Corporate Governance of Financial Institutions: A Survey

Corporate Governance of Financial Institutions:A Survey Jakob de Haan (De Nederlandsche Bank & University of Groningen) Razvan Vlahu (De Nederlandsche Bank) Conference on Corporate Governance of Financial Institutions 8 - 9 November, 2012 Amsterdam, The Netherlands The usual disclaimer applies. The views expressed in this paper are those of the authors and do not necessarily represent those of DNB.

Motivation • “Most studies of board effectiveness exclude financial firms from their samples. As a result, we know very little about the effectiveness of banking firm governance.”(Adams and Mehran, 2012, JFI, p. 243). • This has not kept some officials to come up with strong statements. For instance, according to the Walker Review, boards of listed UK banks were larger than those of other listed companies and this is considered problematic because of “a widely-held view that the overall effectiveness of the board, outside a quite narrow range, tends to vary inversely with its size”(Walker, 2009, p. 41).

Outline of presentation • Context – The impact of financial crisis • What is special about banks ? • What do we know about corporate governance (CG) of banks ? • Board of directors • Bank ownership • Executive compensation • Conclusion

Financial crisis • Banks severely criticized for their role • Weak CG of banks (and in particular the pay-out policy) is frequently identified as a major cause of the crisis (Kirkpatrick, 2009) • CG may affect banks’ performance and risk-taking incentives, subsequently increasing the likelihood for financial crises • Proposals and drafting of new legislations (e.g., U.K. Governance Code, 2010; Dutch Banking Code, 2010) • However, there is evidence that better governance was not necessarily leading to better performance during the crisis (Beltratti and Stulz, 2012)

Corporate governance • Principal-agent theory • Control mechanisms • Size and composition of the board • Management compensation schemes • Market for corporate control • Concentrated ownership • Differences between financial and non-financial firms caused by: • Regulation • Capital structure of banks (funding through deposits and high leverage) • Complexity and opacity of banks

Are banks special ? • If a firm takes excessive risks it may fail • But banks are different due to their capital structure • High leverage • Demand deposits as liabilities • Externalities of bank failure • Damage to the real sector due to position in financial intermediation and payment system • Regulation may lead to more risk-taking (deposit insurance, too-big-to-fail)

Are banks special ? • Interests of shareholders do not coincide with the interests of debt holders • Supervisors expect boards to ensure soundness • Regulation may be complement or substitute for CG • Research on the effect of regulation and country-level governance (Bruno and Claessen, 2010; Laeven and Levine, 2009)

Board effectiveness

Corporate governance • In CG good governance is defined as: how well does the board represent shareholder interests • But: good reasons to differentiate between good governance of financial and non-financial firms • Governance may be endogenous (Adams et al., 2010) • Most studies focus on few CG mechanisms but governance structure is largely endogenous in its entirety • What does literature suggest about: • Board size • Board experience • Board independence

Board size • Boards of US BHCs are bigger than boards of other firms (Adams, 2012) • Large boards may increase expertise and resources. But: decision-making costs increase (due to free-riding and increased decision-making time; Jensen, 1993) and coordination problems • Several studies examine relationship between board size and firm performance and risk-taking • Several studies find that firms with bigger board have better performance (Adams and Mehran, 2012; Beltratti and Stulz, 2012) but Erkens et al. (2012) do not find this. • Also evidence that board size is negatively related to risk-taking (Pathan, 2009; Minton et al., 2010)

Board expertise • Important in view of complex and opaque nature of banks • Empirical evidence is mixed • Positive: Cunat and Garicano (2010) for Spanish cajas and Hau and Thum (2009) for German banks • No effect: Erkens et al. (2010) • Period: crisis vs. non-crisis (Minton et al., 2010)

Board independence (1) • Bank boards in US have on average fewer outside directors than non-financial firms (Adams, 2010) • Independent directors have incentives to scrutinize diligently (Fama and Jensen, 1983) but Adams and Ferreira (2007) argues that more independence may reduces the board’s monitoring and advising role as CEO provides less information • Effectiveness of independent board depends on competence (Wagner, 2011) • Outside directors may lack in-depth knowledge of banks (Adams, 2012)

Board independence (2) • Studies surveyed do not consider reverse causality (Hermalin and Weisbach, 1998) • In contrast to research on non-financial firms, most studies surveyed do not provide much support that board independence is positively related to performance (Minton et al., 2010; Adams and Mehran, 2012; Aebi et al., 2012) • Studies on international samples yield similar findings (Erkens et al., 2012) • Some evidence that board independence is negatively related to risk-taking (Pathan, 2009)

Ownership

Ownership • Outside ownership • Diffuse vs. Concentrated ownership • Ownership and performance • Inside ownership • Government ownership

Diffuse vs. Concentrated ownership • Collectively shareholders have incentives to monitor management • Individually they suffer of lack of monitoring expertise, poor shareholder protection, and free-rider problem • (+) Large shareholders are more likely to be well informed and make better use of their voting rights → active role in monitoring (Shleifer and Vishny, 1997; La Porta et al., 1998; Franks and Mayer, 2001; Grove et al., 2011) • (+) The monitoring costs of blockholders are lower because they internalize the benefits from monitoring in proportion to their shares • (-) Exploit their private benefits of control (tunneling, insider lending) (Johnson et al., 2000) • (-) Stimulate increased risk-taking at the expense of debtholders (and government)

Diffuse vs. Concentrated ownership (cont’d) • Banks have more diffuse ownership than non-financial firms → reduced incentives for monitoring • Ownership more dispersed in US than in Europe (Adams, 2012) • Institutional ownership is significantly lower (Adams and Mehran, 2003) • Institutional ownership is higher in US (Erkens et al., 2012) • Causes • Better shareholder protection in common law countries than in civil law countries (La Porta et al., 1997) • Regulation/restrictions on the percentage of bank capital owned by a single entity (Barth et al., 2004)

Diffuse vs. Concentrated ownership (cont’d) • Caprio et al. (2007) • Banks are generally not widely held • 75% of 244 banks across 44 countries have a dominant shareholder • Differences across regions • Australia, Canada, UK and US have more than 90% of the banks widely held • Austria, Finland, The Netherlands, Sweden, Hong Kong, India, Indonesia, Argentina, Brazil, Mexico – without any large bank being widely held • Conflicts with minority shareholders • More risk-averse due to their higher exposure to the bank • Incentives to share less profits (no large dividends payouts) • (+) May be in interest of other stakeholders

Concentrated ownership and performance • Mixed evidence • Better performance • Glassman and Rhoades (1980): profit rate, deposit growth, costs • Cole and Mehran (1998): stock returns • Weak association • Grove et al. (2011), Aebi et al. (2012) • Worse performance • Erkens et al. (2012): banks with larger institutional ownership took more risk before crisis and suffered large losses

Impact of legal protection and regulation • Better shareholder protection • Can mitigate excessive risk-taking by controlling shareholders (Laeven and Levine, 2009) • Have a positive impact on bank valuation (Caprio et al., 2007) • Stricter regulation • ↓ bank risk when the bank is widely held, • but ↑ the risk in presence of large controlling shareholder • (Laeven and Levine, 2009)

CEO ownership • Managers prefer less risk than desired by shareholders • Private benefits of control • Non-diversifiable human capital • Equity ownership of executives can help align managers’ interest with those of shareholders • Managers with large equity stakes will behave more like principals and less like agents • (-) Not necessarily in line with the interests of debtholders and regulators: • → encourage greater risk-taking • → increase the chance of failure • Interestingly, CEO’s ownership is lower for US banks than for non-financial firms (Booth et al., 2002;Adams and Mehran, 2003)

CEO ownership and performance • Mixed evidence • Positive impact • Spong and Sullivan (2007), Aebi et al. (2012) • Weak association • Cheng et al. (2011): risk measures such as beta or return volatility • Negative impact • Saunders et al. (1990), Anderson and Fraser (2000): ↑ in risk taking over 1978-1985 and 1987-1994 • Demsetz et al. (1997): ↑ risk taking for low franchise value banks • Lee (2002): ↑ risk taking for banks with low probability of failure

CEO ownership and performance (cont’d) • …negative impact • Berger et al. (2012): high shareholdings of outside directors and chief officers imply a lower probability of failure, BUT higher shareholdings of lower-level management increase default risk significantly • Fahlenbrach and Stultz (2011): CEOs did not reduce their stock holdings before the crisis, nor hedge their holdings → they did not anticipate the crisis

Government ownership • State was an important owner of banks even before the crisis (Caprio et al., 2007), and more so after • Government-owned banks have relatively low efficiency (in terms of costs and performance) and high NPLs (Berger et al., 2005; Iannotta et al., 2005; Borisova et al., 2012) • Unintended impact that government ownership may have on the ability of supervisory authorities to execute their monitoring role efficiently and independently • Banking systems with large share of state-owned banks are associated with reduced access to credit, slow economic growth and instability (Claessens, 2004)

Remuneration

Remuneration of executives • Does CEO compensation lead to excessive risk-taking? • Stock bank compensation aligns CEO’s and shareholders objectives • Managers with significant ownership in their bank can exhibit diferent risk-taking attitudes than managers for whom the salary is the only (or the main) form of compensation (Devries et al., 2004) • Stock-option based compensation is more prevalent at banks than at non-financial firms (Chen et al., 2006) • Shares, stock options, & other contingent compensation mechanisms • (-) Stimulate increased risk-taking at the expense of debtholders (government) • (-) Short-term objectives • (-) Government guarantees (i.e., deposit insurance) • (-) Resolution mechanism • (+) Greater stock ownership by management

Remuneration of executives (cont’d) • Stock-based compensation → bank’s leverage & risk strategies ↑ (Mehran, 1992) → share price ↑ (a common measure for performance measurement) (Peng and Roell, 2008; Bebchuck and Spaman, 2010) • Option based compensation makes the problem worse • Option holders are insulated from losses suffered by shareholders when equity price fall • Stock-option based compensation is more prevalent at banks than at non-financial firms (Chen et al., 2006), with executives enjoying higher bonuses (including performance based) over the period 1994-2006 (Gregg et al., 2012) • This was not the case two decades ago (Houston and James, 1995)

Remuneration of executives (cont’d) • More evidence on the association between executive compensation and risk-taking • Large bonusses (as opossed to equity-based compensation) → more risk before the crisis and larger losses during the crisis (Erkens et al., 2012) • Pay-performance sensitivity: mixed evidence • ↓ leverage ratio, ↑ monitoring intensity by subordinated debtholders (John et al., 2010) • ↑ leverage ratio (Mehran, 1992) • No clear association (Kirkpatrick, 2009; Fahlenbrach and Stultz, 2011) • CEOs with higher pay-risk sensitivity → engage in risky mergers → likelihood of failure ↑ (Hagendorff and Vallascas, 2011) → engage in non-traditional banking activities (originate-and-distribute business model) (DeYoung et al., 2010)

Remuneration of executives (cont’d) • Golden parachutes – unambiguous impact • Positive association with poor performance and likelihood of failure prior 1994 (Evans et al., 1997) • Positive association with risky lending over 1994-2006 (Faleye and Krishnan, 2010)

Conclusions (1) • Good corporate governance of financial and non-financial firms differs as banks are different • Differences between financial and non-financial firms caused by: • Regulation • Capital structure of banks (funding through deposits and high leverage) • Complexity and opacity of banks • Much recent research on board characteristics and performance of financial firms • Research does not always give consistent findings, but results suggest that in contrast to results for non-financial firms board size seems to matter while evidence in support of independence is not very strong

Conclusions (2) • Informational asymmetries are more pronounced for banks than for non-financial companies • Board characteristics, ownership structure and remuneration schemes may mitigate the resulting agency problems • With respect to ownership structure, an explanation for the divergent empirical evidence is the role played by regulation, feature not taken into account by most of the studies • With respect to compensation structure of executives, pay-for-performance schemes focused on long-term objectives can be superior to other forms of contingent compensation (i.e., bonuses linked with short-term objectives, or options) • However, the divergence in views documented by our survey suggests that a better understanding of incentives structures and the optimal degree of allignement between executive management and shareholders interests is warranted

Corporate Governance of Financial Institutions: A Survey