Corporate Governance and Banks

The following post comes to us from Hamid Mehran of the Federal Reserve Bank of New York; Alan Morrison of the Saïd Business School, University of Oxford; and Joel Shapiro of the Saïd Business School, University of Oxford. The views expressed in this post are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System.

How did the governance structure of banks perform during the financial crisis? In our paper, Corporate Governance and Banks: What Have We Learned from the Financial Crisis? we examine this question in light of recent academic work and policy discussions.

We begin by providing a twist on the usual question of what is different about banks by asking what differences are important to governance. Two themes are key: 1) the multitude of stakeholders in banks and 2) the complexity of the business. Besides shareholders, the stakeholders in banks are both numerous (depositors, debtholders, and the government as both insurer of deposits and residual claimant on systemic externalities) and large (over 90 percent of the balance sheet of banks is debt). Yet shareholders control the firm, and evidence shows that both the boards and the compensation package for CEOs represent the shareholders’ preference for increasing risks. Meanwhile, banks have become much larger and expanded dramatically into other businesses since the passage of the Gramm-Leach-Bliley Act in 1999.

Meanwhile, banks have become much larger and expanded dramatically into other businesses since the passage of the Gramm-Leach-Bliley Act in 1999. The business of banks has also been taken up by nonbanks in the “shadow-banking” sector, creating unregulated and uninsured exposures. This added complexity has made the job of boards and managers difficult for many reasons. First, the simple number of activities to manage has multiplied. Second, the knowledge needed to understand these activities has also increased substantially. Third, techniques used to manage these activities (such as value at risk in the case of risk management and credit ratings for capital requirements) have not performed well under the greater degree of complexity and duress.

In the paper, we examine in depth four topics in the corporate governance of banks: executive compensation, boards, risk management, and market discipline.

  • Executive Compensation: We discuss in detail trends in compensation packages and recent evidence demonstrating how equity compensation promoted risk taking. Recent research suggests that an effective way to reduce excess risk is by linking executive pay to the price of debt.
  • Boards: Despite views in the policy world, there is little evidence linking the size of boards, the number of outside directors, and the experience and other concerns of the directors to bad outcomes at financial institutions.
  • Risk Management: We address both risk taking at the firm and the risk management function. Here, unambiguous evidence shows the need for reform in addressing risk-taking culture within banks and for strengthening risk management roles.
  • Market Discipline: We focus on two specific inputs to market discipline: capital requirements and the size and scope of banks. In recent years, banks have found ways to get around capital requirements, diminishing the effect of market discipline. At the same time, banks have increased their size, scope, and complexity, making both regulation and market discipline less effective. Nevertheless, not much evidence indicates that structurally changing the business of banks will improve matters because reduced banking also has its problems and current banks may innovate around regulation.

Overall, our paper provides a framework to think about corporate governance in a much changed banking sector. It suggests some policy changes that would have immediate impact, but also highlights areas that are unlikely to yield progress in the near future.

The full paper is available for download here.

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