Luc Laeven

Recent turmoil in financial markets following the announcement of heavy losses by major banks on exposures to mortgage-backed securities has reinvigorated an ongoing debate on whether banks are properly governed and regulated. If bank managers are subject to sound governance mechanisms, this enhances the likelihood that banks will efficiently mobilize and allocate savings, and encourage sound governance of the firms they fund, thereby lowering firms’ cost of capital and accelerating economic growth. Until recently, virtually no research studied how a bank’s private governance arrangements, including those covering its ownership and management structure, combine with national laws and regulations to determine bank performance and stability. This article reviews recent IMF research on the impact of bank governance and regulations on bank risk and valuation.

Research suggests that well-functioning banks promote economic growth. When banks efficiently mobilize and allocate funds, this lowers the cost of capital to firms and accelerates capital accumulation and productivity growth. Furthermore, banks as creditors and equity holders play an important role in governing firms. Thus, if bank managers are subject to sound governance mechanisms, this enhances the likelihood that banks will allocate society’s savings efficiently and encourage sound governance of the firms they fund.

Nevertheless, little is known about which laws and regulations enhance the governance of banks. One standard rationale for government regulation of banks is that shareholders and creditors lack sufficient mechanisms for exerting sound governance over complex and opaque banks, especially in the presence of deposit insurance. But are banks different, and do the same corporate control mechanisms that work in nonfinancial corporations also work in banks?

As for any firm, shareholders of banks have an incentive to increase risk by increasing leverage, thereby enhancing the value of their equity stakes. Managers may prefer to opt for lower risk, given that their human capital is tied up with the firm. These conflicting risk preferences between the bank’s shareholders and managers result in a classical principal-agent problem. There are, however, several reasons to believe that banks are special, both in terms of the complexity and the severity of the problem. First, society may care more about bankruptcies of banks than those of firms, given the strong negative externalities associated with bank failures. Second, banks are highly leveraged institutions, thus exacerbating the shareholder-manager conflict. Third, banks’ debt holders chiefly consist of depositors who are likely to be ineffective in monitoring shareholders’ actions, thus intensifying agency problems. Fourth, banks are considered by many to be extremely complex and opaque, and the resulting information problems may intensify agency problems. Finally, banks are heavily regulated. Banks in most countries face regulations on capital requirements, entry restrictions, portfolio restrictions, and deposit insurance. Although such regulation is a rational response to market failures in banking, certain regulations could exacerbate the problem. For example, deposit insurance, by reducing the incentives of debt holders to monitor the bank, may intensify the ability and incentives of stockholders to increase risk. The existence of bank regulation changes the nature of information problems, because the regulator itself is an interested party.

Recent papers by Caprio, Laeven, and Levine (forthcoming) and Laeven and Levine (2007) assess the impact of ownership structure on bank risk and valuations, while controlling for international differences in bank regulations and investor protection. A critical contribution of these papers is that they simultaneously examine an individual bank’s private governance structure, including its ownership and management structure, and the legal and regulatory environment in which it operates. Since both bank-level and country-level factors influence bank behavior, it is valuable to examine these together. As part of their research, the authors collected new information on the ownership and management structure of banks and merged this with data on bank regulations around the world. The new database covers detailed data on banks across 44 countries and traces the ownership of banks to identify the ultimate owners of bank capital and the degree of ownership concentration.

It turns out that banks around the world are generally not widely held, despite government restrictions on the concentration of bank ownership. About 75 percent of major banks have single owners that hold more than 10 percent of the voting rights. Of these controlling owners, more than half are families. Although concentration of ownership is also common among nonfinancial firms, and is believed by many to be an effective mechanism to exert corporate control, most governments restrict the concentration of bank ownership and the ability of outsiders to purchase substantial stakes in banks without regulatory approval, generally to limit concentrations of power in the economy. Caprio, Laeven, and Levine (forthcoming) show that these regulatory restrictions are often ineffective or not well enforced. Families employ various schemes, such as pyramidal structures, to build up control in banks. Existing regulatory restrictions on bank ownership are largely ineffective in preventing family ownership of banks.

Strong shareholder protection laws may enhance the governance of firms by limiting the expropriation of minority shareholders. For banks, however, not everyone agrees that shareholder protection laws will effectively thwart expropriation. Even with strong investor protection laws, small stakeholders may lack the means to monitor and govern complex banks. Furthermore, bank regulations may be sufficiently pervasive to render shareholder protection laws superfluous. Thus, the impact of investor protection laws on banks may differ from their impact on other firms. Research on non-banks also shows that the incentives of the controlling shareholders to expropriate resources are negatively related to their cash-flow rights, and that greater cash-flow rights can mitigate the adverse effects of weak shareholder protection laws.

The analysis in Caprio, Laeven, and Levine generates four key results on the governance of banks. First, larger cash-flow rights by the controlling owner boost valuations. The evidence is consistent with theoretical predictions that concentrated ownership reduces incentives for insiders to expropriate bank resources, which, in turn, boosts valuations. Second, stronger legal protection of minority shareholders is associated with more highly valued banks. This suggests both that expropriation of minority shareholders is important in many countries and that legal mechanisms can restrict expropriation of bank resources. Third, greater cash-flow rights mitigate the adverse effects of weak shareholder protection laws on valuations. Thus, a marginal improvement in legal protection has less of an impact on a bank’s valuation as the controlling owner’s cash-flow rights increases. Put differently, a marginal increase in ownership concentration has a particularly large impact on valuations when legal protection of minority shareholders is weak. These last two findings support a skeptical view of regulatory strategies seeking to minimize ownership concentration if these strategies also reduce the controlling owner’s cash-flow rights, especially in environments with weak legal protection of minority shareholders. Fourth, after controlling for the cash-flow rights of the controlling owner, bank regulations do not have an independent association with bank valuations. Taken together, the results indicate that the same core corporate control mechanisms that influence the governance of nonfinancial firms also influence bank operations.

Laeven and Levine (2007a) examine the impact of ownership structure, managerial shareholdings, and national laws and regulations on banks’ risk-taking. Given that banks’ risk-taking depends on the charter value of the bank (e.g., Boyd and De Nicolò, 2005), their analysis also controls for bank valuation. They extend the Caprio, Laeven, Levine dataset by adding data on managerial ownership and board representation. They find that large owners with substantial cash-flow rights tend to induce banks to increase risk, but the relationship between ownership structure and risk-taking depends on the role of the large owner in managing the firm, investor protection laws, and regulations. This finding is consistent with a variety of theoretical models predicting that large owners have the incentives to induce managers to increase risk-taking after collecting deposits and debt from investors. They also find that effective legal protection of small shareholders reduces the need for large shareholders and their impact on corporate behavior; further, the impact of cash-flow rights of the large owner on bank risk-taking diminishes when the large owner is also an executive manager with substantial human capital and private benefits of control tied to the bank’s existence.

On management structure, Laeven and Levine (2007a) find that small changes in managerial shareholding are unassoci-ated with bank risk-taking, but bank risk falls when the large shareholder is an executive manager. These findings are consistent with predictions that a bank manager has substantial human capital invested in the bank and may also enjoy private benefits of control (see Litov, and Yeung, forthcoming).

In terms of regulatory policies, the two key components of Basel II—capital requirements and official supervisory oversight of banks—do not reduce bank risk-taking. Rather, regulations that promote loan diversification reduce bank risk, while regulations that restrict banks from diversifying income flows by providing nonlending services increase bank risk-taking.

Laeven and Levine (2007b) provide direct evidence in support of agency problems in banks. They find that diversification of activities within a single financial conglomerate intensifies agency problems between corporate insiders and small shareholders, with adverse implications for the market’s valuation of the conglomerate. Their results are consistent with theories that stress intensified agency problems in financial conglomerates engaged in multiple activities and indicate that economies of scope are not sufficiently large to produce a diversification premium.

Banks’ credit allocation also responds to improvements in the corporate governance of firms. De Nicolo, Laeven, and Ueda (2007) show that firms that depend on banks and other intermediaries for their financing grow more if they have better corporate governance quality. Thus, there are reasons to believe that sound governance of both banks and firms is crucial for economic growth.

Future work on bank governance should consider not just the conflicts that may arise between large shareholders and managers. Laeven and Levine (2007c) show that, in reality, ownership structures are often complex. About one-third of publicly listed firms in Europe have multiple large owners that each control more than 10 percent of the votes. The market value of firms with multiple block holders differs from that of other firms and depends on the distribution of cash-flow rights across these multiple large owners.

Overall, these papers’ findings both question the view that banks do not respond to private governance mechanisms and challenge the current approach to bank supervision and regulation that relies on capital regulations and official supervisory monitoring of banks.