Banking, Corporate Governance and the 2007 Financial Crisis

Banking, collective authorities and the 2007 Financial CrisisThroughout the world, by the end of 2008, many avows had seen nigh of their equity destroyed by the crisis that started in the US subprime sector in 2007. Yet, non all beachs across the world per pretended equally badly. In this paper, we canvas how avows that performed let on during the crisis, measuring execution by stock returns, differed from opposite banks out front the crisis. Academics, journalists, and policy-makers drive home argued that lax legislation, insufficient corking, excessive reliance on short-run financing, and unworthy brass all contri nonwithstandinged to making the crisis as serious as it was. If these factors did contribute to making the crisis worsened, we would behave back that banks that were to a greater extent clear to these factors performed much poorly during the crisis. We investigate the relation between these factors and the stock return performance of vainglorious banks during the crisis, where large banks ar defined as banks with assets in excess of $50 billion in 2006. With our definition of large banks, 32 countries had at least atomic number 53 large bank and our type includes 164 large banks from these countries.Many analyses of the crisis accentuate the run on the funding of banks that relied on short-term finance in the hood markets for a substantial fraction of their financing (see, for instance, Adrian and Shin, 2008, Brunnermeier, 2009, Gorton, 2010, and Diamond and Rajan, 2009). We would expect banks that rely on short-term finance earlier the crisis to perform worse during the crisis. We find that this is the case with two different approaches. First, we find inexpugnable usher that banks that relied to a greater extent on deposits for their financing in 2006 f ard interrupt during the crisis. Second, following Demirg ucKunt and Huizinga (2010), we utilise a measure of short-term funding provided by sources other than guest deposits. We show that performance is strongly negatively cogitate to that mea-sure both for the ensample of large banks and the sample extended to include large fiscal institutions that are not depository banks, much(prenominal) as investment banks. These analyses also evince how losses force banks to reduce their leverage, perhaps through fire gross sales of securities, and how this effect is greater for banks with more(prenominal) leverage. We find that large banks with less leverage in 2006 performed ruin during the crisis.An Organization for Economic Co-operation and Development (OECD) report argues that the financial crisis can be to an authorised extent attributed to failures and weaknesses in corporate governance arrangements (Kirkpatrick, 2008). More recently, the National Commission on the Causes of the Financial and Economic Crisis in the United States concluded that dramatic failures of corporate governanceyat many systematically important financial insti tutions were a key cause of this crisis. (The Financial Crisis Inquiry Report, 2011, pp. xvii). roughly academic studies also emphasize that flaws in bank governance vie a key role in the performance of banks (Diamond and Rajan, 2009, and Bebchuk and Spamann, 2010). The idea is chiefly that banks with poor governance engaged in excessive find taking, do them to make larger losses during the crisis because they were hazardier.We use two proxies for governance. The first one is the ownership of the authorizationling stockholder in 2006. The second one is whether the bank had a stockholder-friendly hop on. To the extent that governance played a role, we would expect banks with better governance to have performed better. It is generally believed that greater ownership by insiders aligns their incentives more closely with the interests of shareholders. However, a postful controlling shareholder could use control of a bank to benefit other related entities, so that it is not nec essarily the case that greater ownership by the controlling shareholder means better alignment of interests of management with shareholders. Some limited indorse shows that banks with high ownership by the control-ling shareholder performed better. In contrast, a strong and unambiguous relation exists between the extent to which a board was shareholder friendly in 2006 and a banks performance during the crisis. Banks with a share-holder-friendly board performed worse during the crisis. The hypothesis that the crisis resulted from excessive risk taking do possible by poor governance would imply the opposite result, so that our severalise poses a considerable challenge to the proponents of that hypothesis. We also investigate whether banks with better governance were less risky in 2006 and find no evidence confirmive of that hypothesis either. Banks with more shareholder-friendly boards had a lower distance to evasion in 2006 but did not have higher idiosyncratic risk or higher leverage than other banks. Like Laeven and Levine (2009), we find that banks with higher controlling shareholder ownership are riskier, as these banks had greater idiosyncratic risk and a lower distance to default before the crisis.Governance and board characteristics are endogenously determined (see, e.g., Hermalin and Weisbach, 1998). In the context of our study, an important form of endogeneity stressed in the literature seems to have little relevance. Though taking into account the possibility that good governance could be caused by expectations almost future outcomes generally is important, the banks with more shareholder-friendly boards are highly un standardisedly to have had such boards because they anticipated the crisis and expected to require better governance during it.At the same time, the concern that governance is significantly related to performance because it is associated with unobserved bank characteristics is important in the context of our study. In fact, the existence of such a relation is the only way to explain the results we find. In other words, shareholder-friendly boards created more value for shareholders through their decisions before the crisis, but during the crisis these decisions were associated with poor outcomes that could not be forecasted. For this explanation to work, these risks must not have been captured by conventional measures because accounting for these measures does not eliminate the relation between governance and performance we document. An example that could explain what we find is that banks with more shareholder-friendly boards invested more aggressively in highly-rated tranches of subprime securitizations. Such investments did not appear risky in 2006 by traditionalistic risk measures, but they did work out poorly for the banks that made them. An preference explanation for our results is that certain banks optimally chose more shareholder-friendly governance before the crisis because they were exposed t o risks that required more independent board monitoring. With this view, the risks were not chosen by the board but instead led to the choice of a shareholder-friendly board. These risks had adverse realizations during the crisis, but because the banks had a shareholder-friendly board, they performed better than they would have had otherwise. With this explanation, banks with good governance had poor returns because of the risks they had, but they would have had even lower returns had they had worse governance. Governance is negatively related to performance in this case because it is correlated with risks that had adverse realizations, but it led to better performance nevertheless. Though we find some support for the latter explanation, neither explanation is consistent with the view that poor bank governance was a first-order cause of the crisis.We use the 2008 World Bank great deal on bank regulation to examine the hypothesis that lax regulation led banks to take excessive risk s that caused large losses during the crisis (see, e.g.,Dooley, Folkerts-Landau, and Garber (2009), Stiglitz (2010)). We use indices for the power of the regulators, oversight of bank capital, restrictions on bank activities, and private monitoring of banks. on that point is no convincing evidence that tighter regulation in general was associated with better bank performance during the crisis or with less risky banks before the crisis. In all our regressions, only the index on restrictions of bank activities is positively related to the performance of banks during the crisis.Barth, Caprio, and Levine (1999) show that the banking system is more fragile in countries where banking activities are more restricted. However, some observers, perhaps most visibly the former chair-man of the national Reserve System Paul Volcker, have blamed the difficulties of banks during the crisis on their activities not related to making loans and taking deposits. Though we find that large banks in coun tries where bank activities were more restricted suffered less from the crisis, no evidence exists that such restrictions made banks less risky before the crisis using common measures of risk. nigh likely, therefore, to the extent that restrictions on bank activities are associated with better performance of banks during the crisis, it is because traditional bank activities were less exposed to the risks that turned out poorly during the crisis than were newer or less traditional bank activities. In addition, we find that stronger regulations for bank capital were associated with less risk before the crisis. Given the attention paid to the clean-living hazard resulting from deposit policy, we investigate whether banks in countries with a deposit insurance scheme performed worse and find no evidence supportive of this hypothesis. However, banks in countries with formal deposit insurance schemes had higher idiosyncratic risk before the crisis. If banks are impeded from making loans because of poor financial health, economic ripening is weaker. It is therefore important to understand whether the variables that patron predict returns during the crisis also help explain loan result. In a related paper,Cornett, McNutt, Strahan, and Tehranian (2011)find that US banks with more exposure to liquidity risk experienced less loan growth during the crisis. We have a much smaller sample than they have, so that our tests do not have as much power as theirs and are less definitive. Nevertheless, we find evidence that is supportive of their results on an international sample composed of much larger banks than the typical bank in their study. Banks with more shareholder friendly boards have lower loan growth during the crisis. Finally, a strong positive relation exists between loan growth and restrictions on bank activities.We also estimate regressions excluding US banks. With these regressions, we can evaluate whether the worse performers were banks from countries where t he banking system was more exposed to the US according to the Bank for world(prenominal) Settlements (BIS) statistics. These regressions allow us to assess whether holding US exposures was a transmitting channel see, e.g.,Eichengreen,Mody, Nedeljkovic, and Sarno (2009)for the view that assets were a contagion channel. We find that banks from countries where the banking system was more exposed to the US performed worse.Our main results hold up in a variety of robustness tests. Our study is limited by the entropy available. Ideally, we would like to have entropy on the nature of holdings of securities by banks. However, such data are generally not available. Another limitation of our study is that, in the fall of 2008, countries stepped in with capital injections and other forms of support of banks. Such handling might have distorted returns. Yet, our results generally hold for returns measured from mid-2007 to respectable before the Lehman Brothers bankruptcy in September 2008. Moreover, Panetta, Faeh, Grande, Ho, King, Levy, Sigboretti, Taboga, and Zaghini (2009) show that the announcement of drive home packages did not have a positive impact on bank stock prices across countries. We estimate our regression that includes the indicator variable for whether the board is shareholder-friendly for a sample that includes investment banks and other financial institutions not undefended to the Basle Accords (i.e., financial institutions that do not report Tier 1 capital and are not subject to the regulations forming the basis for our regulatory variables). We find that our results hold for that sample.The paper proceeds as follows. In Section 2,we introduce the data that we use. In Section 3, we examine how the performance of banks during the crisis relates to governance, regulation, balance sheet composition, and state characteristics other than regulation. We also show how these attributes are related to bank risk before the crisis. We conclude in Section 4 .