Foreword 3

Abstract

After the massive failures in governance during the fi rst decade of the twenty-fi rst century -starting with Enron, Worldcom and Parmalat and building to an impressive crescendo with the global fi nancial crisis of 2007-2009 -this edited volume by Professors Barth, Lin and Wihlborg on banking and governance could not possibly be published at a more timely moment.Banks matter. They mobilize resources, allocate capital, monitor the use of that capital, provide risk management tools, and facilitate payments. When banks do their jobs well, societies benefi t as credit fl ows to those with the best entrepreneurial ideas. As a result, people enjoy faster and more inclusive economic growth. But, when banks do their jobs poorly, societies suff er as credit -and hence economic opportunity -fl ows to the rich and powerful rather than to the innovative and energetic. And, with poorly functioning banks, credit too frequently pours into activities that generate quick bonuses or other perquisites for bank executives at the expense of long-run economic prosperity and stability.Since banks matter, the governance of banks matters, as the recent crisis demonstrated all too well. Many economists and policymakers assumed that privately owned fi nancial institutions would look after their own interests and in the process help society. But this view is based on the belief that those making decisions for the fi nancial institutions are maximizing shareholder value. That is, this free-market approach assumes fi nancial institutions are well governed. However, rather than maximizing the value of the institution to shareholders, executives maximized the value of the fi nancial institution to executives, which often deviated wildly from the goals of shareholders. Executives used their infl uence over the board of directors to obtain enormous bonuses regardless of long-run performance. Indeed, some received lavish compensation despite the wretched performance of the fi nancial institutions under their charge. Shareholders were simply unable to force fi nancial institution executives to behave in the best interests of shareholders. The crisis cannot be understood without recognizing the breakdown in governance.What accounts for the breakdown in the governance of the fi nancial system? Diff use shareholders and creditors have a hard time infl uencing what happens inside fi rms, and banks are particularly diffi cult for outsiders to infl uence because of their opacity. Although information problems are present in all sectors, they are particularly acute in fi nance. For example, consider sales as an indicator of quality. If Apple sells lots of iPods over a few years, this is a reasonable signal of the product's quality. But if a bank makes lots of loans over a few years, this does not necessarily provide accurate information about the quality of those loans. It is exceptionally diffi cult to discern the value of fi nancial instruments and hence the quality of the fi nancial fi rms holding those securities. Thus, the opacity of fi nancial fi ...