How Does Corporate Governance Affect Bank Capitalization Strategies?

The following post comes to us from Deniz Anginer of the Department of Finance at Virginal Tech, Asli Demirgüç-Kunt, Director of Research at the World Bank; Harry Huizinga, Professor of Economics at Tilburg University; and Kebin Ma of the World Bank.

In our paper, How Does Corporate Governance Affect Bank Capitalization Strategies?, which was recently made publicly available on SSRN, we examine how corporate governance and executive compensation affect bank capitalization strategies for an international sample of banks over the 2003-2011 period.

We find that ‘good’ corporate governance—or corporate governance that causes the bank to act in the interests of bank shareholders—engenders lower levels of bank capital. Specifically, we find that bank boards of intermediate size (big enough to escape capture by management, but small enough to avoid free rider problems within the board), separation of the CEO and chairman of the board roles, and an absence of anti-takeover provisions lead to lower capitalization rates. ‘Good’ corporate governance thus may be bad for bank stability and potentially entail high social costs. This disadvantage of ‘good’ corporate governance has be balanced with presumed benefits in terms of restricting management’s ability to perform less badly in other areas—for instance, by shirking or acquiring perks—at the expense of bank shareholders.

However, we do not find consistent evidence that corporate governance schemes that promote shareholder interests cause badly performing banks to continue relatively high payouts to shareholders. This may reflect that banks with ‘good’ corporate governance on average have relatively low capitalization rates, providing them no room to maintain relatively aggressive payout policies in the face of negative income shocks.

Further, we find that capitalization rates increase with CEO overall compensation, and also with CEO options and stock wealth invested in the firm relative to annual cash income when considering the entire sample period from 2003 to 2011. These results favor the interpretation that high executive income and wealth tied to the bank cause managers to increase capitalization so as to reduce the riskiness of their income and wealth. However, executive options wealth is associated negatively with bank capitalization in 2006 prior to the financial crisis when apparently the potential gains from taking on more bank risk outweighed the prospect of additional loss.

We find that our executive options and shares wealth lead to a higher tendency for the bank to continue payouts to bank stock investors even if the bank performs badly, suggesting that higher executive wealth invested in the bank lead to riskier payout strategies. This may be because executives fear that payout cuts could endanger their jobs or wealth (as the share price may drop on the news of lower payouts to shareholders), with these risks becoming more pronounced at higher levels of overall income and of wealth tied to the bank. For the case of US banks, we find that bank capitalization only reflects the CEO’s risk-taking incentives as summarized by delta and vega.

Our findings have important policy implications. In reform discussions since the crisis, the potentially nefarious impact of ‘good’ governance on bank risk-taking often fails to be recognized. The European Commission (2010), for instance, states that the board of directors were unable to exercise effective control over senior management and that directors’ failure to identify, understand and ultimately control the risks to which their financial institutions were exposed was at the heart of the origins of the crisis.

The UK Parliamentary Commission on Banking (2013) similarly concludes that many non-executive directors failed to act as an effective check on, and challenge to, executive managers, recommending the appointment of a Senior Independent Director ensuring that the relationship between the CEO and the Chairman does not become too close and that the Chairman performs his or her leadership and challenge role. This proposed change in the corporate governance of banks potentially increases bank risk-taking as long as boards act on the principle of shareholder primacy (section 172 of the Companies Act of 2006). However, the UK Parliamentary Commission (2013) simultaneously recommends removing shareholder primacy with respect to banks, requiring directors of banks to ensure the financial safety and soundness of the company ahead of the interests of its members. These policy assessments ignore that more effective boards and good corporate governance practices may well increase bank risk taking beyond the level preferred by senior management and they suggest first and foremost that reforms need to address policies that distort risk-taking incentives of shareholders, such as too-big-to-fail policies and government guarantees.

The full paper is available for download here.

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