Bank Ownership and Risk Taking: Improving Corporate Governance in Banking after the Crisis

Abstract

Some have suggested that weaknesses in bank corporate governance played a prominent role in the recent financial crisis, most notably through poorly designed executive compensation packages and from various aspects of the public safety net that may have blunted the normal forces of market discipline. On the other hand, recent research has not led to a consensus on whether shortcomings in corporate governance contributed significantly to the crisis, and this research further indicates the difficulty of condensing corporate governance into a few simple and testable relationships. In this chapter, we examine key aspects of the corporate governance framework for financial institutions and discuss what they tell us about possible reforms and improvements in the wake of the financial crisis. Through the use of a unique data source and a sample of small banks, we are able to simultaneously account for the incentives and constraints that influence the major participants in a bank’s management and oversight. We find that the stock ownership by bank managers, their wealth diversification, the structure of managerial compensation, monitoring by directors and major stockholders, and the composition and characteristics of bank boards all have an important influence on the amount of risk taking in our sample banks. Used properly, tools such as ownership and compensation, monitoring, and other policies can help ensure that risk is managed within desired or acceptable parameters. In the end, we find that governance works best when managers, directors, and stockholders all have a significant personal stake in their decisions.