The Corporate Governance of Banks (Bordeaux, 2007) Andy Mullineux (BRiEF, University of Birmingham) Andy Mullineux Professor of Global Finance Birmingham Business School University House University of Birmingham Birmingham B15 2TT Email: a.w.mullineux@bham.ac.uk
What is Special about banks? They are the dominant financial institutions - more so in lesser developed countries. - less so in the most advanced financial systems (US). - most firms and households rely on banks for payments services. They play a major role in the corporate governance of other firms. - more so in Germany and Japan, but everywhere they have a major role in SME governance (and SMEs are more than 50% of most economies). Banking systems are prone to instability (fractional reserve banking and information asymmetry) and systemic crises are costly. 2
Banks and Corporate Governance Well governed banks are more likely to allocate capital efficiently and to assure that other firms also allocate capital efficiently and to contribute to monetary and financial stability, which itself is likely to encourage investment and growth. In developing and centrally planned economies, government ownership of banks and direction of their lending is common. This raises numerous conflicts of interest if government/politician s objectives are not to maximise welfare. - CG is thus embedded in the wider governance system and can only be expected to be effective if the wider governance structure is supportive. 3
Similarly, the independence of regulators and supervisors is dependent on the quality of the wider governance system. A supportive (independent and trusted) legal system is also required. - bankruptcy laws are particularly important for good CG, especially as banks need to be able to remove capital from poorly performing firms to reinvest in firms with greater potential in order to allocate capital efficiently. 4
Why is the CG Problem for Banks Different from other Firms? Macey and O Hara (2003) argue that banks owe a fiduciary duty to depositors as well as shareholders. - They also implicitly note that because of the existence of funded or non-funded (LOLR) state-backed deposit insurance; the government has a fiscal duty to protect tax payers against costly bail outs ( too big to fail! ) Depositors tend to be risk averse and shareholders risk prone and hence the standard (Anglo Saxon ) CG solution (facilitating shareholder control of management) is inappropriate Hence, governments have an incentive to protect depositors and to regulate banks to deal with the consequent moral hazard problems by preventing excessive risk taking in order to assure financial stability. - good bank regulation thus becomes part of the CG system for banks. 5
A number of the arguments for the specialness of the banks CG problem carry over to other financial firms (who have a fiduciary duty to savers/household investors). Further, the definition of a bank is problematic in this presentation a bank is a deposit taking institution that primarily makes loans, but may also hold shares in other firms. Levine (2003) pinpoints two main sources of bank specialness - greater opacity (due to larger information asymmetry). - greater government regulation (and ownership/direction in developing /centrally planned economies). 6
The Importance of Asymmetric Information Neither Levine (2003) nor Macey and O Hara (2003) ask why banks have high opaqueness and are relatively heavily regulated. The academic literature on the implications of asymmetric information for banking and the wider financial system (nicely summarised in Mishkin s text book) provides some answers. Essentially banks exist (and hence are necessarily opaque) because of information asymmetry between the lending banks and the borrowers concerning credit worthiness. Otherwise, all finance would be direct finance we would only need capital markets. 7
Depositors leave the costly job of collecting and processing information on the credit worthiness of the firms to specialists (banks) and thus are at an information disadvantage with respect to bank management as regards banks asset quality. Un-insured depositors are thus prone to panic and so individual bank failures can be expected from time to time. Domino effects, during which un-insured depositors at other banks also panic, can also be expected; resulting ultimately in systems crises. Deposit insurance (preferably risk-related) can eliminate panics, but at the cost of increasing moral hazard by removing the incentive for depositors to choose the best banks. - additionally flat rate deposit insurance combined with interest rate competition can generate adverse selection (US Savings and Loan crises). 8
Taxpayers (voters) need to be protected against abuse (by bank management) of deposit insurance and against costly systemic crises. Information asymmetry thus explains why banks exist, and are highly opaque and why they are commonly heavily regulated (and why SMEs face credit rationing, herd behaviour amongst banks, and much more). The question then is how best to regulate (and supervise) banks in order to assure their effective CG? 9
Basel ΙΙ s Three Pillars What is the appropriate balance between bank regulation (risk-related capital adequacy requirements etc), supervision and market discipline?. Macey and O Hara (2003) argue for greater formal legal recognition of the fiduciary duty of banks to depositors and clarification of the relationship between that duty and their fiduciary duty to bank shareholders (and other debtors, e.g. bank bondholders). Essentially the Board of Directors should be made responsible and adequate internal controls should be put in place. Supervisors and external auditors then primarily have an oversight role. 10
Levine (2003), tentatively comes down in favour of less regulation (i.e. formal rules backed by legislation) and better information and incentives for private agents and markets to exert governance over banks. - Ross Levine concludes that good CG requires the building, of sound legal and bankruptcy systems (which he notes can be a lengthy process). Levine (2003), also finds that evidence is sympathetic to the establishment of independent supervisors with well defined objectives. 11
We may note, however: - independence is hard to guarantee unless the wider governance system and the legal system is robust - central banks are often more trusted than governments in developing countries and independent agencies staffed by government appointees may be distrusted. - former regulators often descend from heaven to take directorships on the boards of banks they previously regulated, leading to conflicts of interest. Levine (2003) is sceptical about proposals to require banks to take on a sufficient proportion of subordinated debt and debentures to ensure that informed debt holders can perform the bank monitoring role in place of uniformed depositors. - legal rights of bondholders, and especially non-conventional debt holders (CDO market etc) are uncertain and currently being contested. - large creditors may use their insider status at the expense of less informed (and generally smaller) investors. 12
Greater disclosure is required to increase market discipline. - accounts and internal controls need to be reliably audited according to widely accepted international account standards. - there is a limit to how far disclosure can be increased without reducing the incentive of banks to undertake the cost of collecting and processing information (and thereby reducing information asymmetry and risk) free rider problem. 13
Other Related Issues Banking systems commonly have the structure of an oligopoly with a competitive fringe (UK archetypical Germany an exception). Oligopolies can be competitive, but collusion is also potentially beneficial. The Competition Commission and OFT have conducted and continue to conduct a number of investigations into bank exploitation of their oligopolistic ( complex monopoly - see last slide) position in the UK. 14
The FSA has also taken a substantial interest in related issues in light of the clear information advantage of banks and low levels of consumer financial literacy. Too big to fail considerations also come into play. In the UK this may have been encouraged/permitted in the belief that it enhances financial stability (Cruickshank). The UK Treasury expected banks, as a quid pro quo, to perform public duties with regard to access to the payments system and finance, but they have reneged (Cruickshank). 15
Also relevant is the issue of the concentration and the nature of bank ownership. - Should non-financial firms be prevented from owning banks? - risk of using the bank as a cheap source of funding - risk of extending the bank safety net - what is the appropriate organisational structure of financial conglomerates - do fire-walls and Chinese walls really work? Does the social duty of mutual banks imply a lesser need to regulate? - No conflict between the interest of equity shareholders and depositors, but are there conflicts between savings and borrowing members and what about efficiency? The role of auditors in monitoring the internal controls of banks and other firms is contested. - should it be supervisors instead and who should bear the cost of supervision? 16
International accounting standards have yet to be agreed and Common CG standards have yet to be applied. Legal systems vary in type across countries (La Porta et al) and bankruptcy laws also afford widely different protection to banks and their debtors and creditors and few countries are totally happy either with their current bankruptcy laws (recently reviewed in US and UK) or their general CG systems. - The CG code seems to be under almost continuous review in the UK. - Sarbanes-Oxley is under attack in the US. 17
Complex Monopoly A complex Monopoly situation, in relation to the supply of (banking) services in the UK, exists when at least one quarter of the services supplied (by a group of banks in this case) are supplied in such a way that prevents, restrains or distorts competition. Further details can be found in section 7 (2) of the Fair Trading Act. 18