Sanctioning Negligent Bankers

The financial panic started by Silicon Valley Bank in March 2023 might have been new, but its cause was not. Excessive risk-taking and mismanagement by bank executives are the perennial manifestation of moral hazard. Economists and legal scholars have sought to ameliorate this market failure by addressing the mismatch between rewards given to bank executives and the costs of their poor decisions—often by regulating how bank executives are compensated in normal times. The driving intuition is that bank executives should not reap all the benefits in good times while letting others hold the bag during bad times; adjusting their compensation to require more “skin in the game” thereby reduces risk-taking and mismanagement.

In our forthcoming article, “Sanctioning Negligent Bankers,” we begin by noting that existing proposals to deal with this market failure have been limited by two factors. First, previous attempts to solve the problem through agency regulation and enforcement have proven ineffective. On the regulatory front, federal agencies have not acted when it comes to exercising their enforcement powers to deter individual bank executives. Consider that, after the 2007-08 Global Financial Crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. As part of these reforms, Congress instructed financial regulatory agencies to place restrictions on executive compensation that encouraged excessive risk-taking. Yet, fifteen years later, no such regulation has been implemented. On the enforcement front, Da Lin and Lev Menand have shown that although the Federal Reserve has clear authority to hold bank directors and senior management accountable for mismanagement, the Federal Reserve has rarely exercised this power. Likewise, the FDIC has statutory authority to fine executives for “gross negligence” but uses that power selectively and in a manner that our article shows is all but guaranteed not to influence or deter bank executives.

Second, several recent proposals to reduce excessive risk-taking by bank executives focus on clawing back executive compensation. These proposals suffer similar challenges. For example, the SEC only recently finalized executive-compensation clawback regulations mandated by the Dodd-Frank Act. More fundamentally, many proposals presuppose that banks are publicly traded—that is, executives can be paid with their bank’s equity or debt, which can be sold in a liquid secondary market. Yet less than 14% of banks in the United States are publicly traded, and they are not the only institutions that matter for maintaining financial stability. Quite the opposite: Jeremy Kress and Matthew Turk pointed out that “every banking crisis in the United States prior to 2008 consisted exclusively of the simultaneous failure of many small banks.”

Given these challenges, we combine insights from banking regulation, corporate enforcement, and insurance law to argue for an ex post deterrence regime designed to complement existing ex ante options. We recommend imposing (1) a monetary penalty on (2) executives who negligently and materially increase (3) the likelihood of an actual or constructive bank collapse. This sanction will apply to executives at every U.S. bank, regardless of the institution’s size or whether it is publicly traded. Specific triggering events can automatically begin the sanction process, limiting federal agencies’ discretion over whether to bring an action. The magnitude of this sanction will be calibrated according to the executive’s pay, imposing, as a starting point, a baseline penalty equivalent to five years’ worth of total compensation—significantly higher than that of existing proposals—with treble penalties available for circumstances involving, for example, gross negligence or criminal misconduct. Finally, to prevent Directors and Officers (D&O) insurance from blunting the deterrent effect of this new civil sanction, we propose prohibiting the coverage of this sanction through D&O (or equivalent) liability policies.

In building our case, we argue that civil sanctions offer a more effective deterrence mechanism than criminal punishment. Selecting civil liability over criminal punishment might strike many as counterintuitive because criminal punishment is often seen as the highest order of deterrence. But, in practice, the structural and evidentiary challenges of prosecuting high-level executives make it an unreliable tool for addressing excessive risk-taking in banking. For one, the complexity of corporate decision-making and the difficulty of attributing criminal intent to executives frequently forestalls criminal enforcement, as seen in the near-total lack of executive prosecutions coming out of the Global Financial Crisis. For another, expanding criminal liability to capture negligent mismanagement would stretch traditional principles of culpability, potentially criminalizing poor decision-making or good faith mistakes rather than genuinely wrongful conduct. By contrast, a well-calibrated civil penalty, automatically triggered by bank failures or government bailouts, would directly tie executives’ financial incentives to prudent risk management. Criminal law can and should play a role in regulating corporate America. But in this situation, expanding the criminal legal system—namely, by punishing conduct that falls short of extreme acts of personal lawlessness, which existing statutes already criminalize—would be less effective than civil sanctions for incentivizing better behavior from bank executives. A civil, fault-based framework provides a better deterrence framework for reaching much of the conduct that immediately concerns the risks attendant to a bank collapse.

But why a negligence standard as opposed strict liability or something else? The incentive structures underpinning negligence and strict liability regimes are well-studied. Indeed, under specified conditions, either strict liability or negligence could provide incentives for optimal care by bank executives. Selection between the two turns primarily on the underlying epistemic and economic conditions. We believe that a negligence standard is more appropriate for deterrence purposes, all else equal, when the standard of care is easily identified but the damages are comparatively harder to predict and especially when the defendant is judgement-proof against the potentially massive damages that would follow from a bank collapse.

Our endorsing a negligence standard is not to deny that there are benefits to a strict liability approach. Adopting a negligence standard has the disadvantage of all but ensuring adjudication, which may result in extended enforcement periods. But a strict liability regime is almost certainly too onerous given the financial stakes. Put simply, few qualified candidates would seek to be bankers if the position carried with it the risk unpreventable financial ruin that is accompanied by strict liability. At the same time, we think that properly designing the remaining liability conditions can capture some of the benefits of a strict liability rule without sacrificing the basic insight that a duty-based standard encourages optimal care from a judgment-proof defendant.

In sum, designing a credible corporate sanctions regime has long been at the forefront of scholarly ambitions and policymakers’ agendas. This endeavor is even more pressing now given the recent wave of financial panics experienced in the United States and around the world. We have presented a framework in which a well-designed negligent banker sanction—one without an insurance backstop—can bring reassurance by shifting the prospect of liability onto the group best situated to prevent it: bank executives.