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					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


                                                    1
        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
                                                 2
        Why care about corporate
             governance?
Corporate governance matters for development
1. Increased access to financing  investment,
   growth, employment
2. Lower cost of capital and higher valuation 
   investment, growth
3. Better operational performance  better
   allocation of resources, better management,
   creates wealth
4. Less risk, at the firm and country level  fewer
   defaults, fewer financial crises
5. Better relationship with stakeholders 
   improved environment, social/labor
                                                      3
            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


                                                                    4
Access to financing: better creditor rights
             and rule of law lead to
        more developed credit markets
 0.9

 0.8

 0.7




                                                    Depth of the financial system
 0.6

 0.5

 0.4

 0.3

 0.2

 0.1

  0
       1          2                       3     4
                Creditor Rights * Rule of Law




                                                                                    5
Access to financing: higher quality of
shareholder protection leads to more
      developed stock markets




                                         Degree of capital market development
e
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              M iit/ P
              a pi G
              rc z D
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8
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0
3


0
2


0
1


0




                                                                                6
   Weak corporate governance translates into
            higher cost of capital

                                   0.35
           Median Voting Premium



                                    0.3
                                   0.25
                                    0.2
                                   0.15
                                    0.1
                                   0.05
                                     0
                                          1   2    3        4     5   6
                                                  Equity Rights




Excludes Brazil
                                                                          7
   Better corporate governance translates into
       somewhat higher returns on assets

                              8
                              7
           Return on Assets




                              6
                              5
                              4
                              3
                              2
                              1
                              0
                                  1   2    3         4    5   6
                                          Equity Rights



Excludes Mexico and Venezuela
                                                                  8
 But much better higher returns on
investment relative to cost of capital
Return on Investment relative to

                                   1.1

                                    1
       Costs of Capital



                                         1   2    3        4     5   6
                                   0.9

                                   0.8

                                   0.7

                                   0.6

                                   0.5
                                                 Equity Rights




                                                                         9
     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

                                                           10
    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

                                                         11
 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
                                                        12
  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
                                                             13
  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
                                                          14
  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

                                                         15
                 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
                                                                  16
       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
                                                          17
Higher currency depreciation in weaker
corporate governance countries during
           periods of stress




                                         18
 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

                                                         19
 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?

                                                            20
  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

                                                                   21
 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


                                                         22
         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
                                                                      23
                             Ownership and control do deviate
                                                            Control vs Cash-flow rights
                   100

                   90

                   80

                   70                                                                                       Indonesia
Cash-flow rights




                                                                                         Mexico     India
                   60                                                             Finland      Turkey
                                                                                              Peru
                   50                                                           Thailand                                          Argentina
                                                                         Israel
                                                                    France Colombia                                     Brazil
                   40                                                                     Austria
                                                             Greece Pakistan          HK
                   30                                  Venezuela Malaysia                Sw itzerland
                                                                        Philippines
                                                 Singapore S. KoreaAverage
                                             Keyna anJordan
                                                Taiw                                   Chile
                   20
                                        Italy Sri Lanka EgyptSpain
                                    Japan
                                                  Denmark                    Portugal      Netherlands
                   10
                    AustraliaNorw ay                      S. Africa
                                     Germany Sw eden Zimbabw e
                        UKUnited States
                    0
                      CanadaIreland
                      0           10           20         30         40           50         60        70        80          90          100

                                                                            Control

                                                                                                                                              24
                                           Shares of different owners
                       Ar
                            g
                        Auen




                                           0%
                                                20%
                                                      40%
                                                            60%
                                                                  80%
                                                                        100%
                               st tina
                             Aurali
                                 s a
                          C a  Br tria
                              an z
                      C Cad il
                          o          a
                       D lomhile
                           en b
                                m ia




     Widely
                               Egark
                            Fi y
                               nl p
                       G Fraandt
                           er n
                    H G ma ce
                       on re ny
                            g ec
                                K
                      In on e
                          do In g
                               n d




     Family
                             Ireesiia
                                 l a
                               Is and
                                  ra
                                     e
                               JaIt al l
                Ko           J p y
                    re ordan
                       a K a
                           R e n
                        M ep nya




     State
                   N ala . O
                     et M ys f
                        he e ia
                              rl xi
                            N andco
                        Pa orw s
                                                                               Ownership Structures




                    Ph kist ay


     Fin
                        ilip P an
                               p e
                                                                                                           internationally




                     Si Por ineru
                   So ng tu s
                        ut ap gal
                            h or
                                A e
                       Sr S fric
                            i p a
                    Sw S Lanain
     Corp



                         it zwed ka
                              e e
                                                                                                      Bank control varies greatly




              U             Tarlann
                ni Th iw d
                  te          a a
                 U d K T ilann
                   ni i ur d
                     te ng k
                         d
                     Ve S do ey
                                    m
     Other




                     Zi ne tate
                        m zu s
                             ba el
                                 bw a
                                     e
25
               Bank control internationally
                      CF    Widely   Family   State   Fin   Corp   Other
Country mean       27.45%     25%     39%     14%     7%     2%     14%

      1) Banks are generally not widely-held
      2) Family ownership of banks is very important,
         and so is the state ownership
      3) 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%
      4) Legal protection of shareholder is associated
         with more widely-held banks, i.e., with better
         legal protection less need/desire for close control
                                                                           26
   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?
                                                                                  27
       Valuation and shareholder rights

• Valuation
   • 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



                                                                        28
     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


                                                                                   29
        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


                                                                                 30
                                 Bank CG and valuation
                                 Market to Book Value and Equity Rights


                       1.6
                       1.5
Market to Book Value




                       1.4
                       1.3
                       1.2
                       1.1
                        1
                       0.9
                       0.8
                             0     1         2         3          4       5   6
                                                 Equity Rights

                                                                                  31
        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
                                                          32

				
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