Public Organiz Rev (2011) 11:4559 DOI 10.

1007/s11115-010-0146-z

Governance Implications of the Global Financial Crisis: United States Experience

Thomas H. Stanton

Published online: 17 November 2010 # Springer Science+Business Media, LLC 2010

Abstract In the financial debacle, public and private organizations failed to protect owners and stakeholders from calamity. Given the immense financial bubble, could improved governance have made a difference? Many large complex financial institutions may not be sufficiently governable to avoid unpleasant major surprises. Ponderous processes of enacting laws and regulations, and the substantial influence of powerful stakeholders in those processes, mean that fluid markets are likely to mitigate or even avoid the impact of regulatory improvements that policymakers suggest. Better information must flow to decision makers, but the dynamics of a bubble may impede effective risk management by financial firms and government. Keywords Governance . Financial crisis . Risk . Financial regulation

Introduction The United States has experienced the most significant failure of its financial system since the Great Depression. The government of the United States committed over $3 trillion in spending, loan purchases, loans, and loan guarantees through the Treasury, Federal Reserve System and Federal Deposit Insurance Corporation (FDIC) to support financial institutions and automobile companies among other purposes, and enacted a $787 billion economic stimulus package. Millions of households face foreclosure and loss of their homes. Organizations in both the public and private sectors failed to protect their owners and stakeholders from calamity. On the public side, many different financial regulators endorsed liberalization of capital requirements and diminished other supervisory restraints that might have encouraged greater prudence by the regulated institutions. On the private side, the failure of so many different types of
T. H. Stanton (*) Johns Hopkins University, Center for the Study of American Government, 900 Seventh Street, NW, Suite 600, Washington, DC 20001, USA e-mail: Tstan77346@gmail.com

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organizationbanks, savings and loan associations (so-called thrift institutions), government-sponsored enterprises (GSEs), and investment bankssuggests that many firm managers failed to represent the best interests of their owners. Of greater concern, there is reason to believe that many large complex financial institutions may not be sufficiently governable by management to avoid unpleasant major surprises from time to time.1 This article explores the extent that failures of governance led to the financial crisis in the United States and the extent that improvements in governance are needed to help prevent, or at least mitigate, another serious financial debacle in the future. As used here, governance is the means by which public or private sector organizations exercise authority and use institutional resources to address problems and carry out their affairs. For the public sector, governance includes the relationship of stakeholders to government policymakers and regulatory agencies; for the private sector, governance includes the relationship of stakeholders to the management of financial firms. Hereafter, the article is in four sections. The first section provides a brief overview of the financial crisis and the way it unfolded. It also introduces the core question of the article: given the immense financial bubble that grew in the first decade of the new millennium and then collapsed, could improved governance have made a difference? The second section looks at public sector governance and introduces Stantons Law: risk will migrate to the place where government is least equipped to deal with it (Stanton 1989: 41). Ponderous processes of enacting laws and regulations, and the substantial influence of powerful stakeholders in those processes, mean that nimble markets are likely to mitigate or avoid the impact of many of the regulatory and supervisory approaches that policymakers are now suggesting. That is not an argument against trying to reform an obviously flawed supervisory system, but rather a suggestion that, once a new system is in place, innovations once again will help to create new risks in new parts of the financial markets. The third section looks at the governance of private firms. What were shortcomings of the current system of governance, and to what extent can they be ameliorated by mere changes in rules? Currently, the law sets very low standards for the responsibility of officers and directors of a firm to ensure prudent internal controls; changes here might be helpful. The section also suggests that the governance of organizations that are large and complex is more prone to failure than others. The final form of the US response to the financial debacle will shape the behavior of institutions and markets for many years to come. To the extent that government protects holders of debt obligations of insolvent firms that are large, complex and extensively linked to the global financial system, then all major financial firms will gain the incentive to develop the attributes that deter government regulators from allowing them to fail. In the parlance of financial economists, these institutions will be too-big-to-fail.

Among the 16 international financial conglomerates identified by regulators as large, complex financial institutions (LCFIs), each has several hundred majority-owned subsidiaries and 8 have more than 1,000 subsidiaries (Herring and Carnassi 2009).

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The fourth and final section comprises a discussion of the extent that improved governance can increase performance of the financial system. Narrow reforms may merely trigger Stantons Law and actions of private organizations to avoid them; on the other hand, some proposed solutions could at least help to mitigate the effects of future bubbles and their subsequent collapse. One of the most important improvements is to enhance the flow of information about risk so that it is better understood by decision makers, especially in government. How to encourage decision makers to act on that information is a far more difficult question.

Governance and the financial debacle How the debacle unfolded The debacle began as a period of unprecedented prosperity, both in the United States and globally. While analysts long observed that individual households and the United States government were over-leveraged and borrowing to sustain consumption beyond their means, few foresaw the dire consequences when it came to an end. As home values began to decline, it became apparent that many parts of the countrynotably California, Florida, Nevada, and Arizonawere seriously overbuilt. These were parts of the country that had experienced the greatest appreciation in home values; when the bubble burst, housing prices there fell the farthest. Other hard-hit states were in parts of the Midwest that depend on the automobile industry. While mortgage borrowers in much of the rest of the country remained largely current on their payments, homeowners in these states began to experience delinquency, default and foreclosure in record numbers. New complex securities and other financial structures had distributed the risk of pools of mortgages across many different investors. Investors that had purchased highly-rated mortgage securities suddenly found that their holdings lost substantial value. Investors, including commercial banks, Wall Street investment banks, pension funds, foreign central banks and other holders, suddenly found themselves unable to determine the extent of their likely losses as mortgage defaults continued to mount. As analysts looked at each part of the market, the reality of high leverage became apparent. One institution after anothercommercial banks and thrift institutions, Fannie Mae, Freddie Mac, Wall Street investment banks, and nonbank institutions such as large mortgage lenderslacked sufficient capital to cushion against losses. Even though some 97% of American homeowners were paying their mortgages on time, numerous financial companies without adequate capital, including banks, thrifts and nonbank lenders, began to fail. Failing institutions included those concentrating in the mortgage sector such as Fannie Mae and Freddie Mac (which together funded about 40% of the mortgage market), Countrywide Financial Corporation (the countrys largest mortgage lender), IndyMac and Washington Mutual (two of the largest thrift institutions), and other firms that had held risky mortgage securities. Many financial institutions lacked a clear picture of the volume of losses they were about to suffer. More importantly, lenders suddenly realized that companies with whom they did business, namely their counterparties, were going to take losses too. The lack of transparency about capital strength and likely losses meant that

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institutions could not be sure whether their counterparties might become insolvent and unable to repay their loans. Lenders stopped lending to one another and to others. The credit markets panicked and froze, and the housing crisis became a financial crisis (Gorton 2009). The Federal Reserve and Federal Deposit Insurance Corporation rushed to provide off-budget guarantees to key segments of the financial markets to help allay investor concerns. The Treasury provided infusions of taxpayer funds in the form of stock purchases to keep large failed financial firms and automobile companies afloat. For want of credit, companies and other borrowers began to lay off employees and even to close. The crisis, which had expanded from mortgages to a financial crisis, expanded again, this time from the financial sector to the larger American and global economies. The damage is not yet done. As people lose their jobs, increasing numbers are defaulting on their mortgages. Home values continue to fall and assets in investors hands and on lenders books will lose yet more value. Housing prices continue to drop, so that increasing numbers of mortgages in the millions become larger in size than the value of the mortgaged residence, thereby encouraging yet further defaults and foreclosures. The United States and many countries around the world must struggle with the consequences of serious recession. The concept of a Minsky moment Underlying the bubble and its collapse was a dynamic that had been predicted several decades ago by a little-known economist, Hyman Minsky (1975, 1986). Minsky observed that financial boom-and-bust cycles, such as he studied from the Great Depression, were a natural consequence of the financial markets. Understanding these cycles helps to understand why systemic risk is so hard to contain. For Minsky, there are three types of lending: loans based on the ability of the borrower to repay them; loans based on anticipated cash flows from assets; and loans based on the value of collateral. As prosperity flourishes, banks and other lenders take on greater leverage as a way to increase their returns to shareholders and to the managers who are rewarded with stock options. Because asset values such as the value of homes securing mortgage loans increase, lenders begin moving away from loans based on the borrowers ability to repay, or even on cash flows, to loans based on the value of the underlying asset. In other words, lenders begin to believe that loans can profitably be made to borrowers who are not creditworthy according to traditional rules: after all, if the borrower defaults, the lender can simply sell the home and recoup its investment from the increased home price. In the case of home mortgages and mortgage-backed securities, lenders masked their reduced lending standards with econometric models that purported to show the safety of such lending. This was true so long as home prices were increasing. Unfortunately, at some point the growth in asset values stops. Borrowers begin to default on their loans. This forces a decline in the value of assets such as homes, and the cycle spirals downward. Declining asset values force increasing defaults and highly leveraged lenders begin to fail. They are forced to sell even better quality assets to try to stay in business, and these sales further depress asset prices. The downward spiral of asset prices, similar to the upward spiral that preceded it, continues to reinforce itself.

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Minskys model of financial instability nicely describes what happened in the current financial debacle. Bubbles in housing prices and in other forms of lending were based on the borrow-and-consume attitude in the US that was fostered by an unprecedented inflow of funds from the global economy and abetted by an accommodative monetary policy. Minskys model also reveals the paradoxes that underlie the current financial system debacle. At the systemic level, there is tension between interventions to prevent crises from breaking out and the advent of a Minsky moment when, precisely because of prior interventions to forestall financial crises, the market gains unbounded confidence in financial system stability and creates a massive credit bubble followed by catastrophic collapse. In the 1970s, the US government intervened to prevent major insolvent banks from closing because of losses from unwise petrodollar lending. In the 1980s, the US resolved the savings and loan debacle and numerous bank failures without greatly troubling the larger economy. And in the 1990s, the Federal Reserve arranged for liquidation of the failed hedge fund called Long Term Capital Management, again without disturbing the larger economy. Little wonder that regulators and financial firms alike became irrationally exuberant as they marched towards todays Minsky moment. There are paradoxes also at the firm level. Many innovations and actions that appeared to reduce, diversify or shed risk at individual firms in fact turned out to amplify risk at the systemic level. Thus, securitization sought to diversify credit risk by pooling loans and permitting investors to purchase pieces of large diversified loan pools instead of whole loans that embody a concentration of risk in a single house or other asset and in a single borrower. Banks and other financial institutions could sell pools of loans into a trust and thereby take them off their balance sheets. These trusts were seen as efficient because they could fund loans with relatively little capital and thereby increase the returns to investors. What the designers failed to see was the way that the lack of capital left the securities vulnerable to loss when the bubble collapsed; the risk was obscured so that each actor in the chain from origination to investment thought that someone else was bearing it. Other devices for spreading risk away from individual firms, such as derivative securities used to hedge risk or quasi-insurance products such as credit default swaps, had the same effect: to increase linkages across the financial system so that when one highly leveraged institution got into trouble, it threatened to bring down its counterparties and even their counterparties. The question then becomes whether good governance could protect a lender or the lenders regulator from participating in irrational exuberance (Greenspan 1996) and excessive confidence in market stability as a bubble developed, grew, and then burst. Consider, first, the governance of public sector organizations and, then, governance in the private sector.

Public sector governance The importance of improving financial supervision The importance of public sector governance, in the sense of an effective system of financial supervision, is amplified by the way that government involvement alters

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market forces that otherwise might keep imprudent actions in greater check, at least over many parts of the credit cycle. Government charters a bank or thrift institution or government sponsored enterprise, authorizes its permitted lines of business, prescribes the conditions under which it operates (such as capital standards and other regulatory requirements), and determines its fate on becoming insolvent. The entrance of other firms with a comparable charter into the market is also determined by government rather than the private market (Stanton 1994). Thus, while market forces are important, the extent that a regulated financial institution thrives may be determined much more by government than by the market. One concern about a proposed expansion of government regulation of systemic risk to previously unregulated institutions is that government involvement may begin to displace market discipline and distort the nature of those institutions. Several factors combine to make public sector governance unsuitable for protecting the financial markets against major forms of risk. Laws, regulations and other government actions tend to be rigid compared to the fluidity of market forces that often flow around whatever structural rules government may have established. The rigidity of government rules derives from the often cumbersome nature of US financial regulators that, as federal agencies or instrumentalities, may carry out functions only to the extent that they are authorized by law. That requirement means that, to deal with new or expanding forms of risk, federal regulators may need to go to the Congress to obtain new authority. This can be a protracted process, subject to extensive compromises that tend to be the hallmark of the legislative process. One sure sign of legislative compromise is the length of a law; the recently enacted Dodd-Frank financial reform legislation is over 800 pages. When they possess statutory authority, financial regulators may need to promulgate regulations to help provide guidance to financial institutions about the nature of permitted and proscribed activities. Similar to lawmaking, issuing regulations, and especially those disfavored by influential stakeholders, can be time-consuming. Stakeholders often prefer explicit regulations rather than leaving too much discretion in the hands of regulators. Often the law will require a regulator to issue regulations rather than exercising more open-ended discretion. Thus, laws and regulations often may create rigid requirements and proscriptions. As market conditions change, a law or regulation put laboriously into place may exhibit diminishing relevance to new forms of risk that emerge. Even when regulators retain discretion for themselves, they operate in a context where they must remain mindful of the political influence of the regulated institutions. This is especially true in the US financial regulatory context where the regulated institutions often are permitted to shop for the most congenial regulator. The power of financial system stakeholders There is little question that stakeholders with an interest in financial regulation are influential in the US political context. The Center for Responsive Politics (2009a), which tracks and tabulates campaign contributions and lobbying expenditures each year and in each election cycle, reports that, The financial sector is far and away the biggest source of campaign contributions to federal candidates and parties, with insurance companies, securities and investment firms, real estate interests and

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commercial banks providing the bulk of that money. The Center for Responsive Politics (2009b) also reports that in the election cycle 20072008 alone the finance/ insurance/real estate sector provided some $460 million in federal campaign contributions. This stakeholder strength occurs as part of what a World Bank report considers exceptional stakeholder influence over governmental decisions in the US compared to many other developed countries (Kaufmann 2004). One sign of stakeholder influence is the fractionalized system of regulatory agencies for financial institutions in the US. Among other complexities, the Office of Comptroller of the Currency supervises national banks, the Office of Thrift Supervision supervises savings and loan associations and their holding companies, the Federal Deposit Insurance Corporation supervises state-chartered banks that are not members of the Federal Reserve System, and the Federal Reserve System supervises state-chartered banks that are members of the Federal Reserve System and bank holding companies. State regulators supervise insurance companies. Potential regulatory stringency is kept in political check by credible threats of the regulated institutions to restructure and move to a regulator with more attractive rules. The pattern of major financial legislation in the US does not provide assurance that necessary, comprehensive and long-term reforms will be forthcoming from the current debacle to deal with this splintered regulatory system. History indicates: First, reform has frequently been crisis-oriented. Despite an awareness of the structural defects in the financial system or in the monetary authority, little effort is directed toward reform until a crisis has occurred or is about to occur . . . Second, related to the crisis-orientation of reform, financial reform is frequently myopic and backward-looking. It is designed to deal in ad hoc fashion with an immediate set of problems usually within a specific sector of the financial system (Cargill and Garcia 1985). A conundrum: Stantons law A focus merely on trying to shore up oversight of specific parts of the financial system would not be wise. The interaction among financial institutions, whether government supervised or not, reflects the dynamic of Stantons Law: risk will migrate to the place where government is least equipped to deal with it. Thus, in the mortgage market, investors arbitraged across regulatory requirements and ultimately sent literally trillions of dollars of mortgages to Fannie Mae and Freddie Mac, where capital requirements were low and federal supervision was weak, compared to banks or thrift institutions in the same lines of business. The capital markets also found other places where government could not manage the risk, including structured investment vehicles of commercial banks, private securitization conduits, and collateralized debt obligations that were virtually unregulated except by the vagaries of the rating agencies and exuberance of the market during the housing bubble. Huge volumes of subprime, alt-A, interest-only and other toxic mortgages went to these parts of the market. Stantons Law gains its potency from the fact that, while government laws and regulations are cumbersome and often rigid, capital markets are much more fluid. Indeed, the fluidity of the capital markets raises concern about potential tradeoffs

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between financial innovation and protection of the financial system against risk. While some financial innovations in recent years helped to enhance market efficiency, many others served primarily to reduce the impact of regulatory requirements, and especially capital requirements. It can be difficult at best to distinguish efficiency-enhancing innovations from those that are merely a cover for regulatory arbitrage to avoid prudential requirements. Reforms and proposed reforms There have been a variety of suggested improvements in government supervision of the financial system, including several with organizational implications. Given the fluidity of financial markets vis--vis governmental restrictions, a combination of remedies is likely to be more effective than any single prescription. For example, besides improving the capacity and expanding the authority of federal regulators to wind up troubled major institutions, it would be wise to institute improved and more uniform capital requirements across multiple types of financial organization that take account of the incidence of non-quantifiable risk, require issuance of debt obligations that convert to equity in the event of insolvency, strengthen consumer and investor protections and bankruptcy provisions, and prevent institutions from shopping for the most lax regulator. It would also be wise to raise the legal standard of responsibility of officers and directors so that they have an obligation to ensure more effective internal controls for their firms. The US has now enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act. Important provisions of the Act from the perspective of managing systemic risk include: expanded authority of the FDIC to close troubled financial firms; creation of a Bureau of Consumer Financial Protection as an independent organization within the Federal Reserve; creation of a Financial Stability Oversight Council chaired by the Treasury Secretary and composed of nine regulators as voting members and five nonvoting members, supported by an Office of Financial Research in the Treasury to monitor and address systemic risk; expansion of the authority of the Federal Reserve to regulate nonbank financial firms such as insurance companies and investment firms as designated by the Financial Stability Oversight Council; and a requirement that the Federal Reserve prescribe risk management standards for financial firms. The law does not eliminate the Office of Thrift Supervision, but moves it to be a subordinate independent part of the Office of the Comptroller of the Currency. The Act also imposes certain restrictions on derivatives activities of major financial firms. One Obama Administration recommendation (Department of the Treasury 2009) with major governance implications had been the proposal to increase the authority of the Federal Reserve over institutions and activities that could pose systemic risk. The concept of a systemic risk regulator is that supervision is required of the financial system as a whole. This is different from supervision of individual institutions. A systemic risk regulator should survey institutions that are large enough to have systemic significance and the linkages among firms in the capital markets. The systemic risk regulator should have the authority and mandate to intervene to restrict practices that could threaten the safety and soundness of the financial system (Brunnermeier et al. 2009). The regulator also might fill in gaps in regulation that are major enough to have systemic implications.

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The Obama Administration had proposed that the Federal Reserve should be the new systemic risk regulator. On the other hand, some contended that this could conflict with the Feds mission of conducting monetary policy. Would the Fed be deterred from imposing tight monetary policies to fight inflation if this would place stress on financial institutions?2 Creation of a systemic risk regulator also raises organizational questions. As a matter of organizational design, there is a difficult tradeoff between organizational independence from the political process and the amount of discretion that policymakers may be willing to give the organization to intervene preventatively in the actions of major financial institutions and their regulators. Also, from whom and from what would the regulator be independent? If the Federal Reserve were to become a systemic risk regulator, one could imagine that systemically significant institutions might want to make adjustments to the range of stakeholders to whom they are currently most responsive (Becker and Morgenson 2009). By placing responsibility for monitoring systemic risk in the Financial Stability Oversight Council, the new legislation avoids some of these issues, but at the cost of leaving important decisions to a committee made up of disparate interests. The legislation creates a Bureau of Consumer Financial Protection to help protect consumers from taking out mortgages and other financial products that they do not understand and may not be able to afford. There is a clear need for such consumer protection. One important reform would be to require that consumers receive timely disclosures in the form of the one-page mortgage form proposed by Pollock (2007). Another critical issue is to prevent abusive lending practices that result in consumers taking on more debt than they can reasonably be expected to repay. Once again, organizational issues must be addressed. One precedent for the new bureau appears to have been the Consumer Product Safety Commission, a good idea that succumbed to inaction for many years because of weak statutory authority and the power of influential stakeholders, among other reasons. With the consumer financial protection bureau situated between the congressional banking committees and powerful financial sector stakeholders, one must fear a similar fate for the new organization. One question is whether government regulators can keep up with innovations that, following Stantons Law, begin to shift risk away from stringently regulated institutions and to new types of firm and new types of activity that can pose systemic risk in new ways. The problem is compounded, as discussed below, by the fact that top management of systemically significant institutions such as AIG and Citigroup may not have been fully cognizant of the significant risks that were being borne by transactions in remote parts of the company. Or, to frame the issue from the perspective of government regulators, is it possible to overcome the information asymmetries that exist between the individual elements of large complex organizations and the governments examiners who are supposed to detect those risks and understand their full dimensions before major losses materialize? (See, e.g., GAO (2009). With this in mind, it has been proposed that a federal oversight agency be created with the mandate, authority and capacity to raise issues of systemic risk and monitor
2

Federal Reserve monetary policy helped to precipitate the savings and loan debacle starting in 1979. One must wonder whether the Fed could have acted if thrift institutions had been influential stakeholders in the Federal Reserve Banks and Federal Open Market Committee similar to commercial banks.

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risk throughout the US and global financial systems (Stanton 2009a). While such a new agency by itself is not enough, it is a useful complement to a package of supervisory and regulatory improvements. Especially with the current financial debacle in the public mind, it is likely that many of the new agencys reports on systemic risk and supervisory shortcomings would find an attentive audience. The new Financial Stability Oversight Council is not the best way to try to ensure that the common interest in more effective protection against systemic risk prevails over more parochial regulatory interests. Especially given the impact of Stantons law on the effectiveness and durability of rigid regulatory prescriptions (and proscriptions), a more independent analytical voice is required.3 The new agency would not have authority to implement its recommendations. Rather, its mission would be to provide a clear voice on emerging issues and regulatory action needed to address them. Had it been in existence some years ago, for example, this body might have reported on the high leverage of investment banks subject to the Consolidated Supervised Entity (CSE) program of the Securities and Exchange Commission (SEC), the high leverage of Fannie Mae and Freddie Mac compared to other financial institutions serving the residential mortgage market, the questionable standards of the credit rating agencies in assigning credit ratings, or the potential problems of trying to apply loss mitigation to delinquent mortgages that had been securitized in private-label securities. While the new agency might not be able to anticipate the risk implications of each new development, it could try to do so. Perhaps most importantly, the new agency, with authority to obtain access to information from the relevant government organizations, could become the source of knowledge and expertise on systemic risk and the means of addressing threats to the financial system. Reinhart and Rogoff (2009: 27980) suggest how such an agency might monitor emerging bubbles as well. The overall organizational design relies on a simple idea: the problem of regulatory capture which often weakens financial regulators is less likely to impede an agency without regulatory authority. This logic resulted in the creation of the National Transportation Safety Board (NTSB) which can obtain information about transportation accidents but lacks authority to compel the adoption of its recommendations. The NTSB supplements the Federal Aviation Administration (FAA) which is responsible for regulating and supervising airline safety, and other federal, state and local transportation agencies. Similarly, a separate NTSB-type watchdog is needed for the financial sector.

Private sector governance It was not only the public sector that failed to provide adequate protection against the financial debacle. The private sector also failed. There are huge governance implications of Alan Greenspans statement that I made a mistake in presuming
3

Aficionados of organizational design may want to consider structural parallels between the Financial Stability Oversight Council and the Joint Chiefs of Staff (JCS) before enactment of the Goldwater-Nichols Act in 1986. The JCS, too, was a political compromise reflecting the power of divergent government departments and agencies. Only with the enactment of Goldwater-Nichols decades after the JCS was created did the JCS gain needed independent capability: see, Zegart 1999.

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that the self interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders and the equity in the firms (House Oversight Committee 2008). Several fundamental problems contributed to the financial debacle. First, high leverage provides generous shareholder returns in good times. Managers of financial companies acted on behalf of their owners in pressuring the government to permit them to operate with higher leverage: that is, to increase the amount they borrowed in their operations. Thus, Fannie Mae and Freddie Mac used their political power to obtain a law granting much higher leverage than the banks and thrifts that also serve the mortgage market. This benefited their shareholders, at least until the companies failed. Freddie Mac reported returns on equity of over 20% for most years since it became an investor-owned company in 1989, reaching highs of 47.2% in 2002 and 39.0% in 2000. Fannie Mae reported earnings of almost as much, reaching a high of 39.8% in 2001 (Federal Housing Finance Agency 2009, Tables 3 and 12: 110, 127). The two companies fought against higher capital requirements because more capital would have diluted those returns to shareholders. Similarly, other financial companies sought higher leverage than was prudent. A classic case was the SECs Consolidated Supervised Entity program for five large broker-dealers, Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs and Morgan Stanley. The SEC was responsible for monitoring risk and setting capital standards for these firms on a consolidated basis. In a brief meeting on 28 April 2004, the five companies persuaded the SEC to permit them greatly to increase leverage to roughly 33:1 (Labaton 2008). One result was to benefit owners and managers of the companies; the other result was to make the companies more vulnerable to failure. In 2008, Bear Stearns failed and was acquired by JPMorgan Chase, Lehman Brothers failed, the Bank of America acquired Merrill Lynch, and Goldman Sachs and Morgan Stanley obtained financial protection by becoming bank holding companies eligible for federal TARP and other subsidies. The second governance problem is a perennial one: the divergence of interests between management of a financial firm and its owners. The laws of many states set a very low standard for the duty of care of officers and directors of a company. Delaware law, for example, allows corporations to limit severely this fiduciary responsibility. Delaware courts have held that, in the absence of a conflict of interest or other evidence of a breach of the duty of loyalty to the company, directors are unlikely to be held personally liable for failed internal controls. There is a third governance problem, which relates to the problem of firms called too-big-to-fail because of a perception that some firms are so large, complex and entwined with the rest of the financial system that government will not allow them to fail. While some may seek to accept this as a fait accompli, there is a fundamental problem with these firms. As many have observed, firms that are so large and complex often are also too-big-to-succeedthat is, too-big-to-manageand not just too-big-to-fail. There is considerable evidence that, at least in some major firms that became insolvent, top management in fact did not perceive risks that some of their business units had been running. For example, Citigroup sold so-called liquidity puts along with its collateralized debt obligations (CDOs) that were intended to protect purchasers of CDOs against the kind of market collapse that ultimately occurred.

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The Economist (2009) reports that even the most senior Citigroup managers remained unaware of the firms exposure to these puts until purchasers of some $25 billion of the CDOs used them. Significant personal losses suffered by CEOs who had had heavy investments in their own large failed firms also would seem to support the inference that these CEOs did not accurately perceive risks at their firms. A rapidly growing bubble creates additional governance risks. These arise from a Hobsons choice that may face otherwise cautious firms. As the financial sector begins to shift, as Minsky observed, from lending based on borrower creditworthiness to collateral-based lending, firms must choose: do they limit their market share by acquiring only well underwritten loans, or do they join the rush to take on collateralbased loans that their competitors find so profitable? The problem was especially great in the current debacle because of the many years that it took for the bubble to inflate before it finally burst. As late as July 2007, the CEO of Citigroup, Chuck Prince, told the Financial Times (Nakamoto and Wighton 2007) that he foresaw an end to the bubble but was still actively engaged with the market for leveraged loans: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, youve got to get up and dance. Were still dancing. The market does not reward prudent lenders who largely withdraw in prosperous times; it also punishes those who stay at the party for too long. Especially given information asymmetries and the imprecision of knowing when an institution is too-big-to-manage, there seem to be few effective and efficient approaches to trying to prevent firms from growing to a size where they are too-bigto-fail. What is needed is a way to alter the incentives of managers of systemically significant institutions to manage prudently and actively police against risk. One way to create such an incentive is to require large complex financial institutions to retain significant core capital plus the idea of contingent capital (originally proposed in Stanton 1991: 1812). This could be in the form of debt obligations that would convert automatically to common equity in the event that the capital of the firm dropped below a specified trigger point or in the event that a regulator takes the institution into conservatorship or receivership. The benefit of this approach is the way that it creates incentives for managers to police their firms against risk, even if the regulator fails to detect the risk. If a firm becomes troubled or insolvent, the holdings of common stockholders would be diluted by the addition of added capital at the point where it is needed to help protect taxpayers from taking losses. This proposal can help to change the incentives of managers and also, by injecting added capital when a firm becomes troubled, potentially could help to mitigate the costs of a failure. Once again, however, past successes of financial firms in arbitraging around such protective measures need to be recognized. For example, how should one define the trigger point at which debt obligations would be required to convert to equity? While protective provisions tend to be rigid, the markets are much more fluid. Another proposal, heard from many quarters, is to arrange that managers performance bonuses be based not merely on the firms performance for the prior year, but rather on performance over several years. While this would not obviate all governance problems, it would at least extend the time horizon of management to help take account of longer-term risks that have proved so costly in the current debacle. Given the ability of skilled financial engineers and traders to flow from one

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firm to another, a possible counterproductive result would be the migration from larger publicly owned firms that might be subject to such compensation rules to smaller firms and privately owned firms that might not be subject. The outlines of appropriate reforms on the private sector side have not yet been thought through. It is much easier to deal with distorted incentives than to ensure competent management at the top. Earlier reforms such as requirements that major financial institutions install corporate risk officers failed to work in many cases. Corporate CEOs could simply disregard warnings from their risk officers (Hilzenrath 2008; Duhigg 2008a, b), although some top managers in fact did heed warnings and protect their companies (Anderson and Thomas 2007). Stephen Hiemstra (personal communication 2009), an expert on enterprise risk management, explains that the risk officer concept, while reasonable on its face, was defeated not only by the dynamics of trying to keep up with the herd in enjoying profits from the financial bubble, but also because too many organizations treat risk management as a mere compliance exercise.It is not yet clear how best to ensure the flow of high quality information about risks to the top management and directors of a large complex institution. One helpful improvement would be to raise the standard of care that officers and directors owe to their companies to remain properly informed about risks. A particularly troublesome issue is raised by the governments clear reluctance to close major insolvent institutions in the financial debacle. Given that these institutions are likely too-big-to-manage, this approach threatens to build into the financial system institutions that are inefficient but that operate at lower cost because of their access to less expensive borrowing, thanks to the perception of government backing in case of insolvency compared to smaller yet more efficient organizations that are not systemically significant. The concentration among large lenders has increased significantly, among other reasons because of the way that the government encouraged acquisitions of major troubled institutions by other institutions to reduce the impact of the unfolding financial debacle.

Conclusion Improved governance could increase performance of the financial system. One of the most important improvements would be to try to enhance the flow of information about risk so that it is better understood by decision makers, both at firms and in government. The discussion here acknowledges a way to improve the flow of public information based on the creation of a National Transportation Safety Board to monitor and report on systemic risk in the transport sector. On the other hand, the creation of Chief Risk Officers and similar roles in the corporate context did not work well at many firms. How to encourage decision makers to act on available information is an even more difficult issue. The dynamics of a bubble economy greatly weaken the benefits of virtually any system to contain risk. Continuing success as a bubble inflates tends to reduce the ability of public organizations and private companies to perceive risk or act to reduce it. The adoption of some of the improvements recommended above could increase the quality of financial supervision and private management of financial institutions. Prudence also will emerge from the current debacle and the spectacle of major

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institutions disappearing because of insolvency, of forced merger, or of being limited by federal requirements that accompany infusions of taxpayer money, all in a context of significant popular anger at Wall Street and lenders in general (Stanton 2009b). Indeed, one might fear that the next few years will bring targeted and excessive congressional enactments, supervisory stringency, and lender caution. Markets and policies tend to overcorrect on the way down after a bubble has burst, and not just on the way up. But in the end, it is likely that we will go through yet other cycles in the future as Minskys moment appears, disappears and reappears over the years.

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Nakamoto, M., & Wighton, D. (2007). Citigroup chief stays bullish on buy-outs. Financial Times, 9 July, http://www.ft.com/cms/s/80e2987a-2e50-11dc-821c-0000779fd2ac,dwp_uuid=1c573392-3015-11daba9f-00000e2511c8,print=yes.html, accessed 16 May 2009. Pollock, A. (2007). One-page mortgage disclosure form. Washington, DC: American Enterprise Institute, http://www.aei.org/docLib/20070913_20070515_PollockPrototype.pdf, accessed 19 August 2009. Reinhart, C. M., & Rogoff, K. S. (2009). This time is different: Eight centuries of financial folly. Princeton: Princeton University Press. Stanton, T. H. (1989). Testimony before the Senate Banking Committee. The Safety and Soundness of Government Sponsored Enterprises, hearing, 31 October. Stanton, T. H. (1991). A state of risk: Will government sponsored enterprises be the next financial crisis? New York: HarperCollins. Stanton, T. H. (1994). Non-quantifiable risks and financial institutions: The mercantilist legal framework of banks, thrifts and government-sponsored enterprises. In C. Stone & A. Zissu (Eds.), Global risk based capital regulations. Burr Ridge: Irwin Professional. Stanton, T. H. (2009a). Creating a financial system safety board. The American Interest, September/ October: 2630. Stanton, T. H. (2009b). The importance of legitimacy in the governments response to the financial crisis. Elliot Richardson Lecture, American Society for Public Administration and National Academy of Public Administration, 22 March 2009. Zegart, A. (1999). Flawed by design: The evolution of the CIA, JCS, and NSC. Stanford University Press. Thomas H. Stanton teaches at Johns Hopkins University, is a board member of the National Academy of Public Administration, and was a federal Senior Executive. He specializes in organization and program design, and financial supervision. He holds degrees from the University of California (Davis), Yale University, and Harvard Law School.