According to a recent University of Michigan study, when the negligence of bank executives results in financial institution failures or government bailouts, those executives ought to incur civil monetary penalties.

“This paper consolidates our diverse areas of expertise in suggesting a focused remedy to address the issue of moral hazard in banking while enhancing financial stability,” stated Jeffery Zhang, assistant professor at the Law School.

In light of the near-banking crisis of 2023 triggered by the fall of Silicon Valley Bank, Zhang and his colleagues contend that current regulatory recommendations—such as increased bank oversight, stricter regulations, and broader deposit insurance—are inadequate to avert future failures.

Rather, the authors of the study propose an approach that combines these measures with a more straightforward method: making individual bank executives financially liable for negligence that significantly heightens the likelihood of a bank failure.

“By implementing civil monetary penalties, our recommendation seeks to realign executive motivations and reduce reckless risk-taking,” remarked Kyle Logue, professor at the Law School.

The researchers propose a framework that would subject executives at all U.S. banks—regardless of being publicly listed or privately owned—to financial penalties when their negligent actions play a significant role in a bank’s failure or necessitate urgent government intervention. They suggest a sanction that includes a clawback of up to five years’ total compensation, with increased penalties for gross negligence or misconduct.

“If executives recognize that they might lose years of compensation for irresponsible decisions, they will be far more motivated to act prudently,” commented Will Thomas, assistant professor at the Ross School of Business. “This system seeks to deter hazardous behavior while sidestepping the impracticalities of criminal prosecution.”

The authors propose various strategies for Congress and regulators to formulate and execute this sanctions system. One alternative is for Congress to revise the Federal Deposit Insurance Act to strengthen the provisions for sanctions and lessen the burden of proof. They also recommend prohibiting directors and officers insurance, or D&O, from covering these penalties to ensure that executives bear the financial repercussions directly.

Furthermore, they suggest empowering private entities, such as whistleblowers or shareholders, to initiate enforcement actions against negligent bankers, thereby enhancing accountability beyond conventional regulatory supervision.

The article is set to be published in Volume 78 of the Stanford Law Review but currently can be accessed on SSRN.