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The Corporate Governance of Banks Christian Harm University of Münster Agency Theory as a general theory of delegation The agency solution provides for incentives : Overpay in good times Underpay in bad times Versus an optimal risk-sharing contract

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The corporate governance of banks l.jpg

The Corporate Governance of Banks

Christian Harm

University of Münster

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


Agency theory as a general theory of delegation l.jpg

Agency Theory as a general theory of delegation

The agency solution provides for incentives:

Overpay in good times

Underpay in bad times

Versus an optimal risk-sharing contract

Does this really work? Empirical paradox!

The crucial assumption is that ‘x’ is costlessly measurable and divisible:

Money, Share price

Holmström, Bell Journal (1979):

The original model includes a principal and an agent.

The principal wants as much ‘x’ as possible.

The agent is supposed to achieve it.

The agent also wants ‘x’, but economizes on effort.

Effort is non-contractible and non-observable.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


Measurement costs may be just too large l.jpg

Measurement costs may be just too large

Then, ‘x’ is not necessarily measurable or divisible

Military contracting, NASA

Research

Annual report of a corporation

Ship building

Home construction

Contractors (Plumbers, carpenters, electricians … …)

Restaurant cooking

MacLeod, AER (2003):

Principal and agent may assess output subjectively

Different assessments induce conflict

Conflict costs overshadow incentive remuneration

Most people get paid on a fixed schedule!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Corporate Governance and Agency Theory

Tirole, Econometrica (2001):

Shareholder Value Maximization provides a clear mandate, but may impose too many externalities on other stakeholders!

Incentives work <only> for well-defined tasks of delegation

Maximizing Shareholder Value is well-defined

But is it appropriate?

Agency Theory doesn’t address the problem of who is supposed to get property and (thereby) governance rights.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Legal Scholars’ view on the firm

Frank Easterbrook (U of Chicago, 1982):

Shareholder value maximization

Henry Hansmann (Yale U, 2005):

Entity Shielding!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Why entity shielding?

If the firm can be liquidated at no cost, why protect it?

It needs to be protected if there are rents accruing to the firm, but not necessarily its stakeholders.

Oligopoly Rents

Illiquid assets and specific investments

If many stakeholders have made specific investments in the firm

and

If the firms assets are specific and / or illiquid

No one stakeholder should be allowed to pull out at an opportune moment!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Property and Governance Rights

Oliver Williamson (Berkeley U, 1975):

Suppliers and Customers (Vertical Integration)

Since Equity is the most junior and least well-defined claim, it is the obvious candidate as owner of property rights.

If other stakeholders are similarly tied to the firm, they will demand to share property rights!

Stephen Prowse: Depositors <through regulators>

Christian Harm: Creditors generally (SUERF 2002)

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Governance Summary

Property rights in the firm typically rest with equity, but can be allocated to more than one stakeholder group.

E.g.: Equity and debt define a hierarchy of property rights.

But: the more spread out the property rights among different stakeholders, the less clear the objective of the firm.

The less clear the objective of the firm, the more difficult to define managerial incentives, the less appropriate stock options.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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The banking firm

Ross Levine (Brown U, 1992 and onward):

The financial sector is a pivotal foundation of economic growth.

Illiquid assets imply entity shielding.

High leverage implies strong governance interests of depositors.

Other stakeholders?

Closing a bank can impose significant externalities on society!

E.g.: Chilean Banking Crisis!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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The sad world of banking

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Debt and Equity Governance: but how?

The stakeholder character of the banking firm implies a more hazy definition of the objective function for managers.

In ‘hands on’ governance, there is more ‘subjective’ evaluation, both for regulators and board members.

Hüpkes, Quintyn and Taylor (2005):"in some circumstances, the RSAs might decide to forego formal enforcement action in favour of cooperative compliance, while uncooperative, intentional violators may be dealt with strictly"

Demb and Neubauer (1992): “We do not know what directors are supposed to do; we only know that they are supposed to do it ‘with care’.”

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Bank Managers: Objectives for success and risk

With strong regulatory interest, bank managers ought to maximize firm value, not shareholder value.

Expand bank managers fiduciary duty to depositors!

Shareholder value can be both good and bad for depositors:

Charter value

Call option value of equity

Evidence:

The higher charter value, the less responsive managerial risk-taking to option value incentives (from own equity holdings or option incentive packages).

How to reward charter value?

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Competition and Charter Value: a Paradox?

H0: Competition is bad for charter value, at least in the short run.

Evidence on providing charter value through anti-competitive regulation: X-inefficiency outweighs incentives for prudence.

Why?

Even the most liquid debt markets are supported by reputation!

Issues reputation with syndicate loan lead manager

Bond issue lead manager with institutional investors

Reputational equilibria provide barriers to entry!

Competition among financial institutions renders an oligopolistic market structure almost by itself.

Charter Value follows as a consequence.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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How to incentivize bank managers

Principle: reward charter value, discourage option value.

Option awards are legitimate as long as they reflect charter value.

But: for regulators, too aggressive option award schemes may serve as a red flag.

Evidence: bank managers’ pay-performance sensitivities are lower than in industry.

And: bank managers receive more complex performance rewards based on achievements of more general objectives.

If bank-client relationships are the source of charter value, reward progress in customer loyalty! Operating rather than financial goal.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Summary

Banks are the epitome of institutions eligible for a stakeholder rather than shareholder approach.

Hence, bank managers’ objective functions less well-defined.

Incentives do not work as well with bank managers. Options should largely be given to reflect charter value (but how?)

Especially in banks, hands-on governance is necessarily more subjective and discretionary.

McCarthyism is unavoidable!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Outlook

Why not ‘the corporate governance of financial institutions?

Mutual funds:

Liquid assets, no entity shielding

Investment banks:

Comparatively little tied-up capital, no creditor governance

Insurance companies:

Possible exception, since insurance promise to customers is a contingent liability. But assets tend to be largely liquid.

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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Corollary: regulation of consumer interests

E.g.: asset management, investment advice

Prudential consumer issues for ‘honesty’ inhabit a similar space as toxic waste emissions, or corrupt practices.

Such issues are typically dealt with through

-Competition

-Law

-A regulator, which typically does not have governance rights in the firm (although they may have inspection rights in a domain relevant to their mission).

Hence: stakeholders solve externality problem through contract!

SUERF Seminar, Nicosia, Cyprus; March 29-30.

Christian Harm, University of Münster


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