Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries

AuthorEmilios Avgouleas,Jay Cullen
DOIhttp://doi.org/10.1111/j.1467-6478.2014.00655.x
Published date01 March 2014
Date01 March 2014
JOURNAL OF LAW AND SOCIETY
VOLUME 41, NUMBER 1, MARCH 2014
ISSN: 0263-323X, pp. 28±50
Market Discipline and EU Corporate Governance Reform in
the Banking Sector: Merits, Fallacies, and Cognitive
Boundaries
Emilios Avgouleas* and Jay Cullen**
Much contemporary analysis has concluded that the recent financial
crisis and bank failures were, among other things, the result of a
breakdown in corporate governance regimes and market discipline. In
this context, new regulations advocate such market-based remedies as
tighter investor monitoring and greater control over executives'
remuneration, in order to safeguard financial stability. We argue that
this approach largely ignores three very important aspects of modern
financial markets that cannot be constrained through market
discipline: (i) socio-psychological phenomena; (ii) the epistemological
properties of financial market innovation; and (iii) the inherent
inability of market participants to predict uncertain risk correlations.
Therefore, this article argues that excessive EU focus on corporate
governance reforms as a means to improve financial stability detracts
attention from much more significant concerns, chiefly, the issue of
optimal bank structure.
INTRODUCTION
Building the different blocs of corporate governance over several decades
has been a painstaking exercise aimed at curbing the privileges of insider
classes and fostering shareholder democracy. Effective corporate governance
28
*School of Law, University of Edinburgh, Old College, South Bridge,
Edinburgh EH8 9YL, Scotland
Emilios.Avgouleas@ed.ac.uk
** School of Law, University of Sheffield, Bartolome House, Winter Street,
Sheffield S3 7ND, England
Jay.Cullen@sheffield.ac.uk
The authors would like to thank Charles Goodhart and Marc Moore for valuable
comments on an earlier draft of this article.
ß2014 The Author. Journal of Law and Society ß2014 Cardiff University Law School
has been placed at the heart of capitalist growth initiatives and is rightly
regarded as a key component of a free enterprise economy that wishes to
retain its legitimacy in a liberal democracy. As a result, every time that the
economy experiences some form of corporate collapse, policy makers and
the industry try to upgrade their corporate governance toolkit and legislate
for ever-higher standards of governance.
1
Thus, it is not surprising that in the aftermath of the Global Financial
Crisis (`GFC') most commentators' and policy makers' analysis focused on
actual and assumed corporate governance failures within big banks. Accord-
ing to this narrative, if reckless bankers were reined in, and market discipline
restored, banks would be buttressed against the possibility of failure. A flurry
of legislation and legislative proposals has followed, placing sound corporate
governance at the heart of regulatory reforms trying to restore health to the
banking sector.
While some of these initiatives constitute a marked improvement over the
shambolic structures governing banks in the recent past, they are bound to
disappoint in terms of effectiveness. The reason for that is not a lack of good
intentions on the part of the champions of corporate governance reform, but a
number of fallacies in the analysis of the standard narrative. For example, it
may be plausibly argued that no corporate governance model can work when
the principal actors face severe limitations in their knowledge and under-
standing of risk due to objective factors, such as complexity, or lack of
transparency in financial transactions. The interconnected and opaque struc-
ture of banks, the increasing complexity of their operations, and the short-
termism of the financial sector ± that is subject more than other sectors to
fads, herding, and irrational mood swings ± place insurmountable obstacles
both to a board's capacity to run the bank and shareholders' ability to monitor
them.
2
These limitations are compounded by more general cognitive boun-
daries facing shareholders and directors: so-called `bounded rationality'.
3
29
1 A characteristic example, in this context, is the enactment in the United States of the
2002 Sarbanes-Oxley Act in the aftermath of the Enron and WorldCom scandals,
which were a combination of insider abuses and accounting frauds.
2 For a discussion of the limitations of market discipline in the banking sector, see E.
Avgouleas, `Breaking Up Mega-Banks: A New Regulatory Model for the Separation
of Commercial Banking from Investment Banking' in Financial Regulation at the
Crossroads: Implications for Supervision, Institutional Design and Trade, eds. P.
Delimatsis and N. Helger (2011) 179.
3 Bounded rationality refers to the limited ability of humans to process information
because of their limited computational ability and flawed memory. See H.A. Simon,
`A Behavioral Model of Rational Choice' (1955) 69 Q. J. of Economics 99. For an
analysis of these biases and the contexts in which they tend to appear and decisions
that they influence, even when decision makers act under conditions of intense
competition and are sophisticated actors, see E. Avgouleas, `The Global Financial
Crisis and the Disclosure Paradigm in European Financial Regulation: The Case for
Reform' (2009) 6 European Company and Financial Law Rev. 440; E. Avgouleas,
`Reforming Investor Protection Regulation: The Impact of Cognitive Biases' in
ß2014 The Author. Journal of Law and Society ß2014 Cardiff University Law School

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