This paper provides evidence that more shareholder-friendly corporate governance is associated with greater stand-alone and systemic risks for financial
institutions compared to non-financial 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 of
international banks, we also find that the relations between shareholder-friendly
governance and bank risks are stronger in countries with more generous financial safety nets. This is again consistent with the notion that banks try to shift risk onto the financial safety net to increase equity value.
To alleviate endogeneity concerns, we examine changes in risk-taking around an exogenous regulatory change that increased board independence for some banks but not others. We find that regulatory reform towards greater board independence approved in 2003 by US exchanges increased stand-alone and systemic risks more at larger banks that were affected by this reform as compared to non-financial firms. For the sample of
21 In equity return regressions for the international sample of banks analogous to Table 8, we did not find a
35
international banks, we use an instrumental-variable approach to confirm our findings. These results strongly suggest a causal link between shareholder-friendly corporate governance and bank risk-taking.
The interaction between corporate governance and the financial safety net in determining bank insolvency and systemic risks has important implications for public policies towards corporate governance at banks. In particular, the case for more
shareholder-friendly corporate governance at banks is much weaker than in the case of non-financial firms. In the case of banks, particularly large ones, corporate governance that better aligns managerial incentives with shareholder interests may exacerbate the excessive risk-taking resulting from bank shareholders’ incentives to exploit the financial safety. This paper’s finding that regulations towards greater board independence in the US increased the riskiness of the affected banks relative to non-financial firms provides suggestive evidence of this. In the second-best world in which mispriced financial safety nets and too-big-to-fail policies exist, ‘better’ corporate governance could produce worse outcomes. To prevent this, a first priority should be regulatory and safety net reforms to address too-big-to-fail issues and to reduce moral hazard leading to excess risk-taking of banks. After such reforms, the case for ‘better’ corporate governance at banks would become much stronger.
36
Appendix. Variable definitions, data sources, governance attributes, and country coverage Table A1. Variable definitions and data sources
Variable name Definition Data source
Risk and return variables
DD Merton’s (1974) distance-to-default measure computed as the difference between the asset value of a firm and the face value of its debt scaled by the standard deviation of the firm’s asset value
Authors’ calculations
Leverage Market leverage computed by dividing the sum of the market value of equity and the book value of liabilities by the market value of equity
Authors’ calculations
AVOL Asset volatility computed using the Merton (1974) model Authors’ calculations MES Average bank stock return when market return is in the lowest 5% bracket in a given year
SRISK Expected capital shortfall in billions of US dollars when the market return is in the lowest 5% bracket in a given year
Authors’ calculations
COVAR Conditional value at risk measure as the change in the value at risk (VaR) of the system when the firm is at the 5th percentile minus the VaR of the system when the institution is at the 50th
percentile in terms of its stock returns
Authors’ calculations
Return Average monthly stock return during the financial crisis from January to September 2008 Author’s calculations Governance variables
Governance Corporate governance index based on 44 attributes listed in Table A2 ISS/CGQ Entrenchment Entrenchment index of executive entrenchment based on six governance provisions: staggered
boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and
supermajority requirements for mergers and charter amendments with higher values indicating better governance
ISS/Riskmetrics
Independence Share of board members who are not affiliated with the firm ISS/Riskmetrics Affected Dummy variable set to one for firms that were not compliant with the exchange rules requiring
firms to have at least 50% of their board members to independent in 2003.
ISS/Riskmetrics
Firm control variables
Size Logarithm of total assets CRSP and Compustat
Global
Market-to-book Market to book ratio computed as market capitalization divided by the book value of equity CRSP, Compustat North America, and Compustat Global
37
Return on assets Net income divided by total assets CRSP, Compustat North America, and Compustat Global
Macro and institutional control variables
Financial safety net Sum of first four principal components with an eigenvalue exceeding one based on 8 deposit insurance scheme design features as follows: (1) coverage of foreign currency deposits, (2) coverage of interbank deposits, (3) an absence of coinsurance, (4) coverage per depositor per bank per account, (5) funded ex ante, (6) funded by government, (7) risk-insensitive insurance premium, (8) the ratio of insurance coverage and deposits per capita, with a higher value for each feature suggesting a more generous financial safety net and more severe moral hazard
Authors’ calculations based on deposit insurance data in year 2003 from Demirguc-Kunt,
Karacaovali, and Laeven (2005)
Inflation Consumer price inflation rate World Development
Indicators
GDP growth Rate of real GDP growth World Development
Indicators
GDP per capita GDP per capita in thousands of constant 2005 U.S. dollars World Development Indicators
Activity restrictions Index of regulatory restrictions on bank activities Barth, Caprio, and Levine (2004)
Capital stringency Index of regulatory oversight of bank capital with higher values indicate greater stringency Barth, Caprio, and Levine (2004)
Supervisory power Index of power of bank supervisory authorities to take specific actions to prevent and correct problems with higher values indicating greater power
Barth, Caprio, and Levine (2004)
Diversification Index of diversification guidelines imposed on banks with higher values indicating more diversification
Barth, Caprio, and Levine (2004)
Financial freedom Index of financial freedom with higher values indicating greater freedom Heritage Foundation
38 Table A2. Corporate governance attributes
Board attributes
1. All directors attended 75% of board meetings or had a valid excuse 2. CEO serves on the boards of two or fewer public companies 3. Board is controlled by more than 50% independent outside directors 4. Board size is greater than 5 but less than 16
5. CEO is not listed as having a related-party transaction 6. No former CEO on the board
7. Compensation committee composed solely of independent outsiders 8. Chairman and CEO are separated or there is a lead director 9.Nominating committee composed solely of independent outsiders 10.Governance committee exists and met in the past year
11.Shareholders vote on directors selected to fill vacancies 12.Governance guidelines are publicly disclosed
13.Annually elected board (no staggered board)
14.Policy exists on outside directorships (four or fewer boards is the limit) 15.Shareholders have cumulative voting rights
16.Shareholder approval is required to increase/decrease board size 17.Majority vote requirement to amend charter/bylaws
18.Board has the express authority to hire its own advisors 19.Performance of the board is reviewed regularly 20.Board-approved succession plan in place for the CEO
21.Outside directors meet without CEO and disclose number of times met 22.Directors are required to submit resignation upon a change in job
23.Board cannot amend bylaws without shareholder approval or can do so only under limited circumstances 24.Does not ignore shareholder proposal
25.Qualifies for proxy contest defenses combination points Compensation and ownership attributes
26.Directors are subject to stock ownership requirements 27.Executives are subject to stock ownership guidelines 28.No interlocks among compensation committee members 29.Directors receive all or a portion of their fees in stock 30.All stock-incentive plans adopted with shareholder approval
31.Options grants align with company performance and reasonable burn rate 32.Company expenses stock options
33.All directors with more than one year of service own stock
34.Officers' and directors' stock ownership is at least 1% but not over 30% of total shares outstanding 35.Repricing is prohibited
Auditing attributes
36.Board independence: Audit committee
37.Consulting fees paid to auditors are less than audit fees paid to auditors 38.Auditors ratified at most recent annual meeting
Antitakeover attributes 39.Single class, common
40.Majority vote requirement to approve mergers (not supermajority) 41.Shareholders may call special meetings
42.Shareholder may act by written consent
43.Company either has no poison pill or a pill that was shareholder approved 44.Company is not authorized to issue blank check preferred
39 Table A3. Country coverage
Country name Frequency Percentage of the sample
Australia 83 1.88 Austria 15 0.34 Belgium 20 0.45 Canada 33 0.75 Denmark 9 0.2 Finland 8 0.18 France 21 0.48 Germany 42 0.95 Greece 14 0.32 Hong Kong 122 2.76 Ireland 9 0.2 Italy 31 0.7 Japan 294 6.66 Netherlands 18 0.41 Norway 10 0.23 Portugal 12 0.27 Singapore 71 1.61 Spain 10 0.23 Sweden 29 0.66 Switzerland 30 0.68 United Kingdom 167 3.78 United States 3,367 76.25
40
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43 Table 1. Summary statistics
Panel A reports summary statistics for the sample of US banks, Panel B for the sample of US non-financial firms, and Panel C for the sample of international banks. DD is Merton’s (1974) distance-to-default measure computed as the difference between the asset value of a firm and the face value of its debt scaled by the standard deviation of the firm’s asset value. Leverage is market leverage computed by dividing the sum of the market value of equity and the book value of liabilities by the market value of equity. AVOL is asset volatility computed using the Merton (1974) model. MES is marginal expected shortfall computed as the average stock return of a firm when the market return is in the bottom 5th percentile in a given year. SRISK is expected capital shortfall when the market return is in the
lowest 5% bracket in a given year. COVAR is conditional value at risk measure computed as the change in the value at risk (VaR) of the system when the firm is at the 5th percentile minus the VaR of the system when the institution is
at the 50th percentile in terms of its stock returns. Return is the average monthly stock return during the financial
crisis from January to September 2008. Governance is an overall governance index. Entrenchment is an index of executive entrenchment with higher values indicating better governance. Independence is the share of board members not affiliated with the firm. Return on asset is net income divided by total assets. Market-to-book is the market to book ratio computed as market capitalization divided by the book value of equity. Size is the log of total assets. Financial safety net is an index based on 8 deposit insurance design features with higher values indicating a more generous safety net. Inflation is the percentage annual change in the consumer price index. GDP growth is the real rate of GDP growth. GDP per capita is the GDP per capita in thousands of constant 2005 U.S. dollars. Activity restriction is an index of regulatory restrictions on bank activities. Capital stringency is an index of regulatory oversight of bank capital with higher values indicating greater stringency. Supervisory power is an index of the power of bank supervisory authorities to take specific actions to prevent and correct problems with higher values indicating greater supervisory power. Diversification is an index of diversification guidelines imposed on banks with higher values indicating greater diversification. Financial freedom is an index of government regulations and controls on the financial sector with higher values indicating greater freedom. Data in Panels A and B are for the period 1990-2014, while data in Panel C is for the period 2004-2008.
Panel A: US banks Obs Mean Std P25 P50 P75
DD 6,664 5.33 2.50 3.74 5.18 6.72 Leverage 6,638 9.01 16.41 3.40 6.24 9.42 AVOL 6,664 0.10 0.12 0.03 0.06 0.12 MES 6,855 -0.02 0.02 -0.03 -0.02 -0.01 SRISK 6,642 -0.42 8.77 -0.81 -0.11 0.01 COVAR 6,732 -0.01 0.01 -0.02 -0.01 -0.01 Return 712 -0.02 0.05 -0.04 -0.01 0.01 Governance 3,700 0.62 0.09 0.56 0.62 0.68 Entrenchment 4,416 -2.35 1.45 -3.00 -2.00 -1.00 Independence 3,107 0.70 0.17 0.60 0.73 0.82 Return on assets 7,264 0.02 0.05 0.01 0.01 0.02 Market-to-book 7,264 2.05 1.93 1.16 1.63 2.31 Size 7,264 8.27 2.02 6.80 8.21 9.54
44
Panel B: US non-financials Obs. Mean Std P25 P50 P75
DD 32,374 5.22 2.87 3.17 4.78 6.77 Leverage 32,065 2.07 4.04 1.21 1.50 2.10 AVOL 32,374 0.30 0.21 0.16 0.26 0.39 MES 33,310 -0.02 0.02 -0.03 -0.02 -0.01 SRISK 32,158 -3.22 12.65 -1.67 -0.47 -0.13 COVAR 32,786 -0.01 0.01 -0.02 -0.01 -0.01 Return 2,744 -0.02 0.06 -0.05 -0.02 0.01 Governance 14,311 0.63 0.09 0.57 0.64 0.70 Entrenchment 25,629 -2.31 1.40 -3.00 -2.00 -1.00 Independence 19,212 0.69 0.17 0.57 0.71 0.83 Return on assets 34,930 0.01 0.17 0.01 0.04 0.08 Market-to-book 34,930 3.08 3.59 1.28 2.02 3.40 Size 34,930 6.69 1.86 5.50 6.66 7.87
Panel C: Non-US banks Obs Mean Std P25 P50 P75
DD 1,049 5.93 2.98 3.78 5.31 7.58 Leverage 1,041 9.58 10.31 2.10 5.47 13.68 AVOL 1,049 0.11 0.11 0.02 0.07 0.17 MES 1,046 -0.03 0.03 -0.04 -0.03 -0.01 SRISK 1,025 0.800 17.02 1.73 -0.30 1.31 COVAR 917 -0.02 0.01 -0.02 -0.01 -0.01 Return 935 -0.02 0.05 -0.05 -0.02 0.01 Return on assets 1,049 0.03 0.05 0.00 0.01 0.03 Market-to-book 1,049 2.08 2.12 1.06 1.50 2.36 Size 1,049 9.76 1.86 8.37 9.84 11.04 Governance 1,049 0.56 0.07 0.50 0.55 0.61 Country level variables
Financial safety net 566 -0.52 1.69 -0.38 -0.31 -0.30 Inflation 1,049 0.01 0.01 0.00 0.02 0.02 GDP growth 1,049 0.03 0.02 0.02 0.03 0.04 GDP per capita 1,049 35.30 6.70 31.87 35.78 37.72 Activity restriction 1,049 6.09 2.11 4.00 7.00 8.00 Capital stringency 1,049 4.99 1.20 4.00 5.00 6.00 Supervisory power 1,049 10.62 2.18 8.00 11.00 12.00 Diversification 1,049 1.51 0.53 1.00 2.00 2.00 Financial freedom 1,049 67.95 21.66 50.00 70.00 90.00
45
Table 2. Corporate governance and risk at banks vs. non-financial firms
The dependent variables in the 6 columns are DD, -Leverage, -AVOL, MES, -SRISK and COVAR. DD is Merton’s (1974) distance-to-default measure computed as the difference between the asset value of a firm and the face value of its debt scaled by the standard deviation of the firm’s asset value. Leverage is market leverage computed by dividing the sum of the market value of equity and the book value of liabilities by the market value of equity. AVOL is asset volatility computed using the Merton (1974) model. MES is marginal expected shortfall computed as the average stock return of a firm when the market return is in the bottom 5th percentile in a given year. SRISK is
expected capital shortfall when the market return is in the lowest 5% bracket in a given year. COVAR is conditional value at risk measure computed as the change in the value at risk (VaR) of the system when the firm is at the 5th
percentile minus the VaR of the system when the institution is at the 50th percentile in terms of its stock returns. We
multiply Leverage, AVOL and SRISK by -1 so that higher values indicate lower risk consistent with the other risk