As some people might have heard, the economy had a massive meltdown a couple of years ago that started in the housing market and moved into the financial sector. A bunch of banks were bailed out. Some didn't need it. Plenty did. A few might still be insolvent. There's been plenty of talk about how to keep it from happening again. Congress passed the Dodd-Frank Act to curb certain bank activities. The right whined about Fannie Mae and Freddie Mac a bunch, since that was about the closest they could come to blaming it on the government. But not much has been answered.
This summer, I've been doing some research on the specific role of directors at banks, and I'm trying to think through some issues relating to this question. So it's gonna be a long post... Directors in corporations are essentially charged with overseeing management's activities. They're supposed to serve shareholders, and protect their interests. Historically, they were held to a higher duty of care than other corporate directors were. Where directors at, say, Wal-Mart could not be held personally liable (i.e. you couldn't sue them for their own funds) unless they were grossly negligent, directors at banks were held to a higher duty of care. Up to the decision in Litwin v. Allen in 1940, the idea was that they could be held liable for negligence, which the courts defined as acting outside the realm of the way a reasonably prudent businessperson would act.
Litwin caused a bit of an uproar in that it was willing to actually go back and evaluate the consequences of a bank's decision after the fact and decide that it was negligent. In that case, they claimed a transaction had no "profit potential," which many commentators have pointed out isn't necessarily true (they didn't have much upside, but they did extract a fairly high interest rate, though the specifics of the case itself are mostly neither here nor there). While Litwin was controversial, not many directors were actually held liable for negligent decisions for a few decades, so the case kind of went by the wayside until about the mid-1980's.
But here, I think it's useful to pause and consider the reason why bank directors could be held liable more easily than other directors. The common thread running through the relevant cases seems to be that banks have depositors. And this justification does make sense. A typical public company has two sources of funding-- equity and debt. Put simply, equity is an ownership stake in the company. It usually comes with a regular dividend, and potential upside if the company grows, but it can also fall in value, and is the first part of the corporation that's wiped out in bankruptcy. Debt is exactly what it sounds like-- a corporation issues bonds, which investors buy, getting a fixed interest rate based on demand for the bond, and, when it expires, the principal. But banks are different in that they have a third source of debt-- depositor funds. Now, consumers like to think of deposits as being exactly what they sound like: you send your paycheck to the bank, the bank puts it in a vault, and you go to the ATM and get it out. But, really, deposits are just short-term loans made by the public to the banks. The banks take those deposits and reinvest them in longer-duration assets and earn a spread. Because the interest rates on your checking account might get you 3 Happy Meals a year, but the income stream from the Martinez family's mortgage that your deposits bankroll pays for way more Happy Meals. But deposits are especially volatile-- if too many depositors want to take their funds out, the bank will have to dump its assets, and if it has to dump enough assets at fire -sale prices (which, let's be real, it will probably have to do because there aren't all that many investors sitting around the market thinking that the Martinez family's mortgage is THE BOMB, and they need to buy it), it might lose enough money that it can't pay you back. Of course, all of this is an extreme oversimplification-- banks don't keep many whole mortgages that they originate on their books anymore, and definitely didn't around 2008, but the basic principle is the same-- a deposit is a source of funding that's unique to banks.
And the relevant jurisprudence compares bank directors to trustees-- it says that bank directors have a duty to safeguard not just shareholders, but also depositors. The idea is if they're not extra-careful, depositors will lose faith in the safety of their deposits, and there will be bank runs which will knock the entire banking sector to its knees. And that's exactly what happened pretty regularly for years. Then the Great Depression happened, and the Glass-Steagall Act in 1933 created the FDIC and federal deposit insurance. What that means is deposit-taking banks pay a premium, and in exchange the FDIC guarantees the first $X in deposit accounts (this limit gets pushed up regularly). Instantly, bank runs disappeared. If the government guarantees deposits, then your deposit is safe so long as the US government didn't collapse. And if it did, there would be much bigger problems than the bank losing your deposits. But the consequence of that became that any deposit-taking bank got free liquidity from consumers. The reason is pretty straightforward. If I know that my deposits could be wiped out if a bank went bust, I would think three times before depositing my money there. But if the government guarantees my deposits, I could care less which bank gets my money. So long as there's an "FDIC Member" sticker in the window, my deposits are backed by the full faith and credit of the US.
But in recent years, we've run into an interesting issue. While banks pay deposits, the amount they pay isn't all that big. Take Citigroup. It's a big deposit-taking bank (though it has WAY less in deposits than JP Morgan Chase and Bank of America). In 2008, it had about $208 Billion in deposits. And the FDIC fund was at around $45 Billion (I have a cite for this, but I'd have to dig it up; just trust me, these are the numbers). If Citi were to collapse, depositors MIGHT be able to get all of their deposits back through a combination of the liquidation of the bank's assets in bankruptcy (depositors get paid before bondholders and shareholders) and the FDIC reserve fund, but I doubt it. But even if Citi alone could be paid, a Citi collapse would have disastrous system-wide consequences. Because Citi going down wouldn't be an isolated event. Banks deal with each other all the time, and a collapse in one bank has consequences for others. There are plenty of these transactions, but the simplest one is an insurance contract (I'm throwing it out strictly to illustrate the point). If, say, JPMorgan were to buy $100 million of insurance from Citigroup on the possibility of oil dropping below $50 a barrel, but when oil dropped to $45, Citi didn't have the cash to perform, the impact would be pretty significant. JPMorgan would lose its hedge, which would expose it to more risk than it thought it had. And while losing $100 million isn't a big deal for JPMorgan, the entirety of its dealings with Citi could well have been enough to bring it down (as Citi's counterparties, who are also JPMorgan counterparties, found themselves in trouble from Citi's collapse). And if JPMorgan were to go, its $337 billion deposit base would have to be bailed out, too. While the FDIC might be able to do Citi alone, a $45 billion fund is gonna have a hard time covering almost $550 billion in deposits. So who picks up the bill? Well, the FDIC guarantee isn't contingent on the FDIC having enough on reserve to actually cover deposits-- the bill would end up on the Treasury's desk. So, in the end, taxpayers would be bailing out depositors (who are also taxpayers, but the point is that neither depositors nor the taxpayers have any share in the upside if banks do well, but they DO have the potential downside of systemically significant banks like Citi and JPMorgan going bust.
But what does this have to do with the duty of care? Well, in 1985, Delaware courts handed down the Smith v. Van Gorkom decision, which held directors liable for another bad deal. While there was a settlement, and the amount they were on the hook for was barely more than their liability insurance, this spooked directors. So the legislature passed Section 102(b)(7) of the Delaware code, which allows corporations to protect directors from liability for violating their duty of care, provided they act in good faith. Since more or less every large company in the US is incorporated in Delaware (and most states passed similar statutes), bank directors became the same as non-bank directors: essentially judgment-proof if they acted in good faith. The distinction drawn by Litwin between bank directors and other directors essentially disappeared overnight.
My thinking is that, given the taxpayer subsidy banks get through the existence of the FDIC, there need to be additional incentives in place to keep banks from taking undue risks with depositors' money. And the best way to encourage good risk-taking is by making sure that directors have skin in the game. I think potential liability is the best way I can think of to do that. Now, it might not be enough-- I doubt, say, Citi's directors would get into trouble for violating their duty of care for driving it into the ground in the run-up to the financial crisis, since the risks they took weren't necessarily substantially different from the ones much of the banking industry took (and the economists warning of a housing bubble were far from the dominant voice in public discourse).
But it DOES seem to me that if deposit-taking banks are going to get the liquidity guarantee that comes with FDIC membership, at the very least the FDIC member banks that are publicly held should not be allowed to incorporate with 102(b)(7) provisions. In other words, if a bank is public, the threat of liability should be in place to encourage directors to protect not just depositors, but also taxpayers from potentially footing the bill of a collapse.
Now, I'm sure there are some holes in this argument, so I'd be interested in hearing feedback, just in case anyone actually reads it.
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