Corporate governance in the banking and financial services industries

www.elsevier.com/locate/jfi

GuestEditor’sIntroduction

Corporategovernanceinthebankingandfinancial

servicesindustries

Fewissuesinfinancialeconomicshavereceivedasmuchattentioninrecentyearsascorporategovernance.Amongacademics,however,theeffectofgovernanceontheconductandperformanceoffirmsinthefinancialservicesindustrieshasreceivedlessscrutinythanithasinotherindustries.Abetterunderstandingofsoundcorporategovernancepracticesinfinancialinstitutions—mostnotably,bankingfirms—isofparticularconcerntoregulators,taxpayers,andinvestors.SuchconcerniswarrantedbecauseoftheuniqueroleplayedbybanksintheUSandglobaleconomies:banksareanimportantsourceofliquidityintimesofcrisis,theyhaveaccesstothenation’spaymentsystems,andtheymaintaindepositsbackedbygovernmentinsurance.

Accordingly,thisspecialvolumeoftheJournalofFinancialIntermediationisintendedtofosterabetterunderstandingofgovernanceissues,especiallyastheyapplytobankingfirms,amongresearchersandotherinterestedreaders.Therestofthisvolumeconsistsofpaperscoveringthreedistinctareas:

•Anderson,Becher,andCampbell’sinvestigationofCEOcompensationfollowingac-quisitionsandmergers,

•Hirtle’sanalysisofsharerepurchasesbybankholdingcompanies(BHCs),and•Carletti’sstudyofthepracticeofborrowingfrommultiplebanks.

1.Executivecompensationafteracquisitionsandmergers

Theempirically-documentedcorrelationbetweenCEOcompensationandfirmsizeisoftenviewedwithsuspicion.Onewayforexecutivestoincreasefirmsizeandperhapsen-joygreatersize-relatedpersonalbenefits,suchashighercompensation,istoacquireotherinstitutions.Indeed,afteramergerbetweenlargebanks,thechiefexecutive’scompensa-tionincreasesmaterially,seeminglyconsistentwiththenotionthatexecutivepayisnaivelybenchmarkedtothebank’senhancedsize.

Offeringanalternativeviewtothisnotion,Anderson,Becher,andCampbelldevelopandempiricallytestexplanationsderivedfromtheoriesofexecutivecompensationbasedonmanagerialproductivityandoptimalincentives.Specifically,theytheorizethatchangesinCEOcompensationshouldberelatedtothechallengesandpotentialgainsinherent

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inmergers,andthustheobservedpositivecorrelationbetweenexecutivecompensationandbanksizemaybedrivenbythebiggerchallengeinrunningalargerorganization.ThisrationaleisconsistentwithDemsetz(1995),whoarguesthatmoreisdemandedofmanagersinlargerandmorecomplexorganizations.Afteramerger,executivesmustrestructureassets,reconfiguretheorganization,reducecosts,andenhancerevenues.Man-agerialcompensationshouldincreasecommensuratelywiththeexpectedvaluegainsfromthesemerger-relatedresponsibilities.

Anderson,Becher,andCampbell’sstudysampleconsistsofninety-sevenmergersbe-tweenbillion-dollarbanksinthe1990s.Followingamerger,theauthorsobservenotonlyhigherCEOpaybutalsogreaterperformanceincentives,consistentwiththeargumentthatanewly-mergedbankrequires,andrewards,greatermanagerialeffort.Theyhypothesizethatgreatermanagerialeffortwillbedirectedatrealizingexpectedmergergains,predict-ingapositiverelationshipbetweenchangesincompensationandthefinancialmarket’sassessmentofmergergains.Consistentwiththenotionofefficientrestructuringofman-agerialincentives,Anderson,Becher,andCampbellfindthatthehighertheanticipatedgainfromthemerger,thegreatertheincreaseinCEOpay.Incontrast,theyfindnosupportfortheargumentthatcompensationincreasesmerelybecauseofexpandedfirmsize.TheirconclusionisthatgeneralpatternsinCEOcompensationfollowingbankmergersappearconsistentwithamarketforcorporatecontrolthatmotivatesefficientassetconsolidation,andalabormarketforbankCEOsthatrewardsmanagerialproductivity.

2.SharerepurchasesbyBHCs

Whydocompaniesrepurchasetheirshares?Threetheorieshavebeenadvancedintheliteraturetoanswerthisoftendebatedquestion.First,firmswithhighfutureprospectssignaltheiropportunitiestooutsideinvestorsthroughsharerepurchases(see,forexample,Vermaelen,1984;andOferandThakor,1987).Asecondtheorycontendsthatfirmswanttodisgorgefreecashflows,asdiscussedinJensen(1986).Finally,becausethechoiceofpayoutpolicy—suchasdividendsversussharerepurchases—maybeaffectedbytaxcodes(see,forexample,RauandVermaelen,2002),itcouldinfluencefirms’decisions.

Despiteanabundanceofgeneralempiricalresearchonthistopic,verylittleworkhasfocusedonsharerepurchasesinthebankingindustry.Inadditiontotheaforementionedmotivesforrepurchasingshares,repurchases—particularlyinbanking—areoftenacriticaltoolinshapingcapitalstructure.Inveryhighlyleveragedindustries,suchasbanking,afewyearsofhighprofitsandstrongcashflowscaneasilyleadtosubstantialdeparturesfromtargetedcapitalizationratios.Historically,banks,likemanycompanies,useddividendsand/orspecialdividendstocontrolthisprocess.Morerecently,followingadoptionofSECrule10b-18inlate1982,repurchasescouldbeusedtosupplementdividendsasawaytomaintaincapitalstructure.

Inhercontributiontothevolume,Hirtleexpandsthisrelativelysmallbodyofresearchbyexaminingrepurchasesmadebyclosely-heldaswellaspublicly-tradedbankholdingcompanies.Specifically,sheanalyzestheeffectofsharerepurchasesonBHCoperatingperformanceusingasampleofrepurchasesby1717bankholdingcompaniesover1987–1998.Hirtledocumentsthatsharerepurchasesinoneperiodareassociatedwithahigher

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operatingperformanceinthefollowingperiod,althoughthefindingsarestrongerforpub-liclytradedBHCs.

Herfindingsareconsistentwithboththefree-cash-flowandprivate-informationthe-oriesofrepurchases.Thefactthatimprovementsinoperatingperformanceprevailonlyoneyearafterrepurchasesmaybebecausesharerepurchases,unlikepermanentincreasesindividendsorleverage,donotcommitthefirmtopayoutfuturefreecashflows.Itisalsoimportanttonotethattheoriesthatsuggestsharerepurchasesconveyinsiders’privateinformationdonotsuggesthowlongtheimprovementinperformanceshouldlast.Inpar-ticular,changesinfirmperformanceshoulddependonthenatureofthefirm’sinvestmentopportunityset.Bankingfirmshavesignificantlysmallergrowthopportunities,asproxiedbyTobin’sQ,relativetocomparablefirmsinunregulatedindustries(AdamsandMehran,2003).Therefore,increasesinperformanceafterrepurchasesinthebankingindustrymaynotbelargerelativetoincreasesattainedbyfirmsinunregulatedindustries,orlonglasting.Thisargumentisconsistentwiththeviewthatrepurchaseshavenoannouncementeffectinthebankingindustry(Billingsleyetal.,19).

3.Borrowingfrommultiplebanks

Althoughconsiderableempiricalworkhasfocusedonthenumberofbankrelationshipsthatfirmschoosetomaintain,littletheoreticalresearchhasbeenundertakentomodelhowfirmsmakethischoice.ExceptionsareRajan(1992)andDetragiacheetal.(2000).1Yet,Rajan(1992)onlymodelsthechoicebetweenasingleinformedbankandadiffusegroupofwhollyuninformed“arm’s-length”lenders.Moreover,hispaperassumesthatasinglebanklendermonitorsatnocost,abstractingfromthebank’smonitoringdecision.Detra-giacheetal.(2000)modelhowafirmchoosesitsnumberofbankrelationships,but,likeRajan,theyabstractfromthebank’smonitoringdecision.Becauseborrowermonitoringisakeyfunctionofbanks,amodelisneededtoexamineexplicitlyhowthenumberofbankrelationshipsaffectsmonitoring.

ThepaperbyCarlettiaddressesthisgapintheliterature.Inthepaper,afirmrequiresfunds,butitistemptedtoengageinmoralhazardoncethefundsareloaned.Bankscanpre-ventmoralhazardthroughcostlymonitoring.Becausebankscareonlyaboutcontractiblecashflows—whereasborrowersalsocareaboutnoncontractiblebenefitsofcontrol—asin-glebankmaymonitorexcessively.Inthiscase,twobanksmaybepreferable:becauseeachbankbenefitsfromtheother’smonitoring,afree-ridereffectensues,reducingthetotalfre-quencyofmonitoring.Asthecostofmonitoringincreases,thefree-ridereffectbecomesmorepronounced,andtheborrowerpreferstwobankrelationshipsratherthanone.Simi-larly,ifthebenefitsofcontrolincrease,thevalueofthefree-ridereffectisgreater,andtheborrowerismorelikelytoprefertwobankrelationships.

Carlettiprovidesatheoreticalexplanationfortheempiricalobservationthatborrowingfrommultiplebanksdoesnotimplyhigherloanratesorfirmquality,particularlyintermsofsmall-businesslending.Furthermore,sheoffersanewexplanationfortheoptimalityof

1SeealsoBootandThakor(2000).

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multiple-banklendingrelationships—onethatcontrastssharplywiththehold-upliterature.HerresultsarealsoconsistentwithOngenaandSmith’s(2000)findingthatmultiplebank-ingrelationshipsaremorecommonincountrieswithweakerjudicialsystemsandweakerinvestorprotections.2

4.Conclusion

Thegovernanceofbankingandotherfinancialfirmsisclearlyanareaworthyoffurtherresearch.Futurestudies,forexample,couldaddgreatlytotheliteraturebyexaminingthesizeofchangesinCEOcompensationfollowingabankmergerrelativetothesizeofthesechangesinanunregulatedenvironment.Closerexaminationoftherelationshipbetweensharerepurchasesandregulatorycapitalwouldalsoprovebeneficial.Thisvolumetakesanimportantstepinthisdirection,andthesepaperswillnodoubtenrichthegrowingliteratureonthegovernanceoffinancialinstitutions.Thisisapotentiallyrichareaforresearchbecauseoftheinterplaybetweencorporategovernancethatisdesirableforthebank’sshareholdersandcorporategovernancethatisdesirableforbankregulators.

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2ArelatedpaperisThakor(1996)whichfindsthatborrowingfrommultiplebanksbenefitsfirms,butthat

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HamidMehran

FederalReserveBankofNewYork,

ResearchandMarketAnalysisGroup,33LibertyStreet,

NewYork,NY10045-0001,USA

E-mailaddress:hamid.mehran@ny.frb.org

1June2003