The origins of the Global financial crisis of 2008 (GFC) can be traced back to the US subprime mortgage crisis which was triggered by the bursting of the housing bubble at the end of 2006.The speculative bubble was created by a demand in real estate in the US resulting in a drastic increase in property prices that were determined by speculative future expectations rather than sound economic foundations. Inevitably, there was an increase in interest rates and a rise in outstanding loans by borrowers who were unable to honour instalments of matured mortgages. Credit institutions and property owners proceeded to sell properties with liquidated mortgages below their market value, furthermore new houses which flooded the market did not sell at good prices.Banks and other financial institutions resorted to selling subprime mortgages to buyers who were not qualified or unable to honour their obligations.
The effect of the subprime crisis eventually spread and affected the European housing markets and led to the collapse of global financial systems, major banks, and other financial institutions in a crisis second only to the great depression. In August 2009, the IMF provided a figure of $11.9 trillion as the total cost of the crisis which was a fifth of the world’s total economic output.The global reach of the crisis was facilitated by the interdependency of financial systems in today’s economy.
Major financial institutions became victims of the crisis and became insolvent or were bailed out during GFC. The failure of these financial institutions raised eyebrows and questions as to whether the corporate governance mechanisms in place were sound.  Financial institutions developed high risk and innovative financial products such cheap mortgages and this put them at the centre of the debacle, it would only seem just that people who were affected by the crisis identified these corporations as the cause and questioned their corporate governance structures.
With this reasoning, the question must be asked as to what role corporate governance played in the financial crisis? This is the objective of this thesis. It is clear from the onset that the crisis itself represents a failure of corporate governance partly influenced by wrong trading decisions and meteoric rises of banks that often had an element of non-compliance of corporate governance. The soft approach taken by regulators at the time was indicative of a market that emphasized on self-regulation.
The Organization for Economic Co-operation and Development (OECD) concluded that corporate governance was partly the cause of the crisis. The organization acknowledged the existence of adequate corporate governance principles but concluded that a revision of the principles might be necessary. It also suggested that implementation of the existing codes and principles was lacking. This view though true to some extent is wanting because lack of implementation of the mechanisms themselves is a sign of failure of the current systems in place.
Corporate governance codes are soft in nature and adopt the comply or explain approach put forward by the Cadbury report.Under this approach companies can choose to comply with these codes by directly implementing the codes or by providing an explanation as to why they chose not to follow them. The codes in place merely set out expectations to be met by the companies rather than make them a requirement for them to be in place. Companies then opt to deviate through legitimate justifications that are accepted hence non-compliance to some extent can be interpreted as compliance.The comply or explain approach is twofold, first it is mandatory as companies are supposed to comply or explain as to why they have chosen not to, and second the codes represent a form of self-regulation or soft law.
The nature of the principle makes it desirable among companies because it is not fully mandatory nor fully voluntary. The approach however has some fundamental weaknesses. The primary concern is the quality of the response given by companies that have not complied with the corporate governance codes in place, the explanations given are perfunctory, inadequate, or generally void. Another concern is that the comply or explain approach may not be sufficient in jurisdictions that are not shareholder oriented like the US and the UK. This is because enforcement of the comply or explain approach is done by institutional investors and shareholders rather than regulators. However even in shareholder oriented jurisdictions there is a trend of shareholders being passive and not making the companies accountable for governance issues.The lack of or insufficient oversight by shareholders poses a problem for corporate governance enforcement.
The flexible nature of comply or explain approach has it merits however, it does not necessarily assure compliance of the codes. Hard law measures are more effective as they ensure compliance with a strict set of rules that affect all companies while taking into consideration the differences of different types of companies across the board.Hard law prioritizes the assessment and attainment of a solution to existing corporate governance issues unlike soft law which prioritizes on flexibility and part compliance of various and specific issues that affect different companies.
Corporate governance in banks and financial institutions has become an important topic for debate since the GFC evidenced by the systematic risks imposed by banking activities on the economy and its stakeholders. Majority of the literature on corporate governance is on non-financial institutions that traditionally use the agency problem as the foundation of analysis on corporate governance issues. Coincidentally, this will form the basis of the discussion in this thesis by identifying the shortcomings of the unique nature of bank corporate governance. The agency theory denotes that the principal is the owner/shareholder of the firm and the agent is the manager of the firm. Under this model the agent is supposed to ensure the maximization of profits for the shareholders as the primary objective. This model however falls short in this aspect as banking practices have an adverse effect on the depositors who are the primary stake holders and other secondary stakeholders in the economy.
Symptoms of the Financial crisis were manifested as early as 2007 when HSBC announced losses related to the subprime market followed by a string of bank failures in the United States and the European Union such as the nationalization of Northern Rock, the bailout of Bear Sterns and the government rescue of IKB in Germany and Roskilde in Denmark. The crisis however took a turn for the worst with the collapse of Lehman Brothers and AIG. This thesis will use the case examples of Bear Sterns, Lehman Brothers and Northern Rock as their failures had the biggest impact in the financial crisis and they were the largest banks in their respective jurisdictions.
Bear Sterns was a medium sized investment bank that played a crucial role as an underwriter of mortgaged-related securities, a big player in the secondary markets and a sponsor of various investment vehicles. Bear sterns pooled mortgages and issued mortgage asset backed securities. The income from these securities was divided into trenches with low risk senior claims and junior high-risk claims that were difficult to sell. Bear sterns opted to create collateralized debt obligations and sell them through special purpose vehicles. These undervalued high-risk securities were at the root of the financial crisis and stakeholders became increasingly cautious of firms that obtained short term debt to finance long-term illiquid projects. Bear sterns was eventually faced with a funding run and was eventually bailed out by the federal reserve bank and sold to JP Morgan.
The Lehman Brothers bankruptcy petition in 2008 was the largest in US history. Like Bear Sterns, Lehman Brothers obtained short-term debt to finance long-term projects. Despite the clear indication of devaluation of mortgaged-backed securities after the burst of the housing bubble, Lehman brothers continued to invest in more high-risk products with the expectation of high returns. Some of these securities were difficult to sell, and the sale of these securities at losses convinced investors and lenders these assets were overvalued and resulted in a funding run and Lehman Brothers were not able to maintain their highly leveraged operations a float. Unlike Bear Stearns which was bailed out by the Federal reserve, Lehman brothers did not share a similar fate and after failed attempts of seeking redress, it filed for bankruptcy.
Across the Atlantic, Northern Rock Bank which at the time was one of the largest mortgage lenders in the UK was soon hit by the tsunami that was the GFC. At its inception it relied on branch deposits to finance long-term investments. However, as its operations expanded It began to rely on non-retail wholesale funding in the form of securitized notes and interbank lending to fill in the difference left by loans that exceeded its deposits. The securitized notes were however consolidated into the main balance sheet unlike the US counterparts that used off-balance sheet vehicles. The problem was however not in the use of wholesale funding, rather it was the degree of reliance. Northern Rock was unable to roll over its liabilities and this coupled with the depositor bank run eventually led to its collapse.
The three banks had a common factor, they experienced a meteoric rise in growth facilitated by easy and cheap credit. Northern Rock experienced an annual growth rate of 23.2 percent from 17.4 to 113.4 billion pounds between 1998-2008.The use of debt enabled banks to increase their debt-equity level resulting in a significant rise in leverage. The three banks reflect the situation in some banks where debt was a key component of funding growth and while this move initially resulted in an increase in value for the shareholders, there was an over reliance of credit markets banks several studies have focused on accounting based reasons to explain why banks fail.  However, there has been little scholarship to critically analyse the corporate governance characteristics such as ownership and control, management structure and remuneration and their influence of bank failure. The G30 In their Special report stated: “In the wake of the crisis, financial institution (FI) governance was too often revealed as a set of arrangements that approved risky strategies (which often produced unprecedented short-term profits and remuneration), was blind to the looming dangers on the balance sheet and in the global economy, and therefore failed to safeguard the FI, its customers and shareholders, and society at large.”
This sentiment is not only echoed by this thesis, but by other critics who called for a reform of corporate governance mechanisms to control bank risk taking after the GFC.As the case study above among the three banks reflects, risk taking is a common denominator. It is then surprising there hasn’t been sufficient literature to address this.
A study by Berger et al (2016) of 85 failed commercial banks and a control sample of 256 non-failed commercial banks based in the US between 2007-2010 found that failed and non-failed banks have a significant difference in ownership, remuneration, and management structure. They found that non-executive directors and managers held a significant amount shares than in non-failed banks and this increased the probability of bank failure. They also found that all members of the management received a small fraction of their compensation in stock options in failed banks, also all managers except for the CEO and high-ranking managers received significantly smaller annual bonuses in failed banks. Finally, they found that bank CEO’s who had a shareholding interest did not have a direct impact on the probability of bank failure. This is because CEO’s being the public figure heads of companies are less likely to have the risk-taking incentive and are likely to be held accountable in the event of a bank failure whereas the anonymity of other mangers enables them to take on more risk.
The results of their study confirm the moral hazard analysis discussed later in this paper that shareholders who have deposit insurance security are more likely to inefficiently take on excessive high risk. Similarly, managers who have a shareholding and controlling interest are likely to take on more risk. Another conclusion that can be drawn from their research is that most CEO’s earnings originated from hefty bonuses. These bonuses increased even though banks were in a declining phase. In January 2009 President Obama called financial institutions “shameful” for awarding bonuses amounting to $20 billion while the economy was on the decline and the government was spending billions in tax-payer money to bail out financial institutions.
Corporate governance is a structured mechanism that directs and controls the operations of a company. This structure specifies the roles and responsibilities of individuals who have an interest in the company such as the board, managers and stakeholders and sets out the rules and procedures for decision making on matters that affect the company.This definition has been widely accepted in non-financial companies however in recent years, banks have become the subject of scrutiny after the GFC. The success of this form of governance is premised on the appropriate execution board duties and shareholder oversight which will eventually lead to maximization of profit and shareholder protection.
Corporate governance of banks is however unique and different from the general form of governance due to the nature of banks as leverage institutions. Unlike non-financial firms, over 90 % of the bank balance sheets consist of debt which constitutes most of their funding.traditional corporate governance structure cannot be used to adequately address governance issues in banks due to the unique nature of banking practices. These practices have an element of opacity and often, banks can take on risk spontaneously through methods that are not immediately supervised by directors, outside investors, or shareholders. The opacity problem is further compounded by the innovative and evolving nature of technically complex trading activities and financial structures that can only be monitored by specialists who are scarce.
Furthermore, the development of securitization as a way for banks to pool together future debts and sell them as collateral for third party investment in the form of asset backed securities or mortgage backed securities through holding companies which act as special purpose vehicles has added a layer of complexity in banking practices as banks are able to acquire cheap capital and offset liabilities from their balance sheets. Securitization is especially critical as the bursting of the housing bubble in the US was attributed to cheap mortgage backed securities that did not have sound collateral. Since oversight is an essential feature of corporate governance, it comes short in opaque and complex banking practices where it is especially needed the most due to the risky nature of banking practices.
Another difference comes in the shareholder oriented law, predominant in the Anglo-American jurisdictions which governs company regulation practice is modelled in a way that protects and prioritizes the interests of the shareholders. The company law when applied to banks can work against stakeholders such as depositors, institutional investors, and the economy because managers have a legislatively imposed duty to the prioritise shareholder interest. This presents a problematic characteristic of the principal-agent theory. Furthermore, fiduciary duties also arise out between directors and shareholders which raises additional agency costs and raises a conflict of interest since banking practice tends to involve a lot of stakeholders.
It can be concluded that the fundamental thing that makes banks different from other institutions is the liquidity production function and their status as leveraged institutions. “By holding illiquid assets and issuing liquid liabilities, banks create liquidity for the economy.”This is an essential role especially when large financial institutions are involved can have adverse effects on the economy because banks can hold a certain amount of deposits at a given time. This becomes a problem because unlike other institutions that primarily finance themselves through equity, in comparison banks have relatively little equity and obtain most of their capital through debt that Is mainly composed of deposits which are normally available on demand.
This because of maturity transformation. Banks use liquid short-term debt to invest in risky illiquid projects with long-term returns through diversified loans and investment portfolios and incurring the cost of monitoring investments. This maturity mismatch leaves banks open to liquidity risk regardless of sound bank operation. It is this unique nature that makes them particularly vulnerable to a collective-action, for instance in the case of bank-runs when a deficiency in deposits and an increase in liabilities makes them insolvent.
Regulation however comes in and provides a safety nets that provide some level of confidence in depositors in the form of deposit insurance schemes and minimum capital requirements required to start up and run a bank. This however can have the opposite effect as it can substantially affect the behavior of directors, managers and shareholders through taking increased risk which negatively exposes the stakeholders of the bank especially with depositors.
The high number of parties with an interest in a bank makes it difficult to govern them in a manner that meets the expectations of every stakeholder. The Insolvency, bankruptcy or collapse of banks has a wide effect on the socio-economic environment. Failure of these banks leads to social expenses, change in the political and legislative environment and a negative effect on the economy. The conflict eventually gives rise to the agency problem which is used by most literature as the foundation of analysis. However, as the next chapter will show, the traditional principal-agent problem model is not suitable for banks and other financial institutions. 
The agency relationship was defined by Jensen & Meckling (1976) in their famous paper The Theory of the Firm as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent.”
The agency problem arises out of this principal-agent relationship. The problem materializes when interests of the agent and the principal do not align and the principal cannot monitor the actions of the agent. It is this state of obscurity that results in the agency problem. There are three main types of agency problems in banking; (a) between management and shareholders;(b) between management shareholders and debt holders; and (c) between management, shareholders and financial regulators/society. The agency problem in banking is unique as the added inclusion of regulators and the society adds a different dimension from the general agency problem affecting non-financial institutions. The problem proves to be more problematic because banks/managers are pressured to meet the needs of every stakeholder without adversely affecting the other. It is then apparent that a working balance must be maintained and Coincidentally, this last form of agency problem is not well researched unlike the other two.
Banks by their nature owe no duty of care to the society and economy at large however, it is clear that their activities can have an adverse effect on the society through social costs as described in this paper. How can the balance be maintained? The government fills this void through prudential regulation to ensure there is a balance between stakeholder interests. The main role of prudential regulation is to ensure the sound functioning of the financial market and its participants and to ensure the banking business is carried out in a way that prevents any adverse effects on the stability of the financial system. This has traditionally been done through measures such as deposit insurance, capital adequacy requirements, asset composition rules and ethical standards for bank officers. This seems to be secure on the face of it however the problem is more complicated.
The main issue with the Principal-agency problem in banks is the misalignment of interests between managers, shareholders, creditors, stakeholder customers and borrowers. This may take the form of difference in risk preference. Shareholders and managers might prefer high risk short-term investments to ensure expeditious returns, other stakeholders such as creditors and borrowers might prefer long-term low risk investments that are more secure and have a long-term sense of stability.
The nature of the agency problem leads to a moral hazard where a party behaves in a manner that is differs from what it’s supposed to do. The moral hazard can arise out of several situations. Banks being limited liability institutions means shareholders have an incentive to expropriate maximum profit from stakeholders such as depositors. Managers who have an interest in the company e.g through stock based compensation have an incentive to expropriate wealth from its shareholders and stake holders. Because of the nature of limited liability, losses will eventually be shared among the relevant stakeholders. The pursue of these personal interests gives rise to the moral hazard.
The moral hazard between shareholders and mangers can take a different perspective. According to studies by Gorton and Rosen (1995), managers will aim to protect future investments in the face of losses. They argue that managers will indulge in excessively high-risk actions to convince shareholders that the bank is sound when in reality it is in a declining phase. In contrast, other studies have argued that shareholders get an incentive to take on more risk when the value of the bank declines in an attempt to recover losses. These studies from the 80’s argue this was the main explanation to the decline in banks and bank failures. However, this hasn’t changed today and as the recent GFC shows, the failure banks can be explained in the same sense.
There also exists a moral hazard between managers and stakeholders in the asymmetry of information as depositors do not have access to information that will enable them to assess risk associated with assets in the bank portfolio, and even if they did most of them would not be able to understand the information due to the complex nature of banking activities.
Deposit insurance provides a safety net and confidence in depositors that should there be a crisis, their funds will be secure, this creates a deposit insurance moral hazard between depositors and regulators. This sense of security results in the reluctance of shareholder supervision by depositors to prevent them from increasing risk. The laxity in supervision is further compounded as shareholders aim to maximize on the deposit insurance provided by the government by encouraging managers to take on high risk inefficiently.
Deposit insurance however brings up an entirely new form of moral hazard. Because the deposit insurer is responsible for acting as a representative of the tax payer and bearing the risk involved with increased risk taking by managers and shareholders, it can be argued that deposit insurers do not have incentive to efficiently monitor risk taking. why is this so?
Deposit insurance only materializes in crisis situations such as a bank run. It is a reactionary relief that is implemented through political incentive after the outcry of affected individuals forcing the government to intervene. Just like ordinary insurance, it can be considered a low cost means of preventing a crisis or reducing the damaging effect of one as it matures only when risk materializes.
Similarly, the issue of Lender of last resort (LOLR) and the notion that a bank is too big to fail creates a moral hazard between regulators and managers. The LOLR being a discretionary tool, is less prone to moral hazard than deposit insurance which is implicit in nature. The discretion however motivates managers to take on more risk as it is transferrable to the insurer (Central & Federal reserve banks). Furthermore, since the rules for LOLR are ambiguous, managers often gamble that they will be rescued in the event of liquidity deficiency. This is however can have positive and negative effects case example of Lehman Brothers and Bear Sterns discussed in this thesis.
It is then clear that the agency problem is a root problem for corporate governance. Due to the varying interests of participants in the corporate governance of a bank, a complete and satisfactory resolution to the agency problem cannot be found. However, the effects of the agency problem can be mitigated. According to Kern (2007) the major challenge for corporate governance is the redefinition of the principal-agent problem to include the various types of market failures that cause financial instability in the banking sector. Regulation should not only create an incentive framework that aligns with the managers and owners, but should also focus on balancing the interests of various stakeholders affected by bank risk-taking activities.
Popular opinion has pointed the finger of blame to risk management as a primary cause of the GFC. The US congressional Oversight Panel stated:
“As the current financial meltdown makes clear, private financial markets do not always manage risk effectively on their own. In fact, to a large extent, the current crisis can be understood as the product of a profound failure in private risk management, combined with an equally profound failure in public risk management, particularly at the federal level.”
Similarly, the UK House of Commons Treasury Committee stated:
“Bankers complicated banking to the point where the location of risk was obscured, abandoned time-honoured principles of prudent lending, and failed to manage their funding requirements appropriately. There were major failures in the modelling, procedures and structures for risk management.”
Rather than focus on the data related and quantitative aspect of risk management, this thesis will address the underlying qualitative issues related to information that are relevant and crucial to the corporate governance structure.
Internal controls related to financial reporting and independent auditing as expressed in section 404 of the Sarbanes-Oxley Act 2002(SOX) has been the subject of scrutiny. However, it is important to note that internal control systems are only a subset of the broader picture that is effective risk management. In the build up to the GFC, risk management, a key aspect of bank corporate governance had not received adequate attention even though most businesses use enterprise risk management (ERM) frameworks. Coincidentally risk models used by banks during the financial crisis failed due to many assumptions that were included in their variables.
Although this thesis does not agree with Shultz’s (2008) findings, some points can be taken from his argument that losses incurred by a bank does not necessarily mean that risk management in place was to blame. Furthermore, it would prove to be counterproductive if emphasis is put on the revision of risk management with an expectation of more than what it can actually deliver. First it is important to understand the role risk management plays. Risk managers are supposed to assess risks faced by the firm, report these risks to the risk-taking decision makers who are typically the board and senior managers and manage and monitor the risks to ensure that the bank bears risk within its mandate. 
From Shultz’s (2008) explanation, there are other factors in place when assessing risk impact. Risk-taking is especially important as it is the role of the directors to take into consideration the information provided by risk managers and decide whether the subject venture is viable and in the banks interest. This decision-making aspect also means that directors are more likely to be liable in the event of failure or losses associated with a venture. Section 172(a) of the UK Companies Act 2006 states directors must make decision that are likely to promote the company while considering the long-term consequences of these decisions.
Ellul and Yerramilli (2010) developed a risk management index that measured the qualitative and quantitative effect of risk information shared to the board in the run up to the GFC. They conducted the research with the idea that strong and independent risk management is important to effectively manage risk in modern banking. They found that banks with strong and independent risk-control mechanisms had a lower exposure to enterprise wide-risk in banking institutions and banks with strong risk management mechanisms performed better during the GFC. It is important to note that the use of ‘strong’ in these findings does not necessarily mean that a bank will perform well. However, banks with strong risk management practices are more likely to perform better. It is a system that is not full proof but creates a higher probability for better performance.
Since we have identified a probability of risk management failure, it is now important to address the elephant in the room. How did risk management fail?
Information management is a key feature of corporate governance due to its structural and hierarchical formations. A report by the Senior Managers Group found that there was a disparity between the risks that their banks took and those that their boards of directors perceived the banks to be taking. This means that some board members were out of the loop or had no knowledge on what risks were being taken. Furthermore, they found that there was evidence of little or no board involvement in setting the risk appetite of the firms. Supervisors did not disclose crucial information to the boards like, measures and limits of risk exposure, capital required to sustain the firm after a loss arising from taking the risk, and possible recovery options after sustaining such a loss.
Prison et al. concluded that a review of the Lehman Brothers bankruptcy report showed that from 1/ 6/2007, the board was not informed of a 3-month period of excessive risk-taking period. Should the information have been included as a variable in its risk calculation, the firm would probably not have exceeded its risk appetite. A whistle blower also disclosed that accounting irregularities were reported to the auditor Earnest & Young and senior managers but never directly to the board. The CEO Richard Fulls also intentionally excluded critical information that the firm was operating in a credit bubble from his strategy report to the board. 
Information access was another problem found in the Lehman Brothers bankruptcy report. (Minow 2008) found that crucial information was not reported to the board because the Financial and Risk Management Committee only met twice between 2006 and 2007.The frequency was undoubtedly low considering the circumstances and regardless of an increase in board meetings during the financial crisis, the Lehman Brothers management reported on the banks elevated risk profile and leveraged loan risk exposure but failed to mention additional negative information on the banks liquidity.
The complexity of information provided to boards for analysis and interpretation presents another risk management concern. With the ‘Volatile, complex and highly interconnected environments’ that financial systems operate in, it becomes difficult to manage and process risks that are very dynamic and subject to change. These complications often led to a rise in unforeseen circumstances that left boards with little time and resources to adjust and effectively manage the changes in risk. Furthermore, the development of securitization and the use of ‘off balance sheet’ special purpose vehicles that are not adequately regulated due to their prevalence in the shadow banking sectors proves to be problematic. Securitization was used to develop cheap financial products such as mortgage backed securities which as identified earlier on in this thesis were at the root cause of the GFC.
A quote from one of the risk managers interviewed Dr. Simon Ashby for his research paper in the wake of the financial crisis sums this up:
“I think the problem is some firms are too big – how do you manage a massive organisation that’s got retail and investment banking? It’s very difficult for any risk professional to be specialised in all these different areas….. Then you’ve got the complications of all the derivatives and CDOs and all that – you’ve got to have a PhD to understand what they’re doing. If there’s someone who can understand what’s being done and have that knowledge and convert it into a business language that the board can understand – I doubt that very rarely exists.”
Although risk management is not a board mandate, board oversight of the process is essential in determining the risk tolerance of the firm and ensuring discipline is maintained in the face of excessive risk taking.The Basel Committee on Banking Supervision emphasized that the board and senior managers should ensure there is a “comprehensive risk management process to identify, evaluate, monitor and control or mitigate all material risks and to assess their overall capital adequacy in relation to their risk profile.” However, the OECD found in their report that information on various exposures was not shared to the board and senior management and risk management was activity based rather than the preferred enterprise based risk management. In conclusion risk management failed through lack of board involvement in determining the firm risk appetite which could have been done through implementation of appropriate risk control systems. Bank failures and losses during the GFC could have been minimized or avoided if risk managers would have convinced senior managers on the volatility of some risks and advised against them.
In conclusion, information asymmetry was a major contributor to the failure of risk management during the financial crisis. Another conclusion drawn from this is that there was a failure of risk control systems. Since most of the underlying issues were identified by risk managers in most banks but there was a breakdown in reporting mechanisms. This problem is crucial because if boards are not sufficiently aware and/or advised on critical issues after risk assessment, they will not be able to make sound decisions on risk taking. This leads to a breakdown of the corporate governance structure. Every member of the management is a limb in the body that is corporate governance, should one fail, the bank will not be able to progressively advance.
No one would take pleasure in seeing the CEO of a big bank walk away with their pockets filled with bonuses while they are left in the gutter, placed there by the very bank that was supposed to be a haven for their deposits. The financial crisis has put executive compensation structures in the center of debate. This chapter will analyze compensation structures and its relation to risk taking. It will also focus on moral hazard and agency costs between managers and shareholders.
Traditionally managers were more likely to be risk averse, executive compensation was crafted to reduce agency costs and mitigate the moral hazard problem through inclusion of measures such as stock options in manager compensation structure to align manager-shareholder incentives. The rationale is managers are likely to take on more risk because the value of stock options is directly proportional to the firm’s stock price performance. Today, compensation packages are mostly performance based and are designed to provide incentives that induce performance. They include equity based compensation.
During the GFC, there was an initial perception that senior manager compensation was affected with the collapse of banks such as Bear Sterns and Lehmann Brothers. Some concluded that compensation pay had not correlation to risk taking. Indeed some prominent commentators such as Fahlenbrach and Stultz (2011) argue that Incentives are not to blame for the credit crisis or the poor performance of banks during the crisis. Their reasoning for their argument is that since CEO compensation is dependent on firm performance, it would be in their interest to improve on the long-term performance of the bank. 
However, this thesis disagrees with Fahlenbrach and Stultz’s argument. A study conducted by Bebchuk et al (2010) on the executive compensation structures of Bear Sterns and Lehman Brothers during the 2000-2008 period found that the top executives pocketed cash bonuses exceeding $ 300 million and $150 million respectively. It is important not to rule out the fact that these executives did indeed suffer losses. In 2007, Bear sterns stock traded at $ 171.51 at its peak compared to $ 10.84 at the time of the JP Morgan buy out in 2008.That was $ 160.67 loss per share. Similarly, in 2008 the Stock of Lehman brothers was trading at $ 85.50 at its peak compared to a near zero value at its time of bankruptcy.
These findings have led commentators such as Fahlenbrach and Stultz (2011) to the conclusion that executive pay could not have contributed to risk taking. This perception is wrong for two reasons. Firstly, the excessive bonuses reflected short-term investments that were made to generate profits in the short-term since compensation is mostly done on annual basis. Secondly, these executives had the option of cashing out on their shares before the crisis took a turn for the worst and this enabled them to cut their losses.
Furthermore, there were no claw back provisions on bonuses that would have enabled liquidators and creditors to settle debts when these firms were on a downward spiral. During the period between 2000-2008 bank executives received substantial proceeds from the sale of most of their shares before the GFC hit. Lehman Brothers CEO got $ 461 million and the Bear sterns CEO got $ 289 million. The senior executives pocketed a total of $ 1.1 billion and $ 860 million respectively. Another point of importance is that both banks allowed executives to unload stock options five years after the award. These stock options were supposed to be a form of compensation that align manager and shareholder incentives however giving executives the freedom to cash out on them in such a short duration of time invites excessive risk taking since the executives will not be tied or suffer additional losses once a certain threshold has been reached.
Using the above results this chapter will now build up on existing literature to determine the correlation between compensation, risk taking and bank performance. A study by Chen et al (2006) found banks increased option-based compensation after the deregulations in the banking industry and that an increase in option based compensation encourages greater risk. They conclude that unlike common stock that can increase or decrease in value, option-based stock can drastically increase from zero to the millions due to the leverage effect. Similarly, Fortin et la (2010) found that bank CEO’s who received more stock options and higher bonuses in 2005 took on more risk in 2006.Their view is in support of Chen et al (2006) that managers who have a stake in the company will take on more risk and transfer wealth from bondholders to shareholders. Their overall findings are consistent with the agency problem discussed in this paper that this can be an issue for shareholders and bondholders because due to separation of ownership and control, managers tend to enjoy more benefits and control. They interestingly point put that the shareholders attempt to encourage risk taking by managers should be a point of concern for regulators.  However, other commentators are not entirely satisfied with the correlation between compensation and risk-taking. Lin et al (2015) state that although banks that are too big to fail and offer greater equity based compensation to executives, they determine that this can encourage managers to take on more risk but it is not solid evidence to prove this.
In conclusion, the combined empirical evidence showed in this chapter shows the moral hazard problem between managers and shareholders is further inflamed by high and excessive compensation packages to top bank executives. It would then be naïve to conclude that compensation has no correlation to risk taking. As we have found, these compensation packages are usually in the billions and millions of dollars. Such figures have an impact on the performance of banks especially due to the large stock ownership and control features at the disposal of management. Encouraging managers to take on risk without having sound contractual safety nets in place proves to be a double-edged sword. While some commentators have viewed equity based compensation to be a promising means of reducing the moral hazard problem, it is not secure especially with stock based options. Executive compensation had an impact on bank performance in the run up to the financial crisis, not only from a decision-making point of view but also from a financial standpoint.
The position of a bank’s board at the top of the management pyramid comes with a degree of importance and responsibility. This responsibility is especially inherent in situations where dispersed shareholders or debtholders and the market cannot enforce effective governance of banks. The boards function is even more imperative in banks than in non-financial institutions because the reach of a banks activities extends to shareholders, debtholders and regulators. The Board’s influence on the company hence determines the risk appetite and the risk management of the company. It is then clear that different board compositions of executive, non-executive and two-tier board members has an influence on bank policy. This chapter will analyze how their influence and role during in the GFC.
The size of a board plays an important role in the decision-making process of banks because the composition and structure of a board influences bank performance. There have been studies that have determined a negative relationship between board size and firm performance. A study by Cheng (2008) found that board size affects the corporate performance. He noted that large boards are faced with the agency problem and challenges with communication and coordination and concluded that board size is inversely proportional to extremity of decisions.Cheng (2008) further notes that large boards reflect the decisions of the majority consensus and finds that firms with larger boards are less likely to take on extreme risk. This result however applies to non-financial institutions. As we have pointed out several times, bank circumstances differ and because of moral hazards and incentive alignment, bank boards are likely to take on more risks.
Bank board compositions are determined by various reasons. Firstly, regulatory implications unique to banks might not allow the board to be fit or optimal. Secondly, board size and composition in banks is endogenous and determined by the characteristics of the specific bank. New York Banks with more than $ 50 Million in net profits are required to maintain boards of seven to thirty directors and two thirds should be non-executive directors. In the UK the PRA recommends that at least half of the board should be composed of independent non-executive directors with smaller firms required to have a least two independent non-executive directors.Coles et al (2008) conduct a study and find complex firms such as banks that are large and rely on debt financing have larger boards with knowledgeable outsiders to advise the CEO and other board members.In conclusion, finding the optimal balance to suit the preference of a specific bank is key to establishing good board governance. As the walker report states “decisions on board size will depend on particular circumstances, including the nature and scope of the business of an entity, its organisational structure and leadership style.”
Meeting the prescribed quota is however not enough to produce good governance, quality is essential. Board independence in the form of non-executive directors is essential in monitoring the activities of the executive board. Their presence is supposed to make sure the bank risk appetite is kept in check. The rationale is non-executive directors are interested in protecting their own reputation and would help firms avoid losses to protect their image and the firm’s as well. This should result in a negative relationship between board independence and corporate risk taking. However, for this to happen, the non-executive directors must be especially knowledgeable in the practices of their respective banks. However, during the GFC, it was clear that independent directors were appointed for other reasons. The boards of prominent U.S Banks that were affected by the financial crisis including; JPMorgan Chase, Goldman Sachs, Lehman Brothers, Bear Stearns and Citi were composed of more than two-thirds of independent directors with little relevant banking experience and more than half with no financial industry experience. Furthermore, some of these directors were members of technical board committees. For example, Roger Berlind who is a theatre organiser and private investor was a member of the audit and finance and risk committee.
The lack of specialised knowledge especially in complex banking practices was highlighted earlier on in this paper.Banks have high information asymmetry and as such, the inclusion of specialised and knowledgeable directors will ultimately result in positive bank performance. Lack of specialised knowledge and understanding of banking practices would have resulted in poor risk management, an overall lack of efficiency in decision making, inaccurate risk predictions and the inability to foresee the oncoming crisis. It appears that some of these appointments were for political rather than economic reasons and thus lack of specialised knowledge and understanding would have contributed to failure in the respective banks.
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