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The Corporate Governance of Banks

The Corporate Governance of Banks Christian Harm University of Münster Agency Theory as a general theory of delegation The agency solution provides for incentives : Overpay in good times Underpay in bad times Versus an optimal risk-sharing contract

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The Corporate Governance of Banks

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  1. The Corporate Governance of Banks Christian Harm University of Münster SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  2. Agency Theory as a general theory of delegation The agency solution provides for incentives: Overpay in good times Underpay in bad times Versus an optimal risk-sharing contract Does this really work? Empirical paradox! The crucial assumption is that ‘x’ is costlessly measurable and divisible: Money, Share price Holmström, Bell Journal (1979): The original model includes a principal and an agent. The principal wants as much ‘x’ as possible. The agent is supposed to achieve it. The agent also wants ‘x’, but economizes on effort. Effort is non-contractible and non-observable. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  3. Measurement costs may be just too large Then, ‘x’ is not necessarily measurable or divisible Military contracting, NASA Research Annual report of a corporation Ship building Home construction Contractors (Plumbers, carpenters, electricians … …) Restaurant cooking MacLeod, AER (2003): Principal and agent may assess output subjectively Different assessments induce conflict Conflict costs overshadow incentive remuneration Most people get paid on a fixed schedule! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  4. Corporate Governance and Agency Theory Tirole, Econometrica (2001): Shareholder Value Maximization provides a clear mandate, but may impose too many externalities on other stakeholders! Incentives work <only> for well-defined tasks of delegation Maximizing Shareholder Value is well-defined But is it appropriate? Agency Theory doesn’t address the problem of who is supposed to get property and (thereby) governance rights. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  5. Legal Scholars’ view on the firm Frank Easterbrook (U of Chicago, 1982): Shareholder value maximization Henry Hansmann (Yale U, 2005): Entity Shielding! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  6. Why entity shielding? If the firm can be liquidated at no cost, why protect it? It needs to be protected if there are rents accruing to the firm, but not necessarily its stakeholders. Oligopoly Rents Illiquid assets and specific investments If many stakeholders have made specific investments in the firm and If the firms assets are specific and / or illiquid No one stakeholder should be allowed to pull out at an opportune moment! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  7. Property and Governance Rights Oliver Williamson (Berkeley U, 1975): Suppliers and Customers (Vertical Integration) Since Equity is the most junior and least well-defined claim, it is the obvious candidate as owner of property rights. If other stakeholders are similarly tied to the firm, they will demand to share property rights! Stephen Prowse: Depositors <through regulators> Christian Harm: Creditors generally (SUERF 2002) SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  8. Governance Summary Property rights in the firm typically rest with equity, but can be allocated to more than one stakeholder group. E.g.: Equity and debt define a hierarchy of property rights. But: the more spread out the property rights among different stakeholders, the less clear the objective of the firm. The less clear the objective of the firm, the more difficult to define managerial incentives, the less appropriate stock options. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  9. The banking firm Ross Levine (Brown U, 1992 and onward): The financial sector is a pivotal foundation of economic growth. Illiquid assets imply entity shielding. High leverage implies strong governance interests of depositors. Other stakeholders? Closing a bank can impose significant externalities on society! E.g.: Chilean Banking Crisis! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  10. The sad world of banking SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  11. Debt and Equity Governance: but how? The stakeholder character of the banking firm implies a more hazy definition of the objective function for managers. In ‘hands on’ governance, there is more ‘subjective’ evaluation, both for regulators and board members. Hüpkes, Quintyn and Taylor (2005):"in some circumstances, the RSAs might decide to forego formal enforcement action in favour of cooperative compliance, while uncooperative, intentional violators may be dealt with strictly" Demb and Neubauer (1992): “We do not know what directors are supposed to do; we only know that they are supposed to do it ‘with care’.” SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  12. Bank Managers: Objectives for success and risk With strong regulatory interest, bank managers ought to maximize firm value, not shareholder value. Expand bank managers fiduciary duty to depositors! Shareholder value can be both good and bad for depositors: Charter value Call option value of equity Evidence: The higher charter value, the less responsive managerial risk-taking to option value incentives (from own equity holdings or option incentive packages). How to reward charter value? SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  13. Competition and Charter Value: a Paradox? H0: Competition is bad for charter value, at least in the short run. Evidence on providing charter value through anti-competitive regulation: X-inefficiency outweighs incentives for prudence. Why? Even the most liquid debt markets are supported by reputation! Issues reputation with syndicate loan lead manager Bond issue lead manager with institutional investors Reputational equilibria provide barriers to entry! Competition among financial institutions renders an oligopolistic market structure almost by itself. Charter Value follows as a consequence. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  14. How to incentivize bank managers Principle: reward charter value, discourage option value. Option awards are legitimate as long as they reflect charter value. But: for regulators, too aggressive option award schemes may serve as a red flag. Evidence: bank managers’ pay-performance sensitivities are lower than in industry. And: bank managers receive more complex performance rewards based on achievements of more general objectives. If bank-client relationships are the source of charter value, reward progress in customer loyalty! Operating rather than financial goal. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  15. Summary Banks are the epitome of institutions eligible for a stakeholder rather than shareholder approach. Hence, bank managers’ objective functions less well-defined. Incentives do not work as well with bank managers. Options should largely be given to reflect charter value (but how?) Especially in banks, hands-on governance is necessarily more subjective and discretionary. McCarthyism is unavoidable! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  16. Outlook Why not ‘the corporate governance of financial institutions? Mutual funds: Liquid assets, no entity shielding Investment banks: Comparatively little tied-up capital, no creditor governance Insurance companies: Possible exception, since insurance promise to customers is a contingent liability. But assets tend to be largely liquid. SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

  17. Corollary: regulation of consumer interests E.g.: asset management, investment advice Prudential consumer issues for ‘honesty’ inhabit a similar space as toxic waste emissions, or corrupt practices. Such issues are typically dealt with through - Competition - Law - A regulator, which typically does not have governance rights in the firm (although they may have inspection rights in a domain relevant to their mission). Hence: stakeholders solve externality problem through contract! SUERF Seminar, Nicosia, Cyprus; March 29-30. Christian Harm, University of Münster

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