1. Corporate Governance of Banks: Why it is important, how it is special and what it impliesby
Stijn Claessens
Senior Adviser, Operations and Policy Department
Financial Sector Vice-Presidency, World Bank
for the Consultative OECD/World Bank
Meeting on Corporate Governance
December 6-7, Hanoi, Vietnam

2. Outline of presentation
Why care in general about corporate governance (CG)?
Why care specifically about the CG of banks?
What is special about CG of banks?
What does this imply for bank CG, regulation/supervision?
What do we know about CG of banks?
Implications for CG of banks

3. Why care about corporate governance?
Corporate governance matters for development
Increased access to financing  investment, growth, employment
Lower cost of capital and higher valuation  investment, growth
Better operational performance  better allocation of resources, better management, creates wealth
Less risk, at the firm and country level  fewer defaults, fewer financial crises
Better relationship with stakeholders  improved environment, social/labor

4. Why care about corporate governance?
All of these relationships matter for growth, employment, poverty reduction
Empirical evidence has documented these relationships
At the level of country, sector and individual firm and from investor perspective using various techniques
Quite strong relationships
But so far mainly documented for non-financial corporations that are listed on stock exchanges

5. Depth of the financial system
Access to financing: better creditor rights and rule of law lead to more developed credit markets
Depth of the financial system

6. Access to financing: higher quality of shareholder protection leads to more developed stock markets
Degree of capital market development

7. Weak corporate governance translates into higher cost of capital
Excludes Brazil

8. Better corporate governance translates into somewhat higher returns on assets
Excludes Mexico and Venezuela

9. But much better higher returns on investment relative to cost of capital

10. Why care about CG of banks? (I)
Banks are corporations themselves
CG affects banks’ valuation and their cost of capital. CG of banks thereby affects the cost of capital of the firms and households they lend to
CG affects banks’ performance, i.e., costs of financial intermediation, and thereby the cost of capital of the firms and households they lend to
CG affects banks’ risk-taking and risks of financial crises, both for individual banks and for countries’ overall banking systems

11. Why care about CG of banks? (II)
Bank behavior influences economic outcomes
Banks mobilize and allocate society’s savings. Especially in developing countries, banks can be very important source of external financing for firms
Banks exert corporate governance over firms, especially small firms that have no direct access to financial markets. Banks’ corporate governance gets reflected in corporate governance of firms they lend to
Thus, governance of banks crucial for growth, development

12. What is special about CG of banks? (I)
Banks are “special,” different from corporations
Opaque, financial information more obscure: hard to assess performance and riskiness
More diverse stakeholders (many depositors and often more diffuse equity ownership, due to restrictions): makes for less incentives for monitoring
Highly leveraged, many short-term claims: risky, easily subject to bank runs
Heavily regulated: given systemic importance, as failure can lead to large output costs, more regulated

13. What is special about CG of banks? (II)
Because special, banks more regulated, with regulations covering wide area
Activity restrictions (products, branches), prudential requirements (loan classification, reserve reqs. etc)
Regulations often more important than laws
Government, instead of depositors, debt or equity-holders, takes role of monitoring banks
Power lies with government, e.g., supervisor, deposit insurance agency, central bank
Raises in turn public governance questions

14. What is special about CG of banks? (III)
Banks enjoy benefits of public safety net
Banks, as they are of systemic importance, get support, i.e., deposit insurance, LOLR, and other (potential) forms of government support
Costs of support provided often paid for by government, i.e., in the end taxpayers
Implies banks less subject to normal disciplines
Debt-holders less likely to exert discipline
Bankruptcy is applied differently or rarer
Competition is less intense as entry restricted
Public safety net is large, creating moral hazard

15. What is special about CG of banks? (IV)
Same time, banks more subject to CG-risks
Opaqueness means scope for entrenchment, shifting of risks, private benefits and outright misuse (tunneling, insider lending, expropriation, etc.) larger than for non-financial firms
As for any firm, bank shareholder value can come from increased risk-taking
Shareholder value is residual claim on firm value
Increased risk-taking raises shareholder values at expenses of debt claimholders and government

16. Studies on CG of banks: monitoring and risk
Banks are indeed more difficult to monitor
Moody’s and S&P disagreed on only 15% of all non-financial bond issues, but disagreed on 34% of all financial bond issues
Banks are more vulnerable
Recessions increases spreads on all bond issues, but increases spreads on riskier banks more than for non-financial firms
Partly result of a flight to safety, but also greater vulnerability of banks compared to non-financial firms
Consistent with the views that expropriation is important internationally, laws can restrain expropriation, and CF is an important governance mechanism. But, bank supervision and regulation does increase the confidence that investors feel in purchasing bank shares

17. Studies on CG of banks: bank failings and financial crises
In practice, banks with weak corporate governance have failed more often
Accrued deposit insurance, good summary measure of riskiness of banks, higher for weaker CG
State-owned banks enjoy even larger public subsidy, that is often misused: poor allocation, large NPLs, e.g., Indonesia, South Korea, France, Thailand, Mexico, Russia
Fiscal costs of government support up to 50% of GDP, large output losses from financial crises
Countries with weaker corporate governance and poorer institutions see more crises

18. Higher currency depreciation in weaker corporate governance countries during periods of stress

19. What does this imply for bank CG and regulation and supervision?
Quality of bank CG interfaces with supervision and regulation
More effective banks’ CG can aid supervision since with better CG, banks can be sounder, valuations higher, thereby making supervision easier
Good CG-framework can make bank regulation and supervision less necessary, or at least, different
Need to consider therefore bank CG and regulation and supervision together

20. What does this imply for bank CG and regulation and supervision?
Two approaches to CG and supervision
Basel: capital standards and powerful supervisors
Market failures/externalities, so need regulations
Empower private sector through laws & information
Market failures, but also government failures
Approaches not mutually exclusive
What is best mix of private market and government oversight of banks? What does this imply for bank CG?

21. What do we know about CG of banks?
So far, little evidence on the standard CG-questions and more complex issues of CG and regulation/supervision
Some have documented effects of bank ownership
LSV/BCL: banking systems with more state-ownership: less stable, less efficient, worse credit allocation
More foreign banks: more stable, efficient, competitive effects
Few so far investigated bank governance
Many studies on effects of laws & regulations for corporations
But few on banks, except for recent evidence from Caprio, Laeven, and Levine

22. Bank ownership: possible ownership and control patterns
Widely-held, not-controlled by any single owner
Controlling owner
Family (individual)
State
Widely-held (non-financial) corporation
Widely-held financial institution
Other (trust, foundation, which may be “shell”)
With small or large deviations of control rights from ownership (cash-flow) rights

23. Difference between ownership and control
Controlling owner vs. widely-held bank
Controlling owner if direct + indirect control > (say) 10%
Widely-held if no entity owns > 10% directly + indirectly
Ultimate owners versus direct owners
If any major shareholders are (F/NF) corporations, then find their major shareholders. Continue until ultimate owners
Example: Shareholder has x% of indirect control over bank A if she controls directly firm C that, in turn, controls firm B, which directly controls x% of bank A. Control chain can be long
Controlling owner – if any – will be the one with the maximum direct + indirect control

24. Ownership and control do deviate

25. Bank control varies greatly internationally

26. Bank control internationally
Banks are generally not widely-held
Family ownership of banks is very important, and so is the state ownership
Cross-country differences are large, though
In 14 of 44 countries, the controlling owner has more than 50% of voting shares. But in Australia, Canada, Ireland, UK, and US, either NO bank has a controlling owner or the average is less than 2%
Legal protection of shareholder is associated with more widely-held banks, i.e., with better legal protection less need/desire for close control

27. Effects of control on firms and banks
Some firm and bank owners can be better than others
Insiders may expropriate firm resources
Expropriation = theft, transfer pricing, asset stripping, nepotism, and “perquisites” that benefit insiders
Ownership & shareholder protection laws  value
Cash-flow rights up  expropriation less  valuation higher
Shareholder protection laws better  valuations up
Interactions between ownership & protection  valuation
Are banks different?
Laws insufficient with powerful, complex, opaque banks?
Regulations: laws superfluous or superceded?
Role of ownership less important?

28. Valuation and shareholder rights
Market-to-Book Value: Em/Eb
Rights: shareholder rights (0-6)
(1) Mail proxy votes
(2) Not required to deposit shares
(3) Proportional representation of minorities on board allowed
(4) Oppressed minorities mechanism
(5) Percentage for ESM < 10%
(6) When shareholders have preemptive rights, they can only be waived by a shareholders meeting
The ratio of D/E financing can influence valuations, i.e., MM does not hold.

29. Supervision and regulation powers
Official
Power to change internal organization, management, directors, etc
Power to supercede rights of shareholders to intervene or close bank
Power to meet, get reports, from, and take legal action against auditor
Restrict
Regulatory restrictions on banks (i) securities, (ii) insurance, (iii) real estate, and (iv) owning non-financial firms
Capital
Regulatory restrictions on source of funds, BIS minimum, risk-based, are loan, security, FX loses deducted from capital, etc.
Independence
Degree of supervisory independence from government and banks

30. Valuation effects of bank ownership and equity rights
When cash-flow rights of controlling owner higher and equity rights stronger, bank valuation higher. Effects can be large:
A one-standard deviation increase in shareholder protection laws (1.25) raises market-to-book by 0.28, or 21 percent of mean
A one-standard deviation increase in cash flow rights (0.27) raises market-to-book by 0.42, or 31 percent of mean
More cash-flow rights can even offset some of negative effects of weak equity rights
Suggests strong owners, both in share and in their rights, can help corporate governance of banks
Surprising, perhaps, quality of supervision and the degree of regulation does not robustly influence valuations
Consistent with the views that expropriation is important internationally, laws can restrain expropriation, and CF is an important governance mechanism. But, bank supervision and regulation does increase the confidence that investors feel in purchasing bank shares

31. Bank CG and valuation

32. Implications for CG of banks
Bank ownership
Be very careful on state ownership: negatively related to valuation, stability and efficiency
Consider inviting foreign banks
Bank governance, regulation and supervision
Strong private owners necessary, but they need to have their own capital at stake
Better shareholder protection laws can improve functioning of banks
Supervision/regulation less effective in monitoring banks
1st paper to compile detailed data on bank ownership across a broad cross-section of countries for many banks.
1st paper to examine the impact of the legal and regulatory determinants of bank valuation