The Role of Ownership and Governance in Bank Risk And

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The Role of Ownership and Governance in Bank Risk and Performance: An Econometric Study Seán Harkin Doctor of Philosophy The University of Edinburgh 2017 1 Abstract The banking sector is central to the economy, but has recurrent dysfunctions. Following the Global Financial Crisis of 2007-2009, regulators have attempted to reform governance in banks. However, previous empirical studies on the effects of governance structures have important gaps. Using an econometric framework with novel simultaneous equations models and new dependent variables, I investigate whether corporate governance and ownership have significant effects on bank risk and performance. I employ a novel data set combining financial data from the Bankscope database with governance and ownership data collected painstakingly by hand from annual reports and Basel Pillar 3 disclosures of UK banks over the period 2003-2012. My findings are supported by interpretation of relevant literature and are summarised as follows (stated along with policy implications in parentheses for which features of banking should be encouraged, based on normative assumptions stated in section 9.3). My work shows that the effects of a particular ownership or governance structure can be attributed to the ways in which categories of decision-maker within the bank are empowered by that structure, and that factors relating to information processing capability have important effects. Mutual and foreign ownership each have negative effects on risk and return because of managerial incentives and information asymmetries, respectively, without either affecting provision of investment to the wider economy. A foreign parent also increases the probability of bank failure (implying mutuality is socially beneficial while foreign ownership is not). A higher NED ratio reduces the probability of bank failure, as does having a remuneration committee, because of greater accounting for risk in decisions (implying they are desirable). The presence of an independent Chairman increases risk because it weakens CEO accountability and confuses decision-making (implying it is undesirable). An independent CRO (as a full Board member) may have similar effects. A higher proportion of Directors with no previous financial services experience increases both returns and the probability of failure because of weaker use of information (implying it is undesirable). Permission to use IRB models lowers risk and return because it provides information to empower risk-averse agents, again without affecting credit provision to the wider economy (implying it is desirable). I report other novel findings on effects of ownership, governance, remuneration and size. These results can guide bank reform. 2 Lay Summary People and companies need the services of banks, but the banking sector has numerous problems. In 2007-2009 many banks globally almost went bust (or did actually fail) and this had negative effects on everyone else because there was less lending. The authorities have since tried to improve how banks are run. However, we don’t know everything about how best to do this. In my PhD, I use statistics to help us discover more. For 115 banking firms (“banks”) in the UK, I obtained data on important outcomes like profits and bad loans over a ten year period. I also gathered data on key features of these banks, like who owned them and what kinds of people and Committees were in power inside the bank. For example, I noted whether or not each bank (in each year) had a Chairman who was a separate person from the Chief Executive, so that they could monitor him/her. I used patterns in my data to work out the effects of different ways of running banks. For example, if I see that banks with an independent Chairman have more bad loans, then maybe the former caused the latter. To be sure, I used a type of analysis where a computer program took background factors I wasn’t interested in, but which could still have an effect (like how much debt the bank had or what was happening in the rest of the economy) and used these factors to explain-away as much as possible of the ups and downs in the outcome (profit or bad loans). I then analysed the variation in the outcome that was left over and determined if it was still linked to the factors I was interested in (like the presence of an independent Chairman). This approach allowed me be sure effects I found are real. To make the test really tough, I used lots of background factors and varied the set of these I used. I’m also sure effects don’t go the other way (e.g. from bad loans to management structures) because management structures don’t change much from year to year. I found that banks which are owned by their customers (i.e. building societies) have lower profit and less bad loans than other banks but, for their size, give just as much investment into the economy. Banks with lots of independent Directors (who are separate from day-to-day management) are less likely to go bust, and the same is true for banks that have a Committee which oversees pay. Having an independent Chairman actually does the opposite of what people think – it causes more bad loans than in other banks, probably because the Chief Executive feels less accountability and decisions are confused. Banks with lots of Directors who haven’t previously worked in banking (or other kinds of financial services) have higher profits but are more likely to eventually go bust. Banks that have permission (from government authorities) to use 3 advanced methods to forecast risk have lower profit and less bad loans than other banks but give just as much investment into the economy. My results give us more information on how best to run a bank, for the good of people and society. 4 Declaration of Originality This thesis was composed by Sean Harkin. The work it describes was carried out by Sean Harkin, except where explicitly stated otherwise (in references to past studies). The work has not been submitted for any other degree or professional qualification. Signed: _________________________________ Date _________________________________ 5 Acknowledgements I would like to thank everyone who helped me in my research and other parts of my PhD. Firstly, I would like to thank my wife, Fiona, for all her love and support, putting up with me spending long hours in the study and encouraging me to go ahead with it in the first place. I would also like to thank my mother, who first instilled my belief in education and hard work. Sincere thanks to my supervisors, Prof. Jonathan Crook and Dr. Davide Mare for their consistent encouragement, steering me in the right directions, giving insightful suggestions in response to questions on research and technical matters, and understanding my need for flexibility because I worked in banking alongside doing the PhD. Likewise, I am thankful to all those in the School of Economics and the Business School at the University of Edinburgh who improved my knowledge of econometrics, finance and statistical programming. Thanks also to my colleagues in the UK Green Investment Bank for taking an interest in my research and allowing me some time off. Finally, I would like to thank all those in various banks who shared copies of older annual reports not available on their websites. Thanks especially to Simon Rex at the UK Building Societies Association; the large set of annual reports he shared gave me a larger and more balanced data set, without which the results would have been less informative. 6 Abbreviations 2SLS Two-Stage Least Squares. FRC Financial Reporting Council. A public body in the UK and Ireland that produces standards designed to ensure high-quality corporate governance and reporting. FS Financial Services. FSA Financial Services Authority. The UK public body that was responsible for regulation and supervision of banks and other financial institutions in the time period considered in this thesis. It was responsible for both financial stability (prudential regulation) and fair treatment of consumers and investors (conduct regulation). These responsibilities were split between the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) from April 2013, after the period considered in my analysis. FSCS Financial Services Compensation Scheme. The UK scheme which provides deposit insurance and other forms of insurance designed to protect consumers of financial services. GMM Generalised Method of Moments. GOB Government-Owned Bank. GTA Growth in Total Assets. The year-on-year percentage growth rate of balance sheet assets. IRB Internal Ratings Based. An approach to credit risk modelling that banks may use under Basel II and III regulation, subject to national regulators deeming that they have met certain standards. LI Loan Impairments. The ratio of impairments on loans over total loan assets. LII Loan Interest Income. The income earned on loan assets normalised to total loan assets. MOB Mutually Owned Bank. Any bank that is owned by its depositors or employees, on a basis where owners are equal or near-equal with each other.

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