Holding Executives Accountable After Recent Bank Failures – Senate Banking Committee

Senate Banking, Housing, and Urban Affairs Committee

Holding Executives Accountable After Recent Bank Failures

Thursday, May 4, 2023

Topline

• Democrats called for rules to compel regulators to claw back executive pay, while Republicans decried the need for further regulations.
• Republicans maintained the FDIC and Federal Reserve must be held accountable for their supervisory failures.

Witnesses

• Da Lin, Assistant Professor of Law, University of Richmond School of Law
• Thomas Quaadman, Executive Vice President, Center for Capital Market Competitiveness, U.S. Chamber of Commerce
• Heidi Mandanis Schooner, Professor of Law, Columbus School of Law, The Catholic University of America

Opening Statements

Chairman Sherrod Brown (D-Ohio)

In his opening statement, Brown discussed how American taxpayers subsidize the banking industry with government guarantees like deposit insurance and access to emergency loans, explaining that banks get special treatment because they are supposed to play a special role in our economy. He said some bank executives are not holding up their end of the deal, noting the CEOs and executives of Silicon Valley Bank (SVB) and Signature Bank (SB) led their banks off a cliff and failed to manage risk. Brown blamed the Wall Street business model, where executives put short-term profits over everything else. He explained how SVB executive bonuses were tied to the bank’s return on equity, which caused SVB to buy securities with higher yields, chasing higher profits. Brown added that at SB, executives had incentive compensation plans that were tied to return on assets to reflect additional focus on profitability, and that at First Republic, senior executives sold millions of dollars’ worth of the bank’s stocks less than one week after SVB and SB failed, sparking further concerns at each bank.

Brown decried that after Wall Street wrecked the economy in 2008, executives faced no consequences, and did not have their profits and bonuses clawed back. He maintained this can’t happen again and called for legislation to expand the banking agencies’ authority to ban a bank executive or manager from the industry for failing to properly oversee the banks overseen. Brown also called for legislation to make it easier for banking agencies to bring actions against bank executives or managers who were asleep at the switch, and to clarify and expand the FDIC’s authority to claw back compensation. He urged legislation to require the agencies to finally finish Dodd-Frank Section 956. Brown concluded that bank executives can’t continue to operate under the assumption that risk management is optional and secondary to profits.

Ranking Member Tim Scott (R-S.C.)

In his opening statement, Scott criticized banking executives, regulators, and the Biden Administration for their lack of accountability. He said regulators must be held accountable and called for a discussion of accountability across the board, citing the Biden Administration’s inflationary policies.  Scott said the risks that brought down SVB and SB were in plain sight to regulators, adding that regulators must be held accountable for their supervisory failures to the same extent as the banking executives.

Scott noted that after the failure of First Republic, it’s clear that the practices and standards of the California state supervisors merit scrutiny from Congress. He warned that if good governance reforms are not appropriately targeted and calibrated, an overly prescriptive approach has the potential to further siphon talent away from the banking sector to non-banked sectors of the financial services industry.  Scott concluded by noting the U.S. banking system is one of the most heavily regulated industries in the world, and questioned the purpose of laws, regulations, and guidance if the regulators are not using the tools they already have at their disposal.

Testimony

Da Lin, Assistant Professor of Law, University of Richmond School of Law

In her testimony, Lin described how over the last 20 years, America’s largest banks have settled hundreds of major lawsuits and paid hundreds of billions in fines and penalties, admitting to pervasive fraud, bribery, money laundering, price fixing, illegal kickbacks, discriminatory lending, and a host of other consumer protection violations. She noted that despite these offenses, federal banking regulators have only barred the senior management of one major U.S. bank from the industry, instead, primarily excluding rank and file workers for low level misconduct like embezzlement, which has little impact on bank safety. Lin highlighted that regulators did not impose a single sanction on a senior executive after the 2008 financial crisis.

Lin identified and discussed two main obstacles with the FDIC’s prohibition and removal authorities. She said the culpability requirement for the removal and prohibition is overly demanding, explaining how failed management is unlikely to be proven as a deliberate act. Lin noted directors and senior executives are typically shielded from knowledge of operational details by the diffuse decision-making processes that characterize large and mid-sized banks. She also discussed how the statute underlying the prohibition authority has not been substantively updated since 1989, despite the enormous growth and consolidation of banks, which has changed the role of senior leadership. Lin called on Congress to recognize mismanagement and oversight failure as a distinct basis for removal and prohibition, warning other mechanisms cannot replicate or replace a potent removal and prohibition authority.

Thomas Quaadman, Executive Vice President, Center for Capital Market Competitiveness, U.S. Chamber of Commerce

In his testimony, Quaadman detailed how compensation is key for acquiring and retaining the talent needed for long-term success, and noted the existence of multiple checks on compensation. He said the Chamber has been critical of behavior that drives short-termism, specifically the use of quarterly earnings guidance. Quaadman pointed to Credit Suisse as a cautionary tale, noting they never recovered from the implementation of the Swiss law limiting compensation and eliminating bonuses. Quaadman also described the recent failure of supervision as startling.

Quaadman noted the Failed Bank Executives Clawback Act would allow for a five-year claw back of salary and compensation, asking who would want to go work for any business that has a five-year claw back of salary? He explained how this would deprive businesses of the talent they need to govern themselves. Quaadman said the Chamber is sympathetic to the Bank Management Accountability Act but called for more information on it.

Heidi Mandanis Schooner, Professor of Law, Columbus School of Law, The Catholic University of America

In her testimony, Schooner noted Congress recognized the importance of bank executives’ responsibilities by authorizing federal bank regulators to hold bank executives accountable for failures.  She discussed how existing law could be reformed to provide stronger accountability for bank executives who act negligently, or for board members that fail in their oversight responsibilities. Schooner said the relevance of recent proposed claw back reforms became clear when the Fed released its report last week on the failure of SVB, which found that SVB’s executive compensation arrangements encouraged excessive short-term risk taking. Schooner explained that banker compensation should not encourage, let alone reward, excessive risk taking that leads to significant loss or a bank’s failure, and described claw backs are an appropriate response for such mismanagement. She urged members to consider strengthening existing agency enforcement powers applicable to officers and directors of open institutions, as well as closed institutions.

Question & Answer

Regulatory Gaps and Reforms

Sen. Jon Tester (D-MT) asked about gaps in the existing federal structure for holding executives accountable, and whether Congress needs to put more laws on the books. Lin said there are important gaps around the existing prohibition and removal authority that deter effective enforcement. She explained these problems include the culpability requirement, which broadly insulates directors from liability or sanction. Schooner said she agrees with Professor Lin, noting the standards for enforcement are unduly high.

Ranking Member Scott said if the government is always there to intervene and bail out a failing bank, it will lead to riskier decisions in the financial sector moving forward. He explained that by eliminating the reality of failure, there will be no reason for prudent management.

Chairman Brown asked why the existing removal power is not suited for big banks like SVB and SB. Lin cited the culpability requirement, noting executives are shielded from liability due to the structure of large banks. She also cited the mismatch between the responsibilities of directors and executives, which focus on oversight, and the focus of the current authority to prohibit, which narrowly focuses on discrete activities. Lin said Congress should lower the culpability requirement to recklessness or negligence, and identify mismanagement and oversight failure as a discrete basis for removal.

Brown asked how strengthening our enforcement tools to hold banking executives accountable would not only help prevent failures, but also improve fairness and competition between large and small banks. Schooner said that megabanks don’t fail, so they escape accountability. She said reforming the enforcement power would level the playing field.

Sen. Jack Reed (D-RI) asked how depositors, regulators, the banking industry, and the American people would benefit from Congress strengthening the FDIC’s outdated and weakened authorities. Schooner explained this would bolster the public’s confidence in the financial system and impact the ongoing operations of banks by making them more accountable. Lin said that when banks are held accountable, they are incentivized to operate in the public’s interest, not in shareholders’ interest.

Sen. Katie Britt (R-AL) asked which current law could be used to hold bad actors accountable. Schooner said bank regulators have administrative enforcement authority to bring actions in multiple different ways, but noted the standards of culpability are too high. Quaadman explained existing authorities held by banking regulators, the SEC, and the Department of Justice can hold bad actors accountable. He warned Congress not to throw things out of balance and make the system weaker.

Britt asked how to achieve a solution that is narrowly tailored to avoid deterring talent from entering the banking industry. Quaadman urged Congress to examine what broke down with the regulatory structure, noting that if the cop on the beat is not enforcing the laws, new laws are not going to accomplish anything.

Supervisory Failures

Tester asked Quaadman about his views on the sufficiency of federal regulators’ tools. Quaadman said the authorities are there, but explained the regulators did not take action.

Tester said regulators had the ability to stop these bank failures from happening but didn’t drop the hammer. He noted his concerns that the push for more regulation will lead regulators to put the screws to the banks that are following the rules.

Ranking Member Scott asked if there’s any reason to doubt that the FDIC has existing authority to hold senior leadership and directors personally liable. Quaadman said no, explaining that while the authorities exist for the FDIC and the Federal Reserve, sufficient action was not taken.

Sen. Thom Tillis (R-NC) asked why Lin and Schooner didn’t mention the lack of supervision as a root cause of the failure of SVB. Lin explained that while SVB’s senior leadership was incentivized to pursue short-term growth, regulators also missed obvious problems and were slow to address the problems that they did recognize.  Schooner said she believed the primary cause of SVB’s failure was mismanagement, but noted regulatory forbearance is a persistent problem in the system.

Failed Bank Executives Clawback Act

Sen. Elizabeth Warren (D-MA) asked if the Failed Bank Executives Clawback Act would have applied to SVB, SB, and First Republic executives if it had been the law of the land when they failed. Lin said yes.

Warren said new regulations need to do three things: force regulators to claw back compensation from the executives who were responsible for the failure, apply in all cases of bank failures, and allow up to five years of compensation to be clawed back. Warren noted her Failed Bank Executives Clawback Act achieves all three of those goals.

Sen. J.D. Vance (R-OH) asked Quaadman to explain who gets caught up in the statutory definition of an institution affiliated party. Quaadman said the definition is extremely broad, noting it could include an accounting firm or law firm providing services to a banking institution. He explained how firms would be reluctant to engage with these banks if that provision is adopted.

Vance asked whether exposing directors to claw back culpability could be reasonably interpreted by a court or a regulator to cover midlevel managers who have the title of director, or if it would only be applied to the board of directors. Schooner and Lin said this would only be applied to the board of directors, noting this is specifically stated in several provisions and statues. Quaadman said that after reviewing the Failed Bank Executives Clawback Act, he thought some of the definitions could include employees.

Executive Accountability & Compensation

Warren asked if Wall Street would exert significant pressure on regulators not to claw back executive compensation after a bank failure if regulators had that authority. Lin said she expected they would.  Warren said this is why Congress needs to force regulators to use their power.

Warren asked if regulators had the authority to claw back compensation from SVB executives, if it would be reasonable for regulators to consider the executives’ actions and compensation since 2018, when regulators first began warning SVB about its risky practices. Schooner said this would be very reasonable.

Warren said Congress needs to put tough rules in place that make sure executives pay up when their actions lead directly to a bank failure.

Brown asked all witnesses if they agreed that individual executives whose mismanagement and disregard for basic banking principles led to the failure of these banks should face meaningful consequences. Lin and Schooner said yes, while Quaadman said yes, but only if the information proves that to be true.

Sen. Mark Warner (D-VA) said these failures were disasters that could have been avoided and urged Congress to move on claw back legislation.

Britt asked Lin which existing tools she would use to hold executives accountable. Lin listed the removal and prohibition authority, a civil monetary penalty order, and a personal cease and desist order.

Responsibilities for Boards of Directors

Warner said that while positions on bank boards have been viewed as a nice perk, board members must have a greater level of responsibility.

Warner asked what policy recommendations Congress should put in place to ensure that banks’ boards take their responsibilities more seriously. Schooner said administrative enforcement laws could be amended to make oversight function the standard to which directors are held. Lin said enforcement actions that are currently at the disposal of regulators do not take oversight responsibilities into account.

Warned asked if SVB’s board was responsible for holding management accountable or the eight-month absence of a Chief Risk Officer. Schooner said absolutely.

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