Corporate Governance in Banks

• Author: Sara De Masi,Kose John,Andrea Paci
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/corg.12161
• Published date: 01 May 2016

Corporate Governance in Banks

Kose John, Sara De Masi*and Andrea Paci

ABSTRACT

Manuscript Type: Review

Research Question/Issue: We surveythe literature on corporate governance in banks in the US and international settings. We

discuss how the specialness of banks, deposit insurance, high bank leverage, and bank regulation interact with bank gover-

nance. We evaluate bank governance from three perspectives: (1) maximizingbank equity value, (2) maximizingtotal enterprise

value, and (3) maximizing social objectives. Our survey includes evidence on how bank governance differs from that of

manufacturing firms. We also survey studies on managerial incentives in banks and their implications for bank performance

and risk taking before and during the 2007–2008 financial crisis.

Research Findings/Insights: The high leverage (usually above 90 percent) of banking institutions gives rise to a trade-off be-

tween strengthening equity governance and maximizing enterprise value. Aligning managers very closely with shareholders

can give rise to strong incentives for risk shifting to the detriment of firm value. The bank risk choices might also go against

the societal objectives of a stable financial system.

Theoretical/Academic Implications: We providea framework for the optimal design of bank governance and bank regulation,

considering the objectives of both depositors and society-at-large in addition to those of bank shareholders. This framework

could be especiallyimportant in determiningrisk choices by banks and theeffects of such on the stabilityof the financial system.

Practitioner/Policy Implications: Our analysis of the literature surveyed has policyimplications for bank regulation, top-man-

agement compensation in banks, and directivesfor design of governance in banks.We discuss implicationsfor direct regulation

of banks and regulation of bank governance. The findings surveyed provide guidance for board independence, board size,

board composition, and incentive features in top-management compensation.

Keywords: Corporate Governance, Board of Director Mechanisms, Board Composition, ExecutiveCompensation, Owner-

ship Mechanisms

INTRODUCTION

In recent years, no other set of firms has been as closely

examined as banks and financial institutions.Many papers

and policies have been proposed, discussed, and enacted on

every aspect of banking, finance, and governance. In particu-

lar, scholars and policymakers aim to answer the question,

“What is special about banks and how might it affect bank

governance?”

Starting in the 1980s, Eugene Fama (1985) investigated the

differences between banks and nonfinancial companies, un-

derlyingtheir governance issues.Since then, many researchers

have studied issuesof banks’corporate governance in several

countries (for general issues on corporate governance, see

Laeven, 2013 and Levine, 2004; for a US perspective, see

Adams & Mehran, 2003 and Mehran, Morrison, & Shapiro,

2012; for a European perspective, see Ferrarini, 2015 and

Hopt, 2013; for an international perspective, see Acharya

et al., 2009; Macey & O’Har a, 2003; and Mulli neux, 2006).

Banks have uniqu e features that influence and interact with

corporate governance mechanisms. Conflicts of interest be-

tween shareholders and debtholders, bank regulation, opac-

ity, and complexity of bank activities are the main features

that make bankgovernance different from thatof nonfinancial

companies. In spite of the existing research, many questions

remain unanswered. Our purpose is to summarize the recent

literature on the corporate governance of banks. We also pro-

vide a new frameworkfor thinking about the roleof corporate

governance in banks.

Our novel framework is to examine corporate governance

in banks from three different perspectives. First, consistent

with the traditional framework, we examine corporate gover-

nance in banks from the point of view of aligning managers

with shareholders. This governance has been called “equity

governance”in banks. Second, we study corporate gover-

nance from the point of view of maximizing the total value

of the bank, i.e., the total market value of the equity and the

debt. This viewpoint is an important perspective for banks,

which are highly leveraged institutions with debt claims (de-

posits) constituting more than 90 percent of capital claims

(see the next section for additional discussion of this

*Addressfor correspondence:Sara De Masi,Department of Economicsand Management,

Universityof Florence,via delle Pandette,9, Florence, Italy.Phone:+39 (055) 2759684;Fax:

+39 (055) 2759737;E-mail: sara.demasi@unifi.it

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12161

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Corporate Governance: An International Review, 2016, 24(3): 303–321

perspective). Third, we examine bank governance from the

point of view of society at large (including participants in

the economy who might not hold equity or debt claims in

the bank). We view bank governance from the perspective of

the social plannerwho is focused on the role of banksin a safe

and sound financialsystem. The social planner has the ability

to put in place mechanisms of regulation that can restrict the

bank’s activities,its investments and its capital structure. Reg-

ulation can also interact with the mechanisms of corporate

governance, which would affect managerial incentives and

choices (Hubbard & Palia, 1995; Walter, 2004). This social

planner’s perspective helps us to understand the interaction

between bank regulation and bank governance.

Although a significant proportion of the corporate gover-

nance literature focuses on the conflict between shareholders

and managers, in banks, the divergence of interests between

shareholders and debtholders is prominent. In our survey,

we highlight the natural conflict that exists between equity

governance (corporate governance from the equity point of

view) and debt governance (corporate governance from the

debtholders’perspective). Specifically, in banks, as in any

highly leveraged firms, there is a hard-wired relationship be-

tween the strength of equity governance and the strength of

debt governance. Corporate governance mechanisms that

align managers’interests with those of shareholders also in-

crease the costs of conflict between equity holders and

debtholders. Similarly, the debt governance mechanism that

aims to protect depositors and debtholders necessarily blunts

the effectivenessof equity governance. By providinga general

framework to understand equity governance and the debt

governance in highlyleveraged institutions, we hope to bring

additional clarity to the results in the literature on corporate

governancein banks. For our first researchquestion, we study

how strengthening equity governance in banks might aggra-

vate the agency costs of debt and therefore reduce the enter-

prise value of banks. In addition to leverage, we also discuss

the characteristics of banks that make themspecial and hence

affect their corporate governance.

Stulz (2015)highlights the importance of optimalrisk taking

by banks in determining their success and thehealth of the fi-

nancial system. A bank’s ability to measureand manage risks

creates value for shareholders. He stresses the importance of

the right risk management, the right governance, the right in-

centives, and the right culture for risk taking to maximize

shareholder wealth. Although recognizing the importance of

the risk management system examined by Stulz (2015), we

build a framework that recognizes an inherent conflict be-

tween maximizing shareholder wealth and maximizing total

firm value with respect to risk taking in banks. Our frame-

work also recognizes that equity value-maximizing risk

choices by banksmight not be consistent with socially optimal

stability of the financial system. In other words, our frame-

work examinescorporate governance in banks fromthree per-

spectives: (1) share value maximization, (2) total value

maximization, and (3) socially optimal financial system

stability.

De Haan and Vlahu (2015) is a recent survey on corporate

governancein banks. They examine different aspectsof corpo-

rate governance mechanisms in banks primarily from the

point of view of shareholder value maximization. We extend

this work and use a novel framework, described above, to

examine the effectiveness of bank governance. Our new

framework yields several new insights and policy implica-

tions for the optimal design of bank governance and bank

regulation.

Our second researchquestion explores the different mecha-

nisms of bank governance and how these mechanisms differ

by country worldwide. Policymakers around the world have

started to question the appropriateness of the current corpo-

rate governance in banks (in the UK, the Walker Report,

2009; in Europe, the European Commission Green paper,

2010; in the US, Federal Reserve Board, 2013; worldwide,

Basel Committee on Banking Supervision, 2006, 2008, 2010,

2015). Here, we have four aims: (1) to investigate differences

in the boards of banks and nonfinancial companies and how

these differences affect the governance–performance relation-

ship, (2) to survey the international studies about corporate

boards and board effectiveness in banks, (3) to review the re-

search about the ownership structure of banks, and (4) to

study the role of incentive features in CEO compensation in

bank performance and in inducing risk taking by banks.

This paper is organized as follows. Special attributes of

banks and their implications for corporate governance are

discussed in the first section. The empirical literature on cor-

porate governancemechanisms is reviewed in thesecond sec-

tion. These mechanisms include board structure and board

quality, ownership structure, and incentives and compensa-

tion. The third section concludes, offering a critical review of

the existing research and an agenda for further research.

WHAT IS SPECIAL ABOUT CORPORATE

GOVERNANCE OF BANKS?

As with any other company, banksare affected by governance

problems, typically associated with the separation of owner-

ship and control. However, banks have special features that

intensify governance problems and might reduce the effec-

tiveness of standard governance mechanisms (Caprio &

Levine, 2002; Laeven, 2013; Levine, 2004).

There is extensive literature that examines corporate gover-

nance in banks and how it differs from that in nonfinancial

firms (Becht, Bolton, & Roell, 2012; Caprio & Levine, 2002;

Devriese, Dewatripont, Heremans, & Nguyen, 2004; Hopt,

2013; Laeven, 2013; Levine, 2004; Macey & O’Hara, 2003;

Mülbert, 2010; (Mehran & Mollineaux, 2012) Van der Elst,

2015).

1

These studies examine the special attributes of banks

that have given rise to bank governance structures that differ

from those of manufacturing firms.

The first attribute isthe high leverage of banks. It is not un-

common for leveragein banks to exceed 90 percent (Adams &

Mehran, 2003; Berger & Bouwman, 2013; DeAngelo & Stulz,

2015; Esty, 1997, 1998; Hopt, 2013; Laeven, 2013; Levine,

2004; Macey & O’Hara, 2003). Unlikenonfinancial companies,

the major providers of capital to banks are depositors and

other debtholders. Gornall and Strebulaev (2014) show that,

typically, the average leverage of banks,measured as the ratio

of debt to assets, is between 87 and 95 percent, whereas the

average leverage of nonfinancial companies is in the range

of 20–30 percent. This high leverage increases the probability

of bank failures.

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© 2016 JohnWiley & Sons LtdVolume 24 Number 3 May 2016