The impact of corporate governance in financial institutions

Hamid Mehran, Alan Morrison, Joel Shapiro, 6 April 2012

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A recent op-ed by former Goldman Sachs employee Greg Smith has led to an outcry over Goldman Sachs’ perceived mistreatment of their customers. This illustrates two important themes in the financial sector, both of which came to the fore during the crisis, ie corporate culture and incentives. Obviously, neither regulation nor market forces has put either of these issues to rest. In this column, we look at both through the lens of corporate governance and we highlight the contribution of recent research to these topics.

That financial institutions have emphasised cultures of risk-taking is emphasised in official reports such as the Walker Report (2009) and those of the Senior Supervisors Group (2008, 2009). Academic research has had some success in measuring this and understanding its effects. The ‘residual compensation’ measure of Cheng et al (2010) is an attempt to quantify rewards for bearing risk. Tellingly, the firms with persistently high residual compensation include Bear Stearns, Lehman, Citicorp, Countrywide, and AIG. Cheng et al (2010) find that residual compensation is strongly correlated with several measures of risk-taking, and with institutional ownership. Other authors also find a significant positive relationship between institutional ownership and measures of riskiness (Ellul and Yerramilli 2010, Laeven and Levine 2009). At the same time, when financial-sector CEOs have greater incentives to assume risk, their firms have higher volatility (Suntheim 2010, Chesney et al 2010, DeYoung et al 2009).

One way to address risk-taking appears to be through the creation of an effective risk-control culture by creating the right institutional framework and giving executives appropriate compensation packages. For example, risk-taking is reduced in financial institutions that emphasise the Chief Risk Officer”s role (Ellul and Yerramilli 2010,   Keys et al 2009). Managers should experience some of the costs, as well as the benefits, of risk-taking. Bebchuk and Spamann (2010) and Edmans and Liu (2010) suggest that this could be accomplished by linking executive compensation directly to debt, while Bolton et al (2011) propose to tie CEO compensation to credit default swap spreads, with a high and increasing spread resulting in lower compensation.

The boards of financial institutions must give clear leadership on culture and incentives. But several commentators have raised questions about the effectiveness of these boards. Adams and Mehran (2010) have some surprising results:

  • They do not find a negative correlation between board size and performance, and show an ambiguous relationship with risk;
  • They also document that bank performance is unrelated to standard measures of board independence (Minton et al 2010 find a similar result for the crisis years);
  • Lastly, they show that Bank Holding Company performance is worse when bank board directors are particularly busy, and that interlocks adversely affect bank performance.

Many commentators have suggested that inexperienced independent directors are unable to fulfil their governance role. But, as we point out in Mehran et al (2012), experience is no panacea. For example, Northern Rock’s board included a former bank CEO, a top fund manager, and a previous member of the Bank of England’s governing body, while Bear Stearns had a board on which seven of 13 members had a banking background.

Recent calls for more banking expertise in the boardroom reflect the incredible, and growing, complexity of modern financial firms. Modern techniques have been developed for coping with this complexity, using Value at Risk systems and credit ratings. These techniques, however, have proved ineffective, in part because increases in bank complexity have been accompanied by increased bank opacity. The UK's Independent Commission on Banking suggests that the problems that derive from complexity should be met head-on by restricting retail banks to simpler and more easily measured activities. Nevertheless, as we point out in Mehran et al (2012), any regulatory strategy that moves risks out of the most closely regulated parts of the banking sector carries its own risks.1

The complexity of modern banks partly reflects their increasing size and scope. These increases have produced a situation where the social costs of a failure of these institutions are greatly magnified, creating the too-big-to-fail problem. Bank complexity and the too-big-to-fail policy both serve to undermine market discipline. On the one hand, regulators and investors are less able to understand banks, and, hence, are less able effectively to discipline them; on the other hand, shareholders are less inclined to exercise caution when they believe that their institutions are too big to fail.

A well-designed bank capital-adequacy regime can mitigate some governance problems, by exposing shareholders to the risk of failure. Insofar as this exposure improves shareholder incentives, capital-adequacy rules serve as a partial substitute for governance rules. However, banks have found ways to circumvent capital requirements in recent years.

The recent discussion over culture at Goldman Sachs has highlighted the fact that neither regulatory intervention nor market forces have resolved governance problems. Unfortunately, some of these have no simple solution. It is important that they be subjected to further investigation and study.

Author’s Note: 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.

References

Adams, R and Mehran, H (2010), “Corporate performance, board structure and its determinants in the banking industry”, mimeo, Federal Reserve Bank of New York.
Bebchuk, L A and Spamann, H (2010), “Regulating bankers pay”, Georgetown Law Journal 98(2): 247–87.
Bolton, P, Mehran, H, and Shapiro, J (2011), “Executive compensation and risktaking”, mimeo, Federal Reserve Bank of New York.
Cheng, I-H, Hong, H and Scheinkman, J (2010), “Yesterday’s heroes: compensation and creative risk-taking”, mimeo, Princeton University.
Chesney, M, Stromberg, J and Wagner, A (2010), “Risk-taking incentives, governance, and losses in the financial crisis”, Research Paper 10-18, Swiss Finance Institute.
DeYoung, R, Peng, E Y and Yan, M (2009), “Executive compensation and business policy choices at US commercial banks”, mimeo.
Edmans, A and Liu, Q (2011). “Inside debt”, Review of Finance 15(1): 75–102.
Ellul, A and Yerramilli, V (2010), “Stronger risk controls, lower risk: evidence from US bank holding companies”, mimeo, Indiana University.
Keys, B J, Mukherjee, T, Seru, A and Vig, V (2009), “Financial regulation and securitization: evidence from subprime loans”, Journal of Monetary Economics 56: 700–20.
Laeven, L and Levine, R (2009), “Bank governance, regulation, and risk-taking”, Journal of Financial Economics 93: 259–275.
Minton, B, Taillard, J and Williamson, R (2010), “Board composition, risk taking and value: evidence from financial firms”, mimeo, Ohio State University.
Mehran, H., Morrison, A. and Shapiro, J (2012), “Corporate Governance and Banks: What Have We Learned From the Financial Crisis?”, in Dewatripont, Mathias and Xavier Freixas, The Crisis Aftermath: New Regulatory Paradigms, London: Centre for Economic Policy Research.
Senior Supervisors Group (2008), ‘Observation on risk management practices during the recent market turbulence’, Basel: Financial Stability Board.
Senior Supervisors Group (2009), ‘Risk management lessons from the global banking crisis of 2008’, Basel: Financial Stability Board.
Suntheim, F (2010), “Managerial compensation in the financial service industry”,mimeo, Bocconi University.

Walker Report (2009),” A Review of Corporate Governance in UK Banks and Other Financial Industry Entities”, chair D Walker, London: HM Treasury, at http:// www.hm-treasury.gov.uk/d/walker_review_consultation_160709.pdf (accessed Feb 2012).


1 And, of course, the key events of the financial crisis in 2008 were the collapse of Bear Stearns, AIG, and Lehman Brothers, none of which had retail arms.

 

Topics: Financial markets
Tags: banks, corporate governance, too-big-to-fail

Assistant Vice President, Research Group, Federal Reserve Bank of New York
Professor of Finance, Saïd Business School, University of Oxford
Joel Shapiro
University Lecturer of Finance, Saïd Business School, University of Oxford; and Research Affiliate, CEPR