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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
Ior the Consultative OECD/World Bank
Meeting on Corporate Governance
December 6-7, Hanoi, Vietnam

:tline of presentation
W Why care in general about corporate
governance (CG)?
W Why care speciIically about the CG oI banks?
W What is special about CG oI banks?
W What does this imply Ior bank CG,
regulation/supervision?
W What do we know about CG oI banks?
W mplications Ior CG oI banks

Why care abo:t corporate


governance?
Corporate governance matters Ior development
1. ncreased access to Iinancing investment,
growth, employment
. Lower cost oI capital and higher valuation
investment, growth
. Better operational perIormance better
allocation oI resources, better management,
creates wealth
4. Less risk, at the Iirm and country level Iewer
deIaults, Iewer Iinancial crises
5. Better relationship with stakeholders
improved environment, social/labor
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Why care abo:t corporate
governance?
W All oI these relationships matter Ior growth,
employment, poverty reduction
W Empirical evidence has documented these
relationships
W At the level oI country, sector and individual Iirm and
Irom investor perspective using various techniques
W "uite strong relationships
W But so Iar mainly documented Ior non-Iinancial
corporations that are listed on stock exchanges
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ccess to financing: better creditor rights
and r:le of law lead to
more developed credit markets
0
0.1
0.2
0.3
0.4
0.5
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0.9
1 2 3 4
Creditor Rights * RuIe of Law
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ccess to financing: higher q:ality of
shareholder protection leads to more
developed stock markets
0
10
20
30
40
50
60
70
80
Market capitalization/GDP
percent
Lowest quartile
(lowest ranking
in shareholder
and rule of law)
Highest quartile
(highest ranking
in shareholder
and rule of law)
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Weak corporate governance translates into
higher cost of capital
0
0.05
0.1
0.15
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0.5
0.
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1 4 5 6
Eq:ity Rights
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Excludes Brazil

Better corporate governance translates into


somewhat higher ret:rns on assets
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4
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6
7

1 4 5 6
Eq:ity Rights
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Excludes Mexico and Venezuela

B:t m:ch better higher ret:rns on


investment relative to cost of capital
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Eq:ity Rights
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Why care abo:t CG of banks? (I)
W Banks are corporations themselves
W CG aIIects banks` valuation and their cost oI
capital. CG oI banks thereby aIIects the cost oI
capital oI the Iirms and households they lend to
W CG aIIects banks` perIormance, i.e., costs oI
Iinancial intermediation, and thereby the cost oI
capital oI the Iirms and households they lend to
W CG aIIects banks` risk-taking and risks oI Iinancial
crises, both Ior individual banks and Ior countries`
overall banking systems
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Why care abo:t CG of banks? (II)
W Bank behavior inIluences economic outcomes
W Banks mobilize and allocate society`s savings.
Especially in developing countries, banks can be very
important source oI external Iinancing Ior Iirms
W Banks exert corporate governance over Iirms,
especially small Iirms that have no direct access to
Iinancial markets. Banks` corporate governance gets
reIlected in corporate governance oI Iirms they lend to
W %hus, governance oI banks crucial Ior growth,
development
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What is special abo:t CG of banks? (I)
W Banks are 'special, diIIerent Irom corporations
W Opaque, Iinancial inIormation more obscure: hard to
assess perIormance and riskiness
W More diverse stakeholders (many depositors and oIten
more diIIuse equity ownership, due to restrictions):
makes Ior less incentives Ior monitoring
W Highly leveraged, many short-term claims: risky,
easily subject to bank runs
W Heavily regulated: given systemic importance, as
Iailure can lead to large output costs, more regulated
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What is special abo:t CG of banks? (II)
W Because special, banks more regulated, with
regulations covering wide area
W Activity restrictions (products, branches), prudential
requirements (loan classiIication, reserve reqs. etc)
W #egulations oIten more important than laws
W Government, instead oI depositors, debt or
equity-holders, takes role oI monitoring banks
W Power lies with government, e.g., supervisor,
deposit insurance agency, central bank
W #aises in turn public governance questions
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What is special abo:t CG of banks? (III)
W Banks enjoy beneIits oI public saIety net
W Banks, as they are oI systemic importance, get
support, i.e., deposit insurance, LOL#, and other
(potential) Iorms oI government support
W Costs oI support provided oIten paid Ior by
government, i.e., in the end taxpayers
W mplies banks less subject to normal disciplines
W Debt-holders less likely to exert discipline
W Bankruptcy is applied diIIerently or rarer
W Competition is less intense as entry restricted
W Public saIety net is large, creating moral hazard
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What is special abo:t CG of banks? (IV)
W Same time, banks more subject to CG-risks
W Opaqueness means scope Ior entrenchment, shiIting
oI risks, private beneIits and outright misuse
(tunneling, insider lending, expropriation, etc.)
larger than Ior non-Iinancial Iirms
W As Ior any Iirm, bank shareholder value can
come Irom increased risk-taking
W Shareholder value is residual claim on Iirm value
W ncreased risk-taking raises shareholder values at
expenses oI debt claimholders and government
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$t:dies on CG of banks:
monitoring and risk
W Banks are indeed more diIIicult to monitor
W Moody`s and S&P disagreed on only 15 oI all
non-Iinancial bond issues, but disagreed on 4
oI all Iinancial bond issues
W Banks are more vulnerable
W #ecessions increases spreads on all bond issues,
but increases spreads on riskier banks more than
Ior non-Iinancial Iirms
W Partly result oI a Ilight to saIety, but also greater
vulnerability oI banks compared to non-Iinancial
Iirms
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$t:dies on CG of banks:
bank failings and financial crises
W n practice, banks with weak corporate
governance have Iailed more oIten
W Accrued deposit insurance, good summary measure
oI riskiness oI banks, higher Ior weaker CG
W State-owned banks enjoy even larger public subsidy,
that is oIten misused: poor allocation, large NPLs,
e.g., ndonesia, South Korea, France, %hailand,
Mexico, #ussia
W Fiscal costs oI government support up to 50 oI
GDP, large output losses Irom Iinancial crises
W Countries with weaker corporate governance
and poorer institutions see more crises
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igher c:rrency depreciation in weaker
corporate governance co:ntries d:ring
periods of stress

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What does this imply for bank CG and
reg:lation and s:pervision?
W "uality oI bank CG interIaces with supervision
and regulation
W More eIIective banks` CG can aid supervision since
with better CG, banks can be sounder, valuations
higher, thereby making supervision easier
W Good CG-Iramework can make bank regulation and
supervision less necessary, or at least, diIIerent
W Need to consider thereIore bank CG and
regulation and supervision together
0
What does this imply for bank CG and
reg:lation and s:pervision?
W %wo approaches to CG and supervision
W Basel: capital standards and powerIul supervisors
W Market Iailures/externalities, so need regulations
W Empower private sector through laws & inIormation
W Market Iailures, but also government Iailures
W Approaches not mutually exclusive
W What is best mix oI private market and government
oversight oI banks? What does this imply Ior bank
CG?
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What do we know abo:t CG of banks?
W So Iar, little evidence on the standard CG-questions and
more complex issues oI CG and regulation/supervision
W Some have documented eIIects oI bank ownership
W LSV/BCL: banking systems with more state-ownership: less
stable, less eIIicient, worse credit allocation
W More Ioreign banks: more stable, eIIicient, competitive eIIects
W Few so Iar investigated bank governance
W Many studies on eIIects oI laws & regulations Ior corporations
W But Iew on banks, except Ior recent evidence Irom Caprio,
Laeven, and Levine

Bank ownership: possible ownership


and control patterns
W Widely-held, not-controlled by any single owner
W Controlling owner
W Family (individual)
W State
W Widely-held (non-Iinancial) corporation
W Widely-held Iinancial institution
W Other (trust, Ioundation, which may be 'shell)
W With small or large deviations oI control rights
Irom ownership (cash-Ilow) rights

ifference between ownership


and control
W Controlling owner vs. widely-held bank
W Controlling owner iI direct indirect control ~ (say) 10
W Widely-held iI no entity owns ~ 10 directly indirectly
W &ltimate owners versus direct owners
W I any major shareholders are (F/NF) corporations, then Iind
their major shareholders. Continue until ultimate owners
W Example: Shareholder has x oI indirect control over
bank A iI she controls directly Iirm C that, in turn, controls
Iirm B, which directly controls x oI bank A. Control
chain can be long
W Controlling owner if any if any will be the one with the
maximum direct indirect control
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wnership and control do deviate
ontrol vs ash-flow rights
reland anada
Australia
UK
United States
Norway Sweden
Germany
Japan
taly
Keyna
Sri Lanka
DenmarkEgypt
Spain
Jordan
Singapore
Taiwan
S. Korea
Venezuela
Malaysia
Philippines
;erage
Greece
S. Af rica
Zimbabwe
France
Pakistan
srael
olombia
Portugal
Netherlands
hile
Switzerland
HK
Austria
Thailand
Finland
Mexico
Turkey
Peru
ndia
ndonesia
Brazil
Argentina
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Bank control varies greatly
internationally
wnership Structures
0%
20%
40%
60%
80%
100%
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WideIy FamiIy State Fin Corp ther
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Bank control internationally
1) Banks are generally not widely-held
) Family ownership oI banks is very important,
and so is the state ownership
) Cross-country diIIerences are large, though
W n 14 oI 44 countries, the controlling owner has more
than 50 oI voting shares. But in Australia, Canada,
reland, &K, and &S, either NO bank has a
controlling owner or the average is less than
4) Legal protection oI shareholder is associated
with more widely-held banks, i.e., with better
legal protection less need/desire Ior close control
CF Widely Family $tate Fin Corp ther
Co:ntry mean 27.45 25 39 14 7 2 14

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Effects of control on firms and banks
W Some Iirm and bank owners can be better than others
W nsiders may expropriate Iirm resources
W Expropriation theIt, transIer pricing, asset stripping, nepotism, and
'perquisites that beneIit insiders
W Ownership & shareholder protection laws value
W Cash-Ilow rights up expropriation less valuation higher
W Shareholder protection laws better valuations up
W nteractions between ownership & protection valuation
W Are banks diIIerent?
W Laws insuIIicient with powerIul, complex, opaque banks?
W #egulations: laws superIluous or superceded?
W #ole oI ownership less important?

Val:ation and shareholder rights


W Valuation
W Market-to-Book Value: E
m
/E
b
W #ights: shareholder rights (0-6)
W (1) Mail proxy votes
W () Not required to deposit shares
W () Proportional representation oI minorities on board allowed
W (4) Oppressed minorities mechanism
W (5) Percentage Ior ESM 10
W (6) When shareholders have preemptive rights, they can only be
waived by a shareholders meeting

$:pervision and reg:lation powers


W OIIicial
W Power to change internal organization, management, directors, etc
W Power to supercede rights oI shareholders to intervene or close bank
W Power to meet, get reports, Irom, and take legal action against auditor
W #estrict
W #egulatory restrictions on banks (i) securities, (ii) insurance, (iii) real
estate, and (iv) owning non-Iinancial Iirms
W Capital
W #egulatory restrictions on source oI Iunds, BS minimum, risk-based,
are loan, security, FX loses deducted Irom capital, etc.
W ndependence
W Degree oI supervisory independence Irom government and banks
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Val:ation effects of bank ownership
and eq:ity rights
W When cash-Ilow rights oI controlling owner higher and equity
rights stronger, bank valuation higher. EIIects can be large:
W A one-standard deviation increase in shareholder protection laws (1.5)
raises market-to-book by 0., or 1 percent oI mean
W A one-standard deviation increase in cash Ilow rights (0.7) raises
market-to-book by 0.4, or 1 percent oI mean
W More cash-Ilow rights can even oIIset some oI negative
eIIects oI weak equity rights
W Suggests strong owners, both in share and in their rights, can
help corporate governance oI banks
W Surprising, perhaps, quality oI supervision and the degree oI
regulation does not robustly inIluence valuations
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Bank CG and val:ation
arket to Book VaIue and Equity Rights
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Implications for CG of banks


W Bank ownership
W Be very careIul on state ownership: negatively
related to valuation, stability and eIIiciency
W Consider inviting Ioreign banks
W Bank governance, reg:lation and s:pervision
W Strong private owners necessary, but they need to
have their own capital at stake
W Better shareholder protection laws can improve
Iunctioning oI banks
W Supervision/regulation less eIIective in monitoring
banks