Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies

Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies Andrew Ellul 1 Vijay Yerramilli 2 1 Kelley School of Business, Indiana University 2 C. T. Bauer College of Business, University of Houston Conference on Matching Stability and Performance Center for Applied Research in Finance, Università Bocconi Milan September 29, 2010 Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 1 / 19

Motivation Motivation: The Financial Crisis Financial Crisis Many banks had substantial exposure to sub-prime risk, funded by short-term market borrowing (Kashyap et al. (2008), Acharya et al. (2009)) Why did some banks expose themselves, more than others, to such risks in the first place? Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 2 / 19

Motivation Financial Crisis Motivation: The Financial Crisis Many banks had substantial exposure to sub-prime risk, funded by short-term market borrowing (Kashyap et al. (2008), Acharya et al. (2009)) Why did some banks expose themselves, more than others, to such risks in the first place? One prominent explanation is that there was a failure of risk management at banks Risk managers were either unaware of risk exposures...... or were unable to restrain traders and bank executives with high-powered incentive schemes who had incentives to take high risks Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 2 / 19

Motivation Failure of Risk Management The Policymakers View Financial Crisis The failure to appreciate risk exposures at a firmwide level can be costly. For example, during the recent episode, the senior managers of some firms did not fully appreciate the extent of their firm s exposure to U.S. subprime mortgages. They did not realize that, in addition to the subprime mortgages on their books, they had exposures through the mortgage holdings of off-balance-sheet vehicles, through claims on counterparties exposed to subprime, and through certain complex securities... Chairman of the Federal Reserve, Ben Bernanke - May 2008 Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 3 / 19

Motivation Failure of Risk Management The Policymakers View Financial Crisis what distinguished well-managed institutions that fared well during the crisis was that they had strong and independent risk management functions... and there was a robust dialogue between their senior management team and business segments regarding organization-wide risk preferences... Senior Supervisor Group (2008) Survey Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 4 / 19

Motivation Financial Crisis Failure of Risk Management The Policymakers View what distinguished well-managed institutions that fared well during the crisis was that they had strong and independent risk management functions... and there was a robust dialogue between their senior management team and business segments regarding organization-wide risk preferences... Senior Supervisor Group (2008) Survey SSG report highlights specific weaknesses in risk management practices that contributed to heavy losses at institutions that performed poorly Excessive reliance on historical risk measures, and failure to conduct forward-looking stress tests Failure to identify correlation risk Underestimation of liquidity risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 4 / 19

Motivation Financial Crisis Our Paper Research Question: Did bank holding companies (BHCs) with strong and independent risk management functions have lower enterprise-wide risk, all else equal? Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 5 / 19

Motivation Financial Crisis Our Paper Research Question: Did bank holding companies (BHCs) with strong and independent risk management functions have lower enterprise-wide risk, all else equal? We construct a Risk Management Index (RMI) to measure the real importance of the risk management function within the organization We examine how powerful the Chief Risk Officer is within the organization, and how well information on risk is shared between the top management and the business segments within the organization Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 5 / 19

Motivation Financial Crisis Our Paper Research Question: Did bank holding companies (BHCs) with strong and independent risk management functions have lower enterprise-wide risk, all else equal? Why focus on BHCs? Enterprise-wide risk management is critical in BHCs, which typically have multiple independent subsidiaries, engaged in a variety of financial activities Many BHCs are publicly listed, and file periodic reports with SEC Because of regulatory requirements, BHCs file detailed financial statements on a quarterly basis (FR Y-9C reports) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 5 / 19

Hypotheses Hypotheses Why should internal risk controls matter? Risk-taking tendencies of banking institutions are difficult to check the presence of implicit or explicit government guarantees often underpriced and at best mispriced has blunted the instrument of debt monitoring that would otherwise impose market discipline on risk taking by these firms... the size of these institutions has shielded them from the disciplinary forces of the otherwise vibrant market for takeovers and shareholder activism. Finally, their ever-increasing complexity has diminished the power of governance from existing shareholders and non-executive board members. Unlike in industrial firms, it has become increasingly difficult for infrequently meeting boards to fully grasp the swiftness and forms by which risk profiles of these institutions can be altered by traders and security desks. Acharya et al. (2009) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 6 / 19

Hypotheses Hypotheses Why should internal risk controls matter? Risk-taking tendencies of banking institutions are difficult to check A strong and independent risk management function can restrain risk-taking tendencies (Kashyap et al. (2008)) Organization structure influences how effectively information is shared between business segments and top management (Stein (2002), Liberti (2005)) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 6 / 19

Hypotheses Hypotheses Why should internal risk controls matter? Risk-taking tendencies of banking institutions are difficult to check A strong and independent risk management function can restrain risk-taking tendencies (Kashyap et al. (2008)) Organization structure influences how effectively information is shared between business segments and top management (Stein (2002), Liberti (2005)) Alternate Hypotheses: Null hypothesis: Risk management function does not matter because real power rests with traders and executives with highly convex compensation packages Reverse causality: Choice of risk management depends on BHC s risk profile, and not other way round Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 6 / 19

Hypotheses Data and variables Data Sources Organizational structure of the risk management function Hand-collected from 10-K, proxy statements, and annual reports of BHCs Restricted attention to top 100 BHCs at the end of 2007 (92% of total banking assets) We collect this information for 74 publicly-listed BHCs for 1999 2007 Consolidated financial information (FR Y-9C reports) Filed by BHCs with Federal Reserve on a quarterly basis Detailed information, including off-balance sheet items Stock returns (CRSP), and option prices (OptionMetrics) Used to create Downside Risk, Tail Risk, and Aggregate Risk measures Other sources: Execucomp, 13-F (ownership), and IRRC (governance) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 7 / 19

Hypotheses Data and variables Risk Management Index (RMI) Variables that measure importance of risk officers CRO Present identifies if BHC has an officer exclusively tasked with managing enterprise risk ( CRO ) CRO Executive identifies if the CRO is an executive officer CRO-Top5 identifies if CRO is among five highest paid executives CRO/ CFO Centrality: ratio of the CRO s (or CFO s if there is no CRO) total compensation to the CEO s total compensation Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 8 / 19

Hypotheses Data and variables Risk Management Index (RMI) Variables that measure importance of risk officers CRO Present identifies if BHC has an officer exclusively tasked with managing enterprise risk ( CRO ) CRO Executive identifies if the CRO is an executive officer CRO-Top5 identifies if CRO is among five highest paid executives CRO/ CFO Centrality: ratio of the CRO s (or CFO s if there is no CRO) total compensation to the CEO s total compensation Variables that measure quality of risk oversight by the board Board Risk Committee Experience identifies whether at least one of the directors serving on the board s risk committee has some banking experience Active Board Risk Committee identifies if risk committee met more frequently during the year compared to the average across all BHCs Reports to Board identifies if key management-level risk committee reports directly to the board instead of to the CEO Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 8 / 19

Hypotheses Data and variables Risk Management Index (RMI) Variables that measure importance of risk officers CRO Present identifies if BHC has an officer exclusively tasked with managing enterprise risk ( CRO ) CRO Executive identifies if the CRO is an executive officer CRO-Top5 identifies if CRO is among five highest paid executives CRO/ CFO Centrality: ratio of the CRO s (or CFO s if there is no CRO) total compensation to the CEO s total compensation Variables that measure quality of risk oversight by the board Board Risk Committee Experience identifies whether at least one of the directors serving on the board s risk committee has some banking experience Active Board Risk Committee identifies if risk committee met more frequently during the year compared to the average across all BHCs Reports to Board identifies if key management-level risk committee reports directly to the board instead of to the CEO RMI is the first principal component of CRO Exec, CRO-Top5, CRO/CFO Centrality, Board Risk Committee Experience and Active Board Risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 8 / 19

Hypotheses Data and variables Descriptive Statistics: RMI Components Importance of Risk Officer Mean Median Std. Dev. p25 p75 N RMI 0.451 0.410 0.207 0.309 0.609 673 CRO Present 0.618 1 0.482 0 1 673 CRO Executive 0.519 0 0.479 0 1 673 CRO Top5 0.195 0 0.393 0 0 673 CRO Centrality.324.262.182.194.352 673 CRO reported as present in only 62% of BHCs Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 9 / 19

Hypotheses Data and variables Descriptive Statistics: RMI Components Importance of Risk Officer Mean Median Std. Dev. p25 p75 N RMI 0.451 0.410 0.207 0.309 0.609 673 CRO Present 0.618 1 0.482 0 1 673 CRO Executive 0.519 0 0.479 0 1 673 CRO Top5 0.195 0 0.393 0 0 673 CRO Centrality.324.262.182.194.352 673 CRO reported as present in only 62% of BHCs CRO was an executive officer in 49% of BHCs, and was among the 5 highest paid executives in 19% of BHCs On average, CRO/ CFO pay was 29% of the CEO s Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 9 / 19

Descriptive Statistics Quality of Risk Oversight Hypotheses Data and variables Mean Median Std. Dev. p25 p75 N RMI 0.451 0.410 0.207 0.309 0.609 673 Frac. Experienced Directors 0.225 0.217 0.092 0.200 0.360 673 Experienced Board.482 0.402 0 1 673 Risk Committee Experience.232 0.422 0 0 673 Freq. of meetings: Risk Committee 5.052 3 5.321 0 8 673 Active Risk Committee 0.462 0 0.481 0 1 673 On average, only 22.5% of all non-inside directors on the BHC s board have prior financial industry experience Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 10 / 19

Descriptive Statistics Quality of Risk Oversight Hypotheses Data and variables Mean Median Std. Dev. p25 p75 N RMI 0.451 0.410 0.207 0.309 0.609 673 Frac. Experienced Directors 0.225 0.217 0.092 0.200 0.360 673 Experienced Board.482 0.402 0 1 673 Risk Committee Experience.232 0.422 0 0 673 Freq. of meetings: Risk Committee 5.052 3 5.321 0 8 673 Active Risk Committee 0.462 0 0.481 0 1 673 On average, only 22.5% of all non-inside directors on the BHC s board have prior financial industry experience Board risk committee had a director with banking experience in only 23% of cases Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 10 / 19

Descriptive Statistics Quality of Risk Oversight Hypotheses Data and variables Mean Median Std. Dev. p25 p75 N RMI 0.451 0.410 0.207 0.309 0.609 673 Frac. Experienced Directors 0.225 0.217 0.092 0.200 0.360 673 Experienced Board.482 0.402 0 1 673 Risk Committee Experience.232 0.422 0 0 673 Freq. of meetings: Risk Committee 5.052 3 5.321 0 8 673 Active Risk Committee 0.462 0 0.481 0 1 673 On average, only 22.5% of all non-inside directors on the BHC s board have prior financial industry experience Board risk committee had a director with banking experience in only 23% of cases On average, a BHC s risk committee meets 5 times per year Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 10 / 19

Risk Measures Hypotheses Data and variables Downside Risk: Mean implied volatility estimated using put options written on the BHC s stock Tail risk: The negative of the average return on the BHC s stock over the 5% worst days for the S&P500 (Acharya et al. (2009)) Aggregate risk: Standard deviation of the BHC s weekly excess (over S&P500) stock return over the calendar year Mean Median Std. Dev. p25 p75 N Downside Risk 0.397 0.350 0.172 0.281 0.451 400 Tail Risk 0.025 0.016 0.024 0.011 0.028 697 Aggregate Risk 0.038 0.031 0.024 0.022 0.044 698 Annual Return 0.046 0.046 0.293-0.121 0.215 698 Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 11 / 19

Empirical analysis RMI and performance during the crisis years Cross-sectional regression: Y j,t = β 0 + β 1 RMI j,2006 + β 2 X j,2006 + Year FE As a preamble to our analysis, we want to test if BHCs with high RMI 2006 fared better during the crisis years, 2007 and 2008 Y j,t is one of the following: Private-label MBS, Risky Trading Assets, and Deriv. Trading ROA, Bad Loans/Assets and Stock Return to measure operating and stock performance Downside Risk, Tail Risk and Aggregate Risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 12 / 19

Empirical analysis RMI and performance during the crisis years Cross-sectional regression: Y j,t = β 0 + β 1 RMI j,2006 + β 2 X j,2006 + Year FE Private Trading Deriv. Stock Aggr. Tail MBS Assets Trading Return Risk Risk RMI 2006-10.481-67.927-6.765.094 -.019 -.172 Size 2006 5.821 36.044 5.301 -.064 -.0001 -.011 ROA 2006 75.000-871.240-215.977 4.563 -.647-3.991 (Tier-1 Cap/Assets) 2006-20.744 307.760 72.309-1.334.107.799 (Bad Loans/Assets) 2006 50.792-387.483-125.392-4.650 1.416 12.941 (Deposits/Assets) 2006 3.464 59.450 11.269.186 -.028.057 (Loans/Assets) 2006-8.047-34.143-6.664 -.182.009 -.169 Obs. 143 143 143 141 141 112 R 2.514.37.327.317.537.65 Year FE Yes Yes Yes Yes Yes Yes BHCs with a high RMI in 2006 had lower exposures to private-label MBS, (riskier) trading assets and off-balance sheet derivatives, and lower downside risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 12 / 19

Empirical analysis RMI and Enterprise-wide Risk Panel regression: Risk j,t = β 0 + β 1 RMI j,t 1 + β 2 X j,t 1 + BHC FE + Year FE Measures of Risk: Downside Risk, Tail Risk and Aggregate Risk Apart from Size, we also control for: Balance-sheet composition: Deposits/Assets, Loans/Assets, Loan Concentration, Tier1 Capital/ Assets Business Composition: Non-int income/income, UW Assets/Assets, Ins. Assets/Assets Past Performance: ROA, Bad Loans/ Assets, Annual Stock Return Governance and CEO pay: Inst. Ownership, G-Index, CEO s Delta and CEO s Vega Year fixed effects, and BHC fixed effects to control for any time-invariant unobservables that affect risk taking Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 13 / 19

RMI and Downside Risk Empirical analysis (1) (2) (3) (4) RMI t 1 -.325 -.407 -.442 -.526 Size t 1.004 -.015 -.013 -.023 ROA t 1-1.102 -.394 -.558 -.979 Annual Stock Return t 1 -.069 -.077 -.072 -.068 (Deposits/Assets) t 1.273.240.248.148 (Tier-1 Cap/Assets) t 1 -.338 -.555 -.489-1.062 (Loans/Assets) t 1 -.094.015.024.026 (Bad Loans/Assets) t 1 9.153 5.675 5.752 5.594 Inst. Ownership t 1.314.305.286 G-Index t 1 -.004 -.004 -.00009 (Deriv Trading/Assets) t 1 -.001 -.0003 (Deriv Hedging/Assets) t 1 -.075 -.060 CEO s Delta t 1 -.839 CEO s Vega t 1 -.014 Obs. 391 366 366 279 R 2.842.847.849.852 BHC & Year FE Yes Yes Yes Yes One std. dev. increase in RMI associated with 0.43 std. dev. decrease in Downside Risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 14 / 19

RMI and Tail Risk Empirical analysis (1) (2) (3) (4) RMI t 1 -.074 -.062 -.065 -.047 Size t 1.008.005.005.001 ROA t 1 -.030 -.035 -.026 -.150 Annual Stock Return t 1 -.003 -.006 -.006 -.009 (Deposits/Assets) t 1.007.016.015.029 (Tier-1 Cap/Assets) t 1.011.043.046.058 (Loans/Assets) t 1 -.002.0004.0008 -.007 (Bad Loans/Assets) t 1.354 -.360 -.352.166 Inst. Ownership t 1.007.007.019 G-Index t 1.0004.0004.001 (Deriv Trading/Assets) t 1.0004-4.65e-06 (Deriv Hedging/Assets) t 1 -.0004 -.003 CEO s Delta t 1 -.130 CEO s Vega t 1.0007 Obs. 603 484 484 321 R 2.852.9.9.92 BHC & Year FE Yes Yes Yes Yes One std. dev. increase in RMI associated with a 0.62 std. dev. decrease in Tail Risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 15 / 19

RMI and Aggregate Risk Empirical analysis (1) (2) (3) (4) RMI t 1 -.118 -.089 -.091 -.071 Size t 1 -.002 -.005 -.005 -.007 ROA t 1 -.265 -.303 -.296 -.034 Annual Stock Return t 1 -.008 -.011 -.011 -.010 (Deposits/Assets) t 1.011.022.022.017 (Tier-1 Cap/Assets) t 1.027.044.045 -.058 (Loans/Assets) t 1 -.027 -.019 -.018 -.025 (Bad Loans/Assets) t 1.835.985.991.887 Inst. Ownership t 1.024.025.037 G-Index t 1.0004.0004.002 (Deriv Trading/Assets) t 1.0003.0003 (Deriv Hedging/Assets) t 1.0003 -.003 CEO s Delta t 1 -.101 CEO s Vega t 1 -.007 Obs. 604 484 484 321 R 2.8.838.838.868 BHC & Year FE Yes Yes Yes Yes One std. dev. increase in RMI associated with a 0.60 std. dev. decrease in Aggregate Risk Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 16 / 19

Empirical analysis Dealing with Dynamic Endogeneity Relationship between risk and RMI may be dynamically endogenous i.e., causation could run both ways, such that a BHC s past risk determines both current RMI and current risk Dynamic endogeneity may arise in two ways BHCs exposed to greater risk endogenously choose high RMI Underlying risk culture determines both risk and RMI; i.e., conservative BHCs choose low risk-high RMI, while aggressive BHCs choose high risk-low RMI We estimate a dynamic panel GMM estimator developed by Arellano and Bond (1991) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 17 / 19

Empirical analysis Arellano-Bond Dynamic Panel GMM Estimation BHCs with high RMI have lower risk, even after controlling for dynamic endogeneity between risk and RMI Y Variable= Downside Risk Tail Risk Aggregate Risk RMI t 1-2.528-1.995 -.135 -.285 Y t 1 -.255 -.380 1.062.074 Y t 2 -.666 -.799 -.620 -.554 Size t 1 -.002 -.125.017 -.018 ROA t 1 -.074-16.054 -.858-1.256 Annual Stock Return t 1 -.134 -.128.005 -.012 (Tier-1 Cap/Assets) t 1-1.536-1.874 -.062 -.322 (Bad Loans/Assets) t 1 33.696 29.243 2.555 3.982 Inst. Ownership t 1.964 1.164.114.163 G-Index t 1 -.027 -.025 -.0004 -.0007 (Deriv Trading/Assets) t 1.019.030.002.002 (Deriv Hedging/Assets) t 1.010.118.003 -.007 CEO s Delta t 1.137 -.013 -.145 CEO s Vega t 1.059.027.013 Obs. 215 164 234 234 Sargan χ 2 33.747 24.426 35.766 34.886 Sargan p-value 0.142 0.607 0.432 0.474 Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 18 / 19

Conclusion Conclusion: Our Contribution We develop a unique index (RMI) to measure strength and independence of the risk management function at BHCs Our paper highlights that weak internal risk controls at banks may have contributed to the financial crisis Fahlenbrach and Stulz (2009) find no link between executive compensation and bank performance during crisis years Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 19 / 19

Conclusion Conclusion: Our Contribution We develop a unique index (RMI) to measure strength and independence of the risk management function at BHCs Our paper highlights that weak internal risk controls at banks may have contributed to the financial crisis Fahlenbrach and Stulz (2009) find no link between executive compensation and bank performance during crisis years We show that strength and independence of risk management may be an important determinant of risk taking by banks ownership structure and banking regulations (Laeven and Levine (2009)); deposit insurance and competition (Keeley (1990), Hellmann et al. (2000), Demirguc-Kunt and Detragaiche (2002)); Size and franchise value (Demsetz et al. (1997)) Paper contributes to small but growing literature on corporate governance of financial institutions Adams and Mehran (2003), Macey and O Hara (2003), Erkens et al. (2009) Ellul and Yerramilli (2009) BHC Risk Controls CAREFIN 2010 19 / 19