When do regulations matter for bank risk-taking? An analysis of the interaction between external regulation and board characteristics

• DOI: https://doi.org/10.1108/CG-10-2017-0253
• Pages: 440-461
• Date: 24 January 2018
• Published date: 24 January 2018
• Author: Glauco De Vita,Yun Luo
• Subject Matter: Corporate governance,Strategy

When do regulations matter for bank

risk-taking? An analysis of the interaction

between external regulation and

board characteristics

Glauco De Vita and Yun Luo

Abstract

Purpose – According to previous international studies, the impact of external regulation on bank risk is

ambiguous. The purpose of this paper is to ask the question, “When do regulations matter for bank risk-

taking?” by reporting the first empirical investigation of how the relation between bank regulations (capital

requirements, official supervisory power and market discipline) and bank risk-taking is moderated by

board monitoring characteristics.

Design/methodology/approach – Using SYS-GMM, the analysis of the interaction between bank-level

boards of directors’ attributes (board size, board independence and board gender diversity) and

external regulation is based on a sample of 493 banks operating in 54 countries over 2001-2015,

accounting for three measures of bank risk-taking.

Findings – Regulations matter for bank risk-taking conditional on board characteristics: board size,

board independence and board diversity. With the exception of capital requirements, the market

discipline exerted by external private monitoring and greater supervisory power are unable to mitigate

the propensity to greater risk-taking by banks resulting from larger board size, higher board

independence and greater gender diversity of the board.

Originality/value – The bank risk empirical literature is still silent as to the interaction between board

governance and regulation for the purpose of examining banks’ risk-taking. This paper fills this gap, thus

making a significant contribution by extending our knowledge of whether and how board governance

moderates the relationship between external regulation and bank risk-taking.

Keywords Regulation, Corporate governance, Banks, Board of directors, Risk-taking

Paper type Research paper

1. Introduction

The 2007/2008 global financial crisis highlighted severe problems with excessive risk-

taking by banks as well as bank regulation and supervision[1], with the weak

governance of banks frequently pointed to in the literature as the main culprit of the

crisis (Kirkpatrick, 2009; Bruner, 2011; DeYoung et al., 2013). Despite being seemingly

compliant with Basel capital standards[2], many banks had, in fact, accumulated

excessive amounts of leverage, carrying risks which inflicted incalculable losses.

Further, liquidity risk proved to be a key driver of financial contagion during this crisis,

with the bank regulation framework revealing itself as insufficient to prevent the

emergence of the proverbial “too-big-to-fail” financial institutions (Fullenkamp and

Rochon, 2016). The regulatory response with regard to the governance of banks has

been substantial, a central feature of the post-crisis financial reform agenda, at both the

national and international level (see, for example, Walker, 2009; International Monetary

Glauco De Vita is Professor

and Yun Luo is Research

Associate, both at the

Centre for Business in

Society, Coventry

University, Coventry, UK.

Received 19 October 2017

Revised 19 December 2017

22 December 2017

Accepted 23 December 2017

PAGE 440 jCORPORATE GOVERNANCE jVOL. 18 NO. 3 2018, pp. 440-461, © Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-10-2017-0253

Fund, 2014), including innumerable additions and amendments to the Basel Accord

(Basel Committee on Banking Supervision, 2015).

Against this backcloth, the corporate governance literature has highlighted how the agency

problems of banks[3] are exacerbated by the existence of government guarantees and

deposit insurance, which distort bankers’ incentives and encourage risk-taking (Haan and

Vlahu, 2016). This literature has also identified the salient features of the role that both the

board of directors’ structural characteristics and the external national regulator can play to

ensure “good governance”[4].

Yet no prior study has specifically investigated how boards’ internal governance

characteristics moderate the relation between external bank regulations and individual

banks’ propensity to risk-taking. Knowledge of this moderation (interaction) effect is

important, as it can have important policy implications as different types of regulations may

have different effects on bank risk-taking depending on the structure and characteristics of

bank boards. Hagendorff et al. (2010) is the only banking industry study that has

specifically tested the interaction between bank board monitoring characteristics and bank

regulation. However, Hagendorff et al. (2010) do so for the purpose of examining how the

interaction between bank-level monitoring and regulatory regimes influences the

announcement period returns of acquiring banks. The bank risk empirical literature is still

silent as to the interaction between board governance characteristics and external

regulation for the purpose of examining the resulting attitude to risk-taking by banks. This

gap makes the motivation for such a study both timely and opportune.

The aim of our study is to fill this important gap and, in so doing, make a significant

contribution by extending our knowledge of whether and how board governance (in terms

of board size, board independence and board gender diversity) moderates the relation

between external regulation (capital requirements, official supervisory power and market

discipline) and bank risk-taking (here measured by insolvency risk, credit risk and volatility

of equity returns).

2. A brief literature review

In addition to its advisory role, as a monitor, the board of directors (board) is meant to

supervise managers so as to ensure their decisions are in line with the interests of

shareholders. As such, the board is regarded as the key internal governance structure

holding responsibility for the implementation of an effective system of risk management

(Fama and Jensen, 1983; Srivastav and Hagendorff, 2016). Theoretically, the smaller and

the more independent the board is (in terms of board size and representation by directors

without close connections to management), the more likely that “good governance” will be

enforced (Mehran et al., 2011; Aebi et al., 2012). Some prior evidence shows board size to

have a negative relationship with firm performance (Hermalin and Weisbach, 2003). Small

boards are expected to be more effective monitors, as they can reduce the cost of

directors’ free-rider and coordination problems (Jensen, 1993). Large boards have been

found to be less agile and cohesive, more susceptible to communication and coordination

costs and to “free-riding” director problems (Jensen, 1993; Pathan, 2009), all of which point

to less efficient monitoring by large boards. Independent directors in boards are believed to

be better at exerting their monitoring function, as they are less obliged to management and

are better at representing the interest of shareholders (Hermalin and Weisbach, 2003).

There is also a growing debate about gender and its effect on economic outcomes such as

risk preferences (Croson and Gneezy, 2009). Previous literature suggests that women are

less over-confident and more risk averse in financial decision-making than men

(Jianakoplos and Bernasek, 1998; Barber and Odean, 2001). Thus, in theory, a “good”

board, a small-sized one, more independent in nature and with a higher representation of

women, is expected to better monitor bank risk-taking.

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