposed on the bank. For this and other reasons, the SREP and the resolvability assessment should be fully aligned.86 Framed within 83 The appeal procedure against a decision to remove impediments will not be discussed here; see Article 85 of SRMR (Appeal Panel) and Article 86 of SRMR (EU Court of Justice). 84 JPMorgan Chase & Co, 74. 85 In a press release of 19 July 2017, the SRB announced that it collected 6.6 billion euros from 3,512 institutions in annual contributions to the Single Resolution Fund (SRF). As per July 2017, the SRF amounts to 17.4 billion euros. According to an estimate of the European Commission, the SRF will amount between to 55–​60 billion euros in 2023. 86 Other reasons: resolution planning also depends on input from supervisors regarding recovery plans or the outcome of the SREP; ‘SRB Multi-​Annual Planning and Work Programme 2018, 47.

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Bart Bierens the architecture of the EU Banking Union: a better alignment of the first pillar (SSM) and the second pillar (SRM) facilitates a more holistic approach on all going concern and gone concern risk-​reducing measures and safeguards the proportionality and consistency of the bank-​specific prudential measures required by both the ECB and SRB.

VII.  The Transition to Being Resolvable 4.34

Currently, it is uncertain at what level the expectations of the SRB and other resolution authorities in the European Union will stabilize and banks are deemed to be resolvable should they meet expectations. In view of the experiences of the eight US bank as the benchmark, this will take much time, effort, and costs. The pacing towards the required level of resolvability will depend on the views and priorities of the authorities. The SRB, set up in early 2015, is still in the process of building its organization aiming at a staff of 410 full-​time equivalents (FTEs) in 2020.87 It is essentially in a ‘start-​up’ phase and the first resolution plans adopted in 2016, the starting point for the resolvability assessment, did not meet a substantial number of requirements laid down in the Single Rulebook.88 In addition, the projected risk absorbing capital layers and safety nets are subject to a transitional period. The Prudential Regulation Authority (United Kingdom) indicated that the largest banks in the United Kingdom have to meet the MREL in 2022.89 The SRF will be gradually built up during the first eight years and meet its target level in 2023.90 The required level of resolvability also has a nexus with structural changes in the financial industry, political developments including Brexit and, as large EU banks have a footprint in the United States, the willingness to cooperate across the Atlantic.91

4.35

The actions necessary to become resolvable will initially be managed by the bank as a project. In the long term, in order to maintain resolvability, this will have to be embedded in the day-​to-​day processes and become business-​as-​usual. The preparation for a resolution will be part of the risk and crisis governance of a bank, with early warning triggers and an alert mechanism for the escalation of information, 87 ibid, 46. 88 European Court of Auditors, ‘Single Resolution Board: Work on a challenging Banking Union task started, but still a long way to go’, December 2017. 89 ‘The Bank of England’s approach to setting a minimum requirement for own funds and eligible liabilities (MREL)’, November 2016, 7.  See also ‘Internal MREL—​the Bank of England’s approach to setting a minimum requirement for own funds and eligible liabilities (MREL) within groups, and further issues’, October 2017. 90 On this, see SRF, n 12. 91 In a referendum, the UK electorate voted to leave the European Union. On 29 March 2017, the British government invoked Article 50 of the Treaty of the European Union and will consequently leave the European Union on 29 March 2019.

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The Governance of Banks and Resolvability decision making, and the recapitalization and funding of material legal entities. Governance playbooks will provide guidance to the management on the execution of the actions required. This supports a timely and coordinated response to increased levels of stress. It will also entail the identification of key staff with the expertise required to execute the resolution plan.92 However, resolution planning is more than being prepared for an event that is 4.36 unlikely to happen. Resolution cannot be an afterthought93 and maintaining resolvability will become an overarching principle for decisions by the executive and senior management.94 Many issues that regularly appear on the agenda of the executive board have an angle to resolvability, including mergers and acquisitions (to protect and keep a rational legal entity structure), capital and liquidity planning (having funds available to support a resolution), the support of key business lines (including shared and outsources services), and management information systems (to allow for a timely valuation of assets and to sale of non-​critical activities). It requires an on-​going focus of the board on simplification, efficiency, and the avoidance of interconnections that could impede the banks’ resolution strategy.95

VIII.  Rethinking the Governance of Banks Resolvability also urges to rethink the governance of systemically important banks 4.37 on a conceptual level. As mentioned in the introduction, governance involves a set of relationships among a company’s management, its board, its shareholders, and other stakeholders. The resolution framework for banks sheds new light on the parties that belong to this group of ‘other stakeholders’ of banks. It does not need to be said, that a stable financial system and the continuity of critical functions are in the interest of the general public. This is embedded in the objective of resolvability, which is avoiding, to the maximum extent possible, any significant adverse effect on the financial system with a view to ensuring the continuity of critical functions carried out by the bank.96 The interest of the general public demands that the conduct of the banks’ business does not intervene with the objective of resolvability. In other words: the society as a whole is a stakeholder of a systemically important

92 JPMorgan Chase & Co, 70 has developed an employee retention framework designed to appropriately incentivize key employees and personnel to stay in a resolution scenario. 93 BoE, ‘The Bank of England’s Approach to Resolution’, 2017, foreword by Jon Cunliffe. 94 Wells Fargo, 31. 95 Contemplating the risks of a failure and the banks’ mortality are reminiscent of the Roman tradition of memento mori in which a slave would repeatedly whisper that phrase to the general in a victory parade: Steven L Schwarcz, ‘Regulating Complacency: Human Limitations and Legal Efficacy’, Notre Dame Law Review (2018), 1073–​104, 1095. 96 Article 15 of BRRD; Article 10 of SRMR.

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Bart Bierens bank, whose interest should be considered and addressed by the board and the management of the bank. 4.38

The group of stakeholders also consist of contributors to the financial safety nets for failing banks. If the banks’ shareholders and other investors are not able to absorb the losses, the costs of the resolution have to be externalized. Under the SRM framework, the SRF may be used to ensure the efficient application of resolution tools and the exercise of the resolution powers of the SRB. The SRF is composed of the ex-​ante contributions from banks.97 Consequently, banks become mutual stakeholders:  if one bank fails and the costs have to be externalized, the other banks have to pay their share through their contributions to the resolution fund.98 If the financial resources of the resolution fund is insufficient to cover the costs, public funds—​state aid—​may be required or, ultimately, support by the European Stability Mechanism (ESM). The ESM provides financial assistance to EU Member States in the euro-​zone and may grant loans to Member States for indirect bank recapitalization or, in exceptional cases, loans directly to banks. Consequently, the individual EU Member State governments are stakeholders in banks. Meeting the objective of resolvability is also from this perspective in the interest of the public.99

4.39

How to balance the interests among the banks’ management, its board, its shareholders, and other stakeholders? The requirement of resolvability seems to temper the established doctrine of shareholder supremacy,100 a concept that is in continental Europe already less dominant than in the United States.101 Managers of systemically important banks may not consider the consequences of the banks’ actions only from the shareholders perspective. The governance of banks has moved towards a stakeholder oriented approach. Within that approach, the legislator has used the resolvability requirement as an instrument to address the misalignment between private and public interests. Financial stability, continuity of critical activities, and the avoidance of externalized costs of bank failures are the core-​elements of this public interest. In other words:  the BRRD and SRMR are regulatory strategies,

97 On this, see SRF, n 12. 98 A similar dependency between banks is created through the system of burden sharing under the deposit guarantee system (DGS). It ensures that all client deposits up to 100,000 euros are protected from bank insolvency. Individual banks have to finance the DGS fund. Their ex ante contributions are adjusted to the risk profile of each contributing bank. 99 On the burden-​sharing cascade, see Chr. Hadjiemmanuil, ‘Bank Resolution Financing in the Banking Union’, in Binder and Singh (eds), n 2, 193. On state aid under de BRRD-​framework: Van Lambalgen, n 5, 85–​120. 100 H Hansmann and R Kraakman, ‘The end of history for corporate law’, Harvard Law School, Discussion Paper No 280, 2000. 101 As an example, see Article 1.1. of the Dutch Corporate Governance Code (2016): ‘The management board is responsible for the continuity of the company and its affiliated enterprise. The management board focuses on long-​term value creation for the company and its affiliated enterprise, and takes into account the stakeholder interests that are relevant in this context’, emphasis added.

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The Governance of Banks and Resolvability with the SRB and other resolution authorities as enforcers, to balance the conflict of interests between the banks’ shareholders and the public interest.102 Schwarcz has argued that managers of systemically important banks should have a 4.40 public governance duty not to engage their firms in excessive risk-​taking that leads to systemic externalities.103 Requiring managers to account for systemic externalities in their governance decisions would help to correct the misalignment between private and public interests. From an EU regulatory perspective, the BRRD already contains an incentive towards personal liability for senior executives of banks. If their bank fails, the management body and senior management are replaced (unless otherwise required by the circumstances) and natural and legal persons are made liable under civil or criminal law, subject to Member State law, for their responsibility for the failure of the bank.104 This public governance duty and the risk of personal liability of members of the 4.41 executive board of a systemically important bank were considered in the decision of the Enterprise Division of the Amsterdam Court of Appeal on the collapse of Fortis, although the case predates the BRRD legislation. In 2007, Fortis participated, for 24 billion euros, in a consortium with the Royal Bank of Scotland and Banco Santander to acquire the Dutch bank ABN Amro. This was, at that time, the world’s largest bank take-​over with a transaction value of approximately 72 billion euros. Due to deteriorating markets, Fortis ran into serious trouble and had to be bailed out in September 2008. In the subsequent proceedings, the Court of Appeal ruled, inter alia, that a bank has a duty of care and that the executive board, given the systemically importance of Fortis, had to consider the public interests of the continuity of Fortis in its decision-​making process.105

102 J Armour, H Hansmann, and R Kraakman, ‘Agency Problems and Legal Strategies’, in R Kraakman et  al (eds), The Anatomy of Corporate Law, 2017, 29; Corporate Governance and Prudential Regulation, speech of Daniel K Tarullo (Member of the Board of Governors of the Federal Reserve System, 9 June 2014: ‘( . . . ) while the public has an interest in healthy, profitable banks, and thus the interests of shareholders and the public overlap, they are not coincident.’ 103 Steven L Schwarcz, ‘Too Big to Fool:  Moral Hazard, Bailouts, and Corporate Responsibility’, Minnesota Law Review (2017–​18) 761–​801; Steven L Schwarcz, ‘Misalignment: Corporate Risk-​Taking and Public Duty’, Notre Dame Law Review (2016) 1–​50. 104 Article 34(1) under (c)  and (e)  of BRRD. See also EC 2013 Banking Communication (2013/​ C 216/​01) under 37, expecting the replacement of the CEO and other board members if state aid is provided. 105 Enterprise Division of the Amsterdam Court of Appeal (Ondernemingskamer), 5 April 2012, JOR 2013/​41 (VEB/​Aegas), under 4.4. This was undisputed in appeal: Supreme Court of the Netherlands, 6 December 2013, JOR 2014/​65. Personal liability of executives of Fortis assumed but on other grounds; Utrecht Court, 15 December 2012, JOR 2012/​243.

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IX. Conclusion 4.42

Is the resolvability requirement a fundamental change of perspective on the governance of banks? Some will argue that it is too early for far-​reaching conclusions. What in the European Union will become the benchmark for resolvability and the pacing of the process towards this level depends on evolving views and priorities of the resolution authorities as well as uncertain political developments. Resolvability can be seen as just a next stage in an ongoing process of bank regulation, reflecting changing views and insights and past experiences. However, such approach underestimates the intention of the legislator. This chapter discussed the impact that the resolvability requirement will have on the going concern activities of banks. As experiences by large US banks show, it will have a strong impact on the design and structure of banking groups. Resolvability could very well become an overarching principle for the governance of banks. The powers of the resolution authorities to enforce the removal of any impediments prove that the resolvability assessment of a bank is not an open-​ended exercise. But the most important factor is that the governance of banks is no longer only about the going concern perspective, but will now also be driven by gone-​concern considerations. And that is, as I conclude, indeed a fundamental change of perspective on the governance of banks.

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5 CORPORATE LAW VERSUS FINANCIAL REGULATORY RULES The Impact on Managing Directors and Shareholders of Banks Kitty Lieverse and Claartje Bulten

I. Introduction 5.01 II. Taking Stock: The Potential Tension between Corporate Law and Financial Regulatory Rules 5.05

IV. Impact on Shareholders

5.38 A. Conditions for shareholdings in company law 5.38 B. Approval of (candidate) shareholders in the banking sector 5.39 C. Further conditions for shareholdings in a bank 5.40 D. Redemption of capital, distributions 5.42

A. Introduction 5.05 B. Types of tension 5.06 C. The different nature of company law and financial regulatory rules 5.08 III. Impact on the Board 5.11 A. Variety in board models; appointment of board members 5.11 B. Appointing directors 5.15 C. Composition of the boards: diversity criteria 5.20 D. Tasks and duties of directors 5.26 E. Arrangements on remuneration 5.30 F. Zooming in: the prevalence of the financial regulatory rules over company law 5.35

V. Impact of the Single Rulebook on the Interpretation of Corporate Interest A. Shareholder-​driven v stakeholder-​driven B. The application of the rules on corporate interest to banks

VI. Conclusions

5.46 5.46 5.52 5.56

I. Introduction This chapter discusses the impact of financial regulatory rules on the corporate 5.01 governance of banks1 established in Europe. Company law will be considered as 1 Reference in this chapter to ‘banks’ is a reference to ‘credit institution’ within the meaning of Article 4(1)(1) of CRR, that is, an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account.

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Kitty Lieverse and Claartje Bulten it exists in the various Member States, with a specific focus on the Netherlands, Germany, and the United Kingdom (English law). In Europe, banks may take a variety of legal forms, for example cooperatives and private or public limited liability companies.2 The analysis in this chapter is limited to banks that operate as public limited liability companies.3 The shares in the capital of the bank (or its holding company) may or may not be listed on a stock exchange. For listed banks, not only company law such as the UK Companies Act 2006, the Dutch Civil Code (Book 2 on Legal Entities), or the German Stock Corporation Act (Aktiengesetz or AktG) are of relevance. Typically a corporate governance code will apply. The three mentioned jurisdictions all have such a code. The codes are specifically written for listed companies, but mostly contain rules on corporate governance that may be considered ‘universal’ in a jurisdiction. A company must comply with the provisions of a code or must explain why it deviates from a given principle or practice.4 There is only limited European harmonization on the various national systems of company law regarding matters of corporate governance.5 5.02

Where in this chapter reference is made to financial regulatory rules this refers, broadly speaking, to the rules that regulate the financial markets and the financial market participants. This chapter will only look at the financial regulatory rules for the banking sector of European descent.6 For banks in particular, this means that the focus of the chapter will be on the national implementation of CRD IV7 as well

2 Reference is made to the country-​by-​country overview of the European Banking Federation showing great variety in legal form and size of banks within the European banking sector; Facts and Figures 2017, available at https://​www.ebf.eu, accessed 8 October 2018. 3 As listed in Annex I  to Directive (EU) 2017/​1132 of the European Parliament and of the Council of 14 June 2017 relating to certain aspects of company law, [2017] OJ L169/46. 4 Under Dutch law, this is arranged through a transparency requirement in respect of the management report, based on Article 2:391(5) of the Dutch Civil Code (DCC). 5 The most extensive (and important) directive is the Codification Directive, see Directive (EU) 2017/​1132 of the European Parliament and the Council of 14 June 2017 related to certain aspects of company law, [2017] OJ L169/46. This Directive contains rules on, among other things, (cross-​ border) mergers, demergers (division), and capital issues, but very few on corporate governance. The Shareholders Directive (Directive 2007/​36/​EC of the European Parliament and of the Council of 11 July 2007 on the exercise of certain rights of shareholders in listed companies ([2017] OJ L184/​17), as amended by Directive 2017/​828 of the European Parliament and of the Council of 17 May 2017 ([2017] OJ L132/1) is one of the rare examples of European harmonization of a typically corporate governance issue: the encouragement of shareholder engagement. 6 This is in fact not a limitation of this study, as the Single Rulebook that constitutes the focal point of banking supervision is European in origin. Nevertheless, to the extent allowed by the provisions of the Single Rulebook (i.e. to the extent not prohibited by the prescribed level of harmonization), there could be additional national financial regulation for banks, such as the Dutch bonus cap rule of 20 per cent as set out in Article 1:121 of the Dutch Act on financial supervision, (Wet op het financieel toezicht). 7 Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​49/​EC, [2013] OJ L176/338.

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Corporate Law versus Financial Regulatory Rules as the CRR8 including the delegated regulations thereto and the related guidelines and opinions of the European Banking Authority (EBA). In addition, the Single Supervisory Mechanism (SSM)9 system will be considered. The ‘Single Rulebook’ will be used to refer to this set of European banking regulation. This chapter will not focus on the rules for bank recovery and resolution,10 which in fact provide for a very distinctive and far-​reaching impact on the corporate governance of a bank.11 This chapter proceeds on the basis of the description of ‘corporate governance’ de- 5.03 ducted from the G-​20/​Organisation for Economic Co-​operation and Development (OECD) Principles of Corporate Governance:12 ‘Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides for a structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.’ For this analysis, the impact of financial regulatory rules on the board of directors and the shareholders of a bank are looked at. On this basis, two broad elements of corporate governance concerning banks are discussed: the impact of financial regulatory rules on (i) company law systems that may either be shareholder-​driven or stakeholder-​driven, and (ii) the duties and responsibilities of a bank’s managing directors. In this context, the relationship between banks and their shareholders and the management of the banks, and the position of other stakeholders are focused on. If and how, on the basis of company law, this relationship is impacted by the financial regulatory system will be considered. The basic assumption here is that, clearly, banks are not ordinary companies. In 5.04 view of their activities, they also have to deal, through financial supervision, with extensive regulation of public interests. This impacts both the structure of banks and the manner in which they operate. A further dimension is added because of the European origin of the financial regulatory rules for the banking sector, as referred

8 Regulation (EU) No 575/​2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/​2012, [2013] OJ l176/1, [2013] OJ L321/6 (corrigendum). 9 Council Regulation (EU) No 1024/​2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, [2013] OJ L287/63. 10 Consisting of: (i) Directive 2014/​59/​EU establishing a framework for the recovery and resolution of credit institutions and investment firms and the rules on Deposit Guarantee Schemes as set out in Directive 2009/​14/​EU amending Directive 94/​19/​EC on Deposit Guarantee Schemes as regards the coverage level and the pay-​out delay, [2014] OJ L173/190 and (ii) Regulation (EU) 806/​2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending Regulation (EU) No 1093/​2010, [2014] OJ L225/1. 11 See Bart Bierens, Chapter 4, this volume, Section VIII. 12 G20/​OECD, ‘Principles of Corporate Governance’, 2015, 9.

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Kitty Lieverse and Claartje Bulten to above, and because (within the SSM) the ECB acts as a single supervisor.13 The impact of financial regulatory rules, including intervention by the supervisor, on the corporate governance of banks might potentially provide for European harmonization of national company law based on the public interests that are being pursued for this sector.14

II.  Taking Stock: The Potential Tension between Corporate Law and Financial Regulatory Rules A. Introduction 5.05

The starting point of the Single Rule Book is that national company law is respected. Recitals 55 and 56 of CRD IV acknowledge that different corporate governance structures are used across the Member States. Recital 55 states that the definitions used in CRD IV are in fact intended to embrace all existing structures, without advocating any structure in particular (i.e. a one-​tier board versus a two-​tier board). From this Recital it can be deduced that the purpose of the CRD IV definitions is to state a particular outcome in respect of corporate governance, rather than to prescribe a certain allocation of competences that would be determined by national company law. This (effectively) neutral position of the Single Rulebook vis-​à-​vis the system of national company law is confirmed by Article 3(1)(7) of CRD IV, which gives the following definition of ‘management body’: it ‘means an institution’s body or bodies, which are appointed in accordance with national law, which are empowered to set the institution’s strategy, objectives and overall direction, and which oversee and monitor management decision-​making, and include the persons who effectively direct the business of the institution’. This substance-​based description includes both the executive and supervisory function, which may be included in a single board or may be incorporated in a two-​tier system, where the supervisory function is performed by a separate supervisory board and the executive function is performed by a separate management board which is responsible and accountable for the day-​to-​day management of the bank.15 This ‘substance over form’ approach indicates that, on the one hand, the Single Rulebook is flexible in that it facilitates different systems of national company laws, while on the other hand the national

13 Within the scope set forth in Article 4 of Council Regulation (EU) 1042/​2013 and with the prescribed cooperation of national supervisory authorities as set forth in Article 6 thereof. 14 Parts of this study are based on and a further elaboration of a previous study of the impact of financial regulatory laws on Dutch company law by Kitty Lieverse: (i) ‘Doorwerking van het financieel toezicht recht in het vennootschapsrecht’, inaugural lecture of 24 November 2016, Radboud Repository, (http://​hdl.handle.net/​2066/​167585), and (ii) ‘Doorwerking van het financieel toezicht recht in het vennootschapsrecht’, Ondernemingsrecht, 2017/​145. 15 As is also set out in Recital 56 of CRD IV.

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Corporate Law versus Financial Regulatory Rules company law systems also have to be flexible, in order to ensure that the result prescribed by the Single Rulebook is achieved. B. Types of tension The tension resulting from the simultaneous applicability of company law and fi- 5.06 nancial regulatory rules may take several forms. The first, although not necessarily creating ‘tension’, is that financial regulatory rules may provide for additional regulation on top of company law. As a result, a bank not only has to comply with company law, but also with the rules on corporate governance arising from the financial regulatory rules. The second is that provisions of financial regulatory rules on corporate governance may set aside certain company law rules that deviate from the financial regulatory rules. The distinction between the first and second type of tension is not always very strict and depends on variations in national company law systems. For example, if the number of board positions a director may hold is not restricted under national company law, the Single Rulebook may provide additional rules on this subject. If national company law rules differ from the rules in the Single Rulebook in this regard, this constitutes a deviation. For instance, the Single Rulebook provides in respect of significant banks, that in order to ensure that members of the management board may devote sufficient time to their position,16 they may not hold more than one of the following combinations of directorships at the same time: (i) one executive directorship and two non-​executive directorships; or (ii) four non-​executive directorships.17 As mentioned earlier, national company law systems may or may not contain rules on combining functions, and/​or may stipulate different rules on this subject. The third type of tension distinguished here relates to the application by the supervisor (the ECB and/​or the national competent authorities) of certain financial regulatory rules which leads to interference with company laws. Some examples of tension between financial regulatory rules and/​or the application 5.07 by the supervisor on the one hand, and company law rules on the other are provided in the following section. This does not represent an exhaustive inventory of rules on corporate governance of banks. Rather, the examples given serve as illustration for the impact financial regulatory rules have on the corporate structure and operations of the bank, including the management board, and on the relationship with their shareholders.18

16 Article 91(2) of CRD IV. 17 Article 91(3) of CRD IV. 18 For comprehensive studies on corporate governance of banks, see Peter O Mülbert, ‘Corporate Governance on Banks’, European Business Organization Law Review (2009), 10, 411–​36 and the Basel Committee on Banking Supervision (BCBS), ‘Guidelines Corporate governance principles for banks’, 2015.

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Kitty Lieverse and Claartje Bulten C. The different nature of company law and financial regulatory rules 5.08

One of the causes of the tension between company law rules and financial regulatory rules could be their nature. Traditionally, company law has a facilitating nature. It is said to be a law in favour of trade. Too many detailed provisions would only raise barriers. Company law is therefore not based on a comprehensive set of rules. It is not uncommon for a company law system to provide a basic set of rules. Deviating from it (e.g. in the articles of association) is often allowed. In this way, a company can make its own choices in respect of the corporate governance system that best suits the business of that company.19

5.09

The financial regulatory rules are of a different kind. The regulatory framework is extensive and often provides detailed rules. Although proportionality20 allows for some flexibility and avoids a strict ‘one size fits all’ approach, there is nevertheless typically only limited room to waive certain rules, or to deviate from them.

5.10

The guiding principle for regulating the banking sector is to maintain the confidence of the public (i.e. the deposit holders) in their bank and the banking sector as a whole. Against this background, financial regulatory rules are mandatory, with limited or no room to deviate. So, where company law essentially leaves room for tailor-​made companies, financial regulatory rules generally require banks to adopt the uniform result that follows from application of these rules.

III.  Impact on the Board A. Variety in board models; appointment of board members 5.11

Historically, the Dutch board model is a two-​tier model. The operational management and strategy are part of the tasks of the management board. The supervisory board is a separate body. The tasks of the supervisory board consist of supervising and advising the management board.21 These two boards are separate: one cannot be simultaneously a member of the management board and a member of the supervisory board. In 2013, the one-​tier model with executive and non-​executive directors was implemented in the Dutch Civil Code. A non-​executive director in a one-​tier system has at least the same supervisory task as a member of the supervisory board in a two-​tier system.22

19 For the last two decades, an exception has been made in the various corporate governance codes. They often consist of principles, followed by long lists of best practices. Therefore the framework of corporate governance is nowadays rather extensive in comparison with ‘pre-​code times’. 20 Reference is, for example, made to the EBA ‘Guidelines on Internal Governance, EBA/​GL/​ 2017/​11, 21 March 2018, Ch 4, para 17 et seq. 21 Article 2:140 of DCC. 22 Article 2:129a of DCC.

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Corporate Law versus Financial Regulatory Rules In Germany the two-​tier system is mandatory for large companies. If a German 5.12 company prefers a one-​tier board, it often chooses the structure of a SE (Societas Europeae), with a seat based in Germany. In the United Kingdom a single-​tier board model is assumed by the legislation. 5.13 This type of board model, however, is not mandatory. The legislation is silent on this subject.23 In addition, the UK Corporate Governance Code provides for a one-​tier board, although the code does not explicitly require this kind of board structure either.24 In practice, UK companies (including banks) typically opt for one-​tier boards. As mentioned in 5.05, the Single Rulebook does not prescribe either a one-​tier or 5.14 a two-​tier board model. Regardless of the board model as prescribed or allowed under national company law, however, the functions and requirements stipulated in the Single Rulebook in respect of the board must be complied with. B. Appointing directors National company law provides rules for the appointment of managing (executive) 5.15 directors and supervisory (non-​executive) directors of a bank. In the absence of other arrangements in the articles of association, the authority to appoint an individual as a managing or supervisory director of a bank is typically vested in the general meeting of shareholders. In that situation, the general meeting determines who controls the bank in terms of day-​to-​day policy making and who supervises the management as a supervisory (non-​executive) director. Exceptions apply, however. The management board of a German bank is for example appointed by the super- 5.16 visory board.25 The supervisory board in turn consists of members who are appointed by the general meeting of shareholders or by the employees. This system of co-​determination leads to the representation of two groups of stakeholders—​ shareholders and employees—​in one body. It is remarked that this mandatory employee representation leads to a stakeholder-​oriented composition of the boards in Germany; see 5.51.26

23 P Davies, ‘Corporate Boards in the United Kingdom’, in P Davies et al (eds), Corporate Boards in Law and Practice, Oxford University Press, 2013, 716–​17 and 723. 24 The UK Corporate Governance Code mentions ‘the board’, ‘directors’, ‘executive directors’, and ‘non-​executive directors’. 25 German Stock Corporation Act (AktG), Paragraph 84. 26 See M Roth, ‘Employee Participation, Corporate Governance and the Firm: A Transatlantic view focused on Occupational Pensions and Co-​determination’, European Business Organization Law Review (2010), 11, 51, para 5. To avoid the mandatory employee representation in a supervisory board, a German company can decide to change into a (German) SE. The co-​determination within an SE is subject to (compulsory) negotiations between the management and the employees (represented by a special negotiating body).

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Kitty Lieverse and Claartje Bulten 5.17

Dutch company law also recognizes a special role for the employees. Large Dutch companies are subject to labour co-​determination rules. These rules prescribe that members of the supervisory board are appointed by the general meeting of shareholders, on the nomination and proposal of the supervisory board, whereby the supervisory board nominates and selects one-​third of the supervisory directors on the recommendation of the works council.27

5.18

For completeness’ sake:  the United Kingdom has no requirements for employee representation at board level.

5.19

At the same time, however, the Single Rulebook contains certain rules that in fact limit the appointment rights. The first of these is Article 13(1) of CRD IV, which prescribes that a bank must have at least two persons who effectively direct the business.28 The Single Rulebook also anticipates that the bank has arranged for a supervisory function.29 In respect of the individuals that may be appointed to perform these functions, the Single Rulebook provides that they must meet the requirements of Article 91 of CRD IV. This entails as a general rule30 that all members of the management board must be of sufficiently good repute and possess sufficient knowledge, skills, and experience to perform their duties. Furthermore, the overall composition of the management body must reflect an adequately broad range of experiences. The national implementation of this part of the Single Rulebook may differ as to whether individuals are tested by the supervisor on this requirement before they are being appointed (ex-​ante) or afterwards (ex-​post).31 Regardless of this difference in application, the fit and proper requirements included in the Single Rulebook have to be complied with in the context of the appointments of members of the management body. The required stamp of approval of the supervisor must be taken into account. This includes that the national company law rules on appointment of directors of a bank can only be exercised with due consideration of the Single Rulebook provisions, that prevail in this regard.32 C. Composition of the boards: diversity criteria

5.20

National company law may or may not impose certain diversity criteria in respect of the composition of boards.

27 This nomination and proposal is not easy to depart from; see Article 2:158 of DCC. The articles of association may provide alternative provisions, see Article 2:158(12) of DCC. 28 As a condition for the licence, see Article 13(1) of CRD IV. 29 As set out in Recital 55 and Article 3(1)(7) of CRD IV, either as part of the single board, or by means of a separate board of supervisory directors. 30 Article 91(1) of CRD IV, as further detailed in subsections (2)–​(10). 31 Reference is made to the ECB ‘Guide to Fit and Proper Assessments’, May 2017 (Updated in May 2018), para 2.2. and also the ESMA/​EBA ‘Guidelines on the assessment of suitability’, para 49. 32 See extensively on this topic: Iris Palm-​Steyerberg and Danny Busch, Chapter 8, this volume.

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Corporate Law versus Financial Regulatory Rules Dutch company law contains a provision on gender diversity for both the man- 5.21 agement and the supervisory board.33 Diversity is seen as a balanced division of the seats between women (at least 30 per cent) and men (at least 30 per cent). If a company does not meet these target figures, the reasons must be explained in its annual report.34 No sanction is imposed on the company in case of non-​compliance. In the Netherlands, the debate on including mandatory gender diversity quota in legislation is pending. In Germany, the system of co-​determination described in 5.16 has resulted in a 5.22 situation whereby there are slightly more women on the boards than the European average. A special act requires that the number of female employee representatives on the board must be proportional to the number of female employees in the company as a whole.35 Furthermore, the German Corporate Governance Code implies a (non-​binding) duty on the supervisory board to respect diversity when appointing members to the management board. In particular, it must aim for an appropriate participation of women. Another special provision applies to management levels below the board, to the effect that the management board must set targets to increase the share of women in the two management levels below the management board. The consequences of non-​compliance with these rules on gender diversity are comparable to those under Dutch company law: there are no formal sanctions. In the United Kingdom the matter of diversity is addressed in the UK Corporate 5.23 Governance Code. According to the Preface of the code, diversity is broader than gender-​diversity: ‘This includes, but is not limited to, gender and race.’ A separate section in the annual report should describe the work of the nomination committee, including a description of the board’s policy on diversity.36 Just as in the Netherlands and Germany, no sanctions are imposed in the United Kingdom in case of non-​compliance with the principles and best practices in respect of diversity. Under the UK Corporate Governance Code, the rule of ‘comply or explain’ applies. The Single Rulebook37 provides that Member States or competent authorities 5.24 must require institutions and their respective nomination committees to put in place a policy promoting diversity on the management body.38 This explicitly includes gender diversity.39 In addition, banks must provide at least annual updates 33 Article 2:166 of DCC. 34 Article 2:391(7) of DCC. 35 One-​Third Participation Act, Paragraph 4(4) (DrittelbeteiligingsGesetz, DrittelbG). This is similar in practice for (large) companies who fall under the Co-​Determination Act (MitbestG), according to M Roth, ‘Corporate Boards in Germany’, in Davies et al (eds), n 23, 293 (fn 333). 36 See UK Corporate Governance Code Provision B.2.4. 37 In Article 91(10) of CRD IV, as clarified in Recital 60. 38 This topic is also covered by the joint ESMA and EBA ‘Guidelines on the assessment of suitability’; ‘Final report on guidelines on the assessment of the suitability of members of the management body and key function holders’, EBA/​GL/​2017/​12, 26 September 2017. 39 ESMA/​EBA, ‘Guidelines on the assessment of suitability’, paras 43, 44, and 115.

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Kitty Lieverse and Claartje Bulten in respect of their policy on diversity with regard to the selection of members of the management body, its objectives, and any relevant targets set out in that policy, and the extent to which these objectives and targets have been achieved.40 Significant banks41 are additionally required to set up a nomination committee that sets a target for the representation of the underrepresented gender in the management body and that prepares a policy to increase the number of the underrepresented gender in the management body in order to meet that target. The target, policy, and its implementation must be made public.42 According to the EBA/​European Securities and Markets Authorities (ESMA) ‘Guidelines on the assessment of suitability’, if any of the diversity objectives or targets are not met, significant banks must document the reasons why, the measures to be taken, and the timeframe for taking these measures, to ensure that the diversity objectives and targets will be met as yet.43 Against this background, and as part of the fit and proper testing of individuals and the related considerations of a sufficiently diverse composition of the management body as a whole, the provisions of the Single Rulebook should incentivize diversity within the management boards of banks. 5.25

On the topic of diversity within the board of a bank, it is concluded here that both the company law rules and the Single Rulebook focus on setting targets and transparency, rather than on setting strict goals through prescribed quota. D. Tasks and duties of directors

5.26

Company law typically does not include detailed provisions prescribing how directors should perform their tasks. The principal guiding principle for managing and supervisory directors is to act in the best interest of the company. Secondly, it is commonly accepted that a director has a commitment of loyalty towards the company. Apart from these general principles, company law does not give further details on how directors should perform their tasks and duties. This matter is typically addressed further within the legal framework of questions on liability of directors. The rules on directors’ liability are principle-​based and provide for open norms and standards, which must be detailed depending on the specific circumstances of the case. For example, UK company law reflects that the directors’ duties include a duty of care.44 The Dutch Supreme Court has ruled that under Dutch company law, a director has to be competent and must fulfil his task diligently.45 Germany 40 Article 435(c)(2) of CRR. 41 This refers to banks which are significant in terms of their size, internal organization and the nature, scope, and complexity of their activities, as specified in Article 6 of SSM Regulation. 42 Article 88(2) of CRD IV, in conjunction with Article 435(c)(2) of CRR. 43 ESMA/​EBA, ‘Guidelines on the assessment of suitability’, para 108. 44 Section 174(1) of the Companies Act 2006: ‘A director of a company must exercise reasonable care, skill and diligence’. 45 Dutch Supreme Court (HR), 10 January 1997, NJ 1997/​360, annotated by Maeijer (Staleman v Van de Ven).

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Corporate Law versus Financial Regulatory Rules company law does not impose standards for how a director should perform its task and duties.46 The standard expressed in the literature is that managing and supervisory directors should have adequate skills and experience.47 Focusing on the role and responsibilities of the management board, Article 88(1) 5.27 of CRD IV states that Member States must ensure that the management body defines, oversees, and is accountable for the implementation of the governance arrangements that ensure effective and prudent management of an institution, including the segregation of duties in the organization and the prevention of conflicts of interest. The instruction to the management body that the bank’s governance arrangements 5.28 must ensure (inter alia) an effective and prudent management of the bank, is further specified by providing five principles that must be met through these governance arrangements. These principles include that the management body must have the overall responsibility for the institution and approve and oversee the implementation of the bank’s strategic objectives, risk strategy, and internal governance.48 The EBA Guidelines49 further specify that the responsibilities and duties should be documented in writing and approved by the management body and must include (inter alia) the implementation of the bank’s business strategy within the applicable legal and regulatory framework, taking into account the bank’s long-​term financial interests and solvency. Other elements to be included are fostering: (i) a risk culture which addresses the bank’s risk-​awareness and risk-​taking behaviour;50 and (ii) a corporate culture and values which encourages responsible and ethical behaviour.51 In addition to these principles regarding the duties and responsibilities of the management body as a whole, there are guidelines for the performance of the management and supervisory functions.52 In respect of the management function, the Guidelines specify that the managing directors (inter alia) ‘should constructively challenge and critically review propositions’, and must inform the management body in its supervisory function on the risks and developments affecting the bank, for example ‘material decisions on business activities and risks taken, the evaluation of the institution’s economic and business environment, liquidity and sound capital base, and assessment of its material risk exposures’.

46 German Stock Corporation Act (AktG), Paragraph 100. 47 Hopt/​Roth, Grosskommentar Aktiengezetz, Section 100, no 20. 48 Article 88(1)(a) of CRD IV. 49 EBA, ‘Guidelines on internal governance’, EBA/​GL/​2017/​11, 21 March 2018, effective as of 30 June 2018, reference is made to Title II, para 20 et seq. 50 ibid, para 23(j) and Section 9. 51 ibid, para 23(k) and Section 10. 52 ibid, Sections 2 and 3.

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Kitty Lieverse and Claartje Bulten 5.29

On this topic, it is concluded here that financial regulatory rules provide detailed rules for the manner in which directors should perform their tasks and function and the guiding principles that should be applied. In contrast to this, company law addresses the performance by a director of his task and duties in retrospect, by stating standards for breach of such duties and tasks on the basis of questions on liability. E. Arrangements on remuneration

5.30

Although national company law systems and/​or provisions of corporate governance codes may differ somewhat in this regard, one would expect the general meeting to be involved in determining the remuneration policy for the management board, and the remuneration committee (if any) to be leading as regards the individual packages for remuneration.

5.31

Apart from the extensive provisions in the Dutch corporate governance code on remuneration, the comments made in the previous paragraph are indeed valid for Dutch company law.53 Whereas the remuneration policy for managing directors is determined by the general meeting, the remuneration of individual directors is effectively set by the supervisory board. A comparable system applies under German company law, where the general meeting of shareholders passes a resolution approving the remuneration scheme. This is comparable to the Dutch remuneration policy. The resolution passed by the general meeting is however merely a guidance and does not create any rights or obligations in respect of the remuneration of individual directors. The aggregate remuneration of any member of the management board is determined by the supervisory board. These obligations of the supervisory board must remain unaffected.54 There is a difference between the Dutch and the German remuneration rules as regards the level at which the rules are enacted. Under Dutch company law, the basic rules of the Dutch Civil Code are followed by extensive rules in the Dutch Corporate Governance Code. Under German company laws, the German Stock Corporation Act contains detailed clauses in respect of remuneration, while the regulation on remuneration in the German Corporate Governance Code is limited to a few remarks. In the United Kingdom, both the Companies Act 2006 and the UK Corporate Governance Code contain rules on remuneration. The Code focuses on the structure of remuneration packages and the tasks and duties of the remuneration committee. The provisions in the Companies Act are various in nature but all give some sort of approval rights to the general meeting of shareholders, for example a vote on a Directors Remuneration Report of a listed company. 53 Article 2:135 of DCC. There is an (extensive) Chapter  3 on remuneration in the Dutch Corporate Governance Code. 54 German Stock Corporation Act (AktG), Paragraphs 87 and 120 (4).

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Corporate Law versus Financial Regulatory Rules The recently amended shareholders directive also addresses the say-​on-​pay for 5.32 shareholders.55 First of all, it imposes the duty on Member States to ensure that shareholders have the right to vote on the remuneration policy at the general meeting. Secondly, it introduces the obligation to prepare a remuneration report:  Member States must ensure that the company draws up a ‘clear and understandable remuneration report’. The general meeting of shareholders will be given an advisory vote on the remuneration report of the most recent financial year. The Single Rulebook contains specific provisions on remuneration for banks.56 The 5.33 bank’s management body is required, in its supervisory function, to adopt and periodically review the general principles of the remuneration policy.57 Other detailed rules are given in respect of (inter alia) guaranteed variable remuneration (which should be exceptional) and balancing the fixed and variable components of total remuneration. It is prescribed that banks must set an appropriate ratio between the fixed and the variable components, whereby the variable component may not exceed 100 per cent of the fixed component of the total remuneration for each individual.58 National law provisions may however allow shareholders to approve a higher maximum level of the ratio between the fixed and variable components of remuneration, provided the overall level of the variable component does not exceed 200 per cent of the fixed component of the total remuneration for each individual. This means that granting a higher bonus than the 100 per cent cap, up to a 200 per cent threshold, is as a matter of operation of Article 94(1)(g)(ii) of CRD IV allocated to the general meeting. This can be seen as a CRD IV focus on the ‘say on pay’ by the shareholders. On balance, the Single Rulebook provisions clearly add considerable detail to the 5.34 regulation of the remuneration for board members. Regardless of national company law systems that may charge the supervisory directors with determining individual remuneration packages, the Single Rulebook stipulates that only the general meeting may set a bonus at a higher level than 100 per cent of the fixed remuneration. On this central position of the general meeting, the Single Rulebook provisions are in fact in line with the ‘say-​on-​pay’ provisions in the recently amended shareholders directive.

55 Directive (EU) 2017/​828 of the European Parliament and the Council of 17 May 2017 amending Directive 2007/​36/​EC as regards the encouragement of long-​term shareholder engagement, [2017] OJ L132/1. 56 Article 94 of CRD IV. 57 Article 92(2)(c) of CRD IV. 58 Subject to the option for Member States to introduce a lower threshold; Article 94(1)(g)(i) and (ii) of CRD IV.

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Kitty Lieverse and Claartje Bulten F. Zooming in: the prevalence of the financial regulatory rules over company law 5.35

This paragraph discusses a recent judgment of the General Court in respect of the ECB’s refusal to approve the appointment of four candidates as board members at Crédit Agricole, a non-​centralized French banking group.59 Crédit Agricole comprises, inter alia, regional agricultural credit union branches. For those regional branches, the positions included the office of chairman of the management body and, at the same time, of executive officer. The ECB ruled that such ‘double’ appointment, as a result of which the same person would simultaneously carry out the non-​executive position of chairman and that of an executive director, was prohibited under the Single Rulebook and refused to approve the appointments. According to the ECB, the guiding principle is that the exercise of executive and non-​executive functions within the management board must be separated. The bank had appealed the decision of the ECB before the General Court.

5.36

Interestingly, the decision of the General Court provides an interpretation of the basic rule of Article 13(1) of CRD IV, which refers to ‘persons [who] effectively direct the business [of the bank]’ and of Article 88 of CRD IV.60 The General Court concluded that it is apparent from the textual, historical, teleological, and contextual interpretations of Article 13(1) of CRD IV that the concept of ‘persons who effectively direct the business of the bank’ refers to the members of the management body who are part of the senior management of the credit institution. The court referred to the objectives pursued by the EU legislature concerning the governance of credit institutions: ‘That objective is to ensure effective oversight of the senior management by the non-​executive members of the management body, necessitating checks and balances within the management body.’61 According to the Court it was clear that the effectiveness of such oversight may be jeopardized if the chairman of the management body is also responsible, in its supervisory function, for the effective direction of the business of the bank. With this ruling, the General Court upheld the application of the ECB of Article 88(1)(e) of CRD IV, which provides that the chairman of the management body, in its supervisory function of a credit institution, may not simultaneously exercise the function of CEO in the same institution (unless justified by the institution and authorized by the competent authorities), and the French law implementation thereof. The ECB’s decision entailed that the combination of the non-​executive chairman position with any executive directorship (regardless whether this is a formal position of CEO) is not allowed and this decision was upheld by the General Court.

59 Crédit Agricole v ECB ECLI:EU:T:2018:219, 24 April 2018, EU General Court. 60 In France, CRD IV is implemented in the Code monétaire et financier français (French monetary and financial code) (the CMF). The CMF is not considered in this chapter. 61 Crédit Agricole v ECB, n 59, para 77.

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Corporate Law versus Financial Regulatory Rules This decision by the General Court quite clearly confirms the importance of the 5.37 provisions of the Single Rulebook on corporate governance.

IV.  Impact on Shareholders A. Conditions for shareholdings in company law Company law systems typically do not stipulate pre-​approval requirements in re- 5.38 spect of shareholders. This may however be different for vitally important companies, that is, companies that are vital to national security or public policy. Under European and international law, countries may subject (foreign) share ownership to specific regulations.62 In some countries (like the Netherlands) a company may adopt requirements for shareholders in its articles of association. In addition, protection may exist against hostile takeovers, based on measures derived from company law.63 B. Approval of (candidate) shareholders in the banking sector The Single Rulebook stipulates extensive control in respect of shareholdings in a 5.39 bank. As soon as they reach the 10 per cent threshold of a qualifying holding64 shareholders must be approved in advance by the supervisor on their suitability to acquire and retain this holding in the bank.65 The criteria on which a shareholder is tested include:66 (i) the reputation of the proposed acquirer; and (ii) the financial soundness of the new shareholder, in particular in relation to the type of business pursued by the bank. This test includes whether the candidate shareholder, given his financial position and the bank’s plans for the coming years, is able to adequately support the bank as a shareholder. The criteria for testing shareholders set forth in the Single Rulebook are strictly of a prudential nature. On this basis, the supervisor may oppose the proposed acquisition only if there are reasonable grounds for doing so on the basis of specified list of acquisition criteria.67

62 See extensively, Bulten and De Jong, ‘Vital companies in safe hands’, Series VHI No 142 (2017), Ch 7 (English summary). 63 In Dutch company law there are, for example, protective measures facilitated by the certification of shares via a foundation or the grant by the company of an option to an independent foundation that may call for the issuance of preference shares to enable such foundation to exercise a considerable package of voting rights. 64 For the full definition, reference is made to ‘qualifying holding’ as defined in point (36) of Article 4(1) of CRR. 65 Article 14 et seq of CRD IV. 66 Article 23(1) of CRD IV. 67 Or if the information provided by the proposed acquirer is incomplete, Article 23(2) of CRD IV.

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Kitty Lieverse and Claartje Bulten C. Further conditions for shareholdings in a bank 5.40

Interestingly, the European Court of Justice (ECJ) has confirmed that the supervisor may impose certain conditions on such proposed shareholding.68 In this case69 the Dutch supervisor, deciding on the proposed acquisition of a qualifying interest in an insurer, had imposed certain conditions on the declaration of no objection concerning (inter alia) the dividend policy and the composition of the supervisory board. The requirement concerning the dividend policy included that no distributions to shareholders could be made if this would lead to a deterioration of a certain solvency ratio that had been adjusted by the supervisor and the company in the run-​up to the entry into force of Solvency II, a few years later (at that time). The requirement concerning the supervisory board meant that at least half the members, including the chairman, had to be formally independent of the shareholder. The ECJ ruled that the underlying European directive does not in itself prohibit imposing conditions on a declaration of no objection, provided that the rights under the Directive are not violated, and on the understanding that the conditions may not refer to an element that is not included in the exhaustive list of assessment criteria. Furthermore, the conditions must be suitable and necessary to meet these assessment criteria. In other words, imposing conditions on the shareholder does not conflict with the system of the Directive and the restrictive grounds for refusal provided for therein, if the conditions actually cater for granting the application in accordance with the assessment criteria.

5.41

This judgment confirms that the supervisor may impose rules on the shareholder through the system of the declaration of no objection to an acquisition, in addition to regular company law rules. The room for the supervisor is limited, however. The imposed conditions may only serve to ensure that a ground for refusal does not apply. Also, the candidate shareholder will typically have stipulated an unconditional declaration of no objection as a condition precedent for his acquisition. This means that if the conditions imposed by the supervisor would be too burdensome in the candidate shareholder’s view, the acquisition may be aborted and the conditions will never become effective. D. Redemption of capital, distributions

5.42

Banks are subject to extensive capital and liquidity requirements, as included in the CRR. These requirements are as such not related to corporate governance

68 C-​18/​14 CO Sociedad de Gestión y Participación SA v De Nederlandsche Bank NV ECLI:EU:C:2015:419, 25 June 2015, ECJ. 69 Which in fact concerns the insurance industry where a similar pre-​approval requirement for shareholders who wish to acquire a qualifying holding applies.

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Corporate Law versus Financial Regulatory Rules requirements. However, the Single Rulebook provides for an impact on ordinary or typical rights of the general meeting in respect of distribution and redemption of capital, in the context of specific capital protection rules. These rules apply in addition to and/​or in deviation from the common maintenance of capital and distribution rules. Article 77 of the CRR is considered here. This provision requires that a bank needs the prior permission of the competent authority to do either or both of the following: (i) reduce, redeem, or repurchase Common Equity Tier 1 instruments issued by the institution in a manner that is permitted under applicable national law; (ii) effect the call, redemption, repayment, or repurchase of Additional Tier 1 instruments or Tier 2 instruments as applicable, prior to the date of their contractual maturity. As a result of this provision, the general meeting of a bank may only exercise any national company law authority in respect of redemption of capital, if the supervisor has given prior permission to do so. In addition, Article 141 of CRD IV limits the potential for distributions to share- 5.43 holders in connection with Common Equity Tier 1 capital to an extent that such distribution would decrease the bank’s Common Equity Tier 1 capital to a level where the combined buffer requirement70 is no longer met. Banks are obliged to calculate a Maximum Distributable Amount (MDA) in accordance with the provisions of Article 141(4) of CRD IV and if a bank fails to meet, or exceeds, its combined buffer requirement, it shall be prohibited from distributing more than the MDA. Furthermore, the Single Rulebook provides for various means of intervention by 5.44 the supervisor in respect of the protection of the capital and liquidity position of a bank, if there is a breach of Single Rulebook provisions or if such breach is likely to occur within the following twelve months,71 including inter alia: (i) to require institutions to hold own funds in excess of the requirements set out in CRD IV and in the CRR; (ii) to request the divestment of activities that pose excessive risks to the soundness of an institution; and (iii) to restrict or prohibit distributions by the bank to shareholders.72 From these provisions it may be inferred that the Single Rulebook focuses 5.45 strongly on a bank maintaining a strong capital position and that the potential for capital redemption and dividend distribution are restricted to serve this purpose.



Reference is made to the definition in Article 128(6) of CRD IV. Article 102 of CRD IV. 72 Article 104 of CRD IV. 70 71

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V.  Impact of the Single Rulebook on the Interpretation of Corporate Interest A. Shareholder-​driven v stakeholder-​driven 5.46

The question has been raised whether the ‘high and unique leverage’ of banks entails that the shareholder-​driven model is not appropriate for banks.73 Should management boards of banks not be required to pay specific attention to the interests of their creditors, and the deposit holders in particular, as a vital group of stakeholders, rather than to their shareholders? Before answering this question, the two models will be described briefly.

5.47

In a shareholder-​driven model the interests of the company coincide with the interests of its shareholders. The shareholders are basically seen as ‘owners’ of the company. The company’s main goal, in view of the shareholder focus, will be the maximization of shareholder value.

5.48

It is often said that the English company law system is shareholder-​focused. But is it indeed a pure shareholder-​driven model? On the one hand it is true that under English company law the board can be easily removed by the general meeting of shareholders, and that the shareholders can instruct the board. In case of a (hostile) takeover, the inability of the board to take action to block the takeover is remarkable. It is also true that one of the general duties of the director is to promote the success of the company. Section 172 of the Companies Act 2006 underlines the importance of the position of the shareholders by stating that this director’s duty is about the success of the company ‘for the benefits of its members’. However, in doing so the directors must pay attention to the interests of the other stakeholders as well, including the company’s employees, its suppliers, customers, and others. In addition, the impact of the company’s operations on the community and the environment must be taken into account. In English legal literature it is said that this set of provisions in fact constitutes an enlightened shareholder value as guiding principle.74 In this regard, however, no balancing act between the interests of the shareholders and that of other stakeholders is required. The shareholders’ interests remain the principal goal of achieving business success.

5.49

By contrast, the stakeholder-​driven model is all about balancing various interests. For example, in the Netherlands managing and supervisory directors must

73 See, e.g, P Davies et al, ‘Boards in Law and Practice’, in Davies et al (eds), n 23, 8 with further references. 74 See P Davies, ‘Corporate Boards in the United Kingdom’, in Davies et al (eds), n 23, 753 with further references.

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Corporate Law versus Financial Regulatory Rules let themselves be guided by the interests of the company and its business.75 This ‘corporate interest’ is held to be the result of weighing the interests of all parties involved in the company. These stakeholders include (in particular) the company’s shareholders, its employees, creditors and, to a lesser extent, the public interest. The corporate interest is not fixed. The director has to take all specific circumstances into account. This standard refers to the company’s long-​term interest. Short-​term gain (i.e. profit distribution to shareholders) does not fit into such long-​term focus. This focus on the company’s long-​term success applies to all board members, regardless of whether the board members were nominated by employees or by shareholders, or (in some cases) by third parties such as creditors. All board members have to weigh all the interests involved. This Dutch interpretation of corporate interest resembles a stakeholder-​driven model. Nowak writes that the qualified predominance of the interests of the shareholders 5.50 is gaining currency.76 He refers to the view that the interests of the shareholders should normally prevail over the interests of other parties involved, unless these interests would be disproportionately harmed. In Dutch literature this position is referred to as ‘enlightened shareholder value’. It could be said that the impact of shareholders’ interests has recently diminished somewhat; that the predominance of the interests of the shareholders is not the prevailing view. Firstly, the case of Cancun is considered.77 Cancun was a joint-​venture (a private limited company) with two shareholders; its directors were directly linked to respectively one of the shareholders. The Dutch Supreme Court ruled that the board had its own responsibility to focus on the company’s interests and the business as conducted by the company. This may be seen as the autonomy of the board and opposes the idea that the shareholders, as owners, have a decisive say on every subject. The Dutch Supreme Courts added that even if the shareholders are closely involved, the directors must act with due care in respect of all the relevant parties involved. The Dutch Supreme Court78 explicitly applied the abovementioned Cancun-​rule in Fugro v Boskalis (both listed public companies). By applying this rule to listed public companies as well, the Supreme Court underlined the importance of the concept of autonomy of the board and, by extension, the stakeholder-​driven model. Secondly, the Dutch Corporate Governance Code 2016 states in Principle 1.1 that the management board must focus on long-​term value creation for the company and its business, taking into account the relevant stakeholders’ interests. In the Preamble, the code clarifies that a company constitutes a long-​term alliance 75 See Article 2:129(5) of DCC for management directors, and Article 2:140(2) of DCC for supervisory directors. 76 R Nowak, ‘Corporate Boards in the Netherlands’, in Davies et al (eds), n 23, 435–​6. 77 Cancun ECLI:NL:HR:2014:797, NJ 2014/​286, 4 April 2014, para 4.3, Dutch Supreme Court (HR). 78 Fugro v Boskalis ECLI:NL:HR:2018:652, JOR 2018/142, 20 April 2018, Dutch Supreme Court (HR).

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Kitty Lieverse and Claartje Bulten between various stakeholders. It underlines the concept of weighing the interests of all those involved, ‘as the company seeks to create long-​term value’. A focus on the interests of the shareholders is absent. 5.51

With regard to German company law, Roth holds that the assessment that the German company law follows an enlightened shareholder value approach is correct. In his view, directors are primarily bound by the interests of the shareholders, but they may (and should) give attention to the interests of other stakeholders as well. Over the past few years the focus may have shifted somewhat. In 2016, the German Minister of Justice Maas adopted a firm position by stating that the shareholder-​value doctrine no longer prevailed.79 The company’s interests are more than just the interests of the shareholders; it should be stakeholder value, he said. Accordingly, the German Corporate Governance Code states that the management board has to take the interests of the shareholders, employees, and other stakeholders into account, with the objective of creating sustainable value. It might be argued that this tends towards a more stakeholder-​driven model for German companies. B. The application of the rules on corporate interest to banks

5.52

It is difficult to see how a company operating as a bank, in a highly regulated environment, could be successful in the long term without properly considering, first, the literal text but also the prudential spirit of the Single Rulebook. This is confirmed by the text of Article 88(1) of CRD IV and the EBA Guidelines on internal governance. These provide that the management body must define, oversee, and is accountable for the implementation of the governance arrangements to ensure an effective and prudent management80 of an institution, including the segregation of duties in the organization and the prevention of conflicts of interest.

5.53

A Dutch court case in respect of Fortis illustrates this point.81 In this case, which focused on the question whether any mismanagement had occurred, the Enterprise Court (Ondernemingskamer) started from the presumption that the management board of a bank and insurer should, in the performance of its duties, give priority to the interests of Fortis and its business, and the interests of all those involved in its decision making. According to the Enterprise Court, these interests include, in 79 In his own words:  ‘Von der Shareholder-​ value-​ Doktrine dieser Jahre sind wir heute abgekommen.’ See H Maas, ‘Aufsichtrad und Vorstand—​sollten die Rollen neu definieert werden?’, Speech at the 15th Konferenz Deutscher Corporate Governance Kodex, 21 June 2016, available at https://​www.bmjv.de/​SharedDocs/​Reden/​DE/​2016/​06201016_​Corporate-​Governance_​Kodex. html, accessed 8 October 2018. 80 For a discussion on the interpretation of this part of Article 88(1) of CRD IV, see Kleis Broekhuizen, Klantbelang, belangenconflict en zorgplicht, 2016, Ch 6. 81 VEB v Fortis NV ECLI:NL:GHAMS:2012:BW0991, JOR 2013/​41, 5 April 2012, Court of Appeals Amsterdam, Enterprise Court (Ondernemingskamer), annotated by Bulten.

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Corporate Law versus Financial Regulatory Rules addition to the interests of shareholders, the interests of those who have entrusted their interests to Fortis, such as deposit holders and policyholders. The Enterprise Court continued by observing that entrepreneurship naturally entails risk-​taking and that the assessment and weighing of the risks is a task of the management board. However, the discretion that the board has in performing this task is influenced by the nature of the company, namely conducting the banking and insurance business, and the extent to which various stakeholders and—​in some cases—​society as a whole, have an interest in the results of that policymaking. The conclusion is that in view of the nature of the Fortis’ business, being a bank, the management board has a special duty of care to always carefully and adequately monitor the risks, and to assess their policy considerations, decision making, and actions. The fact that Fortis was a systemic bank added extra weight, according to the Enterprise Court. In cassation, the appeal against these legal grounds of the Enterprise Court was dismissed.82 The Dutch Supreme Court ruled that the Enterprise Court’s conclusion of ‘mismanagement’ had been correct. Based on this reasoning, and in view of the inherent risk of a bank run and the 5.54 vast importance of maintaining the trust of the deposit holders and other financiers in the bank, proper bank management would entail that members of a bank’s management board should be a bit more ‘boring’ in their business decisions than the managing directors of ‘ordinary’ companies.83 Against this background, the conclusion made here is that banks almost by definition adhere to a stakeholder model, rather than a strict shareholder model, even if national company law would entail the latter. Concurring with the position adopted by Hopt, it is held here that for banks the 5.55 scope of corporate governance goes beyond the shareholders (equity governance), and includes deposit holders and other creditors as well.84 The bank’s management must keep the interests of the deposit holders and other financiers of the bank as its focal point. Compliance with the provisions of the Single Rulebook, including the restrictions on dividend distributions and repayment of capital, serves this purpose. Against this background, a (pure) shareholder-​driven model cannot be applied to banks.

82 VEB v Fortis NV ECLI:NL:HR:2013:1586, JOR 2014/​65, 6 December 2013, Dutch Supreme Court (HR), annotated by Holtzer. 83 In respect of systemically important banks:  Steven L Schwarcz, ‘Too Big to Fool:  Moral Hazard, Bailouts, and Corporate Responsibility’, Minnesota Law Review (2017–​18) 761–​801; Steven L Schwarcz, ‘Misalignment:  Corporate Risk-​Taking and Public Duty’, Notre Dame Law Review (2016), 1–​50. 84 Klaus J Hopt, ‘Better Governance of Financial Institutions’, Law ECGI Law Working Paper No 207/​2013, II.2.

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VI. Conclusions 5.56

It may be inferred from the examples given above that a bank has a certain national legal form and that the structure and direction of the bank are basically set by the rules of national company law. The financial supervision legislation is increasingly European in origin or is European-​based. Based on the examples given above and techniques of impact, this chapter has tried to map out some areas in which the financial supervisory legislation applies, and how, and thus intervenes in regular (civil-​law) relationships and processes. Based on this exercise, it is observed that with regard to the extent in which action can be taken and national rules can be set aside, a development has in fact been set in motion towards a European company law statute for banks, whereby national differences in the underlying company law increasingly lose their significance.

5.57

This approach and outcome is in line with European legislation for banks. The (European) legislation for banks entails that a certain prudent system of corporate governance must be provided, on the understanding that a certain freedom and proportionality exists to choose an appropriate structure. There is no direct interpretation in the financial supervision legislation of the company’s interests that may serve the management board of a bank as a guideline. However, the status of a bank is linked to the requirement to comply with the related regulations and to have a corporate governance structure in place that ensures compliance with these rules. These rules ultimately aim at safeguarding the public interest, which is served by a properly functioning banking sector. These (European) rules for banks are neutral and apply irrespective of legal form and nationality. A Dutch bank that is a public limited company is subject to the same rules as an English bank that is a limited company. They must both meet the same rules and objectives. It is therefore probable that there will ultimately be fewer national differences in the interpretation of the company’s interests between these banking companies in different jurisdictions than is the case for ‘ordinary’ companies.

5.58

This trend is strengthened by a number of developments. First of all, by the SSM and the ECB’s related role as direct supervisor of the European banking sector, where the rules to be applied by the regulator are to a large extent derived from European regulations (in particular of course: the CRR). Other EU law (including national legislation implementing the European directives) will increasingly move towards fewer national options and less discretion. The legislation on recovery and resolution for banks, including the establishment of a European settlement authority, also confirms this trend.

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Corporate Law versus Financial Regulatory Rules This chapter concludes, therefore, that, in particular with regard to European 5.59 banking legislation, a development has been set in motion towards a European company statute for banks, harmonizing important elements of company law, including corporate governance, even though no formal harmonization of company law has taken place.

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Part II GOVERNANCE STRUCTURES AND REGULATION

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6 NON-​S HAREHOLDER VOICE IN BANK GOVERNANCE Board Composition, Performance, and Liability Paul Davies and Klaus J Hopt

I. Bank Governance and Corporate Governance 6.01 II. Supervisory Approval of Bank Directors and Senior Managers 6.07 A. The United Kingdom B. The Euro area

III. Debt-​Holders and Bank Governance IV. Composition of the Boards of Banks A. Indirect representation of the creditors’ interests in the board B. Direct representation of the creditors’ interests in the board

6.10 6.15

C. Representation of the creditors’ interests in the board by bank regulators D. Board in bank groups

6.43 6.46

V. Liability of Bank Directors and Other Key Function Holders

6.17 6.32 6.33 6.37

6.52 A. Regulatory duties of care and loyalty 6.54 B. Criminal responsibility of bank directors 6.56 C. More severe civil liability of bank directors and key function holders 6.60 D. Stricter enforcement by the board, by the creditors, and/​or by regulators 6.72

I.  Bank Governance and Corporate Governance There is widespread agreement in the academic literature that banks which had 6.01 ‘good’ corporate governance suffered relatively bigger losses in the financial crisis at the end of last decade than those banks with less good corporate governance.1 1 This literature is summarized and analysed in J Armour et al, Principles of Financial Regulation, Oxford University Press, 2016, Ch 17. The leading studies are A Beltratti and R Stulz, ‘The Credit Crisis around the Globe: Why Did Some Banks Perform Better?’, Journal of Financial Economics (2012), 105, 1; D Erkins, M Hung, and P Matos, ‘Corporate Governance in the 2007-​2008 Financial Crisis’, Journal of Corporate Finance (2012), 18, 389; M Becht, P Bolton, and A Röell, ‘Why Bank Governance is Different’, Oxford Review of Economic Policy (2012), 27, 437.

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Paul Davies and Klaus J Hopt ‘Good’ governance for the purpose of these studies means governance based on the UK–​US model which became dominant in corporate law in the three or four decades leading up to the crisis. The theory behind this model is that the welfare of society is best promoted by managers who run the company in the interests of the shareholders who, as residual claimants on the company’s revenues, have the strongest incentive to improve the operational efficiency of the company. Corporate law should favour shareholders, not because shareholders are deserving from a distributional point of view, but because the welfare of society as a whole will thereby be maximized. From this theory it follows that the rules relating to the selection, functions, and accountability of the members of the board should be such as to promote the shareholders’ interests.2 Thus, the board should contain a substantial proportion of ‘independent’ directors, it should focus a significant proportion of its effort on monitoring the activities of the management, and it should be accountable to the shareholders (though the theory does not define precisely the level at which that accountability should be pitched). The findings of the post-​ crisis studies clearly represent a major challenge to this theory, but one confined to the banking (or, possibly, the wider financial) sector. Professor Cheffins has argued that, outside the financial sector, the institutions of corporate governance operated ‘tolerably well’ in the crisis.3 Nevertheless, the studies of the performance of banks in the crisis clearly create a major puzzle. They suggest that there is a tension between good corporate governance, as conventionally understood, and the stability of the banking system. The purpose of this chapter is to explore the implications of these studies for the corporate governance of banks. 6.02

There are three main groups of explanations about what went wrong with bank governance in the crisis:  monitoring failures, accountability failures, and incentive failures. To some degree these explanations overlap and they are certainly not mutually exclusive. Monitoring failure can be attributed to the inherent difficulty of supervising the complex activities of a bank, especially given the opacity of its balance sheet, that is, the difficulty of judging the quality of the bank’s assets.4 A bank loan is an asset, but its value depends on the creditworthiness of the counterparty, which may be difficult to track over time. The value of a financial asset held by the bank may depend heavily on the liquidity of the market for the relevant class of asset and, except for ‘plain vanilla’ financial assets traded on deep and liquid

2 Although the opposite is often stated, there is nothing in this theory which assumes that the shareholders’ interests are to be assessed on a short-​term basis. 3 Brian Cheffins, ‘Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500’, The Business Lawyer (2009), 65, 1. He argues further that a major problem within banks was the failure to follow one general corporate governance good practice, that is, the continued existence in banks of an ‘imperial’ CEO. Brian Cheffins, ‘The Corporate Governance Movement, Banks and the Financial Crisis’ Theoretical Enquiries in Law (2015), 16, 1. 4 Becht et al, n 1, 438.

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Non-Shareholder Voice in Bank Governance markets, market liquidity may be highly volatile. The inherent difficulty of judging the value of the bank’s businesses could be heightened by the stress in conventional corporate governance on the independence of directors, who, as outsiders, might not have the firm-​or industry-​specific understanding necessary to evaluate such information about the bank as was available to the board. Finally, the board might have trusted that overall risk management was something the regulator was taking care of, through regulatory capital requirements. Except in relation to the potential competence of independent directors, the monitoring story is not strongly related to the shareholder-​focused model of corporate governance: whatever the interests the board perceives itself as there to promote, running a bank from the board looks like a tough job. The accountability failure does bring the standard model of corporate governance 6.03 more clearly into focus. An assumption underlying the standard UK–​US theory is that the company is exposed to all or substantially all the costs of carrying on its business. If there are costs of the company’s activities which are borne by others and not the company (‘negative externalities’), then management accountable to shareholders is likely to adopt policies which are excessively risky in relation to that particular cost. As the financial crisis showed, the costs to third parties of a general bank crisis are extremely large, even if banks are bailed out, and likely would have been larger had the banks not been bailed out.5 In the case of bailout, taxpayer costs may subsequently be recouped through a resale of the bank to the private sector, though there is no guarantee of that,6 and in any event the public finances are likely to be distorted by the bailout.7 Bailout is, in fact, a forced investment which would not have been made by a market investor. Whether the bank is bailed out or not, the costs to businesses and households of the reduced availability of credit are likely to be substantial and are not costs for which any legal system makes the failing banks liable. It can be argued that, if the bank shareholders are diversified, they will absorb the externality costs through a diminution in the value of their holdings in non-​bank sectors, and that therefore the shareholders have an incentive to constrain excessive risk-​taking by bank management. However, diversified shareholders are even less well-​placed than board members to monitor bank

5 The financial crisis of 2007 to 2009 is estimated to have cost 15 trillion US dollars in lost production (about one-​fifth of the world’s annual output) and to have led to a substantial increase in unemployment. State efforts to mitigate the crisis led in the euro-​zone to a sovereign debt crisis which worsened the economic impact of the crisis in the countries affected. 6 At one end of the spectrum, the US Treasury made a substantial nominal profit on its bailout and subsequent sale of AIG (an insurance company, not a bank), whilst at the other the UK government still holds its 70 per cent stake in Royal Bank of Scotland (RBS), whose share price is still below the acquisition price. 7 Sometimes to the extent of rendering the state unable to finance its overall operations without itself being bailed out.

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Paul Davies and Klaus J Hopt management effectively, whilst concentrated shareholders do not have the incentive to do so, precisely because they are not exposed to the costs of externalities. 6.04

The incentive failure was arguably the result of the move in the 1990s by banks, along with non-​financial companies, away from predominantly fixed-​pay arrangements to ‘performance’ pay, especially to rewards linked to the grant of share-​options. It is debated whether this move was an application of the standard UK–​US model in order to incentivize managers to be less risk-​averse and to promote the interests of the shareholders or whether it was an expression of managerial greed, contrary to the interests of the shareholders.8 In either case, managers were incentivized to focus on the bank’s share price over the period of the option grant, irrespective of any longer-​term risks that behaviour incurred for the bank. It is true that, when the crash came, managers suffered heavy losses through the destruction of the value of the bank shares then held by them, but research has shown that this loss was outweighed by the bonuses and proceeds from share sales which had occurred in the period before the crash.9

6.05

Since the financial crisis there has been a welter of corporate governance reforms for banks. By and large, these have received a bad academic press.10 The purpose of this chapter is to consider the arguments for and against reforms which aim to make bank boards more sensitive to the risks of negative externalities in the bank’s operating model. The chapter looks at mechanisms for increasing the influence on the board of two groups likely to suffer from the negative externalities of board failure, namely, society at large (taxpayers and those harmed by the loss of access to credit) and, in the post-​crisis world, creditors. A cross-​cutting division of these mechanisms into those which involve board influence short of representation and those which posit representation on the board is adopted. Thus, Section II of the chapter analyses the influence financial supervisors bring to bear on board composition and behaviour falling short of supervisory representation on the board. This mechanism is substantially in place, at least in many jurisdictions. Section III looks at potential reforms which would increase the influence on the board of long-​term debt holders, but again without giving them representation rights.

8 L Bebchuk and J Fried, Pay without Performance, Harvard University Press, 2004. 9 L Bebchuk, A Cohen, and H Spamann, ‘The Wages of Failure’, Yale Journal of Regulation (2010), 27, 257; S Bhagat and P Bolton, ‘The Financial Crisis and Bank Executive Compensation’, Journal of Corporate Finance (2014), 25, 313. What these studies do show, however, is that bank executives were no better at predicting the crisis than anyone else; otherwise, they would have sold out entirely. 10 e.g. L Enriques and D Zetzsche, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’, ECGI Law Working Paper No 249/​2014 (suggesting in particular that new bank board diversity requirements are ill-​adapted to increase the board’s expertise in monitoring the development of the bank’s assets); Christoph Van Der Elst, ‘Corporate Governance and Banks: How justified is the match?’ ECGI Law Working Paper No 284/​2015 (suggesting that post-​crisis reforms have not accurately identified the peculiarities of bank governance).

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Non-Shareholder Voice in Bank Governance Board appointment rights are then covered in Section IV for both supervisors and creditors. It is a common critique of the post-​crisis bank governance reforms that they have not given sufficient weight to creditors’ interests.11 However, our analysis is more supportive of that critique in relation to influence short of representation rights than via representation and, even then, predominantly through market mechanisms. Finally the chapter turns to reforming the civil and criminal liabilities of board members so as to increase their sensitivity to non-​shareholder interests (Section V). The reforms which have upgraded the role and status of risk committees and risk 6.06 officers are not analysed,12 though these reforms are potentially valuable. This is because, without further reform, the board and (ultimately) the shareholders remain in charge of risk strategy. The board may be better informed about risk but not necessarily more risk-​averse; the board may have more ‘known unknowns’ and fewer ‘unknown unknowns’ (an important result), but its risk appetite may be unchanged. A more radical governance strategy is the one analysed in this chapter which provides influence over the board to a group whose risk appetite is likely to be better aligned with the level which is socially optimal.

II.  Supervisory Approval of Bank Directors and Senior Managers Prudential supervisors are one obvious representative of the interests of society as a 6.07 whole and a potential source of risk-​averse influence on boards, since the prudential supervisor’s principal goal is the safety and soundness of the banking system. That influence could be exogenous to the board, deriving, for example, from the capital and liquidity controls which are the traditional tools of bank regulation or from more recently devised tools of macro-​prudential regulation. However, it is also possible to give the prudential supervisor a direct influence upon board appointments and composition (falling short of appointment rights). It is this form of influence which is analysed in this section. If the consent of the supervisor (via a veto right) is needed for an appointment to 6.08 the board and for its continuation, then the director is likely to become sensitive to the views of the supervisor on the proper level of risk-​taking (and other elements of the bank’s business strategy) as well to those of the shareholders. In addition, the 11 See Becht et al, n 1, 438 (‘To make bank governance more effective it might be necessary to experiment with deeper reforms, such as allowing for creditor representation on boards.’); Van Der Elst, n 10, 32 (‘Probably there is no other industry where stakeholder governance is so pivotal. Debt holders and public interest have no voice in the bank governance system and should be represented by the legislator and the regulator.’) 12 Directive 2013/​36/​EU (OJ L176/​338), Article 76 (hereafter CRD IV).

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Paul Davies and Klaus J Hopt approval mechanism could form the basis for the identification of those whom the supervisor would hold responsible for regulatory failures on the part of the bank. Depending on the rigour of the administrative liability rules, they could effectively supplement the standard company law rules on directors’ liability. As discussed in Section V, the standard rules tended not to generate liability for action or inaction in the crisis, because those rules are concerned to limit the risk of judicial hindsight bias by placing high hurdles before claimants.13 However, before the crisis, it was also the case that regulation imposing responsibility on individuals was often lacking.14 6.09

A rather basic framework for regulatory approval of bank directors is laid out in the Capital Requirements Directive (CRD) IV. Article 13 requires, as a condition of initial approval of the bank, that the members of a bank’s management body be of ‘sufficiently good repute and possess sufficient knowledge, skills and experience to perform their duties,’ while Article 91(1) requires that condition to be met ‘at all times’ by the members for the time being of the ‘management body’—​a term which embraces the one-​tier and both tiers of a two-​tier board. In addition, Article 98(7) requires the regulator’s annual supervisory review to ‘include governance arrangements of institutions, their corporate culture and values, and the ability of members of the management body to perform their duties’. This framework clearly leaves a large number of significant decisions to be taken by national governments and lower-​level regulators. A. The United Kingdom

6.10

The development of this framework in the United Kingdom is looked at first, where popular anger at the failure of any senior bankers to be subject to significant sanctions for pre-​crisis managerial actions led to regulatory reform which goes

13 The classic example is the Delaware decision, In re Citigroup Ltd (2009) 264 A 2d 106. (Del Ch), where a shareholder action against directors for failing to monitor the bank’s risks arising out of loans to the sub-​prime market was unsuccessful because the standard for liability was bad faith. Even in jurisdictions where liability is based on some form of negligence, judgments in favour of plaintiffs are difficult to achieve because of the prevalence of the business judgement rule (or an equivalent). 14 See the letter from Lord Turner, then chair of the Financial Services Authority (UK), published in the Financial Times (8 December 2010), defending the FCA’s decision not to take enforcement action against individuals in relation to the Royal Bank of Scotland’s ill-​fated takeover of ABN-​ Amro, on the grounds that the acquisition was ‘highly risky but breached no regulation’. However, he also made the case for regulatory reform to induce bank boards to make a different and more cautious risk/​return trade-​off than would be acceptable in non-​financial companies, precisely because of the size of the social losses associated with bank failure. A fuller version of the letter is available at:  http://​www.fsa.gov.uk/​pages/​Library/​Other_​publications/​Miscellaneous/​2010/​1208_​at.shtml, accessed 16 December, 2017. However, the CEO of the RBS at the time of its collapse, Sir Fred Goodwin, did agree to give up part of his pension and his knighthood was removed by the Queen. So, he suffered some financial loss and his reputational loss was high, but came at the end of his career.

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Non-Shareholder Voice in Bank Governance well beyond what the CRD IV requires. In fact, ‘fit and proper’ person tests for bank managers are of long-​standing in national banking regulation, as are codes of conduct applying post appointment, requiring competence in the discharge of the duties of the office. However, as the Financial Services Authority (FSA) admitted in 2008, its prior practice had been to concentrate on the honesty and integrity of board members rather than their competence, and in practice it had rarely investigated the post-​appointment conduct of individuals.15 After the crisis it introduced an ex ante interview process for future senior bank appointments and, as to past conduct, it stated that ‘we have made a strategic decision to investigate more individuals’.16 Despite this statement of intent, the FSA and its successors (PRA and FCA)17 6.11 proved unable to bring successful regulatory proceedings against any high-​level bankers involved in the failures which occurred in UK banks prior to the financial crisis. In 2013 the Parliamentary Committee on Banking Standards heavily criticized the existing regulatory regime as it applied to top bank appointments. In principle, it is the means by which the regulator can control those who run banks, but in practice it makes no attempt to set clear expectations for those holding key roles. It operates mostly as an initial gateway to taking up a post, rather than serving as a system through which the regulators can ensure the continuing exercise of individual responsibility at the most senior levels within banks.18

The approval system was reformed the same year in the Financial Services (Banking Reform) Act 2013, mainly by way of amendments to the Financial Services Act 2000, with the aim of making the holders of top bank appointments more accountable to the regulators. For the purposes of this chapter, there are three significant features of the re- 6.12 formed regime for ‘senior management functions’ in banks, that is, functions which involve ‘a risk of serious consequences for the [bank] or for businesses or other interests’ in the United Kingdom.19 First, the application to the regulator

15 FSA (UK), ‘The approved persons regime—​significant influence function review’, Consultation Paper 08/​25, December 2008, para 2.2. 16 ibid. 17 After the crisis, the FSA was split in two, with its functions divided between a Prudential Regulatory Authority (PRA) and a Financial Conduct Authority (FCA). Since the interest of this chapter is with the stability of the banking system, the PRA’s rules are its primary concern. 18 House of Lords and House of Commons, Parliamentary Commission on Banking Standards, ‘Changing banking for good’, First Report of Session 2013–​14, June 2013, vol II, para 564 (HL Paper 27-​II; HC 175-​II). 19 Financial Services Act 2000, section 59ZA (emphasis added)—​a clear recognition of negative externalities. There is also a separate regime, not discussed in this chapter, for annual bank certification as fit and proper of those carrying out ‘significant harm functions’, that is, where the function carries the risk of significant harm to the bank or its customers, but not to interests outside the bank and those who deal with it (section 63E and F).

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Paul Davies and Klaus J Hopt for approval as a senior manager must be accompanied by a ‘statement of responsibilities’, that is, ‘a statement setting out the aspects of the affairs of the [bank] which it is intended that the person will be responsible for managing in performing the function’.20 A job title alone is not enough.21 This provides a basis for a more thorough-​going vetting process than a mere job title would allow. Second, in addition to liability for personal breaches of the conduct rules made by the regulator, a senior manager is liable under the regulatory system for breaches of any requirement by the bank where that manager ‘was at that time responsible for the management of any of the [bank’s] activities in relation to which the contravention occurred’ and the manager did not take reasonable steps to avoid the breach occurring or continuing.22 6.13

Clearly, the statement of responsibilities operates so as to define ex ante the manager’s area of accountability. The senior manager is potentially liable for action by subordinates which put the bank in breach of the regulations, even though the manager was unaware of the action.23 For example, a senior manager, into whose area of responsibility interest-​rate reporting falls, is exposed to administrative penalties for rate manipulation carried out by subordinates of which s/​he was not aware, if the regulator can show that the manager was negligent in allowing that behaviour by the subordinates to occur.24 As initially formulated, there was a ‘presumption of responsibility’, that is, the burden of disproving negligence was on the senior manager. Before the legislation came into force, however, it was reformulated as a ‘duty of responsibility’, that is, the burden of proof of negligence lies on the regulator.25 This may prove a significant weakening of the provision, but more will probably turn on how the courts calibrate negligence in this area and whether

20 Section 60(2A). It is up to the bank how it allocates responsibilities. 21 Subsequent significant changes to the responsibilities must be notified to the regulator with such information as the regulator requires (section 62A). It appears that such changes do not automatically trigger a new approval process but the regulator could take the initiative to impose conditions on the existing authorization under section 63ZB. 22 Section 66B(5). 23 Section 36 of the 2013 Act creates a new criminal offence, carrying imprisonment for up to seven years, for a senior manager whose conduct or omissions cause the bank to fail, the standard of liability being somewhere between gross negligence and recklessness. This is discussed further in Section V. 24 For some indication of how the regulator will approach this task, see PRA, Supervisory Statement SS28/​15, ‘Strengthening individual accountability in banking’, May 2017. This policy document specifically excludes escape from individual responsibility because the impugned decision was a collective one. ‘The Duty of Responsibility recognises that individual Senior Managers should be held accountable for their individual contributions to collective decisions and their implementation insofar as those contributions are in scope of their Senior Manager responsibilities.’ (para 2.67) 25 See section 66B(6), repealed by the Bank of England and Financial Services Act 2016, section 25(3)(f ) and (g), before it entered into force. The reasons put forward for the change were disputed in the legislative debates on the 2016 Act.

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Non-Shareholder Voice in Bank Governance they take the overall reform as a signal that they should require a higher standard of care from senior bank managers.26 The third feature which is relevant to this chapter, but which is not a novel feature 6.14 of the revised regime introduced by the 2013 Act, is that the concept of a ‘senior manager’ is not congruent with that of a director of the bank. The senior manager definition, which has been established by the prudential regulator, excludes ‘plain vanilla’ non-​executive directors (NEDs), that is, those who do not perform any of the following roles: chair of the board, senior independent director or chair of the audit, risk, or remuneration committees.27 ‘Standard’ NEDs thus do not require prior approval of the regulator, do not have to provide a statement of responsibilities, and are not subject to the duty of responsibility.28 Even those NEDs within the senior manager regime are not expected to take on executive responsibilities, and so their statement of responsibilities and potential exposure to liability are expected to be less extensive than those of executive managers.29 By contrast, some senior non-​board managers are brought within the regime, broadly those immediately below the board, because of their control of key business areas.30 In some cases those managers might not actually be employed by the bank in question, but elsewhere in the banking group. Overall, this is a highly functional definition of senior management. It does not map onto the distinction between executive and non-​executive directors because some (but not all) non-​executive directors are within the regime, whilst it extends to managers who are not on the board at all. B. The Euro area For ‘significant’ banks the fit and proper purpose test is applied by the European 6.15 Central Bank (ECB) acting as the Single Supervisor.31 However, the powers which the ECB possesses in relation to any particular bank are those which the national regulator has and thus vary from Member State to Member State, subject to the modest degree of harmonization brought about by the CRD IV and European Banking Authority (EBA) guidelines. Moreover, the ECB’s powers are limited to the initial approval and subsequent monitoring of the appointee’s compliance with

26 See Pottage v FSA, Upper Tribunal, 2012 (FS/​2010/​33) for a pre-​reform decision where the regulator failed in its attempt to impose a penalty on an individual on the grounds that that person had done enough to address the problems in the bank of which he was or should have been aware. 27 PRA and FCA, ‘Approach to non-​executive directors in banking’, PRA CP15/​5 and FCA CP7/​ 15, February 2015. Within its sphere the FCA also treats the chair of the nomination committee as a senior manager. 28 However, they are subject to a less intensive regime of regulatory approval, in order to comply with the CRD requirements. See SS 28/​15, n 24, para 4.11. 29 ibid, para 2.9. 30 ibid, para 1.19. 31 Regulation (EU) No 468/​2014 of the European Central Bank (ECB 2014/​17), Articles 93 and 94 (SSM Framework Regulation).

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Paul Davies and Klaus J Hopt the fit and proper test. Disciplinary action for non-​performance of the appointee’s functions is a matter for the national regulators, subject to the ECB’s ‘nuclear option’ of removing the approved person from the board.32 Finally, the ECB, at least initially, took the view that its powers were confined to members of the ‘management body’, that is, to the directors (whether on a single or two-​tier board): they did not extend to non-​board senior managers but, on the other hand, do embrace all non-​executive directors.33 6.16

The recently adopted EBA/​European Securities and Market Authority (ESMA) ‘Guidelines on the assessment of the suitability of members of the management body and key function holders’34 take matters a bit further forward, as the title of the Guidelines indicate. These bring in ‘key function holders’ as well as members of the management body and are likely to influence the ECB’s actions in the future, since the guidelines are addressed to it as single supervisor as well as to national competent authorities. It was controversial in the public debate when the draft guidelines were consulted upon whether the European regulatory authorities had power to bring key function holders within the scope of the Guidelines, since the CRD IV refers to a fit and proper test only in relation to members of the management body. The regulators, however, took the view that the general language in Articles 74 and 88 of CRD IV gave them sufficient cover for the extension of the Guidelines in this way.35 As adopted, the Guidelines extend to ‘the heads of internal control functions and the CFO, where they are not members of the management body, and, where identified on a risk-​based approach by CRD IV institutions, other key function holders. Other key function holders might include heads of significant business lines, European Economic Area/​European Free Trade Association branches, third country subsidiaries, and other internal functions.’36 However, the Guidelines do not touch on administrative sanctions for breaches of the Guidelines.

III.  Debt-​Holders and Bank Governance 6.17

Possible additional or alternative sources of caution in relation to bank board decision making are the holders of bank debt. Clearly, where that debt takes the form

32 Council Regulation (EU) No 1024/​2013, Article 16(2)(m) ([2013] OJ L287/​63). 33 The ECB’s procedures are set out in ECB, ‘Guide to fit and proper assessments’, May 2017. The procedures are not remarkably different from those of the PRA in the United Kingdom. 34 September 2017, in force from 30 June 2018. 35 EBA/​ESMA ‘Guidelines on the assessment of the suitability of members of the management body and key function holders’, 2017, 88. The Board of Appeal (BoA) of the European Supervisory Authorities had come to the same conclusion on the basis of the similar wording of the predecessor Directive to CRD IV (Article 22 of Directive 2006/​48/​EC). See SV Capital OŰ v European Banking Authority, Decisions EBA 2013 002 and BoA 2014-​C1-​02. 36 EBA/​ESMA, Guidelines, n 35, 20.

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Non-Shareholder Voice in Bank Governance of deposits, it would be futile (for coordination reasons) and counter-​productive (because depositors can easily ‘run’ on the bank by withdrawing their deposits) to seek to increase the influence of depositors on the board. However, holders of long-​ term bank debt (bonds or notes) are in a position where it is difficult for them to run,37 and so they might in principle be interested in mitigating their risks through influence on the board. If that influence can be brought to bear (see below), it is likely to be in favour of caution, since bondholders have no strong interest in the pay-​offs from risk-​taking, assuming that, when the risky decision is taken, the bank is still in a position to meet its commitments under the bond.38 It is true, of course, that in the crisis bondholders did not suffer the downside of 6.18 excessive risk-​taking by bank managers, because the banks, largely, were bailed out by states (taxpayers) before they went into liquidation, and it is only in liquidation (or its equivalent) that, in the absence of special regulation, debt-​holders absorb losses (in terms of having their formal contractual claims reduced or eliminated). However, the search post-​crisis for bank resolution procedures which will shift the cost of saving banks away from taxpayers has led to ‘bail-​in’ mechanisms which, if successful, will impose losses on long-​term debt-​holders in resolution (before taxpayers are called on) and, by the same token, will increase the sensitivity of bondholders to pre-​resolution risky behaviour on the part of bank managers. Under the Financial Stability Board’s (FSB) recommendations, internationally active banks are required by 2022 to have ‘total loss absorbing capacity’ (TLAC) equal to a minimum of 18 per cent of their risk-​weighted assets, that is, substantially in excess of the Basel minimum capital requirements.39 The purpose of TLAC is to ensure that, in resolution, significant banks are capable not only of absorbing the losses they have incurred, but also of being recapitalized and thus restored to viability (together with adjustments to their businesses). To this end, it is a crucial requirement of the FSB scheme that a substantial part of TLAC—​a minimum of one third is stipulated—​should consist, not of equity, but of long-​term debt. Debt, unlike

37 They can normally sell their debt, but the price will reflect the market’s concerns about the bank’s current state. 38 If this is not the case, the bondholders may be more in favour of risk than shareholders, since the creditors will be the first to benefit from the upside of the decision. 39 FSB, ‘Principles on Loss-​ absorbing and Recapitalisation Capacity of G-​ SIBs in Resolution:  Total Loss-​absorbing Capacity (TLAC) Term Sheet’, November 2015, Term Sheet 4. In addition the TLAC must amount to a leverage ratio of 6 per cent, as calculated on the Basel basis. Minimum capital requirements count towards the TLAC requirement, except for capital required to meet regulatory buffers (e.g. capital conservation or counter-​cyclical capital buffers). For the implementation of these recommendations in the European Union, see Commission proposal to amend the CRR (COM(2016) 850 final) and EBA, ‘Final Report on MREL: Report on the Implementation and Design of the MREL Framework’, December 2016 (EBA-​Op-​2016-​21). In EU terminology TLAC has become MREL: ‘minimum requirements for own funds and eligible liabilities’.

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Paul Davies and Klaus J Hopt equity, will still be available at the point of resolution to recapitalize the bank, via write-​off or conversion into equity.40 6.19

There is considerable debate about whether bail-​in will in fact work in the way that the FSB envisages and even whether bailout is socially more acceptable than bail-​in. However, for the purposes of this chapter, that is not the central issue. The question is whether there will be in future a quantity of bank debt in issue which faces a realistic chance of being wiped out or converted in resolution. For example, it matters not from this perspective that bail-​in will sometimes turn out to be insufficient to reorganize the bank and the state steps into complete the task, provided bailout occurs after the long-​term debt has been wiped out. Nor does it necessarily matter whether the resolution of the bank takes place via a reorganization of its capital structure (for which bail-​in is a particularly helpful tool) or via a sale of its viable businesses, whether via a bridge bank or not, or via the transfer of its non-​ performing assets to a ‘bad bank’ through the asset separation tool. Provided that in the case of a sale of the viable businesses, the debt holders are left behind in the transferor or, in the case of a ‘bad bank’, they transfer with the assets, the debt holders will absorb losses and thus have incentives to monitor the management of the bank. However, it would undermine the prospect of creditor monitoring were bailout without debt-​holders incurring losses to survive the Bank Recovery and Resolution Directive (BRRD) reforms, which seems unlikely, but not wholly impossible, in the case of global systematically important banks (G-​SIBs).41

6.20

One market reaction to the increased riskiness of bank bonds is for investors to increase the rate of interest required to induce them to purchase these securities. Nobody is obliged to buy bank bonds if the terms of issue are unattractive. However, this merely leads to a reformulation of the question: will banks (to reduce their cost of capital) and lenders (to mitigate risks) find it mutually beneficial to establish governance rights for creditors which aim to manage the risk to which the creditors are exposed? 42 This will depend on the likely effectiveness of such rights,

40 ibid, Term Sheet 6(f ). See also Paul L Davies, ‘The Fall and Rise of Debt:  Bank Capital Regulation after the Crisis’, Oxford Legal Studies Research Paper No 53/​2015, available at https://​ ssrn.com/​abstract=2670052 or http://​dx.doi.org/​10.2139/​ssrn.2670052, accessed 3 October 2018. For a review of the literature in the area of bail-​in and corporate governance, see E Martino, ‘Law & Economics of Banks Corporate Governance in the Bail-​in Era’, available at https://​ssrn.com/​abstract=3100703, accessed 3 October 2018. 41 The recent example of the use of the ‘not in the public interest’ exception to bail-​in in the case of the Italian regional banks, however questionable, is not, it is suggested, a strong pointer in the direction of a general relaxation of the BRRD system, since these banks were not systemically important. See ‘Assessing the Merits of the Recent Italian Bank Bailouts’, International Banker (2017), . 42 Tröger has argued that, given the uncertainties surrounding the bail-​in process, accurate pricing of bail-​in bonds may be difficult (T H Tröger, ‘Too Complex to Work: A Critical Assessment of the Bail-​in Tool under the European Bank Recovery and Resolution Regime’, SAFE Working Paper No 179/​2017). This may increase the attractiveness of covenants. Although inserted at the time of issuance

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Non-Shareholder Voice in Bank Governance a condition which embraces both the size of the benefits conferred on creditors by the governance arrangements and the costs, to both creditors and banks, of providing these benefits. There are a number of possible governance arrangements which could be set up. 6.21 At the most traditional end of the spectrum, bondholders could take one or more seats on the bank board in a non-​executive capacity. However, given the increased responsibilities and potential liabilities of even non-​executive bank directors, it is unlikely that this would be attractive to bondholders. Their primary aim is to secure the performance of the obligation attached to the securities: a governance arrangement targeted on that goal and which does not expose bondholders to responsibility for the general conduct of the bank’s business is likely to be more attractive to them. Alternatively, legislation could mandate creditor representation on boards. This is discussed in Section IV. However, there exists an established, largely contractual mechanism, to give cred- 6.22 itors influence over management strategy, without requiring board representation. When the bank itself acts as a lender, whether on its own or in a syndicate, it will normally insert extensive ‘covenants’ into the loan agreement, that is, contractual provisions which require the consent of the bank to borrower decisions which might substantially alter the risk to which the bank is subject in making the loan. When the borrower wishes to take one of these steps, the consent requirement creates an opportunity for the bank to negotiate with the borrower about the terms on which the change may be implemented—​the sanction for non-​agreement being, normally, an obligation to repay the loan at that point. The conventional wisdom in corporate finance is that in the case of publicly traded bonds the range of covenants is much narrower than in private loans. In particular, covenants requiring lender consent to strategic business decisions by the borrower are rare, being common only in relation to changes in the ownership of the borrower or similar major restructurings.43 This caution in relation to covenants in public debt is typically attributed to the 6.23 collective action problems of dispersed, public bondholders, that is, the costs involved in getting them to decide how to respond to situations where their consent is required. The extent of the collective action problem in relation to bail-​in bonds is worth a moment’s reflection. It is unlikely that retail investors will be substantial holders of the bonds—​indeed, they may be discouraged or prohibited by regulation from purchasing them. Regulation is also likely to direct institutional purchases to

of the debt, the rigour of the debt-​holders’ use of their powers under the covenants can vary subsequently, as information about the resolution authorities’ use of their powers is revealed after issuance. 43 L Hornuf, M Reps, and S Schäferling, ‘Covenants in European Investment-​grade Corporate Bonds’, Capital Markets Law Journal (2015), 10, 345.

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Paul Davies and Klaus J Hopt institutions which are outside the banking area and can suffer loss on the bonds without jeopardizing their own viability. The most likely candidates are insurance companies, pension funds, and certain types of hedge fund, that is, sophisticated investors well able to assess the costs and benefits of contractual protection. They will need, no doubt, a mechanism for coordinating their response to breaches of covenant, but the coordination problem does not appear overwhelming. 6.24

A  potential coordination mechanism already exists in public bond issues in the shape of a ‘trustee’ or some differently named representative of the bondholders who has power under the trust deed to act on behalf of the bondholders. However, for reasons primarily of cost the trustee’s duties are limited and normally confined to receiving and passing-​on information and to taking action when instructed to do so by a sufficient majority of the bondholders.44 In fact, the term ‘trustee’ in relation to corporate bond issues is really a misnomer, for, unlike a trustee under standard trust, the bond trustee is not invested with a broad discretion which it is under a duty to exercise in the best interests of the bondholders. For a trustee to be invested with more pro-​active powers on behalf of the bondholders would require a change in the trustee’s duties and remuneration structure.

6.25

However, such a change could be brought about largely by contract and possibly without any legislative changes. In 1999 a group of US scholars published an article showing how this could be done in a US legal context, which is not enormously different from that employed for bonds not issued under New York law.45 Under their scheme, the trustee would actively acquire information about the borrowing company; monitor compliance with the bond terms; renegotiate covenants when the company seeks an amendment; and decide whether and what kind of enforcement action to take when a covenant is breached.46 Clearly, a trustee with these duties would need to have a sophisticated understanding of all aspects of the business of banks and would command a correspondingly higher remuneration than is paid currently to bond trustees.

6.26

That cost might come to be seen by both bondholders and banks as one worth paying if the price of and risk attached to bail-​in bonds was reduced by an amount which exceeded the cost of the trustee’s extra remuneration. This is particularly likely in the case of investors who aim to hold the bonds until maturity (insurance

44 For an example of the reluctance of trustees to act even when properly instructed by the requisite majority of bondholders, see Concord Trust v Law Debenture Trust Corporation plc [2005] UKHL 27. The court commented that the issuers had ‘terrified the trustee into declining to accept the apparently mandatory obligation to the bondholders imposed by [the contract] and into acting as, in effect, their surrogate in the current proceedings.’ 45 Y Amihud, K Garbade, and M Kahan, ‘A New Governance Structure for Corporate Bonds’ Stanford Law Review (1999), 51, 447. 46 ibid, 470.

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Non-Shareholder Voice in Bank Governance companies, pension funds); perhaps less so in the case of those whose business model involves trading in the bonds (hedge funds). However, the advantage of a contractual model is that it can be adjusted to meet the needs of different types of investor. The model described above could be adjusted so as to put more decisions in the hands of the investors and fewer in the trustee, for example. New issues of bonds could contain covenants reflecting the experience of investors under prior issues. Different contemporaneous issues of bonds could come with different covenant packages, designed to appeal to different classes of investor. Moving away from bond covenants, a third mechanism for investor protection 6.27 makes use of the remuneration systems for rewarding bank executives, especially the variable part of such systems. In this arrangement, high-​powered incentives for bank managers to achieve certain goals are deployed for the protection of bank creditors (rather than to promote the interests of shareholders alone). This protection might operate in a negative or a positive form, that is, it might create disincentives for remuneration arrangements which carry risks for bank creditors or it might create incentives to adopt remuneration systems which promote the interests of creditors. As with covenants, the present factual position does not reveal strong forms of either set-​up, but they might become more important in the future. As to the negative arrangements, there are some provisions in CRD IV which 6.28 supervisors could make use of to this end. Article 92(2)(a) requires the competent authorities to ensure that banks’ ‘remuneration policy is consistent with and promotes sound and effective risk management’, whilst Article 104(1)(g) empowers them ‘to require institutions to limit variable remuneration as a percentage of net revenues where it is inconsistent with the maintenance of a sound capital base’. Both powers could be used by supervisors to require the removal of elements from remuneration systems which are likely to generate risks to the safety and soundness of banks and thus to the bondholders. Much will depend on what use supervisors make of these powers.47 The most famous control in CRD IV over risk-​inducing variable remuneration does not rely on supervisory judgement. This is the cap on bonus levels, set at twice the level of the fixed remuneration (subject to shareholder consent).48 Whilst the cap is there to ‘avoid excessive risk taking’,49 it is likely to be a blunt instrument, discouraging effort as often as it discourages improper risk taking. Whether the trade-​off is worthwhile is a matter of judgement. The cap might appear less important in controlling excessive risk taking were supervisors to make active use of their discretionary powers.50

47 The EBA Guidelines, n 35, are not specific on this issue. 48 Article 94(1)(g). 49 CRD IV, Recital 65. 50 Alternatively, with the cap in place, supervisors may regard it is relieving them of the responsibility to make active use of their discretionary powers.

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The positive use of incentives to promote bondholder protection has been advocated by Bebchuk and Spamann, essentially by linking bankers’ variable rewards, not just to the performance of equity but to the performance of a wider set of the bank’s securities, including its bonds.51 This idea finds a somewhat pale reflection in CRD IV. Apart from the general provisions in Article 92, the CRD IV does not require that the performance criteria for rewards to bank managers should take any particular form. Subject to Article 92, the performance criteria are set by the bank. The bank bodies which set the criteria are accountable predominantly to the shareholders and so they may not be particularly receptive to the Bebchuk/​Spamann proposal—​though, as noted above, it might be in the interests of the shareholders in some case to offer debt investors remuneration schemes which take account of their interests. Article 95 of CRD IV requires the remuneration committee of significant banks to have the primary responsibility for proposing remuneration schemes and to be composed of non-​executive directors. It does not stipulate that those executives shall be chosen other than in the standard way, that is, normally by the shareholders, directly or indirectly; though where national law requires employee representation at board level, the committee must contain at least one employee representative.52 The employees’ interests are likely to be better aligned with those of the creditors than are the shareholders’. The dominance of the shareholders in remuneration setting has been underlined by the recent amendments to the Shareholder Rights Directive.53 Article 9a now provides that the shareholders must be given a vote, either advisory or binding, on the remuneration policy of a listed company. Consequently, both bodies within the company primarily concerned with setting performance criteria are shareholder-​oriented. For the reasons given in Section I of this chapter, increasing the influence of shareholders over remuneration schemes in banks seems the wrong way to go.

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When, however, the remuneration committee moves on from setting the criteria for an award to defining the nature of the award itself, it will find that there is constraining language in the CRD IV. Article 94(1)(l) provides that at least 50 per cent of the award shall consist of a ‘balance’ of shares and ‘where possible . . . other instruments which can be fully converted to [equity] or written down’, both equity and the ‘other instruments’ being subject to a retention period of at least three years. This language raises the prospect of bank managers being rewarded in bail-​in bonds as well as in equity and, over the retention period, building up a significant holding of debt securities in the bank. The EBA Guidelines on sound remuneration policies54 place some emphasis on this provision. ‘Where possible’ is interpreted as 51 L Bebchuk and H Spamann, ‘Regulating Bankers’ Pay’, Georgetown Law Journal (2010), 98, 247. 52 See further Section IV below. 53 Directive (EU) 2017/​828. 54 EBA, ‘Guidelines on sound remuneration policies’ December 2015, 15.4.

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Non-Shareholder Voice in Bank Governance a simple availability question: has the bank issued bail-​in debt instruments in sufficient quantities to make them available for reward purposes? In the EBA’s view, where ‘institutions are primarily wholesale funded, or rely to a large extent on additional Tier 1, Tier 2 or bail-​in-​able debt to meet their capital requirements’ (i.e. the standard case under the FSB’s recommendations), then the EBA expects debt instruments subject to write down/​conversion to be available.55 This still leaves the question of the ‘balance’ between shares and debt in the award, 6.31 a matter on which the CRD IV is not clear. Here the Guidelines require that ‘institutions should be able to demonstrate that they have taken into account the interests of shareholders, creditors, bondholders and other stakeholders when setting the balance between different instruments’.56 Again, the impact of this approach in practice will turn on the rigour of the supervisory scrutiny of the choices which remuneration committees, beholden to shareholders, have actually made. Even if bail-​in debt becomes a significant element in the awards made to bank managers, it is not clear how heavily that will constrain their risk choices if the performance criteria are not focused on the interests of bank creditors.

IV.  Composition of the Boards of Banks One of the conclusions to be drawn from the analysis in Section I  might be to 6.32 change the composition of the boards of the banks57 by giving interested non-​ shareholders a say or even a seat in the board. This has, indeed, been proposed as a reform agenda, though the proposals vary considerably in their content and details. A. Indirect representation of the creditors’ interests in the board Seen from a comparative perspective, it seems advisable to consider first the experi- 6.33 ence made in countries with labour codetermination in the board of the corporation. As to this one must distinguish between the German half/​half codetermination and the more common one-​third parity codetermination in many other European countries.

55 ibid, para 253. 56 ibid, para 255. 57 CRD IV is of primary importance for bank regulation; so is Solvency II for insurance regulation. Many aspects of corporate governance of banks have parallels or may be even identical ones, for corporate governance of insurance firms. cf P Manes, ‘Corporate Governance, the Approach to Risk and the Insurance Industry under Solvency II’, in: M Andenas et al (eds), Solvency II: A Dynamic Challenge for the Insurance Market, Il Mulino, 2017, Ch IV, 93; M Siri, ‘Corporate Governance of Insurance Firms After Solvency II’, in: P Marano and M Siri (eds), Insurance Regulation in the European Union, Solvency II and Beyond, Palgrave Macmillan, 2017, Ch 7, 129.

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(a)  Let us first look at the German experience with the ‘full’ (quasi-​ parity) codetermination that gives the labour side half of the seats in the boards of major corporations, including banks.58 Politically this kind of labour codetermination is still controversial, in particular because it is fully mandatory and does not leave any possibility for agreements between the capital and the labour sides as is foreseen in the Statute of the European Company.59 Labour unions praise codetermination and government parties, whether Social-​democrats or Christian-​democrats, agree or in any case do not want to touch it. The trade unions even advocate the German model as being an ‘export article’ and ignore that there is little sympathy abroad, at least for the half/​half model, as demonstrated again by the recent regulatory discussion in the United Kingdom. It is true that from German industry there are no (longer) strong complaints; one has grown accustomed to it and there is no hope for change. Empirical evidence on the pros and cons of labour codetermination is available, though scarce and with contradictory findings.60 Most of the evidence relates to the works council codetermination, which is more or less generally considered to have positive effects. As to board room codetermination there are both positive and negative effects. On the positive side codetermination played an important role after the German reunification and has helped to bring about the necessary fundamental changes in a way that was compatible with labour interests. Similar effects are to be found when enterprises are in financial difficulties and lay-​offs become necessary. On the cost side there is the slowing down of the decision-​making process; the limited focus on wages and jobs, even in times of stiff competition; the fighting off of takeovers in lockstep with the management and thereby a reduction of the disciplinary effects of takeovers on management; and finally the attempt to keep jobs in Germany and accordingly the contribution to creeping protectionism. In crises and in particular bank crises, labour joins management in exerting pressure on government for rescue by the state. Altogether it seems that the board members from the labour side simply promote labour interests, not the interests of other creditors or stakeholders,61 though more recently—​as

58 German Act on Codetermination of the Workers of 4 May 1976. For details, see M Habersack, M Henssler, and P Ulmer, Mitbestimmungsrecht, 3rd ed, C H Beck, 2013. 59 See the plea for reform by Arbeitskreis ‘Unternehmerische Mitbestimmung’, ‘Entwurf einer Regelung zur Mitbestimmungsvereinbarung sowie zur Größe des mitbestimmten Aufsichtsrats’, Zeitschrift für Wirtschaftsrecht (ZIP) 2009, 885. Similarly S Thomsen, C Rose, and D Kronborg, ‘Employee Representation and Board Size in the Nordic Countries’, European Journal of Law and Economics (2016), 42, 471, 488:  indirect support to sceptics, ‘employee representation as cost factor rather than a contribution to value creation’. 60 See the summarizing article by U Jirjahn, ‘Ökonomische Wirkungen der Mitbestimmung in Deutschland:  Ein Update’, Schmollers Jahrbuch (2011), 131, 3–​ 57; K Pistor, ‘Corporate Governance durch Mitbestimmung und Arbeitsmärkte’, in P Hommelhoff, K J Hopt, and A v Werder (eds), Handbuch Corporate Governance, 2nd ed, 2009, 231. 61 This is the widely held belief. But see recently K Lopatta, K Böttcher, and R Jaeschke, ‘When Labor Representatives Join Supervisory Boards:  Empirical Evidence of the Relationship Between

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Non-Shareholder Voice in Bank Governance membership in trade unions shrinks—​the German trade unions are also trying to play the role of defenders of consumers and the environment. As to the aftermath of the financial crisis, as far as known, there is no evidence that corporations with labour codetermination fared better than corporations without it. This suggests that introducing or strengthening labour in the boards of banks is not a solution for better bank governance. As to Germany at least, this would be incompatible with the German constitution because the present codetermination at quasi-​parity already preserves a difficult balance between shareholders’ (constitutional) rights and those of labour. (b)  While the German half/​half codetermination is an outlier internationally, 6.35 mandatory labour codetermination at one-​third parity or with just one or some labour representatives in the board is relatively common in Europe. In this context one might think of giving labour a specific role solely in the remuneration committee of the boards of banks. Under present German law it is legally unnecessary to have one or more members of the labour side in each committee, including the remuneration committee. The idea would be that labour representatives could functionally act like independent directors, not as far as their own interests are concerned,62 but as to the remuneration of management and board members. But there is the negative experience in the Mannesmann/​Vodafone case, in which an illegal post-​merger premium was given to the former chairman of the management board by the chairman of the supervisory board, Josef Ackermann, with the consent of or at least no opposition from the spokesman of the labour side in the board.63 Most recently, it is interesting to note that German trade unions have taken a stand against a stronger form of shareholders’ say on pay, and this for obvious reasons. Such a reform, which is due when the European Shareholders Rights Reform Directive comes to be transposed, would reduce the role of the codetermined boards considerably. Yet it may be that, under this threat and as a response to frequent criticism of the role of labour in the remunerations excesses in the last years, the trade unions and the labour representatives in the boards will become more sensitive when board decisions on increasing the remuneration of management will be made.

the Change to Parity Codetermination and Working Capital and Operating Cash Flows’, Journal of Business Economics (2018), 88, 1. 62 As to the controversy on whether labour representatives are ‘independent’, see K J Hopt, and M Roth in Großkommentar zum Aktiengesetz, 5th ed, De Gruyter, 2018, Article 100 comments, 176 et seq. Under the majority rule, neither the worker representatives who are working at the corporation nor trade union members are independent. 63 K Pistor, ‘The Mannesmann Executive Compensation Trial in Germany’, in C J Milhaupt and K Pistor, Law and Capitalism, University of Chicago Press, 2008, 69.

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(c) Apart from labour codetermination, one might think of one or more independent directors who would be entrusted with taking care of the public interest, including or even primarily the interests of the stakeholders. The idea of a public interest director was advocated for major companies and banks after World War II as well as after major bank crises in several countries in the last century.64 More recently it has been suggested to provide for a corporate social responsibility director.65 Yet it is hard to define what the public interest is since it is so broad. If one looks at the recent discussion on ESG (environmental, social and governance) criteria, it is doubtful whether such a representative in charge of raising these general public concerns would be able to—​and also actually would—​raise the particular concern of systemic risk of banks in the board of a specific bank, and if he or she did so it is doubtful whether the systemic risk would prevail among all the other public interests.66 B. Direct representation of the creditors’ interests in the board

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If indirect representation is not a satisfactory solution, direct representation of the creditors, in particular long-​term creditors, on the board of the banks might help. This has actually been advocated, though only in more general terms and without more details.67 Different forms of such a special creditor representation in the board of banks are conceivable in parallel to the above-​mentioned labour representation. The problems that arise relate to their role in the board, the compatibility with labour representation, and the possible electors.

6.38

The role of representatives of the creditors in the board is not self-​evident. For labour representation it is commonly accepted, at least under German law, that all board members have the same legal rights and duties. This means that they are legally bound to act in the interest of the corporation, whether this interest is conceived as the long-​term shareholders’ interest or a different form of general stakeholder interest, as traditionally in Germany where the management board has the right and the duty to pursue the interests of the shareholders, the creditors and the public (common good) simultaneously.68 While in practice it is clear that 64 H Krüger, ‘Öffentliche Elemente der Unternehmensverfassung’, in H Coing and J H Kaiser, Planung V, Nomos 1971, 56 et seq. Cf also K J Hopt, Der Kapitalanlegerschutz im Recht der Banken, C. H. Beck 1975, 208 et seq, under the aspect of investor protection, 209 et seq, 212 et seq, 233. 65 E Rehbinder, ‘Unternehmenspublizität im Zeichen sozialer Verantwortung der Unternehmen’, in Festschrift für Baums, Mohr Siebeck, 2017, 959. 66 As to the negative Irish experience with public interest directors, see B Clark and G E Henderson, ‘Directors as Guardians of the Public Interest: Lessons from the Irish Banking Crisis’, Journal of Corporate Law Studies (2016), 16, 187. 67 e.g. J Hagendorff, ‘Corporate Governance in Banking’, in A N Berger, P Molyneux, and J O S Wilson (eds), The Oxford Handbook of Banking, 2nd ed, 2015, 139, 155; M Becht, ‘The Governance of Financial Institutions in Crisis’, in S Grundmann et al, Festschrift für Hopt, 2010, 1615, 1625 et seq. 68 Article 76 of the Stock Corporation Act and the majority of the commentaries, see, e.g.,J Koch in U. Hüffer, and J Koch, Aktiengesetz, 13th ed, 2018, Article 76 comments 28 et seq: plurality of interests, weighing of interests by the managing board.

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Non-Shareholder Voice in Bank Governance the labour directors will voice particularly the interests of labour, the impact of labour codetermination depends on the number of seats, that is, half of the seats in Germany in major corporations and one third in other companies. The role of directors in committees, for example in the remuneration committee 6.39 or the risk committee, is more specific. Since creditor representatives are supposed to have an eye on risk, in particular systemic risk, they could make a contribution in such a committee, possibly also in other committees such as the nomination committee. In this context it is interesting to note that the presence of independent directors in audit and risk committees seems to have led to better results in the financial crisis.69 A major problem of creditor representation in the board would be the compatibility 6.40 of creditor representation with labour codetermination. It is politically untenable to diminish the present status of labour codetermination in the board, certainly in Germany, but probably also in other countries with existing (one-​third parity) labour representation. Yet splitting up the shareholder side that is already under pressure to have more diversity would be problematic. In Germany, more specifically, the carefully balanced equilibrium between capital and labour in the board70 would be destroyed.71 A third question is who should elect such creditors’ representatives. Having them 6.41 elected by the general depositors and small creditors is hardly conceivable, since these persons do not have an incentive nor the capability to make a meaningful election, quite apart from the practical problems of such an election, which would be much more difficult than for the general shareholders. This may be different for long-​term bondholders who have an incentive to take into consideration the systemic risk,72 at least if in the future bail-​in legislation will not only be enacted, but also followed in practice as envisaged in the European Union.73 A more secondary question is who should represent these bondholders, whether it should be one or more of them or possibly a trustee (or some differently named representative of the bondholders).74 What is clear is that such a trustee would need to have a particular qualification and the necessary legal powers to act.75

69 Y-​H Yeh, H Chung, and C-​L Liu, ‘Committee Independence and Financial Institution Performance during the 2007-​08 Credit Crunch: Evidence from a Multi-​country Study’, Corporate Governance: An International Review (2011), 19, 437. 70 German Constitutional Court, 1 March 1979 (Labor Codetermination Decision), Decisions of the Constitutional Court, Vol 50, 290. 71 Already under the present law more mandatory diversity requirements are criticized because of this German particularity. 72 See Section III. 73 The recent Italian banking crisis and the experience with the near failure of the Monte dei Paschi in Siena gives a rather dim outlook on this. 74 See Section III. 75 See Section III.

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In any case it seems clear that the representatives of other banks that are creditors themselves are not the ones who should be considered in this context. Bank representation on bank boards has traditionally been a common feature in German boards,76 though in the wave of demutualization this kind of representation has decreased considerably before and after the financial crisis.77 Experience shows that the representatives of (major) banks in the boards of other banks did not take specific care of the interests of all other stakeholders. Their incentive to monitor increased only after the financial crisis, while before it was negligible because of the fact that their own creditor interests were generally covered by their own securities and pledges. More importantly, the experience with the financial crisis showed that these bank representatives did not see the systemic risks or did not take them into consideration sufficiently.78 C. Representation of the creditors’ interests in the board by bank regulators

6.43

If the problems of the specific role, the conflict with labour representation, and the election of creditor representatives cannot be coped with, one might think of having the bank regulator itself sitting on the board of the banks. At first sight this seems the best solution, because already now it is the task of bank regulators to be mindful of the creditors’ interests and more specifically the systemic risk which traditionally has not or has inadequately been considered by the bank boards.79 This would be in line with and take further the suggestion made above concerning the role of the bank supervisor in approving or dismissing bank directors and senior managers.80 Yet there are two objections, a more formal and a more fundamental one.

6.44

The first objection is that in many jurisdictions with developed bank regulation, the bank supervisors already have a de facto power or even a legal right81 to attend important meetings of the board of the bank if they consider it necessary to obtain the information they need for fulfilling their supervisory task. Since the bank supervisors are in a position to enforce what they deem to be necessary, it would not add much to this task to give them a regular seat and a voice in the board.

6.45

More fundamental is a second objection. Having the supervisors sitting as regular board members would raise serious role conflicts for the supervisors. On the one

76 K Johansen et al, ‘Inside or Outside Control of Banks? Evidence from the Composition of Supervisory Boards’, European Journal of Law and Economics (2017), 43, 31. 77 W-​G. Ringe, ‘Changing Law and Ownership Patterns in Germany:  Corporate Governance and the Erosion of Deutschland AG’, The American Journal of Comparative Law (2015) 63, 493. 78 See the references in Section I, n 9. 79 See Section I. 80 See Section II. 81 For Germany, Bank Supervision Act (KWG), Article 44, section 4.

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Non-Shareholder Voice in Bank Governance side they would participate in the day-​to-​day decision-​making process that is up to the board. On the other hand they have to fulfil their supervisory tasks. It is hard to combine both. The supervisors are not supposed to run the bank themselves; this is not a part of their legal authority nor are they fit to do so. Giving them such a role would entail the consequence that the supervisors would have to face accountability and even liability, a consequence which the German legislature, for instance, has excluded by rejecting state liability for negligent supervision, but which is a real threat in other countries.82 By the same token the supervisory task might be endangered since regular board membership of bank supervisors would in the end amount to supervising their own participation in the board’s activities. It is hard to see how this conflict of roles between active participation in the board and supervisory control over the board could be solved. D. Board in bank groups The problems of good bank governance may be most relevant in the context of 6.46 bank groups and, indeed, in most countries there is special bank group legislation which is administered and enforced by the various national or supranational regulators and which presents particular challenges for the supervision of financial conglomerates.83 Apart from the area of antitrust and recent tendencies in corporate social responsibility and human rights, the traditional separation system is still maintained, that is, the parent and each subsidiary are separate legal persons and their creditors have rights only against their respective partner and not against the parent or other members in the group. For banks it has been observed that there is empirical evidence that bank companies with a controlling shareholder (or a parent) did worse than others that had dispersed ownership or were not members of a group.84 The problem regarding the regulation of bank groups in general and bank govern- 6.47 ance in particular cannot be treated here in more detail. Under the aspect of the composition of the bank board, it suffices to see that there is not a special board of the group as such, though in practice the board of the parent may sometimes function like one. Creating such a group board besides the board of the parent would either change the separation system or lead to a difficult doubling of boards and

82 e.g. German Financial Services Supervisory Act (FinDAG) 2002, Article 4, Section 4:  The supervisory agency acts only in the public interest. 83 cf BCBS, ‘Guidelines:  Corporate Governance Principles for Banks’, July 2015, Principle 5, 22 et seq: Governance of group structures; BCBS, ‘Joint Forum: Principles for the Supervision of Financial Conglomerates, September 2012. cf J -​H. Binder, A Glos, and J Riepe (eds), Handbuch Bankenaufsichtsrecht, 2018, § 5: Grundsätze der konsolidierten Aufsicht über Gruppen. 84 K J Hopt, ‘Corporate Governance of Banks and Other Financial Institutions After the Financial Crisis’, Journal of Corporate Law Studies (2013), 219, at 239 et seq, see also Section I, n 1.

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Paul Davies and Klaus J Hopt their rights and duties. It is better to deal with the board problems of each bank-​ group-​member board individually. 6.48

As to the composition of the board of the parent, the question of the representation of creditors is even more complex than in corporations that are independent, since then the problem arises of how to take into consideration the creditors of the subsidiaries. Similar questions arise, though practically with much less relevance, for the eventual representation of the creditors in the boards of bank subsidiaries.

6.49

Apart from this, all group law problems that exist for non-​banks arise also and some more severely, for bank groups. The strategy which is most often used and may be comparatively more successful is full transparency in the group, in particular in bank groups.85 This transparency is not only relevant for the shareholders and stakeholders as in non-​bank groups, but also and very much so for the bank regulator.

6.50

As to more substantive strategies, a group-​wide internal risk management is indispensable, for banks considerably more than for non-​banks.86 For risk management it is vital for the board and the risk managers to get a ‘complete view of the whole range of risks of the institution’.87 Accordingly, the internal information flow88 within the group, in particular from management to the board and from the board of the subsidiary to the board of the parent, is key. The legal difficulties and controversies in this respect are well known.89 But a rule that would make mandatory the inclusion of the central risk officer on financial institutions boards would be too intrusive.90 It should be up to the bank how it organizes its internal risk management in the bank and in the group, provided it works.

6.51

As to incentives, compensation-​related consequences may be more effective than liability. Under CRD IV the material risk-​takers are not only employees of the parent: rather, all employees of EU-​based groups may be encompassed, even if they work outside the European Union.91

85 Armour et al, n 1, 389. 86 ibid, 378; J-​H Binder et al, n 83, § 11 II. 87 Article 76(5) of CRD IV. 88 This is to be distinguished from transparency and disclosure to third parties or the general public. 89 Hopt and Roth, n 62, Article 93 comments, 288 et seq and Article 116 comments, 203 et seq. 90 Contra A Kokkinis, Corporate Law and Financial Instability, 2018, 188 et seq. 91 Article 92(1) of CRD IV on remuneration policies. Up to 25 per cent of variable compensation may be discounted for the purposes of the cap at a rate that the supervisors may set: Armour et al, n 1, 386. See also Article 94(1)(g)(iii).

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V.  Liability of Bank Directors and Other Key Function Holders Legislators use civil liability as the standard incentive for good behaviour for board 6.52 members too. More recently there is also a tendency in economic law to use criminal liability indiscriminately for all manners of violations, not only for those involving intentional conduct and grave fault. Traditionally, for directors, the duty of care and the duty of loyalty are distinguished, whether or not they are combined as fiduciary duties owed towards the corporation. As to the duty of care, the business judgement rule gives the directors a so-​called safe haven in order to avoid them shying away from taking decisions that involve risk but might nevertheless be in the interests of the corporation and its shareholders. In some countries, for example in Germany, the business judgement rule is codified; in other countries the rule is applied either expressly or de facto by the courts and in legal scholarship. The liability of directors is usually only towards their corporation (internal liability) and only under special circumstance towards shareholders, creditors, and third parties (external liability). In most countries liability provisions for directors are fully or at least partly mandatory; mere self-​regulation and market discipline are not enough. As has been seen, this traditional structure of incentives for directors may not work 6.53 well for banks because it neglects the systemic risk of banks and the particular dangers for depositors and other (consumer) bank clients that do not exist for non-​banks, or not to the same degree. In order to remedy this liability structure, several alternatives are discussed: regulatory duties, criminal responsibility, and more severe civil liability. As will be seen, all options have their pros and cons, though regulatory duties may be preferable, but what counts in the end is their stricter enforcement.92 A. Regulatory duties of care and loyalty As a response to the financial crisis, legislators and regulators have created or 6.54 intensified a host of regulatory duties of care and loyalty for directors and to a lesser degree for key function holders in the bank. The best example is the lengthy catalogue in CRD IV, which by now has been, or is being, transformed into national law in many Member States. This catalogue is constantly being refined by regulators, for example the EBA, ESMA, the German Federal Financial 92 As to the theory and problems of directors’ liability, there is a wide and controversial international discussion, cf P C Leyens and M C Faure, ‘Directors’ and Officers’ Liability: Economic Analysis’, ECGI Law Working Paper No 376/​2017; H Spamann, ‘Monetary Liability for Breach of the Duty of Care?’ ECGI Law Working Paper No 300/​2015, 5:  a cost-​benefit analysis tends to disfavour liability apart from specific situations. G Wagner, ‘Organhaftung im Interesse der Verhaltenssteuerung –​Skizze eines Haftungsregimes’, Zeitschrift für das gesamte Handelsrecht und Wirtschaftsrecht (ZHR) (2014), 178, 227.

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Paul Davies and Klaus J Hopt Supervisory Agency (BaFin) and, at the origin of this development, the Basel Committee on Banking Supervision (BCBS).93 These regulatory duties imitate and stiffen the civil and corporate law duties of directors to a considerable degree, but they do not give shareholders and creditors standing to sue and to ask for damages.94 Instead, enforcement is solely up to regulators. The incentive for directors to obey is great since the regulator may not only enforce compliance but ultimately has the power to remove the directors, as discussed in Section III. 6.55

How well this works in practice is not yet fully clear; much depends on the quality, the information, and the enforcement energy of the regulator. The mechanism may vary considerably among different states, even EU Member States, though efforts are underway to harmonize enforcement by national regulators. There are also other criticisms. As occurs often after a crisis, legislators and regulators react too late and then too much. The newly introduced regulatory duties go far, perhaps too far. In any case, they are much too detailed and tend to involve the regulatory agencies in activities that should be up to the board. This might diminish the self-​initiative of the directors and lead to too much bureaucracy rather than to better management and control. The explanatory note of the German BaFin for members of the management and supervisory boards under bank supervisory law amounts to fifty pages.95 Furthermore it is feared that the extensive regulatory duties that may or may not be apt for banks and financial institutions might spillover to the civil and corporate law duties of directors even though the specific risks and regulatory purpose do not exist there.96 John Armour and others have rightly observed that distinguishing regulatory and private law duties is an obscure task.97 Still, regulatory duties are commonly used and have been very considerably broadened after the financial crises by CRD IV and the ensuing national transformation into Member State supervisory law. One of the major advantages is the possibility of quick, flexible and, if needs be, harsh enforcement by the supervisors, see Section IV.D. Therefore strengthening bank governance by regulatory duties may be the best way to go.98

93 BCBS, July 2015: International Association of Insurance Supervisors, November 2015; Swiss FINMA, September 2016; German BaFin, November 2016; FSB, April 2017; Joint ESMA and EBA Guidelines, 26 September 2017, etc. 94 See most recently J-​ H Binder, ‘Der Aufsichtsrat von Kreditinstituten drei Jahre nach dem “Regulierungstsunami”  –​eine Bestandsaufnahme’, Zeitschrift für Unternehmens-​und Gesellschaftsrecht (ZGR) (2018), 88. 95 German BaFin, ‘Merkblatt zu den Mitgliedern von Verwaltungs-​und Aufsichtsorganen gemäß KWG und KAGB’, 4 April 2016. 96 As to the relationship between corporate law and bank supervisory law, see Binder, n 94, 88, 116 et seq. 97 Armour et al, n 1, 389 and n 90. See also I H-​Y Chiu, ‘Regulatory Duties for Directors in the Financial Services Sector and Directors’ Duties in Company Law: Bifurcation and Interfaces’, Journal of Business Law (2016), 465. 98 Binder, n 94, 88, 123. Contra Kokkinis, n 90, 170, 181.

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Non-Shareholder Voice in Bank Governance B. Criminal responsibility of bank directors One of the suggestions for better incentives of bank board members and managers 6.56 has been to hold them criminally responsible for their acts and omissions.99 In Germany several criminal cases against former bank directors are pending. Most prominent is the case of the HSH Nordbank, a public bank of the two German states (Bundesländer) of Hamburg and Schleswig-​Holstein. The directors of this bank had engaged the bank in 2007 in highly risky credit default swap transactions (so-​called Omega 55 transactions), which ultimately led to a loss of 145 million euros. The directors defended themselves by stating:  (i) that the purpose of the complicated transaction, which contained a repo guarantee by a foreign bank, was to free the balance sheet from high outstanding debts in order to prepare the bank for going public; (ii) that the transaction was prepared by the bank’s personnel and hired lawyers in London; and (iii) that the internal credit and risk committees had signalled approval. The facts are highly complicated and need not be described here in detail. In any case the first instance court acquitted these directors after many months of trial in a long ruling of more than 300 pages on the ground that they had acted negligently, but without gross negligence. The German Bundesgerichtshof100 reversed the acquittal in a widely observed judgment on the ground that, in essence, gross negligence is not necessary for the criminal offence of ‘Untreue’ under section 266 of the Penal Act. Since the lower court had found that the directors had not acted within the ‘free haven’ of the business judgement rule—​basically by not fully living up to their duty of information—​they may be criminally liable even for simple negligence. The case is now back at first instance for more fact-​finding. The maximum penalty under Article 266 is five years of imprisonment. In the United Kingdom, section 36 of the Financial Services (Banking Reform) 6.57 Act (2013) provides for a new criminal offence for senior bank managers whose reckless misconduct causes their firm to fail.101 This section is much more specific than the German one. Four elements must be fulfilled. The senior manager must take, or agree to the taking of, a decision as to the way in which the business of a group institution is to be carried on. He or she must be aware of the risk that the implementation of the decision may cause the failure of the group institution. The incriminated conduct must fall far below what could reasonably be expected of a

99 Criminal proceedings have been instituted after the financial crisis in a number of countries, apart from Germany and the United Kingdom (there against the former CEO and three other former top executives of Barclays Capital). This has occurred, for example, in the United States, Greece, and in particular Iceland, where the CEOs, other top and former CEOs, and even majority shareholders of the three largest failed banks were convicted of fraud and market manipulation. See Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan, Chapter 7, this volume. 100 German Bundesgerichtshof, decision of 12 October 2016, Zeitschrift für Wirtschaftsrecht (ZIP) (2016), 2467. 101 Financial Services (Banking Reform) Act 2013, Chapter 33, Section 36. See Section II, n 23.

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Paul Davies and Klaus J Hopt person in the same position. And the implementation of the decision must have caused the failure of the group institution. The maximum penalty is seven years of imprisonment. 6.58

In Germany the decision of the Bundesgerichtshof was hailed by the financial press and by a number of criminal law professors, but it was severely criticized by others, both civil and criminal law experts. According to the criticism, the penal law senate of the Bundesgerichtshof disregarded the corporate law concept of the business judgement rule. Pursuant to this corporate law concept, the fact that the conditions of the business judgement rule have not been met just means that the director has been negligent, but not necessarily grossly negligent. In other words, according to the Bundesgerichtshof directors may be criminally liable for any, even only slightly, negligent actions or omissions in the course of their management. This is indeed too strict. Criminal law is not made for sanctioning every management mistake but should step in only at a later stage, namely if there is intentional or at least grossly negligent misbehaviour. This is also true for banking and should not be changed even for systemic banks or more generally for systemic risks. Civil and criminal liability must not be applied side by side in the same way; instead the latter must come in only for more serious cases. Furthermore, on the procedural side, the criminal courts should take notice and respect the case law of the civil law judges who deal with more cases and are more specialized in corporate and banking law than the criminal law courts. As it stands now there is no procedural nor even informal coordination between both courts.102

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The UK offence, by contrast, is more carefully and narrowly drafted, though its introduction was controversial. It is certainly right in requiring behaviour that ‘falls far below’ the reasonably expected standard. Still, whether it will actually be applied remains to be seen.103 While in most cases the senior manager will be aware of the risk of failure, it will be difficult to find that the implementation of the decision actually has ‘caused’ the failure. If causation is interpreted as any contribution to the failure, whether substantial or not, as for example in civil law, this causation element would be more or less meaningless. On the other side, if it is taken seriously, it might be very hard to find causation in the concrete case. Still, the preventive effect of the threat may be substantial.

102 Experience shows that even informal coordination among different civil law senates at the Bundesgerichtshof, say between the corporate law senate and the banking law senate or the insolvency law senate, is difficult. 103 Kokkinis, n 90, 135 et seq, 169 fears that enforcement will be too difficult and criticizes the need for causation and gross negligence.

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Non-Shareholder Voice in Bank Governance C. More severe civil liability of bank directors and key function holders Other reform proposals for dealing with bank governance focus on the civil law 6.60 liability of directors as distinguished from regulatory duties. They appear in three different forms: first, it is postulated that there should be another, much stricter level of negligence for them; second, it is recommended to do away with the business judgement rule for bank directors; and third, it is suggested to change the burden of proof, which should be placed on them and not on the bank or the creditors. Yet in the end, all three proposals are unconvincing. (a) Reform proposals that suggest having stronger negligence rules for bank directors than 6.61 for non-​bank directors104 appear in different forms. If this means that there should be a different level of negligence than under general civil or corporate law, then this is unconvincing, since this would go well beyond what would be relevant for the systemic risk and would subject bank directors to a specific liability system for all banking risks. As a further consequence, it might become necessary to create specific liability systems for many other risky professions too, such as medical doctors. In the same vein, it has been proposed to hold bank directors to a strict duty of loyalty without the possibility of release by the shareholders, as for example under Delaware law. A further proposal is to require bank directors to take into consideration specifically the systemic risk of the banks;105 this is a dramatic reform in countries that follow the shareholder value rule in corporate law, while for countries with an enlightened shareholder value rule—​and in particular those with some kind of stakeholder principle that includes the promotion of the public good, as for example in Germany—​this can and should already be the case, though practice has varied. Still another proposal is to change the burden of proof and impose it on the bank director. Instead of all this, it seems more convincing to stick to the general rules of dir- 6.62 ector liability, which means that they are liable if they are negligent. Negligence is a standard which differs of course depending on the facts of the case, that is, more care is needed if there is more risk, professionals are subject to a higher standard than non-​professionals, and those who have or ought to have specific knowledge or abilities must make use of them if need be. Accordingly, under present law it is well established and even self-​evident that bank directors have specific duties of behaviour and organization as necessary for banks in the concrete case.106 There are also detailed duties for board members, including bank directors, on how to act if fellow

104 J R Macey and M O’Hara, ‘The Corporate Governance of Banks’ Economic Policy Review (FRBNY) (2003), 9, 91, 102 et seq, 107 et seq. 105 Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan, Chapter 7, this volume, with further references. See Section I, n 14 for the Royal Bank of Scotland case. 106 In detail, see J-​H Binder, ‘Organisationspflichten und das Finanzdiensleistungs-​Unternehmensrech t:  Bestandsaufnahme, Probleme, Konsequenzen’, Zeitschrift für Unternehmens-​und Gesellschaftsrecht (ZGR) (2015), 667. For the United States, see Litwin v Allen, 25 N Y 2d 667, 668, Sup Ct, 1940).

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Paul Davies and Klaus J Hopt directors or even the whole board acts negligently or otherwise in breach of the law, that is, duties to speak up, to dissent, to inform the chairman of the board or even the bank supervisors and, as an ultimate step, to resign.107 6.63

In Germany at least, the number of civil liability lawsuits against former directors has increased quite considerably,108 this following the financial crisis and a landmark judgment of the Bundesgerichtshof, ARAG v Garmenbeck, according to which the supervisory board members may become personally liable if they do not hold management board members liable.109 The most recent case is the Hypo-​ Vereinsbank case that just commenced at the court of first instance in Munich in January 2018. Three former management board members are being sued by their bank for not having stepped in against doubtful tax transactions (the ‘cum-​ex’ tax trick that amounted to receiving tax repayment from the state twice).110

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Furthermore, the well-​established risk-​related duties of bank directors include systemic risk already under present law. It is rather the case that this risk has not been seen, or if seen, not taken seriously. It is also questionable whether an additional specific duty to take into consideration the systemic risk of banks would be meaningful in light of the enormous damages that are well beyond what the directors could reimburse. It would be a too open-​ended standard.111 Therefore, it seems well justified that the British government rejected the proposal of the Department of Business, Innovations and Skills to introduce ‘a new primary duty on bank directors to promote the financial stability of their companies over the interests of shareholders’.112 To be sure, it is not argued here that shareholder primacy should be the standard, since a long-​standing experience in Germany shows that not only an enlightened shareholder primacy can work, but that even a pluralistic aim of the corporation and the duty of the management board to act in the interest of the shareholders, the creditors, and the public is satisfactory, both in theory and in

107 cf for German law, Hopt and Roth, n 62, § 93 comments, 370 et seq.; for UK law, cf Kokkinis, n 90, 177. 108 K J Hopt, ‘Responsibility of Banks and Their Directors, Including Liability and Enforcement’, in L Gorton, J Kleineman, and H Wibom (eds), Functional or dysfunctional—​the law as a cure? Risk and liability in the financial markets, , 2014, 159; K J Hopt, ‘Die Verantwortlichkeit von Vorstand und Aufsichtsrat’, Zeitschrift für Wirtschaftsrecht (ZIP) (2013), 1793, 1793–​1794 with recent case law. cf H C Grigoleit, ‘Directors’ Liability and Enforcement Mechanisms from the German Perspective—​General Structure and Key Issues’, in H Fleischer et al (eds), German and Asian Perspectives on Company Law, 2016, 105, under IV: overly rigorous set of liability rules. 109 German Bundesgerichtshof, decision of 21 April 1997, Arag v Garmenbeck, Decisions of the Bundesgerichtshof, Vol 135, 244. 110 Frankfurter Allgemeine Zeitung, 12 January 2018, No 10, 17; Handelsblatt, 11 January 2018, No 8, 30. 111 A Hamdani, ‘Bank Directors: Duties Towards the Public?’, lecture, Society of European Contract Law (SECOLA), 16–​17 June 2017, Bocconi University. 112 Contra Kokkinis, n 90, 170 et seq.

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Non-Shareholder Voice in Bank Governance practice.113 Under bank corporate governance aspects one might even postulate that the interests of the creditors come before the interests of the shareholders.114 Yet singling out the systemic risk and therefore digging a civil liability ditch between the few banks carrying systemic risks and all the others is unsatisfactory; while it may work for regulatory purposes, it is not suitable for directors and possible claimants in civil liability. What is certainly helpful is to require specific abilities and experiences of bank 6.65 directors,115 and to have regulators enforce these requirements when, as suggested earlier, bank directors are approved by the regulator.116 One might label this as a specific ‘banking literacy’,117 which would be part of the ‘fit and proper’ requirements imposed by regulators. Yet as for other skills and experience that are necessary in the board, this requirement should be only for the board as a whole, not for each director.118 Otherwise the necessary diversity might not be reached or maintained. (b) In corporate law there are several rationales for the business judgement rule: first, 6.66 to avoid that directors are overly deterred from making decisions for the company that may be commercially promising but risky, and second, to reduce the danger that judges later on succumb to the hindsight bias which is very difficult to avoid.119 It has been proposed not to apply the business judgement rule to bank directors120 in order to incentivize them better to take into consideration bank specific risks, in particular, systemic risk. For this it has been correctly observed that for managers with equity-​based pay, the fear of liability would not lead to undesirable risk-​aversion on the part of managers and for diversified shareholders because of the systemic harm that has effects will beyond the bank.121 Yet this relates only to

113 See Section IV, n 66. For the more recent version of the enlightened shareholder interest approach, see A Keay, The Enlightened Shareholder Value Principle and Corporate Governance, 2013. 114 cf BCBS, Guidelines, n 83, 3, Introduction No 2: ‘The primary objective of corporate governance should be safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis. Among stakeholders, particularly with respect to retail banks, shareholders’ interest would be secondary to depositors’ interest.’ See K J Hopt, ‘Corporate Governance von Finanzinstituten, Empirische Befunde, Theorie und Fragen in den Rechts-​und Wirtschaftswissenschaften’, Zeitschrift für Unternehmens-​und Gesellschaftsrecht (ZGR) (2017), 438, 446 et seq. Same proposal by Kokkinis, n 90, 183. 115 This knowledge and experience is key, also in comparison to independence; see J de Haan and R Vlahu, ‘Corporate Governance of Banks: A Survey’, Journal of Economic Surveys (2016), 30, 228, 250 et seq; Binder, n 94, 88, 101 et seq. 116 See Section II. 117 Macey and O’Hara, n 104, 102 et seq. 118 cf German Corporate Governance Code as of 7 February 2017, s 5.4.1: ‘The Supervisory Board has to be composed in such a way that its members as a group possess the knowledge, ability and expert experience required to properly complete its tasks.’ (emphasis added). 119 For details, see Hopt and Roth, n 62, Article 93 comments, 66–​131. 120 J Armour and J Gordon, ‘Systemic Harms and Shareholder Value’, Journal of Legal Analysis (2014), 6, 35, 39 et seq, and same, ECGI Law Working Paper No 222/​2014. 121 Armour et al, n 1, 379.

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Paul Davies and Klaus J Hopt the systemic risk. For other risks, whether bank specific or the general enterprise risk, both rationales for the business judgement rule remain untouched. This is the reason why the business judgement rule should remain available to bank directors too.122 6.67

(c)  There is also no case for changing the burden of proof, as the reform in the United Kingdom has rightly refused to do.123 In Germany the burden of proof falls on the (bank and non-​bank) director, and this is mandatory.124 But the German reform discussion criticizes this rule as having lost touch with modern reality.125 Usually liability cases against directors are started when the old directors have been ousted and the new directors either are legally bound to or want to show that they enforce the liability of their predecessors. At that point it is difficult or even impossible for the former director to meet this burden of proof, since he or she no longer has access to the email system of the corporation. Giving him or her right of information against the corporation, as the traditional doctrine maintains, no longer works. All this is even more difficult if the lawsuit is only brought years afterwards or a takes very long time. The same analysis applies for bank directors.

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(d) An interesting proposal for an insolvency related responsibility of bank directors has been made recently in the United Kingdom.126 The liability standard proposed is said to be a capped strict liability, with a defence of reasonable management consistent with financial sustainability, but actually it is a sort of mandatory contribution of bank directors to the assets of an insolvent bank that is linked to the total level of the remuneration paid in the last five years. While this liability is supposed to be strict and not dependent on bad faith or negligence nor on causation, the director can defend themselves by showing reasonable management, which thus seems to yield a standard of negligent behaviour. As to the link to insolvency, the proposed provision would be similar to the traditional wrongful trading liability.127 It also resembles to a certain degree the French action en responsabilité

122 G Ferrarini, ‘Understanding the Role of Corporate Governance in Financial Institutions:  A Research Agenda’, ECGI Law Working Paper No 347/​2017, 7, 21 et seq, also referring to the case in the Delaware Court of Chancery; Hamdani, n 11, and T. Tröger, ‘Managers’ Duties Towards Shareholders and Debtholders’, lecture, Society of European Contract Law (SECOLA), 16–​17 June 2017, Bocconi University. 123 See Section II, n 25. Contra Kokkinis, n 90, 176. See the detailed discussion on this issue in Australia: M Legg and D Jordan, ‘The Australian Business Judgment Rule After ASIC v Rich: Balancing Director Authority and Accountability’, Adelaide Law Review (2014), 34, 403. 124 German Stock Corporation Act, Article 93. 125 See K J Hopt, ‘Die Reform der Organhaftung nach § 93 AktG’, in T Ackermann and J Köndgen, (eds), Privat-​und Wirtschaftsrecht in Europa, Festschrift für Wulf-​Henning Roth, 2015, 225, 232 et seq. 126 Kokkinis, n 90, 169 et seq. 127 ibid, 172; but also for an amendment of the wrongful trading and disqualification provisions, 183 et seq. As to wrongful trading, see P L Davies and S Worthington, Gower Principles of Modern Company Law, 10th ed, 2016, s 9-​6 et seq. For a comparison with German law, see F Steffek, Gläubigerschutz in der Kapitalgesellschaft, 2011.

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Non-Shareholder Voice in Bank Governance pour insuffisance d’actif.128 This action, however, presupposes a fault on the part of the directors, a link of causation, and the insolvency of the bank. The amount to be paid by the director lies in the discretion of the court. (e) The Responsibility of key function holders129 is a concept that traditionally is not 6.69 used in corporate law, but one that has rightly been introduced in bank regulation mainly after the financial crisis (though primarily as far as concerns improper remuneration incentives). Normally employees of the company, even those directly under the CEO, are liable to the company under the specific employment rules of labour law, which shield employees from general liability. As to key function holders, one might think of treating them as organs of the company, just like the members of the board.130 This may be particularly relevant for the risk officer of the parent company. But the better solution is to subject key function holders solely to regulatory duties, possibly including a sort of banking literacy131 corresponding to their functions and tasks, and not to extend these duties so as to have them become also civil and corporate law duties given that both regimes have different goals and the specific labour law liability regime for employees should remain open for all employees.132 On the other side, holding the board and its directors personally strictly liable 6.70 for the misbehaviour of key function holders would also go too far. Instead, strict duties of the board to organize the bank processes and to supervise these processes,133 not only for the single bank but group-​wide, is more appropriate and fits into the traditional concept of negligence as mentioned before. (f ) In the end there are proposals to do away with limited liability entirely. For tort 6.71 law this is a classic proposal134 which is not to be pursued further in this context. But 128 Article L. 651-​2 of the French Code de commerce (formerly: action en comblement du passif ). cf M Cozian, A Viandier, and F Deboissy, Droit des sociétés, 30e éd, 2017, 422 et seq, 2057 et seq. 129 See Section II for the United Kingdom. 130 BCBS, Guidelines, n 83, Principle 4: senior management. 131 See Section V.C(a). 132 I H-​Y Chiu, ‘Comparing Directors’ Duties in the Financial Services Sector with Regulatory Duties under the Senior Persons Regime –​Some Critical Observations’, European Business Law Review (2016), 27, 261, 278 et seq. Contra Kokkinis, n 90, 173 et seq, who proposes to extend section 36 of the UK Financial Services (Bank Reform) Act 2013 (see Section V.2) to a civil law responsibility for both directors and senior managers. Yet in this context one should be aware that the dividing line between directors and senior managers differs: in the United Kingdom, apart from the CEO, the board consists nearly exclusively of non-​executive directors, while in Germany all of the managing board directors are executive members. As to separate rules for directors and senior managers in the UK, see Davies and Worthington, n 127, s. 16–​11. 133 As to the growing role of directors’ organizational duties, see for credit institutions, Binder, n 94, 88; for general non-​bank directors, Hopt and Roth, n 62, Article 93 comments, 182 et seq. For the United Kingdom, see Chiu, n 97, 465; Kokkinis, n 90, 176 et seq. 134 H Hansmann and R Kraakman, ‘Toward Unlimited Shareholder Liability for Corporate Torts’, Yale Law Journal (1991), 100, 1879; N A Mendelson, ‘A Control-​Based Approach to Shareholder Liability for Corporate Torts’, Columbia Law Review (2002), 102, 1203. See also R Kraakman et al., The Anatomy of Corporate Law, 3rd ed, 2017, 1.1.2 (limited liability), 5.1.2.3 (externalities, non-​adjusting creditors).

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Paul Davies and Klaus J Hopt similar proposals have been made specifically for the banking sector. Historically bank shareholders were subject to liability for corporate obligations in an amount equal to the par value of their shares.135 After the financial crisis, when it turned out to be difficult or impossible to hold bankers and bank directors liable, one recalled that originally Wall Street firms were run as partnerships with unlimited liability, which amounted of course to a completely different incentive structure as to engaging in unduly high risks. Accordingly it was proposed to impose some personal liability on investment bankers.136 A theoretically interesting and more recent proposal concerns only investor-​managers of shadow banks.137 Investor-​managers under this proposal are equity investors who also have significant power to control the firm’s actions and among them only those with a significant share of their firm’s profit. These investor-​managers should be subject to a liability that is a multiple of their original investment, say double, provided that their firm has not made due contributions to a systemic risk fund to be set up by the systemically risky shadow banks. D. Stricter enforcement by the board, by the creditors, and/​or by regulators 6.72

As we have seen, subjecting bank directors to a specific and stricter rule than ordinary board members is anything but obvious. But this reform agenda becomes even more complicated if one looks at enforcement. It is common wisdom that liability without adequate enforcement is meaningless, and better enforcement may even lead to better deterrence than stricter duties and liabilities.

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(a) Traditionally it is up to the whole board to bring liability suits against the members of management and the board itself. Since it is natural that the board will be reluctant to take action against management colleagues or fellow members in the board, the power to do so is better vested in the independent directors in a one-​ tier system or the supervisory board in a two-​tier system. In addition, a minority of shareholders may have standing to initiate such a lawsuit, though this happens rarely. As mentioned before, in some jurisdictions, such as in Germany under the ARAG–​Garmenbeck decision of the Bundesgerichtshof, there is even a mandatory legal duty that falls on the (supervisory) board to bring an action but for very exceptional circumstances.138 While the number of such lawsuits brought by boards

135 Still in the National Banking Act of 1863 and partially elsewhere until 1935; J R Macey and G P Miller, ‘Double Liability of Bank Shareholders: History and Implications’, Wake Forest Law Review (1992), 27, 31, 36. 136 C Hill and R Painter, ‘Berle’s Vision Beyond Shareholder Interests:  Why Investment Bankers Should Have (Some) Personal Liability’, Seattle University Law Review (2010), 33, 1173. 137 S L Schwarcz, ‘The Governance Structure of Shadow Banking:  Rethinking Assumptions About Limited Liability’, Notre Dame Law Review (2014), 90, 1. 138 Pursuant to the above-​mentioned decision of the German Bundesgerichtshof, ARAG v Garmenbeck.

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Non-Shareholder Voice in Bank Governance is relative small, such a duty requires the board to think twice as to whether or not to enforce a claim of the corporation against a director, since if it fails to do so its members will risk being liable themselves. This seems to work fairly well, though there is criticism that there should be more room for the business judgement of the (supervisory) board too as to whether, in view of the legal and non-​ legal consequences, it is really advantageous for the corporation to initiate judicial proceedings. The proposal to extend standing to each single shareholder has not met with the ap- 6.74 proval of a clear majority.139 It is true, however, that the duty of care of directors even apart from the business judgement rule is seldom enforced,140 whereas violations of the duty of loyalty are more egregious, easier to prove, and more often enforced. A far-​ reaching reform proposal in the United Kingdom would give standing to the stakeholders in conformity with a stakeholder conception in company law that would make directors responsible not to the shareholders but to the company as a whole.141 (b)  For banks, one might wonder whether engaging the creditors in enforcement 6.75 might lead to more liability suits against directors. This could be done by making directors, or even key function holders, directly liable to creditors, possibly even group-​wide, and giving these creditors standing to sue. Under special circumstances, for example product liability, this can be done already today. Yet going further shows the incentive problems. Normal creditors will not have an incentive to bring such suits; rational apathy is experienced not only by ordinary shareholders but also by creditors. Larger creditors, in particular major banks as creditors, usually have no such an incentive because of the securities and pledges that they hold. This may be slightly different for long-​term creditors, in particular bondholders, yet even for them litigation may ultimately be unattractive. (c) The enforcement of the regulatory duties of the directors and key function holders 6.76 is of course up to the regulators and supervisors who have not only the task but also the regulatory and supervisory powers for doing so. Indeed, as said before, these regulatory duties and the corresponding enforcement powers were reformed dramatically after the financial crisis under the CRD IV; at this point there is even the fear of too much intrusion into the organization, management, and day-​to-​day business, in short a fear of overregulation.142 As to the European Union, it must be remembered that the CRD IV is being transformed into national law with the

139 cf 69th German Lawyers’ Association (Deutscher Juristentag), Munich 2012, Resolution No 22 and the discussion at the meeting before, insofar as the expert opinion of M Habersack was not followed. 140 Armour et al, n 1, 389. 141 I H-​Y. Chiu, ‘Operationalising a stakeholder conception in company law’, Law and Financial Markets Review (2016), 10, 173. 142 Ferrarini, n 122, 2: favouring cautious deregulation, 24 et seq.

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Paul Davies and Klaus J Hopt consequence that the enforcement standards vary widely.143 Harmonization not only of substantive law but also of the related procedural and enforcement law, including the concretization of the fit and proper rule and the liability of the supervisors,144 is needed to ensure a level playing field in the governance of European banks.145 6.77

Regulatory duties as dealt with here are public duties under bank supervisory law. But it must not be overlooked that banks may be and are quite often liable under securities regulation in the United States and under—​harmonized or now increasingly genuine—​European capital markets law. In a recent case study the point has been made quite rightly that securities namely capital market law litigation is becoming an increasingly effective substitute for duty of care actions in risk oversight failure scenarios.146

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As to criminal responsibility it is long since established that supervisors inform the public prosecutor if it is found that directors have engaged in criminal behaviour and criminal transactions. This is not to be underestimated because there is a clear tendency for legislators to penalize administrative and supervisory law violations as penal infractions or even as outright crimes.

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But what remains is the proposal to give regulators a role in enforcing civil liability. There are different ways to do this. Regulators could make it easier for private plaintiffs to prove their liability claims by making available their own findings on directors’ violations of regulatory duties.147 A more far-​reaching reform would be to give bank regulators standing for enforcing the civil liability of directors. This has been done, for example, in Australia148 and has occasionally been proposed in Europe too.149 Yet the German Lawyers’ Association has discussed this proposal

143 C Zilioli, Director General of Legal Services of the European Central Bank, ‘Advances in Corporate Governance:  Financial Corporations’, lecture at the Hertie School of Governance, Berlin 20 February 2018. Curiously enough, in its supervisory capacity, the ECB has to apply the national supervisory laws of nineteen Member States. 144 This is also a problem for the ECB for its task of bank supervision under national supervisory law. 145 This is the conclusion of Zilioli, n 143. 146 M T Moore, ‘Redressing Risk Oversight Failure in UK and US Listed Companies: Lessons from the RBS and Citigroup Litigation’, European Business Organization Law Review (2017), 18, 733. 147 From a comparative law perspective, this is similar in France, where civil claimants use the information extracted in the corresponding prior criminal lawsuit, and more generally in those countries where corporate law provides for a special inquiry by experts which the court may grant at the application of shareholders. See also Kokkinis, n 90, 182, who argues for a mandatory in-​depth inquiry by an independent committee in each case of financial institution failure. 148 Australian Securities and Investments Commission (ASIC) Act 2001 (Cth), section 50. For details, see I Ramsay, ‘Increased Corporate Governance Powers of Shareholders and Regulators and the Role of the Corporate Regulator in Enforcing Duties Owed by Corporate Directors and Managers’, European Business Law Review (2015), 26, 49, 63 et seq; J J du Plessis and N Cordes, ‘Claiming Damages from Members of Management Boards in Germany: Time for a Radical Rethink and Possible Lessons from Down Under?’, unpublished manuscript, 2017, 23 et seq, 29 et seq. 149 U H Schneider with a motion at the 69th German Lawyers’ Association; Chiu, n 141, 185 without mentioning the Australian experience.

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Non-Shareholder Voice in Bank Governance and rejected it for a number of reasons.150 The main reason being that regulators have other more direct means of enforcing the obedience of the regulatory duties of bank directors and should devote their limited personnel and financial resources to direct enforcement, leaving civil liability to the corporation, shareholders, and, as the case may be, private creditors.151 As to the incentive structure of the directors, it is doubtful whether the additional threat of financial liability enforced by regulators would add very much to the threat of being censured or even dismissed by a regulator. In the end, such a reform would be motivated more by the social policy argument of securing compensation for damaged persons than by the need to cope with the incentive structure as to bank specific systemic risk.

150 69th German Lawyers’ Association, n 139, Resolution No 17; cf Hopt, n 125, 237 et seq. 151 There may be a role for regulators in securing private redress as part of the settlement of a regulatory action as in the Tesco case in the United Kingdom.

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7 RESPONSIBILITY OF DIRECTORS OF FINANCIAL INSTITUTIONS Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan*

I. Introduction II. Analysis A. Duties generally applicable to directors of firms, including financial institutions

7.01 7.03 7.03

B. Duties specifically applicable to directors of financial institutions C. Normative perspectives

III. Conclusion

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I. Introduction 7.01

This chapter examines the governance responsibilities of directors of financial institutions in the United States and worldwide. The chapter proceeds in three parts. Part A first reviews, as background, the duties generally applicable to directors of firms, including financial institutions. Part B then compares the special responsibilities of directors of financial institutions, including certain responsibilities created in the aftermath of the 2007–​2009 global financial crisis (the ‘financial crisis’). Finally, Part C enquires more normatively about whether—​and if so, how—​financial institution governance should be improved to further reduce excessive risk-​taking and protect the public against systemic economic harm. This last question—​whether directors should have some responsibility to the public—​is a theme of this chapter.

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This chapter does not seek to review comprehensively how legal systems impose duties on directors of financial institutions. Rather, it attempts to describe some of the most important duties facing directors of financial institutions today and to

* The authors thank Professor Alessio M Pacces and other participants in the book conference, as well as Professor Elisabeth de Fontenay, for helpful comments.

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Responsibility of Directors of Financial Institutions suggest how to change the law to improve those duties going forward. In particular, the chapter concludes that the post-​crisis responsibilities of directors of financial institutions are still inadequate, and that such directors should have a public governance duty to help mitigate the potential for systemic economic harm.

II. Analysis A. Duties generally applicable to directors of firms, including financial institutions The duties of directors of firms, including financial institutions, are owed primarily 7.03 to the firm to act in the firm’s best interests.1 Such duties to the firm are usually termed as fiduciary duties of directors. Firms, unlike natural persons, are artificial constructs and exist only because of positive law. As such, any discussion of directors’ duties should start with two questions: the scope of fiduciary duties based the firm’s best interests, which is examined in Section II.A.1; and the substance of fiduciary duties based on the firm’s best interests, which is examined in Section II.A.2. Thereafter, Section II.A.3 examines the mechanisms for enforcing fiduciary duties. 1.  The scope of directors’ fiduciary duties The fiduciary duties of directors to the firm invariably include the duty to con- 7.04 sider the interests of the firm’s shareholders. This is the case both for jurisdictions that embrace the so-​called shareholder-​primacy model2 and for jurisdictions that disavow such a model.3 For the former jurisdictions, the fiduciary duty is often expressed interchangeably as either a duty to the firm or a duty to its shareholders.4 For the latter jurisdictions, directors, in discharging their fiduciary duties to the firms, may be or are required to also consider the interests of non-​shareholder stakeholders, such as creditors, depositors, employees, and consumers.

1 See, e.g., Canada Business Corporations Act (CBCA), RSC 1985, c C-​44, § 122 (Can) (‘Every director and officer of a corporation in exercising their powers and discharging their duties shall (a)  act honestly and in good faith with a view to the best interests of the corporation  . . .’); The Companies Act 2006, c 46, § 172(1) (Eng) (‘A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company.’). 2 See, e.g., Dodge Ford Motor Co, 204 Mich 459, 507, 170 NW 668, 684 (1919) (‘[I]‌t is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others . . .’). 3 See, e.g., BCE Inc v 1976 Debentureholders [2008] 2008 SCC 69 (Can) (‘In considering what is in the best interests of the corporation, directors may look to the interests of, inter alia, shareholders, employees, creditors, consumers, governments and the environment to inform their decisions.’). 4 e.g. Guth v Loft, Inc 23 Del Ch 255, 270, 5 A 2d 503, 510 (1939) (‘[Directors] stand in a fiduciary relation to the corporation and its stockholders.’); see also Robert A Kutcher, ‘Breach of Fiduciary Duty’ in D Soley, Y Gwin, and A Georgehead (eds), Business Torts Litigation, American Bar Association, 2005, 4 (‘As a matter of law, corporate officers [and] directors . . . owe a duty, which will be enforced by the court, to the corporation and, through the corporation, to the shareholders.’).

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In the United States, the fiduciary duty traditionally requires directors to maximize the return to the firm’s shareholders.5 However, thirty-​three US states have enacted ‘other constituency’ statutes, enabling directors to consider non-​shareholder constituencies. There are four distinct variations, depending on whether (i)  the authority to consider non-​shareholder constituencies is limited to the takeover context; (ii) consideration of other constituencies is discretionary or mandatory; (iii) all constituencies are to be considered in equal weight; and (iv) the authority is statutorily granted to all firms or is permitted only if included in the firm’s articles of incorporation.6

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Most countries do not require directors to consider the interests of the public independently from the interests of shareholders in their decision making.7 There are limited exceptions. Under Dutch law, for example, directors of public firms, including financial institutions, have a duty to weigh at least certain public interests—​including the environment, social matters, respect for human rights, and fighting corruption and bribery—​against the interest of shareholders, while giving priority to shareholder interests.8 Similarly, the corporate governance code of Bulgaria requires corporate boards to ‘establish specific rules for addressing the interests of stakeholders. . . . These rules should ensure the balance between the development of the company and the development of the economic, social and ecological environment in which the company operates’.9 The corporate governance code of Slovakia creates an explicit, albeit limited, duty to the public, mandating that directors apply a standard of due care and fair dealing towards ‘employees, creditors, customers, suppliers and local communities’.10

5 This is still the case for Delaware, where more than half of Fortune 500 firms are incorporated. e.g. eBay Domestic Holdings, Inc v Newmark, 16 A 3d 1, 34 (Del Ch, 2010) (‘I cannot accept as valid . . . a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-​profit Delaware corporation for the benefit of its stockholders . . . .’). 6 Melvin Aron Eisenberg and James D Cox, Business Organizations Cases and Materials, 11th ed, Foundation Press, 2014, 259. 7 It worth noting that certain countries, such as the United Kingdom, mandate directors to consider employees, suppliers, customers, and the community when discharging their duties to ‘promote the success of the company for the benefit of its members as a whole’. The Companies Act 2006, c 46, § 172(1) (Eng). While § 172’s language emphasizes that considerations of other constituencies must ultimately benefit shareholders, ‘where a director in good faith and in order to promote the success of the company for the benefit of its members as a whole makes a decision in the wider interests of the community or the environment it may be arguable that he will be protected from reproach.’ Mark Arnold and Marcus Haywood, ‘Duty to Promote the Success of the Company’, in Simon Mortimore (ed), Company Directors:  Duties, Liabilities, and Remedies, 3rd ed, Oxford University Press, 2017, 290 (emphasis added). 8 The Dutch Corporate Governance Code, Principle 1.1.1, 8 December 2016. 9 Bulgarian Code for Corporate Governance, 16 (2012), available at http://​www.ecgi.org/​codes/​ documents/​codeks_​bulgaria_​feb2012_​en.pdf, accessed 17 October 2018. 10 The Corporate Governance Code for Slovakia, 35 (January 2008), available at http://​www. ecgi.org/​codes/​documents/​cega_​code_​slovakia_​jan2008_​en.pdf, accessed 17 October 2018.

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Responsibility of Directors of Financial Institutions Canada also appears to recognize a director duty to the public, arising from case law. 7.07 In BCE Inc v 1976 Debentureholders,11 the court’s opinion broadly articulated a stakeholder model of governance: Where conflicting interests arise, it falls to the directors of the corporation to resolve them in accordance with their fiduciary duty to act in the best interests of the corporation. . . . There are no absolute rules and no principle that one set of interests should prevail over another. In each case, the question is whether, in all the circumstances, the directors acted in the best interests of the corporation, having regard to all relevant considerations, including—​but not confined to—​the need to treat affected stakeholders in a fair manner, commensurate with the corporation’s duties as a responsible corporate citizen.12

One prominent commentator, quoting a prior Canadian decision, observes that such 7.08 a stakeholder model could even take into account ‘the interests of, inter alia, shareholders, employees, creditors, consumers, governments and the environment’.13 There remains fundamental disagreement, however, about how to apply that model of governance, including how to determine which stakeholders’ interests should be taken into account and how directors of firms could attempt to value and balance those interests with investor interests. 2.  The substance of directors’ fiduciary duties. While the exact phrases ‘duty of care’ and ‘duty of loyalty’ may be unfamiliar to some 7.09 legal systems,14 all systems aspire to encourage directors to exercise minimum levels of care in discharging their duties and to encourage directors to act in good faith, to avoid conflict of interests, and to comply with laws and regulations.15 In the United States, directors’ fiduciary duties are often discussed as a duty of care 7.10 and a duty of loyalty.16 In the European Union, nearly all Member States impose

11 [2008] 3 SCR 560 (Can). 12 ibid, 565. 13 Robert Yalden, ‘Canadian Mergers and Acquisitions at the Crossroads:  The Regulation of Defence Strategies After BCE’, Canada Business Law Journal (2014), 55 389, 407. 14 .g., the Dutch Civil Code (DCC) has no explicit reference to the duty of care nor the duty of loyalty. Directors are responsible for ‘a proper performance of the tasks assigned’: DCC, Article 2:9. 15 Virtually all jurisdictions require directors to comply with the law and thus criminalize conduct such as insider trading, accounting fraud, embezzlement, and money laundering. 16 While the Delaware Court of Chancery articulated a triad of fiduciary duties in In re Caremark Int’l Inc. Derivative Litig, 698 A 2d 959, 967 (Del Ch, 1996), the Delaware Supreme Court clarifies in Stone that the fiduciary duties only include a duty of care and a duty of loyalty. See Stone v Ritter, 911 A 2d 362, 370 (Del, 2006) (‘[T]‌he obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty.’).

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan duties of loyalty and care that are not significantly different from those duties in the United States.17 Japan,18 China,19 and Taiwan20 have also adopted the US-​style fiduciary duty standard. 7.11

Some jurisdictions purport to impose duties in addition to the duty of loyalty and the duty of care.21 In the United Kingdom, for example, there are duties to promote the success of the firm, to exercise independent judgement, not to accept benefits from third parties, and to declare one’s interest in proposed transactions.22 Estonia imposes a duty on directors not to take ‘unnecessary risk.’23 Most of these variations, however, fall within a liberal and functional reading of the duties of care and loyalty. Accordingly, this chapter discusses the substance of directors’ fiduciary duties based on those two categories. Duty of care 

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While its exact formulation varies in different jurisdictions, the duty of care addresses the standard by which directors conduct business operations and activities. In the United States, directors are often said to have a ‘duty to the corporation to perform the director’s functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances’.24

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Some jurisdictions, including France and Italy, have an ‘objective/​ subjective’ standard of care. The former constitutes a standard that all directors must satisfy

17 Carsten Gerner-​Beuerle, Philipp Paech, and Edmund Philipp Schuster, Study on Directors’ Duties and Liability 30–​42 (2013), available at http://eprints.lse.ac.uk/50438/, accessed 1 December 2018. 18 Bruce E Aronson, ‘Reconsidering the Importance of Law in Japanese Corporate Governance: Evidence from the Daiwa Bank Shareholder Derivative Case’, Cornell International Law Journal (2004), 36, 12, 22 (‘Shareholder-​elected directors owe fiduciary duties, which are generally similar to those under U.S. law, to the corporation and its shareholders.’). 19 Rebecca Lee, ‘Fiduciary Duty without Equity: Fiduciary Duties of Directors under the Revised Company Law of the PRC’, Virginia Journal of International Law (2007), 47, 897, 901. 20 Hideki Kanda and Curtis J Milhaupt, ‘Re-​ Examining Legal Transplants:  The Director’s Fiduciary Duty in Japanese Corporate Law’, The American Journal of Comparative Law (2003) 51, 887, 892. 21 ibid. 22 ibid, 42. 23 ibid, 33, 81. 24 American Law Institute, Principles of Corporate Governance § 4.01(a). See also the Model Business Corporation Act (MBCA) § 8.30(b) (‘The members of the board of directors . . ., when becoming informed in connection with their decision-​making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.’). The Office of the Comptroller of the Currency echoes this view for directors of banks and federal saving associations. See Office of the Comptroller of the Currency, ‘The Director’s Book: Role of Directors for National Banks and Federal Savings Associations’, 22 (July 2016).

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Responsibility of Directors of Financial Institutions based on what reasonably can be expected of a person in a comparable situation; the latter constitutes a higher standard for directors who possess particular knowledge or experience.25 Other jurisdictions, including Demark, Netherlands, and Germany, have an objective standard without explicit increased expectations for directors with higher-​than-​average skills.26 Still other jurisdictions, including Luxembourg, Greece, and Ireland, allow the objective standard of care to be lessened when directors lack the knowledge or experience of an average business person.27 From a practical standpoint, the exact articulation of the standard of care is less 7.14 important than the standard of review applied by courts. Most jurisdictions appreciate that ex post judicial review of business decisions might be subject to hindsight bias and might also make directors unduly risk adverse. They therefore recognize the need for judicial restraint in evaluating business decisions.28 In the United States, this restraint is evidenced by the business judgement rule, 7.15 which requires courts to exercise a limited review when violations of duty of care are alleged.29 The business judgement rule entails a significant disconnect between the standard of conduct and the standard of review.30 The rationale behind the rule rests on the idea that a court should not intrude improperly into corporate management, and therefore should avoid ‘substitut[ing] its own judgment for that of the corporation’s board of directors’.31 Duty of care violations present ‘possibly the most difficult theory in corporation 7.16 law upon which a plaintiff might hope to win a judgment’.32 A leading Delaware case allowed director liability only for being inattentive,33 lacking a rational basis,34 25 Gerner-​Beuerle, Paech, and Schuster, n 17, 92–​9. 26 ibid. 27 ibid. 28 ibid, 74–​5. See generally William T Allen, Jack B Jacobs, and Leo E Strine Jr, ‘Realigning the Standard of Review of Director Due Care with Delaware Public Policy: A Critique of Van Gorkom and Its Progeny as a Standard of Review Problem’, Northwestern University Law Review (2002), 96, 449 (discussing rationales for the business judgement rule, including hindsight bias and the desire to encourage directors to take business risks). 29 e.g. Kamin v Am Exp Co, 383 NYS 2d 807, 812 (Sup Ct, 1976) (‘The directors are entitled to exercise their honest business judgment on the information before them, and to act within their corporate powers. That they may be mistaken, that other courses of action might have differing consequences, or that their action might benefit some shareholders more than others presents no basis for the superimposition of judicial judgment, so long as it appears that the directors have been acting in good faith.’). 30 Eisenberg and Cox, n 6, 622–​7. 31 Lamden v La Jolla Shores Condo. Homeowners Assn. 21 Cal 4th 249, 257 (1999). 32 In re Caremark Int’l Inc Derivative Litig, 698 A 2d 959, 967 (Del Ch, 1996). 33 It appears that only extreme inattention can lead to liability. See, e.g., Francis v United Jersey Bank, 87 NJ 15, 27, 432 A 2d 814, 819–​20 (1981) (mentioning that the director never read financial statements and did not pay any attention to her duty as a director). 34 See, e.g., Kamin, 383 N Y S 2d, 812 (holding that directors are not liable as long as one school of thought supports their actions); see also MBCA § 8.31(a)(2)(ii)(A) (mentioning that directors are not liable unless they ‘did not reasonably believe to be in the best interest of the company’).

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan or being grossly negligent in failing to initiate reasonable investigation.35 In response to that case, the Delaware legislature further restricted director liability, enacting § 102(b)(7) of the General Corporation Law, which allows firms to opt into an immunity shield to limit or eliminate duty-​of-​care liability for directors. Other US states soon followed suit.36 Absent a showing of bad faith or breach of the duty of loyalty, courts today tend to respect directors’ business judgement unless a decision cannot be ‘attributed to any rational business purpose’.37 7.17

The business judgement rule also exists in some form in most other countries,38 including the United Kingdom,39 Canada,40 and Japan,41 though the exact degree of judicial deference varies widely.42 Typically, one form of the business judgement rule presumes that directors will not be personally liable for decisions made in good faith and without conflicts of interest,43 and another form protects good-​faith decisions made by directors without conflicts of interest so long as they are not grossly negligent.44

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Directors are also protected by indemnification and by directors and officers (D&O) liability insurance. Indemnification allows directors to be reimbursed from their firms for liability and costs incurred in lawsuits. In the United States, for example, indemnification clauses are usually included in the firm’s articles of association.45 Firms have no power to indemnify directors, however, for ‘[a]‌cts or 35 See Smith v. Van Gorkom, 488 A 2d 858, 873 (Del, 1985) (‘[T]‌he concept of gross negligence is also the proper standard for determining whether a business judgment reached by a board of directors was an informed one.’). 36 Richard B Kapnick and Courtney A Rosen, ‘The Exculpatory Clause Defense to Shareholder Derivative Claims’, Business Torts Journal (Winter 2010), 17, 17. 37 In re Walt Disney Co Derivative Litigation, 907 A 2d 693 (Del Ch, 2005) (quotation omitted). 38 The term ‘business judgement rule’ is an invention by the courts in the United States. While the term might be unfamiliar to many jurisdictions, many states have a functional equivalence of the rule. See Gerner-​Beuerle, Paech, and Schuster, n 17, 115–​18. Some countries, like South Korea, do not employ a business judgement rule in corporate law. See, e.g., Ok-​Rial Song, ‘South Korea’, in Helen Anderson, (ed), Directors’ Personal Liability for Corporate Fault, Wolters Kluwer, 2008, 267–​8. 39 Sandrak Miller, ‘How Should U.K.  and U.S. Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct be Reformed?, American Business Law Journal (1999) 36, 579, 618 40 Edward Iacobucci, ‘Indeterminacy and the Canadian Supreme Court’s Approach to Corporate Fiduciary Duties’ Canada Business Law Journal (2004), 48, 232, 233. 41 Vicki L Beyer,’ Judicial Development of a Business Judgment Rule in Japan’, Bond Law Journal (2003) 5, i, 1. 42 e.g., the business judgement rule in Germany appears to afford directors lesser deference than the business judgement rule in Delaware. See Katharina Haehling von Lanzenauer and Oliver Sieg, ‘Germany’, in Edward Smerdon (ed), Directors’ Liability and Indemnification, Globe Law and Business, 2011, 185–​6. 43 Gerner-​Beuerle, Paech, and Schuster, n 17, 108–​18. 44 See ibid, 95 n 114; see also Christine Hurt, ‘The Duty to Manage Risk’, Journal of Corporation Law (2014), 39, 253, 258. 45 e.g., § 145(a) and (c) of Title 8 of the Delaware Code specifies circumstances where indemnification is permitted or mandated by law. Del Code Ann, tit 8, § 102.

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Responsibility of Directors of Financial Institutions omissions . . . which involve . . . a knowing violation of law’.46 Outside the United States, most jurisdictions allow indemnification for all damages and penalties other than those associated with intentional fault, gross negligence, or criminal convictions.47 D&O liability insurance also indemnifies directors against personal liability in civil 7.19 suits. Firms in many jurisdictions are legally permitted to, and in practice usually will, pay D&O insurance premiums.48 D&O insurance theoretically can cover conduct for which indemnification is prohibited.49 Nonetheless, D&O insurance is often unavailable for criminal fraud charges or lawsuits involving other intentional illegal acts.50 Duty of loyalty  The duty of loyalty addresses conflicts of interest between a director and the firm.51 7.20 Most jurisdictions recognize that such conflicts require regulatory intervention.52 The duty of loyalty typically includes a duty not to compete with the firm, a duty of confidentiality, and a standard of conduct for directors involved in interested transactions or transactions involving corporate opportunities.53 In the United States, the duty of loyalty ‘stands for the fundamental propos- 7.21 ition that a director, even if he is a shareholder, may not engage in conduct that is ‘adverse to the interests of [his] corporation’.54 A conflicted director can avoid breaching this duty by disclosing the potential conflict and submitting the transaction (or other conduct) for approval to disinterested directors or shareholders.55 Some non-​US jurisdictions such as Denmark, Finland, and Spain follow a similar approach, which requires related-​party transactions to be disclosed to and approved

46 Del Code Ann tit 8, § 102(b)(7)(ii) (West). 47 See Gerner-​Beuerle, Paech, and Schuster, n 17, 184. 48 See ibid. 49 See Hurt, n 45 and accompanying text. 50 See ibid, 184 (observing that coverage for intentional misconduct is virtually always excluded in the insurance contract). Theoretically at least, firms have the power to buy insurance that covers intentional misconduct. See, e.g., Del Code Ann tit 8, § 145 (West) (‘A corporation shall have power to purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person’s status as such, whether or not the corporation would have the power to indemnify such person against such liability under this section.’ (emphasis added)). 51 In re Walt Disney Co Derivative Litigation, 906 A 2d 27, 66 (Del, 2006). 52 e.g. Gerner-​Beuerle, Paech, and Schuster, n 17, xi. 53 ibid, 118–​45. 54 Shocking Techs, Inc v Michael, No CIV A  7164-​VCN, 2012 WL 4482838, *8 (Del Ch, 1 October 2012). 55 Del Code Ann tit 8, § 144 (West).

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan by a disinterested body.56 Some jurisdictions operate a two-​tier board system that requires approval of related-​party transactions by a supervisory board.57 7.22

Even beyond the classic duty of loyalty outlined above, some countries, including the United States and Japan, sometimes interpret the duty of loyalty as including a monitoring or oversight duty—​although some argue that monitoring or oversight failure should fall within a duty of care.58 Directors might breach such a duty, for example, by failing to act in good faith to ensure the firm’s compliance with legal and regulatory standards.59 In Delaware, the breach also requires ‘a sustained or systematic failure of the board to exercise oversight’.60 Showing that failure, in turn, requires that directors must either have ‘utterly failed to implement any reporting or information system or controls’ or, ‘having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention’.61 Due to this demanding standard, two landmark cases involving financial institutions—​ Stone and Citigroup—​did not result in director liability.62 Nonetheless, claims based on failure to monitor or oversee the firm’s business risk remain a basis for director liability.63

56 Gerner-​Beuerle, Paech, and Schuster, n 17, 146. 57 ibid, 146–​7. 58 cf Claire A Hill and Brett H McDonnell, ‘Stone v. Ritter and the Expanding Duty of Loyalty’, Fordham Law Review (2007), 1769, 76, 1776–​8 (discussing Delaware decisions that have categorized failures of the board to pay adequate attention to company affairs, a classic duty of care question, as a duty of loyalty question). 59 See, e.g., Stone v Ritter, 911 A 2d 362, 369 (Del, 2006) (recognizing the failure to exercise oversight in good faith is inconsistent with directors’ duty of loyalty); Hideki Kanda and Curtis J. Milhaupt, ‘Re-​examining Legal Transplants: The Director’s Fiduciary Duty in Japanese Corporate Law’, American Journal of Comparative Law (2003), 51, 887, 888 (illustrating that the directors’ duty of loyalty in Japan includes the duty to perform their functions in compliance with laws”). 60 In re Caremark Int’l Inc Derivative Litigation, 698 A 2d 959, 971 (Del Ch, 1996) 61 Stone v. Ritter, 911 A 2d 362, 370 (Del, 2006). 62 In Stone, the banks paid millions in civil penalties for violations of the Bank Secrecy Act (BSA) and various anti-​money-​laundering (AML) regulations. ibid, 365. In a derivative suit, shareholders of the banks alleged that banks’ directors breached their oversight duty by failing to implement ‘policies and procedures to ensure compliance with BSA and AML obligations’. ibid, 370. The court affirmed the dismissal of complaint, holding that as long as a reasonable compliance system exists, directors are not liable for the ultimate failure of the system to ‘prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability’.’ ibid, 372. In Citigroup, shareholders in a derivative suit alleged that directors of Citigroup breached their duty of loyalty by failing to diligently monitor and manage the company’s risks related to the subprime mortgage market in light of multiple red flags. In re Citigroup Inc S’holder Derivative Litigation, 964 A 2d 106, 115, 123–​4 (Del Ch, 2009), the court reasoned that ‘the burden to show bad faith is even higher’ than ‘the burden required for a plaintiff to rebut the presumption of the business judgment rule by showing gross negligence’ and held that alleged red flags are insufficient to establish a showing of bad faith: ibid, 125–​8. 63 Kristin N Johnson, ‘Addressing Gaps in the Dodd-​Frank Act: Directors’ Risk Management Oversight Obligations’, University of Michigan Journal of Law Reform (2011), 45, 55, 91–​2; see generally Robert T Miller, ‘The Board’s Duty to Monitor Risk After Citigroup’, University of

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Responsibility of Directors of Financial Institutions 3.  Enforcement mechanisms Legal systems vary in how they hold directors liable for breach of fiduciary duties. 7.23 Because directors’ fiduciary duties are owed to the firm, a firm may bring direct actions against its directors, whether current or former.64 This raises the interesting question of who decides on behalf of the firm to pursue breach-​of-​fiduciary-​duty claims. In some jurisdictions, the board of directors has the authority to instigate proceedings on behalf of the firm; in other jurisdictions, a general meeting of shareholders can decide whether to pursue such claims; and in other jurisdictions still, the board and the general meeting of shareholders each can decide.65 In jurisdictions with a two-​tier board structure, the supervisory board is usually involved in deciding whether to pursue breach-​of-​fiduciary-​duty claims.66 In most jurisdictions, shareholders can also enforce a director’s fiduciary duty. 7.24 Shareholder enforcement serves a dual function:  compensating shareholders for losses sustained by poor management, and deterring future managerial misconduct.67 The most common type of shareholder enforcement is the so-​called derivative action.68 While the exact requirements vary depending on the jurisdiction, these are lawsuits brought by one or more shareholders on behalf of the firm itself, alleging that directors have breached their fiduciary duty.69 More technically, derivative actions are (at least in the United States) two-​part lawsuits, with shareholders first compelling the firm to sue and then bringing an action on behalf of the firm based on harm done to the firm by the actions of the directors.70 A derivative action thus allows shareholders to sue for director breach of fiduciary duty even where the shareholders themselves personally suffer no injury.71

Pennsylvania Journal of Business Law (2010), 12, 1153 (discussing the duty to monitor risk under the duty of loyalty doctrine). 64 e.g. Dan A Bailey and Darius N Kandawalla, ‘United States of America’, in Smerdon (ed), n 42, 572–​73. 65 Gerner-​Beuerle, Paech, and Schuster, n 17, 191–​2. 66 ibid. 67 Wenjing Chen, An Overview of Shareholder Litigation in W Chen, A Comparative Study Of Funding Shareholder Litigation, Springer, 2017, 15. 68 Gerner-​Beuerle, Paech, and Schuster, n 17, at 200–​1. 69 See ibid (illustrating that different countries require different number of shares in meeting the standing requirement to bring derivative actions). 70 See Aronson v Lewis, 473 A 2d 805, 811 (Del, 1984) (‘The nature of the action is two-​fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.’). 71 See Lewis v Knutson, 699 F 2d 230, 237–​38 (5th Cir, 1983) (‘When an officer, director, or controlling shareholder breaches [a]‌fiduciary duty to the corporation, the shareholder has no ‘standing to bring [a] civil action at law against faithless directors and managers,’ because the corporation and not the shareholder suffers the injury. . . [e]quity, however, allow[s] him to step into the corporation’s shoes and to seek in its right the restitution he could not demand on his own.’).

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In certain jurisdictions, including the United States, shareholders who are personally injured can also bring direct actions against directors for breach of fiduciary duties.72 Such a direct action is a possible enforcement approach for a broad category of harms, including ‘suits to compel the payment of a dividend, to protest the issuance of shares impermissibly diluting a shareholder’s interest, to protect voting rights or to obtain inspection of corporate books and records’.73 A direct action cannot be based on a theory of general harm to shareholders; general harm would instead support a derivative action.74

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Shareholder lawsuits or their equivalent are permitted in most jurisdictions, including EU and Asian countries. They are most common, however, in the United States.75 B. Duties specifically applicable to directors of financial institutions

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Part B of this section of the chapter compares the special responsibilities of directors of financial institutions to the general responsibilities discussed in Part A. To that end, Section II.B.1 compares the scope of those special responsibilities, Section II.B.2 compares the substance of those special responsibilities, and Section II.B.3 compares the mechanisms for enforcing those special responsibilities. 1.  Comparing the scope of fiduciary duties of directors of financial institutions

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Surprisingly, most jurisdictions did not change the scope of director fiduciary duties after the financial crisis, even for directors of financial institutions. In the United States, for example, the scope of fiduciary duty of directors is the same for both financial institutions and other firms; it does not consider the interests of the public. Courts generally refuse to recognize any fiduciary relationship between a financial institution and third parties, whether its lenders or the public.76 In response to the financial crisis, US Federal Reserve Governor Daniel Tarullo has suggested (in accord with proposals by one of this chapter’s authors77) that the scope of directors’ 72 See Note, ‘Distinguishing Between Direct and Derivative Shareholder Suits’, 110 University of Pennsylvania Law Review, (1962) 1147 (describing direct action as ‘a suit by the shareholder in his own right to redress an injury sustained directly by him for which he is entitled to personal relief ’). 73 In re Worldcom, Inc, 323 B R 844, 850 (Bankr, SDNY, 2005). 74 See Behrens v Aerial Comm, Inc Del Ch No 17436 (18 May 2001) (‘The distinction between a direct and derivative claim, which is difficult to apply in specific circumstances, turns on the existence of direct or “special” injury to the plaintiff stockholder.). 75 Matteo Gargantini andVerity Winship, ‘Private Ordering of Shareholder Litigation in the EU and the US’, in Sean Griffith, et  al (eds), The Elgar Handbook for Representative Shareholder Litigation, forthcoming 2017/​2018). 76 See Wells Fargo Bank, NA v Vandorn, 2012 NCBC 6, 17 (NC Super Ct, 17 January 2012) (‘[I]‌n an ordinary lender-​borrower relationship, the lender does not owe any duty to its borrower beyond the terms of the loan agreement.’) (quoting Branch Banking & Trust Co v Thompson, 107 N C App 53, 418 S E 2d 694, 699 (1992)). 77 See Section II.C.

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Responsibility of Directors of Financial Institutions fiduciary duty should be broadened to reduce excessive risk-​taking by financial institutions.78 His suggestion, however, does not have the force of law. In most other countries, the scope of fiduciary duty of directors of financial institu- 7.29 tions similarly remains the same as that of directors of other firms.79 Some countries, however, have long taken public interests into account. As mentioned, directors of Dutch public firms, including financial institutions, must weigh the interests of the public against the interest of shareholders.80 Dutch law also requires bank employees to carefully balance the interests of the bank’s customers, its shareholders, its members, its bondholders and other creditors, its employees, and arguably society as a whole.81 2.  Comparing the substance of fiduciary duties of directors of financial institutions Recall that the substance of directors’ fiduciary duties is governed by the duty of 7.30 care and the duty of loyalty. Consider each in turn. Duty of care  Even after the financial crisis, most countries have not increased the duty of care 7.31 for directors of financial institutions. This duty generally remains the same for directors of financial institutions and other firms. In the United States, for example, general common-​law fiduciary responsibility standards continue to apply to directors of financial institutions.82 Thus, for U.S.-​chartered (i.e., national) banks and federal savings associations, ‘directors’ activities [continue to be] governed by common law fiduciary principles, which impose two duties—​the duty of care and the duty of loyalty.’83 However, in the narrower context of directors of U.S. government-​insured deposit-​ 7.32 taking institutions (such as many banks), federal law has slightly increased the duty of care84 by making such directors liable for gross negligence.85 That liability ‘does

78 Governor Daniel K Tarullo, Fed Reserve Sys, remarks at the Association of American Law Schools Midyear Meeting: Corporate Governance and Prudential Regulation 7–​8 (9 June 2014). 79 See, e.g, Carsten Gerner-​Beuerle, Philipp Paech, and Edmund Philipp Schuster, ‘Annex to Study on Directors’ Duties and Liability’ 488, 730, 778–​79 (2013), available at http://eprints.lse. ac.uk/50438/, accessed 1 December 2018 (indicating that while the substance of the duties of bank directors might sometimes be different from that of directors of other firms due to special laws, the scope is largely the same). 80 See n 9 and accompanying text. 81 cf Nederlandse Vereniging van Banken (Dutch Banking Association), Future-​ Oriented Banking 4, 9–​10 (requiring executive board and supervisory board to ‘consider the interests of the bank’s customers and other stakeholders’). 82 Atherton v FDIC, 519 U S 213, 219, 117 S Ct 666, 671–​4 (1997) (holding that state-​law standards of care continue to apply even to directors of federally chartered banks). 83 Office of the Comptroller of the Currency, n 24, 21. 84 See 12 USC, § 1821(k). 85 ibid, (k)(2012).

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan not stand in the way of a stricter standard that’ state law may provide.86 Federal law also prohibits insured deposit-​taking institutions from indemnifying or purchasing D&O insurance to protect their directors for civil monetary penalties resulting from administrative or regulatory actions for violating that law.87 7.33

There are efforts in the United Kingdom to try to increase the duty of care for directors of financial institutions. The Financial Services Consumer Panel, an independent body set up under the Financial Services and Markets Act 2000, has argued that directors of banks and other financial services firms should be held to a higher standard of care.88 Their arguments, though, have not yet been transformed into law.

7.34

Perhaps most notably, few countries have increased the duty of care post-​crisis to cover a financial institution’s excessive risk-​taking.89 Traditionally, risk-​taking has been subsumed in a financial institution’s duty of care to avoid ‘unsafe or unsound’ banking practices.90 A  widely accepted definition of unsafe or unsound banking practices is ‘any action, or lack of action, which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the

86 Atherton v FDIC, 519 U S 213, 227, 117 S Ct 666, 674 (1997). Recently, the Federal Deposit Insurance Corporation (FDIC) has articulated the standard of care for directors of federally insured banks as: The duty of care requires directors and officers to act as prudent and diligent business persons in conducting the affairs of the bank. This means that directors are responsible for selecting, monitoring, and evaluating competent management; establishing business strategies and policies; monitoring and assessing the progress of business operations; establishing and monitoring adherence to policies and procedures required by statute, regulation, and principles of safety and soundness; and for making business decisions on the basis of fully informed and meaningful deliberation. Federal Deposit Insurance Corporation, ‘Statement Concerning the Responsibilities of Bank Directors and Officers’, 3 December 1992, available at https://​www.fdic.gov/​regulations/​laws/​rules/​ 5000-​3300.html, accessed 17 October 2018. However, it remains uncertain whether the above statement has any legal significance; it is merely an FDIC policy statement. 87 12 USC, § 1828(k)(2012). 88 See, e.g., Financial Services Consumer Panel, ‘A duty of care for financial services providers’ (January 2017), available at https://​www.fs-​cp.org.uk/​sites/​default/​files/​duty_​of_​care_​briefing_​-​_​ jan_​2017.pdf, accessed 17 October 2018. 89 Gerner-​Beuerle, Paech, and Schuster, n 17, 95–​8 (concluding that it is difficult to predict whether a claim for breach of the duty of care by excessive risk-​taking would succeed in most countries, and also observing that in ‘the vast majority of Member States, judgments to the point either do not exist at all, or the law is in the process of evolving’). 90 See David Min, ‘Balancing the Governance of Financial Institutions’, Seattle University Law Review (2017), 40, 743, 748(‘Furthermore, bank regulators possess broad statutory enforcement powers to remove bank directors for unsafe or unsound banking practices, which effectively creates another duty of safety and soundness for bank directors.’). Min argues that there is a separate implied duty of safety and soundness.

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Responsibility of Directors of Financial Institutions agencies administering the insurance funds’.91 Because this standard is somewhat vague, US courts have been conflicted about what sort of conduct should be considered unsafe and unsound to justify a director’s removal.92 The main regulatory response to risk-​taking by financial institutions has been pro- 7.35 cedural, not substantive. Many countries, including the United States, have required financial institutions to create special committees to oversee risk-​taking. For example, § 165(h) of the Dodd-​Frank Act93 directs the Federal Reserve Board to require systemically important financial institutions (SIFIs) to establish risk committees, typically consisting of directors, to oversee the SIFI’s risk-​management practices.94 Prior to this regulation, risk committees were permitted but not mandated and few US banks effectively utilized such committees.95 Similarly, EU financial institutions have also been required to establish risk com- 7.36 mittees. Article 76(3) of the Directive 2013/​36/​EU requires ‘all institutions that are significant in terms of their size, internal organisation and the nature, scope and complexity of their activities’ to establish a risk committee composed of non-​ executive directors. Certain other countries, including China,96 Mexico,97 and Japan,98 also require risk committees.

91 Financial Institutions Supervisory Act of 1966: Hearings on S 3158 and S 3695 Before the House Committee on Banking and Currency, 89th Cong, 2d Sess 49–​50 (memorandum submitted by John Horne). 92 Kern Alexander, ‘Comment: the Institutional Framework of US Prudential Regulation: Some Unresolved Problems’, in David Mayes and Geoffrey E Wood (eds), The Structure of Financial Regulation, Routledge, 2007, 155, 157–​8. 93 The Dodd-​Frank Wall Street Reform and Consumer Protection Act, Pub L No 111-​203 (2010). 94 12 USC, § 5365(h) (stating that the risk committee should be responsible for overseeing the bank’s enterprise-​wide risk-​management practices—​that is, overseeing the broad spectrum of risks facing the bank and its affiliates). See Klaus J Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, in E Wymeersch, K Hopt, and G Ferrarini (eds), Financial Regulation and Supervision, A  post-​crisis analysis, OUP, 2011, 337. The risk committee is also required to have independent directors (as the Federal Reserve Board deems appropriate), including at least one risk-​management expert having experience in identifying, assessing, and managing risk exposures of large, complex firms:  ibid. For further discussion of risk committees, see Kristin N Johnson and Steven A Ramirez, ‘New Guiding Principles: Macroprudential Solutions to Risk Management Oversight and Systemic Risk Concerns’, University of St Thomas Law Journal (2014), 11, 386, 416–​18. 95 Vincent Aebi et al, ‘Risk Management, Corporate Governance, and Bank Performance in the Financial Crisis’, Journal of Banking & Finance (2012), 36, 3213, 3214 (stating that, in 2007, most risk committees met infrequently and were not comprised of enough independent and financially knowledgeable members). 96 Dan Konigburg and Henry Ristuccia, A Global View of Risk Committees, Deloitte Touche Tohmatsu Limited, 2013, 11. 97 ibid, 12. 98 Pan Jia, ‘Comparison of Internal Control Systems in Japan and China’, International Journal of Business Administration (2012), 3, 66, 70.

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan 7.37

We view these types of risk committees merely as facades because they have no obligation to assess risk-​taking any differently than directors of financial institutions have always viewed risk-​taking—​generally from the standpoint of the firm and its shareholders.99 Efforts to try indirectly to enhance risk-​taking assessment have also failed. For example, a European Banking Authority (EBA) attempt to address pre-​crisis risk-​taking by requiring boards of directors to meet certain standards, including diversity requirements and a requirement that the board chairman and bank CEO must be independent,100 has been criticized as too intrusive into the private sector and inefficient in controlling excessive risk.101 Part C of this chapter suggests more direct improvements to assessing risk-​taking. Duty of loyalty 

7.38

As with the duty of care, the duty of loyalty remains the same in most jurisdictions for directors—​whether of financial institutions or other firms. In the United States, for example, the basic principles of this duty remain the same, although the duty may vary slightly depending on a financial institution’s purpose. Directors of US government-​insured deposit-​taking institutions are still only required to ‘administer the affairs of the bank with candor, personal honesty and integrity [and to refrain] from advancing their own personal or business interests, or those of others, at the expense of the bank’.102 Directors of federal savings associations are subject to specific conflicts of interest and corporate opportunity regulations as part of their duty of loyalty.103

99 The Federal Reserve Board’s regulations do not require risk committees to take systemic risk into account. See 12 CFR, §§ 252.20–​22, 30–​35 (2015) (at most, indirectly suggesting that possibility by requiring that the ‘level of risk management expertise possessed by the risk committee of a company should rise in accordance with a company’s rising threat of systemic risk to the economy’). Risk committees formed pursuant to the Board’s regulations likewise do not appear to take systemic risk into account. See, e.g., Matteo Tonello, ‘Should Your Board Have a Separate Risk Committee?’, Harvard Law School Forum on Corporate Governance and Financial Regulation (12 February 2012), available at http://​corpgov.law.harvard.edu/​2012/​02/​12/​should-​ your-​board-​have-​a-​separate-​risk-​committee/​, accessed 17 October 2018 (stating that the risk committee’s function is to ‘develop a mutual understanding regarding the risks the company faces over time as it executes its business model for creating enterprise value’); Maureen P Errity and Henry J Ristuccia, Deloitte, Risk Committee Resource Guide for Boards, app A 18–​20 (2012) (stating in its ‘Sample risk committee charter’ that the risk committee’s purpose is to identify and assess ‘the risks that the organization faces’ and to ‘[p]‌rovide input to management regarding the enterprise’s risk appetite and tolerance’). 100 Luca Enriques, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’, Theoretical Inquiries in Law (2015), 16, 211, 214. 101 ibid, 215. 102 Federal Deposit Insurance Corporation, ‘Statement Concerning the Responsibilities of Bank Directors and Officers’, 3 December 1992, available at https://​www.fdic.gov/​regulations/​laws/​rules/​5000-​ 3300.html, accessed 17 October 2018. 103 Office of the Comptroller of the Currency, n 24, 22.

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Responsibility of Directors of Financial Institutions 3.  Comparing enforcement mechanisms Regulatory enforcement  Traditionally, the principal difference in enforcement mechanisms is that regulators, 7.39 in addition to shareholders, usually enforce the duties of directors of financial institutions. In the United States, for example, the Federal Deposit Insurance Corporation (FDIC) may bring suit against directors of deposit-​taking banks either on behalf of the bank’s shareholders or on behalf of the FDIC’s own interest as an insurer.104 The FDIC may seek judgment either to repay depositors of the bank or to replenish its own insurance fund.105 FDIC suits have been described as the ‘most feared’ type of action by bank directors because of the regulatory body’s vast investigatory resources.106 In the European Union, the EBA is the primary regulatory authority overseeing 7.40 banking activity. ‘Significant’ banks in euro-​zone Member States are also subject to prudential regulation by the European Central Bank. Each EU Member State has additional regulators with authority over the state’s corporate law. In the United Kingdom, corporate conduct including enforcement of director duties is regulated by the Financial Conduct Authority (FCA)107 and the Prudential Regulation Authority of the Bank of England.108 Given these regulatory enforcement mechanisms, many have asked why so few 7.41 directors of failed financial institutions were prosecuted in response to the financial crisis. At least part of the answer is that the complexity of financial innovation and the decentralization of managerial responsibilities made it difficult for prosecutors to win cases attempting to impose personal liability.109 This is especially true in the

104 Samantha Evans, ‘An FDIC Priority of Claims Over Depository Institution Shareholders’, Duke Law Journal (1991), 41, 329, 330. 105 ibid, 331. 106 Bloomsburg Law Banking, Lawsuits Against Bank Directors and Officers Trending Down, BloomburgBNA, 11 August 2016, available at https://​www.bna.com/​lawsuits-​against-​bank-​n73014446201/​, accessed 17 October 2018. 107 FCA, available at https://​www.fca.org.uk/​, accessed 4 October 2018. 108 The Bank of England, ‘Prudential Regulation Authority’, available at http://​www.bankofengland. co.uk/​pra/​Pages/​default.aspx, accessed 17 October 2018. These regulatory bodies replaced the Financial Services Authority (FSA) following the perceived regulatory failures that contributed to the financial crisis. Eilis Ferran, ‘The Breakup of the Financial Services Authority in the UK’, in Robin Hui Huang and Dirk Schoenmaker (eds), Institutional Structure of Financial Regulation:  Theories and International Experiences, Routledge, 2013, 110. The FSA was given its duty to regulate in the Companies Act 2006, which also codified the common-​law principles of fiduciary duty and attempted to emphasize corporate social responsibility in dictating how directors should perform. Gordon . Clark and Eric R W Knight, ‘Implications of the UK Companies Act 2006 for Institutional Investors and the Market for Corporate Social Responsibility’, University of Pennsylvania Journal of Business Law (2008), 11, 259, 277–​8. 109 See Steven L Schwarcz, ‘Excessive Corporate Risk-​Taking and the Decline of Personal Blame’, Emory Law Journal (2015), 65, 533 also available at http://​ssrn.com/​abstract=2553511, accessed 17 October 2018.

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan United States, where prosecutorial resources since the 9/​11 attacks have been disproportionately allocated to terrorism-​related cases. Prosecutors instead have been taking the easier and less costly route of imposing firm-​level liability—​a route that is easier and less costly for several reasons, including that firms are more likely to settle as a cost of doing business. Another important part of the answer, though, is that corporate governance law does not cover the type of excessive risk-​taking that led to the financial crisis and that is becoming ever more common—​risk-​ taking that could have systemic consequences to the financial system. Part C of this chapter examines how the responsibilities of directors of financial institutions should be modernized to help control that risk-​taking. Criminal penalties  7.42

The financial crisis spurred some important changes in enforcement. Prior to the crisis, enforcement was traditionally limited to civil law penalties. In response to the crisis, some countries enacted or attempted to impose additional criminal law penalties.

7.43

Most of these attempts to impose criminal penalties have lacked explicit legislation.110 In the United States, for example, criminal charges were filed in 2012 against nineteen directors and employees of Abacus Bank, accusing them of falsifying mortgage-​loan applications. Although ten of the accused pled guilty, the bank’s former chief credit officer and its former loan supervisor were acquitted of all charges.111 Shortly thereafter, the charges against the remaining defendants were dropped. The prosecution was criticized as unfair because the vast majority of Abacus’s borrowers did not default on their mortgages despite the fraudulent applications, whereas directors of other banks where thousands of borrowers defaulted were not criminally charged.112 110 See Roman Tomasic, ‘The Financial Crisis and the Haphazard Pursuit of Financial Crime’, Journal of Financial Crime (2011), 18, 7, 8. Criminal charges are nonetheless common for violating specific laws, such as falsifying bank records; misusing or misapplying bank funds or assets; requesting or accepting fees or gifts as part of influencing bank business; making false statements generally; or committing or attempting to commit fraud. See Office of the Comptroller of the Currency, n 24, 22. A bill was introduced in Senate to create criminal liability for failure to inform and warn risk of imminent serious danger but was not passed. See ‘A Bill to Establish criminal penalties for failing to inform and warn of serious dangers’, 113 Cong 2d Sess 2615 (2014). 111 Karen Freifeld, ‘Abacus bank acquitted of all charges in N.Y. mortgage fraud trial’, Reuters (5 June 2015), available at https://​www.reuters.com/​article/​us-​abascus-​federal-​acquittal/​abacus-​bank-​acquitted-​ of-​all-​charges-​in-​n-​y-​mortgage-​fraud-​trial-​idUSKBN0OK21620150604, accessed 17 October 2018. 112 See Regina Austin, ‘“Abacus:  Small Enough to Jail”:  A Minority Bank, Racial Bias, and the Democratization of Credit’, Penn Law Docs & Law Blog (2017), available at https://​www.law.upenn.edu/​ live/​news/​6864-​abacus-​small-​enough-​to-​jail-​a-​minority-​bank-​racial#sthash.9CMGyi5I.dpbs, accessed 17 October 2018. Perceived unfairness has resulted in dismissing even civil law charges. Juries may also be reluctant to hold individuals liable, even for monetary damages. The Securites and Exchange Commission (SEC), for example, brought federal securities law civil actions against Brian Stoker (SEC v Stoker, 865 F Supp 2d 457 (SDNY 2012), the executive principally responsible for structuring and marketing securities of a risky and highly complex synthetic ABS CDO transaction, backed by credit–​default swaps on other

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Responsibility of Directors of Financial Institutions Criminal charges have also been filed in the European Union against directors of fi- 7.44 nancial institutions, for actions related to the financial crisis. In July 2017, criminal fraud charges were filed against four former Barclays executives.113 More recently, criminal charges were also filed against executives at Greece’s Central Bank and the Greece-​based Piraeus Bank.114 Because these cases have not yet been adjudicated, their outcomes are unknown. Iceland has been the most successful jurisdiction to date in imposing criminal 7.45 penalties against directors of financial institutions.115 After investigation by a special prosecutor, that nation convicted the chief executives, several other top and former chief executives, and even majority shareholders of its three largest failed banks of fraud and market manipulation.116 A number of executives were sentenced to between four and five-​and-​a-​half years’ imprisonment—​the strictest sentences for financial fraud in Iceland’s history.117 Iceland’s stern response to the financial crisis was praised by some commentators, who felt other countries should have followed suit and filed criminal charges against their own executives.118 The United Kingdom has gone further than any other country in criminalizing 7.46 breaches of duty by directors of financial institutions, if those breaches cause a financial institution to fail.119 The statute applies to ‘senior manager[s]‌in relation to a financial institution’.120 Such a manager would be criminally liable if, ‘aware of a

CDOs whose value was tied to the U.S. housing market. Following a two-​week trial, a jury found Stoker not liable, apparently because the jurors did not want to make Stoker a scapegoat for what they perceived as more senior wrongdoing. Peter Lattman, ‘A Jury’s Message for Wall Street’, New York Times, 4 August 2012, B1, available at http://​query.nytimes.com/​gst/​fullpage.html?res=9C04EED71739F937A3575BC0 A9649D8B63, accessed 17 October 2018. 113 BBC News, ‘Barclays charged with fraud in Qatar case’, 20 June 2017, available at http://​www.bbc. com/​news/​business-​40338220, accessed 17 October 2018. 114 Kerin Hope, ‘Greek bankers face charges over financial crisis bond swaps’, Financial Times, 23 April 2017, available at https://​www.ft.com/​content/​f7f1e8ec-​2686-​11e7-​8691-​d5f7e0cd0a16, accessed 17 October 2018. 115 See, e.g., Stefan Simanowitz, ‘Iceland Has Jailed 29 Bankers. Why Can’t the UK and US Do the Same?’, available at https://​www.huffingtonpost.com/​stefan-​simanowitz/​iceland-​has-​jailed-​29-​bankers_​ b_​8908536.html, accessed 17 October 2018;. Edward Robinson and Omar Valdimarsson, ‘This Is Where Bad Bankers Go to Prison’, 2016, available at https://​www.bloomberg.com/​news/​features/​2016-​03-​31/​ welcome-​to-​iceland-​where-​bad-​bankers-​go-​to-​prison, accessed 17 October 2018. 116 CNBC, ‘Iceland convicts bad bankers and says other nations can act’, 12 February 2015, available at https://​www.cnbc.com/​2015/​02/​12/​iceland-​convicts-​bad-​bankers-​and-​says-​other-​nations-​can-​act. html, accessed 17 October 2018. 117 ibid. 118 cf Joe Pinsker, Why Aren’t Any Bankers in Prison for Causing the Financial Crisis?, (2016), available at https://​www.theatlantic.com/​business/​archive/​2016/​08/​why-​arent-​any-​bankers-​in-​prison-​for-​causing-​ the-​financial-​crisis/​496232/​, accessed 17 October 2018 (mentioning that many commentators believe that ‘lack of corporate prosecutions is due to a lack of will rather than a lack of way’). 119 Clare Sibson, ‘Criminal Liability of Directors’, in Mortimore (ed), n 7, 1109. 120 Financial Services (Banking Reform) Act 2013, § 36 (Eng).

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan risk that the implementation of the decision may cause the failure of the group institution’, the manager ‘takes, or agrees to the taking of, a decision by or on behalf of [the financial institution] as to the way in which the business of a group institution is to be carried on, or . . . fails to take steps that [he] could take to prevent such a decision being taken’, provided the manager’s action ‘falls far below what could reasonably be expected of a person in [the manager’s] position’ and the financial institution fails.121 The maximum penalty for the offence is, on summary conviction, twelve months’ imprisonment or a fine or both, or on conviction on indictment, seven years’ imprisonment or a fine or both.122 7.47

This UK legislation is symbolically significant, being the first law that explicitly criminalizes poor corporate governance. Its practical significance is less certain. Because the legislation applies only if a financial institution fails, and only then if the director’s action ‘falls far below what could reasonably be expected,’ one prominent barrister and commentator prognosticates that ‘prosecutions under this [legislation] will be few and far between’.123 Many are thus watching for the outcome of criminal fraud charges recently filed against the former CEO and three other former top executives of Barclays Capital.124 C. Normative perspectives

7.48

This chapter’s authors believe that the responsibility of directors of financial institutions should be modernized to expand its scope. In most jurisdictions, as discussed, directors of financial institutions owe no duty to the public. This creates a quandary because it fundamentally confuses the concept of excessive risk-​taking: From whose perspective is the risk-​taking excessive?

7.49

In most jurisdictions, corporate governance law requires directors of financial institutions to view the consequences of their firm’s actions at most from the standpoint of the firm, its shareholders, and its creditors (including depositors).125 This creates a misalignment between those (private) interests, and the interests of the public who would bear the brunt of systemic economic harm.126

121 ibid. 122 ibid. 123 Sibson, n 119, 1109. 124 The UK’s Serious Fraud Office (SFO) charged ‘Barclays Plc and four individuals with conspiracy to commit fraud and the provision of unlawful financial assistance contrary to the Companies Act 1985.’ For details of the charges, see SFO, ‘SFO charges in Barclays Qatar capital raising case’ (2017), available at https://​www.sfo.gov.uk/​2017/​06/​20/​sfo-​charges-​in-​barclays-​qatar-​capital-​raising-​case/​, accessed 17 October 2018. 125 But cf nn 7–​12 and accompanying text (discussing certain exceptions where countries may take the public interest into account). 126 Steven L Schwarcz, ‘Misalignment:  Corporate Risk-​Taking and Public Duty’, Notre Dame Law Review (2016), 92, 101, also available at http://​ssrn.com/​abstract=2644375, accessed 17 October 2018.

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Responsibility of Directors of Financial Institutions In making corporate governance decisions, directors of financial institutions cur- 7.50 rently satisfy their fiduciary duty if a risk-​taking venture has a positive expected value to the firm, its shareholders, and creditors—​even though that venture might have a negative expected value if the directors consider the public interest. This misalignment is especially significant for a systemically important financial institution, whose failure could trigger a systemic economic collapse. Much of the benefit from the risk-​taking would go to the firm’s shareholders; but if the risk-​taking causes the firm’s failure, much of the systemic harm would be externalized onto other market participants as well as onto the public, including ordinary citizens impacted by an economic collapse.127 The externalities caused by this misalignment differ in two fundamental ways from 7.51 the externalities caused by non-​systemically important firms’ corporate governance decisions. The former externalities tend to create much greater harm because of their potential to trigger an economic collapse.128 Moreover, non-​systemically harmful externalities usually can be, and normally are, addressed by laws that specifically prohibit, or else require the firm to internalize, the harm.129 Corporate governance law therefore should attempt to address the externalities 7.52 caused by this misalignment. Unfortunately, the post-​crisis regulation attempting to improve the responsibility of directors of financial institutions—​even such regulation that purports to address excessive risk-​taking—​fails to take this misalignment into account.130 Even risk committees only have a duty to consider risk to the firm and its shareholders.131 To correct this misalignment, one the authors of this chapter has argued for a 7.53 ‘public governance duty’—​that corporate governance law should require managers of systemically important financial institutions to assess the impact of risk-​taking on the public as well as on investors, and to balance the costs and benefits (using a precautionary principle to protect the public).132 This could even be as simple as expanding the duty of SIFI risk committees to consider public interests in addition to the firm’s interests.133 A  public governance duty would effectively expand the

127 Steven L Schwarcz, ‘Too Big to Fool:  Moral Hazard, Bailouts, and Corporate Responsibility’, Minnesota Law Review (2017), 102, 761, 770–​1. 128 ibid, 770. 129 ibid. See also Stephen M Bainbridge, Corporation Law and Economics, Foundation Press, 2002, 425 (arguing that negative externalities created by corporate conduct should be ‘constrained through general welfare legislation, tort litigation, and other forms of regulation’). 130 ibid, 103. See also Iris H-​Y Chiu et al, The Law on Corporate Governance in Banks, Edward Elgar Publishing Limited, 2015, 15–​18 (discussing the misalignment between the interest of the public and the interest of banks’ shareholders). 131 See nn 93–​101 and accompanying text. 132 Schwarcz, n 126. 133 ibid, 103.

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Steven L Schwarcz, Aleaha Jones, and Jiazhen Yan scope of financial institution fiduciary duties to include the interests of the public, similar to the suggestion of Federal Reserve Governor Tarullo.134 7.54

Two of this chapter’s authors have published a detailed international research agenda for improving the corporate governance of systemically important financial institutions.135 A comprehensive effort to modernize the responsibility of directors of financial institutions should also take that agenda into account.

7.55

These normative arguments to modernize the responsibility of directors of financial institutions are limited to expanding the scope of that responsibility. Changes, for example, to the duty of care are not being proposed. In one or more countries, it is understood that some regulatory enforcement actions may have dismissed the business judgement rule as a defence to director liability.136 For all of the reasons that justify the business judgement rule,137 this chapter’s authors believe that it should remain as a defence even to regulatory enforcement actions. Thus, a director of a financial institution who breaches his public governance duty (were such a duty to apply) should still have protection under the business judgement rule.

III. Conclusion 7.56

Notwithstanding the financial crisis and the many calls for regulatory reform, directors of financial institutions generally remain subject to the same traditional governance responsibilities. The crisis showed, however, that the failure of systemically important financial institutions can trigger a worldwide systemic economic collapse. Financial institution governance should no longer be guided solely by the narrow interests of the firm and its shareholders. The potential for systemic harm makes the public an important constituent as well.

134 See nn 77–​8 and accompanying text. 135 Steven L Schwarcz and Aleaha Jones, ‘Corporate Governance of SIFI Risk-​taking: An International Research Agenda’, in Bob Wessels and Matthias Haentjens (eds), Cross-​Border Bank Resolution, forthcoming 2018, available at http://​ssrn.com/​abstract=2972340, accessed 30 November 2018. 136 Our understanding is based solely on audience comments during the 25–​26 January 2018 conference on this volume, in which Italy was mentioned as one of those countries. 137 See nn 28 and 31 and accompanying text.

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8 FIT AND PROPER REQUIREMENTS IN EU FINANCIAL REGULATION Towards More Cross-​Sectoral Harmonization Danny Busch and Iris Palm-​Steyerberg  

I. Introduction II. Scope and Definitions

8.01 8.02 A. Scope 8.02 B. Definitions 8.04 III. The Impact of the Financial Crisis 8.08

IV. Credit Institutions and Investment Firms A. MiFID I and CRD III B. EBA Guidelines 2012 C. CRD IV D. MiFID II E. The Joint EBA and ESMA Guidelines 2017

V. Cross-​Sectoral Analysis

D. Limited cross-​sectoral convergence

VI. The Dutch Cross-​Sectoral Approach A. General B. Division of labour between AFM and DNB C. Fit and proper testing D. The Dutch Financial Supervision Act E. Fit and proper requirements F. A harmonized approach to fit and proper requirements and fit and proper testing

8.11 8.11 8.12 8.14 8.16 8.17 8.22 8.22

A. General B. Differences in substantive requirements 8.23 C. Differences in scope and definitions 8.31

8.42 8.46 8.46 8.47 8.48 8.49 8.50

8.52 8.54 A. General 8.54 B. The lessons of the financial crisis 8.55 C. A nuanced cross-​sectoral approach 8.66 VIII. Final Remark 8.84

VII. Recommendations

I. Introduction This chapter provides a cross-​sectoral analysis of the fit and proper requirements ap- 8.01 plicable to the different types of financial institutions which are the subject of EU financial regulation, such as credit institutions (banks), investment firms, pension funds, and insurance undertakings (insurance companies). As will be seen, these requirements differ substantially across the different sectors. High standards, laid down in CRD IV and MiFID II, were not followed up upon by EU rules in other sectors. Against this backdrop, the question will be posed whether these differences can be

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Danny Busch and Iris Palm-Steyerberg adequately explained or whether more cross-​sectoral harmonization is actually needed. This chapter concludes that fit and proper requirements in several sectors should be enhanced, taking into account the proportionality principle. This should lead to more cross-​sectoral harmonization, following the example of the Netherlands. This chapter concludes with some recommendations for reform.

II.  Scope and Definitions A. Scope 8.02

The comparison in this chapter examines the fit and proper requirements included in the following instruments of EU financial regulation: • MiFID I1 and MiFID II2—​investment firms, market operators, and data reporting services providers; • CRD III3 and CRD IV4—​credit institutions and certain investment firms;5 • CRA Regulation6—​credit rating agencies; • Solvency II7—​insurance undertakings and special purpose vehicles; • UCITS8—​depositaries, management companies, and investment companies; • AIFMD9—​managers of alternative investment funds; • EMIR10—​central counterparties (CCPs) and trade repositories; • CSD Regulation11—​central securities depositories; • PSD 212—​payment service providers; • EMD13—​electronic money institutions; • IMD14 and IDD15—​insurance intermediaries; • IORP II16—​institutions for occupational retirement. 1 Directive 2004/​39/​EC. 2 Directive 2014/​65/​EU. 3 Directive 2006/​48/​EC. 4 Directive 2013/​36/​EU. 5 See Article 2(1) of CRD IV and Article 4(1)(2) and 4(1)(3) of Regulation (EU) No 575/​2013. 6 Regulation (EC) No 1060/​ 2009, as amended by Regulation (EU) No 513/​ 2011 and Regulation (EU) No 462/​2013, and Commission Delegated Regulation (EU) No 449/​2012. 7 Directive 2009/​138/​EC and Commission Delegated Regulation (EU) No 2015/​35. 8 Directive 2009/​65/​EC, as amended by Directive 2014/​91/​EU and Implementing Directive 2010/​43/​EU. 9 Directive 2011/​61/​EU, including Regulation (EU) No 345/​2013 on European venture capital funds and Regulation (EU) No 2017/​1131 on European social entrepreneurship funds and Commission Delegated Regulation (EU) No 231/​2013. 10 Regulation (EU) No 648/​2012 and Regulation (EU) No 150/​2013. 11 Regulation (EU) No 909/​2014. 12 Directive (EU) 2015/​2366. 13 Directive 2009/​110/​EC, as amended by Directive (EU) 2015/​2366. 14 Directive (EU) 2002/​92. 15 Directive (EU) 2016/​97. 16 Directive (EU) 2016/​2341.

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Fit and Proper Requirements Account has also been taken of the following instruments issued by the three 8.03 European Supervisory Authorities (ESAs), namely the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA),17 as well as relevant instruments issued by the European Central Bank (ECB): • EBA Guidelines on internal governance;18 • EBA Guidelines on the assessment of the suitability of members of the management body and key function holders;19 • EIOPA Guidelines on system of governance;20 • Joint Guidelines on the prudential assessment of acquisitions and increases of qualifying holdings in the financial sector;21 • Joint ESMA and EBA Guidelines on the assessment of the suitability of members of the management body and key function holders;22 • EBA Guidelines on internal governance under Directive 2013/​36/​EU;23 • ESMA Guidelines on the management body of market operators and data reporting services providers;24 • EBA Guidelines on authorization and registration under PSD 2;25 • ECB Guide to fit and proper assessments issued in 2017 and updated in May 2018.26 B. Definitions This chapter focuses on the fit and proper testing of members of the management 8.04 body, senior management, key function holders, and shareholders as part of the authorization or registration process, appointments after authorization or registration, and the approval process in case of a proposed acquisition.

17 EBA, ‘Guidelines on internal governance under Directive 2013/​36/​EU’ (EBA/​GL/​2017/​ 11); ESMA, ‘Guidelines on the management body of market operators and data reporting services providers’ (ESMA70-​154-​271); and the EBA, ‘Guidelines on authorisation and registration under Directive (EU) 2015/​2366/​EU’ (EBA/​GL/​2017/​09). 18 EBA/​GL/​2011/​116 (EBA GL 2011). 19 EBA/​GL/​2012/​06 (EBA GL 2012). 20 EIOPA-​BoS-​14/​253 (EIOPA GL 2015). 21 JC/​GL/​2016/​01 (Joint GL 2016). 22 EBA/​GL/​2017/​12/​ESMA71-​99-​598 (EBA/​ESMA GL 2017). 23 EBA/​GL/​2017/​11 (EBA GL 2017). 24 ESMA70-​154-​271 (ESMA GL 2017). 25 EBA/​GL/​2017/​09 (EBA GL 2017). 26 ECB, ‘Guide to fit and proper assessments’, updated May 2018 in line with the Joint ESMA and EBA GL on suitability, https://​www.bankingsupervision.europa.eu/​banking/​tasks/​authorisation/​html/​index.en.html, accessed 2 October 2018. The ECB Guide clarifies the way suitability tests are performed by the ECB. However, it does not have the same legal status as the ESA Guidelines, which are based on Article 16 of EU Regulations 1093/​2010, 1095/​2010, and 1094/​2010 (Level 3-​legislation).

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The expression ‘fit and proper’ is used to describe a person’s ‘suitability’, including both ‘fitness’ and ‘propriety’ (integrity).

8.06

The expression ‘members of the management body’ refers to the management body in its managerial and supervisory function and includes executive and non-​ executive members of both a one tier and two-​tier board.

8.07

Finally, the term ‘senior management’ is used to describe natural persons who hold high-​level executive positions in a financial institution but are not members of the management body itself. These may include key function holders.

III.  The Impact of the Financial Crisis 8.08

For banks and some other financial institutions, fit and proper requirements have been in place since long before the financial crisis, but have now become broader in scope and more detailed, particularly for banks.27 This should not come as a surprise. After all, it has been suggested in the literature that deficiencies in the profile and practice of members of the management body and senior management, particularly at banks, contributed to the crisis. It has been argued that many members of the management body of banks were simply not sufficiently qualified to know, understand, and deal with the complexities and risks of modern banking. A dramatic example is the failure of state-​owned banks, such as the banks of the German states (Landesbanken). During the crisis their losses greatly exceeded those of the non-​public banks. According to the literature, the management and financial experience of non-​public banks in Germany was systematically superior to that of their public counterparts.28

8.09

Of course, other corporate governance aspects also contributed to the financial crisis, including: (i) risk management and internal control failures; (ii) complex and opaque corporate and bank structures; (iii) perverse incentives; and (iv) failures in disclosure and transparency.29

8.10

Nonetheless, corporate governance failures represented merely one piece of the puzzle. This is why regulatory and supervisory reforms extend far beyond corporate governance issues and cover: (i) stricter capital and liquidity requirements; (ii) regulation of systemic risk; (iii) more power for financial supervisors; (iv) restrictions on certain transactions and products (product governance and product intervention

27 Jens-​Hinrich Binder, Chapter 2, this volume, reaches a similar conclusion (Section II.B.1). 28 See, e.g., Klaus J Hopt, Corporate Governance of Banks After the Financial Crisis, in Eddy Wymeersch, Klaus J Hopt, and Guido Ferrarini (eds), Financial Regulation and Supervision: a post-​ crisis analysis, Oxford University Press, 2012, 337–​67, 344–​5, and 359–​63 (with further references). 29 See ibid, 343ff (with further references); Jens-​Hinrich Binder, Chapter 2, this volume (with further references).

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Fit and Proper Requirements rules); (v) stricter rules for credit rating agencies; (vi) stricter regulation of the OTC derivatives market; and (vii) the creation of the European Banking Union (EBU), including the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM).

IV.  Credit Institutions and Investment Firms A. MiFID I and CRD III This analysis starts before the crisis with the adoption of MiFID I and CRD III 8.11 on 21 April 2004 and 14 June 2006 respectively. These directives required persons who effectively direct the business of a credit institution, investment firm, or regulated market to be of sufficiently good repute and to possess sufficient experience to perform their duties.30 These fairly high-​level criteria have been elaborated and explained in post-​crisis guidelines and regulations. B. EBA Guidelines 2012 First of all, in 2012 the EBA issued Guidelines broadening the scope of the re- 8.12 quirements from persons who effectively direct the business of the credit institution to all members of the management body and key function holders.31 The term management body refers to the governing body (or bodies) of a credit institution, comprising both the supervisory and the management function. Key function holders, such as the heads of internal control functions, are also covered since, as mentioned in the Guidelines, they have significant influence over the direction of the institution.32 The Guidelines also explain how criteria such as good repute and sufficient ex- 8.13 perience should be interpreted by credit institutions and financial supervisors. For example, when assessing ‘good repute’, they should take into account criminal records, tax offences, and administrative sanctions, as well as past personal and business conduct and the relationship with the supervisory or regulatory authorities. ‘Sufficient experience’ should be assessed in the light of the institution’s size and internal organization, the nature, scope, and complexity of its activities and the duties and responsibilities of the specific position that is to be filled (the proportionality principle). This principle does not apply, however, when assessing good

30 Articles 9(1) of MiFID and 11(1) of CRD III. 31 EBA/​GL/​2012/​06, 5(5) and Article 1(a). 32 The validity of the extension of the fit and proper requirements to key function holders in the 2012 EBA Guidelines has been confirmed by the Board of Appeal of the ESAs in its decisions of 24 June 2013 (BoA 2013-​008) and 14 July 2014 (BoA 2014-​C1-​02). See, in particular, in paras 78–​9 of the latter decision.

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Danny Busch and Iris Palm-Steyerberg repute. All members of the management body should be of good repute, regardless of the nature, scale, and complexity of the institution or the position or the member within it. Furthermore, all requirements should be fulfilled at all times. These principles still apply today. C. CRD  IV 8.14

In June 2013 CRD IV was adopted. In this directive the expression ‘persons who effectively direct the business’ has been replaced by ‘members of the management body’, in line with the EBA Guidelines referred to above.33 CRD IV also enhances the suitability test by adding more criteria.34 CRD IV requires that all members of the management body must (i) be of good repute at all times and possess (ii) individually and (iii) collectively sufficient knowledge, skills, and experience to be able to understand the institution’s activities and main risks. Management bodies should, as a collective, be sufficiently diverse and reflect a broad set of qualities and competences. This is to stimulate the presentation of a variety of views and experiences in the decision-​making process, and prevent the phenomenon of ‘groupthink’. Each member of the management body must (iv) act with honesty, integrity, and independence of mind to effectively assess decisions of the senior management and oversee and monitor management decision making. Members are also required (v) to commit sufficient time to fulfil their duties. The number of directorships that can be held at any one time is therefore limited.35 The ECB also applies these five criteria when assessing the suitability of members of the management bodies of credit institutions.36

8.15

The additions laid down in CRD IV were deemed necessary in the light of the global financial crisis of 2007 to 2009. One of the lessons learned from this crisis was that weaknesses in corporate governance, including the absence of effective 33 Article 3(1)(7) of CRD IV defines ‘management body’, as meaning an institution’s body or bodies, which are appointed in accordance with national law, which are empowered to set the institution’s strategy, objectives, and overall direction, and which oversee and monitor management decision making, including the persons who effectively direct the business of the institution. 34 These criteria are in line with international standards as laid down by the Basel Committee on Banking Supervision (BCBS), ‘Guidelines: Corporate governance principles for banks’, July 2015, Principle 2. 35 Article 91 of CRD IV. See also EBA/​GL/​2011/​116, 4, where it is stated that as lack of oversight was one of the most significant weaknesses identified in the financial crisis, it should be ensured that members of the management body (especially in its supervisory function) devote sufficient time to their functions. 36 ECB, ‘Guide to fit and proper assessments’, updated May 2018. The ECB assesses the suitability of the members of the management bodies of significant credit institutions. The ECB also takes decisions following fit and proper assessments during authorization procedures and procedures regarding declarations of no objection. These decisions see on both significant and less significant credit institutions. See Article 4(1)(e) in conjunction with 16(2)(m); Article 4(1)(a) in conjunction with 6(4) in conjunction with 14; and Article 4(1)(c) in conjunction with Article 6(4); and Article 15 of Council Regulation (EU) No 1024/​2013.

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Fit and Proper Requirements governance checks and balances, had contributed to excessive risk-​taking and imprudent behaviour. This, in turn, had led to the failure of individual banks and to systemic problems. The suitability provisions stipulated in CRD IV are meant to remedy the weaknesses that were identified during the financial crisis regarding the functioning of the management body and the qualifications of its members.37 D. MiFID  II MiFID II, which was adopted in May 2014, requires management bodies of invest- 8.16 ment firms to comply with the same suitability requirements as laid down in CRD IV and makes similar references to the financial crisis and the need to strengthen corporate governance in financial institutions.38 E. The Joint EBA and ESMA Guidelines 2017 The Joint EBA and ESMA Guidelines on suitability, issued in September 2017, 8.17 aim to harmonize and improve suitability assessments within the Member States.39 Collective suitability criteria and criteria such as ‘diversity’, ‘sufficient time’, and ‘independence of mind’ are explained in greater detail. Independence of mind means the capacity to exercise objective and independent 8.18 judgement and to act objectively, critically, and independently. This requirement should be assessed without taking into account the proportionality principle, in other words regardless of the scale and complexity of the institution and the specific role and function. The existence of conflicts of interests that may impact the independence of mind should be identified and, if possible, mitigated. Also, as a matter of good practice and taking into account the proportionality 8.19 principle, there should be a sufficient number of independent non-​executive

37 CRD IV, Recital (53) and EBA/​GL/​2012/​06, 3 and 5. See also the Organisation for Economic Co-​ operation and Development (OECD) report, ‘Corporate Governance and the Financial Crisis:  Key Findings and Main Messages’ (June 2009)  and ‘The Corporate Governance Lessons from the Financial Crisis’ (2009); Institute of Financial Finance, Reform in the Financial Services Industry, ‘Strengthening Practices for a More Stable System’ (December 2009); BCSB, ‘Principles for enhancing corporate governance’, Bank for International Settlements (October 2010); and EC, Commission Staff Working Document, ‘Corporate Governance in Financial Institutions: Lessons to be drawn from the current financial crisis, best practices’, which accompanies the Green Paper, ‘Corporate governance in financial institutions and remuneration policies’, July 2010, COM(2010) 284 final. 38 Article 9 and Recital 5 of MiFID II. It should be noted that quite a few types of investment firms are already covered by CRD IV itself. 39 The Joint Guidelines were issued following the EBA report on the peer review of EBA/​GL/​ 2012/​06, dated 16 June 2015. In this report, the EBA concluded that there was a need to foster not only convergent but also enhanced supervisory practice to increase the quality and effectiveness of the general provisions set out in CRD IV (5).

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Danny Busch and Iris Palm-Steyerberg members on the board to ensure effective oversight of the board and challenge its decisions. 8.20

The guidelines further state that members of the management body should uphold high levels of integrity and honesty and should act in line with high standards of conduct. They should possess the required knowledge and expertise, and the right skills to fulfil their role and function. An annex to the report lists the skills that may possibly be needed.40 Members of the management body are also expected to be able to contribute to the implementation of an appropriate culture, corporate values, and behaviour within the institution.41 This expands the test to include more qualitative requirements and elements of a fairly subjective nature (skills, culture, and behaviour).The Joint Guidelines have been applicable since June 2018.

8.21

It may be concluded that since the financial crisis a robust and extensive set of suitability requirements has been put in place for members of the management body and key function holders in credit institutions and investment firms.

V.  Cross-​Sectoral Analysis A. General 8.22

It is tempting to conclude that CRD IV should be considered the post-​crisis turning point for fit and proper testing, in the sense that it served as a blueprint for fit and proper regulation in subsequent EU legislation across the different sectors. However, to answer this question with any certainty, it is necessary to analyse all the post-​crisis EU fit and proper requirements across the different sectors. For an overview of this analysis, see Table 8.1. B. Differences in substantive requirements 1.  Good repute and sufficient experience

8.23

As Table 8.1 shows, all relevant EU rules require the members of the management body in its managerial function, at the very least, to be of good repute. In most cases, members of the management body are also required to possess sufficient experience (and in some cases also sufficient skills and knowledge) to enable them to conduct sound and prudent management of the institution. For

40 Annex II contains a list of sixteen different skills including decisiveness, communication, judgement, teamwork, stress resistance, and leadership. This list is, for the most part, a literal translation of the list of competences used in the Netherlands when assessing suitability. 41 These requirements should be read in conjunction with the EBA Guidelines on internal governance, EBA/​GL/​2017/​11.

182

Art 7(1)(b)

Management company (UCITS)

Special purpose vehicles (Solvency II)

Art 6(2), Annex 1, Section A(2) Art 42(1), Art 273(4) Regulation 2015/​35 EIOPA GL 2015 Art 322(1) of Regulation (EU) 2015/​35

Good Repute

Art 7(1)(b)

Art 322(1) of Regulation (EU) 2015/​35 –​

Art 273(3) of Regulation (EU) 2015/​35 –​

–​

Art 273(3) of –​ Regulation (EU) 2015/​35 EIOPA GL 2015

Art 42(1), Art 273(2) of Regulation (EU) 2015/​35 EIOPA GL 2015

–​

–​

Art 6(2), Annex 1, Section A(2)

Individual Collective Sufficient qualifications suitability/​ board time (experience, composition knowledge, skills)

–​

–​

–​

–​

Independence of mind

Members of the management body (management/​executive function)

Credit rating agencies (CRA-​Regulation) Insurance and reinsurance undertakings (Solvency II)

Financial institutions

Table 8.1 Fit and proper requirements: a cross-​sectoral analysis Senior management/​ key function holders

Art 42(1) and 13 (29) EIOPA GL 2015

Unclear, Art 211(c) Unclear and Art 322(1) of Regulation (EU) 2015/​35 Unclear, Art 2(1)(s) –​

Unclear 1(43), 258(1)(d), of Regulation (EU) 2015/​35 EIOPA GL 2015

Unclear Art 3(1)(n) Unclear

Members of the management body (supervisory/​ non-​ executive function)

(continued )

Art 323(1) of Regulation (EU) 2015/​ 35 Art 8(1)

Art 24(1), 59(1) Joint GL 2016

–​

Members or shareholders (with qualifying holdings)

183

Art 27(2)

Art 8(1)(c)

Art 8(1)(c)

Art 27(2)

Art 23(2)(c)

Art 23(2)(c)

Central counterparty (EMIR)

Art 5(4)

Art 5(4)

Depositary (UCITS) Depositary/​no (central) bank (UCITS) Managers of alternative investment funds (AIFMD) Art 27(2)

Art. 21 Regulation (EU) No 231/​2013

Art 23(2)(c)

–​

–​

–​

Art. 21 Regulation (EU) No 231/​2013

–​

–​

–​

Individual Collective Sufficient qualifications suitability/​ board time (experience, composition knowledge, skills)

Art 29(1)(b)

Good Repute

–​

Art. 21 Regulation (EU) No 231/​2013

–​

–​

–​

Independence of mind

Members of the management body (management/​executive function)

Investment Art 29(1)(b) company (UCITS)

Financial institutions

Table 8.1 Continued

Unclear,Art 27(2), 2(27)

Unclear, Art 8(1) (c),and 21 jo 1(4)) Regulation (EU) No 231/​2013

Art. 23(2)(c), 2(1)(s)

Unclear, Art 5(4) s

Unclear, Art 7(1) (b) and Art 3(4), (5), (6) of Regulation 2010/​43

Members of the management body (supervisory/​ non-​ executive function)

Members or shareholders (with qualifying holdings)

Unclear, Art. 8(1)(c), art. 1(3) Regulation (EU) No 231/​2013 Unclear

Art 30(2), 32(1) Joint GL 2016

Art 8 (1) (d)

Unclear. –​ Art 7(1)(b) and Art 3(4), (5), (6) of Regulation 2010/​43 -​Unclear, –​ Art 5(4) Unclear, –​ Art. 23(2)(c)

Senior management/​ key function holders

184

185

Art 63(1) ESMA GL 2017 Art 27(4)

Data reporting services providers (MiFID II)

Art 5(1) (n), 11(2) EBA GL 2017 Account Art 33, 5(1) information services (n) providers (PSD II) EBA GL 2017

Central securities depositories (CSDR) Payment service providers (PSD II)

Art 45(1) ESMA GL 2017

Market operators (MiFID II)

–​

–​

Art 33, 5(1)(n) EBA GL 2017

Art 91(2)–​(6) EBA/​ ESMA GL 2017 Art 9(1), 9(4) EBA/​ ESMA GL 2017 Art 45(2) (a) ESMA GL 2017 Art 63(1), ESMA GL 2017 –​

–​

–​

Art 27(2),(4)

ESMA GL 2017

Art 45(2)(b) ESMA GL 2017

Art 4(1) EBA/​ESMA GL 2017

Art 91(7) EBA/​ESMA GL 2017

–​

Art 5(1)(n), 11(2) –​ EBA GL 2017

Art 27(4)

Art 63(1) ESMA GL 2017

Art 45(1) ESMA GL 2017

Art 9(1), 9(4) EBA/​ESMA GL 2017

Art 91(1) EBA/​ESMA GL 2017

Art 91(1) EBA/​ESMA GL 2017

Art 9(1), 9(4) EBA/​ESMA GL 2017

Art 78(6)

Art 78(6)

Investment firms (MiFID II)

Trade repositories (EMIR) Credit institutions/​ CRD-​investment firms (CRD IV)

–​

–​

Art 63(1) ESMA GL 2017 –​

Art 45(2)(c) ESMA GL 2017

Art 4(1) EBA/​ESMA GL 2017

Art 91(8) EBA/​ESMA GL 2017

–​

Unclear, 5(1) (n), 11(2) , EBA GL 2017 Unclear, EBA GL 2017

Art 2(1)(45)

ESMA GL 2017

Art 4(1)(36) ESMA GL 2017

Art 4(1)(36) EBA/​ESMA GL 2017

Art 5(1)(n)

Art 5(1)(n), 11(2)

Art 27(1), 2(1)(46)

–​

–​

–​

Unclear, Art 78(6), Unclear 2(27) Art 3(1)(7), 3(1)(8) EBA/​ESMA GL 2017 EBA/​ESMA GL 2017

–​

(continued )

Art 5(1)(m), Art 11 (6), Art 6(3)

Art 27(6)

–​

Art 47(1) Joint GL 2016

Art 10(1), 13(1) Joint GL 2016

Art 14(2), 23(1) Joint GL 2016

–​

185

–​

Art 22(1)(a)

Art 10

–​

–​

–​

–​

–​

Individual Collective Sufficient qualifications suitability/​ board time (experience, composition knowledge, skills)

Art 3(1) Art 3(1) EBA GL 2017 EBA GL 2017

Good Repute

–​

–​

–​

Independence of mind

Members of the management body (management/​executive function)

Insurance and Art 10 reinsurance intermediaries (IDD) Institutions for Art 22(1)(b) occupational retirement provision (IORP II)

Electronic money institutions (EMD)

Financial institutions

Table 8.1 Continued

Unclear, Art 22(1)

Art 10

Unclear,

Members of the management body (supervisory/​ non-​ executive function)

Art 22(1), 6(18)

Art 10

Unclear

Senior management/​ key function holders

–​

Art 3 and Art 5(1)(m), 111(1)(a)(1) PSD II –​

Members or shareholders (with qualifying holdings)

186

187

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Fit and Proper Requirements pension funds, however, no specific individual qualifications are stipulated. In IORP II, the requirement to be a ‘fit’ person is assessed collectively rather than at an individual level. 2.  Requirements for the collective Quite a few directives and regulations (not only IORP II, noted previously) set 8.24 requirements for the collective. In some cases, these requirements are merely designed to ensure that all necessary expertise is present in the management body, without expecting each individual member of the board to be accomplished in all the necessary fields of expertise. In other cases, collective requirements are set with regard to board composition. Relevant criteria in these cases are diversity (requiring the overall composition of the management body to reflect an adequately broad range of qualities and experiences) and independence (underlining the need for a certain number of independent members of the management body, especially in its supervisory function).42 In some cases, no collective criteria apply at all. 3.  Sufficient time and independence of mind The requirement to have ‘sufficient time’ to perform one’s functions is mentioned 8.25 only in CRD IV, MiFID II, and AIFMD. The same is true of ‘independence of mind’. 4.  Interpretation and guidance The substantive fit and proper requirements may therefore differ considerably from 8.26 one sector to another. Moreover, even when cross-​sectoral consistency does exist (e.g. the requirement of good repute43 and—​with the exception of IORP II—​the requirement of individual experience), the exact meaning of these terms may vary, sometimes widely, depending on the specific sector. This is because the fit and

42 Both CRD IV and MiFID II require the management body to reflect an adequately broad range of experience, further explained by CRD IV, Recital 60 and MiFID II, Recital 53 mentioning diversity with regard to age, gender, geographical provenance, and educational and professional background. The CSD Regulation also speaks of an ‘appropriate mix of skills, experience and knowledge’ on the board, as do the EIOPA Guidelines on internal governance (1.42). The CSD Regulation specifically asks for a target to be set for the representation of the under-​represented gender in the management body. Both EMIR and the CSD Regulation require at least one third, but no less than two, of the members of the management body to be independent. Also, the CRA Regulation requires that at least one third, but no less than two, of the members of the administrative or supervisory board of a credit rating agency are independent members who are not involved in credit rating activities. The EBA/​ESMA Guidelines issued in 2017 also contain provisions regarding the independence of the members in their supervisory capacity, but these differ from those in EMIR and CSDR. 43 The exact definitions may, however, differ. While most directives and regulations make use of the term ‘sufficiently good repute’, Solvency II and IORP II require ‘good repute and integrity (proper)’ and PSD 2 and Electronic Money Institutions (EMD) speak of ‘evidence of good repute’. The CSD Regulation merely states that members should be suitable, without specifically mentioning good repute.

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Danny Busch and Iris Palm-Steyerberg proper requirements in the EU legislation consist of open standards that can be interpreted in many different ways. 8.27

In recent years, however, delegated legislation and the ESA Guidelines have meant that there is now more certainty about the interpretation of these requirements and, also, a more harmonized approach. Today, the EBA and ESMA Guidelines cover a wide range of institutions, namely banks, investment firms, market operators, data reporting services providers, payment service providers, account information service providers, and electronic money institutions.44

8.28

Moreover, the three ESAs have issued joint guidelines containing a detailed explanation of how to assess the suitability of a proposed acquirer interested in taking over a bank, investment firm, insurance company, CCP, or payment service provider.45 The guidelines specify the meaning of the term ‘reputation’ of the proposed acquirer, covering both its integrity and its professional competence.

8.29

At the same time, these developments have not led to a fully harmonized set of interpretative rules for the assessment of the high-​level criteria used in EU financial regulation. Noticeably, the relevant EIOPA Guidelines fall short of giving clear guidance about the manner in which the fit and proper requirements should be interpreted or assessed with regard to insurance companies or pension funds.46 Nor is any further guidance given about collective asset managers (UCITS and AIFMs), central securities depositories, and CCPs.47

8.30

This brings about the remarkable situation that, in the case of insurance companies and CCPs, the suitability of a proposed acquirer is subject to detailed and comprehensive assessment, whereas there is little if any explanation of the assessment of the members of the management body itself. C. Differences in scope and definitions 1.  Non-​executive directors

8.31

Neither the requirements nor the scope of EU legislation and the definitions used are fully harmonized. Determining whether or not non-​executive directors come within the scope of the provisions is therefore by no means easy. Consider, for 44 EBA/​GL/​2017/​12/​ESMA71-​99-​598, ESMA70-​154-​271, and EBA/​GL/​2017/​09. See also Regulation (EU) 150/​2013 with regard to trade repositories. 45 JC/​GL/​2016/​01. 46 The EIOPA Guidelines on internal governance (2015) hardly explain the requirement to be ‘proper’ (1.44). Remarkably, earlier EIOPA Guidelines contained more detailed guidance in this respect (see EIOPA-​CP-​13/​08). Commission Delegated Regulation (EU) 2015/​35 does give some further guidance, but lacks a detailed description or explanation. 47 ESA Guidelines are absent, and even Commission Delegated Regulation (EU) No 231/​2013 of 19 December 2012, concerning AIFMs, and Implementing Directive 2010/​43/​EU of 1 July 2010, concerning UCITs, do not contain additional suitability provisions.

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Fit and Proper Requirements example, the phrases ‘persons who effectively conduct the business/​run the undertaking’ (UCITS, AIFMD, Solvency II, and IORP II). They seem to refer only to the executive members of the management body, but it is impossible to be completely sure.48 Even the General Court of the EU Court of Justice was unable in one of its recent judgments to determine with certainty the meaning of the phrase ‘two people who effectively direct the business of the institution’, using a textual and historical interpretation.49 The same uncertainty exists concerning the ‘directors and persons responsible for the management of the institution’ (PSD 2 and EMD).50 On the other hand, several directives and regulations clearly define fit and proper 8.32 requirements for all members of the management body, whether acting in their managerial or their supervisory function (EMIR, CRD IV, CSD Regulation, and CRA Regulation—​although the latter uses the term ‘senior management’). The revised UCITS directive also introduces the term ‘management body’, but the fit and proper requirements for management companies and investment companies still apply to ‘persons who effectively conduct the business’ and ‘directors’. For AIF managers, fit and proper requirements are set for both ‘persons who effectively conduct the business’ as well as ‘members of the governing body’. Whereas the last term does not comprise supervisory board members in a separate supervisory board, it cannot be completely ruled out that these members should, indeed, be regarded as persons who effectively conduct the business.51 In a few cases, delegated legislation or ESA Guidelines such as those for insurance companies provide some clarity, but many uncertainties remain, for example with regard to collective asset managers (UCITS and AIFMs), payment service providers, electronic money institutions, SPVs, and IORPs. 2.  Senior management and key function holders Scope  Likewise, senior management and key function holders do not always come within 8.33 the scope of the provisions. In the case of several types of financial institution, 48 In some cases, non-​executive members in a one-​tier board structure are subjected to the fit and proper requirements but members of a supervisory board, in case of a two-​tier board structure, are not or this is, at the least, unclear (see insurance companies, UCITS-​depositories, and AIFMD-​ management companies). This distinction does not seem to sit well with the international post-​crisis recommendations, mentioned hereafter (Section VII.B). 49 Judgment of the General Court of 24 April 2018, ECLI:EU:T:2018:219. A teleological and contextual interpretation was also needed in order to conclude that the expression ‘two persons who effectively direct the business of the institution’ refers to members of the management body in its managerial function, since the objective of Article 13(1) of CRD IV is to ensure effective oversight of the senior (executive) management by the non-​executive members of the management body. 50 The EBA Guidelines (EBA/​GL/​2017/​09), however, seem to indicate that both executive and non-​executive members of the management body of payment institutions, account information services providers, and electronic money institutions should be suitable. See Guideline 4.1, 16(1), at a(ii), Guideline 4.2, 11(1) at a(ii), and Guideline 4.3, 16(1) at a(ii). 51 See Article 8(1)(c) of Directive 2011/​61/​EU and Article 1(4) and 21 of Regulation (EU) No 231/​2013.

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Danny Busch and Iris Palm-Steyerberg senior management and/​or key function holders are subjected to fit and proper requirements (e.g. insurance companies, pension funds, credit institutions, investment firms, and payment institutions52). However, this is not true, or unclear, of certain other categories such as collective asset managers (UCITS and AIFM), market operators, and CCPs. Senior management  8.34

The use of definitions can be rather puzzling. EIOPA defines the term ‘senior management’ in the same way as it is described in this chapter, meaning the echelon of high-​level management just below the management body.53

8.35

CRD IV and CSDR, however, use the term ‘senior management’ to indicate those natural persons who exercise executive functions within an institution and who are responsible and accountable to the management body for the day-​to-​day management of the institution.54 This definition includes both the ‘senior management’ as defined in this chapter and the executive members of the management body.

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The term ‘senior management’ is used in the CRA Regulation to mean the people who effectively direct the business of the credit rating agency and the member or members of its administrative ‘or’ supervisory board, while the same term in the EMIR Regulation is used to indicate the people who effectively direct the business and (only) the executive members of the board.55

8.37

In UCITS, the term ‘senior management’ in a management company is used as a synonym for ‘persons who effectively conduct the business’, which term seems to include the members of the management body (or at least the executive members) but not necessarily the ‘second echelon’ of managers just below the management body.56 The same uncertainty exists regarding the ’second echelon’ in AIF managers.57

52 PSD II does not use the terms ‘senior management’ or ‘key function holders’, but does contain fit and proper requirements for persons responsible for the management of the payment services activities (not identified as ‘directors’ or ‘persons responsible for the management of the payment institution’). 53 Article 1.21 of EIOPA-​BoS-​14/​253. 54 Article 3(1)(9) of CRD IV and Article 2(1)(46) of CSDR. 55 Article 2(29) of EMIR and Article 3(1)(n) of CRA Regulation. 56 In UCITS management companies, fit and proper requirements are set for all people who effectively conduct the business (see EU Regulation No 2009/​65, Art 7(1)(b). The term ‘senior management’ can be used to indicate the same group of people (see EU Regulation No 2010/​43, Article 3(4). Taking into account Article 3(4), (5), and (6) of this Regulation, it may be concluded that fit and proper requirements probably do apply to non-​executive members in a one-​tier board structure. It remains unclear, however, if this is also the case regarding members in a separate supervisory board (e.g. in a two-​tier board structure). It is also unclear if members of the ‘second echelon’ fall within the definition. Taking into account Recital (10), (15), and (17) of the last mentioned Regulation, this cannot be ruled out. 57 Members of the second echelon may fall under the definition of ‘persons who effectively conduct the business’, but uncertainty remains (see Article 8(1)(c) AIFMD and Recitals (3) and (84) and Article 1(3) Delegated Regulation 231/​2013.

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Fit and Proper Requirements Key function holders  Definitions of the term ‘key function holders’ also differ. The term is used by 8.38 EIOPA to identify those persons who perform functions of specific importance for the insurance undertaking in view of its business and organization. At least risk management, compliance, internal audit, and the actuarial function are considered to be key functions.58 IORP II recognizes the same key functions, with the exception of the compliance 8.39 function. The Delegated CRA Regulation states that those required to be fit and proper are not only members of the management body but also ‘officers’ responsible for the internal audit, internal control, compliance function, risk assessment, and review function (without using the term key function holder), and ‘persons appointed to direct the business of the branches’.59 Neither CRD IV nor MiFID II uses the term ‘key function holders’. However, 8.40 the EBA/​ESMA Guidelines on suitability (2017) explicitly mention the term ‘key function holders’. In these Guidelines they are defined as persons who have significant influence over the direction of the institution, but who are neither the CEO nor members of the management body. They include at the very least the heads of internal control functions and the CFO (where they are not part of the management body). Other key function holders might include heads of significant business lines, European Economic Area/​European Free Trade Association branches, third country subsidiaries, and other internal functions.60 3.  Members or shareholders with qualifying holdings It is also clear from Table 8.1 that members or shareholders (with qualifying hold- 8.41 ings) do not always come within the scope of the provisions. The suitability of those members and shareholders may or may not be one of the requirements needing to be fulfilled as part of the authorization or registration process or to obtain approval for a proposed acquisition (declaration of no objection). D. Limited cross-​sectoral convergence All in all, it may be concluded that cross-​sectoral convergence is still limited, 8.42 although the ESAs are taking important steps to harmonize the fit and proper requirements. It should also be noted here that there has been a further harmonization of fit and proper rules in the payment sector. For example, PSD 2 harmonizes authorization criteria for electronic money institutions and payment service providers, including the introduction of fit and proper requirements for electronic 58 The EBA Guidelines (EBA/​ GL/​ 2017/​ 09), 1.4. See also Articles 42(1) and 13(29) of Solvency II. 59 Article 15(1) (b) and (c) of Delegated Regulation No 449/​2012. 60 Article 15 of EBA/​ESMA GL 2017.

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Danny Busch and Iris Palm-Steyerberg money institutions.61 There is also greater convergence in the case of insurance companies and pension funds, where the legislation employs the same terms (‘fit’, ‘proper’, and ‘key function holders’). Also, some sectoral regimes do provide for certain additional criteria such as independence or diversity and in some cases non-​ executive directors have also been subjected to fit and proper requirements. 8.43

Clearly, it may also be concluded that the lessons of the financial crisis, which led in any event to the adoption of the five suitability criteria listed in Table 8.1 and recognition of the importance of the role of non-​executive directors, were only really put into practice by CRD IV and MiFID II. As it currently stands, the CRD IV fit and proper rules have not served as a blueprint for fit and proper regulation in other sectors.

8.44

Although it could possibly be argued that the EU is currently in a transitional period and that more harmonization of fit and proper requirements will take place in due course, it sometimes seems as though policymakers are already starting to forget the lessons learned from the financial crisis. Whatever the case, it can only be concluded that as of today there is an imbalance in fit and proper regulations across the different sectors. Whereas detailed and extensive rules and regulations have been adopted for banks and investment firms, fit and proper assessment for several other types of financial institution is mostly based on high-​level criteria, which lack adequate interpretative guidance (e.g. insurance companies, collective asset managers—​UCITS managers and AIFMs—​pension funds, central securities depositories, and CCPs). This allows scope for widely varying supervisory practices not only in and between the different sectors but also among Member States.62

8.45

The obvious question, of course, is whether these differences can be adequately explained or whether more cross-​sectoral harmonization is actually needed. This is discussed in Section VI below. First, however, the Dutch system is described, as an example of a harmonized, cross-​sectoral approach to fit and proper assessment.

VI.  The Dutch Cross-​Sectoral Approach A. General 8.46

As has been seen, the EU fit and proper requirements differ quite considerably across the different sectors, not only in terms of their scope but also with regard 61 Article 111(1) of PSD 2. 62 This can be illustrated by the EBA Peer Review, which was conducted in 2015. It was found that despite the existence of the already fairly detailed EBA Guidelines, supervisory practices within the same type of financial institution (in this case banks) showed a huge degree of divergence across the Member States. See the EBA Peer Review Report, EBA/​GL/​2012/​06, 16 June 2015.

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Fit and Proper Requirements to the substantive requirements and the definitions used in this context. So should there be more cross-​sectoral harmonization? The EU regulatory framework adopts a sectoral approach, but in the Netherlands the EU regulatory framework has nevertheless been implemented in national law in a cross-​sectoral manner. It follows that there is much more cross-​sectoral convergence in the Netherlands than might be expected on the basis of the sectoral EU regulatory framework. It is therefore interesting to take a closer look at how the Dutch regulatory framework is organized. B. Division of labour between AFM and DNB On 1 January 2007 the Netherlands adopted the so-​called twin peaks regula- 8.47 tory model. This model is first and foremost reflected in the division of labour between the conduct of business regulator AFM (Stichting Autoriteit Financiële Markten) and prudential regulator DNB (De Nederlandsche Bank NV).63 The AFM is the conduct of business supervisor for all financial institutions subject to conduct supervision. DNB, on the other hand, is the prudential regulator for all financial institutions subject to prudential supervision. In line with the EU regulatory framework, financial institutions such as banks, investment firms, insurance undertakings, managers of UCITS, and AIFs are subjected to both conduct and prudential supervision and are therefore supervised by both the AFM and DNB. This division of responsibility for supervision means that AFM and DNB have to collaborate closely. The effect in practice is that their approaches and interpretations tend to converge. C. Fit and proper testing The following approach has been adopted with respect to fit and proper testing. 8.48 The supervisor who grants a licence to the relevant financial institution takes the lead in the fit and proper testing process. This means that DNB takes the lead with respect to fit and proper testing of managers and key function holders of banks, insurance companies, and so forth, whereas the AFM takes the lead in the case of investment firms and managers of UCITS and AIFs. The other supervisor may, however, veto a positive decision.64 This is to prevent a situation in which the lead

63 See Articles 1:24 and 1:25 Dutch Financial Supervision Act (Wet op het financieel toezicht or Wft). However, within the SSM of the EBU, the supervision of credit institutions (and some other entities) has been a shared responsibility of DNB and the ECB since 4 November 2014. See, e.g., Eddy Wymeersch, ‘The Single Supervisory Mechanism: Institutional Aspects’, in: Danny Busch and Guido Ferrarini (eds), European Banking Union, 1st and 2nd eds, Oxford University Press, 2015 and 2019. 64 See Article 1:47c, 1:48 and 1:49 Wft. Unless the ECB within the framework of EBU’s SSM is the competent supervisor with regard to fit and proper testing. See Article 1:49 (5) Wft.

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Danny Busch and Iris Palm-Steyerberg supervisor reaches a positive decision despite the disagreement of the other supervisor.65 Once a supervisor has found a member of the management board to be of good repute, this judgement is respected by the other supervisor. This simplifies the application process where a director of, say, an insurance company applies for another directorship at a payment institution or an asset manager. Good repute will not be tested again, unless specific circumstances warrant a reassessment.66 D. The Dutch Financial Supervision Act 8.49

The twin peaks model is also reflected in the structure of the Dutch Financial Supervision Act (Wet op het financieel toezicht or Wft). Part  3 of the Wft on prudential supervision of financial institutions is the exclusive competence of DNB,67 whereas Part 4 of the Wft on conduct of business supervision of financial institutions is the exclusive competence of the AFM. In this structure, rules are grouped in a cross-​sectoral and thematic way. This obliged the Dutch legislator to compare the regulatory rules across the different sectors and led to a harmonized approach. E. Fit and proper requirements

8.50

This is also what happened in the case of the fit and proper requirements. The Dutch legislator took a uniform approach to the fit and proper rules due to the functional structure of the Wft. By the same token, the Dutch supervisors adopted the high CRD IV standards across all sectors, taking into account the proportionality principle (with the exception of ‘good repute’).

8.51

These standards, laid down in joint policy rules (Beleidsregel Geschiktheid), divide the different financial institutions into three groups.68 Although all persons must fulfil the same criteria, this may lead to different requirements depending on the specific function and institution, and also how these criteria are assessed differs from group to group. For example, in the case of banks, insurance companies, and pension funds (Group A), an in-​depth ex ante assessment is performed by the supervisory authorities by reference to all five criteria, whereas in the case of UCITS and AIFMD asset managers, depositories, and data reporting services providers (Group B), and electronic money institutions (Group C) only minimum

65 This is what happened with the appointment of a former Dutch Minister of Finance as CEO of ABN AMRO. See Danny Busch, Toezichthouders op ramkoers, Ars Aequi (2010), 414–​16. 66 See Articles 3:9(2) and 4:10(2) Wft. 67 Although the supervision of credit institutions (and some other entities) has been a shared responsibility of DNB and the ECB since 4 November 2014, within the EBU’s SSM. See, e.g., Wymeersch, n 59. 68 Beleidsregel geschiktheid 2012 of 3 July 2012, Stcrt. 2012, 13546 (as amended from time to time, see most recently Stcrt. 2017, 73477).

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Fit and Proper Requirements requirements are assessed in advance, although all criteria still need to be fulfilled on an ongoing basis. F.  A harmonized approach to fit and proper requirements and fit and proper testing All in all, it may be concluded that the Dutch twin peaks model has had a harmon- 8.52 izing effect on fit and proper requirements and testing across the different sectors in the Netherlands. As a result, there is a very high level of harmonization with regard to fit and proper requirements, the scope of application, the definitions used, and the process followed. This is not a plea for or against the adoption of a twin peaks model across Europe. 8.53 It just shows that national legislators and supervisors can still adopt a harmonized approach to fit and proper testing despite cross-​sectoral differences in fit and proper requirements in the sectorally oriented EU regulatory framework. It should also be submitted that this does not necessarily amount to ‘gold-​plating’ in breach of EU financial regulation.

VII. Recommendations A. General As noted above, the Netherlands has a fully harmonized system of fit and proper 8.54 testing, based on the high CRD IV standards to be applied across all sectors, taking into account the proportionality principle. In EU financial regulation, however, the landscape is very varied. This brings us back to the central question of this chapter:  can these sectoral differences be adequately explained, or should there be more cross-​sectoral harmonization in line with the Dutch example? B. The lessons of the financial crisis To answer this question, a return to the lessons of the financial crisis is required. 8.55 Generally speaking, the crisis led to a loss of public confidence in almost all financial institutions. Restoring trust in these institutions and maintaining it in the long term can therefore be regarded as one of the main objectives of (post-​crisis) financial regulation.69

69 The High-​Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, Report, 25 February 2009, 13 (No 40).

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For example, the objective of the revised UCITS Directive in 2014 is to improve investor confidence in UCITS.70 In a similar vein, the new rules laid down in PSD 2 are also intended to strengthen the trust of consumers in a harmonized payments market, which is deemed essential for the functioning of vital economic and social activities.71

8.57

Moreover, recovery and resolution regulation is being implemented in the Netherlands for insurance companies, mirroring to a certain extent the Bank Recovery and Resolution Directive (BRRD) which applies to credit institutions (and certain investment firms). This new regulation is deemed necessary because of the important social function of insurance companies and the need to safeguard public trust in the insurance sector.72

8.58

Pension funds also have an important social purpose in that they supplement retirement income from public sources. The loss of public confidence in private pensions, which occurred in many countries as a result of the financial crisis, needs to be reversed.73 In the Netherlands, the Frijns report concluded in 2010 that, in order to restore trust in the pension system, the expertise of members of the management body should be enhanced by including knowledge and experience (e.g. of risk and asset management) and skills such as independence of mind. This has resulted in additional regulation in Dutch pension laws.74

8.59

Of course, not all sectors are of equal importance to the trust and stability of the system, and major differences may exist among financial institutions. However, even mismanagement in a small pension fund, insurance company, or payment institution, or indeed an integrity scandal affecting an individual board member, may have a significant impact on public trust in the financial sector as a whole. For example, Dutch misselling scandals, especially with respect to very expensive life assurance contracts (beleggingsverzekeringen), led to a serious loss of public confidence, which has still not been restored today. In the same way, the bankruptcy of a relatively small bank such as DSB Bank also led to a considerable loss of confidence among the Dutch public.75

8.60

Financial institutions can only act through people. The members of the management bodies and senior management are the people who direct the course of the business of the financial institution and effectively take the decisions that impact both the financial solidity of the institution and the interests of investors, 70 UCITS Directive, Recital 45. 71 PSD 2, Recitals 6 and 7. 72 Dutch Parliamentary Papers II, 2017/​18, 34 842, No 3, 2. 73 OECD: ‘Core Principles of Private Pension Regulation’, 2016. 74 Wet versterking bestuur pensioenfondsen, Stb. 2013, 302 and the Frijns report, Dutch Parliamentary Papers II, 2009/​10, 30 413, No 138. 75 Dutch Parliamentary Papers II, 2009/​10, 32 432, No 1.

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Fit and Proper Requirements consumers, depositors, and policyholders, and whose decisions may even affect the stability of the financial system as a whole. The restoration of trust is therefore highly dependent on the decisions of the management body and senior management. This stresses the importance of their suitability. The need to rebuild this trust might therefore be of cross-​sectoral relevance in that 8.61 it requires high levels of suitability within all financial institutions. Accordingly, the relevance of the lessons learned from the financial crisis, which are aimed at rebuilding this trust and ensuring a sound governance framework, should not be restricted to banks and investment firms.76 For example, the conclusions that were drawn from the financial crisis in the EU 8.62 Green Paper in 2010 are meant to be of relevance for banks and life insurance companies alike, and may be of relevance for all regulated financial institutions.77 In this paper the EC highlights the importance of suitability criteria such as: (i) financial expertise; (ii) skills; (iii) independence of mind (independent judgement and the ability to challenge the management); (iv) diversity (with regard to cultural, educational, professional, and legal background and also with regard to age and gender); and (v) time commitment. It also stresses the importance of subjecting non-​executive directors (in a unitary board system) and members of the supervisory board (in a dual board system) to the same criteria. Similar suitability requirements can be found in the recently revised OECD 8.63 Guidelines on Insurer Governance, published on 16 November 2017.78 These guidelines advocate a set of fit and proper requirements for board members of insurers (including life, non-​life, and reinsurance), comparable to the requirements laid down in CRD IV.79 According to these international standards, board members of insurance companies should be subject to fit and proper requirements comparable to those applicable to credit institutions.

76 e.g. both Solvency II and IORP II state that an effective system of governance is deemed essential for the adequate management of insurance companies and IORPS, since some risks may only be properly addressed through governance requirements rather than through the quantitative requirements (Solvency II, Recital 29 and IORP II, Recital 52). This seems a relevant notion for all financial institutions. 77 European Commission, Commission staff working document:  ‘Corporate Governance in Financial Institutions:  Lessons to be drawn from the current financial crisis, best practices’, 5, COM(2010)284, 2 June 2010, accompanying document to the EU Green Paper, ‘Corporate governance in financial institutions and remuneration policies’, COM(2011)164. 78 Available at http://​www.oecd.org/​finance/​privatepensions/​oecdguidelinesforpensionfundgover nance.htm, accessed 2 October 2018. 79 The Guidelines state that board members should be of good character and repute, adhere to high standards of ethics and business conduct, and possess, individually and collectively, the necessary competency, skills, expertise, and professional experience. They also stress the importance of—​ both formal and perceived—​independence, objective and impartial judgement, the avoidance of conflicts of interest, diversity in board composition (mix of background and competences, including gender diversity), and sufficient time commitment.

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A cross-​sectoral approach is also found in the Larosière report of 2009. Here corporate governance is identified as one of the most important failures responsible for the crisis. Action is said to be necessary in all financial sectors, leading to equivalent standards throughout the internal market.80 It should also be mentioned that in the Netherlands a parliamentary inquiry committee established after the crisis concluded that there had been a serious loss of public trust in the financial sector, not restricted to credit institutions. Among its recommendations were that the role of non-​executive members of the management body should be strengthened. It also stressed the importance of suitability criteria such as expertise, time commitment, diversity, and independence of mind. These recommendations were meant to be applied not only to credit institutions but also to other financial institutions, particularly insurance companies and pension funds.81

8.65

The more recent G20/​OECD Principles of Corporate Governance published in 2015 also take a cross-​sectoral approach, focusing on all publicly traded companies, both financial and non-​financial.82 These principles state that the management body should apply high ethical standards, commit sufficient time, and be able to exercise objective and independent judgement (thereby preventing conflicts of interests and ensuring that a sufficient number of board members are independent of management).83 The principles are intended to have cross-​sectoral relevance even beyond the financial world. This relevance may not be limited to listed companies, as the principles also provide that in so far as they are deemed applicable, they might also be a useful tool in improving corporate governance in companies whose shares are not publicly traded. C. A nuanced cross-​sectoral approach 1. General

8.66

Of course, the crux lies in identifying the extent to which the principles are indeed applicable in other, or all, types of financial institutions. In this respect, a nuanced approach is favoured here. In the authors’ opinion, the lessons of the financial crisis and the reports mentioned above prove adequate support for application of the five fit and proper criteria laid down in CRD IV not only to banks and investment firms but also to all financial institutions.

80 The High-​Level Group on Financial Supervision in the EU, n 65, 3 and 29. 81 Verloren krediet report, 10 May 2010, Dutch Parliamentary Papers II, 2009/​10, 31 980, Nos  3–​4. 82 See http://​www.oecd.org/​corporate/​principles-​corporate-​governance.htm, accessed 2 October 2018. 83 Principle VI. The Principles are intended to apply to whatever board structure is charged with the functions of governing the enterprise and monitoring management, 45.

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Fit and Proper Requirements However, the proportionality principle should be applied when assessing these cri- 8.67 teria. This means that not only may the exact requirements differ, depending on the function and the type of financial institution (e.g. the required level and areas of knowledge and experience for board members will differ depending on such factors as the type of institution and its size, risk profile, and complexity), but also that how these requirements are to be assessed (by the institution or by the competent authorities, in depth ex ante assessment or assessment of only minimum requirements) may differ too. This will lead to more cross-​sectoral harmonization (all five criteria will apply to all institutions), while at the same time preventing a one-​size-​fits-​all approach. 2.  Good repute A strong case for a comprehensive, cross-​sectoral approach seems to exist in relation 8.68 to the requirement of good repute. It is hard to find a justification for applying different levels of integrity to members of the management body in different sectors of the financial world, especially since the rebuilding of trust seems to be a cross-​ sectoral necessity. In the authors’ opinion, all members should adhere to the same high standards of good repute and integrity. Also, these terms should be defined and explained in a consistent way. While all directives and regulations have incorporated the requirement of ‘good repute’ (or an equivalent such as ‘proper’), these are high-​level, lax, and ambiguous terms that allow for divergent interpretations across the different sectors and among different Member States. In recent years, the ESAs have done much to explain and define the term ‘good repute’ in more detail. It is recommend here that the ESAs follow up on this and harmonize the assessment of ‘good repute’ in all financial institutions. However, this would not prevent the competent financial supervisors from taking a 8.69 risk-​based approach to assessing ‘good repute’, differentiating between the sectors. While members of the management body should at all times be of good repute, ensuring compliance with this requirement is primarily the responsibility of the financial institution itself. Competent financial supervisors may choose to limit the assessment of good repute in the case of certain types of institution, for example to desk research (checking criminal records and evidence of other offences, particularly tax offences), which cannot usually be undertaken by the institutions themselves. This could be followed up by a more in-​depth assessment if the outcome of the desk research gives rise to further questions. 3.  Independence of mind In a similar vein, it is recommended that ‘independence of mind’ be added to the 8.70 suitability test in all financial institutions. All members of the management body, and especially its non-​executive members, should be able to form objective and independent judgements and have the capacity, if needed, to challenge management

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Danny Busch and Iris Palm-Steyerberg decisions effectively. The existence of conflicts of interests that may impact the independence of mind should be identified and, if possible, mitigated. This can be regarded as one of the most important lessons of the financial crisis.84 8.71

In this respect it is recommended that the EBA and ESMA guidelines be followed. In other words, all members of the management body should have independence of mind, regardless of the institution’s size and internal organization, the nature, scope, and complexity of its activities, and the duties and responsibilities of the specific position.85 In keeping with the EBA and ESMA Guidelines, the proportionality principle should therefore not apply when it comes to ‘independence of mind’.

8.72

Nevertheless, a risk-​based approach might result in differentiation between institutions when this requirement is assessed. For some (low-​risk) institutions, the assessment might be left primarily to the institution itself, leaving the competent authorities free to follow up on the findings in the course of ongoing supervision (without carrying out a check in advance). 4.  Sufficient knowledge, skills, and experience, both individually and collectively

8.73

When it comes to identifying the necessary individual qualifications such as knowledge, skills, and experience, it is submitted that much importance should be attached to the proportionality principle. Clearly, individual qualifications are very much connected to the needs of the specific institution, as well as to the specific function of a person within the organization.

8.74

The same risk-​based approach suggested in para 8.73 might be used for the assessment of skills. As a rule, supervisors may well feel more comfortable with identifying current, inappropriate behaviour rather than predicting future behaviour. If they come across such behaviour during ongoing supervision, they could consider reassessment since this would shed a different light on the prior fit and proper approval.86

8.75

Also, since it is often not feasible for each and every member of the management body to possess all the knowledge and expertise necessary to effectively direct and oversee the institution, the management body should at least have this experience

84 See, e.g., EU Green Paper, n 73, 6, EBA Guidelines on internal governance (2017), 26, and—​even before the crisis—​the EU Commission Recommendation on the role of non-​executive or supervisory directors of listed companies and on the committees of the (supervisory) board, 15 February 2005. 85 EBA/​ESMA Guidelines (2017), GL 22. 86 It is noted here that many Member States apply an ex post assessment process. In those cases, inappropriate behaviour observed during ongoing supervision could be taken into account when performing the (first) suitability test.

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Fit and Proper Requirements and expertise collectively. This means that individual qualifications may differ within a given institution. Yet, in the authors’ opinion, all members of the management body should have a 8.76 basic understanding of the major risks faced by the institution and possess a minimum degree of expertise in order to understand and challenge management decisions effectively.87 This might pose a challenge in cases of (mandatory) employee representation in the management body and in (smaller) pension funds.88 In these cases, however, the necessary expertise could be gained by additional training and education or the use of external advisors.89 5.  Time commitment It is also recommended that a ‘time commitment’ be added to the suitability test 8.77 in all financial institutions.90 Management in all institutions should be able to devote sufficient time to their functions in order to fulfil their duties effectively. It is believed that it would add value to the test if the time commitment were to be specifically addressed. However, what constitutes ‘sufficient’ time is naturally assessed differently from one organization to another and from one function to another. This provision should therefore be assessed according to the principle of proportionality. Also, the intensity of the test may vary. An extensive assessment of this requirement as laid down in the EBA/​ESMA Guidelines of 2017 may not always be necessary and may place an excessively heavy administrative burden on the institution.91 In such cases a simplified method might suffice. 6. Scope As for the scope of the five criteria, it is recommended that they be applied to all 8.78 members of the management board, including executive and non-​executive members in both one-​tier and two-​tier board structures. As follows from the reports mentioned in this chapter, strengthening the role of non-​executive directors and members of the supervisory bodies, providing for adequate checks and balances, can be regarded as one of main lessons of the crisis.

87 See also: EU Green Paper, n 73, 3. 88 See OECD Guidelines for pension fund governance, 5 June 2009 (Annotation I.4) and the OECD Core Principles of private pension regulation, 2016. The IORPS Recital 5 notes that the way in which IORPs are organized and regulated varies significantly between Member States. Hence, a ‘one-​size-​fits-​all’ approach is not considered appropriate. However, since IORPS do fulfil an important social function, the individual expertise of their decision makers should, in the opinion of the authors, at least be on this basic level. Reference should also be made to The Frijns report, mentioned earlier. 89 See also G20/​OECD, ‘Principles of corporate governance’, 2015, (VI.G). 90 See also G20/​OESO IV.E.3. 91 EBA/​ESMA Guidelines 2017, Title III, Chapter 4.

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It is also recommended that all members of the senior management and key function holders, who have significant influence over the direction of the institution and the risks taken, fulfil certain fit and proper requirements, including good repute and experience. However, a proportionate approach can be adopted to the assessment of this test. This assessment should be mainly the responsibility of the institutions, leaving the competent financial supervisors to perform fit and proper assessments of members of the senior management and key function holders based on a risk-​based analysis only, leaving room for a sector-​ specific approach.

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Other requirements for board composition (diversity and formal independence) may also call for a proportionate and/​or a sector-​specific approach. However, financial institutions are expected to at least take note of the relevant international recommendations and consider applying them in their organizations (to be laid down in internal policies).92 7. Definitions

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It is also recommended that the definitions used in the different directives, regulations, and guidelines should be aligned and interpreted in a harmonized way. This applies, in particular, to the definitions of ‘non-​executive director’, ‘senior management’, and ‘key function holders’ (clarifying the scope of fit and proper testing).

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The adoption of clear definitions and harmonized interpretations of ‘good repute’ and ‘independence of mind’ is also recommended since the cross-​sectoral application of these criteria are advocated. Here lies an important task for the three ESAs, namely enhancing consistent application of these definitions in all financial institutions and all Member States and fostering a level playing field in Europe.

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In addition, clear and harmonized interpretations would provide for more legal certainty for institutions and persons subjected to fit and proper testing. Here too lies an important task for the national legislators, ensuring a harmonized implementation of the fit and proper criteria mentioned in the EU directives.93

92 These recommendations, for example, entail promoting diversity among board members with regard to professional and educational background, age, and gender and providing for a sufficient number of independent members in the management body. 93 Recently, the ECB has emphasized the need for a more harmonized implementation of CRD IV. The same rules should be implemented in the same way throughout Europe to ensure that management bodies are assessed equally and the complexity of fit and proper assessments is indeed reduced (https://​www.bankingsupervision.europa.eu/​press/​publications/​newsletter/​2018/​html/​ssm. nl180214_​4.en.html, accessed 2 October 2018).

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VIII.  Final Remark As a final remark, it is hoped that this analysis and these recommendations will 8.84 encourage EU policymakers to make consistent and well-​considered choices when drafting or revising directives or regulations containing fit and proper requirements. These choices concern the selection of the specific fit and proper criteria, scope, and definitions. And if they do not opt for harmonization they should explain why a sector-​specific approach is indeed appropriate.

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9 RISK, RISK MANAGEMENT, AND INTERNAL CONTROLS Lodewijk van Setten

I. The Concept of ‘Risk’ 9.01 II. Risk Management is an Intrinsic Component of the Governance Design of a Firm 9.06 III. Culture and Conduct Inform Risk Management 9.20 IV. Risk Management is Part of the Internal Controls of a Firm 9.29 V. The Risk Management and Internal Control Provisions of CRD IV 9.36

VI. The Risk Management and Internal Control Provisions of MiFID II VII. Risk Management and Internal Controls in the UCITS Directive and AIFMD VIII. Specific Risk-​Management Controls: Remuneration Policies IX. Concluding Remarks

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I.  The Concept of ‘Risk’ 9.01

Peter Bernstein opens his ingenious book on the history of risk with an enlightening question: ‘What is it that distinguishes thousands of years of history from what we think of as modern times?’ The answer follows swiftly: The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature. . . . This book tells the story of a group of thinkers whose remarkable vision revealed how to put the future at the service of the present. By showing the world how to understand risk, measure it, and weigh its consequences, they converted risk-​taking into one of the prime catalysts that drives modern Western society.1



1

Peter L Bernstein, Against the Gods—​The Remarkable Story of Risk, Wiley, 1996, 1.

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Risk, Risk Management, and Internal Controls The shift to the analysis of risk-​taking as a data-​driven analytical process can be traced back to the Renaissance. In 1654, messrs Pascal and Fermat, the French mathematicians, formulated the theory of probability, the mathematical heart of the scientific concept of risk. Over the years, this discovery was transformed into a tool for organizing, interpreting, and applying information.2 It culminated in the mathematical apparatus of modern risk analysis that seeks to underpin forward-​looking decision making. The development of quantitative analytical techniques raised the question whether 9.02 risk must be defined as a quantity susceptible of measurement. If so, measurable uncertainties (risk) would need to be treated separately from unmeasurable uncertainties (not risk). F H Knight writes in 1921: Uncertainty must be taken in a sense radically distinct from the familiar notions of Risk, from which it has never been properly separated . . . It will appear that a measurable uncertainty, or ‘risk’ proper . . . is so far different from an unmeasurable one that it is not in fact an uncertainty at all.3

That, in essence, equates risk with probability, that is, measurable uncertainty, which is, perhaps, not uncertainty at all. And, indeed, Knight insists that forecasts ‘must be radically distinguished from probability or chance . . . [I]‌t is meaningless and fatally misleading to speak of the probability, in an objective sense, that a judgment is correct.’4 Keynes did not distinguish categorically between measurable and unmeasurable 9.03 uncertainty, but between what can be defined or known, in some mathematical fashion, and what not. In 1937 he wrote: By ‘uncertain’ knowledge . . . I do not mean merely to distinguish what is known for certain for what is only probable. The game of roulette is not subject, in this sense, to uncertainty . . . The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention . . . About these matters, there is no scientific basis on which to form an calculable probability whatsoever. We simply do not know!5

In that mould, Damodaran observes that in the concept of risk, all uncertainty 9.04 matters, whether measurable or not.6 He offers the view of Holton, who notes that two ingredients are needed for risk to exist: uncertainty about potential outcomes from an experiment and relevance of the potential outcomes in terms of providing

2 ibid,  5–​6. 3 F H Knight, Risk, Uncertainty and Profit, Hart, Schaffner & Marx, 1921, 205, as cited by Bernstein, n 1, 219 and A Damodaran, Strategic risk taking—​A Framework for Risk Management, Pearson, 2008, 5. 4 Knight, n 3, 227, as cited by Bernstein, n 1, 221. 5 J M Keynes, ‘The General Theory’, Quarterly Journal of Economics (1937), LI, 209–​33, as cited by Bernstein, n 1, 229. 6 Damodaran, n 3, 5.

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Lodewijk van Setten utility.7 This permits a definition of risk that captures both potential positive and negative outcomes, specified relative to a certain desired or expected objective. 9.05

Risk thus denotes a set of potential outcomes assessed against a specific objective, such as market risk, liquidity risk, or operational risk. This is the prevailing approach to the concept of risk in the financial services industry, that is, the coupling of downside potential (cost or loss) and upside potential (revenue, profitability, or investment return), which recognizes that risk is a component of strategic decision making: the potential for upside, typically, correlates to the potential for downside. Risk, therefore, is part of the spectrum of choices to exploit or not to exploit opportunities for sometimes certain (measurable probability), sometimes uncertain (unmeasurable probability) reward that expose the decision maker to sometimes certain, sometimes uncertain adverse outcomes.8

II.  Risk Management is an Intrinsic Component of the Governance Design of a Firm 9.06

The governance of a firm is commonly understood to refer to the system by which that firm is directed and controlled.9 The ‘system of direction’ means the manner in which executive decisions concerning the business of the firm are taken and implemented, and the ‘system of control’ means the design of the checks and balances in relation to that decision making, and its implementation, that exist to provide assurance that these processes are performing as intended.

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The concepts of risk and risk management, therefore, are intrinsic components of the design of a firm’s governance system. A firm that fails to ensure that decision making and its implementation is controlled in the context of the identification and analysis of potentially adverse conditions, might avoid adverse events for a period of time, but is exposed to a higher probability that it will be meaningfully adversely affected—at some point in the future—than a firm whose governance system does incorporate effective risk-​management framework.10

7 ibid, citing G A Holton, ‘Defining Risk’, Financial Analysts Journal (2004) 60, 6, 19–​25. 8 Damodaran, n 3, 10. 9 A definition used in the Cadbury Report on the Financial Aspects of Corporate Governance (1992), which has stood the test of time. 10 It should be noted that the focus on risk as a component of governance accelerated after the manifestation of the systemic failures in the financial system during 2007 and 2008. Klaus Hopt observes quite pointedly that it ‘is telling that in the Basel Committee’s eight principles of good corporate governance of banks in 2006, the word “risk” does not appear at all, while in its 14 principles of 2010 it appears in nine of the 14 principles—​in fact, in principle 11 it even appears five times’, see Klaus Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, in E Wymeersch, K Hopt, and G Ferrarini (eds), Financial Regulation and Supervision—​A Post Crisis Analysis, Oxford University Press, 2012, 11, 17.

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Risk, Risk Management, and Internal Controls The Walker Review of corporate governance of UK banks in 2009 presents the 9.08 notion that the concept of risk is at the heart of a firm’s governance structure quite clearly (emphasis added): Thus in parallel with, but separately from, compliance and audit the board has responsibilities for the determination of risk tolerance and risk appetite through the cycle and in the context of future strategy and, of critical importance, the oversight of risk in real-​time in the sense of approving and monitoring appropriate limits on exposures and concentrations. This is largely a forward-​looking focus. There is an important concentricity between these functions, above all in assurance from internal audit that the processes in place for the management and control of risk are fully adequate to the overall strategy decided by the board and in assessment of appropriate reserving in respect of potential loss resulting from past decisions.11

The lack of financial firms’ focus on sophisticated, independent, and authoritative 9.09 risk assessment as an ingredient of its governance design in relation to both the funding and the transactional side of the balance sheet was dramatically on display when the market dynamic changed fundamentally in 2007. Improvements of the risk component of the governance of firms followed swiftly. An important tool that is now widely used by financial firms is the risk ap- 9.10 petite framework, ‘RAF’. Although there is significant variation among firms in the development, comprehensiveness, and implementation of RAFs, the common features capture both the strategic and the structured character of risk-​taking:12 • RAFs help drive strategic decisions and right-​size a firm’s risk profile. • RAFs establish an explicit, forward-​looking view of a firm’s desired risk profile in a variety of scenarios and set out a process for achieving that risk profile. • RAFs include a risk appetite statement that establishes boundaries for the desired business focus and articulate the board’s desired approach to a variety of businesses, risk areas, and in some cases, product types. • The more developed RAFs are flexible and responsive to environmental changes; however, risk appetite is definitive and consistent enough to contain strategic drift. • RAFs set expectations for business line strategy reviews and facilitate regular discussions about how to manage unexpected economic or market events in particular geographies or products.

11 Sir David Walker, ‘A review of corporate governance in UK banks and other financial industry entities—​Final recommendations’ (26 November 2009), 6.9. 12 Financial Stability Board (FSB), ‘Thematic Review on Risk Governance—​Peer Review Report’, 12 February 2013, 22.

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In the United Kingdom, the Financial Services Authority (FSA) put risk at the heart of its concept of effective governance in a Consultation Paper that was published in January 2010 following the Walker Review (emphasis added): The effectiveness of governance in a firm is demonstrated by evidence of its practical operation, as well as by the design of governance structures and processes. The level of a Board’s interest in and engagement with the businesses it governs, its strength of understanding and challenge of the risks and issues in play at any time, the visibility and accessibility of its members and the clear evidence of active oversight through the regular scrutiny and challenge of management information and reporting are all contributing factors in what we would consider good governance.13

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Note that the first sentence refers to ‘effective’ governance and the last to ‘good’ governance, as if these concepts equate. However, a governance system that performs effectively is not necessarily the same as good governance. ‘Effective’ is a functional concept. It concerns cause and effect. Does the system deliver what it was designed to deliver? ‘Good’ is a normative concept. It relates to what is considered permitted or desirable in relation to the environment in which the firm operates. Is what the system delivers ‘good’?

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On the given concept of risk as a set of potential outcomes assessed against a specific objective, there is no such thing as ‘bad’ or ‘good’ risk. The identification and measurement of risk is a norm-​neutral effort. Whether a particular risk is ‘good’, that is, permitted or desired, depends on whether the decisions that are made based on (effective) assessment of that risk are considered permitted or desirable. In other words, an effective process of risk identification and measurement may be conducive to effective governance, but it does not necessarily result in ‘good’ decision making. Alas, informed risk-​taking has the capacity not to be sensible. Equally, poor risk identification and measurement does not necessarily lead to bad decision making.

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The UK’s Financial Reporting Council recognizes this bifurcation of sensible risk-​ taking and informed risk-​taking: Good stewardship by the board should not inhibit sensible risk taking that is critical to growth. However, the assessment of risks as part of the normal business planning process should support better decision-​taking, ensure that the board and management respond promptly to risks when they arise, and ensure that shareholders and other stakeholders are well informed about the principal risks and prospects of the company. The board’s responsibility for the organisation’s culture is essential to the way in which risk is considered and addressed within the organisation and with external stakeholders.14

13 FSA, ‘Effective corporate governance (Significant influence controlled functions and the Walker review’) (CP10/​3, January 2010). 14 Financial Reporting Council, ‘Guidance on Risk Management, Internal Control and Related Financial and Business Reporting’ , United Kingdom, September 2014, 1.

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Risk, Risk Management, and Internal Controls Nevertheless, the lack of distinction between functional and normative concepts 9.15 of (risk) governance permeates the discussion of governance in reports and rules of the various governmental and industry bodies. The guidelines of banking regulators in particular tend to mix functional and normative governance requirements, including the risk component, without a clear distinction between the quality of the design and the quality of the objective (the normative aspects are italicized below): • Basel Committee on Banking Supervision (BCBS) (2015): ‘Corporate governance determines the allocation of authority and responsibilities by which the business and affairs of a bank are carried out by its board and senior management, including how they:  set the bank’s strategy and objectives; select and oversee personnel; operate the bank’s business on a day-​to-​day basis; protect the interests of depositors, meet shareholder obligations, and take into account the interests of other recognised stakeholders; align corporate culture, corporate activities and behaviour with the expectation that the bank will operate in a safe and sound manner, with integrity and in compliance with applicable laws and regulations; and establish control functions.’15 • UK’s Prudential Regulatory Authority (PRA) (2016):  ‘[T]‌he PRA expects the boards and management of regulated firms to run the business prudently, consistent with the firm’s own safety and soundness and the continuing stability of the financial system. The desired outcome from a regulatory standpoint is an effective board, which is one that:  establishes a sustainable business model and a clear strategy consistent with that model; articulates and oversees a clear and measurable statement of risk appetite against which major business options are actively assessed; and meets its regulatory obligations, is open with the regulators and sets a culture that supports prudent management. . . . To be effective a board needs to include individuals with a mix of skills and experience that are up to date and cover the major business areas in order to make informed decisions and provide effective oversight of the risks. This also requires robust and well-​targeted management information.’16 It is difficult to disagree with a statement that a bank should be organized so that it 9.16 operates in a ‘sound and prudent’ manner, and ‘with integrity’. Such a prescription is rhetorical in nature and although the broad reference to some (presumably) commonly shared value may provide direction to a management body when it formulates a firm’s risk appetite as part of its strategy, it does not provide much guidance for the design of a governance system. It is not unlike the well-​meant but ultimately

15 BCBS, ‘Guidelines—​Corporate governance principles for banks’, July 2015, 3. 16 PRA, ‘Corporate governance: Board responsibilities’ (Supervisory Statement, SS5/​16, March 2016), 5.

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Lodewijk van Setten uninformative parental admonishment to a child that is about to cross a road: be careful! What does it mean, to be ‘careful’? What does it mean, to act in a ‘sound and prudent’ manner? What does it mean, to act with ‘integrity’? These questions can only be answered in the context of facts and circumstances, and, given the uncertainties, that is, the unmeasurable probabilities, that the management body of any business must face as part of its business model, often only properly so after the fact. The question must be asked whether it is meaningful to regulate risk governance based on an open-​ended norm that only crystallizes ex post. 9.17

More substantive guidance does exist. The European Banking Authority (EBA) does not clutter its guidelines with normative rhetoric. The EBA is focused on design aspects, including risk, without a normative component. Accordingly, the EBA’s Guidelines are placed within the common meaning of the concept of governance as a system of direction and control: Internal governance includes all standards and principles concerned with setting an institution’s objectives, strategies, and risk management framework; how its business is organised; how responsibilities and authority are defined and clearly allocated; how reporting lines are set up and what information they convey and how the internal control framework is organised and implemented, including accounting procedures and remuneration policies. Internal governance also encompasses sound information technology systems, outsourcing arrangements and business continuity management.17

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The EBA continues in a similar, design oriented, approach with a specific description of the risk component of the governance system: The Guidelines aim to establish a strong risk culture in institutions. Risks should be taken within a well-​defined framework for the institutions’ risk strategy and appetite. This includes the setting of a system of limits and controls. Risks within new business areas, but also risks that may result from changes to institutions products, processes and systems are to be duly identified, assessed, managed and monitored. The risk management function should be involved in the setting of the framework and the approval of such changes. . . . To improve the decision-​making and to ensure compliance with the institutions’ strategies and risk limits, institutions should implement a conflict of interest policy and internal whistleblowing procedures.18

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In conclusion, the various reports and guidelines concur, generally, on the functional purpose of the risk component of a firm’s governance framework, that is, to

17 EBA, ‘Final Report—​Guidelines on internal governance under Directive 2013/​36/​EU’ (EBA/​ GL/​2017/​11, 26 September 2017), 7. The Guidelines are issued by EBA based on Article 74(3) of Directive 2013/​36/​EU, in the context of the requirement for regulated institutions to have robust governance arrangements. Regulatory authorities and regulated institutions will have to comply with the Guidelines as of 30 June 2018. 18 ibid, 8.

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Risk, Risk Management, and Internal Controls ensure that the governance framework is designed so that risk assessment underpins the decision-​making and the implementation processes of the firm firmly. In some instances, the regulatory approach includes an open-​ended normative component, thus providing an expectation as to the outcome that the system will produce. It is not clear that this approach is either right or effective, and to the extent that it has a rhetorical character, it could be argued not to meet due process requirements because the scope of a rule can only be known ex post. As governance and risk is about the system by which the management of a firm selects and implements business options, there is a strong argument to suggest that the regulatory focus ought to be on the efficacy of the design, and on ‘[p]‌roactive, nimble and imaginative ex ante supervision’.19 Should a pragmatic parent not provide the child with a set of issues to consider when it needs to cross a road, rather than issue an essentially uninformative instruction to be careful?

III.  Culture and Conduct Inform Risk Management The ubiquitous regulatory reviews that followed the unexpected correlations and 9.20 adverse conditions that caused systemic failure in the global financial system in 2007 and 2008 concluded broadly that ‘culture’ is to be treated as a relevant concept in the regulation of financial institutions, in particular in relation to the governance of risk-​taking.20 Accordingly, most regulators include culture conceptually

19 See N Moloney, ‘Supervision in the Wake of the Financial Crisis’, in Wymeersch, Hopt, and Ferrarini (eds), n 10, 4, 11, observing that ‘careful application of rules to particular situations, may remain the best line of defence’. 20 See, e.g., Group of Thirty (G30), ‘Banking Conduct And Culture—​A Call For Sustained And Comprehensive Reform’, July 2015, 11: Poor cultural foundations and significant cultural failures were major drivers of the recent financial crisis, and continue to be factors in the scandals since then, exacerbated by staff with questionable conduct and values who move from bank to bank with impunity. Unhealthy cultural norms, or subcultures within large banks, including in some cases criminal behavior, have hurt the public, caused reputational damage and loss of public trust, and have been financially costly in terms of fines, litigation, and regulatory action . . . Federal Reserve Bank of New York, ‘Corporate Governance and Banks: What Have We Learned from the Financial Crisis?’ (H Mehran, A  Morrison, and J Shapiro, Staff Report no 502, June 2011), 2: ‘However, the notion of causation is a tricky one: does a given characteristic lead a bank to make risky choices, or does a culture of risk taking lead a bank to have certain characteristics?’ FSB, ‘Guidance on Supervisory Interaction with Financial Institutions on Risk Culture—​A Framework for Assessing Risk Culture’, 7 April 2014, 1: ‘An anticipatory and strategic approach to supervision rests, among other things, on the ability to engage in high-​level sceptical conversations with the board and senior management on the financial institution’s risk appetite framework, and whether the institution’s risk culture supports adherence to the board-​approved risk appetite.’ EBA, n 17: ‘The guidelines are based on an earlier set of guidelines on internal governance and in particular add additional requirements that aim to foster a sound risk culture implemented by the management body, to strengthen the management body’s oversight of the institution’s activities and to strengthen the risk management frameworks of institutions.’

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Lodewijk van Setten in their assessment of the quality of governance arrangements, but usually without defining it with any precision. That need not be surprising, given that ‘culture’ is an elusive concept. 9.21

The Financial Stability Board (FSB) observes in this respect: Culture can be a very complex issue as it involves behaviours and attitudes. But efforts should be made by financial institutions and by supervisors to understand an institution’s culture and how it affects safety and soundness.21

The FSB notes that the regulatory attention to the risk culture of a firm means a focus on ‘norms, attitudes and behaviours related to risk awareness, risk taking and risk management, or the institution’s risk culture’.22 The FSB refers in that context to the definition used in a report of the International Institute of Finance (IIF),23 which defines risk culture as: [T]‌he norms and traditions of behavior of individuals and of groups within an organization that determine the way in which they identify, understand, discuss, and act on the risks the organization confronts and the risks it takes.24 9.22

IIF’s definition aligns with an authoritative definition of the concept of culture that has been given by Edgar Schein:25 The culture of a group can be defined as accumulated shared learning of that group as it is solving problems external adaptation [(strategy)] and internal integration [(process)]; which has worked well enough to be considered valid [to be applied] . . .; this shared learning evolves into a [shared] system of believes, values, behavioural norms . . .

Schein identifies the content of accumulated shared learning as the basic assumptions of a group, the cultural DNA, its legitimacy derived from the previous success of that group,26 and a source of the group’s stability. Culture, in other words, is an experience and value base that provides a set of norms that informs decision making at every level of the organization.27 It gives direction to the use of discretion by decision makers. 21 See FSB, n 20, 1. The FSB, in footnote 6, defers to the definition used in a report of the, which defines risk culture as: ‘the norms and traditions of behavior of individuals and of groups within an organization that determine the way in which they identify, understand, discuss, and act on the risks the organization confronts and the risks it takes’. 22 ibid. 23 ibid, footnote 6. 24 IIF, ‘Reform in the financial services industry:  Strengthening Practices for a More Stable System’, December 2009, 31. 25 Edgar H Schein, Organisational Culture and Leadership, Wiley, 2017, 6. 26 That also means that if the group experiences a fundamentally new situation, e.g. Brexit, new shared experience is built, which will influence culture. 27 See the definition of ‘risk culture’ in BCBS, n 15: ‘A bank’s norms, attitudes and behaviours related to risk awareness, risk-​taking and risk management, and controls that shape decisions on risks. Risk culture influences the decisions of management and employees during the day-​to-​day activities and has an impact on the risks they assume’.

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Risk, Risk Management, and Internal Controls Culture, as a set of value and experienced based norms, may therefore probably be 9.23 best described as a determinant of conduct, that is, the manner in which a person behaves. The Group of Thirty (G30) published a report in 2015 that defines culture in those terms:28 We define culture as the mechanism that delivers the values and behaviors that shape conduct and contribute to creating trust in banks and a positive reputation for banks among key stakeholders, both internal and external.

Values, as an ingredient of culture, shape conduct or, to use an alternative word for the same concept, behaviour.29 The FCA also focuses on culture as the prime determinant of conduct (or behav- 9.24 iour) in a 2016 statement entitled ‘Culture in Banking’: A focus on the culture in financial services firms is a priority for the FCA. Culture drives individual behaviours which in turn affect day-​to-​day practices in firms and their interaction with customers and other market participants. Culture is therefore both a key driver, and potential mitigant, of conduct risk. The experience of the past demonstrates that a poor culture can lead to poor outcomes for consumers and markets. This is widely recognised and there has been a considerable amount of work done across the industry to increase the focus on culture.

The FCA and the PRA thus place culture in the context of ‘conduct risk’, loosely 9.25 defined as behaviour that leads to a poor outcome for the firm, markets, or customers.30 In essence, the regulatory concept of conduct risk adds a prescriptive component to governance by singling a specific set of objectives of a firm’s business and operating models out for separate and distinct risk management that includes shaping culture. Accordingly, in governance design terms, conduct risk management is part of the internal control framework. The UK’s PRA places accountability and responsibility for the (risk) culture firmly 9.26 in the hands of the management body of a firm:31

28 Group of Thirty (G30), ‘Banking Conduct and Culture:  A Call for Sustained and Comprehensive Reform’, July 2015, 17. 29 Although the thrust of the G30’s definition is clear, culture shapes conduct, it is perhaps not clear how the reference to ‘behaviour’ as a force that shapes ‘conduct’ should be understood. ‘Conduct’ and ‘behaviour’ are not separate and distinct concepts. 30 In a statement on its website, last updated 21 April 2014 when accessed in March 2018, the FCA observes in relation to the definition of ‘conduct risk’: ‘Most firms consider defining ‘conduct risk’ an essential first step. Definitions typically refer to client outcomes and some include factors such as sustainability of their business and market integrity. Other elements include the danger of actions or behaviours, or the conduct of business, that may:  • harm clients; • cause the firm reputational damage; • risk undermining the integrity of the financial markets.’ 31 See PRA, n 16, 7.

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Lodewijk van Setten The board should articulate and maintain a culture of risk awareness and ethical behaviour32 for the entire organisation to follow in pursuit of its business goals. The PRA expects the culture to be embedded with the use of appropriate incentives, including but not limited to remuneration, to encourage, and where necessary require, the behaviours the board wishes to see, and for this to be actively overseen by the board. The non-​executives have a key role to play in holding management to account for embedding and maintaining this culture. 9.27

The notion that culture is a matter for direction and control by the governing body is widely accepted and returns in most regulatory reports and guidelines. The PRA has enshrined it into its rule book by requiring firms to appoint senior managers with responsibility for ‘overseeing the adoption of the firm’s culture in the day-​to-​day management of the firm’ and for ‘leading the development of the firm’s culture by the governing body as a whole’.33 The FCA observes in a similar vein in its Consultation Paper on the introduction of the Senior Manager and Certification Regime (SM&CR) for investment management and other non-​bank firms in July 2017: The SM&CR is a key part of our priority of Culture & Governance at firms set out in our 2017/​18 Business Plan. Culture is the product of a number of different drivers within firms and is shaped by many influences that drive the behaviour of everyone in an organisation. The ‘tone from the top’, the effectiveness of management and governance and incentive structures all contribute to the overall culture of a firm.34

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The emphasis on senior management’s responsibility for culture is presumably based on the assumption that culture is formed through learning, and learning can occur through leadership.35 This assumption possibly does not do justice to the complexity of organizational reality. If, as Schein proposes, culture is the result of an evolutionary process that shapes a shared system of believes, values, and behavioural norms over a significant period of time, of which senior management itself is a product, a management team can only seek to manage a given and often complex set of circumstances. Thoughtful governance design can assist leadership with evolving organizational culture by embedding certain values in the organizational structure, in particular in its control framework. That would justify requiring the management body to have a good grasp of the corporate culture and to seek to address perceived defects. It may be less justifiable to hold the management body responsible for the status quo of that culture. 32 In the context of culture as a set of norms that informs or requires a certain behaviour, PRA possibly means ‘ethics’ rather than ‘ethical behaviour’. 33 See PRA Rule Book, ‘Allocation of Responsibilities’, 4.1(6) and (14). 34 FCA, ‘Individual Accountability: Extending the Senior Managers & Certification Regime to all FCA firms’, CP17/​25, July 2017, 2.14. 35 See also Schein, n 25, 14.

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IV.  Risk Management is Part of the Internal Controls of a Firm The governance of a firm is commonly understood to refer to the system by which 9.29 that firm is directed and controlled.36 In that context, the system by which a firm is controlled is referred to as ‘internal controls’. The internal controls may be described, broadly, as the framework of checks and balances that is embedded in the organizational structure that provide reasonable assurance regarding the achievement of the organization’s objectives,37 both in terms of the execution of the business model and in (financial) reporting terms. Not all definitions of corporate governance distinguish consistently between the 9.30 notions of directing and controlling. For instance, the European Commission wrote in a June 2010 Green Paper on corporate governance, that corporate governance ‘determines the structure used to define a company’s objectives, as well as the means of achieving them and of monitoring the results obtained.’38 Subsequently, the Green Paper contradicted its own definition: ‘The Green Paper focuses on this limited definition of corporate governance and does not deal with some other important aspects, such as separation of functions within a financial institution, internal controls and accounting independence.’39 That does not appear to recognize that internal controls are very much part of the system by which a firm achieves and monitors its objectives. The cause for this, presumably unintentional, contradiction may be a misconception of the notion of internal controls. The Green Paper lists ‘internal controls’ as separate and distinct from ‘separation of functions’ and ‘accounting independence’. Nevertheless, as will be addressed below, both the separation of functions and the accounting independence are forms of (hard-​wired) internal controls. The control framework may be divided into three areas: (i) structural (hard-​wired) 9.31 controls; (ii) control activities; and (iii) the control environment. Risk management, that is, the identification, measurement, and potential mitigation of inherent risks, forms part of the internal control framework of a firm, or, more specifically, the control activities. Each of these areas are addressed in turn below. Structural (hard-​wired) controls, concern both organizational controls and system-​ 9.32 based controls. An example of the former is an operating model that is organised

36 See para 9.06 above. 37 See Committee of Sponsoring Organizations of the Treadway Commission (COSO), ‘Internal Control—​Integrated Framework (Executive Summary)’ (PwC, 2013), 3. 38 See European Commission Green Paper, ‘Corporate governance in financial institutions and remuneration policies’ (COM(2010) 284 final, 2 June 2010), 3. 39 ibid, footnote 7.

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Lodewijk van Setten on the basis of the principle of segregation of duties.40 This principle holds that in order to reduce the risk of, in particular, fraud, certain functions, such as trading, settlement, and reporting functions, should not be given into the hands of a single person or department. These are typically referred to as ‘incompatible functions’. When in the hands of a single person, a fraud can theoretically be perpetrated without detection.41 An example of system-​based controls is the coding of a trading system so that the user who wishes to execute a transaction in the market will not be able to do so if the transaction is impermissible or exceeds a certain threshold, each as ‘coded’ into the system. 9.33

Control activities concern people processes based on policies and procedures that contribute to the identification, measurement, and mitigation of inherent risks, that is, risk management. Inherent risk is the natural level of risk of unintended adverse outcome inherent in a business process or activity, not taking mitigating controls into account.

9.34

In the context of financial services firms it is expected that firms organize the control activities along the so-​called three lines of defence:42 (a) The business line—​the first line of defence—​takes and manages the risks that it incurs in conducting its activities. (b) The independent risk management and compliance functions, as a second line of defence are responsible for further identifying, measuring, monitoring, and reporting risks and ensuring compliance with internal and external requirements on an individual and consolidated basis, of all business lines and internal units, independently from the first line of defence. (c) The independent internal audit function as the third line of defence, conducts risk-​based and general audits and reviews that the internal governance arrangements, processes, and mechanisms are sound and effective, and are implemented and applied consistently. The internal audit function is also in charge of the independent review of the first two ‘lines of defence’.

40 See, e.g., Article 9(3) of MiFID II, para 9.45ff below, and Article 88 CRD IV, addressed in para 9.36ff below. 41 For instance, a small department (less than twenty people) in Bernard L Madoff Securities Inc controlled all the functions involved in the purported management of the portfolios of portfolio management clients: the discretionary investment decisions, the execution of those decisions, the confirmations and settlement instructions, the record-​keeping, and the reporting, see Greg N. Gregoriou and François-​Serge Lhabitant, Madoff: A Riot of Red Flags (EDHEC Research Report, May 2009), 6. That permitted the execution of what, by reference to the amount of money involved, was probably the greatest Ponzi scheme ever perpetrated. 42 See EBA, n 17, 8. Each of the three lines of defence, in turn is subject to internal control activities, see (b). To ensure their proper functioning, all internal control functions need to have the highest level of independence of the business they control and have the appropriate financial and human resources to perform their tasks.

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Risk, Risk Management, and Internal Controls The control environment concerns the control culture, that is, the values that deter- 9.35 mine conduct in the context of the system of internal controls, and consequently, the extent to which the organization:43 ( a) demonstrates a commitment to integrity and ethical values; (b) has a governing body that demonstrates independence from management in and exercises oversight of the development and performance of the internal control framework; (c) demonstrates a commitment to attract, develop, and retain competent individuals in alignment with objectives; (d) monitors its activities, that is, selects, develops, and performs ongoing and/​or separate evaluations to ascertain whether the components of internal control are present and functioning; (e) Remediates internal control deficiencies in a timely Manner; (f ) Holds individuals accountable for their internal control responsibilities in the pursuit of objectives.

V.  The Risk Management and Internal Control Provisions of CRD IV Directive 2013/​36/​EU, the ‘Capital Requirements Directive’ (CRD IV),44 does 9.36 not contain articulate sets of definitions of ‘governance’, ‘risk’, ‘risk management’, and ‘internal controls’. Instead, CRD IV prescribes design requirements that cover specific risk categories. CRD IV places risk management in the hands of the management body and, clearly inspired by the deficits observed in 2007 and 2008, that body’s ability to understand and manage the relevant risks.45 Article 74(1) (Internal governance and recovery and resolution plans) of CRD IV, 9.37 which can be found in Section II (Arrangements, processes and mechanisms of institutions), Sub-​Section 1 (General principles), identifies risk management explicitly as a constitutive component of a firm’s governance arrangements (emphasis added): Institutions shall have robust governance arrangements, which include a clear organisational structure with well-​defined, transparent and consistent lines of

43 See COSO, n 37, 3–​5. 44 Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​ 49/​EC. 45 Article 74(1) of CRD IV, discussed in para 9.37.

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Lodewijk van Setten responsibility, effective processes to identify, manage, monitor and report the risks they are or might be exposed to, adequate internal control mechanisms, including sound administration and accounting procedures, and remuneration policies and practices that are consistent with and promote sound and effective risk management.

Sub-​Section 2 (Technical criteria concerning the organisation and treatment of risks), Articles 76 to 87 of CRD IV, provides detailed regulatory expectations concerning risk management, which presumably give meaning to the words ‘robust’ and ‘sound’ as used in the general principles. 9.38

Article 76 (Treatment of risks) appears inspired by the common finding after 2007 that the management bodies’ level of understanding of the various risks financial institutions were exposed to and continued to choose to be exposed to, and their engagement with risk management, was insufficient. Paragraph 1 provides: Member States shall ensure that the management body approves and periodically reviews the strategies and policies for taking up, managing, monitoring and mitigating the risks the institution is or might be exposed to, including those posed by the macroeconomic environment in which it operates in relation to the status of the business cycle.

9.39

Article 76(1) of CRD IV constitutes direction to the management body of a regulated firm to ensure that it organizes the manner in which the firm informs itself about (presumably: all the material) risks involved with its business and the manner in which decision making affects these risks. Paragraph 2 adds to that an instruction to ensure it ‘devotes sufficient time to consideration of risk issues’. Paragraph 3, logically in light of the requirement to spend sufficient time and energy on risk issues, instructs firms that have a certain level of significance or complexity to establish a specialist risk committee composed of members of the management body. Members of the risk committee must ‘have appropriate knowledge, skills and expertise to fully understand and monitor the risk strategy and the risk appetite of the institution’.

9.40

Article 79 (Credit and counterparty risk), Article 80 (Residual risk), Article 81 (Concentration risk), Article 82 (Securitisation risk), Article 83 (Market risk), and Article 85 (Operational risk) prescribe risk-​management design requirements in relation to specified risks in a drafting style similar to Article 76 (Treatment of risks). Of particular interest are Article 86 (Liquidity risk) and Article 87 (Risk of excessive leverage) which address the circumstances that surrounded the bank failures in 2007 and 2008. Liquidity risk is the risk that an institution cannot meet its short-​term liabilities, including but not limited to deposits, due to shortage of liquid funds. Leverage risk is the risk that the debt-​equity profile of a firm’s

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Risk, Risk Management, and Internal Controls funding methodology becomes unsustainable. Both risks materialized in relation to Lehman Brothers. Accordingly, Article 86 (Liquidity risk) provides in paragraphs 1, 4, and 5:

9.41

1. Competent authorities shall ensure that institutions have robust strategies, policies, processes and systems for the identification, measurement, management and monitoring of liquidity risk over an appropriate set of time horizons, including intra-​day, so as to ensure that institutions maintain adequate levels of liquidity buffers. Those strategies, policies, processes and systems shall be tailored to business lines, currencies, branches and legal entities and shall include adequate allocation mechanisms of liquidity costs, benefits and risks.  . . .  4. Competent authorities shall ensure that institutions develop methodologies for the identification, measurement, management and monitoring of funding positions. Those methodologies shall include the current and projected material cash-​flows in and arising from assets, liabilities, off-​balance-​sheet items, including contingent liabilities and the possible impact of reputational risk. 5. Competent authorities shall ensure that institutions distinguish between pledged and unencumbered assets that are available at all times, in particular during emergency situations. They shall also ensure that institutions take into account the legal entity in which assets reside, the country where assets are legally recorded either in a register or in an account and their eligibility and shall monitor how assets can be mobilised in a timely manner. Observe the level of articulate detail in the requirements. Paragraph 1 references 9.42 liquidity risks relative to time horizons (in particular intra-​day, which proved to be the Achilles’ Heel of many institutions in 2008) and the need to assess the risk in the context of the specific circumstances, as well as the requirement to allocate the cost of liquidity, including a cost/​benefit analysis. Paragraphs 4 and 5 drill down to operational levels, and require firms specifically to look at their funding positions and mobility of their liquidity pools. A similar level of detail can be observed in the provisions of Article 87 (Risk of 9.43 excessive leverage): 1. Competent authorities shall ensure that institutions have policies and processes in place for the identification, management and monitoring of the risk of excessive leverage. Indicators for the risk of excessive leverage shall include the leverage ratio determined in accordance with Article 429 of Regulation (EU) No 575/​2013 and mismatches between assets and obligations. 2. Competent authorities shall ensure that institutions address the risk of excessive leverage in a precautionary manner by taking due account of potential

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Lodewijk van Setten increases in the risk of excessive leverage caused by reductions of the institution’s own funds through expected or realised losses, depending on the applicable accounting rules. To that end, institutions shall be able to withstand a range of different stress events with respect to the risk of excessive leverage.

Here, too, experience directs the regulatory response in Article 87(1) to the heart of the mechanics of balance sheet leverage, and in Article 87(2) to specific ex ante risk measurement and reduction. If the category of risk and the manner in which it may be managed is understood, there appears to be no need to resort to rhetorical notions that the leverage must be ‘prudent’ or ‘sound’. 9.44

Sub-​Section 3 (Governance), Articles 88 to 96 of CRD IV, returns to the requirements relating to governance arrangement that are first addressed in Article 74 of Sub-​Section 1.46 Article 88(1) (Governance arrangements) provides: Member States shall ensure that the management body defines, oversees and is accountable for the implementation of the governance arrangements that ensure effective and prudent management of an institution, including the segregation of duties in the organisation and the prevention of conflicts of interest.

Where Article 74(1) identifies risk management and internal controls as constitutive building blocks of a firm’s governance arrangements, Article 88(1) identifies the management body as the party responsible and accountable for the definition, implementation, and management of the governance arrangements, and therefore the risk management and internal controls. 47

VI.  The Risk Management and Internal Control Provisions of MiFID II 9.45

Like CRD IV, Directive 2014/​65/​EU, the ‘Markets in Financial Instruments Directive’ (MiFID II),48 uses the terms governance, risk, risk management, or internal controls without definition. Like CRD IV, MiFID II (at Level 2, through an implementing regulation relating to organizational requirements49) prescribes design requirements that cover specific risk categories, although in much less detail

46 Cited in para 9.37. 47 It is not clear why Article 88(1) singles out two types of internal controls in the context of the obligation of the management body to implement and oversee prudent management: segregation of duties is a form of structural internal control, see para 9.32, and conflicts of interest represent a specific form of conduct risk that a firm needs to manage. The remainder of Article 88(1) only addresses the scope and content of the role of the management body, not any internal controls. 48 Directive 2014/​65/​EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/​92/​EC and Directive 2011/​61/​EU. 49 Commission Delegated Regulation (EU) 2017/​565 of 25 April 2016 supplementing Directive 2014/​65/​EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.

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Risk, Risk Management, and Internal Controls than CRD IV. That recognizes that where CRD IV risk management and internal control provisions are directed at banks and investment firms that deal on own account,50 that is, seek to regulate balance-​sheet-​based business models, MiFID II risk management and internal control provisions seek to regulate agency-​based business models with a much wider scope for variety. MiFID II lacks an organizing provision such as Article 74(1) of CRD IV that lists 9.46 the principles that apply to the design of an investment firm’s governance. Bits and bobs can be found in various places, though. Article 16 of MiFID II contains a rambling, somewhat incoherent list of organizational requirements, including a requirement to maintain ‘internal control mechanisms’ and ‘effective procedures for risk assessment’.51 Article 21(1)(a) of Commission Delegated Regulation (EU) 2017/​565, a MiFID II Level 2 implementing regulation,52 imposes organizational governance requirements on investment firms that echo those of Article 74(1) of CRD IV, and Article 21(1)(c) provides that ‘internal controls’ must be ‘designed to secure compliance with decisions and procedures at all levels of the investment firm’, which is in line with the common understanding of the function and scope of internal controls. Article 23(1) implements Article 16(5) of MiFID II (Level 1) and prescribes that a firm must establish and maintain risk-​management policies and procedures that aim to identify business and operational risks, set risk appetite, and manage and monitor risk accordingly. Article 23(2) insists on an independent risk function if proportionate in view of the size and complexity of a firm. Like CRD IV, MiFID II places responsibility and accountability for govern- 9.47 ance, including risk management and (other) internal controls, in the hands of the management body. Article 9(1) (Management body) of MiFID II imports Articles 88 (Governance arrangements) and 91 (Management body) of CRD IV. Notwithstanding, Article 9(3) MiFID II repeats the provision of Article 88 CRD IV verbatim, with one very meaningful addition (emphasis added): Member States shall ensure that the management body of an investment firm defines, oversees and is accountable for the implementation of the governance arrangements that ensure effective and prudent management of the investment firm including the segregation of duties in the investment firm and the prevention of conflicts of interest, and in a manner that promotes the integrity of the market and the interest of clients.

50 See Article 1(a) of CRD IV, in conjunction with Article 4(1)(2) of Regulation (EU) No 575/​ 2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/​2012 (CRR). 51 See Article 16(5) of MiFID II, which, curiously, groups the requirement among requirements concerning material outsourcing. 52 Commission Delegated Regulation (EU) 2017/​565, n 49.

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Lodewijk van Setten 9.48

Although the integrity of the market and the interests of clients are unquestionably deserving of protection, it is odd to see that requirement introduced as a normative objective of the governance arrangements.53 That is tantamount to regulatory direction of the objective or purpose of the regulated firm, which is not in scope of the regulatory mandate. It is also superfluous. A firm must be directed and controlled ‘in a manner that promotes’ compliance with applicable laws and regulations.54 Those obligations include obligations under Regulation (EU) No 596/​2014, the ‘Market Abuse Regulation’,55 which deals with market integrity. They also include conduct of business obligations that are directed at the protection of customer interests.

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CRD IV and MiFID II appear to take different approaches to the concept of ‘internal controls’. Where Article 74(1) of CRD IV,56 in line with the common understanding of the concept of internal controls, refers to ‘internal control mechanisms’ as ‘including sound administration and accounting procedures’, Article 16(5) (Organisational requirements) of MiFID II separately lists ‘sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, and effective control and safeguard arrangements for information processing systems’.

9.50

MiFID II, through Article 23(1) (Risk management) of Commission Delegated Regulation (EU) 2017/​565, places risk management more generically in the context of risk identification, risk tolerance, and monitoring, which is in line with the common approach to risk as a component of a firm’s governance arrangements. In particular, a firm authorized and regulated under MiFID II is required to ‘identify the risks relating to the firm’s activities, processes and systems, and where appropriate, set the level of risk tolerated by the firm’. MiFID II therefore places risk management firmly in the context of a risk appetite framework. Those investment firms who qualify, will also be subject to the prudential supervision under CRD IV and therefore, the specific risk governance arrangements of CRD IV.

53 See also para 9.15 above. 54 See, e.g., Article 16(2) (Organisational requirements) MiFID II: 2: ‘An investment firm shall establish adequate policies and procedures sufficient to ensure compliance of the firm . . . with its obligations under this Directive . . .’. 55 Regulation (EU) No 596/​2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/​ 6/​EC of the European Parliament and of the Council and Commission Directives 2003/​124/​EC, 2003/​125/​EC and 2004/​72/​EC. 56 Cited in para 9.37.

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Risk, Risk Management, and Internal Controls

VII.  Risk Management and Internal Controls in the UCITS Directive and AIFMD The UCITS Directive57 and the Alternative Investment Fund Manager Directive 9.51 (AIFMD)58 regulate the management of, and raising of capital for, collective investment schemes. The UCITS Directive regulates the raising of capital from the public by undertakings for collective investment in transferable securities (UCITS).59 AIFMD regulates operators of alternative investment funds (AIF), that is, not the AIFs itself.60 An AIF is an undertaking for collective investment that is not required to be authorized as a UCITS.61 The portfolios held by UCITS and AIFs belong to the collective investors. UCITS 9.52 and AIFs pass all benefits, losses, and costs of the collective portfolios to the investors. Risks associated with the investment of a collective portfolio, therefore, are risks of the collective investors in the UCITS or AIF, and not risks of the UCITS or AIF itself. Nor are these risks of any of the regulated firms that act for the UCITS or AIF, that is, the authorized fund manager, the investment manager, or the custodian. The UCITS Directive and the AIFMD, therefore, bifurcate between risks to the clients of the authorized firms who invest in the UCITS and AIFs operated and distributed by these firm, and risks to the authorized firms themselves. The risk governance provisions of CRD IV and MiFID II focus on risks to the authorized firms themselves. The risk governance provisions of the UCITS Directive and AIFMD are also directed at the risks to the collective investors. The Level 2 implementation rules made pursuant to both the UCITS Directive and 9.53 AIFMD contain requirements aimed at the management of the regulated firms’ risks. These requirements concern the management structure and internal controls of fund management firms authorized under the UCITS Directive or AIFMD that are nearly identical to the requirements applicable to investment firms authorized under MiFID II.62 57 Directive 2009/​65/​EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (recast). 58 Directive 2011/​61/​EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/​41/​EC and 2009/​65/​EC and Regulations (EC) No 1060/​2009 and (EU) No 1095/​2010. 59 Article 1(2) of UCITS Directive. 60 Article 1 of AIFMD. 61 Article 4(1)(a) of AIFMD. 62 See respectively, Article 4 (General requirements on procedures and organization) of Commission Directive 2010/​43/​EU of 1 July 2010 implementing Directive 2009/​65/​EC [UCITS] as regards organizational requirements, conflicts of interest, conduct of business, risk management, and content of the agreement between a depositary and a management company (‘UCITS ImpD’), and Article 57 (General requirements) of Commission Delegated Regulation (EU) No 231/​2013

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Lodewijk van Setten 9.54

Article 51 of the UCITS Directive and Article 15 AIFMD are directed at the risks to the collective investors and require that the authorized UCITS and AIF management firms must employ risk-​management systems and controls that aim to identify, measure, and monitor all risks to which the investment portfolios and the UCITS or AIF are exposed to.63 The authorized fund manager of a UCITS or of an AIF needs to design a risk-​management policy that includes ‘such procedures as are necessary to enable the [authorized fund manager] to assess for each [UCITS/​ AIF] it manages the exposure of that [UCITS/​AIF] to market, liquidity and counterparty risks, and the exposure of the [UCITS/​AIF] to all other [relevant] risks, including operational risks, which may be material for each [UCITS/​AIF] it manages’.64 Accordingly, it has been left to the authorized fund manager to determine which risks are relevant to the UCITS or AIF it is managing. That is sensible, as the risk will vary significantly depending on the nature and character of the investment strategy of the UCITS or AIF.

9.55

Both the UCITS Directive and the AIFMD specifically single liquidity risk out for separate regulation.65 Liquidity risk is defined in the context of the UCITS or AIFs ability to meet redemption and other payment obligations. The authorized fund manager needs to ensure that the portfolio of the UCITS or AIF can raise enough funds within the required timeframe to meet those obligations.

VIII.  Specific Risk-​Management Controls: Remuneration Policies 9.56

Commission Recommendation 2009/​384/​EC on remuneration policies in the financial services sector recommended that ‘Member States should ensure that financial undertakings establish, implement and maintain a remuneration policy which is consistent with and promotes sound and effective risk management and which does not induce excessive risk-​taking’.

9.57

Article 74(1) of CRD IV implements the Commission’s Recommendation by requiring that firms subject to CRD IV must establish ‘remuneration policies and

of 19 December 2012 supplementing Directive 2011/​61/​EU [AIFMD] with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision (‘AIFMD SupR’). The MiFID II governance structure requirements are discussed in para 9.49 above. 63 Articles 38–​43 UCITS ImpD and Articles 38–​45 AIFMD SupR provide detailed rules around the design and maintenance of UCITS and AIF risk-​management policies. 64 See the near identical provisions in Article 38(1) of UCITS ImpD and Article 40(2) of AIFMD SupR. 65 Article 40(3) and (4)  of UCITS ImpD, and Article 16 of AIFMD and Articles 46–​49 AIFMD SupR.

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Risk, Risk Management, and Internal Controls practices that are consistent with and promote sound and effective risk management’.66 Articles 92 to 97 of CRD IV place responsibility for remuneration policies in the hands of the management body, and where size and complexity of the firm requires it, a remuneration committee, and are prescriptive as to the structure of remuneration for ‘senior management, risk takers, staff engaged in control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on their risk profile’.67 The remuneration provisions of CRD IV are aimed at the management of balance 9.58 sheet risk-​taking. MiFID II, on the other hand, is aimed at the management of conduct risk. Article 9(3)(c) of MiFID II requires the management body to implement remuneration policies that apply to ‘persons involved in the provision of services to clients’ and which aim ‘to encourage responsible business conduct, fair treatment of clients as well as avoiding conflict of interest in the relationships with clients’.68 Articles 14a and 14b of the UCITS Directive implement the Commission 9.59 Recommendation for financial undertakings that are authorized under the UCITS Directive and have operating responsibilities for a UCITS, that is, an authorized fund manager if the UCITS is established as a common fund69 or if the UCITS is established as an investment company and has designated a ‘management company’.70 The remuneration policy must apply to the same staff as identified by Article 92(2) of CRD IV, plus ‘risk takers whose professional activities have a material impact on the risk profile of the management companies or the UCITS they manage’.71 AIFMD established nearly similar rules.72 The UCITS Directive, nor the AIFMD, nor the ESMA Guidelines73 clarify the 9.60 meaning of ‘risk profile’ of the UCITS or AIF or how it is ‘materially impacted’. Some interpretative guidance may be derived from Articles 14a(1) and 14b(1),

66 Articles 74(3) and 75(2) of CRD IV instruct the EBA to issue further guidelines on remuneration policies, see EBA, ‘Guidelines on sound remuneration policies under Articles 74(3) and 75(2) of Directive 2013/​36/​EU and disclosures under Article 450 of Regulation (EU) No 575/​2013’ (EBA/​GL/​2015/​22, 27/​06/​2016). 67 See Article 92(2) of CRD IV. 68 Article 16 of Commission Delegated Regulation (EU) 2017/​565, n49, implements further detailed requirements. 69 A common fund is a collective investment scheme authorized as a UCITS and established in contractual form or as a unit trust, see Article 1(3) of UCITS Directive. 70 Article 14a(4) of UCITS Directive instructs ESMA to issue further guidelines on the establishment and application of UCITS remuneration policies; see ‘ESMA Guidelines on sound remuneration policies under the UCITS Directive’ (ESMA/​2016/​575, 14 October 2016). 71 Article 14a(3) of UCITS Directive. 72 Article 13 and Annex II of AIFMD. 73 n 70.

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Lodewijk van Setten which both place the remuneration policy in the context of risk management with a view to discouraging ‘risk-​taking that is inconsistent with the risk profile of the UCITS’.74 In a risk-​management context, the common meaning of ‘risk profile’ concerns the risk appetite and risk controls of a business. In an investment context, that would refer to market and counterparty risks that an investor is willing to accept, and the potential controls around that, as commonly set out in the chosen investment policy that applies to the investment of a certain portfolio of assets. The risk appetite, the investment policy, and investment strategy, will be determined at the level of the UCITS by its board and the authorized fund manager, if any. 9.61

The determination of the investment policy, however important, is not the only form of risk-​taking that impacts the risk profile of the UCITS or AIF. Recital (2) of Directive 2014/​91/​EC on remuneration policies for UCITS funds75 considers ‘fund managers and persons who take real investment decisions’ to be ‘staff whose professional activities have a material impact on the risk profile of the UCITS’. The wording in Recital (2) suggests that risk profiles are not merely the boundaries set around the risk that the UCITS is willing to take, the risk appetite, but includes the risks that are actually taken within those boundaries. A portfolio manager of an actively invested portfolio by implication has room to move the risk dial up or down depending on the market outlook. Inversely, it would be reasonable to conclude that the activities of an investment team that has no meaningful discretion, that is, it executes a passive or formulaic investment strategy, do not have a material impact on the risk profile of the UCITS or AIF.

IX.  Concluding Remarks 9.62

The reviews that followed the systemic market failures in 2007 and 2008 commonly point at weaknesses in governance frameworks and risk-​management arrangements as a result of which certain, but not all, financial institutions failed to temper the market, credit, and liquidity risks they were able to take because of the buoyant macro-​economic conditions, that is, low interest rates, booming housing and securities markets, and high levels of market liquidity.76 In response, CRD IV, MiFID II, the UCITS Directive, and the AIFMD were updated to specifically

74 Similarly Article 13(1) and para 1(a) of Annex II of the AIFMD. 75 Directive 2014/​91/​EC amends the UCITS Directive by inserting Articles 14a and 14b. 76 See Simon Ashby, Linda Peters, and James Devlin, ‘When an Irresistible Force Meets an Immovable Object: The Interplay of Agency and Structure in the UK Financial Crisis’, Journal of Business Research (2014) 67, 2671–​83.

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Risk, Risk Management, and Internal Controls address the need for risk management. As observed, the approach is not necessarily consistent, suffers in places from rhetoric, and could certainly benefit from a clearer policy and definitional context. But on the whole, important strides have been made to put risk strategy and risk management, as an internal control, at the core of a regulated firm’s governance system and its supervision.

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10 FINANCIAL MARKET INFRASTRUCTURES The Essential Role of Risk Management Paolo Saguato*

I. Introduction II. FMIs and the Business of Managing Risk III. The Public Regulation of Risk Management: EMIR and CSDR and their Implementing Regulations A. The international context B. EMIR and the regulation of risk managements: CCPs and TRs

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C. An overview of the regulation of risk management in CSDs

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IV. The Challenges of Regulating Risk Management

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A. Regulatory capture of policymakers B. The costs of regulating risk management: distortion of economic incentives and moral hazards

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V. Conclusion

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I. Introduction 10.01

In the last ten years the financial system has undergone radical transformations. Innovation and the 2008 financial crisis challenged the foundations of modern finance and forced policymakers to re-​evaluate the existing approaches to the regulation of financial markets.

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How to effectively manage risk in the financial system became central to both domestic and international political agendas.1 The necessity of building resilient and efficient financial markets drove regulators to articulate policy

* Assistant Professor of Law, Antonin Scalia Law School, George Mason University, p.saguato@ gmail.com. I thank Jens-​Hinrich Binder and Lodewijk van Setten for their very helpful comments. 1 Christopher Hood et al, The Government of Risk, Understanding Risk Regulation Regimes, Oxford University Press, 2001.

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Financial Market Infrastructures recommendations that set risk-​management standards for the governance of financial firms 2 and require the use in different market segments of specialized ‘risk managers’—​so-​called financial market infrastructures.3 A perfect example of regulatory interest in risk management was the reform of the 10.03 over-​the-​counter (OTC) derivatives markets. The derivatives markets, considered to be one of the causes or accelerators of the financial crisis, experienced a profound makeover.4 A vivid policy discussion scrutinized the incentives of market participants to effectively internalize the costs and externalities of their businesses. Criticism built up around the ineffectiveness and incapacity of financial institutions to privately manage the risks of their activities. Commentators pointed to the moral hazard present in financial institutions’ and qualified firms’ actions—​ during the financial crisis and in its run-​up—​as rational calculations to externalize the costs of their activities onto the system. Policymakers identified critical structural vulnerabilities and failures in the OTC 10.04 derivatives markets. The opacity of the markets weakened market participants’ capacity to effectively assess the risks of dealing in derivatives and public authorities’ capacity to effectively supervise and promptly intervene when the financial crisis erupted.5 During the crisis, the interconnectedness among derivatives dealers combined with the lack of any sort of system-wide financial buffer to absorb the potential systemic shocks or counterparties’ failures made the derivatives markets prone to sudden runs and instability. Finally, policymakers censured the dealers’ internal procedures to monitor and manage the risks of their derivatives businesses and questioned the efficacy of the risk-mitigation provisions in derivatives contractual boilerplates.6 Sceptical about the effectiveness of a pure industry-driven self-regulatory approach 10.05 in establishing resilient and robust risk management tools and infrastructures, and

2 Geoffrey P Miller, The Law of Governance, Risk Management, and Compliance, 2nd ed, Wolters Kluwer, 2017, 709–​84 (defining risk management as ‘any activity that an organization undertakes to deal with futures uncertainties’); Iris H-​Y Chiu, Regulating (from) the Inside—​The Legal Framework for Internal Control in Banks and Financial Institutions, Oxford University Press, 2015. 3 Peter Norman, The Risk Controllers, Central Counterparty Clearing in Globalized Financial Markets, Wiley, 2011. 4 David Murphy, OTC Derivatives:  Bilateral Trading & Central Clearing, Palgrave MacMillan, 2013. 5 For a discussion of the regulatory failures in the pre-​crisis derivatives markets, see Paolo Saguato, ‘The Ownership of Clearinghouses: When “Skin in the Game” is Not Enough: The Remutualization of Clearinghouses’ Yale Journal on Regulation (2017), 34, 601, 623–​30; Lynn Stout, ‘Derivatives and the Legal Origin of the 2008 Credit Crisis’, Harvard Business Law Review (2011), 1, 1. 6 Embedded in derivatives master agreements were procyclical features which exacerbated the herd behaviours in market participants—i.e. margin call triggers, default, close-out, and set-off provisions—. Over-reliance on external rating in setting the risk profile of products and the creditworthiness of contractual counterparties weakened firms’ internal risk-assessment capacity. And

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Paolo Saguato under substantial political pressure to police the excessive risk taking in the financial system, policymakers opted to directly intervene in financial markets’ risk management. Risk management, broadly, was the central pillar of post-financial crisis derivatives reform,7 which targeted three segments: systemic risk management,8 organizational risk management, and transactional risk management. 10.06

First, systemic risk management acts as a macro-prudential tool. Policymakers required and designated financial market infrastructures (FMIs) to intervene as market-wide risk managers;9 and vested FMIs with a public policy function: to reduce and contain systemic risk in the financial system. Lawmakers also mandated that standardized derivatives be processed by FMIs. Central clearing counterparties (CCPs) or clearinghouses10 were empowered to centralize, manage, and eventually mutualize the risks of dealing in derivatives; and trade repositories (TRs) were endowed with a transparency role.

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Second, organizational risk management operates at a micro-​prudential level. Having channelled derivatives (and their risks) into FMIs, lawmakers set new rules and requirements to reduce conflicts of interest and agency costs within FMIs. Corporate governance rules, risk management mechanisms, internal audit, and compliance systems are the legal devices most widely adopted.

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Third, transactional risk management presents both micro-​and macro-​prudential features. This last ensemble of provisions includes hybrid risk-​management tools that use financial resources to absorb counterparty credit risk and avoid the risk of

finally, in many instances, collateral type requirements and investment strategies of derivatives firms were positively correlated causing, as in the AIG case, massive losses and eventually a public bailout; Richard Squire, ‘Shareholder Opportunism in a World of Risky Debt’, Harvard Law Review (2010), 123, 1151, 1153. 7 The FSB and the G20 statements on the post-​crisis reforms of the OTC derivatives markets describe the new regulatory architecture of this critical segments of the financial system as built on three pillars: (i) mandatory central clearing for standardized OTC derivatives (and complementary new mandatory regimes for non-​centrally cleared transactions); (ii) mandatory trading of eligible derivatives on specialized platforms; (iii) mandatory reporting of all derivatives (OTC and traded derivatives); FSB, ‘Improving Financial Stability, Report of the Financial Stability Board to the G20 Leaders’ (2009). 8 Steven Schwarcz, ‘Systemic Risk’, Georgetown Law Journal (2008) 193, 198. 9 The definition of FMIs this chapter embraces includes solely post-​trading market infrastructures. In previous work, the author has expanded the definition of FMIs to embrace also trading facilities; see Guido Ferrarini and Paolo Saguato, ‘Regulating Financial Market Infrastructures’, in Niamh Moloney et  al (eds), The Handbook of Financial Regulation, Oxford University Press, 2015, 568 (discussing the impact of the post-​Crisis reforms on the FMIs landscape and on market structures). 10 Technically, clearinghouse is a broad term that refers to a firm that performs confirmation, reconciliation, and assistance in the handling of a financial transaction (i.e. margin management, assessment of open positions, etc). A clearinghouse can either operate as an agent of the original parties of a contract or as a principal. By novating the original transaction and substituting itself to the original counterparties, a clearinghouse acts as a principal and becomes a central clearing

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Financial Market Infrastructures spillovers (and contagion). Transactional risk management intervenes in the structure of the FMI’s capital and financial defences, support firms’ resilience, and assures systemic reliability and stability. International and domestic regulators intervened in all three segments of risk man- 10.09 agement. The Financial Stability Board (FSB) designed the systemic architecture of risk managers for the derivatives markets and the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) 11 set guidelines and principles for the governance and business of FMIs.12 On the domestic level,13 the European Market Infrastructures Regulation (EMIR)14 and its secondary regulations and technical standards built a new rule apparatus for FMIs and for derivatives markets’ participants.15 This chapter explores post-​financial crisis policies and their impact on risk manage- 10.10 ment in FMIs; systematically assesses practices, mechanisms, and structures adopted to manage financial risks; and considers the implications of regulating risk management. This chapter is structured in four sections. Section I investigates the economics and 10.11 business of FMIs. Section II analyses the regulatory architecture for FMIs and risk

counterparty (CCP). When acting as a CCP, the clearinghouse assumes the counterparty risk of the original parties and becomes the buyer to the original seller and the seller to the original buyer. In this chapter, CCP and clearinghouse are used interchangeably. 11 The CPMI operates within the boundaries of the Bank of International Settlement (BIS) and promotes the efficiency and safety of the post-​trading markets (i.e. payment, clearing, and settlement); see https://​www.bis.org/​cpmi/​index.htm, accessed 20 October 2018. 12 Committee on Payment and Settlement Systems (CPSS) [now CPMI]-​IOSCO, Principles of Financial Market Infrastructures, 16 April 2012 (hereafter PFMI) (https://​www.bis.org/​cpmi/​publ/​ d101.htm, accessed October 20, 2018) (providing rageneral and principles based recommendations for the safety and efficiency of FMIs); CPMI-​IOSCO, Final Report —​Resilience of central counterparties (CCPs):  Further guidance on the PFMI, 5 July 2017 (https://​www.bis.org/​cpmi/​publ/​ d163.pdf, accessed 20 October 2018) (setting granular rules on the internal organization of central counterparties). 13 In the United States, the Dodd-​Frank Act and the secondary regulations implemented by the Federal Reserve, the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC) provide the FMI industry with a new set of rules to deal with counterparty and operational risk. See Dodd-​Frank Wall Street Reform and Consumer Protection Act, PL No 111–​203, (2010) (to be codified in many dispersed sections of the US Code). Title VII of Dodd-​ Frank is the equivalent of EMIR. However, it is interesting to note that US lawmakers dedicated a complete Title of Dodd-​Frank—​Title VIII—​to the systematic regulation of ‘systemically important financial market utilities’, providing an organic analysis and regulation of FMIs. EU lawmakers, on the other hand, adopted a piecemeal approach, setting up specific regimes and regulation for each individual FMI. See Paolo Saguato, ‘The Political Economy of Regulating Market Infrastructures’ (2018) https://​ssrn.com/​abstract=3269060 accessed 20 October 2018 (investigating the economic and political rationales for Title VIII of Dodd-​Frank). 14 European Parliament and the Council Regulation (EU) 648/​2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories [2012] OJ L201/​1 (hereafter EMIR). 15 The EU approach to the regulation of FMIs is fragmented. EMIR is the main source of regulation for FMIs, but important provisions are also included in MiFID II, MiFIR, CSDR, and a new proposed regulation on the recovery and resolution of CCPs is still on the EU Parliament’s floor.

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Paolo Saguato management implemented by EU policymakers and how they fit within the international policy framework. Section III looks at the political economy of regulating risk management and offers some critical reflections on such regulation. Finally, Section IV provides some brief conclusions.

II.  FMIs and the Business of Managing Risk 10.12

FMIs are multilateral (centralized) systems (networks) that provide clearing, settlement, and depository services for securities and derivatives markets.16 Historically, FMIs have supported the development of securities and futures markets as transactional efficiency and financial stability providers. Clearinghouses, securities depositories, trade repositories, and payment systems are the FMIs that operate in modern financial markets.17

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Once a trade is executed on a trading venue (or, in some instances, bilaterally between parties), a FMI steps in. Generally, a clearinghouse confirms the terms of the transaction, assists and handles its execution, and builds different layers of risk-​management mechanisms into the transaction. Then, a securities depository or trade repository records it. Post-​trading FMIs have a mixed nature. On one side, they contribute to the efficiency of financial markets by ‘providing network services[,]‌facilitating connections among market participants [,and enhancing transparency]’.18 On the other, they also serve a systemic and public interest function by operating as risk managers, legal and operational certainty mechanisms, and data warehouses. Clearinghouses, trade repositories, and central securities depositories (CSDs) aim and deal with different aspects of systemic risk.

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CCPs, interposed between two counterparties and acting as the ‘buyer to every seller and the seller to every buyer’, mitigate and manage counterparties’ credit risk by netting offsetting positions and creating loss-​absorbing financial buffers. TRs are data warehouses, they collect, maintain, and process data on derivatives markets and disclose them to regulators, and, in aggregated format, to market participants. 16 In the derivatives markets, the role of CCPs’ risk management is particularly critical because of the structure and maturity of a derivative contract. While security transactions are ‘spot contracts’, derivatives have generally a variable maturity, which means that parties to a derivative contract have open positions that might change over the lifespan of the contract. Furthermore, claims arising from a derivative position are contingent on the occurrence of different events. Obligations to pledge additional collateral (i.e. margin calls) are triggered, for instance, by a change in the creditworthiness (i.e. increase in counterparty risk) of the contractual party, or by the fluctuation in value of the underlying asset of the derivative or of the asset originally pledged as collateral (i.e. initial margin). See Robert Bliss and Robert Steigerwald, ‘Derivative Clearing and Settlement: A Comparison of Central Counterparties and Alternative Structures’, Economic Perspective (2008), 30, 22. 17 Payment systems are included in the CPMI-​IOSCO definition of FMIs, however the analysis of the risk-​management regime in payment systems is outside the scope of this chapter. 18 Ferrarini and Saguato, n 9, 582–​3.

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Financial Market Infrastructures Finally, CSDs traditionally operate in the securities markets and support the settlement of cash transactions, managing the transfer of the securities from buyers to sellers, and, in the derivatives and repurchase agreement markets, assisting with the management of securities collaterals.19 FMIs are critical nodes in the functioning of financial markets and historically 10.15 have developed as industry-​driven organizations to deal with transaction costs and counterparty risk.20 FMIs were borne out of necessity. Financial institutions needed to: (i) simplify and strengthen their mutual relationships; (ii) mitigate their reciprocal exposures via multilateral netting;21 (iii) provide a mechanism to enhance contract performance; (iv) orderly manage open positions and manage pledged collateral; and (v) (eventually) mutualize the costs of a counterparty’s default.22 FMIs were originally private ordering mechanisms built as ‘contractual institutional 10.16 arrangements’ between groups of market participants.23 Either organized as member-​ owned enterprises or operated as government-​owned public monopolies, FMIs traditionally provided their services as not-​for-​profit (at costs) utilities. When structured as mutual firms, FMIs were either directly owned and governed by their members and users or were subsidiaries or business units of a mutual exchange, and thus still indirectly controlled by the exchange members. Members were (and still are) the financial institutions that require and access the FMIs’ services.24 When FMIs were organized as member-​owned firms, their economic interest and risk profile aligned 19 From a practical perspective, CSDs hold (dematerialized) securities and convert them into ‘book-​entry securities’, thus simplifying the transfer of them into simple electronic bookkeeping records. 20 From an economic perspective, the creation of FMIs as firms is a neat exemplification of the Coasian transaction costs economics nature of the firm. The high transaction costs of monitoring the creditworthiness of contractual counterparties, the costs of managing counterparty default risk, and the lack of effective mechanisms to efficiently minimize them through the markets, created the economic incentives for securities and derivatives markets participants to organize their (trading and) post trading services within firms. See Ronal H Coase, ‘The Nature of the Firm’, Economica (1937), 4, 386. 21 Netting is the process of consolidating offsetting positions. Paolo Saguato, ‘The Law and Economics of Netting’ (2018) https://​ssrn.com/​abstract=3269062, accessed 20 October 2018 (analysing the legal and economic effects of netting). 22 From a transactional perspective, clearinghouses also perform a critical function in reducing transaction costs by increasing transparency in market contracting (CCPs disclose to their members aggregated information about their open positions, the financial lines of defences to deal with a default situation, and collateral requirements) and reducing monitoring costs for clearing counterparties. 23 Randall Kroszner, ‘Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-​the-​counter Innovations’, Journal of Money, Credit, and Banking (1999), 31, 569. 24 A complementary model to the pure private structure of FMIs was the public model embraced by the majority of continental European markets, where FMIs were formal public monopolistic infrastructures either run as independent public agencies or controlled by another public entity—​in some instances the national central bank, the ministry of finance, etc. Nevertheless, members had a primer role in the running of the commercial and risk management businesses of the firm.

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Paolo Saguato with the collective interest of their members.25 Members participated in the control and governance of FMIs and, at the same time, they had full ‘skin-in-the-game’ so they were interested and invested in having an effective business that was risksound. Risk management was a pure private activity: the FMI—and its members indirectly—determined the risk profile and calibrated the adequate risk management resources and procedures to internalize and mitigate the business’s costs and risks . Membership requirements; the admission of new members; the amount of pre-funded financial resources to absorb members’ defaults; the amount, quality, and frequency of margin contributions; and the representation of different stakeholders in the governance of the firm were only some of the risk-management tools traditionally used by CCPs to deal with the risks of clearing financial transactions.26 10.17

However, the premises underlying private regulation and mutual organization of FMIs changed in the late 1990s when the first FMIs reorganized their corporate structure as for-​profit corporations. The increasing heterogeneity of the exchanges’ membership—​the direct controllers of the CCPs—​made the governance of these firms too costly. In addition, the need to raise fresh resources to compete with foreign FMIs and to keep up with the radical transformations fostered by technological innovation in the trading environment called for new funding sources.27 All these factors triggered a demutualization wave in the FMIs’ ownership structure. All major FMI groups opened up their equity capital to market investors and listed their shares on public markets.28 Cross-​border consolidation of FMIs followed and few champions emerged as winners in this market makeover. Copious literature has covered the demutualization of exchanges and the effects it had on trading markets’ structures and practices.29 However, the indirect effects of the demutualization of exchanges onto other FMI firms were almost completely overlooked.

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Post-trading FMIs and their activities also developed in a substantially unregulated environment, until the crisis-driven financial reforms of the 2010s. The mutual structure of FMIs, with strong member involvement in the governance of the firms (which encouraged a low risk-taking profile of the FMIs) in tandem with a

25 Saguato, n 5, 623–​35 (critically analysing the evolution in ownership structure of CCPs). 26 Generally speaking, the CCP operated as a private regulator, standard setter, and supervisor and administrator of its operated markets. 27 Even more so, because a large majority of FMIs’ members reconsidered the value of their equity investment in FMIs, they were reluctant to inject new resources in the capital of FMIs, and actually saw profitable opportunities in liquidating their ownership stake and reinvested the proceeds in more profitable ventures. 28 See Guido Ferrarini and Paolo Saguato, ‘Governance and Organization of Trading Venues: The Role of Financial Market Infrastructure Groups’, in Danny Busch and Guido Ferrarini (eds), Regulation of the EU Financial Markets, MiFID II and MiFIR, Oxford University Press, 2017, 285 (identifying in the group structure of FMI a critical issue of the development and regulation of the FMIs). 29 Saguato, n 5, 637–​42 (providing an analysis of the demutualization of FMI groups).

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Financial Market Infrastructures successful historical record of effective risk management, resulted in a soft policy touch with regards to the governance of FMIs’ risk management . However, this ‘back-seat’ approach experienced its first revisions with the regulatory responses to the capital markets frauds and scandals of the early 2000s. While not targetting FMIs per se, this first wave of risk management and compliance regulation covered all public corporations, including the holding companies of those FMIs that had demutualized their capital strcutures. Board composition, independent directors, audit committees, and compliance programs were the focus of this early intervention in risk management. The second wave—or tsunami—for risk management followed the crisis. Policymakers 10.19 intervened in the structure of derivatives markets mandating the use of FMIs as risk managers and systemic risk buffers; set stringent rules on the internal corporate governance of FMIs; and, finally, directly impacted the FMIs’ risk management business. The next section looks at the regulatory approach to FMIs: FMIs as risk managers and risk management in FMIs. This chapter mainly focuses on CCPs because of their unique and central role as ‘risk managers’ in the post-crisis financial market (CCPs are also the FMIs that actually carry and potential pose a systemic risk to financial markets),30 however, it will offer an overview of the regime for TRs and CSDs.31

III.  The Public Regulation of Risk Management: EMIR and CSDR and their Implementing Regulations A. The international context The international policy discourse that followed the financial crisis was built on the 10.20 assumption that transparency, resilience, and efficiency had to be re-​established in the financial system and that a public bailout of the financial industry had to be avoided in the future. At the G20 and FSB level, FMIs were seen as the solution to the market and systemic failures that had emerged, particularly in the OTC derivatives markets. Clearinghouses were taken as the archetype of FMIs and policy recommendations were modelled and built around them. In 2010,32 the FSB recommended that the authorities and lawmakers of the G20 10.21 countries mandate in their home jurisdictions:33 (i) the mandatory central clearing 30 CCPs and their regulation were also the model used by EU lawmakers to build the general regime for FMIs. 31 EMIR simply focuses on CCPs and trade repositories; while CSDs are regulated by the CSDR. 32 The FSB recommendations were the outcome of the reform agenda agreed on by the G20 in Pittsburg in September 2009; see Pittsburg G20 Summit, September 2009, Leaders’ Statement, ‘Strengthening the International Financial Regulatory System’, available at https://​www.ft.com/​content/​5378959c-​aa1d-​11de-​a3ce-​00144feabdc0, accessed 20 October 2018. 33 FSB, ‘Implementing OTC Derivatives Market Reforms, 25 October 2010 (http://​www.fsb.org/​ 2010/​10/​fsb-​report-​on-​implementing-​otc-​derivatives-​market-​reforms/​, accessed 20 October 2018).

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Paolo Saguato of standardized derivatives and the use of CCPs as stability buffers and shock absorbers in the markets;34 (ii) the implementation of resiliency-​driven regulation and supervision of CCPs;35 (iii) and the adoption of robust risk-​management requirements for non-​centrally cleared derivatives.36 The international guidelines emphasized FMIs’ public function and role as stability and transparency enhancers in the financial system.37 Moreover, they called for public intervention in building prudential and corporate governance standards for FMIs.38 10.22

The FSB recommendations were followed in 2012 by a joint document of CPSS-​ CPMI and IOSCO on the Principles of Financial Market Infrastructures (PFMI).39 The twenty-​four principles constitute the ‘commandments’ given by the international financial regulator community to strengthen and enhance financial stability in the post-​trading FMI landscape. The PFMI set the foundations of the risk-​management regulation of CCP and FMIs in general.40

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The PFMI acknowledge the systemic and critical role of FMIs in fostering financial stability and efficiency in financial markets.41 In building this new architecture and by concentrating risk in FMIs, the drafters were aware that if FMIs were not properly managed, they could become a source of financial shock and a major vector for financial contagion across domestic and international markets.42 To address these issues, CPMI-​IOSCO advised domestic regulators, in implementing the PFMI in their legal systems, to consider two sets of principles to enhance the safety, soundness, and robustness of FMIs. The first set of principles targets organizational risk management and stresses the importance of setting well-​founded, clear, transparent, and enforceable legal bases for FMIs’ activities. This translates into clear governance arrangements that should include the ownership structure of FMIs, their internal governance policy (i.e. composition and responsibilities of the board of directors), the design of robust risk management and internal controls 34 ibid, 23–​8 (focusing on the slow industry-​driven process to central clearing as the cause for a regulatory mandate to use CCPs for standardized derivatives as a key mechanism to mitigate counterparty credit risk and systemic risk). 35 ibid 29–​33, 59–​60 (discussing the importance of sound CCPs with robust risk management). 36 ibid 33–​8 (recommending the implementation of robust risk management for bilateral non-​ centrally cleared derivatives that can also address the risk of interconnectedness). 37 The FSB also recommended the use of TRs to record all concluded derivatives transactions (either OTC bilateral contracts or traded instruments), and the trading and execution of standardized derivatives on authorized trading facilities. 38 ibid (providing a broad definition of the role, structure, and governance of CCP and TRs). 39 See above n 12. 40 The PFMI identifies seven key risk in FMIs and their activities. Systemic risk and liquidity risk that are connected to the macro-​prudential systemic role and regulation of FMIs as systemic risk management. And counterparty credit risk, business risk, operational risk, and cyber risk that are mainly addressed by the micro-​prudential institutional and organizational provisions of the public risk management; see CPSS-​IOSCO, PFMI, n 12, 18–​20. 41 Ferrarini and Saguato, n 9, 583–​4. 42 CPSS-​IOSCO, PFMI, n 12, 5.

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Financial Market Infrastructures (i.e. audit, risk-​management policies, procedures, and systems).43 The second set of principles addresses the business of managing risk and focuses on transaction and hybrid risk management. It called on regulators to: (1) ensure that FMIs have in place effective risk-​management mechanisms aimed at measuring, monitoring, and managing credit and liquidity, operational, and business risk;44 and (2) require FMIs to maintain sufficient financial resources to cover their credit exposure to their member-​counterparties (i.e. collateral, margin, default management strategies), limit the procyclicality of their risk-​management pratices, and maintain the liquidity of their risk-​mitigation financial resources. As the next section will highlight, many of the EMIR provisions on CCPs’ internal governance and risk-​ mitigation mechanisms and techniques are modelled around the principles set by the CPMI-​IOSCO.45 B. EMIR and the regulation of risk managements: CCPs and TRs Before EMIR, EU authorities commissioned assessments and studies of the post-​ 10.24 trading environment in the European internal market. The outcomes of these studies underlined the critical and vital importance of resilient post-​trading infrastructures for the efficient functioning of financial markets.46 However, no actions were taken in response to the studies’ findings. The turning point was the financial crisis and EMIR, its response. The regulatory architecture created by EMIR and the delegated regulations adopted by the Commission under ESMA created a unique systematic set of rules on robust risk management for FMIs.47 The systemic ability 43 ibid, 21–​35, 101–​15, Principles 1–​3. 44 ibid 36–​63, 78–​100, Principles 4–​7, 13–​17. 45 For a comprehensive assessment of the implementation of the PFMI in the EU, both at an industry and regulatory level, CPMI-​IOSCO, ‘Implementation Monitoring of PFMIs:  Level 2 Assessment Report for Central Counterparties and Trade Repositories—​European Union’, 26 February 2015, available at https://​www.bis.org/​cpmi/​publ/​d128.htm, accessed 20 October 2018; CPMI-​IOSCO, ‘Implementation Monitoring of PFMI: Level 3 Assessment Report on the Financial Risk Management and Recovery Practices of 10 Derivatives CCP’, 16 August 2016, available at https://​www.bis.org/​cpmi/​publ/​d148.htm, accessed 20 October 2018. 46 The first pioneering policy works analysing the market structures of the European post-​trading FMIs were the 2001 and 2003 Giovannini Reports; see Giovannini Group, ‘Cross-​border clearing and settlement arrangements in the European Union—​First Report’ (2001); Giovannini Group, ‘EU clearing and settlement arrangements—​Second Report’ (2003), available at https://​ec.europa. eu/​info/​publications/​giovannini-​reports_​en, accessed 20 October 2018; and the following Commission Communication 312, ‘Clearing and Settlement in the European Union:  The Way Forward’, 2004, available at http://​www.europarl.europa.eu/​meetdocs/​2004_​2009/​documents/​ com/​com_​com(2004)0312_​/​com_​com(2004)0312_​en.pdf, accessed 20 October 2018 (looking for the first time into the regulatory approach to the governance of FMIs, 9–​20). 47 For a comprehensive analysis of the legislative history of EMIR and a comprehensive account of the post-​crisis regulation of the EU international financial markets, see Niamh Moloney, EU Securities and Financial Markets Regulation, 3rd ed, Oxford University Press, 2014, 573–​626 (discussing EMIR and its history); Guido Ferrarini and Paolo Saguato, ‘Reforming Securities and Derivatives Trading in the EU: From EMIR to MIFIR’, Journal of Corporate Law Studies (2013), 13, 319.

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Paolo Saguato of FMIs to effectively perform their risk manager and transparency enhancer functions is, in large part, correlated to the effectiveness of their internal risk management and governance. This section provides a systematic analysis of the European post-​financial crisis architecture of CCPs and TRs, and offers an organic inquiry of the three layers of risk management measures regulated by lawmakers. 1. Systemic and macro-​prudential risk management: the clearing and reporting mandate 10.25

The essential role of FMIs’ risk management in the derivatives markets spills from the clearing and reporting mandates.48 EMIR Article 4 requires the use of CCPs as risk managers in all standardized derivatives markets and tasked them with providing systemic stability and mitigating systemic risk in the markets. All eligible standardized derivatives shall be centrally cleared by an authorized CCP.49 Under Title III of EMIR, in order to provide clearing services in the EU internal market,50 a CCP shall be authorized by a competent authority of a Member State51 or recognized by ESMA.52 To be authorized, a CCP shall comply with all provisions laid

48 EMIR, Article 4(1); EMIR Article 9(1). Policymakers justified the use of the ‘mandatory’ rule on the insufficiency of ‘private incentives to promote the use of CCPs’, EMIR, Recital 13. 49 EMIR, Articles 5 and 7 of Commission Delegated Regulation (EU) 149/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-​financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP [2013] OJ L52/​11 (hereafter Delegated Regulation 149/​2013). EMIR foresees two alternative processes for the identification and designation of OTC derivatives subject to the clearing mandate. A bottom-​up industry driven initiative where ESMA, after a consultation phase initiated by an authorized CCP, determines the classes of derivatives subject to the clearing mandate. And a top-​down approach, where ESMA proactively identifies those classes of derivatives that should be subject to central clearing. On paper, the top-​down approach appears to be a mechanism to reduce regulatory costs for CCPs that want to apply for the authorization to clear derivatives (and eventually might be seen as a driver for competition among CCPs to clear new clearable contracts). On the other hand, this approach risks being either an ineffective provision or an extremely intrusive and risky one for the market. First, the top-​down process could be ineffective because, if there is no industry-​driven initiative, it is very unlikely that a CCP would start offering clearing after an ESMA designation. Also, if there is a market demand for a specific class of derivatives, then CCPs would compete for that market and initiate the declaration process. Second and hypothetically, the idea of ESMA mandating on CCPs the clearing of derivatives that they deem not appropriate, might create a situation of capture on the EU authorities, where they would be eventually required to financially step in should the CCP face a situation of distress. As of 1 June 2018, only five asset classes of derivatives have been required to be centrally cleared through an authorized (or recognized) CCP—​and all via a bottom-​up procedure; see Public Register for the Clearing Obligation under EMIR, available at https://​www.esma.europa. eu/​sites/​default/​files/​library/​public_​register_​for_​the_​clearing_​obligation_​under_​emir.pdf, accessed 1 June 2018. 50 ibid, Articles 4(3), 14. Third-country CCPs can apply to be recognized by ESMA to access the EU markets; if ESMA deemed the third-country prudential regulation and supervision equivalent to the EU one, complying with it would be a substitute to a formal re-authorization, EMIR, Article 25. 51 EMIR, Articles 14, 17 (defining the step of the authorization procedure). 52 ibid, Article 25.

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Financial Market Infrastructures down by EMIR and its delegated regulations.53 Furthermore each competent authority is responsible for the oversight and prudential supervision of the CCP and its activities.54 To ensure the breadth of the reach of the clearing mandate, CCPs shall offer their 10.26 clearing services without discriminating on the trading platform that executed the trade.55 This provision reflects the market dynamics and structure of the EU trading and post-​trading markets. Trading and post-​trading firms are generally organized as vertically integrated silos, with the group’s CCP clearing all transactions executed on the group’s trading venues.56 While not being directly a risk management provision, the non-discriminatory access rule, which gives a CCP the authority to require a trading venue to comply with its own risk management requirements, and also expands the scope of the CCP’s clearing economics.57 From a systemic and macro-​prudential perspective, the clearing mandate (and its 10.27 risk mitigation purpose) was coupled with the mandate to report all derivatives transactions to authorized trade repositories.58 Article 9 of EMIR requires all derivatives transactions to be centrally reported to a newly created FMI: TRs. TRs operate as data warehouses, but, as with CCPs, in order to provide their services to the EU markets, they must be registered with ESMA.59 EMIR, despite the systemic role of TRs, subjects them to lighter regulation, as they pose lower risk to the financial system.60 2. Organizational and micro-​prudential risk management: the internal governance of CCPs and TRs Policymakers, after mandating the use of FMIs as systemic risk managers and 10.28 transparency enhancers, intervened in their internal corporate governance to ensure their sound and prudent management. Title IV of EMIR and its delegated administrative rules contains micro-​prudential organizational risk-​management

53 ibid, Article 18. A  Member State authority can decide to establish a college of competent authorities—​ESMA included—​for the performance of the CCP’s oversight and prudential supervision, when the CCP business is cross-​border. 54 ibid, Articles 20–​2, 49, 51, and 54. 55 ibid, Article 7. 56 FMI groups—​ conglomerates of firms offering trading, post-​ trading, and information services—​characterize the EU financial markets; Ferrarini and Saguato, ‘Governance of FMIs’ (n 28) 305–​314 (discussing the economic implications of the FMI group structure). 57 The clearing business benefits from the advantages of scope and scale economies: the larger and deeper the pool of cleared transactions is, the more efficiently the business operates. 58 EMIR, Article 9.  TRS centrally collect and maintain records of all derivatives transactions concluded bilaterally OTC or on a trading venue; and centrally cleared or not centrally cleared. 59 ibid, Article 55. 60 TRs do not assume any risk; they do not manage any risk, and their business model is the simple collection, aggregation, refining, and publication of data.

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Paolo Saguato provisions aimed primarily at addressing conflicts of interest, increasing internal transparency, and promoting accountability. 10.29

A  CCP shall have robust governance arrangements, with clear, consistent, well-​ documented, and well-​ defined lines of responsibility, internal reporting and compliance procedures, and adequate internal control mechanisms.61 The senior management of a CCP shall meet reputational and experience standards to ensure the sound and prudent management of the firm.62 All directors sitting on the board shall possess adequate expertise in financial services, risk management, and clearing services and shall be of good repute. A third of the directors (and not less than two) must be independent.63 Furthermore, and to build more internal accountability, representatives of clearing members’ clients shall be invited to board meetings on matters pertaining to pricing and fees of the clearing services and margin management.64

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CCPs must have a transparent ownership structure. Shareholders or members of a CCP that, directly or indirectly, hold a qualifying stake in the CCP’s equity capital must disclose it to the competent authority. The authority retains the power to refuse or withdraw the authorization of a CCP, when it deems its members or shareholders not suitable, namely if the authority considers the influence of the shareholder or member prejudicial to the sound and prudent management of the CCP.65 Furthermore, any change to the management and to the qualifying ownership holdings shall be disclosed to the competent authority.66

10.31

To address conflicts of interest issues and to curb moral hazard behaviours, the remuneration of non-​executive and independent directors, as well as staff engaged in risk management, compliance, and internal audit, shall not be linked to the CCP’s business performances.67 Generally speaking, sound and effective remuneration policies for executives shall be designed to align the level and structure of remuneration with prudential risk-​management standards.68 The CCP shall adopt comprehensive and strict organizational and administrative arrangements to identify, manage, and resolve any potential conflicts of interest.69

61 EMIR, Article 26(1)(2)(3); and Article 3 Commission Delegated Regulation (EU) 153/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties [2013] OJ L52/​41 (hereafter Delegated Regulation 153/​2013). 62 EMIR, Article 27(1); Delegated Regulation 153/​2013, Article 7. 63 ibid, Article 27(2). 64 ibid, Articles 27(2), 38–​9. 65 ibid, Article 30(1)(2). 66 ibid, Article 31. 67 ibid, Article 27(2). 68 Delegated Regulation 153/​2013, Article 8. 69 EMIR, Article 33.

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Financial Market Infrastructures Due to the essential role of CCPs in risk management and because of the crit- 10.32 ical exposure of CCPs to multiple classes of risks, each CCP shall adopt a sound framework to comprehensively manage all the risks stemming from its activities.70 In this regard, the CCP shall establish risk-​management policies, practices, procedures, and systems to identify, monitor, and manage such risks. A  CCP shall create direct reporting lines to the board for issues pertaining to risk management. A risk committee must operate in every CCP. The risk committee shall represent the voices and interests of the different CCP’s stakeholders. The independent directors shall sit together with representatives of the clearing members and of the members’ clients.71 And none of the groups shall have a majority of the voting rights in the committee.72 The competent authority may request to participate in risk committee meetings as a non-​voting member and to be duly informed of the decisions and activities of the committee. The risk committee reports directly to the board and shall advise it on any arrangements that might impact the risk management of the CCP; however, its votes and recommendations are not binding on the board of directors or the executives.73 However, the CCP shall promptly inform the competent authority of any decision in which the board decides not to follow the advice of the risk committee.74 Finally, a CCP shall establish and maintain permanent and effective compliance policies and procedures to assure compliance with its applied regulatory frameworks and, eventually, detect and fix any failure to do so.75 As for their registration regime, TRs micro-​prudential regulation is also ‘softer’ 10.33 than the governance framework created for CCPs.76 TRs are subject to a disclosure regime for the ownership structure and holding interests similar to the CCPs’ regime.77 TRs must show the independence of the corporate governance structure from external and internal conflicts. They must adopt a clear organizational structure, with defined internal corporate governance policies,78 internal compliance,

70 Delegated Regulation 153/​2013, Article 4. 71 EMIR, Article 28(1). Representatives of the CCP’s employees and external independent expert may be invited to join the committee as non-​voting members. 72 The risk committee shall be presided by an independent director. 73 EMIR, Article 28(3) (for instance, the risk committee shall advise on changes in risk models, default procedures, criteria for accepting clearing members, clearing of new classes of derivatives, etc). 74 ibid, Article 28(5). 75 Delegated Regulation 153/​2013, Articles 5–​6 (a chief compliance officer shall oversight and administer the compliance police and procedures and shall report to the board of directors). 76 Commission Delegated Regulation (EU) 150/​2013 of 19 December 2012 supplementing Regulation (EU) 648/​2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards specifying the details of the application for registration as a trade repository [2013] OJ L52/​25 (hereafter Delegated Regulation 150/​2013). 77 EMIR, Articles 3–​4. A TR must disclose all holdings equal or higher than 5 per cent of its equity capital, or voting rights, or any holding which provide the power to exercise a significant influence on the business. 78 ibid, Articles 5–​6.

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Paolo Saguato and control policies and procedures adequate to effectively monitor and evaluate risk and detect potential conflicts of interest.79 Finally, TRs must guarantee the business continuity and the orderly functioning of their services.80 3. Transactional and hybrid risk management: the business of managing risk 10.34

‘When providing services to its clearing members . . . a CCP shall act fairly and professionally in accordance with sound risk management.’81 The essential aspect of the risk management performed by FMIs—​and especially CCPs—​is how they can orderly deal with the default of one of their members.82 To ensure the financial resilience of the CCPs and to mitigate or even absorb the costs of a member’s default, EMIR imposes specific prudential requirements which take the form of different layers of financial resources that are deployed by the CCP to manage the risk spilling from its counterparties’ exposure. Policymakers, after mandating the use of FMIs for derivatives and regulating their internal governance, directly intervened in the core business of FMI-risk management: the calibration and use of the financial lines of defence against risk. This risk-​management mechanism, unique to CCPs, are hybrid in nature. A CCP can act as a resilient macro-​prudential risk manager if, and only if, it is a safe and sound institution from a micro-​prudential perspective. CCPs typically use three tiers of financial safeguards to manage the risk they potentially face: (i) membership requirements; (ii) margins; and (iii) default fund.83

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Even before CCPs can deploy their specific risk-​management tools to internalize and absorb risk, CCPs can preemptively monitor the risk they will assume and process by setting prudent and robust membership requirements. In order to access clearing services, a market actor must be admitted as a member. Membership requirements ensure that only those market participants with sufficient financial resources and operational capacity to meet the critical obligations arising from their participation in the CCP are directly admitted to the clearing services. Members are also subject to periodic monitoring of their internal risk-​management policies.84

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CCPs, generally speaking, have in place two types of defensive tools to deal with the default of a clearing member: transaction-​specific defences and mutualization defences. The so-​called default waterfall sets the order in which the CCP uses these default management instruments.85 The regulation and nature of the default

79 ibid, Articles 7–​9, 13–​15. 80 ibid, Article 79. 81 ibid, Article 36(1). 82 Jon Gregory, Central Counterparties, Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives, Wiley, 2014, 133–​43. 83 Tina P Hasenpush, Clearing Services for Global Markets, Cambridge University Press, 2009, 28. 84 EMIR, Article 37. 85 ibid, Article 45 and 48.

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Financial Market Infrastructures waterfall reflect the hybrid structure of transaction risk management. While ensuring the internal resilience of the FMI and capacity to absorb risk stemming from different sources, the default waterfall, which pools (countercyclically) financial resources, provides a systemic mechanism to absorb, internalize, and mutualize losses, and eventually contain risky systemic spillovers.86 In setting the prudential requirements members have to contribute to, and in maintaining adequate capital buffers, the CCP shall measure and assess its liquidity and credit exposure to its members.87 Margins are the first line of defence and the first resources to be deployed to ab- 10.37 sorb potential counterparty losses.88 Each clearing member is required to post adequate margins when entering in a clearing agreement with the CCP.89 Margins are transaction-​specific defences structured to cover the exposure resulting from a potential counterparty default or market movement.90 Margins shall be sufficient to cover ‘at least 99% of the exposures movements over an appropriate time horizon’ of a cleared position.91 CCPs are required to adopt resiliency models for their margin calculation and subject them to validation by the competent authority.92 Finally, the CCP shall accept as margin only highly liquid collaterals (i.e. assets),93 and subject them to prudent ‘haircuts’ that reflect their potential volatility over time.94

86 FMIs and CCPs are not immune from failure and do not eliminate risks from the financial system. However, they provide orderly, countercyclical, and pre-​funded mechanisms to internalize spillovers and more effectively manage risk. See Mark Roe, ‘Clearinghouse overconfidence’, California Law Review (2013), 101 1641(taking a sceptical position of the role of clearinghouses). 87 EMIR, Article 40 (when the CCP has in play interoperability agreements with other CCPs, it shall also take into account its exposure to other CCPs). 88 Gregory, n 82, 75–​104. A ‘margin’ is the financial guarantee a party provides to its counterparty as a security against losses deriving from an underlying transaction. Collateral generally refers to any property or assets (i.e. securities or cash) pledged as a guarantee for an open exposure, or more broadly is the asset used as a margin. See Reuters, Financial Glossary, http://​glossary.reuters.com/​ index.php?title=Main_​Page, accessed 20 October 2018. 89 EMIR, Article 45(1). The CCP can impose, call, and collect two main types of margins: initial margins, collected at the time the contract is cleared; and variation margin, collected at different moments in the lifespan of a financial contract, whose economic purposes is to adjust the fluctuation in riskiness of an open position. 90 Margins are managed in segregated accounts for each member and distinct from the CCP’s assets; EMIR, Article 37. 91 Delegated Regulation 153/​2013, Articles 24–​8 (setting the percentages for the calculation of initial margin—​Article 24; defining the limits and procedure for portfolio margining, including procyclicality in the variable to be considered in calculating the amount of margins—​Article 27). 92 ibid, Article 41(2). 93 EMIR, Article 46; Delegated Regulation 153/​2013, Articles 37–​42 and Annex I and II (examples of highly liquid collateral are cash, gold, and government issued financial instruments that meet specific requirements). 94 Delegated Regulation 153/​2013, Articles 17–​31. ‘Haircut’ is the percentage by which the market value of an asset used as collateral is reduced to reflect the degree of risk—​i.e. legal risk, market risk, and liquidity risk—​underlying it. See Reuters, Financial Glossary, http://​glossary.reuters.com/​index.php?title=Main_​Page, accessed 20 October 2018.

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Paolo Saguato 10.38

If the margin posted by the defaulting clearing member is not sufficient to cover the losses incurred by the CCP, the second line of defence kicks in:95 the default or guarantee fund.96 The default fund, a pre-​funded countercyclical pool of resources provided by each clearing member, represents the quintessential feature of CCP, and the main driver of the regulatory mandate to use CCPs as risk managers. The default fund’s purpose is to internalize the losses caused by the default of one or more clearing members within the CCP and mutualize them among its clearing members, thus avoiding the risk of spillovers and systemic contagion. Each CCP shall establish the amount of members’ contributions to the guarantee fund in proportion to the exposure and risk each member brings to the CCP. If a CCP clears different classes of derivatives, it can opt to set up different default funds for each class of derivatives.97 Nevertheless, the fund shall be deep enough to withstand, ‘under extreme but plausible market conditions’, the default of the largest clearing member, or the simultaneous default of the second and third largest members—​if their exposure is larger.98

10.39

In a dynamic scenario, after the defaulting member’s margins are exhausted, the CCP draws first from the defaulting member’s contributions to the default fund,99 and then, only after using its own allocated loss absorbing resources, it proportionally allocates the losses to the non-​defaulting members.100 This intermediate buffer of the CCP’s own financial resources is generally referred to as the CCP’s ‘skin-​in-​the-​game’.101 ESMA sets clear rules for the calculation of the amount of skin-​in-​the-​game.102 The economic rationales for a specific provision on this line of defence stems from the fact that CCPs are no longer member-​owned institutions, but investor-​owned subsidiaries or business units of for-​profit public conglomerates.103 By having the CCP partially absorbing the losses caused by a member’s default, ESMA aimed to align the economic incentives of the CCP to those of the non-​defaulting members, and empower the CPP to partially self-​discipline itself.

10.40

Overall a CCP shall maintain an amount of member-​provided pre-​funded prudential financial resources (margins plus default fund) that enable the firm to



EMIR, Article 45(2). ibid, Article 42. Gregory, n 82, 181–​203. 97 ibid, Article 42(4). 98 ibid, Article 42(3). 99 ibid, Article 45(3). 95 96

100 ibid, Article 45(2)(3)(4); Delegated Regulation 153/​2013, Articles 29–​31. 101 The CCP’s skin-​in-​the-​game is used before the CCP can distribute the losses of the defaulting member on the non-​defaulting members. 102 Delegated Regulation 153/​2013, Articles 35–​6, (the minimum amount of dedicated CCP own resources in the default fund shall be calculated multiplying the minimum capital—​including retained earnings and reserves, by 25 per cent). 103 See Saguato, n 5, 640–​52 (looking at the trade-​offs between investor-​owned and member-​owned CCPs and providing different alternatives to increase resilience in the organizational structure of CCPs).

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Financial Market Infrastructures withstand the default of the two clearing members with the largest exposures to the CCP ‘under extreme but plausible market conditions.’104 In a closing provision in the financial resources’ toolkit available to the CCP, EMIR takes two different stances. First, EMIR imposes on CCPs the duty to maintain pre-​funded available financial resources to cover potential losses not covered by the pledged margins or by the default fund.105 Second, to ensure the CCP’s business continuity, EMIR gives the CCP the power to require non-​defaulting clearing members to provide additional financial resources in case another clearing member defaults. However, in a conclusive sentence, it generally states that ‘the clearing members . . . shall have limited exposures toward the CCP’.106 In FMI jargon, this tool of last resort for the CCP is called assessment rights. Major CCPs have assessment rights provisions in their default waterfall, which, in practice, are generally triggered when the failure of one or more clearing members causes the depletion of the default fund, and the CCP seeks new resources to keep its infrastructural business running.107 Finally, and ancillary to the discussion on the public regulatory intervention on 10.41 internal risk management,108 EMIR intervenes in the ‘traditional’ prudential safety and soundness of CCPs and establishes capital requirements for CCPs. In order for a competent authority to authorize a CCP to offer its services, the CCP shall have solid minimum initial equity capital: seven and a half million euros shall be the minimum permanent and available capital base.109 Furthermore, administrative rules require CCPs to maintain an equity capital proportionate to the risk stemming from its activities,110 and sufficient to ensure an orderly recovery or resolution of the CCP.111 Furthermore, ESMA sets fixed calculation mechanisms to

104 EMIR, Article 43(2). 105 ibid, Article 43(1). 106 ibid, Article 43(3). 107 At this stage of the default waterfall, the line between an operating CCP and a CCP that should begin or should be directed to a recovery or even resolution procedure is very subtle. It is outside the scope of this chapter to discuss the procedures to keep a CCP afloat through a recovery or resolution; policy discussion both internationally and at an EU level is still open; see Paolo Saguato, ‘The Unfinished Business of Regularing Clearinghouses’ (2018) https://ssrn.com/abstract=3269063 accessed 20 October 2018 (investigating the still existing vulnerabilities of the CCPs regime). 108 Pertinent to the discussion on risk management and its policy implications, but outside the perimeter of the activities of FMIs, is the direct and stringent regime built by EMIR for non-​centrally cleared derivatives. If a derivative is bilaterally concluded between two counterparties and it is not centrally cleared, the new rules requires the parties to meet strict margin requirements regarding the appropriate collateralization of uncleared positions and to comply with more comprehensive disclosure and transparency rules. EMIR, Article 11; Delegated Regulation 149/​2013, Articles 12–​20 (governing risk mitigation techniques for bilateral derivatives transactions). 109 EMIR, Article 16(1). 110 ibid, Article 16(2); Commission Delegated Regulation (EU) 152/​2013 of 19 December 2012 supplementing Regulation (EU) No 648/​2012 of the European Parliament and of the Council with regard to regulatory technical standards on capital requirements for central counterparties [2013] OL J52/​37 (hereinafter Delegated Regulation 152/​2013). 111 Delegated Regulation 152/​2013, Article 2.

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Paolo Saguato evaluate and assure the adequacy of the CCP capital against credit, counterparty, and market risks;112 operational and legal risks;113 and business risks.114 Finally, CCPs must be subject to periodic stress-​testing, back-​testing, and sensitivity analysis to ensure their financial resilience and reliability.115 10.42

The overall regulatory architecture of FMI’s prudential risk management is still missing a critical piece:  a harmonized regime for the recovery and resolution of a CCP. When the CCP’s risk management and governance fail, and the default waterfall exhausts all its available financial resources, how can the continuity of the clearing operation be guaranteed? The Proposed Regulation offers two sequential options.116 First, the Proposal requires CCPs to prepare preventive recovery plans to guarantee the CCP’s business continuity if the firm faces critical financial distress that cannot be contained within the default waterfall resources.117 Second, the proposal sets out resolution tools to be triggered by a resolution authority when a CCP has failed or is failing and no market solutions are feasible.118 It is outside the scope of this chapter to analyse the mechanics of the proposed recovery and resolution regulation, however, it is worth noting that policymakers embraced a similar approach to the one used in prudential risk management: namely the centrality of risk and loss mutualization on the CCP’s members. C. An overview of the regulation of risk management in CSDs

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As previously discussed, CCPs and TRs are the primary recipients of regulatory attention because of their unique role in revolutionizing the structure of the derivatives markets. However, embracing the IOSCO definition of FMIs and to offer a complete picture of the post-financial crisis FMI reforms in the European Union, an overview of the regulation of central securities depositories (CSDs) is required.119

112 ibid, Article 3. 113 ibid, Article 4 (all capital requirements calculations should not take into account the risks that are already covered by the risk management financial resources of the default waterfall). 114 Delegated Regulation 152/​2013, Article 5. 115 EMIR, Article 49; Delegated Regulation 153/​2013, Articles 47–​60. 116 European Parliament and Council Proposal Regulation (EU) 856/​2016 of 28 November 2016 on a framework for the recovery and resolution of central counterparties and amending Regulations (EU) 1095/​2010, (EU) 648/​2012, and (EU) 2015/​2365, https://​eur-​lex.europa.eu/​legal-​content/​EN/​TXT/​ PDF/​?uri=CELEX:52016PC0856&from=EN, accessed 20 October 2018 (hereafter Recovery Proposal). 117 Recovery Proposal, Arts 9–​12. 118 ibid, Arts 21–​3, 27. 119 European Parliament and Council Regulation (EU) 909/​2014 of the of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/​26/​EC and 2014/​65/​EU and Regulation (EU) 236/​2012 [2014] OJ L257/​1 (hereafter CSDR) Commission Delegated Regulation (EU) 2017/​390 of 11 November 2016 supplementing Regulation (EU) 909/​2014 of the European Parliament and of the Council with regard to regulatory technical standards on certain prudential requirements for central securities depositories and designated credit institutions offering banking-​type ancillary services [2016] OJ L65/​9.

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Financial Market Infrastructures CSDR completes the FMI-picture.120 While traditionally supporting the post-​ trading of the securities and equity markets, CSDs have expanded their activities to the derivatives markets by providing collateral management services to CCPs and their members. Like CCPs and TRs, CSDs are subject to prudential regulation121 and capital requirements,122 corporate governance and transparency rules, disclosure obligations of both relevant holdings, and potential conflicts of interest.123 The organizational and governance requirements for CCPs and CSDs are very 10.44 similar; however, there are a few differences and peculiarities. As previously discussed, the required presence of the risk committee with its advisory role and its hybrid and multi-​stakeholder structure is a central feature of the CCPs’ risk-​ management regime. CSDs are not required to have a risk committee, nevertheless, they must establish a user committee.124 Representatives of issuers and participants in the securities settlement system shall sit on the committee. The committee, acting in complete independence from the CSD’s management, reports directly to the board on matters related to the business of the securities settlement business. Finally, CSDs are required to have continuity and stability business plans to guarantee orderly provisions of their services in situations of distress.

IV.  The Challenges of Regulating Risk Management The post-​financial crisis reforms of financial markets represent one of the most 10.45 comprehensive and direct regulatory interventions in the European financial markets. In particular, the derivatives markets experienced a radical transformation. The financial crisis intensified the political pressure on lawmakers to directly intervene in the governance of financial institutions and curb their moral hazard, risky behaviours, and tendency to externalize their losses on the system. A deep and shared mistrust of market self-​discipline and concern with the ineffective- 10.46 ness of private risk-​management mechanisms pervaded the post-​financial crisis policy debate. The financial crisis-​driven reforms fully embraced a direct public intervention in risk management. The legal apparatus adopted by lawmakers and regulators rebuilt the foundations of the financial market on top of FMIs. FMIs were entrusted with a public policy function. Transactions were mandated to be concluded and processed

120 CSDR Title III. 121 ibid, Arts 42–​8. A CSD shall adopt a sound risk-​management framework for comprehensively managing legal, business, operational, and other risks, including measures to mitigate fraud and negligence. 122 ibid, Art 47. 123 ibid, Art 26–​7. 124 ibid, Article 28. The user committee may submit to the management and board non-​binding opinions regarding the pricing structure of the CSD. If the CSD decide not to follow the advice of the user committee, it shall promptly inform the competent authority and the user committee itself.

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Paolo Saguato by FMIs. FMIs were designated as systemic mechanisms to manage risk. Their internal governance was subject to a comprehensive set of prudential requirements, and their risk-​management business broadly regulated. But what are the challenges posed by the codification and proceduralization of risk-​management policies, practices, and arrangements?125 How does the regulation of risk management affect regulators and FMIs? How does the systemic function bestowed on FMIs effect their economic and risk-​taking incentives?126 10.47

EMIR review is ongoing, but no proposed amendments are aimed at the core aspects of the regulatory architecture that was discussed in the present chapter.127 Therefore, the current framework for FMIs will likely stay in place for a few more years to come. If that is the case, some reflections on the political economy of regulating risk management seems appropriate to more effectively understand such a critical—​and under studied—​segment of the financial markets. This last section endeavours to offer a few critical reflections on the direct regulation of risk management and risk managers. A. Regulatory capture of policymakers

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From a public choice angle, because of their public policy function in the post-​ crisis markets and because of public authorities so completely rely on FMIs to maintain sound and fair financial markets, FMIs are in the position to capture regulators. When looking in general at regulated industries and their regulators, public authorities are potentially always prone to be captured (or dominated) by the industry.128 In particular, post-​trading services are a highly technical and complex business. ‘Revolving door’ opportunities expose examiners and regulators to the risk of ‘being soft’ on the regulated industry to pave the way for possible private job opportunities once they have concluded their time in public service. The lack of resources and the challenges of keeping up with technical and market expertise might position public regulators to over-rely on industry-​provided input, thus reducing the effectiveness and accountability of the regulatory framework, its supervision and enforcement.

125 Luca Enriques and Dirk Zetzsche, ‘The Risky Business of Regulating Risk Management in Listed Companies’, European Company and Financial Law Review (2013), 271, 282–​8, 292–​301 (challenging the juridification of risk management). 126 Saguato, n 107; Paolo Saguato and Guido Ferrarini, ‘Clearinghouses and Systemic risk’ in Douglas W Arner et  al (eds), Systemic Risk in the Financial Sector:  Ten Years After the Great Crash (CIGI Press forthcoming fall 2019) (offering policy consideration on how to mitigate organizational and cross-​border systemic risk in clearinghouses).  127 The regulation on recovery and resolution of CCPs is also still at a proposal stage. It would not change the current regulatory apparatus of risk management to FMIs, it would rather complete it. 128 George Stigler, ‘The Theory of Economic Regulation’, Bell Journal of Economics and Management Science (1971) 2, 3.

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Financial Market Infrastructures On the flip side, the very same rationales that might induce public servants to go 10.49 ‘soft’ on the regulated industry, might induce others to be ‘too hard’. Imposing excessive regulatory and compliance costs on the FMI industry because of their systemic function might suffocate business opportunities. Being too restrictive in the procedures to set transactional and operational risk-​management standards might alter FMIs’ incentive to invest in innovation and shift their profile from active risk managers to passive ‘box tickers’. Being overly interventionist in the risk-​management sector might drastically increase the accountability costs for regulators, or, even more seriously, might completely wipe out trust in the public institutions if the next crisis proves to have been exacerbated or even caused by wrongly tuned risk-​management practices and mechanisms imposed by regulators.129 B. The costs of regulating risk management: distortion of economic incentives and moral hazard Hundreds of pages have been written on whether and how the use of FMIs might 10.50 increase, simply shift, or reduce systemic risk in financial markets.130 Nowadays, however, FMIs are part of large listed for-​profit conglomerates. Their new role as systemically important infrastructures and risk managers for the post-​crisis financial markets, coupled with their for-​profit business nature, might create potential costs and distortive incentives in the FMIs. FMIs might be, on one side, in the position to extract anti-​competitive benefits 10.51 from market participants, and, on the other, they might leverage their systemic role to take on risky investments at a group level. Because of the complete reliance of regulators on FMIs’ smooth and orderly functioning to support financial markets, FMIs might be prone to moral hazard. They might be driven to take profitable but risky business decisions privatizing the profits among their shareholders. However, if things were to go south, they might mutualize their losses on their members, and externalize the costs on the society, leveraging their ‘too-​important-​to-​fail’ role. Because of the extensive reach of risk-management regulation, FMIs might turn into simple compliance ‘box ticker’ institutions. Doesn’t the current approach to risk management disincentivize FMIs from investing in or exploring different alternatives to risk management? As of today, FMIs have been very effective risk managers. In relations with public 10.52 authorities, FMIs have been collaborative and constructive advocates. They have

129 Directors and officers are held accountable to meet ‘fitness and properness’ standards, but are regulators and enforcers subject to the same accountability regime? Do they comply with the ‘fit and proper test’ imposed on directors of financial institutions? 130 Saguato, n 5, 605.

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Paolo Saguato shared information and data with competent authorities, complied with their new legal regime, and privately and internally promoted even more stringent risk-​management practices. It is too early to draw conclusions on the merit of the risk-​management reforms embraced by post-​financial crisis regulators. Yet, some concerns should be raised. 10.53

Traditionally, FMIs were either private ordering member-​owned institutions—​ where members had full economic interests and control rights over the firm, with full ‘skin-​in-​the-​game’—​or a publicly owned monopoly, heavily regulated and fully backed by the government. Now, after EMIR implementation, FMIs are subsidiaries of large listed for-​profit corporations. Members, as per their membership status, do not retain any formal control rights over the FMI business. Furthermore, complying with the risk-​management framework set by EMIR, members are still ‘all in’ if financial distress hits the FMI because of members’ mandatory contributions to the default fund. In other words, final risk bearing costs and control rights are assigned to different stakeholders. Those setting the risk profile and appetite of the FMIs are not the ones that, at the end of the day, bear the final costs of these decisions.

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The micro-​prudential organizational structure imposed by EMIR has some components that might create incentives on the FMIs and its shareholders to externalize the costs of their business onto the members. More studies should have been conducted by policymakers before setting the internal governance of FMIs. As this chapter’s author argued in a different work, a stronger (and more binding) voice should be given to the final risk bearers in FMIs—​the members—​if the goal is to build more accountability and enhance the robustness of the current risk-​management structure of FMIs.131 Binding opinions and decisions of the risk committee to the board of directors; giving representation and voting rights to members proportionate to the amount of the default fund contributions—​similar to dual class share structures; increased liability for the FMIs’ shareholders or equity claw backs:  these are just a few possible policy ideas to better align the incentives of FMIs’ stakeholders and create stronger risk-​management practices through alternative paths.

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Another aspect missed by EMIR in its assessment of the risks FMIs face, is the intra-​group risk: the risk that the failure of a FMI, which is part of a group, might trigger distress in the group’s other firms, or vice versa. Ring-​fencing the FMI’s business within the larger FMI group could be a straightforward solution to these concerns.132 Alternatively, (systemic) risk-​management policies should be tuned at

131 Saguato, n 5, 653–​66. 132 Ferrarini and Saguato, n 28, paras 11.58–​ 11.86; Steven L Schwarcz, ‘Ring-​ Fencing’ (2013) Southern California Law Review 69.

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Financial Market Infrastructures the holding company level: imposing strict rules on the holding company of the FMI group regarding business and risk preferences and requiring special committees for the monitoring of intra-​group risk could be options. As a final consideration, risk culture is a hotly debated issue when discussing po- 10.56 tential policy reforms. When EMIR drafters were completing the regulatory framework for the internal risk management of FMIs, the ‘risk culture’ that they had as a reference was the risk culture of either member owned or publicly owned FMIs. However, looking at the two largest FMI groups operating in the European Union, the London Stock Exchange and Deutsche Börse, both are run by former investment bankers.133 If the culture of a firm can be effectively tuned by who runs its business, then, EMIR review should have more carefully reassessed the micro-​ prudential regulatory architecture put in place for FMIs.

V. Conclusion The current regime for FMIs, while not perfect, helped to create more transparent, 10.57 more stable, more accessible, and better managed financial markets. However, is the current regime for the regulation of risk management the optimal approach to mitigate and control risk in the financial system? This chapter has looked at FMIs and their essential systemic role as risk 10.58 managers and the vital importance and essential role of their internal risk-​ management architecture in performing their systemic function. After the financial crisis hit the global markets, international organizations and domestic regulators acknowledged the importance of CCPs, TRs, and CSDs as critical infrastructures to support efficient and resilient financial markets and the essential role that internal risk management plays in supporting FMIs in their business. Comprehensive regulations for FMIs were adopted in all major jurisdictions. General principle-​based provisions were combined with more prescriptive rules. The core principles of the risk-​management regulation of FMIs can be summarized in three main concepts:  (i) multi-​stakeholder (but weak) representation in the risk governance of the FMIs; (ii) adoption of policies and procedures to identify, monitor, and address risks and conflicts of interests; and (iii) implementation of default management and continuity plans. These principles were implemented in a large set of provisions and, while increasing the reach and accountability of regulators in setting risk-​management standards, nonetheless

133 Philipp Stafford, ‘LSE springs a surprise with appointment of CEO’, Financial Times (2018) https://​ www.ft.com/​content/​99e8087c-​3f0c-​11e8-​b7e0-​52972418fec4, accessed 1 June 2018; Olaf Storbeck, ‘New Deutsche Börse chief appointed from UniCredit unit’ Financial Times (2017) https://​www.ft.com/​ content/​1ac9d58c-​caec-​11e7-​ab18-​7a9fb7d6163e, accessed 1 June 2018.

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Paolo Saguato partially altered the incentives of the industry to invest in cost internalization and risk-​management mechanisms. 10.59

EMIR was a critical step in restoring confidence in financial markets; however, when looking at the governance and risk management provisions implemented for FMIs, there is still more space for improvement:  increasing market participants’ financial accountability is a ripe avenue for exploration.

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11 COMPENSATION IN FINANCIAL INSTITUTIONS Systemic Risk, Regulation, and Proportionality Guido Ferrarini

I. Introduction II. Grounds for Regulation A. Role of incentives in the crisis B. Policy issues

III. International Principles and Standards

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A. The FSB principles and standards B. The choice between standards and rules

C. Criticism of the cap D. Impact of the cap in practice

V. EU Regulation of Insurers, Asset Managers, and Investment Undertakings A. Insurers B. Asset managers C. Investment firms

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IV. European Banking Regulation A. CRD IV B. The cap on variable remuneration

11.01 11.02 11.02 11.07

11.17 11.21 11.22

VI. Ways to Improve EU Regulation A. Focusing on systemic risk B. Enhancing proportionality

11.36 11.43

11.48 11.49 11.53 11.57 11.58 11.59 11.63

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I. Introduction The topic of executive and employee compensation in financial institutions raises 11.01 some interesting issues at the frontier between corporate governance and banking regulation that this chapter tries to highlight. Section II shows that excessive pay at financial institutions has often been indicated as one of the possible causes of the recent financial crisis, but the case for regulating compensation structure is rather weak, while regulation of remuneration and risk governance, and of remuneration disclosure are to some extent justified. Section III argues that the international principles interfere with compensation structures in a prescriptive way, particularly with regard to deferred variable pay and pay-​out in instruments. For the rest, they mostly track best practices already followed by large institutions before the

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Guido Ferrarini financial crisis, leaving some room to flexibility. Section IV argues that EU law shifted the setting of compensation from a supervisory approach to a regulatory one, adopting detailed and rigid provisions on the structure, governance, and disclosure of pay. Moreover, CRD IV introduced an unprecedented cap to variable remuneration, which may distort incentives and produce unintended consequences on bank risk-​taking. Section V analyses the EU provisions on remuneration which apply to insurance undertakings, asset managers, and investment firms. Section VI examines possible ways to overcome the shortcomings of EU regulation of financial institutions in the remuneration area and suggests that it should be made more flexible and proportionate within the limits allowed by the international principles. The focus will be on systemic risk in order to identify the institutions which should be subject to the most stringent provisions as to the setting and monitoring of pay. Moreover, it is suggested that proportionality be implemented in wider terms than recently proposed by the European Commission in its review of CRD IV.1

II.  Grounds for Regulation A. Role of incentives in the crisis 11.02

Official policy documents issued after the crisis argue that the recourse to flawed remuneration structures, including the excessive use of short-​term incentives for managers and other risk-​taking employees, contributed to the failure of many banks and other financial institutions.2 Some scholars take issue with this hypothesis, while others offer empirical evidence in support of the same. This topic is intertwined with the more general one concerning the role of corporate governance in the crisis, as governance structures shape managerial incentives and monitor risk-​taking by financial institutions. Official policy documents converge on the fact that the malfunctioning of corporate governance at banks and other financial institutions contributed to their crisis in the financial turmoil.3 Once again, scholars 1 On the role of culture and motivation in setting managerial incentives, see Shanshan Zhu and Guido Ferrarini, Chapter 16 in this volume. 2 See The High-​ level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, 25 February 2009 (De Larosiére Report), 30 (the excessive level of remuneration and remuneration structure induced too high risk-​taking and encouraged short-​termism); Commission Recommendation of 30 April 2009 on remuneration policies in the financial services sector (2009/​ 384/​EC), [2009] OJ L120/​22 (whilst not the main cause of the financial crisis, inappropriate remuneration practices in the financial services industry induced excessive risk-​taking and thus contributed to significant losses of major financial undertakings); Commission Staff Working Document, ‘Corporate Governance in Financial Institutions: Lessons to be drawn from the current financial crisis’, accompanying document to the Green Paper, ‘Corporate governance in financial institutions and remuneration policies’, Brussels 2 June 2010, SEC(2010) 669, 9; ‘A review of corporate governance in UK banks and other financial industry entities’ (the Walker Review), 16 July 2009, 90ff. 3 See the de Larosière Report, 29ff. (corporate governance is one of the most important failures of the present crisis); Commission Green Paper, ‘Corporate governance in financial institutions and remuneration policies’, 2 June 2010, COM(2010) 284 final, 2 (boards of directors rarely

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Compensation in Financial Institutions are divided: some argue that failed institutions often complied with best corporate governance standards (or at least appointed a majority of independent directors to their boards), while others criticize pre-​crisis governance practices for lack of adequate monitoring on internal control and risk-​management systems. Some empirical studies analyse the structure of bank CEOs’ pay before the crisis 11.03 asking whether short-​term incentives may have distorted risk-​taking by their institutions. Rüdiger Fahlenbrach and René Stulz4 identify some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity in the crisis.5 Lucian Bebchuk, Alma Cohen, and Holger Spamann6 offer a different view arguing that the large losses on shares that the top financiers suffered when their firms melted down do not offer a full picture of their payoffs. In the observed timeframe (2000–​2008), the relevant executives received large amounts of cash bonus compensation and ‘regularly took large amounts of money off the table by unloading shares and options’.7 Other scholars offer different explanations, especially with regard to the circum- 11.04 stance that CEOs were heavily invested in their firms and lost tremendous amounts of money when the latter were brought down by the crisis. What could have led top managers to take huge risks threatening their firms’ survival if they were heavily invested in the same? One possible explanation is sheer incompetence of these managers, who arguably knew little of what was really going on at their firms.8 However, it is hard to apply a similar explanation to the majority of top managers

comprehended either the nature or scale of the risks they were facing); Basel Committee on Banking Supervision (BCBS), ‘Principles for enhancing corporate governance’, October 2010; OECD, ‘Corporate Governance and the Financial Crisis. Conclusions and emerging good practices to enhance implementation of the Principles (2010). 4 Rüdiger Fahlenbrach and René Stulz, ‘Bank CEO Incentives and the Credit Crisis’, Journal of Financial Economics (2011), 99, 11–​26. 5 ibid, 12. According to this study, CEOs had substantial wealth invested in their banks, with the median CEO portfolio including stocks and options in the relevant bank worth more than eight times the value of the CEO’s total compensation in 2006. Similar equity holdings should have led CEOs to focus on the long term, avoiding too much risk and excessive leverage for their banks. Instead, the study shows that a bank’s stock return performance in 2007–​2008 was negatively related to the dollar value of its CEO’s holdings of shares in 2006, and that a bank’s return on equity in 2008 was negatively related to its CEO’s holdings in shares in 2006. 6 Lucian Bebchuk, Alma Cohen, and Holger Spamann, ‘The Wages of Failure:  Executive Compensation at Bear Stearns and Lehman 2000-​2008’, Yale Journal on Regulation (2010), 27, 257–​82. 7 ibid, 260. Indeed, performance-​based compensation paid to top executives at Bear Stearns and Lehman Brothers substantially exceeded the value of their holdings at the beginning of the period. Bebchuk et al argue that this provides a basis for concern about the incentives of the two banks’ executives. Rather than producing a ‘tight alignment’ of their interests with long-​term shareholder value, the design of performance-​based compensation provided executives of the relevant firms with substantial opportunities ‘to take large amounts of compensation based on short-​term gains off the table and retain it even after the drastic reversal of the two companies’ fortunes’ (ibid, 274). 8 Raghuram Rajan, Fault Lines. How hidden fractures still threaten the world economy, Princeton, 2010, 141ff.

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Guido Ferrarini at financial institutions in the early 2000s, given that ‘the corporate hierarchy is inherently a tough climb and weeds out a lot of incompetents, especially in the unforgiving and fiercely competitive financial sector’.9 A seemingly better explanation focuses on CEOs competing ‘for prestige by making more profits in the short-​term or by heading league tables for underwriting or lending, regardless of the longer-​ term risk involved’.10 Another explanation may be found in a study showing that some banks had a culture of risk-​taking and of compensating very heavily over the short term which influenced their performance.11 When these banks did well during boom times, their CEOs were acclaimed as heroes; however, in the recent crisis the same banks either did poorly or failed, and their CEOs became villains. Indeed, aggressive risk-​taking in some banks paid off handsomely for a considerable period of time, but this was largely based on luck. Similar bets made by bank managers more recently led to disastrous outcomes in the financial crisis, once the tail risks which had been taken materialized.12 11.05

The studies cited so far focus on the remuneration of top executives at large banks. However, the remuneration of other employees should also be taken into account, particularly that of high-​earners who contribute to risk-​taking by the firm. Even though precise empirical data are lacking, it is well known that many of these employees were paid short-​term incentives in amounts much greater than that of their fixed salaries. As explained by Diamond and Rajan, in the case of traders ‘many of the compensation schemes paid for short-​term risk-​adjusted performance. This gave traders an incentive to take risks that were not recognized by the system, so they could generate income that appeared to stem from their superior abilities, even though it was in fact only a market-​risk premium’.13

11.06

No doubt, assuming that CEOs and other top managers had the right incentives—​ that is, not only short-​term, but also long-​term incentives—​the fact that other employees had mainly short-​term incentives should not have been a big problem, provided that sound risk-​management systems were in place and an effective oversight was exercised on risk-​takers by their superiors. However, as widely acknowledged in the aftermath of the crisis, this was not always the case at large banks, where risk-​management systems were often deficient and top managers did not 9 ibid, 142. 10 ibid, 143, making reference to a previous study by the same author: Ranghuram Rajan, ‘Why Bank Credit Policies Fluctuate:  A Theory and Some Evidence’, Quarterly Journal of Economics (1994), 109, 399. 11 Ing-​Haw Cheng, Harrison Hong, and Jose Scheinkman, ‘Yesterday’s Heroes: Compensation and Creative Risk Taking’, Journal of Finance (2014) (pay and risk are correlated not because misaligned pay leads to creative risk-​taking; rather, as principal-​agent theory predicts, riskier firms have to pay more total compensation to provide the same incentives for a risk-​averse manager than less risky firms). 12 Rajan, n 8, 144–​5. 13 Douglas Diamond and Raghuram Rajan, ‘The Credit Crisis: Conjectures about Causes and Remedies’, American Economic Review (2009), 99, 2, 606–​10, 607.

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Compensation in Financial Institutions always understand, either as a result of flawed risk-​management systems or just out of sheer incompetence, what their subordinates were doing. The problem was exacerbated by the huge amounts at play both for employers and employees, who were often incentivized to place financial bets in the crazy way aptly described by Professor Alan Blinder: ‘Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for another job . . . Faced with such skewed incentives, they place lots of big bets. If heads come up, they acquire dynastic wealth. If tails come up, OPM [other people money] absorbs almost all losses’.14 B. Policy  issues As the author argued in another paper, the case for regulating the structure of 11.07 compensation appears to be rather weak.15 Firstly, it is not sure that pay structures generally contributed to excessive risk-​taking before the recent crisis. According to some of the studies cited above, corporate governance and compensation structures of CEOs at institutions that failed were not necessarily flawed. Secondly, even assuming that compensation structures were flawed—​particularly those of traders and other middle-​managers taking excessive risks—​the need for their regulation would not be automatically established. In fact, excessive risk-​taking could be curbed directly through prudential regulation of financial institutions, rather than by modelling the incentives of their employees, given that regulators may not be professionally qualified for designing pay structures.16 Thirdly, mandating pay structures hampers the flexibility of compensation arrangements, which need tailoring to individual firms and managers, in light of the latter’s portfolios of their institutions’ securities. Moreover, boards of directors lose one of their key governance functions, finding it more difficult to align executives’ incentives to corporate strategy and risk profile. This may also create problems in keeping and attracting managerial talent, particularly from countries that adopt a more liberal stance or from firms that are not subject to regulatory constraints (such as hedge funds or private equities). There is no doubt that competent authorities should supervise compensation from 11.08 the perspective of the supervised institutions’ safety and soundness.17 Rather than designing compensation structures ex ante, which is a matter for boards, they

14 Alan Blinder, After the Music Stopped. The Financial Crisis, the Response, and the Work Ahead, Penguin, 2013, 82. 15 Guido Ferrarini and Maria Cristina Ungureanu, ‘Economics, Politics, and the International Principles for Sound Compensation Practices: An Analysis of Executive Pay at European Banks’, Vanderbilt Law Review (2011), 64, 431–​502. 16 Blinder, n 14, 84 and 284. 17 Luc Laeven and Lev Ratnovski, ‘Corporate Governance of Banks and Financial Stability’, Vox, 21 July 2014, available at http:voxeu.org (accessed 30 September 2018).

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Guido Ferrarini should analyse the impact of remuneration structures on risk-​taking and conduct their surveillance activities accordingly, for instance by imposing higher capital requirements to institutions adopting ‘aggressive’ remuneration mechanisms which may lead to excessive risk-​taking. Moreover, supervisors should check bank compliance with compensation governance requirements and with the disclosure requirements concerning remuneration policies. Rather than interfering with pay structures, this type of regulation aims to ensure that organizational structures and procedures are in place for the setting of pay in compliance with safety and soundness requirements. 11.09

The case for regulating remuneration governance is stronger than that for mandating structure, at least to the extent that corporate governance was found deficient and in need of improvement after the financial crisis.18 In fact, some of the studies already cited show that ailing institutions were often the ones with the best corporate governance in place under international standards.19 However, the alignment of managerial interests with those of shareholders which ‘good’ governance determines is not enough from a financial stability perspective, for shareholders’ interests are not aligned with those of other stakeholders, like depositors and taxpayers, who will in the end pay for the costs of a crisis.20 Indeed, shareholders tend to push managers and boards to take risks in an amount higher than socially desirable, while the interest alignment deriving from good governance and remuneration practices works in the same direction, rather than that of financial stability.21

11.10

To the extent that risk-​management practices are flawed and board oversight on them is also deficient, an improvement of board organization and functioning is in the interest of shareholders, who would otherwise be negatively affected by

18 See, however, for heavy criticism of post-​crisis regulation, Luca Enriques and Dirk Zetzsche, ‘Quack Corporate Governance, Round III? Bank Board Regulation Under the New European Capital Requirement Directive’, ECGI Law Working Paper No 249/​2014. 19 See the studies by Andrea Beltratti and René Stulz, ‘The Credit Crisis around the Globe: Why Did Some Banks Perform Better?’, Journal of Financial Economics (2012), 105, 1–​17and Renée Adams, ‘Corporate Governance and the Financial Crisis’, International Review of Finance (2012), 12,  7–​38. 20 See Laeven and Ratnovski, n 17 (better corporate governance, by itself, is unlikely to make banks safer); Marco Becht, Patrick Bolton, and Ailsa Roell, ‘Why Bank Governance is Different’, Oxford Review of Economic Policy (2012), 27, 437–​63, 445 (not only shareholders, but also depositors, other creditors, transaction counterparties, and the taxpayers are at risk from banks’ activities; therefore, not just the interests of shareholders, but also those of other constituencies should be protected). 21 See Lawrence White, ‘Corporate Governance and Prudential Regulation of Banks: Is there Any Connection?’, in James Barth, Chen Lin, and Clas Wihlborg (eds), Research Handbook for Banking and Governance, Elgar, 2012, 344–​59, 344 (senior managers who properly respond to the interest of shareholders ought—​unless restrained by the debt holders or by prudential regulators—​to be undertaking activities that might otherwise appear to be excessively risky); Hamid Mehran, Alan Morrison, and Joel Shapiro, ‘Corporate Governance and Banks: What Have We Learned from the Financial Crisis?’, Federal Reserve Bank of New York, Staff Report No 502/​2011.

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Compensation in Financial Institutions excessive risk-​taking.22 Therefore, some regulation of corporate governance is justified from a prudential perspective; moreover, supervision should ensure that there is proper oversight of risk management within institutions, not only from a shareholders’ perspective, but also from a societal and systemic viewpoint. Also remuneration practices of risk-​takers are subject to oversight by the board, which should therefore check that they are sound from a risk-​management perspective, while prudential supervision could exert further pressure on boards in the same way.23 In addition, mandatory disclosure of compensation practices is justified on at least 11.11 two counts. Firstly, detailed disclosure of pay structure and amounts makes boards and managers more accountable to shareholders and the capital markets. Secondly, disclosure allows shareholders to better exercise their say-​on-​pay rights, while enabling supervisors to perform their function more effectively.24

III.  International Principles and Standards A. The FSB principles and standards The FSB principles are addressed to ‘significant financial institutions’, which more 11.12 than others deserve an internationally uniform regime. They cover four main compensation areas:  governance, structure, disclosure, and supervision. As to compensation governance, they incorporate well-​known best practices concerning the strategic and supervisory role of the board. In addition, they reflect the post-​crisis emphasis on bank risk management and monitoring of the same by the board of directors, who should determine the risk appetite of the firm. They reiterate the role of the remuneration committee, requiring its liaison with the risk committee to ensure compliance with the relevant requirements. Compensation structures are considered by the principles along lines that reflect, 11.13 to a large extent, best practices generally followed before the crisis. Indeed, the role and limits of equity-​based compensation, as well as the potentially perverse effects of short-​term incentives, have attracted much attention over the last twenty years.25 However, pre-​crisis practices mainly emphasized the alignment of managers’ incentives with shareholder wealth maximization. The principles break new ground by requiring financial institutions to align compensation with prudent risk-​taking.

22 See Andrew Ellul and Vijay Yerramilli, ‘Stronger Risk Controls, Lower Risk: Evidence from U.S Bank Holding Companies’, Journal of Finance (2013), 68, 1757–​803; Senior Supervisors Group, ‘Observations on risk management practices during the recent market turbulence, 2008. 23 See Laeven and Ratnovski, n 17; Mehran, Morrison, and Shapiro, n 21. 24 See, for the role of pay disclosure and its regulation, Guido Ferrarini and Maria Cristina Ungureanu, ‘Executive Remuneration. A  Comparative Overview’, in Jeffrey Gordon and Georg Ringe (eds), Oxford Handbook of Corporate Law and Governance, Oxford University Press, 2018. 25 See Ferrarini and Ungureanu, n 15.

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Guido Ferrarini Accordingly, compensation should be adjusted for all types of risk, including those considered difficult-​to-​measure, such as liquidity risk, reputation risk, and capital cost. Compensation outcomes should be symmetric with risk outcomes. 11.14

Deferment of compensation, traditionally used as a retention mechanism (on the basis that a ‘bad leaver’ would generally lose unpaid deferrals), should make compensation pay-​out schedules sensitive to the time horizon of risks. In particular, a substantial portion of variable compensation (i.e. 40–​60 per cent) should be payable under deferral arrangements over a period of not less than three years, provided that this period is correctly aligned with the nature of the business, its risks, and the activities of the employee in question. Furthermore, a substantial portion (i.e. more than 50 per cent) of variable compensation should be awarded in shares or share-​linked instruments, as long as the same create incentives aligned with long-​ term value creation and the time horizons of risk. In any event, awards in shares or share-​linked instruments should be subject to an appropriate retention policy.

11.15

The principles also tackle concerns relative to bonuses, which famously emerged during the recent crisis. They require ‘malus’ and ‘clawback’ mechanisms, which enable boards to reduce or reclaim bonuses paid on the basis of results that are unrepresentative of the company’s performance over the long term or later prove to have been misstated. They consider ‘guaranteed’ bonuses (i.e. contracts guaranteeing variable pay for several years) as conflicting with sound risk management and the pay-​for-​performance principle. Severance packages need to be related to performance achieved over time and designed in a way that does not reward failure.

11.16

Compensation disclosure, despite being widely practiced pre-​crisis, did not always meet the relevant standards. After the crisis, there has been consensus that disclosure should benefit not only shareholders, but also other stakeholders (e.g. creditors and employees). Moreover, disclosure should identify the relevant risk management and control systems and facilitate the work of supervisors in this area. The principles add new items of disclosure, such as deferral, share-​based incentives, and criteria for risk adjustment. They also require effective supervision. In the case of a failure by a firm to implement ‘sound’ compensation policies, prompt remedial action should be taken by supervisors and appropriate corrective measures should be adopted to offset any additional risk that may result from non-​compliance or partial compliance with the relevant provisions. B. The choice between standards and rules

11.17

The FSB principles represent a political compromise between the various interests at stake in the area of compensation, incorporating traditional criteria and adapting them to new circumstances. Firstly, they focus on long-​term incentives, in order to counter the role allegedly played by short-​term incentives in the crisis. Since executive compensation packages at most large banks before the crisis were

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Compensation in Financial Institutions already balanced between short-​term and long-​term incentives at least for CEOs (as shown by the Fahlenbrach and Stulz paper cited above),26 the international principles track already existing practices, but extend the same to a greater number of bank employees. Secondly, the principles widen the powers of supervisors by explicitly making pay at financial institutions subject to prudential supervision. Thirdly, similar to other international financial standards, the principles remain at a sufficient level of generality and allow for flexibility in implementation; in several instances, financial institutions are permitted to depart from a given principle or standard, if application of the same would lead to unsound consequences. However, the principles also interfere with compensation structures by asking in- 11.18 stitutions, for instance, to defer 40–​60 per cent of variable compensation and to award at least half of variable compensation in shares. This type of ‘one-​size-​fits-​all’ approach is open to criticism for all the reasons indicated in Section I. There is no doubt that states are free to implement the principles through either regulation or supervision and, if they adopt a supervisory approach to implementation, the interference with remuneration structures might be softer. Nonetheless, the existence of detailed principles and standards such as the ones just indicated—​which are indeed ‘rules’ rather than ‘standards’ for their level of specificity—​will inevitably shape supervisory actions producing results not entirely dissimilar from those of ad hoc regulation. The FSB principles have been implemented along different models.27 Some jur- 11.19 isdictions follow a primarily supervisory approach to implementation, involving principles and guidance and the associated supervisory reviews. In other jurisdictions the model includes a mix of regulation and supervisory oversight, with new regulations often supported by supervisory guidance that illustrates how the rules can be met. In jurisdictions like the European Union, a regulatory approach to implementation prevails grounded on two layers of directives and leaving only a narrow scope to supervisory discretion (see Sections III and IV below). In all jurisdictions, however, the law in action for remuneration at financial in- 11.20 stitutions consists of rules rather than standards. In fact, either the law foresees detailed requirements—​such as those concerning the deferment of compensation over a stated period of time—​or similar requirements are enforced by supervisors in practice on the basis of the standards foreseen by the law. Similar comments hold for the FSB principles and standards, which on one side offer a significant level of specificity; on the other, are enforced internationally by the FSB checking the level of compliance with the principles by individual states and making the results of

26 See n 4. 27 FSB, ‘Thematic Review on Compensation:  Peer Review Report’ 10-​11, 2010, available at http://​www.fsb.org/​wp-​content/​uploads/​r_​100330a.pdf, accessed 30 September 2018.

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Guido Ferrarini similar reviews public so as to stimulate convergence by all the jurisdictions concerned.28 Clearly, financial supervisors are comfortable with this approach, to the extent that their actions towards the supervised institutions are based on pre-​fixed standards. But even supervisees often prefer to know in advance the criteria under which their remuneration practices will be assessed, despite the fact that this inevitably reduces the space for autonomy and flexibility in the setting of bankers’ pay.

IV.  European Banking Regulation 11.21

The European Union initially adopted a supervisory approach to remuneration through the Commission Recommendation on remuneration in the financial sector (2009) touching upon the governance and structure of pay along lines similar to those followed by the FSB principles.29 At the same time, the Committee of European Banking Supervisors (CEBS) issued high-​level principles for remuneration policies at banks.30 However, subsequent reviews on the national implementation of these documents revealed shortcomings in several areas,31 such as the measurement of risk-​adjusted performance, the scope of the new standards, proportionality, and home/​host relationships. Similar differences, together with increased pressure from the media, politicians, and the public, led to a change in regulatory approach. The Capital Requirements Directive (implementing the Basel capital requirements) was amended twice also to include provisions on bankers’ remuneration: in 2010 when CRD III was enacted 32 and in 2013 when the CRD IV package was adopted, including a new directive concerning, inter alia, bankers’ remuneration.33 In addition, CEBS issued supervisory guidance in order to facilitate

28 FSB, ‘Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards’, Progress report, 13 June 2012; Second progress report, 26 August 2013. 29 Commission Recommendation on remuneration policies in the financial sector, C (2009) 3159, (April 2009). In June 2010 the Commission also published a Green Paper on corporate governance in financial institutions and remuneration policies, which analysed the deficiencies in corporate governance arrangements in the financial services industry and proposed possible ways forward; Commission Green Paper on corporate governance in financial institutions and remuneration policies (May 2011). 30 Committee of European Banking Supervisors (CEBS), ‘High-​ Level Principles for Remuneration Policies’, April 2009. 31 Commission Report on the application by Member States of the EU of the Commission 2009/​ 384/​EC Recommendation on remuneration policies in the financial services sector; CEBS, ‘Report on national implementation of CEBS High-​level principles for Remuneration Policies’ (June 2010). 32 Directive 2010/​76/​EU of the European Parliament and of the Council of 24 November 2010 Amending Directives 2006/​48/​EC and 2006/​49/​EC As Regards Capital Requirements for the Trading Book and for Re-​Securitisations, and the Supervisory Review of Remuneration Policies, [2010] OJ L329/​3. 33 Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​ 49/​EC, OJ [2013], L176/​338.

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Compensation in Financial Institutions compliance with the remuneration principles included in CRD III,34 while the EBA issued new Guidelines under the new directive.35 A. CRD  IV Notwithstanding the fact that executive pay at large banks was lower and more 11.22 balanced after the crisis,36 the European regulation in this area was deeply overhauled by Directive 2013/​36/​EU (Capital Requirements Directive, CRD IV).37 The new regime applies on a consolidated basis, that is, to ‘institutions at group, parent company and subsidiary levels, including those established in offshore financial centres’ (Article 92(1)). The ratio for an EU-​wide scope of application is ‘to protect and foster financial stability within the Union and to address any possible avoidance of the requirements laid down in this Directive’ (67th considerandum). Moreover, the new regime applies to different categories of staff including senior management, risk-​takers, staff engaged in control functions, and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk-​takers, whose professional activities have a material impact on their risk profile (Article 92(2)). In this regard, the Commission has recently adopted a delegated Regulation including regulatory technical standards on the identification of risk-​takers.38 Article 74 (1)  of CRD IV requires institutions to have in place a remuneration 11.23 policy for all staff, which should comply with the principles set out in Articles 92 and 93 of the Directive and with EBA Guidelines on sound remuneration policies. The remuneration policy should specify all components of remuneration and include the pension policy too. It should be consistent with the objectives of the institution’s business and risk strategy, corporate culture and values, long-​term

34 CEBS, ‘Guidelines on Remuneration Policies and Practices’ (CP42) (December 2010). The CEBS oversaw the implementation of the CRD until the European Banking Authority (EBA) was established in 2011. 35 EBA, ‘Guidelines on sound remuneration policies under Articles 74(3) and 75(2) of Directive 2013/​36/​EU and disclosures under Article 450 of Regulation (EU) No 575/​2013’, 21 December 2015. 36 The impact of CRD III on remuneration practices has been substantial, even though empirical research shows that changes also occurred before the Directive’s adoption: Roberto Barontini et al, ‘Directors’ Remuneration before and after the Crisis: Measuring the Impact of Reforms in Europe’, in Massimo Belcredi and Guido Ferrarini (eds), Boards and Shareholders in European Listed Companies, Cambridge University Press, 2013), 251–​314. 37 See, for the author’s previous work on this topic, Guido Ferrarini, ‘Regulating Bankers’ Pay in Europe:  The Case for Flexibility and Proportionality’, in Festschrift für Theodor Baums, Mohr Siebeck, 2017, I, 401–​16; Guido Ferrarini, ‘CRD IV and the Mandatory Structure of Bankers’ Pay’, ECGI Law Working Paper 289/​2015. 38 Commission Delegated Regulation (EU) No 604/​2014 of 4 March 2014, supplementing Directive 2013/​36/​EU of the European Parliament and of the Council with regard to regulatory technical standards with respect to qualitative and appropriate quantitative criteria to identify categories of staff whose professional activities have a material impact on an institution’s risk profile.

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Guido Ferrarini interests of the institution, and the measures used to avoid conflicts of interest, and should not encourage excessive risk-​taking. The remuneration policy should contain the performance objectives for the institution, the methods for the measurement of performance, the structure of variable remuneration, and the ex ante and ex post risk-​adjustment measures of the variable remuneration.39 11.24

Under Article 92(2) institutions comply with the principles just stated and other principles ‘in a manner and to the extent that is appropriate to their size, internal organization and the nature, scope and complexity of their activities’. As explained in Recital 66: The provisions of this Directive on remuneration should reflect differences between different types of institutions in a proportionate manner, taking into account their size, internal organisation and the nature, scope and complexity of their activities. In particular, it would not be proportionate to require certain types of investment firms to comply with all those principles.

The EBA Guidelines further specify that the proportionality principle ‘aims to match remuneration policies and practices consistently with the individual risk profile, risk appetite and strategy of an institution, so that the objectives of the obligations are effectively achieved’.40 However, the EBA’s recent opinion on proportionality expressed the view—​shared by the European Commission—​that ‘the wording of Article 92 (2) does not permit exemptions or waivers to the application of the remuneration principles’.41 11.25

A similar interpretation had already been adopted in the EBA Consultation Paper on the draft guidelines stating: Where the CRD sets some specific requirements with numerical criteria (i.e. the minimum deferral period of three to five years; the minimum proportion of 40% to 60% of variable remuneration that should be deferred . . .), institutions should apply the criteria based on proportionality, considering that in particular for significant institutions and their senior management and members of the management body more strict criteria should be set, and in any case apply at least the minima criteria set in the CRD.42

According to this interpretation, proportionality can only determine an enhancement of the applicable criteria, not a waiver of the same. As a result, ‘neutralization’ practices, which were allowed under the CEBS Guidelines with respect to the

39 EBA, ‘Guidelines on sound remuneration policies’, 14–​22. 40 ibid, 75. 41 EBA, ‘Opinion on the application of proportionality to the remuneration provisions in Directive 2013/​36/​EU’, EBA/​Op/​2015/​25,  13. 42 EBA, ‘Consultation Paper. Draft Guidelines on sound remuneration policies’, EBA/​CP/​2015/​ 03, 73.

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Compensation in Financial Institutions requirements previously in force,43 are no longer admitted by the European authorities with a significant restraint of the proportionality principle. Nonetheless, EBA opinion acknowledged that information provided by competent 11.26 authorities, together with evidence gathered from stakeholders during the consultation period, show that ‘there are different legal interpretations of the proportionality clause as established in Article 92(2) of Directive 2013/​36/​EU, which have led to different applications of the remuneration principles at national level. These approaches would be in line with the CEBS Guidelines on remuneration policies and practices’.44 As a result, the EBA concluded that action is necessary at the level of the EU institutions in order to ensure that remuneration requirements are applied consistently across the Union. In the EBA’s view, CRD IV should be amended ‘to exclude certain small, non-​complex institutions from the requirements to apply the remuneration principles regarding deferral and payment in instruments for variable remuneration, and to limit the scope of those remuneration principles as regards staff who receive low amounts of variable remuneration, including large institutions’.45 The European Commission has recently presented a proposal to this effect, as explained in Section IV.C below. Article 94(1) provides several requirements for the variable elements of remuner- 11.27 ation. Some of them are rather generic, such as the one requiring performance pay to be based on a combination of the assessment of the performance of the individual and of the business unit concerned and of the overall results of the institution. In addition, performance should be assessed in a multi-​year framework in order to ensure that the assessment process is based on longer-​term performance and that the actual payment of performance-​based components of remuneration is spread over a period which takes account of the underlying business cycle of the credit institution and its business risks. The EBA Guidelines specify that when the award of variable remuneration, including long-​term incentive plans (LTIP), is based on past performance of at least one year, but also depends on future performance conditions, institutions should clearly set out to staff the additional performance conditions that have to be met after the award for the variable remuneration to vest.46 The additional performance conditions should be set for a predefined performance period of at least one year and, when they are not met, up to 100 per cent of the variable remuneration awarded under those conditions should be subject to malus arrangements.47



CEBS, ‘Guidelines on remuneration policies and practices’, 20 and Annex 2. EBA, n 40, 13. 45 ibid,  21–​2. 46 EBA, ‘Guidelines on sound remuneration policies’, 124. 47 ibid. 43 44

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In addition under Article 94(1), the total variable remuneration should not limit the ability of the institution to strengthen its capital base. Furthermore, the fixed and variable components of total remuneration should be appropriately balanced and the fixed component should represent a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component.

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Other requirements are more specific, particularly the cap on variable remuneration that the European Parliament asked to be included in CRD IV and that will be analysed in the following paragraph. Severance payments are also covered by the provision: they will have to reflect performance achieved over time and should not reward failure or misconduct. In addition, remuneration packages relating to compensation or buy out from contracts in previous employment must align with the long-​term interests of the institution concerned, including retention, deferral, performance, and clawback arrangements.

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In general, the measurement of performance used to calculate variable remuneration should include an adjustment for all types of current and future risks and take into account the cost of the capital and the liquidity required. A substantial portion, and in any event at least 50 per cent of variable remuneration shall consist of a balance of (i) shares or equivalent ownership interests, subject to the legal structure of the institution concerned or share-​linked instruments or equivalent non-​cash instruments, in the case of a non-​listed institution; (ii) where possible, other instruments within the meaning of Articles 52 or 63 of Regulation (EU) No 575/​2013 or other instruments which can be fully converted to Common Equity Tier 1 instruments or written down, that in each case adequately reflect the credit quality of the institution as a going concern and are appropriate to be used for the purposes of variable remuneration. B. The cap on variable remuneration

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While Directive 2010/​76/​EU (CRD III) simply required an ‘appropriate balance’ between fixed and variable remuneration (Article 23), CRD IV also establishes a maximum ratio between the two remuneration components. The definition of these components is found in the Directive’s 64th considerandum, stating that fixed remuneration includes ‘payments, proportionate regular pension contributions, or benefits (where such benefits are without consideration of any performance criteria)’, while variable remuneration includes ‘additional payments, or benefits depending on performance or, in exceptional circumstances, other contractual elements but not those which form part of routine employment packages (such as healthcare, child care facilities or proportionate regular pension contributions)’. Both monetary and non-​monetary benefits are comprised in the relevant

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Compensation in Financial Institutions definitions. The criteria for setting fixed and variable remuneration are found in Article 92(2)(g) stating that basic fixed remuneration should primarily reflect relevant professional experience and organizational responsibility, while variable remuneration should reflect ‘a sustainable and risk adjusted performance as well as performance in excess of that required to fulfil the employee’s job description as part of the terms of employment’. Under Article 94(1)(f), the fixed and variable components of total remuneration 11.32 should be appropriately balanced and the fixed component should represent a sufficiently high proportion of the total remuneration ‘to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component’. However, Article 94(1)(g) further constrains this proportion by stating that the variable component should not exceed 100 per cent of the fixed component of the total remuneration for each individual. Moreover, Member States may set a lower maximum percentage (as Belgium and the Netherlands did, by setting 50 per cent and 20 per cent respectively). Alternatively, Member States may allow shareholders of the institution concerned to approve a higher maximum level of the ratio between fixed and variable remuneration provided the overall level of the variable component shall not exceed 200 per cent of the fixed component of the total remuneration for each individual. Member States may also set a lower percentage. In any case, approval of a higher percentage should occur through a special procedure that is described in detail by Article 94(1)(g)(ii). The official justification for the cap on variable remuneration is ‘to avoid excessive 11.33 risk taking’ (65th considerandum). The Directive implicitly assumes that an excessive level of variable remuneration is likely to induce excessive risk taking by the managers of financial institutions, as (arguably) shown by the financial crisis. The need for capping variable pay, based on the assumption that excessive bonuses contributed to recent bank failures, was brought forward quite vigorously by France and Germany in the aftermath of the crisis, but was not recognized at international level, where the FSB rejected any suggestion of introducing a cap on bonuses given the firm opposition of the US government.48 However, the initial Commission proposal of CRD IV did not include a similar cap, which was later suggested by the European Parliament among a number of amendments to the Commission’s proposal.49

48 See Eilis Ferran, ‘New Regulation of Remuneration in the Financial Services in the EU’, European Company and Financial Law Review (2012), 9, 1–​34. 49 See European Parliament, ‘Report on the proposal for a directive of the European Parliament and of the Council on the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms etc’. (A 7-​0170/​2012) of 30 May 2012, Article 90(1)(f ) (‘institutions shall set the appropriate ratios between the fixed and the variable component of the total remuneration where the variable component shall not exceed one time the fixed component of the total remuneration’).

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The adoption of a cap was nonetheless controversial. The United Kingdom, in particular, vehemently contested the same, reflecting the City of London’s concerns that capping variable pay would disrupt remuneration practices of investment banks, which rely heavily on bonuses and other types of performance-​related pay.50 The UK government brought proceedings against the European Parliament and the Council seeking the annulment of the CRD IV provisions regarding the limits on variable remuneration, the EBA’s rule-​making powers in this area and the public disclosure of certain details of the material risk-​takers’ salaries required by the Capital Requirements Regulation (CRR). The United Kingdom mainly maintained that the contested provisions have an inadequate Treaty legal base in addition to being disproportionate and failing to comply with the principle of subsidiarity.51

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However, the Opinion of Advocate General Jääskinen found the UK’s pleas ungrounded, firstly by arguing that the cap on variable remuneration ‘does not impact directly on the level of pay’, rather it ‘merely establishes a ratio between the fixed and variable element without affecting the level of remuneration as such’.52 As contended below, this is disputable from an economic perspective, as it is likely that the cap on variable pay will push fixed pay upwards, while variable remuneration will stay below the amount that the labour market would otherwise require. Therefore, the cap may have an impact both on the structure and on the level of remuneration. Secondly the Advocate General argued that ‘all the procedural requirements relating to the assessment of the compliance of the proposal with the principles of proportionality and subsidiarity were duly respected by the EU legislature’, which ‘possesses a wide margin of discretion’.53 However, the Opinion largely ignores (or is agnostic about) the possible arguments—​summarized below—​against regulating the level of bankers’ pay, implicitly relying on the post-​crisis populist debate about excessive pay at financial institutions and on the assumption that all arguments in favour and against regulation have been duly considered by the legislature.54 Nevertheless, the United Kingdom—​immediately after publication of the

50 See Kate Allen, ‘Goldman top bankers lead UK pay league with £3m packages’, Financial Times, 1 January 2015: in 2013 Goldman Sachs paid its senior staff bonuses worth 5.5 times their average salary, the highest ratio among the five top banks; Citigroup was the only top bank consistent with the EU cap in 2013, paying staff bonuses averaging 1.6 times salary. 51 Action brought on 20 September 2013—​Case C-​507/​13 United Kingdom of Great Britain and Northern Ireland v European Parliament, Council of the European Union. 52 Opinion of Advocate General Jääskinen delivered on 20 November 2014, Case C-​507/​13 United Kingdom of Great Britain and Northern Ireland v European Parliament and Council of the European Union, para 120. 53 ibid, para 103. 54 ibid, para 98, focusing on procedural issues rather than substance: . . . the material that was available to the decision-​makers clearly demonstrated that restricting incentives to excessive risk taking by the management and staff of financial institutions was likely to reduce such risk taking and, in consequence, any risk for the stability of financial markets following therefrom. Under such circumstances, the question

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Compensation in Financial Institutions Advocate General’s Opinion—​withdrew its application and the case was therefore discontinued.55 C. Criticism of the cap The de Larosiére Report suggested that there are two dimensions to the problem of 11.36 bankers’ remuneration: one is the often excessive level of remuneration in the financial sector; the other one is the structure of this remuneration . . . Social-​political dissatisfaction has tended recently to focus, for understandable reasons, on the former. However, it is primarily the latter issue which has had an adverse impact on risk management and has thereby contributed to the crisis. It is therefore on the structure of remuneration that policy-​makers should concentrate reforms going forward.56

Similar arguments are found, across the Atlantic, in a report by a committee of highly distinguished economists (the ‘Squam Lake Group’) who argued that governments should generally not regulate the level of executive compensation in financial institutions. Indeed, no convincing evidence has been seen to suggest that high levels of compensation in financial companies are inherently risky for the companies themselves or the overall economy. Moreover, limits on pay are likely to cause unintended consequences, so that society is better off if compensation levels are set by market forces.57 In a similar vein, Richard Posner argues: ‘. . . efforts to place legal limits on compensation are bound to fail, or to be defeated by loopholes, or to cause distortions in the executive labour market and in corporate behaviour’.58 Indeed, experience relative to the use of ‘role-​based allowances’ by around thirty-​ 11.37 nine European banks shows that efforts to circumvent the EU cap were soon made after its introduction. Role-​based allowances are linked to the position and organizational responsibility of staff. As explained by the EBA in an opinion given to the European Commission, ‘allowances’ are payments or benefits paid in addition where and by whom the concrete limits to such initiatives were to be set concerned, in my opinion, the degree of regulation that was appropriate. This has clearly involved economic and political choices. However, such choices need to have been manifestly inappropriate before the legislative measure can be annulled. 55 See Order of the President of the Court 9 December 2014 (Removal from the register) in Case C-​507/​13. 56 ‘High-​Level Group on Financial Supervision in the EU, Final Report’, February 2009, para 117. 57 Kenneth French et al, The Squam Lake Report. Fixing the Financial System, Princeton 2010, 75. 58 Richard Posner, A Failure of Capitalism. The Crisis of ‘08 and the Descent into Depression, Harvard, 2009, 297; similar comments in Sanjai Bhagat, Brian Bolton, and Roberto Romano, ‘Getting Incentives Right: Is Deferred Bank Executive Compensation Sufficient?’, ECGI Law Working Paper No. 241/2014, February 2014, 35; and Rui Albuquerque, Luís Cabral, and José Corrêa Guedes, ‘Relative Performance, Banker Compensation, and Systemic Risk’, ECGI Finance Working Paper No 490/​2016, who argue that, without a regulatory constraint on relative performance evaluation (RPE), some of the restrictive measures on executive compensation that are found in regulation are ineffective in reducing systemic risk.

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Guido Ferrarini to basic salary and variable remuneration (bonus).59 Banks tended to consider all allowances, including role-​based allowances, as fixed remuneration, arguing that they were not based on performance. However, role-​based allowances are generally not part of the basic salary and are not pensionable; are initially granted for a limited period of time; can be reduced, suspended, or cancelled by banks on a fully discretionary basis; and include other contractual conditions which do not form part of routine employment packages. In the EBA’s opinion, in order to qualify as fixed remuneration ‘the conditions for their granting and the amount of the role-​based allowance should be predetermined, transparent to staff, permanent, i.e. maintained over time and tied to specific role and organisational responsibilities, not provide incentives to take risks and, without prejudice to national law, be non-​ revocable.’60 As a result, the EBA believes that role-​based allowance not complying with these conditions (e.g. it is not predetermined, is not permanent, or provides incentives to take risks) should be classified as variable remuneration ‘in line with the letter and purpose of the CRD’.61 Similar criteria are now included in the the EBA Guidelines, which in section 7 identify the categories of remuneration (fixed and variable) and in section 8.1 deal specifically with allowances. 11.38

Going back to the widespread criticism of the maximum ratio, several arguments show that neither the objective to reduce excessive risk-​taking nor the one to reduce perceived excesses in the level of banking remuneration will be achieved by capping variable remuneration.62 Firstly, the cap will likely increase the level of fixed remuneration, making banks more vulnerable to business cycles and therefore increasing the risk of bank failure. Anecdotal evidence already shows that fixed pay at large European banks is on the rise,63 while the EBA reached similar findings for EU 59 See ‘Opinion of the European Banking Authority on the application of Directive 2013/​36/​EU (Capital Requirements Directive) regarding the principles on remuneration policies of credit institutions and investment firms and the use of allowances’, EBA/​Op/​2014/​10, 15 October 2014, 2. See also the EBA Report, ‘On the application of Directive 2013/​36/​EU (CRD) regarding the principles on remuneration policies of credit institutions and investment firms and the use of allowances’, 15 October 2014. 60 EBA, n 41, 2. 61 ibid, 3. 62 Kevin Murphy, ‘Regulating Banking Bonuses in the European Union:  a Case Study in Unintended Consequences’, European Financial Management (2013), 19, 631–​57. A slightly different position is taken by John Thanassoulis, ‘The Case for Intervening in Bankers’ Pay’, Journal of Finance (2012), 67, 849–​95, who argues that a modest bonus cap—​‘modest in that it is close to the current equilibrium rate of bonuses’—​lowers default risk; however, stringent bonus caps, such as those introduced by CRD IV, enhance default risk, and are value destroying. 63 The case of Deutsche Bank is interesting. At the 2014 AGM the bank proposed to raise the maximum bonus senior managers can receive to twice their fixed annual salary, double the current level. Deutsche Bank officials said the move was necessary so that the bank could comply with European rules on pay, while also competing for staff with US rivals. They said that if the bonus increase was rejected, the bank would need to raise base salaries to retain top talent. But opposition to the proposals (which was however approved) was mounting from shareholder groups who argued that the payment was excessive and fostered improper behaviour: see Eyk Henning, ‘Some Deutsche Bank Shareholders Plan to Protest Bonus Proposal’, Wall Street Journal, 16 May 2014, available at

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Compensation in Financial Institutions banks in general (as reported in the following section), even though a similar trend predates the introduction of a maximum ratio for fixed-​variable pay. Secondly, the traditional bonus system at investment banks, which is characterized 11.39 by below-​market salaries and high-​bonus opportunities, provides strong incentives to avoid ‘bad’ risks and take ‘good’ ones. On the contrary, the new system—​which will be characterized by above-​market salaries and ‘capped’ bonuses—​provides incentives to take ‘bad’ risks and avoid ‘good’ ones. In fact, if bad risks materialize, the bank manager will not suffer, for his or her remuneration is to a large extent fixed. But, if the bank shuns good risks and the relevant profits, the responsible manager will not be worse off given that his or her bonus is capped. Indeed, the bonus cap reduces incentives to create value, which is the main purpose of variable pay.64 Thirdly, executive remuneration is largely set by the markets, so that a bonus 11.40 cap could have unintended consequences on the firms’ ability to hire people of adequate standing in the international market for managers. In the end, remuneration ‘will reflect a less-​talented workforce as the top producers leave for better-​ paying opportunities in financial firms not subject to the pay restrictions’. In other words, the cap ‘will not lead to lower levels of overall remuneration after adjusting for ability and the risk of the remuneration package’.65 Furthermore, the cap on variable pay will reduce the competitiveness of the EU banking sector relative to non-​EU banks and other non-​bank financial intermediaries which are not subject to similar restrictions. Fourthly, the mandatory cap reflects a ‘one-​size-​fits-​all’ approach which is clearly 11.41 too rigid, for different types of credit institutions and investment firms present different levels of risk exposure, so that an incentive structure which is appropriate for one firm is not necessarily suited to another. Moreover, the EU bonus cap applies to all credit institutions, without regard to their size and to systemic risk considerations. Additional problems may derive from the combination of different tools to deal 11.42 with the same problem (excessive pay). Indeed, a good part of the CRD IV provisions are based on the international principles’ approach to bankers’ remuneration, which is flexible and relies on pay governance, transparency, and the requirement of an adequate proportion between fixed and variable pay. Other provisions incorporate the international requirements for the deferment of variable pay and the

http://​online.wsj.com/​articles/​SB10001424052702304908304579566140929304688 accessed 24 November 2014. 64 See also Bhagat, Bolton, and Romano, n 58, 36 (the EU cap will make pay even less sensitive to performance than it was before the crisis, which is the opposite of what is desirable in an incentive compensation plan). 65 Murphy, n 62.

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Guido Ferrarini payment of a portion of the same in equity and other financial instruments issued by the bank. The juxtaposition of a cap on variable pay to similar requirements not only may appear redundant and counterproductive, for the reasons explained by Murphy, but could determine further unintended consequences. In particular, the pressure to increase fixed pay deriving from the cap could be enhanced by the requirement that variable pay should be deferred and partly paid in equity or other financial instruments. In fact, a similar requirement pushes variable pay to a higher level than what would be agreed if remuneration were paid in cash and without deferment; but higher variable pay determines an increase in fixed pay given the fixed ratio between the two components of remuneration. The final result of the cumulus of different criteria will be an increase of overall remuneration, including fixed and variable components. D. Impact of the cap in practice 11.43

The EBA conducted a benchmarking exercise on remuneration practices with regard to 2014, examining the impact of the bonus cap.66 One of the EBA’s main findings is that the fixed remuneration of identified staff increased, while the variable remuneration was reduced; on average, following the introduction of the cap, the ratio between fixed and variable plunged to 65.48 per cent from 104.27 per cent in 2013. The highest variable remuneration and total remuneration were paid in investment banking where the ratio of variable to fixed remuneration for identified staff dropped on average from 191.17 per cent in 2013 to 88.89 per cent in 2014. In retail banking the same ratio dropped from 35.05 per cent in 2012 and 24.97 per cent in 2013 to 30.29 per cent in 2014; in asset management from 128.86 per cent in 2012 and 107.88 per cent in 2013 to 100.19 per cent in 2014. Therefore, the mandatory cap introduced by CRD IV easily accommodates the average ratio between fixed and variable remuneration in retail banking, while it is close to the average ratio in asset management and investment banking. In other words, the ratio could be higher in the last two sectors in the absence of the cap.

11.44

These data were commented on by the Commission’s report to the European Parliament including an assessment of the remuneration rules under CRD IV.67 The Commission rejected the idea of a causal link between the Directive’s maximum ratio and the decrease in the variable part of remuneration with respect to the fixed one arguing that a similar trend had already begun several years before

66 EBA, ‘Benchmarking of remuneration practices at the European Union level and data on high earners (data as of end 2014)’, EBA-​OP-​2016-​05, 30 March 2016. 67 Report from the Commission to the European Parliament and the Council, Assessment of the remuneration rules under Directive 2013/​36/​EU and Regulation (EU) No 575/​2013, Brussels, 28 July 2016. See also Commission Staff Working Document, Detailed assessment of the remuneration rules under Directive 2013/​36/​EU and Regulation (EU) No 575/​2013, Brussels, 28 July 2016.

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Compensation in Financial Institutions the introduction of the maximum ratio.68 The Commission added that there are other elements impacting on the levels and proportions of the remuneration components, such as financial performance, profitability, and general prudential requirements, and that an increase in the fixed portion of remuneration has also been observed in several non-​EU jurisdictions, including the United States and some Asian countries. Moreover, the EBA’s findings have been reached on the basis of averages mainly collected from large banking groups and need to be interpreted with care. However, the Commission conceded that ‘while the overall shift towards fixed remuneration cannot be clearly attributed to the maximum ratio, it is likely that in some individual cases the maximum ratio has led to a shift from variable to fixed remuneration’.69 This is consistent with the criticism of the maximum ratio advanced in the previous section on a theoretical level. The Commission however dismissed other criticism of the maximum ratio. Firstly, it 11.45 argued that it is too early to establish whether reducing the variable part of remuneration has substantially affected the risk-​taking incentives at financial institutions.70 In addition, a study made by the Institut für Finanzdienstleistungen for the Commission reports the answers to a questionnaire on remuneration structure and incentives sent to banks, showing that 41 per cent of identified staff stated that an increase in fixed pay would not affect their risk-​taking behaviour and 27 per cent said that it would have little effect.71 An overwhelming 94 per cent of respondents disagreed that more fixed pay would reduce motivation to take risks. The study comments on these data by arguing that the reaction of bankers to fixed incentives may be cultural: ‘Certain cultures respond to higher fixed pay as an incentive, while others are more motivated by the opportunity to earn more through more variable pay.’72 Secondly, the Commission downplayed the impact of the maximum ratio on fixed 11.46 costs and profitability, arguing that fixed remuneration of identified staff in the institutions examined represented, in 2014, below 5 per cent of the total administrative costs, while variable remuneration accounted for only 1 to 2 per cent of the total administrative costs of most of the institutions examined. Moreover, the total fixed remuneration cost of identified staff on an aggregate basis was relatively small compared with the net profits of institutions: ‘This suggests there is a non-​ negligible margin for fixed remuneration to increase before reaching a level that would threaten the overall profitability of institutions.’73

68 Report, n 67. 69 ibid, 10. 70 ibid. 71 Study on the remuneration provisions applicable to credit institutions and investment firms prepared by the Institute for financial services for European Commission’s DG JUST (Contract JUST/​2015/​MARK/​PR/​CIVI/​0001), Final Report, January 2016,  93. 72 ibid, 94. 73 Report, n 67, 11.

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Thirdly, the Commission rejected the claim that the maximum ratio would reduce institutions’ competitiveness by negatively affecting their ability to attract and retain talent. In its view, ‘many elements play a part in a staff’s member decision to move, such as job security, promotion prospects, the reputation enjoyed by the sector, taxation, family, language and living conditions’.74 Also the choice of the proportion between fixed and variable remuneration may depend on personal or cultural preferences. However, the Commission conceded that this issue may merit further assessment when more experience with the rule is gained in practice.

V.  EU Regulation of Insurers, Asset Managers, and Investment Undertakings 11.48

Banks are at the core of the remuneration regime fixed at international and EU levels for the simple reason that they experienced the most serious problems in this area throughout the financial crisis and were also the target of the greatest financial stability concerns as a result of repeated crises both in the United States and the European Union. However, other institutions are not immune from the problems concerning employees’ remuneration and its impact on risk-​taking, while the international principles on sound compensation practices apply to all financial institutions. The present analysis should therefore briefly be complemented by a review of the EU provisions extending and adapting the remuneration regime to financial institutions other than banks, such as insurance undertakings, asset managers, and investment firms. A. Insurers

11.49

The provisions on insurers’ remuneration policy and its regulation are found in the Commission Delegated Regulation (EU) 2015/​35 of 10 October 2014 supplementing Directive 2009/​138/​EC on the taking-​up and pursuit of the business of insurance and reinsurance (Solvency II).75 Article 275 of this Regulation (Solvency II Regulation) provides that, when adopting their remuneration policy, insurance and reinsurance undertakings shall comply with a number of principles, including the following. Firstly, the remuneration policy and remuneration practices shall be established, implemented, and maintained in line with the undertaking’s business and risk-​management strategy, its risk profile, objectives, risk-​management practices, and the long-​term interests and performance of the undertaking as a whole,

74 ibid. 75 See Michele Siri, ‘Corporate Governance of Insurance Firms after Solvency II’, ICIR Working Paper Series No 27/​ 2017, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR), available at https://​ideas.repec.org/​p/​zbw/​icirwp/​2717.html, accessed 30 September 2018.

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Compensation in Financial Institutions and shall incorporate measures aimed at avoiding conflicts of interest. Moreover, the remuneration policy shall promote sound and effective risk management and shall not encourage risk-​taking that exceeds the risk tolerance limits of the undertaking. In addition, the remuneration policy shall apply to the undertaking as a whole and contain specific arrangements that take into account the tasks and performance of the administrative, management, or supervisory body; persons who effectively run the undertaking or have other key functions; and other categories of staff whose professional activities have a material impact on the undertaking’s risk profile. Secondly, the administrative, management, or supervisory body of the undertaking 11.50 shall establish the remuneration policy for those categories of staff whose professional activities have a material impact on the undertaking’s risk profile and is responsible for the oversight of its implementation. An independent remuneration committee shall be created if appropriate in relation to the significance of the insurance or reinsurance undertakings in terms of size and internal organization. Thirdly, some principles shall apply to the remuneration policy of insurance under- 11.51 takings. To start with, the fixed and variable components of remuneration schemes shall be balanced so that the fixed or guaranteed component represents a sufficiently high proportion of the total remuneration to avoid employees being overly dependent on the variable components and to allow the undertaking to operate a fully flexible bonus policy, including the possibility of paying no variable component. Where variable remuneration is performance related, the total amount of the variable remuneration is based on a combination of the assessment of the performance of the individual and of the business unit concerned and of the overall result of the undertaking or the group to which the undertakings belongs. In addition, a substantial portion of the variable remuneration shall contain a flex- 11.52 ible, deferred component that takes account of the nature and time horizon of the undertaking’s business. The deferral period shall not be less than three years and the period shall be correctly aligned with the nature of the business, its risks, and the activities of the employees in question. Financial and non-​financial criteria shall be taken into account when assessing an individual’s performance. Moreover, the measurement of performance, as a basis for variable remuneration, shall include a downwards adjustment for exposure to current and future risks, taking into account the undertaking’s risk profile and the cost of capital. B. Asset managers Under Article 14a, Directive 2009/​65/​EC as amended by Directive 2014/​91/​EU 11.53 of 23 July 2014 (UCITS V), Member States shall require management companies to establish and apply remuneration policies and practices that are consistent with, and promote, sound and effective risk management and that neither encourage

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Guido Ferrarini risk-​taking which is inconsistent with the risk profiles, rules, or instruments of incorporation of the UCITS that they manage nor impair compliance with the management company’s duty to act in the best interest of the UCITS. The remuneration policies and practices shall include fixed and variable components of salaries and discretionary pension benefits. 11.54

When establishing and applying their remuneration policies, management companies shall comply with the Directive’s principles in a way and to the extent that is appropriate to their size, internal organization and the nature, scope and complexity of their activities (Article 14b). In particular, the remuneration policy must be in line with the business strategy, objectives, values, and interests of the management company and the UCITS that it manages and of the investors in such UCITS, and includes measures to avoid conflicts of interest. In addition, the assessment of performance is set in a multi-​year framework appropriate to the holding period recommended to the investors of the UCITS managed by the management company in order to ensure that the assessment process is based on the longer-​term performance of the UCITS and its investment risks and that the actual payment of performance-​based components of remuneration is spread over the same period. Moreover, subject to the legal structure of the UCITS and its fund rules or instruments of incorporation, a substantial portion, and in any event at least 50 per cent of any variable remuneration component consists of units of the UCITS concerned, equivalent ownership interests, or share-​linked instruments or equivalent non-​cash instruments with equally effective incentives as any of the instruments referred to above. The instruments shall be subject to an appropriate retention policy designed to align incentives with the interests of the management company and the UCITS that it manages and the investors of such UCITS.

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Furthermore, a substantial portion, and in any event at least 40 per cent, of the variable remuneration component, is deferred over a period which is appropriate in view of the holding period recommended to the investors of the UCITS concerned and is correctly aligned with the nature of the risks of the UCITS in question. This period shall be at least three years. However, the variable remuneration, including the deferred portion, is paid or vests only if it is sustainable according to the financial situation of the management company as a whole, and justified according to the performance of the business unit, the UCITS, and the individual concerned. The total variable remuneration shall generally be considerably contracted where subdued or negative financial performance of the management company or of the UCITS concerned occurs, taking into account both current compensation and reductions in pay-​outs of amounts previously earned, including through malus or clawback arrangements.

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Similar principles apply to Alternative Investment Fund Managers (AIFMs) under Directive 2011/​61/​EU of 8 June 2011.76 Article 13 of this Directive provides that 76 See Lodewijk van Setten and Danny Busch (eds), Alternative Investment Funds in Europe: Law and Practice Oxford University Press, 2014; Niamh Moloney, EU Securities and Financial Markets

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Compensation in Financial Institutions Member States shall require AIFMs to have remuneration policies and practices for those categories of staff, including senior management, risk-​takers, control functions, and any employees receiving total remuneration that takes them into the same remuneration bracket as senior management and risk-​takers, whose professional activities have a material impact on the risk profiles of the AIFMs or of the AIFs they manage, that are consistent with and promote sound and effective risk management, and do not encourage risk-​taking which is inconsistent with the risk profiles, rules, or instruments of incorporation of the AIFs they manage. The AIFMs shall determine the remuneration policies and practices in accordance with Annex II to the Directive. C. Investment  firms Investment firms are subject to the regime applicable also to credit institutions 11.57 (CRD IV), to which MiFID II adds the requirement that the management body has to develop a specific remuneration policy for persons involved in the provision of services to clients so as to ‘encourage responsible business conduct, fair treatment of clients as well as avoiding conflict of interest in the relationship with client’ (Article 9(3)(c)).77 Article 27 of the Delegated Council Regulation (EU) 2017/​565 of 25 April 2016 supplementing MiFID II provides more detailed requirements. Firstly, investment firms shall define and implement remuneration policies and practices under appropriate internal procedures taking into account the interests of all the clients of the firm, with a view to ensuring that clients are treated fairly and their interests are not impaired by the remuneration practices adopted by the firm in the short, medium, or long term. In addition, remuneration policies and practices shall be designed in such a way as not to create a conflict of interest or incentive that may lead relevant persons to favour their own interests or the firm’s interests to the potential detriment of any client. Secondly, investment firms shall ensure that their remuneration policies and practices apply to all relevant persons with an impact, directly or indirectly, on investment and ancillary services provided by the investment firm or on its corporate behaviour, regardless of the type of clients, to the extent that the remuneration of such persons and similar incentives may create a conflict of interest that encourages them to act against the interests of any of the firm’s clients. Thirdly, principles reflecting those already analysed in this chapter apply to the governance aspects of remuneration and to the balance between its fixed and variable components.

Regulation, Oxford University Press, 2014, 211, noting that it was the AIFM Directive which influenced the reform of the UCITS Directive as to remuneration. 77 See Jens-​Heinrich Binder, ‘Governance of Investment Firms under MiFID II’, in Danny Busch and Guido Ferrarini (eds), Regulation of the EU Financial Markets: MiFID II and MiFIR, Oxford University Press, 2017, 72.

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VI.  Ways to Improve EU Regulation 11.58

In this section, two possible ways to improve EU regulation of remuneration at financial institutions are examined, always assuming that there should be regulation, as is presently agreed at international level. One is focusing on systemic risk, the other is enhancing proportionality. The bonus cap is not discussed here given that it has already been argued in this chapter that there should not be one. A. Focusing on systemic risk

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The FSB principles and standards only apply to ‘significant financial institutions’. The Financial Stability Forum (FSF) (now the Financial Stability Board (FSB)) specified in its Introduction to the Principles that ‘they are intended to apply to significant financial institutions, but they are especially critical for large, systemically important firms’. This establishes a clear link between the Principles and systemic risk. The Principles do not apply only to global systemically important financial institutions (G-​SIFIs) or banks (G-​SIBs); however, the ‘significance’ of a financial institution, which is required for their application, should be assessed from the perspective of systemic risk too.

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Another way to look at the Principles is by focusing on institutions that are ‘too-​ big-​to-​fail’ (TBTF). Indeed, significant financial institutions are likely to benefit from a government bailout in the case of a crisis, despite recent reforms providing for the resolution of insolvent institutions without recourse to taxpayer money. As argued by Thanassoulis and Tanaka, in the presence of deposit insurance and the implicit possibility of government bailouts risk-​taking is subsidized to the point that special rules on incentives may be justified.78 Indeed, there are three types of agency problems which might lead to remuneration contracts that incentivize excessive risk-​taking. The first runs between the institution’s executives and shareholders, to the extent that the former may not adequately take the long-​term interests of the latter into account. This agency problem can be solved through deferred equity-​linked pay, as also foreseen under the international principles. The second runs between the institution’s executives and debt holders: the former may have incentives to take excessive risks at the expense of the latter if the debt market cannot monitor the risks and price them accurately. This agency problem can be solved by either linking variable remuneration to the price of debt or to credit default swap

78 John Thanassoulis and Misa Tanaka, ‘Bankers’ Pay and Excessive Risk’, Bank of England Staff Working Paper No 558/​2015.

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Compensation in Financial Institutions (CDS) premia,79 or by using Contingent Convertible bonds (CoCos) as part of the remuneration. The third problem runs between the executives and taxpayers and the deposit in- 11.61 surance fund. Given deposit insurance and/​or the implicit possibility of a government bailout, higher risk-​taking is not reflected by a proportionally higher cost of funding and risk-​taking is effectively subsidized. The mechanisms employed to solve the other two agency problems (such as equity-​linked pay and pay in debt instruments) cannot help to solve this problem, because the equity prices may be inflated by the explicit or implicit guarantees on debt (deposit insurance and government bailout) and debt prices may be similarly distorted by those guarantees. Thanassoulis and Tanaka see a possible remedy to this agency problem in the pay-​ adjustment mechanisms, which are also foreseen by the international principles, known as bonus malus and clawback. Both mechanisms ‘have the effect of putting a fixed monetary value of the executive’s pay at risk’, in other words a ‘penalty’.80 Under malus arrangements, an institution may prevent the vesting of all or part of the deferred remuneration already awarded in relation to risk outcomes or performance. Under clawback clauses, staff members agree to repay variable remuneration that has already been paid by the institution under certain circumstances.81 However, these mechanisms work imperfectly ‘if bankers believe that they could be applied in the event their bank suffers large losses, even if they themselves have conducted appropriate risk management’.82 As a result, the authors suggest ‘to link financial losses imposed on bank executives through bonus malus and clawback to ex ante risk management, rather than making them depend on ex post risk outcomes alone’.83 These arguments shed light on the international principles from various angles. 11.62 Firstly, they clarify that the deferment of variable pay and the payment of the same in equity instruments solve the first type of agency problem, but not necessarily the others. Secondly, they explicitly connect some of the FSB Principles—​such as malus and clawback—​to systemic risk (or TBTF) by showing that the relevant mechanisms put an additional pressure on bank managers to prevent excessive risk-​ taking by the same. Thirdly, they help understanding as to why the FSB Principles 79 Alex Edmans and Qi Liu, ‘Inside Debt’, Review of Finance (2011), 15, 75–​102; Patrick Bolton, Hamid Mehran, and Joel Shapiro, ‘Executive Compensation and Risk Taking’, Review of Finance (2015), 19, 2139–​218. 80 ibid, 24. 81 ibid. 82 See Misa Tanaka and John Thanassoulis, ‘Fixing bankers’ pay: punish bad risk management, not bad risk outcomes’, Bank Underground, 7 December 2015, available at https://​bankunderground. co.uk/​2015/​12/​07/​fixing-​bankers-​pay-​punish-​bad-​risk-​management-​not-​bad-​risk-​outcomes/​, accessed 30 September 2018. 83 ibid. See also Albuquerque, Cabral, and Corrêa Guedes, n 58, on the need to regulate RPE in order to reduce systemic risk.

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Guido Ferrarini are addressed to significant institutions, with a special focus on ‘large, systemically important firms’. Fourthly, they suggest special care in the design of malus and clawback arrangements, particularly with respect to TBTF institutions, so as to avoid risk-​taking which may be excessive from a social perspective. B. Enhancing proportionality 11.63

The FSB Principles and standards have left some room for proportionality in their implementation to the extent that they concern ‘significant’ institutions. Institutions that are not significant can be regulated under a lighter regime, which could further differentiate depending on the size and business of the relevant firms. In fact, medium-​sized institutions are less risky from a systemic perspective and less likely to undergo a government bailout, while small institutions do not individually create systemic problems (which could however be generated by them collectively through herding behaviour). Medium and small institutions are therefore less problematic as to the third type of agency costs highlighted in the previous section. However, the business model of an institution can also be relevant in terms of proportionality. Deposit-​taking institutions like commercial banks, for instance, are in principle less prone to compensate their executives and employees through variable remuneration than investment banks and asset managers, which traditionally make wide recourse to bonus payments and other pecuniary incentives.

11.64

Nonetheless, proportionality has been interpreted differently across jurisdictions. US regulation, in particular, is more flexible than CRD IV. The US Federal Supervisory Agencies jointly exercised their mandate under the Dodd-​Frank Wall Street Reform and Consumer Protection Act of 21 July 2010 by approving a Proposed Rule on incentive-​based compensation arrangements for ‘covered financial institutions’ in February 2011.84 These are institutions under the supervision of the respective Federal Regulator, with total consolidated assets of one billion US dollars or more. As required by Section 956 of the Act, the proposed Rule prohibits ‘excessive’ compensation, that is, compensation that is ‘unreasonable or disproportionate to the services performed by a covered person’. Moreover, compensation should not encourage the taking of ‘inappropriate risks’ by the covered financial institution, by providing executives or employees with incentives that could lead to

84 Section 956 of the Dodd-​Frank Wall Street Reform and Consumer Protection Act requires the Agencies (the Board of the Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Association, the Office of the Comptroller of the Currency, the Federal Housing Finance Agency, and the Securities and Exchange Commission) to jointly prescribe regulations or guidelines with respect to incentive-​based compensation practices at certain financial institutions (referred to as ‘covered financial institutions’). In April 2011, the Agencies published a joint notice of proposed rule making that proposed to implement section 956 (2011 Proposed Rule).

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Compensation in Financial Institutions a ‘material financial loss’ to the institution.85 The use of standards, which are general in character, rather than rules analytically defining the compensation structure, reflects the US regulators’ willingness to keep the needed flexibility in compensation arrangements.86 Nonetheless, specific rules apply to ‘larger covered financial institutions’, such as bank holding companies with consolidated assets of more than fifty billion US dollars, which are required to defer at least 50 per cent of the incentive-​based compensation payments to executive officers over a period of at least three years, with the release of the deferred amount to occur no faster than on a pro-​rata basis. A ‘malus’ mechanism also applies, in that the deferred amount should be adjusted for actual losses incurred by the institution or other measures of performance during the deferral period.87 The proposed Rule is currently being reviewed by the Federal Regulators in light of 11.65 their supervisory experience since 2011.88 Like the 2011 Rule, the new Proposed Rule would apply less prescriptive incentive-​based compensation program requirements to the smallest covered institutions and progressively more rigorous requirements to the larger institutions. However, three categories of covered financial institutions (rather than two) would be identified based on average total consolidated assets: Level 1 (greater than or equal to 250 billion US dollars); Level 2 (greater than or equal to 50 billion and less than 250 billion US dollars); Level 3 (greater than or equal to one billion US dollars and less than 50 billion US dollars).89 The EU legislator has followed a different path. As already stated (Section III.2), 11.66 institutions should comply with the CRD IV principles in a manner and to the extent that is appropriate to their size; internal organization; and the nature, scope, and complexity of their activities. Moreover, the provisions of this Directive on remuneration should reflect differences between different types of institutions in a proportionate manner, taking into account their size; internal organization; and the nature, scope, and complexity of their activities. However, both the EBA and

85 See, for a short comment of the Rule from a comparative perspective, Guido Ferrarini and Maria Cristina Ungureanu, ‘Bankers’ Pay after the 2008 Crisis: Regulatory Reforms in the US and the EU’, Zeitschrift fur Bankrecht und Bankwirtschaft (2011), 23, 418–​30, 422ff. 86 ibid. 87 Moreover, if the covered financial institution has consolidated assets of 50 billion US dollars or more, the board of directors or a board committee shall identify those covered persons (other than executive officers) who individually have the ability to expose the institution to possible ‘substantial’ losses. 88 See the Board of the Governors of the Federal Reserve System, Incentive-​based Compensation Arrangements, Notice of Proposed Rulemaking and Request for Comment, available at https://​ www.federalreserve.gov/​newsevents/​pressreleases/​files/​bcreg20160502a2.pdf, accessed 30 September 2018. 89 ibid, 40.

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Guido Ferrarini the European Commission expressed the view that CRD IV does not permit exemptions or waivers to the application of the remuneration principles.90 11.67

The CRD IV requirements concerning the deferral of variable remuneration and the pay-​out in instruments have been particularly criticized from the perspective of small institutions and staff with low variable remuneration. This has led most Member States to introduce waivers from such requirements based on proportionality, which were however found legally inadmissible by the EBA and the Commission. Indeed, as recognized by the Commission in a report to the European Parliament, small institutions face high compliance costs related to the fact that they have to make considerable investments in human resources, IT, and advisory services with respect to complex remuneration requirements.91 Moreover, small institutions encounter difficulties in creating appropriate instruments to comply with the pay-​out requirement for variable remuneration, often due to their corporate statute or ownership structure.

11.68

As a result, the Commission presented a proposal for a directive amending CRD IV with respect to remuneration requirements too, some of which could be waved by Member States with respect to small and non-​complex institutions and to staff members with low variable remuneration.92 Under the proposed new Article 94(3) the requirements as to pay-​out in instruments and deferral of variable remuneration shall not apply to: (a) an institution the value of the assets of which is on average equal to or less than EUR 5 billion over the four-​year period immediately preceding the current financial year; (b) a staff member whose annual variable remuneration does not exceed EUR 50.000 and does not represent more than one fourth of the staff’s member’s annual total remuneration.

However, a competent authority could decide that institutions whose total asset value is below the threshold referred to in point (a) ‘are not subject to the derogation because of the nature and scope of their activities, their internal organisation or, if applicable, the characteristics of the group to which they belong’. Similarly, a competent authority may decide that staff members whose annual variable remuneration is below the threshold and are referred to in point (b) ‘are not subject to the derogation because of national market specificities in terms of remuneration practices or because of the nature of responsibilities and job profile of those staff members’.

90 EBA, ‘Opinion on the application of proportionality to the remuneration provisions in Directive 2013/​36/​EU’, EBA/​Op/​2015/​25,  13. 91 Report, n 67, 8. 92 See Proposal for a Directive of the European Council and of the Council amending Directive 2013/​36/​EU, COM(2016) 854 final, Brussels, 23 November 2016.

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Compensation in Financial Institutions The new proposal would no doubt improve on the present treatment of small in- 11.69 stitutions, but the comparison with the US regulation of bankers’ pay would still show a big divide, raising the question whether the EU views on proportionality in remuneration matters are appropriate. Building on the US model, particularly on the recent proposals of the Federal Agencies, EU institutions could also be grouped into more than one category and different requirements should apply to them depending on their category. Only the largest institutions should be subject to all CRD IV requirements, which reflect the international principles (save for the bonus cap) and have therefore been designed with respect to significant financial institutions. The threshold of five billion euros still appears too low for identifying significant institutions (which in the United States must possess more than fifty billion US dollars in consolidated assets), while it is appropriate for defining the smallest ones.

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12 CORPORATE GOVERNANCE, FINANCIAL INFORMATION, AND MAR Carmine Di Noia* and Matteo Gargantini*

I. Inside Information and Listed Banks: An Introduction II. A Snapshot of the MAR Regime for Inside Information III. Is Inside Information Relevant to Bank Governance? IV. Internal Information Flows

V. Listed Banks and Their Subsidiaries and Associates 12.01 12.06 12.16 12.28

A. Subsidiaries B. Associates  C. Common directors 

VI. Listed Banks and Their Shareholders VII. Financial Reporting VIII. Conclusion

12.38 12.39 12.45 12.47 12.49 12.61 12.67

I.  Inside Information and Listed Banks: An Introduction 12.01

Proper management of information is a crucial element of banks’ corporate governance, and an equally challenging task. Timely and accurate information flows are at the heart of adequate risk-​management procedures and effective internal control systems. Furthermore, no group management could occur smoothly without instructions issued from the controlling entity, and reports flowing from the (direct or indirect) subsidiaries. For the same reason, sharing relevant information is a precondition for consolidated accounting and supervision.

12.02

However, policymakers are also increasingly focusing on information from the point of view of capital markets’ integrity and efficiency. Public disclosure of inside information conveys relevant news to the markets, and therefore contributes to * The opinions expressed are personal and do not necessarily represent those of the organizations the authors belong to. Although the chapter is the result of common reflections, Sections I, VII, and VIII shall be attributed to Carmine Di Noia, and Sections II, III, IV, V, and VI to Matteo Gargantini.

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Corporate Governance and Inside Information improving the quality of prices. At the same time, restricting selective circulation of inside information helps reduce the number of insiders that, having access to it, might perpetrate insider dealing. This enhances market integrity by reducing the risk that asymmetric information taints market transactions and insiders systematically outbid outsiders, ousting them from the marketplace. Prudential regulation and the regulatory framework on market integrity are therefore 12.03 both concerned with the circulation of information in banks and bank groups. These two overarching regulatory purposes may sometimes lead to conflicting outcomes, though. The reason for these potential inconsistencies is intuitive. Circulation of information may be functional to better group governance—​especially from the point of view of risk management—​but it is problematic from the perspective of insider dealing prohibition. The EU regulatory framework on market abuse—​which comprises Regulation (EU) No 596/​2014 (MAR) and Directive 2014/​57/​EU (MAD II)—​restricts the possibility that inside information freely circulate within banking groups, unless this is justified on specific grounds and on exceptional basis. This chapter addresses the impact of the MAR and MAD II regime concerning 12.04 selective disclosure of inside information on the governance of banks having their securities admitted to trading on a regulated market or a multilateral trading facility (MTF), and identifies some of the issues concerning the uneasy relationship between MAR and bank governance. In principle, a broad understanding of corporate governance should encompass all the formal and informal factors that affect the way firms (banks, in our case) are run and monitored.1 These factors include both internal and external mechanisms, as the ability to influence managerial behaviour is not exclusive to formal powers within the corporation and its group—​such as appointing and removal rights. Rather, it extends to external monitoring by gatekeepers and, even further, to less formal dynamics that affect managers’ incentives—​such as takeovers. Rules on inside information affect all these elements, but for reasons of space this chapter confines its analysis to some core elements of governance. After highlighting the most relevant features of MAR from the point of view of 12.05 bank corporate governance (Section II), the chapter assesses the importance of inside information management and its potential impact (Section III). The analysis then considers some implications in more detail. Section IV considers banks as individual entities and addresses the internal flows of (inside) information from the point of view of market abuse prevention. Section V broadens the analysis to bank groups where the listed bank controls other similar entities or has a significant influence on them. Section VI addresses the symmetric case where a listed bank plays the role of an investee company of either controlling or non-​controlling



1

See, e.g., Donald Nordberg, Corporate Governance: Principles and Issues, SAGE, 2010), 5–​7.

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Carmine Di Noia and Matteo Gargantini shareholders. Section VII separately considers financial reporting rules because of their pervasive implications on the circulation of inside information. Section VIII concludes.

II.  A Snapshot of the MAR Regime for Inside Information 12.06

Information flowing within bank and corporate groups can be classified according to various criteria. The most convenient taxonomy for this analysis relies on the level of confidentiality. Leaving aside non-​confidential information, we can distinguish between confidential inside information, and confidential non-​inside information. While the former kind of information falls within the scope of MAR because it meets all the elements of the legal definition, confidential non-​inside information is entirely subject to a private ordering regime. Broadly speaking, banks can treat this latter kind of information as any other corporate assets, including by restricting its circulation with a view to preserving its value. However, this chapter only focuses on inside information, as this is the most difficult to address from a regulatory point of view.

12.07

MAR adopts a single definition of ‘inside information’ for the purpose of both setting issuers’ obligation to disclose new material facts and preventing misuse of information.2 Information is considered as ‘inside information’ when it relates to one or more financial instruments or to the issuer thereof, and is at the same time precise, unpublished, as well as likely to have a significant effect on the prices of those financial instruments (or of related derivative financial instruments) once published (Article 7 of MAR). Information has to meet all the requirements of the definition to qualify as ‘inside’ information.

12.08

To clarify the general definition of inside information, Article 7 further details some of its requirements. In particular, precision occurs when the information refers to a set of circumstances or an event that either exists or will reasonably occur, and when at the same time it is specific enough to enable a conclusion as to the possible effect of that set of circumstances or event on the prices of the financial instruments (or the related derivative instrument). The requirement that information be specific partially overlaps with the condition that it is likely to have a significant effect on market prices, which occurs when a reasonable investor would be likely to use it as part of the basis of his or her investment decisions (Article 7(2) and (4) of MAR).

2 For further analysis see C Di Noia and M Gargantini, Issuers at Midstream:  Disclosure of Multistage Events in the Current and in the Proposed EU Market Abuse Regime, European Company and Financial Law Review (2012), 9, 484; J Hansen, ‘The Hammer and the Saw—​A Short Critique of the Recent Compromise Proposal for a Market Abuse Regulation’, Nordic & European Company Law, LSN Research Paper Series 2013.

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Corporate Governance and Inside Information When all these conditions are triggered, trading upon the information would 12.09 amount to insider dealing. However, in order for an issuer to be obliged to disclose it, inside information must also ‘directly’ concern the issuer itself (i.e. it must be in the issuer’s own sphere of activity: ‘corporate information’) (Article 17 of MAR). To the contrary, insider trading can also hinge upon the abuse of inside information which only ‘indirectly’ refers to the issuer (‘market information’).3 Most importantly, MAR clarified, following the ECJ case law,4 that in the case of a protracted process that may result in future material events, not only those events but also the intermediate steps of that process may be deemed to be inside information if they satisfy all the applicable criteria (Article 7(2) and (3) of MAR).5 All in all, this approach results in an anticipation of the moment when inside 12.10 information arises. This seems sensible from the point of view insider dealing prevention, as the definition of inside information encompasses all the instances where investors may not be on equal footing because of unequal availability of corporate information. However, MAR considers disclosure as a regulatory tool for preventing abuse, and therefore makes disclosure subject to the same definition of inside information. This may prove more problematic instead.6 In general, premature disclosure of inside information may hamper the feasibility of 12.11 the transaction it refers to, thus increasing the costs of regulation. At the same time, early disclosure creates the risk that the announcement be regarded by competent authorities or criminal prosecutors as a misleading statement, possibly qualifying as information-​based market manipulation. Two sets of rules may contribute to reducing, at least on the books, the costs of mandating disclosure at an early stage. The first one relates to the time needed to fulfil the obligation to disclose. The second one, of much greater importance, is the possibility of delaying publication under certain circumstances. When inside information triggers a disclosure duty, issuers must disseminate it ‘as 12.12 soon as possible’. Therefore, a short period of time can elapse before issuers may be able to disseminate the information, as this requires at least that information is identified, verified, and assessed, and that the responsible employees draft a public

3 P Staikouras, ‘The Conundrum of the Market Abuse Directive Preventative Measures for EU Financial Services’ Integration: In Search of Equilibrium between Market Integrity Enhancement and Undue Regulatory Encumbrance’, Legal Issues of Economic Integration (2008), 35, 351, 356. 4 Case C-​19/​11 Markus Geltl v Daimler AG, 28 June 2012, [2012] ECR, §§ 38–​40. See also the Opinion of the Advocate General Mengozzi delivered on 21 March 2012 [2012] ECR, § 55 H. Krause and M Brellochs, ‘Insider Trading and the Disclosure of Inside Information after Geltl v Daimler—​ A Comparative Analysis of the ECJ Decision in the Geltl v Daimler Case with a View to the Future European Market Abuse Regulation’, Capital Markets Law Journal (2013), 8, 283. 5 Moreover, intermediate steps shall be taken into account not only when they have already come into existence, but also when they may reasonably be expected to occur: Daimler, n 4, § 38. 6 Staikouras, n 3, 355–​60.

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Carmine Di Noia and Matteo Gargantini statement that is sufficiently clear for investors to fully and correctly assess the information.7 When information does not originate from within the issuer or comes unexpectedly, the whole process may take some material time, albeit short. 12.13

As for delay, listed banks may rely on two regimes to postpone disclosure. The first one, which also applies to other listed companies, allows issuers to retain inside information, under their own responsibility, if this is needed to protect their legitimate interests, provided that confidentiality is ensured and the deferred publication is not likely to mislead investors (Article 17(4) of MAR). Member States may require issuers to inform the competent authority of the decision to delay the dissemination of inside information, and on the reason why the conditions were met, once publication occurs, but they may also simply provide that issuers give such explanation upon request (Article 17(4), paragraph 3).

12.14

Article 17(4) plays a critical role when multistage events are developing, but the pre-​requisite that the deferral would not be likely to mislead the public may sometimes be uncertain. Since the definition itself of inside information requires that a reasonable investor would use it as part of her investment decisions, any delay could by definition be regarded as misleading.8 Such a circular interpretation cannot of course resist the objection that, if it were correct, the criteria for delaying could never be met.9 The European Securities and Markets Authority (ESMA) has provided instructions by clarifying that immediate disclosure is required whenever the market would reasonably expect the company to publish inside information in order to correct an erroneous market consensus,10 where such expectations are based on signals that the issuer has previously sent to the market.11 By the same token, delayed publication is likely to mislead the public when inside information is materially different from the previous public announcements of the issuer, including when it contradicts the issuer’s financial objectives that were previously made public.

12.15

The second regime listed banks can rely upon to delay publication of inside information is available in the exceptional circumstances where this is needed to preserve the stability of the issuer and of the financial system, to the extent that

7 ibid; J Hansen and D Moalem, ‘The MAD Disclosure Regime And the Two-​Fold Notion of Inside Information—​The Available Solution’, Capital Markets Law Journal (2009), 323, 4, 328. 8 K Sergakis, The Law of Capital Markets in the EU: Disclosure and Enforcement, Palgrave 2018, 109–​10. 9 Committee of European Securities Regulators (CESR), Level 3 –​Second set of CESR guidance and information on the common operation of the Directive to the market, (CESR/​06-​562 b) (July 2007), at 11. 10 As originally suggested in European Securities Markets Expert Group (ESME), ‘Report on Market abuse EU legal framework and its implementation by Member States’ (6 July 2007), 9. 11 ESMA, ‘MAR Guidelines. Delay in the disclosure of inside information’ (ESMA/​2016/​1478), 20 October 2016, 5.

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Corporate Governance and Inside Information deferred publication of the information is in the public interest (Article 17(5) of MAR). The typical case—​and the only one MAR mentions as an example—​refers to the provision of liquidity assistance from a central bank, and is inspired by the Northern Rock experience during the recent financial crisis. Delay of disclosure remains in the bank’s responsibility, but in this case an authorization is needed from the national competent authority, which shall consult the national central bank, the macro-​prudential authority, or the prudential authority as the case may be (Article 17(6) of MAR). Banks can delay disclosure only as long as this is necessary in the public interest, which is up to the national competent authority to verify at least on a weekly basis (Article 17(6) of MAR).

III.  Is Inside Information Relevant to Bank Governance? Overall, the duty to promptly disseminate inside information once this reaches 12.16 a sufficient level of precision would seem to reduce the scope of application of the rules concerning inside information management. Once information is made public, it loses its inside nature and, by definition, it falls outside the scope of application of MAR restrictions. In principle, only in case of delayed publication, and under the strict conditions required to defer disclosure, can inside information exist within listed banks, with the limited exception of the relatively short time-​ span running between detection and publication of inside information. Is therefore inside information management a trivial problem for listed banks, and 12.17 for bank groups that include a listed entity? The answer, as anyone involved in the day-​to-​day management of any listed firm can confirm, is in the negative for at least three reasons. First, however narrow the scope of inside information relative to the much larger 12.18 amount of confidential and non-​confidential information, this may not be negligible in absolute terms. Once a bank classifies some information as inside information, managing it may become particularly burdensome, also in the light of the uncertainties of the MAR framework. The second reason also has to do with compliance risk. The boundaries between (non-​ 12.19 inside) confidential information and inside information are often blurred due to the inevitably generic wording of Article 7 of MAR. Consequently, banks may tend to err on the side of caution when assessing developments concerning their activity, and to classify as inside information events whose features might not meet all the conditions required for them to qualify as inside information under closer scrutiny. The third reason why banks cannot dismiss inside information management as a 12.20 negligible concern is more factual. It is indeed a notorious fact that information asymmetries persist between listed companies and their investors in spite of the

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Carmine Di Noia and Matteo Gargantini strict MAR regime.12 Experience shows that insiders retain pieces of information that, if disclosed altogether, would easily affect market prices. In general, insider traders seem to retain comparative advantages over outsiders in all sectors and not just in banking,13 but the traditional opacity that surrounds the quality of banks’ assets may deepen this asymmetry.14 A counterfactual of this observation is that MAR has not removed the need to carry out due diligence or to set up data rooms in view of mergers and acquisitions transactions involving listed companies, whether these belong to the financial sector or not. The insiders’ persistent advantage in the access to price-​sensitive information suggests that banks and other listed companies may retain a significant amount of undisclosed data, even in the absence of systematic delay in the publication of inside information.15 This does not necessarily hint, of course, towards widespread violations of the applicable rules, nor does it suggest the need for stricter enforcement. Rather, it may simply highlight that fragments of relevant information that individually do not amount to inside information may still be able to convey price-​sensitive information if taken together (mosaic theory).16 From a more cynical, but perhaps more realistic perspective, this also demonstrates that any attempt to remove the risk of abuse by mandating full disclosure of inside information is inherently misguided.17 12.21

All these features of inside information—​in general and in the banking industry—​ make the regulatory framework for selective disclosure of inside information more relevant in practice. Under Article 10 of MAR, selective disclosure amounts to unlawful disclosure unless made ‘in the normal exercise of an employment, a profession or duties’.18 When inside information circulates outside the issuer, public

12 See, e.g., J Armour et  al, Principles of Financial Regulation, Oxford University Press, 2016, 176 (in spite of tight MAR regulatory framework and of its narrow interpretation by the European Court of Justice, European issuers keep highly material information confidential as long as they reasonably can). 13 F Spargolia and C Upper, Are Banks Opaque? Evidence from Insider Trading’, BIS Working Paper No 697/​2018 (finding no evidence that insider trading on banks’ stocks delivers higher abnormal returns than insider trading on other stocks). 14 B Blaua et  al, ‘Bank Opacity and the Efficiency of Stock Prices’, Journal of Banking and Finance (2017), 76, 32 (finding evidence that bank opacity reduces the efficiency of stock markets by delaying incorporation of information into share prices). 15 In ESMA’s view, delayed publication of inside information should remain exceptional:  see ESMA, ‘ESMA’s policy orientations on possible implementing measures under the Market Abuse Regulation’, Discussion Paper (ESMA/​2013/​1649), 14 November 2013, § 304; ESMA, ‘Guidelines on the Market Abuse Regulation—​market soundings and delay of disclosure of inside information’, Final Report (ESMA/​2016/​1130), 13 July 2016, § 52. 16 A reference to this theory may be traced in the wording of Article 7(2) of MAR, which refers to inside information as a ‘set of circumstances’. For the United States, see Securities and Exchange Commission (SEC), ‘Final Rule: Selective Disclosure and Insider Trading’, Release Nos 33-​7881, 34-​43154, 15 August 2000, § II.B.2. 17 Di Noia and Gargantini, n 2. 18 Onward disclosure by tippees is equally unlawful, provided that these know or ought to know that the information they disclose is inside information (Articles 8(4) and 10 of MAR).

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Corporate Governance and Inside Information disclosure is mandated to avoid uncontrolled dissemination, unless the person receiving the information is bound by a legal or contractual duty of confidentiality (Article 17(8) of MAR). As its wording hinges upon normality as the main criterion to identify what consti- 12.22 tutes a legitimate behaviour, Article 10 can produce different results depending on the specific context it applies to. This regulatory technique has a bright and a dark side. The bright side is that the rule is flexible enough to accommodate for conducts that market participants consider as aligned with regular market practices. In the field of market abuse, this is all the more important because the protection of market integrity largely depends on investor trust,19 so that market participants’ expectations are key to identifying the most dangerous misbehaviours. The dark side of the rule is that, in so doing, MAR does not provide clear guidance in all circumstances. While in Article 10 market practices contribute to shaping the rule, rather than vice versa, this does not necessarily lead to a safer legal environment, because normality is subjective. Not only may market participants have different opinions on borderline practices but, what is more important, supervisors and courts will likely have yet another perception of what is fair in the market. On top of this, the European Court of Justice adopts a narrow interpretation of 12.23 what represents ‘normal course’ in the exercise of a profession, employment, or duty. The reasoning of the Court rests on the observation that the basic aim of Article 10 is in the sense of curbing selective disclosure, and that the reference to the normal execution of legitimate activities only works as an exception. This ‘normality’ has to be understood restrictively, because it carves out an exception from the principle of equal access to inside information. Consequently, selective disclosure can only occur when it is closely linked to the exercise of an employment, profession, or duties. This leads the Court to conclude that selective communication is allowed only if it is strictly necessary for that exercise.20 As the next sections will show, what is ‘necessary’ is often hard to define, because what is required to fulfil a duty and—​especially—​to carry out a task may not always be so simple as black and white. For instance, corporate groups may pursue a more or less integrated business strategy, so that what information companies need to share will depend in part on the business plans of the controlling entity, which on its turn will also depend on how much information companies can share, in a rather circular connection. By the same token, consolidated financial reporting may rely more or less intensely on the financial reporting of consolidated entities, depending on the adopted level of confidence. In principle,

19 See, e.g., T Frankel, ‘Regulation and Investors’ Trust in the Securities Markets’, Brooklyn Law Review (2002) 68, 439. 20 C-​384/​02 Grøngaard and Bang, 22 November 2005, ECJ. The decision refers to Article 3(a) of Directive 89/​592/​EEC, whose wording corresponds, for the purposes of this analysis, to Article 10 of MAR.

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Carmine Di Noia and Matteo Gargantini sharing more (inside) information may allow the consolidating entity to perform its own assessments, which may sometimes help harmonize the accounting criteria adopted at group level. At the same time, more limited circulation of information does not necessarily prevent the consolidating entities from preparing sufficiently accurate financial reports, so that deciding whether additional information can circulate is in part a matter of judgement. 12.24

Also relevant for the assessment required by Article 10 of MAR are the rules governing the profession, employment, or duty that the disclosing entities and their addressees invoke.21 As the European Court of Justice stresses, Article 10 simply provides guidelines that judges—​and, one can add, supervisors and market participants—​have to apply in the light of national rules, which are rarely harmonized. As we shall see, this lack of harmonization makes the management of cross-​border information flows more problematic, and weigh in favour of a more homogeneous regulatory framework at European level. The problem here lies primarily with the need to comply with potentially divergent rules in the management of transnational organizations (whether companies with multiple establishments or corporate groups).

12.25

However, an additional issue arises from MAR’s conflict of laws system, which might lead to further uncertainties on the applicable rules. While the adoption of a single rulebook reduces the risk of divergent rules among different Member States, national interpretations inevitably play a role in defining the law in action. These are often codified in national documents that address matters not covered by EU law and ESMA measures such as guidelines and Q&As.22 These documents may occasionally be quite pervasive, as the next sections will demonstrate.

12.26

Persistent national approaches may uneasily combine with MAR connecting factors. Article 22 of MAR in fact provides for a multiple competence of both: (i) the authority in the territory of which the relevant actions are carried out and (ii) the authority in the territory of which the trading venue where the relevant financial instruments are negotiated operates. Unless the violation is performed in the same country where the regulated market or the MTF is based, more than one authority will have competence to detect and prosecute possible violations. Consequently, multiple authorities will interpret and enforce the applicable rules. Multiple listing 21 In the opinion of the ECJ, another condition to consider is the sensitivity of the information. Information that is more likely to have an impact on market prices should be subject to stricter limitations to circulation (ibid, §§ 37–​8). 22 See, e.g., Bafin, ‘FAQ on insider lists pursuant to Article 18 of the Market Abuse Regulation (EU) No 596/​2014’, 13 January 2017; Bafin, ‘Frequently asked questions (FAQs) on managers’ transactions pursuant to Article 19 of Market Abuse Regulation (EU) No 596/​2014, 16 December 2016 (Germany)’; AMF, ‘Guide de l’information permanente et de la gestion de l’information privilégiée’ (DOC-​2016-​08), 26 October 2016 (France); Consob, ‘Gestione delle informazioni privilegiate’ (Linee guida n 1/​2017). 13 October 2017 (Italy).

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Corporate Governance and Inside Information further increases the number of authorities that are potentially involved in the enforcement of MAR. While this approach makes perfect sense from the point of view of market abuse repression, listed banks may feel uncomfortable with a system that puts them under the supervision of multiple authorities, in case these adopt divergent interpretation. Furthermore, identifying the competent authorities may not always be easy, with 12.27 the exception of those that supervise the relevant trading venue. In principle, the enforcement of abusive selective disclosure should fall into the remit of the authority where the conduct is perpetrated. This can be the place where a person making a phone call or sending out an email was located at the relevant moment. Perhaps the same approach may apply to omissions as well, so that the lack of disclosure of inside information would seem to fall—​broadly speaking—​into the competence of the authority where the listed bank has its principal place of business. However, the connecting factor for the notification of delay in disclosing inside information calls this preliminary conclusion into question. Whether the listed bank delays the publication to protect a legitimate interest (Article 17(4)) or to preserve the stability of the financial system (Article 17(5)), it shall notify the competent authority of the domestic market or, if the company is listed only abroad, the competent authority of the market where its shares are admitted to trading for the first time (Article 6 of Regulation (EU) 2016/​52223). As this authority is not necessarily the only competent one under Article 22 of MAR, it will have to closely coordinate with its foreign counterparties to facilitate homogeneous enforcement.

IV.  Internal Information Flows The impact of MAR on bank governance mainly depends on its consequences on 12.28 the organization of the internal company’s processes. In general, banks’ internal governance relies on the circulation of information, as this is crucial to ensure that banks effectively and prudently manage their operations; that they properly measure and control their risks, including through sound accounting procedures, and that they comply with legal, regulatory, and supervisory requirements.24 Adequate information flows are therefore the basis of the internal control framework, which includes risk management, compliance, and internal audit functions.25 This means that all the relevant information should circulate among the functions that need it to perform their tasks. For instance, banks need to evaluate their risks—​and react

23 The registered office is the relevant connecting factor for equity issuers only when it is in the same country of the relevant market. 24 EBA, ‘Guidelines on Internal Governance under Directive 2013/​36/​EU’ (EBA/​GL/​2017/​11), §§  127–​9. 25 ibid, § 130.

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Carmine Di Noia and Matteo Gargantini when these do not match their risk appetite—​not only along each business line but also across different lines and, at the same time, at both individual and consolidated level. Top-​down and bottom-​up information flows will therefore lead to the transmission of information along business lines and, at a higher hierarchical level, to functions that are responsible for more than one business line, including internal controls. 12.29

These information flows combine with the internal processes listed banks have to set up under MAR with a view to assessing the inside nature of information and, when this is confirmed, to deciding whether they should delay disclosure and for how long. Before the information is disclosed, the competent corporate bodies have to evaluate it and decide whether the company has an interest in delaying its dissemination. In order for them to publish inside information ‘as soon as possible’, as Article 17 of MAR requires, listed banks are therefore bound to set ad hoc organizational measures aimed at managing inside information so that this is conveyed to those in charge of these decisions.

12.30

Good governance of inside information requires a clear allocation of tasks within the bank’s organization. Internal procedures should identify in advance those in charge of assessing the information and make sure that they have the powers that are necessary to take the (final) decisions on its qualification and on its management.26 This includes direct access to data concerning not only the (potentially inside) information as such, but also all the other elements required to run the Article 17 test for delaying dissemination. For instance, the responsible person may need to have access to data concerning the stage of development of a decision to buy or sell a major shareholding in another entity and to consult with those in charge of taking such a decision, because this will help him or her to assess the potential consequences of an early disclosure. Next to having access to all these data, the person charged with these tasks shall also have the power to evaluate them and to take the final decision on the publication of inside information, which often entails some margins of discretion.

12.31

As the task of evaluating the publication of inside information or its delay may be particularly sensitive, ESMA also considers the possibility that managing board members or senior executive directors have the responsibility of the final decision. At the same time, ESMA admits that other persons—​clearly identified within the organization—​may perform the same role, in the light of the variety of the organizational structures each issuer may have.27 As long as they enjoy proper delegation of powers within the bank’s corporate structure, nothing seems to prevent employees below the top organizational layers from performing these tasks. If different

26 ESMA, ‘Final Report. Draft technical standards on the Market Abuse Regulation’ (ESMA/​ 2015/​1455), 28 September 2015, § 239. 27 ibid.

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Corporate Governance and Inside Information parts of the organization are involved in the decisions concerning different pieces of information—​for instance depending on the nature or the source of the relevant information—​the process should ensure coordination so that the bank has a consistent approach across the board. The arrangements adopted to detect inside information and decide on its publi- 12.32 cation or delay also support the creation and maintenance of insider lists (Article 18 of MAR), because no delayed publication can exist without adding an entry to those registers, or relying on an existing one for persons that are permanently registered.28 MAR and its level 2 measures set a detailed regulatory framework for this tool, which seems particularly apt to facilitate inside information management by tracking its circulation within the bank and its group as well as externally, across consultants and gatekeepers. As ESMA recently clarified, persons acting on behalf or account of he issuer are also subject to the duty to open their own register, so that a chain of registers will cover the entire route of inside information.29 As anticipated, some national discretion seems to persist, however, in spite of the 12.33 MAR single rulebook. Particularly pervasive are, for instance, the Italian guidelines on inside information management, which go as far as to recommend issuers map information (defined ‘relevant information’) that is not yet material enough to qualify as inside information under MAR but it is likely to qualify as such in the future.30 The guidelines also recommend that the listed issuers open a specific ‘Relevant Information List’ that mirrors MAR insider lists, with the difference that the Relevant Information List requires early entry of insiders on the basis of ‘relevant information’. In this case, issuers—​and listed banks among them—​are required to carry out a sort of second degree assessment, as they evaluate whether some facts are likely to develop into a more advanced stage where they will, on their turn, satisfy the requirement to indicate an event ‘which may reasonably be expected to occur’ under Article 7(2) of MAR. Insider lists are also a key tool for monitoring and enforcing restrictions to the 12.34 circulation of information within banks. Limitations to selective disclosure of inside information also apply among individuals (directors and employees) operating within a legal entity,31 and are therefore relevant for the organization of the information flows. Article 10 of MAR therefore also makes internal information flows subject to the normality (or necessity) test. Once again, this requirement combines with bank governance rules, which often provide for barriers to information

28 Di Noia and Gargantini, n 2. 29 ESMA, ‘Questions and Answers on the Market Abuse Regulation’ (MAR) (ESMA70-​145-​ 111), 23 March 2018, Q 10.1. 30 Consob, n 22. 31 C Mosca, ‘Article 10’, in M Ventoruzzo and S Mock (eds), Market Abuse Regulation. Commentary and Annotated Guide, Oxford University Press, 2017, § II.1.

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Carmine Di Noia and Matteo Gargantini sharing. For instance, under the EBA Guidelines on bank internal governance, internal functions whose tasks may be in conflict should not share any relevant information.32 12.35

MAR also considers organizational measures such as barriers that segregate information and prevent it from circulating across different areas of the bank. To make sure multidivisional banks do not face restrictions in their ability to trade because some areas of their organizations—​such as those in charge of providing advice to undertakings on their capital structure—​possess inside information, MAR provides them with an exemption from the insider trading ban. This exception relies on Chinese walls within the bank (Article 9(1)). MAR enables multidivisional banks to carry out their typical activities without the need to segregate some of them—​such as the trading activity—​into separate legal entities. In particular, MAR specifies that the mere fact that a legal person (i.e. a natural person working within such legal person) possesses inside information does not mean that that legal person has used such information, and has thus engaged in insider dealing. This however only applies to the extent that the legal person has ‘adequate and effective internal arrangements and procedures’ in place that shield trading desks and those that have an influence on a decision to trade from having access to such information.33

12.36

To sum up, MAR should be in principle neutral when it comes to the circulation of inside information that banks’ internal governance needs to foster a safe and prudent management. Article 10 of MAR cannot be interpreted to restrict selective circulation of inside information that facilitates effective operations and internal controls. As a consequence, MAR should restrict the circulation of information only as long as this restriction does not go to the detriment of good governance practices.

12.37

If, on the contrary, good governance practices require segregation of information, MAR can buttress them by restricting the availability of inside information in the corporate structure. The mapping exercise required to prepare insider lists and the alert system for those included in the registers can easily assist the bank in isolating parts of the organization that perform conflicting activities from access to confidential and inside information. The same applies to the internal arrangements banks should adopt to separate their trading desks from inside information that is available to other departments.

32 EBA, n 24, § 133. 33 A recommendations to trade from an area of the banks that has access to inside information to a trading desk (tuyautage) is tantamount to a violation of the information barriers (Article 9(1)(b) of MAR).

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V.  Listed Banks and Their Subsidiaries and Associates Many listed banks belong to broader banking groups or conglomerates. Therefore, 12.38 it is far from unusual that relevant developments may occur in other entities of the same group, including controlling, controlled, associated, and affiliated undertakings.34 However, Article 17 of MAR only requires disclosure of inside information that ‘directly concerns’ the company subject to the MAR regime—​the listed bank in this case. What if a major development occurs within the group? Subsidiaries will be considered first. A. Subsidiaries In spite of its narrow scope, Article 17 seems to encompass events that, while 12.39 taking place in controlled entities, are relevant enough to have an impact on the parent (listed) bank.35 Typically, this occurs when the development is as material as to affect the bank’s financial position, because of the impact on the value of the bank’s investment in the subsidiary. A  more restrictive interpretation would deprive the MAR disclosure duties of their ability to convey relevant information to the market. To understand this, one may consider the example of a listed entity that mostly operates through its subsidiaries, as is the case with financial holding companies (Article 3(1)(26) of Directive 2013/​36/​EU). If the MAR duties did not apply to such entities, market prices would not reflect a large amount of material information, a paradoxical result that seems incompatible with the basic principles of MAR. Disclosure duties concerning developments occurring within subsidiaries lie with 12.40 the parent (listed) bank, as this qualifies as ‘issuer’ under MAR (Articles 1(21) and 17(1)). Nothing seems to prevent the subsidiary from disclosing inside information on behalf of its parent, though, provided that the ultimate responsibility rests with this latter. In any event, the decision to disclose will often involve the listed bank. First, internal group procedures may allocate the power to decide on a sensitive matter like disclosure of inside information to the parent bank. Second, and most importantly, the materiality of the information is measured on its impact on the price of the listed bank’s shares, so that only this bank may be in a position to assess

34 In this chapter, we refer to entities on which the listed bank has a significant influence as ‘associates’ (or ‘associated entities’). By ‘affiliates’ (or ‘affiliated entities’) we mean, in a narrow sense, companies controlled by the same entity that also controls the listed bank. See Article 2(12) and (13) Directive 2013/​34/​EU; International Accounting Standard 28 (Investments in Associates). 35 In Italy, the law expressly adopts this interpretation. It requires controlled entities to communicate inside information to their controlling (listed) companies, so that these latter can disclose it (see Article 114(2) Consolidated Law on Finance).

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Carmine Di Noia and Matteo Gargantini whether the developments occurring in a subsidiary are likely to qualify as inside information in light of their size and nature. 12.41

Consequently, applicability of Article 17 of MAR to events affecting subsidiaries would seem to require an information flow from the subsidiary to the parent bank. What is the legal framework concerning such information flow? As Section II displays, the general principle allows selective disclosure when this is done in the normal course of an employment, a profession, or a duty (Article 10 of MAR). A significant amount of inside information may fall into the scope of application of the legal regime for consolidated accounting, which surely qualifies intragroup communications as a ‘duty’ under the MAR regime. In particular, because prudential requirements and bank disclosure duties apply on a consolidated basis, EU law prescribes that parent banks and their subsidiaries set up proper organizational structures and internal control mechanisms to ensure accurate processing and consolidation of relevant data (Articles 11 to 14 of Regulation (EU) No 575/​ 2013—​CRR). These internal procedures shall also ensure that relevant data are forwarded, thus enabling the parent bank to aggregate them. It seems consequential that intragroup inside information flows can easily accommodate within this regulatory framework.

12.42

What, however, about other pieces of inside information falling outside the scope of this (and other) express duties on accounting and supervision? A fair interpretation of the MAR regime seems to be that selective disclosure should normally be allowed in this case as well. From a policy perspective, applying a restrictive reading of Article 10 of MAR to curb information flows from subsidiaries would run against the MAR underlying philosophy. MAR understands both restrictions to selective disclosure and issuer disclosure duties as regulatory tools concurring to improving market integrity and the quality of prices. Curbing information flows towards the entity charged with the obligation to disclose them would have the net effect of reducing the overall level of disclosure, contrary to the rationale of the MAR framework.

12.43

From a more normative perspective, the dynamics of bank groups lead to the same conclusions, as they inevitably play a role in defining what is ‘normal’, under Article 10 of MAR, in the relationship between listed banks and their subsidiaries. In this respect, one can apply here, mutatis mutandis, the considerations we develop in the next section on the flows of inside information from listed banks to their controlling entities within groups.

12.44

To sum up, it is fair to conclude that bank groups can, and have to, rely on their internal governance functions to circulate inside information towards listed banks. Whether this information is relevant for the CRR disclosure requirements or not, not only is its circulation admissible, but it can be required in most circumstances.

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Corporate Governance and Inside Information B. Associates What can be more problematic in practice is the treatment of inside information 12.45 that originates in the sphere of activity of listed bank’s associates. In this case, the bank holds a stake that—​albeit insufficient to give control—​determines a significant influence over the investee company. If this shareholding is large enough relative to the listed bank’s total assets, a variation in the value of the equity stake in the associate can be sufficiently material to qualify as inside information. In this case, the CRR rules on prudential consolidation do not apply, and national company law on corporate groups can hardly help as there is no control over the investee company. Hence, the question arises whether circulation of this information is due—​just like it generally is for subsidiaries—​or at least allowed. One way to answer this question may be to explore whether accounting rules can offer a sufficient basis for selective circulation of information. Rules on consolidated accounts may indeed play a role in defining the regulatory 12.46 framework for selective disclosure of inside information between banks’ subsidiaries or associates and their participating entity. Because financial reporting raises issues that are also common to the flows of information between listed banks and their shareholders, these aspects will be considered in Section VII. As the analysis will demonstrate, accounting rules often provide a legal basis for information sharing, but they are not able to dispel all the doubts concerning selective disclosure of inside information and therefore do not suffice to ensure legal certainty (at least not at EU level). C. Common directors On a different note, there is (at least) another way MAR affects the governance of 12.47 banks and their groups. This comes from situations where banks share a director with other entities, within and outside their group. Some bank groups strengthen the implementation of their common business strategy with the appointment of the same directors in different entities of the group (cross board membership). This streamlines group management and, most importantly, reduces the information flows required to run a coherent business across different entities of the group. The reason is intuitive: having a seat in more than one group board enables information sharing among entities through the director even if no formal transmission of information occurs. At the same time, entities not belonging to a bank group may want to appoint to their board a member who is also a bank director to take advantage of his or her expertise in finance, or to build connections that they deem useful to facilitate access to funding. While cross board membership within bank groups may simplify the group governance, it also has some drawbacks. The first one may affect a director who has access to inside information originating from a company, to the extent that such information could also be relevant to the other company where he or she has a seat. In this scenario,

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Carmine Di Noia and Matteo Gargantini this director’s duty of confidentiality towards the first company may not fit easily with his or her duty of loyalty towards the second company. The second drawback, which we analyse in the next paragraph, depends on the regulation of managers’ transactions. 12.48

From the point of view of MAR, a common director among different companies plays a role in defining the scope of application of rules concerning managers’ transactions. If a bank whose key manager is also a key manager of a listed company trades on the listed company’s securities, then under certain circumstances MAR considers that the trading activity of the bank is carried out on behalf of such key manager and, therefore, requires disclosure as a manager’s transaction (Article 19). This rule may affect bank governance because of its influence on the composition of the board. Immediately after MAR became applicable in July 2016, the scope of application of Article 19 rose concern that the broad wording of the rule defining the ‘persons closely associated’ to ‘persons discharging managerial responsibilities’ (Article 3(1)(26) of MAR) could lead to a regulatory overshooting. In particular, many feared that whenever a member of the board of a listed company was also seated in the board of a bank, any trading activity of the bank could trigger the disclosure duty of Article 19. This led ESMA to clarify that the managerial responsibilities discharged in the entity other than the listed company only include cases where the relevant person takes part in or influences the decisions to carry out transactions in financial instruments of the listed company.36 As a consequence, if the cross board membership involves a listed company and a bank, the director will be considered to discharge managerial responsibilities only if he or she can contribute to determining the trading activity of the bank concerning the listed company.

VI.  Listed Banks and Their Shareholders 12.49

To what extent listed banks may share inside information with their shareholders is a long debated issue, which also remains subject to large uncertainties in the day-​to-​day management of investor relations. In this respect, banks are no exception.

12.50

Beside Article 10 of MAR, which brings with it all the problems stemming from its generic wording, the most relevant rule that addresses selective disclosure with shareholders is the one concerning market sounding (Article 11 of MAR). This enables issuers (and other prospective offerors) to selectively disclose inside information in order to gauge the interest of potential investors in securities offerings. This definition contributes to defining a safe harbour that qualifies selective communication as ‘made in the normal exercise of a person’s employment, profession

ESMA, n 29, Q 7.7.

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Corporate Governance and Inside Information or duties’ under Article 10(1) of MAR, provided that issuers comply with the other procedural requirements set forth in Article 11 of MAR and in its implementing measures.37 The rationale of the safe harbour for market sounding includes the facilitation of 12.51 shareholder dialogue, but this is limited to periods where an offer is in sight. The market sounding framework applies ‘prior to the announcement of a transaction’, and the protection it provides remains of course applicable regardless of the actual subsequent launch of a securities offering. This broad wording leaves room for equally broad—​or, more cynically, instrumental—​interpretations, which could in theory cover a number of selective communications. For instance, many banks issue non-​equity securities in a continuous or repeated manner.38 As a consequence, these banks will often be able to rely on an ongoing offering that they can invoke as a reason to sound potential investors, including their shareholders. Limitations to instrumental uses of markets soundings that lead to circumvent restrictions to selective disclosure will crucially depend on the supervisory approach in the interpretation of misuse, and plain abuse, of MAR flexibility. Out of the scope of application of market soundings, selective disclosure towards 12.52 shareholders falls under the general principle of Article 10 of MAR. As anticipated, the interpretation of what is ‘normal’ in the communication between issuers and their investors is case-​specific, so that clear-​cut statements are unwise in this field. Bearing these limitations in mind, the analysis will now distinguish the different qualifications of the shareholders that may potentially be the addressees of selective disclosure. The most intense connection between a listed bank and a shareholder occurs when 12.53 the two are part of a corporate group. In this case, the shareholder that controls the company (or the entity controlling the controlling shareholder) typically defines a common business strategy for the whole group, which it runs an integrated business. Jurisdictions where corporate groups have an express legal basis normally enable some form of influence of the controlling entity on its subsidiaries, which inevitably requires some feedback on the business operations of these latter. Running a corporate group as an integrated enterprise in fact requires frequent 12.54 exchanges of information from the controlling entity to the controlled one(s), and vice versa, just as it happens with firms run by a single company (see Section

37 These procedural requirements aim at recording the assessment of the disclosing market participants, and at informing the person receiving the market sounding of the limitations stemming from the communication of inside information (see also Commission Delegated Regulation (EU) 2016/​960). 38 Depending on their size and on the nature of the offered bonds, these offerings can enjoy an exemption from the prospectus regime (Article 1(4)(j) and (5)(i) Regulation (EU) 2017/​1129).

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Carmine Di Noia and Matteo Gargantini IV above). This may easily include confidential information, and inside information within it. How far can a listed entity go in disclosing inside information therefore depends on the restriction in place at national level, although some form of selective disclosure may easily occur in the day-​to-​day management of the group. 12.55

One way to approach intra-​group dynamics is to consider inside information as a corporate asset, and to make selective circulation subject to the rules applicable to intra-​group transactions. This approach will likely apply only to circumstances where the information involved has an autonomous market value. The typical case is of course that of confidential data concerning research and development that are mature enough to lead to a patent with reasonable certainty. For other inside information, corporate law will hardly address the topic of selective disclosure in a direct manner. The major regulatory concern is, in such cases, to protect the asset integrity of the subsidiary from the risk of tunnelling or, in any event, of asset depreciation to the detriment of creditors or minority shareholders. However, MAR does not rely on any misappropriation theory when it comes to regulating the circulation of inside information. Not only does the underlying MAR philosophy establish a negative property right on inside information—​so that this latter has in principle to be disclosed—​but it also prevents issuers producing such information from freely disposing of it when delayed.39

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This does not mean, however, that the law of corporate groups is not relevant in defining when selective communication is a legitimate behaviour. On the contrary, information flows may fall under the scrutiny of supervisors if they do not appear to serve the purpose of facilitating an integrated management of the corporate group within the limits of the law. How strict this test will be is in part a country-​ specific issue, because the applicable law and the relevant case law determine the intensity of the influence the controlling entity may have on the subsidiary. As jurisdictions display different levels of flexibility when enabling the interference of controlling entities toward their subsidiaries,40 courts may equally diverge in their scrutiny when it comes to determining if sharing a specific piece of confidential information has a justification in the coordination of the companies’ activity. In some countries, group coordination may have weak legal bases, or may be possible only under strict conditions, so that the margins for conveying inside information from the subsidiary bank to the controlling entity will be narrower. The opposite is true

39 The only partial exception may be the issuer permission managers need to trade, in specific circumstances, during closed periods (Article 19(12) of MAR; Article 8 of Regulation (EU) 2016/​ 522). To be sure, this permission does not enable managers to exploit inside information, as the ban on insider dealing remains applicable. However, it leads to an increased risk that violations will be perpetrated, as it removes a prophylactic measure aimed at reducing opportunities of violations. 40 Kraakman et al, The Anatomy of Corporate Law, Oxford University Press, 2017, 163–​4.

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Corporate Governance and Inside Information in countries where flexibility is higher, for instance because courts tend to assess the overall effects of centralized coordination, rather than checking each intragroup transaction on an individual basis. In practice, courts and supervisors may be less (more) inclined, in the first (second) set of jurisdictions, to regard selective disclosure of confidential information as ‘normal’ or ‘necessary’, because the typical group structure is less (more) integrated than in other countries. In countries where the law enables the controlling entity to run the entire group as a single enterprise, one can fairly conclude that selective communication among the group entities is allowed under Article 10 of MAR. When local rules or interpretations enable a listed bank to share some inside infor- 12.57 mation with their controlling entity, such information can remain confidential, at least until the listed bank decides—​as soon as possible—​to disseminate it and not to activate a procedure to delay the publication (Article 17(8) of MAR). Absent a legal or factual relationship like the one among entities belonging to 12.58 the same corporate group, selective disclosure requires alternative legal bases to pass the MAR Article 10 test. Whether the shareholder has a major shareholding or a lower stake in the listed bank, mere possession of part of the bank’s capital does not seem to suffice as a justification for restricted circulation of inside information. In particular, reference to shareholders as primary insiders (Article 8(4)(b) of MAR) 12.59 does not seem to provide a justification for selective disclosure. First, inclusion in the list of primary insiders does not certify that all primary insiders have obtained information in a lawful manner, as the presence in the same list of those involved in criminal activities demonstrates. More simply, MAR may just acknowledge that contacts between issuers and their shareholders may easily lead to leaks, whether intentionally or not—​all the more so in a context where those contacts are incentivized (Recital 32 of MAR). Second, holding a stake in the capital of the bank may give access to inside information regardless of selective disclosure from the bank. For instance, when a shareholder is likely to be pivotal in a general meeting vote, its intention (not) to vote, as well as its intention to vote in a certain manner, easily qualify as inside information, especially if such intention contradicts market expectations. It is therefore important that meetings between banks’ representatives and investors 12.60 do not lead to share inside information, and that unintentional selective disclosure that may occur is immediately followed by public disclosure (Article 17(8) MAR). Not even minority access to the board, in countries where external shareholders can appoint their own directors, seems to justify preferential access to inside information by those external investors. Minority representation aims to reduce the risk that directors be captured by controlling shareholders, but it should not lead to increased capture by non-​controlling shareholders.

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VII.  Financial Reporting 12.61

As anticipated, rules on financial reporting deserve a separate analysis because of their ability to provide a legal basis for selective disclosure of some inside information. We can only sketch out some implications here, but the main takeaway of the analysis is that, while rules on consolidated accounts sometimes justify the circulation of inside information, their ability to meet the MAR Article 10 test may not always be straightforward. This leaves room for national interpretations and divergent local supervisory approaches, making the management of cross-​border bank groups more prone to legal uncertainty. The best example is the treatment of the investments in associates.

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The regime applicable to financial reporting concerning associates varies depending on the trading venue where the securities of listed banks are traded. If the consolidating entity has it shares traded on an MTF, the regime applicable41 to consolidated accounts enables to display the participating interest in the associate either at its book value or for the amount corresponding to the proportion of the associate’s capital and reserves (Article 27 of Directive 2013/​34/​EU).42 The participating entity can therefore in principle assess its equity stake under either criterion without having direct access to confidential (and inside) information from the associates. When relying on public financial statements of its investee, the participating entity does not however enjoy much flexibility in the preparation of the consolidated accounts. First, it has to wait for the publication of the relevant statements before being able to prepare the draft consolidated accounts. Second, it has little room to foster a homogeneous approach to the applicable accounting principles.

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If the bank is listed on a regulated market (and not simply on an MTF), then the financial statements are prepared under the International Accounting Standards (IAS)/​ International Financial Reporting Standards (IFRS). Here, consolidated accounts report the investment in the associates under the equity method—​so that the investment is initially recognized at cost and then adjusted to reflect the profits, losses, and distributions of the investee company (IAS 28, § 10).43 The accounts rely on the most recent available financial statements of the associates (IAS 28, § 33), so that in principle no communication of (inside) information is needed. However, if a loss event emerges that requires impairment of the investment (IAS 28, § 40–​41A; IFRS 9), then the listed entity should assess the recoverable amount 41 Unless Member States decide to extend the IAS/​IFRS regime to such banks as well (Article 5(b) of Regulation (EC) No 1606/​2002). 42 Assessment at fair value is ruled out (Article 8(4)(c) of Directive 2013/​34/​EU). 43 If the bank prepares separate financial statements, it can account for investments in associates either at equity value, or at cost, or according to the rules applicable to financial instruments under IFRS 9 (IAS 27, § 10).

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Corporate Governance and Inside Information for its participation. This is the higher figure between the value in use and the fair value less costs of disposal. In principle, assessing the fair value does not require as such selective disclosure from the investee to the shareholder,44 so that no restricted circulation of this kind occurs when the fair value less cost of disposal is higher than the carrying amount. When this condition does not occur, the consolidating entity shall calculate the 12.64 value in use, which is based on an estimate of the cash flows that the associate will either generate or distribute (IAS 28, § 42). The two methods for determining the value in use—​estimation of generated or distributed cash flows—​should lead to the same result under appropriate assumptions (IAS 28, § 42), but they may require access to different sets of information. While an estimate of dividends seems to rely more heavily on publicly available information, based as it is on dividend discount models, assessing future cash flows an associate can generate through its cash generating unit(s) might require access to confidential data of this latter. What is more, it appears that in some circumstances dividend discount models provide less reliable results, which may be problematic especially for consolidated accounts in the financial sector.45 As cash flow projections rely on financial budgets or forecasts (IAS 36, § 33), the broader the information available on the associate, the more accurate the data in the financial reports. By the same token, direct access to interim financial data originating in associates 12.65 can be beneficial when the consolidating entity and its associate(s) have adopted different valuation methods, because in such a case the consolidating entity has to adopt homogeneous accounting criteria. On its turn, this may require a revaluation of the associates’ accounting data (IAS 28, § 36; Article 27(3) Directive 2013/​34/​ EU, which however allows to retain different methods, if this is disclosed). The question therefore remains as to the relationship between Article 10 of MAR 12.66 and the applicable financial reporting standards. Do financial reporting standards entail a duty to share confidential, including inside, information with shareholders bound to prepare consolidated accounts? If the answer is negative, is such 44 Even when based on the income approach (IFRS 13, § 38(c)(1)), calculation of fair value relies on the assumptions market participants would use, while the value in use refers to entity-​specific assessments (J Cochrane, ‘Preparing Cash Flow Projections for Value in Use Impairment Tests’, 1 May 2015, available at http://​www.iaseminars.com, accessed 5 October 2018. 45 See the debate that has surrounded the International Financial Reporting Interpretations Committee (IFRIC) Update of September 2010 (available at https://​dart.deloitte.com, accessed 27 May 2018)  (calculations using dividend discount models deemed rarely appropriate when determining value in use of a CGU in consolidated financial statements):  European Financial Reporting Advisory Group (EFRAG), ‘Comment Letter on IFRS IC Agenda Decision—​IAS 36 Impairment of Assets—​Calculation of Value In Use’, 8 March 2011 (available at https://​www.efrag. org, accessed 27 May 2018) (no presumption, albeit rebuttable, should be introduced that using dividend discount models would rarely be appropriate for consolidated accounts; the draft version of the comment letter specified that the issue related to a subsidiary operating in the financial sector).

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Carmine Di Noia and Matteo Gargantini communication allowed, albeit not mandated? These uncertainties leave broad margins to divergent interpretations, and to national discretion. In some countries, lawmakers46 and standard-​setters47 may dispel some doubts at local level, but this is of little help in building a Single Rulebook (Recital 3 of MAR) that may facilitate the management of cross-​border groups.

VIII. Conclusion 12.67

This chapter has addressed the impact of MAR on banks’ corporate governance. Its analysis rests on the assumption that circulation of information—​and of inside information within it—​is a key tool for proper management. Effective internal control systems rely on selective disclosure of information to measure banks’ risk exposure and to verify its alignment with the predetermined level or risk appetite and tolerance. However, MAR looks at selective disclosure of inside information with suspicion, as sharing inside information increases the number of persons having the capability to abuse it by committing insider dealing. While protection of market integrity and effective corporate governance are surely not in contrast with each other, their equilibrium also depends on the interpretation of the MAR regime on selective disclosure.

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As this chapter shows, the legal framework for the circulation of information within banks and within bank groups still leaves margins to divergent interpretations and national discretion, in spite of the aim to have a single rulebook in place across the European Union. Fostering supervisory convergence could help reduce the costs of running banks and bank groups operating on a cross-​border basis. Other simplifications would require further harmonization of national laws, such as those concerning groups of companies. Last but not least, changes in EU rules should be explored in the field of corporate group law, including greater coherence between MAR, IFRS, and the CRR.

46 For instance, the Italian law provides for an express duty for all subsidiaries to disclose all the information required for the preparation of consolidated accounts to their controlling entities (Article 43 of legislative decree No 127/​1991). For banks, the same applies to associates as well (Article 38(2) of legislative decree No 136/​2015). 47 Once again in Italy, the local standard setter for the national GAAP recommends that revaluation of assets and liabilities, which is required when the methods adopted by different entities diverge, be in principle carried out at each company’s level. Only when this proves impossible shall the consolidating entity adjust the original valuations when drafting the consolidated accounts (Organismo Italiano di Contabilità (OIC), Principle No 17, December 2016, § 41).

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Part III OWNERSHIP STRUCTURES

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13 ENGAGEMENT OF INSTITUTIONAL INVESTORS Maria Cristina Ungureanu

I. Financial Institutions and Investor Activism II. Active Ownership

IV. Engagement and Voting

13.01 13.13 A. The role of shareholders 13.13 B. Active investors 13.18 III. Stewardship Principles 13.23 A. Premises for stewardship 13.23 B. Stewardship codes and principles 13.28 C. Sustainable and responsible investment (SRI) 13.35

A. Engagement—​a rising trend B. Individual and collective engagement C. Board—​investor engagement D. Board elections—​a form of engagement

V. Exercise of Voting Rights VI. Conclusions

13.45 13.45 13.53 13.56 13.59 13.65 13.70

I.  Financial Institutions and Investor Activism Banks have built a history of stakeholder oversight following the financial crisis 13.01 and several commentators pointed at investors for the need for better oversight of financial institutions to prevent misconduct and failures.1 Ever since the crisis, international organizations and regulators have put forward 13.02 standards of best practices in response to the financial institutions’ insufficiencies. Many recommendations and provisions have directly or indirectly been aimed also at investors, to stimulate oversight over financial institutions. Specifically, short-​termism, both on the part of companies and of investors, was 13.03 considered a malfunction of the markets.

1 European Commission, Directive (EU) 2017/​828 of the European Parliament and of the Council of 17 May 2017 amending Directive 2007/​36/​EC as regards the encouragement of long-​ term shareholder engagement; OJ L132/​1.

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In 2009, the Organisation for Economic Co-​operation and Development (OECD) was among the first global institutions to issue a report analysing the impact of failures and weaknesses in corporate governance, concluding that the financial crisis could be, to an important extent, attributed to failures and weaknesses in corporate governance arrangements that did not serve their purpose to safeguard against excessive risk-​taking in a number of financial services companies.2 The report mainly focused on the mismanagement of financial institutions’ risk framework, encouraging companies to improve internal risk assessments and investors to promote related risk due diligence on companies.

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Banks’ governance practices have further been considered by David Walker’s independent review and examination of corporate governance in the UK banking industry, a study requested by the UK government.3 This prominent report also addressed, among other issues, the role of institutional shareholders in engaging effectively with companies and monitoring of boards.

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Executive remuneration has been a specific objective addressed by the reforms aimed at financial companies, as one of the factors that had led to a short-​term approach in corporate governance. The ultimate objective has been to align company executive incentives with the interest of shareholders.4 Specifically, the EU Capital Requirements Directive has revealed the rise of mandatory structure of executive pay as a main criticism of pre-​crisis remuneration practices at financial institutions. The Directive has called for increased disclosure of executive pay and marked a new trend in the regulation of bankers’ pay in Europe by imposing a bonus cap, together with its approval by the shareholders.5

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Within a few years, the role of governance regulation has spread from the financial sector to non-​financial companies, empowering investors to have a more active stance in the governance of firms. Moreover, regulation, principles, and standards have also responded to social issues and political pressures, reflecting concerns

2 Grant Kirkpatrick, ‘The Corporate Governance Lessons from the Financial Crisis’, OECD, 2009, available at https://​www.oecd.org/​finance/​financial-​markets/​42229620.pdf, accessed 13 October 2018. 3 A Review of Corporate Governance in UK Banks and Other Financial Entities (The Walker Report, 2009), available at https://​www.icaew.com/​library/​subject-​gateways/​corporate-​governance/​ codes-​and-​reports/​walker-​report, accessed 13 October 2018. 4 Guido Ferrarini, Niamh Molone, and Maria C ​ ristina Ungureanu ‘Executive Remuneration in Crisis: A Critical Assessment of Reforms in Europe’, Journal of Corporate Law Studies, (2010) 10, 1, 73–​118. http://​papers.ssrn.com/​sol3/​papers.cfm?abstract_​id=2593757. 5 Directive 2013/​36/​EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/​87/​EC and repealing Directives 2006/​48/​EC and 2006/​49/​ EC, OJ [2013], L176/​338; Guido Ferrarini ‘CRD IV and the Mandatory Structure of Bankers’ Pay’, ECGI Law Working Paper No 289/​2015, available at http://​dx.doi.org/​10.2139/​ssrn.2593757, accessed 13 October 2018. Guido Ferrarini and Maria Cristina Ungureanu, ‘Executive Remuneration.

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Engagement of Institutional Investors about inequality in the distribution of wealth or incentives to undertake ‘excessive’ risks.6 An initiative marking the global efforts towards reducing short-​term behaviours of 13.08 organizations across industries was the independent review conducted by Professor John Kay over the mechanisms of control and accountability provided by UK equity markets (the ‘Kay Review’).7 One of the main messages coming out of the Kay Review is that the necessary changes in culture cannot simply be achieved through regulation, but rather through the development of active practices in the investment chain. The European Commission has pursued its road towards increased investor par- 13.09 ticipation. In its 2012 Action Plan on company law and corporate governance, the Commission announced several actions in the area of corporate governance, in particular to encourage long-​term shareholder engagement and to enhance transparency between companies and investors.8 Consequently, the role of shareholders has been amplified through enabling the 13.10 ‘say on pay’ system in various countries, which has been introduced as a governance mechanism allowing shareholders of companies across industries to have a voice on the suitability of companies’ executive compensation.9 All these initiatives have directed investors to step up and exercise their ownership 13.11 rights in an active and conscious manner in all issuer companies, irrespective of industry and sector. While the attention to the financial industry has continued, and in some cases, amplified, the concept of investor active ownership has spilled over all companies. More recently, there has been consensus that good governance practices and related 13.12 disclosure should benefit not only shareholders, but also other stakeholders (e.g. creditors and employees).10 These new approaches are explored in the next sections.

A Comparative Overview’, in Jeffrey Gordon and Georg Ringe (eds), Oxford Handbook of Corporate Law and Governance, 2018, 334–​62. 6 Roberto Barontini et  al, ‘Directors’ Remuneration before and after the Crisis:  Measuring the Impact of Reforms in Europe’, in Massimo Belcredi and Guido Ferrarini (eds), Boards and Shareholders in European Listed Companies, Cambridge University Press, 2013, 251–​314. 7 The Kay Review of UK Equity Markets and Long-​Term Decision Making (July 2012), available at www.gov.uk, accessed 13 October 2018. 8 Communication from the Commission to the European Parliament, the Council, The European Economic and Social Committee and the Committee of the Regions Action Plan: Action Plan: European company law and corporate governance—​a modern legal framework for more engaged shareholders and sustainable companies, COM(2012) 740 final, available at https://​eur-​lex. europa.eu/​legal-​content/​EN/​ALL/​?uri=celex%3A52012DC0740, accessed 13 October 2018. 9 Ferrarini and Ungureanu, n 5. 10 Ferrarini, 2015.

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II.  Active Ownership A. The role of shareholders 13.13

Elevated standards of corporate governance are important for the fair and effective functioning of the capital markets. Good governance ensures that company policies and practices are robust and effective, defining the extent to which a company operates responsibly in relation to its shareholders, as well as in relation to other stakeholders, that is, customers, employees, authorities, and the wider community.

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In his 1992 report, Sir Adrian Cadbury stated that ‘the shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place’.11 Twenty-​five years forward, this approach has evolved. Investors’ weight has become much more relevant.

13.15

The evolving role that investors play in preserving and enhancing long-​term value on behalf of beneficiaries, has been acknowledged by several global policymakers in the recent years, following the financial crisis. In 2011, OECD states that ‘the effectiveness and credibility of the entire corporate governance system and company oversight depend on institutional investors that can make informed use of their shareholder rights and effectively exercise their ownership functions in their investee companies’.12

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As the list of institutional investors has grown, their calibre has evolved, and they have become more global in operations and outlook, there is higher demand for good corporate governance, but also for accountability and transparency on the part of investors. Due to size and relevance, institutional investors now play a central role in defending the sustainability of the financial markets.

13.17

In the past decade, the changing landscape of corporate governance has been stimulated by increasingly more active, more responsible, more powerful and vocal institutional investors. Stewardship, as well as sustainable and responsible investing (SRI) have gathered momentum across the world, as investors look for financial returns, while also contributing to the achievement of a positive impact on the world around them.13

11 Report of the Committee on the Financial Aspects of Corporate Governance (1992), available at http://​cadbury.cjbs.archios.info/​report, accessed 13 October 2018. 12 OECD, ‘The Role of Institutional Investors in Promoting Good Corporate Governance, Corporate Governance’, 2011, available at https://​www.oecd-​ilibrary.org/​governance/​the-​role-​of-​ institutional-​investors-​in-​promoting-​good-​corporate-​governance_​9789264128750-​en, accessed 13 October 2018. 13 Ferrarini and Ungureanu, n 5.

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Engagement of Institutional Investors B. Active investors Following the reforms directed at financial institutions, the role of investors has 13.18 evolved from rights to responsibilities. Shareholder  activism  has  entrenched  itself in the modern climate of corporate governance. As mentioned above, there are several reasons for an increasingly proactive stance 13.19 among large investment firms in recent years. Starting with macro reasons promoted by global regulations, such as the rise of stewardship codes, the initiatives put forward by the principles for responsible investment (PRI),14 national say-​on-​ pay rules,15 and the revision of the EU Shareholders’ Rights Directive.16 Mounting social pressures on companies and investors to adopt more sustainable business practices has also contributed to the activist trend.17 Beyond the financial industry, activism has entered industries that, until re- 13.20 cently, have generally steered clear of such investors (e.g. the energy sector, the oil and gas sector). There is an increased emphasis by prominent investors on challenging transactions, corporate strategy, companies’ approach to environment, and traditional corporate governance concerns, such as board composition or executive remuneration across companies and markets. Investors have become more sophisticated and their approach to risk has evolved. Shareholder activism could be divided into three categories: traditional activism, 13.21 hedge fund activism, and corporate social responsibility activism.18 Traditional activism is typically exercised by investment funds or pension funds and generally concerns topics related to corporate governance or restructuring. Hedge fund activists seek to create financial value by influencing corporate strategy and structure. Activism on social responsibility aims to improve corporate citizenship, mainly focusing on issues related to environmental and social topics. Unlike most hedge funds, which tend to focus on short-​term corporate actions, 13.22 active investors are focused on activity that can deliver long-​term, meaningful changes in governance and sustainable strategies. This chapter further discusses the

14 ‘Principles for Responsible Investment’, PRI, 2014, available at https://​www.unpri.org/​pri/​ what-​are-​the-​principles-​for-​responsible-​investment, accessed 13 October 2018. 15 Ferrarini et al, n 4; Guido Ferrarini and Maria Cristina Ungureanu, ‘Economics, Politics, and the International Principles for Sound Compensation Practices:  An Analysis of Executive Pay at European Banks, Vanderbilt Law Review (2011), 62, 431. 16 Directive (EU) 2017/​828. 17 Ferrarini and Ungureanu, n 5. 18 Elroy Dimson, Oğuzhan Karakaş, and Xi Li, ‘Active Ownership’, Review of Financial Studies (2015), 28, 12, 3225–​68, doi:10.1093/​rfs/​hhv044; Tamas Barko, Martijn Cremers, and Luc Renneboog (2017), ‘Shareholder Engagement on Environmental, Social, and Governance Performance’, ECGI Working Paper No 509/​2017, available at http://​www.ecgi.global/​sites/​default/​files/​working_​papers/​documents/​5092017_​1.pdf., accessed 13 October 2018.

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Maria Cristina Ungureanu recent approach taken by active investors through stewardship, which unites the traditional active approach with an increasing attention towards social responsibility and sustainability issues.

III.  Stewardship Principles A. Premises for stewardship 13.23

In Europe, the first Shareholder Rights Directive that predated the crisis established requirements for the exercise of certain shareholder rights attached to voting shares in relation to general shareholder meetings of companies.19 Many European countries had updated their corporate governance regulatory framework not only to transpose the Directive but also to implement further reforms in this regard.

13.24

With enhanced rights, greater responsibilities have also emerged. The Directive was revised in 2017, setting a wider space for investors, providing enhanced responsibilities for asset managers, asset owners, and issuer companies. The main objective of the second Shareholder Directive is to promote investor engagement with issuer companies.20

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The United States followed a similar trend with the adoption of the Dodd-​Frank Wall Street Reform and Consumer Protection Act in July 2010, and the subsequent measures taken by the Securities and Exchange Commission to: introduce say-​on-​pay and say-​on-​golden parachutes provisions; permit shareholder proposals on CEO succession; and allow certain shareholders proxy access for director nominations at annual meetings subject to majority consent.21

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Investors also have responsibilities towards the investee companies. The concept of active investment has been clearly marked by the concept of ‘stewardship’. At an investor level, stewardship helps to preserve and enhance long-​term value, as part of a responsible investment approach.22 This includes the consideration of wider ethical, environmental, and social factors as core components of fiduciary duties. At an individual company level, ‘stewardship’ stimulates and promotes high standards of corporate governance, contributing to sustainable value creation, thereby

19 Directive (EC) 2007/​36. 20 European Commission, Directive (EU) 2017/​828; Ferrarini and Ungureanu, n 5. 21 The Dodd–​Frank Wall Street Reform and Consumer Protection Act (‘The Act’), Pub L No 111-​203, enacted 21 July 2010. 22 International Corporate Governance Network (ICGN), ‘Global Stewardship Principles’, 2016, available at https://​www.icgn.org/​sites/​default/​files/​ICGNGlobalStewardshipPrinciples.pdf, accessed 13 October 2018.

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Engagement of Institutional Investors increasing the long-​term return to investors and their beneficiaries. In a broad context, stewardship enhances overall financial market stability and economic growth. The role of institutional investors cannot be separated from the fiduciary duty as- 13.27 sumed when they become responsible for managing funds on behalf of individuals or entities. They become the stewards of third parties’ funds, meaning that they ‘take care’ of the investments of their clients, which, in fact, represent their own assets. Responsible engagement regarding the activities of the issuers is part of the institutional investors’ fiduciary duty. B. Stewardship codes and principles A  stewardship code—​incorporating the relative principles—​is a set of fiduciary 13.28 principles for institutional investors who hold shares and voting rights in companies, as part of the fiduciary duty of investors to behave as good owners of companies. Stewardship codes require investors to monitor and, where necessary, engage with companies on material matters, including environmental, social, governance, strategy, performance, and risk issues and to vote their shares at company general meetings. The United Kingdom was the first country to adopt a stewardship code in 2010 13.29 (revised in 2012),23 inspired by recommendations of Sir David Walker’s 2009 post-​ crisis review of corporate governance in UK banks.24 At the European level, the European Fund and Asset Management Association (EFAMA) issued the Code for External Governance in 2011.25 Italy was the first Continental European country to adopt stewardship principles, which were emanated by Assogestioni (the Italian Association of Investment Companies),26 while outside Europe, Japan was among the first to embrace the stewardship cause.27

23 Financial Reporting Council, ‘The UK Stewardship Code’, 2012, available at https://​www. frc.org.uk/​getattachment/​d67933f9-​ca38-​4233-​b603-​3d24b2f62c5f/​UK-​Stewardship-​Code-​ (September-​2012).pdf, accessed 13 October 2018. 24 ‘A review of corporate governance in UK banks and other financial industry entities’, 2009, available at http://​webarchive.nationalarchives.gov.uk/​+/​www.hm-​treasury.gov.uk/​d/​walker_​review_​261109.pdf, accessed 13 October 2018. 25 EFAMA, ‘Code for external governance—​Principles for the exercise of ownership rights in investee companies’, 2011, available at http://​www.efama.org/​Publications/​Public/​Corporate_​ Governance/​11-​4035%20EFAMA%20ECG_​final_​6%20April%202011%20v2.pdf, accessed 13 October 2018. Revised: EFAMA, ‘Stewardship Code, Principles for asset managers’ monitoring of, voting in, engagement with investee companies’, available at http://​www.efama.org/​sitepages/​publications.aspx?Choice=Corporate%20Governance, accessed 13 October 2018. 26 Assogestioni, ‘Italian Stewardship Principles’, 2013, 2016, available at http://​www.assogestioni. it/​index.cfm/​1,815,0,49,html/​principi-​italiani-​di-​stewardship, accessed 13 October 2018. 27 FSA, ‘Principles for Responsible Institutional Investors’ 2014, 2017, available at http://​ www.assogestioni.it/​index.cfm/​1,815,0,49,html/​principi-​italiani-​di-​stewardship, accessed 13 October 2018.

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A  number of other jurisdictions have followed.28 As at 2018, the Institutional Corporate Governance Network has records of over twenty stewardship codes globally.29 In some of the jurisdictions the code was implemented by a regulatory or a quasi-​regulatory body, while in other jurisdictions investor or industry associations jointly decided to sign on the code.

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The United States has not adopted a stewardship code per se but advanced a set of initiatives in this regard. In 2016, a working group of leading independent directors and representatives from some of the largest long-​term institutional investors established the Shareholder-​Director Exchange Protocol (SDX Protocol), an engagement guide for public company boards and shareholders.30 In 2017 the Investor Stewardship Group, a coalition of large US investors, issued a stewardship framework for institutional investors.31

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These codes can be seen as a real game-​changer in the balance of responsibilities in corporate governance, setting out principles and practices for institutional investors that aim to enhance the quality of engagement with companies, to improve long-​term returns to shareholders and the efficient exercise of governance responsibilities.

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Stewardship principles prioritize essence over form. Across jurisdictions, they have been developed to achieve important objectives: to ensure that investors fulfil their responsibilities to manage their investments; to stimulate investors to monitor and engage with the companies in which they invest; to increase the quantity and quality of engagement between companies and investors; to exercise their voting rights in a conscious and transparent manner; and, not least, to help asset owners differentiate between them by judging how they carry out their stewardship responsibilities. The principles also encourage investors to explain their stewardship policies and practices, thereby aiming to improve transparency on the relationships between investors and companies, behaviours and values.

28 The proliferation of stewardship codes is also mentioned in: OECD, ‘Principles of Corporate Governance’, 2015, available at https://​www.oecd.org/​daf/​ca/​Corporate-​Governance-​Principles-​ ENG.pdf, accessed 13 October 2018. 29 ICGN website: https://​www.icgn.org/​global-​stewardship-​codes-​network; Jennifer Hill, ‘Good Activist/​Bad Activist: The Rise of International Stewardship Codes’, 2017, available at http://​www. ecgi.global/​working-​paper/​good-​activistbad-​activist-​rise-​international-​stewardship-​codes, accessed 13 October 2018. 30 The Shareholder-​Director Exchange (SDX) working group includes leading independent directors and representatives from some of the largest and most influential long-​term institutional investors. The SDX Protocol is a ten-​point guide for public company boards and shareholders, see http://​www.sdxprotocol.com/​what-​is-​the-​sdx-​protocol/​, accessed 13 October 2018. 31 Investor Stewardship Group, ‘Stewardship Framework for Institutional Investors’, 2017, available at https://​www.isgframework.org/​stewardship-​principles/​, accessed 13 October 2018.

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Engagement of Institutional Investors While stewardship codes are fundamentally a statement of investor responsibil- 13.34 ities, the effective implementation of stewardship activities requires constructive coordination of many market participants:  asset owners and asset managers; companies; regulators; and service providers. These participants have differing agency roles throughout the investment chain for the successful application of stewardship. The success of stewardship implementation also relies on participants understanding their roles and working in good faith to contribute positive outcomes.32 C. Sustainable and responsible investment (SRI) Engagement between investors and companies is one of the hallmark stewardship 13.35 principles. In addition to traditional governance topics such as executive compensation, shareholder rights, and board of directors’ topics, a growing number of investors are engaging with companies on sustainability issues. How a company manages, and how the board oversees, the company’s environmental and social impacts is integral to whether the company is being well run for the long term. Many investors view how companies address climate change and other environmental and social challenges as a proxy for the strength of the board and management and a metric for measuring governance risk. Socially Responsible Investment (SRI) is a long-​term oriented investment ap- 13.36 proach, which integrates environmental, social, and governance (ESG) factors in the research, analysis, and selection process of securities within an investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors in order to better capture long-​term returns for investors and to benefit society by influencing the behaviour of companies.33 Institutional investors began to look closely at the intangible aspects of companies’ 13.37 strategic business choices a few years ago. The financial crisis was an important milestone, as financial institutions’ attention to wider stakeholder issues, corporate behaviours, and impact on the society has become more acute in order to restore trust in the markets. To date, the SRI phenomenon has taken on important dimensions in the global fi- 13.38 nancial markets landscape, becoming a major part of the asset allocation process of the world’s largest institutional investors. As at 2016, ESG investing encompassed

32 ICGN, ‘Global Stewardship Principles’, 2016, available at https://​www.icgn.org/​policy, accessed 13 October 2018. 33 Eurosif, SRI Study, 2016, available at https://​www.eurosif.org/​sri-​study-​2016/​, accessed 13 October 2018.

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Maria Cristina Ungureanu 22.9 trillion US dollars, so approximately a quarter of the world’s professionally managed assets (an increase of 25 per cent since 2014).34 13.39

This approach has also been overseen by the PRI (Principles for Responsible Investment), which has prompted a clear trend in the treatment of investor fiduciary duty towards recognizing the importance of ESG issues.35

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There are various factors that have driven the growth of ESG investing. Improved risk-​adjusted returns are one important contributor.36 Since the beginning of the 1970s, scholars and investors have published more than 2000 empirical studies and several review studies on the relation between ESG criteria and corporate financial performance. Overall, evidence that investing sustainably leads to better long-​term outcomes for institutional investors looks clear, as the large majority of studies report positive findings regarding the relation between ESG and company financial performance.37

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The evolution of fiduciary duty is another important element. The notion of fiduciary duty is evolving to encompass certain principles that are core to responsible investing. How asset managers exercise due care, skill, and diligence evolves as the world changes. ESG analysis can raise important pre-​financial information that our fiduciary obligations require us to consider.

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The European Commission has put forward important initiatives in this regard, recommending adoption of minimum stewardship standards for investment mandates covering all asset classes and applicable to all institutions in the investment chain that act on behalf of others.38

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The exercise of stewardship responsibilities is a key expression of investor duties to integrate material ESG risks into the investment process. This approach is also driven by large asset owners themselves. Long-​term asset owners are evolving their strategic asset allocation, taking into consideration the impact of ESG factors on 34 Global Sustainable Investment Alliance, ‘Global Sustainable Investment Review’, 2016, available at http://​www.gsi-​alliance.org/​wp-​content/​uploads/​2017/​03/​GSIR_​Review2016.F.pdf, accessed 13 October 2018. 35 Principles for Responsible Investment (PRI), available at https://​www.unpri.org/​, accessed 13 October 2018. 36 A study by MSCI found that portfolio construction employing an ESG momentum (improving ESG scores) strategy delivered an annualized active return of 2.2 per cent over a seven-​year period. Zoltán Nagy, Altaf Kassam, and Linda-​Eling Lee, ‘Can ESG Add Alpha? An Analysis of ESG Tilt and Momentum Strategies’ MCSE, 2015, available at https://​www.msci.com/​documents/​10199/​ 4a05d4d3-​b424-​40e5-​ab01-​adf68e99a169, accessed 13 October 2018. 37 Gunar Friede, Timo Busch, and Alexander Bassen, ‘ESG and Financial Performance: Aggregated Evidence from More Than 2000 Empirical Studies’, Journal of Sustainable Finance & Investment (2015), 5, 4. 38 European Commission, ‘Commission action plan on sustainable finance’, 2018, available at https://​ec.europa.eu/​info/​business-​economy-​euro/​banking-​and-​finance/​sustainable-​finance_​en, accessed 13 October 2018.

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Engagement of Institutional Investors risk/​return outcomes. At the portfolio level, such investors require underlying managers to integrate appropriate consideration of ESG issues into the investment processes. The ‘ESG movement’ is seen as positive by investors, in the belief that an engaged 13.44 and sustainable investment approach, especially one that recognizes the importance of ESG issues, is likely to help create and preserve long-​term investment capital. The expectation is that companies will continue to expand their activism on and investment in the issues that matter to their employees, customers, and communities.

IV.  Engagement and Voting A. Engagement—​a rising  trend The increasing relevance of stewardship, the evolvement of responsible investment, 13.45 and the ever more present debate around fiduciary duty have given further impetus to investors’ engagement and voting activities. One of the most significant recent developments in corporate governance is the 13.46 move towards more engagement between issuers and investors. In several countries, such engagement was almost inexistent few years ago, certainly before the crisis, whilst in recent years investors increasingly engage with companies to build understanding of their long-​term strategy, progress in achieving it, and how corporate culture supports it. Engagement on ESG aspects is one of the fastest growing responsible investment 13.47 strategies globally, as shown in Figure 13.01. At the European level, the ESG-​ related engagement and voting strategy grew by 30 per cent between 2013 and 2015.39 In its 2013 Shareholder Stewardship report, the European Sustainable Investment Forum (Eurosif ) highlighted the different motivations behind ESG engagement: ‘these include maximising risk-​adjusted returns, improving business conduct, advancing ethical or moral considerations, and contributing to sustainable development. Many investors also see engagement as part of their fiduciary duty to beneficiaries’.40 The engagement process and measurement of its success, however, depend on the 13.48 context of the issuer company. At country level, there are factors related to the role and impact of culture, law, geography, and demographics. At firm level, the role

39 Eurosif, n 33. 40 Eurosif, Shareholder Stewardship:  European ESG Engagement Practices, 2013, available at http://​www.eurosif.org/​wp-​content/​uploads/​2014/​06/​eurosif-​report-​shareholder-​stewardship.pdf, accessed 13 October 2018.

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Maria Cristina Ungureanu EUR in millions 4 500 000

4 270 045

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Growth 2013–2015 +30%

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Figure 13.01 Growth of engagement and voting in Europe Source: Eurosif (2016)

and impact of corporate governance policies, corporate ownership, and its liquidity are also relevant factors. 13.49

Ultimately, a successful engagement requires a two-​way dialogue between companies and investors. A well-​informed board that understands the perspective and expectations of shareowners is able to take the initiative, deal pre-​emptively with problems and avoid the risk of finding itself on the defensive. Conversely, investors who understand boards’ thinking and business purpose will be less likely to seek explanations and more likely to cast their votes in favour of the board when their support is most needed.

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There are changes within the internal structure of the institutional investors as well. A number of investors are establishing new roles overseeing ESG and stewardship. Many are developing a more holistic approach that combines investment and corporate governance perspectives and that includes strengthened communications between governance teams and portfolio managers.

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The significant policy drive for this strategy is also underscored by the 2017 Shareholder Rights Directive, as part of the European Commission’s action plan to modernize corporate governance and increase corporate transparency.41 As mentioned above, the aim of the Directive is to increase shareholders’ ability to demonstrate further accountability and engagement—​both characteristics which underpin SRI.



Directive (EU) 2017/​828.

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Engagement of Institutional Investors There is increasing interest for investors’ engagement of corporations on ESG 13.52 issues in research and practice too, and empirical evidence of a business case for active ownership has started to emerge. Several studies discuss the mechanisms and forms of value creation resulting from the engagement process, showing that meaningful changes through engagement are possible:  investors have been delivering reforms through company meetings, public votes, and even through media debate.42 B. Individual and collective engagement Investor engagement can be individually or collectively conducted. Some com- 13.53 panies may favour individual forms of ESG engagement, tailoring the engagement process to the specific needs of a given investor. However, collective engagement is also seen as more likely to provide opportunities for relationship building and give more traction to ESG issues within companies, given the total amount of assets under management usually involved in such processes.43 When a number of investment managers are willing to engage and share their views, 13.54 the effects of engagement towards the issuer companies are amplified. Coordinated, collaborative, and international efforts to influence investee companies on governance and sustainability issues can also prove successful.44 In fact, one of the principles found in stewardship codes refers to the need for in- 13.55 vestors to consider cooperating with other investors, where appropriate.45 It may be appropriate to carry out collective engagement, for example in the case of significant corporate events or issues of public interest (such as serious economic or sectoral crises), or when the risks discovered could compromise the ability of the investee listed issuer to continue its activity, paying particular attention to regulations regarding acting in concert.46 C. Board—​investor engagement Over the past few years, institutional investors have held boards increasingly 13.56 accountable for company performance and have demanded greater transparency and engagement with the management of companies. For investors, the interest in more disclosure and interaction arises from the desire for improved

42 Dimson et al, ‘How ESG Engagement Creates Value for Investors and Companies’, PRI, 2018, available at https://​www.unpri.org/​esg-​issues/​how-​esg-​engagement-​creates-​value-​for-​investors-​and-​ companies/​3054.article, accessed 13 October 2018. 43 ibid. 44 Dimson, Karakaş, and Li, n 18. 45 For the United Kingdom, see FRC, n 23; for Italy see Assogestioni, n 26. 46 Assogestioni, n 26.

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Maria Cristina Ungureanu performance, both on the part of boards and in terms of overall corporate governance. 13.57

Just a few years ago, directors engaging with investors was not often heard about. In recent years the attitude has started to change, also driven by the stewardship initiatives and the evolution of corporate governance codes. Investors expect board directors to be open and conversant not only on topics related to financial and strategic oversight, but also on emerging risks such as digital transformation and environment (e.g. associated with climate issues); and on long-​term opportunities.47

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Investor expectations for engagement on these topics mean some board directors may have to step forward. Directors need to expand their horizons and learn more about governance, risks, and opportunities related to sustainability and technology. Alternatively, directors may risk being caught in a crisis when they are forced to engage, having to be aware of the repercussions that come if the board is not addressing these issues. D. Board elections—​a form of engagement

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For many investors, the board needs to be fit for the future, forward-​looking with regards to future commercial and industry contexts, and seeking to understand the driving forces that are impacting on the business. Many companies are looking not only to long industry experience, but for first-​time directors who demonstrate good judgement, intellectual agility, knowledge of technology, including digital, and the ability to deal with complex and fast-​changing marketplace challenges.

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Around the world, institutional investors have called for reforms to enable them to elect independent directors who would constructively challenge management on strategy and hold them accountable for performance. The 2015 OECD Corporate Governance Principles define a basic shareholder right to elect and remove board members and call for the facilitation of effective shareholder participation in, inter alia, the nomination and election of board members.48

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Across jurisdictions, there are several mechanisms for nominating and electing members to sit on the boards of listed companies. While most of the systems enable shareholders to express their voting rights on board elections, some of the systems also allow shareholders to nominate directors as candidates for the board to be submitted for the final election.

47 Ronald P O’Hanley, ‘Long-​Term Value Begins with the Board’, Harvard Law School Forum on Corporate Governance and Financial Regulation, July/​August 2017, available at https://​corpgov. law.harvard.edu/​2017/​03/​20/​long-​term-​value-​begins-​at-​the-​board/​, accessed 13 October 2018. 48 OECD, ‘Corporate Governance Principles’, 2015, available at http://​www.oecd.org/​corporate/​principles-​corporate-​governance.htm, accessed 13 October 2018.

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Engagement of Institutional Investors In this context, it is important to highlight the particularity of the Italian slate 13.62 voting (‘voto di lista’), which is among the world’s admired board election systems. Given Italy’s ownership concentration, slate voting enables minority shareholders to nominate at least one member for the board of directors or the board of statutory auditors, thereby counterbalancing the presence of any controlling shareholders and ensuring that the interests of the minority shareholders are adequately represented.49 This mechanism is regarded as positive in terms of enhancing board accountability and independence. Other countries have been inspired by the Italian slate voting system and developed 13.63 systems around the same principle of allowing shareholders to nominate representatives on the board, among the most recent ones being the US proxy access. Proxy access also gives shareowners a meaningful voice in corporate board elections. It refers to the right of shareholders fulfilling certain ownership requirements to place their nominees for director on the company’s proxy card.50 As a result, many investors are seeking influence on board composition, requiring 13.64 more information about companies’ director nominees, pushing for refreshment and suggesting new members. All of this is occurring within an environment of increasing shareholder activism, in which board composition often becomes a central focus. Board elections are an important form of engagement.

V.  Exercise of Voting Rights These developments often gather many leading investors behind common govern- 13.65 ance and stewardship principles and encourage other investors to take a more active approach to stewardship responsibilities. They also grant investors more influence over the companies they own. Whether active, passive, activist, short term or long term, investors’ voting deci- 13.66 sions can make a significant difference at holding companies. A stake in a company confers voting rights, which are as important for all types of investors, regardless of the reason why the investor chooses to hold it. Voting is one of the fundamental shareholder rights and, in recent years, shareholders have actively pushed for change at the investee companies through exercising their voting rights consciously. The strong culture of engagement between issuers and shareholders in Europe has 13.67 proved to be a defining theme of the voting seasons since the years 2014–​2015.

49 Massimo Belcredi, Stefano Bozzi, and Carmine Di Noia, ‘Board Elections and Shareholder Activism:  the Italian Experiment’, in Massimo Belcredi and Guido Ferrarini (eds), Boards and Shareholders in European Listed Companies, Cambridge University Press, 2013. 50 ibid.

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Maria Cristina Ungureanu Boards have made significant progress in terms of transparency and responsiveness to minority shareholders. As a relevant example, Italy has experienced a significant increase in minority shareholder participation in board elections.51 In recent years, several companies in the United Kingdom and France have bowed to shareholder pressure to revisit remuneration policies.52 While across Europe and the United States many companies have improved reporting and engagement on ESG-​related risks responding to regulatory and shareholder pressure. 13.68

In the European Union, the Directive on disclosure of non-​financial and diversity information53 requires large companies to disclose relevant ESG-​related information to provide investors and other stakeholders with a more complete picture of their development, performance, and position and of the impact of their activity. In the United States, while there is no regulation specifically addressing ESG disclosure, shareholders have started to put pressure on companies to provide disclosure of particular concerning matters such as climate change, human rights, and improvement of investor rights.54

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More recently, the rising voices of investors increasingly relate to the impact that investors have on the social sphere. Just by looking at the main takeaways from the 2017 AGM season, the evolving policies of voting and engagement of many institutional investors on ESG matters can be observed. At US companies (where submitting shareholder proposals is relatively common practice), among all the shareholder proposals on the AGM agendas, resolutions related to environmental and social topics account for the largest category of proposals submitted.55

VI. Conclusions 13.70

Ever since the financial crisis, an increasing recognition of the importance of the institutional investors’ role as stewards of capital has been seen. Of course, establishing a culture of stewardship by investors takes time, even while real progress is being made. By launching the stewardship principles, international investor associations and regulators seek to develop a stewardship culture in the country of reference, to promote a proprietary attitude among institutional investors and create responsible

51 Assogestioni, Stagione Assembleare, 2017, available at http://​www.assogestioni.it/​index.cfm/​ 1,161,0,49,html/​comitato-​dei-​gestori-​e-​liste-​di-​minoranza, accessed 13 October 2018. 52 See, e.g. BP and Renault cases below. 53 Directive (EU) 2014/​95. 54 Thomas Singer, ‘The Conference Board, Environmental and Social Proposals in the 2017 Proxy Season’, 2017, available at https://​corpgov.law.harvard.edu/​2017/​10/​26/​environmental-​and-​ social-​proposals-​in-​the-​2017-​proxy-​season/​, accessed 13 October 2018. 55 EY, ‘2017 Proxy season review’, available at http://​www.ey.com/​Publication/​vwLUAssets/​ ey-​2017-​proxy-​season-​review/​$File/​ey-​2017-​proxy-​season-​review.pdf, accessed 13 October 2018; Singer, n 54.

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Engagement of Institutional Investors engagement standards. The development of stewardship activities by institutional investors will drive the adoption of good corporate governance practices, which will support value creation for companies, as active investors lead them to adopting more structured management processes, mitigating potential risks, and leveraging the opportunities. This also requires a long-​term perspective on the purpose of each company, its fi- 13.71 nance, culture, values, and corporate governance. By weaving a healthy corporate culture and governance into the business model, companies are not just contributing to the overall success of their own business. They are creating an environment which investors can rely on. Stewardship sways this and, as such, both companies and investors create sustained growth in the economy. The focus is now moving further, along with a wider discussion around the role of 13.72 finance in promoting the social good and having positive real impact. The financial industry may no longer be considered only as a function of returns, it must also be assessed in terms of the impact on the real economy, on efficient allocation of capital, and on the sustainable economic growth. These will be among the challenges, opportunities, and drivers of change in the investment environment.

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14 STATE-​OWNED FINANCIAL INSTITUTIONS Johannes Adolff, Katja Langenbucher, and Christina Skinner

I. Introduction II. A Theoretical Case for State-​Owned Institutions

14.01

A. Possible rationales

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III. State-​Owned Institutions: The Practical Challenges

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A. The United States B. Germany

IV. Alternative Legal Paths to the Same Policy Goals? A. The German perspective B. The US perspective

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I. Introduction 14.01

Following the global financial crisis of 2008, lawmakers worldwide adopted a sweeping set of regulatory reforms. For the most part, these reforms—​and the debates that surround them—​have addressed questions of regulatory and financial institution design. Less probed, however, have been questions of financial institution ownership. But as much the financial crisis prompted a re-​examination of the ideal scope and boundary of the state’s intervention in financial markets, it should also, the authors of this chapter believe, provoke thought about whether the state—​as opposed to private stakeholders—​is better placed to act as the owners of financial institutions. This chapter considers whether state-​ownership of financial institutions can (and should) further systemic stability and allocative efficiency, goals that can maximize the collective aggregate welfare.

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In most Western developed and capitalist economies, the answer to that question is generally assumed to be ‘no’.1 State-​owned financial institutions are not (or have not 1 For a pre-​crisis view, see Rafael La Porta, Florencio Lopez-​De-​Silanes, and Andrei Shleifer, ‘Government Ownership of Banks’, The Journal of Finance (2002), 57, 265 et seq, available at https://​ dash.harvard.edu/​bitstream/​handle/​1/​30747188/​w7620.pdf?sequence=1, accessed 5 October 2018 (offering evidence to the effect that state banks are less capable of efficient allocation of financial

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State-Owned Financial Institutions been for decades) common in these economies. The United States and Germany may, however, be seen as partial exceptions among their peer Western economies, with the United States’ Government-​Sponsored Enterprises (GSEs) and Germany’s state-​owned banks. Notably, theories in favour of state-​ownership of financial institutions have gained traction among some academics and policymakers in both of these countries over the past several years. In the United States, the state-​ownership conversation has been framed largely in 14.03 terms of public utility regulation. With financial regulators such as Vice President of the Federal Deposit Insurance Corporation (FDIC), Thomas Hoenig, and Minneapolis Federal Reserve Bank President, Neel Kashkari, suggesting that banks should be regulated as such.2 Legal scholars like Morgan Ricks,3 Mehrsa Baradaran,4 and Saule Omarova and Robert Hockett5 have each, as well, considered banks as providers of a public good, service, or utility—​which institutions should in turn be regulated as such. Likewise, in Germany, where almost half of banking activities are carried out by ‘al- 14.04 ternative banks’ (savings banks mainly controlled by municipalities, Landesbanken mainly controlled by the savings banks and the federal states (Bundesländer), and cooperative banks mainly owned and controlled by their customers),6 there is a certain level of support for the notion that such ‘alternative’ ownership structures have their merits and that,7 therefore, a good mix of private and non-​private ownership resources and for a negative correlation between the market share of state banks in the banking sector and overall economic growth of a country), and for a post-​crisis view see W di Mauro and R Haselmann, ‘Die Rolle der öffentlichen Hand im deutschen Bankensektor’, in K Hopt and G Wohlmannstetter (eds), Handbuch Corporate Governance von Banken, 2011, 270 et seq (offering an overview of the more recent economic literature, which also reflects much scepticism of state banks, especially with respect to the allocative efficiency of their credit decision). 2 Joe Rauch, ‘Big Banks are Government Backed: Fed’s Hoenig’, Reuters, 12 April 2011, available at https://​www.reuters.com/​article/​us-​fed-​hoenig/​big-​banks-​are-​government-​backed-​feds-​hoenig-​ idUSTRE73B3S820110412, accessed 5 October 2018; Mark Olson, ‘Why Banks Should Never Become Utilities’, American Banker, 7 March 2016, https://​www.americanbanker.com/​opinion/​ why-​banks-​should-​never-​become-​utilities, accessed 5 October 2018; see also Stephanie Kelton and Paul McCulley, ‘The Fed Chair Should Be a Principled Populist’, New York Times, 30 October 2017 (quoting banking expert Paul McCulley as remarking, ‘[b]‌anks are many things, but at their core, they have a public utility function’). 3 Morgan Ricks, ‘Money as Infrastructure’, unpublished manuscript, November 2017, available at https://​ssrn.com/​abstract=3070270, accessed 5 October 2018. 4 Mehrsa Baradaran, ‘Banking and the Social Contract’, Notre Dame Law Review (2014), 89, 1283. 5 Robert C Hockett & Saule T Omarova, ‘The Finance Franchise’, Cornell Law Review (2017), 102, 1143. 6 See Section II.B.1 for a description of the ‘three pillar’ structure of the German banking industry. 7 P Behr and R H Schmidt, ‘The German Banking System: Charkteristics and Challenges’, SAFE White Paper Series No 23/​2015, available at http://​safe-​frankfurt.de/​fileadmin/​user_​upload/​editor_​ common/​Policy_​Center/​Behr_​Schmidt_​German_​Banking_​System.pdf, accessed 5 October 2018; K Mettenheimer and O Butzbach, ‘Alternative Banking and Recovery from Crisis’, Progressive

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Johannes Adolff, Katja Langengbucher, and Christina Skinner structures may well be the most promising approach for pursuing allocative efficiency and overall system stability.8 The mainstream view, however, remains skeptical, especially regarding allocative efficiency and the level of professional qualification and banking skills in the boards of public banks in Germany.9 14.05

This chapter engages with, and expands, this ongoing debate in financial regulation law and policy by revisiting the matter of state-​ownership in a new and comparative light. Ultimately, this chapter does not espouse state-​ownership of financial institutions; but it does:  (i) explore some aspects of the various theories that could support (at least a portion) of the banking system coming, or as the case would be in Germany, remaining under public ownership, and on this basis: (ii) offer some tentative suggestions for accomplishing the myriad efficiency and/​or social-​policy goals that often motivate state-​ownership governance structures.

II.  A Theoretical Case for State-​Owned Institutions 14.06

In traditional law and economics thinking, the state is justified in intervening in financial markets (and, accordingly, in the business operations of financial institutions) in order to correct market failures. Commonly, these failures involve some inefficiency in the allocation of resources or the persistence of systemic risk.10 From that normative perspective, this section considers whether—​conceivably—​state-​ ownership of financial institutions serves those efficiency and stability ends better than private ownership can.

Economy Forum, 2014, available at http://​www.progressiveeconomy.eu/​sites/​default/​files/​papers/​ Kurt%20Von%20Mettenheim%20Alternative%20Banking%20and%20Recovery%20from%20 Crisis.pdf, accessed 5 October 2018. 8 R Ayadi et al, ‘Investigating Diversity in the Banking Sector in Europe’, Center for European Policy Studies, 2010, with an introduction by G Ferrarini speaking about the ‘biodiversity of banking’, available at http://​aei.pitt.edu/​32647/​1/​70._​Investigating_​Diversity_​in_​the_​Banking_​ Sector_​in_​Europe.pdf, accessed 5 October 2018. The Final Report of High-​level Expert Group on reforming the structure of the EU banking sector of 2 October 2012 (‘Liikanen Report’) devotes an entire chapter to ‘Diversity of Bank Business Models in Europe’, arriving at an overall positive assessment, 32 et seq. 9 H Hau and M Thum, Subprime crisis and board (in-​) competence:  private versus public banks in Germany, Economic Policy (2009), 24 60, 701–​52, available at https://​doi.org/​10.1111/​ j.1468-​0327.2009.00232.x; and K Hopt, ‘Corporate Governance of Banks after the Financial Crisis’, in E Wymeersch, K Hopt, and G Ferrarini (eds), Financial Regulation and Supervision—​A post-​crisis Analysis, 2012, para 11.18. For a balanced summary from the economist’s perspective, see di Mauro and Haselmann, n 1, 226, 227 et seq; see also German Council of Economic Experts (Sachverständigenrat), ‘Das deutsche Finanzsystem  –​Effizienz steigern, Stabiltät erhöhen’, 2008, paras 140, and 245 et seq (https://​www.sachverstaendigenrat-​wirtschaft.de/​fileadmin/​dateiablage/​ Expertisen/​Das_​deutsche_​Finanzsystem.pdf, accessed 5 October 2018) in which the council is very critical of the large state-​owned Landesbanken, but less so of the municipal savings banks. 10 See John Armour et al, Principles of Financial Regulation, Oxford 2016.

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State-Owned Financial Institutions A. Possible rationales 1.  The shareholder perspective According to the traditional mainstream view in corporate finance law and eco- 14.07 nomics,11 the bearers of the residual risk of a firm should exercise ultimate control, and the firm’s management should serve the long-​term interests of these bearers of the residual risk. In a simplified model of a firm (ignoring hybrid and loss absorbing debt instruments), the bearers of the residual risk are the equity investors. In a publicly listed company, these are the shareholders, and they have the ability to mitigate the risk of their overall investment position by way of diversification in a portfolio. If the shareholder base is highly dispersed, principal-​agent problems arise as ra- 14.08 tional apathy induces shareholders to refrain from exercising control at an appropriate level of intensity. To the extent no mitigating mechanisms are in place, principal-​agent problems result in agency costs. These costs of a failure to align interest between shareholders and management diminish cash flows to equity. On the macro-​level, agency costs result in an overall misallocation of resources, especially as free cash flows are not being returned to the equity investors and thus prevented from being reinvested more productively elsewhere in the economy. Mitigating mechanisms resulting in an alignment of interest between management 14.09 and shareholders include: (i) performance-​based remuneration (such as stock options); (ii) the market for control; (iii) activist shareholders; and (iv) information transparency vis à vis the capital markets. As a rule, the ability of these mechanisms to reduce agency cost is strongly correlated to the capital market’s allocative efficiency: if stock prices adequately reflect a listed company’s fundamentals, mitigants (i) to (iv) may be expected to reduce agency cost by effectively aligning the interests of shareholders and management. If not, they may even be counterproductive, the interdependencies between performance-​based remuneration and the exploitation of short-​term market inefficiency being an example.12 Against this theoretical backdrop, the model world to which the vast majority of 14.10 lawmakers (legislatures and judges developing corporate and capital markets law) aspire in the UK/​US context is focused on the base case of a listed stock corporation with a dispersed ownership base whose stock is traded and priced on a public

11 See M Jensen and W Meckling, ‘Theory of the Firm:  Managerial Behavior, Agency Costs, and Ownership Structure,’ Journal of Financial Economics (1976), 3, 305–​60; A Shleifer and R W Vishny, ‘A Survey of Corporate Governance, Journal of Finance (1997) 52, 737. 12 M C Jensen and Kevin J Murphy, ‘Performance Pay and Top-​Management Incentives’, Journal of Political Economy (1990), 98, 98, 225–​64; L A Bebchuk and J Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation, Harvard University Press, 2004.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner market efficient enough to allow for mitigants (i) to (iv) reducing agency cost.13 When it comes to the part of the law that determines to whom management owes its duty of loyalty, the focus of this model is on shareholder value (the ‘Shareholder Value Model’). 14.11

Among the continental EU Member States, there is a fair number subscribing to a more open, somewhat softer approach, requiring management to serve the interest of other stakeholders, too (without perceiving this as a mere disguise for management pursuing its own self-​interest at the cost of the shareholders and general allocative efficiency). Among such other stakeholders, which the law on the continent acknowledges as the bearers of interest which are to legitimately guide the conduct of management, are in particular debtholders, employees, customers, the local economy and sometimes even society at large (the ‘Stakeholder Value Model’).14

14.12

Even jurisdictions leaning to the Stakeholder Value Model—​such as traditionally Germany—​would, however, nowadays acknowledge the existence of the principal-​ agent problem, the need for mitigants capable of reducing agency cost, and the need for a shareholder-​oriented corporate governance that ensured the effectiveness of such mitigants. Mitigants (i) to (iv) therefore play a central role in the corporate governance of banks under the Shareholder Value Model as well as under the Stakeholder Value Model: if banks are publicly listed and have a highly dispersed shareholder population, there is the problem of rational apathy, and thus there is a need for mechanism ensuring the alignment of interests between shareholders and management. Hence, performance-​based remuneration, the market for control, activist shareholders, information transparency, etc. can help to mitigate principal agent problems between shareholders and management of banks.

13 From a bank-​ centric perspective of agency theory, see L Laeven and R Levine, ‘Bank Governance, Reglation and Risk Taking’, NRER Working Paper (2008), available at http://​www. nber.org/​papers/​w14113.pdf, 5, accessed 5 October 2018, taking (and underpinned by empirical evidence) the view that the concentration of ownership in the hands of few owner with ‘great cash-​ flow rights’ will tend to increase risk for the bank. 14 Interestingly, the Basel Committee on Banking Supervision (BCBS) explicitly subscribes to the Stakeholder Value Model (with regards to banks), see BCBS’s Guidelines ‘Corporate Governance Principles for Banks’, 2015, 3 where it says: ‘The primary objective of corporate governance should be safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis. Among stakeholders, particularly with respect to retail banks, shareholders’ interest would be secondary to depositors’ interest’. Similarly open to the notion of embracing, for banks in particular and due to systemic risk, a more stakeholder oriented model under corporate (and not only regulatory) law, see J Armour and J Gordon, ‘Systemic Harms and Shareholder Value’, Journal of Legal Analysis (2014), 6, 15, arguing in favour of a fiduciary duty of management towards debtholders. Critical of the BCBS’s stance and of Armour/​Gordon in this respect is, G Ferrarini’s, ‘Understanding the Role of Corporate Governance in Financial Institutions: A Research Agenda’, ECGI Working Paper No 347/​2017, 21, arguing that the task of protecting the interest of debtholders should be exclusively allocated to external regulation and interference of the regulator, not internal corporate governance.

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State-Owned Financial Institutions 2.  The debtholder perspective But, regarding banks, this is not the end of the story. Even from the perspective of 14.13 a strict proponent of the Shareholder Value Model it appears necessary to take into account that, as the global financial crisis has painfully brought to mind, banks are special.15 To start with, banks are leveraged far more aggressively than firms of the real 14.14 economy. The portion of the liabilities side of a bank’s balance sheet which is contributed by equity investors (‘shareholders’) and instruments with some loss absorbing capacity (‘hybrids’) is small when compared to the portion contributed by depositors, holders of bonds, and other debt instruments, and the bank’s counterparties under its liability-​side derivatives, and so on (collectively the ‘debtholders’). In comparison to typical finance structure in the real industry, this gives the debtholders of banks a more prominent place among the constituencies providing funds to the firm. Their investment into the bank can be framed as creating a principal-​agent relationship, too: from the perspective of the debtholders, the bank (as agent) acts in their interest in the process of advancing the funds provided by the debtholders (as principals) to the bank’s asset-​side customers, such as retail borrowers, corporate borrowers, issuers of bonds, and stock purchased by the bank, counterparties under its asset-​side derivatives, and so on (collectively the ‘borrowers’). Arguably, this intermediation service rendered to the debtholders is the centerpiece 14.15 of a bank’s function, and thus the main reason why banks exist at all: in addition to maturity transformation and risk diversification, a bank offers debtholders a way to efficiently deal with information asymmetries that would otherwise arise in their (then direct) relationship to the borrowers.16 From the perspective of a Debtholder (who is neither insured nor covered by an explicit or implicit state guarantee), the use of having a bank acting as the middlemen between the Debtholder and the borrower crucially depends on how well the bank acts as his agents when selecting the right borrowers, charging them interest at a level that is appropriate for the risk they represent, and keeping an eye on them until interest and principal are fully repaid. To the extent a Debtholder could lend, in a commercially sound manner, directly to a borrower, there would be no reason for letting the bank pocket the margin that would otherwise increase the interest that can be earned by the debtholders on their fixed income financial asset (or be split, in some manner, between the borrowers and the debtholders). Sophisticated debtholders can quite easily build portfolios of debt instruments to diversify their risk and satisfy their maturity preferences. What 15 For a current overview, see Ferrarini, n 14, 5 et seq. 16 For a good summary of economists’ views regarding this intersection of the general theory of the bank, agency theory, and the theory of asymmetrical information, see Mettenheimer and Butzbach, n 7, 21.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner is not so easy to substitute if the bank falls away as the intermediary and what therefore constitutes the core element of a bank’s value creation for debtholders is the process of selecting, appraising, and monitoring borrowers (the ‘Credit Process’). 14.16

With regards to the Credit Process, the interest of the bank’s management and the debtholders are not automatically aligned. Rather, managers (including not only board members but also other risk-​takers, especially those with access to the bonus pool) may, if left unchecked, create agency cost for the debtholders to the extent they take risks that benefit the managers, and possibly also the Shareholders, but which are of no interest, or even detrimental, from the perspective of any debtholders not covered by deposit insurance or explicit/​implicit state guarantee. Such excessive risk-​taking may consist of selecting borrowers with a poor credit risk, but also in engaging in risky asset-​side activities outside the loan book, such as investing in sub-​prime collateralized debt obligation (CDO), take ‘naked’ credit risk under a credit default swap (CDS), or proprietary trading in financial assets and derivatives.

14.17

For this reason, there need to be mitigants capable of reducing agency cost for the debtholders, that is, mechanisms aligning the interests of management with those of debtholders. The mitigants reducing the agency cost for shareholders (stock options, the market for control, activist shareholders, information transparency, etc.) will often not be of help17 to the debtholders who look at their fixed income future cash flow, do not participate in the residual profit, are exclusively interested in the bank’s capability to repay its debt when due, or as the case may be, on demand—​ and consequently have much lower risk appetite than the shareholders. Thus, the corporate governance of banks needs to reach beyond the traditional instruments developed to ensure an alignment of interests between shareholders and management. As Klaus Hopt put it, with banks, there needs to be ‘some sort of debt governance’ in addition to the traditionally more accentuated ‘equity governance’.18 3.  The state’s perspective

14.18

A  second specialty of banks, closely related to their high leverage, is their fragility: typically, a large portion of the claims of the debtholders is payable on demand. Whilst the traditional textbook example for this is current account deposits, the practically much more important source of vulnerability for many modern-​day banks is the possibility of derivative counterparties to terminate a derivatives master 17 See Armour and Gordon, n 14, 39, who make the—​extremely interesting—​point, that a highly diversified model-​shareholder (i.e. the equity-​investor who is, at all times, holding the market portfolio which modern finance industry—​and thus mainstream agency theory—​conceptualizes as its model shareholder) will suffer from the failure of a systemic bank due to losses ‘produced throughout the diversified portfolio’, so that the excessive risk-​taking by management is long term detrimental to both, (model-​)shareholders and (model-​)debtholders. 18 Hopt, n 9, para 11.29.

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State-Owned Financial Institutions agreement, and close out all derivatives contracts entered thereunder, resulting in a net claim by one of the parties (which is, at this point in time, already collateralized by the asset posted under the term of the master agreement). Unlike firms of the real economy, banks fail in the instance that a critical portion of their debtholders lose faith in their sustainability and make use of their right to reclaim the funds extended to the bank. The (modern variety of the) bank run risk is the reason why banks cannot, at the brink of a crisis, sit down with their key debtholders and negotiate a settlement, such as a package of haircuts and debt-​to-​equity conversions, and thus avert insolvency in the manner that is customary in the real industry. With regards to interconnected (often big) banks, the third specialty is their systemic 14.19 relevance: if systemically relevant institutes fail, they must be expected to take a number of their peers with them, among which there may be further highly interconnected institutes, thus spreading the contamination to the point of systemic failure which the states have done so much to avert from 2008 to 2010. Potential contamination channels are numerous and complex, ranging from direct bank-​to-​bank exposure as the most direct one to the erosion of overall market confidence as the most indirect one. For the purposes of this chapter, it may suffice to say that systemically relevant banks have become a clearly defined class of credit institution under Basel standards as well as under EU regulatory law, especially when it comes to the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM), and a whole new body of law, with the Bank Recovery and Resolution Directive (BRRD) as its EU centrepiece, has sprung up to deal with the problem of needing to put the state in a place where it can, when a crisis occurs, prevent the collapse of systemically relevant institutes without using (too much) of the taxpayer’s money in doing so. Likewise, Title II of the Dodd-​Frank Act gives US financial regulators the legal power to resolve failing institutions which are systemically important, which is known as the ‘Orderly Liquidation Authority’. With banks, therefore, the state is in the picture regardless. As a result of leverage, 14.20 fragility, and systemic relevance, the shareholders of big and/​or interconnected banks are not alone as the bearers of the residual risk. Rather, to the extent (i) bank debt is explicitly insured by the state or (ii) implicitly guaranteed because a bailout would (predictably) be necessary to preserve systemic stability, such risk is being shared with them by the state and its taxpayers. The key issue in this respect is the implicit state guarantee: There is little doubt 14.21 that markets and rating agencies have long recognized the implicit state guarantee as an economic reality, resulting in a tangible funding advantage and in openly awarded rating upgrades, often by several notches, for ‘too-​big-​to-​fail’ institutes.19

19 For a detailed survey of the available data and post-​crisis economic analysis, see the 2014 Global Financial Stability Report, http://​www.imf.org/​en/​Publications/​GFSR/​Issues/​2016/​12/​31/​ Moving-​from-​Liquidity-​to-​Growth-​Driven-​Markets, accessed 7 October 2018, 101–​32.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner This pricing by the markets (correctly) reflects a massive externalization of risk from the banks’ management (and equity) to the state. Scholars and regulators also agree that moral hazard arises as a result of this externalization of risk, inducing managers to take more risk than they would if they (or equity) needed to fully bear the consequences of a realization of such risk. 14.22

Since the state, acting as the rule-​setter and regulator, is hardly comparable to a private law owner, it would probably lead to more confusion than clarification if one attempted to frame the incentive structure resulting from the implicit state guarantee in terms of principal-​agent theory.

14.23

That said, any theory of bank governance must take into consideration that, as a result of the implicit state guarantee, the state is exposed to the residual risk of the bank in much the same way as an equity investor. Any such theory must, in other words, make the state visible as the third large constituency invested in a bank: Even if the state holds none of such bank’s equity or debt instruments and receives no compensation for bearing residual risk, the state, by bearing it nonetheless, provides for a loss-​absorption capability that is functionally equivalent to there being simply more equity. From the perspective of the debtholders, in particular, there is no difference between more loss absorbing equity being available (as a result of the bank having, e.g. issued more common stock) and an implicit state guarantee. Under the implicit guarantee, the state shoulders residual risk just like equity would. The state may not be the principal of banks (in which it holds no equity), but it is a bearer of risk of systemically significantly institutes, as long as it does not put on its hat as regulator and rule maker to do something to shift this part of the residual risk back to shareholders, hybrids, and debtholders. To the extent this does not happen, there is ‘Risk Bearing Cost’ weighing down on the state in a very similar manner as agency cost on the shareholders and debtholders. 4.  Triangular relationships around management

14.24

Thus, a triangular structure of relationships in which interests need to be aligned in order to avoid agency cost (with regards to shareholders and debtholders) and Risk Bearing Costs (with regards to the state) are being dealt with here. Simplified, this triangular relationship looks as follows (see Figure 14.01).

14.25

Within this triangular structure, the line of division that proved most problematic in the great financial crisis does not run—​as the authors of this chapter would argue—​between management and shareholders. They key challenge was, in other words, not related to the corporate governance issues which arise when dealing with the classic Berle/​Means principal/​agent problem which has, for decades, dominated the textbooks in corporate finance courses. Rather, the decisive line of division

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State-Owned Financial Institutions State/Supervisor

interested in systemic stability, allocative efficiency, and avoiding the use of taxpayer’s money

Bank Management

(executive board members plus other risk takers in the bonus pool)

Shareholders

Debtholders

interested in a commercially attractive risk/return profile, given their ability to diversify risk in a portfolio of equity stakes

interested in the stability of the individual bank, staying able to repay debt when due/upon demand

Figure 14.01 Bank Management has run between an ‘equity camp’ comprising management and shareholders on the one side and a ‘systemic camp’ comprising debtholders and the state on the other: as long as all members of the ‘equity camp’ could jointly externalize risk, expected cash flows to equity could be generated by management taking risks that neither management nor shareholders needed to bear. Shareholders could hardly have been expected to reign in management in that respect. On the contrary, the risk externalization was factored into their expectation with regards to the cash flow to equity and thus increased the cost of capital for banks. Diminished risk appetite meant a competitive disadvantage on the market for equity investment and made a bank vulnerable on the market for corporate control. One had to dance to the music while it played. Obviously, governance rules which aimed at paying better attention to shareholder 14.26 value are not the right instruments for the purposes of scaling back on the externalization of risk from the banks to the state. Therefore, there need to be other instruments aiming at achieving this objective. Framed in the terminology introduced above, there needs to be other mitigants capable of reducing Risk Bearing Cost being incurred by the state (under the scope of the implicit state guarantee) and agency cost incurred by the debtholders (outside that scope).

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Johannes Adolff, Katja Langengbucher, and Christina Skinner 5.  State-​ownership as an appropriate mitigant? 14.27

One such mitigant could be state-​ownership of banks. On the face of it, this appears to be a highly effective approach to reduce the Risk Bearing Cost of the state. If the state fully owns a bank, the mismatch between the risk exposure of the state under the implicit state guarantee and the lack of control goes away. So does the externalization of risk. So does its flip-​side, namely the subsidy to the bank resulting from the state bearing a risk without a share in the return.

14.28

Being invested as a loss absorber (under the implicit state guarantee) anyway, the state, when taking this approach, gets invested properly, takes the position of the sole shareholder, participates in the returns, and can effortlessly guide management towards its interests.

14.29

To the extent the state directly controls a bank as its sole shareholder, the need for Debtholder governance is also substantially reduced:  the credit risk of the bank becomes de facto identical with the credit risk of the state (even de lege, if the state choses to make the implicit state guarantee explicit). Accordingly, funding cost will decrease, reflecting the lower risk for the debtholders. This will, as a valuable side effect, give the bank the leeway to generously fund enterprises in the real economy, and continue to do so in times of crisis, when the volume of commercial loans extended by private banks will likely contract. There is no question that such capability to avert a credit crunch lies at the heart of what the state would expect from its banking sector—​and the absence of which hurts most at times of crisis. Thus, it seems ceteris paribus, state banks are better placed to avert a credit crunch. Because of their funding advantage, this holds true even if their Credit Process is run under purely commercial principles, without partial subsidies or development of the state objective being in the picture. 6.  Challenges of state-​ownership of banks

14.30

Effective as the state-​ownership approach may be, it comes at a high price. The crux is the process for decision making within the state when it comes to exercise its rights and powers as sole bank shareholder: as long as ‘the state’ is conceptualized as one single monolithic decision maker, taking ownership would surely fix the Credit Process. But, of course, it is not, and, as it is, state-​ownership leads to interdependencies between the Credit Process and the political process. This entails inefficiencies and risks that, in the authors of this chapter’s view, tend to (almost) always outweigh the benefits.

14.31

More specifically, this chapter has, so far, neglected the multilayer principal-​agent problems that exist within the institutions of the state. This is, obviously, a vast field of political science, in which the authors of this chapter, as lawyers, are no experts. That said, from a legal (and practical) perspective, the main challenge of state-​ownership seems to centre around the Credit Process. In a state-​owned bank

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State-Owned Financial Institutions it is up to the state to use its full control over management to prevent it from excessive risk taking. Typically, representatives of the executive branch—​for example, of the finance ministry—​are being tasked with monitoring the conduct of the state-​owned bank’s management in general, and the allocation decisions under the Credit Process in particular. Whilst effective state oversight may not be impossible, numerous problems of the 14.32 incentive structure around such a monitoring role of the executive branch of government appear obvious: having ultimate control over the Credit Process and, at the same time, access to cheap funding back-​stopped by the taxpayer, the federal, state, or local government can use the state bank to cause or encourage politically motivated allocation decisions as part of the Credit Process. If the executive branch makes use of this possibility and consequently state-​owned banks grant loans for (partially) political reasons and accept more risk than is commercially sound, there is, outside the state itself, no one to stop them: since state-​ownership, underpinned by an implicit, or as the case may be, even explicit state guarantee, unlocks access to cheap funding, it also removes any capability of the funding market to discipline management. Taking more risk will, in this institutional setup, not increase funding cost, as the debtholders will look at the state, rather than the individual state-​owned bank, when assessing their credit risk. Equity markets, on the other hand, will not be capable of disciplining management, as state-​owned banks do not depend on equity markets for their funding. Often, parliament will have no effective control either, as the funding and the allocation of resources via loans takes place outside the budgetary process (despite the budget being ultimately the need to provide the means if and when there is a crisis and the risk taken under the implicit state guarantee ultimately materializes). Finally, even if one was to conceive a model world in which no political influence 14.33 existed at all with respect to the decision making of management, the allocation of funds to borrowers under the Credit Process and the subsequent monitoring of such borrowers, the failure of the debt market would remain the central challenge. Even a shareholder-​value oriented management that was guided by the purely commercial objective of optimizing the cash flow to equity (and was rewarded by its political owners solely on this basis) would be incentivized to take more risk, so as to generate better revenues, and would—​this is the key issue—​remain unchecked in doing so by market forces on either the equity market (doesn’t exist) or the debt market (doesn’t care to the extent there is a state guarantee). The moral hazard that has been identified as one of the most important causes 14.34 for the financial crisis would be made more substantial and more permanent. The state, one must conclude under this line of argument, is simply not equipped with decision-​making processes that would be necessary to ensure, by way of appropriately monitoring and incentivizing management, a commercially efficient Credit

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Johannes Adolff, Katja Langengbucher, and Christina Skinner Process. And an inefficient Credit Process will, at least in the long run, entail misallocation of resources on the micro-​and macro-​level, even if there is no additional element of politically motivated credit allocation under the ‘umbrella’ of an (implicit) state guarantee. This detrimental effect will be reinforced by the distortion of competition between state-​owned and privately held banks that comes with the access to cheaper funds which the state-​sheltered banks enjoy irrespective of the stand-​alone risk bearing capability. 14.35

There are ways to improve the institutional design of responsible organs of the state, for example, by creating special monitoring bodies, by staffing them with well educated, well paid experts, by having the regulator oversee state-​owned banks in the same manner as privately held ones, by requiring additional capital buffers which need to be taken from the budget and transferred to the state-​owned bank in pre-​crisis times already, by integrating parliamentary committees into the monitoring process, by granting the civil servants overseeing the state banks access to independent outside experts, and so on. But, as the authors of this chapter see it, the challenge remains to achieve, on the basis of such improvements of the internal decision-​making processes of the state, a disciplining effect on management that would reach the level attainable when a privately held bank is exposed to a functioning equity market as well as a function debt market.

14.36

The state, in short, has not been designed to act as a good banker. It has been designed as a democratically legitimized intermediary between taxpayers and recipients of public funding; as such it stands no chance to perform equally well as an intermediary between debtholders and borrowers.

III.  State-​Owned Institutions: The Practical Challenges 14.37

While the foregoing discussion presented an analysis of the theoretical benefits and challenges to state-​ownership, this section endeavours to test the theoretical consideration, to the extent possible, against empirical evidence. For the United States, it suggests, through its set of comparative case studies, that state-​ownership structures pose acute—​perhaps insurmountable—​obstacles to the efficient allocation of resources and systemic stability. For Germany, the picture is more nuanced, since in this country, a vast portion of the banking industry is in the hands of savings banks (mostly controlled by municipalities), Landesbanken (mostly controlled by the savings banks and the federal states/​Bundesländer), national development banks (mostly owned and controlled by the Federal Republic of Germany), and cooperative banks (mostly owned by their customers). Many of these non-​private sector banks have roots that go back to the nineteenth century, and have survived, quite well, and, arguably, on the whole no worse than their competitors in the private sector, the numerous crises since then, including the global financial crisis of 2008.

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State-Owned Financial Institutions A. The United States At a glance, the United States would appear to disfavour state ownership of finan- 14.38 cial institutions. Even in the early days of the Republic, notions of state ownership in banking were unpopular. A First National Bank was chartered in 1791—​for a twenty year period—​but Congress did not renew the bank’s charter in 1811.20 The subsequent iteration—​the Second National Bank—​which was chartered in 1816, suffered a similar fate when its charter expired in 1836.21 (It was not until 1913 that the Federal Reserve System was created by the Federal Reserve Act).22 Since that time, financial regulation (albeit, not state ‘ownership’ per se) in the 14.39 United States has generally followed what Professor John Coffee refers to as a ‘sine curve’—​where periods of financial regulation tend to follow panics or crisis but, over time, that regulation is gradually rolled back in the name of freer and more competitive markets.23 So, for example, several key pieces of post-​Depression era banking regulation—​including those regarding entry restrictions into banking;24 controls on deposit rates;25 and prohibitions on banks combining with securities underwriting firms26—​were eliminated in the 1980s and 1990s. Likewise, some pieces of the regulatory framework which were imposed after the 2007–​2008 global financial crisis may also be pared down if certain legislative proposals—​pending at the time this chapter was written—​are passed by the US Congress, in whole or in part.27

20 Federal Reserve Bank of Philadelphia, 2009 Annual Report, ‘The First and Second Banks of the United States: The Historical Basis for a Decentralized Fed’, available at https://​www.philadelphiafed. org/​publications/​annual-​report/​2009/​first-​and-​second-​banks, accessed 5 October 2018; Gerard Caprio, ‘The Future of State-​Owned Financial Institutions’, Brookings, 1 September 2004, available at https://​www.brookings.edu/​research/​the-​future-​of-​state-​owned-​financial-​institutions/​, accessed 5 October 2018; Federal Reserve Bank of Philadelphia, above; see also MuCulloch v Maryland 17 US 316 (1819) (challenging Congress’s authority to establish a Bank of the United States). 21 President Jackson vetoed the re-​authorization of the Bank, and Congress did not override that veto. Federal Reserve Bank of Philadelphia, n 20. 22 For a general history of the Federal Reserve, see Peter Conti-​Brown, The Power and Independence of the Federal Reserve, Princeton University Press, 2015. 23 John C Coffee, Jr, ‘The Political Economy of Dodd-​Frank: Why Financial Reform Tends to Be Frustrated and Systemic Risk Perpetuated’, Cornell Law Review (2012), 97, 1019, 1059. 24 Office of the Comptroller of the Currency, Clarification and Revision of Charter Policy (final rule), 45 Fed Reg 68603, 68604 (15 October 1980). 25 Depository Institutions Deregulation and Monetary control Act of 1980 (DIDMCA), P L 96-​221, 94 Stat 132. 26 See Gramm-​Leach-​Bliley Act, P L 106-​102, 113 Stat 1338 (1999) (codified as amended in scattered sections of 12 and 15 USC (2006)). At the time, then-​Treasury Secretary Larry Summers referred to the repeal legislation as a system better suited ‘for the 21st century’ which would ‘better enable American companies to compete in the new economy’. Cyrus Sanati, ‘10 Years Later, Looking at Repeal of Glass-​Steagall’, New York Times (12 November 2009), available at https://​dealbook.nytimes.com/​2009/​11/​12/​10-​years-​later-​ looking-​at-​repeal-​of-​glass-​steagall/​, accessed 8 October 2018. 27 See Financial CHOICE Act of 2017, HR 10, 115th Cong. 2017–​2018.

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Notwithstanding what appears to be America’s historic reversion to the free-​market mean, the United States does have some form of state-​sponsorship (though not technical ownership) by virtue of its GSEs. Additionally, the United States also hosts a credit-​export finance agency, the Export-​Import Bank (‘Ex-​Im’), which is a bona-​fide state-​owned financial institution. In principal, these institutions exist to serve a social goal: a manner of credit allocation that is perceived to be under-​met by the private banking sector. In the case of the housing GSEs, colloquially known as Fannie Mae and Freddie Mac, this allocative deficiency relates to finance for housing among low-​and middle-​income borrowers; for the Ex-​Im Bank, the allocative shortfall pertains to the exporters of American goods and services. Without debating the normative merits of those goals, what follows is a brief descriptive case study of why, in pursuing them, the state’s backing (either explicit or implicit) may create systemic risk or suboptimally allocate public resources. 1.  Government-​sponsored enterprises

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The story of the housing GSEs and the financial crisis is not a happy one. Some scholars and policymakers identify the GSEs as a significant source (or at least contributor) to the mortgage bubble (though this is a debated point). On that critical view of the GSEs’ role in the financial crisis, it was the very fact of the GSE’s implicit state-​backing that incentivized them to oversupply subprime mortgages which, in turn, fueled a systemically damaging debt bubble.

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The GSEs are privately held corporations that were created by the US Congress—​ Fannie Mae in 1938, and Freddie Mac in 1970. Specifically, these institutions were created ‘to improve the efficiency of capital markets’ and to overcome ‘statutory and other market imperfections which otherwise prevent funds from moving easily from suppliers of funds to areas of high loan demand.’28 For the housing GSEs in particular, this translates into a mandate to increase the supply of mortgage credit for low-​and middle-​income borrowers.29 Fannie and Freddie pursue that goal by buying qualifying loans from other lenders, which is intended to provide liquidity to the mortgage market; these GSEs either hold those credit assets on their balance

28 Kevin R  Kosar, ‘Government-​Sponsored Enterprises (GSEs):  An Institutional Overview’, CRS Report for Congress (2007), available https://​fas.org/​sgp/​crs/​misc/​RS21663.pdf, 2, accessed 5 October 2018 (quoting Thomas H. Stanton, Government Sponsored Enterprises: Their Benefits and Costs As Instruments of Federal Policy (Washington: Association of Reserve City Bankers, April 1988), p. v.). 29 In 1992 Congress passed the Federal Housing Enterprises Finance Safety and Soundness Act which gave GSEs an ‘affirmative obligation to facilitate the financing of affordable housing for low-​ income and moderate income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return’. See 12 USC § 4501(7); see also The White House, The Budget for Fiscal Year 2018, Government-​Sponsored Enterprises, available at https://​www.whitehouse.gov/​sites/​whitehouse.gov/​files/​omb/​budget/​ fy2018/​gov.pdf, accessed 5 October 2018.

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State-Owned Financial Institutions sheet, as part of a portfolio business, or they securitize pools of mortgages into mortgaged-​backed securities and provide guarantees on those MBS.30 Although the GSEs are technically privately owned, ‘[t]‌he law treats the GSEs as 14.43 instrumentalities of the federal government, rather than as fully private entities’.31 The Congressional Budget Office sets out the myriad ways in which this is so: via their federal statute chartering; exemption from state and local taxes; exemption from SEC registration requirements and fees; and by virtue of their access to the Federal Reserve as a fiscal agent.32 Furthermore, GSE debt gets special treatment:  federally chartered banks and thrifts can make unlimited investments in it; it can serve as collateral for public deposits, and the Fed can buy it in in open-​ market operations.33 And GSE securities are exempt from some state investor protection laws because they are classed as government securities under the Securities Exchange Act of 1934.34 Fannie and Freddie suffered during the crisis, as they had become highly exposed 14.44 to mortgage risk. According to Laurie Goodman, the GSEs accounted for 27.4 per cent of the outstanding mortgage market in 1990; at the end of 2003, that figure had increased to 43.8 per cent.35 Importantly, beyond pure market share, the riskiness of the GSE’s 1.71 trillion (as of 2011) US dollar mortgage portfolio had increased over time. As Viral Acharya and his co-​authors set out, in 2006 and 2007, the GSEs purchased 227 billion US dollars of subprime and Alt-​A MBS (and perhaps an additional 500 billion US dollars of other kinds of high-​risk mortgages.36 Meanwhile, to remain competitive with private label mortgage-​backed securities, the GSEs had been loosening their underwriting standards since around 2003.37 As Michael Barr, Howell Jackson, and Margaret Tahyar surmise, these institutions 14.45 experienced ‘colossal failures’ during the crisis.38 On 6 September 2008, the Federal

30 See Michael S Barr, Howell E Jackson, and Margaret E Tahyar, Financial Regulation: Law and Policy, Foundation, 2016, 1170–​9. Barr, Jackson, and Tahyar provide a comprehensive overview of the GSEs’ business model and associated critiques, from which much of the following material in this chapter is drawn. See also Fannie Mae and Freddie Mac, available at https://​www.fhfa.gov/​ SupervisionRegulation/​FannieMaeandFreddieMac/​Pages/​About-​Fannie-​Mae-​-​-​Freddie-​Mac.aspx, accessed 5 October 2018. 31 ibid, 1176 (excerpting Congressional Budget Office, ‘Federal Subsidies and the Housing GSEs’, 13–​14, 2001). 32 ibid. 33 ibid. 34 ibid. 35 ibid, 1170–2 (excerpting Laurie Goodman, ‘A Realistic Assessment of Housing Finance Reform’, Urban Institute, (2014), 1–​6). 36 Viral Acharya et al, Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, Princeton, 2011, 136–​8). Chapter two of this book discusses in detail how Fannie and Freddie increased the riskiness of their mortgage portfolio between the mid 1990s and 2003. 37 ibid,  41–​2. 38 Barr, Howell, and Tahyar n 30, 1168.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner Housing Finance Agency (the independent regulator created to oversee these GSEs) placed both Fannie and Freddie under federal conservatorship; the following day, the Treasury entered into a Senior Preferred Stock Purchase Agreement (PSPA) with both Fannie and Freddie to make investments of up to 100 billion US dollars in senior preferred stock, as needed in order to ensure the institutions had positive equity.39 In 2009, this commitment was increased to 200 billion US dollars (or 200 billion US dollars plus any cumulative net worth deficits between 2010–​2012 that exceeded surplus at year-​end 2012).40 As of March 2017, Fannie had received 116.1 billion US dollars under the PSPA and, as of December 2017, Freddie had received 71.3 billion US dollars.41 14.46

Several prominent experts of financial regulation consider the GSEs’ risk-​ management and related governance problems to have been a byproduct of these institutions’ implicit state-​backing. For one, critics point out, the GSEs had a housing policy mandate with which they had to comply. Some argue that this policy mandate incentivized a supply of more than the socially optimal amount of subprime credit. One of the most vocal proponents of this view, Peter Wallison, wrote that ‘[t]‌hese policies . . . forced the loosening of traditional mortgage underwriting standards in order to make mortgage credit more available to low-​income borrowers. However, the loosened standards spread to the wider market and helped to build a massive housing price bubble between 1997 and 2007.’42 Wallison points out that: ‘Almost two-​thirds of all bad mortgages in our financial system . . . were bought by government agencies or required by government regulations.’43

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There is another common and related view that the GSE state-​backed-​structure bred a type of moral hazard, born of the perception that the federal government would step in to rescue the GSEs should they become insolvent—​which they ultimately did.44 Where both managers and stakeholders come to expect government

39 White House, n 29, 1246–​7 . 40 ibid. 41 ibid. It also bears noting that, though never used, on 13 July 2008, the Federal Reserve Board in Washington authorized the New York Fed to extend emergency loans to the GSEs. See Financial Crisis Inquiry Report, US Government Printing Office, 2011, 309–​20. 42 Peter J Wallison, ‘US Housing Policy and the Financial Crisis’, in James R Barth and George G Kaufman (eds) The First Great Financial Crisis of the 21st Century, World Scientific, 2015, abstract. 43 Peter J Wallison, ‘Barney Frank, Predatory Lender’, Wall Street Journal, 15 October 2009, available at https://​www.wsj.com/​articles/​SB1000142405274870410720457447511015218944 6, accessed 7 October 2018. But see Andra C Ghent, Rubén Hernández-​Murillo, and Michael T Owyan, ‘Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?’, Federal Reserve Bank of St Louis, Working Paper No 2012-​005F (December 2014)  (finding no evidence that housing policy increased subprime originations); Adam J Levitin and Janneke H Ratcliffe, ‘Rethinking Duties to Serve in Housing Finance’, Harvard Joint Center For Housing Studies, HBTL-​12, 213 (October 2013) (same); David Min, ‘Faulty Conclusions Based on Shoddy Foundations’, Centre For American Progress, 1–​3 (2011) (same). 44 See Barr, Howell, and Tahyar et al, n 30, 1175–​6 .

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State-Owned Financial Institutions support in a time of crisis, the incentives to act prudently—​and properly oversee risk-​taking—​become diluted. Such critiques are not unique to government sponsorship, of course; they are also often made in connection with other forms of public backstops, such as the power of central banks to act as lender of last resort and deposit insurance. Arguably, however, this kind of moral hazard becomes more acute when the market assumes that the financial institution in question is (functionally) co-​extensive with the government, because the actual limitations on government support may be assumed away. And because the market assumed that the US government would be standing ready 14.48 and willing to support the GSEs, those institutions were able to get funding at cheaper than normal market rates.45 This debt subsidy meant that the GSEs’ investment in mortgage-​assets—​their retained portfolios—​was highly profitable; as Acharya and his co-​authors dubbed it, the retained portfolio became the ‘cash cow’ of the GSEs.46 Arguably, the debt subsidy—​which flowed from the GSEs’ de facto governmental status—​would have incentivized the GSEs to create more than the systemically safe amount of mortgage credit. Finally, given the close link between the GSEs and political elites, change to their 14.49 business model—​even where recognized as systemically dangerous—​was difficult to achieve. After the crisis, Henry Paulson, former Treasury Secretary, remarked that ‘Fannie and Freddie were disasters waiting to happen’.47 However, Paulson noted, ‘The GSEs wielded incredible power on the Hill thanks in no small part to their long history of employing—​and enriching—​Washington insiders as they cycled in and out of government.’48 Though many may disagree with some of these commentators’ views on how (or if 14.50 at all) the GSEs contributed to the housing bubble, it is difficult to deny that the implicit backing of the US government weakened the GSEs’ incentives to manage their mortgage risk-​taking, which governance weaknesses ultimately served as the source of their fragility, conservatorship, and taxpayer bailout. Moreover, it is not at all clear that whatever social welfare gains their lending actions could have had—​in pursuing their affordable housing mandate—​were not then netted out by the consequences of the oversupply. Not only were numerous low-​and middle-​ income borrowers foreclosed upon, but society more broadly also suffered from the mortgage bubble and ensuing recession as well. As Professor Acharya and his co-​authors have written, in this GSE model, all gains are privatized, but the losses

45 See Alan Greenspan, Remarks, ‘Government-​sponsored Enterprises’, 2005, available at https://​ www.federalreserve.gov/​boarddocs/​speeches/​2005/​20050519/​, accessed 7 October 2018. 46 Acharya et al, n 36, 136–​8. 47 Henry M Paulson, Jr, On the Brink, Hatchett Book, 2010, 57. 48 ibid.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner all socialized.49 Consequently, ‘[w]‌hen the credit risk that [the GSEs] took on materialized, the tax payer was stuck with a huge bill’.50 14.51

To be fair, the GSEs suffered many of the same governance failures as the private depository and investment banking institutions. And so it is difficult to know whether the implicit backing of the state (and their other state-​like features) made the GSEs a larger contributor to systemic risk than these other financial institutions. That seems unlikely. Nevertheless, on a conceptual level, considering the problems that attend state-​sponsorship should prompt further academic and policy thought as to whether the existing GSE structure in the United States is the ideal way to accomplish the social policy goal of affordable housing, given the systemic stability concerns that it presents.51 Perhaps not surprisingly, housing finance reform has been a major tenet of the post-​crisis reform debate for the past ten years.52 2.  Export-​import  bank

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While the Ex-​IM Bank did not play a role in the financial crisis (and it is difficult to see any connection to systemic risk), a study of that institution does illustrate other governance-​related problems that can result from state-​ownership of a financial institution. As such, the US experience with the Ex-​Im Bank may give one even further pause regarding the desirability of state-​ownership as a means of achieving a particular type of credit allocation.

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The Ex-​Im Bank is an export credit agency that is entirely owned by the US federal government.53 The Bank was created in 1934, as part of the New Deal package of reforms that responded to the Great Depression.54 It thus operates pursuant to a general statutory charter—​in the Export-​Import Bank Act of 1945, as amended—​ which is periodically renewed.55 Congress has established a set of mandates (relating

49 Acharya et al, n 36, 4–5. 50 ibid, 137–8. 51 Indeed, there is a longstanding and ongoing debate regarding GSE reform. See, e.g., Victoria Finkle, ‘Mnuchin Wants GSE Reform in 2019. There’s A Problem With That’, American Banker, 30 April 2018, https://​www.americanbanker.com/​opinion/​mnuchin-​wants-​gse-​reform-​in-​2019-​ theres-​a-​problem-​with-​that, accessed 7 October 2018. 52 See, e.g., Rob Blackwell and Ian McKendry, ‘Breaking Down Hensarling’s GSE Reform Overture’, American Banker, 6 December 2017, https://​www.americanbanker.com/​news/​breaking-​ down-​hensarlings-​gse-​reform-​overture, accessed 7 October 2018. 53 Shayerah Ilias Akhtar, ‘Export-​Import Bank:  Frequently Asked Questions’, Congressional Research Service, April 2016, available at https://​fas.org/​sgp/​crs/​misc/​R43671.pdf, accessed 5 October 2018 (hereafter CRS, Ex-​Im Bank). 54 ibid, 1–​2. The lending focus of the Ex-​Im Bank has shifted over time—​from funding post-​war reconstruction projects (in the 1940s), to infrastructure projects in developing countries (in the 1970s), to smaller projects and capital goods and services (in the 1980s). See ibid, 2. 55 ibid, 1.

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State-Owned Financial Institutions to the provision of competitive financing for US exports)56 for the Ex-​Im Bank, though it does not approve individual transactions.57 Its mission, in brief, is to support US employment by facilitating the sale of goods and services abroad by providing various forms of ‘export finance’.58 Export finance generally refers to funding used to cover the period between a for- 14.54 eign buyer ordering the goods or services from a US supplier, and the time in which payment is made from the foreign buyer to the US supplier.59 Exporting businesses can require export financing for a number of different reasons: among others, to protect against the risk that the foreign buyer will default; because exports require more working capital than the supplier has on-​hand; or because of the long delay (on average, five months) between shipment and payment.60 Accordingly, the Ex-​ Im Bank can provide qualifying exporters and qualifying transactions with a range of financial products, including direct loans, loan-​guarantees to commercial banks that lend to the foreign buyers of the US exporter, working capital finance, or export credit insurance to the exporters and their lenders to protect against cases of non-​repayment.61 As with the GSEs, commentators have long debated whether it is appropriate for 14.55 the US government to intervene in financial markets via the Ex-​Im Bank to further the policy goal of export promotion. The Bank’s proponents mainly point out that the institution is necessary to fill gaps in private-​sector financing of certain large, capital-​intensive projects (like infrastructure, nuclear power plants, or aeroplanes)62 and, relatedly, the need to place American exporters on an equal footing with foreign companies that are backed by their own governments and respective export-​credit agencies.63 The criticisms of the Ex-​Im Bank are numerous. From an efficiency standpoint, 14.56 some argue that the Bank wastes taxpayers’ money and inefficiently allocates

56 The Charter of the Export-​Import Bank of the United States, P L 114-​94, codified at 12 USC, § 635 et seq, available at https://​www.exim.gov/​sites/​default/​files/​2015_​Charter_​-​_​Final_​As_​ Codified_​-​_​02-​29-​2016.pdf, accessed 7 October 2018. 57 CRS, Ex-​Im Bank, n 53, 2. 58 ibid, 4. 59 Ibid,  4–​5. 60 ibid, 4. Sources of export finance include export-​credit agencies, commercial banks, capital markets, and self-​financing. Commercial banks account for about 80 per cent of the trade finance market. ibid, 5. 61 ibid. 62 See Jordan Jay Hillman, ‘Exim Bank as a Public Enterprise:  The Role of Congress and the Executive Branch’, Northwestern Journal of International Law and Business (1982) 4, 374–​76, available at https://​scholarlycommons.law.northwestern.edu/​cgi/​viewcontent.cgi?referer=https://​ www.google.co.uk/​&httpsredir=1&article=1122&context=njilb, accessed 7 October 2018. 63 See CRS, Ex-​Im Bank, n 53, at 3.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner resources by subsidizing certain companies. In the extreme, the system has been referred to as one of ‘corporate welfare’.64 14.57

As one detractor points out, the Congressional Budget Office might report a billion US dollar loss between 2015 and 2024 if the Ex-​Im Bank is held to the same fair-​value accounting standards as private businesses.65 Separately, though related, other commentators dislike the Bank for its subsidization of certain ‘national champions’.66 But the most trenchant and substantive critiques are grounded in governance. For one, because the very existence of the Bank is a politically charged question, it suffers from political–​economy drags on its operations. As of the writing of this chapter, the Bank lacks a quorum because certain members of Congress have blocked the President’s nominees to the board. Without the three-​person quorum, the Bank is unable to approve any financing deal over ten million US dollars.67

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The Ex-​Im Bank has also suffered from lapses in conduct in the past several years, prompting one commentator to refer to it as ‘an entity that’s become synonymous with corruption and fraud’.68 The issue was discussed during a 2015 Congressional hearing that was held in connection with the Bank’s reauthorization. There, the Deputy Inspector General, Michael T. McCarthy, aired some of the Bank’s internal control failings. As he stated: [o]‌ne of the consistent observations arising out of audits, evaluations, and investigations conducted by the OIG are weaknesses in governance and internal controls for business operations. We have reported that internal policies providing clear guidance to staff and establishing clear roles and authorities have not been prevalent at Ex-​Im Bank.69

Further, McCarthy testified: An FY 2013 audit of direct loans found that loan officers did not always document sufficient evidence of the borrower’s need for Ex-​Im Bank financing, ensure or

64 ibid; Andrew Ackerman and Josh Zumbrun, ‘Export-​Import Bank Could be a Drain on Taxpayers Next Year’, Wall Street Journal, 1 December 2017, available at https://​www.wsj.com/​articles/​export-​import-​bank-​on-​track-​to-​be-​a-​drain-​on-​taxpayers-​next-​year-​1512124201, accessed 7 October 2018. 65 ‘Reformers Not Welcome at Ex-​Im Bank’, Wall Street Journal, 21 July 2017, available at https://​www.wsj.com/​articles/​reformers-​not-​welcome-​at-​ex-​im-​bank-​1500678548, accessed 7 October 2018. 66 ‘Garrett Is the Right Man To Clean Up Ex-​Im’, Opinion, Wall Street Journal, 19 July 2017, available at https://​www.wsj.com/​articles/​garrett-​is-​the-​right-​man-​to-​clean-​up-​ex-​im-​1500494241, accessed 7 October 2018. 67 12 USC, §635a(c). Ex-​Im Bank, ‘Board of Directors’, available at http://​www.exim.gov/​ about/​leadership/​board-​of-​directors, accessed 8 December 2017; CRS, Ex-​Im Bank, n 53, 4; see ‘Reformers Not Welcome at Ex-​Im Bank’, n 65. 68 ‘Garrett Is the Right Man To Clean Up Ex-​Im’, n 66. 69 Statement of Michael T McCarthy, Deputy Inspector General, Export-​Import Bank of the United States, Hearing on ‘Assessing Reforms at the Export-​Import Bank’, 114th Congress, 1st session, 15 April 2015, 3–​4.

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State-Owned Financial Institutions document borrower eligibility and compliance with Ex-​Im Bank credit policies and standards, and document that comprehensive due diligence reviews were completed prior to loan approval. These conditions occurred, in part, as a result of inadequate recordkeeping and reliance on institutional knowledge.70

Consider one former loan officer who pled guilty in federal court in 2015 for ac- 14.59 cepting over 78,000 US dollars in bribes in exchange for recommending the approval of unqualified loan applications.71 In one instance, his behaviour caused the bank to lose almost 20 million US dollars.72 An opinion in the Wall Street Journal remarked, ‘It’s hard to defend the Ex-​Im Bank as it faces roughly 800 fraud claims and nearly 90 criminal indictments as of 2015.’73 Looking at the Ex-​Im Bank, it is yet again difficult to conclude that state-​ownership 14.60 maximizes the aggregate collective welfare. Although the Bank’s overarching mission is to support US employment, it is unclear whether a state-​owned institution accomplishes that goal in the optimal way. As others have also pointed out, in the absence of Ex-​Im financing, economic theory might predict that jobs would be created in other sectors of the economy, even as some dissipate in the export industry—​with no net loss in employment over the long term, and with fewer dredges on public resources and fewer anticompetitive credit allocations (and their foreign policy implications).74 B. Germany 1.  The three pillars of the German banking system The German system of financial intermediation is bank-​based in the sense that 14.61 many debtholder–​borrower relationships that are directly established in the market for corporate bonds and commercial paper in the US/​UK markets, have the bank as the middleman in Germany, resulting in much larger corporate loan books of the German commercial banks. For this reason, the banking sector in Germany is quite large. It comprises three ‘sectors’ (Sektoren) that constitute the German three-​ pillar banking system. Privately held commercial banks constitute the first pillar. The second pillar comprises the savings banks (Sparkassen, mostly controlled by the municipalities) and Landesbanken (mostly controlled by the savings banks and the federal states, Bundesländer). Cooperative Banks, which have emerged from

70 ibid, 4. 71 Press Release, US Department of Justice, ‘Former Loan Officer at Export-​Import Bank Pleads Guilty To Accepting Over $78,000 in Bribes’, 22 April 2015, available at https://​www.justice. gov/​opa/​pr/​former-​loan-​officer-​export-​import-​bank-​pleads-​guilty-​accepting-​over-​78000-​bribes, 7 October 2018. 72 ibid. 73 ‘Garrett Is the Right Man To Clean Up Ex-Im’, n 66. 74 CRS, Ex-​Im Bank, n 53, 27.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner self-​held initiatives in the nineteenth century, and which are owned and controlled by their own customer base, constitute the third pillar. 2.  First pillar: commercial credit and private banks 14.62

Within the first pillar, the private credit banks can be divided into two sub-​ groups consisting of the large universal banks and the smaller commercial banks. Large banks such as Deutsche Bank AG, Commerzbank AG, and HypoVereinsbank AG (now belonging to UniCredit) are legally formed as stock companies, whereas smaller commercial banks may be organized in other legal forms, for example a German limited liability company. Historically, these privately held banks were fairly focused on retail or corporate banking with a close client relationship. In the world of corporate lending, in particular, the famous German-​style Hausbank-​relationship focused on personal acquaintances on the management level, long-​term thinking, loyalty, and mutual trust. Today, the large banks, in particular, have expanded and offer the entire spectrum of retail, commercial, capital markets, real estate, investment banking, and product creation the global competitors are offering, and the Hausbank-​concept has almost entirely been replaced by open, and often fierce, competition among German and international banks on the market for corporate and commercial lending. Throughout their history, determining the corporate purpose of the banks in the German private sector was fairly straightforward: their business objective has always been to maximize profits for their owners (shareholders), with some fluctuation of the consideration given to what would today be called corporate social responsibilities (strong after World War II, then much weaker in the 1980s and 1990s, now coming back, arguably as a long-​term effect of the crisis on the overall legislative climate on the European Union and national level). 3.  Second pillar: savings banks and Landesbanken

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Banks in the second pillar have no private equity investors. They fall into two sub-​categories: • Savings Banks (Sparkassen) are primarily established by the municipalities. Typically, their regional scope of business is restricted to their municipal borders. As public agencies, savings banks used to enjoy the protection of an explicit state guarantee (Gewährträgerhaftung), which was abolished as a result of having been found to constitute an illegal state-​aid (subsidy) under EU law in 2005. Today, there is still the protection by a solidarity regime (Sicherungsreserve) under which all German Savings Banks (and the Landesbanken) have made a rather strong mutual commitment to support each other in the event of a crisis or failure of any individual member. This system of mutual support is considered (by the EU regulator) to be as robust as to allow for a zero risk-​weight

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State-Owned Financial Institutions on all receivables and claims among the members of the Sparkassen-​Sector, as the solidarity system is called. The statutory purpose of the savings banks is not (exclusively) profit generation. Rather, it is to provide and safeguard savings, credits, and banking services for local citizens, and promote local economic growth to support public welfare and to fund for local and cultural events, initiatives, or projects. • Landesbanken such as Landesbank Baden-​Württemberg (LBBW), Norddeutsche Landesbank-​Girozentrale (Nord/​LB), etc are held and controlled by the federal states, often together with the confederation of the Savings Banks of that particular federal state (Sparkassenverband). Their original business purpose has been to provide assistance, banking expertise, and financial support for all banking transactions and services the local savings banks are not handling, and to operate on a higher financial level with and in the interests of their related federal states. Some of them—​for example the now liquidated WestLB—​have, from this basis, ventured into competition with global universal banks, expanding to activities like derivatives trading and investment banking. Savings Banks and Landesbanken do not, as a rule, compete with one another, but they do compete, in some fields very successfully, with banks from the other two pillars, namely the privately held banks and the cooperative banks. 4.  Third pillar: cooperative bank The third pillar comprises local or regional cooperative banks. Their basic insti- 14.64 tutional design dates back to the nineteenth century, when they sprung up as self-​help initiatives for groups of the population who were not granted loans by the then existing private banking sector, such as workers, farmers, or small shop owners. Their equity holders are cooperative members, which mean they are not state-​owned, but privately held. However, these members come, in principle, form the customer base of the bank, their equity stakes are not transferable outside this class of members, and one stake affords one vote, irrespective of its size. Thus, there is no public trading, let alone a market for corporate control for cooperative banks. Maximizing profit is not their corporate purpose. Rather, their historically determined key objective is to preserve financial independence of their members, as well as to maintain their access to credit, to strengthen their competitiveness, and to contribute to local or regional community development. Like the second pillar banks, they have a system of mutual solidarity and support, and have, especially through a number of central institutes operating on the federal level, expanded into more sophisticated banking activities, partially on an international scale. Similar to the second pillar banks, the credit cooperatives do not compete between one another and remain in their regional market without expanding. However, they compete with the universal banks of the two other pillars for market shares.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner 5.  Market Shares 14.65

The ‘alternative banks’ (savings banks, Landesbanken, and co-​operative banks) have a considerable market share in Germany, as is evident from the right hand side of Figure 14.02. Market shares by business volume. As at December 2016

Total market volume EUR 6,998.6 billion

21.6% other credit institutions

16.8% savings banks

19.2% regional banks/other credit banks/branches of foreign banks 18.5% big banks

11.8% landesbanken

12.1% co-operative banks

Figure 14.02 Market shares by business volume* as at 31 December 2016 Source: Financial Report 2016 of the Savings Bank Finance Group, 33 *Excluding derivative financial instruments of trading portfolio

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If one looks at corporate loan books (loans to enterprises) they even dominate the market (see Figure 14.03). 6.  Development banks, especially KfW

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Outside the tree pillars, there is a number of development banks (Förderbanken). Typically, these are fully state-​owned and openly pursue the objective of supporting certain development objectives in the interest of the general public, such as infrastructure, or innovation. The most prominent German development bank is the state-​owned credit institution for reconstruction (Kreditanstalt für Wiederaufbau, KfW), a special purpose bank in the legal form of a public agency of the Federal Republic of Germany and the federal states (Bundesländer). KfW was formed in 1948 as the agency responsible for the execution of the Marshall-​Plan tasked with

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State-Owned Financial Institutions Market shares in loans to enterprises. As at December 2016

Total market volume EUR 1,333.6 billion

13.0% other credit institutions

28.4% savings banks

16.0% regional banks/other credit banks/branches of foreign banks 11.0% big banks

11.8% landesbanken

17.8% co-operative banks

Figure 14.03 Market shares in loans to enterprises* as at 31 December 2016 Note: *Loans to enterprises and self-​employed persons (including commercial housing loans) Source: Financial Report 2016 of the Savings Bank Finance Group, 34

financing and facilitating the post-​war reconstruction work and related projects. Today, its statutory mission has been adjusted to present purposes which are stipulated in Section 2 § 1 KfWG. Namely, KfW’s objectives are to execute government orders concerning financial state funding initiatives or subsidy programs, to grant loans to public regional authorities or administration unions, to fund social or educational programs, and to bankroll other projects for the benefit of the German or European economy. KfW is the third biggest German bank. 7.  Overall assessment The difference between the US and Germany are glaringly obvious: the non-​private 14.68 ‘alternative’ bank sector in Germany is very sizable and has been stable for more than a century. Allocative efficiency  On the plus side, when it comes to the quality of their Credit Process, the explicit 14.69 local focus of these ‘alternative banks’ often gives them a competitive advantage in dealing with the large number of Mittelstand-​small and medium-​sized enterprises (SMEs) that form such a central part of the German economic and social model.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner They do not have profit maximization as their explicit corporate objective, but need to generate profit nonetheless, especially since, having no access to external equity investors, they need to build regulatory capital base from retained earnings. The monitoring problem referred to above, they have, at least partially, solved by having formed highly professional, central monitoring entities within their respective systems of mutual solidarity. However, the question remains whether such monitoring is capable of fully compensating the incentive problems created by taking away market discipline from the debt side (where the state guarantee diminishes competitive pressure) as well as from the equity side (where there is no access to the market for a state bank).75 Thus, it comes as no surprise that the German Council of Economic Experts has found that the savings banks and cooperative banks lend to significantly more productive corporate borrowers than private banks.76 14.70

On the minus side, their access to certain skillsets associated with international capital markets, structured products, complex derivatives, and investment banking activities is somewhat limited, due, in particular, to their organizational framework and the limitation of their remuneration systems. In many instances in which they ventured—​especially on the level of the Landesbanken77—​beyond their primary task of supporting the focused business of the regional members of the respective solidarity network—​sizable losses have been incurred, and had to be either covered by the Länder or the Federal Republic, or, as in the case of WestLB, has resulted in the resolution of the affected banks. Systemic stability 

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The case can be made that the diversity of models and ownership structures, such as within the three-​pillar German system, tends, on balance, to increase overall systemic stability, since ‘diversity strengthens the resilience of the banking system as it mitigates vulnerability to systemic interconnections and promotes effective competition’.78 In the authors’ of this chapter’s view, there is merit to this case, as long as these banks stay focused on the core banking model of taking deposits to fund a loan book, and are therefore less exposed to spillover risk from investment banking activities. That said, in the global financial crisis, strong and weak banks

75 A  negative conclusion in this respect is reached by R Gropp, A  Guetller, and V Saadi in ‘Public Bank Guarantee and Allocative Efficiency’ (http://​gcfp.mit.edu/​wp-​content/​uploads/​2017/​ 09/​Gropp-​Guettler-​Saadi.pdf, accessed 5 October 2018), 1 and 3 (state guarantee results in ‘fewer incentives to screen and monitor’ in the context of the Credit Process, which, in turn, makes less productive firms more likely to obtain funding, and thus reduces overall allocative efficiency). 76 German Council of Economic Experts (Sachverständigenrat), n 9, 29. 77 Very critical of the business model and investments strategies of the Landesbanken prior to the crisis German Council of Economic Experts (Sachverständigenrat), n 9, paras 240 and 245. 78 From the EU-​perspective see Liikanen-​Report, n 8, 32. For Germany, see Behr and Schmidt, n 7, 18, and 24.

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State-Owned Financial Institutions seem to have been quite evenly distributed between private and state-​owned banks in Germany. Of the two very large affected banks, one (Hypo Real Estate) was a publicly listed private bank, and the other one, WestLB, was a Landesbank. The regional savings banks and cooperative banks, were, arguably, less affected by credit contraction on the asset side, thus contributing to the overall absence of a credit crunch in Germany after 2008, especially when it came to financing SMEs of the Mittelstand.79 With regards to the next financial crisis, the focus on traditional core banking activities may, however, work to the disadvantage of the ‘alternative banks’:  being less well hedged against interest rate change and having no other significant sources of profit generation, a departure from the super-​low-​interest-​ rate policy of the European Central Bank (ECB), the Bank of England, and the Federal Reserve Bank would hit them harder than the more diversified private sector banks.80 KfW  KfW, finally, is generally perceived as an overall success story. This is a view to which 14.72 this chapter subscribes: if the state has resolved to give development subsidies in the first place—​for example, for a certain class of infrastructure project—​and this is compatible with EU Member State aid law, a good method for the implementation of such a subsidy (and the subsequent monitoring of its use) seems to involve an institution like KfW, which goes through the well-​established steps of the commercially driven Credit Process, thereby clearly separating what portion of the overall package is, economically, a subsidy, and what portion is not.

IV.  Alternative Legal Paths to the Same Policy Goals? In this final part, the question of whether there are alternative paths to achieving 14.73 the same—​or substantially similar—​policy goals that motivate state-​ownership of financial institutions is turned to. A. The German perspective There is a need to differentiate with regards to Germany and the European Union. 14.74 In the light of the overall assessment set out above, the German authors of this

79 The German Council of Economic Experts (Sachverständigenrat), n 9, para 240, see the savings bank also a ‘stabilizing factor’ within the financial system. 80 For recent data, see the 2017 Financial Stability Review of Deutsche Bundesbank (English version, available at: https://​www.bundesbank.de/​Redaktion/​EN/​Downloads/​Publications/​Financial_​ Stability_​Review/​2017_​financial_​stability_​review.pdf?_​_​blob=publicationFile accessed 5 October 2018), 71: an abrupt interest rate rise of 200 basis points would reduce the present value of the loan books of the German savings and cooperative banks by about 20 per cent across all maturities, whereas large private banks would only suffer from a reduction of about 2 per cent.

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Johannes Adolff, Katja Langengbucher, and Christina Skinner chapter would not support a notion to abruptly abolish the traditional three-​pillar system. They think that, within limits, it has its merits, especially with regards to the quality of the Credit Process when it comes to lifting the value of strong regional relationships and knowledge. On the other hand, the authors would not wish to promote the expansion of the market share of savings banks, Landesbanken, and Cooperative Banks beyond the boundaries of its traditional focus on regional banking (and the central support for the resulting network of regional banks). 14.75

Thus, with respect to the first pillar—​the presently private banks, among which there are a number of systemically relevant institutes—​the problems created by the implicit state guarantee are still ongoing. If nationalization (state-​ownership of formerly private banks) is not the solution to this problem, another solution is called for. Possible theoretical approaches are presenting themselves and being actually put into practice.

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Firstly, the state can exercise more control over the banks for which it bears residual risk, for example, by regulating them more strictly, requiring them to hold more regulatory capital, sending state representatives to their board meetings, etc. Such increased regulatory supervision and increased requirements for systemically relevant banks have been introduced in the European Union, especially under the SSM already mentioned above:  the SSM-​regime identifies systemically relevant banks under a number of criteria (chief among which is total assets), puts them under direct ECB supervision, and requires additional capital buffers. Likewise, the Financial Stability Board (FSB) individually identifies globally systemically relevant intuitions.

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Secondly, the mismatch between the state bearing substantial residual risk and having (too) little control can be reduced by bearing less residual risk. In the European Union, this was achieved mainly by introducing the BRRD bail-​in instruments in order to shift (a portion of ) the risk born by the state under the implicit state guarantee back to, in this order, shareholders; hybrids; and debtholders. Under this—​very finely facetted—​set of instruments the state can, by way of a decision of a special EU administrative body, the Single Resolution Board (SRB), assisted by the EU Commission, the ECB, and the Member States, re-​capitalize a bank by a combination of wiping out shareholders and hybrids, and subjecting a portion of the debtholders to a reduction of the debt instruments (haircut) and also to conversion of a part of their claim against the failing bank into shares (debt-​ to-​equity-​swap), all of which happens by virtue of an administrative order, that is, without the need for individual consent of any member of these investor groups.

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The losses absorbed by shareholders, hybrids, and debtholders in this manner do not need to be covered by the state any more. Because all market participants know this, ‘too-​big-​to-​fail’ does not, any more, mean, ‘too-​big-​for-​a-​Debtholder-​ to-​lose-​his-​money’. In theory, this puts an end to the implicit state guarantee. As

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State-Owned Financial Institutions the haircuts and debt-​to-​equity swaps under the BRRD can be effected unilaterally by the state (and literally overnight), the fragility problem is, so the theory runs,81 overcome, and the taxpayer does not, anymore, need to pour billions into failing banks to prevent systemic meltdown at a time of crisis. This, in turn, puts an end to market failure on the debt market for banks (which has previously been a consequence of the implicit state guarantee):  if bail-​in makes it possible for (unsecured and uninsured) debtholders to lose their money, debtholders have a reason to care about the risk bearing capacity of the banks they invest in. Thus, management will be rewarded for taking less risk by getting access to cheaper debt funding. Market discipline restored, one can expect a higher level of efficiency of the Credit Process. These new instruments come with incentive problems, too. For example, when a 14.79 public body—​like the SRB—​is ordering a bail-​in, there is a strong incentive to ‘better err on the side of caution’ and rather cut too deep into the positions of the debtholders, thus over-​capitalizing the very bank that has just been on the brink of failure. As the BRRD leave some room for discretion in the selection of the debtholders subjected to bail-​in (especially for the reason of preserving systemic stability), there is also a risk of politically motivated selective decisions. Still, this approach of escaping the trap of the implicit state guarantee by bringing market discipline back to the banks—​rather than taking them off-​market completely—​appears, to the authors of this chapter, as the overall more promising option. B. The US perspective 1.  Performance-​based standards In the United States, where the state intervenes in an otherwise private banking in- 14.80 dustry with a more (limited) ‘needlepoint’ style of ownership, one possibility, explored in other regulatory settings, is to set performance-​based standards for private institutions. Performance-​based standards generally refer to legal obligations to achieve a set outcome (i.e. a policy goal), but do not prescribe the manner in which regulated firms must achieve it.82 Emissions standards are often cited as a quintessential example. Pursuant to this regulatory model, financial regulators might set policy goals regarding affordable housing or export-​finance for private firms, in a world where GSEs and the Ex-​Im Bank played a lesser (or no) role.

81 For a very instructive critical assessment of this theory, see T Tröger, ‘Too Complex to Work: Critical Assessment of the Bail-​in Tool under the European Bank Recovery and Resolution Regime’, Journal of Financial Regulation (2018), 35. 82 See generally, Cary Coglianese, Jennifer Nash, and Todd Olmstead, ‘Performance-​Based Regulation: Prospects and Limitations in Health, Safety and Environmental Protection’, Harvard Center For Business and Governments, Regulatory Policy Program Report No RPP-​03 (2002).

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Johannes Adolff, Katja Langengbucher, and Christina Skinner 14.81

To be fair, this kind of model already more or less exists in the housing finance area with the Community Reinvestment Act (CRA),83 which requires that FDIC-​ insured deposit-​taking institutions demonstrate to their supervisors that they are working to meet the finance needs of the communities in which they are chartered. Bank supervisors examine banking institutions for compliance with the CRA, and may consider the institution’s record in this regard when considering its application for a deposit facility.84 Granted, the CRA may not be a perfect instantiation of the performance-​based model—​some refer to the Act’s requirements as a contributing factor in the subprime bubble (i.e. by incentivizing too much subprime lending).85

14.82

Nevertheless, it may be a fruitful area of future research to consider how the CRA as legislation could be improved upon, and expanded, if the role of the GSEs were dialed back. And certainly there is room to adapt a similar performance-​based legislative standard to achieve the distinct social policy goal of supporting American exports abroad. Ultimately, of course, whether to pursue a performance-​based model at all, in lieu of the state-​sponsored/​owned institutions, will turn on a broader policy decision about whether the state should be responsible for correcting these perceived deficiencies in the way that the market naturally allocates credit. 2.  Flexible mandates to ‘have regard’

14.83

There are even softer forms of state intervention which steer—​but not direct—​ financial institutions towards a desired social outcome. In particular, legislation can impose requirements on a regulator to consider—​or ‘have regard’ to—​certain factors while making a decision or taking an action. These kinds of requirements stipulate part of the decision-​making process, but leave discretion with the regulator as to the ultimate decision taken.

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Consider, for example, the Financial Policy Committee in the United Kingdom, a body that exercises its functions with a view to furthering the Bank of England’s financial stability objective and, subject to that, the government’s economic policy.86 The Bank of England Act—​which empowers the Financial Policy Committee (FPC)—​states that HM Treasury may make recommendations to the FPC about any matters which the FPC should ‘regard as relevant’ in interpreting the Bank’s financial stability mandate.87 Section 9F of that Act requires that the FPC ‘have 83 Community Reinvestment Act, P L 95-​128, 91 Stat 1147, Title VIII of the Housing and Community Development Act of 1977, 12 USC, § 2901 et seq. 84 P L 95-​128, Stat 1147, Title VIII, §§ 802, 804, 91; see also Community Reinvestment Act, https://​www.ffiec.gov/​cra/​history.htm, accessed 8 October 2018. 85 See, e.g., Neil Bhutta and Daniel Ringo, ‘Assessing the Community Reinvestment Act’s Role in the Financial Crisis’, 26 May 2015, available at https://​www.federalreserve.gov/​econresdata/​notes/​ feds-​notes/​2015/​assessing-​the-​community-​reinvestment-​acts-​role-​in-​the-​financial-​crisis-​20150526. html, accessed 7 October 2018. 86 Bank of England Act 1998, § 9C. 87 ibid, § 9E.

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State-Owned Financial Institutions regard’ to the Bank’s financial stability strategy when exercising its functions.88 In effect, using statutory requirements to ‘have regard’ to a particular objective requires a regulatory body to consider certain factors in its process, but does not legally mandate any particular substantive outcome. In the US context, this could translate into, for instance, a power given to the 14.85 Treasury to direct the Fed—​the supervisor for systemically important financial institutions—​to have regard to the way in which a relevant subsidiary of a bank holding company extends housing finance to low-​or mid-​income households, or the extent to which it provides export financing, (alongside an examination of the soundness of that lending) as part of the Fed’s supervisory examinations. Statutory have regards could, in that way, offer one method for operationalizing a weaker version of the performance-​based standards model discussed above.



ibid, § 9F.

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15 COOPERATIVE BANKING—​A DUTCH EXPERIENCE Martin van Olffen* and Gerard van Solinge

I. Introduction 15.01 II. A Short History of Cooperative Banking 15.05 A. The emergence of cooperatives in Europe B. The Rochdale Principles of Co-​operation C. The Raiffeissen Principles

15.05 15.09 15.11

III. A Short History of Cooperative Banking in the Netherlands: Rabobank 15.13 IV. Main Characteristics of Dutch Cooperative Law 15.21 A. General B. Members C. Governance models

V. Specific Features of Cooperatives: Assets or Risks? A. Members, no shareholders B. No shares, no listing C. Corporate governance

A. General B. Governance in and supervision over local Rabobanks C. Governance in Rabobank D. Events driven change E. Preliminary discussion for a new governance

VII. Rabobank Corporate Governance Structure—​ The Present A. Group structure B. Rabobank—​general C. Rabobank—​executive board and mandates for local banks D. Member influence within Rabobank E. Business of local banks F. Employee influence within the group

15.21 15.23 15.28 15.31 15.31 15.36 15.38

VI. Rabobank Corporate Governance and Finance Structure—​ The Recent Past 15.40

VIII. Regulatory Framework IX. Summary

15.40 15.41 15.44 15.45 15.47

15.52 15.52 15.53 15.54 15.55 15.64 15.67 15.68 15.70

* For the sake of transparency, it is noted that Martin van Olffen is legal counsel to Rabobank and was involved in the reorganization described in this chapter and Gerard van Solinge is a member of the supervisory board of one the local banks (i.e. Rabobank Rijk van Nijmegen).

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Cooperative Banking—A Dutch Experience

I. Introduction Most banks in the world are organized in the form of public or private limited 15.01 companies. A smaller number are organized as cooperative banks. Although smaller in number, cooperative banks are significant players in the financial market. For instance, the European Association of Co-​operative Banks has 3,135 associated cooperative banks, 80.5 million members, and 209 million customers.1 In other parts of the world, such as the United States, Japan, and India, cooperative banks are also in a strong position. All cooperative banks have in common the fact that they are key players in local 15.02 communities and provide access to finance at a local level. The purpose of cooperative banks is value creation for their members as opposed to the profit maximization that defines other types of banks. Each member of a cooperative bank has a vote in the strategy and the governance of their cooperative bank. The cooperative movement has traditionally been ethically driven. The govern- 15.03 ance structures and strategies that guide cooperative banks today have their roots in ethical principles that were developed in the nineteenth century. An interesting question is, however, whether these moral and ethical standards still influence the day-​to-​day practice of banking.2 Based on the history and recent developments taking place at Rabobank, one of 15.04 the major Dutch banks, this chapter will examine whether cooperative banking makes a difference in terms of governance, financial stability, conduct, and social responsibility.

II.  A Short History of Cooperative Banking A. The emergence of cooperatives in Europe The first cooperatives arose in pre-​ industrial Europe. Allegedly, the Fenwick 15.05 Weavers’ Society, established in 1761, was the first cooperative.3 This society united sixteen (apprentice) weavers, when they signed a charter in which they agreed to work together to set purchasing prices for yarns, selling prices for the cloth produced by them, and to deal fairly and honestly in their work. The weavers also set 1 See EACB Key Figures 2016 (www.eacb.coop/​en/​cooperative-​banks/​key-​figures.html accessed 1 July 2018). 2 For a study on cooperative banking during the crisis of the 1920s see, Cristopher L Colvin, ‘Banking on a Religious Divide:  Accounting for the success of the Netherlands’ Raiffeissen Cooperatives in the Crisis of the 1920s’, The Journal of Economic History (2017), 77, 866–​919. 3 However, earlier archetypes were found in the form of dairy cooperatives in the valleys of the Pyrenees. See Stefan Naubauer, ‘Predecessors and Perpetrators of Cooperative Systems in Europe’, Lex ET Scientia International Journal (2013), 20, 40.

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Martin van Olffen and Gerard van Solinge up a store for victuals and a credit union, which may be seen as the precursor of cooperative banks.4 15.06

In 1844, the Rochdale Society of Equitable Pioneers was founded as a consumer cooperative aiming to break the capitalistic powers of the Industrial Revolution. The Rochdale Society is considered to be the first structured business organization with the characteristics of a modern cooperative.5 It became famous as a result of its principles on cooperative entrepreneurship (See Section II.B).

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During the nineteenth century the cooperative movement developed rapidly throughout Europe.6 Agricultural cooperatives, credit unions, and mutual insurance societies appeared in countries like Germany, France, the United Kingdom, Italy, Austria-​Hungary, and the Netherlands.7 Unlike, for instance, in Germany and the Netherlands, the British cooperative movement was of a socialist nature. Although emancipatory in its goals, most cooperatives in continental Europe were of a more ethical-​conservative nature. The credit unions were the first step in a development towards cooperative banking.

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Traditionally, cooperatives combine social benefit interests with capitalistic property rights interests. This hybrid nature is still one of the main characteristics of modern cooperative entrepreneurship. Cooperatives were then, and still are nowadays, seen as an expression of economic democracy. Every cooperative operates with the following key elements:  (i) one member one vote; (ii) the distribution of benefits to its members; and (iii) ownership of the bank by its members. Those key elements are derived from two sets of principles which endure to this day: the Rochdale Principles of Co-​operation and the Raiffeisen Principles. B. The Rochdale Principles of Co-​operation

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The founders of the Rochdale Society drew up rules of conduct for their economic activities, which started with a store for the sale of provisions. These original rules included, inter alia, that capital should be of their own providing and bear a fixed rate of interest; that market prices should be charged and no credit given nor asked; that profits should be divided pro rata upon the amount of purchases made by each member; that the principle of ‘one member one vote’ should obtain in government

4 www.fenwickweaverscooperative.com/​fenwich-​weavers-​society/​history, accessed 1 July 2018. 5 Antonio Fici, ‘The Essential Role of Cooperative Law’, The Dovenschmidt Quarterly (2014), 147, 150. 6 In other parts of the world, for instance the United States, the cooperative enterprise by agricultural and industrial workers also goes back for many centuries. See John C Scatterfield, ‘The Cooperative in our Free Enterprise System’, Mississippi Law Journal (1961), 33 14. The immigrants who came to the United States, brought the Rochdale Principles with them, see Elaine Waterhouse, ‘Cooperatives: The First Social Enterprise’, DePaul Law Review (2017), 66, 1013, 1020. 7 For an overview, see Naubauer, n 3, 40.

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Cooperative Banking—A Dutch Experience and in the equality of the sexes in membership; that the management should be in the hands of officers and the periodically elected committee; that a definite percentage of profits should be allotted to education; and that frequent statements and balance sheets should be presented to members.8 These original rules of conduct have been summarized into what now are known 15.10 as the Rochdale Principles of Co-​operation, by which cooperatives can put their ethical values into practice: • voluntary and open membership; • democratic member control; • economic participation by members; • autonomy and independence; • education, training, and information; • cooperation among cooperatives; and • concern for community. In 1995, the International Co-​operative Alliance (ICA) adopted the Rochdale Principles in their revised Statement on the Cooperative Identity.9 Without exaggeration, one can say that the Rochdale Principles are the contemporary standard for cooperative entrepreneurship, and highly relevant for today’s cooperative banking, as will be seen in the example of Rabobank Nederland (see Section VII). International organizations like the United Nations, the International Labour Organization, and the European Commission often refer to these principles, although the latter does not actively promote their implementation in EU legislation.10 C. The Raiffeissen Principles A  leading role in the history of cooperative banking was played by Friedrich 15.11 Wilhelm Raiffeissen (1818–​1888). As a small town mayor in the rural German province of Rhineland-​Palatinate, he was inspired by the troublesome circumstances in which farmers and craftsmen had to live and work. In 1862, Raiffeissen founded the first credit union in Germany.11 In his book ‘Die Darlehnskasse-​Vereine als Mittel zur Abhilfe der Noth der ländlichen Bevölkerung sowie auch der städtischen Handwerker und Arbeiter’, published in 1866,12 Raiffeisen unfolded his ideas on how farmers could unite in their own credit unions in order to get access to credit

8 The Rochdale Principles of Co-​operation, available at www.rochdalepioneersmuseum/​about-​ us/​the-​rochdale-​principles, accessed 1 July 2018. 9 www.ica.coop/​en/​whats-​co-​op/​co-​operative-​identity-​value-​principles, accessed 1 July 2018. 10 Ger J H van der Sangen, ‘How to Regulate Cooperatives in the EU’, The Dovenschmidt Quarterly (2014) 131, 139. 11 Heribert Hirte, ‘Das neue Genossenschaftsrecht (Teil I)’, Deutsches Steuerrecht (2007), 2167. 12 Translated: The Credit Unions as a remedy for the distress of the rural population and also for the urban manufacturers and workers.

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Martin van Olffen and Gerard van Solinge facilities and become independent from the traditional urban-​orientated banking system. This book made Raiffeissen the German pioneer in the development of cooperative theory and practice. Raiffeissen is also considered to be one of the founding fathers of modern cooperative banking. In several countries cooperative banks still operate under his name or a name derived from his name. One of them is Rabobank Nederland (see further Section III). 15.12

Raiffeissen saw clearly the connection between poverty and dependency: who wants to fight poverty, should fight dependency first. As a result of this idea, he came up with the three S’s formula: Selbsthilfe, Selbstverwaltung, and Selbstverantwortung.13 Raiffeissen also developed a set of principles: • member liability based on solidarity; • management and administration free of charge; • adding profits to reserves (retained earnings) for further growth; • limited local operating area; and • membership of cooperative central bank. These Raiffeissen Principles show some similarities with the Rochdale Principles of Co-​operation, but they are more practical and realistic and less idealistic, and, of course, focused on cooperative banking. These principles are still visible in modern cooperative banks like Rabobank. However, one of these principles is not topical anymore. When Raiffeissen developed his principles, management and administration free of charge was a realistic principle, as the local banks used to be managed by their own members. Today, management and supervisory board members are paid professionals, but the local members’ councils14 still consist of unpaid members working on a voluntary basis (see Section VII.D).

III.  A Short History of Cooperative Banking in the Netherlands: Rabobank 15.13

At the end of the nineteenth century the first cooperative agricultural banks were founded in the Netherlands. They were small-​sized credit unions located in local agricultural communities throughout the country. The emergence of these local cooperative banks in the Netherlands was rather late15 compared to Germany, France, and the United Kingdom.

13 Translated: self-​help, self-​governance, and self-​responsibility. 14 See Section IV.B, and Section VI.B. 15 See Heinrich Heine’s famous words: ‘If the world would perish, I will move to Holland, where everything happens fifty years later.’

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Cooperative Banking—A Dutch Experience In 1898 two central cooperative banks were founded:  the Coöperatieve Centrale 15.14 Raiffeisen-​Bank, located in Utrecht, and the Coöperatieve Centrale Boerenleenbank, located in Eindhoven. Soon after, sixty-​seven local cooperatives were affiliated with one of these central banks. About fifty years later, more than 1,300 local banks were affiliated with them. Unlike in other countries, in the Netherlands the cooperatives were often initi- 15.15 ated and supported by the nobility and bourgeoisie, and both the Roman Catholic Church and the Protestant churches. The former Central Raiffeissenbank, located in Utrecht, had a Protestant signature and the former Central Boerenleenbank, located in Eindhoven, had a Catholic signature. In the decades thereafter the local banks began to merge into larger local entities. 15.16 In 1972, the two central cooperative banks merged into one central bank, today called Coöperatieve Rabobank UA (hereafter Rabobank).16 Recently, this central bank merged with the 106 local banks. Since 2016, Rabobank is one legal entity with one banking licence. See further Section VII. Nowadays, Rabobank is one of the largest banks in the Netherlands, with branches 15.17 and representative offices in many countries all over the world (see Section VII.B). It is a dominant player in the housing mortgage market and the food and agribusiness sector.17 Rabobank also conducts business through separate legal entities, not only in the 15.18 Netherlands but also worldwide. Rabobank is the (ultimate) shareholder of about 700 subsidiaries and participations. These subsidiaries focus on retail banking and financial services, as well as insurance (Interpolis) and leasing (Lage Landen). They are not organized in the form of cooperatives, but in the form of public limited companies or private limited companies. Rabobank currently has 6.5  million retail clients and 800,000 corporate clients 15.19 worldwide; approximately two million of them are members of the cooperative. For the vast majority of the members of the local Rabobanks the cooperative value 15.20 orientation is a strong impact factor:  being owner, client, supervisor, and stakeholder all in one. Most members of the local Rabobanks indicate that their drivers are the values created by the bank in the local community and society at large rather than the individual benefits of membership. Those driving values are related to the concept of ‘community banking’. This is the typical approach for cooperative

16 ‘Ra-​’ stands for Raiffeissen, and ‘-​bo’ stands for Boerenleenbank. The abbreviation ‘UA’ stands for:  uitgesloten aansprakelijkheid (excluded liability). This implies that members cannot be held liable for the deficit of Rabobank in case of dissolution (see Section IV.B). 17 See Rabobank’s mission statement:‘Rabobank wants to make a substantial contribution to welfare and prosperity in the Netherlands and to feeding to world sustainably.’

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Martin van Olffen and Gerard van Solinge banks, aiming at an enhanced commitment of the clients in their local community, for instance through members initiating, supporting, and monitoring donations in charitable projects, and supporting local entrepreneurship and community activities. The relatively new focus on supporting food and agricultural projects in developing countries attract growing support from the members.18

IV.  Main Characteristics of Dutch Cooperative Law A. General 15.21

This paragraph gives a short oversight of the legal structure of the cooperative under Dutch law. In the Dutch Civil Code (DCC), the cooperative is a legal person, defined as a special type of the association.19 This Dutch approach, in which the cooperative is an association, differs from other jurisdictions where the cooperative is organized more or less like a public company with an equity capital divided into shares. This approach also differs from the one defined in European legislation, with the creation of the European Cooperative (Societas Cooperativa Europaea or SCE). In legal terms the SCE is basically a hybrid; both an association and a public company.20

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If organized as a holding entity of a group of companies, the distribution of benefits of such companies through the cooperative parent to its members were, under certain circumstances, not subject to Dutch withholding tax. That may explain the strong growth of the number of cooperatives in the Netherlands in recent years,21 especially in energy distribution, healthcare, finance, and even law firms. In 2018, new tax rules have put an end to this exemption for holding cooperatives, but it still applies to ‘classic’ cooperatives. B. Members

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Typically, an association has a body of members. The members form the general meeting, often by way of delegation in a members’ council (‘ledenraad’). In a members’ council each member of the cooperative should be represented.22 In larger cooperatives, like Rabobank, local members can also be represented by the chairman of the local supervisory board in a central members’ council (‘algemene ledenraad’; see Section VII.D). 18 See Ryan van Hout, ‘Cooperative Banks: The Strength of Impact Factors on the Cooperative Value Orientation and their Effects on the Behavior of Cooperative Members’ (PhD thesis, Open University) 2017. 19 See Article 2:53, para 1 of DCC. 20 See Van der Sangen, n 10, 135ff. 21 In 2017, there were more than 8,000 cooperatives registered with the trade register. 22 See Article 2:53a of DCC jo. Article 2:39 of DCC.

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Cooperative Banking—A Dutch Experience The cooperative purpose cannot be classified in the dichotomy between for-​profit 15.24 and not-​for-​profit. For-​profit organizations aim at maximizing profits to distribute to the participants or owners. Although they are allowed to make profits, not-​for-​ profit organizations may not distribute these profits to its members, founders, or officers, as they are not the owners. The cooperative has a mutual purpose; sharing elements of the purposes of both for-​profit and not-​for-​profit enterprises.23 According to Dutch law, the cooperative purpose is to supply the specific material 15.25 interests of its members, that is, to produce earned income for its members and to save expenses for them.24 The economic interaction between the cooperative and its members is through contracts.25 This interaction is not on an exclusive basis, as cooperatives may contract with third parties, provided that the agreements with the members are not of subordinate significance.26 Nevertheless, a cooperative remains a business for its members; the business activities of the cooperative must stem from the economic activities of its members. Members are not liable for the cooperative’s business. Unlike limited companies, cooperatives typically do not issue shares. Technically, a 15.26 cooperative can issue shares. Other than limited companies, however, such shares cannot provide the shareholder with voting rights, as voting rights are related to a membership.27 Therefore, cooperatives in practice typically do not have a capital divided by shares. The cooperative is financed by its members and they must supply sufficient funds. If they do not, the members can be held liable, at certain levels, for the deficit in case of dissolution. This liability can be excluded in the articles of association, which is the case at Rabobank.28 In practice, other more sophisticated instruments to finance the cooperative have 15.27 been developed (see Section VI.A). C. Governance  models A regular cooperative has an executive board (or management board), but coopera- 15.28 tives often have a two-​tier system consisting of a managing board and a supervisory board. This may be on a voluntary basis, but the two-​tier system is mandatory for cooperatives that have qualified as ‘large’ cooperatives.29 Rabobank is one such ‘large’ cooperative. See further Section VI.B. 23 Henry B Hansmann, The Ownership of Enterprise, Harvard University Press, 1996, 17ff. 24 Article 2:53, para 1 DCC. 25 Ibid. 26 ibid, paras 3 and 4 of DCC. 27 The possibility to provide a maximum of 1/​3 of voting rights in the members meeting to non-​ members as allowed under Article 2:38, para 3 of DCC is not discussed here. 28 See Article 2:56, para 1 of DCC. 29 A cooperative qualifies as ‘large’ if the cooperative has an equity of at least 16 million euros, the cooperative (or an independent entity) has established a works council as required by law, and

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In this mandatory system the supervisory board members are appointed by the members on nomination by the supervisory board, whereas the general meeting, the works council, and the executive board have a right of recommendation.30 The supervisory boards in such large cooperatives have broader powers than regular supervisory boards: many relevant decisions of the executive board require prior approval by the supervisory board.31 The mandatory two-​tier system, which also applies to public and private limited companies, is the Dutch alternative to the more direct form of employee participation like the German model of Mitbestimmung.32

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The one-​tier system, which in 2013 was introduced in the DCC for public and private limited companies, will be an alternative governance model for cooperatives in the near future.33

V.  Specific Features of Cooperatives: Assets or Risks? A. Members, no shareholders 15.31

The self-​image of Rabobank is reflected in a promotional video that aired from 2003 to 2007.34 A bank employee said the following:

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‘Rabobank is a cooperative bank, which was established in the late nineteenth century by farmers. We are a bank with principles. So, at Rabobank it’s not all about making profit, because Rabobank doesn’t have shareholders. Instead Rabobank has members, who have a voice in the bank’s decisions . . . ’

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It is clear that the bank sees its cooperative structure as an asset, because of the involvement of its members in the decision-​making process, the advantages of community banking, and particularly because it has no shareholders. But members may also entail risks. Being strong in both the retail and the wholesale market, Rabobank has approximately two million members, varying from households and small local firms to big corporates. This makes a large number of potential

the cooperative, together with its independent entities, normally employs 100 or more persons. The qualifying cooperative should have been registered with the trade register to that effect for three consecutive years, before it has to amend its articles of association. See Article 2:63b and 2:63c of DCC. To complicate things further, the mandatory two-​tier system may also be adopted by non-​qualifying cooperatives on a voluntary basis with immediate effect, see Article 2:63e of DCC. 30 Article 2:63f, para 2 and 4 of DCC. 31 Article 2:63j of DCC. 32 Maarten Muller (ed), Corporate Law in the Netherlands, Wolters Kluwer, 2013, 111–​12. See further on the German codetermination and board composition, Paul Davies and Klaus Hopt, Chapter 6, this volume. 33 See the envisaged Article 2:63k of DCC, as proposed by legislative document (Kamerstukken) 34491. 34 The video is still available at: www.nrc.nl/​nieuws/​2015/​12/​11/​zo-​anders-​is-​de-​rabobank-​niet-​ meer-​1566347-​a25573, accessed 1 July 2018.

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Cooperative Banking—A Dutch Experience plaintiffs, which involves a significant litigation risk. Moreover, history shows that being a cooperative with members is no guarantee against risks normal banks may have. See further Section VII. Rabobank’s cooperative structure with its more than 100 local membership councils 15.34 and its numerous consultation structures on local, regional, and national level is quite time-​consuming and expensive. This is one of the causes of the high cost/​income ratio that Rabobank is struggling with to meet the European Central Bank’s (ECB) Common Equity Tier 1 Capital Ratio. The members of a cooperative cannot be shareholders, because the cooperative may 15.35 not issue shares. Therefore, cooperatives like Rabobank are not listed on a stock exchange. Not being listed means no easy access to the financial market. On the other hand, not being listed means that the cooperative is not subject to market discipline, shareholder activism, and takeover pressure. But there are alternative ways in which members can invest in their own cooperatives. See Section V.B. B. No shares, no listing Although the cooperative typically does not issue shares, financing by alternative 15.36 instruments is possible. Through that, cooperatives can have access to the capital market. Rabobank, for instance, issues bond-​like financial instruments to its members and directors. See further Section VI.A. As those instruments are non-​voting, the holders thereof do not have voting rights like shareholders would have. Of course, the bondholders have their voting rights as members of the cooperative. No shares also means no share compensation for directors. The concept of the 15.37 alignment of the interests of directors and shareholders does not play a role in cooperatives. However, by issuing alternative (non-​voting) instruments to members of the executive board and supervisory board, a certain level of alignment can be achieved. C. Corporate governance The principle of member dominance means that executive directors are nominated 15.38 by the general meeting, even if the so-​called large cooperative regime is applicable, according to which essential powers of the general meeting are transferred to the supervisory board. See Section IV.C. This can be organized otherwise, provided that every member can participate, dir- 15.39 ectly or indirectly, in the voting with respect to the nomination of the board members.35 The principle of member dominance leads to boards that are composed by



Article 2:53a jo. 2:37, para 2 of DCC.

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Martin van Olffen and Gerard van Solinge and out of the members. Typically, a cooperative board consists of directors who are long-​time members. It is not common for lateral hires to get a position in the executive board. The advantage is, of course, that the executives are thoroughbred followers of cooperative entrepreneurship. On the other hand, an inflow of fresh blood is sometimes missed.

VI.  Rabobank Corporate Governance and Finance Structure—​The Recent Past A. General 15.40

Before the 2016 reorganization, the Rabobank Group consisted of 107 cooperatives: 106 cooperatives as local banks, each of them a member of the central cooperative bank, Rabobank.36 Each local bank was active in a certain geographical part of the Netherlands and had a number of branches in its area. The local banks together had approximately 1.9  million members. Each local bank had its own banking licence and its own annual accounts. In the context of financing the operational activities of the Rabobank Group and providing assurance to the financial market, different schemes were available, amongst others: • a cross-​guarantee scheme, linking the assets of the local banks, Rabobank, and several subsidiaries. This scheme ensured that if one participating entity had insufficient funds, its obligations would be covered by the other;37 • issuance of Rabobank Participaties for an amount of approximately six billion euros;38 and • (consolidated) reserves of approximately twenty-​five billion euros. As discussed above (Section IV.B), under Dutch law there are distinct possibilities for liability of members of a cooperative. In the Rabobank structure there was no liability for customer members. B. Governance in and supervision over local Rabobanks

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The governance model of all local banks was identical. Customers of a local bank could become a member of its local bank. There was, however, no obligation to

36 On the restructuring of Rabobank in 2016, see also I P van den Heuvel, A van Breda, and B. Snijder-​Kuipers, ‘Herziening governance Rabobank; succes voor de coöperatie’, Ondernemingsrecht 2017/​5 and J M Groeneveld, ‘The road towards one cooperative Rabobank, publication of the Directorate Cooperative and Governance Affairs’, Rabobank (2016). 37 The obligations under the Rabobank Participatiesare not included in this programme. 38 The Rabobank Participaties are a so called Tier 1 instrument and are issued to a foundation against the issuance of depositary receipts for shares. These depositary receipts for shares were originally traded between members of the local banks and since 2014 listed on Euronext.

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Cooperative Banking—A Dutch Experience become a member. Based on the membership model of a cooperative, the governance was build up of different layers.39 For logistical reasons, it was not practical to organize meetings for more than 100,000 members of one local bank. As a first layer, each member was allocated to a certain geographical area depending 15.42 on his or her place of residence, which was set up as a department (afdeling). A department can be set up as an independent corporate body.40 Each department had its own board, appointed by the department meeting. As a second layer there was a members’ council. This body consisted of all department board members and hence represented all members of a local bank. This members’ council was authorized to resolve on almost all resolutions otherwise attributed to a members’ meeting, including the appointment of the members of the supervisory board, amendment of the articles of association, and approval of the accounts. Certain special resolutions were reserved for an all members meeting, such as dissolution and termination of the membership with Rabobank. Each local bank was subject to the statutory regime for large companies with special rules for codetermination of employees in the appointment of members of the supervisory board.41 As a result, a works council had the opportunity to nominate a director for each vacancy on the supervisory board and could oppose candidates nominated by the supervisory board. Members of the executive board were appointed by the supervisory board. In this governance scheme, each member of a local bank had an influence over its own bank. The local banks had a discretionary authority to spend a certain percentage of its income on charity, underscoring the local presence and its contribution to the local community. Under the Financial Supervision Act 2007 (Wet financieel toezicht (Wft)), 15.43 Rabobank had been assigned with supervisory authority over its member banks. The Wft included specific provisions for banks that were related to a central credit institution.42 These provisions aimed to create a level playing field and a structure comparable with local branches of other national banks. Based on this scheme, Rabobank was supervisor of its members, the local banks. The articles of association of Rabobank included special provisions for this supervising authority, enabling Rabobank to provide instructions in its capacity as supervisor to local banks. The

39 For a more detailed description of the possibilities under Dutch law to create various layers of membership influence in associations, cooperatives, and mutual, see G J C Rensen, Mr C Assers Handleiding tot de beoefening van het Nederlands Burgerlijk Recht. 2. Rechtspersonenrecht. Deel II. Overige rechtspersonen. Vereniging, coöperatie, onderlinge waarborgmaatschappij, stichting, kerkgenootschap en Europese rechtsvormen, Wolters Kluwer 2017 (Asser/​Rensen 2-​III), nr 186ff. 40 See A L G A Stille, ‘De afdeling in het verenigingsrecht’, (PhD thesis University of Amsterdam), 1986 and Asser/​Rensen 2-​III, n 40, nr 187. 41 See, for more information on this regime for cooperatives, Asser/​Rensen 2-​III, n 40, nr 261ff. 42 Article 2:105 and 3:111 Wft.

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Martin van Olffen and Gerard van Solinge Dutch regulatory authorities (the Dutch Central Bank and Authority on Financial Market) reviewed Rabobank, including its supervision on local banks. C. Governance in Rabobank 15.44

Rabobank had all local banks as members. There were no other members. As a member, each local Rabobank had access to the members’ meeting. The members’ meeting appointed the members of the supervisory board, subject to the codetermination rights of the large company regime.43 The supervisory board appointed the members of the executive board. Further, each local bank was represented in the central district meeting (centrale kringvergadering), which among others things, was authorized to advise management of Rabobank on banking and other activities within the Rabobank Group. In this governance scheme, each member of a local bank had, through its own bank, influence over Rabobank. D. Events driven change

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The Rabobank Group implemented changes on a structural basis in response to laws, regulations, and social developments. In earlier years, the local banks had to give up some of their independence, but always remained independent entities with their own management, supervisory directors, equity, and banking licence. Rabobank survived the financial crisis during 2007 to 2010, and as one of the few large banks without government support. In 2010, Rabobank recorded the highest profit in its history. Rabobank, however, did not manage to steer away from the fallout from the financial crisis and the related sovereign debt crisis. The turmoil in the financial industry led to stricter banking regulation and supervision. New and stricter supervisory authorities were created on a national and supranational level. Europe created the Banking Union and the supervision of systemically important banks, including Rabobank, was transferred from national supervisory authorities to the ECB. In the Netherlands new rules were introduced for executive directors and supervisory directors of financial institutions. These had a material impact on the supervisory directors of the local banks. To be eligible and remain eligible for their supervisory tasks at the local level, they had to comply with so-​called ‘fit and proper’ tests. Consequently, the population of local supervisors became less diverse and more people with a feeling for compliance such as lawyers and accountants became local supervisory board members.

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The financial crisis had many victims:  the financial industry lost trust and reliability. ‘Banker-​bashing’ became a popular attitude. Rabobank incurred extra reputational damage due to its role in the LIBOR affair44 and the Calexico

43 See n 40. 44 https://​www.dnb.nl/​en/​news/​news-​and-​archive/​persberichten-​2013/​dnb298704.jsp#, accessed 1 July 2018.

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Cooperative Banking—A Dutch Experience affair45. The LIBOR affair resulted in financial settlements of 774  million euros (one billion US dollars) with various authorities in connection with their investigations into Rabobank’s historical LIBOR submission processes. The involvement of Rabobank in the LIBOR affair and the settlement caused great commotion, both in the Rabobank Group and in Dutch society. It also triggered far-​reaching organizational changes. Although the local banks were in no way involved in this affair, their reputation was impaired. In the public domain, there was no difference between Rabobank as central organization and holding company of international activities and Rabobank as local bank. Many representatives of local banks expressed their concern and disappointment. The name Rabobank, once a phenomenon for triple A banking, was contaminated. A long-​term continuation of the existing governance structure did not seem possible. There was a need for a fundamental review of Rabobank’s existing governance structure. E. Preliminary discussion for a new governance Although there were earlier discussions within the Rabobank Group, the appoint- 15.47 ment of an internal governance committee in early 2014 marked the start of the largest reorganization in Rabobank’s history. A  major overhaul was necessary to find a solution for the issues discussed above. The governance committee was assigned to present proposals for governance changes establishing future-​proof governance. A governance scheme was established that would recover and maintain trust and confidence among internal and external stakeholders in Rabobank. The committee consisted of four chairmen of supervisory boards of local banks, four executive directors of local banks, two executive board members of Rabobank, and some specialist staff members of Rabobank. Numerous road shows, round table discussions, webinars, and plenary meetings have been held to collect input and views as well as to involve and inform stakeholders. Crucial elements in this debate were trust and confidence among all stakeholders. Along the way, the committee formulated different alternatives, with two more 15.48 prominent structures. These structures consisted of: • a merger of all local banks with Rabobank, with Rabobank as the acquiring entity and only surviving cooperative; and • a hive down of all assets and liabilities of all local banks to Rabobank. The first alternative was a giant leap forwards, resulting in one Rabobank, where 15.49 all customers would become a member of one and the same bank. The second alternative obviously left part of the governance structure in existence with the local

45 https://​www.justice.gov/​opa/​pr/​rabobank-​na-​pleads-​guilty-​agrees-​pay-​over-​360-​million, cessed 1 July 2018.

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Martin van Olffen and Gerard van Solinge cooperatives as a service organization rather than a bank. In both alternatives, the local banks could continue to exist as branches of Rabobank. 15.50

In the early stages of discussion, there was some hesitation whether the first alternative could include sufficient countervailing powers between members and management. The architects behind the governance committee, however, were able to create a legal structure with a governance that could mirror most of the existing governance with certain new features to cater for appropriate countervailing powers.

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After many meetings and discussions, the committee proposed a merger between the 106 local banks and Rabobank. The legal documentation for the merger, a merger proposal, amounted to 12,534 pages and approximately 1,000 signatures. The merger encompassed a transfer of equity of approximately twenty-​one billion euros and twenty-​seven thousand employees from the local banks to Rabobank. On 9 December 2015 all 106 local banks unanimously approved the merger. On 1 January 2016, the legal merger and the new governance structure of Rabobank became effective, starting a new era in the bank’s 120-​year history. The merger resulted in one Rabobank with one balance sheet and all assets and liabilities in one legal entity in the legal form of a cooperative.

VII.  Rabobank Corporate Governance Structure—​The Present A. Group structure 15.52

The Group is comprised of Rabobank as the top holding entity together with its subsidiaries in the Netherlands and abroad.46 The Group’s cooperative core business is carried out by the local banks, as discussed below. B. Rabobank—​general

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The central institution of the Group is Rabobank. Rabobank is a licensed bank, in the legal form of a cooperative with excluded liability. It was established under Dutch law. Rabobank operates not only from the Netherlands, but also from branches and representative offices all over the world. These branches and offices all form part of the legal entity Rabobank and focus on wholesale banking. Rabobank branches are located in Sydney, Antwerp, Toronto, Beijing, Shanghai, Dublin, Frankfurt, Madrid, Paris, Mumbai, Milan, Labuan, Wellington, New York, Singapore, Hong

46 A  part of the description is based on the language in a Rabobank’s prospectus for its Tier 2 Notes programme, see https://​www.rabobank.com/​en/​images/​a34354526-​rabobank-​2017-​t2-​ prospectus-​clean.pdf, accessed 1 July 2018.

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Cooperative Banking—A Dutch Experience Kong, and London. Rabobank representative offices are located in Mexico City, Buenos Aires, Moscow, Istanbul, Kuala Lumpur, Tokyo, Atlanta, Chicago, Dallas, San Francisco, Nairobi, and St Louis. Through their mutual financial association, various legal entities within the Group, including Rabobank, make up a single organization. C. Rabobank—​Executive board and mandates for local banks As a result of the merger, Rabobank became the owner of all assets of all local 15.54 banks and hence, the statutory management of and supervision over the business activities of the individual cooperatives disappeared as a result. From one day to another, the executive board of Rabobank was fully responsible for the overall banking business, including that of all local banks. Under the former governance structure, supervision over the local banks took place through the executive board of Rabobank and the supervisory board of the local bank. The supervisory board of the local bank acted as ‘internal supervisor’ based on corporate law and the executive board of Rabobank as ‘external supervisor’ based on regulatory law.47 The supervision of the supervisory board of Rabobank was extended to this new management role. To enable the local banks to continue their business and to create a governance structure for the future, next to the merger documents, the executive board of Rabobank granted mandates to the management of the local banks. In their future role as managers of the local banks, they were empowered to run the business of these local banks.48 The members of the supervisory boards of the local banks were also granted mandates. These mandates included certain supervisory tasks, including the power to appoint and to dismiss certain (future) directors. These mandates empower the individuals referred to above with the possibility for the Executive board of Rabobank to exercise these powers itself if necessary.49 For a further discussion on the powers of the management and supervisors of local banks, see Section VII.E. D. Member influence within Rabobank As a cooperative, Rabobank has members, not shareholders. Customers of Rabobank 15.55 in the Netherlands have the opportunity to become members of Rabobank. There is no obligation. Early in 2017, Rabobank had approximately two million members. Rabobank is a cooperative with excluded liability. Members do not make capital contributions to Rabobank and do not have claims on the equity of Rabobank.

47 See Section VI.B. 48 This process included the filing of approximately 1,200 proxies and 580 branches with the trade register. 49 See, on mandates under Dutch law, J G Groeneveld-​Louwerse, ‘Publieke wenselijkheid of private beleidsvrijheid’ (PhD thesis Free University Amsterdam), 2004.

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Rabobank is a decentralized organization with decision-​making powers at both a local and central level. The members of Rabobank are organized, based on, amongst other things, geographical criteria, into about 100 departments. Each local bank is linked to a department. Within each department, members are organized into delegates’ election assemblies. These assemblies elect the members of the local members’ councils.

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The local members’ councils consist of thirty to fifty members and have a basis in the local bank rules. Local members’ councils report to, and act as sparring partner of, the management team of the local bank on the quality of services and the contribution on social and sustainable development of the local environment. These councils have a number of formal tasks and responsibilities. One of the powers of the local members’ council is appointment, suspension, and dismissal of the local supervisory body, including its chairman.

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The local supervisory body consists of three to seven members and is part of the department. It is a corporate body with a basis in the local bank rules and has various tasks and responsibilities, including a supervisory role on the level of the local bank. As part of that role as referred to above, the executive board of Rabobank has granted the local supervisory body a number of powers in respect of material decisions of the local management team chairman. The local supervisory body monitors the execution by the management team chairman of the local strategy. The local supervisory body also exercises the functional employer’s role in relation to the management team chairman of the local bank. The local supervisory body is accountable to the local members’ council. The members of the local supervisory body have to be members of Rabobank. See Section VII.E for more information on the interaction between the local management and the local supervision.

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Every chairman of a local supervisory body represents the members of its department in the general members’ council of Rabobank.50 This council is the highest decision-​making body in the Rabobank governance. Although the chairmen of the local supervisory bodies participate in the general members’ council of Rabobank without instruction and consultation, they will also take the local points of view into account. The general members’ council of Rabobank has a focus on strategy, identity, budget, and financial results and has powers on these matters. On behalf of the members, the general members’ council of Rabobank safeguards continuity as well as acts as the custodian of collective values. In that context it adopts the

50 Rabobank makes use of the possibility of having a members meeting consisting of representatives as set forth in Article 2:39, para 1 of DCC.

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Cooperative Banking—A Dutch Experience financial statements of Rabobank and has the right of approval for major decisions by the executive board, including: • determination of general principles of Rabobank’s identity and strategic frameworks; • general principles of the annual budget; and • mergers and aquisitions transactions, (dis)investments, and strategic partnerships with a value of more than two billion euros. The general members’ council of Rabobank has three permanent committees: the 15.60 urgency affairs committee, the coordination committee, and the committee on confidential matters. Preparation for discussion and decision making in the general members’ council takes place through regional assemblies. These are not formal corporate bodies in the Rabobank governance. The assemblies are consultative bodies where the chairmen of the supervisory bodies and the management chairmen of the local banks meet to discuss. The members of the supervisory board of Rabobank are appointed by the general 15.61 members’ council of Rabobank, subject to the employees codetermination rules under the statutory large company regime (see also Section IV.C). Two-​thirds of the number of members of the supervisory board must be members of Rabobank.51 The supervisory board performs the supervisory role and is accountable to the general members’ council of Rabobank. In this respect, the supervisory board monitors compliance with laws and regulations and, inter alia, achievement of Rabobank’s objectives and strategy. The supervisory board has the power to approve material decisions of the executive board. The supervisory board also has an advisory role in respect to the executive board. The supervisory board has several committees, inter alia a risk committee and an audit committee, that perform preparatory and advisory work for the supervisory board. The members of the executive board are appointed by the supervisory board. The 15.62 default regime under Dutch law for a cooperative is that members of the executive board are appointed by the members’ meeting.52 Dutch law allows, however, for other schemes, as long as members of the cooperative indirectly can vote on appointments. Members of Rabobank have an indirect vote on the appointment of supervisory board members or Rabobank through the chain of member influence discussed above and hence have an indirect vote on the appointment of members of the executive board. 53

51 This requirement can be included in the articles of association under the large company regime; Article 2:63h of DCC and underscores the influence of members on the organization. 52 Article 2:53a DCC jo. Article 2:37, para 2, first sentence of DCC. 53 There has been a discussion in Dutch legal literature on this scheme. See P J Dortmond, ‘Rabobank Nederland en het structuurregime’, Ondernemingsrecht 2002/​11; M E Engelaar, ‘Reactie op: Rabobank Nederland en het structuurregime’, Ondernemingsrecht 2002/​14; Gerard van Solinge, ‘Benoeming van bestuurders en commissarissen van een structuurcoöperatie’, Ondernemingsrecht 2012/​78.

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The executive board of Rabobank is responsible for the management of Rabobank including the local banks and, indirectly, its affiliated entities. The executive board has the ultimate responsibility for defining and achieving the targets, strategic policy and associated risk profile, financial results, and corporate social responsibility aspects. In addition, the executive board is in charge of the Groups’ compliance with relevant laws and regulations. Rabobank, represented by the executive board, is the hierarchical employer of the management team chairmen of the local banks. The executive board members are accountable to the supervisory board and the general members’ council of Rabobank. E. Business of local banks

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The local business is organized through about 100 local banks. These local banks are not separate legal entities; as branches they are part of the legal entity Rabobank. To preserve local orientation and local entrepreneurship as distinguishing features of Rabobank, the executive board has granted the management team chairmen of the local banks a number of authorizations; see also Section VII.C. Consequently, these chairmen are able to perform their tasks locally and to take responsibility for their designated local bank. The management team chairmen have additional responsibilities for the department that is related with the local bank.

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The local supervisory body and the local management team are expected to aim at alignment of locally formulated targets and the achievement of such targets. If this is not the case, the supervisory roles of the executive board of Rabobank and the local supervisory body may conflict. In such a situation, whether a common approach could be agreed upon to bridge diverging opinions and solve potential problems will be explored. At any time, the executive board of Rabobank may withdraw the authorizations granted to the local supervisory body and local management. The executive board will only exercise this power in exceptional circumstances and will inform the local supervisory body about a likely withdrawal of these mandates in advance. To ensure that the executive board does not abuse its authority, a right of appeal at the supervisory board of Rabobank is provided for within the governance framework.

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The business of local banks is assisted by the directors’ conference. This body has a basis in the articles of association of Rabobank but is not a decision-​making body. It is a preparatory, informative, and advisory meeting for proposals and policies concerning the business of the local banks. The executive board, management team chairmen of the local banks, and directors of local banks participate in this meeting. The director’s conference also constitutes a linking pin between the highest echelons of the bank and the task of safeguarding customers’ interests.

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Cooperative Banking—A Dutch Experience F. Employee Influence within the Group Issues concerning the Dutch business of Rabobank are handled by the works 15.67 council (ondernemingsraad) of Rabobank. (Local) issues concerning the business of one, two, or three local banks are handled by the local work(s) council(s). Issues concerning a subsidiary are handled by the works council of that subsidiary. Rabobank has also installed a European works council for issues concerning the businesses that operate in more than one EU Member State.

VIII.  Regulatory Framework As most banks in the world are organized in the form of public or private limited 15.68 companies, legislators and regulators sometimes oversee that the design of new rules does not cater for cooperatives. Other than cooperatives, public and private companies always have a share capital, and voting rights in the shareholders’ meeting are solely based on a shareholding. One example is the formulation of instruments of ownership in the Bank Recovery and Resolution Directive that does not take into account membership rights or (depositary receipts for) securities issued by a cooperative. In the Dutch implementation of this Directive, the scope of instrument of ownership has been widened.54 Another example is the alignment of the concept of supervision by a central credit institution as discussed in Section VI.B with the CRD IV/​CRR Regulations. At the end of the day, the EU legislation or its implementation has so far always 15.69 seemed to meet the specific demands for a cooperative. It is, however, sometimes after fierce lobbying activities by or on behalf of cooperatives. The cooperatives always need to pay attention to ensure that their specific characteristics are recognized and included in legislation.

IX. Summary The Dutch experience shows that cooperative banking makes it possible to op- 15.70 erate in a highly competitive market with a system of stakeholder democracy with (proportional) voting rights for shareholders, customers, employees, and other stakeholders. From that point of view, Rabobank is a special bank amidst the other banks.



Chapter 3A, Article 1 Wft.

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Given their higher moral and ethical standard—​see the Rochdale Principles and the Raiffeissen Principles—​cooperative banks supposedly have different business and investment policies. One might expect that cooperative banks have, as a matter of nature, for instance a ban on ‘bad’ investments in weapons, fossil fuels, or products made by child labour. Maybe they have, but in practice, standard banks (like ABN AMRO) have those bans too. Corporate social responsibility and commitment to sustainability are now widespread in the financial world and are no longer the exclusive issues of cooperative banks.

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During the financial crisis that started in 2008, Rabobank survived whereas many listed banks went bankrupt or needed state aid. One could argue that not being a listed company at that time was a great advantage. However, several studies show that there is no evidence that banks with higher-​quality governance performed better during the 2008 crisis.55

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Rabobank came out of the crisis without a scratch or state interference. Elsewhere, in the aftermath of the financial crisis the large ‘banche popolari’ in Italy were forced to become standard public companies. The Italian government decided to do so, obviously from the thought that the cooperative form exposes banks to higher risks in times of crisis, eventually resulting in the bank’s collapse.56

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Nevertheless, after the financial crisis, Rabobank has had its portion of crises with the LIBOR scandal and other issues (interest rate derivatives and money laundering e.g. in the Calexico branch). From that point of view, Rabobank is a normal bank amidst the other banks.

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Is the cooperative form maybe a regulatory risk? That raises the question of whether regulatory supervision may prevent crises and collapses at all. Or, regardless of its form, is any bank with a weak risk-​management function a risk? Indeed, several studies show that banks with strong and independent risk-​management functions identify risks, and prevent excessive risk-​taking which cannot be controlled entirely by regulatory supervision or external market discipline.57 If regulatory supervision and market discipline (i.e. shareholder control) are not that relevant, this holds true for any bank regardless of its form. In other words, the lack of market discipline which is typical for cooperatives has no significant influence on their performance. Early risk identification seems to be more relevant in avoiding financial distress. However, this is not only true for financial companies, but for all companies.

55 Guido Ferrarini, ‘Understanding the Role of Corporate Governance in Financial Institutions: A Research Agenda’, Ondernemingsrecht 2017/​13 (72-​83), 75. Also published as ECGI Law Working Paper 347/​2017. See also Guido Ferrarini, Chapter 11, this volume. 56 See Paolo Giudici, Chapter 21, this volume. 57 See n 55.

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Part IV CONDUCT AND CULTURE

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16 CORPORATE CULTURE IN THE GOVERNANCE OF FINANCIAL INSTITUTIONS An Interdisciplinary Approach Shanshan Zhu and Guido Ferrarini  

I. Financial Institutions and Culture A. Introduction B. A new approach to financial reform C. Culture and morals

II. The Notion of Culture A. Defining culture B. Diagnosing culture

III. Governing Corporate Culture: (A) Leadership IV.

16.01 16.01 16.07 16.12 16.17 16.17 16.22

A. Tone at the top B. The ethical leader

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Governing Corporate Culture: (B) Managerial Incentives

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A. Traditional theories B. A broader perspective

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Governing Corporate Culture: (C) Codes of Conduct A. A global practice B. The limited effectiveness of codes of conduct

VI.

Cognitive Framing and Group Dynamics A. Not just ‘bad apples’ B. Decision-​making in the boardroom

VII. Concluding Remarks

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I.  Financial Institutions and Culture A. Introduction Only in the last few years financial regulators, supervisors, and scholars have fo- 16.01 cused on the role of ethics and culture in the financial services industry as determinants of either good or bad behaviour. The current attention to ethics and culture can be easily understood considering the disdain that followed the

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Shanshan Zhu and Guido Ferrarini shocking misconducts carried out by financial firms both in the United States1 and in Europe.2 Inadequate rules and lack of public enforcement cannot fully explain malpractice. Neither can they clarify why financial firms apparently operating in similar contexts, under similar rules and incentive structures, did not reach the same outcomes in terms of viability and performance. 16.02

In order to get to the root of the problem, it is necessary to first assert something obvious: banks are run by human beings. As a consequence, to understand how to fix banks, it is necessary to first understand how to fix people’s behaviour. In terms of policy, scholars and authorities should pay renewed attention to corporate governance structures in the financial sector in addition to regulation. However, following the traditional lawyerly approach to corporate governance based on standards and procedures may not be sufficient, while the risk of adding costs and bureaucracy within financial institutions is high. Governance models should be rather analysed with a focus on the organizational and cultural aspects of institutions. Scholars in this area should therefore undertake in-​depth studies on the determinants of human behaviour, the relevant processes, and the motivations leading people to act the way they do. A number of research questions should be asked in particular, such as the following: (i) What drives white-​collar criminals, who often are wealthy and highly educated professionals, well paid and highly esteemed in influential parts of society, to risk their success, reputation, and prospected incomes when committing fraud? (ii) How did it happen that some financial firms awarded for their good corporate governance system were heavily hit by scandals? (iii) What makes codes of ethics just valueless and ineffective pieces of paper?

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These questions should be answered from an interdisciplinary perspective, involving not only law and economics, but also other social sciences, such as anthropology, sociology, and psychology, which offer fundamental insights on the determinants of financial misconduct. This will better explain why financial scandals not only concern ‘bad apples’, but also good people acting in highly unethical contexts (‘bad barrels’), where they confront moral dilemmas (‘bad cases’).3

1 The Wells Fargo case will be considered below at 16.32. See Susan M Ochs, ‘The Leadership Blind Spots at Wells Fargo’, Harvard Business Review, 6 October 2016. 2 For instance, the JP Morgan’s London Whale case, the Libor and Forex manipulation scandals, and the infamous episodes involving BSI, Swiss Bank, BNP, and Deutsche Bank. See Thomas C Baxter, ‘Reflections on the New Compliance Landscape, Remarks at The New Compliance Landscape: Increasing Roles Increasing Risks Conference’, New York City, 2014. See Paolo Giudici, Chapter 21; Maribel Sáez-Lacave and María Gutiérrez-Urtiaga, Chapter 22; José Engrácia Antunes, Chapter 23, all this; and Bas de Jong, Chapter 24 all this volume, for an in-depth analysis of banking scandals in Italy, Spain, Portugal, and the Netherlands respectively. 3 Jennifer J Kish-​Gephart, David A Harrison, and Linda Klebe Treviño, ‘Bad Apples, Bad Cases, and Bad Barrels: Meta-​Analytic Evidence About Sources of Unethical Decisions at Work’ Journal of Applied Psychology (2010), 95, 1, 1–​31.

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Culture of Financial Institutions The idea that a cultural shift is needed in the financial industry is already wide- 16.04 spread amongst national and international regulators, as will be better explained in the next section. Contrary to Milton Friedman’s suggestion that the only responsibility of business is to maximize shareholder value, many are convinced today that firms should also pursue ethical values and that this goal is not opposite to profit.4 As highlighted for the first time by Bowen in 1953,5 in order to create long-​term value, financial institutions should enhance the ability of people working for them at each level to make decisions in a responsible manner.6 The UK Financial Reporting Council (FRC), in its 2016 Report on Corporate Culture and the Role of Boards, similarly stated: ‘a healthy culture both protects and generates value. It is therefore important to have a continuous focus on culture, rather than wait for a crisis’. To be sure, there is a significant literature on the determinants of organizations’ cul- 16.05 ture, its connection with firm performance,7 and the ways to measure and change it for the better,8 but few have studied organizational culture with specific reference to financial institutions.9 This chapter suggests a new approach to the study of culture in financial institutions, which could assist the regulatory reform and the revamping of the financial sector and prevent malpractice with the help of concepts and methodologies drawn from social sciences other than law and economics. Moreover, this chapter makes some proposals, which are particularly addressed to boards of directors, institutional investors, and financial supervisors, and are aimed to implement an effective culture in financial institutions, that is to say a culture

4 See, e.g., Lynn A Stout, ‘Shareholder Value Myth’, Cornell Law Faculty Publications, Paper 771/​2013. 5 See Howard R Bowen, Social Responsibilities of the Businessman, Harper, 1953, 8–​13. 6 Incidentally, non-​financial value drivers (such as company’s reputation, customer satisfaction and loyalty, staff competence, employee satisfaction and turnover, and innovative potential, proved to be relevant in determining a bank’s value in a study on Latvian banks. See Jelena Titko and Inga Shina, ‘Non-​financial Value Drivers: Case of Latvian Banks’, Procedia Engineering (2017) 178, 192–​9. 7 See, e.g., Benjamin E Hermalin, ‘Economics and Corporate Culture’, in Cary L Cooper, Sue Cartwright, and P Christopher Earley (eds) The International Handbook of Organizational Culture and Climate, Wiley, 2001, 217–​61; Luigi Guiso, Paola Sapienza, and Luigi Zingales, ‘Does Culture Affect Economic Outcomes?’ Journal of Economic Perspectives (2006), 20, 23–​48; John P Kotter and James L Heskett, Corporate Culture and Performance, Free Press, 1992; Jesper B Sørensen, ‘The Strength of Corporate Culture and the Reliability of Firm Performance’ Administrative Science Quarterly (2002), 47, 1, 70–​91; Daniel R Denison, Corporate Culture and Organizational Effectiveness, Wiley, 1990; George G Gordon and Nancy Di Tomaso, ‘Predicting Corporate Performance from Organizational Culture’, Journal of Management Studies (1992), 29, 83–​798. 8 See, e.g., Sonia A Sackmann,‘Uncovering Culture in Organizations’, The Journal of Applied Behavioural Science (1991), 27, 3, 295–​317; and John R Graham et  al, ‘Corporate Culture: Evidence from the Field’, Duke I&E Research Paper No 33/​2016, available at http://​ ssrn.com/​abstract=2805602, accessed 10 September 2018, or http://​dx.doi.org/​10.2139/​ ssrn.2805602, accessed 10 September 2018. 9 See Andrew W Lo, ‘The Gordon Gekko Effect: The Role of Culture in the Financial Industry’ FDRNY Economic Policy Review (2016), 18; Anjan Thakor, ‘Corporate Culture in Banking’, Economic Policy Review, Issue August 5–​16 2016, available at http://​ssrn.com/​abstract=2828071, accessed 10 September 2018; Gordon Gwendolyn and David T Zaring,.‘Ethical Bankers’ The Journal of Corporation Law (2017), 42, 3, available at https://​ssrn.com/​abstract=2932317, accessed 10 September 2018.

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Shanshan Zhu and Guido Ferrarini stimulating practices and behaviours that would allow each firm to reach its own goals in a responsible manner and with a long-​term view.10 16.06

The rest of the chapter proceeds as follows. Section II briefly offers an overview of the scholarly definitions of culture in social sciences and of the models suggested to diagnose it. Section III discusses the role of leadership in shaping culture. Section IV recommends a new approach to incentives and remuneration schemes, which is grounded on a critical view of the same as currently used in financial and non-​ financial firms. Section V discusses the effectiveness of codes of conduct in the financial sector. Section VI shows how framing culture can either enhance or hamper good decision making and analyses group dynamics in the boardroom. Section VII suggests some practical ways in which supervisory authorities and institutional investors can induce boards to measure culture and reshape it, so as to restore trustworthiness in the financial services industry, and concludes. B. A new approach to financial reform

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The need for approaching financial reform also in terms of a change in corporate culture has been increasingly highlighted by eminent figures of the financial community. William Dudley, President of the Federal Reserve Bank of New York and Vice-​Chairman of the Federal Open Market Committee, in 2014 stated that ‘improving culture in the financial services industry is an imperative . . . in order to ensure financial stability over time, but also to ensure the public trust in our financial system’.11 The Group of 30 in 2015 issued a report providing several suggestions to encourage boards and supervisors to establish sound culture, values, and behaviour, since ‘problematic cultural norms, and subcultures within large banks, have caused widespread reputational damage and loss of public trust’.12

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A  proactive inclusion of cultural and ethical issues in banking supervision has been accomplished by the De Nederlandsche Bank (DNB), which was in 2010 the first banking supervisor globally to treat culture and behaviour as risk factors in supervision.13 Since then, DNB has conducted more than fifty assessments targeting banks, insurance companies, pension funds, and trust offices.14 Moreover, the Financial Supervision Act 2013 (amended in 2015) introduced the so-​called ‘banker’s oath’, by which all bank employees are bound by the rules of conduct for the ethical and careful practice of their profession.15 The DNB hired organizational 10 Graham et al, n 8. 11 William Dudley, ‘Enhancing Financial Stability by Improving Culture in the Financial Services Industry’, Remarks at the Workshop on Reforming Culture and Behaviour in the Financial Services Industry, New York Fed, 20 October 2014. 12 G30, ‘Banking conduct and culture: A call for sustained and comprehensive reform’, 2015. 13 Netherlands Authority for the Financial Markets (AFM) and De Nederlandsche Bank (DNB), ‘Capacity for change in the financial sector’, 2014. 14 ibid. See also Wijnand Nuijts, Chapter 17, this volume. 15 See Peter Laaper and Danny Busch, Chapter 18, this volume.

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Culture of Financial Institutions psychologists to assess whether candidates are fit for executive office in banks and to occasionally take part in board meetings and analyse the members’ behaviour.16 Similarly, the Financial Conduct Authority (FCA) that protects consumers and promotes competition amongst more than 56,000 financial institutions in the United Kingdom,17 has published several papers dealing with issues concerning the culture of compliance in the financial industry from the perspective of behavioural economics,18 sociology, and psychology.19 At EU level, the EBA Guidelines on common procedures and methodologies 16.09 for the supervisory review and evaluation process (SREP)20 make reference to culture and ethics in banks. Besides providing standards for the evaluation of their business model and strategy, capital, and liquidity adequacy, Title V of the Guidelines provides criteria for the assessment of the internal governance and controls of banking institutions, which should have an ‘appropriate and transparent corporate structure that is ‘fit for purpose’ in line with EBA Guidelines on internal governance’. Amongst the elements considered, the need is highlighted for a transparent organizational culture, a clear distribution of responsibilities between corporate bodies, an effective communication to all relevant staff, and attention to the institution’s ethical corporate and risk culture. Specifically, it is suggested that this should establish an environment of effective challenge in which decision-​making processes promote a range of views. In its final report,21 among several suggestions, the High-​Level Expert Group 16.10 (HLEG) added the establishment of a corporate culture that considers sustainability issues as key factors. In particular, the report suggests an update of ‘the “fit and proper” tests to include an assessment of the individual and collective ability of the members of governing bodies in financial institutions to address sustainability risks, to understand the broader stakeholder context and to take account of

16 See John M Conley and Cynthia Williams, ‘Fixing Finance 2.0’, in Bertram Lomfeld, Alessandro Somma, and Peer Zumbansen (eds), Reshaping Markets. Economic Governance, the Global Financial Crisis and Liberal Utopia, Cambridge University Press, 2016, 222. 17 https://​www.fca.org.uk/​about/​the-​fca, accessed 10 September 2018. 18 FCA, ‘Applying behavioural economics at the Financial Conduct Authority’, Occasional Paper No 1/​ 2003, available at https://​www.fca.org.uk/​publication/​occasional-​papers/​occasional-​paper-​ 1.pdf, accessed 10 September 2018. 19 FCA, ‘Behaviour and Compliance in Organisations’,Occasional Paper 24/​ 2016 https://​ www.fca.org.uk/​publication/​occasional-​papers/​op16-​24.pdf, accessed 10 September 2018; FCA, ‘Incentivising Compliance with Financial Regulation’, Occasional Paper No 25/​2016; and FCA, ‘From advert to action: behavioural insights into the advertising of financial products, Occasional Paper No 26/​2017 https://​www.fca.org.uk/​publication/​occasional-​papers/​op17-​26.pdf, accessed 10 September 2018. 20 EBA, ‘Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP)’, EBA/​GL/​2014/​13, 19 December 2014. 21 HLEG, ‘Financing a Sustainable European Economy’, 2018, 38–​41.

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Shanshan Zhu and Guido Ferrarini clients’ sustainability preferences’. In order to fulfil their duties, including the duty to evaluate the impact of the business strategy on society and the environment, board members are recommended to participate in specific education and training measures. 16.11

Most of the documents and standards just reviewed do not clearly indicate what should be intended by ‘culture’, nor how to evaluate and measure it. Therefore, the next section offers an overview of the studies on culture and the measuring methodologies applied within different fields of the social sciences. C. Culture and morals

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However, before defining culture and suggesting how to implement a sound culture which constrains illicit behaviour and fraudulent phenomena, the ethical approach on which this chapter is based is briefly explained. For centuries, moral philosophers have tried to address questions like: What is justice? What kind of behaviour can be claimed to be fair? Nowadays they are still struggling to solve them. This chapter, does not intend to give conclusive answers to those issues, nor to cope with complex philosophical questions. Rather, it follows an approach developed by virtue ethicists.

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Confucius was perhaps the first philosopher to have built his view on moral virtues, whereas in Western culture Aristotle’s ‘Ethica Nicomachea’ notably laid the foundation for modern virtue ethics.22 In opposition to moral models based on universal principles—​such as Kant’s deontological approach—​or utility maximization—​ developed in Adam Smith’s and utilitarian philosophers’ theories—​virtue ethicists do not intend to identify all-​inclusive rules that should shape human behaviour, since there are no such fixed and reliable rules. Rather, moral virtues and sound character offer some practical guiding criteria to face complex reality.23

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According to Aristotle, well-​being, the so-​called eudaimonia,24 can be achieved only through a virtuous life. And a virtuous life is defined as an existence conducted in

22 See, among others:  Gertrude E M Anscombe, ‘Modern Moral Philosophy’, in Roger Crisp and Michael Slore (eds) Virtue Ethics, Oxford University Press, 1997, 26–​44; Philippa R Foot, ‘Virtues and Vices’, in Roger Crisp and Michael Slote (eds), Virtue Ethics, Oxford University Press, 1997, 163–​77; Craig Walton, ‘Character and Integrity in Organizations: The Civilization of the Workplace’, Business and Professional Ethics Journal, (2001), 20, 105–​28; Alasdair MacIntyre, After Virtue, University of Notre Dame Press, 3rd ed, 2007); Geoff Moore, ‘Humanizing Business:  A Modern Virtue Ethics Approach’, Business Ethics Quarterly (2005), 15, 237–​55; and Edwin M Hartman, Virtue in Business. Conversations with Aristotle, Cambridge University Press, 2013. 23 Hartman, n 22, 9–​11. 24 Many studies use Aristotle’s concept of eudaimonia, which has been translated into ‘happiness’, ‘flourishing’ or ‘well-​being. See, e.g., Thomas Nagel, ‘Aristotle on Eudaimonia’, Phronesis (1972), 17, 252–​59; William J Prior, ‘Eudaimonism and virtue’, Journal of Value Inquiry, 2001, 35, 325–​42.

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Culture of Financial Institutions accordance with the essential function of human nature, which is being sociable and rationale.25 Virtues, which can be divided into soul-​related moral virtues (courage, temperance, liberality, magnificence, magnanimity, gentleness, friendliness, truthfulness, wittiness, and justice) and intellectual-​based virtues (art, knowledge, practical judgement, wisdom, and intellect)—​and lay in the mean between two vices, excess and defect—​26 can be mastered only by constant training and experience. In other words, virtue manifests itself in action and, as a skill, requires both practice and rational deliberation.27 Practical wisdom, for instance, can help solve dilemmas deriving from apparent conflicting values and principles. According to this approach, immoral and irrational behaviour derives from a failure of perception and/​ or a weakness of will, problems solvable by constant and correct training. MacIntyre, one of the best known virtue ethicists, defines virtues as ‘dispositions 16.15 not only to act in particular ways but also to feel in particular ways’, and states that to act virtuously ‘is to act from inclination formed by the cultivation of the virtues’.28 However, building on Aristotle’s philosophy, he condemns capitalism and businesses as they ‘provide(s) systematic incentives to develop a type of character that has a propensity to injustice’,29 while Moore has developed the idea that business character can be trained towards the achievement of internal goods and, as a consequence, applies MacIntyre’s notions to business organizations.30 In particular, Moore distinguishes between virtues and values, as ‘valuing is something we do, while virtues are something we have (or not)’. Specifically, virtues are tools that are trained in order to live according to specific values, since ‘it takes courage not to tell a lie’ and ‘it takes temperance to say “No” to a bribe’.31 In the last decade, this vision has been confirmed by the social sciences and 16.16 neuroscientific research in particular, which study individual, organizational, and economic phenomena by looking for more than universal principles, common practices, and behaviours.32 In line with this approach, Hartmann’s Aristotle-​ oriented lessons to businesses is espoused.33 Rather than following strict rules and principles, people should develop virtues always with practical wisdom, which is endowed with the flexibility and creativity needed in each situation. Moreover, individual interest and collective interest do not necessarily conflict, while dialectics can enhance ethical thinking. 25 Aristotle, Ethica Nicomachea, Clarendon Press, 1894, Book I, Ch 7. 26 Hartman, n 22, 9–​11; Aristotle, n 24, Book II, Ch 8. 27 Hartman, n 22, 9–​11. 28 MacIntyre, n 22, 149. 29 Alasdair MacIntyre, Marxism and Christianity, Duckworth, 1995, XVI. 30 Geoff Moore, ‘On the Implications of the Practice-​Institution Distinction: MacIntyre and the Application of Modern Virtue Ethics to Business’, Business Ethics Quarterly, (2002) 12, 1, 19–​32. 31 Moore, n 22, 237–​55. 32 The following sections cover this issue in more detail. 33 Hartman, n 22, 249–​50.

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II.  The Notion of Culture A. Defining culture 16.17

‘As regulators focus on culture, Wall Street struggles to define it’ was the heading of an article in The Wall Street Journal,34 which went on, stating: ‘culture is the buzzword of the moment at banks and a puzzle that regulators and Wall Street firms are wrestling to solve’. Also in the social sciences, despite the rich body of studies on culture developed over a relatively long period of time, the slippery nature of this concept has made it difficult to reach a common definition.35

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The term ‘culture’ derives from the Latin ‘còlere’ whose meaning indicates the cultivation of the soil. The first modern definition of culture was given by the British anthropologist Edward Tylor in 1871,36 according to whom culture is ‘that complex whole which includes knowledge, belief, arts, morals, law, custom, and any other capabilities and habits acquired by man as a member of society’. In the twentieth century, anthropologists analysed the concept of culture in an attempt to make its definition more precise. The so-​called evolutionary/​ecological theories viewed culture as all those means that serve human communities adapting to their ecological surroundings.37 The attention later moved to a semiotic notion of culture,38 focused on language and symbols. Kroeber and Kluckhohn,39 in particular, wrote that ‘culture consists of patterns, explicit and implicit, of and for behaviour acquired and transmitted by symbols, constituting the distinctive achievements of human groups, including their embodiments in artefacts’.

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As organizational culture studies emerged and developed in the 1980s,40 anthropologic theories were applied to investigate organizational

34 Emily Glazer and Christina Rexrode, ‘As Regulators Focus on Culture, Wall Street Struggles to Define It’, Wall Street Journal, 1 February 2015, available at http://​www.switchtocommunity. com/​article/​912-​as-​regulators-​focus-​on-​culture-​wall-​street-​struggles-​to-​define-​it, accessed 10 September 2018. 35 Two anthropologists, Krowber and Kluckhohn, found 164 definitions of culture. See Alfred L Kroeber and Clyde Kluckhohn, ‘Culture: A Critical Review of Concepts and Definitions, Peabody Museum of American Archaeology, 1952, 35. 36 Edward B Tylor, Primitive culture, J Murray, 1871, 1. 37 See Lewis R Binford, ‘Post-​Pleinstocene adaptations’ (1968), in Sally R Binford and Lewis R Binford (eds), New Perspectives in Archaeology, Aldine, 1968, 373. 38 Bruce, M Tharp, ‘Defining “Culture” and “Organizational Culture”: From Anthropology to the Office (2009), Haworth. 39 Kroeber and Kluckhohn, n 35, 35. 40 For the literature on organizational culture, see, inter alia, Allan A Kennedy, and Terrence E Deal, Corporate Cultures as the Rites and Rituals of Corporate Life, Addison-​Wesley, 1982; Robert H Waterman, Jr and Tom Peters, In Search of Excellence: Lessons from America’s Best-​Run Companies, Harper & Row, 1982; Cary L Cooper, and Sue Cartwright, ‘The Role of Culture Compatibility in Successful Organizational Marriage’, Academy of Management Executive (1993), 7, 2, 57–​70; Kim

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Culture of Financial Institutions environments.41 In 1996, Lundy and Cowling offered a well-​known definition of culture as ‘the way we do things around here’.42 A more structured definition was given by Schein,43 as ‘a pattern of shared basic assumptions that was learned by a group . . . that has worked well enough to be considered valid and, therefore, to be taught to new members as the correct way to perceive, think, and feel in relation to problems’.44 The same view of culture as a collection of shared values and norms accepted by a given group was shared by Pettigrew,45 O’Really, and Chatman,46 and Brown.47 Some scholars described it as the software of an organization, a sort of ‘collective programming of the mind that distinguishes the members of one group or category of people from others’.48 Even though definitions of culture are numberless, Hofstede in 199049 identified 16.20 some common traits, describing culture as: (i) holistic; (ii) historically determined; (iii) related to anthropological concepts; (iv) socially constructed; (v) soft; and (vi) difficult to change. This last trait derives from another common assumption, which resides in the fact that culture is a multilevel concept, made of observable artefacts (visual organizational structure and processes), espoused values (strategies, goals, and philosophies), and basic assumptions (implicit beliefs, perceptions, and

S Cameron and Robert E Quinn, Diagnosing and Changing Organizational Culture, Prentice Hall Series in Organizational Development, 2011. 41 For a detailed review of some cultural theories developed by anthropologists, see Roger M Keesing, ‘Theories of Culture’, Annual Review of Anthropology (1974), 3, 1, 73–​97. 42 Olive Lundy and Alan Cowling, Strategic Human Resource Management, Routledge, 1996, 168. 43 Edgar Schein, Organizational Culture and Leadership, Jossey-​Bass, 2004, 17. 44 In literature, the term ‘climate’ is often used, and sometimes confused with the term ‘culture’. However, ‘climate’ refers to how things are, whereas culture concerns why things are the way they are. For a definition of climate, see Arnon E Reichers and Benjamin Schneider, ‘Climate and Culture:  An Evolution of Constructs’, in Benjamin Scheider (ed), Organizational Climate and Culture, Jossey Bass, 1990, 5–​39, and Michael W Grojean et al, ‘Leaders, Values, and Organizational Climate:  Examining Leadership Strategies for Establishing an Organizational Climate regarding Ethics’, Journal of Business Ethics (2004), 55, 3, 223–​41. For a further explanation on the difference between the two concepts, see Daniel R Denison, ‘What is the Difference between Organizational Culture and Organizational Climate? A Native’s Point of View on a Decade of Paradigm Wars’, The Academy of Management Review (1996), 21, 3, 619–​54. 45 Andrew M Pettigrew, ‘On Studying Organizational Cultures’, Administrative Science Quarterly (1979), 24, 4. Pettigrew conceives culture as the system of publicly and collectively accepted meanings operating for a given group at a given time. It is constituted of several concepts: symbol, language, ideology, belief, ritual, and myth. 46 Charles A O’Reilly and Jennifer A Chatman, ‘Culture as Social Control: Corporations, Culture, And Commitment’ (1996), in Barry M Staw, Larry L Cummings (eds), Research in Organizational Behaviours, 1996, JAI Press, 18, 157–​200, 166. According to the authors, corporate culture is ‘a system of shared values that define what is important, and norms that define appropriate attitudes and behaviours for organizational member’. 47 Andrew Brown, Organizational Culture, Pitman, 1995, 9, 33, 176. 48 Geert Hofstede, Cultures and Organizations: Software of the Mind, McGraw-​Hill, 1991, 4. 49 See Geert Hofstede, Culture’s Consequences:  International Differences in Work-​Related Values, Sage, 1980 and Geert Hofstede,‘Measuring Organizational Cultures: A Qualitative and Quantitative Study across Twenty Cases’, Administrative Science Quarterly (1990), 35, 1, 286–​316.

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Shanshan Zhu and Guido Ferrarini feelings).50 It can be visualized like an onion51—​the layers of which, from outside in, consist of symbols, heroes, rituals, and values52—​or an iceberg,53 the upper visible part of which is made of corporate artefacts, verbal and nonverbal behaviours, while the hidden part consists of basic beliefs, which are tacit and emotionally anchored.54 As a consequence, any cultural change in the organization should affect all levels, not only common practices—​which by themselves reveal little about an institution—​but also beliefs and values, which undoubtedly require longer time and a basic genetic compatibility among team members (that is the reason why the hiring function is so decisive). 16.21

Economists have developed a different approach to corporate culture since the ’90s, linking it to firm performance.55 For them culture is a means to economic efficiency serving as an informal and flexible tool to cope with new contingencies in a more cost-​effective way. Kreps stresses that corporate culture plays a role in firms’ game-​theoretic interactions involving incomplete contracts, coordination, reputation, unforeseen contingencies, and multiple equilibria.56 In this respect, corporate culture is useful to the extent that it helps to select among multiple equilibria categorizing unforeseen contingencies. By substituting explicit communication57 and homogenizing beliefs,58 culture leads to lower monitoring costs, faster coordination, and higher utility.59 This enables the organization to delegate more effectively 60 by providing—​in a sort of hereditary way—​‘the method, context, values, and language of learning, and the evolution of group and individual competences’.

50 Schein, n 43, 25–​37. 51 Hofstede, n 48. 52 Interestingly, even though values are at the core of the inner human behavioural motivations, shared perceived practices are the key determinants of the company’s culture and they are easier to shape. Indeed, values form mostly in early age, in family and school, while practices develop in adult life, generally in the workplace. See Waterman, and Peters, n 40. 53 Sackmann, n 8, 295–​317. 54 Sackmann calls for an in depth study of this hidden part of culture, since looking only at the most superficial part can be misleading. First, because corporate artefacts and behavioural manifestations often reveal nothing about the basic values and beliefs of the firm. Secondly, because same artefacts and manifestations can be found in different organizations, but they do not correspond to the same underlying cultural processes and principles. See Sackmann, n 8, 295–​317. 55 See, e.g., Hermalin, n 7; Guiso, Sapienza, and Zingales, n 6; Kotter and Heskett, n 7; Sorensen, n 7; Denison, n 7; Gordon and Di Tomaso, n 7. 56 David M Kreps (1990), ‘Corporate culture and economic theory’, in James E Alt, Kenneth A Shepsle (eds) Perspectives on Positive Political Economy, Cambridge University Press, 1990, 90–​143. 57 Jacques Cremer, ‘Corporate Culture and Shared Knowledge’, Industrial and Corporate Change (1993), 2, 3, 351–​86. 58 Of course, this standardizing process is stronger in smaller and older firms, among more important employees, Eric Van de Stein, ‘On the Origin of Shared Beliefs (and Corporate Culture)’, Ran Journal of Economics (2010), 41, 4, 617–​48. 59 Eric Van de Stein, ‘Culture Clash:  The Costs and Benefits of Homogeneity’, Management Science (2010), 56, 10, 171. 60 Thakor, n 9.

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Culture of Financial Institutions B. Diagnosing culture In addition to defining corporate culture, socio-​economic studies tried to diag- 16.22 nose it and to understand how it relates to corporate performance. These studies mainly used surveys and interviews, as well as group discussions and participant observation.61 As for corporate culture identification, Hofstede did one of the first empirical 16.23 studies and developed a model based on five dimensions differentiating one national culture from another: (i) power distance; (ii) collectivism versus individualism; (iii) femininity versus masculinity; and (iv) uncertainty avoidance. Two other dimensions have been added later, that is, long-​term orientation versus short-​ term orientation and indulgence versus restraint.62 This study’s ideas have been widely applied with some variations in other researches.63 Thakor64 diagnosed culture under the Competing Values Framework (CVF)65 and identified firm culture along four tendencies: (i) collaborative; (ii) competitive; (iii) control-​centred; and (iv) creative, which correspond respectively to: (i) a partnership culture; (ii) a competitive, individual-​performance-​oriented culture; (iii) a risk-​minimization culture; and (iv) a culture focused on product innovation and organic growth. According to Thakor, in order to shape the cultural structure of a firm, one should first be aware of these tendencies, of the intersections between them, and of the fact that the adoption of an approach automatically excludes another. Then the firm could hire, train, and allocate resources in accordance with the choice of one cultural model rather than another. If the current actors in the financial sector are analysed, it is immediately apparent that it is almost entirely shaped in terms of competitive culture. As for the relation between firm culture and performance, the prevailing research 16.24 claims that ‘strong corporate cultures’ lead to better firm performance, in line with the economists’ belief that high consistency in norms, values, and practices shared in a group leads to better coordination and control. Quantitative analyses have shown that in certain circumstances companies characterized by a strong culture, mostly measured by the consistency of responses to survey items across people, outperformed companies with a weak culture,66 and have a more stable (less variable) 61 About the different methods adopted, see Sackmann, n 8, 295–​317. 62 Geert Hofstede, Gert Jan Hofstede, and Michael Minkov, Cultures and Organizations: Software of the Mind, Rev 3rd ed, McGraw-​Hill, 2010, 235–​96. 63 See, e.g., the model designed by Paul J Hanges et al, Culture, Leadership, and Organizations. The Globe Study of 62 Societies, Sage, 2004. 64 Thakor, n 9. 65 Robert Quinn and Kim Cameron, ‘Organizational Life Cycles and Shifting Criteria for Effectiveness’, Management Science (1983), 29, 1, 33–​51. 66 Denison, n 7; Kotter and Heskett, n 7; G G Gordon and N Di Tomaso, ‘Predicting Corporate Performance from Organizational Culture’, Journal of Management Studies (1992), 29, 783–​99; and R S Burt et  al, ‘Contingent Organization as a Network Theory:  The Culture Performance Contingency Function’, Acta Sociologica (1994), 37, 345–​70.

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Shanshan Zhu and Guido Ferrarini performance in relatively stable environments.67 Graham et al68 published another significant empirical study based on an anonymous survey directed to detect how the role of culture was perceived within firms operating in several industries. The results highlighted that culture was considered important with reference to firm performance as well. 16.25

However, in almost all studies conducted on both culture diagnosing and on the relationship between corporate culture and performance, only CEOs, CFOs, and managers were interviewed, while other levels of the firm organization were not considered. Moreover, studying only the consistency in corporate behaviour does not give any information on the quality of firm culture. Short-​term strategies, illicit behaviour aimed at high profit at any cost became common goals and values in some top executives’ perceptions and their firms did not perform in a sustainable way.

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It can therefore be suggested that all (levels of ) employees’ convictions, practices, and opinions should be included in future studies in order to provide a wider and more complete vision of a company profile. Moreover, research studies should also evaluate the quality of the relevant culture, in order to assess its sustainability towards companies’ stakeholders in the long run.

III.  Governing Corporate Culture: (A) Leadership 16.27

Some legal scholars have found a correlation between corporate governance structures, in terms of shareholder voting rights and creditor protection, and national cultures. Licht, in particular, criticized the La Porta et al law and finance approach,69 arguing that legal cultures cannot just be divided into those protecting shareholders and creditors’ rights (common law systems) [better] than others (civil law systems). Indeed, there are other national cultural traits, already classified by Schwartz70 and Hofstede, such as Harmony vs Mastery or Individualism vs Collectivism, which inevitably affect corporate governance structures and regulation, and which prevent the predicted convergence towards the American-​style culture.71

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This chapter, however, focuses on specific organizational and cultural factors, already analysed by social and management studies, that determine the corporate structure of a firm. Some of them—​such as leadership, incentives, codes of conduct,

67 Sørensen, n 7. 68 Graham et al, n 8. 69 Rafael La Porta et al, ‘Investor Protection and Corporate Governance’, Journal of Financial Economics (2000), 58, 3–​27. 70 Shalom H Schwartz, ‘A Theory of Cultural Value Orientations: Explication and Applications’, Comparative Sociology, (2006), 5 (2–​3), 137–​82. 71 Amir N Licht, Chanan Goldschmidt, and Shalom H Schwartz, ‘Culture, Law and Corporate Governance’, International Review of Law and Economics, (2005), 2–​5, 229–​55.

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Culture of Financial Institutions and group dynamics—​play a determinant role in the long-​term sustainability of a business, with respect to both internal and external stakeholders, but usually are just ignored by corporate governance and economic studies. A. Tone at the top A firm’s identity is largely shaped by the rules and practices enacted by the person 16.29 who is in charge, the so-​called ‘leader’. We might call it either ‘tone at the top’72—​if we want to emphasize a leader’s statements and appearance—​or ‘character at the top’73 focusing on the leader’s behaviour. However, there is no doubt that his or her personality, charisma, and authority influence board composition and practices,74 as well as employees’ behaviours and habits at all levels. That is why the hiring processes, training courses, and remuneration schemes were recently put under the spotlight within organizations’ dynamics. Since leaders design the ‘soul’ of an organization by transmitting their values and 16.30 beliefs to the corporate structure,75 they can also encourage their subordinates to carry out unethical behaviour76 by sending messages that influence their readiness to comply with legal and/​or ethical standards.77 It is enough here to consider the case of John Gutfreund, CEO of Salomon Brothers, whose ‘leadership led to a culture that was tailor-​made for greedy and power-​hungry employees whose commitment to ethical behaviour was suspect’.78 Gutfreund sent very clear but wrong messages to his employees by rewarding aggressiveness and linking the incentive system to the bank’s short-​term performance. He reacted to crises in the organization by covering-​up illicit behaviours and made betrayal the key to his success in the company. 79 His policies for promoting and firing employees were vague. As a

72 William C Dudley, Remarks at the workshop on ‘Reforming Culture and Behaviours in the Financial Services Industry’, Federal Reserve Bank of New York, New York City, 20 October 2014. 73 Thomas C Baxter, ‘The Rewards of an Ethical Culture’, Remarks at the Bank of England, London, 20 January 2015. 74 Gary Abrahams, Joanne Horton, and Yuval Millo, ‘The Dynamics of Managerial Entrenchment: The Corporate Governance Failure in Anglo-​Irish Bank’, 2017, available at https://​ ssrn.com/​abstract=2955610, accessed 10 September 2018. 75 See, e.g., Van de Stein, n 58 and Schein, n 43, 25–​37. 76 See, Lo, n 9;Ronald R Sims and Johannes Brinkman, ‘Leaders as Moral Role Models:  The Case of John Gutfreund at Salomon Brothers’, Journal of Business Ethics (2002), 35, 4, 327–​39; and Lorenzo Patelli and Matteo Pedrini, ‘Is the tone at the top associated with financial reporting aggressiveness?’, Journal of Business Ethics (2015), 126, 1, 3–​19. 77 Tom R Tyler and Steven L Blader, ‘The Group Engagement Model: Procedural Justice, Social Identity, and Cooperative Behaviour’, Personality and Social Psychology Review (2003), 7, 349. 78 Sims and Brinkman, n 76, 327–​39. 79 He sold the company to Philip Brothers without even telling to the owner of Salomon Brothers, Billy Salomon. See Sims and Brinkman, n 76.

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Shanshan Zhu and Guido Ferrarini result of this leadership and management style, Salomon Brothers ran into what became known as the Treasury bond scandal of the ’90s.80 16.31

Dysfunctional leadership also characterized the history of Deutsche Bank in the last two decades and the scandals in which it was embroiled.81 The cultural shift from the traditional German bank to an Anglo-​American style investment bank after 1994 provoked an identity crisis, which resulted in the appointment of an all-​powerful CEO, Josef Ackermann, and of senior managers like Edson Mitchell, who once introduced himself as ‘God’, in addition to many traders hired directly from the United States.82 Wrongly incentivized employees, a weak compliance function, inadequate risk management, and lack of internal controls created the perfect conditions for the bank to take part in many illicit and abusive practices.83

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Wells Fargo and its Chairman and Chief Executive Officer John Stumpf offer another meaningful example. The latter managed the bank according to the ‘Gr-​Eight’ philosophy,84 setting up a high-​pressure environment, which ultimately led first-​line employees to open more than two million fake accounts. The toxicity of the bank’s corporate culture was so deeply engrained that during his testimony before the House’s Financial Services Committee Stumpf claimed, with no shame nor sense of guilt, that he ‘care(ed) about outcomes, not process’.85 It is no wonder that it was then reported that many employees had been fired after speaking-​up about the unethical practices carried out within the firm, and that a petition, signed by five thousands employees, had just been ignored during the years preceding the outbreak of the Wells Fargo scandal.86

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The topic of the ‘imperial CEO’ has been largely studied by scholars in the last decades.87 It is worth noticing in this regard that a recent judgment of the Milan

80 In 1991, John Gutfreund, John Meriwether (President of Salomon from 1986 to 1991), and Thomas Strauss (Vice Chairman of Salomon) went under SEC investigation (No 3-​7930) for violation of their supervisory responsibilities on firm employees. In particular, after being informed by Donald Feuerstein, the firm’s chief legal officer, about the submission of false bids in US Treasury Securities by Paul Mozer, the head of the firm’s Government Trading Desk, they did not take action and did not report the information to the government. 81 Ullrich Fichtner, Hauke Goos, Martin Hesse, ‘The Deutsche Bank Downfall. How a Pillar of German Banking Lost Its Way’, Spiegel Online, 28 October 2016, available at http://​www.spiegel. de/​international/​business/​the-​story-​of-​the-​self-​destruction-​of-​deutsche-​bank-​a-​1118157.html, accessed 10 September 2018. 82 ibid. 83 ibid. 84 This is the bank’s internal goal of selling at least eight different financial products to each customer; see https://​www.theguardian.com/​business/​us-​money-​blog/​2016/​sep/​22/​wells-​fargo-​ scandal-​john-​stumpf-​elizabeth-​warren-​senate, accessed 10 September 2018. 85 Ochs, n 1. 86 ibid. 87 Brian R Cheffins, ‘The Corporate Governance Movement, Banks and the Financial Crisis’, ECGI Law Working Paper No 232/​2014; University of Cambridge Faculty of Law Research Paper

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Culture of Financial Institutions Tribunal88 upheld the decision of an international company leader in the insurance brokerage and risk-​management sectors, to fire its CEO because of the corporate climate he had built in the company—​which was described as ‘unnecessarily authoritarian’ and ‘de-​motivating’, while abuse of power and of competencies were the rule—​despite the fact that he had led the company to huge profits and to a better market position than previously. Those just reported are simply a few examples of rotten practices at financial insti- 16.34 tutions which were widely acknowledged by policymakers and supervisors in their recent statements and reports. Sutherland89 was the first scholar to acknowledge that criminal offences committed by white-​collars workers are as frequent as the crimes committed by lower-​class individuals, but less prosecuted and punished than the latter. In his opinion, the reaction of society and even of the crime perpetrators once convicted seemed to be rather weak considering the serious consequences produced by the same; which sounded as absurd given that ‘the financial cost of white-​collar crime is probably several times as great as the financial cost of the crimes which are customarily regarded as the crime problem’.90 A possible explanation is that the lack of physical harm and the ‘abstractness’ of the crime make us perceive these kinds of offences as different,91 which can also explain the lack of guilt that offenders feel after being convicted. A rich literature links bad leadership to bad firm performance.92 Managerial over-​ 16.35 optimism, overconfidence, dominance, narcissism, arrogance, self-​absorption, and miscalibration are some of the common traits describing unethical and ineffective leadership.93 Brennan and Conroy analysed a bank CEO’s letters to shareholders included in annual reports, finding evidence of narcissistic and hubris symptoms from a clinical perspective.94 Other studies proved that a substantial percentage of corporate executives present psychopathic traits, which are commonly perceived

No 56/​2013, available at https://​ssrn.com/​abstract=2365738, accessed 10 September 2018 or http://​dx.doi.org/​10.2139/​ssrn.2365738, accessed 10 September 2018. 88 Tribunale di Milano, No 10334/​2014 RG, Uberto Ventura c Aon Global Emea. 89 Edwin H Sutherland, ‘White-​Collar Criminality’, American Sociological Review (1940), 5,  1–​12. 90 Edwin H Sutherland, ‘Hits Criminality in White Collars’, New  York Times, December 28, 1939; see also S R Donziger, The real war on crime:  The report of the National Criminal justice Commission, Harper Perennial, 1996. 91 Guy Rolnik, ‘What Differentiates White-​Collar Criminals From Other Executives? A Q&A With Eugene Soltes’, Promarket.org, 19 October 2016. 92 See Jakob de Haan and David-​Jan Jansen, ‘Corporate Culture and Behaviour:  A Survey’ De Nederlandsche Bank Working Paper No. 334/​ 2011, 6.  Available at https://​ssrn.com/​abstract=1979326, accessed 10 September 2018 or http://​dx.doi.org/​10.2139/​ssrn.1979326, accessed 10 September 2018. 93 ibid,  6–​8. 94 Niamh M Brennan and John P Conroy, ‘Executive Hubris:  The Case of a Bank CEO’, Accounting, Auditing & Accountability Journal (2013), 26, 172–​95.

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Shanshan Zhu and Guido Ferrarini as associated with ‘good communication skills, strategic thinking, and creative/​innovative ability’.95 To give an idea of CEOs’ overconfidence, an unnamed executive of Anglo-​Irish Bank, one of the first casualties in the banking crisis, was quoted as saying that the bank CEO, Sean Fitzpatrick, ‘began to think he could walk on water’.96 Similarly it was reported that Goldman Sachs’ Chief Executive, Lloyd Blankfein, while defending bankers’ high compensation, stated he was just ‘doing God’s work’.97 B. The ethical leader 16.36

Given that leaders might compromise a firm’s future performance and reputation, as they influence workers’ behaviour, they should first be looked at for establishing an ethical corporate culture.98 William Dudley similarly noted that ‘the problems originate from the culture of firms, and this culture is largely shaped by the firms’ leadership’, 99 so that solutions ‘need to originate from within the firms, from their leaders’. This topic has been developed by the literature on transformational leadership, which was defined as the process in which ‘leaders and followers help each other to advance to a higher level of morale and motivation’.100

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Other leadership theories have followed a different path,101 such as transactional leadership, which is a performance-​based system where employees are rewarded for reaching performance objectives agreed through contracts, without a long-​term

95 Paul Babiak, Craig S Neumann, and Robert D Hare, ‘Corporate Psychopathy: Talking the Walk’ Behavioural Sciences and the Law (2010), 28, 174–​93. 96 Shane Ross, The Bankers: How the Banks Brought Ireland to its Knees, Penguin, 2010. 97 Matt Phillips, ‘Goldman Sachs’ Blankfein on Banking:  “Doing God’s Work” ’, Wall Street Journal, 9 November 2009 https://​blogs.wsj.com/​marketbeat/​2009/​11/​09/​goldman-​sachs-​ blankfein-​on-​banking-​doing-​gods-​work/​, accessed 10 September 2018. 98 Ronald R Sims, ‘The Challenge of Ethical Behaviour in Organizations’, Journal of Business Ethics (1992), 11, 505–​13; Lynn Sharp Paine, Cases in Leadership, Ethics, and Organizational Integrity: A Strategic Perspective, Irwin, 1997; and W Edward Stead, Dan L Worrell, and Jean Garner Stead, ‘An Integrative Model For Understanding and Managing Ethical Behaviour in Business Organizations’, Journal of Business Ethics (1990), 9, 233–​42. 99 Dudley, n 11. 100 James MacGregor Burns, Leadership, Harper and Row, 1997, 20. 101 Among these are, the Great Man theory, Trait theory, Contingency theory, Situational Leadership, Behavioural theories, and Transactional theory. For a review on leadership theories and styles, see Rose Ngozi Amanchukwu et al, ‘A Review of Leadership Theories, Principles and Styles and their Relevance to Educational Management’, Management (2005), 5, 1, 6–​14; and Richard Bolden et al, ‘A Review of Leadership Theory and Competency Frameworks’, Centre for Leadership Studies, (2003). For a comparison between transactional and transformational leadership theories, see Bernard M Bass, ‘From Transactional to Transformational Leadership: Learning to Share the Vision’, Organizational Dynamics (1990), 18, 3, 19–​31. For a critical response, see Colin W Evers and Gabriele Lakomski, Exploring educational administration: Coherentist applications and critical debates, Elsevier Science, 1996; and Gary Yukl, ‘An Evaluation of Conceptual Weaknesses in Transformational and Charismatic Leadership Theories’, Leadership Quarterly (1999), 10, 2, 285–​305.

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Culture of Financial Institutions vision or high social purpose.102 This type of approach, focusing on the fulfilment of performance goals in view of the organization members’ and leaders’ selfish needs, has dominated the financial industry over the last decades. In contrast, transformational leadership would require leaders and employees to set aside their self-​interests and move ‘toward higher and more universal needs and purposes’,103 to a sense of mission, by means of charisma, inspirational motivation, intellectual stimulation, and individualized consideration.104 CEO’s ability to intellectually stimulate the firm’s employees, inducing them to question old assumptions and beliefs so as to deal with new contingencies in an innovative way,105 seems to determine the firm’s propensity to engage in corporate social responsibilities (CSR). The notion of ‘ethical leader’ combines transformational leadership with engage- 16.38 ment in CSR issues. Reference is made to the honest, trustworthy decision maker, who behaves ethically in her personal and professional life, by frequently communicating values to followers, setting clear ethical standards, role modelling, and using the reward system linked to those standards.106 Grojean et al identify several ways leaders may transmit ethical values to members of an organization.107 They pay special attention to the establishment of a clear vision through codes of conduct enforced by training courses and coaching. Another famous distinction between management styles was developed by 16.39 McGregor, who labelled two kinds of leadership styles as Theory X and Theory Y.108 Leaders following Theory X structure their organization on the assumption that workers dislike their work, are lazy, and can only be motivated by money. Under this pessimistic view, leaders set up strict rules and controls, performance appraisals, and ‘carrot and stick’ schemes. On the contrary, those following Theory Y believe that their employees like their job, are moved by purpose, are happy to take initiatives, and can be self-​motivated by their own passion. This optimistic view assumes a strong relationship of trust, which leads to a collaborative, innovative, and happier workplace. According to McGregor’s view, workers will adapt

102 Bernard M Bass and Bruce J Avolio, Improving organizational effectiveness through transformational leadership, Sage, 1994. 103 Lee G Bolman and Terry Deal, Reframing Organizations. Artistry, Choice and Leadership, Jossey Bass, 1997, 2nd ed, 314. 104 Bass, n 101, 19–​31. 105 See Bernard M Bass, ‘Does the Transactional-​ Transformational Leadership Paradigm Transcend Organizational and National Boundaries?’, American Psychologist (1997), 52, 130–​9. 106 Michael E Brown and Linda K Trevino, ‘Ethical Leadership: A Review and Future Directions’, The Leadership Quarterly (2006), 17, 595–​616. 107 See Grojean et al, n 44, 223–​41. They make reference to the following ways of transmitting ethical values: (i) use values-​based leadership; (ii) set the example; (iii) establish clear expectations of ethical conduct; (iv) provide feedback, coaching, and support organizational values; (v) recognize and reward behaviours that support organizational values; (vi) be aware of individual differences among subordinates; (vii) establish leader training and mentoring. 108 Douglas McGregor, The Human Side of Enterprise, McGraw-​Hill, 1960, 45–​77.

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Shanshan Zhu and Guido Ferrarini their values and behaviour to the expectations set by the leaders. Fear will lead to fear, whereas trust will develop a trustworthy workforce. 16.40

In the case of financial institutions, therefore, executives should first set a higher purpose transcending financial results, such as serving customers, employees, or society’s interests.109 Second, they should get to know their institution by conducting a cultural diagnostic survey110 to identify culture groups within it.111 Third, they should better communicate with lower levels, so as to prevent the establishment of subcultures conflicting with the main culture.112 In the London Interbank Offered Rate (LIBOR) and Foreign Exchange (FOREX) manipulation scandals, for instance, unlawful practices spread out across banks horizontally through strong traders’ networks with no control by senior management.113 Fourth, caution has been suggested before finalizing a merger, since the compatibility between firms’ cultures should be tested in advance.114 Of course, the adoption of a leadership style and strategy should take into account the dimension and business model of the financial institution, as well as the national culture in which it operates.

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To conclude this brief review on leadership, neuroscientific studies analyse brain processes influencing moral judgement115 and offer tools which in theory could be used to assess the leaders’ profiles—​other than through traditional surveys and interviews—​and to enhance ethical leadership.116 Just to mention a few, a high degree of frontal right hemisphere coherence—​which is defined as the coordinated electrodes’ activity in the right frontal region of the brain measured by means of quantitative electroencephalogram (qEEG) technique—​has been found to be

109 Thakor, n 9. 110 ibid. 111 Alan D Morrison and Joel D Shapiro, ‘Governance and Culture in the Banking Sector’, 2016, available at https://​ssrn.com/​abstract=2731357, accessed 10 September 2018. 112 In this regard, Mulasem talked about the presence of ‘silos’ and ‘tribes’. See Remarks by Alberto G Musalem, Executive Vice President of the Integrated Policy Analysis Group of the Federal Reserve Bank of New York, at the Institute of Law and Finance conference ‘Towards a New Age of Responsibility in Banking and Finance:  Getting the Culture and the Ethics Right’, Goethe-​ University, Frankfurt am Main, 23 November 2015. 113 ibid. 114 See Thakor, n 9. 115 See, e.g., Matthew D Lieberman, ‘Social Cognitive Neuroscience: A Review of Core Processes’, Annual Review of Psychology (2007), 58, 259–​89; Joshua D Greene et al, ‘An FMRI Investigation of Emotional Engagement in Moral Judgment’, Science, (2001), 293, 2105–​8; Hauke R Heekeren et al, ‘An FMRI Study of Simple Ethical Decision-​Making’, Neuroreport (2003), 14, 1215–​19; Jorge Moll et al, ‘The Neural Correlates of Moral Sensitivity: A Functional Magnetic Resonance Imaging Investigation of Basic and Moral Emotions’, Journal of Neuroscience (2002), 22, 2730–​6; Christian Voegtlin and Ina Maria Kaufmann, ‘Neuroscience Research and Ethical Leadership: Insights from an Advanced Neurological Micro Foundation’, 2002, paper presented at the Society for Business Ethics Annual Meeting, Boston 2012. 116 David A Waldman, Pierre A Balthazard, and Suzanne J Peterson, ‘The Neuroscience of Leadership: Can We Revolutionize the Way that Leaders are Identified and Developed?’, Academy of Management Perspectives (2011), 25, 1, 60–​74.

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Culture of Financial Institutions related to greater emotional balance and socialized vision of the future. Similarly, the analyses of chemicals in the brain may allow to develop new individual-​specific leadership development programmes.117 Coaching and training should therefore be promoted for developing ethical leadership skills.118

IV.  Governing Corporate Culture: (B) Managerial Incentives A. Traditional theories In order to reshape behaviour in the financial sector, remuneration should also 16.42 be reconsidered. Following agency cost theory,119 incentive compensation is traditionally regarded as the fundamental means for aligning the interests of shareholders and managers, on the assumption that individuals are mere self-​interested utility maximizers. However, there are limitations to this approach. Firstly, it usually focuses on executive remuneration, without considering the compensation of ‘non-​boardroom’ employees,120 who are however taken into account by financial regulation to the extent that they are risk-​takers.121 In addition, agency theory tends to overlook that corporate performance is influenced not only by managerial compensation, but also by group dynamics and social context.122 For instance, O’Really and Main123 argue that CEOs influence the board of directors when determining their compensation through two psychological mechanisms. The first is reciprocity, as shown by the evidence that CEOs receive higher cash compensation when the Chairman of the compensation committee is remunerated more. The second mechanism is social influence, as shown by the fact that CEOs’ compensation is higher when they also serve as board chairmen (a practice which is however open to criticism).124 In other words, under the agency cost theory culture of the firm is

117 Waldman, Balthazard, and Peterson, n 116. 118 Voegtlin and Kaufmann, n 115. 119 Michael C Jensen and William H Meckling, ‘Theory of the Firm:  Managerial Behaviour, Agency Costs, and Ownership Structure’, Journal of Financial Economics (1976), 3, 305–​60; Eugene Fama, ‘Agency Problems and the Theory of the Firm’, Journal of Political Economy (1980), 88, 288–​307; Eugene Fama and Michael C Jensen, ‘Separation of Ownership and Control’, Journal of Law and Economics (1983), 26, 327–​49. 120 See Ian Larkin, Lamar Pierce, and Francesca Gino, ‘The Psychological Costs of Pay-​For-​ Performance: Implications for the Strategic Compensation of Employees’, Strategic Management Journal (2012), 33, 1194–​214. 121 See Guido Ferrarini, Chapter 11, this volume. 122 See Larkin, Pierce and Gino, n 120, 1194–​214; and John Roberts, Terry McNulty, and Philip Stiles, ‘Beyond Agency Conceptions of the Work of the Non-​Executive Director: Creating Accountability in the Boardroom’, British Journal of Management (2005), 16, 5–​26. 123 Brian G Main, Charles A O’Reilly, and James Wade, ‘Economic and Psychological Perspectives on CEO Compensation: A Review and Syntheses’, Industrial and Corporate Change (2010), 9, 3, 675–​712. 124 ibid.

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Shanshan Zhu and Guido Ferrarini not considered, even though this represents ‘the connector between incentive and actions’.125 16.43

Agency theory also overlooks the fact that the link between money, motivation, and performance does not always work in the direction that might be expected. Economists, with the exception of behaviourists, often do not consider the psychological mechanisms which limit rationality and therefore the reaction to economic incentives.126 Kamenica, by reviewing experiments in social psychology, identified four situations in which the idea that monetary incentives lead to better performance may fail.127 Motivation and performance may decrease when: (i) the task is inherently interesting, but monetary incentives are introduced after a certain period of time;128 (ii) the task is noble and money is paid;129 (iii) the salary is either too high;130 or (iv) too low.131

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The experimental studies on which these findings are based often focused on tasks of a kind very distant from those usually performed in the financial sector. They nonetheless show the complex relationship between monetary incentive and motivation. Besides, empirical evidence confirms these psychological findings by showing that monetary incentives are not always associated with increased effort and, therefore, better performance. For example, Bonner et al, by reviewing 131 laboratory studies on incentives, found that incentives improved performance only in half of the studies and that the positive effect of monetary incentives decreased as the complexity of the task increased, where good cognitive strategy skills instead of strong motivation was required.132

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Bénabou and Tirole similarly stress that, because of the ‘forbidden fruit’ psychological principle, high rewards are associated with less attractive tasks and that

125 Andreas Dombret, ‘Why Focus on Culture?’, in Patrick S Kenadjian and Andreas Dombret (eds), Getting the Culture and the Ethics Right—​Towards a new age of responsibility in banking and finance, De Gruyter, 2016, 15. 126 Christopher Hodges, Law and Corporate Behaviour, Hart, 2015, 25. 127 See Emir Kamenica, ‘Behavioural Economics and Psychology of Incentives’, Annual Review of Economics (2012), 4, 13.1–​13.26. 128 Through some laboratory experiments, Deci found that when money is used as an external reward for an intrinsically interesting activity, people’s intrinsic motivation for performing that activity decreases: Edward L Deci, ‘The Effects of Externally Mediated Rewards on Intrinsic Motivation’, Journal of Personality and Social Psychology (1971), 18 (1), 105–​15. 129 In an experiment, Titmuss found that when the task is noble (in the experiment, the task represented was to undergo some exams to become blood donors), under some circumstances the introduction of monetary incentive decreased women’s inclination to perform the task. See Richard Titmuss, The Gift Relationship: From Human Blood to Social Policy, Allen & Unwin, 1970. 130 ‘Paying a very high wage contingent on the successful completion of a task can lead the worker to become so nervous that she is unable to get the task done’, Kamenica, n 127, 13.1–​13.26. 131 Many experiments suggested that offering no money is better than too little. See ibid. 132 Sara E Bonner et  al, ‘A Review of the Effects of Financial Incentives on Performance in Laboratory Tasks: Implications for Management Accounting’, Journal of Management Accounting Research (2000), 13, 19–​64. See also Colin F Camerer and Robin M Hogarth, ‘The Effects of Financial Incentives in Experiments: A Review and Capital Labor Production Framework’, Journal

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Culture of Financial Institutions offering rewards can be counterproductive in the long run, even though it can boost performance as an immediate effect.133 Similarly Deci, on the basis of several experiments with rats, showed that certain 16.46 external monetary rewards, at given stages, decrease the intrinsic motivation, in opposition to other non-​monetary rewards, such as social approval, because of people’s perception of the locus of control (the rationale) of their behaviours.134 This ‘overjustification effect’ was also commented on as saying that money can have a positive or negative effect, depending on the moment it is offered and the related information to agents.135 Monetary incentives can either increase intrinsic motivation, if perceived as providing information about the agents’ ability, or be counterproductive if seen as a means of control. B. A broader perspective Motivational processes, therefore, should be at the core of studies on incentive schemes. 16.47 In 1943, Maslow had already developed a motivational theory according to which human beings satisfy three related sets of personal goals, in the following order: basic (physiological and safety) needs; psychological (esteem and belongingness) needs; and self-​fulfilment needs.136 In this hierarchical model, based on the Aristotelian approach,137 the necessities at the top cannot be satisfied without first realizing those on lower levels. When applied to compensation issues, this theory suggests that employees should be paid fairly and that the working environment should enhance security and a culture of respect and dignity for all team members, rather than promoting aggressiveness and sense of danger. In addition, employees should receive periodic feedback concerning their work and be motivated through a prospect of self-​potential achievement. Similarly, Herzberg’s Two-​Factors Theory138 specifically addressed employees’ mo- 16.48 tivational strategies. Herzberg viewed basic needs (such as those related to working conditions, status, job security, salary, and fringe benefits) as simple hygiene factors, the absence of which may create dissatisfaction, but the increase of which does not boost motivation. Being indispensable, they are different to those factors of Risk and Uncertainty (1999), 19, 7–​42; Karl Duncker, ‘On Problem Solving’, Psychological monographs (1945), 58. 133 Roland Bénabou and Jean Tirole, ‘Intrinsic and Extrinsic Motivation’, The Review of Economic Studies (2003), 70, 3, 489–​520. 134 Deci, n 128, 105–​15. 135 Uco J Wiersma, ‘The Effects of Extrinsic Rewards in Intrinsic Motivation: A Meta-​Analysis’, Journal of Occupational and Organizational Psychology (1992), 65, 2, 101–​14. 136 Abraham H Maslow, ‘A Theory of Human Motivation’, Psychological Review (1943) 50, 370–​96. 137 Maslow often cited Aristotelian moral philosophy in his studies. See A Maslow, Motivation and personality, Harper and Row, 1987, 3, 270–​1. 138 Frederick Herzberg, Bernard Mausner, and Barbara Bloch, The Motivation to Work, Wiley, 1959.

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Shanshan Zhu and Guido Ferrarini (such as recognition, good relationships, and growth potential) which provide extra-​motivation. Moreover, satisfaction and dissatisfaction are not necessarily interrelated. Getting promoted, for example, does not decrease the dissatisfaction deriving from bad working conditions, while an increase in salary does not translate into job satisfaction. 16.49

Furthermore, several factors—​in addition to and sometimes more effectively than money and rewards—​can be decisive in inducing people to act in a given way, such as making a desired behaviour the default option or performing priming interventions.139 Delegating and giving more autonomy can boost the agents’ intrinsic motivation, self-​confidence, and self-​determination, if perceived as an expression of trust in the agents’ professional skills and competence.140 Providing good and immediate feedback may also help employees to better internalize certain practices.141 Of course, whether similar steps are successful also depends on the nature of the tasks and may be more effective in jobs involving creative skills.142 In addition, modifying situational factors can influence decision-​making processes under so-​ called ‘choice architecture’.143

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The history and values of each national culture also interfere with the way in which motivation and economic incentives determine individual behaviour. In China, for example, people have weak trust in government and politics, which makes some indirect and long-​term benefits (such as life insurance, education subsidy and vacation leave) less attractive and motivating to the Chinese144 than short-​term compensation in cash, bonuses, or housing.145 Further examples of how compensation structures are linked with the diverse social values engrained in national cultures were offered by other scholars146 based on the cultural dimensions theory developed by Hofstede.147 Organizations in high power distance countries, such as France,

139 Through a priming intervention a person’s behaviour can be influenced by exposing him to a particular stimulus, in an explicit, implicit, or subliminal way. See Kamenica, n 127, 13.1–​13.26. 140 See Bénabou and Tirole, n 133, 489–​520. 141 Richard H Thaler and Cass R Sunstein, Nudge, Yale University Press, 2008, 82. 142 David M Kreps, ‘Intrinsic Motivation and Extrinsic Incentives’, The American Economic Review (1997), 87, 2, 359–​64. 143 FCA, ‘Behaviour and Compliance in Organisations’, Occasional Paper 24/​2016; Kamenica, n 127, 13.1–​13.26. On how to influence people’s behaviour, see also, e.g., Robert B Cialdini, Influence: The Psychology of Persuasion, William Morrow, 1993. 144 Randy K Chiu, Vivienne Wai‐Mei Luk, and Thomas Li‐Ping Tang, ‘Retaining and motivating employees. Compensation preferences in Hong Kong and China’, Personnel Review (2002), 31, 4, 402–​31. 145 Martin J Conyon and Lerong He, ‘CEO Compensation and Corporate Governance in China’, Corporate Governance: An International Review (2012), 20, 575–​92; and Chiu, Wai‐Mei Luk and Li‐Ping Tang, n 144, 402–​31. 146 Henry L Tosi and Thomas Greckhamer, ‘Culture and CEO Compensation’, Organization Science (2004), 15, 6, 657–​70. 147 Geert Hofstede, Culture’s Consequences:  International Differences in Work-​ Related Values, Sage, 1980.

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Culture of Financial Institutions have higher CEO pay and a lower proportion of variable pay over total compensation than low power distance countries such as Sweden. Similarly, more individualistic countries, such as the United States, show higher CEO pay and higher proportion of variable compensation to total CEO compensation than collectivist countries, such as Taiwan. Societies high in uncertainty avoidance, such as Japan and Germany, present a lower proportion of variable compensation to total compensation than countries with weaker compliance to rules and authority, such as the United States. Consistently with these findings, Herkenoff found that a rather strong collectivist culture in Zanzibar drove local employees of a Swiss-​owned company to prefer an hourly wage rather than the pay-​for-​performance compensation offered to them.148 In addition, every week they pooled all wages earned and divided them up equally amongst all employees. Motivation varies within groups working at different levels of an organization too, 16.51 and in different historical periods.149 Surveys conducted for 1946, 1980, 1986, and 1992 on motivational factors in the work environment revealed how motivational determinants change over the years150 and vary especially in relation to the gender, income, and occupational position of individuals.151 To draw a preliminary conclusion, remuneration and incentives are multifaceted 16.52 concepts. Far from suggesting a radically new model of compensation, it is recommended that firms in general and financial institutions in particular follow an approach where the psychological mechanisms and the cultural factors influencing people’s motivation and decision making are duly taken into account. Future practices will also benefit from advances in neurosciences, given that brain scanning methods and other techniques are already showing the biases on which current reward policies are built152 and the reasons why an evidence-​based approach would be preferable. Also, regulation in this sector should be reviewed, starting from the international principles, since motivational factors depend on national cultures, gender, and occupation of the individuals concerned, and time in history. The FSB

148 Linda Herkenhoff, ‘Culture:  The Missing Link Between Remuneration and Motivation’, World at Work Journal Third Quarter (2014), 6–​15. 149 Carolyn Wiley, ‘What Motivates Employees According to Over 40 Years of Motivation Surveys’, International Journal of Manpower (1995), 18, 3, 263–​80. 150 In 1946, the most important factor among employees was represented by appreciation for the work done; in 1980 and 1986, having interesting work was decisive; and in 1992, a good wage became the factor of major concern. 151 In the 1992 survey, results showed that women gave more importance to appreciation than males, who were more concerned about interesting work; sympathy in understanding personal problems was particularly significant for low income groups and plant employees. 152 Shan Luo et al, ‘Behavioral and Neural Evidence of Incentive Bias for Immediate Rewards Relative to Preference-​Matched Delayed Rewards’, The Journal of Neuroscience:  The Official Journal of the Society for Neuroscience (2009), 29, 47, 14820, available at http://​doi.org/​10.1523/​ JNEUROSCI.4261-​09.2009, accessed 10 September 2018.

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Shanshan Zhu and Guido Ferrarini Principles and Standards for Sound Compensation Practices and the CRD IV provisions should therefore be re-​examined in light of the considerations above.

V.  Governing Corporate Culture: (C) Codes of Conduct A. A global practice 16.53

Over the years, professional associations and individual firms (both financial and non-​financial)153 have drafted many ‘codes of conduct’, ‘codes of ethics’, ‘statements of business principles’, and ‘charters’154 modelling the organizational culture of corporations in order to prevent future misbehaviour. Most firms have been pressured to adopt codes of conduct by legislation, the media, their shareholders and/​or stakeholders.155 The Corporate governance principles for banks issued by the Basel Committee on Banking Supervision (BCBS) in 2015 exhort banks to adopt internal codes of conduct and practice guidelines.156

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This chapter has analysed the data published by the thirty systemically important banks (G-​SIBs) identified by the FSB on their websites and found (Table 16.1) that almost all banks based in Europe and the United States have adopted either a code of ethics or a code of conduct.157 Asian banks, especially in China, are less compliant with this requirement. However, ethical issues and concerns are obviously not ignored by banks in these countries. The China Banking Regulatory Commission, in particular, issued a Guidance on Professional Conducts for Staff

153 These include, for example: the Chartered Financial Analyst (CFA) Institute Code of Ethics and Standards of Professional Conduct; the Chartered Institute for Securities and Investment Code of Conduct; the Alternative Investment Management Association Guides to Sound Practices; the European Code of Good Conduct for Microcredit Provision; the United Nations Global Compact; the Organization for Economic Cooperation and Development Guidelines for Multinational Enterprises; and the International Organisation for Standardisation (ISO) environmental management system standards. 154 For a brief review on terminology used to indicate this kind of codes and how variations in the usage of the terms could lead to methodological deficiencies, see Muel Kaptein and Mark S Schwartz, ‘The Effectiveness of Business Codes:  A Critical Examination of Existing Studies and the Development of an Integrated Research Model’, Journal of Business Ethics (2008), 77, 111–​27. 155 Sandra A Waddock, Charles Bodwell, and Samuel B Graves, ‘Responsibility:  The New Business Imperative’, Academy of Management Executive (2002), 16, 132–​47; Mark S Schwartz, ‘Effective Corporate Codes of Ethics: Perceptions of Code Users’ Journal of Business Ethics (2004), 55, 323–​43. 156 Basel Committee on Banking Supervision (BCBS), ‘Corporate governance principles for banks’, 1915, 30, 135. 157 FSB, ‘2016 list of global systemically important banks (G-​SIBs)’, November 2016, available at http://​www.fsb.org/​2016/​11/​2016-​list-​of-​global-​systemically-​important-​banks-​g-​sibs/​, accessed 10 September 2018.

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Culture of Financial Institutions Table 16.1 G-​SIBs: Codes of conducts and ethics Bank

Country

Code of conduct or Code of Ethics

Waivers/​ exceptions

1) Citigroup

US

Yes

2) JP Morgan Chase

US

3) Bank of America

US

4) BNP Paribas 5) Deutsche Bank 6) HSBC

France Germany UK

7) Barclays

UK

8) Credit Suisse 9) Goldman Sachs 10) Industrial and Commercial Bank of China Limited 11) Mitsubishi UFJ FG 12) Wells Fargo

Switzerland US China

13) Agricultural Bank of China 14) Bank of China 15) Bank of New York Mellon 16) China Construction Bank 17) Groupe BPCE 18) Groupe Crédit Agricole 19) ING Bank 20) Mizuho FG 21) Morgan Stanley 21) Nordea 23) Royal Bank of Scotland 24) Santander 25) Société Générale 26) Standard Chartered

China

Code of Conduct Code of Ethics for financial Profession Code of Conduct Code of Ethics Code of conduct Code of Ethics Code of Conduct Code of Business Conduct and Ethics Statement of Business Principles and Code of Ethics Code of Conduct Code of Ethics Code of Conduct Code of Business Conduct and Ethics Annual CSR Report (the issuance of a Code of Ethics is mentioned in a 2012 Statement) Principles of Ethics and Conduct Code of Ethics & Business Conduct 2016 Annual CSR Report

China US

2016 Annual CSR Report Employee Code of Conduct

N/​A Yes

China

2016 Annual CSR Report

N/​A

France France

“Being responsible” Annual Report Code of Ethics

N/​A No

Netherlands Japan US Baltic States UK

Ethical Principles Code of Conduct Code of Ethics and Business Conduct Code of Conduct Code of Conduct

No No Yes No No

Spain France UK

General Code of Conduct Group Code of Conduct Code of Conduct

No No No

Japan US

Yes Yes No No No Yes No Yes N/​A No Yes N/​A

(continued )

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Shanshan Zhu and Guido Ferrarini Table 16.1 Continued Bank

Country

Code of conduct or Code of Ethics

Waivers/​ exceptions

27) State Street

US

Yes

28) Sumitomo Mitsui FG 29) UBS 30) Unicredit Group

Japan

Code of conduct for employees Code of conduct for directors Code of Ethics for Senior Financial Officers CSR Policy Code of Conduct and Ethics Code of Ethics Code of Conduct Integrity Charter

No No

Switzerland Italy

No

of Banking and Financial Institutions in 2009.158 CSR and ethical issues are usually considered in Chinese banks’ CSR reports.159 16.55

The relevant codes are generally structured as written statements in which the bank expresses its culture and vision, specifies its main values, and prescribes the rules of conduct that top managers and employees have to comply with.160 The adoption of these codes generally benefits the firm’s reputation and image, since it communicates a focus on CSR issues to customers and other stakeholders.161 Codes are also considered as tools able to make wrongdoings less frequent,162 and reduce consumer claims and the need for government regulation,163 in addition to providing guidance to decision makers facing a moral dilemma.164

158 William Blair, ‘Reconceptualising the role of standards in supporting financial regulation’, in Ross P Buckley, Emilios Avgouleas, and Douglas W Arner (eds), Reconceptualising Global Finance and its Regulation, Cambridge University Press, 2016, 419–​41. 159 Jingchen Zhao, Corporate Social Responsibility in Contemporary China, Elgar, 2014, 192ff. 160 Johan Graafland, Bert van de Ven, and Nelleke Stoffele, ‘Strategies and Instruments for Organising CSR by Small and Large Businesses in the Netherlands’, Journal of Business Ethics (2003), 47, 45–​51. 161 ibid, and Gary R Weaver et  al, ‘Integrated and Decoupled Corporate Social Performance:  Management Commitments, External Pressures, and Corporate Ethics Practices’, Academy of Management Journal (1999), 42, 539–​52. 162 Mark John Somers, ‘Ethical Codes of Conduct and Organizational Context: a Study of the Relationship between Codes of Conduct, Employee Behaviours and Organizational Values’, Journal of Business Ethics (2001), 30, 2, 185–​95. 163 Janelle Diller, ‘A Social Conscience in the Global Marketplace? Labour Dimensions of Codes of Conduct, Social Labelling and Investor Initiative’, International Labour Organization (1999), 138, 2, 99–​129; Harvey L Pitt and Karl A Groskaufmanis, ‘Minimizing Corporate Civil and Criminal Liability:  A Second Look at Corporate Codes of Conduct’, Georgetown Law Journal, (1989–​1990), 78, 1559–​654. 164 John M Stevens et al, ‘Symbolic or Substantive Document? The Influence of Ethics Codes on Financial Executives’ Decisions’, Strategic Management Journal (2005), 26, 2, 181–​95.

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Culture of Financial Institutions There is also strong empirical evidence on the relationship between the quality of codes 16.56 of conduct and CSR performance, measured on the basis of the presence of a company in CSR and ethical ranking systems (such as Dow Jones Sustainability Index, 100 Best Corporate Citizens, World’s Most Respected Companies, and Covalence Ethical Rankings).165 Companies listed in top CSR ranking systems were found to have ‘significantly higher quality codes on average compared to the population of all companies’.166 In the United States, a study reported that the adoption of codes of ethics pursuant to section 406 of the Sarbanes-​Oxley Act, addressed to top financial and accounting officers of public companies in their financial reporting activities, promoted the integrity of the financial services industry in terms of better scrutiny on financial reports.167 B. The limited effectiveness of codes of conduct However, many scholars have criticized the effectiveness of codes of conduct. Blair 16.57 et al168 examined the Chartered Financial Analyst (CFA) Institute’s Code of Ethics and Standards of Professional Conduct, arguing that information asymmetries and lack of credibility in the enforcement of disciplinary sanctions represent limitations to a meaningful influence of the code on members’ behaviours. The effectiveness of reputational sanctions too seems to be low because of the lack of information within the marketplace. Empirical studies also show mixed results. Kaptein and Schwartz169 found that out of seventy-​nine empirical studies on the effectiveness of companies’ codes, 35 per cent reported that they played a positive effect, 33 per cent found no significant effect, 16 per cent considered their effectiveness to be weak, 14 per cent reported mixed results and one study found codes of conduct to be counterproductive. Several circumstances can explain this failure. Firstly, adopting a code of con- 16.58 duct is the norm today. As a result, adoption may become a mere formality, if not a ‘greenwashing’ practice intended to cover companies’ less than ethical business.170 Secondly, codes of conduct and ethics frequently contain waiver clauses formally in compliance with regulation. In the analysis of the documents published by the G-​SIBs (Table 16.1), this was found to be a common practice for US banks.171 However, waiver clauses in ethical codes are a questionable and 165 Patrick M Erwin, ‘Corporate Codes of Conduct: The Effects of Code Content and Quality on Ethical Performance’ (2010) Journal of Business Ethics 99, 535–​48. 166 ibid. 167 Saurabh Ahluwalia et al, ‘Sarbanes–​Oxley Section 406 Code of Ethics for Senior Financial Officers and Firm Behaviours’, Journal of Business Ethics (2016), 1–​13. 168 Dan Awrey, William Blair, and David Kershaw, ‘Between Law and Markets: Is There a Role for Culture and Ethics in Financial Regulation?’ LSE Legal Studies Working Paper No 14/​2012. Available at https://​ssrn.com/​abstract=2157588, accessed 10 September 2018, or http://​dx.doi.org/​ 10.2139/​ssrn.2157588, accessed 10 September 2018. 169 Kaptein and Schwartz, n 154, 111–​27. 170 Erwin, n 165, 535–​48. 171 However, in response to the clamorous ratification by Enron’s board of waivers of conflict-​ of-​interest provisions of its code of ethics (Christopher J Gyves, ‘The Enron Failure and Corporate

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Shanshan Zhu and Guido Ferrarini dangerous practice, which compromises the seriousness of the values declared in them.172 Thirdly, the level of internalization of the codes’ values and rules within the organization is low for lack of sufficient knowledge.173 16.59

Internalization of values, based on an Aristotelian approach, could be enhanced through education and training,174 ethics and compliance programs,175 morally oriented conversation,176 and slower decision-​making processes.177 Recalling values established in the code of ethics can also induce executives to take moral issues into account in their decision-​making processes.178 In fact, some experimental researches proved that students tend to cheat less in performing tasks when they are asked to recall moral considerations and principles, whether it is the Ten Commandments or a code of honour.179 Codes should be enforced, which means that any wrongdoing should immediately be reported and measures taken,180 and senior managers should demonstrate commitment to the code by supporting its diffusion and enforcement.181

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Stakeholders’ pressure, especially from customers, shareholders, suppliers, and employees, also turned out to be beneficial to incorporate the ethical principles mentioned in a code in the managers’ strategic decision-​making,182 while pressure from non-​market stakeholders (regulatory agencies, public institutions, and government

Governance Reform’, Wake Forest Law Review (2003), 38, 3, 855–​84) most codes now require a prompt disclosure of the waiver to shareholders. See Reed Abelson, ‘Enron’s collapse: the directors. One Enron Inquiry Suggests Board Played Important Role, The New York Times, 18 January 2002; Note, ‘The Good, the Bad, and Their Corporate Codes of Ethics: Enron, Sarbanes-​Oxley, and the Problems with Legislating Good Behaviours’, Harvard Law Review (2003), 116, 7, 2123–​41. 172 See http://​www.huffingtonpost.com/​gregory-​unruh/​why-​code-​of-​ethics-​safety_​b_​645913. html, accessed 10 September 2018. 173 Patrick E Murphy, ‘Corporate Ethics Statements:  Current Status and Future Prospects’, The Journal of Business Ethics (1995), 14, 727–​40; Isaac D Montoya and Alan J Richard, ‘A Comparative Study of Codes of Ethics in Health Care Facilities and Energy Companies’, Journal of Business Ethics (1994), 13, 713–​17. 174 Susan L Harrington, ‘What Corporate America is Teaching About Ethics’, Academy of Management Executive (1991), 5, 1, 21–​33; John Thomas Delaney and Donna Sockell, ‘Do Company Ethics Training Programs Make a Difference? An empirical Analysis’, Journal of Business Ethics (1992), 11, 9, 719–​27; Stevens et  al, n 164, 181–​95; Schwartz, n 155, 323–​43; Stead, Worrell, and Stead, n 98, 233–​42. 175 Ethics Research Center, ‘Global Business Ethics Survey 2016’, Ethics & Compliance Initiative. 176 Max Messmer, ‘Does Your Company Have a Code of Ethics?’ (2003), Strategic Finance 84, 10, 13–​14; Awrey, Blair, and Kershaw, n 168. 177 Stevens et al, n 164, 181–​95. 178 Zanna Iscenko et al, ‘Behaviour and Compliance in Organisations’, FCA Occasional Paper No 24/​2016, available at https://​ssrn.com/​abstract=2939687, accessed 10 September 2018. 179 Nina Mazar, On Amir, and Dan Ariely, ‘The Dishonesty of Honest People: A Theory of Self-​ Concept Maintenance’, Journal of Marketing Research (2008), 635–​7. 180 Messmer, n 176, 13–​14; Schwartz, n 155, 323–​43; Pitt and Groskaufmanis, n 163, 1559–​654. 181 Montoya and Richard, n 173, 713–​17. 182 See, e.g., Kaptein and Schwartz, n 154, 111–​27; and Stevens et al, n 164, 181–​95.

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Culture of Financial Institutions bodies) proved to have no influence.183 The development phase of the code is also crucial for shaping personnels’ conduct. The drafting of the code should include managers184 and employees’ active participation185 and the provision of many behavioural examples in order to offer the employees real-​life examples of ethical/​ unethical conduct.186 Codes should also be tailored specifically to the culture of the company, avoiding simply copying codes already issued by other companies.187 Codes should be periodically revised188 and the company should establish a monitoring system over compliance with them,189 including effective reporting channels for employees. The ways in which reports of violations are coped with and how disciplinary procedures are carried out should also be carefully and seriously designed. In the Wells Fargo scandal, for example, an ethics hotline was established, but calling this number or trying to contact the human resources department would have cost employees their jobs.190

VI.  Cognitive Framing and Group Dynamics A. Not just ‘bad apples’ It is a common belief that only immoral individuals, the so-​called ‘bad apples’, 16.61 commit serious misbehaviour. However, it is well established that corporate crimes often involve people within an organization who are not ‘bad apples’, but ‘ordinary men and women’.191 When individuals act under a particular cognitive framing or in a group context their behaviour may deviate from the rational norm and their decision making and judgemental processes may be altered.192 Many studies 183 Murphy, n 173, 727–​40; Stevens et al, n 164, 181–​95. 184 Stead, Worrell, and Stead, n 98, 233–​42. 185 Earl A Molander, ‘A Paradigm for Design, Promulgation and Enforcement of Ethical Codes’, Journal of Business Ethics (1987), 6, 619–​631; Montoya and Richard, n 173, 713–​17; Messmer, n 176, 13–​14; Kaptein and Schwartz, n 154, 111–​27; Schwartz, n 155, 323–​43. 186 Saurabh Ahluwalia et al, n 167, 1–​13; Murphy, n 173, 727–​40; Schwartz, n 155, 323–​43. 187 Pitt and Groskaufmanis, n 163, 1559–​654. 188 Patrick E Murphy, ‘Implementing Business Ethics’, Journal of Business Ethics (1988), 7, 907–​15. 189 Alan Doig and John Wilson, ‘The Effectiveness Of Codes Of Conduct’, Business Ethics (1998), 7, 3, 140–​9. See also Geneviève Helleringer and Christina Skinner, Chapter 20, this volume. 190 See, e.g., http://​money.cnn.com/​2016/​09/​21/​investing/​wells-​fargo-​fired-​workers-​retaliation-​ fake-​accounts/​index.html, accessed 10 September 2018 and https://​www.nytimes.com/​2016/​10/​ 12/​business/​dealbook/​at-​wells-​fargo-​complaints-​about-​fraudulent-​accounts-​since-​2005.html?_​r=0, accessed 10 September 2018. 191 Saul W Gellerman, ‘Why “Good” Managers Make Bad Ethical Choices’, Harvard Business Review, (1986), 6, available at https://​h br.org/​1986/​07/​why-​good-​managers-​make-​bad-​ethical-​ choices, accessed 10 September 2018. 192 This is well explained in the contraposition between the expected-​utility theory and the prospect theory, in Amos Tversky and Daniel Kahneman, ‘Rational Choice and the Framing of Decision’, The Journal of Business (1986), 59, 4, 251–​78 and Daniel Kahneman and Amos Tversky, ‘Prospect Theory: An Analysis of Decision under Risk’, Econometrica (1979), 47, 2, 263–​92.

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Shanshan Zhu and Guido Ferrarini concern group behaviour both in social psychology193 and behavioural economics.194 Common results from these studies are that cognitive frames matter195 and that decision makers do not always follow profit maximization as the main criterion for acting. Compliance and conformity might depend on authority and obedience, social norms, reciprocation, ‘rejection-​then-​moderation’ procedures,196 all based on three main motivations:  accuracy, affiliation, and the maintenance of a positive self-​concept.197 In a famous experiment, Asch proved that people’s opinion usually changed if they were put under conformity pressure in a group context, even if this meant giving clearly wrong answers during a test following the majority trend.198 Another experiment by Milgram shed light on the dangerous implications of authority’s pressure on ethical behaviour,199 as later confirmed by a survey which found superiors’ behaviour as the most influential factor leading to unethical actions.200 16.62

Moreover, the use of an aggressive corporate language,201 such as one recalling war and fear in a Hobbesian way, is also common amongst unethical leaders, who have led unethical working teams. Deutsche Bank’s senior manager Edson Mitchell and his team, for example, used to refer to themselves as ‘mercenaries’ and

193 For a review see, inter alia, James H Davis, ‘Some Compelling Intuitions about Group Consensus Decisions, Theoretical and Empirical Research, and Interpersonal Aggregation Phenomena:  Selected Examples, 1950-​1990’, Organizational Behaviour and Human Decision Processes’ (1992), 52, 3–​38. A famous experiment on the effect of cognitive framing was conducted by Tversky and Kahneman; see A Tversky and D Kahneman, ‘The Framing of Decisions and the Psychology of Choice’, Science (1981), 211, 453–​8. 194 For a review see, inter alia, Michael J O’Fallon and Kenneth D Butterfield, ‘A Review of The Empirical Ethical Decision-​Making Literature’, Journal of Business Ethics (2005), 59, 375–​413; and Christopher Engel, ‘The Behaviours of Corporate Actors: A Survey of the Empirical Literature’ Journal of Institutional Economics (2010), 4, 445. 195 A frame is defined as ‘a stable, coherent cognitive structure that organizes and simplifies the complex reality that a manager operates in’; J Edward Russo and Paul J H Schoemaker, ‘Managing Frames to Make Better Decisions’, in Stephen J Hoch and Howard C Kunreuther (eds), Wharton on Making Decisions, Wiley, 2001, 131–​55. 196 This strategy, based on the norm of reciprocation, implies that one makes an excessive request (likely to be rejected), but later makes some concessions. Because of these concessions, ‘the target feels a normative obligation to reciprocate the influence agent’s concession with a concession of his or her own’ and, as a consequence, he would probably accept to comply to the new request. See Robert B Cialdini and Noah J Goldstein, ‘Social Influence: Compliance and Conformity’, Annual Review of Psychology (2004), 55, 591–​621. 197 See ibid. 198 Solomon E Asch, ‘Opinions and social pressure’, Scientific American (1955), 193, 31–​355. 199 Stanley Milgram, Obedience to Authority: An Experimental View, Harper and Row, 1974. 200 Blake.E Ashforth and Vikas Anand, ‘The Normalization of Corruption in Organizations’, Research in Organizational Behaviour (2003), 25, 1–​52. 201 Patelli and Pedrini, n 76, 3–​19; Guido Palazzo, Franciska Krings, and Ulrich Hoffrage, ‘Ethical Blindness’ Journal of Business Ethics (2011), 109, 3, 323–​38; Kevin Allen, ‘How Language Shapes Your Organization’, Harvard Business Review, 2012, available at https://​hbr.org/​2012/​07/​ how-​language-​shapes-​your-​organization, accessed 10 September 2018..

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Culture of Financial Institutions ‘conquistadors’.202 According to an experiment run by McNeil in 1982,203 the way information is spread within an organization is likely to influence its members’ decision making under risk, especially when information is limited and members rely on a very limited number of biasing heuristics.204 However, risks arise both from inside and outside the organization. If a broad 16.63 view of the current financial system is adopted, the institutional context is often characterized by a systemic moral disconnection of companies and their members from the societal context.205 An organization may promote misbehaviour by encouraging values such as aggressiveness, competitiveness, and profit at all costs.206 Specialization and a competence-​based model of professional behaviour increase efficiency, but may reduce the agents’ attention to other aspects and dimensions of decision making,207 causing a sort of ‘moral disengagement’ from the real issues that they are dealing with.208 Common people who find themselves in strong unethical contexts, in ‘bad larders’,209 sometimes commit crimes being unaware of the unethicality of their conduct. Some scholars talk about ‘ethically blind’ individuals,210 as a result of group pres- 16.64 sures. Ethical blindness is defined as the ‘temporary inability of a decision maker to see the ethical dimension of a decision at stake’;211 the individual deviates from her own values and beliefs as a result of some psychological process. However, this view could be a dangerous justification for misbehaviour. Strong contexts can no doubt facilitate the rise of a corrupt corporate culture and therefore influence members’ behaviour, but it is difficult to believe that the relevant agents are entirely unaware of the immorality of their action. We are rather confronted with an ethical rationalization212 or a normalization of dishonest behaviour,213 as described by Ashforth

202 Fichtner, Goos, and Hesse, n 81. 203 Barbara J McNeil et  al, ‘On the elicitation of preferences for alternative therapies’, New England Journal of Medicine (1982), 306, 1259–​62. 204 See Amos Tversky and Daniel Kahneman, ‘Judgement under Uncertainty:  Heuristics and Biases’, Science (1974), 185, 1124–​31. 205 Michael Gonin, Guido Palazzo, and Ulrich Hoffrage, ‘Neither Bad Apple Nor Bad Barrel: How the Societal Context Impacts Unethical Behaviours in Organizations’, Business Ethics: A European Review (2012), 21, 1, 31–​46. 206 Sims, n 98, 505–​13; Stead, Worrell, and Stead, n 98, 233–​42. 207 Gonin, Palazzo, and Hoffrage, n 205, 31–​46. 208 Albert Bandura, ‘Selective Moral Disengagement in the Exercise of Moral Agency’, Journal of Moral Education (2002), 31, 2, 101–​19. 209 Gonin, Palazzo, and Hoffrage, n 205, 31–​46. 210 Palazzo, Krings, and Hoffrage, n 201, 323–​38. 211 ibid. 212 John M Darley, ‘How Organizations Socialize Individuals into Evildoing’ in D Messick and A Tenbrunsel (eds), Codes of Conduct: Behavioral Research into Business Ethics, Russell Sage Foundation, 1996,  13–​43. 213 According to Ashforth and Anand, this normalization process consists of three main phases: institutionalization, rationalization, and socialization.

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Shanshan Zhu and Guido Ferrarini and Anand:214 moral concerns are suppressed to prioritize other interests, which are more direct, urgent, or advantageous. ‘Ethical short-​sightedness’, rather than ‘ethical blindness’ should be cautiously referred to. It should also be considered that, notwithstanding the influence of organizational and situational factors, there is always space for individuality and virtues training when it comes to ethical decision making. Trevino and Youngblood found that individual differences as to locus of control determine variances in the probability for an individual to act unethically. Based on these findings, they conclude that selection and training are important for organizations that want to be ethical.215 B. Decision-making in the boardroom 16.65

Boards’ decision-​making should be studied from the perspective of their complex social dynamics. Empirical research should not be limited to the composition of boards and the number of their members, but extend to the functioning of these groups both inside and outside the boardroom.216 Similarly, financial regulation should not insist too much on the detailed setting of composition requirements for boards and of professional and time availability requirements for their members. Clearly, the time dedicated by directors to the performance of their duties does not necessarily correlate with their efforts, nor do the required professional competences assure careful and expert directorship.217 Indeed, the lack of trust between managers and the board, the absence of critical analysis of corporate information by the latter, and the non-​consideration by either boards or managers of the claims of whistle-​blowers (as shown by the case of Wells Fargo) are common features of many failures and scandals in the financial and non-​financial sectors.

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One should therefore start by restoring effective decision making in boards in order to make financial institutions more ethical. Boards should be able to balance the need for trust and collaboration with that for control and constructive conflicts.218 While a collaborative board may promote the sound and transparent management

214 Ashforth and Anand, n 200. See also Gellerman’s model, which identifies four beliefs leading to unethical decisions: (i) the activity is is not ‘really’ illegal or immoral; (ii) the activity is in the company’s best interest; (iii) the activity will never be found out; and (iv) the company will protect the person engaging in the activity, since he perform it in its interest: Gellerman, n 191. 215 Linda Klebe Trevino and Stuart A Youngblood, ‘Bad Apples in Bad Barrels: Causal Analysis of Ethical Decision-​Making Behaviours’, Journal of Applied Psychology (1990), 75, 4, 378–​85. 216 See Andrew M Pettigrew, ‘On Studying Managerial Elites’, Strategic Management Journal (1992), 13, 163–​182. 217 See Daniel P Forbes and Frances J Milliken, ‘Cognition and Corporate Governance: Understanding Boards of Directors as Strategic Decision-​ Making Groups’, The Academy of Management Review (1999), 24, 3, 489–​505. 218 Chamu Sundaramurthy and Marianne Lewis, ‘Control and Collaboration:  Paradoxes of Governance’, The Academy of Management Review (2003), 28, 3, 397–​415.

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Culture of Financial Institutions of an organization, cognitive conflicts219 involving ‘the consideration of more alternatives and the more careful evaluation of alternatives’220 can also be beneficial. Indeed, too much cohesiveness amongst the directors may translate into a weak board dominated by an imperial CEO, as shown by the failure of Anglo Irish Bank.221 Consequently, board diversity should be fostered to the extent that it improves an exchange of views and ideas between the directors, provided it is founded on reciprocal trust and common values.222 The role of non-​executive and independent directors is also crucial, since their relative distance from management allows the board to maintain an objective and critical stance in strategic decision making.223 As a result, the board avoids the narrow framing which gives rise to ethical blindness.

VII.  Concluding Remarks In the previous sections, several cultural aspects that shape behaviour and character 16.67 in financial institutions have been analysed, reinterpreting governance mechanisms in the light of psychological and sociological studies. In order to change culture as a multilayered reality, a combination of practical values, norms, and formal institutions are required.224 As explained in the previous sections, the board is key to developing an organizational structure based on ethical values which should shape every decision-​making process, guide managers and employees to behave with integrity, and, to a certain extent, take into consideration stakeholders’ interests (in order to prevent substantial costs of future litigation). Moreover, the organizational framework may prove effective only when it is set into 16.68 a good institutional framework. Supervisory authorities, firm’s shareholders—​in particular, institutional investors—​and the entire financial community should support the board in this new path for sustainable development and finance. Indeed, external pressure can incentivize a long-​term view in managing the firm, by making ethicality and sustainability a convenient and profitable trend. Even though this chapter is mainly focused on organizational factors, it is suggested that regulators, supervisors, investors, and customers could perform some positive actions in order

219 Amason distinguishes between cognitive affective (personal) and cognitive (task-​related) conflict. While the former can prevent boards from functioning, the latter improve decision-​making processes. See Allen C Amason, ‘Distinguishing the Effects of Functional and Dysfunctional Conflict on Strategic Decision Making: Resolving a Paradox for Top Management Teams’, Academy of Management Journal (1996), 39, 123–​48. 220 Forbes and Milliken, n 217, 489–​505. 221 Abrahams, Horton, and Millo, n 74. 222 Sundaramurthy and Lewis, n 218, 397–​415. 223 Roberts, McNulty, and Stiles, n 122, 5–​26. 224 Graham et al, n 8.

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Shanshan Zhu and Guido Ferrarini to enhance ethics in finance through, by instance: (i) promoting more adequate financial education;225 (ii) making it difficult for those who have carried on illegal activities and have been convicted, to continue working in the financial sector (e.g. by creating a central registry that tracks the hiring and firing of traders and other financial professionals across the industry or prohibiting future employment to those individuals);226 and (iii) strengthening the environmental, social, and corporate governance (ESG) movement in supporting the board in pursuing long-​ term objectives, especially in light of the recent implementation of the revised Shareholders’ Rights Directive227 that provided institutional investors with broad powers of intervention in relation to remuneration and related-​party transactions. 16.69

To conclude, without entirely rejecting the idea of financial capitalism, this chapter claims that finance should be a functional science that exists to support the goal of constructing a good society.228 For this to be achieved, a new path needs to be taken towards an evolution in terms of ‘democratizing and humanizing and expanding the scope of financial capitalism’ and, therefore, to further study what factors induce financial operators to commit crimes and misbehaviours and what is needed to reshape their values and character in order to build a harmonious society.229

225 Neuroscientific studies can help to identify how different genetic and behavioural traits influence the way investors react to financial choices and results, making a one-​size-​fits-​all approach inadequate in financial literacy policies too. See Duccio Martelli, ‘Improving financial literacy through neuroscience and experiential learning’, in Nadia Linciano and Paola Soccorso (eds), Challenges in ensuring financial competencies, Consob Quaderni di finanza, October 2017, 111–​18. 226 Dudley, n 11. 227 Shareholder Rights Directive 2007/​36/​EC, amended by Directive 2007/​828/​EU. 228 Robert Shiller, Finance and the Good Society, Princeton, 2012, 5–​9. 229 ibid.

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17 PUBLIC SUPERVISION OF BEHAVIOUR AND CULTURE AT FINANCIAL INSTITUTIONS Wijnand Nuijts

I. Introduction 17.01 II. Development of the Supervision of Behaviour and Culture 17.05 III. What is the Supervision of Behaviour and Culture? 17.11 A. General overview B. Findings and effects of the supervision of behaviour and culture

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C. How is the supervision of behaviour and culture performed? 17.30 D. Legal concepts that are relevant for the supervision of behaviour and culture 17.31 E. Recent and future developments 17.35 F. Summary and conclusion 17.44

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I. Introduction Research often emphasizes the crucial role of psychology and behaviour in the un- 17.01 folding of financial crises. For example, Nobel prize winners Akerlof and Schiller, assert that ‘we will never really understand important economic events unless we confront the facts that their causes are largely mental in nature’.1 They abandon the perspective of human beings as purely rational decision makers and basically explain economic cycles as reflections of human confidence: ‘When people are confident they go out and buy; when they are unconfident they withdraw and sell. Economic history is full of cycles of confidence followed by withdrawal’.2 These macro-​level observations also apply to the functioning of firms. Cyert and 17.02 March’s Behavioural Theory of the Firm dismisses the assumption that firm decisions 1 George Akerlof and Robert Schiller, Animal Spirits; How human psychology drives the economy, and why it matters for global capitalism, Princeton University Press, 2009, 1. 2 ibid, 13.

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Wijnand Nuijts are the product of a rational search for the best alternative. Instead, they explain such decisions as random outcomes of struggles between opposing coalitions of managers, dominated by cognitive limitations, conflicting ambitions, and unnoticed group dynamical patterns.3 Research on team/​board effectiveness further emphasizes the importance of facilitative leadership styles and constructive debate between board members as an important contributor to a firm’s success.4 And finally, research from various other streams evidences a direct relationship between organizational culture and firm performance and the level of risk or ethical behaviour in a firm.5 17.03

Despite the growing attention for behaviour and culture among financial supervisors (e.g. by including behavioural perspectives into their supervisory methodologies in a structured manner and by performing examinations) they still mainly rely on analysis of organizational structures and processes as well as financial outcomes to further financial and firm stability. And although these aspects are of course highly relevant to financial supervision, their analysis is not enough to thoroughly understand what drives firm performance. The central thesis in this chapter is therefore that financial supervision needs to combine ‘structural’ perspectives with insights into the behavioural and cultural drivers of firm performance, in order to become more effective in fostering firm and financial stability (being financial supervision’s core strategic objective).

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In 2009 the Dutch Central Bank (DNB)6 decided to develop such a double-​sided approach, which eventually led to what is now called the supervision of behaviour and culture. This chapter describes what the supervision of behaviour and culture actually entails (see for reading the literature mentioned in Table 17.1 and n 18).

3 Richard Cyert and James March, The Behavioural Theory of the Firm, Prentice-​Hall, 1963. 4 See, e.g., Daniel Forbes and Frances Milliken, ‘Cognition and Corporate Governance: Understanding Boards of Directors as Strategic Decision-​Making Groups’, Academy of Management Review (1999), 24, 3, 489–​505; Morten Huse, ‘Accountability and Creating Accountability:  A Framework for Exploring Behavioural Perspectives of Corporate Governance’, British Journal of Management (2005), 16, S65–​S79; Alessandro Minichilli et al, ‘Board task Performance: An Exploration of Micro-​and Macro-​level Determinants of Board Effectiveness’, Journal of Organizational Behaviour (2012), 33, 193–​215; and Peter Crowe, James Lockhart, and Kate Lewis (2013), ‘The relationship between governance and performance: Literature review reveals new insights, ECMLG2013-​Proceedings For the 9th European Conference on Management Leadership and Governance’. 5 See, e.g., Sonja Sackmann (2011), ‘Culture and performance’ in Ashkenasy and Wilderom Peterson (eds), The Handbook of Organizational Culture and Climate, Sage, London, 188–​224. Sackmann performed a meta-​analysis of fifty five scientific studies into the relation between culture and organizational performance and concluded that most of these studies support a direct link between corporate culture and firm performance. In addition, several authors described the psychological and behavioural foundations of unethical behaviour within firms: Blake Ashford and Vikas Anand, ‘The Normalization of Corruption in Organizations’, Research in Organizational Behaviour (2003), 25, 1–​52; and Celia Moore and Francesca Gino, ‘Ethically Adrift: How Other Pull Our Moral Compass from True North, and How We Can Fix It’, Research in Organizational Behaviour (2013), 33, 53–​77; and Wieke Scholten, Banking on Team Ethics: A team climate perspective on root causes of misconduct in the financial sector (dissertation), Leiden, 2018. 6 De Nederlandsche Bank (DNB) is the Central Bank and prudential supervisor in the Netherlands.

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Public Supervision of Behaviour and Culture Table 17.1 Overview of DNB publications on the supervision of behaviour and culture DNB publications on the supervision of behaviour and culture Year

Publication

Description

April 2010

Policy Paper: ‘The Seven Elements of an Ethical Culture’

November 2011

Interim report about DNB’s supervision of behaviour and culture Report: ‘Leading by Example’

Starting point for the development of the supervision of behaviour and culture. This policy paper emphasized the importance of balanced decision making, of realistic organisational objectives, and of 'challenge' for sound decision making. Most important findings of DNB’s first thematic examination into behaviour and culture, focusing on sound decision making. Most important findings of DNB’s second thematic examination into behaviour and culture, focusing on board effectiveness. Tools for financial sector institutions and supervisors to examine behaviour and culture. Most important findings of DNB’s thematic examination into change effectiveness (together with Dutch market conduct supervisor, the Autoriteit Financiele Markten (AFM). Book explaining the scientific foundations, methodologies, findings, and effects of DNB’s supervision of behaviour and culture. Overview of five years of behaviour and culture supervision by DNB. Conference organized by DNB for international financial supervisors aiming to share DNB’s expertise with respect to the supervision of behaviour and culture. Press release relating to an DNB/​AFM examination (survey) into adherence to the Dutch banker’s oath. Report following an examination into good practices relating to self-​evaluation of Dutch pension fund boards.

March 2013 August 2013 October 2014

Report: ‘Supervisory Methodologies Relating to Behaviour and Culture’ Report: ‘Capacity to Change in the Financial Sector’

October 2015

Book: Supervision of Behaviour and Culture: Foundations, Practice & Future Developments

October 2015 October 2015

Report: ‘Behaviour and Culture in the Dutch Financial Sector’ Conference: ‘Supervision of Behaviour and Culture’

September 2016

Press Release: Examination Relating to Banker’s Oath

May 2017

Report: ‘Self-​ Evaluation: Cooperating Towards Improvement of Board Functioning’

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Wijnand Nuijts First, it will provide some background on the development of the supervision of behaviour and culture within DNB thus far (Section II). In Section III.A, the methodologies that DNB uses in the context of the supervision of behaviour and culture will be elaborated on, including the core theoretical concepts on which they are based. Section III.B describes the findings and observations that have been generated by approximately 100 behaviour and culture assessments (performed between 2011 and 2017). Section III.C will touch upon the manner in which the supervision of behaviour and culture is structured within DNB’s supervisory organization and how it is performed. Section III.D will be dedicated to the relation between (core concepts of ) the supervision of behaviour and culture and relevant (governance related) regulation. Subsequently, an overview of recent developments in the field of behaviour and culture will be provided on a European and global level, which may serve as a marker for further future directions (Section III.E). This chapter will conclude with a summary and conclusion (Section III.F).

II.  Development of the Supervision of Behaviour and Culture 17.05

The supervision of behaviour and culture is a response to the global financial crisis of 2008. However, it would be a misconception to think that it is the product of a deliberate and pre-​conceived plan. To a large extent, it’s origination was a bottom up initiative that sprang off from a serendipitous idea of two colleagues who were then working under DNB’s Anti-​Money Laundering/​Counter Terrorist Financing (AML/​CTF) supervision. In the aftermath of Lehman’s collapse, they were struck by the fact that analyses into the causes of the financial crisis at that point in time were predominantly (macro) economical in nature and overlooked the ‘human factor’. Permission was granted by their manager (the author of this chapter) to explore ways to include a behavioural perspective into DNB’s supervision.

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Ultimately, this led to the adoption of the policy paper ‘The Seven Elements of an Ethical Culture’7 in November 2009. The paper emphasized the importance of balanced decision making, aimed at reconciling opposing interests (commercial versus customer/​other stakeholders). Other elements in the paper highlighted the role of leadership and constructive challenge to facilitate this reconciliation. Finally, it drew attention to the importance of setting feasible and realistic targets as a means to prevent irresponsible behaviour. 7 DNB, ‘The Seven Elements of an Ethical Culture, Strategy and approach to behaviour and culture at financial institutions 2010-​2014’, available at https://www.dnb.nl/en/binaries/The%20Seven%20 Elements%20of%20an%20Ethical%20Culture_tcm47-233197.pdf? 2017090904, accessed 17 October 2018.

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Public Supervision of Behaviour and Culture The paper was published in April 2010 and served as a starting point for the de- 17.07 velopment of a supervisory approach. This development was further encouraged by DNB’s position that a pure regulatory response to the financial crisis, would not lead to a more stable and healthier financial system. Instead DNB wanted to focus on enhancing the effectiveness and quality of supervision.8 In line with the International Monetary Fund (IMF),9 DNB felt it needed to make its supervision more forward looking10 in order to ‘track down and tackle the possible root causes of later problems before they even translate into deteriorating financial indicators’.11 DNB identified two main areas with forward looking potential: one was business models and strategy and the other was behaviour and culture. Another factor that was important in the development of the supervision of behav- 17.08 iour and culture, was the demise of a midsized Dutch bank, called DSB, in October 2009. This event sparked off an external evaluation by an independent committee into the manner in which DNB had exercised its supervision. One of the conclusions of its June 2010 report12 was that DNB—​while constantly demanding enhancement of DSB’s structural governance—​did not sufficiently address the behaviour of DSB’s CEO/​shareholder. The Committee concluded that the lack of expertise of this CEO and his unpredictable leadership style was one of the most important factors for DSB’s failure. The Committee advised DNB to encourage the further development13 of the supervision of behaviour and culture in order to address such behaviour in the future. Following up on these recommendations, DNB transformed its supervisory or- 17.09 ganization as well as its supervisory methodology in June 2010. On the organizational side, DNB created the Expert Centre Governance, Behaviour and Culture to build and concentrate expertise relating to behaviour and culture. It hired organizational psychologists to facilitate sound and verifiable judgements about behaviour, based on their skills to observe, analyse, and qualify behaviour in a structured and methodological manner. To support policy making, DNB’s Research Department undertook several studies. On the methodological side, DNB integrated behaviour 8 DNB Supervisory themes, 2009, available at https://​www.dnb.nl, accessed 17 October 2018. 9 J Viñals and J Fiechter (2010), ‘The making of good Supervision: learning to say “no” ’, IMF Staff position note of 18 May 2010, available at https://​www.imf.org, accessed 2018. 10 DNB Supervisory Strategy, 2010–​ 2014, available at https://​www.dnb.nl, accessed 17 October 2018. 11 Joanne Kellermann and Robert Mosch, ‘Good Supervision and it’s Limits in the Post-​Lehman Area’, in J Kellermann., J De Haan, and F De Vries (eds), Financial Supervision in the 21st Century, Heidelberg, Springer, 2013, 5. 12 Report of Scheltema Committee into DSB Bank (2010), available at, https://​www. rijksoverheid.nl/​documenten/​rapporten/​2010/​06/​29/​rapport-​van-​de-​commissie-​van-​onderzoek-​ dsb-​bank, accessed 17 October 2018. 13 This transformation process was called VITA! and is described in DNB, ‘From Analysis to action. Action plan for the change in the conduct of supervision’, August 2010, available at https://​ www.dnb.nl, accessed 17 October 2018.

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Wijnand Nuijts and culture into DNB’s supervisory risk-​assessment framework called Focus. This framework was designed to create individual risk profiles of all institutions under DNB’s supervision. The framework includes all relevant risk categories, such as capital, liquidity, and operational risk. In this framework, behaviour and culture is positioned as a risk driver. This is to express that financial outcomes are the reflection of underlying behavioural and cultural patterns. It is important to mention that behaviour and culture is not the only risk driver in the focus-​methodology;14 strategy and business models, macro-​economic developments, and IT and infrastructure are positioned as risk drivers as well. 17.10

Over the years DNB has gradually developed its supervision of behaviour and culture: • It designed and regularly updated assessment frameworks to examine several aspects of organizational behaviour. These frameworks are discussed below. Whereas from the start DNB focused on top echelons (because of their important impact on firm performance),15 later frameworks also included lower organizational levels. Nevertheless, most frameworks take the group (board, management, or team) as the level of analysis; DNB studies ‘group behaviour and the interaction between certain individual roles—​such as the CEO—​and the group’.16 • Although the supervision of behaviour and culture started off as an ‘integrity’ approach, it took an ‘effectiveness’ perspective quite early after its origination. This shift was deemed necessary to: (i) create added value for DNB’s supervision in general; and (ii) facilitate open discussions between supervisors and firm management. As will be seen later, the supervision of behaviour and culture relies on interviews in order to reveal personal mindsets, emotions, and behaviours. The willingness to share such personal information with supervisors depends to a large extent on an atmosphere of trust. This trust is jeopardized when interviewees fear their personal integrity is at stake. This also explains why fit and proper testing is organizationally separated from the supervision of behaviour and culture. Both are performed in separate organizational units, each with their own management and staff. This implies that findings relating to behaviour and culture are not automatically shared with fit and proper testing.17 14 This methodology is described in DNB, ‘Focus! The new supervisory approach of De Nederlandsche Bank’, May 2012, available at https://​www.dnb.nl, accessed 17 October 2018. 15 See n 4. 16 M Raaijmakers, ‘Model and Basic Assumptions’, in M Raaijmakers (ed), DNB, The Supervision of Behaviour and Culture, Foundations, Practice & Future Developments, 2015, 48 https://​www.dnb. nl, accessed 17 October 2018. 17 Whereas fit and proper testing primarily focuses on individual capabilities, the supervision of behaviour and culture is looking for behavioural patterns in a group. Since 2013, both activities are organized in separate expert centres, each having their own independent management and experts. This distinction facilitates the openness that is required for the supervision of behaviour and culture.

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Public Supervision of Behaviour and Culture

III.  What is the Supervision of Behaviour and Culture? A. General overview DNB’s supervision of behaviour and culture aims at identifying behavioural pat- 17.11 terns that may jeopardize the financial position, risk profile, and integrity of financial firms (banks, insurance companies, pension funds, and trust company service providers). As such, it tries to answer the following two questions: (i) What is the—​positive and/​or negative—​impact of behavioural patterns and their cultural drivers on the financial strength, risk profile, and integrity of an institution? (ii) What are the measures that supervised institutions could take to mitigate the risks associated with these observed patterns and drivers? DNB has developed multiple frameworks to capture several important drivers of 17.12 firm performance:18 • Board Effectiveness: this framework assesses to what extent leadership, group dynamics, decision making, and communication impact a firm’s prudential and risk performance. The instrument is predominantly used to assess the effectiveness of (non) executive boards, but may also be used for (management or trading) teams at lower levels in the organization. • Strategic decision making:  this framework is similar to board effectiveness, but specifically assesses to what extent a firm has undertaken rigorous efforts to define new strategies and business models. DNB attempts to prevent that a firms’ future comes to depend on ill-​considered strategies that are based on incomplete or incorrect information, assumptions, and/​or scenarios. • (Culture) Change Effectiveness:  Change Effectiveness and Culture Change Effectiveness are separate frameworks, aimed at assessing to what extent firms are capable of successfully transforming their organization/​business model and/​

Fear that comments would immediately affect a board member’s fit and proper status, might hamper open communication. Consequently, behaviour and culture findings do not automatically feed into fit and proper testing. Internal DNB policy prescribes that behaviour and culture findings will only be shared for fit and proper purposes in case of (i) serious findings that may lead to a reconsideration of fitness and propriety, and (ii) following agreement between management of fit and proper testing, behaviour and culture, and line supervision. 18 It is important to note that (i) these frameworks focus on certain behaviours and their drivers and are not comprehensive in the sense that they are intended to assess the entire organizational, and (ii) DNB is currently developing other frameworks to include specific areas of attention. E.g. DNB is working on a framework aimed at identifying specific behaviours that may encourage or impede change initiatives relating to digitalization and technological innovation.

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Wijnand Nuijts or culture. These frameworks underscore the importance of change for a firm’s survival in today’s rapidly changing world. • Risk Culture: this framework focuses on behavioural patterns that affect risk awareness, risk-​taking, and risk management in a specific group (e.g. in the executive board or in a trading department). Basically, the instrument is aimed at assessing how decision makers deal with tensions between risk and reward. • Integrity Climate: this approach focuses on behavioural and culture root causes of misconduct at team level. The framework is based on the principle that unethical behaviour largely depends on contextual factors. Whereas financial firms often assume that unethical behaviour is the result of individual ‘rotten apples’, DNB emphasizes that individuals often act in accordance with cultural cues they receive from the environment in which they work.19 17.13

In their core, most frameworks are built around a set of common elements. These elements pertain to: (i) leadership; (ii) decision making (including group dynamics); (iii) reflective learning; and (iv) the impact of contextual factors on behaviour (as illustrated below—​further illustrations can be found in the literature mentioned in n 18).20 1. Leadership

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Leadership receives prominent attention in DNB’s supervision of behaviour and cul­ture, as it is one of the most important determinants of organizational performance. Leader’s perceptions, backgrounds, values, and convictions influence firm performance,21

19 Ashford and Anand , n 5, 1–​52; Moore and Gino, n 5, 53–​77; and Scholten, n 5. 20 A selection of publications by DNB authors: Paul Cavelaars et al (2013), ‘Uitdagingen voor financieel toezicht na de crisis’, in P Welp et al (eds), De staat van toezicht. Sector en themastudies, WRR/​Amsterdam University Press, 279–​328; Jakob De Haan and David Jansen ‘Corporate culture and behaviour: A survey’. DNB Working Paper No 334/​2011; Jakob De Haan, Wijnand Nuijts, and Mirea Raaijmakers, ‘Vijf jaar toezicht op gedrag & cultuur bij financiële instellingen’, ESB 100, 4713 & 4714, 2015, 397–​400; Wijnand Nuijts, ‘Hoe gaat dat eigenlijk: toezicht houden op gedrag & cultuur? Uitkomsten van het DNB thema-​onderzoek Besluitvorming’. Tijdschrift voor Compliance nr 1, Januari 2012, 41–​6; Wijnand Nuijts and Jakob De Haan, ‘DNB supervision of conduct and culture’ in Kellermann, De Vries, and De Haan, n 10; Wijnand Nuijts, ‘Supervision of Behaviour and Culture: An Effective Response to Governance and Risk Management Problems Within Financial Institutions’, European Journal of Business Compliance (2013), 5–​21; Wijnand Nuijts, ‘Managing culture: the role of regulation and supervision’, in FCA, Transforming Culture, Financial Services, London, 2018, 53–​6; Jildau Piena and Celine Cristensen, ‘Mag ik van u twee frappucino’s en één integrale cultuurverandering?’ in Jaarboek Compliance, 2015, 33–​45; Mirea Raaijmakers and Wieke Scholten, ‘Reflectie in de bestuurskamer’, De Psycholoog, October, 2014, 47–​54; Wieke Scholten and Naomi Ellemers, ‘Bad Apples or Corrupting Barrels? Preventing Traders’ Misconduct’, Journal of Financial Regulation and Compliance (2016), 24, 4, 366–​82; C Van der Cruijsen, Jakob De Haan, and David Jansen, ‘Trust and financial crisis experiences’, Social Indicators Research (2016), 127, 2, 577–​600; Dennis Veltrop et al, ‘A Tale of Two Factions: Why and When Factional Demographic Faultlines Hurt Board Performance’, Corporate Governance: An International Review, (2015), 23, (2), 145–​60. 21 See n 5.

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Public Supervision of Behaviour and Culture employees,22 as well as organizational culture.23 As such, the firm is perceived as a reflection of its top management team.24 Leadership exerts influence through its decisions, role modelling, through setting up procedures, and establishing structures.25 More specifically, in its supervision of behaviour and culture DNB assesses how 17.15 mindsets and values of board members are translated into the institution’s strategic objectives. As such, organizational goals are the reflection of leadership’s ambitions and beliefs. To the extent these goals are unrealistic and/​or overprioritize profit over considerations relating to risk management or customer interests, they may lead to irresponsible risk taking or unethical conduct (Section III.E). DNB also assesses leadership in terms of organizational role modelling. Leadership 17.16 behaviour and decision making implicitly or explicitly expresses what are desirable values and behaviours. Social learning theory26 explains that employees learn by observing and imitating (leadership) behaviour. Furthermore, shared behaviours ultimately culminate in social/​group norms, that group members are (or feel they are) expected to follow. Social identity theory in turn explains that this may also be the result of an individual’s urge to belong to a group.27 2.  Decision making DNB’s approach places large emphasis on board/​team decision making, mainly be- 17.17 cause of its direct relationship with firm performance and risk taking.28 Central in DNB’s approach is the assumption that the quality of decision making depends on a ‘well-​tuned interplay between the structural design of decision making and human interaction’.29 DNB’s approach on decision making combines both approaches. On the one hand, DNB works from the assumption that ‘groups are more likely to

22 Moritz Römer, ‘Leadership’, in Raaijmakers, (ed), n 16, 139. See further, Robert Hogan and Robert Kaiser, ‘What We Know About Leadership’, Review of General Psychology (2005), 9, 169–​ 80; Robert Lord and Douglas Brown, Leadership Processes and Follow Self-​Identity, Erlbaum, 2004. 23 Edgar Schein, Organizational Culture and Leadership, Wiley, 2010; Römer, n 16, 140. 24 Donald Hambrick and Phyllis Mason ‘Upper Echelon Theory; The Organization as a Reflection of Its Top Managers’, Academy of Management Review (2004), 9, 193–​206. 25 Römer, n 16, 140. 26 Moore and Gino, n 5, 56; Römer, n 16, 152–4. 27 Moore and Gino, n 5, 56; Henri Tajfel, ‘Social Psychology of Intergroup Relations’, Annual Review of Psychology (1982), 1–​40; Henri Tajfel and John Turner, ‘An integrative theory of intergroup conflict’, in W G Austin S Worchel (eds), The Social Psychology of Intergroup Relations, Monterey, Brooks/​Cole, 1979, 33–​47; Michael Hogg, ‘Social categorization, depersonalization and group behaviour’, in M A Hogg and S. Tindale (eds), Blackwell Handbook of Social Psychology: Group Processes, 2017, 56–​85. 28 Wijnand Nuijts, ‘Decision making’, in Raaijmakers (ed), n 16, 103–​38: Sydney Finkelstein, Donald Hambrick, and Albert A Cannella Jr, Strategic Leadership: Theory and Research on Executives, Top Management Teams, and Boards, Oxford University Press, 2009; Kathleen Eisenhardt and Mark Zbaracki, ‘Strategic Decision Making’, Strategic Management Journal (1992), 13, 17; Michael Porter, ‘Towards a Dynamic Theory of Strategy’, Strategic Management Journal (1991), 12, 95–​117. 29 Nuijts, n 28, 112.

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Wijnand Nuijts make better decisions if they follow a methodical and structured decision making process’. These methodical steps are aimed at information gathering, problem analysis, process planning and, most importantly, the development and testing of alternative options/​possible negative consequences of these options.30 On the other hand, DNB holds that ‘complex decisions are largely the outcome of behavioural factors rather than a mechanical quest for economic optimisation’, whereby ‘the more complex the decision, the more applicable this behavioural theory is thought to be’.31 As already mentioned above, this may be caused by limited cognitive abilities, conflicting goals, varying aspirations levels, and personal values. 17.18

In its supervision of decision making, DNB emphasizes the importance of ‘constructive challenge’ between board/​team members. Challenge can be understood as a critical and investigative debate between group/​board members, in which diverse perspectives, scenarios, and their consequences/​risks are explored and discussed. Whereas diversity among decision makers in terms of age, gender, background, and expertise creates the basis for effective decision making, constructive challenge is the best way to mould this diversity into good decisions.32 Challenge leads to better decision making because it forces ‘teams to accommodate and synthesize multiple points of view’33 into a common position that ‘mirror[s]‌the true state of the world’.34 The quality of challenge requires the observance of structural and behavioural conditions. As most decisions are taken in groups, group members need to have a collective understanding of who is responsible for what. Without such role clarity interactions will be hampered.35 Furthermore, firms need to deliberately organize that all board members and (control) functions are timely and meaningfully

30 ibid, 110. 31 Hambrick and Mason, n 24, 194. 32 John Mathieu et al, ‘Team Effectiveness 1997-​2007: A Review of Recent Advancements and a Glimpse Into the Future’, Journal of Management, (2008), 34, 3, 410–​76; Steve Kozlowski and Daniel Ilgen, ‘Enhancing the Effectiveness of Work Groups and Teams’, Psychological Science in the Public Interest (2006), 7, 77–​124; Shawn Burke et  al, ‘Understanding Team Adaptation:  A Conceptual Analysis and Mode’, Journal of Applied Psychology (2006), 91, 6, 1189–​207; Allen Amason, ‘Distinguishing the Effects of Functional and Dysfunctional Conflict on Strategic Decision Making:  Resolving a Paradox for Top Management Teams’, Academy of Management Journal (1996), 39, 1, 123–​48; Richard Hackman and Charles Morris, ‘Group Tasks, Group Interaction Process, and Group Performance Effectiveness: A Review and Proposed Integration’, Advances in Experimental Psychology (1975), 8, 47–​99. 33 Ann Mooney et al, ‘Don’t Take it Personally: Exploring Cognitive Conflict as a Mediator of Affective Conflict’, Journal of Management Studies (2007), 44, 5, 733. 34 Bryan Edwards et al, ‘Relationships Among Team Ability Composition, Team Mental Models, and Team Performance’, Journal of Applied Psychology (2006), 91, 3, 728. 35 Susan Mohammed, Lori Ferzandi, and Katherine Hamilton, ‘Metaphor No More: A 15-​Year Review of the Team Mental Model Construct’, Journal of Management, (2010), 36, 4, 876–​910; John Mathieu et al, ‘The Influence of Shared Mental Models on Team Process and Performance’, Journal of Applied Psychology (2000) 85, 2, 273–​83.

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Public Supervision of Behaviour and Culture involved in the decision-​making process. Finally, and obviously, good decisions require high-​quality, comprehensive, and well-​prepared decision materials.36 But even then, the quality of challenge may be hampered by behavioural patterns, 17.19 such as: • Group conformity. A group’s desire to reach consensus may erode the diversity of opinions. Research indicates that group conformity is more likely to occur in complex, unclear, or ambiguous situations. Given the complexity of the financial sector, group conformity is of specific concern for DNB;37 and • Conflict. Task conflict is known to promote ‘the exchange of ideas, the surfacing of assumptions, and the synthesis of various perspectives into balanced and well-​ reasoned decisions’38 If not organized well however, task conflict may cause negative emotions and escalate into relationship conflict, which generally has a negative impact on the quality of decision making. DNB assesses if firms have taken adequate steps to organize the process of constructive 17.20 challenge. In this respect, DNB examines: • whether leadership encourages and facilitates the participation of all decision makers. Such facilitative leadership styles are known to enhance constructive challenge;39 • whether debating techniques are introduced to ‘depersonalize’ conflict, like devil’s advocacy, bringing in outsiders and replacing advocacy by inquiry (which is exploratory in nature);40 • whether a social group norm is created that tolerates and even expects that opposing views are expressed and maintained in case of resistance. Such shared norms contribute to constructive challenge, especially when they coincide with

36 Nuijts, n 28, 119–20. 37 Rakesh Khurana and Katharina Pick, ‘The Social Nature of Boards’, Brooklyn Law Review (2005), 70, 4, 1258–​312. 38 Mooney, n 33, 734; Frank De Wit, Lindred Greer, and Karen Jehn, ‘The Paradox of Intragroup Conflict: A Meta-​Analysis’, Journal of Applied Psychology (2012), 97, 2, 360–​90; Charlan Nemeth and Brendan Nemeth-​Brown, ‘Better than individuals: The potential benefits of dissent and diversity for group creativity’ in Paul Paulus and Bernard Nijstad (eds), Group Creativity—​Innovation Through Collaboration, Oxford University Press, 2003, 63–​84. 39 Carsten De Dreu, Bernard Nijstad, and Daan Van Knippenberg, ‘Motivated Information Processing in Group Judgment and Decision Making’, Personality and Social Psychology Review (2008), 12, 1, 22–​49; Natalia Lorinkova, Matthew J Pearsall, and Henry Sims Jr, ‘Examining the Differential Longitudinal Performance of Directive versus Empowering Leadership in Teams’, Academy of Management Journal (2013). 56, 2, 573–​96. 40 David Garvin and Michael Roberto, ‘What You Don’t Know About Making Decisions’. Harvard Business Review, (2001), 1–​10; Edward Russo and Paul Schoemaker,.Winning decisions: Getting it Right the First Time, Currency Doubleday, 2002; Kees Van der Heijden, Scenarios: The Art of Strategic Conversation, John Wiley, 2011.

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Wijnand Nuijts group confidence about its ability to handle and solve conflicts (‘resolution efficacy’);41 • the level of psychological safety within a group. Psychological safety refers to a sense of ‘confidence that the team will not embarrass, reject or punish someone for speaking up’.42 As such, psychological safety is a prerequisite for constructive challenge.43 Psychological safety is the product of positive interactions/​communication between group members, especially under situations of stress.44 3.  Reflective learning 17.21

DNB takes the position that self-​reflection is an important skill for individuals within financial firms, as it enables them to identify the impact of their behaviour on others. It is a prerequisite for learning from prior experiences and for adjusting ineffective or counterproductive behaviour. DNB assesses for example, whether leaders take deliberate measures to organize and actually spend time on self-​reflection. DNB’s position is that in the absence of self-​reflection, leaders are incapable of truly and effectively changing behavioural patterns. Without self-​reflection, there is no self-​correction. 4.  The impact of contextual factors on (individual or group) behaviour

17.22

Organizations, their boards, and their individual staff do not operate in isolation. They are all subject to contextual or cultural factors that exert influence on behaviour. Organizations may experience pressures from competitive market forces, shareholders, or a changing regulatory environment. Boards have to deal with these pressures and need to translate them into actions to safeguard the long-​term stability of the organization. This translation is reflected in organizational strategies, objectives, decisions, and behaviours. All these aspects, in turn, provide the context within which employees have to operate. And, hence, influence their behaviour.

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Several social and psychological aspects play an important role in how contextual factors play out in terms of behaviour. To understand this dynamic process, DNB uses a perspective on culture that to a large extent corresponds with Schein’s three-​ layered conceptualization of culture. According to Schein, culture simultaneously

41 Karen Jehn et al, ‘The Effects of Conflict Types, Dimensions, and Emergent States on Group Outcomes’, Group Decision and Negotiations (2008), 17, 465–​95; Sonja Rispens, ‘Beneficial and Detrimental Effect of Conflict’, in O B Aoyoko, N M Ashkanasy, and K A Jehn, Handbook of Conflict Management Research, Elgar, 2014, 19–​32. 42 Burke et al, n 32, 1189–​207; Amy Edmondson, ‘Psychological Safety and Learning Behavior in Work Teams’, Administrative Science Quarterly (1999), 44, 2, 350–​83. 43 Bradley Postlethwaite et al, ‘Reaping the Benefits of Task Conflicts in Teams: The Critical Role of Team Psychological Safety’, Journal of Applied Psychology (2012), 97, 1, 151–​8; Edmondson, n 42, 350–​83. 44 Burke et al, n 32, 1195.

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Public Supervision of Behaviour and Culture exists at three levels: (i) assumptions; (ii) values and beliefs; and (iii) behaviours and artefacts (see Figure 17.01). (Invisible) assumptions and values are seen as drivers for (observable) behaviours, which—​in turn—​produce (observable) outcomes, like company performance. In a similar vein, DNB’s methodology distinguishes between—​slightly different—​layers, whereby the sub-​surface levels of mindset and group dynamics, drive the ‘behavioural’ layer above the waterline (see Figure 17.02).45

Artifacts Values Assumptions

Figure 17.01 Schein’s mode of culture Decision making leadership communication

Behaviour

Group dynamics

Mindset

Figure 17.02 DNB’s ‘iceberg’ relating to behaviour and culture It is important to note that it is not only mindsets, assumptions, and beliefs that 17.24 drive behaviour, organizational structures do as well. Structures, procedures, and systems are designed ‘to shape, direct and coordinate behaviour towards the accomplishment of common organisational objectives’.46 Culture and structure each



Nuijts, ‘Managing Culture: The Role of Regulation and Supervision’, n 20, 53–​6. Nuijts, n 20, 55. See also Ivan Steiner, Group Processes and Productivity, Academic Press, 1972.

45 46

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Wijnand Nuijts consist of a variety of factors that mutually influence eachother over time in non-​ linear ways. As a result, there is no clear dividing line between culture and structure. This symbiotic perspective is well-​reflected in the following quote: ‘organizational culture represents the collective values, beliefs and principles of organizational members and is a product of such factors as history, product, market, technology, strategy, type of employees, management style, and national culture:  culture includes the organization’s vision, values, norms, systems, symbols, language, assumptions, beliefs and habits’.47 17.25

DNB’s supervision of behaviour and culture is aimed at: (i) identifying the various contextual, cultural, and structural factors that influence individual and/​or collective behaviours (by using various qualitative and quantitative methods);48 and (ii) revealing how and to what extent these behaviours drive a firm’s performance or risk profile. Having a comprehensive overview of this complex of factors, helps to create a broad insight into the root causes of firm failures, supervisory issues, and/or misconduct. In turn, knowing these true (behavioural and structural) root causes, is important to design truly effective interventions and solutions. Basing solutions on the examination of isolated or only a subset of factors , will probably not produce the same results, because: (i) such analyses are incomplete; and (ii) factor out the interplay—and hence indirect effects—between these factors. Obviously this has implications for the way institutions and supervisors have to approach behavioural and cultural change; these implications will be touched upon below in Section III.F.

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It would go beyond the scope of this chapter to discuss all contextual (cultural and structural) factors that may have an impact on behaviour. However, one should be given specific attention: social norms. Although invisible to the human eye, they are one of the most powerful forces that drive behaviour.49 In essence, they are generally accepted group norms that prescribe how people are expected to behave in a given context. Social norms may relate to a wide variety of topics: the acceptance of conflict during decision making, the balance between reward and risk, accepted levels of risks, or the tolerance of deviant opinions. Their influence is due to several powerful underlying psychological processes.50 First of all, individuals look at the behaviour of others to determine what is the right thing to do in a particular 47 David Needle, ‘Business in Context:  An introduction to Business and its Environment, Thomson, 2004; Nuijts, n 20, 53–​6. 48 See section II on DNB’s Focus approach as well as Section III.C. 49 See n 27; see also Robert Cialdini, Carl Kallgrenn, and Raymond Reno, ‘A Focus Theory of Normative Conduct, a Theoretical Refinement and Reevaluation of the Role of Norms in Human Behaviour’, Advances in Experimental Social Psychology (1991), 24, 201–​34; Peyton Young, ‘The Evolution of Social Norms’, Economics (2015) 7, 1, 359–​87; Noah Goldstein, Robert Cialdini, and Vladas Griskevicius, ‘A Room With a Viewpoint: Using Social Norms to Motivate Environmental Conservation in Hotels’, Journal of consumer research (2008) 35, 3, 472–​82; see also Richard Hollinger and John Clark, Theft by Employees, Lexington Books, 1983. 50 Moore and Gino, n 5, 53–​77. See also n 28.

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Public Supervision of Behaviour and Culture situation (imitation, modelling). Furthermore, people want to behave in socially approved ways (social proof ). And finally individuals are inclined to follow norms that are accepted by individuals that are similar to us (social categorization). It is of great value for institutions as well as supervisors to identify the social norms that drive behaviours. Knowing these underlying drivers creates a starting point for influencing these norms towards behaviours that contribute to the firm’s sustainable performance. B. Findings and effects of the supervision of behaviour and culture 1.  Examples of assessment findings Since DNB started to perform the supervision of behaviour and culture, it has 17.27 regularly communicated findings that flowed from the approximately 100 assessments it has performed since spring 2011.51 Most assessments relate to board effectiveness and (culture) change effectiveness. Table 17.2 provides examples of assessment findings relating to these frameworks (largely taken from DNB’s publication in 2015). 2.  Effects of supervision of behaviour and culture On a firm specific level, DNB has experienced that a large majority of assessed 17.28 firms follow up on the assessment findings at their own initiative. Based on monitoring efforts, it can be seen that institutions take action as a result of behaviour and culture assessments to address the findings that were observed. The following effects are observed: • First of all, the assessments contributed to a growing awareness among financial institutions that behaviour and culture are important for firm performance and responsible risk-​taking. Of course DNB is not alone in this effort. Various international standard setters, auditor organizations, and supervisors addressed this prominence as well. In the Netherlands, the Dutch market conduct supervisor, AFM, also performs its own type of supervision of behaviour and culture. The AFM has integrated behaviour and culture perspectives into its supervision aimed at identifying behavioural patterns within the organization that may jeopardize customer centricity. In this respect they have conducted assessment into decision making (2017) and organizational learning (2017);52 • Due to this increasing awareness, much more weight is attached to the importance of effective interactions between board members. Many boards started to



See Table 17.1. See https://​www.afm.nl, accessed 17 October 2018.

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Poor reflective abilities and little reflective learning.

Good examples

A management board that carefully weighs opportunities and risks. The board verifies that all risks are discussed and asks external experts for support in doing so. A financial institution that consciously attempts to strike a balance between insiders and outsiders to create a diversity of perspectives (and brings newcomers that dare to question the board’s basic assumptions). This may initiate a conscious debate about the development of organizational culture in motion, and the quality of decisions will improve. Different perspectives are effectively managed (see below under B. Board Effectiveness) to prevent miscommunication and friction between board members. Boards and staff do not reflect on their own A management board that after each meeting behaviour and hence don’t learn enough from their evaluates the process followed during the meeting. own experiences (through board reflections or root Questions that need to be answered include: were cause analyses). Not learning from mistakes or the dynamics between the board members conducive successes creates the risks that ineffective approaches to effective discussions and decision making? survive and good practices are not embedded. Were the contributions of the individual members especially effective or was it the opposite? What made our decision successful and how did our own behaviour play a role?

Risks

Risks are not sufficiently acknowledged in the decision-​making process. As problems are only addressed at a late stage, they escalate and are more difficult to solve. Insular subculture Boards are primarily recruiting new members that (in group/​out group). fit in the prevailing culture. This may reinforce ineffective behavioural patterns and restricts diversity of backgrounds, expertise, and opinions. Within the prevailing subculture, mutual behaviour is primarily confirmed and not sufficiently criticized. This creates the risk of group think and may cause staff, customers, and other stakeholders to feel their interests are not represented in the board.

A. General Tendency towards consensus and excessive optimism.

Findings

Table 17.2 Behaviour and culture assessment findings 2011–​2018

Group dynamics Leadership; (Culture) Change Effectiveness.

Group dynamics.

Leadership; group dynamics; decision making.

Key words

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Risks/​stakeholder interests are not sufficiently acknowledged and incorporated in the decision­ making process. This may be caused by a variety of behavioural impediments (overconfidence, dominant leadership, group conformity, negative emotions, conflicting personal ambitions, or resistance to change), as well as through the insufficient presentation of decision materials or the lack of timely/​meaningful involvement of second line functions.

C. (Culture) Change Effectiveness Board is not After announcing a new ambitious strategy, sufficiently the board transfers the responsibility for the visible during the implementation to lower levels within the transformation. organization. This gives the message to the organization’s staff that the transformation is not the highest priority of the board. Few or no priorities Changes are not carried through due to a lack of in change initiatives priorities, and staff and stakeholders are unclear about the organization’s strategy and intentions. Staff members eventually set their own priorities, and the organization fails to achieve its objectives. Little attention for Not enough attention is paid and dialogue time implemen-​tation into is spent on exploring what the transformation day-​to-​day behaviour means for day-​to-​day behaviour for managers and change. employees throughout the entire organization. Ideas get stranded and are not put into practice. Staff is demotivated and results are missed as the organization fails to implement change effectively.

B. Board Effectiveness Inadequate constructive challenge due to a combination of factors.

(Culture) Change Effectiveness.

An institution that constantly reflects on the progress (Culture) Change of the change and translates expectations into concrete Effectiveness. new behaviours. The organization changes gradually in a well-​considered direction without dictating the exact route. Progress is frequently evaluated. These leaning experiences are incorporated and redirections are made if necessary.

An organization defines clear priorities for change, and is (Culture) Change able to implement, monitor, and adjust the process as it Effectiveness. concentrates on a small number of top priorities, rather than a large number of changes.

A board that sets a clear direction, is personally and visibly involved in the implementation of the change, and role models behaviour that is desired in the new situation.

A management that has structurally organized the Decision-​making process of constructive challenge (e.g. through dialectical Group dynamics enquiry, inviting outsiders, devil’s advocate) and carefully debates/​weighs opportunities and risks. The board safeguards that all relevant people are meaningfully and timely involved. All these actions are reinforced by leadership that encourages participation and debate, resulting in individual board members contributing their own perspectives, being able to accept opposing views in a constructive way, and being willing to arrive at a balanced decision with a long-​term perspective.

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Wijnand Nuijts periodically and structurally reflect on their own behavioural patterns, check-​in on emotions, address sensitive issues directly, and take action if the institution’s dynamics are ineffective; • Management boards have also taken measures to reinforce constructive challenge explicitly, for example by: • specifically organizing time for debate; • structuring the debate to enhance diversity of perspectives; • explicitly involving and reinforcing second line functions; • More attention is given to behavioural and cultural aspects of change. Firms specifically design culture change plans prior to their transformation efforts and/​or task internal audits to monitor the progress of these efforts through specifically designed frameworks. Increasingly often, cultural change is considered to be the visible responsibility of top management; • Finally, evidence can be seen that ineffective behavioural patterns result in departure of board members, not even as a consequence of DNB’s assessments but on an institution’s own initiative. 17.29

On a more general level, DNB believes the supervision of behaviour and culture contributed to the effectiveness of financial supervision itself. First of all, by digging into the behavioural root causes of supervisory issues, a more complete picture of the problem and its underlying causes is created. This contributes to the identification of effective interventions with respect to often persisting supervisory problems. Another contribution relates to the language that DNB created to communicate about behaviour and culture. This language aims to make concepts from social and organizational psychology accessible for professionals with financial, risk, or legal backgrounds. The resulting ‘common language’ is crucial for the understanding (of the relevance) of behaviour and culture for their own and their firm’s performance. A final merit lies in the fact that the supervision of behaviour and culture introduced validated qualitative research methods to examine these topics. These methods are rooted in social science and enable verifiablestatements about behaviour and culture. Thisis crucial for the acceptance of behaviour and culture in the financial sector. The fact that a large majority of the examined boards recognize, acknowledge, and (can be influenced to) follow up on assessment findings speaks positively in this respect. However, the foregoing does not imply that the supervision of behaviour is a ‘cure for all ails’. If boards follow up findings relating to board interaction, this does not guarantee that all will remain well over a longer period of time. Neither does it automatically ensure organization-wide change. The current challenge for behaviour and culture supervision (with its limited resources), is to ensure effective board interaction and organizational change over a longer period of time.

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Public Supervision of Behaviour and Culture C. How is the supervision of behaviour and culture performed? The supervision of behaviour and culture is an integral part of DNB’s prudential 17.30 supervision. As mentioned in Section II, expertise relating to the supervision of behaviour and culture is concentrated in DNB’s Expert Centre on Governance, Organizational Behaviour and Culture. This expert centre does not work in isolation, but closely cooperates with line supervision on banks, insurance companies, and pension funds. This cooperation includes: • Joint off site risk assessment in accordance with DNB’s Focus methodology to identify potential risks relating to behaviour and culture and their potential impact on financial outcomes and responsible risk-​taking. This initial risk assessment combines line supervisors’ firm knowledge and expert insights. The outcome of this assessment is reflected in a firm’s risk profile which serves as an indicator for planning and prioritization of supervisory resources. • The initial risk assessment may, for example, lead to a root cause analysis into the behavioural causes of specific supervisory problems. This is an off-​site instrument and is performed by experts, in close cooperation with line supervision. Based on the outcome of the analysis, experts and line supervisors will jointly decide if and how to further investigate behaviour and culture at a specific firm. • This may for example occur through an on-​site examination. This examination is based on one of the assessment frameworks described above. Irrespective of the selected framework, an assessment starts with a kick off meeting with the firm’s management body. This meeting is held to open the dialogue and to explain the scope/​approach of the assessment. This contributes to a climate of trust between supervisor and firm. Following the kick off, assessments usually comprise of: • Desk research, which involves an off-​site context analysis into the position of the firm. The desk research includes several relevant documents relating to the firm’s strategy, market position, and governance mechanisms. Information about existing supervisory issues or incidents is also included. • Employee surveys may be used to gain insight into perceptions of a larger group of employees and to collect quantitative data. The survey, for example, may inquire if senior managers and directors behave in accordance with the core values of the organization or if employees feel encouraged to adopt a constructively critical attitude towards management. • Self-​assessments are sent to members of the (management and supervisory) board to gain more insight into their personal mindset, into their connection to the values and strategy of the firm, and into their perceptions on the quality of interaction within the board. • Interviews are the core of the assessment, because they are essential to gain in-​depth knowledge of specific behavioural and cultural patterns. Interviews are held with people from all levels and quadrants of the firm (not only board level). Per assessment fifteen to twenty-​five interviews are held.

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Wijnand Nuijts • Finally, observations of board/​team meetings are conducted to gain further insight into behavioural patterns within the selected task group. It is important to note that experts to do not participate in these meetings. Nor are they intently listening to what is being said. As a ‘fly on the wall’ they observe how board members interact. As such, the experts observe group processes, but also try to assess how personal behaviours, and most notably those of the CEO and Chairman of the Board, influence such processes. The aim is not to assess the quality of these individuals, but to understand what drives the quality of group interaction. • All the above-​mentioned information is analysed so as to discover behavioural patterns. For example, interviews are recorded, transcribed, and subsequently categorized. Categorization means that interview quotes are transferred to a textual analysis tool containing the various categories of an assessment framework (leadership, decision making, etc). Often more than 400 pages of transcript need to be categorized. This generates a large amount of quotes—​and hence individual perceptions—​on leadership styles and other interaction patterns. Analysing these quotes reveals recurring behavioural patterns. This analysis is then triangulated with other sources of information, like self-​assessments, and ultimately lead to the identification of dominant behavioural patterns and their impact on the effective functioning of the group and/​or the performance of the firm. • An important activity throughout the entire assessment is the continuous challenge between the members of the assessment team. This is crucial in reaching clear and sound judgements of the observed behavioural patterns and their cultural drivers. This challenge involves multiple sessions; initially amongst the behaviour and culture experts, subsequently, between the experts and line supervisors (who challenge the findings on the basis of their knowledge of the organization and supervisory issues). Finally, the challenge requires an independent view from other behaviour and culture experts that were not involved in the assessment. • Once finalized, the findings are presented to and discussed with the institution’s key players in a so-​called challenging dialogue. The aim of this dialogue is to ensure that the firm ‘recognizes and acknowledges’ the observed behavioural patterns and the (potential) risks that may be associated with them. This dialogue serves as a ‘mirror’, through which the relevant players are able to ‘see’ and hence reflect upon their own personal and group behaviour. In DNB’s experience this is an effective tool for initiating behavioural change: it’s hard to deny a mirror. • Finally, a written report is drafted including not only DNB’s findings, but also DNB’s expectations about follow up remediation measures. DNB monitors and tracks whether these measures are effectively implemented in the institution’s organization.

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Public Supervision of Behaviour and Culture D. Legal concepts that are relevant for the supervision of behaviour and culture As mentioned above, the supervision of behaviour and culture does not create 17.31 (extra) rules for financial firms. DNB takes the position that it is impossible and undesirable to prescribe certain behaviours. For, what is effective behaviour in one situation may be totally counterproductive in another. As such, DNB takes the position that the supervision of behaviour and culture is a set of tools, not a set of rules. This does not mean that there are no legal concepts that are relevant for the supervision of behaviour and culture, and to the extent possible, DNB includes such legal concepts in its supervision of behaviour and culture. The most relevant concepts are described below. They refer to the tone from the top, the importance of challenge, the role of the chair in the context of decision making, and the role culture plays in ensuring responsible risk behaviours and ethical conduct. As such, these concepts correspond with the above-​described elements of DNB’s supervisory approach on behaviour and culture. Several international governance codes and principles stress the importance of 17.32 behaviour and culture for the functioning of financial firms. For example, the The Basel Committee on Banking Supervision (BCBS) Corporate Governance Principles for Banks (2015) state that ‘sound corporate governance, is an essential element in the safe and sound functioning of a bank and may adversely affect the bank’s risk profile if not operating’ (Recital 5). The Principles further state ‘a corporate culture of reinforcing appropriate norms for responsible and ethical behaviour’ are a fundamental component of good governance. In particular, boards have the responsibility to: • ‘[A]‌lign corporate culture, corporate activities and behaviour with the expectation that the bank will operate in a safe and sound manner, with integrity and in compliance with applicable laws and regulations’ (Recital 3). In particular the BCBS Principles focus on enhancing the board’s responsibility to create a responsible risk culture and to define conduct risk (Recital 14); • Reinforce a tone from the top (and draft a code of ethics) that states corporate values that:  (i) enhance ethical behaviour and promotes risk culture and risk awareness; and (ii) encourage and enables employees ‘to communicate, confidentially and without the risk of reprisal, legitimate concerns about illegal, unethical or questionable practices’ (paragraphs 29–​31). Also on a European level, and most notably through the EBA’s recent Guidelines 17.33 on Internal Governance (2017), the importance of certain behaviours is mentioned as a prerequisite of good governance. For example, it highlights that: • a bank’s decision making should not be dominated by a single member or a small subset of its members (Article 22);

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Wijnand Nuijts • the management body should engage actively in the business of an institution and should take decisions on a sound and well-​informed basis (Article 28); • the management body in its supervisory function and in its management function should interact effectively (Article 22). In particular they must for themselves and between each other ‘constructively challenge and critically review propositions, explanations and information received when exercising its judgement and taking decisions’ (Articles 30, 31, and 33b); • the chair should encourage and promote open and critical discussion and ensure that dissenting views can be expressed and discussed within the decision-​making process and should ensure that decisions of the management body are taken on a sound and well-​informed basis (Articles 34 and 35); • the bank should have a risk culture that enhances the institution’s risk awareness and risk-​taking behaviour (Article 23j), whereby the supervisory board should monitor the consistent implementation of the bank’s risk culture (Article 33f ). Whereby this risk culture includes but is not limited to tone from the top, accountability, effective challenge, and appropriate incentives (Article 98); and • the bank should have a corporate culture, which fosters responsible and ethical behaviour (Article 23j). 17.34

In addition, the International Association of Insurance Supervisors (IAIS) Insurance Core Principles (2015) and the European Insurance and Occupational Pensions Authority (EOIPA) Guidelines on the Systems of Governance (2014), at several instances, highlight the importance of corporate culture and values for the effective functioning of an insurer’s corporate governance and most notably the implementation of the firm’s strategies and objectives with an eye on long-​term viability and various stakeholder interests (IAIS ICP 7.1). In this respect, the board should set the appropriate tone from the top, thereby advocating adherence to corporate values that encourage responsible risk behaviours (IAIS ICP 7.2.3). Also the importance of challenge and debate and open and frank communication is promoted, with an eye on reporting bad news without the fear of reprisal (ICP 7.2.4, EIOPA Guidelines 1.24). E. Recent and future developments 1.  Recent developments

17.35

As explained above, DNB’s supervision of behaviour and culture aims to increase the effectiveness of its financial and integrity supervision by preventively influencing the firm’s culture and behaviour. Performing and following up on assessments to mitigate firm-​specific behaviour and culture risks is an indispensable way to accomplish this goal. To have a more sector-​wide impact, DNB regularly publishes generic (anonymized) assessment findings, good practices, and/​or (scientific) research. By doing so, it aims to increase awareness of behaviour and culture

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Public Supervision of Behaviour and Culture and to encourage behaviour and culture perspectives within (inter)national financial firms and supervisors (for an overview of publications see Table 17.1 and n 6). More recently, DNB:

17.36

• Supported (inter)national supervisors with the development of behaviour and culture perspectives in their own contexts.53 This may involve the performance of pilot assessments and/​or the design of methodologies. More specifically, DNB actively contributed to the development of behaviour and culture supervision in the context of European banking supervision, which is performed by the Single Supervisory Mechanism (SSM) under coordination of the European Central Bank (ECB). In the years 2015–​2017, the author of this chapter chaired an SSM Task Force on Behaviour and Culture, to explore if and how behaviour and culture could become part of the SSM supervisory methodology in significant banking institutions. The ECB, as well as several national banking supervisors, were members of this task force. The task force prepared a methodology relating to Board Effectiveness and Change Effectiveness, which were field tested at a number of significant banks in five different European countries. In October 2017 the SSM adopted a proposal to integrate both frameworks into its methodology. • Supported the Central Bank of Ireland in performing behaviour and culture assessments into the five largest Irish retail banks (largely corresponding to the entire Irish Retail Banking sector). This culture review relates to the manner in which five Irish banks (three of which are ‘part owned’ by the Irish government) treated their customers in relation to tracker mortgage contracts; banks were ‘accused’ of withholding customers beneficial mortgage rates (‘tracker mortgages’). Although the Central Bank of Ireland (CBI), as the financial supervisor, undertook strong efforts to ensure that banks identified and compensated affected customers, ultimately, in late 2017, the Irish Minister of Finance wanted to dig deeper and ‘mandated the Central Bank to prepare a report on the current cultures and behaviours and the associated risks in the retail banks today and the actions that may be taken to ensure that banks prioritise customer interests in the future.’ The outcome of this culture review was presented to the Minister of Finance and subsequently published in July 2018.54 The report noted several positive points as well as some concerns. In short, the report concluded that while all banks were making efforts to embed the customer interest into their 53 e.g. OSFI, APRA, MNB, Central Bank of Thailand, and the New York Federal Reserve Bank to gain experience with behaviour and culture. Also, DNB contributed to the development of the supervision of behaviour and culture at the Dutch market conduct regulator, the AFM. DNB seconded one of its staff for a period of six months to prepare a proposal for the organizational structuring and methodological design of this supervision. 54 Report Behaviour and Culture of the Irish Retail Banks, July 2018, https://​www.centralbank. ie/​publication/​behaviour-​and-​culture-​report, accessed 17 October 2018.

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Wijnand Nuijts decision-​making processes, several demonstrated behaviours that may jeopardize the success of the transformation efforts. Organization wide transformation requires a long-​term perspective and a clear and collective understanding of the transformation’s ‘what’ and ‘how’; this requires collaboration at all levels of the organization and leadership styles that accommodate the reconciliation of diverse perspectives. Not all observed behaviours were conducive to this outcome. For example, not all banks had a clear and collective understanding of what consumer focus actually means and what behaviour it requires. Also, some executive committees displayed ‘firefighting behaviour’, focusing on urgent and short-​term issues (at the expense of the long-​term perspective). In addition, remnants of the crisis-​era mindset in some instances resulted in an occasional reversal to directive, or ‘command and control’, leadership styles when the emphasis should be on collaborative approaches. The review also reflected concerns around over-​optimism regarding the successful transition to a consumer-​focused culture, whereby banks underestimated the complexity of the transformation task that lies ahead. At the time the article was written all five banks were devising action plans in response to the institution-​specific findings of the behaviour and culture examinations. Contributed to the culture work undertaken by the Financial Stability Board’s Working Group on Governance Frameworks (FSB respectively WGGF). This working group was tasked ‘to consider how progress could be made in using governance frameworks to address misconduct risk’. The WGGF produced two reports, both dedicating prominent parts to the role that culture could play in the origination and possible mitigation of the risk of misconduct.55 For the Phase 1 report DNB: (i) led and contributed to a literature study that analysed the root causes of twelve misconduct cases in the financial as well as in the non-​financial sector; and (ii) undertook a scientific review into the effectiveness of various approaches against misconduct. In addition, DNB contributed to the Phase 2 report, which provides a tool kit to assist financial firms as well as supervisors to mitigate the risk of misconduct. 17.37

The Phase 1 as well as the Phase 2 report explain that misconduct in most cases is the product of (the interplay between) a variety of structural and cultural factors. The above-​mentioned root cause study (see also Figure 17.03) revealed (i) pressures from external forces that influenced (ii) board and management mindsets. These mindsets were then translated into (iii) overambitious targets, risky decisions, and/​ or a tone from the top that reflected an eagerness for growth at the expense of risk management, safety, or compliance. The risks emanating from these factors were often amplified through (iv) dominant leadership, (v) group conformity at top level 55 FSB, ‘Stocktake of efforts to strengthen governance frameworks to mitigate misconduct risks’, May 2017, available at www.fsb.org/​, accessed 17 October 2018.

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Public Supervision of Behaviour and Culture Context A. External pressure

Organization board

B. Leadership and board translation 1. Mindset 2. Strategy/Targets 3. Behaviour/Decision making 4. Normalization of deviance

C. Internal pressure

Non-board

D. Translation into organizational behaviour

E. Structural translation

1. Mindset 2. Behaviour/Social norms 3. Openness/Speaking up 4. Normalization of deviance

1. Financial incentives 2. Position control functions 3. Escalation procedures

Figure 17.03 Structural and cultural factors related to misconduct (both eroding constructive challenge), (vi) limited opportunities for staff to speak up or report bad news, and (vii) marginalization of control functions and of contrarian views. Finally, most misconduct cases demonstrated a process called (viii) ‘normalization of deviance’, which is basically a slippery slope process where the organization gradually takes on and condones increasing risks, up to a level that it is unacceptable and irresponsible. Normalization remains unnoticed and only reveals itself through its consequences of having slowly eaten away the safety buffers that organizations need when times get rough. As the literature study demonstrated, it is often too late then. The Phase 2 report recommends financial institutions and their supervisors to 17.38 explicitly pay attention to behaviour and culture in order to identify and manage factors that may lead to misconduct. For example, financial supervisors should ‘build a supervisory programme focused on culture to mitigate the risk of misconduct’. Such a programme should include ‘a broad range of—​qualitative and quantitative—​information and techniques to assess the cultural drivers of misconduct at firms’. These recommendations (similar ones apply to financial institutions) aim to promote root cause analyses, so as to create as complete an overview of the structural and cultural drivers of inappropriate behaviour as possible. As partial explanations deliver only partially valid interventions, this comprehensiveness is perceived to be a prerequisite for effective interventions to prevent misconduct.

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Wijnand Nuijts 3.  Future developments 17.39

The above-​mentioned developments demonstrate the growing recognition of behaviour and culture as an influencer of financial performance, risk management, and ethical conduct. There is confidence that supervisors and financial institutions will increasingly develop approaches relating to behaviour and culture in the near future. This is process which is already well underway.

17.40

The question, however, is how these developments will play out over a longer period of time. In this respect, several challenges lie ahead: • The first challenge relates to the perspective that shortcomings within financial institutions should predominantly be addressed through enhanced regulation and/or by reinforcing structures and processes . Of course, such measures are necessary to address failures. However, the scientific review that was undertaken in the course of the FSB Phase 1 work , demonstrated that rules-based approaches may have limited effectiveness if applied in isolation. This may be because rules and processes do not give guidance in every situation . They may even have counterproductive effects, as they may foster resentment, resistance, and may even lead to calculating behaviour.56 Hence, the FSB WGGF concludes that rules-​ based approaches (and enforcement) should be complemented by culture-​based approaches, aimed at: (i) changing the underlying mindsets, beliefs, and social norms that shape culture; and (ii) fostering psychological safety in order to encourage staff to report bad news and learn from mistakes (instead of being punished or blamed). These culture-​based programs require a long-​term perspective. The challenge for financial institutions and their supervisors will be to maintain this long-​term perspective, while at the same time being under pressure from the public, politicians, and/​or law enforcement agencies to respond with swift, decisive, and visible actions that solve the problem ‘once and for all’. • This challenge is further amplified by the fact that many institutions and supervisors struggle with the operationalization of culture. It is one thing to acknowledge their importance, it’s a whole different ballgame to design long-term approaches that are effective at an organization-wide scale. Knowledge and expertise on the ‘behavioural side of business’ in general is not abundantly available within financial institutions or supervisors. Effective and practical operationalization may be

56 Eugene Bardach and Robert Kagan, Going by the Book:  The Problem of Regulatory Unreasonableness, Temple University Press, 1982.; Linda Trevino et al, ‘Managing Ethics and Legal Compliance—​What works and what hurts’, California Management Review (1999), 41, 2, 131–​ 51; Raymond Pasternoster, ‘How Much Do We Really Know About Criminal Deterrence?’ The Journal of Criminal law & Criminology (2010), 100, 3, 765–​824; Kristina Murphy, and Tom Tyler, ‘Procedural Justice and Compliance Behaviour: The Mediating Role of Emotions’, European Journal of Social Psychology (2008), 38, 652–​66; Uri Gneezy and Aldo Rustichini, ‘A Fine is a Price’, Journal of Legal Studies (2000), 1–​18; Neil Gunningham and Darren Sinclair, ‘Organisational Trust and the Limits of Management-​Based Regulation Law & Society Review’ (2009), 43, 4, 865–​900.

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Public Supervision of Behaviour and Culture especially challenging for large, internationally operating firms. Most of these firms are currently going through large and complex transformation processes that affect their business models, core processes, IT/systems and, hence, interaction/cooperation patterns within the organization. To a large extent, they are entering new territories where traditional organizational models or transformation approaches may not be valid. This all requires multilayered and long-term interventions where structure and culture go hand in hand and where specialists are able to communicate in a common language (that is not yet ‘spoken’ by everyone). The question is whether institutions will have the stamina to complete these efforts when a new crisis occurs. Despite these challenges and questions, in the author of this chapter’s view, there 17.41 is no doubt that sound organizational development and performance requires the integration of behavioural perspectives into the governance and management of financial institutions. Only if it is understood how and to what extent organizational structure and culture influences behaviour and organizational outcomes, will it be possible to design interventions that produce adequate results. On another note:  is it an option to continue on the road of regulation and 17.42 process-​driven solutions, when most financial institutions seem to have reached the maximum of what can be absorbed? Should the risk that more regulation may contribute to misconduct not be acknowledged? An illustrative example in this respect, is how employees of the Dutch ABN AMRO Bank acted in the context of the bank’s mortgage approval process. The Dutch market conduct supervisor, AFM, demanded reinforcement of this process to eliminate obvious flaws. Wanting to top the AFM’s expectations, ABN AMRO decided to add additional steps to its already complicated process. However, and although this process involved several organizational units, central process responsibility was not established. At the same time, employees had to achieve ambitious mortgage approval targets, which were jeopardized by the complexity of the process. One of the largest obstacles was that several actions required the customer’s signature. Employees felt embarrassed to approach the client to obtain this signature for administrative purposes. Under these circumstances, some employees took the decision to copy the customer’s signature for the purpose of procedural progress. Obviously, this behaviour is inappropriate and unacceptable. But what this example makes clear is, that by adding layer after layer of rules and procedural steps, individuals may feel stuck and may see no other option than to cut corners in order to meet (too) ambitious organizational objectives. To prevent such behaviour in the future, it is crucial to understand how structural and cultural factors influence individual or group behaviour. In the author of this chapter’s opinion, the financial sector as a whole will benefit if 17.43 organizational processes are tuned in such a manner so as to facilitate appropriate

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Wijnand Nuijts behaviour aimed at desirable outcomes. In other words, the tradition of first looking at structure and only at the end at culture, should be revised. Instead, behavioural aspects should be considered simultaneously when designing organizational structures and processes. F. Summary and conclusion 17.44

In the previous paragraphs, the evolution, methodologies, and merits of DNB’s supervision of behaviour and culture have been described. Only through learning and experience did DNB develop the principles that underly today’s supervision of behaviour of culture. Some of them have been the foundations of the supervision of behaviour and culture from the start; others have been gradually developed. As a means to summarize this chapter, an overview of these basic principles is provided: • Behaviour and culture are important drivers of a company’s performance. • DNB does not prescribe a specific culture; nor does it define what is ‘good’ or ‘bad’ behaviour. DNB predominantly relates behaviour and culture to effectiveness, thereby acknowledging that what is effective in one situation, may be counterproductive in another. DNB’s approach is risk based: it identifies behavioural and cultural risks and their (potential) impact on the firm’s performance and risk profile. However, the supervision of behaviour and culture is not entirely ‘culture neutral’; interventionaction may be required when firms engage in (intentionally) irresponsible or unethical behaviour and/or the violation of regulation. • It is possible to identify culture and behaviour, as: (i) culture can be broken down into a large number of identifiable components and behaviours; and (ii) these components can be measured by using scientifically proven (quantitative and qualitative) methods. • There is no clear dividing line between culture and structure. Each consists of multiple components that mutually influence each other. Given this relation, an effective supervisory approach is ‘double sided’ and acknowledges and addresses the interplay between the various constituent components. Consequently, a supervisory approach needs to include as many components as possible. Assessing components in isolation, may lead to inadequate problem-​identification and solutions. • DNB does not enforce behaviour and culture (since there are no strict rules). DNB influences firms to mitigate observed behaviour and culture risks and monitors the firm until this is accomplished. In most cases, firms have taken convincing measures to address DNB’s findings with respect to behaviour and culture. In the other cases, firms did not act to follow up on assessment findings, in turn resulting in violations of regulation. In these cases DNB responded by taking enforcement measures. For clarity’s sake: in such cases DNB did not enforce the behaviour itself, but only the violation of regulation.

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Public Supervision of Behaviour and Culture • Growing evidence emerges from scientific research that rules and enforcement have limited effectiveness in terms of influencing firm behaviour, if applied in isolation. As such, financial supervision may benefit from including behavioural and cultural perspectives. Behavioural risks serve as predictors for financial or risk-​management problems. They often precede supervisory problems. Understanding the behavioural and cultural drivers creates opportunities for early and effective intervention and, hence, prevention. • Culture can be changed. Although this is a complex process, organizational cultures may be changed by influencing the underlying beliefs, assumptions, and values. This stems from the fact that ‘organisational culture is the collectiveness of beliefs that drive and guide individual and group behaviour. Culture-​based approaches focus on changing these underlying collective beliefs and norms. Open, honest, and constructive dialogues throughout an organisation are a prerequisite for such change’. • Culture change requires a long-term perspective. There are no easy solutions and culture change cannot be ‘enforced’. Supervisors must be closely involved in monitoring the firm’s actions and its wilingness to accomplish culture change, and should do so over a longer period of time. In the event the willingness and/ or ability to achieve culture change is absent, action may be required.57



A similar overview is include in Nuijts, n 45, 53–6. See also FSB, n 55, 66.

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18 THE DUTCH BANKER’S OATH AND THE DUTCH BANKING DISCIPLINARY COMMITTEE Peter Laaper and Danny Busch*

I. Introduction II. The Dutch Banker’s Oath III. The Dutch Banking Disciplinary Committee: Actors, Procedures, and Sanctions IV. Right to a Fair Trial V. Independence and Impartiality of the Tribunal VI. Anonymizing Files by Notifying Banks

18.01 18.05

18.10 18.22 18.37

VII. Demarcation of the Bank’s Acts, Professional Acts, and Private Acts VIII. Conflicting Interests of the Notifying Bank IX. Deviation from Internal Policies X. Transparency XI. Evaluation

18.52 18.60 18.65 18.70 18.77

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I. Introduction 18.01

The great financial crisis has led to the adoption of various measures around the world to pursue the individuals behind ‘misbehaving’ financial institutions. Of course, the financial institutions themselves remain the target of sanctions and other measures as well.

18.02

One important example of this ‘trend’ is the post-​crisis administrative sanctioning regime of the EU regulatory framework. Not only does it impose sanctions such as fines on banks and other financial institutions for breaching their regulatory duties, but it also targets the responsible persons ‘behind’ the relevant institutions. This may take the shape of the following administrative measures imposed by the * For the sake of transparency, it should be noted that the second author of this chapter is a member of the Dutch Banking Disciplinary Committee.

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The Dutch Banker’s Oath competent financial supervisor: (i) a public statement identifying the nature of the breach and the person responsible for the breach; (ii) an order requiring the natural person responsible for the breach to cease the conduct and refrain from future breaches; (iii) a temporary ban imposed against a member of the institution’s management body or against any other natural person responsible for the breach; and (iv) administrative pecuniary penalties of up to 5,000,000 euros.1 The Dutch banker’s oath and the Dutch Banking Disciplinary Committee are yet 18.03 another example of this trend. The Dutch initiative nevertheless deserves special attention as mandatory disciplinary law for bankers is unique in the world. The goal of this chapter is to analyse and discuss the first experiences of the Dutch 18.04 banker’s oath and the Dutch Banking Disciplinary Committee, which started its work as recently as 2015. But before doing so some context is needed.2

II.  The Dutch Banker’s Oath The great financial crisis severely damaged trust in the banking sector and raised 18.05 doubts about the conduct and culture of bankers. Those doubts were intensified by the high variable remuneration—​bonuses—​granted to individual bankers. Against this backdrop, the Board of the Dutch Banking Society (Nederlandse Vereniging van Banken or NVB) appointed the Advisory Committee on the Future of Banks (the Maas Committee) in November 2008. The Committee operated entirely independently from the NVB. Its principal task was to make recommendations aimed at restoring trust and confidence in the Dutch banking sector. On 7 April 2009 it published its report entitled ‘Towards restoration of trust and confidence’ (Naar herstel van vertrouwen). One of its recommendations was to introduce a moral and ethical declaration for bank directors and certain other groups of employees.3 The idea of a banker’s oath was born. Its exact calibration evolved over time. 1 See, e.g., (i) Article 67(2), opening words, and sub (a), (b), (d), and (f ) of Directive 2013/​36/​EU, [2013] OJ EU L176/​338–​436 (CRD IV); (ii) Article 70(6), opening words, and sub (a), (b), (d), and (g) of Directive 2014/​65/​EU, [2014] OJ EU L173/​349–​496 (MiFID II); (iii) Article 1(16), under sub (6), opening words, and sub (a), (b), (d), and (f ) of Directive 2014/​91/​EU, [2014] OJ EU L257/​ 186–​213 (UCITS V); (iv) Article 63(2), opening words, and sub (a), (b), (d), and (f ), of Regulation (EU) No 909/​2014, [2014] OJ EU L257/​1–​72 (CSD Regulation); (v) Article 30, opening words, and sub (a), (c), (e), (f ), and (i) of Regulation (EU) No 596/​2014, [2014] OJ EU L173/​1–​61 (MAR). 2 As this chapter was completed on 13 March 2018, it does not cover disciplinary decisions since that date. There is little literature in English on the Dutch banker’s oath and the Dutch Banking Disciplinary Committee. For a critical empirical study, see Tom Loonen and Mark R Rutgers, ‘Swearing to be a good banker: Perceptions of the obligatory banker’s oath in the Netherlands’, Journal of Banking Regulation (2016), 18, 1, 1–​20. See also Wim Meijs, ‘The Dutch experience: Can an Oath repair the Dialogue?’, in Patrick S Kenadjian and Andreas Dombret (eds), Getting the Culture and the Ethics Right (Institute for Law and Finance Series volume 20), De Gruyter, 2016, 85–​95. 3 Adviescommissie Toekomst Banken, Naar herstel van vertrouwen (7 April 2009), available at https://​www.dekamer.be/​kvvcr/​pdf_​sections/​comm/​common/​asset.pdf, 7, 14–​ 15, accessed 1 October 2018.

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Peter Laaper and Danny Busch 18.06

Since 1 January 2013, directors and supervisory directors of banks with their seat in the Netherlands have been legally obliged to swear a banker’s oath or make an equivalent affirmation, whereby they swear or promise to carefully weigh the interests of shareholders, clients, staff, and society as a whole and to put the interests of their clients first. This duty has been included in the Dutch Financial Supervision Act (Wet op het financieel toezicht or Wft) in conjunction with the Oath or Affirmation (Financial Sector) Regulation (Regeling eed of belofte financiële sector).4 If a director or supervisory director violates the banker’s oath, he or she can no longer be deemed to be of good repute and/​or a fit and proper person and his or her employment may have to be terminated.

18.07

In 2014 the NVB introduced its Future-​oriented Banking Package, which included (i) a proposal to extend the Dutch banker’s oath to a much larger group and (ii) a proposal for a proper system of disciplinary law. These proposals were endorsed by all members of the NVB.5

18.08

The idea was picked up by the legislator and since 1 April 2015 all bank employees and even people working for third parties to whom material operating processes have been outsourced must take the banker’s oath.6 Below is the text of the banker’s oath required by law and taken by some 87,000 people working in the Dutch banking industry. Besides signing the oath, employees commit themselves personally by participating in a special ceremony arranged by their employers. Those who take the oath also undertake to adhere to the Code of Conduct. I swear /​promise that, within the boundaries of my function in the banking sector, I will: • Execute my function ethically and with care; • Draw a careful balance between the interests of all parties associated with the business, being the customers, shareholders, employees and the society in which the business operates; 4 More specifically in Article 3:8 sub (1)  and (2)  Wft, read in conjunction with the Oath or Affirmation (Financial Sector) Regulation. Please note that since 1 January 2013, the banker’s oath has also applied to directors and supervisory directors of other financial institutions with their seat in the Netherlands, such as insurance companies and investment firms. See Article 3:8 sub (1) and (2) Wft (insurance companies) and Article 4:9 sub (1) and (6) Wft (investment firms), each time read in conjunction with the Oath or Affirmation (Financial Sector) Regulation. 5 Information in English is available at https://​www.nvb.nl/​english/​2273/​future-​oriented-​ banking-​toekomstgericht-​bankieren.html, accessed 1 October 2018. 6 See Article 3:17b sub (2) Wft, read in conjunction with the Oath or Affirmation (Financial Sector) Regulation. Please note that since 1 April 2015, the duty to take the oath or make the affirmation has been extended to people who work for non-​bank financial institutions (such as insurance companies and investment firms) (i) whose activities can have a material impact on the risk profile of the firm (such as traders) and (ii) who have substantive contact with clients. See Article 3:17b sub (1) Wft and 4:15a Wft, each time read in conjunction with the Oath or Affirmation (Financial Sector) Regulation. The Dutch Banking Disciplinary Committee has however no jurisdiction over them and the same is true for directors and supervisory directors working for non-​bank financial institutions (such as insurance companies and investment firms). See Article 3:17c Wft.

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The Dutch Banker’s Oath

• When drawing that balance, making the customer’s interests central; • Will comply with the laws, regulations and codes that apply to me; • Will keep confidential that which has been entrusted to me; • Will not abuse my knowledge; • Will act openly and accountably, knowing my responsibility to society; • Will make every effort to improve and retain trust in the financial sector. So help me God! /​This I pledge and promise!7

The rules in the Code of Conduct, which is linked to the banker’s oath, are the following: 1 The bank employee works with care and integrity. This means, among other things, that the bank employee: • is honest and reliable; • prevents the conflict of his/​her interests with the interests of others; • prevents the appearance of conflicts of interests.

2 The bank employee carefully balances interests. This means that the bank employee carefully balances the interests of the bank’s customers, its shareholders, its members, its bondholders and other creditors of the bank, its employees and society as a whole. 3 The bank employee puts the customer’s interests first. This means, among other things, that the bank employee: • offers customers the best possible information about products and services, and their associated risks; • does not offer customers products or services that do not suit them; • helps to ensure that products do not expose customers to irresponsible risks; • helps to ensure that products are understandable for customers.

4 The bank employee abides by legislation and other regulations that apply to the bank. This means, among other things, that when carrying out his or her duties the bank employee abides by the legislation, regulations, rules of conduct and instructions that apply to working at the bank. 5 The bank employee does not disclose confidential information. This means, among other things, that the bank employee does not provide any confidential information about customers to third parties without the customer’s permission. The employee only discloses information about customers when required to do so by law, a judge or the supervisory body. The certified employee is also prohibited from misusing the information that he or she has access to.



7

See https://​www.tuchtrechtbanken.nl/​en/​the-​bankers-​oath, accessed 1 October 2018.

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Peter Laaper and Danny Busch 6 The bank employee is open and honest with regard to his or her behaviour and is aware of his or her responsibility to society. This means that the bank employee allows his or her behaviour at work to be tested for adherence to these rules of conduct. 7 The bank employee contributes to promoting society’s trust in the bank. This means, among other things, that when carrying out his or her duties the bank employee does not take any risks that may endanger the bank or others.8 18.09

The taking of the oath has been linked to statutory disciplinary law since 1 April 2015. Bank staff, including directors and supervisory directors, who have taken the banker’s oath, can be punished individually by the Dutch Banking Disciplinary Committee (Tuchtcommissie Banken) if they infringe the relevant rules of the Code of Conduct (quoted earlier ). However, only the staff of banks having their seat in the Netherlands are bound by the rules.9 Foreign banks are required to comply with the rules in their country of origin (in the form of regulation or self-​regulation).

III.  The Dutch Banking Disciplinary Committee: Actors, Procedures, and Sanctions 18.10

To enforce compliance with the banker’s oath, the NVB established the independent Foundation for Banking Ethics Enforcement (Stichting Tuchtrecht Banken, FBEE). The FBEE has set up the world’s first statutory disciplinary board for the banking sector. The primary aim of the disciplinary law is to assess whether an individual has complied with the ethical standards and rules that apply to the group and are laid down in the Code of Conduct.10 It is thus intended to promote ethics and the development of professional values, norms, and standards within a group, but the imposition of measures by the Dutch Banking Disciplinary Committee may also have a deterrent effect.11 Ultimately, the Code of Conduct and disciplinary law should help restore society’s trust in the banking sector.

18.11

Disciplinary proceedings before the Dutch Banking Disciplinary Committee are instituted by means of a complaint. After a complaint has been filed, its admissibility is assessed.12 If the complaint is held to be inadmissible, the complainant

8 ibid. 9 See Article 3:17c Wft. 10 See Section II above for the text of the Code of Conduct. 11 Dutch Parliamentary Papers II, 2013/​14, 33 918, no 10, 5. 12 Disciplinary Regulations, Article 2.2.1–​2.2.4. For the complete text of the Disciplinary Regulations (Tuchtreglement Bancaire Sector) (version 1 September 2016), see https://​www.

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The Dutch Banker’s Oath may (but is not obliged to) apply for review of that decision.13 But if it is held to be admissible (either at first instance or on review), the complaint is put before the Dutch Banking Disciplinary Committee.14 Finally, the complainant may (but is not obliged to) appeal against a decision of the Dutch Banking Disciplinary Committee to the Appellate Committee.15 Consequently, the disciplinary system consists of a minimum of two and a maximum of four stages: (i) an admissibility procedure; (ii) a review procedure; (iii) a procedure before the Dutch Banking Disciplinary Committee; and (iv) a procedure before the Appellate Committee. Anyone can file a complaint with the managing director of the FBEE.16 Most com- 18.12 plainants are bank customers. However, banks themselves may also file complaints against their employees. In fact, according to the legislator, banks must file complaints if employees violate the Code of Conduct, particularly where the violation is serious.17 This is important because although most complaints are filed by customers, they are rarely successful.18 In many cases, complaints are filed because the customer is angry (e.g. when a bank enforces its security rights), not because the bank employee violated the Code of Conduct. On the other hand, twelve of the seventeen complaints submitted to the Disciplinary Board were made by banks. This is understandable. The bank, as the employer, often has the best access to relevant information regarding the behaviour at issue. The admissibility of the complaint is assessed by the Managing Director,19 who 18.13 investigates every complaint that is not clearly unfounded.20 Banks are obliged to provide the information requested by the Managing Director, unless the request is unreasonable in the given circumstances or it would require the bank to act in violation of laws or regulations.21 The Managing Director decides whether to submit a complaint to the Dutch 18.14 Banking Disciplinary Committee. No complaint is submitted if the alleged violation is not serious enough. In deciding on this, the Managing Director takes into account factors such as the nature and frequency of the violation, the responsibilities of the bank employee, and the degree of culpability.22 The Managing Director tuchtrechtbanken.nl/ ​ e n/ ​ a bout- ​ t he- ​ f oundation- ​ f or- ​ b anking-​ e thics-​ e nforcement/​ regulations-​ statutes, accessed 1 October 2018. 13 ibid, Article 2.1.7. 14 ibid, Articles 2.2.1 and 2.2.8. 15 ibid, Article 4.4.1. 16 ibid, Article 2.1.1. 17 Dutch Parliamentary Papers II, 2013/​14, 33 918, no 11, 9. 18 See P Laaper and J W P M van der Velden, ‘Twee jaar bankentuchtrecht onder de loep’, Tijdschrift voor Financieel Recht, 2017, 6, 269–​70. 19 Disciplinary Regulations, Article 2.2.1. 20 ibid, Article 2.1.3. 21 ibid, Articles 3.8.2 and 6.2.2. 22 ibid, Article 2.2.3.

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Peter Laaper and Danny Busch may decide not to submit a complaint if—​essentially—​the complaint is being or has already been assessed by another tribunal or the financial supervisor, or if five years have elapsed since the behaviour giving rise to the complaint occurred.23 18.15

Decisions by the Managing Director not to submit a complaint to the Disciplinary Board are not published on the FBEE’s website. However, decisions in review proceedings are published. It is evident from the published decisions that the most common reasons for the Managing Director to reject the admissibility of a complaint are: (i) that the complaint concerns civil law (a claim for damages) and not disciplinary law, and/​or relates to an action of the bank itself; and (ii) that the complaint does not provide sufficient evidence that the bank employee violated the Code of Conduct.

18.16

This illustrates the low-​threshold nature of disciplinary law for the banking sector. An example is a case in which a customer filed a complaint because he disagreed with the banker’s answers he received to his questions. A low threshold can make disciplinary law an outlet for anger or general dissatisfaction. This emphasizes the importance of the Managing Director’s role in sifting out complaints that are outside of the scope of disciplinary law.

18.17

If the Managing Director dismisses the complaint, the complainant may apply to the chair of the Dutch Banking Disciplinary Committee for review of the decision.24 If the chair upholds the complaint, the Managing Director is obliged to file a complaint after all.25 Of the forty-​seven decisions referred for review, it was held in only two of them that the complaint should be submitted to the Disciplinary Board after all.26

18.18

If the Managing Director decides to submit a complaint to the Dutch Banking Disciplinary Committee, he or she acts as prosecutor.27 The complainant does not become a party to the proceedings. The bank employee who is the subject of the disciplinary proceedings may, however, submit a written defence and documents.28 Upon request, the Managing Director and the bank employee may subsequently submit a written reply and a rejoinder respectively.29 Later, the parties may explain

23 ibid, Article 2.2.4. 24 ibid, Article 2.2.7. 25 ibid, Article 2.2.8. 26 These were cases TRB-​ 2016-​ 3551H and TRB-​ 2016-​ 3593H (available at https://​www. tuchtrechtbanken.nl/​uitspraken/​herzieningsuitspraken, accessed 1 October 2018, unfortunately only in Dutch). The cases decided by the Dutch Banking Disciplinary Committee and the Appellate Committee are downloadable from the FBEE’s website. A summary in English is available in some but not all cases. 27 e.g. Disciplinary Regulations, Article 2.2.8. 28 ibid, Article 3.7.3. 29 ibid, Article 3.7.4.

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The Dutch Banker’s Oath their statements orally in a session called a ‘meeting’. The meeting is closed to the public.30 The bank employee may be accompanied by counsel.31 Parties may ask for witnesses and experts to be heard.32 The Dutch Banking Disciplinary Committee may ask questions about the facts that are the subject of the complaint.33 If the Dutch Banking Disciplinary Committee reaches the conclusion that the 18.19 Code of Conduct has indeed been violated, it may (but is not obliged to) impose one or more of the following measures: (i) a compulsory training order; (ii) a reprimand; (iii) a fine of to 25,000 euros (to be paid to the FBEE); or (iv) a professional ban for a maximum of three years.34 The Dutch Banking Disciplinary Committee cannot award compensation since 18.20 disciplinary law is concerned not with settling disputes with the bank but with assessing the behaviour of individual employees. Nevertheless, a complainant may be able to use the disciplinary procedure as a basis for civil proceedings in which he claims compensation from the bank employee and/​or the bank if the employee’s conduct also constitutes a wrongful act against the complainant. As far as is known, no incidents of this kind have yet occurred, but disciplinary law for the banking profession is still in its infancy. Both the bank employee and the Managing Director can appeal to the Appellate Committee.35 In the appellate proceedings, virtually the same procedural provisions as in the proceedings before the Dutch Banking Disciplinary Committee apply mutatis mutandis.36 Once disciplinary measures become irrevocable, they are entered in the disciplinary 18.21 register (tuchtrechtelijk register) kept by the FBEE for three years.37 The disciplinary register can only be viewed by banks whose employees have taken the Dutch banker’s oath, and is used for the purpose of pre-​employment and in-​employment screening.38 The competent financial supervisors do not currently have access to the register.39

30 ibid, Article 3.7.5. 31 ibid, Article 3.7.8. 32 ibid, Article 3.7.9. 33 ibid, Article 3.7.5. 34 ibid, Article 3.9.2. 35 ibid, Article 4.4.1. 36 ibid, Articles 4.3.1 and 4.3.2. 37 Disciplinary Regulations, Article 5.2 and 5.4, and Disciplinary Register Protocol (Protocol Tuchtrechtelijk Register Stichting Tuchtrecht Banken), Article 6.2 (November 2016 version) (available at https://​www.tuchtrechtbanken.nl/​reglementen, accessed 1 October 2018, unfortunately only in Dutch). 38 Disciplinary Regulations, Article 5.5. 39 See further Section X of this chapter.

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IV.  Right to a Fair Trial 18.22

For a banker against whom disciplinary proceedings are brought, there is a lot at stake. If the complaint is upheld, sanctions can be imposed, including a professional ban or a fine of up to 25,000 euros.

18.23

The first question that arises is whether a defendant banker has a right to a fair trial as laid down in Article 6 of the European Convention for the Protection of Human Rights and Fundamental Freedoms (ECHR). Article 6 ECHR provides protection both when determining ‘civil rights and obligations’ (civil limb) and in the case of ‘any criminal charge’ (criminal limb). The protection is more far-​reaching in the case of a criminal charge, including: (i) the duty to caution the suspect; (ii) the presumption of innocence; (iii) the right not to cooperate; and (iv) the ne bis in idem principle. The second question that arises is therefore whether a disciplinary procedure constitutes a criminal charge.

18.24

The question of whether Article 6 ECHR applies is not at all clear-​cut. Article 6 ECHR is directed at states, not professional associations. Two forms of disciplinary law must therefore be distinguished: statutory disciplinary law and non-​statutory disciplinary law for professional associations.

18.25

Non-​statutory disciplinary law is a system of disciplinary law established by a professional association. An example is disciplinary law for architects who are members of the Dutch Association of Architects (Bond van Nederlandse Architecten, BNA). A member can simply withdraw from the disciplinary law by cancelling his or her membership of the BNA, while continuing to practise as an architect (although not as an architect who is a member of the BNA).

18.26

In the case of statutory disciplinary law, however, statute law dictates to whom it applies and which procedures apply. An example is the disciplinary law for attorneys-​ at-​law (advocaten) in the Netherlands. An attorney-​at-​law cannot easily withdraw from the disciplinary law. As long as he wishes to practise law in that capacity, he is subject to the statutory disciplinary law for attorneys-​at-​law.

18.27

Disciplinary law for bankers is an odd variant of the two. In essence, it resembles non-​statutory disciplinary law for professional associations since it is established by the NVB and applicable only within the sphere of its members (banks). On the other hand, it is not applicable to its members (banks), but to their employees (bankers). Moreover, although Dutch law does not prescribe the disciplinary procedures, it does require banks to subject their employees to disciplinary law for the banking sector. In consequence, like an attorney-​at-​law, a banker cannot simply withdraw from disciplinary law: as long as he is a banker (for a Dutch bank), he is subject to disciplinary law for the banking sector.

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The Dutch Banker’s Oath All in all, the authors of this chapter are not convinced that the European Court of 18.28 Human Rights (ECtHR) would find disciplinary law for the banking sector to be a form of non-​statutory disciplinary law for professional associations; there is a fair chance that it would hold that Article 6 ECHR is applicable to Dutch disciplinary law for the banking sector. The follow-​up question is whether disciplinary proceedings constitute a criminal 18.29 charge. The ECtHR decides autonomously whether the criminal limb or civil limb of Article 6 ECHR applies to a national procedure. It follows that whether the procedure is of a civil or criminal law nature under national law is not decisive. As a general rule, the ECtHR classifies disciplinary proceedings under the civil 18.30 limb.40 However, it allocates them to the criminal limb if they meet the Engel criteria.41 These criteria are: (i) the classification of the offence in domestic law; (ii) the nature of the offence itself; and (iii) the nature and severity of the sentence which can be imposed.42 The ‘offences’ involved in banker’s disciplinary law are violations of the Code of 18.31 Conduct. These ‘offences’ may occasionally be punishable under criminal law, too, as in the case of a banker who used the bank’s systems to obscure the origin of monies that did not belong to him43 or the banker who stole cash from a colleague.44 In itself, such an overlap is insufficient to bring disciplinary proceedings within the criminal limb.45 The ECtHR tests the criterion of the nature of the offence by considering: • whether the violated rule is directed solely at a specific group or is of a generally binding character;46 • whether the proceedings are instituted by a public body with statutory powers of enforcement;47

40 See, e.g., ECtHR 23 June 1981, ECLI:CE:ECHR:1981:0623JUD000687875 (Le Compte, Van Leuven & De Meyere v Belgium); ECtHR 30 November 1987, ECLI:CE:ECHR:1987:11 30JUD000895080 (H v Belgium); ECtHR 26 September 1995, ECLI:CE:ECHR:1995:0926 JUD001816091 (Diennet v France); and ECtHR 15 December 2005, ECLI:CE:ECHR:2005:1215 JUD005314699 (Hurter v Switzerland). 41 ECtHR 24 November 1998, ECLI:CE:ECHR:1998:1124DEC003864497 (Brown v the United Kingdom). ‘Engel’ refers to the case of ECtHR 23 November 1976, ECLI:CE:ECHR:1976: 0608JUD000510071 (Engel & others v the Netherlands), paras 80–​82. 42 See, e.g., Brown v the United Kingdom and ECtHR 19 February 2013, ECLI:CE:ECHR:2013 :0219JUD004719506 (Müller-​Hartburg v Austria), para 42. 43 CVB-​2016-​1 (a decision of the Appellate Committee). 44 TRB-​2017-​3604. 45 See, e.g., Müller-​Hartburg v Austria, para 43. 46 ECtHR 24 February 1994, ECLI:CE:ECHR:1994:0224JUD001254786 (Bendenoun v France), para 47. 47 ECtHR 10 June 1996, ECLI:CE:ECHR:1996:0610JUD001938092 (Benham v the United Kingdom), para 56.

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Peter Laaper and Danny Busch • whether the legal rule has a punitive or deterrent purpose;48 • whether the imposition of any penalty is dependent upon a finding of guilt;49 • how comparable procedures are classified in other Council of Europe member states.50 18.33

The rules of conduct for the banking sector are intended for a specific group. The procedure is not conducted by a public body with powers of enforcement. Although the imposition of sanctions was explicitly intended when disciplinary law was introduced for the banking sector, the primary aim of imposing sanctions has always been to achieve a preventive effect.

18.34

Admittedly, the imposition of a punishment depends on a determination of guilt. However, that is not in itself a compelling factor, unlike the position in every (other) form of disciplinary proceedings. The ECtHR nevertheless usually classifies disciplinary proceedings as belonging to the civil limb.

18.35

The unique feature of disciplinary law for the banking sector in the Netherlands compared with that in other countries is that participation in the disciplinary system is prescribed by law. Although many non-​banking disciplinary law systems share that feature, that does not bring them within the criminal limb.

18.36

In assessing the nature and severity of the sentence which can be imposed, the ECtHR weighs what is potentially at stake and hence the maximum penalty that can be imposed.51 If the maximum sanction is a permanent professional ban, the ECtHR does not bring disciplinary proceedings under the criminal limb.52 However, in several cases the ECtHR has held—​in various wordings—​that the purpose of the disciplinary fine was ‘punitive and deterrent rather than compensatory, . . . suggest[ing] that the matter is ‘criminal’ in nature if the penalty is sufficiently substantial’.53 Nonetheless, the ECtHR has held in respect of a fine of 36,000 euros that ‘[a]‌lthough the size of the potential fine is such that it must be regarded as having a punitive effect, the severity of this sanction in itself does not bring the charges into the criminal sphere’.54 A fine of 45,000 euros could not bring the ECtHR to even reconsider its punitive character.55 As the maximum fine the 48 ECtHR 21 February 1984, ECLI:CE:ECHR:1984:0221JUD000854479 (Öztürk v Germany), para 53; Bendenoun v France, para 47. 49 Benham v the United Kingdom, para 56. 50 Öztürk v Germany, para 53. 51 Engel & others v the Netherlands, para 85; Müller-​Hartburg v Austria, para 46. 52 ECtHR 21 December 1999, ECLI:CE:ECHR:1999:1221JUD002660295 (W R v Austria), para 27. 53 See, e.g., Brown v the United Kingdom (from which the citation) and Müller-​Hartburg v Austria, para 47. 54 Müller-​Hartburg v Austria, para 47. 55 ECtHR 5 April 2016, ECLI:CE:ECHR:2016:0405JUD003306010 (Blum v Austria), para  58–​9.

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The Dutch Banker’s Oath Disciplinary Board can impose is 25,000 euros, there seems no reason to assume that proceedings in the context of disciplinary law for the banking sector entail a criminal charge.

V.  Independence and Impartiality of the Tribunal The right to a fair trial includes the banker’s right to have his case heard by an in- 18.37 dependent and impartial tribunal.56 Even if Article 6 ECHR were not applicable in this case, Dutch disciplinary law for the banking sector is required under Dutch law to provide adequate safeguards for a proper procedure.57 Naturally, a proper procedure requires an independent and impartial tribunal. Moreover, a lack of independence and impartiality would cause the disciplinary tribunal to lose authority. A number of issues may raise questions about independence or impartiality; they 18.38 are discussed and evaluated here. These issues revolve around: • the NVB’s involvement with disciplinary law; • general relations between the FBEE and the NVB; • relations of persons involved in the enforcement of disciplinary law with the financial sector at large and banks in particular; • review of dismissals of complaints by the chair of the Disciplinary Committee. The NVB is involved in disciplinary law in several ways. It was the NVB that introduced disciplinary law for the banking sector and arranged for the mandatory participation of bankers to be recorded in the Dutch Financial Supervision Act (Wft). The Code of Conduct was drawn up and can only be amended by the NVB.58 In our opinion, the NVB’s involvement is reasonable. Disciplinary law is about professional standards in a particular profession. Such standards need to come from within that profession. The need for the NVB’s involvement is therefore obvious. In other professions too, such as the legal and accountancy professions, it is the professional organisation that draws up these standards. The Disciplinary Regulations were drawn up by the NVB. They can be amended by 18.39 the FBEE, but any amendment requires the NVB’s approval.59 Amendments to the Disciplinary Regulations are a more sensitive matter as they deal with such issues as admissibility of complaints, who can be on the Dutch Banking Disciplinary Committee, challenging a member of the Dutch Banking Disciplinary Committee, and the right to be heard. It is noted that the NVB’s right of approval does not 56 ECtHR, Guide to Article 6 of the Convention—​Right to a fair trial (civil limb), updated to 30 April 2017, 34. 57 Article 3:17c(2)(b) Wft. 58 Disciplinary Regulations, Article 1.1. 59 ibid, Article 6.4.

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Peter Laaper and Danny Busch constitute a right to make amendments to the Disciplinary Regulations. It is therefore felt that this right to approve does not impair the tribunal’s independence. Nonetheless, the NVB’s involvement may create an appearance of dependence, in particular in the eyes of a complainant whose complaint does not lead to a ‘verdict’. It is thus believed that it would be an improvement if the NVB no longer had the right to approve amendments to the Disciplinary Regulations. The FBEE should, however, be required to solicit non-​binding advice from the banking sector, and perhaps also from other stakeholders. 18.40

The FBEE was founded by the NVB. Its constitution was drawn up by and can only be amended with the approval of the NVB.60 The NVB has a right to advise (i.e. not to decide) on the nomination of the FBEE’s board members.61 The FBEE’s board members have experience of the banking sector, but only one of them was employed by a bank (until 2005). Their independence therefore seems assured. Yet these rights of the NVB may create an appearance of dependence, especially its right to advise on the nomination of FBEE’s board members in combination with its financial ties to the FBEE.

18.41

A  member of the Dutch Banking Disciplinary Committee or the Appellate Committee may not at the same time be: (i) an employee of the Dutch Securities Institute (DSI)62 or the NVB; (ii) the Managing Director; and (iii) board member of the FBEE, DSI, or NVB.63 Nor may a member of the Dutch Banking Disciplinary Committee be a member of the Appellate Committee.64 Furthermore, the Chairman of the Dutch Banking Disciplinary Committee may not have been affiliated with a bank, in any capacity whatever, in the year before his appointment, unless his or her independence is sufficiently guaranteed in the opinion of the FBEE’s Board.65 The Chairman is appointed by the President of Amsterdam District Court (rechtbank Amsterdam), on the nomination of the FBEE’s Board.66 The Chairman can be removed early only by the President of Amsterdam District Court, at the request of the FBEE’s Board, for pressing reasons.67 Members of the Dutch Banking Disciplinary Committee or Appellate Committee are appointed and may be removed early by the FBEE Board after consultation with the Chairman. Removal is only possible for pressing reasons.68

60 Constitution of the FBEE, Article 13.1. 61 ibid, Article 6.1. 62 The prosecutor is an employee of the DSI. 63 Disciplinary Regulations, Article 3.3.3. 64 ibid, Article 3.3.4. 65 ibid, Article 3.3.3. 66 Disciplinary Regulations, Article 3.3.5. If the President of Amsterdam District Court waives his right to appoint, the FBEE Board can make the appointment itself. 67 ibid. 68 Disciplinary Regulations, Article 3.3.6.

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The Dutch Banker’s Oath Three of the eleven members of the Dutch Banking Disciplinary Committee are 18.42 employed by a bank. The same is true of one of the eleven members of the Appellate Committee. The Chairman of the Dutch Banking Disciplinary Committee or Appellate Committee decides on the composition of the tribunal in a given case, and bank employees may never form the majority of the tribunal. Moreover, a member can excuse himself or be challenged, for example if his or her employer is involved in the case at hand.69 In the opinion of the authors, this system both ensures that the tribunal can draw on in-​depth experience of the banking sector and prevents conflicts of interest. To pay for its activities, the FBEE receives periodic contributions from the NVB.70 18.43 The FBEE sets its own budget, though, leaving it financially independent from the NVB and the banks it represents. Another source of income for the FBEE could be fines imposed by the Disciplinary 18.44 or Appellate Committee.71 At superficial consideration, this might appear as a possible source for conflict of interest. However, the strict financial independence of the FBEE ensures the FBEE does not rely on fines as a source of income. Lastly, it is noted that the impartiality of the Dutch Disciplinary Committee (or 18.45 perception of its impartiality) is not at stake if its Chairman upholds a complaint when hearing a case on review. To prevent a perception of partiality, the Disciplinary Committee’s Chairman will excuse himself in the subsequent proceedings and another member of the Disciplinary Committee will act as Chairman.

VI.  Anonymizing Files by Notifying Banks In at least two cases where the bank was the complainant—​apparently the same 18.46 bank in both cases—​the bank provided the Managing Director and the Dutch Banking Disciplinary Committee with files in which clients and colleagues and former colleagues of the defendant banker had been anonymized. The Managing Director asked for de-​anonymized files. The bank refused. Banks are, in principle, obliged to provide all information requested by the 18.47 Managing Director. However, they are not obliged to do so if this would involve them in infringing laws and regulations.72 The bank in this case cited the Dutch Personal Data Protection Act (Wet bescherming persoonsgegevens).

69 ibid. 70 Article 3.1 FBEE’s Articles of Association. 71 ibid. For reasons of completeness: a last possible source of income consists of ‘donations, legacies and other benefits’. According to the FBEE’s treasurer, no such incomes have yet been received. 72 Disciplinary Regulations, Article 3.8.2.

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Peter Laaper and Danny Busch 18.48

The Dutch Banking Disciplinary Committee gave as its opinion that if a bank bases a complaint on an anonymous internal investigation report, the Disciplinary Committee may need to declare the Managing Director’s prosecution inadmissible. The Dutch Banking Disciplinary Committee reasons that disciplinary law for the banking sector is required by statute law to provide adequate guarantees for a proper procedure.73 In this sense, it must provide safeguards for the defence. For the defence of the defendant banker, it is very important to know the subject of the investigation report.

18.49

For the proper execution of the disciplinary procedure and a correct assessment of the charges against the banker it is also important for the Managing Director (as prosecutor) and the Dutch Banking Disciplinary Committee to have the relevant documents. The adequate procedural safeguards require not only careful and complete compilation of the documents, but also that the participants in the disciplinary hearing and the Dutch Banking Disciplinary Committee have effective access to the documents.

18.50

The Dutch Banking Disciplinary Committee also provided an analysis of why it believes the Dutch Personal Data Protection Act does not preclude the provision of non-​anonymized investigation reports and other documents. It noted that the Act contains an exception when the processing of personal data is necessary in order to comply with a legal obligation of—​in this case—​the bank. It also noted that banks are obliged to provide for an effective system of disciplinary law. Finally, it pointed out that the disciplinary procedure has stringent privacy guarantees.

18.51

Although the bank still refused to provide completely de-​anonymized files, it eventually lodged partially anonymized files in which names had been consistently replaced with a letter. Apparently, the Dutch Banking Disciplinary Board’s objections were not insurmountable, at least not in this case. The partially anonymized files enabled it to reach a verdict on the banker’s acts and impose a penalty. As the penalty does not appear to have been reduced, it seems the anonymizing was not a real obstruction to proper disciplinary proceedings.

VII.  Demarcation of the Bank’s Acts, Professional Acts, and Private Acts 18.52

Many complaints filed by clients seem to be motivated by disagreement with a bank’s decision, often a decision to enforce security rights. The disgruntled client then files a complaint against the banker who informed the client of the bank’s decision. To date, all such complaints have been dismissed. Disciplinary law is not



Article 3:17c(2)(b) Wft.

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The Dutch Banker’s Oath about a bank’s decisions or actions, or about a client’s issues with them.74 Naturally, a bank can only act through its employees. Providing that a banker has properly executed the bank’s decisions and actions, he or she will not face disciplinary proceedings. However, two types of cases can be identified in which a banker may face disciplinary prosecution. First, the banker may have improperly executed the bank’s decisions or actions. This 18.53 was the case where a banker blocked a client’s payments account because he could not get in touch with the client. Although this approach unsurprisingly proved an effective way of contacting the client, it was not considered proper conduct.75 In other cases too, the crucial issue was whether a banker’s actions were in accordance with the bank’s policies.76 Second, the manner of execution of the bank’s decisions or actions may be im- 18.54 proper. In a dispute between a client and a bank, the client complained of having been snubbed by the banker involved. The banker argued in his defence that the client had avoided a real discussion and refused to get to the point. The banker denied having snubbed the client, but admitted having said that the client’s statements were ‘baloney’. The Managing Director concluded that such a statement was not appropriate in relations between a bank (represented by the banker) and its client, but that the offence was not serious enough to merit putting the complaint before the Dutch Banking Disciplinary Board.77 It follows that the statement was not in accordance with the Code of Conduct for Bankers and that if stronger language had been used it could have led to proceedings before the Dutch Banking Disciplinary Board. A banker cannot be prosecuted for private acts. There has only been one such com- 18.55 plaint so far. In the case in question, the banker involved was not only employed at a bank but also sat on the Complaints Committee of the Police Force. The complaint was related to a hearing of the Complaints Committee and had nothing to do with the job as banker. The complaint was dismissed.78 There is, however, a grey area. In one case, a banker worked for Bank A. He received 18.56 a payment on a private account that he held at Bank B. The payment was made by a company that was a client of Bank A. In addition, the payment was prepared by his (then) girlfriend, who happened to work at that company. The description of the payment clearly indicated that he was not entitled to the money. After receipt of

74 This is represented in the Banker’s Code of Conduct which states rules that apply to bankers, not to banks. 75 TRB-​2016-​3548H. 76 See, e.g., TRB-​2017-​3622H and TRB-​2017-​3623H. 77 TRB-​2016-​3566H. 78 TRB-​2017-​3702H.

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Peter Laaper and Danny Busch the payment, the banker redistributed the money over several other accounts and eventually transferred it to three private accounts that he held at Bank A. Finally, he transferred half of the money to his girlfriend. 18.57

At first instance, the Dutch Banking Disciplinary Committee ruled that the case was inadmissible because it concerned private acts, not acts performed in the course of the banker’s professional duties. The Appellate Committee ruled otherwise. Although it did not provide generally applicable criteria for distinguishing between purely private acts and professional acts in the course of (banking) employment, it did indicate that private acts are—​in principle—​outside the scope of disciplinary law for the banking sector. In this particular case, it considered that although the transactions were essentially outside the actual course of the banker’s duties, the banker’s acts did have a bearing on his duties in view of: (i) the disadvantaging of Bank A’s client; and (ii) the use of the banker’s accounts at Bank A. Another factor taken into account by the Appellate Committee was the banker’s refusal to answer questions.

18.58

The Appellate Committee ruled that the acts of the bank employee were in violation of the Code of Conduct for Bankers, which provide that bankers must act with integrity and care, are open and honest about their behaviour, and know their responsibility to society. It also considers that bank employees, and especially those with frequent client contact, must act with integrity and care in their personal payment transactions when dealing with someone else’s money. To this end, it notes that a customer who knows that the person advising him or her on behalf of the bank does not meet that requirement he or she will likely avoid contact with the banker concerned.79

18.59

The case could easily have turned out differently, as evidenced by the Dutch Banking Disciplinary Committee’s decision at first instance. It could well be argued that the banker’s acts were not committed in the course of his professional duties and were thus private acts. But this is admittedly a grey area and his acts certainly had a bearing on his professional work.

VIII.  Conflicting Interests of the Notifying Bank 18.60

To date banks have only filed complaints against bankers who have already been dismissed. That is understandable. As an employer, banks have an obligation to ‘act as a good employer’.80 It would seem more appropriate for them to file complaints



CVB-​2016-​1. Article 7:611 of Dutch Civil Code (Burgerlijk Wetboek).

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The Dutch Banker’s Oath only in cases involving serious errors. In this respect it is worthwhile noting that lack of seriousness of the error is a ground for dismissing the complaint. It is noted that banks may feel conflicted about filing a complaint if the transgres- 18.61 sive behaviour involves an employee who is important to the bank. Such employees are most likely to be senior employees. If a professional ban is imposed on that employee, it has a serious impact on the bank as well. When a bank files a complaint against an employee or former employee, conflicting 18.62 interests arise. The bank would naturally wish to see its complaint lead to a ‘conviction’. However, filing a complaint against an employee who is subsequently dismissed may not be in accordance with the bank’s duty to ‘act as a good employer’. It may also result in a court ruling, in a labour law case, that the dismissal was unfair. A  bank’s complaint which is submitted to the Dutch Banking Disciplinary 18.63 Committee will contain information from the bank’s systems and possibly be supplemented with statements from other employees. The bank seems to have no interest in proactively providing exculpatory information. In fact, the bank has a duty to cooperate with the Managing Director’s investigation.81 The Managing Director will certainly take into account any exculpatory information. However, he or she does not have direct access to the bank’s systems and must instead rely on information provided by the bank on request. If the Managing Director does not know what specific information to ask for, it is questionable whether he will receive such exculpatory information. The banker who is the subject of the proceedings and has been dismissed may be able to point out what information to ask for, but this is by no means certain. After all, the banker no longer has direct access to the bank’s systems following his or her dismissal. The cause of a banker’s error may lie in circumstances for which the bank can be 18.64 blamed. That is another source of conflicting interests. A banker is more likely to make errors if he is not properly prepared for or properly supervised in his job. An error can be the violation of some internal regulation of the bank. The bank may have a large number of relevant regulations. Some of these may be mutually contradictory, at least in a particular situation. The banker’s defence may then be that some or all of the blame is attributable to the bank. If this defence succeeds, the complainant may use the Dutch Banking Disciplinary Committee’s decision as a stepping stone for proceedings against the bank. The bank may also have to answer to its financial supervisor. The bank thus has an interest in arguing that the blame rests solely with the banker.



Disciplinary Regulations, Article 3.8.2.

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IX.  Deviation from Internal Policies 18.65

A bank employee is expected to comply with the law and with the bank’s internal policies. It is, however, conceivable that acting in accordance with these internal policies is not in the best interests of the customer. At least two types of cases can be distinguished.

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First, it is possible that the internal policies are deficient only in the specific circumstances of the relevant customer and not generally. In such a case, is it reasonable to expect a bank employee to deviate from the policies on his or her own initiative or, perhaps more realistically, depending on the employee’s seniority and position, to liaise with his or her superior and seek permission to deviate from the internal policies? And if this permission is not granted, should the bank employee then be expected to escalate the matter within the organization?

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Second, it is possible that a bank employee is of the view that internal policies or processes are deficient as such. For example, an employee may consider that the product approval process within the bank does not work in the sense that the bank still develops financial products that are not in the interests of the target market or part of it. Should the bank employee be expected to discuss the matter with his or her superior, or even escalate the matter further within the organization?

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Some commentators emphasize that bankers are employees and have to deal with superiors. They submit that this is fundamentally different from the position of medical doctors and attorneys-​at-​law who have more autonomy. These commentators submit that disciplinary law for bankers does not work.82 Although this may have been true in the past, nowadays many medical doctors and attorneys-​at-​law are no longer independent but are actually employed by a hospital or law firm. Yet the same rules of conduct apply to both employed and self-​employed medical doctors and attorneys-​at-​law.83 Why should that be any different for bankers?

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Arguably, much will depend on the exact position of the employee within the organization. Autonomous behaviour is more likely to be expected of a higher-​ ranking employee. And whether an employee is actually willing to share his or her view with others within the bank (direct colleagues, superiors, higher echelons, the compliance department, etc) may depend to a considerable extent on the culture

82 J E Soeharno, ‘Tuchtrecht en de wens tot integere bankiers. Een kritische beschouwing’, Tijdschrift voor Financieel Recht (2014), 6, 243–​51; C F J van Tuyll van Serooskerken, ‘Tuchtrecht banken: over klachten, sancties en arbeidsrechtelijke maatregelen’, ArbeidsRecht 2015/​55, 16; E J J M Kimman, ‘Bankierseed?’ Ondernemingsrecht 2012/​125. 83 See the following decision of the Dutch Supreme Court (Hoge Raad der Nederlanden, HR): HR 18 September 2015, ECLI:NL:HR:2015:2745, JOR 2015/​289 with annotation by S C C J J Kortmann; NJ 2016/​66 with annotation by P van Schilfgaarde.

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The Dutch Banker’s Oath within the organization. Do employees feel safe to discuss these matters within the bank?

X. Transparency The decisions of the Dutch Banking Disciplinary Committee and the Appellate 18.70 Committee are published on the FBEE’s website. However, the names of the bankers concerned are omitted for privacy reasons. The names of the banks are also left out. It may be wondered whether this is the 18.71 right approach. If the bank knows that its name will be disclosed in a decision, this may serve as an extra incentive to prevent misbehaviour within its organization. This could in theory contribute to the integrity of the banking sector, which is the primary goal of the disciplinary law for the banking sector. On the other hand, disclosure of the bank’s name could also serve as an incentive for banks not to file claims for reputational reasons. As virtually all successful complaints have so far been filed by the banks, this may well be detrimental to the effectiveness of disciplinary law. The authors are inclined to give more weight to the argument against disclosure than the arguments for disclosure. After all, it is very important for the desired culture change to come from within the banking sector. Once disciplinary measures become irrevocable, the name of the banker and the 18.72 disciplinary measures are entered in the disciplinary register kept by the FBEE. Only the banks who have employees required to take the Dutch banker’s oath have access to the register. The register is only accessible to the banks for the purpose of pre-​employment and in-​employment screening and can be accessed through the FBEE.84 The competent financial supervisors do not currently have access to the register. 18.73 Once again, it may be wondered whether this is the right approach. There is a risk that a financial supervisor could deem a proposed member of the management board or a key function holder of an insurance company to be a fit and proper person even though he or she has been the subject of disciplinary measures apparent from the disciplinary register. After all, neither the financial supervisor nor the insurance company will have access to the register. It is submitted by the authors that the effectiveness of the disciplinary law for bankers would benefit from the competent financial supervisors having direct access to the register, at least in the context of fit and proper person testing. It follows from the above that the disciplinary register is not public. In the United 18.74 States, the Financial Industry Regulatory Authority (FINRA) has taken a different

Disciplinary Regulations, Article 5.5.

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Peter Laaper and Danny Busch approach with regard to brokers and investment advisers registered with FINRA (for brevity’s sake jointly referred to below as ‘brokers’). FINRA maintains a database called BrokerCheck, which is publicly available on its website.85 BrokerCheck provides a snapshot of the employment history, licensing information and regulatory actions, arbitrations, and complaints with regard to brokers. The disciplinary records of brokers are thus a matter of public record in the United States. 18.75

Recent research conducted by FINRA itself suggests that the information available through BrokerCheck offers valuable information to assist investors in making informed choices about which broker to use. Quereshi and Sokobin assess the predictability of investor harm associated with brokers based on BrokerCheck information. They find that BrokerCheck information, including disciplinary records, financial disclosures, and employment history of brokers, has significant power to predict investor harm. The 20 per cent of brokers with the highest ex-​ante predicted probability of investor harm are associated with more than 55 per cent of the investor harm cases and the total dollar investor harm in their sample. Their findings suggest that investors have access to valuable information that allows them to discriminate between brokers with a high propensity for investor harm from other brokers.86

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At the same time, research conducted by Egan, Matvos, and Seru suggests that in the United States a market exists for financial adviser misconduct, notwithstanding initiatives like BrokerCheck. These authors constructed a novel database contai ning the universe of financial advisers in the United States from 2005 to 2015, representing approximately 10 per cent of employment in the finance and insurance sector. They find that 7 per cent of advisers have misconduct records, and that this share reaches more than 15 per cent at some of the largest consultancies. Roughly one third of advisers with a misconduct record are repeat offenders. Prior offenders are five times more likely to engage in new misconduct than the average financial adviser. Firms discipline misconduct: approximately half of financial advisers lose their jobs after misconduct. The labour market partially undoes firm-​level discipl ine by rehiring such advisers. Firms that hire these advisers also have higher rates of prior misconduct themselves, suggesting ‘matching on misconduct’. These firms are less desirable and offer lower compensation. Egan, Matvos, and Seru argue that heterogeneity in consumer sophistication could explain the prevalence and persist ence of misconduct at such firms. Misconduct is concentrated at firms with retail customers and in counties with low education attainment, elderly populations,

85 See https://​brokercheck.finra.org/​, accessed 1 October 2018. For more information about FINRA, see https://​www.finra.org/​about, accessed 1 October 2018. 86 Hammad Quereshi and Jonathan Sokobin, ‘Do Investors Have Valuable Information About Brokers?’, FINRA office of the Chief Economist Working Paper, August 2015, available at https://​ www.finra.org/​sites/​default/​files/​OCE-​Working-​Paper.pdf ), accessed 1 October 2018.

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The Dutch Banker’s Oath and high incomes. The authors submit that their findings are consistent with some firms ‘specializing’ in misconduct and catering to unsophisticated consumers, while others use their clean reputation to attract sophisticated consumers.87

XI. Evaluation Whether or not Article 6 ECHR (right to a fair trial) applies to disciplinary pro- 18.77 ceedings in the Dutch banking sector is an issue that is by no means clear-​cut. If it does apply, Dutch disciplinary law for the banking sector as it stands may give rise to some issues. And even if it does not apply, some issues concerning independence and impartiality (or perceptions of them) still need to be resolved in order to restore public trust in the banking sector. As there have been only a few decisions, there is still some uncertainty—​for 18.78 now—​about the demarcation of bank’s acts, professional acts, and private acts, and hence about whether particular behaviour could be subject to disciplinary review. Furthermore, a bank may—​at least theoretically—​have conflicting interests when or after filing a complaint against an employee. The bank may, for example, have an interest in not filing a complaint against an employee who is important to the bank, even though a complaint would otherwise have been filed. If the bank does file a complaint, it may have an interest in not taking a proactive approach to the provision of exculpatory evidence. Sanctions imposed are registered. Banks use the register for the purpose of pre-​ 18.79 employment and in-​employment screening. Although US research suggests there may be a market for employees with a record of misconduct, the register is expected to bar re-​entrance of such employees to the banking labour market. The effectiveness of the register would be enhanced if it were public. At present, as neither the financial supervisors nor non-​banking financial institutions have access to it, it is relatively easy for such employees to find employment in another part of the financial sector. The primary goal of disciplinary law is to promote ethical conduct and develop 18.80 professional values, norms, and standards for bank employees. In that respect, it complements regulatory law and supervision. EU financial law provides for fit and proper testing of a financial institution’s board 18.81 members, supervisory board members, and key function holders, and the imposition of sanctions on its higher-​ranking employees. By contrast, Dutch disciplinary

87 Mark Egan, Gregor Matvos, and Amit Seru, ‘The Market for Financial Adviser Misconduct’, September 2017, available at https://​papers.ssrn.com/​sol3/​papers.cfm?abstract_​id=2739170), accessed 1 October 2018.

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Peter Laaper and Danny Busch law for the banking sector also extends to ‘ordinary’ employees. Indeed, all cases to date have been against ordinary employees. Admittedly, however, almost all the cases decided so far have been relatively straightforward, involving behaviour such as browsing through client data without a valid business reason. As it may be more difficult to bring cases against higher-​ranking employees, they may still be pending. After all, disciplinary law for the Dutch banking sector was introduced only three years ago. 18.82

Still, it raises the question of what the added value of disciplinary law is in relation to labour law. This question is even more pertinent when it is realized that almost all successful complaints have been filed by banks and that all of them involved cases where the employee had already been dismissed. It could be reasoned that if banks file complaints against employees they have already dismissed, they can claim compliance with the regulatory duty to submit their employees to disciplinary law while not causing any significant extra reputational damage. However, it appears there are two reasons for banks to be reluctant to file complaints for lesser violations. First, banks, as an employer, have a statutory duty to behave like ‘a good employer’.88 Filing a complaint for a lesser violation seems to be at odds with the duty to behave like a good employer, taking into account the stress caused by disciplinary proceedings and other possible consequences it may have for the employee. Second, filing complaints for lesser violations will probably only cause a repressive culture. After all, to err is human. A repressive culture would probably lead people to try and cover up instead of coming forward after committing an error. That would be the exact opposite of what the disciplinary law for the banking sector is trying to achieve. The authors feel that in an ethical culture, employees should feel safe to come forward and admit to an error with a view to solving the problem.89 In this respect, it is noted that the disciplinary law for the banking sector also provides that an employee should not be ‘prosecuted’ if the case is not serious enough.90

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The added value of disciplinary law for the banking sector seems to lie in its preventive effect. Dutch banks provide extensive training programmes. These programmes aim to make employees aware of ethical banking. The programmes are set up on a continuous basis, because working ethics is an ongoing responsibility. Anecdotal evidence suggests that this approach is effective, but it is too early to draw definite conclusions.91

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In Dutch literature, the question has been raised whether it would not be better if disciplinary law for the banking sector were to be arranged at institutional (bank) 88 Article 7:611 of Dutch Civil Code. 89 P Laaper and J W P M van der Velden, ‘Bankentuchtrecht’, in M Jurgens and R Stijnen, Compliance in het financieel toezichtrecht, Wolters Kluwer, 2018. 90 Disciplinary Regulations, Article 2.2.3. 91 Laaper and Van der Velden, n 88.

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The Dutch Banker’s Oath level rather than at the level of individual bankers.92 These authors cite as an example the Dutch insurance sector, which also has its own disciplinary law. There, the institution is always the party addressed if something goes wrong, whether it is an impersonal error within the organization or a personal error by an employee. Disciplinary law at the institutional level does have the advantage that it is easier 18.85 to deal with cases where the error is by a collective rather than an individual. The authors would like to point out, however, that although disciplinary law for the insurance sector is regulated at the institutional level, this did not prevent insurers from selling very expensive life assurance contracts (beleggingsverzekeringen) to consumers on a massive scale over a period of many years. The conclusion is perhaps that no disciplinary system should be expected to be a perfect solution. The advantage of disciplinary law at an individual level is that individuals may be- 18.86 come more aware of their personal role and the need to take responsibility for their own acts. Anecdotal evidence suggests that, as a result of the sense of individual responsibility, employees involved in collective processes such as product development ask aloud how customer interests are served by this or that choice.93 This seems to have been less common in the past. Hence, disciplinary law at the individual level may have a positive effect when it comes to collective processes as well. Still, this is not expected to herald the end of financial scandals.

92 C F J van Tuyll van Serooskerken in his annotation under Chairman Disciplinary Committee 3 August 2017, TRB-​2017-​3701H, JOR 2017/​323, in which he also refers to an interview with J E Soeharno in W Keuning, ‘Maak aanklagen van bancaire organisatie ook mogelijk binnen tuchtrecht’, Financieele Dagblad 3 November 2017. 93 Laaper and Van der Velden, n 88.

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19 MANAGING CONDUCT RISK From Rules to Culture Antonella Sciarrone Alibrandi and Claudio Frigeni

I. Introduction II. Examples of Misconduct and Analysis of the Related Costs III. Definitional Issues Related to ‘Conduct Risk’

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A. The definition of ‘conduct risk’ according to the FSB B. The definition of ‘conduct risk’ according to supervisory authorities C. The definition of ‘conduct risk’ within the Banking Union context—​EBA

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D. The definition of ‘conduct risk’ within the Banking Union context—​ESRB

IV. Conduct Risk: Between the ‘Conduct Perspective’ and the ‘Prudential Perspective’ A. The conduct perspective B. The prudential perspective

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V. A New Approach: From Rules to Culture

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I. Introduction 19.01

In the years following the financial crisis of 2007–​2008, the issue of ‘conduct’, although mentioned in a few official documents that studied the roots of the crisis and envisaged some possible responses, was not considered to be at the heart of the problem and attracted limited attention. In the period immediately after the crisis, the expressions ‘conduct risk’ and ‘misconduct risk’ were not commonly heard.

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Only since 2015 have the concepts of ‘misconduct’ as applied to banks (and to financial institutions more broadly) and ‘conduct risk’/​‘misconduct risk’ started to attract attention. One of the first relevant documents stressing the significance of ‘conduct’ and the need to improve the ‘culture’ of the banking sector, ‘Banking Conduct and Culture:  A Call for Sustained and Comprehensive Reform’, was

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Managing Conduct Risk: From Rules to Culture issued in 2015 by the Group of Thirty,1 an influential, private, consultative body that advises on international economic and monetary affairs. This document put forward recommendations to banks, regulators, and supervisors highlighting the need to draw up a new conceptual framework to address conduct risk. Since then, the relevance of the issue has sharply increased, becoming one of the main topics of discussion among international financial bodies, authorities, and scholars.2 In particular, reference is made to the work of the Financial Stability Board (FSB), 19.03 which, following an explicit mandate from the G20, has launched a comprehensive initiative to study the causes and effects of and possible remedies for ‘misconduct risk’. The concept of conduct risk was hinted at in FSB’s ‘Guidance on Supervisory Interaction with Financial Institutions on Risk Culture: A Framework for Assessing Risk Culture’3 (April 2014), but the topic was addressed in greater detail in the its letter of February 2015 sent to G20 leaders,4 in which it highlighted that ‘[t]‌he scale of misconduct in some financial institutions has risen to a level that has the potential to create systemic risks’, asked for ‘reforms to reduce the likelihood of misconduct’, and announced a broad, extensive workplan to address ‘conduct risk’.5 Beginning at that time, conduct risk has ranked very high in FSB’s list of priorities, as reflected in its published documents. In particular, the FSB has devoted much effort to analysing the role that compensation schemes and corporate governance may play in minimizing this risk. With respect to compensation, in March 2018 the FSB published the document, ‘Supplementary Guidance

1 Downloadable at http://​group30.org/​publications/​detail/​166, accessed 2 October 2018. 2 See C P Skinner, ‘Misconduct Risk’, Fordham Law Review (2016), 84, 1559; L G.  Arias Barrera, ‘Ethical Perspective of the Financial Sector’, 18 January 2017, available at https://​ssrn.com/​ abstract=3018242, accessed 2 October 2018; R Plato Shinar and K Borenstein Nativ, ‘Misconduct Costs of Banks—​The Meaning Behind the Figures’, Business and Finance Law Review, (2017), 32, 495; in economic literature, see also A Carretta and P Schwizer, ‘Risk culture in the regulation and supervision framework’, in A. Carretta, F. Fiordalisi, and P. Schwizer (eds), Risk Culture in Banking, Palgrave Macmillan, 2017, 73 ff.; H Köster and M Pelster, ‘Financial Penalties and Bank Performance’, Journal of Banking & Finance (2017), 79, 57–​73; S V Tilley, B Byrne, and J-​ Coughlan, ‘An Empirical Analysis of the Impact of Fines on Bank Reputation in the US and UK’, 2018, available at https://​ssrn.com/​abstract=2980352, accessed 2 October 2018. 3 Available at http://​www.fsb.org/​wp-​content/​uploads/​140407.pdf?page_​moved=1, accessed 2 October 2018. 4 Available at http://​www.fsb.org/​wp-​content/​uploads/​FSB-​Chair-​letter-​to-​G20-​February-​2015. pdf, accessed 2 October 2018. The FSB sent other letters to G20 leaders in April and October 2015. 5 In May 2015 the FSB issued a workplan outlining measures to reduce misconduct risk, which was sent in June to the G20 deputies meeting. Since then, the FSB has published Progress Reports, periodically, summarizing the initiative launched and the results reached:  in November 2015 (‘Measures to reduce misconduct risk  —​Progress Report’, available at http://​www.fsb.org/​ 2015/​11/​measures-​to-​reduce-​misconduct-​risk/​, accessed 2 October 2018), the second in September 2016 (‘Measures to reduce misconduct risk—​Second Progress Report’, available at http://​www. fsb.org/​2016/​09/​measures-​to-​reduce-​misconduct-​risk-​second-​progress-​report/​, accessed 2 October 2018)  and the last in July 2017 (‘Reducing misconducts risks in the financial sector—​Progress Report to G20 Leaders’, available at http://​www.fsb.org/​2017/​07/​reducing-​misconduct-​risks-​in-​ the-​financial-​sector-​progress-​report-​to-​g20-​leaders/​, accessed 2 October 2018).

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Antonella Sciarrone Alibrandi and Claudio Frigeni to FSB Principles and Standards on Sound Compensation Practices’,6 in order to specifically include conduct and conduct risk in the 2008 framework on compensation, outlined immediately after the financial crisis and aimed at aligning compensation at large institutions with prudent risk-​taking and long-​term results. The new document recognizes that a proper alignment cannot be achieved without emphasizing misconduct, and advances the idea that compensation tools can provide both ex ante incentives for good conduct and ex post adjustment mechanisms that ensure appropriate accountability. With respect to corporate governance, the FSB established a specific Working Group on Governance Frameworks (WGGF) with a mandate to elaborate on the widely held idea that governance tools may be effective in preventing misconduct. The results achieved by WGGF are described in the recent document, ‘Strengthening Governance Frameworks to Mitigate Misconduct Risk’7 (20 April 2018), directed at both firms and financial supervisors and recommending a set of governance measures (the ‘toolkit’). 19.04

In addition to the FSB, other important international institutions, especially supervisory authorities, have devoted some attention to the issue of conduct risk. IOSCO (the International Organization of Securities Commissions), for example, has addressed the subject on two different occasions. The first was in its ‘Securities Markets Risk Outlook’ of March 2016,8 in which ‘harmful conduct’ was included in a list of ‘risks related to core securities markets objectives of financial stability, market efficiency and/​or investor protection’.9 Then, in June 2017, it published a

6 Available at http://​www.fsb.org/​2018/​03/​supplementary-​guidance-​to-​the-​fsb-​principles-​ and-​standards-​on-​sound-​compensation-​practices-​2, accessed 2 October 2018. On this topic, see also previous documents issued by the FSB:  ‘Round Table on Compensation Tools to Address Misconduct in Banks’, 10 May 2016 (at http://​www.fsb.org/​2016/​07/​fsb-​round-​ table-​on-​compensation-​tools-​to-​address-​misconduct-​in-​banks/​, accessed 2 October 2018); ‘Consultative Document on Supplementary Guidance to FSB Principles and Standards on Sound Compensation Practices’, 20 June 2017 (at http://​www.fsb.org/​wp-​content/​uploads/​R200617. pdf, accessed 2 October 2018; ‘Supplementary Guidance to FSB Principles and Standards on Sound Compensation Practices: Overview of Responses To The Consultation’, 8 March 2018 (at http://​www.fsb.org/​wp-​content/​uploads/​P090318-​2.pdf, accessed 2 October 2018). Furthermore, a consultation is currently pending on ‘Recommendations for Consistent National Reporting of Data on the Use of Compensation Tools to Address Misconduct Risk’, which outlines the goal of ‘improv[ing] supervisory consideration of compensation practices’. See http://​www.fsb.org/​2018/​ 05/​recommendations-​for-​consistent-​national-​reporting-​of-​data-​on-​the-​use-​of-​compensation-​tools-​ to-​address-​misconduct-​risk/​, accessed 2 October 2018. 7 This document, available at http://​www.fsb.org/​2018/​04/​strengthening-​governance-​ frameworks-​to-​mitigate-​misconduct-​risk-​a-​toolkit-​for-​firms-​and-​supervisors/​, accessed 2 October 2018, followed a preliminary document published in 2017 titled ‘Stocktake of Efforts to Strengthen Governance Frameworks to Mitigate Misconduct Risk’, available at http://​www.fsb.org/​2017/​05/​ stocktake-​of-​efforts-​to-​strengthen-​governance-​frameworks-​to-​mitigate-​misconduct-​risks/​, accessed 2 October 2018. 8 Available at https://​www.iosco.org/​library/​pubdocs/​pdf/​IOSCOPD527.pdf, accessed 2 October 2018. 9 See IOSCO, n 8, 7 and Ch 5.

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Managing Conduct Risk: From Rules to Culture document entitled ‘Task Force Report on Wholesale Market Conduct’,10 in which it sought to identify the main causes of misconduct in large investment firms and some measures that might minimize the problem. The topic was taken into consideration in the insurance context by IAIS (the International Association of Insurance Supervisors) in its ‘Issues Paper on Conduct of Business Risk and its Management’ dated November 2015. At the European level, the issue of conduct risk clearly emerged as a crucial deter- 19.05 minant of financial stability in 2015, in a report from the European Systemic Risk Board (ESRB) that focused on misconduct in the banking sector.11 In addition, the European Banking Authority (EBA) stressed the relevance of conduct risks and the need to evaluate their impact on bank capital, highlighting their relevance both in the context of the supervisory review and evaluation process (SREP)12 and the stress test.13 It should be recalled that the concept of conduct risk has garnered increased at- 19.06 tention at the national level too, especially by financial authorities, sometimes even before the topic had been considered by the aforementioned international bodies. For instance, in 2013 the United Kingdom decided to establish a new supervisory authority with the specific task of addressing conduct risk issues (the Financial Conduct Authority, or FCA), thus separating ‘conduct supervision’ from ‘prudential supervision’ (the latter handled by the Bank of England’s Prudential Regulation Authority, or PRA). In its first year, the FCA published the document ‘Risk Outlook 2013’,14 in which it sought to pinpoint the root causes of conduct risk and to describe its implications. The discussion in this document formed the basis of many subsequent studies conducted in other countries and at the international level. Following the UK example, in 2014 ASIC (the Australian Securities and Investments Commission) conducted its ‘Survey on Conduct Risk’. In the United States, the topic has become quite central for financial authorities, to the

10 Available at https://​www.iosco.org/​library/​pubdocs/​pdf/​IOSCOPD563.pdf, accessed 2 October 2018. 11 See ESRB, ‘Report on Misconduct Risk in the Banking Sector’, June 2015, 5, available at https://​www.esrb.europa.eu/​pub/​pdf/​other/​150625_​report_​misconduct_​risk.en.pdf, accessed 2 October 2018. 12 EBA, ‘Guidelines on Common Procedures and Methodologies for the Supervisory Review and Evaluation Process (SREP)’, 19 December 2014, available at https://​www.eba.europa.eu/​documents/​10180/​935249/​EBA-​GL-​2014-​13+(Guidelines+on+SREP+methodologies+and+processes). pdf, accessed 2 October 2018. 13 See EBA, ‘EU‐Wide Stress Test—​Methodological Note 2016’, point 338, 89, available at https://​ www.eba.europa.eu/​documents/​10180/​1259315/​2016+EU-​wide+stress+test-​Methodological+note. pdf, accessed 2 October 2018; see also the new ‘EU-​Wide Stress Test—​Methodological Note 2018’, point 353, available at https://​www.eba.europa.eu/​documents/​10180/​2106649/​2018+EU-​ wide+stress+test+-​+Methodological+Note.pdf, accessed 2 October 2018. 14 Available at https://​www.fca.org.uk/​publication/​business-​plans/​fca-​risk-​outlook-​2013.pdf, accessed 2 October 2018.

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Antonella Sciarrone Alibrandi and Claudio Frigeni point that in December 2017 the Federal Reserve Bank (the Fed) published a paper dedicated entirely to misconduct risk,15 in which it stressed the importance of financial firms investing in the development of an healthy risk culture in order to prevent and mitigate misconduct. 19.07

Against this background, it is clear that there is a need to better understand the nature and features of ‘conduct risk’/​‘misconduct risk’, and the impact of its increasing prevalence in the context of financial markets. Moreover, there is also a need to understand the reasons that led international institutions to identify conduct risk as being crucial to the operation of the financial markets, especially in light of the far-​ reaching nature of this conclusion, which is in the process of bringing about major changes in both financial regulation and supervision. A clarification is needed not only for the purpose of defining the scope of and better understanding the regulatory agenda that purports to address conduct risk, but also to assess the objectives and features of the new tools that have been put forward for this purpose.

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This chapter aims at deepening the discussion concerning all these issues. Section II analyses some well-​known financial scandals that drew attention to the concept of misconduct and attempts to assess the nature of costs associated with them. Section III discusses definitional issues surrounding conduct risk and summarizes the various definitions that have been offered for it. Then, Section IV discusses two important perspectives for looking at conduct risk. Finally, remedial measures that have already been adopted to minimize conduct risk are discussed in Section V, and Section VI concludes, assessing the role of culture of financial firms in conduct risk.

II.  Examples of Misconduct and Analysis of the Related Costs 19.09

In order to begin fleshing out a discussion of the issues identified above, it is important initially to highlight the context in which the debate over conduct risk began. The increasing prominence of the issue began with some real-​life cases of misconduct that shook public opinion.16 One of the most notorious cases of misconduct was the LIBOR manipulation scandal. From 2005 to 2012, various important banks agreed to manipulate the daily submissions utilized to calculate this benchmark rate.17 There were also other cases involving collusive behaviour

15 See Federal Reserve Bank, ‘Misconduct Risk, Culture, and Supervision’, December 2017, available at https://​www.newyorkfed.org/​medialibrary/​media/​governance-​and-​culture-​reform/​ 2017-​whitepaper.pdf, accessed 2 October 2018. 16 See Skinner, n 2, 1562; IOSCO, n 8, 49. 17 For a detailed analysis of this case, see Skinner, n 2, 1572ff; see also ESRB, n 11; IOSCO, n 8, 49; FCA, n 14, 7.

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Managing Conduct Risk: From Rules to Culture among banks aimed at influencing relevant indexes (e.g. foreign exchange rates18 and Euribor19) for the purpose of altering the cost of specific products. In all these cases, this conduct had the potential to undermine the correct functioning of financial markets as a whole. Other financial scandals that are frequently referred to as examples of misconduct 19.10 are the various cases of mis-​selling of financial products to customers (both retail and professional), in which intermediaries sold their clients financial products that were not aligned with their interests. The most famous example, often cited in the conduct risk literature, is the subprime mortgage-​backed securities mis-​sold by US banks, creating a bubble that triggered the great financial crisis. Another famous case of mis-​selling is the Payment Protection Insurance (PPI) scandal, in which many UK banks sold insurance products to retail clients after supplying them with misleading information about their usefulness.20 More recently, the case of Wells Fargo, in which the bank opened ‘ghost’ accounts in the name of unwitting clients, clearly involved misconduct, and, in light of the sanctions imposed on the bank by US supervisory authorities,21 raises questions concerning how conduct risk should be addressed. The idea that misconduct occurs every time there is a violation of national or 19.11 international rules or regulations (such as tax rules, anti-​money laundering rules, anti-​terrorism rules, rules governing economic sanctions, etc)22 has led to a further broadening of the cases that are seen as falling within the category of conduct risk. From this perspective, for example, the ESRB has treated the infringement of US trade bans against Sudan, Iran, and Cuba by EU banks as cases of misconduct.23

18 See ESRB, n 11, 5; IOSCO, n 8, 49. 19 See Skinner, n 2, 1574; IOSCO, n 8, 49. 20 See IOSCO, n 8, 49; this scandal was also cited by FCA, n 14, 7; more in general, about mis-​ selling conduct, see ESRB, n 11, 4 ‘mis-​selling of financial products leads to a suboptimal allocation of investments and risks (as witnessed in the years preceding the financial crisis)’. 21 Wells Fargo was recently fined by US authorities involved in both prudential and conduct supervision. From a conduct perspective, the US Office of the Comptroller of the Currency (OCC) levied, among other penalties, a 500 million US dollar fine (https://​www.occ.gov/​news-​issuances/​ news-​releases/​2018/​nr-​occ-​2018-​41.html, accessed 2 October 2018); in addition, the US Consumer Financial Protection Bureau (CFPB) assessed a 1 billion US dollar penalty against the bank (crediting the 500 million US dollar fine collected by the OCC) (https://​www.consumerfinance.gov/​about-​ us/​newsroom/​bureau-​consumer-​financial-​protection-​announces-​settlement-​wells-​fargo-​auto-​loan-​ administration-​and-​mortgage-​practices, accessed 2 October 2018). From a prudential point of view, the Federal Reserve Board required the bank to bolster its governance and control systems (https://​ www.federalreserve.gov/​newsevents/​pressreleases/​enforcement20180202a.htm, accessed 2 October 2 2018). On this case, see also FCA, ‘Transforming Culture in Financial Services, Discussion paper’, March 2018, 9, available at https://​www.fca.org.uk/​publication/​discussion/​dp18-​02.pdf, accessed 2 October 2018. 22 See ESRB, n 11; IOSCO, n 10, 4. 23 See ESRB, n 11, 5.

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Antonella Sciarrone Alibrandi and Claudio Frigeni 19.12

Misconduct cases obviously involve certain costs. While it is difficult to estimate the amount of these costs,24 it is important to at least describe the various categories they fall into.

19.13

On the one hand, as has frequently been pointed out, misconduct imposes large costs on customers. It is well known that misconduct is capable of harming the interests of those who are active in the financial sector in a direct or indirect way. Mis-​selling of financial products, for example, harms the customers to which the inappropriate product is sold,25 while the manipulation of an index rate has the effect of making the financial products linked to this benchmark more expensive for everyone. From a broader perspective, it has also been argued that misconduct has the potential to harm the entire economy and the society at large26—​ misconduct may reduce public confidence in the markets and more broadly in the financial system, and since trust is vital for the health of that system, it could lead to systemic risk.27

19.14

In addition, misconduct may also have a negative impact on intermediaries forced to bear financial penalties and other costs (such as costs of redress, litigation costs, etc). To provide an idea of the amount of these costs, the ESRB has estimated that fines and penalties imposed on EU systemically important banks have absorbed all the capital issued by systemically important banks in the European Union from 2010 to 2015.28 Other independent studies have shown that the sharp increase in penalties and settlements for misconducts affected both EU and US large banks (see Figure 19.01).

19.15

In addition to monetary costs, financial intermediaries that do not behave properly also risk incurring important indirect costs such as reputational damage (often but 24 To better understand the costs related to misconduct, the European Parliament commissioned three studies on the topic: see E. Carletti, ‘Fines for misconduct in the banking sector –​what is the situation in the EU?’, March 2017, available at http://​www.europarl.europa.eu/​RegData/​etudes/​ IDAN/​2017/​587402/​IPOL_​IDA(2017)587402_​EN.pdf, accessed 2 October 2018; M R Götz and T H Tröger, ‘Fines for misconduct in the banking sector—​what is the situation in the EU?’, March 2017, available at http://​www.europarl.europa.eu/​RegData/​etudes/​IDAN/​2017/​587401/​ IPOL_​IDA(2017)587401_​EN.pdf, accessed 2 October 2018; A. Resti, ‘Fines for misconduct in the banking sector—​what is the situation in the EU?’, March 2017, available at http://​www.europarl. europa.eu/​RegData/​etudes/​IDAN/​2017/​587400/​IPOL_​IDA(2017)587400_​EN.pdf, accessed 2 October 2018. 25 See ESRB, n 11, 6. 26 ESRB, n 11; see also Skinner, n 2, 1562. 27 Systematic risks connected with misconducts are often emphasized: see ESRB, n 11, ‘A misconduct case in one bank can quickly undermine the confidence of the public in the entire banking sector, because it is difficult for outsiders to differentiate between banks which behave well and those which behave badly.’; see also the FSB, n 4; FSB, ‘Strengthening Governance Frameworks’, n 7, 1; FED, n 15, 10f.; IOSCO, n 10, 3; in the academic literature: Skinner, n 2, passim. 28 See ESRB, n 11, 14f. See also FSB, Letter of July 2017, which estimates that ‘Global banks’ misconduct fines and litigation costs have reached over $320 billion since the crisis’; Resti, n 24, 5ff.; Carletti, n 24, 7; FED, n 15, 1. For an empirical research, see Köster and Pelster, n 2.

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Managing Conduct Risk: From Rules to Culture Total fines, penalties, & settlements for the 18 largest U.S. & E.U. Banks1, from 2009 to February 2016 $70

$65

$60

$ Billions

$50

$44

$46

$40

$32

$30

$22

$20 $10

$12 $3

$3

2009

2010

$0 2011

2012

2013

2014

2015

2016 YTD

Figure 19.01 Total fines, penalties, and settlements for the eighteen largest US and EU Banks, from 2009 to February 2016 Note: 1. Peer group of the eighteen largest US and EU banks includes the following six US banks: Bank of America, JPMorgan Chase, Citigroup, Morgan Stanley, Wells Fargo, and Goldman Sachs, and the following twelve EU banks: BNP Paribas, Credit Suisse, Deutsche Bank, UBS, HSBC, Barclays, The Royal Bank of Scotland, Rabobank, Lloyds Bank, Standard Chartered, ING, and Banco Santander. Data only includes fines, penalties, and settlements of 50 million US dollars or greater. Source: BCG analysis for the years 2009 to 2014. CPG analysis for the year 2015 and YTD 2016.

not always associated with the application of penalties), which may reduce their ability to operate effectively in the financial markets.29 In other words, once misconduct is discovered it may affect the offending intermediary and jeopardize its sustainability. In summary, misconduct costs may affect financial intermediaries, everyone that 19.16 deals with them, and society at large. Misconduct may harm the clients of the financial institution responsible for such behaviour; the customers of other financial institutions, especially in cases affecting market integrity; and the economy and society as a whole, since it negatively impacts trust in the financial system (both intermediaries and markets). On a different level, misconduct harms the financial intermediary involved because it incurs significant direct costs (i.e. fines, penalties, and costs of redress) and indirect costs (e.g. reputational costs). In some cases, these costs may affect the viability of the institution and, especially if such behaviour is widespread or the institution involved is significant, this could also lead to a loss of confidence and to systemic risk.

See FED, n 15, 1; G30, n 1, 11; Tilley, Byrne, and Coughlan, n 2.

29

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The serious consequences of misconduct explain the global focus on conduct risk and the significant of attention paid to it by supervisory authorities.

III.  Definitional Issues Related to ‘Conduct Risk’ 19.18

Despite the attention paid to this subject by regulators, commentators, and others, there is some confusion about what ‘conduct risk’ specifically is. Documents often refer to ‘conduct risk’ or ‘misconduct risk’ without clarifying whether these terms are synonymous or not.30 There is no generally agreed-​on definition of ‘(mis)conduct risk’,31 nor a definitive taxonomy of related terms. In general, ‘(mis)conduct risk’ refers to risks arising from the ‘behaviour’ or the ‘decisions’ at financial firms, thus implying that it has to do with people’s attitudes and choices. In most cases, such behaviour or decisions are considered to be possible sources of conduct risk when they fall short of expected standards. Beyond this expansive definition, there are different views among institutions, authorities, financial intermediaries, and in the academic literature as to the specific meaning of conduct risk and what falls within its scope. It has also been debated whether conduct risk relates only to wilful or fraudulent misconduct or extends beyond that to inadvertent or negligent behaviour; some supervisory authorities have taken the view that conduct risk may arise not only from deliberate actions but also as a consequence of negligence, and even from inadequacies in an organization’s practices, frameworks of control, or even education programs.32 Moreover, different views have been expressed as to the nature of such risk and to the category of risk it belongs among the various already identified in banking literature. In this light, it has often been remarked that ‘conduct risk’ has to do with ‘operational risks’,33 but the relationship between conduct risk and legal risk remains unclear. The common perception is that conduct risk arises from breaches of legal standards but also of codes of conduct and ethical principles; at the same time, it has frequently been pointed out that not all legal risks constitute conduct risk.34 Also unclear is the relationship between compliance risk and conduct risk.35 It should also be stressed that some international

30 See also IOSCO, n 8, which employs the term ‘harmful conduct’. 31 See FSB, ‘Stocktake of efforts’, n 7, 5; Carletti, n 24. 32 See, e.g., the definition of conduct risk given by EBA which also includes negligent behaviour (Part III.3). Contra, Skinner, n 2, 1562 who considers a conduct risk as ‘the intentional distortion of information that, when aggregated and synchronized across institutions, undermines market safety and soundness’. 33 See FSB, ‘Supplementary Guidance’, n 6, 4 ‘reputational and operational risk . . . both include misconduct risk’; EBA, ‘EU-​Wide Stress Test—​Methodological Note 2018’, n 13, 99 ff.; Resti, n 24, 5. 34 See FSB, ‘Stocktake of efforts’, n 7, 5. 35 See FSB, ‘Stocktake of efforts’, n 7, 5 ‘Responses to the survey suggest a general trend among financial institutions to link misconduct risk to day-​to-​day risk decisions of the different businesses

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Managing Conduct Risk: From Rules to Culture institutions, instead of clearly specifying the nature of conduct risk, focus attention on where the breach of standards of conduct is more likely to occur.36 Reference is usually made to the area of fair treatment of customers and more specifically to consumers (investors). The integrity of markets and prevention of financial crime is also frequently mentioned as a the subject of focus. Effective competition is sometimes considered to be another potential area where the breach of legal or ethical obligation may be considered to amount to misconduct. Factors that create conduct risk are often divided into three categories.37 First, some 19.19 of the drivers of conduct risk are considered to be ‘inherent’ in financial markets (the ‘Inherent Factor’), in the sense that some of the features of these markets—​ including information asymmetry, demand-​side weakness, the low level of financial skills among customers—​often lead customers and financial firms operating in these markets to make poor decisions. Second, the way in which the financial sector is structured and managed, together with its predominant culture (the ‘Structures and Behaviours Factor’), are thought to be at the root of some acts of misconduct, since these phenomena may allow financial firms to obtain undeserved profits (e.g. by making decisions under the influence of conflicts of interest or by engaging in unfair competition). Finally, third, market and societal conditions (such as economic and financial trends, along with regulatory changes and technological developments) have also been identified as important drivers of conduct risk, drivers that may influence firm and consumer decisions (the ‘Environmental Factor’). In sum, (mis)conduct risk is generally viewed as the risk associated with illegal 19.20 or unethical conduct engaged in by financial firms and their employees. Beyond this broad definition, different institutions have focused their attention on specific areas or activities in which misconduct may occur and attempted to understand the drivers of conduct risk in these areas or activities. Despite the fact that some institutions have expressed the view that a specific definition of conduct risk is not necessary,38 the authors of this chapter believe that such a definition is needed in order to better understand the problem and the factors characterizing this risk. It is therefore necessary to briefly outline the various available definitions of ‘conduct risk’ or ‘misconduct risk’.

as a first line of defence, or breaches related to codes of conduct, whereas compliance risk is seen as abiding by laws, regulations and rules’. 36 See FCA, n 14, 9, which expresses the view that assessing conduct risk has to do with evaluating behaviour of firms in the light of consumer protection, market integrity, and effective competition. 37 This scheme was developed by the FCA, n 14, 9 and has been followed by other supervisory authorities (or their associations):  see IAIS, ‘Issues Paper on Conduct of Business Risk and its Management’, November 2015, 11ff. 38 FCA, e.g., decided to avoid defining ‘conduct risk’.

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Antonella Sciarrone Alibrandi and Claudio Frigeni A. The definition of ‘conduct risk’ according to the FSB 19.21

The FSB, which has devoted great effort to studying this topic, defines ‘misconduct’ as ‘conduct that falls short of expected standards, including legal, professional and ethical standards’,39 and considers ‘conduct risk’ to be any type of risk that may arise from a misconduct event. Such a broad definition follows the common perception of what constitutes conduct risk. The FSB also provides an extremely broad list of activities that may give rise to conduct risk concerns—​it considers that conduct risk may occur in several sectors of banking activity, both internal and external to a financial firm itself, and includes all operational risks related to internal fraud, employment practices, and workplace safety; clients; products and business practices; business disruption and damage to assets; and execution, delivery, and process management.40 It is clear that this approach does not help clarify the specific nature of conduct risk or to distinguish it from other kinds of risk that may arise in the financial sector. B. The definition of ‘conduct risk’ according to supervisory authorities

19.22

A different approach has been adopted among supervisory authorities, which prefer specific definitions based on the areas in which supervision is required to address conduct risk, clearly linked to the scope and objective of the supervision in each of the areas.41

19.23

IOSCO, for example, defines ‘harmful conduct’ as ‘conduct (not necessarily illegal) that could: (1) harm the interest of investors; (2) jeopardize fair, efficient and transparent markets or (3) lead to potential systemic risk’.42 It is clear that this definition is more detailed than that adopted by the FSB, as it is grounded in specific negative consequences that may occur if the conduct risk materializes. Moreover, the definition used by IOSCO is based on the type of harm and distinguishes among the mis-​selling of products, fraud on investments, and negligent behaviour.

19.24

A similar approach has been adopted by the FSA, whose task is to monitor the behaviour of financial firms. Even if this conduct authority has decided not to define the term ‘conduct risk’, it focuses attention on the potential drivers of this risk,

39 See FSB, ‘Stocktake of efforts’, n 7, 5. Actually, in ‘Supplementary Guidance’, n 6, 1, the FSB decided to ‘not propose a definition of misconduct’ believing ‘that each firm should internally define misconduct risk based on the firm’s characteristics and business and in a way that promotes adherence to legal, professional, internal conduct and ethical standards’. For a similar broad treatment, see: Carletti, n 24, 6, ‘conduct undesirable from the perspective of customers, investors or proper functioning of markets’. 40 See FSB, ‘Stocktake of efforts’, n 7, 6. 41 See IAIS, n 37, 6. 42 IOSCO, n 8, 14. It is also to be stressed that this definition is fully in line with IOSCO’s objectives as outlined on its website (www.iosco.org, accessed 2 October 2018).

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Managing Conduct Risk: From Rules to Culture which ‘may lead to faultiness in financial markets that drive poor consumer outcomes, weaken competition and threaten market integrity’.43 ASIC broadly defines conduct risk as ‘inappropriate, unethical or unlawful be- 19.25 haviour on the part of an organisation’s management or employees’, but especially focuses its attention on conflicts of interest that have the potential of harming customers.44 Along the same lines is IAIS, which has stated that ‘conduct of business risk can 19.26 be defined as the risk to customers, insurers, the insurance sector or the insurance market that arises from insurers and or intermediaries conducting their business in a way that does not ensure fair treatment of customers’.45 It is important to note that, even if this definition limits conduct risk to the potential to harm insurance customers, IAIS recognizes the existence of a link between this risk and prudential risk, since misconduct may also affect the viability of the offending insurance firm.46 A  similar approach is taken by the Fed (the prudential supervision authority of 19.27 the United States), which adopts both a broad definition of misconduct risk (‘the potential for behaviours or business practices that are illegal, unethical, or contrary to a firm’s stated beliefs, values, policies and procedures’)47 and emphasizes the negative impact misconduct can have on financial firms, stating that it can undermine the ‘intermediation function by diverting management attention, damaging a firm’s reputation, driving a change in the composition of the firm’s workforce, depleting its capital, and making a firm less resilient’.48 The focus on the firm’ perspective is usually stressed by other national prudential 19.28 authorities. For example, the Australian Prudential Regulation Authority (APRA) adheres to the broad definition of conduct risk adopted by ASIC, but explains that, as a prudential authority, its point of view differs from ASIC’s because it focuses on the risk that financial firms could incur significant losses that could undermine their viability and consequently harm depositors.49 The same applies to UK’s Financial Prudential Authority (FPA) which views conduct risk in the context of the procedures set forth to ensure a prudential evaluation of the amount of capital

43 FCA, n 14, 9. 44 ASIC, ‘Culture, conduct and conflicts of interest in vertically integrated businesses in the funds-​ management industry’, March 2016, 8 available at https://​download.asic.gov.au/​media/​ 3583028/​rep474-​published-​21-​march-​2016.pdf, accessed 2 October 2018. 45 IAIS, n 37, 6. 46 See IAIS, n 37, 6ff. 47 FED, n 15, 5. 48 FED, n 15, 1. 49 APRA, ‘Risk culture. Information paper’, October 2016, available at https://​www.apra.gov.au/​ file/​2221, accessed 2 October 2018.

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Antonella Sciarrone Alibrandi and Claudio Frigeni available to a bank and has recently stressed its relevance by asking the banks to apply a separate and additional stress test related to misconduct costs, in addition the ordinary stress tests used to measure the resilience of the banks against all other types of risks.50 C. The definition of ‘conduct risk’ within the Banking Union context—​EBA 19.29

The negative impact that misconduct may have on financial firms is particularly evident in the definition of conduct risk adopted by the EBA in its ‘Methodological Note’ on the new EU-​wide stress test (2016) and in its Guidelines on SREP (2014). In both these documents, conduct risk is defined as ‘the current or prospective risk of losses to an institution arising from inappropriate supply of financial services including cases of wilful or negligent misconduct’.51 The central point of this definition is the risk that banks will incur losses as a result of breach of expected standards of conduct. Moreover, in the SREP Guidelines, conduct risk is considered to be part of operational risk and more specifically a sub-​category of legal risk.52 These Guidelines provide a non-​exhaustive list of hypotheses under which conduct risk is particularly high and may result in losses, namely: a) mis-​selling of products (retail and wholesale markets); b) pushed cross-​selling of products to retail customers; c) conflicts of interest in conducting business; d) manipulation of benchmarks; e) barriers to switching financial products or financial services providers; f ) poorly designed distribution channels (conflicts of interest or false incentives); g) automatic renewal of products; and h) unfair processing of complaints.53

It is important to note that these areas of concern are very similar to those highlighted by the supervision authorities54 whose principal concern is to protect investors. However, in the view of EBA, as appears to be the case with prudential supervisory authorities, concern with conduct risk is aimed chiefly at ensuring that banks’ exposure to losses is correctly measured and that their capital holdings are sufficient to address this exposure. In other words, EBA (and the prudential supervisors) have recognized that misconduct is a risk not only for

50 See FPA, ‘Stress testing the UK banking system:  key elements of the 2018 stress-​test’, March 2018, 15 (available at https://​www.bankofengland.co.uk/​-​/​media/​boe/​files/​stress-​testing/​ 2018/​stress-​testing-​the-​uk-​banking-​system-​key-​elements-​of-​the-​2018-​stress-​test.pdf, accessed 2 October 2018). 51 See EBA, ‘EU‐Wide Stress Test –​Methodological Note 2016’, n 13, point 338, 89; and the new EU-​Wide Stress Test, Methodological note (2018)’, n 13, point 353; EBA, n 12, 16. This definition has also been adopted by other works: see European Parliament, ‘Regular public hearing with Danièle Nouy, Chair of the Single Supervisory Mechanism’ (November 2016), 3f.; Resti, n 24, 5. 52 EBA, n 12, 97 (point 252–​3). 53 ibid (point 253). 54 See Section III.2.

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Managing Conduct Risk: From Rules to Culture external parties, but also for the bank itself. For this reason, it has to be taken into account in the process aimed at assessing compliance of a bank with the capital requirements. D. The definition of ‘conduct risk’ within the Banking Union context—​ESRB The ESRB has adopted a partially different point of view. It adheres to a broad 19.30 definition of misconduct, but focuses specific attention on some aspects of conduct risk other than those already highlighted. Like the other bodies, ESRB defines misconduct risk as ‘risks attached to the way in which a firm and its staff conduct themselves’.55 From there, the ESRB selects specific concerns related to ‘how customers and investors are treated, mis-​selling of financial products, violation of rules and manipulation of markets’.56 Finally, given the macro, prudential perspective of ESRB’s activity, it highlights two different dimensions of (mis)conduct risk. First it stresses that this risk could be a threat to the proper functioning of the entire financial system because, as has already been seen,57 it harms confidence and trust and may discourage the use of financial services. Second, it views misconduct risk as a potent threat because of the penalties and costs incurred by banks in misconduct cases, penalties and costs that may create uncertainty as to the business model, solvency, and profitability of banks (and other financial institutions), and thus also affect the users of the financial system. In conclusion, ESRB considers conduct risk to be a serious internal problem for banks, but also focuses on the negative impact misconduct could have for the entire financial system.

IV.  Conduct Risk: Between the ‘Conduct Perspective’ and the ‘Prudential Perspective’ The above analysis shows that conduct risk is generally considered as arising out 19.31 of misconduct; that is to say, it is risk connected with the violation of legal rules, ethical principles, or codes of conduct. As has been suggested, this risk can be assessed from two different perspectives: the ‘conduct perspective’ and the ‘prudential perspective’.58



See ESRB, n 11, 3. See ESRB, n 11, 3. 57 See Section II. 58 IAIS, n 37, 6; ESRB, n 11, 4. 55 56

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Antonella Sciarrone Alibrandi and Claudio Frigeni A. The conduct perspective 19.32

The first of these, the ‘conduct perspective’, was the only one emphasized at the beginning of the debate about conduct risk.59 It focuses its attention on the negative consequences that misconduct causes for consumers, investors, and society at large. As has already been seen, misconduct may damage not only bank customers who have a contractual agreement with the offending bank, but also (indirectly) other stakeholders operating in the financial market and, more generally, the proper functioning and integrity of the market.60 Moreover, some institutions have also stressed that the impacts resulting from conduct risk could have consequences beyond the financial markets, since they can distort competition among banks or have political repercussions (consider the case of the breaches of embargo regulations). In other words, from a conduct perspective, conduct risk, when actualized in acts of bank misconduct, can affect bank customers, financial markets, and the society at large. In this sense, conduct risk is not a new risk, unknown before the financial crisis. Rather, in the wake of the various scandals discussed above,61 conduct risk has become important on its own; it can no longer be reduced to one (or more) of the categories of risk elaborated within the prudential framework.62 Conduct risk is not just a species of legal risk or compliance risk, but has become its own category of risk.

19.33

From the conduct perspective, the traditional remedy for reducing conduct risk is to improve conduct regulation and strengthen penalties for violations. In order to avoid damage to third parties (and possibly the entire financial system) resulting from misconduct, this remedy involves the adoption of new rules specifically governing the behaviour of intermediaries (conduct regulation) and assigning specific supervisory tasks to authorities (conduct supervision).63 However, this traditional ex post enforcement approach is not enough: because of the potentially significant disruptive effects of misconduct, prevention must be the primary objective of conduct supervision. Even if ex post enforcement and new sanctions

59 FSA approached the problem from this perspective in its first letter to the G20 leaders of February 2015. 60 See the remarks of Mr William C Dudley (President and Chief Executive Officer of the Federal Reserve Bank of New York) at the workshop on ‘Reforming Culture and Behavior in the Financial Services Industry’, available at https://​www.bis.org/​review/​r141021c.pdf, accessed 2 October 2018: The financial sector plays a key public role in allocating scarce capital and exerting market discipline throughout a complex, global economy. For the economy to achieve its long-​ term growth potential, we need a sound and vibrant financial sector. Financial firms exist, in part, to benefit the public, not simply their shareholders, employees and corporate clients. Unless the financial industry can rebuild the public trust, it cannot effectively perform its essential functions. For this reason alone, the industry must do much better. 61 See Section II. 62 ESRB, n 11, 4; this is also hinted at in FSB, ‘Stocktake of Efforts’, n 7. 63 IOSCO, n 10, 26ff.

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Managing Conduct Risk: From Rules to Culture imposed on financial firms are important tools, they have not been an adequate deterrent. This conclusion has been supported by some institutions and scholars, agreeing that ‘[t]‌he fear of penalties alone is unlikely to prevent misconduct sufficiently’.64 In this light, there is a need to rethink the way in which sanctions operate in order to achieve a greater deterrent effect. For example, the necessity of identifying specific employees who have not behaved properly, thereby enhancing individual responsibility, rather than increasing sanctions on financial firms, has often been highlighted.65 In addition, new tools are needed (in addition to sanctions and penalties) to help prevent misconduct. These new tools may include better corporate governance and compensation incentives.66 B. The prudential perspective Quite different is the approach followed by those institutions that emphasize a 19.34 ‘prudential perspective’.67 This perspective also defines conduct risk as a risk relating to the possibility of misconduct. However, from this point of view, conduct risks are taken into consideration not because misconduct may cause harm to third parties (customers or other stakeholders), but because it may damage the bank (or other financial institution) responsible for it. In fact, as has already been seen, misconduct, when discovered, imposes important costs on offending financial firms, including costs of redress and litigation costs. Moreover, even when the misconduct does not involve violations of the law (and is not punished by the law), the offending bank can suffer reputational damage and lose clients. Conduct risk is thus viewed as involving potential financial losses68 that may reduce the amount of a bank’s capital and implicate its ability to fund its exposure, thus threatening

64 ESRB, n 11, 9. 65 ESRB, n 11, 9; IOSCO, n 10, 16; FSB, ‘Strengthening Governance Frameworks’, n 7, V. See also the new UK ‘Senior Managers and Certification Regime’ provided by FCA, available at https://​ www.fca.org.uk/​firms/​senior-​managers-​certification-​regime, accessed 2 October 2018. 66 As has been seen (see Section I), after two years of studying misconduct risk, the FSB decided to establish the Working Group on Governance Framework to investigate how corporate governance might be used as a tool for reducing conduct risk. 67 The FSB has adopted a prudential perspective in its recent documents; see, e.g., the ‘Progress Report’, September 2016 where it states that: Misconduct is also relevant to prudential oversight as it can potentially affect the safety and soundness of a particular financial institution and result in financial and reputational costs to that firm’; see also ‘Stocktake of Efforts’: ‘For prudential regulators, misconduct of the magnitude mentioned above can become a prudential issue for three reasons. First, fines and redress payments are losses that deplete the loss-​absorbing capacity of a financial institution. Second, misconduct cases can be a reflection of underlying weaknesses of the governance framework. Third, misconduct of this magnitude suggests that some financial institutions may be unwilling or unable to get their employees to adhere to proper standards of conduct. This may further indicate that they are also unable to get their employees to adhere to other standards, including those for sound risk management. 68 See EBA’s definition of conduct risk. See also FED, n 15, 1; ESRB, n 11, 9.

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Antonella Sciarrone Alibrandi and Claudio Frigeni its viability. In addition, the harsh consequences that a financial intermediary has to face, when misconduct is unveiled, may give rise to concerns as to the viability of the institution itself and, especially when misbehaviour is widespread among financial institutions or involve important banks, this may lead to systemic risk.69 Therefore, it is clear why prudential authorities have begun to consider conduct risk: it involves a prudential dimension that cannot be overlooked. There is a need to consider the consequences of misconduct with respect to capital and liquidity rules, and to address these consequences in the relevant regulations and in the approach of supervisory authorities. From this ‘prudential perspective’, the most important concern is to assess whether the capital of a specific bank is sufficient to bear potential misconduct costs without jeopardizing its stability. As has been seen in the European Union, conduct risk has recently been taken into consideration in EBA explanations of how to carry out prudential tests, including the stress test and the SREP test,70 which assess whether the amount of regulated capital is adequate to face the potential costs of misconduct, and if it is not, to ensure the availability of new equity. In this context, conduct risk is rightly considered to be a type of ‘operational risk’, and more specifically a legal risk, at least for the purposes of measuring the direct costs a bank may incur from it (penalties and costs of redress). However, as has already been mentioned, conduct risk does not involve only legal risk. The fact that conduct risk often entails behaviour that falls short of ethical standards or codes of conduct, behaviour that does not expose the bank to penalties or legal costs, implies the need to assess reputational risk. In any case, recent financial scandals have shown that conduct risk is by far the most important operational risk in the financial sector, and that it deserves to be specifically considered in determining adequate levels of bank capital and liquidity.71 19.35

The prudential perspective is not limited to assessing the adequacy of capital levels; it also requires measures to manage and reduce the risks of potential losses. This means that, like the conduct perspective, the prudential perspective implies the implementation of appropriate new tools designed to prevent misconduct. Similarly to the conduct perspective, from a prudential point of view it is clear that imposing new penalties on financial institutions is not an adequate solution, and may even have the effect of exacerbating the problem of adequacy of capital. Rather, in the context of prudential regulation, especially after the financial crisis of 2007–​2008, corporate governance and systems of controls, together with compensation tools,

69 This negative outcome is emphasized by ESRB, n 11. 70 EBA made clear in its Methodological Note 2016 that conduct risk is part of these exercises. The consultation document for the 2018 Stress Test aims at further emphasizing conduct risk. 71 ‘Conduct risk’ is not a ‘Pillar 1 risk’, but its potential effect on capital should considered under the ‘Pillar 2 requirements’. This means that each bank must conduct its Internal Capital Adequacy Assessment Process (ICAAP) process giving due consideration to conduct risk, and that supervisory authorities have the power to assess this process within the context of SREP.

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Managing Conduct Risk: From Rules to Culture have assumed a central role. In addition, prudential regulation has given to supervisory authorities a broad power to assess, in their prudential capacity, internal governance and institution-​wide controls. More specifically, supervisory authorities have been asked to assess the capacity of banks’ internal governance mechanisms to identify, measure, and control all risks, including the conduct risk.72 In sum, conduct risk from two different points of view has been analysed: first, the 19.36 conduct perspective, which focuses on the customer side (and particularly consumers) and market integrity; and second, the prudential perspective focusing on the viability of the intermediary in the face of misconduct-​related losses. Depending on which of these perspectives is adopted, the features of preventative tools and the assessment of their adequacy by supervisory authorities may differ.73 In any case, both points of view stress the importance of developing a system cap- 19.37 able of preventing misconduct.74 There has been a convergence of institutional opinion towards ex ante remedies, primarily in the area of internal governance of financial intermediaries, and with respect to the crucial role that risk culture plays in this context.

V.  A New Approach: From Rules to Culture Taking into account that the main objective should be the prevention (rather than 19.38 punishment) of misconduct, the international debate on conduct risk has begun stressing the importance of fostering robust firm cultures, in which customer satisfaction and ethical behaviour would become widespread among financial firms and their employees.75 Poor corporate culture has, in fact, been seen as one of the main causes of misconduct. For this reason, the need to improve firm culture seems to lie behind every new tool designed to manage conduct risk. To better understand the relationship between culture and these new tools, it is useful to analyse the tools as

72 See, e.g., the measures adopted by the Fed in the Wells Fargo Cases (n 21) requiring the improvement of governance and control systems. 73 Given the importance of conduct risk from a supervisory perspective, the architecture of financial supervision and the division of powers among financial authorities should be made taking into account its features and, in particular, the fact that it is two-​sided. In particular, should conduct risk be considered as the main subject of supervision, then the idea of drawing a bright line between a ‘conduct’ authority and a ‘prudential’ authority should be considered very carefully. 74 The need for a more efficient prevention system has been widely recognized, see in particular: FSB, ‘Strengthening Governance Frameworks’, n 7, V; ESRB, n 11, 9ff.; Carletti, n 24, 7f.; Resti, n 24, 1. 75 See ex multis:  FCA, n 21; Carletti, n 24, 7, ‘The development of a robust banking culture is thus considered key to addressing misconduct risk.’; FED, n 15, 4–​5, ‘Though there are undoubtedly many contributing factors that give rise to this type of widespread breakdown, there is a growing academic literature that focuses on a firm’s organizational culture as a key driver of behaviour and resultant misconduct risk.’.

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Antonella Sciarrone Alibrandi and Claudio Frigeni falling into the following three categories: conduct regulation; product governance; and internal governance. 19.39

With respect to the first of these, recent years has seen the implementation of new conduct regulations applicable to the financial sector requiring intermediaries to adopt specific conduct policies protective of customers and of the integrity of financial markets. For example, under MiFID II (Directive 2014/​65/​EU) intermediaries are now required to comply with new rules of conduct aimed at better protecting investors. This is also the case for the AIFMD Directive, which for the first time imposes specific duties on Alternative Investments Fund Managers (AIFMs) to protect their customers and the financial market. Although such approach, focused on the imposition of sanctions for the breach of such new rules is a typical ex post mechanism, it should also be considered that such rules seem to consider crucial the deterrence effect and be designed to prevent misconduct instead of simply punishing the offending financial firm. The common feature of these new regulations, in fact, is that they better delineate the way in which intermediaries (and other financial firms) must behave, replacing previous general standards with more detailed ones. In this way, they provide guidance to intermediaries and their employees as to how to carry out their duties properly according to the minimum standard of behaviour expected of them,76 and attempt to establish an improved culture among employees.77 Moreover, in order to enhance the deterrent effect of conduct regulation, stress has been placed on the need to introduce new sanctions affecting not only banks as entities, but also the specific employees responsible for misconduct (especially if they are at the top of the internal hierarchy).78 Enhanced personal accountability may heighten the fear of sanctions and reduce the temptation to misbehave, fostering a healthy corporate culture.

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In any case, new conduct rules, even if they are important as indications to banks concerning how to behave properly and encourage a change in culture, have only an indirect and limited preventative effect.

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A second category of tools aimed at tackling conduct risk are the European regulations related to ‘product governance’, and include those regulations requiring that financial institutions fashion their financial products keeping in mind the type of client to which they will be sold.79 These regulations provide for sanctions in case

76 See, e.g., n 5 of MiFID II; ‘Incorrect conduct of firms providing services to clients may lead to investor detriment and loss of investor confidence. In order to address the potentially detrimental effect of those weaknesses in corporate governance arrangements, Directive 2004/​39/​EC should be supplemented by more detailed principles and minimum standards’. 77 This is hinted at in FCA, n 21, 2, who requires to ‘foster cultures which support the spirit of regulation in preventing harm to consumers and markets.’ 78 See n 65. 79 See the new Insurance Distribution Directive (2016/​97/​UE) and also Article 16 of MiFID II Directive. See also, EBA, ‘Final Report. Guidelines on Product Oversight and Governance Arrangements for Retail Banking Products’, July 2015, available at https://​www.eba.europa.eu/​

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Managing Conduct Risk: From Rules to Culture of violation; however, it is clear that their main objective is the prevention of misconduct (particularly mis-​selling) before it occurs. There is a direct relationship between product governance and culture. Product 19.42 governance helps to create a healthy culture, since banks and their employees must always consider the interests of their clients. In addition, product governance works only if banks have a strong culture, because otherwise it risks remaining a mere formality. Along the same lines as product governance are the AIFMD rules, which, among 19.43 other things, require AIFMs to be organized in such a manner as to prevent conflicts of interest. Emphasis is placed on the need to prevent misconduct by avoiding conflicts of interest and on the adoption of corporate organizational forms that encourage good behaviour. These rules will be effective only if the internal organization of the financial firm encourages a healthy culture. The last tool to help prevent conduct risk is the improvement of internal govern- 19.44 ance, which should be structured so as to foster a strong corporate culture. In fact, it is the internal governance dimension that has received most attention in the context of preventative remedies against conduct risk. This category could be split into two sub-​categories: compensation practices and internal governance in the strict sense. The FSB has specifically addressed both of these in two different documents. With respect to the compensation tool, it is clear that the structure of a firm’s em- 19.45 ployee compensation (especially of those in top management whose compensation is widely variable) influences employee behaviour, either for good or ill. FSB has stressed the importance of this tool, and in its Supplementary Guidance to the FSB’s ‘Principles and Standards on Sound Compensation Practices’ it provides recommendations for implementing a compensation system that will promote ethical behaviour.80 As respects internal governance, FSB has recently published a document81 outlining 19.46 various governance tools. Importantly, FSB stressed the close link between governance and culture, expressing the view that senior managers should identify the existence of an unhealthy culture and attempt to change it. The FSB noted that good governance structure, in which each employee has clear tasks and responsibilities, may be useful for improving individual accountability and identifying individuals responsible for misconduct. In this way, sound governance paired with individual sanctions can improve firm culture and reduce conduct risks. In order to reduce

documents/​10180/​1141044/​EBA-​GL-​2015-​18+Guidelines+on+product+oversight+and+governa nce.pdf/​d84c9682-​4f0b-​493a-​af45-​acbb79c75bfa, accessed 2 October 2018. 80 FSB, ‘Supplementary Guidance’, n 6. 81 FSB, ‘Strengthening Governance Frameworks’, n 7.

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Antonella Sciarrone Alibrandi and Claudio Frigeni conduct risk, internal governance (and systems of internal control) should not be limited to a set of formal procedures; it is crucial that these things reflect principles and values widely embedded in a firm’s internal organizational structure. 19.47

At EU level the importance of culture in the context of internal governance as a means to prevent misconduct has clearly been stated in the new Guidelines on Internal Governance (2017). An entire section of such document, entitled ‘Risk Culture and Business Conduct’, is devoted to stressing that a sound and consistent risk culture is essential for the governance mechanism to be effective and capable of preventing and minimizing misconduct.82 All these culture-​enhancing tools show that it is risk culture, in the end, that lies behind the remedies put forward to prevent misconduct, especially in the field of governance. This means that not only firms have to adjust to such new approaches but also supervisory authorities will need to adapt their supervisory practices. As APRA has recently pointed out: ‘The traditional focus of supervisors on governance, risk management and internal controls would likely be inadequate if insufficient attention was given to risk culture.’83 In the end, if prevention of misconduct depends on the effectiveness of tools based on culture, supervision of behaviour and culture, either from a conduct or prudential perspective, becomes crucial.84

82 See EBA, ‘Guidelines on internal governance under Directive 2013/​36/​EU’, 2017, 33ff. 83 APRA, n 49, 5. 84 See, DNB, ‘Supervision Behaviour and Culture’, available at https://​www.dnb.nl/​binaries/​Supervision%20of%20Behaviour%20and%20Culture_​tcm46-​334417.pdf, accessed 2 October 2018.

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20 CONFLICTS OF INTEREST Comparing Compliance and Culture in the United States and the United Kingdom Geneviève Helleringer and Christina Skinner

I. Introduction II. Protecting the Retail Investor: The Legal Framework A. Fiduciary duties as financial regulation B. Developments in fiduciary duty law

III. Navigating the Conflicts of Interest Ahead

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A. Retail conflicts on the horizon 20.35 B. Bringing culture into compliance 20.55

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IV. Building Cultural Infrastructure Around Legal Frameworks 20.68

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A. Conflicts modelling B. Pioneering industry standards C. Proxies for personal liability

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V.

Conclusion

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I. Introduction The retail markets in the United States and the United Kingdom have been troubled 20.01 by incidents of misconduct over the past ten years. Consider a few prominent examples. Prior to the financial crisis of 2008, in the United States and elsewere, numerous retail banks sold customers mortgage products that were not in their best interests.1 Nearly a decade later, in 2016, it was uncovered that employees at Wells Fargo—​striving to meet sales quotas—​opened about three and a half million false and unauthorized deposit and credit card accounts on behalf of existing clients.2 1 See generally, Financial Crisis Inquiry Commission, ‘The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States’ xxii (2011), available at https://​www.gpo.gov/​fdsys/​pkg/​GPO-​FCIC/​pdf/​GPO-​ FCIC.pdf, accessed 8 October 2018. 2 Laura Keller, ‘Wells Fargo Boosts Fake-Account Estimate 67% to 3.5 Million’, Bloomberg (August 2017), available at https://www.bloomberg.com/news/articles/2017-08-31/wells-fargoincreases-fake-account-estimate-67-to-3-5-million, accessed 10 October 2018; see also Jabbari v Wells

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Geneviève Helleringer and Christina Skinner Meanwhile, in the United Kingdom, concerns of misconduct in the British pension market have been stirring since 2017. Recent changes in UK law gave pensioners the ability to cash out their employer pension plans, which cash they can then move into personal pension plans.3 The Financial Conduct Authority (FCA) has expressed concern that financial advisers may be pressuring and scare-​mongering plan-​holders to roll their accounts in this way.4 20.02

Because of the structure of incentives, conflicts of interest situations regularly arise in the context of retail investment advice. In parallel, empirical studies show that advisers from the financial industry, as from other professions, often give biased advice in the presence of a conflict of interest.5 So it should come as no surprise that conflicts of interest have been the focal point of regulators’ efforts to improve conduct in the retail investment space. In law, formal fiduciary duties attempt to align professional norms with professional responsibilities in order to alleviate some of the negative effects that arise from conflict of interests.6

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In the United States, both the Securities and Exchange Commission (SEC) and the Department of Labor (DOL) have embarked on rule-​making projects to heighten and refine the fiduciary duties that investment advisers owe to retail clients—​and, in particular, the duty of loyalty that dictates the identification and management of conflicts of interest. Similarly, as a result of the FCA’s ‘Retail Distribution Review’, UK regulators issued new guidance on how the investment adviser can best comply with his or her fiduciary duties. However, with the bulk of regulatory attention so focused on revamping the legal and regulatory frameworks surrounding fiduciary duties, one wonders whether an important element will go missing. Specifically, will firms be sufficiently compelled to focus on building the cultural infrastructure which, while perhaps not mandated by regulators, is nonetheless necessary to support—​and fill gaps in—​fiduciary duty rules?

Fargo, No 3:15-cv-02159 (ND Cal, 2017); Carmel Crimmins and Karen Freifeld, ‘Best Banker in America’ Blamed for Wells Fargo Sales Scandal, Reuters, 10 April 2017, available at https://www. reuters.com/article/us-wells-fargo-accounts/best-banker-in-america-blamed-for-wells-fargo-salesscandal-idUSKBN17C18P, accessed 8 October 2018; E Scott Reckard, ‘Wells Fargo Pressure-cooker Sales Culture Comes at a Cost’, LA Times, 21 December 2013, available at http://www.latimes.com/ business/la-fi-wells-fargo-sale-pressure-20131222-story.html, accessed 8 October 2018. 3 Oliver Ralph and Josephine Cumbo, ‘Life Assurers Rake in Billions from Pension Fund Transfers’, Financial Times, 26 October 2017, https://​www.ft.com/​content/​859d625c-​b8ae-​11e7-​ 9bfb-​4a9c83ffa852, accessed 8 October 2018. 4 ibid; see FCA, ‘Improving the Quality of Pension Transfer Advice—​Feedback on CP18/​7 and Final Rules and Guidance’, October 2018, available at https://​www.fca.org.uk/​publication/​policy/​ ps18-​20.pdf, accessed 8 October 2018. 5 D A Moore et al, ‘Conflicts of Interest and The Case of Auditor Independence: Moral Seduction and Strategic Issue Cycling’, Academy of Management Review (2006), 31, 1, 10–​29. 6 This chapter principally focuses on how the law addresses conflicts of interest in the retail investment space—​though it touches briefly, for illustrative purposes, on related spaces, like retail banking.

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Conflicts of Interest The core claim of this chapter is that the prudent and forward-​looking investment 20.04 firms will see the incentives for doing so. These firms, anticipating novel conflicts-​ of-​interest challenges on the horizon, and reading the tea leaves of supervisory expectations, will begin to think more expansively and creatively about how their internal compliance functions might include a culture dimension. Indeed, it is predicted in this chapter that both supervisors and the market will soon come to demand proof that a cultural shift in retail investment firms is happening, in the form of evidence that a firm espouses and abides by certain norms of business conduct that govern its employees’ interactions with retail clients. Accordingly, those investment firms that start expanding their view of compliance now, to address ‘culture’—​that is, firm values and attitudes towards the proper treatment of retail investment clients7 —​alongside their formal processes for dealing with conflicts of interest, will no doubt have a head start in confronting the next generation of retail investment regulations. In that vein, this chapter will first examine the traditional legal frameworks that 20.05 address conflicts of interest in the retail investment space, outlining how they are narrowly anchored in fiduciary duty law, as well as recent developments in these regimes. Then, the chapter will offer some predictive analysis concerning where conflicts-​of-​interest challenges are likely to lie on the horizon in retail investing, and how existing and proposed fiduciary duty rules are likely to fall short in addressing them. Finally, and prescriptively, the chapter will explore the implications of that prediction for integrating compliance (a legal construct) with culture (an ethical, professional, and behavioural one). Specifically, the chapter will conclude by suggesting how the compliance function of retail investment advisory firms can evolve—​indeed, expand—​to incorporate legal risk considerations together with cultural risk considerations. Concretely, the chapter will set out some tentative ideas for constructing this new legal-​cultural apparatus in the retail investment firm.

II.  Protecting the Retail Investor: The Legal Framework Investor protection is a fundamental goal of the securities law in both the United 20.06 States and Europe.8 The US Securities Act of 1933 and the Securities Exchange Act of 1934 were introduced with the express goal of protecting investors from

7 Given space constraints, this chapter does not further define ‘culture’ here, though it is acknowledged by the authors that it is an inherently slippery concept. For an in-​depth analysis, see Guido Ferrarini and Shanshan Zhu, Chapter 16, this volume. See also Dan Awrey, William Blaire, and David Kershaw, ‘Between Law and Markets: Is There a Role for Culture and Ethics in Financial Regulation’, Delaware Journal of Corporate Law (2013), 191, 205. 8 See generally, John Armour et al, Principles of Financial Regulation, Oxford University Press, 2016, 62.

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Geneviève Helleringer and Christina Skinner misconduct-​related abuse, like fraud.9 And investor protection is one of the SEC’s three direct mandates (alongside the support of efficient markets and capital formation).10 20.07

Indeed, investor protection may well be the backbone of the SEC’s work. Precisely as former SEC Chair Mary Jo White remarked, ‘Each part of our mission circles back to the first—​to protect investors—​because if our markets are not fair and safe, they will not attract investors to provide the capital companies are seeking.’11 In similar ilk, investor protection goals feature prominently in each of the major EU Directives regulating investments.12

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Retail investors comprise a significant segment of investors. As the SEC has described: Over half of Americans, either personally or jointly with a spouse, report that they own a stock directly or through investment vehicles, like a self-​directed 401(k) or IRA. And over 44 percent of Americans—​including most retail investors—​invest in a mutual fund, which . . . pools money from many investors and invests it in stocks, bonds, money-​market instruments, other securities, or even cash.13

And as a public policy matter, the law views the retail investor—​as compared to institutions and high net-​worth individuals—​as requiring special protection from fraud and abuse.14 Thus, as the SEC notes, the retail investor ‘must be a constant focus’ of financial law and regulation.15 A. Fiduciary duties as financial regulation 20.09

Although US and EU securities laws protect the retail investor in myriad ways, one of the primary vehicles for doing so is a robust framework of fiduciary duty laws and rules. As was well summarized by SEC Commissioner Kara Stein, ‘[t]‌he lynchpin of investment adviser regulation is the fiduciary duty’, and the essence of the duty is ‘that the adviser must avoid conflicts of interest and cannot take unfair

9 See ibid; see also Donald C Langevoort, ‘The SEC, Retail Investors, and the Institutionalization of the Securities Markets’, Virginia Law Review (2009), 95, 1025, 1026 n 4. 10 SEC, What We Do, https://​www.sec.gov/​Article/​whatwedo.html , accessed 7 January 2018. 11 Speech, Mary Jo White, SEC Chair, ‘Protecting the Retail Investor’, 21 March 2014, available at https://​www.sec.gov/​news/​speech/​mjw-​speech-​032114-​protecting-​retail-​investor, accessed 9 October 2018. 12 Directive 2003/​ 71/​ EC (Prospectus Directive) [2003] OJ L345/​ 64, Recitals 10, 12, 16; Directive 2014 65/​EU (Second Markets in Financial Instruments Directive or ‘MiFiD II’ [2014] OJ L173/​349, Recitals 7, 39, 45, 57, 58, 97, 133; Directive 2004/​109/​EC (Transparency Directive) [2004] OJ L390/​38, Recitals 1, 5, 7. 13 White, n 11. 14 ibid; see also Code of Federal Regulations, Title 17, Chapter II, Part 230, § 501 (defining ‘accredited investor’). 15 ibid; see also Armour et al, n 8, 64 (defining retail investors as ‘individuals investing modest sums on their own account’).

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Conflicts of Interest advantage of a client’s trust’.16 Bank regulators have spoken on the matter as well. Citing the common law (Restatement of Trusts),17 the Office of the Comptroller of the Currency (‘OCC’) has explained that ‘bank fiduciaries have a heightened responsibility to avoid impermissible conflicts of interest and to ensure that they are acting in the best interests of fiduciary accounts’.18 The most ‘fundamental’ of fiduciary duties is generally taken to be the duty of loyalty, 20.10 that is, the duty not to engage in ‘self-​dealing’ transactions or transactions ‘that otherwise involve or create a conflict between the . . . fiduciary duties and personal interest’.19 As explained in a statement by the SEC Director of Compliance and Investigations: [A]‌conflict of interest [is] a scenario where a person or firm has an incentive to serve one interest at the expense of another interest or obligation. This might mean serving the interest of the firm over that of a client, or serving the interest of one client over other clients, or an employee or group of employees serving their own interests over those of the firm or its clients.20

In the United States, the fiduciary standards that apply to investment advisers have 20.11 been hardwired into federal securities law.21 In particular, any investment adviser registered with the SEC is considered to be a fiduciary, and therefore ‘has a duty to make full and fair disclosure of all material facts to, and to employ reasonable care

16 Speech, Kara M Stein, SEC Commissioner, ‘Surfing the Wave:  Technology, Innovation, and Competition—​Remarks at Harvard Law School’s Fidelity Guest Lecture Series’, 9 November 2015, available at https://​www.sec.gov/​news/​speech/​surfing-​wave-​technology-​innovation-​and-​ competition-​remarks-​harvard-​law-​schools-​fidelity, accessed 9 October 2018; see also White, n 11. For a basic definition of conflict of interest, see Hamid Mehran and Rene M Stulz, ‘The Economics of Conflicts of Interest in Financial Institutions’, NBER Working Paper No 12695/​2006, available at http://​www.nber.org/​papers/​w12695, accessed 9 October 2018 (‘A conflict of interest exists when a party to a transaction could potentially make a gain from taking actions that are detrimental to the other party in the transaction.’). 17 See Uniform Trust Code, § 802, Duty of Loyalty (‘a trustee shall administer the trust solely in the interests of the beneficiaries’); Uniform Prudent Investor Act, § 5 (‘A trustee shall invest and manage the trust assets solely in the interest of the beneficiaries.’). See generally John H Langbein, ‘Questioning the Trust Law Duty of Loyalty:  Sole Interest or Best Interest?’, Yale Law Journal (2005), 114, 929. 18 Comptroller’s Handbook, Asset Management, Conflicts of Interest 1 (January 2015), available at https://​www.occ.treas.gov/​publications/​publications-​by-​type/​comptrollers-​handbook/​conflicts-​ of-​interest/​pub-​ch-​conflicts-​of-​interest.pdf, accessed 9 October 2018. 19 ibid. 20 Speech, Carlo V di Florio, SEC Director, Office of Compliance Inspections & Examinations, ‘Conflicts of Interest and Risk Governance’, 22 October 2012, available at https://​www.sec.gov/​ news/​speech/​2012-​spch103112cvdhtm, accessed 7 January 2018. 21 It bears clarifying, however, that fiduciary duties as a matter of general corporate law are based in state law. ‘Delaware is the preeminent state in corporate law and fiduciary duties, and has been for the last century.’ American Bar Association, ‘Corporate Governance and Fiduciary Duties’, available at https://​apps.americanbar.org/​buslaw/​newsletter/​0026/​materials/​46.pdf, 3, accessed 11 October 2018.

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Geneviève Helleringer and Christina Skinner to avoid misleading, clients’.22 Retail clients should be able to ‘understand the investment adviser’s business practices and [any] conflicts of interest’.23 More specifically, SEC (and related Financial Industry Regulatory Authority (FINRA)) rules24 promulgated pursuant to the Investment Advisers Act of 1940 generally require that registered investment advisers act in the best interests of [their] clients and to provide investment advice in [their] clients’ best interests. [Investment advisers] owe [their] clients a duty of undivided loyalty and utmost good faith. [They] should not engage in any activity in conflict with the interest of any client, and [they] should take steps reasonably necessary to fulfill [their] obligations. [Advisers] must employ reasonable care to avoid misleading clients and [they] must provide full and fair disclosure of all material facts to [their] clients and prospective clients.25

This is commonly referred to as the ‘best interests’ standard, which, again, applies to registered investment advisers. Meanwhile, broker-​dealers are subject to FINRA rules that require investment advice to be ‘suitable’ for their clients.26 As applied, the suitability standard is viewed as somewhat less rigorous than the best interest standard that is imposed on advisers under the Investment Advisers Act. However, the SEC has recently proposed a new rule under the Exchange Act which would require broker-​dealers also to act in the ‘best interests’ of their retail clients when making recommendations about securities transactions or investment strategies involving securities.27 20.12

As for banks, although normally exempt from securities law regulation, those institutions are required to invest funds of any fiduciary account ‘in a manner consistent with applicable law’, which is defined to mean, among other things, ‘any applicable Federal law governing [a bank’s fiduciary relationships], the terms of the instrument governing a fiduciary relationship, or any court order pertaining to the relationship’.28

22 SEC, Division of Investment Management, IM Guidance Update 3 (February 2017), available at https://​www.sec.gov/​investment/​im-​guidance-​2017-​02.pdf, accessed 7 January 2018 [hereinafter SEC, IM Guidance Update]. 23 ibid, 3. 24 FINRA, ‘Conflicts of Interest’, http://​www.finra.org/​industry/​conflicts-​of-​interest, accessed 7 January 2018. 25 SEC, ‘Information for Newly-​Registered Investment Advisers’, https://​www.sec.gov/​divisions/​ investment/​advoverview.htm, accessed 7 January 2018. 26 See FINRA Manual, ‘Suitability’, available at http://​finra.complinet.com/​en/​display/​display.html?rbid=2403&record_​id=13390&element_​id=9859&highlight=2111, accessed 10 October 2018. 27 See Regulation Best Interest, Proposed Rule, Release No 34-​83062, available at https://​www. sec.gov/​rules/​proposed/​2018/​34-​83062.pdf, accessed 7 January 2018; see also SEC, ‘Information for Newly-​Registered Investment Advisers’, available at https://​www.sec.gov/​divisions/​investment/​ advoverview.htm, accessed 7 January 2018. 28 12 CFR, §§ 9.2, 9.11.

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Conflicts of Interest Rules in the United Kingdom governing the provision of investment advice are simi- 20.13 larly grounded in fiduciary law. Notably, the UK Securities and Investments Boards (SIB) adopted the Core Conduct of Business Rules pursuant to the Financial Services Act 1986. Under these Rules, independent financial advisers were subject to a ‘best advice rule’29 when making personal recommendations for investments in ‘packaged investment products’, such as units in regulated collective investment schemes. According to a number of scholars, the best advice rule was, in effect, an applica- 20.14 tion of the best execution principle, which applies to independent financial advisers acting as investors’ agents. Of fiduciary origin, the best execution principle imposes a duty on investment advisers to act in the best interests of the client. In 2004, the Financial Service Authority revamped the 1986 system,30 adopting the Principles for Businesses that, among other things, require financial advisers to pay ‘due regard’31 to the interests of customers and to treat them fairly. Although formulated somewhat mildly, this duty to consider customers’ interests and to ensure their fair treatment is in effect a fiduciary duty of loyalty; it certainly precludes the provision of investment advice driven by a conflict of interest. B. Developments in fiduciary duty law While this basic fiduciary framework has been a mainstay of the securities law for 20.15 decades (in the United States), and since the early days of EU financial services law (in Europe), regulators have doubled-​down on fiduciary duty rules in their recent effort to improve the conduct of the retail investment sector. In the United States, both the DOL and the SEC have either promulgated or have considered reinforcing fiduciary duty rules pursuant to their statutory authority. In the United Kingdom, the FCA undertook a comprehensive Retail Distribution Review with much the same goal in mind, while the EU has introduced even more stringent rules. The DOL ‘fiduciary rule’ also known (informally) as the ‘conflict of interest rule’ 20.16 was adopted in 2016 and expands the scope of fiduciary duties in the retirement investment space. Presently, the future of the rule remains uncertain: key provisions were delayed until July 2019,32 and a recent decision by the Fifth Circuit Court of Appeals vacated (i.e. invalidated) the rule.33 Despite this uncertainty about the

29 Though tied agents were also subject to this requirement, they could market their firm’s products, and therefore remain salespersons on behalf of companies that offer financial instruments. See Niamh Moloney, How to Protect Investors. Lessons from the EC and the UK, Cambridge University Press, 2010. 30 Luca Enriques and Matteo Gargantini, ‘The Overarching Duty to Act in the Best Interest of the Clients in MiFID II’, in Danny Busch and Guido Ferrarini, Regulation of the EU Financial Markets: MiFID II and MiFIR, Oxford University Press, 2017, 85–​122, 87. 31 FCA Principles for Business, Principle 6. 32 82 Federal Register 56545 (29 November 2017). 33 Chamber of Commerce of the US v US Dep’t of Labor, No 17-​10238 (5th Cir, 15 March 2018).

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Geneviève Helleringer and Christina Skinner rule’s future impact, it is nonetheless useful to explore the rule’s parameters—​if for no other reason than an academic study of how forward-​leaning fiduciary duty regulations could be structured, and as a case study of regulatory appetite for strengthened fiduciary duty law. 20.17

In broad strokes, the rule aims to ensure that all retirement advice is given pursuant to the retiree’s best interests.34 It requires that any financial professional giving advice or recommendations in connection with retirement plans (e.g., 401K plans or IRAs)—​which includes investment advisers as well as broker-​dealers—​will be considered a fiduciary giving ‘fiduciary investment advice’ under the Employee Retirement Income Security Act of 1974 (ERISA).35

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There are two key components to note. First, the rule expands the category of investment professionals which come within the scope of the ERISA definition of ‘investment advice fiduciary’.36 Specifically, the new fiduciary rule applies to any financial professional that makes a recommendation in connection with a retirement account. This would include, for example, ‘advice’ given on securities or other property transactions; decisions regarding distributions or plan rollovers; and general investment management decisions, among other things.37 It bears emphasis that broker-​dealers used not to be considered ERISA fiduciaries, and so this new rule significantly expands the conduct standards that apply to this category of investment professional.

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The rule also contains a substantial exemption. As a baseline, the rule seeks to discourage commission fee structures, on the view that these can be more conflict-​ prone than flat fee based structures. However, the rule’s ‘Best Interest Contract Exemption’ or ‘BIC Exemption’ permits fiduciaries to receive commissions—​and other similar types of compensation that might otherwise give rise to conflicts of interest—​in certain cases. The BIC exemption can apply where the fiduciary: • agrees to provide advice that is in the ‘best interests’ of the retirement investor; • does not charge more than reasonable compensation; • does not make any misleading statements.38 34 US Department of Labor, ‘Conflict of Interest Final Rule’, available at https://​www.dol.gov/​ agencies/​ebsa/​laws-​and-​regulations/​rules-​and-​regulations/​completed-​rulemaking/​1210-​AB32-​2, accessed 7 January 2018; see also Opinion, Alexander Acosta, ‘Deregulators Must Follow the Law, So Regulators Will Too’, Wall Street Journal, 22 May 2017, available at https://​www.wsj.com/​articles/​ deregulators-​must-​follow-​the-​law-​so-​regulators-​will-​too-​1495494029, accessed 7 January 2018. 35 81 Federal Register 20946 (8 April 2016). 36 ‘ERISA safeguards plan participants by imposing trust law standards of care and undivided loyalty on plan fiduciaries, and by holding fiduciaries accountable when they breach those obligations’. ibid. 37 Maureen J Gormen and Lennine Occhino, ‘DOL Fiduciary Rule: Impact and Action Steps’, Harvard Law School Forum on Corporate Governance and Financial Regulation, 21 July 2017, available at https://​corpgov.law.harvard.edu/​2017/​07/​21/​dol-​fiduciary-​rule-​impact-​and-​action-​ steps, accessed 7 January 2018. 38 ibid.

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Conflicts of Interest As a possible downside, the DOL rule would make fiduciary standards uneven 20.20 across retail investment advisers. Under the rule, retirement advice (whether given by broker-​dealers or investment advisers) would be held to a different, some argue higher, fiduciary standard than other forms of retail investment advice.39 Already, as SEC Commissioner Hester Peirce points out, ‘fiduciary’ has different legal meanings in ERISA and under the Investment Advisers Act of 1940.40 Moreover, as discussed, broker-​dealers and registered investment advisers are held to different conduct standards generally—​a ‘suitability’ standard for the broker-​dealers and the ‘best interests’ standard for advisers—​a disparity which preexisted the new DOL rule. Indeed, the Dodd-​Frank Act required the SEC to consider this unevenness between registered investment advisers and broker-​dealers, and gave the SEC authority to create a uniform ‘best interest’ standard of conduct for investment advisers and broker-​dealers if needed.41 On that mandate, the SEC has, as discussed, proposed a new rule which would require broker-​dealers to act in the ‘best interests’ of their retail clients—​thus bringing their duties in line with those imposed on registered investment advisers.42 This SEC rule may yet come to render moot and/​or supplant the DOL rule. In the European Union, the Markets in Financial Instruments Directive (MiFID 20.21 II), adopted in 2014 and applied from the beginning of 2018, governs the relationship between financial advisers and their clients.43 Article 24(1) of MiFID II requires investment firms to act honestly, fairly, and professionally, in accordance with the best interest of their clients.44 In practice, a network of rules covers the various stages of the relationship between the client and the adviser, including the marketing phase.45 The rules require in particular that investment advice be suitable for the client and not be tainted by conflicts of interests. Firms must also implement policies and procedures to manage conflicts of interest as well as systems to monitor and maintain those conflicts systems. The broad, fiduciary-​like ‘fair treatment’ obligation provides national regulatory 20.22 authorities with a convenient, flexible mechanism to assess firms’ behaviour, and

39 See Department of Treasury, ‘Protect Consumers and Investors from Financial Abuse, Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation’ 2009,  70–​1. 40 Speech, Heather M Peirce, ‘What’s in a Name? Regulation Best Interest v. Fiduciary’, available at, https://​www.sec.gov/​news/​speech/​speech-​peirce-​072418#_​ednref20, accessed 10 October 2018. 41 Dodd-​Frank Act, § 913. 42 See Regulation Best Interest, Proposed Rule, Release No 34-​83062, available at https://​www. sec.gov/​rules/​proposed/​2018/​34-​83062.pdf, accessed 7 January 2018. 43 MiFID II and Regulation (EU) No 600/​2014, [2014] OJ L173/​84: they recast and replace Directive 2004/​39/​EC, [2004] OJ L145/​1 (MiFID I). 44 MiFID II, Article 24(1). 45 Communication must be ‘fair, clear and not misleading’ (MiFID II, Article 24(3)). See Martin Brennke, ‘The Legal Framework for Financial Advertising:  Curbing Behavioural Exploitation’, European Business Organization Law Review (2018), forthcoming.

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Geneviève Helleringer and Christina Skinner even proactively address the asymmetry in bargaining power between firms and their clients.46 In addition, Member States can supplement the compulsory core ‘fair treatment’ obligation and adopt legislation that goes above and beyond the EU provisions. For example, the United Kingdom introduced, as from 1 January 2013, a prohibition on the taking of commissions by independent advisers that gold-​plated the requirements that were then in place. 20.23

Moreover, pursuant to its Retail Distribution Review (RDR), the FCA concluded that notwithstanding the existing ‘best interests standards’ (similar to what existed in the United States), the market for financial advice was still too conflicted.47 The main changes that emerged from the RDR, in addition to the banning of commissions,48 include: • a requirement that independent advisers document that their advice considered/​ addressed all of the of retail products available;49 • the addition of more stringent qualifications to obtain a licence as a financial adviser, including subscribing to a code of ethics and fulfilling continuing professional education requirements.50 This regulatory project is ongoing and in some respects historic.51 In May 2018, the FCA retired two pieces of guidance on the RDR, on the ground that the guidance had been superseded by new rules implementing MiFID  II.52 46 Niam Maloney, EU Securities and Financal Makets Regulation, 3rd ed, Oxford University Press, 2014, 800. 47 Evan Cooper, ‘Regulatory Changes Abroad Hint at the DOL Fiduciary Rule’s Potential Impact’, available at http://​www.investmentnews.com/​article/​20160417/​FREE/​160419944/​ regulatory-​changes-​abroad-​hint-​at-​the-​dol-​fiduciary-​rules-​potential, accessed 7 January 2018. 48 ‘One of the central objectives of the Retail Distribution Review (RDR) was to remove the potential for adviser remuneration to distort the advice consumers receive. By ending commission payments from investment product providers (providers) to advisory firms, we wanted to help ensure that: providers compete on the price and quality of their products to secure distribution rather than on commission levels, and advisory firms are not inappropriately influenced by the payment of commission when providing advice to their customers.’ FCA, ‘Supervising Retail Investment Advice: Inducements and Conflicts of Interest, Finalised Guidance’, para 1.2 (January 2014), available at https://​www.fca.org.uk/​publication/​finalised-​guidance/​fg14-​01.pdf, accessed 7 January 2018 [hereinafter FCA, Final Guidance]. See also FCA, ‘Retail Investment Advice: Adviser Charging and Services’, available at https://​www.fca.org.uk/​publications/​thematic-​reviews/​tr14-​21-​ retail-​investment-​advice-​adviser-​charging-​and-​services, accessed 15 June 2018). 49 This requirement does not apply to tied agents. 50 See Cooper, n 47. 51 In January 2014, the FCA issued a final guidance document on ‘Supervising Retail Investment Advice: Inducements and Conflicts of Interest.’ FCA, Final Guidance, n 48. In addressing how investment firms should, ideally, manage conflicts of interest and potential inducements, the FCA noted that the guidance was relevant to ‘all providers of retail investment products to be sold by advisers and any advisory firm providing personal recommendations in relation to retail investment products.’ ibid, para 1.7. 52 FCA, PS1/​10:  Retiring FG12/​15 and FG14/​1, available at https://​www.fca.org.uk/​publications/​policy-​statements/​ps18-​10-​retiring-​fg12-​15-​and-​fg14-​1, accessed 9 October 2018.

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Conflicts of Interest Developments in UK banking regulation have also had some cross-​over into the 20.24 retail investment space. In particular, the Parliamentary Commission on Banking Standards (PCBS) was established in 2012 to conduct an inquiry into professional standards and culture in the UK banking sector and to make recommendations for legislative and other action. PCBS published its final report in June 2013 entitled ‘Changing Banking for Good’, including recommendations to make senior bankers more responsible, as well as encouraging behavioural change through increased individual accountability. The Prudential Regulation Authority (PRA) and the Financial Conduct Authority 20.25 (FCA) responded to these recommendations with proposals introducing a new regime included in various consultation papers between July 2014 and July 2015. This new regime is made up of three components: • The senior managers regime creates direct accountability to the regulators for individuals taking (or participating in) important decisions about a firm’s affairs. It also ensures that firms allocate the most important senior management functions to individuals in a clearly defined manner; • The Certification Regime requires firms to certify that certain employees are ‘fit and proper’ to perform their functions, having regard to their qualifications, training, competence, and personal characteristics; and • The Conduct Rules are the Regulator-​prescribed code of conduct applying to all non-​ancillary staff within firms. Firms are required to report breaches of the Conduct Rules to the appropriate Regulator. The new regime came into force for all ‘relevant authorized persons’ on 7 March 20.26 2016 and will be extended to all ‘authorized persons’ during 2018. ‘Relevant authorized persons’ include banks, building societies, credit unions, PRA-​ designated investment firms, and branches of foreign banks operating in the United Kingdom. The government has estimated that the proposed extension to ‘authorized persons’ will apply to 60,000 additional firms, including 17,200 investment firms. Pursuant to this regime, individuals (senior managers) who hold one or more key 20.27 functions within a firm (senior management functions) must be approved by the appropriate regulator before they can be formally appointed. Senior managers typically include a firm’s board members; executive team members and heads of key business areas such as risk, internal audit, and finance; compliance officers; and money laundering reporting officers. Under the duty of responsibility, the FCA and the PRA can take action against senior managers if they are responsible for the management of any activities in their firm in relation to which their firm contravenes a regulatory requirement, and they do not take such steps as a person in their

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Geneviève Helleringer and Christina Skinner position could reasonably be expected to take to avoid the contravention occurring (or continuing).53 20.28

The duty of responsibility requires the regulators to prove a contravention of a regulatory requirement by the firm, and that the senior manager was responsible for the management of any activities in their firm in relation to which the firm’s contravention occurred. The burden of proof lies with the regulators to show that the senior manager did not take such steps as a person in their position could reasonably be expected to have taken to avoid the firm’s contravention occurring. In substance, then, the Senior Manager and Certification Regime builds on (but goes further than) certain fiduciary duty principles.

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In the US especially, given the possibility of the DOL phase-in and/or a new SEC rule, retail investment firms face the prospect of increased costs of compliance.54 The sources of these additional compliance costs are likely to run the gamut from installing new procedures for ensuring that all relevant professionals are appropriately categorized as fiduciaries, and properly training these fiduciaries regarding their legal obligations, particularly as they relate to actual or potential conflicts. Additionally, as other experts have pointed out, firm compliance departments will be tasked with reviewing the roles played by their various vendors and service providers, and evaluating whether these third parties provide information in ways that will qualify as investment advice or recommendations under the new rules.55 In tandem with that review, firms will have to ensure that all service agreements, contracts, and fiduciary liability insurance policies cover relevant employees and third parties.56

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But with compliance professionals hyper-​focused on digesting new rules and guidance in the first instance, and then installing the necessary procedures to ensure that these new requirements are met, there may be few resources left to think more expansively about ways to fundamentally change institutional behaviour—​ culture—​to align with the broader spirit of the invigorated fiduciary duty rules.

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The next section of this chapter urges that embracing a broader vision of compliance—​ which addresses the cultural underpinnings of the fiduciary duty rules—​is not just

53 FCA, ‘Guidance on the duty of responsibility: final amendments to the Decision Procedure and Penalties Manuel’: Policy Statement PS17/​9, May 2017, available at https://​www.fca.org.uk/​ publication/​policy/​ps17-​09.pdf, accessed 7 January 2018. 54 It is difficult to say with certainty whether the DOL rule will come to be. In the spring of 2018, the Labor Department stated that it would not enforce the fiduciary rule. See ‘Labor Department Won’t Enforce Investor Protection Rule After Court Decision’, CNBC, 19 March 2018, available at https://www.cnbc.com/2018/03/19/dol-shelving-enforcement-of-fiduciary-rule-after-court-decision. html, accessed 27 November 2018. 55 Gormen and Occhino, n 37. 56 ibid.

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Conflicts of Interest academic idealizing or aspirational. To the contrary, it is suggested that incorporating cultural elements into retail investment firms’ compliance functions will be essential to their task of managing the kinds of non-​traditional conflicts of interest that are likely to arise in the near and medium term. In particular, the authors seek to show that there is good reason for investment firms to embrace a proactive approach to conflicts-​ of-​interest compliance, and to begin thinking innovatively about the sorts of cultural infrastructure that can be implemented internally to support (and advance) the goals that animate this new fiduciary duty regime.

III.  Navigating the Conflicts of Interest Ahead While heightening fiduciary standards is certainly an important—​and tangible—​ 20.32 step towards improving conduct in the retail investment space, there is some danger that too steady a focus on rules will unduly narrow the conduct reform project. Fiduciary rules are likely to focus firms and their advisers on process—​incentivizing these firms to add layers of internal disclosure (regarding fees and all manners of conflicts) and documentation (regarding what range of investment options were considered and which reasons advanced for the advice/​recommendation given). But this manner of layered process may fail to adequately address the next gener- 20.33 ation of conflicts of interest likely to arise in an evolving retail investment market. In particular, the typical ‘look and feel’ of a conflict of interest may change as financial institutions become larger and more diversified, robo-​advising proliferates, competition among retail advisers intensifies, and retail investors continue to flock into passive funds. In this environment, a solely process-​oriented approach to complying with fiduciary duty rules will have limited agility to head off reputation-​ damaging (even if not legally prohibited) conflicts. With this imperative in mind, this section intends to press retail investment firms 20.34 to think ahead of the regulatory curve, and to consider whether the current regulatory initiatives in the fiduciary duty space may be soon bypassed by certain market developments. A. Retail conflicts on the horizon Some of the most significant innovations in the financial markets are happening 20.35 in the retail space. And inevitably, innovation gives rise to new potential conduct problems, including novel conflicts of interest.57

57 See Christina Parajon Skinner, ‘Whistleblowers and Financial Innovation’, North Carolina Law Review (2016), 94, 861 (discussing ways in which financial innovation can create opportunity and incentive for misconduct).

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Geneviève Helleringer and Christina Skinner 1.  Mega firms: allocating investment opportunity 20.36

Despite some efforts to reduce the size (or systemic footprint) of the largest financial institutions, in actuality, the largest financial institutions have become larger.58 Some banks grew larger in the last decade because they rescued—​thereby absorbing—​other failing institutions; others, like Goldman Sachs, converted to Bank Holding Companies, which meant eventual expansion of a retail deposit and investor base that did not exist before. With the growth of these financial institutions came increased diversification along a number of business lines.

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On a corporate level, the largest financial institutions now have a broader range of competing interests, all vying for the most attractive investment opportunities available to the firm. One conflicts-​related question, then, is who decides which investor base gets the opportunity? And by what criteria?

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Consider a hypothetical: the CEO of Goldman Sachs becomes aware of a unique investment opportunity, one that is 90 per cent likely to generate a handsome (and safe) return. The opportunity could go to Goldman’s asset management subsidiary, its retail group, or to its wholesale trading arm. How is that decision made, and who considers the conflicting interests between the retail investment arm and the others? The answer is not likely to be dictated by fiduciary duty rules,59 but the way in which the allocation is made does arguably implicate the best interests of the retail investor and whether that group is being treated fairly in the mix of the holding company’s subsidiaries. 2.  Robo-​advisers: evaluating best interests

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A  second likely source of future conflicts stems from the rise of robo-​advisers. These are automated, internet-​based investment services that make investment recommendations and offer investment advice to retail customers using computer algorithms (drawing from responses given to answers to online questions).60 Robo-​ advisers have become attractive to the retail investor because they are easy to use (often available on smart phone applications), less expensive than traditional investment advisers (with lower fees and lower minimum investment amounts), and—​attractive to some—​the ability to avoid interaction with a human adviser.

58 See, e.g., Jeff Cox, ‘5 Biggest Banks Now Own Almost Half the Industry’, CNBC, 15 April 2015, available at https://​www.cnbc.com/​2015/​04/​15/​5-​biggest-​banks-​now-​own-​almost-​half-​the-​ industry.html, accessed 7 January 2018. 59 Even assuming that the DOL rule would be relevant in this scenario (i.e., that a retirement plan is involved), it is not clear that the Goldman employee making the allocative decision would be covered, as he or she may fall under a carve-​out for employee advice given to a retirement plan sponsor. 60 Melanie L Fein, ‘Are Robo-​Advisors Fiduciaries?’, 12 September 2017, available at https://​ www.ssrn.com/​abstract=3028268, accessed 7 January 2018; see Stein, n 16.

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Conflicts of Interest Robo-​advice is on a tremendous growth trajectory. One study refers to estimates 20.40 that predict over 2 trillion US dollars of assets will be managed with the help of robo-​advisers; and by 2015, over 16 trillion US dollars (which, as that study puts into context, would be three times the assets managed by the world’s largest asset manager, BlackRock).61 The United States leads the market in robo-​advice, but Asia and Europe are also growth areas.62 Facially, the fiduciary standards that apply to robo-​advisers are straightforward. 20.41 Robo-​advisers are ‘investment advisers’ under the Investment Advisers Act of 1940 (thus have to register under the Act).63 As such, the SEC treats them like fiduciaries—​and they therefore must provide their advice consistent with that role.64 (Obligations under the Investment Company Act may also apply, depending, in particular, whether Rule 3a-​4 is applicable.65) As will be recalled, this means that a robo-​adviser, as a fiduciary, has an obligation ‘to act in the best interests of its clients and to provide only suitable investment advice’ based on its assessment of the client’s ‘financial situation and investment objectives’.66 But practically, how can a robo-​adviser meaningfully be held to a fiduciary duty 20.42 of loyalty standard? Robo-​advisers are not capable of varying their electronic questionnaire/​script based on in-​the-​moment judgements about their client’s needs, hesitations, or subconscious biases.67 As relating to conflicts, then, the robo-adviser may not have sufficient data to know that the advice being given is actually, in a broad sense, conflicted—the robo-advice may inadvertently serve the interests of the investment company affiliated with the robo-adviser (by channeling capital into one of its funds) more so than the retail investor-client’s interests.68 There is also a question of whether a robo-​adviser can explain its business model 20.43 consistent with a best-​interest type standard.69 Do the investors get adequate and comprehensible information about the algorithms that drive the advice? That kind of information would likely not be considered investment ‘advice’ under the DOL

61 Deloitte, ‘The Expansion of Robo-​Advisory in Wealth Management’ (August 2016), available at https://​www2.deloitte.com/​content/​dam/​Deloitte/​de/​Documents/​financial-​services/​Deloitte-​ Robo-​safe.pdf, accessed 10 October 2018 (on German robo-​advisor market); Fein, n 60; see Accenture, ‘The Rise of Robo-​Advice’ (2015), available at https://​www.accenture.com/​_​acnmedia/​ PDF-​2/​Accenture-​Wealth-​Management-​Rise-​of-​Robo-​Advice.pdf, accessed 8 January 2018. 62 Gerrard Cowan, ‘Robo Advisers Start to Take Hold in Europe’, Wall Street Journal, 4 February 2018, https://​www.wsj.com/​articles/​robo-​advisers-​start-​to-​take-​hold-​in-​europe-​1517799781, accessed 10 October 2018. 63 See Fein, n 60, 1. 64 SEC, IM Guidance Update, n 22, 10 n 8. 65 ibid,  2–​3. 66 ibid. 67 See Fein, n 60, 14, 18. 68 See SEC, IM Guidance, n 22, 6. 69 ibid, 3.

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Geneviève Helleringer and Christina Skinner rule, but arguably could give rise to conflicts of interest. Consider, for example, the possibility that a third party could offer the robo-​adviser an algorithm at a discount, which could then ultimately affect the direction of investment advice given.70 More generally, one may also wonder whether robo-​advisers will make disclosures—​about fees or other possible sources of conflicts—​in a way that is comprehensible to the retail investor.71 A robo-​adviser may not be as effective as a human adviser in explaining potential conflicts of interest. 20.44

Conflicts can also arise from the algorithmic coding itself. The technology behind robo-​adviser algorithms can allow the program to draw relationships directly. But there could be some risk that when the program confronts relationships it has not seen before, it will react incorrectly. For example, with the use of big data processing, an algorithm could intake information that retail investors wake up and eat breakfast each day and, from those data points, ‘conclude’ that these investors wake up because they are hungry. More likely, however, any one given investor wakes up because her alarm is set to that time, and then later eats breakfast as part of a morning routine.

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This stylized example simply underscores that correlation is not causation. But one could readily see the potential for misconstruing two seemingly linked data points into a causal chain and, accordingly, the risk that robo-​advisers would give investment advice on that flawed basis. Perhaps this kind of data-​interpretive error may come to be seen as another form of conflicted advice, insofar as such advice would place an investor into financial products that grow an investment firm’s assets under management, but which advice is not in that client’s best interests. 3.  Fragmentation and competition among advisers

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Competition among financial advisers could become another possible source of conflicts of interest. Not only have financial services become more globalized in general, but the options available to retail investors have expanded along with the rise of exchange-​traded funds (‘ETFs’) and new alternative mutual funds, called ‘hedge funds for the masses’.72 The retail investor, in short, has access to a wider range of funds, platforms, and services than ever before. In this environment, the traditional financial adviser will quite likely be pressed to show prospective clients why his or her services are needed, in a world where the retail investor is increasingly able to access funds more simply and directly—​without the help of an adviser.

70 ibid, 4. 71 ibid, 6. 72 SEC, ‘Mutual Funds and Exchange-​Traded Funds (ETFs)—​A Guide for Investors’, available at https://​www.sec.gov/​reportspubs/​investor-​publications/​investorpubsinwsmfhtm.html, accessed 10 August 2017.

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Conflicts of Interest The question then becomes how financial advisers will distinguish their services. 20.47 How might financial advisers seek to demonstrate themselves as the ‘best’ fiduciary on the market? Ideally, this kind of competition would drive a race to the top, as fiduciaries strive to find ways of proving to the retail client that their approach to considering and recommending investment products surpasses their peers in fulfilling a client’s bona fide best interests. But it is also possible that the competitive race among fiduciaries will create new incentives and opportunities for advisers to mislead investors—​that is, to point to metrics or heuristics that are not in fact reliable indicators of the adviser’s future performance, let alone indicative of his or her methodology for satisfying the client’s best interests. 4.  The rise of passive funds An increase of conflicts among passive fund managers could be a knock-​on effect of 20.48 heightened fiduciary duty rules for retail investment advice. ETFs and other passive funds have become hugely popular with retail investors over the past several years.73 But passive fund managers may be susceptible to a very particular form of conflict of interest which has not yet been legally diagnosed as such. In the passive fund model, managers’ performance is ordinarily measured on 20.49 a quarterly basis relative to their peers. Some academic literature now suggests that due to the reputational risk of underperforming peers in the short term, this structure creates incentives for passive fund managers to follow market momentum and ride systemically dangerous bubbles.74 According to these theories and research, rather than acting in what may be the individual investor’s (or the market’s) best interest—​that is to ‘prick’ the bubble—​some passive fund managers will be incentivized to forgo acting on information that points to the long-​term benefit of investing in directions contrary to the market’s movement. Stated differently, these managers may choose to ride bubbles in order to demonstrate short-​term (but possibly spurious) good performance—​all the

73 See Jose Garcia-Zarate, ‘Why Passive Funds are Growing in Popularity’, Morningstar, 20 February 2017, http://www.morningstar.co.uk/uk/news/156449/why-passive-funds-are-growingin-popularity.aspx, accessed 27 November 2018; Sarah Krouse et al, ‘Why Passive Investing is Overrunning Active, in Five Charts’, Wall Street Journal, 17 October 2016, available at http://www. wsj.com/graphics/passive-investing-five-charts, accessed 7 January 2018; Attracta Mooney, ‘Passive Funds Grew 4.5 Times Faster Than Active in 2016’, Financial Times, 12 February 2017, available at https://www.ft.com/content/c4f6ee56-e48c-11e6-9645-c9357a75844a, accessed 7 January 2018; Andrew Osterland, ‘Passive Investing Hums with Activity as ETFs Grow, Evolve’, CNBC, 3 October 2017, available at https://www.cnbc.com/2017/10/03/passive-investing-hums-withactivity-as-etfs-grow-evolve.html, accessed 7 January 2018. 74 See, e.g., Amil Dasgupta, Andrea Prat, and Michela Verardo, ‘The Price Impact of Institutional Herding’, The Review of Financial Studies (2011), 24, 892; Brad Jones, ‘Asset Bubbles: Re-​thinking Policy for the Age of Asset Management’, IMF Working Paper, WP/​15/​27 (February 2015), available at https://​www.imf.org/​external/​pubs/​ft/​wp/​2015/​wp1527.pdf, accessed 10 October 2018.

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Geneviève Helleringer and Christina Skinner while growing their assets under management—​rather than act as ‘rational arbitrageurs’.75 20.50

While not exhaustive, this brief predictive survey of the conflicts of interest that may develop in retail investment markets is meant to illustrate the very general point that conflicts are dynamic.76 No fiduciary duty (legal) rule, regardless how comprehensively crafted, will be capable of anticipating the wide range of possible conflicts likely to face investment advisers in the years to come. Accordingly, for the retail investment firm, managing conflicts of interest among its employees will require more than straightforward ‘compliance’. Instead, it will require the development of a holistic compliance function that is designed to instill a firm-​wide culture that is committed to the ethical treatment of customers, which may go beyond what law and regulation strictly require.77

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Reflecting again on the Wells Fargo case, one may well wonder to whom fiduciary duties were owed. Wells Fargo shareholders filed a derivative lawsuit alleging, among other things, that the bank’s officers, directors, and senior management breached the fiduciary duties which are owed by directors of federal banking institutions—​citing explications of those duties by the FDIC and the OCC.78 However, it is not legally certain that the bank owed a fiduciary duty to its retail depositor-​customers.79 But the sales force’s failure to account for the broader interests of the bank’s retail customers surely reflects, the authors think, a cultural lapse. There were arguably ethical commitments at stake in safeguarding the Wells customers’ interests in the security of their personal information, the integrity of their credit scores, and the peace of mind that their banking institution would not act in an unauthorized way. 5.  Perceived professional norms and disclosure of conflicts of interest

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According to the conclusion of recent behavioural studies, fiduciary duties are likely to have a different effect on how advisers manage their conflicts of interest,

75 Dasgupta, Prat, and Verardo, n 74; see also, e.g., Dilip Abreu and Markus K Brunnermeier, ‘Bubbles and Crashes’, Econometrica (2003) 173, 71. 76 di Florio, n 20. 77 ibid. 78 Compliant, In re Wells Fargo & Company Shareholder Derivative Litig, No 3:16-​cv-​05541 (N D Cal, filed 24 February 2017), available at https://​www.maglaw.com/​publications/​books/​ in-​re-​wells-​fargo-​company-​shareholder-​derivative-​litigation-​consolidated-​amended-​verified-​ stockholder-​derivative-​complaint/​_​res/​id=Attachments/​index=0/​In%20re%20Wells%20Fargo%20 &%20Company%20Shareholder%20Derivative%20Litigation%20-​ % 20Consolidated%20 Amended%20Verified%20Stockholder%20Derivative%20Complaint.pdf, 27–​ 28, accessed 11 October 2018; see also FDIC, ‘FDIC Law, Regulations, and Related Acts, 5000 Statements of Policy’, available at https://​www.fdic.gov/​regulations/​laws/​rules/​5000-​3300.html, accessed 11 October 2018. 79 See Lawrence G Baxter, ‘Fiduciary Issues in Federal Banking Regulation’, Law and Contemporary Problems (1993), 56, 14, and n 1 (and sources cited therein).

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Conflicts of Interest depending on how such advisers perceive their professional norms. Conflicts of interest situations directly test the content of the firm’s culture and, more precisely, what the advisers’ perceived professional norms are. There might be a difference between the norms that are expressed and the ones that are perceived. Typically, advisers can perceive the norms of their environment, or institution, as either prioritizing self-​interests or placing clients first in the context of a conflict of interests.80 These professional norms are developed from employees’ perceptions of both injunctive norms (what we believe we should do) and descriptive norms (what we believe others actually do). They may align with professional responsibilities to place clients first if the perceived norms dictate ‘clients first’, or differ from professional responsibilities if the norms dictate ‘self-​interest first’. Empirical studies show that norms direct behaviour only when they are made sa- 20.53 lient.81 For example, the requirement to disclose conflicts of interests—​which is a common method for managing conflicts of interests—​will prompt advisers to consider the dilemma they face more deeply, which in turn makes the perceived professional norm more salient. Depending on the content of this perceived norm (‘clients first’ or ‘self-​interest first’), advisers will give less or more biased advice than they would if they were not asked to disclose their conflict of interest.82 These findings demonstrate more generally the impact of culture, or as psych- 20.54 ologists call it ‘context’, defined as ‘the surroundings associated with phenomena which help to illuminate that phenomena’,83 in the context of conflicts of interests. The growing importance granted to compliance may nudge firms’ culture towards a more ethical content. B. Bringing culture into compliance 1.  Existing law on compliance Federal securities law mandates that investment advisers have compliance 20.55 programs; but the law does not specify how, precisely, those programs should be designed.84 The United States Federal Sentencing Guidelines (§ 8B2.1) also addresses

80 The use of the word ‘client’ encompasses all types of advisees, e.g., patients, consumers, etc. 81 R B Cialdini, C A Kallgren, and R R Reno, ‘A focus theory of normative conduct: A theoretical refinement and reevaluation of the role of norms in human behavior’, Advances in Experimental Social Psychology (1991), 24, 20, 201–​34; R B Cialdini, C A Kallgren, and R R Reno, ‘A focus theory of normative conduct: recycling the concept of norms to reduce littering in public places’, Journal of Personality and Social Psychology (1990), 58, 6, 1015. 82 Sunita Sah, ‘Conflict of Interest Disclosure as a Reminder of Professional Norms:  Clients First!’ (on file with the author). 83 P Cappelli and P D Sherer, ‘The missing role of context in OB-​the need for a meso-​level approach’, Research in Organizational Behavior (1991), 13, 55–​110. 84 SEC, ‘Information for Newly-​Registered Investment Advisers’, available at https://​www.sec. gov/​divisions/​investment/​advoverview.htm, accessed 7 January 2018.

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Geneviève Helleringer and Christina Skinner compliance: they promise reduced corporate criminal sentences for companies that have adopted ‘effective’ compliance programs. In essence, what makes a compliance program ‘effective’ is the extent to which it figures centrally in corporate culture (e.g., that it be well-​designed, regularly evaluated, sufficiently funded and staffed, embraced by top management, the object of training). Compliance policies that are mere ‘window dressing’,85 are insufficient when it comes to seeking sentence reductions under the organizational sentencing guidelines. 20.56

Similar principles seem to be on the rise in European countries. In the corruption context, for example, France’s 2016 law on transparency, anti-​bribery, and modernization of the economy (known as Sapin II law)86 requires that companies implement compliance policies to prevent and detect acts of bribery and corruption87 The law requires that compliance policies be regularly updated, evaluated for effectiveness, and that key management and employees be trained on anti-​corruption compliance policies and procedures. These types of compliance obligations become much simpler to implement company-​wide (particularly in sprawling companies) when a commitment to effective compliance figures centrally in corporate culture.

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While the US Federal Sentencing Guidelines apply to all corporate entities, including those in the financial services sector, the new French obligations do not relate to compliance with fiduciary duties in the provision of investment advice. But, French judges—​like American judges—​enjoy substantial discretion in imposing sentences in criminal cases, and it would not be surprising if a French judge were to be persuaded, in a case involving a corporate defendant in the financial services industry, to take into account the existence of an effective compliance program as a mitigating factor in sentencing. (Of note here is that under the American rules, the mere existence of a legal violation in a particular case is not conclusive evidence of the overall ineffectiveness of the compliance program).88

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It is suggested by the authors that these are related phenomena, both deriving from inadequacies in the company’s cultural commitment to compliance. Conversely, embracing a robust compliance culture—​as now mandated by French law in the corruption context—​could have spillover effects and minimize not only the specific illegalities for which compliance systems are legally mandated (e.g. bribery), but also other legal violations including breaches of fiduciary duties.

85 See Kimberly D Krawiec, ‘Cosmetic Compliance and the Failure of Negotiated Governance’, Washington University Law Quarterly (2003), 81, 487, 513. 86 LOI No 2016-​1691 du 9 décembre 2016 relative à la transparence, à la lutte contre la corruption et à la modernisation de la vie économique, JORF no 0287 du 10 décembre 2016.  87 Article  17-​II. 88 See Federal Sentencing Guidelines, § 8B2.1(a) .

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Conflicts of Interest 2.  Regulation and supervision of compliance The previous sections suggested that the compliance function of retail investment 20.59 firms should address culture by establishing ethical norms for interacting with (i.e. serving) the retail client. But before discussing concrete options for operationalizing this cultural program, some fundamental questions of compliance governance and design are addressed first. A firm’s ‘compliance function’ is generally responsible for ensuring that employees 20.60 (and the corporate entity) comply with binding legal frameworks as well as the firm’s internal codes of conduct.89 The compliance function thus functions as the firm’s internal system for enforcement. Compliance personnel focus and draw on various sources of hard and soft law—primary legislation, regulatory rules, and supervisory standards or guidance.90 Accordingly, dealing with conflicts issues usually falls within the compliance function of an organization. And for a financial institution specifically, supervisors may examine its compliance system to evaluate how well it is equipped to manage legal risk, including, for relevant investment firms, conflicts of interest.91 How and where culture fits in is still, for many firms, an open and evolving ques- 20.61 tion. Culture, as ‘the set of explicit and implicit norms, practices, and expected behaviors that influence how firm executives, supervisors and employees make and implement decisions in the course of conducting a firm’s business’,92 refers to the intangible ethos (or values) of an institution that should, for example, guide employee behaviour in situations where a fiduciary duty law, or a provision in a corporate code of conduct, might seem silent or unclear. And, despite the fact that all of the action on the rule-​making front has focused on fiduciary duty rules, conduct authorities have given signs (through speeches, announcements, and letters setting out enforcement priorities) that they expect retail investment firms to integrate culture into their overarching compliance systems. For example,

89 See Geoffrey P Miller, ‘The Compliance Function: An Overview’, 2014, 1, available at https:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2527621, accessed 7 January 2018; see generally Geoffrey P Miller, The Law of Governance, Risk Management and Compliance, Wolters Kluwer, 2nd ed, 2017. 90 See Basel Committee on Banking Supervision (BCBS), ‘Compliance and the Compliance Function in Banks’, April 2005, 7, available at https://www.bis.org/publ/bcbs113.pdf, accessed 7 January 2018. 91 See, e.g., FINRA, ‘2016 Regulatory and Examination Priorities Letter’, 5 January 2016, 1, available at http://​www.finra.org/​sites/​default/​files/​2016-​regulatory-​and-​examination-​priorities-​ letter.pdf.; cf Testimony of Thomas J Curry, to Financial Services Committee of the US House of Representatives (19 June 2012), available at https://​financialservices.house.gov/​uploadedfiles/​hhrg-​ 112-​ba00-​wstate-​tcurry-​20120619.pdf, 10, accessed 10 October 2018 (noting that ‘As part of their ongoing supervision, OCC examiners are evaluating the state of these key oversight functions and identifying areas that require strengthening’). 92 FINRA, n 91.

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One senior FCA official has remarked: [c]‌ulture drives individual behaviours, which in turn affect day-​to-​day practices in firms and their interaction with customers and other market participants. Culture is therefore both a key driver, and potential mitigate, of conduct risk. The experience of the past demonstrates that a poor culture can lead to poor outcomes for consumers and markets.93

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In a similar vein, a letter setting out FINRA’s 2016 enforcement priorities noted: A firm’s culture is both an input to and product of its supervisory system, including its approaches to identifying and managing conflicts of interest and ensuring the ethical treatment of customers.94

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And, as one SEC official stated publicly, At the end of the day, managing conflicts is much more than just having a strong compliance program, although that is obviously critical. It also requires establishing a culture that, regardless of regulatory requirements, does not tolerate conduct that casts doubt on the organization’s commitment to high ethical standards, and that values the firm’s long-​term reputation over any possible short-​term benefit from exploiting its clients or customers.95

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In short, as a matter of supervision, the regulators certainly seem eager for retail investment firms to integrate culture as part and parcel of their compliance functions—​ regardless of whether such efforts can or should be legally mandated or measured.96

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Symmetrically, investment firms have indicated their willingness to change their culture and move from an industry closer to a profession.97 Some may ask whether a tiger

93 FCA, ‘Culture in Banking’, available at https://​www.fca.org.uk/​publication/​foi/​foi4350-​ information-​provided.pdf, accessed 7 January 2018. 94 FINRA, n 91, at 1. 95 di Florio, n 20. 96 The SEC has also made clear that it ‘focus[es] on conflicts of interest as an integral part of our assessment of which firms to examine, what issues to focus on, and how closely to scrutinize’. ibid; see also Peter Tsirigotis, ‘SEC Examinations Focused on Private Equity Fund Conflicts of Interest’, Financier Worldwide, September 2016, available at https://​www.financierworldwide.com/​ sec-​examinations-​focused-​on-​private-​equity-​fund-​conflicts-​of-​interest/​#.WjZEvSOcbjA, accessed 7 January 2018. Though a self-​regulatory organization, FINRA does act consistently with SEC priorities and has itself set out how it will assess a firm’s culture, by looking to five indicators: ‘whether control functions are valued within the organization; whether policy or control breaches are tolerated; whether the organization proactively seeks to identify risk and compliance events; whether supervisors are effective role models of firm culture; and whether sub-​cultures (e.g., at a branch office, a trading desk or an investment banking department) that may not conform to overall corporate culture are identified and addressed.’ FINRA n 91, 1. 97 Klaus Hopt, ‘A Plea for a Bankers’ Code of Conduct’ in Patrick S Kenadjian and Andreas Dombret (eds), Getting the Culture and the Ethics Right. Towards a New Age of Responsibility in Banking and Finance, De Gruyter, 2016, 75–​84.

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Conflicts of Interest can change its stripes. If changes in banking culture are any indication, then, indeed, change to retail advisers’ habits and priorities may also be possible.98 When traditional banks added trading-​related activities, the traditional long-​term relationship in which bankers acted as agents for their clients—owing them fiduciary duties—changed to a transaction-​oriented business, with bankers acting as principals and customers as counterparties subject to the caveat emptor rule.99 Thus, the question for the retail investment firm is not whether culture has a ne- 20.67 cessary or proper place within compliance, but rather, how a compliance system designed to process legal and regulatory inputs can expand to integrate behavioural ones.

IV.  Building Cultural Infrastructure Around Legal Frameworks To be sure, conduct regulators remain in the relatively early days of their efforts 20.68 to supervise culture as a component (and not only a by-​product) of firm compliance. As such, investment firms have both a challenge and an opportunity to be innovative in the compliance-​culture space. Retail investment firms have room not only to demonstrate industry leadership to their supervisors, but also to distinguish themselves to customers as conduct leaders. Considered carefully, then, there is a strong regulatory as well as business case for dedicating compliance resources to developing cultural infrastructure. Concretely, what steps might firms take (other than disclosures)? The following 20.69 offers three possibilities for operationalizing culture into the retail investment firm’s compliance function. A. Conflicts modelling As one possible strategy, firms could employ scenario-​based exercises in connec- 20.70 tion with their efforts to improve their conduct towards retail investors. After all, financial firms routinely engage in stress-​testing in order to assess quantitative risk, that is, their vulnerability to market and credit risk. As one of the authors has previously argued, there is opportunity also to develop similar strategies for stressing qualitative risks, like conduct risk, as well.100 Such qualitative, conduct-​focused

98 J-​Cl Trichet, ‘Summary of Group of Thirty Findings’, in Kenadjian and Dombret (eds), n 97,  3–​6. 99 John Reed, Opinion, ‘We Were Wrong about Universal Banking’, Financial Times, 11 November 2015, available at https://​www.ft.com/​content/​255fafee-​8872-​11e5-​90de-​f44762bf9896, accessed 10 October 2018. 100 Christina Parajon Skinner, ‘Misconduct Risk’, Fordham Law Review (2016), 84, 1559.

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Geneviève Helleringer and Christina Skinner stress-​testing could involve, for example, a hypothetical scenario of misconduct, with which compliance prompts employees, and then collects employee responses akin to modelling results. These scenarios could be tailored to conflict-​type situations, with the idea being to anticipate, in a forward-​looking fashion, what types of conflicts might be coming down the pike. One could readily imagine scenarios crafted around the kinds of conflicts that could emerge in the context of investment allocation decisions, fintech platforms, and the marketing of advisory services, as discussed earlier. 20.71

Internally, with this this kind of qualitative stress-​testing, firms could encourage thinking outside the box, endorse employee challenging of ideas (both up and down firm hierarchy), and generally send a firm-​wide message that addressing the risks posed by conflicts is a priority on a par with the management of quantitative risks like market and credit risk. Moreover, to the extent results of the simulation were voluntarily shared with regulators, that collaboration might in fact speed regulators’ understanding of the most appropriate (and helpful) role of supervisory authorities intervening in firm culture. B. Pioneering industry standards

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Externally, there are several opportunities for retail investment firms in the conduct and culture space. First, those firms that move fastest (creatively and effectively) in the conduct and culture space will be able to lead the development of the next generation of industry standards. This would require firm management to expand the institution’s compliance function to include a mandate to innovate new ways of socializing, among the employees, the ethical treatment of retail clients. The firm’s compliance professionals could then go a step further in pioneering methodologies of propagating those firm innovations at the industry level. Firms could also lead their peers by convening forums, working groups, knowledge sharing programs, and other initiatives for spreading culture-​related ideas.

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Second, and related, investment professionals might begin to self-​regulate. Were several firms to decide to pursue certain (higher) norms, the industry as a whole might agree to a unified and higher set of fiduciary standards—​which would apply across all forms of investment advice and to investment advisers and broker-​dealers alike.101 An industry-​agreed standard might pre-​empt supervisory authorities from establishing more specific (and perhaps less fitting) requirements.

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This kind of firm-​ leading-​ the-​ supervisor strategy resonates with various theories of administrative governance, like experimentalism and management-​based



See Section I.B.

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Conflicts of Interest regulation.102 As one of the authors has argued elsewhere, these kinds of experimental regimes allow firms to: take the lead in designing internal compliance policies and procedures to meet general regulatory objectives that are aimed at the drivers of misconduct risk. It thus gives institutional stakeholders the opportunity to advise regulators about what types of compliance systems work best—​and then to prove their success—​before top-​down regulation is imposed, if at all.103

Third, firms could gain a competitive advantage by leading the industry in conduct 20.75 standard-​setting. For one, by experimenting and innovating, interesting ideas for complying with certain duties might emerge. Typically, to go back to the example above, it might be more efficient for investment advisers to adhere to heightened standards for all clients. This would potentially help to ensure that no specially regulated account falls through the cracks, leading to lawsuits or enforcement actions. It could also create efficiency gains from an operations standpoint because investment advisers would not need to track and apply different sets of rules and standards to different accounts, depending on the purpose of the investment. Broadly, the ability to ‘market’ high quality and innovative conduct standards could increase their customer base and loyalty. C. Proxies for personal liability Firms could also demonstrate leadership by innovating responsibility structures. In 20.76 particular, firms might focus compliance efforts on filling gaps in the law where individual accountability is concerned. In the United States, at least, individual accountability in the compliance arena 20.77 has been difficult to accomplish via law or regulation.104 A proposal by the former superintendent of New York State’s Department of Financial Services for executive liability for anti-​money laundering controls largely fell flat.105 As a matter of state corporate law, meanwhile, Delaware law has taken a reserved approach to holding board members accountable for compliance systems—​all but the most egregious failures to establish and monitor a compliance function are shielded by the business judgement rule.106 (That being said, director liability may yet be found in the

102 See generally Charles F Sabel and Jonathan Zeitlin, ‘Experimentalist Governance’, in David Levi-​Faur (ed), The Oxford Handbook of Governance, Oxford University Press, 2012, 169–83. 103 Skinner, n 100, 1601. 104 But see Stavros Gadinis and Amelia Miazad, ‘The Hidden Power of Compliance’ (unpublished draft, February 2018), available at http://​dx.doi.org/​10.2139/​ssrn.3123987, 36–​39 (noting growing risk of liability for ‘legal and compliance personnel’). 105 Christina Parajon Skinner, ‘Executive Liability for Anti-​ Money-​ Laundering Controls’, Columbia Law Review Sidebar (2016), 116, 1. 106 See, e.g., In re Citigroup Inc Shareholder Deriv Litig, 964 A 2d 106, 123–​24 (Del Ch 2009); Stone v Ritter, 911 A 2d 362 (Del Supr 2006); In re Caremark Int'l Inc Derivative Litig, 698 A.2d 959 (Del Ch 1996).

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Geneviève Helleringer and Christina Skinner particular case of the Wells Fargo mis-​selling scandal for, among other possible things, the directors’ failure to monitor the bank’s compliance system.107) 20.78

As private actors, firms therefore have considerable latitude to innovate responsibility mechanisms that could become the industry (and even supervisory) gold standard. Responsibility mechanisms might, for instance, be fortified through compensation schemes. Positively, firms might choose to tie bonus compensation to an employee’s contribution to the firm’s retail culture or values (in addition to traditional performance or sales targets). Culture-​based compensation awards could also be negative, that is, whereby firms reduce discretionary compensation awards in cases where the employee is unable to carry forth a burden of showing his or her contribution to firm culture/​values surrounding the ethical treatment of the retail customer. (An even more aggressive approach would be to impute responsibility to managing directors for associates’ and analysts’ serious conduct shortcomings.108)

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With little doubt, there is a wide range of ways that firms could design compensation systems to better hold employees responsible for the failure to behave consistently with the fiduciary duty of loyalty. The key, here, is persuading firms to do so in ways that go beyond what the formal rules require.

V. Conclusion 20.80

Conduct regulators are increasingly focused on conflicts of interest in the retail investment space and, in particular, heightening the legal standards surrounding the fiduciary duty of loyalty. However, with so much rule making and guidance-​ giving centred on fiduciary duty rules, there is some risk that firms, hewing close to the regulatory agenda, will fail to anticipate the next generation of conflicts on the horizon. Forward-​looking retail investment firms thus have an opportunity to demonstrate industry leadership, both to the supervisor and to the client, along a conduct dimension. They might do so by pioneering innovative methods for establishing an organizational culture that values conflict-​free interactions with the retail client. Such efforts, though not demanded by law or regulation, could nonetheless be incentivized by the opportunity to set industry standards and garner some (conduct-​based) competitive advantage in a rapidly evolving marketplace of retail investment services and products.

107 See In re Wells Fargo & Co Shareholder Derivative Litig, No 16-​5541, slip op, at 49 (N D Cal 4 October 2017). This suit was still ongoing at the time this chapter was finalized. 108 See Skinner, n 100 (discussing these compensation-​related mechanisms as keyed to conduct).

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21 THE VENETIAN BANKS’ COLLAPSE Paolo Giudici

I. Introduction II. The Collapse of Banca Popolare di Vicenza A. A short introduction on the legal framework B. BPVI’s short history: from birth to Zonin C. From apparent success to the crisis D. Veneto Banca (VB)

III. Public Enforcement A. Sanctioning decisions

21.01 21.08 21.08 21.10 21.13 21.39 21.41 21.41

B. General assessment on the quality of public enforcement 21.50 IV. Red Flags 21.52 A. Domination by a single individual 21.52 B. The problems of the cooperative structure 21.54 C. Massive growth 21.58 D. Excessively easy access to capital 21.59 E. Massive elusion of MiFID rules 21.65

V. Would MiFID II Have Prevented the Disaster?

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I. Introduction Banca Popolare di Vicenza (BPVI) and Veneto Banca (VB) were declared insolvent 21.01 by the European Central Bank (ECB) on 23 June 2017. The two banks were based in the wealthy province of Veneto, in North Eastern Italy. They became insolvent after a prolonged period in which they sought to raise, by any means, fresh capital in order to sustain their lack of profitability and the capital thresholds provided by the ECB. The failing of the two banks came during a very troublesome period for the Italian 21.02 banking system, which followed the deep recession that started in 2007–​2008. The first and largest bank to face problems was Monte dei Paschi di Siena (MPS), which entered into a prolonged crisis following its overpaid acquisition of the Antonveneta Group in 2007. MPS was finally bailed out by the Italian state through a precautionary recapitalization approved by the EU Commission, which agreed that the bank was not deemed failing or likely to fail under Article 32 of the Bank Recovery and Resolution Directive (BRRD). In the meantime, four small local

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Paolo Giudici lenders (Banca Marche, Banca Popolare dell’Etruria e del Lazio, Cassa di Risparmio di Ferrara, and Cassa di Risparmio di Chieti) had been rescued by a controversial bank resolution fund, formed with money put up by Italy’s strongest banks. 21.03

Both in the MPS’s case and in the four banks’ case, depositors and bondholders were saved, but shareholders and holders of subordinated bonds were not. However, special reliefs were granted to certain categories of retail holders of subordinated debt, which were generally considered victims of mis-​selling, on the assumption that each bank had sold subordinated bonds to its own customers as if they were senior bonds, and therefore without any proper disclosure regarding the difference from senior debentures.

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The collapse of the Venetian banks was different. In this case depositors and bondholders were spared as well, through an asset sale arranged in a rush by the Italian government and the only Italian bank that was prepared to make a deal (Intesa San Paolo, at the price of one euro); and subordinated debts were not. However, the problem this time was that the mis-​selling affected a huge number of undiversified equity holders. There were around 120,000 with regard to BPVI, and 90,000 with regard to VB, almost entirely formed by retail investors and small businesses, mainly localized in the Venetian area and with investments predominantly concentrated in the banks’ shares. They lost almost all their savings in financial instruments.

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The banking crisis was a social and political bombshell in the areas where the banks were most active. A parliamentary commission was set up in order to analyse the causes of the seven banks’ crises. The work of the banking authority (Banca d’Italia) and the securities watchdog (Consob) was put under scrutiny, and severely criticized.1 The government bore the brunt of the banks’ crises management and the losses faced by investors: according to many commentators, the seven banks’ crises has been one of the main reasons for the centre-​left government’s debacle at the 4 March 2018 elections.

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The Venetian banks’ case is extremely interesting at a European level for many reasons. It is, of course, a great corporate governance and public enforcement fiasco. It is also probably the most significant mis-​selling case in Italian financial history, at least in the few last decades.2 It mainly concerns the banks’ shares, not 1 Commissione parlamentare d’inchiesta, Relazione Conclusiva, 30 gennaio 2018, available at documenti.camera.it/​leg17/​resoconti/​commissioni/​bollettini/​pdf/​2018/​01/​30/​leg.17.bol0950. data20180130.com75.pdf, accessed 10 October 2018. 2 Italy had a long row of mis-​selling cases. In the new millennium the Tango-​bond scandal is usually mentioned as the first one, with Italian retail investors packed with Argentina Bonds that promised high interest rate in an era of diminishing yields. A  smaller case, Cirio, was certainly closer to a true mis-​selling scandal, since banks sold Cirio bonds to their customers in order for Cirio to repay, with the proceeds of the bond issuance, its debt. Then came Parmalat. For a review, see A Perrone and S Valente, ‘Against All Odds:  Investor Protection in Italy and the Role of Courts’, European Business Organization Law Review (2012), 13, 31–​44; G Ferrarini and P Giudici, ‘Financial Scandals and the Role of Private Enforcement: The Parmalat Case’, in J Armour

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The Venetian Banks’ Collapse complex financial products. The shares were not listed, and the banks were in control of the informal secondary market of their own shares. The banks were financing a large part of the purchases through secret lending schemes. The share value was overstated. MiFID I  rules concerning investment advice and the suitability test were completely disregarded. Clients’ portfolios were largely concentrated in the banks’ shares and thus not diversified—​when the banks failed, they lost almost the whole portfolio. Before the banks’ collapse, some clients were granted a quick sale of shares to other clients who had not spotted the red flags, whereas some clients could not get rid of their shares in time, as their sell orders were postponed. The Venetian case is covered in this chapter through the story of BPVI, the largest 21.07 of the two banks, and the one whose failure was the most surprising and created the largest shockwave. VB’s story was almost identical. The two banks were basically twin entities, and simul stabunt, simul cadent.

II.  The Collapse of Banca Popolare di Vicenza A. A short introduction on the legal framework The story of BPVI is the tale of a massive violation of MiFID rules as implemented 21.08 by Italian regulation, international bank capital adequacy standards, and issuer information rules. In order to put this tale into perspective, a preliminary remark concerning applicable Italian rules is needed. After the Parmalat scandal and the ensuing legislation that sought to curb the dif- 21.09 ferent mis-​selling scandals that had marked the beginning of the new millennium,3 Italian financial regulation extended the rules of conduct applicable to investment services to the selling by banks and investment firms of financial instruments issued by themselves. Accordingly, when MiFID was implemented, if a bank was selling its own financial instruments to clients, MiFID rules of conduct were applicable as if the bank was placing financial instruments of a different issuer. For this reason, in Italy, there were no discussions on whether MiFID rules were applicable when a bank acts as a counterparty.4 The current provisions contained in MiFID II’s Article 4(1)(5), stating that ‘ “execution of orders on behalf of clients” includes the conclusion of agreements to sell financial instruments issued by an investment firm

and J A McCahery (eds), After Enron, Hart, 2006, 159–​213. Other smaller mis-​selling cases concerning complex products followed, and then the Venetian Banks case exploded and took the front pages of Italian and international financial newspapers. 3 Ferrarini and Giudici, n 2, 159–​213. 4 On this issue, see D Busch, ‘Conduct-​of-​Business Rules under MiFID I and II’, in D Busch and C Van Dam (eds), A Bank’s Duty of Care, 2017, 16–​18.

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Paolo Giudici or a credit institution at the moment of their issuance’, provides an extension of the investment service category that Italian law had been applying for more than a decade. This point makes the BPVI case even more interesting, since the Italian approach on this issue has been embraced by MiFID II. B. BPVI’s short history: from birth to Zonin 21.10

BPVI was established in 1866. The ‘banca popolare’ at the time was the Italian transplant of the German Volksbanken. For more than a century BPVI kept its local dimension, serving the wealthy area of Vicenza. In the ’90s the cooperative bank started an expansion campaign at a national level. Other ‘banche popolari’ were following the same path of growth in a banking and financial market that was becoming more and more competitive.5

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In 1996 Gianni Zonin, the president of a family firm which was (and still is) one of the most international and successful vineyard owner and wine producer groups in the world,6 was appointed as the chairman of BPVI’s board. He kept the post for almost twenty years.

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When BPVI’s story unfolded, Gianni Zonin became the main culprit of the bank’s collapse, and mass media widely reported the aggressive, self-​confident leading style of the winemaker who had morphed into a banker, his highly respected social status in the Venetian area, and his connections with the politicians, the church, local judges, and police authorities.7 C. From apparent success to the crisis 1.  BPVI is among the top 120 European banks

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Even after the financial crisis of 2007–​2008 and until October 2014 BPVI was presented by its own board as an extraordinary success story. It had become the eighth largest Italian bank in terms of size, with a book value of assets of about 45 billion euros. It was one of the few credit institutions able to prosper in a very unfavourable market scenario.

5 The most significant example was Banca Popolare di Lodi, whose expansion ended in a fraudulent scheme aimed at taking over Banca Antonveneta by eluding mandatory takeover rules, and with a multitude of crime charges against its CEO Giampiero Fiorani. See V Malaguti and M Onado, ‘Andava a piedi da Lodi a Lugano. Storia della scalata alla Banca Antoveneta’, Mercato Concorrenza Regole (2005), 2, 331–76. 6 Zonin established Virginia as a major wine region and a wine tourism destination and got from Virginia’s Governor the ‘Wine Enthusiast’s 2013 Lifetime Achievement Award’: US Official News, 26 September 2013. 7 A Greco and F Vanni, Banche impopolari:  Inchiesta sul credito popolare e il tradimento dei risparmiatori, 2017.

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The Venetian Banks’ Collapse The 2012 consolidated financial report showed a net profit of 100 euros and her- 21.14 alded a strong Core Tier 1 Capital (8.23 per cent with the intention to reach 9 per cent) and an increasing number of registered shareholders—​from 62,082 to 69,491: ‘thanks to the continuous demand of shares from the clients of any business area of the Group; this positive trend, which has been continuing for many years, is another confirmation of the appreciation and trust that the Bank enjoys among its clientele.’8 On 23 October 2013 the ECB announced that it was launching its comprehensive assessment of large European banks, among which BPVI was included.9 Rating agencies, however, did not assess the bank positively. The bank’s assets were 21.15 weak and its profitability was modest. But rating agencies were impressed by the support that the bank was receiving from its shareholders when cash was needed.10 BPVI was paying this support with very competitive prices offered to its shareholders, which is normal for a cooperative bank,11 but also with very lax lending standards, which would place a huge burden of non-​performing loans on the bank. 2.  The capital increases of 2013 and 2014 During 2013 BPVI had launched a large capital increase in order to strengthen 21.16 its capital adequacy requirements. Part of it, 508 million euros, was addressed to existing shareholders. The other part, 100  million euros, was aimed at receiving admission requests to the cooperative by new shareholders and thereby expanding the bank’s shareholder base. Interested investors could ask to be financed by the bank, and more than 7,000 of the 17,000 new investors who became shareholders of the bank by subscribing to the capital increase availed themselves of the lending facility offered by the issuer. As a result of this capital issuance, Common Equity

8 Consolidated Financial Report 2012, 88. 9 The exercise had three main goals: ‘transparency—​to enhance the quality of information available on the condition of banks; repair—​to identify and implement necessary corrective actions, if and where needed; and confidence building—​to assure all stakeholders that banks are fundamentally sound and trustworthy’ (BCE, ‘ECB starts comprehensive assessment in advance of supervisory role’, press release, 23 October 2013, available at https://​www.ecb.europa.eu, accessed 10 October 2018. 10 S&P, 4 March 2014, Banca Popolare di Vicenza ScpA Ratings Affirmed; Withdrawn At The Issuer’s Request. 11 In December 2013’s words of an analyst: the Bank’s earnings power is modest and has been impacted by the challenging Italian environment which has added to funding costs and reduced overall margins and profitability. The carry trade on the Bank’s sovereign portfolio, funded by the long-​term refinancing operation facilities (LTRO), has helped to partially offset margin pressure, yet is only a temporary benefit. Overall, BPVI’s margins are lower than peers and will come under pressure once the carry trade is wound down. Earnings have also been impacted by pressure to maintain competitive lending terms for shareholder clients, as well as the rigidity of the Bank’s cost structure. ‘DBRS Assigns BBB (low) Rating to Banca Popolare di Vicenza, Trend Negative’. DBRS Rating Limited DBRS, 18 December 2013.

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Paolo Giudici Tier 1 (CET1) had reached 9.21 per cent according to the 2013 financial report. Moreover, client numbers were on the rise, as well as general profitability. The report’s tone was positive, but the financial result was negative because of increased loan loss provisions. The Group reported a 28.2 million euro loss. 21.17

In 2014 the bank launched a second capital increase. Part of it, 300 million euros, was addressed to new shareholders. Once again, they could use lending facilities provided by the bank to fund their purchase. The other part, 608 million euros, was offered to existing shareholders and was coupled with a bond issue of equal amount that was subscribed for 156 million euros.

21.18

This second capital increase was another great success. In two years (2013–​2014) the bank had successfully raised almost 1.3 billion euros of fresh equity. Only a small part of it (around 46 million euros) was openly funded by the bank and considered as such in the bank’s accounts. 3.  The issue price and how it was assessed

21.19

In both the 2013 and 2014 capital increases the issue price had been 62.5 euros per share. In the offer documents the bank remarked with very clear words that the value, if compared to the Price-​To-​Book-​Value and Price-​To-​Earnings ratios of its peers, was very high, well above that of listed banks, and also well above the value of similar non-​listed banks. The message, however, was that listed banks were too Table 21.1 Share Prices Banca

P/​BV 2012

P/​E 2012

Banca Popolare di Vicenza Media banche non quotate Media banche quotate

1,49x 1,18x 0,33x

49,36x 69,22x 21,91x

heavily discounted by financial markets which were short-​sighted and plagued by speculators, and that BPVI was different. See Table 21.1. 21.20

In the documents, there was no clear indication of precisely how the value of the bank and its shares had been assessed. However, the ‘popolari’ are cooperative banks with a variable, not fixed capital. Shares are issued and can be redeemed (under certain conditions) to let shareholders enter and exit the entity. The share price for issuance and redemption is proposed by the board of directors and approved by the shareholder meeting.12 The value of 62.5 euros had been proposed with the

Article 6 of BPVI articles of association.

12

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521

The Venetian Banks’ Collapse assistance of an independent expert, and the shareholder meetings had happily accepted the extra premium that BPVI attributed to itself. Since the market seemed to be eager to subscribe any capital increase launched by BPVI, everybody was happy: the successful managers as well as the widely dispersed shareholders, who could congratulate themselves for their financial acumen and who were continuing to accumulate shares in the apparently superbly managed bank. Indeed, investors flocked to get the bank’s shares at this very high price. The price issue has been the one issue that has drawn most of the parliamentary 21.21 commission’s attention. It was discovered that already in 2001 the Bank of Italy had questioned the (almost inexistent) procedures that the board had been following in order to assess the price, that in 2009 the supervisor had specifically required the board to get an assessment by an independent expert, and that the board had followed this indication only since 2011. Even after the adoption of the suggested procedure, however, the Bank of Italy continued to think that the price assessment by the bank board remained an exercise in value inflation. The Bank of Italy had informed the securities watchdog, which nevertheless had not put the prospectuses’ statement on the issue in the spotlight. The ensuing discussion between the two authorities during the parliamentary commission’s meeting focused on whether the banking supervisor’s communication had been sufficient and clear enough. 4.  The ECB spots some issues that deserve more investigation On 26 October 2014, the ECB announced that BPVI had failed the comprehen- 21.22 sive assessment, along with eight other Italian banks among which were Monte dei Paschi di Siena and Carige.13 But the assessment referred to the financial year of 2013 and since BPVI had issued fresh and sufficient equity in 2014, the board appeared unconcerned. During the exercise, however, the inspectors had spotted a different problem. The 21.23 bank had repurchased some of its own shares without asking the supervisors for authorization. Thus, when the financial health check was completed the bank supervisors started an inspection within the new framework of the Single Supervisory Mechanism (SSM) in order to assess whether the bank had repurchased its own shares in violation of Regulation (EU) No 575/​2013.14 In the course of the inspection, which took place from 26 February to July 2015, it was discovered that the bank had actually bought its own shares without requesting any authorization from the ECB. Moreover, it was discovered that the bank had guaranteed fixed incomes to some of the investors who had bought the shares issued in 2013 and then again

13 ECB, ‘Aggregate Report on the Comprehensive Assessment’, October 2014. 14 Under Article 77, banks have to require the supervisor’s authorization before purchasing CET1 instruments.

521

52

Paolo Giudici in 2014 and from whom BPVI had repurchased the shares. But the real discovery was that the bank had massively financed the subscription of its own shares by its own clients, and not in the amounts that had been stated in the prospectuses. Consequently, almost one billion euros could not be counted any more as CET1,15 and BPVI was therefore unable to meet the 11 per cent CET1 ratio that the ECB had imposed. 21.24

The bank’s intensive self-​funding strategy was well known to anybody—​whether firm, sole trader, or retail customer—​who had approached BPVI with a loan request in the last years. The practice had even been denounced by consumers’ associations in 2008. Moreover, the Bank of Italy had discovered in 2013 that a very similar cooperative bank, Veneto Banca, was also using this same self-​funding strategy. However, with regard to BPVI the supervisors only became aware of the issue in 2015. 5.  The 2014 financial statements—​an exercise in disguise

21.25

The implications of the discovery concerning CET1 were not yet reported in the 2014 financial statement, prepared while the inspection was running, even though the board was obviously well aware of what would have happened if the self-​funding practice were to be officially discovered. This statement is an exercise in disguise. The board reports its satisfaction for having led the bank to within the 120 top European banks, even though this result has brought BPVI into the SSM. The capital strengthening initiatives have been successful, with a ‘pro forma’ CET1 ratio of 11.10 per cent. There is a significant increase in income deriving from traditional operations with customers. However, a ‘particularly prudential approach to provisions on receivables and goodwill write-​down’ leads a consolidated net result of the 2014 financial statements originally announced at 497 million euros loss,16 and later fixed at 759.5 euros, presumably because of pressure by the banking authorities.

21.26

There were, however, 116,797 shareholders at the end of the 2014 financial year. The 27,000 increase from the previous year was astonishing. Apparently, in the

15 Article 28 of the Capital Requirements Regulation (CRR) on Common Equity Tier 1 instruments states as follows: 1. Capital instruments shall qualify as Common Equity Tier 1 instruments only if all the following conditions are met: (a) the instruments are issued directly by the institution with the prior approval of the owners of the institution or, where permitted under applicable national law, the management body of the institution; (b) the instruments are paid up and their purchase is not funded directly or indirectly by the institution; ( . . . ). 16 BPVI’s press release, 10 February 2015.

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The Venetian Banks’ Collapse Venetian area in 2014 almost every member of a family business wanted to become a bank’s shareholder, imagining a great future for the old banking business. In reality, mass media were increasingly reporting the same circumstances that the European authorities were discovering in the course of 2015. The bank was systematically proposing to all its main business clients that they accept loans larger than the ones requested, with the extra cash to be used for subscribing or purchasing the bank’s shares and, in many cases, with the extra bonus of promised guaranteed returns and resale options granted to top clients. In short, the bank was self-​financing the purchase of its own shares and was exposing itself to serious risk towards its main clients. 6.  A bold board defends the bank’s honour With regards to CET1, on 9 January 2015, an article by Claudio Gatti of Sole 21.27 24Ore, the main Italian business newspaper, reported rumours that the ECB was fixing BPVI’s CET1 threshold at 11.6 per cent. The bank was furious, and strongly denied the information in the article, announcing the intention ‘to take legal action in all appropriate courts to protect its own interests’.17 It would be discovered later that the threshold was 11 per cent. It would be reduced to 10.3 per cent on 7 May 2015.18 As mentioned, the 2014 financial report did not state the true problems with CET1 21.28 that the bank was facing. They reported, instead, that the CET1 ratio would have reached 11.34 per cent with the exercise of a redemption option and conversion of 253 million euros of bonds into shares. In a bold press release dated 25 March 2015 the board mentioned a CET1 that would exceed 13 per cent by 2019. It was not mentioned, however, that the ECB’s inspection had been running since 26 February 2015 and that the inspectors were checking the correspondence between client’s loans and clients’ share purchases. With the ECB’s inspectors in the bank’s offices, on 19 March 2015, Zonin wrote a hugely optimistic letter to shareholders, reassuring them about the promising future of the bank. 7.  April 2015: the share price is lowered and BPVI starts sliding towards collapse On 8 April 2015 the drama started to unravel. Probably feeling the pressure of the 21.29 ECB, the board announced that it was going to propose a reduction of the share value from 62.5 euros to 48 euros (see table 21.2). Around 120,000 shareholders were losing 23.2 per cent of their investment in one shot, after a decade of apparent success. The correction was determined—​according to the board—​by the comprehen- 21.30 sive assessment results. Nevertheless, the general manager of the bank, Samuele



BPVI’s press release, 9 January 2015. BPVI’s press release, 12 May 2015.

17 18

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Paolo Giudici Table 21.2 price of BPVI’s shares from 1996 to 2013 Anno

Numero azioni

Capitale sociale

Prezzo

Dividendo

Note

1996

24.990.445

2,58

28,15

1,08

1997

25.586.985

2,58

32,54

1,08

1998

48.886.591

2,58

35,64

0,85

1999

51.391.155

2,58

40,28

0,85

2000

51.403.445

2,58

44,00

0,90

Valori tradotti in Euro Valori tradotti in Euro Valori tradotti in Euro Valori tradotti in Euro Valori tradotti in Euro

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

51.407.845 51.422.070 51.439.960 51.500.550 61.272.246 61.564.876 69.775.066 69.722.736 69.491.864 78.071.788 79.728.529 79.179.454 83.658.475

3,00 3,00 3,00 3,00 3,00 3,75 3,75 3,75 3,75 3,75 3,75 3,75 3,75

46,00 47,00 49,00 51,00 54,00 58,00 60,00 60,50 61,50 62,50 62,50 62,50 62,5

0,95 0,95 0,95 0,95 1,00 1,00 1,00 1,15 0,50 0,50 0,80 0,50

Source: Registration document 2013

Sorato, wanted to reassure the shareholders called to approve the price reduction. He stressed, in the press release concerning the shareholder meeting approval and following Zonin’s optimistic tone, the good results that the bank was achieving.19 21.31

Behind the façade, however, a large reshuffling of the top management was underway during the ECB’s inspection, which was to be completed by 3 July 2015.20 Only Zonin remained in his position.

19 BPVI’s press release, 11 April 2015. 20 Greco and Vanni, n 7, 31. On 12 May 2015, Samuele Sorato resigned and was substituted by Francesco Iorio. On 27 May, director Franco Miranda resigned too, and a few days later BPVI announced the consensual termination of the employment contracts of two top managers, Emanuele Giustini, deputy general manager and head of the markets division, and Andrea Piazzetta, deputy general manager and head of the finance division.

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The Venetian Banks’ Collapse 8.  The mandatory transformation into a public company and the need to raise 1.4 billion euros The Italian government, in the meantime, had taken a straightforward decision: to 21.32 get rid of the largest ‘banche popolari’, mixed creatures with features both of a cooperative and a public company,21 which seemed to put together, from a bank stability perspective, the worst of the two worlds.22 Accordingly, ‘popolari’ bank groups with assets that were worth more than eight billion euros had to be transformed into public joint-​stock companies. BPVI largely surpassed the eight million euro threshold, and so, on 30 June 2015, the board of directors informed the market that the bank would have to be transformed into a public joint-​stock company, and, on 7 July 2015, communicated that the CEO Francesco Iorio was in charge of the transformation plan. He was also in charge of a work plan aimed at the bank’s listing on the Italian stock exchange. The board of directors had furthermore entrusted Francesco Iorio to carry out a 21.33 proper investigation of the bank’s assets ‘also in the light of the outcomes of ECB inspection just ended’. The outcomes were made public on 28 August 2015,23 and it became clear that BPVI had largely misrepresented its CET1, because it had funded the subscription of its equity for an amount of 974.9 million euros. Around three-​quarters of the capital raised in 2013–​2014 had been self-​funded; and as 1.4 billion euros were now officially missing from CET1, the board was calling a shareholder meeting to propose a 1.5 billion euro capital increase. On 22 September 2015, BPVI announced that its offices in Vicenza and Milano 21.34 had been raided by the Italian financial police, and newspapers reported that Zonin had been charged with the crimes of supervision obstruction and market abuse. But it took a further two months for Zonin to resign. His defence, as it would become clear later on, was that the top management level of the bank was solely responsible for the equity self-​funding scheme. The board, and the chairman in particular, knew nothing about it.

21 R Costi, ‘Verso un’evoluzione capitalistica delle banche popolari?’, Banca borsa titoli di credito (2015), I, 575. 22 Law Decree no 3 of 24 January 2015, amended and converted into law by Law no 33 of 24 March 2015. The law has been largely commented on in Italian law journals. cf F Fiordiponti, ‘Lo scopo mutualistico:  un’assenza certificate’, Diritto della banca e del mercato finanziario (2015), I, 417; C Fiengo, ‘Il riassetto della disciplina delle banche popolari’ Giurisprudenza commerciale (2016), I, 234; S Mazzamuto, ‘La riforma delle banche popolari e l’Europa come pretesto’ Europa e diritto private (2016), 1; E Ricciardello, ‘La riforma delle Banche popolari nella legge di conversione del d.l. 24 gennaio 2015 n.  3 tra capitalismo ed esigenze di vigilanza uniforme’, Banca Impresa Società (2016), 141; F Salerno, ‘La mutualità delle (restanti) banche popolari dopo il d.l. 24 gennaio 2015, n. 3’, Banca borsa titoli di credito (2016), I, 704; V Santoro and G Romano, ‘L’ultimo atto di riforma delle banche popolari’, Nuove leggi civili commentate (2016), 210. 23 BPVI’s press release, 28 August 2015.

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526

Paolo Giudici 21.35

A few days after Zonin’s resignation, BPVI received the ECB’s final results of the supervisory review and evaluation process (SREP) conducted pursuant to EU Regulation No 1024/​2013 of 15 October 2013. The ECB asked BPVI to bring its consolidated CET1 ratio to at least 10.25 per cent. Because, on 30 September 2015, the CET1 ratio was running at 6.94 per cent, the bank had to raise its capital by 1.5 billion euros by April 2016, otherwise its fate would be sealed. Moreover, the ECB required BPVI to rearrange its internal control functions, prepare a contingency plan in order to deal with possible outflows that could affect the group’s liquidity position until the completion of the capital rise, strengthen its internal capital adequacy assessment plan (ICAAP), and conduct stress testing and capital planning processes.24 9.  The IPO failure and the fall into insolvency

21.36

The bank’s final chapter is very brief. The initial public offering (IPO) was a huge fiasco. The bank’s shares were offered at a price of 0.10 euros. The subscribed amount was 114,948,562 euros, equal to 7.66 per cent of the whole offer. The listing requirements were not met. Atlante, an AIFM supported by the main Italian banks with the blessing of the Italian government, subscribed the whole newly issued capital and became almost the sole shareholder of the bank with a 99.33 per cent stake. The 120,000 original shareholders of the bank had lost everything.

21.37

In the meantime, thousands of legal proceedings were brought against the bank, accused of having mis-​sold its shares; proposed fraudulent contractual schemes to sell its shares; misrepresented its financial conditions; refused to process sell orders of its own shares or discriminated clients’ sell-​orders. Nobody really knew what the bank’s potential liability might be to its customers/​shareholders. In a desperate move to redeem itself and to clear any links with its past management, BPVI presented a public settlement offer to its clients. The proposal was to pay 9 euros per share and settle any litigation concerning the 2013–​2014 capital issuance and the conversion of three convertible bond issuances dated, respectively, 2007, 2009, and 2013, subject to the acceptance of at least 80 per cent of the interested shares. Self-​funded shares were not included in the offer. The 80 per cent threshold was not reached, but the bank renounced the condition precedent and paid 193 million euros.25

21.38

Notwithstanding all the efforts and a late attempt to negotiate a merger with VB and get the ECB’s approval, BPVI was not able to survive the damage to its reputation. On 23 June 2017, the ECB announced that the bank was considered



BPVI’s press release, 27 November 2015. BPVI, Regolamento dell’Offerta di Transazione: Termini e condizioni.

24 25

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527

The Venetian Banks’ Collapse insolvent or close to insolvency under Article 18(1)(a) of Regulation (EU) 2014/​ 80, but stated also that its insolvency procedure would be governed by Italian law. In a frantic weekend, the Italian government issued a special law that allowed the only offeror of BPVI’s activities, Banca Intesa, to buy those activities for one euro and reopen BPVI’s offices on Monday 26 June 2017 without any apparent disruption of the bank’s business. Depositors and bondholders went with Banca Intesa, whereas subordinated bondholders and shareholders stayed in the sinking boat, subject to insolvency liquidation of an entity left with its non-​performing loans. However, following a scheme already adopted by the government in the previous insolvency procedures of Banca Marche, Banca Popolare dell’Etruria e del Lazio, Cassa di Risparmio di Ferrara, and Cassa di Risparmio di Chieti, subordinated bondholders were entitled to receive back 80 per cent of their investment, subject to the fulfilment of certain requirements. The 117,000 shareholders sunk with their ship with no available emergency boats. D. Veneto Banca (VB) The story of VB runs parallel to the one of BPVI and is almost identical. VB was 21.39 also a ‘banca popolare’. It was based in the wealthy area of Montebelluna, in the province of Treviso, one of the richest provinces in Italy. VB had gone through a significant dimensional growth in the last fifteen years of its life, with a great number of acquisitions led by its dominant CEO, Vincenzo Consoli, who stayed in control of the bank for seventeen years. During this period there had been many rumours about a possible merger between BPVI and VB, a merger that was also part of the rescuing project that the management of the two banks proposed to the ECB and the European Commission before their insolvency declaration, which was decided on the same day. VB shared with BPVI a huge portfolio of non-​performing loans as well as the 21.40 bundling of its lending services with its own financial instruments and the self-​ funding of its capital.26

III.  Public Enforcement A. Sanctioning decisions 1.  Competition law authority fine for aggressive selling practices The Italian Competition Law Authority (AGCM) started a proceeding in 2016, 21.41 accusing BPVI of unfair competition practices. According to this charge the bank, in connection with the issue of new capital from 2013–​2014, had systematically



Consob, decisions nos 20033–​20035, 14–​21 June 2017.

26

527

528

Paolo Giudici pushed prospective retail clients to purchase the bank’s shares in order to take benefit of the very favourable loan terms and conditions offered by the bank to its shareholders. The authority sanctioned the bank with a 4.5 million euro fine.27 21.42

The bank’s selling methods were certainly aggressive. However, the competition law authority did not raise the issue that the bank was offering to retail clients more credit than requested in order to finance the clients’ share purchase. Instead, the charge was that the bank was discriminating among clients, pushing prospective clients to become shareholders. However, a cooperative bank which offers services both to shareholders and to non-​shareholders should offer a better treatment to shareholders, thereby inducing prospective clients to become shareholders. From the perspective of the AGCM’s decision, in other words, BPVI was leveraging its banking services to get new capital, taking benefit of its right, as a cooperative, to discriminate against clients by offering better conditions to shareholders. Apart from the methods used, this should not be illegal—​unless the cooperative form is removed from the banking landscape. 2.  Bank of Italy and the ECB sanctioning decisions

21.43

The Bank of Italy fined the bank’s directors, its statutory auditors, and its top management for a long list of violations related to lack of corporate governance and internal control processes. Unfortunately, it is not possible to know more precisely the details of what was wrong within the management and the control system of the bank, because the public part of Bank of Italy’s decisions do not provide details.28

21.44

The same is true with regard to a decision taken by the ECB on 10 May 2017 that found the bank in breach of reporting and public disclosure requirements and large exposures limits. A penalty of 8.7 million euros was imposed for breaches of quarterly reporting requirements in Q4 2014 and Q1 2015, and for breaches of annual public disclosure requirements in 2014. A penalty of 2.5 million euros was imposed for a breach of the large exposures limit from 4 December 2015 to 31 March 2016. 3.  The securities watchdog’s decisions

21.45

The most interesting decisions are the ones taken by Consob, the securities watchdog. Recall that MiFID rules are also applicable in Italy when banks sell financial instruments that they issued.

21.46

On 16 and 17 November 2015 some newspapers reported that BPVI’s directors, statutory directors, and top management had been fined on 30 July 2015 because of deficits in the procedures and widespread deficiencies in suitability assessments.



AGCM, 6 September 2016. Bank of Italy, 25 May 2017.

27 28

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529

The Venetian Banks’ Collapse The overall fine was 73,000 euros. The information was drawn from a prospectus. The decision had never been published in the watchdog’s bulletin. Closer to the collapse, in a run of six decisions, the authority accused the bank of six 21.47 blocks of illegal conducts. One decision concerns the pre-​marketing information that BPVI had transmitted to clients, getting interest offers for almost 158 million euros without previously informing the authority.29 Another one accuses BPVI of having solicited buying orders in such a massive way as to be considered equivalent to a public offer.30 Three decisions concern mis-​statements contained in the press releases,31 and in the prospectuses regarding the capital increases32 and the bond issues.33 The last decision concerns the breach of investment service rules of conduct.34 BPVI has systematically breached suitability rules, has unduly influenced the decision-​making process of clients, has adopted wrong procedures with regards to process of clients’ orders, has not followed acceptable procedures with regard to the pricing of its own shares, and has provided false information to the authority in connection with the 2014 capital increase. Reference to the breach of the suitability rule means that Consob had ascertained 21.48 that BPVI was providing advice to its clients. Accordingly, the BPVI scandal is an example of a massive breach of investment advice rules. Another decision by Consob concerns KPMG, the auditor of BPVI, accused of breach of many different auditing standards in relation to the auditing of the 2014 financial report of the bank.35 With regards to Veneto Banca, in 2013 Consob had already fined the bank’s directors 21.49 and statutory directors for an overall amount of 495,000 euros for massive violations of MiFID rules on investment advice and suitability assessment.36 Similarly to BPVI and on the edge of liquidation, the bank and its management were fined by Consob for a range of violations similar to the ones that had concerned BPVI.37 B. General assessment on the quality of public enforcement A fierce discussion between the banking and the securities authorities was sparked 21.50 at the hearings before the parliamentary commission. The banking supervisor was

29 Consob, decision no 19331, 30 March 2017. 30 Consob, decision no 1934, 30 March 2017. 31 Consob, decision no 1930, 30 March 2017. 32 Consob, decision no 1932, 30 March 2017 33 Consob, decision no 1933, 30 March 2017. 34 Consob, decision no 1935, 30 March 2017. 35 Consob, decision no 20212, 6 December 2017. 36 Consob, decision no 18446, 23 January 2013. 37 Consob, decisions no 20022, 1 June 2017; no 20031, 7 June 2017; no 20033, 14 June 2017; no 20034, 21 June 2017.

529

530

Paolo Giudici accused of not being clear and open in its communications about the shares’ value, while the securities watchdog was accused of being too timid in the use of its powers of inspection. Indeed, Bank of Italy’s style of supervision has always been very secretive, and keen not to create alarm concerning the supervised bank’s health and put the bank’s reputation and its ability to get access to capital in danger; whereas the securities watchdog has never been particularly entrepreneurial in its investigative style. 21.51

Two other issues are really striking. The first one is how late the two authorities discovered that the two banks were self-​financing their capital issuances. The second one, and even more significant, is how the extraordinary concentration of the banks’ shares in their clients’ portfolios was never considered by any of the two authorities as a red flag of MiFID violations. Indeed, this issue has never been discussed in the parliamentary commission’s report with regards to the two Venetian banks. It appears that excessive concentration of clients’ portfolios into the bank’s own shares and bonds had never been taken into account as a sign of alarm by the Italian public enforcers. This is very surprising. On one side, this issue should be at the top of the securities watchdog’s checklist. On the other side, a massive violation of MiFID rules could affect, when discovered, the bank’s reputation—​an issue that should be top of the banking watchdog’s priorities.

IV.  Red Flags A. Domination by a single individual 21.52

From a corporate governance perspective, it appears that both banks were dominated by one dominant figure; the chairman Zonin in BPVI and the CEO Consoli in Veneto Banca. They remained in office for nineteen and seventeen years respectively and there are many anecdotes concerning the immense power that they exercised within their local communities and each bank’s board. Individual dominance over the board is classically identified as a red flag, since it can facilitate fraud tending to exclude the ordinary supervision and oversight that corporate checks and balances would otherwise provide.38 A  domination of this kind also has a psychological dimension: a single dominating individual or small group may tend to display aggressive personalities who may be more inclined to cover up bad

38 cf International Standard on Auditing 240, The Auditor’s responsibilities relating to fraud in an audit of financial statement; SAS 2401: Consideration of Fraud in a Financial Statement Audit (‘There is ineffective monitoring of management as a result of the following:  . . .  domination of management by a single person or small group (in a nonowner-​managed business) without compensating controls’ (see https://​pcaobus.org/​Standards/​Auditing/​Pages/​AS2401.aspx), accessed 17 October 2018.

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The Venetian Banks’ Collapse decisions, and rationalize or justify fraud when the motivation or opportunity presents itself, or when pressure requires it.39 The problem of the dominating CEO is well known to the corporate govern- 21.53 ance literature concerning public companies. In public companies, however, the dominating CEO faces financial markets’ reactions to his decisions and is subject to the potential pressure of the market for corporate control. In cooperatives, the dominating CEO is subject to patrons’ ongoing surveillance, which is not only legal but also social. This social surveillance can become very ineffective in certain situations. Accordingly, the cooperative structure of the two banks was considered a concurrent factor in the two banks’ scam. B. The problems of the cooperative structure According to the most accredited theory about firms’ ownership, a cooperative 21.54 is a firm owned by a single, homogeneous class of patrons (customers, workers, etc) that would be exposed to the opportunistic behaviour of the firm in terms of market power over the patrons. This market power would stem from monopoly or the circumstance that patrons would be locked into dealing with the firm once the relationship was established.40 In order to avoid this exploitation, the patrons take control of the firm, becoming its owners. One of the essential features of the cooperative scheme, the ‘one-​person, one-​vote principle’, is precisely aimed at avoiding any patron becoming the controlling shareholder of the firm and exploiting the firm’s market power to its own benefit. Homogeneity among patrons is an important feature of cooperatives because it 21.55 facilitates the collective action of owning the firm, appointing the managers and taking other decisions concerning the common organization. Owners’ homogeneity is not exclusively related to their personal features, but also to their geographical localization. A rich body of research on cooperative banks suggests that one of the competitive advantages of these banks is the strong social tie between the bank and the borrowers, which provides the credit institution with an informational advantage over differently structured, competing organizations. The cooperative bank’s patrons live in a restricted, socially linked environment where personal information concerning their economic potentials and risks as borrowers are more easily accessible to the cooperative bank than to rival institutions. This can give

39 For a review and analysis of the dominating CEO’s problem with regard to another Italian banking case, see F Zona, M Minoja, and V Coda, ‘Antecedents of Corporate Scandals:  CEOs’ Personal Traits, Stakeholders’ Cohesion, Managerial Fraud, and Imbalanced Corporate Strategy’, Journal of Business Ethics (2013) 113, 265–​83. 40 H Hansmann, ‘The Role of Nonprofit Enterprise’, Yale Law Journal (1980), 89, 835; H Hansmann, ‘Ownership of the Firm’ Journal of Law, Economics, and Organization (1988), 4 267; H Hansmann, The Ownership of Enterprise, 1996, Harvard University Press.

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Paolo Giudici an edge to the cooperative bank over competitors, and can also be effective in preventing fraud.41 21.56

However, banks such as BPVI and VB, in order to cope with market pressure and demanding targets in terms of economies of scale and scope, morphed themselves into different entities. They enlarged their patrons and their operations to a point where homogeneity was lost. Thus, patrons’ control over managers diminished, and the relational lending’s advantages42 offered by the cooperative structure were overcome by the costs of a legal structure where directors are not subject to takeover bid pressure or any other action that can lead to a concentration of ownership and, therefore, are prone to empire-​building. In short, the cooperative form was no more aligned with the structure, the dimension, and the variety of the bank’s operations and clientele.43

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Needless to say this narrative should be empirically tested in order to see whether there are comparable cooperative institutions around the world that followed the same path of BPVI or VB and yet remained successful. In any event, behind this explanation lies the Italian Parliament’s decision to force large ‘banche popolari’ to become standard public companies, exposing their managers to the test of the financial market. C. Massive  growth

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Both banks displayed massive growth in the several years preceding their insolvency. As mentioned, at least to a certain extent, this growth was justified by the need to cope with economies of scale and scope required by the changing world of banking during the ’90s. However, the risk of empire-​building by unconstrained managers of cooperative banks is well known in the literature; when a firm displays massive growth it is likely to commit itself to unsustainable projects for the future, which then result in reduced profits down the line. Massive growth can greatly complicate the task of auditors and others who are seeking to understand the firm’s operations, since a firm which is growing rapidly does not present a baseline which can be used to identify unusual changes that may be the characteristics of fraudulent accounting. More importantly with regards to the Venetian banks, massive growth can represent an attempt by the incumbent managers to disguise the results of bad business decisions by growing out of the problem.44

41 M Ghatak, ‘Screening by the Company You Keep:  Joint Liability Lending and the Peer Selection Effect’, Economic Journal (2000), 110, 601–631. 42 A W A Boot, ‘Relationship Banking: What Do We Know?’, Journal of Financial Intermediation (2000), 9, 1, 7–​25. 43 On the policy issues raised by cooperative banks in Europe, see W Fonteyne, ‘Cooperative Banks in Europe’, IMF Working Paper 07/​159/​2007. 44 J J C Coffee, ‘A Theory of Corporate Scandals: Why the USA and Europe Differ’, Oxford Review of Economic Policy (2005), 21, 198–​211; R Tillman and H N Pontell, ‘Organizations and

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The Venetian Banks’ Collapse D. Excessively easy access to capital However, the most astonishing red flag was the incredibly easy access to capital that 21.59 the two banks could enjoy. This easy access was granted by a concomitant series of factors. Apart from the very good reputation that the two banks had gained among their local communities in the course of the previous decades, five factors stand out among from the others. 1.  Bundling lending services and shares sale The first factor is the bundling of lending services at competitive prices and share sub- 21.60 scriptions. This bundling is engrained in the cooperative mechanism, where members are the only who can be served by the cooperative or, such as in ‘banche popolari’, can get lending services at favourable conditions. Accordingly, the cooperative mechanism that leads the bank to offer the sale of shares to prospective clients might have helped in to reduce the signs of danger that was coming from the intense pressure to sell their shares that the employees were showing. In other words, the cooperative form and culture might have helped in disguising or diminishing the strength of the danger signs that were coming from the banks’ impellent need to sell their own shares. 2.  Prospectus ambiguity A second factor was the misrepresentation of the banks’ value in prospectuses and 21.61 public information. Indeed the prospectuses’ information concerning the banks’ value and the criteria used to assess it were very unclear, and one might argue that there were enough warning signs for an investor to think that the issuing bank was overstating its value. Those warning signs would have probably been more than sufficient to raise suspicions among professional investors, and, therefore, would have rung alarm bells in households as well. In fact, when BPVI tried to access the public markets through the IPO, the disastrous results of the book-​running anticipated the fate of the bank, communicating the bad sense about the bank’s future that professional investors were feeling.45 This confirms that prospectuses are not really helpful; the information contained in issuing documents is useful only when it is read and processed by professional advisers. If a bank is in a position to influence its customers’ choice concerning the sale of its own shares, and the same bank Fraud in the Savings and Loan Industry’, Social Forces (1994), 73, 1439–​63; C R Alexander and M A Cohen, ‘New Evidence on the Origins of Corporate Crime’, Managerial and Decision Economics (1996), 17, 421–​35; S Kedia and T Philippon, ‘The Economics of Fraudulent Accounting’, Review of Financial Studies (2009), 22, 2169–​99; I Kim and D J Skinner, ‘Measuring Securities Litigation Risk’, Journal of Accounting and Economics (2012), 53, 290–​310. 45 There is a large amount of literature on the essential informational role that professional investors play in IPOs:  see A Ljungsqvist, ‘IPO Underpricing:  A Survey’, in B Espen Eckbo (ed), Handbook of Corporate Finance: Empirical Corporate Finance, Elsevier, 2004, 375; L M Benveniste and P A Spindt, ‘How Investment Bankers Determine the Offer Price and Allocation of New Issues’, Journal of Financial Economics (1989), 24, 343–61.

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Paolo Giudici does not need to raise capital among professional investors, prospectus regulation loses its bite, simply because households and small firms do not read prospectuses and, when they do, have not enough financial literacy to notice the danger signs.46 3.  Control of the secondary market in the banks’ financial instruments 21.62

Third, the full control of the secondary market of the financial instruments of the banks, whose shares were not listed and were not negotiated on any multilateral trading facility, was key to the easy access to household finance that the two banks enjoyed. This control was granted by the fact that the two banks acted as brokers between shareholders interested to sell and clients interested to buy. Without any organized platform for negotiations, the selling and the buying sides had no practical way to meet each other. The bank’s informal cooperation was necessary. When the secondary market of the financial instruments is in the hands of the issuing bank, which orchestrates sales and purchases among customers and controls information about volumes, prices, and liquidity, the price system cannot function well because the market can be too easily manipulated. BPVI and VB were able to run informal markets that were outside the controls of market abuse regulation. This enabled the possibility of distorting the market, through fraudulent financing of the purchases or discrimination in the treatment of clients’ orders. In short, the secondary market was manipulated by the banks, which were able to sustain sale contracts at prices which were artificially inflated. 4.  Investors’ nature and financial illiteracy

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It may appear incredible that the shares were non-​listed and yet households and small to medium sized enterprises (SMEs) bought them with few suspicions about the potential danger of the situation. There is no doubt that the two banks’ management teams were very effective in persuading gullible investors that the non-​ listed status of the shares was a plus and not a minus, and in many interviews on media outlets BPVI management praised the virtues of an investment in financial instruments that were not subject to market fluctuations and speculators’ activism. Accordingly, the case shows that investors easily believe in narratives about listed stock exchange manipulation by powerful and secret forces (speculative funds and

46 See O Ben-​Shahar and C E Schneider, ‘The Failure of Mandated Disclosure’, University of Pennsylvania Law Review (2011), 159, 647–749; L Enriques and S Gilotta, Disclosure and Financial Market Regulation, in E Ferran, N Moloney, and J Payne (eds), The Oxford Handbook on Financial Regulation, Oxford University Press, 2015, 511–​36; T A Paredes, ‘After the Sarbanes-​Oxley Act: The Future of the Mandatory Disclosure System’, Washington University Law Quarterly (2003), 81, 229; T Paredes, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’, Washington University Law Quarterly (2003), 81, 417. For a critical discussion of the European approach, see L Burn, ‘KISS, but tell all: short-​form disclosure for retail investors’, Capital Markets Law Journal (2010), 5, 141–​68.

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The Venetian Banks’ Collapse other professional investors) that are able to alter and depress at their wish the value of financial instruments, and basically do not trust the market and the price mechanism. The story of dark, mysterious and yet gigantic speculators that depressed the value of Italian bonds had been used by politicians and complacent journalists many times to explain the increase of the spread between Italian and German bonds at the time of the Greek crisis. It is no surprise, therefore, that the same narration was also used by the two banks in order to convince their investors that by staying away from the stock market they could avoid any attack by speculators, thereby enjoying the ‘true’ value of the investment in the banks’ shares, which would have remained stable along a medium–​long-​term timeline.47 In the end, both the prospectus factor and the factor concerning investors’ reliance 21.64 on informal market mechanisms rather than regulated markets lead to the value, for the two banks, of the investors’ nature. The conformation of the banks’ shareholders and bondholders, entirely formed by households and SMEs with a very low level of financial literacy and apparently unaware of the irrational risk to which they were going to be exposed by concentrating all their savings on the fortunes of a single institution, and by entering into loans that were exclusively aimed at buying further shares, was key to the delay of the crisis and persuading investors to blindly invest in the banks. E. Massive elusion of MiFID rules Mandatory disclosure, prospectus regulation, and market abuse are part of the 21.65 whole framework addressed at protecting investors and their trust in the financial market. Under the European regulatory framework, the final instrument of protection is in the hands of banks and financial intermediaries, acting in their role of retail investors’ and SMEs’ gatekeepers. The tale of the Venetian banks is therefore also about the massive elusion of MiFID rules concerning conflicts of interest and investment advice, with the two banks recommending the purchase of their own shares and bonds to their non-​professional clients.

47 The need to increase financial literacy and the difficulties in performing the task is discussed at length by a rich body of financial literature: cf N Linciano and P Soccorso, Le sfide dell’educazione finanziaria, Consob—​Quaderni di finanza, n 84 (2017); O A Stolper and A Walter, ‘Financial Literacy, Financial Advice, and Financial Behavior’, Journal of Business Economics (2017), 87, 581–​643; M M Kramer, ‘Financial Literacy, Confidence and Financial Advice Seeking’, Journal of Economic Behavior & Organization (2016), 131, 198–​217; H-​M V Gaudecker, ‘How Does Household Portfolio Diversification Vary with Financial Literacy and Financial Advice?’, The Journal of Finance (2015), 70, 489–​507, R Calcagno and C Monticone, ‘Financial Literacy and the Demand for Financial Advice’, Journal of Banking & Finance (2015), 50, 363–​80, M van Rooij, A Lusardi, and R Alessie, ‘Financial Literacy and Stock Market Participation’, Journal of Financial Economics (2011), 101, 449–​72; L E Calvet, J Y Campbell, and P Sodini, ‘Down or Out: Assessing the Welfare Costs of Household Investment Mistakes’, Journal of Political Economy (2007), 115, 707–​47.

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Paolo Giudici 21.66

This elusion of MiFID rules consisted both in the disapplication of conflict of interest rules and in the gigantic circumvention of rules concerning investment advice and suitability assessment. As to conflicts of interest, it is self-​evident that the two banks were not in compliance with the organizational and procedural rules that should reduce the impact of a conflict of interest of the financial intermediary.

21.67

With regard to investment advice, it is highly likely that when all the banks’ clients want to subscribe or buy the financial instruments issued by the bank, the bank is recommending to its own clients the investment in its own financial instruments. When this recommendation is personal in character, the bank is offering investment advice under MiFID regulation even in the absence of a written contract that governs the advisory relationship with the client. Indeed, MiFID investment advice does not actually need a contract, since it comes with the mere provision of personal investment recommendations to an investor. In the ensuing litigation with clients, however, the banks’ defences against investors’ claims were that there were no written contracts able to offer evidence that an investment advice was actually offered, and then that it was entirely on the client the burden of showing that the bank had provided recommendations which, according to Article 52 of Directive 2006/​73/​EC, were presented as suitable for the client or based on a consideration of the circumstances of the client. The banks’ strategy, accordingly, was to rely on the demanding burden of proof that an investor must satisfy when arguing, in the absence of a written contract, that the financial intermediary was not only distributing, but was also advising.48

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The securities watchdog’s decisions concerning the systemic violation of the suitability assessment would have probably broken the banks’ defences in any legal proceeding, since the plaintiffs would have been able to use the public enforcer decision as evidence that the banks were indeed providing investment advice, and were not running any proper suitability test in order to protect their clients. Unfortunately, the BPVI decision arrived in 2017, when the bank were already on the brink of insolvency, and the VB decision arrived when the bank was already under the procedure of insolvency liquidation.

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Accordingly, at least from 2013 but certainly from much earlier, two of the most important Italian banking groups massively violated MiFID rules on investment advice and suitability assessment in a situation where the boiler room tactics of the two banks were openly denounced in newspapers, especially with regard to the financial support that the banks were offering to clients in order to push them to buy their shares, and with civil proceedings concerning the violation of those rules

48 This issue was covered in P Giudici, ‘Independent Financial Advice’, in G Ferrarini and D Busch (eds), Regulation of the EU Financial Markets—​MiFID II and MiFIR, Oxford University Press, 2017, 153–​4.

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The Venetian Banks’ Collapse exploding around Italy and especially in the Venetian area. The Venetian banks’ case, accordingly, is a spectacular case of ineffective public enforcement, concerning a non-​complex and well-​known financial instrument such as shares. The case also shows, therefore, that financial products’ complexity is not a prerequisite for massive mis-​selling. At the same time, the whole corporate governance system and the chain of controls 21.70 that starts from statutory auditors and goes through the audit firm and then public enforcers collapsed, probably under the assumption that the desperate need of the two banks to raise capital should not be blocked. The banks’ internal systems and controls should have granted that conflict of interest rules were respected, and that the recommendation of its own financial instruments were done properly. A situation where the great majority of the bank’s customers hold undiversified portfolios should ring an alarm bell of massive MiFID violations. The board and all the involved gatekeepers should run internal controls in order to assess how and why there is this systematic bias towards the bank’s own products, and to check how and whether the suitability assessment is run. All this did not occur within the Venetian banks.

V.  Would MiFID II Have Prevented the Disaster? The author has argued in a previous paper that MiFID II does not address the am- 21.71 biguity problems stemming from MiFID I  regulation of investment advice.49 An important novelty of MiFID II, instead, is the product governance regime. Under this regime, the manufacturer has to ensure that the financial instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients. Moreover, the manufacturer must ensure that the strategy for distribution of the financial instruments is compatible with the identified target market, and the bank or the investment firms that distribute the product must take all reasonable steps to ensure that the financial instrument is distributed to the identified target market. The latter must understand the financial instruments and assess the compatibility of the financial instruments with the needs of the clients to whom they provide investment services. In doing so, the investment firm shall also take into account the identified target market of the clients, and ensure that financial instruments are offered or recommended only when this is in the interests of the client.50

49 See n 50. 50 Article 16(3). On the product governance regime, see ESMA, ‘Guidelines on MiFID II product governance requirements’, 2018; D Busch, ‘Product Governance and Product Intervention under MiFID II/​MiFIR’, in Busch and Ferrarini (eds), n 50, 123–​46; V Colaert, ‘MiFID II and Investor Protection: Picking up the Crumbs of a Piecemeal Approach’, in Busch and Ferrarini (eds), n 50, 589–​611; V Colaert, ‘Building Blocks of Investor Protection:  Ever Expanding Regulation Tightens its Grip’, Journal of European Consumer and Market Law (2017), 229–​44.

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Accordingly, there is a double-​check system. The manufacturer monitors the distribution system, and the offering or recommending firm takes into account the target market that has been identified by the manufacturer. For this purpose, the latter must have appropriate arrangements in place to obtain and understand the relevant information concerning the product approval process, including the identified target market and the characteristics of the product they recommend.

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In a banking case that followed the Venetian banks one, a medium sized bank (Credito Valtellinese), which had been transformed from a cooperative into a public company following the 2015 law that was previously mentioned, was in need of fresh capital and under pressure by the Bank of Italy. The bank, as opposed to BPVI and VB, was under the new framework of MiFID II, and in particular of MiFID II product governance rules. Accordingly, the bank’s board had to have effective control over the firm’s product governance process and the bank had to identify the target market. The shares were classified as instruments not addressed to investors that were not able to face a total loss of value or that were fully risk-​ adverse, and the bank declared that the suitability assessment would have taken this into account.

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The case was upheld as a triumph of the new regime, whereas—​as mentioned—​a proper application of the investment advice provisions and, accordingly, the suitability test would have prevented the sale of shares to any client, in any form, and with no respect whatsoever of basic principles of diversification of risk. The red flags should also have brought the issue to the attention of the Venetian banks’ boards and monitoring bodies. In short, product governance assessment has certainly raised the awareness of boards and maybe also of securities watchdogs, but it cannot be said that the Venetian bank case came out of a regulatory loophole that MiFID II has prevented.

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22 THE SPANISH BANKING CRISIS AS A CORPORATE GOVERNANCE PROBLEM Maribel Sáez-Lacave and María Gutiérrez-Urtiaga

I. Introduction II. The Cajas de Ahorros III. Recapitalization Efforts

22.01 22.09 22.17

IV. The Bankia Case: The Bank that Broke Spain V. The Unhappy Ending VI. Conclusions

22.27 22.34 22.41

I. Introduction Quoting Tolstoy, it might be said that even though healthy banking systems are 22.01 alike, every banking crisis develops in its own way. The particularity of the Spanish banking crisis resulted from the interaction of large global credit flows—​which were mainly directed to the real estate sector—​with the faulty governance institutions of a big segment of the Spanish banking system: the Cajas the Ahorro. Spain experienced strong economic growth and a real estate boom during the first 22.02 years of the century. Real GDP grew by 34.5 per cent from 2000 to 2007, with real estate prices increasing by 250 per cent in real terms.1 The accompanying loan increase was funded with bank debt. The debt of the Spanish banks, in the form of covered bonds, senior unsecured debt, and securitization deals, was mainly owed to other euro-​zone banks. Nevertheless, by the end of 2007, when the first signs of trouble appeared in the 22.03 international financial markets, this phenomenal growth period in Spain had come

1 Unless otherwise stated, the data used in this document come from the ‘Informe sobre la crisis financiera y bancaria en España, 2008-​2014’ published by the Banco de España in May 2017, available at https://​www.bde.es/​bde/​es/​secciones/​informes/​Otras_​publicacio/​informe-​sobre-​la/​, accessed 19 November 2018.

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga to an end. During the following two years GDP contracted by 4.6 per cent in real terms and real estate prices fell by 10 per cent while unemployment rose from an all time minimum of 7.95 per cent of active population to more than 20 per cent. 22.04

The deterioration of the economic situation brought about an increase in non-​ performing loans from 1 per cent in 2007 to 6 per cent in 2009. The banking crisis that ensued was exacerbated by three key factors.

22.05

The first factor, which was common to other European countries, was the strong dependence of the Spanish banks on international debt markets. Figure 22.01 illustrates how international bank funding grew in parallel with the real estate bubble during the period 2000–​2007. This figure shows the growth of housing prices, total bank loans, and net international investment into Spain with values in year 2000 normalized to 100. Housing prices more than doubled from 2000 to 2007 but international investment grew more than 400 per cent. Most of this international investment was coming from German and French banks.

Housing prices

NIIP

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2006Q1

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500 450 400 350 300 250 200 150 100 50 0

Loans

Figure 22.01 Financing the boom years Note: Assessment of housing prices in €/​m2 (SI010604), absolute value of Net International Investment Position (NIIP; BE172101) and loan portfolio of all credit institutions (BE040301). All normalized to 100 in 2000Q1. Source: Boletín Estadístico Banco de España.

22.06

The second factor, common to all the euro-​zone countries, was that, being part of the monetary union, Spain lacked a Lender-​of-​Last-​Resort and the Bank of Spain was unable to offer liquidity when the crisis struck. In this scenario, when the funding that the banking system was receiving from international debt markets dried up, the liquidity crisis threatened to become a solvency crisis.

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The Spanish Banking Crisis Finally, the third factor, which was unique to the Spanish banking crisis, was the 22.07 importance of the Cajas the Ahorros in the Spanish banking system. The Cajas, many dating from the nineteenth century, operated like banks but were regional foundations. Figure 22.02 shows the importance of the Cajas sector within the Spanish banking industry, both in terms of deposits and loans. The Cajas had always held a very significant share of the banking business, but from 2000 to 2007 they grew faster than banks and expanded beyond their initial region of influence to become national players. They became strong competitors to banks both in terms of deposits and loans and by 2007 they represented almost half of the entire financial sector.

Banks (%)

Cajas (%)

Banks (%)

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1992

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2000

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1996

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1992

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Panel A. deposits (%) 70 60 50 40 30 20 10 0

Cajas (%)

Figure 22.02 The growth of Cajas Note: Panel A. Deposits of banks (BE045202) and Cajas (BE046202) as a fraction of total deposits issued by both. Panel B. Loans to the private sector (households and firms) of banks (BE045104) and Cajas (BE046104) as a fraction of total loans granted by both. Source: Bolet BoletBoletraction of total loan.

As will be explained in the following sections, the Spanish banking crisis can be 22.08 understood as a crisis of the Cajas since almost all of the failed institutions were Cajas.2 The special status of the Cajas created important political economy problems that made the resolution of the Spanish banking crisis particularly slow and painful.

2 Only two small banks failed: Banco Guipuzcoano (with 12,000 million euros in assets) and Banco de Valencia (with 23,000 million euros in assets). Interestingly, in both cases their largest shareholders were Cajas, BBK, and Kutxa in the case of Banco Guipuzcoano and Bancaja in the case of Banco de Valencia. The only important bank to fail has been Banco Popular (with 150,000 million euros in assets). Nevertheless, this failure, which happened very late during the crisis, did not require any public spending because the Single Resolution Board decided, on 7 of June 2017, its sale to Banco Santander for one euro plus any recapitalization needed. By way of comparison, the Cajas that received public funds during the crisis had assets amounting to 830,000 million euros.

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II.  The Cajas de Ahorros 22.09

The first Cajas were founded in the early nineteenth century as non-​for-​profit provincial credit institutions aimed at channelling the savings of the popular classes towards profitable investments and helping the very poor, using their profits for charity and social works.

22.10

After the liberalization of the banking system that took place during the 1980s and was completed in 1988 with the Ley 26/​1988, Cajas were able to operate like banks and to offer their depositors the same range of financial products. Nevertheless, two important differences subsided.

22.11

The first difference was their legal status as foundations. This meant that their growth opportunities were limited by their retained profits, because Cajas were not corporations and were unable to issue shares. To soften this restriction, the Ley del Entidades de Crédito of 1988 allowed Cajas to issue a tradable security that could share in their profits: the ‘coutas participativas’.

22.12

However, cuotas participativas never really took off. The reason for this lies in the second important difference that still existed between banks and Cajas, which had to do with their corporate governance. Cuotas participativas carried economic rights but no decisions rights. Because of this, potential investors faced a very real risk of expropriation by very powerful stakeholders.

22.13

The Cajas were controlled by their boards of directors, where representatives of depositors held between 15 per cent and 45 per cent of the votes, employees represented between 5 per cent and 15 per cent, founders took between 10 per cent and 35 per cent of the votes with the remaining (15 per cent to 45 per cent) going to public administrations (including city halls, local and regional governments). In practice, because many Cajas were public foundations, adding up the percentage of founders and public administrations, politicians had total control. This meant that many Cajas were not run or managed to pursue the maximization of economic value, but to foster the political agenda of local governments.

22.14

This is clearly shown in a study by Garcia-​Cestona and Surroca.3 They study the differences in performance between Cajas formally controlled by depositors and employees and those controlled by politicians for the period 1998–​2002. They find that Cajas controlled by politicians performed worst because they favoured contributing to regional development (measured as the proportion of loans granted

3 M Garcia-​Cestona and J Surroca, ‘Multiple Goals and Ownership Structure:  Effects on the Performance of Spanish Savings Banks’, European Journal of Operational Research (2008), 187, 582–​99.

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The Spanish Banking Crisis to public administrations over the total volume of loans) above other goals such as maximizing profits and offering universal access to financial services. Moreover, there is evidence indicating that expansion decisions during the boom years followed political rather than economic reasons.4 The Cajas that were dominated by politicians were more likely to expand to other regions whenever the same political party was dominant in both regions. Additionally, politically controlled Cajas were likely to have chairmen that were previous political appointees, offering them a ‘golden retirement’. Cuñat and Garicano5 show that Cajas where the chairman was a previous political appointee and Cajas where the chairman had no previous banking experience exhibited significantly worst loan performance during the crisis.6 Finally, the crisis has uncovered widespread abuse. There have been many cases of 22.15 self-​dealing in expense reimbursement and pension benefits for board members and subprime lending to cronies of the regional ruling party. Many of these cases are still pending in court.7 Therefore, in terms of corporate governance, the particularity of the Spanish crisis 22.16 is that the perverse incentives of the managers were not caused by high powered incentive schemes that induced risk shifting,8 but by politically appointed boards 4 M llueca, L Norden, and GF Udell, ‘Liberalization and Risk-​ taking:  Evidence from Government-​controlled Banks’, Review of Finance (2014), 18, 1217–​59. 5 V Cuñat and L Garicano, ‘Did Good Cajas Extend Bad Loans? Governance, Human Capital and Loan Portfolios’, Working Paper FEDEA 2010-​08, available at http://​documentos.fedea.net/​ pubs/​dt/​2010/​dt-​2010-​08.pdf, accessed 19 November  2018. 6 Two former presidents of failed Cajas testified in Congress on 28 February 2018. Narcis Serra was Defence minister from 1982 to 1991 and president of Caixa Cataluña from 2005 to 2010. He revealed that when Adolf Todó was nominated as new CEO in 2007 he organized lectures for board members to explain to them the different items in the balance sheet and profit and loss account. Caixa Catalunya received over 13,000 million euros from the FROB in 2012 and was later bought by BBVA. Modesto Crespo, a small entrepreneur in the automobile industry and close friend of Francisco Camps (president of the Comunidad Autónoma Valenciana from 2003 to 2011), was president of Caja de Ahorros del Mediterráneo (CAM) from 2007 to 2011. He excused himself saying that he was unable to exert any control over the managers because of his ‘complete technical incompetence’ in banking, arguing that he was only a graduate in social work. He explained that the representatives of the depositors in CAM where chosen in a lottery draw, which accounts for the presence of a ballet dancer and a taxi driver on the board. CAM was sold to Banco Sabadell in 2012 after receiving over 5,000 million euros from the FROB. 7 Among them the ‘black cards’ case involving Bankia board members receiving limitless and fiscally opaque credit cards as part of their compensation agreements; the Caja Castilla-​La Mancha case, where allegedly friendly entrepreneurs were given loans disregarding any due diligence; and the cases of excessive compensation and over generous pension plans at Novagalicia, Caixa Penedés and Caja del Mediterráneo. 8 There is international empirical evidence showing that banks where executives received more equity compensation took more risks during the boom years. In particular, Cheng, Hong, and Scheinkman show that residual executive compensation in the banking industry (controlling for size and business model) predicts risk taking. See I-​H Cheng, H Hong, and J Scheinkman, ‘Yesterday’s Heroes:  Compensation and Risk at Financial Firms’ Journal of Finance (2014), 70, 839–​79. Fahlenbrach and Stulz argue that high levels of equity compensation were consistent with incentive alignment and that the executives were serving the interests of bank shareholders in taking extra risk. However, Bebchuk, Cohen, and Spamann show that bank insiders with large stock and

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga pursuing their own goals and funding bad risks to promote local growth and to help politically connected cronies.

III.  Recapitalization Efforts 22.17

The Spanish banking system had no exposure to the US subprime market but, as previously discussed, it was heavily dependent on international wholesale financial markets. Because of this, financial authorities (the Ministry of Finance and the Bank of Spain) understood the risk posed by unstable international markets and responded early during the crisis.9 In 2008 they launched a debt guarantee program and in 2009, through the Real Decreto Ley 9/​2009, they created the Fondo de Reestructuración Ordenada Bancaria (FROB) as a vehicle to provide liquidity and recapitalize banks and Cajas buying their subordinated debt and equity issues. The design of the FROB followed a scheme that was maintained throughout the crisis.10 The initial capital allocated was 9,000 million euros with a compromise to provide additional funds to the FROB as needed. The solvency of each entity was to be evaluated on an individual basis. If problems were discovered, both the entity and the Bank of Spain had thirty days to prepare a restructuring plan that could include FROB funding and proposals for mergers and acquisitions and that would have to be approved by the supervisors. However, during this initial period, only one Caja, Caja Castilla-​La Mancha (CCM) was intervened by the Bank of Spain.11 Nevertheless, because of the opacity of their balance sheets, markets were still suspicious of the solvency situation of the Cajas.

22.18

Because of the difficulties raising funds in wholesale markets, the Cajas turned to retail funding. During 2008 and 2009 banks, and specially Cajas, issued a substantial amount of ‘preferentes’ to retail investors (essentially to depositors). Preferentes are perpetual junior debt with a fixed coupon that is paid depending on the issuing entity profitability and they are computed as Tier I capital. The attractiveness of option remuneration packages ‘cashed out’ before the crisis, suggesting that incentives were not properly aligned and that the level of risk-​taking was above the level that would maximize shareholders’ value. See R Fahlenbrach and R Stulz, ‘Bank CEO Incentives and the Credit Crisis’, Journal of Financial Economics (2011), 99, 11–​26, and L Bebchuk, A Cohen, and H Spamann, ‘The Wages of Failure:  Executive Compensation at Bear Stearns and Lehman 2000-​2008’, Yale Journal on Regulation (2009), 27, 257–​82. 9 For the interested reader, Tano Santos provides a superb detailed analysis of the Spanish banking crisis and the policy responses of the Spanish authorities in ‘Antes del Diluvio: The Spanish Banking System in the First Decade of the Euro’, in Edward L Glaeser, Tano Santos, and E Glen Weyl (eds), After the Flood: How the Great Recession Changed Economic Thought, University of Chicago Press, 2017. 10 S Carbó and C Ocaña, ‘Reestructuración bancaria, banca relacional y cajas de ahorros en España’, Perspectivas del Sistema Financiero (2013), 106, 9–​19. 11 CCM was merged with Cajastur and their joint banking operations placed in a jointly owned bank, Banco Liberta. Interestingly, this initial restructuring operation would also be the model for the later restructuring of all the Cajas sector.

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The Spanish Banking Crisis preferentes was obvious to the Cajas in trouble that were unable to issue equity or raise debt in international markets. The preferentes allowed them to raise capital to absorb potential loses and meet regulatory capital requirements with low issuing costs, since they were sold to depositors through their retail branch network. This was done with the approval of both the Bank of Spain and the CNMV (the Spanish Securities and Exchange Commission). Neither of them raised concerns about the adequacy of this high-​risk financial product for small savers that turned to their trusted institutions for investment advice during a period of low interest rates. Figure 22.03 shows the total issues of preferentes by credit institutions in millions of euros before and during the crisis with a peak in 2009. 14000 12000 10000 8000 6000 4000

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

0

1998

2000

Figure 22.03 Issues of preferentes (million euros) Note: Total annual issues of preferentes by financial institutions in millions of euros. Source: Comisión de Seguimiento de Instrumentos Híbridos de Capital y Deuda Subordinada, 17 May 2013. Comisión Nacional del Mercado de Valores (CNMV).

At this stage, the institutional foreign investors with claims on the liability side of 22.19 the balance sheet had been substituted to a large extent by small Spanish savers. Although in the short term this solved the liquidity problems of the Cajas, it created a long-​term problem that would delay crisis resolution. Any bail-​ins would have to start with the write-​offs of the preferentes and subordinated debt, which would affect the small depositors, creating a huge political problem. Moreover, recapitalization via bailouts was not easy either because state intervention would mean the recognition of previous mismanagement of the Cajas by the political class. Because of this, the regional political elites put pressure on successive governments to avoid intervention, and so the bad management problem persisted. Nevertheless, with bad loans piling up, the authorities proposed a restructuring of 22.20 the entire Cajas sector. Real Decreto Ley 11/​2010 forced the Cajas to merge and to transfer their joint business operations to a new bank whose largest shareholder would remain the Cajas. In fact the term ‘merger’ is not totally accurate. Mergers were unpalatable to the Cajas boards, since many board seats would be lost. For this reason, most Cajas integrated into SIPs (Sistemas Institucionales de Protección),

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga Table 22.1 Integration process of the Cajas after the passage of Real Decreto Ley 11/​2010. Name of new institutions created as of the end of 2011

Total Assets Cajas integrated into new institution (million euros) as of the end of 2011

Type of integration

Bankia/​BFA

312,343

SIP

Banca Cívica

71,827

Kutxabank Banca Mare Nostrum Liberbank

70,951 67,201

Banco Caja 3

20,725

La Caixa Catalunyacaixa

376,701 77,049

Novacaixagalicia Banco CEISS Unicaja Unnim

72,236 42,337 38,155 29,288

50,847

Caja Madrid, Bancaja, Caja Ávila, Caja Segovia, Caja Rioja, Caixa Laietana, Caja Insular de Canarias. CajaSol, Caja Guadalajara, Caja Navarra, Caja Burgos, Caja Canarias BBK+Caja Sur, Caja Vital, Kutxa Caja Murcia, Caixa Penedés, Sa Nostra, Caja Granada Caja Asturias+CCM, Caja Cantabria, Caja Extremadura Caja Inmaculada, Caja Círculo de Burgos, Caja Badajoz La Caixa, Caixa Girona Caixa Catalunya, Caixa Tarragona, Caixa Manresa Caixanova, Caixa Galicia España, Duero Unicaja, Caja Jaén Caixa Manlleu, Caixa Sabadell, Caixa Terrassa

SIP SIP SIP SIP SIP Merger Merger Merger Merger Merger Merger

Source: Informe sobre la crisis financiera y bancaria en España, published by the Banco de España in May 2017.

under which each Caja would remain as an independent legal entity with its own board but would place its financial business in a jointly owned bank. Table 22.1 shows the integration process of the Cajas during 2010 and 2011. 22.21

This legal reform was meant to increase size and facilitate access to equity markets, but it stopped short of changing the corporate governance and balance of power in the Cajas. Therefore, rather than solving the funding problems, the mergers had unintended negative consequences.

22.22

First, the logic behind many of these mergers was political rather than economic, with mergers occurring among Cajas controlled by the same political party.12 Second, the increase in size also meant an increase in balance sheet opacity, which



llueca, Norden, and Udell, n 4.

12

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The Spanish Banking Crisis made international institutional investors suspicious of these new entities. Finally, and even more worrying, the mergers created systemic institutions, like Bankia, with assets above 300,000 million euros. It is important to notice that throughout all of this long process the Spanish finan- 22.23 cial authorities made constant reassurances—​and seem to have been really convinced themselves—​that there was only a liquidity problem and that the strength of the Spanish financial system remained strong.13 In fact, the results of the stress test carried out by the Committee of European Banking Supervisors (CEBS) and released on July 2010 showed little recapitalization needs. None of the twenty-​seven Spanish institutions analysed was below the target 6 per cent Tier 1 capital ratio in the base scenario, and only four Cajas failed to meet the target under the adverse scenario. These positive results were consistent with the important effort in credit loss 22.24 provision that the credit institutions had already performed, reaching a total of 138,353  million euros during 2008–​2011. The Spanish credit institutions had taken losses on about 6 per cent of the loan portfolio. Still, the underlying problem was the lack of a credible loss discovery mechanism. 22.25 As Santos explains, ‘merging two opaque balance sheets does not result in a transparent one’.14 Credit institutions had strong incentives to refinance delinquent loans to avoid loss recognition (a practice known as evergreening or zombie lending).15 In February 2011 the Socialist government passed a new law (Real Decreto Ley 2/​ 22.26 2011) that finally recognized the inefficient organization of Cajas and forced them to issue equity, increasing their capital requirements. The SIPs that had been created under the previous Real Decreto Ley 11/​2010 were reluctant to issue equity since this would reduce the control rights of the Cajas. The new law introduced a new requirement for Tier I capital to be above 8 per cent of risk weighted assets,

13 The governor of the Bank of Spain, Miguel Angel Fernández-​Ordóñez, in a statement to parliament on 7 October 2008 said that the ‘Spanish financial system is well managed, well regulated and well supervised’. The idea that the Spanish financial system was in a good position to face the global financial crisis is carefully discussed in JA Álvarez, ‘La banca española ante la actual crisis financiera’, Estabilidad Financiera (2008), 15, 21–​38. 14 T Santos, ‘El Diluvio: The Spanish Banking Crisis, 2008–​2012’, Columbia Business School and NBER Working Paper (2017), available at https://​www8.gsb.columbia.edu/​researcharchive/​articles/​25448, accessed 19 November 2018. 15 See ‘Zombie Buildings Shadow Spain’s Economic Future’, The Wall Street Journal, 16 September 2010, arguing that ‘Instead of disclosing troubled credit, many Spanish lenders have chosen to refinance loans that could still prove faulty and to report foreclosed or unsold homes as assets, often without posting their drop in market value’. Empirical evidence of zombie lending in Japan is provided by RJJ Caballero, T Hoshi, and AK Kashyap, ‘Zombie Lending and Depressed Restructuring in Japan’, American Economic Review (2008), 98, 1943–​77. See also M Bruche and G Llobet, ‘Preventing Zombie Lending’, The Review of Financial Studies (2014), 27, 3, 923–​56, explaining why zombie lending is both difficult to detect and to credibly deny by financial institutions during a crisis period.

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga and above 10 per cent for the entities that had not yet placed at least 20 per cent of their capital in public equity markets. This effectively forced the SIPs to issue equity and to reduce their control grasp over the newly created banks. To help the entities cope with these new requirements, in March 2011, the Bank of Spain made public its estimations of additional capital requirements for each entity and required the deficitary entities to present their recapitalization plans by April 2011. Among the entities that needed to recapitalize, four Cajas opted for selling their shares to the FROB,16 who acquired over 90 per cent of their capital. Only two Cajas, Bankia and Banca Cívica, opted for an initial public offering (IPO), raising respectively 3,000 and 600 million euros in July 2011. By then, Bankia had become ‘too-​big-​ to-​fail’, as was to be painfully revealed only a year later.

IV.  The Bankia Case: The Bank that Broke Spain 22.27

On 19 July 2017, Miguel Blesa, former CEO of Caja Madrid (1996–​2009), was found dead in his hunting grounds in Cordoba. He had committed suicide. He was facing a six-​year prison sentence for mismanagement during his presidency.17

22.28

Blesa, a lawyer with a successful career in public office, was a close school friend of President Aznar. He presided over the boom years during which Caja Madrid expanded very quickly. Total assets increased from 33,000 million euros in 1996 to 190,000 million euros in 2009. During this period the board of the Caja was dominated by the conservative party that ruled the Madrid Autonomous Community. An internal audit by a new and independent management team in 2012 discovered that Blesa had started the practice of offering the board members credit cards as part of their compensation packages. Initially intended for protocolary expenses, the practice soon degenerated into fiscally opaque and limitless compensation. These ‘black cards’ would later become the symbol of all the corporate governance problems of the Cajas.

22.29

In 2010, when Cajas were forced to merge, Caja Madrid became the leading institution in Bankia, the bank that resulted from the merger between Caja Madrid and six smaller Cajas. Interestingly, almost all of these Cajas were also controlled by Partido Popular and at least one of them, Bancaja, from the region of Valencia, was known to have severe solvency problems.

22.30

Bankia, with assets above 300,000  million euros, became a systemic institution. By this time Blesa had been replaced by a much more qualified manager, Rodrigo

16 Novacaixagalicia, Catalunya Caixa, Unnim, and CAM. 17 This infamous title, ‘The Bank that Broke Spain’, was awarded by the Financial Times on 21 June 2012.

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The Spanish Banking Crisis Rato, who was a former finance minister of Aznar (1996–​2004) and managing director of the International Monetary Fund from 2004 to 2007. Recognizing the risks posed by this new financial giant, the authorities devised a 22.31 particular structure to segregate and clarify its balance sheet and to enhance Bankia’s access to credit markets. Two banks were created, a good one (Bankia) and a bad one (BFA). Under this very reasonable resolution plan, BFA would initially own 100 per cent of Bankia, and would hold the most toxic assets and some liabilities. Nevertheless, the credibility of the segregation of the balance sheet into two banks was low. The reasons for this was the unattractiveness of bail-​ins of the preferentes and the wish to minimize taxpayer exposure. In order to prevent the emergence of a really bad bank there was an incentive to leave many of the non-​performing assets in Bankia. In year 2011, after the passage of Real Decreto Ley 2/​2011, Bankia’s capital was 22.32 found to be below the 8 per cent minimum limit for Tier I capital and a recapitalization plan that required an IPO was devised under the supervision of the Bank of Spain. The IPO took place in July 2011. The price at which Bankia went public, 3.75 22.33 euros, was below the prospectus range (4.41–​5.05 euros). This indicated the low interest that the offer received from institutional investors. In fact, just like in the case of preferentes, most of the shares were sold to its small depositors through Bankia’s retail branches, which received instructions to place as many shares as possible among their customers. Finally, on 20 July 2011 Bankia went public with a total market capitalization of 6,496 million euros.

V.  The Unhappy Ending In December 2011 the government changed hands, but the new conservative gov- 22.34 ernment of Partido Popular was still optimistic. And, maybe, there could still have been a happy ending if Spain had not suffered a double dip during 2012–​2013. Since the beginning of 2012 the global economic situation began to deteriorate again and the Greek crisis became a crisis of confidence in the euro and its most vulnerable economies. As a result of the first dip, Spanish public debt, which stood at a modest 35.6 per cent of GDP in 2007, had increased to almost 70 per cent by 2011. Financial conditions for Spain became extremely tight, with the risk premium of Spanish government bonds relative to German bonds reaching 700 basis points at its peak. Spain entered a second recession, which was harder to bear than the first, with GDP contracting by 4.6 per cent, unemployment reaching a historical maximum of 27 per cent during the first quarter of 2013, and housing prices dropping by 44 per cent in real terms. Spanish public debt would reach a peak of 100 per cent of GDP in 2014.

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga 22.35

During this period, the percentage of non-​performing loans reached a maximum of 14 per cent in 2013, with non-​performing loans in the construction sector reaching an astonishing 37 per cent. Figure 22.04 shows the evolution of non-​performing loans from 2000 until 2016. 16 14 12 10 8 6 4 2 Jan-15

Jan-14

Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

0

Figure 22.04 Non-​performing loans (%) Note: Ratio of Non-​Performing Loans over total loan portfolio of credit institutions (BE040312 divided by BE040301 and multiplied by 100). Source: Boletín Estadístico Banco de España.

22.36

Just before the beginning of this ‘perfect storm’ one of the first measures of the new cabinet, hoping to restore the credibility of the financial system, was to raise the required provisions for bad loans under Real Decreto Ley 2/​2012.18 Unfortunately this measure had completely the opposite effect to the one intended. With meagre profits, financial debt markets closed for Spain, and with a drop in the Spanish stock exchange of more than 30 per cent, the banks were unable to reach the new requirements.

22.37

In May 2012, with the shares of Bankia trading at 3.25 euros, its management team, still dominated by the political class, was forced to step down. It was replaced by a team of highly reputed professional bankers. The new team restated the profits for 2011 from a net gain of 309 million euros to a loss of 3,030 million euros and disclosed that the bank needed a capital injection of 19,000 million euros.

22.38

This was terrible news that made Bankia’s price fall by 83 per cent and that ultimately threatened the solvency of the whole system. Through the Real Decreto Ley 2/​2012 the FROB only had received additional funding for up to 6,000 million

The extent of the new provisions was established at 50,000 million euros.

18

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The Spanish Banking Crisis euros, not even enough to assist Bankia, and the accounting restatement had raised fears that other institutions also had hidden problems. As Santos points out, when the FROB was designed with a commitment to increase its capital as needed, the regulator did not consider the possibility that when the funds might be needed the government would be unable to provide them.19 The lack of funding and the problems in the sovereign debt market now threatened the solvency of the country. In this scenario, the Spanish government was forced to nationalize the bank and request assistance from the European authorities. An agreement was reached on 25 June 2012 under a Memorandum of Understanding (MoU) offering an amount of 100,000  million euros and stating restructuring measures that should be implemented from July 2012 to June 2013.20 The implementation was carried out through the passing of two new laws. The first of these two norms was the Real Decreto Ley 24/​2012 passed in August 22.39 2012, which would later be turned into Ley 9/​2012 in November 2012. The main novelty that this law introduced over the initial scheme of the FROB was that it established bail-​in mechanisms to force the holders of preferentes and other subordinated debt to assume part of the costs of recapitalization. This was problematic because 83 per cent of these instruments were in the hands of small investors. This caused social unrest and exposed the incorrect commercialization practices that had been common in the placing of subordinated debt and equity issues through the branch network of banks and Cajas. The second norm, Ley 26/​2013, was the final chapter for the financial business of 22.40 the Cajas. It meant a radical change in their legal status. If Cajas wanted to continue operating as banks they would have to keep to their traditional characteristics, maintaining a local focus and social character and respecting strict limits on their geographical expansion and deposit volume. Importantly, Cajas were forced to professionalize their management teams. In particular, the new law imposed: (i) a majority of expert independent board members; (ii) an increase in the number of board members nominated by the depositors; (iii) the exclusive dedication of the executive president of the board; and (iv) a public annual report on board remuneration. Today only two very small Cajas exist in Spain.21 All other Cajas were forced to convert into standard foundations, not being able to function as financial institutions and having to focus only on their role as charities. Moreover, since many of these foundations still maintain significant stakes in the banking system, a special status (fundación bancaria) was designed for any foundation owning, directly or indirectly, more than 10 per cent of a bank. The representation of politicians in these new institutions can never exceed 25 per cent and they are required

Santos, n 14. The final extent of the required funding was 41,000 million euros. 21 Caixa Ontinyent and Caixa Pollenca with joint assets of 1,800 million euros in 2017. 19 20

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Maribel Sáez-Lacave and María Gutiérrez-Urtiaga to prepare a public annual corporate governance report explaining their policies with respect to board composition, remuneration, conflicts of interest, investment, and risk management.

VI. Conclusions 22.41

Reasonable tools to deal with the crisis, such as the FROB, were created early by the Bank of Spain and the Ministry of Finance. The reason why the Spanish banking crisis took so long to resolve was not lack of disposition on the part of the regulator. The problem was that these tools didn’t go beyond technical measures to tackle the recapitalization needs, and never confronted the corporate governance problems of the Cajas that were at the roots of the financial woes of the system. This made the situation deteriorate for too long and lead to a very painful late resolution.

22.42

The corporate governance of the Cajas represented a problem that could only be solved by politicians choosing to give up their control of half of the Spanish financial system. This was never going to be easy, and the successive governments tried to solve the funding crisis without renouncing the political control of the Cajas. The perverse incentives of the governments are clear. First, losing control of the Cajas meant giving up direct political control of the flow of credit, an important source of patronage. Second, loss recognition would expose the mismanagement, and even corruption, of the Cajas, to which politicians had contributed so much. Worst of all, these perverse incentives could be rationalized, and inaction could be justified, as a wish to avoid bail-​ins of the preferentes or taxpayer funded recapitalizations that would cause social unrest.

22.43

Because of these political constraints, the many attempts at partial reforms carried out by the Spanish financial authorities were fated to fail. In fact, the end of the political control of the Cajas was only decided when the situation deteriorated so much that control was removed from the national authorities under the MoU. Only the European financial authority was independent enough from the national political arena to be able to implement the inescapable measures that needed to be taken: unpopular bail-​ins and the removal of politicians from the financial system.

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23 BANCO ESPÍRITO SANTO Anatomy of a Banking Scandal in Portugal José Engrácia Antunes

I. From Cradle to Grave: 150 Years of Banking History A. The origins B. The growth C. The downfall D. The funeral

II. The BES’s Autopsy: On the Causes of Death A. The usual suspect: the global financial crisis

B. The supervisory prop: ‘laissez-​faire’ and other stories C. The explosive blend: banking and commerce D. The War of the Roses: the race for succession E. At the Penthouse: unethical leadership

23.01 23.02 23.04 23.08 23.11 23.13

III. Epitaph

23.14

23.16 23.18 23.20 23.22 23.25

I.  From Cradle to Grave: 150 Years of Banking History The Banco Espírito Santo (BES) was the oldest and one of the largest Portuguese 23.01 banks. It was created in 1869, precisely at the same year that Goldman Sachs was founded, and it was resolved in 2014. A. The origins The BES’s origins began with a small currency exchange and securities business 23.02 (Caza de Cambio) run by José Maria do Espírito Santo e Silva in the centre of Lisbon in 1869. Since then, and until 1920, he founded several banking institutions, such as Beirão, Silva Pinto & Cª (1884–​1887), Silva, Beirão, Pinto & Cª (1897–​1911), and J M Espírito Santo Silva & Cª (1915). After World War I, it was transformed into a public limited liability company in 1920 under the name Banco Espírito Santo, SARL, managing to consolidate its position within the context of

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José Engrácia Antunes national banking by opening agencies and using a renewed management model. In 1937, after merging with another bank (Banco Comercial de Lisboa), it became the Banco Espírito Santo e Comercial de Lisboa (BESCL): the BESCL soon developed into the leading privately owned bank in Portugal, succeeding to quadruple the value of its stock even during World War II, due to the reinforcement of its international presence, business expansion, and connections with wealthy families (Rockefellers, Firestones) and aristocracy (e.g. the King of Spain, Juan Carlos). 23.03

After the revolution of 1974, the bank, as well as all the major affiliated companies, were nationalized and the Espírito Santo family was prevented from doing business in Portugal. The exiled family, however, swiftly reorganized its business and financial interests abroad, in countries such as Switzerland, France, Luxemburg, Brazil, and the United States. In the end, with the wave of reprivatization of the major banks and enterprises during the 1990s, the BESCL was partially back under family control (due to the creation of a holding company in association with the French Credit Agricole) and Ricardo Salgado, one of the youngest members of the Espírito Santo dynasty, took over as CEO of the bank. In 1999, the bank was renamed ‘Banco Espírito Santo’. B. The  growth

23.04

Since the 90’s, after being reprivatized, the BES underwent a staggering expansion, becoming a major financial institution in Portugal, both as a bank, as the head of an economic group, and an economic player.

23.05

The BES was the second major private bank in Portugal, operating in twenty-​ five countries, with net assets estimated at 80 billion euros, with more than 650 branches, more than two million clients, and more than seven thousand employees, and with an average market share of 20.3 per cent. It was also the second largest listed Portuguese bank, the ninth largest contributor to the NYSE Euronext Lisbon (the main Portuguese stock index), and the most internationally reputed of the Portuguese banks (being nominated as the ‘Best Trade Financial Bank’ for five consecutive years by the Global Finance magazine and the sole Portuguese bank to be included on the sustainability FTSE4Good Index).

23.06

However, the BES also became the axis of one of the largest Portuguese corporate groups: the Grupo Espírito Santo (GES). Following a strategy of organic growth, the cash generated by the banking business was used to form a major conglomerate or corporate group with significant investments in diversified businesses (including real estate, construction, transport, agriculture, hotels, energy, and development, among others), and geographical areas (such as Switzerland, Luxemburg, Libya, Angola, Panama, and the United States). The GES group was a large and international corporate group, with hundreds of companies located in different countries, both in financial and non-​financial areas, with a complex internal network.

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Anatomy of a Banking Scandal in Portugal In 2014, the head of the GES group was Espírito Santo Control (ESC), ultimately owned by the Espírito Santo family, which controlled the intermediate holding, Espírito Santo International (ESI), which in turn owned, both directly and indirectly, two major subholdings: Rioforte, a holding in the non-​financial area of the group, owning and controlling dozens of commercial companies (e.g. real estate, transport, hotels, mining, and energy); and Espírito Santo Financial Group (ESFG), a holding in the financial area, which controlled the BES, as well as more than a dozen financial companies (e.g. insurance, investment services, and brokerage). In addition, it is worth mentioning that the BES also became a key player in 23.07 the Portuguese economy:  in 2013, it held 25.5 per cent of the market share in the enterprise segment, being considered the financial motor for Portuguese small and medium enterprises, while at the same time having important interests in the Portuguese larger non-​financial companies (namely, Portugal Telecom). In 2011, the leader of the BES, Ricardo Salgado, was nominated as the most powerful businessman in Portuguese economy by the financial magazine Jornal de Negócios—​earning him the nickname ‘lord of all this’ (‘dono disto tudo’). C. The downfall After decades of ‘annus mirabilis’, where the BES became the pivot in the for- 23.08 mation of a large, internationally based conglomerate, a long and intricate chain of events occurred during 2013 and 2014—​truly ‘annus horribilis’—​eventually bringing the BES down. In May 2011, in the wake of the global financial crisis, Portugal entered into a three-​ 23.09 year ‘program of economic adjustment’ (2011–​2014) in return for bailout assistance of 78 billion euros from a so-​called ‘troika’ of official lenders (the International Monetary Fund (IMF), the European Union, and the European Central Bank (ECB)). During 2013, the first signs of instability appeared. In March 2013, rumours about financing difficulties at some of GES’s holdings began to circulate, revealing an off-​balance sheet exposure of BES clients to the GES group in excess of 1.8 billion euros. In September 2013, the Bank of Portugal, in its supervisory authority capacity, ordered a full forensic audit on Espírito Santo International (ESI), a top holding company of GES:  it soon transpired that the group’s debt had been underestimated since at least 2008, with a negative equity of 2.4 billion euros and a total unrecorded debt of 6.3 billion euros, almost 80 per cent of which was held by the BES and its customers (4.9 billion euros). In November 2013, the race to succession in the group leadership within the Espírito Santo family began: José Maria Ricciardi, CEO of an investment bank of the BES (BESI), challenged the leadership of his cousin, Ricardo Salgado, claiming loss of trust in his management and conduct. In January 2014, a huge financial hole in the BESA,

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José Engrácia Antunes the Angolan subsidiary of the BES, was exposed, revealing that it had unrecorded and uncovered credit exposures of up to 5.7 billion euros (equivalent to 220 per cent of the subsidiary’s deposits), more than 60 per cent of which were funded by loans from its parent company, the BES (3.5. billion euros). In February 2014, during the presentation of the BES’s annual report, the BES’s CEO announced a loss of 0.5 billion euros and, while rejecting the Troika bailout funds still available to Portuguese banks, mentioned a future increase of capital. In May, the BES announced a stock capital increase of approximately one billion euros, at a price of 0.65 euros, at a time when the stock was trading at 1.06 euros: the prospectus was the first document that publicly disclosed the existence a very poor financial situation at the top of the GES group. 23.10

In spite of the success of the capital increase (supported by a strong underwriter syndicate), events accelerated in the opposite direction over the following two months, sealing the fate of the BES. By the end of May, only a few days after the BES capital increase, rumours grew about the delicate financial situation of the group holding ESI and the BES share prices tumbled. On 20 June, Ricardo Salgado, the bank’s CEO, announced he was leaving the BES administration. On 3 July, the group financial holding ESFG announced that its exposure to the GES group had increased by almost 70 per cent (2.4 billion euros) due to the reimbursement of GES commercial paper sold to the BES’s retail clients. On 10 July, the Portuguese securities exchange commission (CMVM) suspended trading on ESFG’s shares due to overwhelming selling pressure. On 13 July, in order to restore confidence to markets and the public, the Portuguese central bank (BdP) forced the exit of Ricardo Salgado, the bank’s CEO, and Amílcar Salgado, the bank’s CFO. On 14 July, with the support of the BdP, a new executive committee for the management of the BES is announced, lead by Victor Bento, a former BdP director, as the new bank’s CEO. On 18, 22, and 25 July, respectively, the group holdings ESI, Rioforte, and ESFG filed for creditor protection in Luxemburg after defaulting on their obligations. On 26 July, Ricardo Salgado was detained for questioning by police officers in an unrelated tax fraud and money laundering investigation. He was later released on bail for 3 million euros. On July 30, the BES’s new executive committee presented the results of the second quarter of 2014, announcing record losses of 3.5 billion euros (mostly due to impairment of GES exposure, SPV operations, and bond losses issues). These losses reflected seriously detrimental acts of mismanagement, as well as intragroup exposures issuing from the violation of previous determinations of the Portuguese supervisory authority establishing ring-​ fencing prohibitions amongst entities of the GES group. On 1 August, the CMVM suspended trading of the BES’s shares, as they were falling to about 50 per cent of their value (being traded at 0.12 euros), while customer panic caused a withdrawing of bank deposits to the value of two billion euros.

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Anatomy of a Banking Scandal in Portugal D. The funeral On 3 August 2014, the Portuguese central bank (Banco de Portugal (BdP)) pro- 23.11 posed the resolution of the BES. This decision, which sentenced to death an institution with one and a half centuries of history, was the end of a very long and intricate chain of events. Facing the imminent suspension of its counterparty status with the ECB, and given 23.12 the systemic risks involved to the overall banking system, the Portuguese resolution authority (BdP) decided to apply to the BES a resolution measure in the form of the bridge institution tool, which was speedily approved by the European Commission and which essentially split the bank in two. On the one hand, the BES was left behind as a ‘bad bank’, with the equity (3.7 billion euros) and liabilities to subordinated creditors (927  million euros), as well as other toxic assets, contingent liabilities, and claims of related parties. On the other hand, a new ‘good bank’ was formed, incorporating all the staff, branches, deposits, and credit customers of the BES and assuming the rest of its balance sheet, including deposits, senior debt obligations, and healthy assets:  this newly created bridge institution was named Novo Banco (NB), whose share capital of 4.9 billion euros was fully subscribed and held by the ‘Portuguese Resolution Fund’. The resolution measure was taken with the goal of ensuring the continuity of the services provided by the resolved bank BES (which is now under liquidation) while preparing its future sale to private parties: in October 2017, the NB was acquired by the American private equity firm, Lone Start Fund, who purchased 75 per cent of its share capital in return for a capital injection of one billion euros. Aside from the case of improbable resurrection, the BES was dead.

II.  The BES’s Autopsy: On the Causes of Death The BES was a Portuguese institution with one and a half centuries of history. It 23.13 survived to two world wars, it prevailed over different political regimes (a monarchy, a republic, and a revolution), and it endured diverse economic regimes (nationalization and subsequent reprivatization). What reasons might then explain the abrupt end of such an apparently solid institution? While the story of the BES collapse has yet to be fully unveiled, there is a set of plausible causes of death which, at least in abstract, may be considered here. Was the BES’s collapse a by-​product of the global financial crisis of 2007–​2008? Was it a result of failures of banking supervisors or regulators? Was it due to the organic growth of the BES leading to a conglomerate with a dangerous mix of financial and commercial activities? Or was it instead a result of family quarrels at the heart of a family-​based business? Finally, was the bank’s collapse caused by unethical leadership?

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José Engrácia Antunes A. The usual suspect: the global financial crisis 23.14

A first possible cause of the BES collapse is the global economic and financial crisis of 2007–​2008. In fact, this crisis brought to light some hidden vulnerabilities of the Portuguese banks, including over-​reliance on wholesale funding resulting in low levels of liquidity (with one of the highest loan-​to-​deposit ratios in the euro area, increasing from 100 per cent in 1999 to 172 per cent in 2008) and credit concentration and misallocation (which was heavily concentrated in the real estate and construction sectors, rocketing from 8.4 billion euros in 1999 to 26.1 billion euros in 2008, accounting for 70 per cent of the total credit portfolio by 2008, exposing them to the crash in those industries). On top of this, the financial crisis quickly evolved into a sovereign debt crisis, with large feedback repercussions in the banking system: unable to repay or refinance its debts, Portugal entered a three-​year ‘program of economic adjustment’ (2011–​2014) in return for bailout assistance of 78 billion euros from a so-​called ‘troika’ of official lenders (IMF, the European Union, and the ECB).

23.15

While the market turmoil and the country bailout certainly accelerated the BES collapse, it was not its cause. As had happened with most of the other Portuguese banks, the BES had a little exposure to toxic financial instruments related with the American subprime credit. Of the largest Portuguese banks, the BES was the only one who rejected resorting to taking the 12 billion euros of Troika bailout funds made available to the Portuguese banking industry: instead of state aid, the BES undertook a succeeded capital increase of one billion euros by mid 2012, thereby rising its Core Tier 1 ratio to around 11 per cent (above the minimum fixed by Portuguese bank supervision authorities). Above all, the history of the BES proves its resilience to extremely adverse environmental conditions:  a bank institution that survived the Great Recession of 1929 and two world wars, while quadruplicating its worth in the process, has unequivocally proven to be prepared to pass any stress test. B. The supervisory prop: ‘laissez-​faire’ and other stories

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Another usual suspect for the banking crisis is banking supervision: although it is not a supervisor’s role to prevent bank failures, supervisory oversight is crucial to reduce both the probability and impact of such failures. At this point, one should underline that the BES collapse was not an isolated case: as a matter of fact, before and after the BES downfall, a good deal of Portuguese banks underwent various forms of crisis, including ‘Banco Português de Negócios’ (which was nationalized in 2008), ‘Banco Privado Português’ (whose liquidation was ordered in 2010), and ‘Banco Internacional do Funchal’ (which was bailed-​in in 2015). It is now increasingly clear that the crisis of the Portuguese banking system could never have reached such a scope and dimension unless the Portuguese central bank, as the

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Anatomy of a Banking Scandal in Portugal national supervision and resolution authority, had failed to perform its basic prudential mission. To put it bluntly, according to some viewers, during the first decade of the twenty-​first century, the Portuguese central bank (BdP), lead by a former general-​secretary of the Socialist Party, had been little more than a mere decorative piece installed in its ivory tower, remaining oblivious to the significant macro and microeconomic changes then occurring at the level of the banking system that it was supposed to oversee. No wonder that the measures to prevent the BES collapse undertook by the BdP 23.17 from 2010 onwards, already under the leadership of a new Governor, Carlos Costa, were doomed to fiasco. In 2013, somehow anticipating the Asset Quality Review strategy of the ECB, the BdP ordered a full forensic audit of the GES in order to identify possible hidden debts in other group holdings and subsidiaries that could materially affect the BES: as a result, a total unrecorded debt of 6.3 billion euros was disclosed, almost 80 per cent of which was held by the BES and its costumers (4.9 billion euros). As many of those group members, due to their non-​financial nature and foreign registered offices, were not subjected to its prudential supervision, the BdP sought to implement a ‘ring-​fencing’ strategy aimed at immunizing the BES and its customers from the credit exposure to GES. During the first half of 2014, the supervising authority also undertook other measures, such as, for instance, imposing on the ESFG, the holding company of the BES, the liability to redeem the BES retail clients who acquired commercial paper issued by GES (in the amount of some 700 million euros) and to increase its solvency ratios. But it was just too late. C. The explosive blend: banking and commerce As mentioned earlier (see Section I.B), contrary to other Portuguese banks, the BES 23.18 sought to undergo a strategy of organic growth, thus becoming the financial key to the formation of the Grupo Espírito Santo (GES), an international and diversified corporate group composed of both financial and non-​financial companies located in different countries. One may thus wonder whether there were also structural factors concerning group organization to be considered when assessing the causes of the BES collapse. There is an old debate on the separation between commercial banking and in- 23.19 vestment banking, as well as, more broadly, between banking and commerce. The recent crisis revived this debate as concerns about the negative effects of the lack of such separation in Europe have become increasingly intense: an example is the so-​ called ‘Liikanen Report’ (Report of the European Commission’s High-​Level Expert Group on Bank Structural Reform of 2012), proposing a separation or ring-​fencing of high-​risk and third-​party trading by universal banks. The integration of the BES within the perimeter of a broader economic group, the GES, seems to confirm

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José Engrácia Antunes those concerns. For years, the cash generated by the banking business was used to develop a conglomerate composed of commercial companies operating in diversified businesses (e.g. real estate, construction, transport, agriculture, hotels, energy, and development, among others). This group ownership structure is also likely to have induced credit misallocation in commercial and industrial sectors of the group, exposing them to the crash in those sectors, with the subsequent climb of non-​performing loans resulting in huge impairment losses. On top of this, as large parts of the GES were not subjected to any prudential supervision, regulators and supervisors faced difficulties seeing the boomerang dangers lurking beneath the surface of the BES organization, namely the exposure of the bank to the risk of refinancing the debts of other group members. D. The War of the Roses: the race for succession 23.20

One of the main reasons for the BES’s longevity was undoubtedly its ownership model: family businesses usually out-​perform non-​family owned firms over a long period of time, and the BES is a good example of that. Since its creation in 1869 by José Maria do Espírito Santo e Silva, and safe for the short period of time after its nationalization in 1974, the history of the BES has been always inextricably linked with the history of the family Espírito Santo—​which thus also became the oldest banking dynasty in Portugal.

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Family-​owned firms, especially big ones, face, however, a major challenge: how to manage succession from one generation of leaders to the next while avoiding the destructive force of family quarrels and disputes. It is clear that, after more than a century of successfully dealing with such challenges, the family went through a ‘War of the Roses’ that eventually advanced the BES’s collapse. As a matter of fact, the entire GES was governed and overseen by an unofficial board, named Top Council (‘Conselho Superior’):  this council, composed of representatives of the major branches of the family tree, was actually above the group formal structure and took the most strategic decisions concerning any relevant group matter on a consensual basis. From 1991, when he became CEO of the BES (then BESCL), Ricardo Salgado was the undisputed leader of the group, being the mentor of its strategic development for two decades. However, during 2013, rumours about a race for succession within the group started to circulate. In November 2013, José Maria Ricciardi, cousin of Ricardo Salgado and son of António Ricciardi (the eldest of the members of the Top Council), challenged Salgado’s leadership, claiming loss of trust in his management both at a professional and personal level. The 14 million euro alleged ‘gift’ received by Salgado from a bank customer, who’s lawfulness was certified by the legal opinion issued by law professors of the University of Coimbra, became an well-​known episode in this respect. Other members of the family, like Ricardo Abecassis Espírito Santo (another cousin of Salgado’s and chairman of BES Investimento in Brazil), also entered the race for succession. In

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Anatomy of a Banking Scandal in Portugal its capacity as supervisor authority, the BdP forced an armistice agreement between the contenders in order to ensure the stability of the BES in that delicate moment of its life, with the Top Council expressing a unanimous vote of confidence in Salgado’s leadership. But the poison of the hidden ‘War of the Roses’ had already corroded the foundations of the family’s unity, at precisely the time it was most needed, thus sealing its fate. E. At the Penthouse: unethical leadership The importance of ethics on business, and the disruptive impact of unethical be- 23.22 haviour of CEOs and top management in the value and future of firms, is a matter on the agenda. To be true, this is nothing new: already in 1494, the Italian Medici Bank, owned by the Medici family, went bankrupt after running up large debts due to the family’s reckless spending, extravagant lifestyle, and failure to control their managers. But recent scandals bringing down large publicly held companies, at the turn of the second millennium, such as Worldcom (2000), Enron (2001), Parmalat (2003), Madoff (2008), and others, pushed it again to the forefront of public attention, media debate, and scientific research. Ricardo Salgado was the undisputed mentor and head of the BES and of the 23.23 GES for more than twenty years. He was the acknowledged leader of the BES:  notwithstanding that the bank was governed by a large board of directors including several family members, representatives of other major shareholders, and independent directors, board meetings were often said to be a mere formality for the approval of the CEO business policies and decisions. Salgado was also the indisputable frontrunner of GES, responsible for the strategy of rebuilding and developing one of the largest Portuguese business conglomerates, with significant investments and interests both internationally and internally (including, in some larger Portuguese non-​financial companies, such as Portugal Telecom). Finally, pursuing a tradition of banking dynasties, he was able to maintain ties with successive governments and exert influence in major areas of the Portuguese corporate sector. It is thus no wonder that in 2011 Salgado was nominated the most powerful businessman in Portugal by the financial magazine Jornal de Negócios, earning him the nickname ‘lord of all this’. However, leadership is a double-​edge sword: leaders may go from genius to dunce 23.24 in a heartbeat. It is a fact that the misuse of the BES lending money to its own shareholders, the exposure of the bank and of its clients to ruinous businesses from the GES, the uncontrolled default bank loans to BESA, the accounting concealment of the real financial situation of the group holdings, and other similar harmful events that dug the bank’s grave, occurred under the kingship of Salgado. On top of this, he was involved in a number of criminal proceedings, including unrelated proceedings of tax fraud and money laundering (Operação Monte Branco): in 2016 he was

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José Engrácia Antunes fined by the BdP up to 4 million euros, and banned from any banking activity (a final decision is still pending); and in 2017 he was also indicted in a vast criminal proceeding involving a former Portuguese Prime-​Minister, José Sócrates (who was in charge from 2005 until 2011, shortly before the country’s bailout), along with a long list of other well-​known Portuguese politicians and businessmen (Operação Marquês). It is no wonder that, in 2014, he was nominated the worst CEO of the world in the ‘Finkelstein’ ranking.

III. Epitaph 23.25

In the most famous Portuguese book ever written—​the epic poem ‘Os Lusíadas’ (1572)—​Luís Vaz de Camões sung that ‘a weak king makes weak strong people’ (Canto III, verse 138). In this verse, the greatest Portuguese poet alludes to King Fernando I, later surnamed ‘The Inconstant’, who, thanks to his feeble and erratic governance, turned Portugal into a weak and submissive country steeped in futile palace intrigue and frivolous wars with the Kingdom of Castil, paving the way to a broad political and social crisis arising immediately after his death. Once again, in a single stanza, the inspired pen of the poet immortalized a recurrent governance feature of a country, with an almost millenarian history, capable of the best and the worst—​where great and memorable leaders, responsible for major achievements (e.g. Prince Henrique, mentor of the Portuguese Discoveries of the fifteenth and sixteenth centuries, that gave new worlds to the world) have perplexingly coexisted and alternated with insignificant, disruptive leaders who swiftly fade into oblivion.

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The downfall and subsequent death of the BES shall remain in future as a symptom and a symbol of the ongoing crisis of the III Portuguese Republic. Of course, as previously discussed, the bank’s autopsy may suggest a number of other possible causes of death, ranging from macroeconomic and external factors (global financial crisis, soft supervision) to microeconomic or internal ones (group structure, family battles, unethical leadership). However, in this author’s opinion, the decisive reason for the collapse of such a long-​established institution—​which survived two world wars, one Great Depression, and a nationalization—​lies elsewhere. It is simply the by-​product of the collapse of an entire political regime, induced by a succession of weak, unqualified, and even sometimes obscure leadership, who have caused the main political, economic, social, and cultural institutions of the country, both public and private, to fall one after the other before our own eyes.

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24 GOVERNANCE PROBLEMS IN DUTCH FINANCIAL INSTITUTIONS FROM 2007 TO 2017 Bas de Jong

I. Introduction II. The Case of DSB Bank

24.01 24.05 A. Origins and structure of DSB bank 24.05 B. Governance at DSB bank 24.08 C. Culture at DSB bank 24.12 D. DSB’s downfall 24.13 E. Subsequent developments 24.14

III. Reflections on Governance and Supervision in the DSB Case 24.15 A. Special features of bank governance

24.15

B. DSB’s flawed governance: an inadequate board and the presence of a controlling shareholder 24.16 C. Supervision on culture and governance 24.21

IV. Legislative and Policy Changes after DSB V. EU Rules and the DSB Case VI. Main lessons from the Netherlands

24.27 24.31 24.35

I. Introduction From 2007/​2008 and onwards, the Netherlands had its fair share of serious problems 24.01 involving financial institutions. Three cases are especially worth mentioning: (i) the takeover of ABN AMRO Bank by a consortium involving Fortis Bank, Santander, and RBS and the subsequent rescue of Fortis/​ABN by the Dutch state; (ii) the collapse of DSB Bank after a bank run; and (iii) the nationalization of SNS Reaal (the holding company of bank and insurance companies) by the Dutch state. The takeover of ABN AMRO Bank in 2007 was followed by financial distress at 24.02 the acquiring bank Fortis. Fortis was dangerously exposed to the effects of the financial crisis. It issued a prospectus to raise additional capital in 2007, but ultimately it was unable to avoid financial distress and had to be nationalized in 2008. The Dutch state had to buy several of the former parts of ABN AMRO. Governance problems in this case related to misrepresentation and nondisclosure

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Bas de Jong of information. Fortis was subject to claims by injured investors that is was guilty of misrepresentation in its prospectus and other corporate communication, and failed to timely disclose inside information. A settlement has been achieved for 1.3 billion euros, which the Amsterdam Court of Appeal has declared binding on all investors. 24.03

In 2009, DSB Bank collapsed after a bank run. DSB Bank was not a systemically relevant bank, so the Dutch state did not nationalize the bank. Nevertheless, DSB’s bankruptcy sent a shockwave through the Netherlands. Some prominent politicians were also involved as board members at DSB Bank. The government commissioned a report to analyse what went wrong. The Commission-​Scheltema issued a report, which stated that the ‘governance of DSB is the core of the problem that led to its fall’.1 The many governance problems will be further explained below. The third case deals with the the nationalization of SNS Reaal in 2013. SNS Reaal was the holding company of banking and insurance companies in the group, and was considered systemically relevant. It had a ‘sick’ unit in the group, namely real estate holdings on which it suffered heavy losses. Ultimately, its financial position became compromised. The Dutch state expropriated the shareholders and holders of subordinated loans. It is unclear whether there was a failure of corporate governance in this case, especially regarding the acquisition of the real estate holdings. Shareholders have initiated so-​called inquiry proceedings at the Amsterdam Court of Appeal, but so far the court has only dealt with formal issues.

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The remainder of this chapter focuses on the DSB case. It is the clearest example of governance problems among Dutch financial institutions during the last ten years. The details of the case will be spelled out first (Section II). Subsequently, the chapter will reflect on DSB’s flawed governance and supervision on culture and governance by the supervisory authorities (Section III). The DSB case led to legislative and policy changes (Section IV). After the collapse of DSB in 2009, many rules have been adopted at the European level dealing with governance of financial institutions and supervision. Whether these prevent cases such as DSB will be assessed in Section V. Finally, the chapter concludes with the main lessons from the Netherlands (Section VI).

II.  The Case of DSB Bank A. Origins and structure of DSB Bank 24.05

DSB Bank originated out of intermediary companies owned by Dirk Scheringa. They provided intermediary services between providers of credit and consumers.

1

Scheltema et al, Rapport van de commissie van Onderzoek DSB Bank, Den Haag, 2010, 267.

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Governance Problems in Dutch Financial Institutions Substantial profits were made by simultaneously offering insurance to consumers. This occurred specifically by offering and selling single-​premium insurance policies, that is, insurance for which the premium is paid up-​front. The provisions that customers paid for these policies were high. In the course of time, intermediation by Scheringa’s companies was partly substituted by providing credit and offering insurance directly. For this purpose, banks and insurance companies were founded. In 2000, a bank licence was obtained by DSB Bank, by then only a small organization. In 2005, a reorganization took place. Intermediation and banking activities were merged together in a new DSB Bank. The organization became much larger and had a different board than the previous DSB Bank. At the end of 2005, DSB Bank obtained a new bank licence. Scheringa was CEO and chairman of the management board of DSB Bank. 24.06 Moreover, he was (indirectly) the only shareholder of DSB Bank. Hence, he had full control over DSB. A simplified structure of the DSB group at the time is depicted in Figure 24.01.

Scheringa

DSB beheer Distributions and loans

Management board: Scheringa and others

DSB Fico holding

Management board: Scheringa and others

DSB bank

DS sport art

Figure 24.01 Structure DSB group

The shares of DSB Bank were (fully) owned by DSB Fico Holding. Scheringa 24.07 was again a member of the management board of this company and indirectly owned all the shares in DSB Fico Holding through DSB Beheer. DSB Beheer was Scheringa’s personal holding company. Through DSB Beheer, Scheringa financed other activities, such as a museum and a soccer club (AZ). For this purpose, DSB Sport en Art Beheer BV was created. To finance the activities, Scheringa used distributions made by DSB Bank and loans which DSB Bank provided to DSB Beheer.

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Bas de Jong B. Governance at DSB Bank 24.08

DSB Bank had a management board and a supervisory board. According to the articles of association during the relevant period, the management board should consist of at least two directors. The general meeting of DSB could appoint, dismiss, or suspend directors of the management board. The supervisory board could also suspend directors. As Scheringa was (indirectly) the controlling shareholder, he ultimately decided on the composition of the management board. In the case of DSB Bank, Scheringa was both CEO/​chairman of the management board and (indirectly) controlling shareholder.

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According to the articles of association, the supervisory board should consist of three members. DSB Bank’s general meeting of shareholders could appoint, dismiss, or suspend supervisory board members. As of 2009, the rules for the supervisory board stipulated that it no longer has advisory rights regarding the dividend policy of DSB Bank. The supervisory board only had to be informed.

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The rules on conflicts of interests between DSB Bank and Scheringa were quite limited in scope until 2009. In case of a conflict of interest between a director of the management board and DSB Bank, the power to represent the company remained with two directors acting jointly, just as in the situation without a conflict of interest. This would only be different if the general meeting appointed someone else to represent the company. The supervisory board had to approve the decision of the management board, but the power to represent the company was not affected. Transactions by the controlling shareholder whereby DSB Bank was also represented by this shareholder had to be documented in written form, although this did not apply in the course of normal business operations. These rules on conflicts of interests resulted in sharp criticism of the supervisory authorities. Eventually, just before the collapse of DSB Bank, new and stricter rules were adopted for the management board. The liberal rules on conflicts of interests may have contributed to the fact that Scheringa’s interests prevailed over the interests of DSB Bank. Large distributions (of dividends) and loans from DSB Bank to DSB Beheer were made to finance the soccer club and museum. This made DSB Bank’s financial position vulnerable.

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The Scheltema Commission report further illustrated governance practices. The composition of the management board changed frequently, notably regarding the key position of CFO. Scheringa and the head of commercial organization were permanently in the management board, but the CFO was replaced four times in five years (2005–​2009). The work atmosphere was informal, also within the management board. This was a deviation from common practice in the banking sector at the time. Decisions were often taken on an informal basis and outside the formal meeting of the management board. Hence, the decision making was not always transparent and testable. Moreover, it was unclear whether important topics

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Governance Problems in Dutch Financial Institutions relating to supervision and the sudden departure of CFOs were ever discussed by the management board. The controlling shareholder and CEO Scheringa had a strong influence on decision making, the composition of the board, and the commercial focus of the organization. The supervisory board was relatively weak. C. Culture at DSB Bank The culture at DSB bank was very commercially focused. Scheringa’s expertise and 24.12 interests were in the area of credit intermediation, not (prudent) banking. The primary focus was commercial, that is, growth of the company and making profit. The Scheltema Commission report observed that there was insufficient attention for a banking perspective in which risks need to be controlled and financial solidity should be a primary focus. This is illustrated by the fact that the management board was permanently staffed by Scheringa and the commercial head, but the CFO was replaced frequently as mentioned above. Further down in the organization, the commercial positions were also more strongly developed. This resulted in a culture that focused more on commercial targets than on controlling risks and respecting duties of care vis à vis customers. Incentives for sales employees related to turnover of commercially interesting products. The total remuneration of approximately 30 per cent of the employees consisted for more than 50 per cent of variable remuneration. For more than 60 per cent of the employees the variable remuneration was more than 40 per cent of the total remuneration.2 The most successful sales employees were specifically recognized and awarded. No attention was given to the way customers were treated in the remuneration.3 Thus, there was an apparent conflict between high-​powered financial incentives and risk management.4 D. DSB’s downfall When DSB obtained a bank licence in 2005, it was a profitable company. 24.13 Commissions on single-​premium insurance policies were its main source of income. However, DSB’s revenue model came under scrutiny, and stricter legislation regarding protection of consumers forced DSB to make changes to its revenue model. DSB recognized this in 2006 and tried to make adjustments. Halfway through 2009 DSB Bank made the strategic choice to continue as an internet bank and abandon its previous revenue model. The consequences of the credit crisis of 2007–​2008 were underestimated. To finance the provision of credit, DSB could no longer use the common ways. This was addressed by attracting deposits. However, deposits are usually withdrawable on demand, which created risks when these deposits were used to finance long-​term credit provision. The granting of credit to

Scheltema et al, n 1, 118. ibid, 268. 4 Armour et al, Principles of Financial Regulation, Oxford University Press, 2016, 378, 383. 2 3

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Bas de Jong DSB Beheer made DSB Bank vulnerable as well. In the course of 2009, the number of complaints from consumers and interest organizations increased. DSB did not professionally deal with these complaints. This resulted in bad publicity for DSB Bank about the way it handled its duty of care. Eventually, Lakeman—​the chairman of a foundation that investigates transparency of companies—​called for a bank run on television, which proved fatal for DSB Bank.5 Other banks were not interested in rescuing (parts of ) DSB Bank, due to the negative publicity and uncertainty surrounding the costs of legal claims. As a result, DSB Bank went bankrupt. E. Subsequent developments 24.14

After DSB Bank’s collapse, the government commissioned an investigation. This resulted in a substantial report of the Commission Scheltema. The report contained numerous recommendations, which resulted in legislative and policy changes (see Section IV). In 2016, former CEO and controlling shareholder Scheringa and the head of the commercial organization settled with the bankruptcy trustees on civil liability. In 2017, the bankruptcy trustees communicated that all creditors could probably be paid.

III.  Reflections on Governance and Supervision in the DSB Case A. Special features of bank governance 24.15

It is acknowledged that banks differ from most non-​financial firms in terms of financing, business models, and balance sheets.6 Banks are highly leveraged, bank failures place high costs on society, and certain types of bank assets are difficult to observe and measure.7 After the credit crisis, it is believed that optimal corporate governance is different for banks than for other firms.8 This section will discuss the DSB case against the background of the themes that are especially relevant in bank governance: the operation of the board of directors (including risk management), shareholder rights, executive pay, and liability rules for directors.9 Moreover, some aspects of supervision that were suboptimal in the DSB case will be commented on.

5 The Dutch government investigated whether criminal enforcement of a call for a bank run was desirable after the DSB scandal. A legislative proposal was drafted, but it was never adopted. 6 Armour et  al, n 4, 370; G Ferrarini, ‘Understanding the Role of Corporate Governance in Financial Institutions: A Research Agenda’ [2017] Ondernemingsrecht 72. 7 Armour et al, n 4, 374–​5. 8 ibid, 370–​90. 9 ibid, 370.

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Governance Problems in Dutch Financial Institutions B. DSB’s flawed governance: an inadequate board and the presence of a controlling shareholder DSB had a two-​tier board structure. The controlling shareholder Scheringa was 24.16 CEO/​chairman of the management board and had the power to appoint and dismiss fellow directors (via the general meeting). This was and is unusual in the Dutch banking landscape.10 In the government report about DSB Bank, it is observed that there was a lack of a balanced governance structure: it was Scheringa’s bank.11 It created the risk that the controlling shareholder’s personal interests would prevail over the interests of the company (DSB Bank) and its other stakeholders. This actually seems to have happened via dividend distributions and loans to the personal holding company DSB Beheer to finance museum and sports activities. Hence, there was insufficient separation of the responsibilities of chairman of the management board and the position of controlling shareholder. The lesson is that at the least it would be necessary to incorporate sufficient checks and balances in the articles of association, to counter the CEO/​controlling shareholder’s power. To take this one step further, one could ask whether the structure of a CEO who is also the controlling shareholder should be allowed at all for banks, due to its inherent risk.12 Arguably, checks and balances in the articles of association and adequate supervision by the state could be sufficient. The author of this chaper does not see a strong argument to prohibit this structure entirely. A further problem is that DSB’s board as a whole, and the CEO in particular, was 24.17 not ‘fit and proper’. There was a dominance of commercial skills and perspective, which particularly applied to Scheringa, at the cost of (knowledge of ) prudent banking. In other words, there was insufficient financial literacy.13 A more balanced board composition might have prevented the resulting problems of the aggressive business model and violations of duties of care towards customers. Scheringa lacked expertise in banking, risk management, audit and compliance, and was not particularly interested in these areas.14 There were attempts to strengthen the management board‘s expertise in these areas, but ultimately these were not successful. The frequent departures of CFOs (four in five years) are illustrative. Unfortunately, the supervisory board in the DSB case was ill-​informed, lacked au- 24.18 thority, and was quite passive.15 It was only informed at a late stage about the

10 Scheltema et al, n 1, 16, 80. 11 See Armour et  al, n 4, 388 who describe governance problems by presence of controlling shareholder. 12 In this sense, see Scheltema et al, n 1, 270. 13 At the conference on governance of financial institutions in January 2018, Klaus Hopt stressed the importance of financial literacy in particular. 14 Scheltema et al, n 1, 92. 15 ibid,  94–​7.

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Bas de Jong financial problems at the controlling shareholder’s personal holding company DSB Beheer, the recruitment and departure of certain CFOs, and certain dividend decisions. There is some debate to what extent the supervisory board members could have done a better job to enforce a better flow of information. The supervisory board lacked authority among members of the management board. It operated more as an advisory board. From the supervisory board’s own perspective, this was an inherent consequence of the CEO/​controlling shareholder model. However, the Scheltema Commission report is more critical: it argues that the supervisory board reconciled itself too much with its limited role, but should have been more proactive. In general, it takes the position that the supervisory board had less powers than is appropriate for a bank, for example, it could not dismiss directors and also did not decide on remuneration. One of the recommendations is then to strengthen the supervisory board in financial institutions through independence requirements and fit and proper testing.16 24.19

The commercial culture at DSB bank trickled down from the board to the organization at large. DSB took more risk than was socially desirable. The apparent conflict between high powered financial incentives and risk management has been mentioned already. Incentives for sales employees related to turnover of commercially interesting products. Such an incentive structure has been reported to be associated with greater default risk.17 To some extent, the European rules for executive compensation in CRD IV have mitigated the possibility for such inadequate incentive schemes (see Section V).

24.20

It has been suggested that liability rules could play a role in good bank governance.18 After DSB’s bankruptcy, the bankruptcy trustees filed a damage claim against Scheringa and another member of the management board (which was settled in 2016). Dutch law makes directors of a company jointly and severally liable for mismanagement if the mismanagement was likely to be a cause of the bankruptcy.19 This rule, which was already in place during the DSB scandal, did not seem to have had a particularly strong deterrent effect in the DSB case.20 In the Netherlands, there have not been strong pleas for stricter liability rules in the discussion about bank governance. 16 ibid,  270–​1. 17 Armour et al, n 4, 383 refer to V Acharya, L P Litov, and S M Sepe, ‘Seeking Alpha, Taking Risks: Evidence from Non-​Executive Pay in US Bank Holding Companies ‘, Working Paper NYU/​ University of Arizona (2014), and S M Sepe and C K Whitehead, ‘Paying for Risk:  Bankers, Competition and Compensation’, Cornell Law Review (2015), 100, 655. 18 Armour et al, n 4, 389–​90. 19 Article 138 and 248 of the Dutch Civil Code. The provision applies to mismanagement in the three years before bankruptcy. 20 During the conference on governance of financial institutions in January 2018, Klaus Hopt was somewhat pessimistic about the usefulness of liability rules for better bank governance. The Dutch DSB case could serve as an illustration.

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Governance Problems in Dutch Financial Institutions C. Supervision on culture and governance In the Netherlands there are two supervisory authorities for banks. The prudential 24.21 supervisory authority is De Nederlandsche Bank, and the supervisory authority for conduct is the Autoriteit Financiële Markten.21 In the Scheltema Commission report, it is correctly stated that the supervisory authorities have the task of monitoring whether a bank’s culture and governance sufficiently take all stakeholders’ interests into account. Relevant interests include shareholders, employees, depositors, as well as the public interest. In the DSB case, the prudential supervisory authority struggled with DSB’s flawed 24.22 governance and commercial culture. It acknowledged the risks that the interests of a particular stakeholder, that is, the CEO/​controlling shareholder, would take priority over other relevant interests. Although there were regular discussions and meetings with DSB Bank‘s board, this did not have the desired results. The Scheltema Commission report concludes that the prudential supervisor could 24.23 have done a better job. Regarding supervision on financial developments, the prudential supervisor did not properly assess the relationship between DSB bank and Scheringa’s personal holding company DSB Beheer. There was pressure on DSB Bank to make distributions and loans to DSB Beheer to finance Scheringa’s museum and sports activities, and there was a lack of adequate rules on how to deal with conflicts of interests. As a result, DSB Beheer had big claims on DSB Bank which jeopardized the latter’s financial position. At the time a bank licence was provided in 2005, the legislation required the pru- 24.24 dential supervisor to assess whether the ownership structure, expertise, and reliability of the board members and the banking organization’s design were adequate. The Scheltema Commission report concludes that the supervisor underestimated the problems in these areas. After the bank licence was provided, the supervisor insisted repeatedly on improvements that needed to be made, but this should have happened already at the time the bank licence was requested. With hindsight, accepting a powerful CEO who was also controlling shareholder and ignorant of banking was a mistake. A bank licence should not have been provided, at least not before significant improvements in the area of governance were made. After the bank licence was provided, the prudential supervisor was well aware of the 24.25 developments at DSB Bank. However, it did not succeed in showing its teeth sufficiently and was too patient. The supervisor followed a softer approach of communicating its concerns and trying to convince DSB to change. The urgency of these

21 Although since 4 November 2014, within the European Banking Union’s Single Supervisory Mechanism (SSM) the supervision of credit institutions (and some other entities) is a shared responsibility of DNB and the ECB.

571

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Bas de Jong messages was not recognized by DSB Bank. Although the supervisor planned intervention measures in the summer of 2009 to deal with DSB’s precarious financial position, these were thwarted by the call for a bank run in the media later in 2009. 24.26

In conclusion, the main lesson from the DSB case regarding (prudential) supervision is that governance should be a central focus in the decision to grant a bank licence, and also in subsequent ongoing supervision. It is better to prevent problems from the beginning than to combat negative consequences of an inadequate structure later on. Supervision should focus on structural factors that determine a bank’s behaviour, rather than on specific cases of non-​compliance with rules.22

IV.  Legislative and Policy Changes after DSB 24.27

DSB’s downfall led to several legislative and policy changes, following up on recommendations made by the government commissioned Scheltema report.23 Important changes relate to fit and proper testing. Where at the time of the DSB case management board members were tested for expertise (and reliability), the test has been widened to a test of fitness (and reliability) of board members, also in view of the total board composition.24 As a result it should be possible to address better the specific problems in the DSB case of having an unbalanced board which consists primarily of commercially focused individuals who lack banking expertise. Moreover, the weak position of DSB’s supervisory board led to a change in legislation so that fit and proper testing now also applies to supervisory board members.25 Finally, changes were made to improve coordination of the prudential and behavioral supervisors on fit and proper testing. Both supervisors need to agree that a person is fit and proper.26 This happened against the background of a conflict between both supervisors regarding the outcome of the test for former minister of finance, Zalm, who was CFO at DSB Bank for a brief period and later became CEO of the (much larger and systemically relevant) ABN AMRO bank.

24.28

After DSB Bank’s demise, the Dutch government announced it would address the governance structure of having a CEO who is also a controlling shareholder. This structure has to date not been explicitly prohibited. However, the supervisory authorities will look very critically at this structure given the lessons from the DSB case. Under current legislation, the prudential supervisor now more explicitly has

22 Scheltema et al, n 1, 269. 23 See Kamerstukken II 2009/​10, 32432, nr 1. 24 See article 2:12, 3:8, 1:77(2), 2:116(1), 2:120(3) and 2:121(3) Wet op het financieel toezicht (Wft). 25 See article 3:8(1) Wft. 26 See article 1:47c en 1:49 Wft. On fit and proper testing, see Iris Palm-​Steyerberg and Danny Busch, Chapter 8, this volume (in particular Section IV.3).

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Governance Problems in Dutch Financial Institutions the power to address concerns regarding governance and culture in financial institutions.27 Hence, it is unlikely that a bank licence by DSB type organizations will be obtained, or maintained over time. It was recommended by the Scheltema Commission report that the culture and 24.29 governance of the supervisory authorities needed to be improved as well, considering how they performed in the DSB case. As a result, several organizational changes were made to the prudential supervisor to improve supervision on culture, behaviour, and risk management of banks and to optimize intervention and enforcement.28 New people were appointed in key positions at the prudential supervisor. The role of the supervisor’s supervisory board was also reinforced. Many other initiatives have been taken after the DSB case that can briefly be 24.30 mentioned here. The first is an increase in intervention powers for the state and the supervisor for banks in financial distress, for example, due to governance problems.29 Furthermore, legislation now requires an oath for all bank employees, enforced by disciplinary rules,30 to promote integrity in the banking sector as a whole. One of the elements of the oath is to act in the interests of clients, which went wrong in the DSB case. Stricter rules on product development have been adopted since 2012. Banks (and other financial institutions) need to have adequate procedures so that clients’ interests are taken into account in a balanced manner when financial products are developed.31 DSB type products would no longer be allowed. The rules on variable remuneration have become much stricter (there is a bonus cap of 20 per cent of the total remuneration, which is stricter than what EU law requires). Dutch banks have also subjected themselves to self-​ regulation in the form of a new banking code, which among other things stresses good governance. Banks need to comply with this code, or explain why they do not follow it.

V.  EU Rules and the DSB Case Since DSB’s bankruptcy in 2009, many new rules have been adopted at EU level 24.31 for banks. Several of these rules address governance at banks. The question thus arises as to what extent a DSB case could still happen within the European Union.

27 See, e.g., article 2:12, 3:10, and 3:17 Wft. Fit and proper testing is also used as a tool to promote prudent banking. 28 See Van analyse naar actie. Uitvoering plan van aanpak cultuurverandering toezicht DNB, 2011, https://​www.dnb.nl, accessed 1 July 2018. See Wijnand Nuijts, Chapter 17, this volume (in particular, Section II). 29 The Intervention Act of 2012, incorporated in the Wft. 30 Article 3:17b and 3:17c Wft. See also Peter Laaper and Danny Busch, Chapter 18, this volume. 31 Article 32 Besluit gedragstoezicht financiële ondernemingen.

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Bas de Jong Some governance measures are briefly looked at here, in particular where they relate to the specific problems in the DSB case. 24.32

The Capital Requirements Directive IV (CRD IV)32 addresses several key points of bank governance which went wrong in the DSB case. For example, CRD IV requires adequate knowledge, skills, and experience of members of the board and the board as a whole.33 The European Banking Authority’s (EBA) guidelines further specify these requirements.34 Fit and proper testing in EU Member States is based on this part of CRD IV. The European Central Bank (ECB) takes fit and proper decisions for the 129 biggest banks it supervises directly. For the less significant banks, decisions are still taken by the national supervisors, except in the case of a new bank licence. According to CRD IV, the management body shall also define, oversee, and is accountable for the implementation of governance arrangements that ensure effective and prudent management of the institution,35 which includes the segregation of duties in the organization and the prevention of conflicts of interests.36 Remuneration policies for board members and material risk-​takers are regulated as well. Specifically, the policy needs to promote sound and effective risk management and does not encourage excessive risk-​taking.37

24.33

Supervisors shall review and evaluate the bank’s governance arrangements.38 This includes the risks to which the institution is or might be exposed, and the business model. Finally, the supervisors shall require an institution to address relevant problems in these areas at an early stage.39

24.34

In the DSB case, compliance with these rules probably would have prevented most or all of the problems. However, it should be noted that fit and proper supervision differs widely across countries, so unbalanced board structures may not be scrutinized in all Member States to the same degree. The intensity of supervision based on CRD IV may also differ more generally between Member States.

32 Council Directive 2013/​36/​EU, OJ L176/​3. 33 Article 91 of CRD IV. 34 ibid. See Joint ESMA and EBA Guidelines on the assessment of the suitability of members of the management body and key function holders, 2017, www.eba.europa.eu, accessed 1 October 2018. 35 See also EBA Guidelines on internal governance under Directive 2013/​36/​EU, 2017, www. eba.europa.eu, accessed 1 July 2018. 36 Article 88 and 74 of CRD IV. 37 Article 92 of CRD IV. 38 Articles 97–​101 of CRD IV. 39 Articles 102 and 104 of CRD IV.

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Governance Problems in Dutch Financial Institutions

VI.  Main Lessons from the Netherlands The main lessons from governance problems at Dutch financial institutions over 24.35 the last decade can be summarized as follows. The DSB case, dealing with a not systemically relevant bank, clearly shows that an unbalanced governance structure can eventually lead to bankruptcy. Checks and balances are especially important if there is a controlling shareholder who is also chairman of the management board, as in the DSB case. These checks and balances can prevent that the shareholder’s personal interests prevail over the interests of the financial institution and its other stakeholders. DSB Bank became vulnerable due to excessive distributions and loans to the controlling shareholder/​chairman’s personal holding company. Board composition and fit and proper testing also matter a great deal. In the DSB case, the controlling shareholder/​chairman lacked expertise in banking. This gap was not sufficiently filled by others in the management board. As a result, a commercial culture was created with insufficient attention for prudent banking and risk management. Incentive pay of employees related to turnover further exemplified and exacerbated this commercial focus. Fit and proper testing in the Netherlands is now stricter, taking into account not only individual board members, but also the board as whole. Civil liability rules were in place and enforced by the bankruptcy trustees, but did not prevent problems, although it did result in compensation for injured parties. Finally, an important lesson is that the supervisor (the ECB) should be strict on governance when it provides a bank licence, because it is better to prevent problems beforehand than to combat negative consequences of an inadequate governance structure later on. Supervisors should also be willing to show their teeth if necessary. In the DSB case, supervisors were considered too passive.

575

576

57

INDEX

access to capital, excessive ease of 21.60 activism, see investors actuarial function of insurance companies 3.54 administrative sanctions  18.02, 18.22 administrators of benchmarks, cross-​sectoral regulation  2.01, 2.17 agency cost theory 16.42 aggressive corporate language, use of 16.62 allowances, see remuneration alternative investment funds liquidity risk management  9.55 portfolios 9.51 regulatory framework  9.51 remuneration 11.56 remuneration policy risk management  9.59 risk management and internal controls  9.51 ‘risk profile’  9.6 asset managers category 1.03 cross-​sectoral regulation  2.01, 2.06, 2.09 focus of governance  1.11 fragility of  1.11 remuneration need for regulatory reform  11.48 regulatory principles  11.53 variable remuneration  11.55 role of  1.05 associates of listed banks, disclosure of inside information to 12.45 audits, cross-​sectoral regulation internal audits 2.18 Australia, conduct risk  19.06, 19.28 ‘bad apples’, notion of 16.61 bail-​ins and no creditor worse off (NCWO) principle 4.17 Banca Popolare di Vicenza (BPVI), collapse of, see Italy Banco Espírito Santo (BES) (Portugal) collapse banking supervision failures  23.16 family succession problem  23.20 Financial Crisis of 2008  23.14 group structural problems  23.18 legacy of  23.22

reasons for  23.13 unethical leadership  23.22 dissolution  23.01, 23.11 downfall 23.08 establishment 23.01 growth 23.04 origins 23.02 Bankia, collapse of, see Spain banks, see also European Banking Union associates, disclosure of information to  12.45 bank governance bank debt-​holders and  6.17 corporate governance in relation  6.01 inside information, and  12.16 Netherlands, see Netherlands post-​crisis reforms  6.05 reasons for failure  6.02 regulatory approval  6.07 banking sector market shares in Germany 14.65 BCBS Corporate Governance Principles for Banks 1.21 BCBS Guidelines  1.17 bundling of lending services and shares sale 21.61 collapse of, indicators of danger of (‘red flags’) bundling of lending services and shares sale 21.61 control of secondary market in bank’s financial instruments  21.63 cooperative structure, problems with  21.57 dominating CEO  21.53 excessive growth  21.59 excessively easy access to capital  21.60 financial illiteracy of investors  21.64 misleading information in financial statements 21.62 collapses and crises, see Banco Espírito Santo; Italy; Netherlands; Spain company law appointment of directors  5.15 board models  5.11 corporate governance  5.03, 5.57 corporate interest  4.46 difference to financial regulatory rules  5.08

577

578

Index banks (cont.) company law (cont.) director diversity  5.20 directors’ duties and tasks  5.26 financial regulatory rules as addition to  5.06 harmonisation, moves towards  5.58 national basis  5.56 prevalence of financial regulatory rules  5.35 regulatory framework  5.01 remuneration policies  5.30 setting aside by financial regulatory rules 5.06 complexity reduction as aim  4.27 conduct risk, definition of  19.29 cooperative banks, see cooperative banks corporate governance bank governance in relation  6.01 definition of  5.03 requirement for  5.57 corporate interest application of corporate interest rules to banks 5.52 Germany 5.51 Netherlands  5.49, 5.53 shareholder-​driven v stakeholder-​driven  5.46 UK 5.48 creditors direct representation of creditor interests 6.37 enforcement by  6.75 indirect representation on board  6.33 regulator representation on board  6.33 crises and collapses, see Banco Espírito Santo; Italy; Netherlands; Spain cross-​border issues  4.22 cross-​sectoral regulation  2.01, 2.04, 2.06, 2.11, 2.21 debt-​holders and bank governance  6.28 directors appointments 5.15 bank regulator representation of creditor interests 6.43 civil liability  4.40, 6.08, 6.52, 6.79 criminal responsibility  6.56, 6.78 cross-​sectoral regulation  2.11, 2.16 direct representation of creditor interests 6.37 diversity 5.20 duties and tasks  5.26 duties of care and loyalty  6.54 enforcement by or against  6.72 groups of banks  6.46 indirect representation of creditor interests 6.33

578

non-​shareholder representation  6.32 regulatory approval  6.07 remuneration 5.30 role of remuneration in Financial Crisis of 2008 11.02 shared by several entities, disclosure of information by  12.47 disciplinary law in Netherlands, see Netherlands enforcement civil liability, regulatory enforcement  6.79 creditors, by  6.74 criminal responsibility, regulatory enforcement 6.78 EU framework  7.40 need for better enforcement  6.72 regulators, by  6.76 whole board, by  6.73 EU Banking Union European Deposit Insurance Scheme  4.06 origin in euro-​crisis  4.05 regulatory framework  4.07 Single Resolution Mechanism (SRM)  4.06 Single Rulebook  4.06 Single Supervisory Mechanism (SSM)  4.06 structure 4.06 EU Member State governments as stakeholders 4.38 European Deposit Insurance Scheme  4.06 family ownership, problem of succession  23.20 Financial Crisis of 2008  4.02 financial instruments, secondary market control of bank’s  21.63 financial intermediary role  1.04 financial regulatory rules (Single Rulebook) addition to company law, as  5.06 definition of  5.02 difference to company law  5.08 European basis  5.56 impact of  5.04 prevalence over company law  5.35 setting aside of company law rules  5.06 Single Rulebook  5.05 fit and proper requirements  8.62 fragility of  1.11 group boards  6.46 information, see inside information key function holder liability  6.69 legal forms of  5.01 lending services bundled with share sales  21.61 liability directors  4.40, 6.08, 6.52 enforcement, and  6.72 key function holders  6.69

579

Index limitations of traditional regulatory focus on 2.20 management information systems (MIS)  4.20 managers, regulatory approval  6.07 multiple point of entry (MPE) strategy  4.23 mutual stakeholders, as  4.38 non-​financial firm governance contrasted  1.09 non-​shareholder representation on board  6.32 performance-​based standards  14.80 regulatory  4.01, 5.01 representation hypothesis  1.28 resolution-​stay clauses in contracts  4.25 resolvability aim of  4.37 assessment  4.10, 4.28 balancing of interests  4.39 decision to remove impediments  4.28 definition of  4.08 directors’ liability for bank failures  4.40 going-​concern requirement, as  4.09 iterative process  4.10 new approach to bank governance  4.37, 4.42 stakeholder groups, identity of  4.37 supervisory review and evaluation process (SREP) 4.32 transformation of bank-​as-​is into bank-​to-​be  4.11 transition to  4.34 resolvable banks complexity reduction as aim  4.27 cross-​border issues  4.22 financial resources  4.16 key features of  4.12 Legal Entity Rationalisation (LER) process 4.14 legal structure  4.15 management information systems (MIS) 4.20 multiple point of entry (MPE) strategy  4.23 no creditor worse off (NCWO) principle for bail-​ins  4.17 operations 4.13 resolution-​stay clauses in contracts  4.25 risk mitigation  4.19 single point of entry (SPE) strategy  4.24 structure 4.13 risk mitigation  4.19 secondary market control of bank’s financial instruments 21.63 senior managers, regulatory approval  6.07 shareholders capital distribution and redemption  5.42 company law  5.38

cross-​sectoral regulation  2.16 disclosure of information to  12.49 further conditions for bank shareholdings 5.40 Single Rulebook  5.39 share sales bundled with lending services  21.61 single point of entry (SPE) strategy  4.24 Single Resolution Mechanism (SRM)  4.06 Single Rulebook appointment of directors  5.24 bank debt-​holders and bank governance 6.28 board models  5.14 contents 4.06 corporate interest  5.46 regulatory approval of directors  6.09, 6.15 respect for national company law  5.05 shareholders 5.39 Single Supervisory Mechanism (SSM)  4.06 state-​ownership, see state-​owned institutions subsidiaries, disclosure of information to  12.38 supervisory review and evaluation process (SREP) 4.32 unethical leadership as cause of collapse  23.22 Venetian banks collapse (BPVI and VB), see Italy Basel Committee on Banking Supervision (BCBS) Corporate Governance Principles for Banks 1.21 Guidelines 1.17 behaviour, see corporate culture and conduct benchmark administrators, see administrators of benchmarks Blesa, Miguel, suicide of 22.27 board of directors appointments 5.15 bank collapses in Italy, role in, see Italy banks, see banks composition requirements  2.11 conflicting interests, fiduciary duties and  20.03, 20.09 corporate culture, and, see corporate culture and conduct creditor representation direct 6.37 indirect 6.33 criminal liability  6.56 criminal penalties  7.42 cross-​sectoral regulation  2.11 decision making  16.65 directors shared by several entities, directors shared by several entities, disclosure of inside information  12.47

579

580

Index board of directors (cont.) diversity criteria company law  5.20, 5.25 Germany 5.22 Netherlands 5.21 Single Rulebook  5.24 UK 5.23 dominating CEO, problem of  21.53 duties and tasks applicable to all directors  7.03 company law  5.26 duty of care  6.54, 7.12, 7.31 duty of loyalty  6.54, 7.207.38 enforcement mechanisms for financial and non-​financial sectors compared  7.39 fiduciary duties  7.03 lessons from Financial Crisis of 2008  7.56 need for regulatory reform  7.48 ‘public governance duty’, proposals for  7.53 regulatory enforcement  7.39 Single Rulebook  5.27 specific to financial institutions  7.27 elections, investor engagement in  13.59 enforcement by or against civil liability, regulatory enforcement  6.79 creditors, by  6.75 criminal responsibility, regulatory enforcement 6.78 need for better enforcement  6.72 regulators, by  6.76 whole board, by  6.73 fiduciary duties category of  7.03 conflicting interests, and  20.03, 20.09 developments in law of  20.15 duty of loyalty  20.10 enforcement of  7.23 financial regulation, as  20.09 scope of  7.04 stewardship principles and  13.41 substance of  7.09 financial institutions duties specific to directors of  7.27 duty of care  7.31 scope of fiduciary duties  7.28 substance of fiduciary duties  7.30 fit and proper requirements, see fit and proper requirements governance responsibilities  7.01 groups 6.46 inadequacies as cause of collapse  24.16 independent non-​executive directors, requirement for  8.19 insurance companies  3.15 investor engagement  13.56

liability assignment of  6.08 civil, reforms to increase  6.60 criminal 6.56 criminal penalties  7.42 regulatory framework  6.52 resolvability, and  4.40 liability insurance  7.18 models Germany 5.12 Netherlands 5.11 Single Rule Book  5.14 UK 5.13 non-​executive directors, fit and proper requirements  8.19, 8.31 organizational requirements  2.15 performance standards  2.15 qualification requirements  2.11 regulator representation of creditor interests 6.43 regulatory approval assignment of liability for regulatory failures 6.08 influence of prudential supervisors  6.07 Single Rulebook  6.09, 6.15 UK 6.10 remuneration, see remuneration risk committees  7.35 Venetian bank collapses, role in, see Italy bonuses, see remuneration Bulgaria, fiduciary duties of directors 7.06 bundling of bank lending services and shares sales 21.61 Cajas de Ahorros, see Spain Canada directors’ duty of care  7.17 fiduciary duties of directors  7.07 cap on variable remuneration, see remuneration care, directors’ duty of  6.54, 7.12, 7.31 central clearing counterparties (CCPs) fit and proper requirements  8.30 recovery and resolution  10.42 risk management  10.06, 10.12 role of  10.14, 10.16, 10.21, 10.24 central securities depositories (CSDs) fit and proper requirements  8.24, 8.35 risk management  10.43 role of  10.14 ‘senior management’, definition of  8.35 China corporate codes of conduct  16.54 corporate culture  16.50 risk committees  7.35 circulation of information, see inside information

580

581

Index civil liability, see liability clearinghouses, see central clearing counterparties codes of conduct corporate performance, and  16.56 effectiveness of  16.57 global practice  16.53 stakeholders and  16.60 cognitive framing of corporate culture 16.61 company law, see also corporate governance corporate interest  5.36 difference to financial regulatory rules  5.08 directors, see board of directors EU statute for financial institutions  1.25 financial regulatory rules as addition to  5.06 national basis  5.56 prevalence of financial regulatory rules  5.35 setting aside by financial regulatory rules  5.06 compensation of directors, see remuneration compliance mechanisms, cross-​sectoral regulation of 2.18 ‘conduct regulation’ 19.39 conduct risk behavioural risk  19.19 better understanding of, need for  19.07 concept of  19.02 conduct perspective  19.31 conduct regulation  19.39 culture-​oriented approach  19.38 definition of  19.18 environmental (market and societal) risk 19.19 factors that create  19.19 global focus on  19.17 ‘inherent’ risk  19.19 internal governance  19.44 issue of  19.01 misconduct arising of  19.11 concept of  19.02 costs of  19.11 examples of  19.09, 20.01 national responses  19.06 ‘product governance’, and  19.41 prudential perspective  19.34 relevance for governance  19.05 research and recommendations on  19.03 structural risk  19.19 conflicting interests arising of  20.02 bank disciplinary procedures, and  18.6 culture-​oriented approach conflicts modelling  20.70 cultural infrastructure around legal frameworks 20.68 existing law on compliance  20.55

new industry standards, introduction of 20.72 proxies for personal liability  20.76 regulation and supervision of compliance 20.59 use of  20.04 Dutch rules on  24.10 duty of loyalty, and  20.10 fiduciary duties, and  20.03, 20.09 financial advisers, increased competition and fragmentation 20.46 forward-​looking approach to regulation  20.32 innovation in financial markets, and  20.36 investor protection, and  20.06 mega firms  20.36 modelling, use of  20.70 passive funds  20.48 professional norms as to disclosure  20.52 robo-​advisers  20.39 scope for reform  20.8 cooperative banks emergence in Europe  15.05 ethical basis  15.03, 15.71 Germany 14.64 governance 15.04 local importance  15.02 market size  15.01 Netherlands, see Netherlands Raiffeisen Principles of Co-​operation  15.11 regulatory framework  15.68 regulatory risk, as  15.75 Rochdale Principles of Co-​operation  15.09 success of cooperative model  15.70 Venetian banks collapse (BPVI and VB), see Italy corporate culture and conduct, see also conduct risk; conflicting interests aggressive corporate language, use of  16.62 ‘bad apples’, notion of  16.61 behavioural theories  17.02 change, factors for  16.67 codes of conduct corporate performance, and  16.56 effectiveness of  16.57 global practice  16.53 stakeholders and  16.60 cognitive framing  16.61 conduct regulation  19.39 conflicting interests, and, see conflicting interests corporate performance, and  16.22, 16.56, 17.02 cultural aspect of financial reform  16.07 cultural shift in financial industry, need for 16.04

581

582

Index corporate culture and conduct (cont.) ‘culture’, definition of  9.23 definition of ‘culture’  16.17 directors’ decision making  16.65 dysfunctional leadership  16.30 ethical blindness  16.64 ethical leadership  16.36 finance as means for building good society 16.69 governance in relation  1.31 group dynamics  16.61 human factor  16.02 ‘imperial CEO’  16.33 insurance companies  3.01 interdisciplinary perspective on  16.03 internal governance  19.44 lack of research on financial industry culture  16.05 language aspect  16.62 leaders’ role  16.27 leaders’ style and tone  16.29 morality and  16.12 ‘product governance’, and  19.41 psychological perspectives  16.61, 17.01 recent focus on  16.01 remuneration and agency cost theory  16.42 conceptual complexity of relationship  16.52 motivational factor variability  16.51 motivational theory (Maslow)  16.47 national culture influences  16.50 Two-​Factors Theory (Herzberg)  16.48 risk management in relation  9.20 senior management’s responsibility for  9.28 stakeholders and  16.6, 16.68 supervision behavioural perspectives  17.01 characteristics in general  17.11 decision-​making mechanisms, of  17.17 development of  17.05 effects of  17.28 examples of assessment findings  17.27 future developments  17.39 impact of contextual factors on individual or group behaviour  17.22 leaders, of  17.14 legal concepts relevant to  17.31 overview of principles  17.44 process of  17.3 recent developments  17.35 reflective learning, role of  17.21 supervision in Netherlands  24.21 values within  9.23 corporate governance, see also governance-​related regulation

bank governance and  6.01 conduct regulation  19.39 corporate culture, and, see corporate culture and conduct definition of  2.01, 4.01, 5.03, 9.36, 9.45 directing and controlling in relation  9.30, 9.48 environmental, social, and corporate governance (ESG), see corporate governance ESG (environmental, social, and corporate governance) creditor representation  6.36 fiduciary duties, and  13.41 growth of ESG investment  13.40 importance of  13.44 investor engagement  13.47 principles for responsible investment, and 13.39 socially responsible investment, and  13.36, 13.52 sustainable and responsible investment, and 13.35 Financial Crisis of 2008, and  6.01 financial information, see inside information financial institutions, see governance of financial institutions ‘good’ governance  6.01 internal controls  9.29 internal governance  19.44 long-​term perspective  13.71 management body responsibility for  9.47 non-​financial companies  13.07 OECD Principles  1.16 organisational requirements for  9.46 problems in Netherlands, see Netherlands ‘product governance’, and  19.41 ‘public governance duty’, proposals for  7.53 requirement for  5.57 risk management and  9.06 shareholder value model  14.10 short-​termism, problem of  13.03, 13.08 stakeholder value model  14.11 ‘system of direction’  9.06 UK–​US model  6.01, 6.03 corporate interest application of corporate interest rules to banks 5.52 shareholder-​driven v stakeholder-​driven  5.46 corporate interest rules, application to banks 5.52 corporate social responsibility activism by investors 13.21 costs agency cost theory  16.42

582

583

Index misconduct, of  19.11 regulatory costs for FMIs  16.42 Credit Institution for Reconstruction (Kreditanstalt für Wiederaufbau, KfW) (Germany)  14.67, 14.72 credit institutions fit and proper requirements  8.11, 8.57 good repute requirement  8.13 ‘management body’, meaning of  8.12 sufficient experience requirement  8.13 creditors, see also stakeholders direct representation on directors board  6.37 enforcement against directors  6.45 indirect representation on directors board  6.33 regulator representation on board  6.43 credit unions cross-​sectoral regulation  2.12, 2.15 directors  2.12, 2.15 financial intermediary role  1.04 criminal penalties for directors 7.42 criminal responsibility of directors  6.56, 6.78 cross-​sectoral regulation, see governance-​related regulation CSDs, see central securities depositories culture, see corporate culture and conduct debt-​holders bank governance, and  6.28 state-​owned institutions  14.13 Denmark directors’ duty of care  7.13 directors’ duty of loyalty  7.21 depositor protection, cross-​sectoral regulation 2.25 development banks in Germany 14.67 directors, see board of directors disciplinary measures, see enforcement; right to fair trial disclosure of information, see inside information diversity criteria for directors 5.25 DSB Bank, collapse of, see Netherlands Dutch Banker’s Oath extension of  18.07 obligation to swear  18.06 recommendation for  18.05 statutory disciplinary law in relation  18.09 text of  18.08 uniqueness as disciplinary measure  18.03 Dutch Banking Disciplinary Committee anonymised files submitted by notifying banks 18.46 civil proceedings for compensation  18.20 complaints to  18.12 conflicting interests of notifying bank  18.60

demarcation of bank’s Acts, professional acts, and private Acts  18.52, 18.78 disciplinary register  18.21 establishment 18.10 impartiality 18.45 membership 18.39 proceedings 18.11 sanctions 18.19 transparency 18.70 uniqueness as disciplinary measure  18.03 Dutch Central Bank (DNB), supervision of behaviour and culture characteristics in general  17.11 decision-​making mechanisms  17.17 development of supervisory approach  17.04 effects of supervision  17.28 examples of assessment findings  17.27 future developments  17.39 impact of contextual factors on individual or group behaviour  17.22 leaders 17.14 legal concepts relevant to supervision  17.31 overview of supervision principles  17.44 process of supervision  17.3 recent developments  17.35 reflective learning, role of  17.21 duties of directors, see board of directors easy access to capital, problem of excessively 21.60 economic total balance sheet approach to risk 3.44 elections to board, investor engagement 13.59 employee compensation, see remuneration enforcement, see also right to fair trial administrative sanctions  18.02, 18.22 forms of disciplinary law  18.24 non-​statutory disciplinary law  18.25 by or against directors, see board of directors public availability of professional disciplinary records 18.70 right to fair trial  18.22 sanctions register  18.70, 18.79 statutory disciplinary law  18.26 engagement, see investors environmental, social, and corporate governance (ESG), see corporate governance ESG (environmental, social, and corporate governance), see corporate governance ethics, see also morality cooperative banks  15.03, 15.71 corporate culture, and  16.12 ethical blindness  16.64 ethical leadership  16.36 unethical leadership as cause of collapse  23.22

583

584

Index European Banking Authority (EBA), supervisory review and evaluation process (SREP) Guidelines 1.27 European Banking Union (EBA) definition of conduct risk  1.27 SREP Guidelines  1.27 European Court of Human Rights, see right to fair trial European Deposit Insurance Scheme 4.06 European Union (EU) company law statute for financial institutions 1.25 enforcement framework for financial institutions 7.40 financial institutions governance, see governance of financial institutions governance-​related regulation, see governance-​ related regulation proportionality 1.23 excessive growth of banks as warning sign 21.59 excessive leverage, management of risk 9.43 excessively easy access to capital 21.60 executive compensation, see remuneration experience, knowledge and skills, see fit and proper requirements Export-​Import (Ex-​IM) Bank (US) 14.52 failures assignment of liability for bank failures  6.08 banks, see Banco Espírito Santo; Italy; Netherlands; Spain fair trial, see right to fair trial family-​owned banks, problem of succession 23.20 fiduciary duties, see board of directors finance as means for building good society 16.69 finance companies, intermediary role 1.04 financial advisers, increased competition and fragmentation 20.46 Financial Crisis of 2008 bank governance failure  6.02 bank governance reforms after  6.05 corporate governance failure  6.01 lessons for financial institutions governance  1.02, 1.12 systemic risk, and  1.07 financial illiteracy of investors 21.64 financial information, see inside information financial institutions, see also asset managers; financial intermediaries; financial market infrastructures; investment firms directors’ responsibilities, see board of directors finance as means for building good society 16.69

governance, see governance of financial institutions investors, see investors problems in Netherlands, see Netherlands public confidence and trust, loss and rebuilding of  8.55, 8.64 risks 1.07 role of  1.07 state-​owned, see state-​owned institutions types of  1.03 financial instruments of banks, secondary market control of 21.63 financial intermediaries, see also banks; credit unions; finance companies; insurance companies; investment funds; pension funds category of  1.03 costs of misconduct financial 19.14 reputational 19.15 non-​financial firm governance contrasted  1.09 transformational role of  1.04 types of  1.04 financial market infrastructures (FMIs), see also central clearing counterparties; trade repositories category of  1.03 cross-​sectoral regulation  2.01, 2.03, 2.07 Financial Crisis of 2008, and  10.01 recovery and resolution  10.42 risk management business of managing risk  10.12 challenges for regulation of  10.45 clearing mandate  10.25 core principles of  10.58 costs of regulation  10.50 design of system  10.09 distortion of economic incentives, and 10.50 effectiveness of current regime  10.57 international context for regulation  10.20 macro-​prudential risk management  10.25 micro-​prudential risk management  10.28 moral hazard, and  10.51 organisational risk management  10.07, 10.28 post-​crisis recommendations  10.02 regulatory capture of policymakers  10.48 regulatory framework  10.24 reporting mandate  10.25 systemic risk management  10.06, 10.25 transactional risk management  10.08, 10.34 role of  1.06, 10.12 financial market innovation, conflicting interests in relation 20.36

584

58

Index financial reporting, inside information and 12.61 financial scandals, see conduct risk financial services, increased competition and fragmentation 20.46 Financial Standards Board (FSB) definition of conduct risk  19.21 Principles for an Effective Risk Appetite Framework 1.20 Principles for Sound Compensation Practices  1.22, 2.02 financial statements, misleading information in 21.62 Finland, directors’ duty of loyalty 7.21 fit and proper requirements banks 8.62 credit institutions  8.11, 8.57 cross-​sectoral analysis contribution to EU reform  8.84 good repute requirement  8.23 harmonisation of interpretative rules  8.29 ‘independence of mind’ requirement  8.25 key function holders  8.33, 8.38 limited cross-​sectoral convergence  8.42 management body collective requirements 8.24 members or shareholders with qualifying holdings 8.41 need for  8.22 Netherlands 8.46 non-​executive directors  8.31 scope of  8.01 senior management  8.33 sufficient experience requirement  8.23 ‘sufficient time’ to perform functions, requirement for  8.25 cross-​sectoral approach contribution to EU reform  8.84 good repute requirement  8.68 harmonisation of definitions  8.81 independence of mind  8.70 nuanced approach  8.66 proportionality 8.67 sufficient knowledge, skills, and experience 8.73 time commitment  8.77 experience requirement  8.11, 8.23 expertise and knowledge requirement  8.20 Financial Crisis of 2008, and  8.08, 8.21 financial regulatory rules  8.02 ‘fit and proper’, meaning of  8.05 good repute requirement  8.11, 8.23 guidance on  8.26 harmonisation of rules  8.17, 8.29, 8.54 honesty and integrity requirement  8.20

‘independence of mind’ meaning of  8.18 requirement for  8.18 ‘independence of mind’ requirement  8.25 independent non-​executive directors, requirement for  8.19 insurance companies  3.26, 8.57, 8.62 investment firms  8.57 key function holders  8.33, 8.38 lessons from Financial Crisis of 2008  8.15, 8.55 management body collective requirements  8.24 meaning of  8.12 members of the management body meaning of  8.06 requirements applicable to  8.14 members or shareholders with qualifying holdings 8.41 Netherlands 8.46 non-​executive directors  8.31 pension funds  8.58 public confidence and trust, loss and rebuilding of 8.55 scope of  8.02 senior management  8.33 ‘senior management’, meaning of  8.07 ‘sufficient time’ to perform functions, requirement for  8.25 testing for  8.04 France conflicting interests, culture-​oriented approach 20.55 corporate culture  16.50 directors’ duty of care  7.13 investor engagement  13.67 Germany appointment of directors  5.16 banking sector market shares  14.65 banking system  14.61 board models  5.12 civil liability of directors  6.61, 6.63, 6.67 cooperative banks  14.64, 15.11 corporate culture  16.31, 16.50, 16.62 corporate interest  5.51 Credit Institution for Reconstruction (Kreditanstalt für Wiederaufbau, KfW)  14.67, 14.72 creditor representation on directors board direct 6.38 indirect 6.34 regulator representation  6.45 criminal responsibility of directors  6.56, 6.58

585

586

Index Germany (cont.) development banks  14.67 director diversity  5.22 directors’ duties and tasks  5.26 directors’ duties of care and loyalty  6.54 directors’ duty of care  7.13 enforcement by or against directors  6.73, 6.79 fit and proper requirements  8.08 Landesbanken 14.63 private credit banks  14.62 Raiffeisen Principles of Co-​operation  15.11 remuneration policies  5.31 savings banks  14.63 stakeholder value model of governance  14.12 state-​owned institutions challenges for  14.02, 14.04, 14.37 efficiency 14.69 policy towards  14.74 systemic stability  14.71 global principles of financial institutions governance 1.16 global SIFIs, see systemically important financial institutions going-​concern requirement for bank resolvability 4.09 good repute, see fit and proper requirements good society, finance as means for building 16.69 governance of financial institutions, see also board of directors basic concepts of  1.03 comparative cross-​sectoral analysis  2.01 cooperative banks, see cooperative banks global principles of  2.11 importance of  1.11 introduction to  1.01 lessons from Financial Crisis of 2008  1.02 prudential regulation in relation  1.25 regulation in EU Legislation  2.01 risk committees  7.35 role of conduct and culture within  1.31 scholarly literature on  1.01 systemic stability as aim  2.24 governance-​related regulation banks, limitations of traditional focus on  2.20 board organization  2.15 board performance standards  2.15 board qualification and composition  2.11 board responsibilities  2.15 compliance mechanisms  2.18 cross-​sectoral analysis findings  2.19 cross-​sectoral convergence perspective  2.01, 2.30 functional approach to cross-​sectoral governance 2.20

internal audits  2.18 owners of qualifying holdings  2.16 remuneration policies  2.14 risk governance  2.17 shareholders 2.16 sources of  2.06 stakeholder (depositor/​investor) protection as aim 2.25 systemic stability as aim  2.24 government-​sponsored enterprises (GSEs) (US) 14.41 Greece criminal penalties for directors  7.44 directors’ duty of care  7.13 group dynamics in corporate culture 16.61 groups, board of directors 6.46 ‘have regard’ requirement for regulators 14.84 hedge fund activism by investors 13.21 Herzberg, Frederick, Two-​Factors Theory of motivation (Herzberg) 16.48 human factor in corporate culture 16.02 Iceland, criminal penalties for directors 7.45 idiosyncratic risks 1.07 incentives, see remuneration independence of mind cross-​sectoral approach  8.70 meaning of  8.18 independent directors, see board of directors independent non-​executive directors, requirement for 8.19 information, see inside information innovation in financial markets, conflicting interests in relation 20.36 inside information arising of  12.10 associates of listed banks, disclosure to  12.45 bank governance, and  12.01 bank governance in relation  12.16 capital market integrity and efficiency, and 12.02 circulation of  12.03 circulation of information as management tool 12.67 criteria for  12.08 decision to publish  12.31 deferred disclosure  12.13 definition of  12.07 directors shared by several entities, disclosure by 12.47 disclosure duty  12.12 financial reporting, and  12.61 harmonisation of rules, scope for  12.68

586

587

Index insider dealing  12.09 internal information flows  12.28 market abuse regulation, and bank governance in relation  12.04 inside information  12.03, 12.06 insider dealing  12.09 premature disclosure  12.11 regulatory framework  12.03 restriction by market abuse regulation  12.07 shareholders of listed banks, disclosure to  12.49 subsidiaries of listed banks, disclosure to  12.38 insider dealing, inside information and 12.09 institutional investors, see investors insurance, directors and officers (D&O) liability insurance 7.18 insurance companies actuarial function  3.54 complexity of insurance business  3.07 corporate culture  3.02 corporate governance after Financial Crisis of 2008 3.06 corporate governance requirements  3.05 cross-​sectoral regulation  2.01, 2.17 divergent interests within  3.70 financial intermediary role  1.04 fit and proper requirements  8.57, 8.62 governance-​related regulation board-​related requirements  3.15 fit and proper requirements  3.26 key functions, concept of  3.29 outsourcing-​related provisions  3.32 policyholder protection as priority  3.23, 3.71 remuneration policies  3.38 sources of  3.08 internal control  3.58 medium-​term capital management plan  3.67 moral hazard  3.03 non-​financial firm governance contrasted  1.10 OECD Guidelines on Insurer Governance  1.19 own risk and solvency assessment (ORSA) 3.55 policyholder protection  3.23, 3.71 prudential regulatory framework  3.04 Prudent Person principle  3.62 quantitative requirements medium-​term capital management plan  3.67 Prudent Person principle  3.62 regulatory framework, in  3.61 remuneration need for regulatory reform  11.48 regulatory principles  11.49 variable remuneration  11.52 risk arising of  3.07

economic total balance sheet approach to 3.44 regulatory framework  3.43 role of risk management  3.41 risk management system elements 3.47 elements of  3.45 function 3.53 governance system in relation  3.48 policies 3.51 reporting of processes and procedures  3.52 requirement 3.46 strategies 3.50 role of  3.01 internal audits, cross-​sectoral regulation of 2.18 internal controls alternative investment funds  9.51 areas of  9.31 concept of  9.49 control activities  9.33 control environment  9.35 definition of  9.29, 9.36, 9.45 design of  9.46 directing and controlling in relation  9.30, 9.48 insurance companies  3.58 management body’s responsibility for  9.44, 9.47 risk management and  9.29 structural (hard-​wired) controls  9.32 UCITS 9.51 ‘internal governance’ 19.44 internal information, see inside information investment firms category of  1.03 cross-​sectoral regulation  2.01, 2.03, 2.06, 2.12 definition of  2.08 directors 2.12 fit and proper requirements  8.11, 8.16, 8.57 remuneration need for regulatory reform  11.48 regulatory principles  11.57 role of  1.05 investment funds, intermediary role 1.04 investors, see also shareholders; stakeholders activism 13.01 activism, growth of  13.18 corporate social responsibility activism  13.21 engagement and voting activities board elections, engagement in  13.59 director-​investor engagement  13.56 ESG and  13.47 growth of engagement  13.45 individual and collective engagement  13.53 financial illiteracy  21.64

587

58

Index investors (cont.) hedge fund activism  13.21 principles for responsible investment (PRI)  13.19, 13.39 protection conflicting interests, and  20.06 cross-​sectoral regulation  2.25 short-​termism, problem of  13.03, 13.08 stewardship codes and principles  13.28 fiduciary duties, and  13.41 importance of  13.70 rationale for  13.23 socially responsible investment (SRI)  13.36 sustainable and responsible investment (SRI) 13.35 traditional activism  13.21 voting engagement activities, and  13.45 exercise of voting rights  13.65 Ireland, directors’ duty of care 7.13 Italy Banca Popolare di Vicenza (BPVI), collapse of apparent success of BPVI  21.13 Bank of Italy sanctions  21.44 beginnings of collapse  21.30 board’s denials  21.28 bundling of lending services and shares sale 21.61 capital increase of 1.5 billion euros, need for 21.34 capital increases of 2013 and 2014  21.17 Competition Law Authority (AGCM) fine for aggressive selling practices  21.42 Consob (securities regulator) sanctions 21.46 control of secondary market in bank’s financial instruments  21.63 cooperative structure, problem of  21.57 dominating CEO, problem of  21.53 ECB sanctions  21.45 effectiveness of public enforcement  21.51 elusion of EU financial market rules  21.66 excessive growth, problem of  21.59 excessively easy access to capital, problem of 21.60 financial illiteracy of investors  21.64 history of BPVI  21.10 initial public offering (IPO), failure of  21.37 insolvency declaration  21.01, 21.39 investor losses  21.04, 21.37 issue price, method of assessment  21.20 legal proceedings  21.38 mandatory transformation into public company 21.33

misleading information in financial statements  21.26, 21.62 possible prevention by upgraded EU rules 21.72 regulatory background to  21.08 share price reduction  21.30 significance of  21.06 unauthorised share repurchase  21.24 VB collapse compared  21.40 Zonin, Gianni (chairman of BPVI), role in collapse  21.11, 21.29, 21.31, 21.35, 21.53 banking legal framework  21.08 banking sector difficulties  21.02 cooperative banks (banche popolari) regulatory risk, as  15.73 structural problems of  21.55 directors’ duty of care  7.13 effects of banking crisis  21.05 investor engagement  13.62, 13.67 stewardship code  13.29 Veneto Banca (VB), collapse of BPVI collapse compared  21.40 bundling of lending services and shares sale 21.61 Consob (securities regulator) sanctions 21.50 control of secondary market in bank’s financial instruments  21.63 cooperative structure, problem of  21.57 dominating CEO, problem of  21.53 effectiveness of public enforcement  21.51 elusion of EU financial market rules  21.66 excessive growth, problem of  21.59 excessively easy access to capital, problem of 21.60 financial illiteracy of investors  21.64 insolvency declaration  21.01 investor losses  21.04 misleading information in financial statements 21.62 possible prevention by upgraded EU rules 21.72 significance of  21.06 Japan corporate culture  16.50 directors’ duty of care  7.17 directors’ duty of loyalty  7.21 risk committees  7.35 stewardship code  13.29 key function holders fit and proper requirements  8.33, 8.38 liability 6.69 key functions, concept of 3.29

588

589

Index KfW (Kreditanstalt für Wiederaufbau), see Credit Institution for Reconstruction knowledge, experience and skills, see fit and proper requirements Landesbanken (Germany) 14.63 language aspect of corporate culture 16.62 leadership dysfunctional leadership  16.30 ethical leadership  16.36 role of  16.27 style and tone  16.29 supervision of  17.14 unethical leadership as cause of collapse  23.22 Legal Entity Rationalisation (LER) process 4.14 liability directors, see board of directors directors and officers (D&O) liability insurance 7.18 key function holders  6.69 proxies for personal liability  20.77 liquidity risk management  9.41, 9.55 long-​term perspective of corporate governance 13.71 loyalty, directors’ duty of  6.54, 7.20, 7.38, 20.10 Luxembourg, directors’ duty of care 7.13 macro-​prudential risk management, see risk management management information systems (MIS) in banks 4.20 managers fit and proper requirements  8.33, see fit and proper requirements ‘management body’, meaning of  8.12 ‘members of the management body’ meaning of  8.06 qualities required of  8.14 regulatory approval  6.07 remuneration, see remuneration responsibility for corporate culture and conduct 9.28 responsibility for corporate governance  9.47 responsibility for risk management and internal controls  9.44, 9.47 ‘senior management’, meaning of  8.07, 8.35 ‘sufficient time’ to perform functions, requirement for  8.25 market abuse, inside information and 12.03 Maslow, Abraham, motivational theory of needs 16.47 mega firms, conflicting interests 20.36 Mexico, risk committees 7.35 micro-​prudential risk management, see risk management

misconduct, see conduct risk misleading information in financial statements 21.62 modelling of conflicts 20.70 moral hazard insurance companies  3.03 risk management, and  10.51 morality, see also ethics ‘bad apples’, notion of  16.61 corporate culture, and  16.12 moral blindness  16.64 motivational theories agency cost theory  16.42 Herzberg’s Two-​Factors Theory  16.48 Maslow’s theory  16.47 multiple point of entry (MPE) strategy by banks 4.23 Netherlands, see also Dutch Banker’s Oath; Dutch Banking Disciplinary Committee; Dutch Central Bank; Rabobank ABN AMRO Bank takeover  24.02 appointment of directors  5.17 bank culture supervision  24.21 bank governance flaws in  24.16 special features of  24.15 supervision of  24.21 bank governance supervision  24.21 banking sector disciplinary law bank employee deviation from bank’s internal policies, cases of  18.65 disciplinary system prescribed by law 18.35 employees subject to  18.81 independence and impartiality of tribunal 18.37 individual-​level law, advantage of  18.86 institutional-​level law, advantage of  18.84 insurance sector compared  18.84 labour law in relation  18.82 non-​statutory disciplinary law  18.25 preventive effect  18.83 primary goal of  18.8 professions, disciplinary mechanisms  18.25 right to fair trial  18.25, 18.77 sanctions register  18.70, 18.79 statutory disciplinary law  18.26 see also Dutch Banker’s Oath; Dutch Banking Disciplinary Committee bank shareholdings, extra regulatory conditions for 5.40 cooperative banks history of  15.13 Rabobank, see Rabobank

589

590

Index Netherlands (cont.) cooperatives corporate governance  15.38 governance models  15.28 legal characteristics generally  15.21 membership 15.23 no shareholders  15.31 no share-​listing  15.36 success of cooperative model  15.70 corporate culture  17.04 corporate culture aspect of financial reform 16.08 corporate culture supervision, see Dutch Central Bank corporate interest  5.49, 5.53 director diversity  5.21 directors’ duties and tasks  5.26 directors’ duty of care  7.13 DSB Bank board inadequacies  24.16 collapse 24.03 conflicting interests, rules on  24.10 controlling shareholder, role of  24.16 culture 24.12 downfall 24.13 Dutch regulatory and policy changes after collapse 24.27 EU rule changes after collapse  24.31 example of governance problems  24.04 governance 24.08 governance flaws  24.16 investigation of collapse  24.08 lessons from collapse  24.31 origins 24.05 ownership structure  24.07 special features of governance  24.15 fiduciary duties of directors  7.06, 7.29 fit and proper requirements credit institutions  8.57 example for EU harmonisation  8.54 financial supervision legislation  8.49 fit and proper testing  8.48, 8.52 harmonised approach  8.52 implementation of EU regulatory framework 8.46 insurance companies  8.57 investment firms  8.57 lessons from Financial Crisis of 2008  8.55 pension funds  8.58 public confidence and trust, loss and rebuilding of  8.64 regulatory model  8.47 standards for  8.50 Fortis/​ABN rescue  24.02

governance problems ABN AMRO Bank takeover  24.02 DSB Bank collapse  24.03, 24.04 examples of  24.01 Fortis/​ABN rescue  24.02 SNS Reaal nationalisation  24.03 remuneration policies  5.31 two-​tier board model  5.11 new technology, robo-​advisers and conflicting interests 20.39 no creditor worse off (NCWO) principle for bail-​ins 4.17 non-​executive directors, see board of directors non-​financial companies corporate governance  1.09, 13.07 enforcement mechanisms  7.39 investor activism  13.20 shareholders 13.07 OECD Guidelines on Insurer Governance  1.19 Principles of Corporate Governance  1.16 organisational risk management, see risk management outsourcing by insurance companies 3.32 over-​the-​counter (OTC) derivatives, risk management  10.03, 10.09 owners of qualifying holdings, cross-​sectoral regulation 2.16 own risk and solvency assessment (ORSA) 3.55 passive funds, conflicting interests 20.48 payment institutions cross-​sectoral regulation  2.01 definition of  2.01 pension funds cross-​sectoral regulation  2.01, 2.06, 2.10 financial intermediary role  1.04 fit and proper requirements  8.58 performance standards banks 14.80 directors, cross-​sectoral regulation  2.15 policyholder protection as priority for insurance regulation  3.23, 3.71 Portugal, collapse of BES, see Banco Espírito Santo principles BCBS Corporate Governance Principles for Banks 1.21 BCBS Guidelines  1.17 EBA SREP Guidelines  1.27 EU, see European Union FSB Principles for an Effective Risk Appetite Framework 1.20 FSB Principles for Sound Compensation Practices  1.22, 2.02

590

591

Index global principles of financial institutions governance 1.16 international principles of corporate governance 1.23 no creditor worse off (NCWO) principle  4.17 OECD Guidelines on Insurer Governance  1.19 principles for responsible investment (PRI)  13.19, 13.39 Principles of Corporate Governance (OECD) 1.16 proportionality, see proportionality Prudent Person principle  3.62 Raiffeisen Principles of Co-​operation  15.11 Rochdale Principles of Co-​operation  15.09 socially responsible investment (SRI)  13.36, 13.52 stewardship principles, see investors sustainable and responsible investment (SRI)  13.35 private credit banks in Germany 14.62 ‘product governance’ 19.41 professional norms as to disclosure of conflicting interests 20.52 professions, disciplinary mechanisms, see Dutch Banker’s Oath; Dutch Banking Disciplinary Committee; enforcement; right to fair trial proportionality EU approach to  1.23 fit and proper requirements  8.67 governance structures, in  1.21 international principles of corporate governance, in  1.23 remuneration policies  11.63 prospectuses, misleading information in 21.62 prudential regulation corporate governance in relation  1.25 extension of  1.29 influence of prudential supervision on directors 6.07 insurance companies  3.04 macro-​prudential risk management  10.25 prudential perspective on conduct risk  19.34 representation hypothesis of bank governance  1.28 Prudent Person principle 3.62 psychological perspectives of corporate culture  16.61, 17.01 publication of inside information, decision for 12.31 public confidence and trust, loss and rebuilding of  8.55, 8.64 ‘public governance duty’, proposals for 7.53 qualifying holdings, owners of cross-​sectoral regulation  2.16 fit and proper requirements  8.41

Rabobank (Coöperatieve Rabobank UA) (Netherlands) active sectors  15.17 bond issues  15.36 clients 15.19 cooperative ethos  15.20 corporate governance central governance  15.44 events-​driven change  15.45 general characteristics  15.40 group structure  15.52 local Rabobanks  15.41 new approach  15.47 Financial Crisis of 2008, and  15.72 foundation 15.16 governance model  15.28 group structure employee influence  15.67 Executive board  15.54 general characteristics  15.53 holding entity  15.52 local bank business  15.64 local bank mandates  15.54 member influence  15.55 subsidiaries 15.52 membership  15.23, 15.26, 15.31 size 15.17 subsidiaries 15.18 Raiffeisen, Friedrich Wilhelm, Principles of Co-​operation 15.11 reflective learning, role in supervision of corporate culture and conduct 17.21 regulators definition of conduct risk  19.22 enforcement against directors  6.76 ‘have regard’ requirement for  14.84 representation on directors board  6.43 remuneration agency cost theory  16.42 alternative investment funds  11.56 asset managers need for regulatory reform  11.48 regulatory principles  11.53 variable remuneration  11.55 banks cap on variable remuneration  11.29 compliance 11.24 criticism of remuneration cap  11.36 proportionality principle  11.24 reform of regulation  11.22 regulatory framework  11.21 remuneration policies  5.30, 11.23 variable elements of remuneration  11.27 bonuses  11.15, 11.39

591

592

Index remuneration (cont.) cap on variable remuneration adoption of  11.34 balance of fixed and variable components  11.32, 11.42 bonuses 11.39 criticisms of  11.36 fixed remuneration  11.38 impact of  11.43 rationale for  11.33 requirement for  11.29, 11.31 role-​based allowances  11.37 choice between standards and rules  11.17 comparative cross-​sectoral analysis  2.14 corporate culture, and agency cost theory  16.42 conceptual complexity of relationship  16.52 motivational factor variability  16.51 motivational theory (Maslow)  16.47 national culture influences  16.50 Two-​Factors Theory (Herzberg)  16.48 corporate governance and banking regulation in relation 11.01 deferment 11.14 disclosure  11.12, 11.16 FSB Principles for Sound Compensation Practices  1.22, 2.02 Germany 5.31 governance 11.12 grounds for regulation of  11.02 improvement of regulation  11.58 insurance companies need for regulatory reform  11.48 post-​crisis reforms  3.38 regulatory principles  11.49 variable remuneration  11.52 international principles and standards  11.12 investment firms need for regulatory reform  11.48 regulatory principles  11.57 motivational factor variability  16.51 motivational theory (Maslow)  16.47 national culture influences  16.50 Netherlands 5.31 policy issues  11.07 proportionality  11.24, 11.63 risk management  9.56 role-​based allowances  11.37 role in Financial Crisis of 2008  11.02 shareholder activism (‘say on pay’)  13.06 Single Rulebook  5.31 structure  11.12, 11.13 supervision 11.12 systemic risk  11.59

Two-​Factors Theory (Herzberg)  16.48 UK 5.31 variable elements  11.27 variable remuneration, cap on  11.29 representation hypothesis of bank governance 1.28 reputation (good repute), see fit and proper requirements resolution-​stay clauses in bank contracts 4.25 resolvability, see banks right to fair trial determination of right  18.23, 18.77 disciplinary proceedings as civil or criminal procedure 18.29 independence and impartiality of tribunal 18.37 nature and severity of sentence  18.36 nature of offence  18.31 non-​statutory (professional) disciplinary mechanisms 18.25 statutory disciplinary mechanisms  18.26 risk concept of  9.01 definition of  9.36, 9.45 economic total balance sheet approach to  3.44 FSB Principles for an Effective Risk Appetite Framework 1.20 governance of, cross-​sectoral regulation  2.17 idiosyncratic risks  1.07 management, see risk management mitigation resolvable banks, and  4.19 state ownership of institutions, by  4.19 risk committees  7.35 systemic risk, see systemic risk risk management alternative investment funds  9.51 business of managing risk  10.12 clearing mandate  10.25 concept of  9.50 conduct risk, see conduct risk corporate culture and conduct, and  9.20 definition of  9.36, 9.45 design of system  10.09 excessive leverage, risk of  9.43 financial market infrastructures, see financial market infrastructures insurance companies, see insurance companies internal controls, and  9.29 intrinsic component of governance design  9.06, 9.37, 9.44 lessons from Financial Crisis of 2008  9.62 liquidity risk  9.41 macro-​prudential risk management  10.25

592

593

Index management body’s responsibility for  9.44, 9.47 micro-​prudential risk management  10.28 moral hazard, and  10.51 organisational risk management  10.07, 10.28 over-​the-​counter (OTC) derivatives  10.03, 10.09 regulatory expectations for  9.37 remuneration policies  9.56 reporting mandate  10.25 requirements for specific risks  9.40 risk appetite framework (RAF)  9.10 ‘risk profile’, meaning of  9.60 sufficient time and energy requirement  9.39 systemic risk management  10.06, 10.25 transactional risk management  10.08, 10.34 UCITS 9.51 robo-​advisers, conflicting interests 20.39 Rochdale Principles of Co-​operation 15.09 sanctions administrative 18.02 register of  18.70 sanctions, administrative 18.22 savings banks in Germany 14.63 ‘say on pay’, shareholder activism 13.06 scandals, see conduct risk secondary market control of bank’s financial instruments 21.63 senior managers, see managers shareholders, see also investors; stakeholders banks, see banks controlling shareholder, role of  24.16 cooperatives 15.31 corporate interest, and  5.46 cross-​sectoral regulation  2.16 executive remuneration, and (‘say on pay’)  13.06 governance-​related regulation  2.16 governance role  13.13 listed banks, of, disclosure of inside information to 12.49 non-​financial companies  13.07 shareholder value model of governance  14.10 state-​owned institutions  14.07 share sales bundled with bank lending services 21.61 short-​termism, problem of  13.03, 13.08 single point of entry (SPE) strategy by banks 4.24 Single Resolution Mechanism (SRM) 4.06 Single Rulebook appointment of directors  5.19 bank debt-​holders and bank governance  6.28 board models  5.14

contents 4.06 director diversity  5.24 directors’ duties and tasks  5.27 European basis  5.56 regulatory approval of directors  6.09, 6.15 remuneration policies  5.31 respect for national company law  5.05 shareholders 5.39 Single Supervisory Mechanism (SSM) 4.06 skills, knowledge and experience, see fit and proper requirements Slovakia, fiduciary duties of directors 7.06 social function of finance 16.69 socially responsible investment (SRI)  13.36, 13.52 solvency, own risk and solvency assessment (ORSA) 3.55 Spain banking crisis Bankia, collapse of  22.27 beginning of  22.04 Blesa, Miguel, suicide of  22.27 climax of  22.34 collapses of Cajas de Ahorros  22.05 lessons from  22.41 overreliance on international debt markets 22.05 particularity of  22.01, 22.16 reasons for  22.04 recapitalization efforts  22.17 Cajas de Ahorros abusive practices  22.15 Bankia, collapse of  22.27 control of  22.13 cuotas participativas, issuing of  22.11 foundation status  22.11 history of  22.09 importance of  22.07 recapitalization efforts  22.17 role in banking crisis  22.01, 22.07 directors’ duty of loyalty  7.21 national economic growth bank debt and  22.02 slowdown 22.03 SRI, see socially responsible investment; sustainable and responsible investment stakeholders, see also creditors; investors; shareholders banks, in  4.37 benefits of good governance  13.12 corporate culture, and  16.6, 16.68 corporate interest, and  5.46 costs of misconduct  19.13 cross-​sectoral protection  2.25

593

594

Index stakeholders (cont.) oversight by, history of  13.01 representation on directors board  6.32 stakeholder value model of governance  14.11 standards choice between standard-​based or rule-​based remuneration regime  11.17 performance standards for banks  14.80 performance standards for directors  2.25 state-​owned institutions challenges for  14.37 challenges of state-​ownership of banks  14.30 debtholder perspective  14.13 Germany banking sector market shares  14.65 banking system  14.61 challenges of state-​ownership  14.02, 14.04, 14.37 cooperative banks  14.64 development banks  14.67 efficiency 14.69 KfW  14.67, 14.72 Landesbanken 14.63 pillars of banking system  14.61 private credit banks  14.62 savings banks  14.63 risk mitigation by  14.27 shareholder perspective  14.07 stakeholder perspective  14.11 state ownership of financial institutions  14.01 state’s perspective  14.18 theoretical case for  14.06 triangular relationships around management 14.24 US challenges of state-​ownership  14.02, 14.38 Export-​Import (Ex-​IM) Bank  14.52 government-​sponsored enterprises (GSEs) 14.41 ‘have regard’ requirement for regulators 14.83 performance-​based standards  14.80 policy towards  14.80 stewardship, see investors subsidiaries cooperative banks  15.18 listed banks, disclosure of inside information to 12.38 supervisory review and evaluation process (SREP) EBA Guidelines  1.27 use of  4.32 sustainable and responsible investment (SRI) 13.35

Sweden, corporate culture 16.50 systemically important financial institutions (SIFIs) effects of failure of  1.08 global SIFIs  1.08 governance structure requirement  1.22 systemic risk definition of  1.07 idiosyncratic risks distinguished  1.07 importance of  1.07 remuneration 11.59 risk management  10.25 systemic stability as aim of regulation 2.24 trade repositories (TRs), risk management  10.13, 10.24 transactional risk management, see risk management tribunals, independence and impartiality 18.37 Two-​Factors Theory of motivation (Herzberg) 16.48 UCITS liquidity risk management  9.55 portfolios 9.52 regulatory framework  9.51 remuneration policy risk management  9.59 risk management and internal controls  9.51 ‘risk profile’  9.60 undertakings for collective investment in transferable securities, see UCITS United Kingdom (UK) appointment of directors  5.18 cap on variable remuneration  11.34 civil liability of directors  6.64, 6.67, 6.68 conduct risk  19.06, 19.10, 19.24, 20.01 conflicting interests arising of  20.03 culture-​oriented approach  20.62 fiduciary duties, and  20.13, 20.15, 20.22 investor protection, and  20.06 cooperative banks  15.05 corporate culture aspect of financial reform 16.08 corporate governance model  6.01, 6.03 corporate interest  5.48 criminal penalties for directors  5.32 criminal responsibility of directors  6.57, 6.59 director diversity  5.23 directors’ duties and tasks  5.26 directors’ duty of care  7.17, 7.33 enforcement by or against directors  6.73 enforcement framework for financial institutions 7.40 fiduciary duties of directors  7.11, 20.13, 20.15, 20.22

594

59

Index ‘have regard’ requirement for regulators  14.84 institutional investor activism  13.05, 13.08, 13.14 investor engagement  13.67 investor protection as to conflicting interests 20.06 regulatory approval of directors  6.10 remuneration policies  5.31 risk management  9.08, 9.11, 9.26 Rochdale Principles of Co-​operation  15.09 single-​tier board model  5.13 stewardship code  13.29 United States (US) bank debt-​holders and bank governance  6.25 BrokerCheck database  18.74 civil liability of directors  6.61 conduct risk  19.10, 19.11, 19.27, 20.01 conflicting interests arising of  20.03 culture-​oriented approach  20.55, 20.63 fiduciary duties, and  20.09, 20.15, 20.29 innovation in financial markets, and  20.36 investor protection, and  20.06 passive funds  20.51 proxies for personal liability  20.77 robo-​advisers  20.40 corporate codes of conduct  16.54, 16.58 corporate culture  16.01, 16.30, 16.32 corporate culture aspect of financial reform 16.07 corporate governance model  6.01, 6.03 criminal penalties for directors  7.43

directors’ duty of care  7.12, 7.15, 7.18, 7.31, 7.34 directors’ duty of loyalty  7.21, 7.38 duty of loyalty  20.10 enforcement of fiduciary duties  7.24, 7.39, 7.41 Export-​Import (Ex-​IM) Bank  14.52 fiduciary duties of directors  7.05, 7.10, 7.28, 20.09, 20.15, 20.29 government-​sponsored enterprises (GSEs) 14.41 institutional investor activism  13.25 investor engagement  13.69 investor protection as to conflicting interests 20.06 passive funds  20.51 remuneration policies, proportionality and 11.64 state-​owned institutions challenges for  14.02, 14.38 ‘have regard’ requirement for regulators  14.83 performance-​based standards  14.80 policy towards  14.80 stewardship code  13.31 values within corporate culture 9.23 variable remuneration, cap on, see remuneration Venetian banks collapse (BPVI and VB), see Italy Veneto Banca (VB), collapse of, see Italy voting, see investors Zonin, Gianni (chairman of BPVI), role in collapse of BPVI  21.11, 21.29, 21.31, 21.35, 21.53

595

596