Governance of banks

Luc Laeven, Ross Levine 29 September 2008

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Banks matter.1 When banks efficiently mobilise and allocate funds, they lower the cost of capital to firms and accelerate capital accumulation. When banks allocate credit to entrepreneurs with the best ideas (rather than to those with the most accumulated wealth or strongest political connections) productivity growth is boosted and more people can pursue their economic dreams. And, when banks manage risk prudently, the likelihood of systemic crises is reduced.

Of course, banks are double-edged. Banks that collect deposits with one hand and lend to friends and political cronies with the other stymie innovation and growth, while enriching the elite. And banks that gamble, protected on the downside by a generous government safety net, too frequently have sparked devastating crises that have exacted enormous human costs in virtually every country.

In turn, bank regulations and governance matter. If official regulations and private governance mechanisms foster well-functioning banks, the probability of costly crises is reduced and economic growth is accelerated along with the expansion of economic opportunities.

Unfortunately, regulations and governance systems too often fail to promote sound banking as exemplified by the turmoil embroiling financial markets today.

Bank regulation and private governance: A critical, little understood nexus

In fact, little is known about how private governance mechanisms interact with national regulations to shape bank risk taking. Rather, researchers and policymakers have focused on using official regulations to induce sound banking, while largely ignoring how owners, managers, and debt holders interact to influence bank risk.

Bank owners, debt holders, and managers frequently disagree about risk.2 As in any corporation, diversified owners of banks (owners who do not have a large fraction of their personal wealth invested in the bank) have a greater incentive to increase risk than uninsured debt holders. Stock holders disproportionately enjoy the fruits of high-risk, potentially high-return investments, while debt holders want the bank to take as little risk as possible, while earning enough to pay them back. On risk, non-shareholder managers (managers who do not have a substantial equity stake in the bank) frequently align themselves with debt holders against diversified owners. Non-shareholder managers generally prefer to take less risk than owners because their jobs are linked to the survival of the bank. Of course, to the extent that the manager has a large equity stake in the bank or holds stock options, this would enhance his or her risk-taking incentives through enticing potentially large rewards for high-return investments. In practice, however, bank managers often do not hold much bank stock, placing them at odds with diversified bank owners in their views on risk taking.

Thus, the comparative power of owners, managers, and debt holders within bank’s governance structure matters. Banks with an ownership structure that empowers diversified owners will tend to take more risk than banks in which owners have less influence.

New evidence

In a recent paper (Laeven and Levine, 2008), we test how national regulations interact with a bank’s private governance structure to determine its risk-taking behaviour. It is crucial to examine regulations and governance simultaneously.

If regulations boost the risk-taking incentives of bank owners but not those of managers and debt holders, then the actual change in bank risk depends on the comparative power of owners within the bank’s governance structure. Thus, the same regulation will yield different effects depending on the governance structure of each bank. Similarly, changes in policies toward bank ownership, such as allowing private equity groups to invest in banks or changing limits on ownership concentration, could have differential effects depending on bank regulations.

Examining national regulations or bank governance in isolation will almost certainly yield misleading results since regulations and governance structures differ across countries. To address this, we first collected new information on the ownership and management structure of banks and merged this with data on bank regulations around the world. The new database covers detailed data on banks across 48 countries and traces the ownership of banks to identify the ultimate owners of bank capital and the degree of ownership concentration.

Most big banks have very concentrated ownership

It turns out that banks around the world are generally not widely held, despite government restrictions on the concentration of bank ownership, though there is enormous cross-country variation.

·     About 75% of major banks have single owners that hold more than 10% of the voting rights.

·     20 out of 48 countries do not have a single widely held bank (among their largest banks).

·     Of those banks in our sample with a controlling owner, more than half are families.

Most governments restrict the concentration of bank ownership and the ability of outsiders to purchase substantial stakes in banks without regulatory approval, generally to limit concentrations of power in the economy. But regulatory restrictions on the concentration of bank ownership are often ineffective or not well enforced. Families employ various schemes, such as pyramidal structures, to build up control in banks.

Key results

·     We find that banks with more powerful owners (as measured by the size of their shareholdings) tend to take greater risks.

This supports arguments predicting that equity holders have stronger incentives to increase risk than non-shareholding managers and debt holders and that large owners with substantial cash flows have the power and incentives to induce the bank’s managers to increase risk taking.

Furthermore, the impact of bank regulations on bank risk depends critically on each bank’s ownership structure such that the relationship between regulation and bank risk can actually change sign depending on ownership structure.

·     For example, our results suggest that deposit insurance is only associated with an increase in risk when the bank has a large equity holder with sufficient power to act on the additional risk-taking incentives created by deposit insurance.

·     The data also suggest that owners seek to compensate for the loss in value of owning a bank from capital regulations by increasing bank risk.

·     Stricter capital regulations are associated with greater risk when the bank has a sufficiently powerful owner, but stricter capital regulations have the opposite effect in widely held banks.

Ignoring bank governance leads to incomplete and sometimes erroneous conclusions about the impact of bank regulations on bank risk taking.

Policy implications

These findings have important policy implications. They question the current approach to bank supervision and regulation that relies on internationally established capital regulations and supervisory practices. Instead, we find that:

(1) private governance mechanisms exert a powerful influence over bank risking, and

(2) the same official regulation has different effects on bank risk taking depending on the bank’s governance structure.

Since governance structures differ systematically across countries, bank regulations must be custom-designed and adapted as financial governance systems evolve.

Regulations should be geared toward creating sound incentives for owners, managers, and debt holders, not toward harmonising national regulations across economies with very different governance structures.

References

Galai, D. and R. Masulis, 1976, “The Option Pricing Model and the Risk Factor of Stock,” Journal of Financial Economics, 3, 53-81.

Jensen, M. and W. Meckling. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics 3, 305-360.

John, K., L. Litov, and B. Yeung, 2008, “Corporate Governance and Managerial Risk Taking: Theory and Evidence,” Journal of Finance, forthcoming.

Laeven, Luc, and Ross Levine, 2008, “Bank Governance, Regulation, and Risk-Taking,” Journal of Financial Economics, forthcoming. Available at: http://www.nber.org/papers/w14113.



1. Disclaimer: While one of the authors of this column is a staff member of the International Monetary Fund, the views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

2. See influential theories by Galai and Masulis (1976) and Jensen and Meckling (1976), and recent empirical work on nonfinancial firms by John, Litov, and Yeung (2008).

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Topics:  Financial markets

Tags:  bank regulation

Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow

Willis H. Booth Chair in Banking and Finance, Haas School of Business, University of California, Berkeley

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