Corporate Governance of Banks and Financial Crisis

1. Corporate Governance of Banks and Financial Crisis Vicente Salas Fumás Universidad de Zaragoza March 2011

2. Summary of the main ideas • The corporate governance problem of banks should go beyond the traditional conflict of interests between managers and shareholders: It should be extended to include also the conflict between shareholders and debt holders resulting from the incentives of shareholders to take excessive risks. • New regulations that intent to curve down excessive risk taking behaviour of banks can be viewed as part of the solution to the extended governance problem. Asking for higher equity capital in regulatory capital of banks can then be analyzed as part of the extended governance problem.

3. Summary… • Preliminary evidence with Spanish data suggests that social costs of new capital regulation in term of rising interest rates of bank loans will be modest. • Changing the codes of good governance for banks in the sense of including as duty of managers to maximize the total economic value of banks’ assets (joint value of debt and equity) would be a way of aligning Regulation interests and Good governance of banks.

4. References • A. R. Admati, P. M. DeMarzo. M. F. Hellwig, P. Pfleiderer (2010) “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”. Stanford GSB Research Paper No. 2063 • A. K Kashyap, J. C. Stein (2010) “An Analysis of the Impact of “Substantially Heightened” Capital Requirements on Large Financial Institutions”. Harvard University • S. G. Hanson, A. K. Kashyap, and J. C. Stein (2011) “A Macro-prudential Approach to Financial Regulation” Journal of Economic Perspectives, Vol. 25, 1, pp 3–28. • Haldane, Andrew, Simon Brennan and Vasileios Madouros (2010), “What is the Contribution of the Financial Sector: Miracle or Mirage?” Chapter 2 of The Future of Finance, LSE. • EEAG Report on the European Economy (2011) “Taxation and Regulation of the Financial Sector”. CESifo. • David Miles, Jing Yang and Gilberto Marcheggiano (2011) “Optimal Bank capital”. DP 31. Bank of England.

5. Outline • 1.- Paradoxes: The good performance of banks in the pre-crisis period • 2.- When risk taking by banks is excessive and why banks have incentives to excessive risk exposure? • 3.- Understanding the pre crisis performance of Spanish banks: Efficiency, leverage and liquidity effects. • 4.- Capital regulatory reforms: preliminary evidence of costs with Spanish data • 5.- Conclusion

6. 1.-Paradoxes • A.- Banks that experienced the highest decline in the prices of their shares (higher losses for their shareholders) from the summer of 2007 and the end of year 2008, were those that punctuated the highest in the standard scores of good governance practices. (A. Beltratti, R. Stulz, “Why did some banks perform better during the credit crisis? A cross-country study of the impact of governance and regulation”. NBER, WP 1518, July 2009). • B.- The financial crisis was preceded by a period of extraordinary good performance of banks around the world in terms of both productivity and profitability. (Haldane et al, 2010). • C.- This applies to Spanish banks too.

7. Cumulative aggregate TFP. Spanish banking industry

8. Year by year and average TFP growth rates

9. 27000 Profit 18000 16% 9000 ROE 10% 00 04 08

10. 2.-Excessive risk taking • Illustrative example. Project selection with limited liability. • Leverage decisions and financial risk.

11. Two investment projects financed with equity Investment Final pay-offs 120 100 150 40 1/2 Expected return= 10% Standard Deviation 7.07% Expected return= -5% Standard Deviation 39% A 1/2 100 1/2 B 1/2 100

12. Project finance: 80% debt, 20% equity

13. Leverage effects on risk and return • Within project A, leverage increases the expected return on equity five times, compared with the expected return with 100% equity finance. • However, leverage also increases risk (standard deviation of ROE) in the same proportion. • The Risk conservation theorem of Modigliani and Miller establishes that the two effects compensate and the economic value of an asset is independent on how it is financed.

14. ROE=RRC+(RRC-i)L ROE L high Sd(ROE)=(1+L)Sd(RRC) E(ROE(La)) E(ROE(Lb)) L low i i 0 E (RRC) RRC RCC =Return on regulatory capital i= cost of debt Effects of leverage L within regulatory Capital on expected return and risk

15. Leverage and excessive risk • With leverage, shareholders prefer project B to project A (higher expected return). • This happens because with limited liability the shareholders can extract rents to debt holders: Shareholders capture all the extraordinary gains in good states of nature and limit their losses in the bad ones. • This result is independent of the time horizon of the project.

16. Excessive Risk Taking • We say that risk taking is excessive when the selection of a particular investment project destroys economic value (negative net present value). In the example shareholders choose project B • Shareholders have incentives to take excessive risks because limited liability rules create situations where they can increase the expected share prices with projects having negative NPV by means of extracting rents from debt-holders. • Shareholders can increase their expected gains increasing economic risk of projects and/or increasing leverage (financial risk). • Secured deposits and bail out expectations by debt holders contribute to excessive risk taking by banks.

17. 3.-Explaining performance of Spanish banks: Efficiency, leverage and liquidity • Spanish banks: Sources of productivity

18. TFP of Spanish banks before and after the euro (dark line) controlling for banks’ characteristics (constant average growth rate 3%)

19. 4.-Regulatory reforms • Revision of Macro-prudential regulation • Basel III • Systemic banks • Perimeter of regulation (shadow banking) • Reform of compensation practices • Other areas of reform • Convergence of international accounting standards • Derivative markets and Rating agencies.

21. Concerns around increase in equity capital ratios: transition • Asymmetric information between managers and investors increases the cost of new equity raised by issuing shares, compared with equity from retained earnings (Pecking order theory). • A solution to this is to raise new equity with retained earnings over a long period of time (Basel III). • Another solution is to force all banks to increase capital at a time issuing equity if necessary

22. Concerns…:steady state • Does the Modigliani-Miller theorem applies to banks? • Evidence from the US: • Equity over assets ratios of 50% in US banks before deposits’ insurance • Larger banks persistently lower capital ratios than smaller ones: Capital ratios do not seem to affect survival to competition. • No clear evidence of positive effects of capital ratios on interest of loans granted by banks. • Leverage ratios increase with competition and market liberalization

24. Interest of loans and equity ratio • Small banks charge higher interest rates of loans than large banks, compensating for their higher capital ratio. • Saving banks obtain higher spread than commercial banks. • One hundred basic points more of the equity ratio implies around 4 basic points more of interest of loans. Cost of substituting 100 basic points of long term debt at 10% nominal interest rate by equity implies an increment of cost in terms of higher tax payment of 3,5 basic points if the tax rate is 35%.

25. Conclusion and recommendations • Banking regulation should view the corporate governance of banks under the perspective of social welfare maximization, not shareholders’ value maximization (Tirole 2000). • Conflicts of interests with debt holders from incentives of shareholders to excessive risk taking are at the core of Regulation and the extended view of good governance of banks. • Increasing regulatory equity capital requirements for banks under macro prudential regulation and other initiatives such as regulation of managerial compensation, can be analyzed in the context of the conflicts of interest between shareholders and debt holders.

26. Conclusion and recommendations • Regulatory and supervisory initiatives should be taking to avoid regulatory capital arbitrage decisions by banks (shadow banking) as they are a way of increasing return by increasing leverage and financial risk. • There are arguments in favor in setting a regulatory maximum leverage ratio for banks and financial institutions (Equity to total accounting assets). Difficulties of credit risk models in calculation of RWA. • Eliminate tax deductibility of interest expenses of debt like regulatory capital. Lower the opportunity cost of equity within regulatory capital.

27. Conclusions and recommendations • From more conventional approaches to good governance of financial institutions there are reasons that justify modifying the codes of good governance for banks, in the sense of including as duties of managers making decisions that maximize the total economic value of the assets of the bank. • This would align the interests of managers with the interests of both debt holders and shareholders and, more importantly, the interests of Regulation with good governance of financial institutions.