The American system of corporate governance is deeply flawed. The theory is that a company's board of directors should keep an eye on management on behalf of shareholders. If the management boosts the value of the firm, directors reward management. If the company gets in trouble, the board determines whether management can fix the problem -- and if not, replaces it.
But that theory is just a legal fantasy. In most companies, the board is in management's pocket. So if management has most of its personal wealth tied up in the company stock, chances are good that it will do things to boost the value of the stock. But if management gets most of its money from corporate cash, it will shape the company's financial results so it gets the biggest possible bonus each year.
In banking, there is a special problem of corporate governance. About 60 percent of revenues are paid out in compensation. So the banks have a huge incentive to generate ever bigger revenues -- regardless of the consequences to future earnings. That urge to boost short-term revenues is a big reason why the financial system collapsed last fall.
And thanks to government stepping in to the breach of a failed system of bank governance, the $12.8 trillion of government money jammed into the hole in the financial dike is now giving President Barack H. Obama a chance to apply a stress test to the bank managers.
More specifically, the May 7th stress test report requires banks to review both top executives and board members over the next month "to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment."
Obama has already announced that he'll change the way bankers get paid -- and as I posted, he should put their bonuses in escrow. Now he's going to start changing out some of the CEOs who got that government money. As far as I'm concerned, the two most obvious CEOs who need to hit the road are Citigroup's (C) Vikram Pandit and Bank of America's (BAC) Ken Lewis.
Why Pandit? As I posted, there are many reasons. He has presided over $28 billion in losses even as Citi has taken $351 billion in taxpayer money while shrinking lending 24 percent. He grossly understated his compensation in Congressional testimony. And his first quarter report showed $1.6 billion in earnings -- $2.5 billion of which was accounting tricks.
As for Lewis, two of the most obvious reasons are his absolutely bone-headed decision to buy Merrill Lynch without conducting due diligence and his insistence that Bank of America didn't need any more government capital -- weeks before the U.S. required him to raise $34 billion. It also doesn't help Lewis's case that he reported a $4.2 billion first quarter profit -- $5.6 billion of which was accounting gimmicks.
There is no question in my mind that government does not want to be in the business of running banks. But when the banking system demonstrates so clearly that it cannot be trusted to run itself -- thus required $12.8 trillion in government intervention -- then replacing CEOs is only going to be a short-term solution.
Unless our approach to corporate governance can be fixed so we can trust the banks to operate in a way that does not put the entire global economy at risk, government is the only bulwark between us and disaster.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares and has no financial interest in the other securities mentioned.