The Limits of Good Governance in the Great Recession
“Prudent” banks couldn’t resist subprime investments — and took a bigger hit in the stock market.
Title: The Credit Crisis Around the Globe: Why Did Some Banks Perform Better? (Subscription or fee required)
Authors: Andrea Beltratti (Università Bocconi) and René M. Stulz (the Ohio State University)
Publisher: Journal of Financial Economics, vol. 105, no. 1
Date Published: July 2012
Many theories have been advanced to explain the Great Recession. Reckless decisions made by leaders of banks with weak boards are widely viewed as one of the prime causes of it. But this paper finds that banks with strong corporate governance — and thus, in theory, more prudent and conservative investment policies — played a significant role as well and, in fact, performed worse than many others once the financial crisis hit.
The problem, the authors say, is that these so-called shareholder-friendly banks couldn’t resist placing even heavier bets than their competitors did on certain investments, like subprime securitizations, that appeared to be safe. These banks enjoyed large stock returns in 2006. But then, when the crisis took hold in 2008, those investments turned out to be highly toxic. After they sustained huge losses, these banks were severely punished by investors; they suffered the largest market declines in the sector.
Media analysts, researchers, and legislators have contended that negligent regulation, lack of capital, and too much dependence on short-term financing, as well as poor bank governance, were all factors that led to and intensified the crisis. This paper explores the relationship between those factors and the stock returns of large banks during the main phase of the downturn, from July 2007 through December 2008.
Compiling information from the BankScope database, the authors define large banks as those of “systemic importance,” with assets exceeding US$50 billion at the end of 2006. Under that definition, 164 banks from 32 countries were included in the main sample, but the authors’ findings also held when extended to a larger sample of 387 banks with assets of more than $10 billion.
In line with many other analyses, the authors found that banks that relied largely on short-term loans from the capital markets performed worst during the crisis. Banks that depended more heavily on customer deposits for their financing before the downturn fared better, as did banks with less leverage. All this was recognized by the industry and regulatory experts. The Organisation for Economic Co-operation and Development, for example, has stated that ‘‘the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements.’’ The prevailing view is that banks with poor governance encouraged managers and traders to take excessive risks leading up to the downturn, placing investment bets that were at odds with shareholders’ best interests and that put these institutions in a worse position as the crisis unfolded.
But the authors find that the environment for making bad decisions was more complicated — and that even banks with strong corporate governance made decisions that ultimately were harmful to their shareholders. The authors used the Institutional Shareholder Services database — which measures factors such as board size, transparency, and independence, as well as how committees are structured and work is conducted — to determine which boards in their sample group were shareholder friendly before the downturn. They found that banks with a shareholder-friendly board performed much worse in the stock market during the crisis, and in some respects took more risks in their investment decisions than other banks in 2006.
“Surely, it cannot be the case that a shareholder-friendly board wanted to position a bank so that its performance during a crisis would be poor,” the authors write. “Instead, the most likely explanation is that shareholder-friendly boards positioned banks in ways that they believed maximized shareholder wealth, perhaps by taking advantage of implicit or explicit governmental guarantees, but left them more exposed to risks that manifested themselves during the crisis and had an adverse impact on banks.”
For example, banks with more shareholder-friendly boards invested more aggressively in subprime securitizations that were rated highly secure before the crisis. Although these moves did not look dangerous in 2006 according to traditional risk measures, they turned out to be extremely poor investments once the downturn hit.
The authors also note that the banks that performed better during the crisis operated in much more tightly regulated countries, such as Denmark and Switzerland, with more powerful supervisors, more restrictions on banking activities, and more private monitoring. In addition, banks with less exposure to the U.S. real estate market fared better, whereas banks from countries such as Ireland and Italy, with financial systems more intertwined with the U.S. system, performed worse.
“Banks with more restrictions on their activities could have had higher returns because they did not have the opportunity to diversify into activities that unexpectedly performed poorly during the crisis,” the authors conclude.
Banks with more shareholder-friendly boards, which conventional wisdom suggests would be less risky in their investment decisions, entered the Great Recession with portfolios filled with toxic subprime instruments and were heavily punished by investors as the financial crisis unfolded. Conversely, banks in countries with high levels of regulation, on average, performed better during the crisis.