OPPORTUNITY AND RESPONSIBILITY IN A FINANCIAL INSTITUTION

(By Donald D. Hester*)

This paper examines the organization structure of regulated financial institutions in an attempt to ascertain how responsibility for actions of the institution is distributed. It reports no original empirical findings and contains no summary of legal precedents. Instead the approach is to depict broadly the roles played by important groups of individuals who propel the institution in order that potential conflicts of interest and sources of aberrant behavior may be better understood. The goal is not to propose a strict new moral code, but rather to provide guidance for drafting legislation which may resolve conflicts of interest and cause behavior to conform to norms which Congress and an informed public may prescribe.

The paper is written during a period when a number of recent large bank failures and bad investments have caused concern about the stability of the financial system. The premise underlying the subsequent pages is that these shortcomings are largely a result of a failure of both the public and regulatory agencies to appreciate the structure of command and the diverse interests of persons responsible for guiding financial institutions.

1. Introduction

At the outset it is useful to describe how a limited liability corporation is organized. Once promoters of a new venture manage to obtain a charter and sell stock, an enterprise takes on a life of its own. By electing a board of directors, stockholders specifically delegate and convey authority to the board so that it may act in ways which will cause the enterprise to prosper. Stockholders of course typically have the right to challenge the board at periodic meetings either through questions or proxy fights and may sue if it appears that directors are not acting honestly, competently, or in accordance with the organization's charter and the laws of the land. As A. A. Berle has repeatedly stressed, however, such challenges and suits are inevitably clumsy controls since stockholders will rarely be in possession of sufficient information to identify malfeasance or incompetence. The costs of keeping stockholders informed are sufficiently great that the board effectively has complete responsibility for guiding the corporation except when the firm attracts take-over bids or misbehaves so obviously that it draws legal challenges from other enterprises or government. The board has wide latitude to move, but its actions are limited by competition in factor and product markets. Information is imperfect in these markets and it is this fact which

* Professor of Economics. University of Wisconsin. Paper prepared for the Financial Institutions and the Nation's Economy (FINE) Study of the House Committee on Banking, Currency and Housing.

permits directors to have considerable freedom of movement and not merely be automatons.1 One can hardly be irresponsible if his actions are entirely dictated by outside forces.

The board of directors, while bearing full responsibility, is not omniscient and typically its members have other commercial activities apart from supervising the firm in question. Therefore, it appoints officers to administer the firm and monitors their activities at periodic board meetings. The officers have no independent powers apart from those conveyed by the board from whence all power in this firm flows. If officers break rules they can be disciplined by the board and if they commit felonies they are subject to the criminal codes. However, if they are merely incompetent or if their actions are inconsistent with the goals of the firm it is the board and not the officers who are responsible. Delegation of authority in no way implies disposing of responsibility.2

An important elaboration of the traditional limited liability corporation occurs when the corporation acquires interests in other enterprises which themselves are limited liability corporations. If such subsidiaries are wholly owned by the corporation, their boards of directors are exactly like officers of the parent company and serve at the pleasure of that company. However, unlike a division of the parent corporation, a subsidiary may be allowed to default on its obligations without endangering the capital and resources of the parent. Subsidiaries are thus like water-tight compartments in the hold of a ship; their limited liability serves to limit the damage which is sustained by a corporation when difficulties or tax collectors are encountered. Subsidiaries may not operate so that each maximizes profits, but presumably they operate so that total returns of the conglomerate are maximized.

a. Financial institutions.-In contrast to the conventional limited liability corporation just described, financial institutions from the earliest days of this country have been regarded as deserving additional special consideration within the legal fabric. The Constitution of course assigns to Congress the power to coin and regulate money. Implicitly its drafters recognized that the business of creating money and operating facilities for closing transactions within a decentralized economy involves much power and many potentially harmful effects in the event of its failure. In fulfilling its responsibilities Congress has introduced many safeguards to protect the public interest, above and beyond those legal recourses which the Courts offer to any person dealing with a corporation. These safeguards have been of two types: (1) deterrent and (2) confiscatory.

Examples of deterrent safeguards are (a) minimum capital requirements for organizing a bank, (b) required evidence that bank directors and officers are of good character, (c) bans on "excessive" concentration of bank offices, (d) required bonding of employees and

1 Indeed the amount of freedom is potentially so great that Congress has found it desirable to create a large number of regulatory agencies. such as the S.E.C., the F.D.A., and the I.C.C.. in order to protect the unwitting public from socially harmful behavior. There is, of course, currently a great debate about whether even these safeguards are adequate or whether these agencies are independent of the industries which they regulate in principle. No new agencies are proposed in the following pages.

2 Principal officers of a firm may also be members of the board. In this dual role they are first responsible for the activities of the firm as directors and secondarily administrators, agents of the board.

examinations of banks, (e) deposit insurance, and (f) restrictions on the amounts and types of investments an institution may make. Less widely appreciated but perhaps no less important are confiscatory safeguards which Congress has imposed to appropriate some of the enormous potential profits which exist because competition among financial institutions is limited. For example, in order to obtain a charter 19th century state bank organizers were often required to underwrite or buy canal, bridge, highway, and other state authorized bonds. Similarly the National Banking Acts of 1863-64 required national banks to hold debt of the United States in proportion to their note issue and taxed note issues of state banks in order to coerce them to buy Federal debt. In the present day, a credible interpretation for why required reserves at Federal Reserve banks bear no interest is that through this arrangement banks are forced to share some of their power and profits with the government (and hence the public).

It is useful to examine briefly why banks and other financial institutions merit this special attention. Relative to other corporations financial firms are distinctive in the following respects:

1. They engage in large numbers of confidential transactions with many different individuals: the multiplicity, complexity, diversity, and secrecy of these transactions are such that a bank's soundness cannot be accurately judged by its clients or even perhaps by its directors. A bank failure can have catastrophic consequences for innocent individuals in a community.

2. Financial information about individuals is exceptionally valuable and together with unfair contracts can be used to harm individuals unless adequate disclosure and oversight exist. The costs of defending oneself against usurious loan terms and the misuse of confidential information are very high for most individuals; paternalistic intervention seems very desirable in this instance.

3. Most financial contracts differ from other contacts in that they include "tie-in" clauses which protect the lender; tie-in sales are ordinarily illegal under anti-trust laws.

4. The services offered by banks and certain thrift institutions are very similar to the services afforded by money created by the Congress under the Constiution. Indeed many "monetarist" economists can find no meaningful differences between currency and demand deposits (and often time and savings deposits as well) since they feel such quantities can be meaningfully aggregated. If the drafters of the Constitution wished to control and regulate currency, then presumably they would also have wished demand deposits and their issuing enterprises to be regulated by Congress.

5. The technical expertise of financial institutions makes them very convenient agents for the distribution, servicing, and retiring of Federal debt. This agency relationship requires the existence of a number of protective covenants.

6. Congress has attempted to redirect flows of credit in the economy from time to time by specifying terms and conditions under which financial institutions may undertake transactions and has provided credit facilities and other arrangements which effectively are available only to selected financial firms and not to other corporations.

7. Finally, and by no means least, as a result of legislation and regulations associated with the aforementioned distinctive features,

financial institutions have acquired an aura of respectability and safety. Through the FDIC, the Federal Reserve, the FSLIC and other agencies, financial corporations can often trade on the good name and credit of the United States government. The Congress has a special responsibility to insure that this boon is not used to redistribute wealth and power in the economy in ways which lawmakers did not intend. Because Congress does distinguish financial institutions from other business enterprises, legislation has emerged which (1) provides them with certain rights and privileges, (2) restricts their set of allowable activities, (3) imparts rigid and discretionary regulatory powers to government agencies that supervise financial institutions, and (4) requires that specified services be provided and actions be taken by them. These stipulations of course appear in the National Bank Act, the Federal Reserve Act, the Glass-Steagle Act, the Federal Deposit Insurance Act, the National Housing Act, the Federal Home Loan Bank Act, the Bank Holding Company Acts, etc. These stipulations exist in order to change the situation of financial institutions so that they will function as Congress thinks proper and differently from what directors of financial institutions thought proper. In subsequent sections of this paper, it is suggested that these laws do not sufficiently guide behavior of financial institutions. Directors of financial institutions of course have an obligation to observe the laws of the land; this paper is not concerned with the detection and elimination of illegal activities. However, laws are inherently inflexible and it requires no great wisdom to observe that it is often possible to achieve results that are not desired by law makers through ingenious machinations that do not violate the letter of the law.

Informed directors surely understand the intent of the laws and they may well allow their actions to be partly guided by what they perceive to be the wishes of Congress and the public. This informal compliance may or may not constitute irresponsible behavior as judged by the criterion of maximizing the expected returns to stockholders. If corporations flout the conspicuous wishes of the public, they will surely incur Congressional displeasure and the strong likelihood of additional restrictive legislation which could impair the value of common stock. On the other hand, unnecessary compliance surely sacrifices potential profits as critics of the trend towards public interest ventures by corporations have repeatedly stressed. The inelegant conclusion seems to be that corporations will comply with the wishes of the public only to the extent that society establishes standards of integrity and fair play and then relentlessly points out deviations from these standards. Congress may outlaw certain specific types of bad behavior, but surely human ingenuity and technological advance prevent any effective prescription of "good" behavior.

Perhaps two other conclusions flow from this introduction. First, because of the vast amounts of confidential information which naturally accumulates in financial institutions and of the secrecy which attends successful operations in capital markets, the public is especially vulnerable to irresponsible and unfair behavior in this sector. Second, as a consequence Congress has determined that financial institutions require considerably more governmental guidance than other corporations and, therefore, they are distinctive in being unusually subject to arbitrary non-market forces.

b. Summary of legislative proposals.-The following proposals are explained more fully and briefly justified in the following pages:

(i) Because of the quasi-public nature of insured financial institutions, complete minutes of board meetings should be available for inspection by shareholders with a lag of no more than one year. These minutes should be available to bank examiners at all times. In the event a bank is held by a holding company, stockholders of the holding company should have the right to examine minutes of bank board meetings.

(ii) Directors of banks and, if different, bank holding companies should be required to disclose all of their other directorships and business affiliations in the annual report of the bank or bank holding company; such information should be freely available to all shareholders at the principal office of the bank.

(iii) A detailed statement of all substantive informal or formal business transactions between a financial institution and other companies where its directors hold directorships or function as officers should appear in the institution's annual report; such information. should be freely available to all shareholders at the principal office of the bank.

(iv) In the event of a financial institution's being declared insolvent, the governmental agency that insures the institution should have first claim on all assets of other firms owned by the institution's holding company up to the amount of the agency's losses.

(v) A mutual institution should be required to mail an annual report to its members and to maintain quarterly reports at its principal office which shall be available for inspection by the public. The annual report should disclose financial interests of the directors of the institution and transactions which the institution may have made which involve firms with which directors are affiliated.

(vi) The mutual institution's annual report should include a detailed statement of the goals of the institution, especially as regards its lending policies to members and, in the case of real estate loans, the extent to which they are secured by commercial and residential properties in the immediate vicinity of the institution's principal offices.

(vii) The mutual institution's annual report should explain any increase in its net worth above levels which are viewed as adequate by governmental insuring agencies. In the event of a proposed reorganization or conversion, the institution's members must be provided with information which compares the institution's ratio of net worth to total assets with corresponding local and national ratios.

(viii) Any significant minority of the membership of a mutual institution should have the right to petition a government regulatory agency for an independent audit if they have doubts about the veracity of information appearing either in the annual report or in any conversion proposal. Membership mailing lists should be available for circulating such petitions and the mailing costs must be borne by the institution.

(ix) Government agencies regulating and insuring financial institutions should be required to disclose fully all information appearing on the present detailed call report forms, including footnotes, qualifications and addenda. Detailed call reports should be collected at least