Board (in)competence and the subprime crisis

Harald Hau, Johannes Steinbrecher, Marcel Thum, 12 January 2009

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“Who were the first bank supervisory board members?” Answer: “The three Magi in the holy bible. They were politicians with time to spare, were dressed in expensive clothing, and did not really know where the journey was going!”

This joke pokes fun at the debacle of the German public banks called “Landesbanken”, which suffered particularly large losses in the recent financial crisis. Their supervisory board members are often local barons who owe their board seats to political connections. But, unlike the biblical Magi, no shining star seemed to provide them any guidance in their role as bank supervisory board members, given the dismal outcome of the journey. Even though the asset share of the Landesbanken is only 21% in the total German banking market, those banks account for 43% of the total write-downs in the current crisis (Sachverständigenrat 2008).

Does bank governance matter?

Can bank supervisory board members really provide the management board with guidance and control as their mandate formally requires? Does the composition of the bank board matter for bank performance in a financial crisis like the current one? To explore this important question, we examine the biographical background of 593 supervisory board members of Germany’s leading banks and find a pronounced difference in the finance and management experience of board representatives across private and state-owned banks. Did “boardroom competence” matter in the recent subprime crisis? Our data confirm that supervisory board (in-)competence in finance is related to losses in the financial crisis. Improving bank governance is therefore a suitable policy objective in the pursuit of more bank stability.

What does the literature say?

Unfortunately, the economic literature so far provides only relatively weak evidence on the role of boards for firm performance. Most of the corporate finance literature so far has focused on formal rather than qualitative measures of boardroom composition: board independence, board size, and directors’ stock ownership. For instance, board size is generally found to be negatively correlated with performance measures (Brown and Maloney 1999, Yermack 1996). With a large supervisory board, the free-riding of individual board members may lead to a low monitoring effort. Research has also dealt with the role of board independence as measured by the number of outside directors. Here, the evidence remains mixed (Klein 1995, Mehran 1995, Baysinger and Butler 1985, Schellinger, Wood, and Tashakori 1989). Very few papers take a closer look at qualitative properties of board composition. For instance, the industry experience of board members correlates positively with abnormal stock returns and negatively with earnings manipulation as measured by fewer negative income restatements (Papakonstantinou 2008).

Why look at the German banking industry?

The recent financial crisis has revived interest in bank governance. The German banking industry provides a particularly interesting case study. First, international banks only have a very small market share in Germany. Therefore, banks competing in the German market face more or less the same market conditions and the same regulatory constraints. Second, state-owned banks still play an important role in the German banking industry. The state banks account for more than 40% of all assets in the German banking system – much more than in any other (non-transition) EU country. Third, state ownership has important consequences for the composition of bank boards and their respective financial competence. State banks feature many politicians and state representatives on their boards, who often lack any experience in financial matters. Differences in bank ownership therefore drive differences in board competence and this allows us to avoid the reverse causality whereby board competence is a consequence of the board choice of the management board.

Different governance within the same competitive environment

Germany’s state banks operate in the same market as their private counterparts. They face the same regulatory constraints. This suggests that the poor performance of state-owned banks may be due to a lack of efficient monitoring by their supervisory boards. We cannot observe monitoring directly but we can at least check whether supervisory boards have the necessary competencies for monitoring the executives. To obtain a measure of the monitoring potential in the supervisory boards of German’s largest banks, we define 14 different biographical criteria that proxy for boardroom competence in the context of the subprime crisis. The variables capture a board member’s educational background (3 indicator variables), finance experience (6 indicator variables), and management experience (5 indicator variables). With finance experience, for instance, we ask whether a board member has some banking experience, whether the board member has financial market experience, and whether this experience was gained after 1990. For every affirmative answer, we assign one point to the board member and then calculate the average experience for each of the supervisory boards. Figure 1 shows the competence indices for private and state banks. In each dimension, the supervisory boards of private banks exhibit significantly higher competence levels.

Figure 1. Supervisory board members in private and public banks

Note: The figure shows the means for the competence indices of all private and public bank supervisory board members, respectively. Each index is scaled so that values can vary over the range 0 to 10. The sample consists of all German banks with more than 30 billion Euros in total assets in 2007.

Is there a link between governance and crisis performance?

Next, we explore if the relative underperformance of state-owned banks compared to private banks in the recent subprime crisis can be related to governance structures. As a performance measure, we use the write-downs and losses reported by the banks during 2007 and 2008. The most reliable sources are interim reports, which are systematically scrutinised for all banks in our sample. Self-reported losses for 18 banks were initially collected by the council of economic experts for a study on the subprime crisis published in May 2008 (Sachverständigenrat 2008). We extend this data set to the 29 largest German banks and update reported losses into the third quarter of 2008.

Figure 2 shows the index of financial competence, which is the most important competence for effectively governing banks, on the horizontal axis. On the vertical axis, we plot the losses during the financial crisis (first quarter 2007 to third quarter 2008 as far as available). As banks differ in size, we normalise the losses by total assets of each bank. As expected from the aggregate measures, banks with financially competent supervisory boards exhibit lower losses. Figure 2 shows again that private banks absorbed significantly lower losses than state banks.

Figure 2. Subprime-related bank losses and board competence in finance

Note: We plot the magnitude of bank losses (relative to assets) as a function of the bank’s supervisory board index for financial market experience. The sample consists of all German banks with more than 30 billion Euros in total assets in 2007.

Policy conclusions

Many voices advocate stricter bank regulation as the main solution to the current banking crisis. A political economy perspective casts doubts on such hopes. The lenient enforcement of existing bank regulation prior to the current crisis was largely a consequence of opportunistic political pressures. Such powerful interests will continue to operate even if bank regulation appears to become tougher.

Improving bank governance may therefore provide an additional and more robust policy objective to reduce bank fragility. Our investigation into the German banking sector suggests that there is considerable potential for improving bank governance. In particular, privatising state-owned banks is likely to make a positive contribution to governance quality and indirectly to bank stability. This finding is important given that state-ownership is more prevalent in the banking sector than in any other industry. But a positive role of bank governance also implies that private institutions may similarly benefit from a more competent supervisory board. It seems worth exploring whether prudential bank regulations should explicitly encompass criteria for board competence and quality.

References

Baysinger, B. and H. Butler (1985). ‘Corporate Governance and Board of Directors: Performance Effects of Changes in Board Composition’, Journal of Law, Economics and Organization 1, 101—124.

Brown, W. O. and M. T. Maloney (1999). Exit, Voice, and the Role of Corporate Directors: Evidence from Acquisition Performance, Unpublished manuscript, Claremont McKenna College.

Hau, H. and M. Thum (2008). Subprime-Related Losses and Board (In-)Competence: Private vs. Public Banks in Germany, preliminary version of a paper prepared for the 49th Panel Meeting of Economic Policy in Prague, INSEAD & TU Dresden.

Klein, A. (1995). ‘Firm Performance and Board Committee Structure’, Journal of Law and Economics 41, 275—303.

Mehran, H. (1995). ‘Executive Compensation Structure, Ownership, and Firm PerformanceJournal of Financial Economics 38, 163—84.

Papakonstantinou, F. (2008). Boards of Directors: The Value of Industry Experience, mimeo, Princeton University.

Schellinger, M., D. Wood and A. Tashakori (1989). ‘Board of Director Composition, Shareholder Wealth, and Dividend Policy’, Journal of Management 15, 457—467.

Sachverständigenrat (2008). Das deutsche Finanzsystem. Effizienz steigern – Stabilität erhöhen, Report of the Council of Economic Advisors to the German Federal Government, Wiesbaden, June 2008.

Yermack, D. (1996). ‘Higher market valuation of companies with a small board of directors’, Journal of Financial Economics 40, 185—211.

Topics: Europe's nations and regions, Microeconomic regulation
Tags: bank supervisory board, Germany, governance

Harald Hau

Professor of Economics and Finance, Swiss Finance Institute, University of Geneva; and Research Fellow, CEPR

Researcher, Ifo Institute for Economic Research in Dresden

Professor of Economics at TU Dresden, Director of the Ifo Institute for Economic Research in Dresden