Corporate Governance and Performance in the Wake of the Financial Crisis: Evidence from US Commercial Banks

• Author: Hugh Grove,Lorenzo Patelli,Pisun (Tracy) Xu,Lisa M. Victoravich
• Published date: 01 September 2011
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00882.x
• Date: 01 September 2011

Corporate Governance and Performance in the

Wake of the Financial Crisis: Evidence from US

Commercial Banks

Hugh Grove, Lorenzo Patelli, Lisa M. Victoravich,

and Pisun (Tracy) Xu*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Does corporate governance explain US bank performance during the period leading up to the

f‌inancial crisis? We adopt the factor structure by Larcker, Richardson, and Tuna (2007) to measure multiple dimensions of

corporate governance for 236 public commercial banks.

Research Findings/Insights: Findings reveal corporate governance factors explain f‌inancial performance better than loan

quality. We f‌ind strong support for a negative association between leverageand both f‌inancial performance and loan quality.

CEO duality is negatively associated with f‌inancial performance. The extent of executive incentive pay is positively

associated with f‌inancial performance but exhibits a negative association with loan quality in the long-run. We f‌ind a

concave relationship between f‌inancial performance and both board size and average director age. We provide weak

evidence of an association of anti-takeover devices, board meeting frequency, and aff‌iliated nature of committees with

f‌inancial performance.

Theoretical/Academic Implications: We apply agency theory to the banking industry and expect that the governance-

performance linkage might differ due to the unique regulatory and business environment. Results extend Larcker et al.

(2007), especially regarding the concave relationship between board size and performance, and the role of leverage. Given

the lack of support for our agency theory predictions, we suggest that alternative theories are needed to understand the

performance implications of corporate governance at banks.

Practitioner/Policy Implications: We offer contributions to regulators, especially for ongoing f‌inancial reforms of capital

requirements and executive compensation. Specif‌ically, we show a consistent negative association between leverage and

performance, which supports the current debate on Tier I capital limits for banks.

Keywords: Corporate Governance, Banking Industry, Global Financial Crisis, Loan Quality

INTRODUCTION

In the wake of recent f‌inancialcrisis, corporate governance

practices in the banking industry have received height-

ened attention. Anecdotal evidence suggests that corporate

governance at banks were ineffective at preventing detri-

mental lending practices, leading to an extremelyvulnerable

f‌inancial system. Theglobal economic impact of the f‌inancial

crisis and the alleged role played by corporate governance

signify the need for more empirical research on the role of

corporate governance at banks. Empirical questions arise

regarding the current corporate governance structure in the

banking industry. These questions include whether corpo-

rate governance practices promoted in the non-regulated

and non-f‌inancial industries can also effectively enhance the

governance of banking f‌irms and the role of these corporate

governance mechanisms in shaping bank performance

during the f‌inancial crisis period.

This study seeks to promote theoretical development of

corporate governance structures at banks and practical

implications for monitoring bank risk-taking and executive

compensation at banks. First, we provide a picture of the

*Address for correspondence: Pisun (Tracy) Xu, Reiman School of Finance, Daniels

College of Business, University of Denver, 2101 S. University Blvd., Denver, CO

80208-8951. Tel: 303-8714228; Fax:303-8714580; E-mail: pxu@du.edu

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Corporate Governance: An International Review, 2011, 19(5): 418–436

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00882.x

current corporate governance structure in the banking

industry by studying a comprehensive set of corporate gov-

ernance variables identif‌ied as relevant by academics and

practitioners. Second, in developing the study’s hypotheses,

we build on agency theory and test its theoretical implica-

tions in the banking industry. The linkage between tradi-

tional corporate governance mechanisms and performance

might differ due to the regulatory environment and unique

nature of the banking business (Mülbert, 2010; Ungureanu,

2008).

To empirically examine a wide spectrum of corporate gov-

ernance mechanisms and their impact on US public com-

mercial bank performance, we ref‌ine the factor structure

created in Larcker, Richardson, and Tuna (2007). As stated

by Larcker et al. (2007), adopting this methodology is ben-

ef‌icial given that employing a single governance variable for

a complex construct would cause measurement errors and

inconsistent regression coeff‌icients while arbitrarily con-

structed governance indices might be hard to interpret and

cause an omitted variables problem. This improved method-

ology enables the construction of reliable structural mea-

sures from a broad set of governance variables, which

enhances the validity of the regression analysis. We con-

struct 11 governance factors to capture six dimensions of

bank governance, including characteristics of the board of

directors, stock ownership by executives and board

members, block ownership, f‌inancial leverage, anti-takeover

mechanisms, and executive compensation.

Our study yields several key f‌indings based on a rela-

tively consistent pattern of the statistical signif‌icance of cor-

porate governance factors across multiple year regressions.

First, we f‌ind that banks with higher leverage exhibit

worse performance across our f‌inancial performance mea-

sures in terms of return on assets and excess stock returns

and loan quality in terms of non-performing assets.

Second, we f‌ind a negative association between chief

executive off‌icer (CEO) duality and f‌inancial performance

but no indication of an association with loan quality. Third,

we f‌ind that incentive pay has a positive impact on f‌inan-

cial performance and a negative impact on loan quality in

the long run. Fourth, we f‌ind weak evidence that board

meeting frequency is positively associated with f‌inancial

performance. Lastly, we f‌ind mixed evidence regarding an

association between block ownership and performance;

however, we f‌ind no association between performance and

anti-takeover devices or aff‌iliated audit and compensation

committees. In terms of board characteristics, we f‌ind evi-

dence that board size exhibits a concave relationship with

return on assets (ROA) and a negative linear association

with loan quality. Busy directors exhibit a concave associa-

tion with f‌inancial performance but no association with

loan quality. Average director age exhibits a concave rela-

tionship with f‌inancial performance.

We compare our f‌indings with those presented in Larcker

et al. (2007) and offer contributions to bank regulation

reform, especially regarding capital requirements and

executive compensation. Moreover, similar to Larcker et al.

(2007), our f‌indings call for more research adopting theories

different from agency theory, which appears to have partial

explanatory power in investigating performance implica-

tions of corporate governance at banks.

The remainder of this paper is organized as follows.

Section II discusses the different variables determining

strong and weak corporate governance structures and devel-

ops our hypotheses. In Section III, we describe our sample

selection, descriptive statistics,and measurement of the vari-

ables used in our study. In Section IV,we present our model

specif‌ication and empirical results. In the f‌inal section, we

draw conclusions, discuss the implications of our f‌indings

and our study’s limitations,and make suggestions for future

research.

CORPORATE GOVERNANCE AND BANK

PERFORMANCE HYPOTHESES

The theoretical foundation of this paper is agency theory

based on the work of Jensen & Meckling (1976), which

opened the important research area concerning the separa-

tion of ownership and control in the modern corporation.

According to agency theory, strong corporate governance

mechanisms better align the interests of managers and

shareholders and subsequently enhance f‌irm performance.

We employ the methodology from Larcker et al.

(2007) who employ 14 factors of corporate governance in

explaining f‌irm performance. The objective of the study by

Larcker et al. (2007) is to provide a reliable and valid instru-

ment to measure the complex construct of corporate gover-

nance. The instrument developed overcomes several

limitations of prior empirical research. First, by relying on a

comprehensive list of 39 corporate governance indicators,

the instrument reinforces the robustness of the operational-

ization. Second, since it combines the different indicators

into corporate governance dimensions through a factor

analysis, the instrument enhances construct validity. Third,

by examining multiple dimensions of corporate governance,

the instrument prevents f‌lawed resultsand misleading inter-

pretations caused by omitted variables and poor empirical

measurement. To develop the instrument, Larcker et al.

(2007) used a sample comprising 2,106 f‌irms operating in 65

different f‌inancial and non-f‌inancial industries, and their

sample period was the f‌iscal year 2002. Since our focus is on

commercial banks, few adaptations were needed as

explained in detail in the methodological section. Our

research focus enables us to investigate the validity of

agency theory and the methodology proposed by Larcker et

al. (2007) to study the performance implications of corporate

governance within banks.

Corporate governancemay play a different role at banking

f‌irms and may not be as effective at mitigating agency con-

f‌licts. First, regulators play a special role in the banking

industry, which may change the incentive to monitor by

directors and shareholders. On one hand, regulatory over-

sight is considered to be an active monitoring force, which

might limit the incentives of boards or blockholders to

monitor. On the other hand, regulators might act in their

own interests and intervene in banks’ operations, which

might create more governance problems. Second, since

depositors are also bank stakeholders, the objective of

banking f‌irms is not only to maximize shareholder wealth

but, more importantly, to protect the interests of these non-

shareholding stakeholders. Third, banks are considered to

CORPORATE GOVERNANCE AND U.S. BANK PERFORMANCE 419

Volume 19 Number 5 September 2011© 2011 Blackwell Publishing Ltd