Corporate governance of banks and financial stability

https://doi.org/10.1016/j.jfineco.2018.06.011Get rights and content

Abstract

We find that shareholder-friendly corporate governance is associated with higher stand-alone and systemic risk in the banking sector. Specifically, shareholder-friendly corporate governance results in higher risk for larger banks and for banks that are located in countries with generous financial safety nets as banks try to shift risk toward taxpayers. We confirm our findings by comparing banks to nonfinancial firms and examining changes in bank risk around an exogenous regulatory change in governance. Our results underline the importance of the financial safety net and too-big-to-fail guarantees in thinking about corporate governance reforms at banks.

Introduction

The global financial crisis has led to a reexamination of corporate governance practices at banks, with some policy makers questioning the extent to which managerial entrenchment and the failure of the boards to monitor executives may have led to excessive risk-taking and financial instability. From a theoretical perspective, however, it is not at all clear that the implementation of good governance practices, such as having an independent board, should lead to less risk-taking. Corporate governance that aligns managerial incentives with shareholder interests can potentially result in more risk-taking, as shareholders face payoffs that are restricted on the downside by limited liability.1

Moreover, banks, especially those that are systemically important, tend to be supported by the financial safety net when they are in distress. Specifically, banks can benefit from explicit state guarantees in the form of risk-insensitive deposit insurance, as well as potential implicit guarantees, in the form of liquidity and capital support that prevent their failures. Banks’ contingent access to the financial safety net represents a put option provided by public authorities. The value of this put option increases in the riskiness of bank activities and in bank leverage.2 Furthermore, banks have incentives to herd and take on correlated (or systemic) risks if the state guarantees are more likely to be triggered in the event of multiple bank failures.3 Bank shareholders can thus benefit from taking on more stand-alone as well as systemic risk, and the benefits of additional risk-taking increase with the strength of financial safety nets as shareholders try to shift risk to taxpayers.

Shareholder incentives to take on greater risks can be opposed by managers who tend to be more risk averse compared to shareholders. Unlike shareholders who are likely to hold diversified stock portfolios, managers can have their jobs, reputations, as well as a substantial portion of their personal wealth tied to the performance and health of their firm (Gilson and Vetsuypens, 1993). A bank's corporate governance is a key determinant of how this potential conflict between bank shareholders and managers to take on risk is resolved.

In this paper, we empirically examine the relations between banks’ corporate governance and risks for a sample of US banks over the period 1990–2014, and for an international sample of banks over the period 2004–2008. Our main goal is to examine how the relation between corporate governance and bank risk is affected by the fact that banks tend to be covered by a financial safety net (see Laeven, 2013, for a discussion). In particular, we examine whether shareholder-friendly corporate governance results in greater risk-taking for banks compared to nonfinancial firms, since typically only financial firms benefit from financial safety nets provided by the state. We also examine whether shareholder-friendly corporate governance leads to greater risk-taking at larger banks compared to their smaller counterparts, as larger banks generally benefit from greater protection by the financial safety net on account of their too-big-to-fail status (see Acharya et al., 2016, Bertay et al., 2013). Finally, we consider whether shareholder-friendly corporate governance increases bank risks more in countries with more generous financial safety nets.

By examining a range of bank risk variables, corporate governance proxies, and samples of US and international banks as well as nonfinancial firms, our analysis is able to provide a comprehensive picture of how the relation between corporate governance and bank risk is affected by the existence of the financial safety net. We examine three variables reflecting a bank's stand-alone risks (distance to default, leverage ratio, and asset volatility) and also three variables that capture a bank's contribution to financial sector systemic risk. The systemic risk variables we consider are the marginal expected shortfall (MES) and systemic risk (SRISK) variables proposed by Acharya et al. (2012), and the CoVaR variable proposed by Adrian and Brunnermeier (2016). Following Aggarwal et al. (2009), we use an overall index of shareholder-friendly corporate governance dealing with board composition, compensation, auditing, and takeover related issues. In addition, following Bebchuk et al. (2008), we use an index of management entrenchment. Finally, we consider a variable that captures a board's independence vis-à-vis management.

Using US data, we find that there is a stronger relation between shareholder-friendly corporate governance and stand-alone and systemic risks for banks compared to nonfinancial firms. This finding is consistent with banks being the main beneficiaries of a financial safety net compared to nonfinancial firms. We also find that the relation between risk and shareholder-friendly corporate governance is stronger for larger banks, consistent with larger banks benefiting from a too-big-to-fail guarantee. Finally, we compare large banks to large nonfinancial firms through triple differencing. We show that the too-big-to-fail relation that we find between governance and risk-taking in the banking sector is not present in the nonfinancial sector.

The differences in the governance and risk-taking relation that we observe between large and small banks, as well as between banks and nonfinancial firms, could be driven by unobserved heterogeneity and omitted variables. Corporate governance can also, to some extent, be endogenously determined. For instance, a strong preference for risk on the part of a bank's shareholders could jointly give rise to both considerable bank risk-taking and shareholder-friendly corporate governance. We include bank fixed effects in all regressions in the paper, thereby controlling for any time-invariant unobservable bank characteristics that can affect both bank corporate governance and bank risks. To further address potential endogeneity concerns, we examine changes in risk-taking around an exogenous regulatory change that required increased board independence at some but not all banks.

Specifically, in 2003 the NYSE and Nasdaq stock exchanges announced new regulations requiring at least 50% of board members at listed firms to be independent and not affiliated with the firm. Firms were required to comply with the new rules starting in 2004. We use the fact that some firms already had a majority of independent directors on their boards and thus complied with the new rules when they were announced, while other firms had to increase the number of independent directors by the time the rules came into effect.

We find that banks affected by the reforms increased their stand-alone and systemic risk more (compared to banks that were already compliant) if they were larger. This result is consistent with our other findings and the notion that larger banks benefit more from financial safety net protection compared to smaller banks. Furthermore, we find that the tendency of larger affected banks to increase their risk was stronger compared to larger nonfinancial firms. This finding is again consistent with mainly banks benefiting from the financial safety net. These results strongly suggest a causal link between shareholder-friendly corporate governance and greater risk-taking for larger banks as well as larger banks compared to larger nonfinancial firms.

Our estimates of the differential effects of shareholder-friendly corporate governance on the riskiness of banks compared to nonbanks, and of large banks compared to small banks, are economically significant. Relative to nonbanks, a one standard deviation increase in the governance variable reduces the distance-to-default measure of banks by 0.35 (or 0.14 standard deviation); it also reduces banks’ MES by 41 basis points (or 0.21 standard deviation) and increases banks’ SRISK by 0.89 billion US dollars (or 0.1 standard deviation). With respect to bank size, a one standard deviation increase in the governance measure reduces distance to default by 0.36 and MES by 68 basis points for banks that have assets of $5 billion, while the corresponding decreases in distance to default and MES for banks with assets of $50 billion are substantially larger at 0.79 and 152 basis points, respectively.

Going beyond the US setting, we use an international sample of banks to examine the impact of the strength of national financial safety nets. We find that shareholder-friendly corporate governance varies more positively with bank stand-alone and systemic risks in countries with more generous financial safety nets. Specifically, our estimation implies that a one standard deviation increase in the corporate governance variable augments risk as measured by the distance to default, asset volatility, and MES variables by 2.3%, 1.7%, and 4.7% more in the country where the index of financial safety net strength is one standard deviation higher.4 These findings are confirmed when we use an instrumental-variable estimation in which a bank's corporate governance is instrumented by the annual country-mean value of the corporate governance variable for all nonfinancial firms. The results based on international data provide additional evidence that the relations between a bank's corporate governance and risks reflect its incentives to exploit the financial safety net.

Our study fits in an emerging literature that has examined the impact of corporate governance on bank risk-taking.5 Pathan (2009) finds that small boards and boards that are not controlled by the CEO lead to higher risk for a sample of US bank holding companies over the 1997–2004 period. Chen et al. (2006) find a positive relation between option-based executive compensation and market measures of risk for a sample of US commercial banks. DeYoung et al. (2013) find that CEO risk-taking incentives lead to riskier business policy decisions with respect to loans to businesses, noninterest based banking activities, and investment in mortgage-backed securities at US commercial banks. Calomiris and Carlson (2016) examine bank ownership and risk-taking at US banks in the 1890s and find that higher managerial ownership is associated with lower bank default risk.6

Several papers have examined how banks with different corporate governance regimes fared during the crisis. Berger et al. (2016) find that high share ownership by lower-level management leads to a substantially higher probability of default for US commercial banks over the 2007–2010 period. Beltratti and Stulz (2012), and Fahlenbrach and Stulz (2011) find that banks with more shareholder-friendly boards and CEO compensation contracts that better align the interests of management and shareholders experienced worse stock market performance during the financial crisis. Ellul and Yerramilli (2013) show that US bank holding companies that had a strong and independent risk management function in place before the onset of the financial crisis fared better in terms of operating and stock performance during the crisis.

Multicountry studies of bank corporate governance and risk-taking are relatively scarce. Laeven and Levine (2009) examine the relation between bank ownership and bank risk-taking for an international sample of banks. They find that stronger cash flow rights of large owners are associated with higher bank risks, consistent with the hypothesis that bank shareholders favor greater risk-taking as compared to managers and creditors. These authors also consider the interaction between bank regulation and ownership, finding that deposit insurance is associated with an increase in risk only when the bank has a large equity holder. For a sample of international banks, Anginer et al. (2016) find that shareholder-friendly corporate governance varies negatively with bank capitalization rates. Using international data, Erkens et al. (2012) find that financial institutions with more independent boards and higher institutional ownership experienced worse stock returns during the global financial crisis.

Our contribution to this literature is three-fold. First, this paper is the first to study the relation between a bank's corporate governance and its contribution to stand-alone as well as systemic risk. Second, we examine how the generosity and credibility of financial safety nets affect the relation between governance and bank risk. In particular, we compare banks to nonfinancial firms, compare larger banks to their smaller counterparts, and also consider cross-country differences in the strength of the safety net, adding to a literature that has mostly relied on US data. Third, we examine changes in risk-taking behavior around an exogenous regulatory change in governance and use nonfinancial firms in our analyses as a control group, which alleviates potential endogeneity concerns.

Our findings on the interaction of bank-level corporate governance variables and the financial safety net have important implications for corporate governance reforms in the financial sector. In particular, our results suggest that one has to be cautious to call for “better” corporate governance at banks as long as generous financial safety nets and too-big-to-fail guarantees are in place. In fact, governance reforms designed to better align the incentives of managers and shareholders could fail to be in the interests of taxpayers who ultimately bear the cost of maintaining the financial safety net.

The rest of the paper is organized as follows. Section 2 discusses the data and variable construction. We present the empirical results in Section 3. We start with an analysis of the relations between corporate governance and stand-alone and systemic risks for US banks as well as nonfinancial firms. Then we consider the impact of the NYSE and Nasdaq reforms towards greater board independence on measures of bank risk. Finally, we consider the relation between corporate governance and bank risk using international data so that we can bring cross-country variation in the strength of financial safety nets into the analysis. Section 4 concludes with policy implications.

Section snippets

Data and variable construction

In this study, we relate measures of firm stand-alone and systemic risks to indices of corporate governance for a sample of US banks and nonfinancial firms for the 1990–2014 period and also for an international sample of banks for the 2004–2008 period. We describe the US and international samples in turn.

Empirical results

In this section, we first discuss our methodology followed by a presentation of the empirical results based on the US and the international data.

Conclusion

This paper provides evidence that more shareholder-friendly corporate governance is associated with greater stand-alone and systemic risks for financial institutions compared to nonfinancial firms, consistent with the notion that banks benefit more from financial safety nets. Furthermore, shareholder-friendly corporate governance is associated with greater risk-taking by large banks compared to small banks, consistent with larger banks benefiting from too-big-to-fail guarantees. For the sample

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    We thank an anonymous referee and participants at the 18th annual International Banking Conference at the Federal Reserve Bank of Chicago, and the EBC Network Conference at the Lancaster School of Management for useful comments and suggestions. This paper's findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its executive directors, or the countries they represent.

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