Open Review of Management, Banking and Finance

«They say things are happening at the border, but nobody knows which border» (Mark Strand)

Being a banking director: regulatory difficulties between sanctions and interlocking directorates

by Valerio Lemma and Susan Clements

Abstract: This paper analyzes the possibilities of an adverse selection perspective in the market of banking managers due to both the restatement of sanctions and the ban on interlocking directorates. The result of this research shows the risk that credit institutions will not find managers because them will not accept the increasing risk in exchange of the current payments.

The analysis of the regulatory framework – and in particular of Directive no. 2013/36/EU and Regulation EU no. 575/2013 – will focus on the purpose of sanctions in the banking business, having regards both to the European regulation and to certain examples of national implementations. This is why we focus on the relevance of professional duties and the current ways of enforcement.

The paper concludes that the supervising authorities shall verify if the externalities of the ban on interlocking directorates will affect the banking industry, which is already under pressure because of its market condition, and then suggest specific action in order to improve the convenience of being a banking director.

Summary: 1. Introduction. – 2. The purpose of sanctions in the banking business. – 3. Professional duties and ways of enforcement. – 4. Externalities of the ban on interlocking directorates. – 5. Adverse selection perspectives.

1. The current regulatory framework places strict responsibilities over the top management of credit institutions. After the implementation of the last Capital requirement directive and regulation (i.e. Directive no. 2013/36/EU and Regulation EU no. 575/2013), recent studies highlight the weight of responsibility which rests on subjects who, in various ways, cooperate in the business of a credit institution.[1] Several scholars outlined the features of a legal system that, after the European innovations, finds – in dissuasiveness and pervasiveness of sanctioning interventions – new essential criteria for the protection of capital and financial-services market.[2]

The conclusions reached by the aforementioned scholars suggest that the forthcoming sanctions are characterized by amounts higher than those resulting from the application of the existing rules. And also, it seems possible to consider that the procedure, just because now inspired by the adversarial principle, is appropriate to calculate higher fines.[3]

Hence, bank directors are called to review the analysis methods that, in the past, have justified the access to the boards of credit institutions. In the new regulatory framework, in fact, the risk they assume in supervising, managing and controlling the business of a bank has changed. This risk improved because of specific changes in the scope of both the law (that provides new types of violations) and the supervisory practices (that increase the likelihood of finding a violation).[4]

These elements, ceteris paribus, result in a modification of the individual utility curve of the people interested to take a membership in the boards of a credit institution. Thus, such a modification affects the expectations for appropriate behavior in these roles and then the individual’s propensity to carry out them.

But ceteris paribus are not.

In the Italian legal system, for example, Article 36 of the Law Decree 6 December 2011, No. 201, converted with amendments by Law 22 December 2011, No. 214, introduced the prohibition of interlocking dictatorates in order to provide a two-way relationship between a bank director and his/her business functions. This has the obvious effect of creating a sole risk of sanctions by correlating the individual person and the relevant credit institution. And this effect becomes more evident by taking into consideration the top management of a banking group, that is the point of convergence of the business conduct placed in any company of the group itself.

Properly understood, the conditions for being a bank officer have changed also as a result of the duty of ensuring a specific efforts in carrying out these tasks. Undoubtedly, supervising authorities do not appreciate boards that are limited to a role of mere approval of decisions already taken (by CEOs).

Therefore, this new regulatory framework outlines the possibility of an adverse selection in the market for the managers. This can also cause a sort of ‘knock-on effect’ and then can unravel this market. An additional implication is the exit – from the market for banking managers – of individuals who, prudently, do not accept unsatisfactory compensations (i.e. a payment inadequate to remunerate the strengthening efforts required by the regulatory framework and the high risk of incurring in heavy penalties).

2. Main recipients of the new provisions enacting penalties for the mismanagement of credit institutions are the individuals placed at the top of their organization, and this seems to be a new reason for implementing corporate governance models that shall be compliant with the free market prerogatives.[5]

At the same time, the regulatory framework set a link between the tasks of corporate governance and the responsibilities for any control concerning the proper functioning of the banking business.[6]

Undoubtedly, the European mainstream – which, as highlight by several scholars, connects the procedures for carrying out the administrative functions with the structural organization of credit institutions – leads the supervising authorities to take specific action to ensure the efficient functioning of the credit institution, bot for corporate governance and internal controls.[7]

There is no doubt that, in recent times, the growing interest (of the European regulator) for the administrative structuring of banks refers to the need for overcoming certain limits of regulatory supervision (sometimes limited to a mere verification of mathematical models required by capital adequacy controls, i.e. Basel Accords). The same shall be said with regard to the restatement of governance models provided by the law, and to the prevision of new backstops in case of outsourcing (involving core functions related to the credit business).[8]

Hence, we shall focus on the mechanisms used to apply these sanctions provided by the Directive 2013/36/EU, which sets the rules concerning the banking license and the related sanctions to ensure compliance with the standards imposed by this directive, its Regulation (EU) No. 575/2013 and the Regulation (EU) No. 1024/2013. This clarify whether, in their current configuration, these mechanisms can promote the appropriateness of the bank’s organization and the professionalism of its human resources, compared to the need for the efficient provision of any banking service. In this way, we shall consider that the safeguard of the banking authorization standards will be one of the main goal of any banking director.

That said, it is useful to point out the choice of defining the bank by both the business that qualifies its essence (that is, the credit intermediation) and the structure that supports its activities (which should provide adequate levels of professionalism). Therefore, these specific elements affect the prevision of sanctions (and their capability of being proportionate and dissuasive).[9] Hence, it seems possible to identify a link among the need for a safe and sound management (of banking activities) and the necessity for the involvement of qualified directors (under effective sanctions, able to influence their choices).

On the other hand, in the European regulations, one or more management bodies are the core of any credit institution’s corporate governance. And, according with the credit institution’s bylaws, these bodies shall be entitled to set its strategies and goals (i.e. strategy, objectives and overall direction), together with the duty of supervising the choices of its (senior) management. Henceforth, this explains why these bodies shall include the persons who effectively direct the business of the institution, in order to improve the transparency of the organizational structure, and then the possibility (for these persons) of taking on their own responsibilities art. 3, para 1, ponts 7 – 8, dir. 2013/36/EU).[10]

We shall focus our interest on the regulator’s choice to sum in one sole category, named ‘senior management’ those natural persons who exercise executive functions being responsible for the day-to-day management, and accountable to the aforesaid bodies (art. 3, para 1, point 9, dir. 2013/36/EU). It is clear also the choice to place in the operators’ autonomy the organization of the human resources that shall cooperate with that community of persons being subject to the aforesaid sanctions, which concretely represents the top management. This people shall comply with the EBA’s (regulatory and implementing) technical standards (adopted by the EU Commission) and any other (national) applicable regulations.[11]

In order to understand the contents of these overseeing and monitoring tasks, we shall refer to the business model of the credit institution, because the choice between the ‘originate to hold’ or ‘originated to distribute’ follows an alternative strategies in the application of the ‘production function’ (or rather the ‘intermediary function’) of the bank. Those models raise specific question on the possibility to understand anyone’s personal responsibility in the bank’s management and then the opportunity to personalize the aforesaid function. Indeed, the implementation – by the management body – of any tools provided by a third party (concerning the creditworthiness assessment or trading or any other business) implies specific consequences on the internal regulation of the organizational structure, both for the path dependence (between the tool’s provider and the bank) and the outsourcing of business activity that are the essence of the banker.[12] Moreover, from an operational perspective, the top management shall oversight the integrity of any system (used by any of its business units), and in particular shall control its information and communication system, in order to afford the prudential supervision of the relevant activities. Therefore, there is a web of information and functions wove in the spaces among the bodies responsible for the corporate governance.

Hence, we reach a first conclusion on the possibility that these models influence the set-up of any technical standard for the management and the internal control of the bank. [13] And this influence goes under the control of the supervising authorities in order to catch any data useful to their institutional objectives. In fact, the EU regulation calls for the control of tools, strategies, processes and mechanisms implemented by the credit institutions in order to comply with EU Directives (and in particular 2013/36/EU) and Regulations (i.e. no. 575/2013).

3. All the above casts the doubt that the implementation of Directive 2013/36/EU allows national authorities to restate their regulations on professional duties and any applicable way of enforcement. Indeed, the new sanctions go beyond the punishment of to both the credit institution and the individual responsible for the relevant breach, and will cover the need for a system able to support the proper functioning of the capital markets.[14]

Therefore, the attention will focus on the role of the individuals managing the intermediaries, and the influence due to the new criteria used to apply higher penalties.[15]

The new structure of the remedies has been designed by national regulators not only as an heavy deterrent (against certain behaviors), but also as a risk to be managed through an organization (of banks’ management) where the strategic and operational directions have been clearly defined, transparent and coherent (with the interests of both shareholders and stakeholders). Hence, we can understand the preference of these regulators for measures (or rather remedies) able to encourage the implementation of effective processes (for the identification, management, monitoring and early warning of the main risks related to banking activities) and suitable structures (able to support the tasks required by the new banking regulations). Thus, we shall also take into account the new assignments (of bank’s boards) arising from the aforesaid structure of the remedies, because these assignments refers to the organization and the management of the risks ‘posed by the macroeconomic environment in which it operates in relation to the status of the business cycle’, and this refers to the risks that any credit institution ‘is or might be exposed to’ (art. 76, dir. 2013/36/UE).

Undoubtedly, it is clear in the EU regulation that any competent authorities should be empowered to impose administrative pecuniary penalties, and that the amount of them has to be sufficiently high both to offset any benefit that can be expected, and to be dissuasive even to larger institutions and their managers (Recital no. 36, dir. 2013/36/EU). Obviously, it seems to be easier to understand that this system shall consider the computation of previous negative behaviors, which will be considered as an increasing factor in computing the penalties, and so it is linked to the insufficient dissuasive effect of any former penalty suffered by the recidivist.

National regulators, then, will take into account any advantage (for the author) and the negative externalities (for other parties) connected to the breaches, together with their potential systemic impact.[16] In this case, the regulators are called to the application of economic models able to sustain a comparative evaluation in order to reach an equilibrium between individual utilities of the banks’ managers and the savers.[17] On the contrary, we expect that authorities will focus on the link between violations and safe management, focusing on the significally important effects, and then they will incur in the difficulties in linking any individual breach (and its relevant behavior) and the systemic consequences arises in the capital market.

It should be clear that national regulations shall consider that the (sanctionable) directors and auditors must easily understand the elements that will be used to choose among several penalties and measures and to calculate their amount. This will allow rational choices in considering the risk and the benefits in accepting these roles in any bank’s board. Hence, there is the specific need for a reliable mechanism of enforcement, in order to avoid any mistake in the computation of the specific remedies.[18]

From another perspective we shall consider also the general application of outsourcing strategies in the banking industry, whereby managers are not exempted from the aforesaid system of sanctions. Directors and auditors will keep their own responsibilities in case of certain breaches made by third parties to whom the credit institutions have outsourced operational functions or activities. On the contrary, outsourcing policy can be used for regulatory arbitrages (that are not compliant with the rules governing the capital market).

In this context, we shall conclude that the supervising authorities have the duty to analyze the costs and the timing of any set of sanctions, whereby those elements will influence any rational choice of the individuals. Therefore, it comes into consideration the need for a EU supervision able to verify whether the administrative penalties (and other administrative measures laid down by Member States) satisfy the essential requirements related to their effectiveness. This supervision, in fact, will cast any doubt on any potential breaches in transposing the Directive 2013/36/EU and Regulation (EU) No 575/2013.

4. All the above suggests that people joining the board of a credit institutions shall review their choices, and in particular the convenience of being a top manager, a director or an auditor (under the burden of new tasks and responsibilities). As we have observed, the higher size of penalties and the heaviest content of other administrative measures changes the dynamics of the market for top management professionalism.[19]

Supply, demand and market equilibrium are shifting to new paths and then to new points that will require more money to convince someone in accepting the current legal and reputational risks.

That said, we shall focus on the structure of the market for managers (i.e. directors or auditors). In the internal market, in fact, the offering of these roles is restricted by the ban on interlocking directorates (that, in Italy for example, has been introduced in a very strict form by law 22 December 2011, no. 214). All in all, this regulation unifies the risk of sanctions for the bank and the members of its boards, because the individual cannot have a seat in a board of any other competitor of this bank.

Consequently, this ban amplifies the possibilities of an adverse selection perspective in the market, and then the risk that credit institutions will not find prudent managers accepting the role of (sanctionable) director or auditor (because they will not accept the increasing risk in exchange of the offered compensation).[20]

5. Haven of the above is the perspective of an adverse selection in the managers willing for the credit institutions’ management. This conclusion relies on the aforesaid interpretation of the regulations of the management bodies, which influence the balance of demand (for compensation) and supply (of professionalism). This balance, in fact, shall provide the optimal structure of the high-level bodies, and then the presence of qualified human resources in the top management.

According to these premises, we shall consider that the new sanctions provided by the recent EU regulations modify the aforesaid balance, whereby low demand for compensation implies low supply of professionalism, and then a period of adverse selection in the top management. This implies the risk of an exit – from the market for bank’s managers – of the people that are not amenable to accept compensation unable to compensate the increasing commitment and the forecast of higher amount to pay in the event of sanctions.[21] And to this risk follows the possibility of moral hazards that are not suitable with the aforesaid market regulation.[22]

These are the main features that, in our analysis, help understanding the growth of the risk – for the shareholders of a credit institution – of hiring top managers. The latter should be the first precaution for the safe and sound management; the bank should rely on their attitude to risk-avoidance in order to set up the proper mechanisms for providing credit to the real economy within the prudential limits (or the monetary backstops).

In conclusion, it can be said that the supervising authorities shall verify the weight of the aforementioned externalities, having regard both to the risk of sanctions and the ban on interlocking directorates. These authorities shall verify if the current outline of their supervisory practices will affect the banking industry, which is already under pressure because of its market condition. If we agree on this, we can easily agree that all the above suggests specific actions in order to improve the convenience of being a banking director.

Authors

Valerio Lemma is Associate Professor of Law and economics at the Law Faculty of Università degli Studi Guglielmo Marconi in Rome, and Coordinator at «Financial market regulation» master programme at Luiss University. He is Visiting Associate Professor at Centre for Banking and Finance – Regent’s University of London.

Susan Clements is Head of European Commercial Law Observatory. She has Diplomas in Legal Practice and Law at the College of Law, Guildford, and Politics MA Honours (First Class) and Certificate of High Scholarship, respectively at The University of Edinburgh and the University of Washington.

Although this paper is the result of a joint reflection of the authors, Valerio Lemma wrote the paragraphs 1-4 on the basis of the speech at the conference ‘Sanzioni e procedimento sanzionatorio Consob e Banca d’Italia’, her in Milan on October 20, 2016, and Susan Clements wrote the paragraph 5 .

[1] See Capriglione, Nuova finanza e sistema italiano, Milanofiori Assago (MI), 2016, p. 177 ff.

[2] We refer to a specific analysis widespread in the Italian literature, see Rordorf, Sanzioni amministrative e tutela dei diritti nei mercati finanziari, in Società, 2010, p. 991 ff.; Baldassarre, Le sanzioni della Banca d’Italia, in Le sanzioni delle Autorità amministrative indipendenti, Padova, 2011, p. 598 ff.; Condemi, Commento sub art. 144 d. lgs. 385 del 1993, in Commentario al testo unico delle leggi in materia bancaria e creditizia, Padova, 2012, p. 2370 ff.; Zagrebelsky, Le sanzioni Consob l’equo processo e il ne bis in idem nella CEDU, in Giurisprudenza italiana, 2014, c. 1196 ss.; Clarich, Le sanzioni amministrative bancarie nel meccanismo di vigilanza unico, in Banca impresa società, 2014, p. 333 ff.; Visco, Il sistema sanzionatorio bancario europeo e nazionale, Speech of 4th December 2015;

[3] See van Bemmelen van Gent, Harmonising Criminal Laws and EU’s Significant Bankers: First Use of Article 83 (2) TFEU, Rights of the Accused and Learning Organisations in Governance and Security Issues of the European Union. Challenges Ahead, 2017, p. 5 ff. where the Author focused on the Market Abuse Regulation (EU) no. 596/2014

[4] See Tomasic, Corporate Governance Failure: The Role of Internal and External Gatekeepers in UK Banks and Financial Institutions, in Corporate Governance – International Journal for Enhanced Board Performance, 2010, Vol. 10, No. 1, p. 8 where the A. highilights that internal regulation needs to be backed up by effective external regulatory mechanisms which impose some sanction for failure.

Moreover this A. provides that prior to the financial crisis of 2007-2008, government regulators seemed to have the role of providing reassurance rather than sanction; thus, banks would turn to regulators for comforting reaffirmation that the bank’s risk management policies and practices were adequate. A key means of achieving effective corporate governance has been through the roles of “gatekeepers” both within and outside of the corporation. Those gatekeepers inside the banks included its board and CEO as well as the general meeting; in contrast, external gatekeepers included auditors, credit rating agencies, and government regulators.

He concludes that the failure of bank gatekeepers has set the scene for the subsequent financial crisis that we have seen. This failure was made all the more likely due to the complexity of financial instruments that bank gatekeepers were meant to scrutinise, but were poorly equipped to do this. This paper examines some of these issues in greater detail.

[5] See Alpa, Presentazione, in Banche e etica, edited by Sabbatelli, Padova, 2013, p. XIV

[6] In this context, detects the connection between the company’s organization and the enterpreneur’s correctness and the attempt to rebalance the role and powers of the members of the various boards that, according to the management model, participate between autonomy (of the internal choices) and the responsibilities (for the offer to the public).

[7] See Capriglione, Commento sub art. 10 d. lgs. 385 del 1993, in Commentario al testo unico delle leggi in materia bancaria e creditizia, Padova, 2012, p. 115.

[8] However, the regulation mentioned in the text, just in part, appears to be adequate to prevent the unrestrained pursuit of outsourcing policies and, consequently, the emptying of the company structure. It is therefore essential – for the purpose of the sanctioning system aimed at safeguarding credit institutions’ stability – the identification of a balance in the relationship between “banking business”, “company organization” and “people”, that relates to the ability to ensure that the intermediation process refers to a behavior able to link the efficiency levels of the structure to an amount of relief appropriate to give solidity to the bank.; see Lemma – Thorp, Sharing Corporate Governance: The Role of Outsourcing Contracts in Banking, in Law and Economics Yearly Review, 2014, Vol. 3, Part 2, p. 357 ss.

Note that, in this case, outsourcing contract previsions are replaced with those of the service relationship that qualifies the work out subordinate employee in charge of the tasks in question. So, relations (between the management bodies of the bank and the executors of the services) will have treaty features, having to necessarily find an adequate regulation in contracts that the management must conform to the supervisory authorities dispositions.

[9] See Kupiec, Fixing Prompt Corrective Action, in AEI Economic Policy Working Paper, 2016, p. 4 ff. where the Author suggest that any prompt corrective action requires regulators to sanction banks before they become insolvent and to resolve institutions within 90 days of reaching critically undercapitalized status.

[10] It is useful to take into account also the article providing that ‘the competent authorities shall grant authorisation to commence the activity of a credit institution only where at least two persons effectively direct the business of the applicant credit institution’. (art. 13, dir. 2013/36/EU). Indeed, this minimal size (two persons) whether on the one hand overrides the question on the possibility of a monocratic direction of a credit institution, on the other it lies on a level that seems to be too low to ensure the standard functioning, compliant with the well-known criterion of collegiality required for a qualified discussion, and so able to come to a prudent decision.

[11] See Amorosino, Commento sub art. 14 d. lgs. 385 del 1993, in Commentario al testo unico delle leggi in materia bancaria e creditizia, cit., p. 191 ff.

[12] See Lemma, The Shadow banking system, London, 2016, passim.

[13] See article 98, para 1, lett. i, directive 2013/36/EU

[14] See Chwieroth – Walter, Policy Responses to Banking Crises Over the Longer Run, SSRN Research Paper no. 2715468, 2015, p. 8 ff. where the Authors – using a new database of government responses to 122 separate systemic banking crises with start dates from 1976 to 2009 – investigate the role of different factors in the evolving policy responses to such crise, highlighting a specific bailout propensity in democratic countries associated with the relative importance of banks and private sector leverage.

[15] It is clear that the new rules will go far beyond the question of ethics in finance; see Dempsey, Ethical Finance: An Agenda for Consolidation or for Radical Change? in Critical Perspectives on Accounting, 2000, p. 531 ff. where the A. highlights that conceptual frameworks exist not to portray truth as an absolute, but rather to provide order and guidance to actions and behavior.

From such perspective, the A. also considers that ethical frameworks assist in our attempt to balance the instinct that we have to look out for our own individual welfare with the conscience of obligation that we have to care for a wider community. In this light, the development of ethical frameworks may be interpreted in terms of a process of natural selection with regard to the mutual interdependence of the individual and the community. The net outcome of the article is that institutionalized activity may be co-ordinated to function under the banner of ethical codes of practice, while broader ethical issues for the institution as a whole remain suppressed.

[16] See Barbagallo, Il rapporto tra BCE e autorità nazionali nell’esercizio della vigilanza, Speech of 26th February 2014; Guarracino, Le “procedure comuni” nel meccanismo di vigilanza unico sugli enti creditizi, in Rivista Trimestrale di Diritto dell’Economia, 2014, p. 275 ff.

[17] See Rangone, Mercati finanziari e qualità delle regole, in Scritti in onore di Francesco Capriglione, Padova, 2010, p. 177 ff.

[18] See the classic approach suggested by Robinson, Hybrid Principles for the Distribution of Criminal Sanctions, in Northwestern University Law Review, 1987, Vol. 82, p. 19 ff. where the A. highlights that most criminal codes, and most criminal law courses, begin with the ‘familiar litany’ of the purposes of criminal law sanctions – just punishment, deterrence, incapacitation of the dangerous, and rehabilitation, and the he tried to suggest a preference for both the drafting and interpretation of criminal statutes and the imposition of criminal sentences in individual cases.

[19] See Pesic – Mure, Are Sanctions Effective in Improving Bank Performance? A Study on Supervision and Administrative Sanctions Upon Italian Banks During the 1998-2009 Period, in CAREFIN Research Paper, 2010, p. 22 ff. where the Authors highlights that the design of the right incentives for a sounder and more prudent management of banks has attracted increasing attention, especially for those who are attempting to identify an effective discipline for bank organizations and their board members, creating a dataset (including the entirety of administrative sanctions issued by the Bank of Italy during this period) which has been matched with the economic performance achieved before and after the sanctions.

[20] See Caiazza – Cotugno – Fiordelisi – Stefanelli, Bank Stability and Enforcement Actions in Banking, in SSRN Research Paper no. 2505873, 2015, where the Authors try to explain that enforcement actions (or sanctions) pursue two complementary goals, namely to penalize guilty companies and to provide an example to other companies that bad behaviour will be penalized. These Authors – focusing on the Italian banking industry – assume that non-sanctioned banks care about the enforcement actions taken against other similar banks, and show that the stability of non-sanctioned banks increases as the probability of being sanctioned increases.

[21] See Khalil – Saffar – Trabelsi, Disclosure Standards, Auditing Infrastructure, and Bribery Mitigation, Canadian Academic Accounting Association, 2011, p. 5 ff. where the Authors investigate the impact of disclosure standards and auditing infrastructure on firm-level corruption, finding out that firms are less likely to grant gift to secure a government contract in countries having more extensive financial reporting requirements and countries where audit firms face a higher litigation and sanction risk.

[22] See DiLorenzo, Mortgage Market Deregulation and Moral Hazard: Equity Stripping Under Sanction of Law, in St. John’s Legal Studies Research Paper, 2009, for an analysis of the failure of the current regulatory structure in protecting consumers suggesting ‘a rejection of the net societal benefits standard as the determinant of regulatory intervention’.

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