Board (In)Competence and Crisis Performance · Subprime Crisis and Board (In-)Competence: Private vs. Public Banks in Germany Unfortunately, we do not yet know the first and last

Subprime Crisis and Board (In-)Competence:Private vs. Public Banks in Germany

Unfortunately, we do not yet

know the first and last digit

of this number ….

Harald HauINSEAD

www.haraldhau.com

Marcel ThumTU Dresden, Ifo Dresden, CESifo

1

Quote from the Financial Press:

“The more interesting point is whether it is accidentalg pthat all the German banks in trouble are essentiallypublicly owned. [...] The episode tells us, once again,that Germany has too many banks and in fact toothat Germany has too many banks, and in fact, toomany bankers. Most of the supervisory board membersof these institutions are themselves financially illiterate

f fand do not fully understand the ins and out ofinvestments in new financial instruments, such as CDOsor CDS. They have failed to implement proper risky p p pmanagement systems - something which a private bankcould ill afford.” (Wolfgang Münchau, 2008)

© Harald Hau, INSEAD 2

Evidence from Germany

Crisis performance of private and state banksp p

Evidence on board competence

Nexus of board competence and crisis performance

CEO Pay and crisis performance

Summary and policy conclusions


Our Sample

Largest German banks with more than 40 billion in total assets13 state-owned banks (mostly ‘Landesbanken’)( y )16 private banks

Small sample allows a detailed qualitative analysis of supervisory board compositionboard composition

Corporate governance literature mostly about formal aspects of boards (board size, director independence, etc.)Here: board competenceHere: board competence

Differences in governance quality are conditioned by state ownershipSt t d i t b k t i titi i tState and private banks operate in same competitive environment (natural experiment)


Did State-Owned Banks Perform Worse?

4.0

4.5

3.0

3.5

es)

1 5

2.0

2.5

log(

Loss

e

Private Banks

0 5

1.0

1.5Public Banks

0.0

0.5

4.0 4.5 5.0 5.5 6.0 6.5


log(Assets)

Did State-Owned Banks Perform Worse?


State Banks and their Performance

Underperformance of state banks is economically large: Around 200% larger lossesNon-parametric test also highly significantEvidence based on total reported losses Q1-2007 to Q3 2008Q3-2008

What are plausible explanations?


Evidence of Differences in Bank Governance?

Develop proxies for governance qualityDevelop proxies for governance qualityHow competent are bank boards?Evaluate 593 supervisory board members alongEvaluate 593 supervisory board members along 14 binomial criteria

Are State and Private Bank Boards Different?Create competence metric and evaluate each supervisory board member in the 29 largest German banks

Educational Measures:Educational Measures:E1: Business/Economic Degree?E2: MBA Degree?E3: PhD Degree?

Finance Experience Measure:F1: Bank experience?F2: Financial market experience?F3: Financial market experience after 1990?F3: Financial market experience after 1990?F4: Financial market experience in same bank?F5: U.S. Financial market experience?F6: U.S. Financial market experience after 1990?

Management Experience: M1: Consulting experience?M2: Mid-level management experience?M3: Top level financial management experience?


M3: Top-level financial management experience?M4: Top-level financial management experience in same bank?M5: Multiple board memberships?

Competence Metric for an Average Board Members

Sum of indicators in each dimension is scaled to a maximum value of 103.5

Private Banks

2.5

3.0Public Banks

1.5

2.0

0.5

1.0

0.0Education

IndexFinancial

ExperienceManagement Experience

Total Index


Index Experience Index

Experience Index

Index

Why are Average Competence Levels so different?


Are State and Private Bank Boards Different?

Private banks board members show (significantly) higher average competence in ( g y) g galmost all of the 14 dimensionsFocus only on owner representatives gives same resultDifference particularly strong for financial experience measures (F1-F6): ‘‘Financially illiterate boards for state banks’’


Is there a Governance Performance Nexus?

Does poor board competence translate intoDoes poor board competence translate into higher crisis losses?Need to control for bank size in performance pevaluation

Nexus of Board Competence and Crisis Performance

© Harald Hau, INSEAD 14Note: Bootstrapped t-values are in blue

Nexus of Board Competence and Crisis Performance

2.0 Private Banks

1.5

sets

)

Public Banks

1.0osse

s/A

ss

0.5log(

1 +

L

0.0


0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Financial Market Experience (AIF)

OLS Regressions


Note: Bootstrapped t-values are in blue

Endogeneity Issues

What drives board composition?CEOs might have a large influence on board compositionCEOs might have a large influence on board composition => Board competence becomes endogenousBut for state banks: Number of political appointments may be exogenous and determined by public ownershipState ownership as a driver of board composition makes the endogeneity problem less virulentthe endogeneity problem less virulentPossible Instruments: State ownership and number of political appointments in board


IV Regressions


Executive Pay and Crisis Performance


Executive pay correlates positively with crisis loss

Summary of the German Evidence

State banks underperformed in crisisState banks have financially illiterate boardsState banks have financially illiterate boardsBanks with financially illiterate boards have higher crisis losses

Other insights?

No evidence that board competence – crisis performance nexus is driven by reverse causalityNo evidence that state banks under-perform because of executive pay p p yconstraintsSome evidence that higher executive pay correlates with higher bank losses


Policy Implications

State ownership can be a big liability when is comes to financial stabilityy

Large share of world banking sector is still state controlledPrivatize banksAdverse governance effects of crisis related nationalizationsAdverse governance effects of crisis related nationalizations

Better bank governance is a legitimate concern for bank regulation

Standards for board competenceBetter governance requires better market informationExtend exchange trading of credit risk instrumentsExtend exchange trading of credit risk instrumentsExecutive training for bank boards?


Documents

Board (In)Competence and Crisis Performance · Subprime Crisis and Board (In-)Competence: Private vs. Public Banks in Germany Unfortunately, we do not yet know the first and last