For many year the CG of banks was approached as CG if they were manufacturing companies;

Especially after the financial crisis, it became clear that this is not the case: if they go bankrupt, for
example, they can create a bomb in the stability of the financial system.

The smartest guys in the room → movie.

What is special abt CG in banks?

1. Conflict of interest:
a. Agency problems arising from the separation of ownership and control
b. Agency problem between SH and DH, the #1 conflict of interest:
2. Because of these different agency problems, we have 2 main consequences:
a. Some governance problems can be amplified
b. Interaction of the two different conflict of interest, which might limit the
effectiveness of standard CG mechanisms put in place to limit one of the two:
i. CEO compensation is a mechanism that has been used to give incentives to
CEOs to align them w/ SH’s interest, but might create negative externalities
bc of the interaction w/ DH.

Research Questions:

1. Difference w/ manufacturing firms

2. How does features and CG in banks interact
3. Need for regulation
4. Differences in managerial incentives, which might be more appropriate in banks and which
spill-over effects might have.

Difference w/ manufacturing firms

Given by the differences in agency costs, namely that between SHs and DHs.

Capital structure: most of the funding is in the form of debt; in a bank’s BS the main providers of
capital are DHs and depositors. It means that banks are highly leveraged institutions, where the
leverage is the ratio of debt to equity → abt 80%. This is consistent with their role of intermediaries
between lenders and borrowers.
When managers invest in a risky project, if successful, the project will produce large benefits for
the SHs, while DHs will receive a fixed yields; if the project is not successful, however, DHs will
bear the majority of the cost, because DHs are the primary providers and bc if the bank goes
bankrupt, they might not receive back their money, while SHs simply walk-away.

This poses some implications on the CEO compensation.

Regulations

Regulations vary across countries, but nonetheless, there are common points:

 Restriction of ownership structure (and dispersion of shares on the market)

o Dispersed of not
o Type of majority SH allowed.
 I.e., given the different stakeholders, if the major one is the State, the type of
interests are completely different from a family, or a cooperative.
 Capital requirements
 Deposit insurance, especially after the last financial crisis
 Mandatory standards for the quality of the board and management
 Governance variables
o Laeven and Levine:
 Ownership Concentration: if there are restrictions on governance structure
i.e., a cap on number of shares that can be on the market, it is easy to see how
the market for corporate control will be weakened, because the ownership
structure is concentrated and there is no possibility of takeovers
 Deposit insurance, reduces the incentive of depositors to monitor banks,
although it is thought of in a positive fashion for depositors
 Complexity and opaque activities: bank activities are, at the board level,
very complex and opaque. Opacity is related to timing: usually, in every
bank, loan quality is assessed by middle-management; if the loan are
particularly risk/costly, also the BoD makes an assessment. But loan quality
might be not readily-observable: if a firm today asks for a loan to a bank, it
will be evaluated by middle-management; the BoD, on the other hand, meets
only six to seven times per year, which means that loan quality assessment
will take time: BoD will be able to evaluate quality only months later. I.e.,
the real risk-profile might be only understandable after some time.
I.e., monitoring is made much more complex.
Again, incentives: which kind of incentives are the most appropriate for
banks?
Stock-options? They have been (and still are) largely used in manufacturing
companies, but wrt banks, we should also evaluate appropriateness: what are
the consequences of linking CEO compensation w/ bank firm performance?
Ofc, performance is important: the majority of banks are listed, market reacts
to their performance, and to governance changes, but shareholders are not
the end of the story. We need to go beyond. Most people suggest to link
CEO compensation w/ debtholder interest or to capture the risk-profile
of the bank.
Personal insights

 Focuses solely on CEO-Shareholder alignment, not Agency cost with debt-holders

 Does not investigate Causality.

Working paper John, Kose; Mehran, Hamid; Qian, Yiming (2007) : Regulation, subordinated debt,
and incentive features of CEO compensation in the banking industry

(1) the pay-for-performance sensitivity of bank CEO compensation decreases with total leverage;
(2) the pay-for-performance sensitivity of bank CEO compensation increases with the intensity of
the outsider monitoring by regulators and subordinated debtholders.