The Roles of Corporate Governance in Bank Failures During the Recent Financial Crisis

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The Roles of Corporate Governance in Bank Failures
during the Recent Financial Crisis

Berger, Allen N.1 | Imbierowicz, Björn2 | Rauch, Christian3 July 2012

Abstract
This paper analyzes the roles of corporate governance in bank defaults during the recent financial crisis of 2007-2010. Using a data sample of 249 default and 4,021 no default US commercial banks, we investigate the impact of bank ownership and management structures on the probability of default. The results show that defaults are strongly influenced by a bank’s ownership structure: high shareholdings of outside directors and chief officers (managers with a “chief officer” position, such as the CEO, CFO, etc.) imply a substantially lower probability of failure. In contrast, high shareholdings of lower-level management, such as vice presidents, increase default risk significantly. These findings suggest that high stakes in the bank induce outside directors and upper-level management to control and reduce risk, while greater stakes for lower-level management seem to induce it to take high risks which may eventually result in bank default. Some accounting variables, such as capital, earnings, and non-performing loans, also help predict bank default. However, other potential stability indicators, such as the management structure of the bank, indicators of market competition, subprime mortgage risks, state economic conditions, and regulatory influences, do not appear to be decisive factors in predicting bank default.

JEL Codes: G21, G28, G32, G34
Keywords: Bank Default, Corporate Governance. Bank Regulation

                                                             1
University of South Carolina, Moore School of Business, 1705 College Street, Columbia, SC, USA, Phone: +1803-576-8440, Wharton Financial Institutions Center, and CentER, Tilburg University, Email: aberger@moore.usc.edu

2
Goethe University Frankfurt, House of Finance, Grueneburgplatz 1, Frankfurt am Main, Germany, Phone: +49-69798-33729, Email: imbierowicz@finance.uni-frankfurt.de 3
Goethe University Frankfurt, House of Finance, Grueneburgplatz 1, Frankfurt am Main, Germany, Phone: +49-69798-33731, Email: christian.h.rauch@googlemail.com

The authors would like to thank Lamont Black, Meg Donovan, Xiaoding Liu, Raluca Roman, Sascha Steffen, Nuria Suárez, Larry D. Wall, and participants at the 29th GdRE International Symposium on Money, Banking and Finance for useful comments.

1
 

Why do banks fail? After every crisis, this question is asked by regulators, politicians, bank managers, customers, investors, and academics, hoping that an answer can help improve the stability of the financial system and/or prevent future crises. Although a broad body of research has been able to provide a number of answers to this question, many aspects remain unresolved. After all, the bank failures during the recent financial crisis of 2007-2010 have shown that the gained knowledge about bank defaults is apparently still not sufficient to prevent large numbers of banks from failing. Most studies of bank default have focused on the influence of accounting variables, such as capital ratios, with some success (e.g., Martin, 1977; Pettway and Sinkey, 1980; Lane, Looney, and Wansley, 1986; Espahbodi, 1991; Cole and Gunther, 1995, 1998; Helwege, 1996; Schaeck, 2008; Cole and White, 2012).

However, almost no research to date has empirically analyzed the influence corporate governance characteristics, such as ownership structure or management structure, have on a bank’s probability of default (PD).1 This is perhaps surprising for two reasons. The first is the calls for corporate governance-based mechanisms to control bank risk taking during and after the recent financial crisis (e.g., restrictions on compensation and perks under TARP, disclosure of compensation and advisory votes of shareholders about executive compensation under DoddFrank, guidance for compensation such as deferred compensation,...
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