Good Governance Was Not a Blessing During the Credit Crisis
A shareholder-friendly board turned out to be a liability for large international banks during the credit crisis which stretched from mid-2007 to the end of 2008. This is the most striking, counterintuitive and perhaps disturbing conclusion of The Credit Crisis around the Globe: Why Did Some Banks Perform Better?, an article by Andrea Beltratti (Department of Finance) and René Stultz (Ohio State University) published in Journal of Finance Economics (Volume 105, Issue 1, July 2012, Pages 1-17, doi: 10.1016/j.jfineco.2011.12.005).
In their article the scholars investigate why some banks performed better than others during the crisis, testing the arguments, suggested by academics, journalists and policy-makers, that "lax regulation, insufficient capital, excessive reliance on short-term financing, and poor governance all contributed to making the crisis as serious as it was". They end up confirming the negative role played by insufficient capital and short-term financing, reassessing the effects of regulation and rebutting conventional wisdom on governance.
In their sample of 164 banks from 32 countries, with total assets in excess of $50 billion as of December 2006, Beltratti and Stultz highlight a sharp difference between the performance (measured as average buy-and-hold dollar return) in 2006 (32.37%) and in the six crisis quarters, July 2007-December 2008 (-51.84%), and observe a high standard deviation in the crisis period (27.74%, with the return ranging from -99.5% to 29.14%). They then divide the return performances in quartiles, compare the characteristics of the banks that had the worst and the best performance and estimate multiple regressions to investigate the determinants of performance.
The crisis, they remark, somehow inverted the performance ranking. The banks of the bottom quartile (average return during the crisis -85.23%) had been better performers in 2006 (38.71%) than the banks in the top quartile (which record an average return of -15.15% during the crisis, but a relatively small 25.96% in 2006). "The better-performing banks are more traditional banks", the scholars write, with "significantly more equity and hence lower leverage at the end of 2006". They have a higher ratio of deposits, not subject to run with deposit insurance, to assets, and are less diversified than the rest, often coming from countries with stricter regulation.
The tightness of regulation is however relevant only for one aspect: the restrictions on the activities of banks, which prevented them from engaging in activities that performed unexpectedly poorly during the crisis. The authors concede, though, that they couldn't measure the activism of national regulators and that this could have played a role.
The diversification of activities could also explain the most counterintuitive result of the paper. Beltratti and Stultz point out in fact that the only dimension of governance with a significant effect on banks performance during the crisis is the board's shareholder-friendliness, as measured by an index constructed using data on bank board attributes such as independence, composition of committees, size and transparency, collected by Institutional Shareholder Services – and this effect is negative. While conventional wisdom states that banks with shareholder-friendly boards should be less risky than the rest, evidence shows that this was not the case even before the crisis and that their performance during the crisis was significantly worse than the performance of other banks. "This evidence", the authors conclude, "is consistent with the view that banks that grew more in sectors that turned out to perform poorly during the crisis were pursuing policies favoured by shareholders before the crisis". Shareholders, in other words, were satisfied with the high returns of risky diversified activities until these led to unexpectedly large losses during the crisis.