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by Stijn Claessens Senior Adviser, Operations and Policy Department

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1 Corporate Governance of Banks: Why it is important, how it is special and what it implies
by 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

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