Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iimahd.ernet.in

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Wed, 08 Jul 2009

Governance of banks

I read two interesting pieces today about bank governance. First was John Kay’s column (“Our banks are beyond the control of mere mortals”) in the Financial Times in which he says that the top management of UK banks were people of exceptional ability:

... most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract ... Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity.

The statement of Kay that I agreed with most was:

If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.

Needless to say my understanding is that the true patron in this case was not the shareholder but the government.

Today, I also read a paper (“Subprime Crisis and Board (In-)Competence: Private vs. Public Banks in Germany ”) by Hau and Thum (hat tip FinanceProfessor). This paper tries to understand why during the current crisis, the losses at the large public sector banks in Germany were far worse than those of private sector banks. While the big three private banks (Deutsche, Commerzbank and Dresdner) have suffered quite badly, the losses (as a percentage of assets) of the large public sector banks (like Bayern LB, West LB and KfW) are truly dismal.

Hau and Thum do a painstaking job of going through the biographical data of each and every board member of each of the 29 banks in Germany with assets above € 40 billion and rating each of these 593 board members on 14 different indicators measuring three dimensions of competence – educational qualification, management experience and finance related experience. They first show that the board members of public sector banks fared badly on all these three dimensions. Next, their regression results show that performance of banks is strongly related to the finance experience of the board members. They conclude that the poor performance of the German public sector banks is due to their poor governance.

My only problem with this conclusion is that their first regression equation using just a dummy variable for state ownership has much higher explanatory power (R-square) than their later regressions using board competence measures. Unfortunately, they do not report any regressions containing both board competence and the ownership dummy. Therefore, we do not know whether board competence has any incremental explanatory power over and above that as a proxy for state ownership. The only light that they throw on this is a regression where they show that state ownership has only a small impact on executive compensation. They use this result to argue that state ownership is not the causal variable. But state ownership can affect performance in other ways – for example, by encouraging greater risk taking because of the implicit government support.

Posted at 17:29 on Wed, 08 Jul 2009     View/Post Comments (1)     permanent link




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