Corporate Governance in the 2007-08 Financial Crisis: Evidence from Financial

Institutions Worldwide

Yale University SOMNovember 12, 2010

Comments by

Luc Laeven(IMF, CEPR, CentER)

The views expressed are my own and should not be attributed to the staff, Management and Board of the IMF

Contribution of this Contribution of this paperpaper

Literature on corporate governance of banksLiterature on corporate governance of banks Banks are specialBanks are special

shareholders do not internalize social costs associated shareholders do not internalize social costs associated with bank failures (excessive risk taking)with bank failures (excessive risk taking)

deposit insurance weakens debtholder disciplinedeposit insurance weakens debtholder discipline

Paper convincingly shows that corporate Paper convincingly shows that corporate governance traits (independent board and governance traits (independent board and ownership concentration) are negatively ownership concentration) are negatively associated with stock returns, exploiting associated with stock returns, exploiting financial crisis as shockfinancial crisis as shock

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Specific resultsSpecific results (Institutional) ownership concentration is (Institutional) ownership concentration is

associated with greater risk taking and associated with greater risk taking and consequently lower stock returns during crisisconsequently lower stock returns during crisis

shareholders do not internalize cost of bank failureshareholders do not internalize cost of bank failure cf. Saunders et al; Laeven and Levinecf. Saunders et al; Laeven and Levine

Independent board is associated with more Independent board is associated with more capital raising during crisis, resulting in lower capital raising during crisis, resulting in lower stock and higher bond returns during crisisstock and higher bond returns during crisis

Capital issues reduce bankruptcy risks and dilute Capital issues reduce bankruptcy risks and dilute shareholder value (Myers 1977)shareholder value (Myers 1977)

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Corporate governance Corporate governance traitstraits

What is an independent board member? What is an independent board member? In the paper, every non-executive board memberIn the paper, every non-executive board member

Why is institutional ownership associated with Why is institutional ownership associated with negative returns, but a large shareholder is not?negative returns, but a large shareholder is not? Is this about ownership concentration or IO per se? If Is this about ownership concentration or IO per se? If

latter, what is different about IO?latter, what is different about IO? Cyclicality of governanceCyclicality of governance

Governance traits that destroy shareholder value Governance traits that destroy shareholder value during bad times may create value during good timesduring bad times may create value during good times

Paper only studies bad times, not complete cyclePaper only studies bad times, not complete cycle

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Missing governance Missing governance traitstraits

Managerial ownershipManagerial ownership Owner-managed banks display different risk Owner-managed banks display different risk

taking behavior than widely held banks taking behavior than widely held banks (Saunders; Laeven and Levine)(Saunders; Laeven and Levine)

Should control for managerial ownershipShould control for managerial ownership CompensationCompensation

Many have argued that compensation schemes Many have argued that compensation schemes gave bankers even steeper incentives for gave bankers even steeper incentives for excessive and short-sighted risk takingexcessive and short-sighted risk taking

Compensation schemes vary considerably Compensation schemes vary considerably across financial institutions and countriesacross financial institutions and countries

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Bank specific factorsBank specific factors Why did some banks have more MBS exposure Why did some banks have more MBS exposure

than others? Bad luck? Did governance play a than others? Bad luck? Did governance play a role? role? Banks with large real estate exposure experienced Banks with large real estate exposure experienced

larger deterioration in market values (Huizinga and larger deterioration in market values (Huizinga and Laeven)Laeven)

Coverage in Bloomberg of writedowns by non-US Coverage in Bloomberg of writedowns by non-US banks incomplete; mostly focuses on US lossesbanks incomplete; mostly focuses on US losses

Writedowns subject to managerial discretion; Writedowns subject to managerial discretion; distressed firms understated losses (Huizinga and distressed firms understated losses (Huizinga and Laeven)Laeven)

Flight to quality effect during crisisFlight to quality effect during crisis Control for bank capital and liquidityControl for bank capital and liquidity

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Increased discrepancy between Increased discrepancy between market and book values of U.S. market and book values of U.S.

banksbanks

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Tobin’s Q is the ratio of market value to book value of assets. Zombie share is the fraction of banks with Tobin’s Q less than 1.

0.94

0.96

0.98

1.00

1.02

1.04

1.06

1.08

1.10

1.12

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Tobin's Q(LHS)

Zombie share(RHS)

Huizinga and Laeven, 2009

Country specific factorsCountry specific factors Sample period includes third quarter of 2008Sample period includes third quarter of 2008 Problematic because following collapse of Problematic because following collapse of

Lehman in mid-Sep 2008, governments Lehman in mid-Sep 2008, governments announced large-scale intervention packages announced large-scale intervention packages (including recapitalization measures) that (including recapitalization measures) that influenced the value of banksinfluenced the value of banks

These country-specific announcements of These country-specific announcements of government interventions interact with bank government interventions interact with bank specific factors (e.g. real estate exposure) to specific factors (e.g. real estate exposure) to influence market values of banks, and are not influence market values of banks, and are not controlled for using country fixed effectscontrolled for using country fixed effects

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Bank Interventions in Selected Countries, Bank Interventions in Selected Countries, 2008-092008-09

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Source: Laeven and Valencia (2010)

Fiscal Costs associated with Bank Fiscal Costs associated with Bank Interventions (% of GDP, over 2007-Interventions (% of GDP, over 2007-

09)09)

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Source: Laeven and Valencia (2010)

Exploit country Exploit country variationvariation

Analysis is done in a cross-country settingAnalysis is done in a cross-country setting Yet, little is done to exploit this variation Yet, little is done to exploit this variation

(other than controlling for some country (other than controlling for some country traits)traits) There are large cross-country differences in There are large cross-country differences in

governance systems and bank characteristics, governance systems and bank characteristics, including exposure to USincluding exposure to US

Sample splits or interaction effectsSample splits or interaction effects Is effect more pronounced in US (Anglo-Is effect more pronounced in US (Anglo-

Saxon/pro-shareholder countries) ?Saxon/pro-shareholder countries) ?

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Foreign Claims on U.S. by Bank Foreign Claims on U.S. by Bank Nationality (end-2006, % of Nationality (end-2006, % of

GDP)GDP)

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300 80

0

5

10

15

20

25

30

35

40

45

50Switzerland

Netherlands

UK

Canada

Belgium

France

Ireland

Germany

Japan

Sweden

Spain

Austria

Denm

ark

Finland

Portugal

Australia

Italy

Chile

Greece

Brazil

Turkey

Mexico

Source: BIS

Interpretation of Interpretation of results and policy results and policy

implications?implications? Paper concludes that independent boards are Paper concludes that independent boards are ineffective because they destroy shareholder ineffective because they destroy shareholder value during crises (by getting banks to issue new value during crises (by getting banks to issue new capital)capital)

Shareholder value creation is not the right metric Shareholder value creation is not the right metric herehere Control of insolvent banks should be transferred to Control of insolvent banks should be transferred to

debtholdersdebtholders Independent boards are found to increase CDS returns, Independent boards are found to increase CDS returns,

i.e., they reduce probability of bank failure and create i.e., they reduce probability of bank failure and create debtholder value during crises, so could be welfare debtholder value during crises, so could be welfare enhancing (especially in a world of regulatory enhancing (especially in a world of regulatory forbearance)forbearance)

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