Market Discipline and Corporate Governance in the EU Banking Sector: Intellectual Fallacies, Cognitive Boundaries, and Groupthink

Much contemporary analysis has concluded that the recent financial crisis and bank failures were, inter alia, the result of a breakdown in corporate governance regimes and market discipline. Reform of corporate governance structures and remuneration incentives is at the heart of regulatory reform both in the EU, and internationally. New regulations strongly advocate tighter investor monitoring and greater control over executives' remuneration as market based remedies to the woes of the financial sector, which will safeguard future financial stability. Aside from the markets' tendency to be short-termist, which puts an obvious limitation to this remedy, the biggest shortcoming of this approach is that it largely ignores three very important aspects of modern financial markets that cannot be contained through market discipline: (a) the interaction between socio-psychological phenomena, such as irrational exuberance, herding and panic induced contagion, (b) the epistemological properties of financial market innovation, which can result in complex structures that stretch to a breaking point the markets' and individuals' limited capacity to measure the risks involved in opaque institutional structures and markets, (c) inherent inability to predict the uncertain risk correlations that risky products, financial market, interconnectedness, and too-big-to-fail institution behaviour can bring about. Furthermore, even rationally and well-managed financial institutions can be a threat to the stability of the financial system. Therefore, this paper argues that recent EU regulatory reform to corporate governance, as a means to improve financial stability is a large-scale intellectual fallacy. Absent EU-wide structural reform to control risk-taking in large and complex financial institutions, the stability of the EU banking sector will remain compromised. Smaller and less interconnected banks will both improve bank corporate governance and create a safer and more stable financial sector.