Monday, June 7

Show me the money and who owns it

Over the past couple of years, there has been a steadily rising crescendo of voices, initiatives, conferences and papers, all concentrating on enhancing and improving the regulatory framework around the banks so as to avoid another banking crisis. By and large, all of the initiatives and suggestions concentrate on the risk element of the bank’s portfolios. Whether they related to the portfolio being too big (too big to fail), having badly designed instruments (toxic debt and credit instruments), bad remuneration policies (the hoo haa over bonuses), separation of prop trading from deposit making (the Volker plan aka Glass Steagal v 2.0), to globally coordinated regulation to improved liquidity standards and the like. What has not been considered, at least the little bits that I have read, is the factor of bank corporate governance. Thankfully, a recent paper sheds some light on this issue.

The authors find that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Their sample has 279 publicly listed banks across 48 countries, so it’s pretty much a global study of the top banking firms in the world. In other words, you can pretty much take these outcomes to the bank (if you excuse the rather laboured pun) and generalise the results. The bank corporate governance is defined as relating to control rights and cash flow rights usually expressed in terms of one large shareholder having more than 10% of voting rights. If there is no single shareholder with more than 10% of voting rights, then it’s considered to be widely held. So what they find is that banks with a single large shareholder have a statistically significant greater bank risk and this is, surprisingly so, holding for all the 48 countries in the sample. No outliers at all. Policy implications are simple, regulators should also aim to get banks to diversify their shareholding, so that there is no single shareholder who manages to have banks hold greater risk than usual.

But then, there is a different angle to this. If the regulations are too onerous, then the utility value of holding a bank reduces because of increased capital requirements, and therefore existing owners can be tempted to increase risk to show greater returns. And the authors find that this behaviour is exacerbated when there is a single large shareholder in the bank. In other words, just increasing the requirement to hold more capital may not make the banking sector less risky if there are banks with large single shareholders. By how much you ask? The regression figures show that for widely held banks, for every 1 standard deviation increase in capital stringency, bank risk falls by 0.3 standard deviations, but increases by 0.1 standard deviations if the bank has a single large shareholder.

More worryingly, the authors find that capital requirements no longer have a robust direct link with banking stability and posit that this is due to the lack of attention paid to bank governance elements. Putting it in another way, it is crucial for regulators to factor in the bank governance elements in their analysis of the efficacy of proposed bank regulations. If they do not, then their attempts to reduce bank risk will be compromised at best and be ineffectual or even negative at worst.

Quite an interesting paper.

(Laeven Luc and Levine Ross, 2009, Bank Governance, regulation and risk taking, Journal of Financial Economics, 93, pp 259-275.

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