Let me briefly mention another piece of the puzzle that I think is sometimes overlooked, but strikes me as having the potential to play an important complementary role in efforts to address the TBTF problem--namely, corporate governance. Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board. As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

The costs [of Sarbanes-Oxley] are relatively easy to delineate. The benefits are harder to delineate, but that doesn't mean they don't exist.

As reported by Market News International

Corporate governance is more than effective risk management.

Any bank of any size should always be on guard for suspicious activities, and whenever they know, suspect, or have reason to suspect a violation of law, they should file suspicious activity reports according to Federal Reserve and FinCEN regulations. Bankers must practice enough due diligence to know when a transaction is suspicious.

I want to assure you that the approach taken by the Fed and the other federal banking agencies is not one of zero tolerance and that supervisors do not issue enforcement actions against banking organizations because they have failed to file a single suspicious activity report. On the contrary, we continue to expect examiners to use their best judgment and to look for systematic weaknesses in programs, policies, procedures, and internal controls.

As the U.S. economy began on its path to a slow recovery, accounting scandals and corporate governance issues created new uncertainties, and what some referred to as another “soft spot” in the economy.

In the aftermath of recent scandals, I’ve heard a number of young people express skepticism about investing in equities. Given the huge losses in recent years, it’s understandable that folks are being more cautious in how they allocate their hard-earned savings.

This hesitancy on the part of businesses to expand risk-taking, as I have noted in the past, is an apparent consequence of scandals surrounding corporate accounting and governance, an aftermath of the stock market surge. Although there is no compelling evidence that corporate governance risk has fully subsided, with time, it should. An increased willingness to borrow, and ample liquid assets, should provide a further lift to capital investment and, with it, economic activity.

Investor confidence seems to have recovered, at least somewhat, from the corporate governance and accounting scandals revealed in 2002 and 2003.

Recent studies suggest that differing disclosure and corporate governance standards preserve home bias. Researchers have shown that, in most countries, holding a controlling interest in a firm yields significant benefits that do not accrue to minority shareholders, and that a substantial portion of home bias in those countries can be attributed to local holdings of closely held firms.7 Additionally, staff at the Federal Reserve Board and International Monetary Fund have shown that, for firms from emerging-market economies that meet U.S. standards for disclosure and protection of minority shareholder rights, U.S. residents hold the theoretically predicted proportion of company shares in their portfolios.8 Thus, it appears that an improvement in global reporting and corporate governance standards could significantly reduce global home bias.

Manifestations of lax corporate governance, in my judgment, are largely a symptom of a failed CEO.
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If a CEO countenances managing reported earnings, that attitude will drive the entire accounting regime of the firm. If he or she instead insists on an objective representation of a company's business dealings, that standard will govern recordkeeping and due diligence. It has been my experience on numerous corporate boards that CEOs who insist that their auditors render objective accounts get them. And CEOs who discourage corner-cutting by subordinates are rarely exposed to it.

I recognize that I am saying that the state of corporate governance to a very large extent reflects the character of the CEO, and that this is a very difficult issue to address. Although we may not be able to change the character of corporate officers, we can change behavior through incentives and penalties. That, in my judgment, could dramatically improve the state of corporate governance.