Banks that were more responsive to shareholders performed much better before the financial crisis and much worse during it, a new study demonstrates.
A pair of finance professors examined the returns and governance styles of banks before and during the crisis. What they found is that many of the banks with that are considered “better governed” according to standard models of corporate governance, fared far worse during the crisis.
- One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006.
- In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006. This evidence suggests that the attributes that the market valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. The market did not expect these attributes to be a source of weakness for banks and did not expect the banks with these attributes to perform poorly as of 2006.
This supports a couple of positions we’ve been arguing for around here for some time. First, it wasn’t bad bonus incentives that drove banks to take risky bets in asset backed securities. It was a widespread mistake about the values of those assets. And that mistake was shared by bankers as well as investors in banks.
Second, investors in banks were demanding the kind of investment profile that became so much trouble for the banks. That suggests that all of the shareholder democracy, bonus clawback, and say on pay provisions wouldn’t have made a dime’s worth of difference. And, more importantly, they are useless when it comes to avoiding a future crisis.
Here’s the conclusion:
Overall, our evidence shows that bank governance, regulation, and balance sheets before the crisis are all helpful in understanding bank performance during the crisis. However, banks with more shareholder-friendly boards, which are banks that conventional wisdom would have considered to be better governed, fared worse during the crisis. Either conventional wisdom is wrong, as suggested by Adams (2009), or this evidence is consistent with the view that banks that took more risks rewarded by the market –perhaps because the market did not assess them correctly ex ante – before the crisis suffered more during the crisis when these risks led to unexpectedly large losses. Strong evidence supportive of the latter interpretation is that the performance of large banks during the crisis is negatively related to their performance in 2006. In other words, the banks that the market rewarded with largest stock increases in 2006 are the banks whose stock suffered the largest losses during the crisis.
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