1 Post-crisis Banks’ Corporate Governance Xavier Freixas Universitat Pompeu Fabra and CEPR 1

2 Outline The crisis’ impact Financial institutions’ corporate governance Banks’ bail-out/liquidation process 2 The crisis’ impact

3 The crisis impact Banks criticized for the size of their managers’ bonuses What mechanisms to discipline banks’ management? What banks’ incentives A failure of regulation or a corporate governance failure?

4 Pay out policy Executive compensation Dividend policy Why pay out policy is symptomatic of inadequate corporate governance

5 Outline The crisis’ impact Banks’ bail-out/liquidation process 5 Financial Institutions’ corporate governance

6 What is different about banks? Banks’ leverage –Higher leverage –Speedily modified leverage Opaque assets Long assets and short liabilities Heavily regulated

7 Who are the banks’ stakeholders? Shareholders Subordinate debt holders Debt holders Uninsured depositors Deposit Insurance Company Taxpayers

8 Subsidizing the cost of bank debt Insured deposits Implicit guarantees The safety net Political economy of bank lending

9 Implications Excessive risk taking Compensation based on current profits not on expected profits –Mark-to-market accounting and incorrect provisioning –Off balance sheet –“Fake alpha”

10 Corporate Governance in Banks Set corporate objectives and operate the bank’s business on a day to day basis (standard) Meet the obligation of accountability to their shareholders and take into account the interests of other recognized stakeholders. Align corporate activities and behavior with the expectation that the bank will operate in a safe and sound manner Protect interests of depositors. (BCBS, 2006)

11 What is different about banks corporate governance? Adams and Mehran (2003): –BHC have larger boards –higher percentage of outside directors –meet more frequently –lower percentage of option pay to salary – institutions hold smaller percentages of BHC shares (Limited power of block holders, low level of investors’ activism)

12 A vicious circle Depositor protection and the objective of credit expansion lead to subsidized risk- insensitive banks’ debt Banks have an incentive to –Increase leverage –Take higher risks –Engage in regulatory arbitrage through financial innovations Which leads to additional regulation to protect depositors and expand credit

13 Outline The crisis’ impact Financial Institutions Corporate Governance 13 Banks’ bail-out/liquidation process

14 Bankruptcy procedures Private –Reverse convertibles –Redefinition of stakeholder rights –Living will Public –Nationalization –Bridge bank –Good bank/bad bank (The Swedish 92 crisis)

15 To conclude Banks have reacted to the incentives the regulator has set. Subsidized cost of funds implies banks’ risk taking Changing the bankruptcy rules so as to limit the implicit and explicit guarantees will lead to take into account the effective cost of funds and change the banks’ strategies. The alternative, regulatory escalade would be a terrible mistake.