Management Incenives and Bank Risk-aking

Transcription

1 Managerial Incenives, Marke Power and Bank Risk aking* Words coun: 142. This Version: February 14, 2010 Absrac We invesigae he effec of managerial incenives and marke power on bank risk-aking for a sample of 212 large US bank holding companies over (i.e. 1,534 observaions. Bank managers have incenives o prefer less risk while bank shareholders have preference for excessive risk. Likewise, he marke power is he cenre piece of any bank regulaion. However, he lieraure is inconclusive as o he effec of managerial incenives and marke power on bank risk-aking. Our resuls reveal a U-shape relaion beween bank risk and CEO ownership (proxy for managerial incenives and beween bank risk and charer value (proxy for marke power. Paricularly, we find ha bank risk iniially decreases and hen increases wih boh CEO ownership and charer value. These convex relaions are robus o various bank risk proxies, differen esimaion approaches o accoun for endogeneiy and several bank specific conrol variables. JEL classificaion: G21; G28; G30; G32; G38 Keywords: Bank risk-aking; Managerial incenives; Marke power, CEO ownership; Charer value; Bank holding companies * The auhors wish o hank Mark Flannery, Renée Adams, Richard Heaney, Maureen O Hara, Benjamin Hermalin, and seminar paricipans a UWA, UTS and Macquire Universiy for heir helpful commens. The auhors also acknowledge he financial suppor received from AFAANZ. As usual, he auhors are responsible for any residual shorcomings of he paper.

2 1. Inroducion We examine he effec of managerial incenives and marke power on bank risk aking for he U.S. bank holding companies (BHCs. In he presence of agency problems, bank managers and shareholders have conflicing risk aking incenives. Generally, bank managers are risk-averse and have incenives o ake less risk mainly because heir wealh (boh angible and human capial is concenraed in he banks hey manage (Smih and Sulz However, bank shareholders have incenives o ake excessive risk a he expense of ax-payers funds and crediors because of he well known moral hazard problem from limied liabiliy and mispriced deposi insurance premium (Galai and Masulis 1976; Meron This is compounded by he oo-big-o-fail effec in large banks. In response o he moral hazard problem, he marke power (proxied by charer value 1 considered o be insrumenal of any bank regulaion o resrain bank risk-aking. The disciplining role of he charer value has firs been poined ou by Marcus (1984, who argues ha increased compeiion in he bank indusry erodes banks charer values which in urn increase incenives for excessive risk-aking. However, as discussed laer in Secion 2, he exising lieraure on bank risk-aking is inconclusive as o he naure of impac of boh managerial incenives and marke power on bank risk aking. As he financial crisis is aking is olls, he collapse of he Lehman Brohers, Washingon Muual, Wachovia and he ongoing problems wih banks such as Ciigroup, Bank of America, signifies he inheren flaws wih he exising financial sysem regulaion. In response o he global financial crisis, he G-20 leaders in London meeing agreed o reform financial secor regulaory framework including common principles for remuneraion so as o discourage ousized risk aking on banks. Since he incepion of he crisis in 2007, much of he public debae surrounds he incenives srucure in place which is blamed o have promoed shor-ermism and excessive impruden risk-aking by banks a he expense of ax payers money. In his regard, Fahlenbrach and Sulz (2009 provide evidence ha banks wih CEOs whose ineress were beer aligned wih heir shareholders perform worse. Similarly, Chen, Seiner and Whye (2006 find ha banks have increasingly employed sockbased compensaion following deregulaion in 1992 o 2000 periods which encourage more 1 The charer value, also known as franchise value, of a bank is he presen value of a bank s fuure economic profis when considered as a going concern (Demsez, Saidenberg and Srahan 1997, p.6. 1

3 risk-aking. Likewise, he financial indusry including banks in U.S. has been enjoying leas regulaion since he passing of he Riegle-Neal Inersae Banking and Branching Efficiency Ac of 1993 and he Gramm-Leach-Bliley Ac of Apparenly, banks pursue o capialize on his regulaory laxiy which may have eroded banks marke power by underaking excessively risky invesmens. Therefore, his sudy is imely in ha i follows recen financial crisis impacing upon he banking sysem and relevan in ha i expands our knowledge of he inerrelaions beween moral hazard problem, marke compeiion, regulaion and bank risk-aking incenives. Using a sample of 212 large U.S. BHCs over 1997 o 2004 period, we find ha he effec of boh bank CEOs shareholdings (proxy for managerial incenive and charer value (proxy for marke power is U-shape. The bank risk iniially decreases wih CEO shareholding indicaing he dominance of managerial enrenchmen effec and hen increases wih CEO shareholding indicaing he dominance of shareholders asse-subsiuion effec. CEO shareholding a he inflecion poin (3.62% for oal risk is greaer han he mean CEO shareholding of 4.1%. This implies ha bank shareholders asse-subsiuion effec dominaed in he pre-crisis period and hence encouraged bank managers o underake over-sized risk exposing o he financial crisis. Wih regard o he marke power, he bank risk iniially decreases wih charer value proving he well-known charer value paradigm dominance and hen increases wih charer value indicaing he dominance of Boyd and De Nicole (2005 risk-shifing paradigm in he loan marke. This sudy conribues o he exising bank risk aking lieraure in several imporan ways. This is he firs sudy o provide evidence of a U-shape relaion beween bank risk and managerial incenives and beween bank risk and marke power afer conrolling for capial regulaion, size and oher imporan bank specific variables. This sudy uses CEO shareholding as a proxy for managerial incenives while prior sudies on bank risk-aking use insider shareholding (i.e., board direcors and officers shareholding as a proxy. Kim and Lu (2009, pp. 4-5 describes several reasons for he superioriy of CEO shareholding as a beer proxy for managerial incenives compare o insider shareholding. For insance, CEOs have more power compare o oher execuives or direcors o capure he incenive conracing process and CEO shareholding is a cleaner proxy han insider shareholding. CEO shareholding also has greaer wihin firm variabiliy o remove he Zhou s (2001 concern relaed o he power of he es if insead insider shareholding is used as a proxy. 2

4 Mehodologically, we use muliple proxies of bank risk (e.g. oal risk, sysemaic risk and credi risk o check he robusness of he resuls. This is imporan as various ineres groups have heir reasons o follow paricular ype of bank risk. For insance, bank regulaors are specifically concern abou he insolvency and sysemaic risks of banks while bank invesors are concerned abou oal and idiosyncraic risks. We have also checked he robusness of our resuls using various esimaion echniques including several approaches o accoun for endogeneiy. For example, we have esimaed he economeric model wih boh fixed effec and sysem generalized mehod of momens (GMM o reduce biases in our coefficiens esimaes from unobserved heerogeneiy, simulaneiy and dynamic endogeneiy (if any. The remainder of he paper is srucured ino four secions. Secion 2 presens a criical review of lieraure on managerial risk-aking incenives and marke power which help in formulaing he relevan hypoheses. Secion 3 describes he daa and economeric mehods. Secion 4 provides he empirical resuls while secion 5 shows he robusness of he resuls. Finally, Secion 6 concludes he paper. 2. Relaed lieraure and hypoheses developmen 2.1. Managerial incenives and bank risk The separaion of ownership from conrol in corporae firms creaes agency problem beween shareholders and managers (Berle and Means This separaion besows he bank s criical porfolio decisions on managers and he laer may no always ac in he bes ineress of shareholders. Thus, i is crucial o undersand bank managers incenives regarding risk-aking. Generally, bank managers are risk-averse and have reasons o prefer less risk (known as managerial enrenchmen heory. Like any invesor, bank managers wealh consiss of a porfolio of angible and financial asses as well as human capial (alen, job relaed experience. In conras o oher invesors, he managers wealh is mosly concenraed in he firms ha managers manage. To he exen ha bank managers have concenraed wealh including heir nondiversifiable human capial, managers are expeced o proec his inernally by selecing excessively safe asses or by diversificaion (e.g., Smih and Sulz 1985; and May While shareholders can diversify heir porfolio risk in he capial marke, managers can effecively do so only a he firm level (May 1995, p In addiion, he expeced value of deb ax shield and bankrupcy coss conribue furher oward managerial incenives a 3

5 levered firms like banks o selec overly safe projecs, raher han excessively risky projecs (Parrino, Poeshman and Weisbach Furhermore, bank managers could have differen risk-aking incenives if managers are compensaed hrough wage and salary conracs raher han hrough shares and share opion programs. When receive fixedwages, managers behave in a risk-averse manner and so are unlikely o exploi he same moral hazard incenives as sock owner-conrolled banks. This is because managers have lile o gain if heir banks do excepionally well (when heir salaries are fixed bu will probably lose heir jobs and human capial invesmens if heir bank fails (Saunders and Corne 2006, p.532. Thus, bank shareholders wan managers o inves in all posiive nepresen-value projecs, irrespecive of heir associaed risks (Guay Conversely, he risk-averse bank managers may accep some safe, value-reducing projecs, and rejec some risky bu value-increasing projecs (May Consisen wih he incenives alignmen heory, several sudies suppor a saisically significan posiive associaion beween board officers and direcors shareholding (proxy for managerial incenives and bank risk-aking (e.g., Saunders, Srock and Travlos 1990; Demsez e al. 1997; Cebenoyan, Cooperman and Regiser Fahlenbrach and Sulz (2009 also sugges ha he incenives alignmen beween bank CEOs and shareholders could explain he excessive risk-aking by banks leading o he financial crisis According o Anderson and Fraser (2000, he naure of he relaionship beween managerial ownership and bank risk-aking behaviour may depend upon he charer value of banks. They furher illusrae ha managerial ownership and risk-aking behaviour are posiively relaed only a low charer value during periods of deregulaion while hey are negaively relaed a high charer value during periods of re-regulaions. On he oher hand, a few sudies show a negaive or non-monoonic relaion beween managerial shareholdings and bank risk-aking consisen wih he managerial risk-aversion heory (e.g., Brewer and Saidenberg 1996; Demsez e al For insance, Brewer and Saidenberg (1996 offer a convex (i.e., U-shaped relaion beween bank risk and insider shareholding. This demonsraes ha bank risk iniially decreases (due o he dominance of managerial enrenchmen heory and hen increases wih managerial shareholdings (due o he dominance of shareholders risk-shifing effec. However, Goron and Rosen (1995 find a concave (i.e, invered U-shaped relaion beween bank risk and insider shareholding. The non-linear relaion beween bank risk and insider shareholding sugges he rade-off 4

6 beween managerial risk aversion/enrenchmen effec and shareholders assesubsiuions effec in he incenives conrac. Thus, based on exising evidence, for banks i is difficul o predic he naure of nonlinear relaion beween bank risk and managerial incenives ex ane or a priori. Hence, our firs hypohesis relaed o managerial shareholding (proxy for managerial incenives is kep open and leave i o he empirical analysis o discover. Thus, he firs hypohesis (H1 is formulaed as follows: Hypohesis 1 (H1: The naure of relaion beween bank risk and managerial shareholding is non-linear (due o he rade-off beween managerial risk-aversion and shareholders asse-subsiuion effec a differen level of managemen shareholdings Marke power and bank risk Among oher, an imporan regulaory approach o abae moral hazard problem in banks is o faciliae monopoly rens for bank equiy-holders by reducing compeiion in he financial sysem. Concenraed marke wih monopoly profis raises bank charer value which proved o be more valuable han bankrupcy coss o he equiy holders. Informaion is considered o be anoher imporan source of bank charer value (Brewer and Saidenberg Informaion ren is possible because of banks accumulaion of valuable privae informaion from heir lending relaion wih heir cusomers which is imporan as i canno be realized if banks defaul. Accordingly, boh heoreical and empirical sudies have documened an inverse relaionship beween charer value and bank risk aking. For 150 large BHCs over 1970 o 1986 period, Keeley (1990 found ha a bank wih high marke-obook value of oal asses (a proxy for charer value had incenive o avoid high risk projecs as he resuling loss migh ouweigh is charer value. Galloway, Lee and Roden (1997, using a sample of 86 BHCs over , saed ha increased regulaion raised bank charer value hrough enry barriers and hence lowered bank risk. Noneheless, he exising lieraure on charer value is criicized as bank compeiion effecs bank risk no only via deposi channel bu also via loan marke channel (Boyd and De Nicoló Specifically, Boyd and De Nicoló (2005 noe ha concenraion in bank (i.e. less compeiion among banks also allows banks o charge higher ineres rae on business loans, which migh increase he credi risk of borrowers. Thus concenraion in banks may increase bank problem loans and insolvencies resuling from he moral hazard problem in 5

7 loan marke (ermed as risk-shifing effec. In his regard, several sudies some evidence of a posiive relaion beween bank risk and marke power based on he assumpion of a perfec correlaions in probabiliies of boh loan defaul and bank defaul (Boyd, De Nicoló and Al Jalal 2006; De Nicoló and Loukoianova Likewise, in a cross-counry sudy, González (2005 found ha regulaory resricions seem o increase bank risk-aking incenives by reducing heir charer value. González (2005 reinforces Barh, Caprio and Levine (2001, 2004 findings ha counries wih sricer regulaory resricions face higher probabiliy of banking crisis as igher regulaions favor lower charer value. However, Marinez-Miera and Repulllo (2009 argues ha i is more realisic o assume an imperfec correlaion as low ineres raes (due o compeiion does no necessarily ranslae ino low bank defaul, as he ineres income from non-defauled borrowers also decreases (due o margin effec. Based on his se up and exending Boyd and De Nicoló (2005 work, hey argue for a U-shaped relaion beween charer value and bank risk and hence resolve he wo opposing views in exising bank risk lieraure. Jiménez, Lopez and Saurina (2007 empirically es he Marinez-Miera and Repullo (2009 heoreical predicion using daa on Spanish banks. However, hey find a linear negaive relaion beween marke power and bank risk favoring classic charer value paradigm. Our sudy is similar o Jiménez e al. (2007 in ha we also inend o examine he Marinez-Miera and Repullo (2009 s heoreical predicion of a convex relaion beween bank risk and marke power using US bank sample and also conrolling for oher bank characerisics. As such, i is also imporan o invesigae he relaion beween marke power and bank risk in a more deregulaed period in he US bank hisory following he inroducion of he Riegle-Neal Inersae Banking and Branching Efficiency Ac of 1993 and he Gramm-Leach-Bliley Ac of Hence, our second esable hypohesis (H2 relaed o bank marke power is saed as follows: Hypohesis 2 (H2: The naure of relaion beween bank risk and marke power is U- shaped, i.e., bank risk iniially decreases (due o he dominance of charer value paradigm and Marinez-Mierra and Repullo (2009 margin effec and hen increases wih bank marke power (due o he dominance of Boyd and De Nicoló s (2005 risk-shifing effec. 6

8 3.Daa and economeric mehods 3.1. Sample and daa The iniial sample examined in his paper consiss of he larges BHCs headquarered in he US wih sandard indusrial classificaion of 6021 and 6022 for respecive naional and sae commercial banks over he period 1997 o The daa is sourced from DEF 14A proxy saemens, BANKSCOPE, FR Y-9C, DATASTREAM, Federal Reserve Bank of S Louis and SDC Plainum. The deailed informaion on bank board srucures are hand colleced from DEF 14A proxy saemens of annual meeings found in he SEC s EDGAR filings. Following Adams and Mehran (2008, he governance daa is measured on he dae of he proxy saemen, i.e. a he beginning of he respecive fiscal year. The daa collecion procedure is hen adjused o accoun for when he proxies disclose some governance informaion for he previous fiscal year (e.g., he percenage of CEO shareholding and ohers for he following fiscal year (e.g., he number of direcors. The financial informaion on BHCs is mosly obained from BANKSCOPE daabase and complemened by fourh quarer Consolidaed Financial Saemens for BHCs, i.e. Form FR Y-9C, from Federal Reserve Board. The marke informaion on BHCs is colleced from DATASTREAM daabase. Similarly, he US hreemonh Treasury bill rae in he wo-index marke model for bank risk compuaions, is obained from he Federal Reserve Bank of S. Louis. The informaion on M&A aciviies of he sample BHCs over he sample period are obained from Thomson Financial s SDC Plainum daabase. The iniial sample begins wih he 300 larges BHCs as ranked by 2004 year-end book value of oal asses. The final sample, an inersecion of he daa on BHCs wih SIC 6021 and 6022 in DEF 14A proxy saemens, BANKSCOPE, DATASTREAM, and wih minimum wo consecuive years daa over , consiss of 1,534 observaions for 212 BHCs Measures of bank risk Muliple proxies of bank risk are seleced o show wheher managerial incenives and marke power have any non-monoonic impac on he bank risk-aking. The hree primary marke measures of bank risk-aking include oal risk (TR, idiosyncraic risk (IDIOR, and sysemaic risk (SYSR. Following Anderson and Fraser (2000, TR of a bank is calculaed as he sandard deviaion of is daily sock reurns (R i for each fiscal year. The daily sock reurn is calculaed as he naural logarihmic of he raio of equiy reurn series, 7

9 i.e. R i = ln(p i /P i-1 where P i sock price which is also adjused for any capial adjusmen including dividend and sock splis. TR capures he overall variabiliy in bank sock reurns and reflecs he marke s percepions abou he risks inheren in he bank s asses, liabiliies, and off-balance-shee posiions. Boh regulaors and bank managers frequenly monior his oal risk. SYSR and IDIOR are calculaed using he following wo-index marke model as suggesed by Chen, Seiner, and Whye (2006, and Anderson and Fraser (2000. This model is esimaed for each year for each bank: R i = α i 1 irm 2iINTEREST ε i (1 where, i and denoe bank i and ime respecively; R is he bank s equiy reurn; R m is he reurn on S&P 500 marke index; INTEREST is he yield on he hree-monh Treasurybill rae 2 ; α is he inercep erm; ε is he residuals. 1i is he SYSR of bank i. while IDIOR is calculaed as he sandard deviaion of residuals of eq.(1 for each year. The coefficien esimae using he above wo-index marke model, i.e. eq.(2, may be biased if here is any relaionship beween he ineres rae changes and he marke reurns (Akhigbe and Whye However, orhogonalizaion (i.e. E(Y i, X i = 0 could address his problem (Chance and Lane 1980 which may also provide some bias -saisics (Kane and Unal Therefore, following Kane and Unal (1988, and Anderson and Fraser (2000, his sudy use he un-orhogonalized wo-index marke model. Three addiional measures of bank risk, i.e. asses reurn risk (ARR, Z-score and credi risk, are also used o check he robusness of he resuls. Following Flannery and Rangan (2008, ARR is compued as he sandard deviaion of he daily sock reurns imes he raio of marke value of equiy o marke value of oal asses imes square-roo of 250. The marke value of oal asses is he sum of book-value of liabiliies and he marke value of equiy. Following Boyd, Graham and Hewi (1993, Z-score for each fiscal period is compued as Z = {[Average(Reurns Average(Equiy/Toal asses]/tr}. The Z-score has an inverse form, i.e. 1/Z, so as o make he inerpreaion of he signs of coefficiens comparable. Oherwise a high Z-score means less insolvency risk whereas a high TR, SYSR, 2 This sudy also uses he reurn on 5-year Treasury bond rae as an alernaive ineres rae index. The qualiaive resuls, however, remain he same as using hree-monh T-bill yield and so only he laer one (i.e. hree-monh T-bill rae is repored. 8

10 IDIOR, or ARR indicaes more risk. Finally, credi risk (IMP/GL is he impaired loan as a percenage of gross loans where gross loan is he sum of oal loans and loan loss reserve Measures of explanaory variables The measuremens of he wo explanaory variables - relaed o he esing hypoheses abou managerial incenives and marke power - are as follows. Following Kim and Lu (2009, we use CEO ownership (CEOWN as a proxy of managerial incenives. CEOWN is he percenage of he BHC CEO s shareholding as repored in DEF 14A proxy saemen. We expec a negaive relaion beween bank risk and CEOWN and posiive beween bank risk and squared of CEOWN. We have also conrolled for ouside direcors shareholding (OUTSIDEOWN which is he percenage of oal ousanding shares owned by he BHC officers and direcors excluding hose of he CEO. Following Keeley (1990 bank marke power is proxied by charer value (CV. CV is compued as he sum of he marke value of equiy plus he book value of liabiliies divided by he book value of oal asses. A posiive relaion is expeced beween bank risk and CV and a negaive relaion is expeced beween bank risk and squared of CV. Following prior sudies (e.g., Saunders e al. 1990; Demsez e al. 1997; Anderson and Fraser 2000; Siroh and Rumble 2006 four oher variables are included o conrol for bank size (TA, capial regulaion or financial leverage (CAPITAL, diversificaion index (DIVER, and any previous M&A aciviy (MERGER. Bank size (TA: Prior sudies showed ha bank size could negaively affec bank riskaking (e.g., Saunders e al. 1990; Boyd and Runkle 1993; Demsez and Srahan Generally, large banks can diversify heir asses risk. They also have access o more flexible source of capial and hence can mee any unexpeced shorfall of liquidiy. Large banks may also exhibi low informaion risk because hey are subjeced o frequen invesigaion by boh securiy analyss and regulaors. Finally, invesors may have he percepion ha he regulaors will no allow large banks o fail, i.e. oo-big-o-fail policy. Following Anderson and Fraser (2000 bank size (TA is measured as he naural logarihm of end of year bank s oal asses, and is expeced o be negaively relaed o bank risk-aking. Capial regulaion (CAPITAL: Following Saunders e al. (1990 and Galloway e al. (1997, his research conrols for financial leverage. Financial leverage (CAPITAL is calculaed as he book value of bank equiy as a percenage of oal asses. According o Kim and Sanomero (1988 and Furlong and Keeley (1989 financial leverage has been helpful in 9

11 mainaining sabiliy of he banking sysem. Due o is disciplinary effec, CAPITAL is expeced o negaively affec bank risk. Diversificaion index (DIVER: Prior sudies also show ha banks may benefi from diversifying heir risk hrough non-radiional aciviies, like he securiies business, as heir reurns have low correlaions (Siroh and Rumble Following Siroh and Rumble (2006, p. 127, bank revenue diversificaion index (DIVER is compued as one minus he sum of he squared fracion of operaing income from ineres and he squared fracion of ne operaing income from non-ineres sources. Bank risk and DIVER is expeced o be negaively relaed. Previous M&A (MERGER: Finally, variabiliy in bank s reurn may increase afer i merges or acquires anoher firm. Therefore, a dummy variable for M&A is also inroduced o capure his effec which equals one for BHC ha involve wih any ake-over aciviies in a year, oherwise zero. For he sake of breviy, furher deails on he conrol variables are omied as hey are shown in Panel C of Table 1. [INSERT TABLE 1 ABOUT HERE] 3.4. Empirical models and esimaion mehods Empirical models The following regression equaion is formulaed o es empirically he wo main hypoheses, H 1, and H 2, given he lieraure discussion in Secion 2. ln( RISK 2 0 1ln(1 CEOWN 2[ln(1 CEOWN] 3ln(1 OUTOWN / 2 = 4ln( CV 5[ln( CV] 6ln( TA 7( CAPITAL 8( DIVER ( MERGER δ ( YEAR ε = 1 where subscrips i denoes individual BHC (i = 1, 2,, 212, ime period ( = 1998, 1999,.., 2004 and ln is he naural logarihmic., and δ are he parameers o be esimaed. ε is he idiosyncraic error erm. The definiion of he variables in he regression eq.(2 is as menioned in Secions 3.2 and 3.3 and also as summarized in Table 1 above. The sign beneah each variable indicaes he expeced naure of relaion beween he dependen and relevan explanaory variables. As can be seen laer from descripive saisics of variables in Table 2, CEOWN and OUTSIDEOWN assume fracional numbers and zeros. Therefore, while aking logarihmic of ownership variables, for ease of inerpreaion (2 10

12 and o avoid any inconsisency/irraional number, we add 1 (one o boh CEOWN and OUTSIDEOWN variables Esimaion mehod Following prior sudies (e.g., Saunders e al. 1990; Demsez e al. 1997; and Anderson and Fraser 2000, he primary esimaion mehod of regression equaions (2 for bank risk is pooled ordinary leas squares (OLS. A prior he variance-covariance marix in he pooled-ols esimaes will be adjused wih Huber (1964 or Whie s (1980 esimaors, which are robus wih respec o heeroskedasiciy. To address reverse causaliy issues, one year lagged values of relevan righ-hand side variables are used. Adoping Peersen (2009 procedure, observaions are also clusered by boh panels (i.e., by banks and ime period o address random unobserved serial and cross-secional correlaion respecively (if any in residuals. This sudy applies several measures o reduce endogeneiy in he righ-hand side variables. For example, following Kim and Lu (2009, equaion (2 is also esimaed wih bank fixed-effec (FE o reduce unobserved heerogeneiy and he resuls are repored in Secion 5.1. Following Jaminéz e al. (2007, wo-sep sysem generalized mehods of momens (GMM esimaes in Secion 5.2 are also robus o unobserved heerogeneiy, simulaneiy and dynamic endogeneiy (if any Descripive saisics and correlaion marix The descripive saisics for he various ownership and bank-characerisics variables are presened in Table 2. The measures for managerial incenives and marke power in Panel A of Table 2 show ha he mean (median CEOWN is 4.41% (1.30% wih a minimum of 0% and a maximum of 65%. The mean (median CEOWN of 4.41% (1.30% is greaer han ha repored by Adams and Mehran (2008 of 2.27%. The mean (median OUTSIDEOWN is 10.25% (7.24%, which is comparable o he 9.63% repored by Anderson and Fraser (2000. The mean (median charer value, CV, is 1.10 (1.09 imes wih a minimum of 0.94 and a maximum of 1.64 imes. The descripive saisics in Panel B of Table 2, wihin he bank-specific variables, indicae ha he mean (median book value of bank oal asses is US$ (US$ 2.07 billion wih a minimum of US$ million o maximum of US$ 1, billion. The posiively skewed disribuion of TA suggess he use of naural logarihmic of TA in he regression analysis. The mean (median capial raio, CAPITAL, is 9.26% (9.09% which is well 11

13 over he 5% required by he regulaors for a bank o be considered well-capialized. Thus, he sample banks are unanimously well-capialized. The mean (median value of diversificaion variable, DIVER, is 0.36 (0.36 which indicaes ha hey have also diversified heir operaions beween core banking and oher aciviies. Finally, 11% of he sample BHCs involve wih eiher a merger or acquisiion aciviy during he sample period. [INSERT TABLE 2 ABOUT HERE] Turning o he descripive saisics of bank risk measures in Panel C of Table 2, he mean (median TR of 2.26% (2.02% is comparable o ha mean TR (2.13% repored by Anderson and Fraser (2000. The mean (median IDIOR is 1.98% (1.85% which resembles he mean value (2.08% shown by Anderson and Fraser (2000. The mean (median SYSR is 0.52 (0.47 and he mean (median ARR is 5.06% (4.60%. The mean (median Z-score for he sample BHCs is ( Finally, he mean (median impaired loan as percenage of gross loans, IMP/GL, is 0.58% (0.43%. [INSERT TABLE 3 ABOUT HERE] Table 3 presens he Pearson s pair-wise correlaion marix beween variables. The correlaion coefficiens beween managerial incenives, marke power measures and bank risk measures are largely in consisen wih he expecaion. For example, he correlaion coefficien beween CEOWN and all bank risk measures excep SYSR and ARR are posiive and saisically significan a 5% or beer. Likewise, he correlaion coefficien beween CV and all measures of bank risk excep for SYSR and Z-score are negaive and saisically significan. Mulicollineariy among he regressors should no be a concern as he maximum value of correlaion coefficien is which is beween diversificaion index (DIVER and bank size (TA. 4. Empirical resuls Table 4 below presens he resuls of pooled OLS esimaes of regression eq.(2 when eiher TR, IDIOR, SYSR, ARR, 1/Z or IMP/GL is he dependen variable. Paricularly, he odd columns (i.e. column 1, 3, 5, 7, 9 and 11 show he esimaes of eq.(2 wihou he squared erms of CEOWN and CV while he even columns (i.e. column 2, 4, 6, 8, 10 and 12 demonsrae he resuls of eq.(2 wih he squared erms. The relevan diagnosic ess in model fis secion of Table 4 are based on pooled-ols wihou any robus adjusmen for residuals. The average variance inflaion facors (AVIF across all he columns indicae ha he mulicollineariy among he regressors could be a concern paricularly in esimaing he 12

14 regression eq.(2 wih squared erms of LN(1CEOWN and LN(CV. 3 The saisically significan F-saisics (Π1 of Wald (1943 es of join significance of he year dummies validaes heir inclusion in he srucural model for all risk measures. The Whie (1980 alernaive es for heeroskedasiciy (Π2 shows saisically significan LM-saisics for each regression, which confirms he presence of heeroskedasiciy wih normal OLS esimaes. Likewise, he pooled-ols esimaes appear o suffer from firs-order serial correlaion, as indicaed by saisically significan F-saisics across all regressions wih Wooldridge s (2006 es for firs-order serial correlaion (Π3. The presence of firs-order serial correlaion in he panel daa also indicaes he presence of an unobserved firm-fixed effec (Wooldridge 2002, p.176. These jusify he pooled-ols esimaes of eq. (1 wih Huber (1964 or Whie (1980 heeroskedasiciy robus sandard errors wih clusered observaions by boh banks and imes o conrol for unknown fixed- and ime-effecs in he esimaes. The regression eq.(2 is well-fied wih an overall R-squared ranging from 5.2% o 56%. [INSERT TABLE 4 ABOUT HERE] Wih regard o managerial incenives measures, he coefficiens on LN(1CEOWN in odd columns are all posiive bu saisically significan for TR, IDIOR, and ARR. However, as anicipaed, he coefficiens on LN(1CEOWN and is quadraic erm, [LN(1CEOWN] 2, in even columns are negaive and posiive respecively and boh coefficiens are saisically significan across all bank risk measures. Therefore, in relaion o our firs hypohesis (H1, we find ha bank risk iniially decreases (dominance of managerial risk aversion effec and hen increases wih CEO shareholdings (dominance of shareholder s asse-subsiuion effec. This resul is also consisen wih Brewer and Saidenberg (1996 findings for savings holding insiuions. Solving for he level of CEO shareholding ha makes he oal effec on CEO ownership become negaive for TR (for example, he inflecion poin is 3.62% CEO shareholding. 4 This suggess ha he negaive effec of CEO enrenchmen (risk-aversion effec on bank risk dominaes over he posiive asse subsiuion effec for CEO ownership 3 4 According o Chaerjee, Hadi and Prince (2000, he guidelines for deecing mulicollineariy are: (i he larges VIF is greaer han 10, and (ii he mean VIF is larger han 1. Following Cebenoyan e al. (1999, he full effec of he CEO ownership for he non-linear specificaion is equal o he coefficien on CEOWN plus wo imes he produc of he coefficiens on squared of CEO ownership and a given CEO ownership level. The urning poin is calculaed by solving for he unknown CEO ownership level ha makes his full effec equal o zero, i.e. δ 5 2*{δ 6 *LN(1CEOWN} = 0. 13

15 of less han 3.62%, and vice-versa for CEO ownership greaer han 3.62%. I also specifies ha he mean CEO shareholding (4.1% in Panel A of Table 2 was well above he inflecion poin (3.62% in he pre-financial crisis period. Thus, he comparaive saisics on CEOWN o some exen sugges ha bank managemen incenives were more aligned wih hose of bank shareholders and shareholders risk-shifing effec dominaed paricularly in pre-crisis period. Hence bank underook excessive risk leading o he financial crisis. [FIGURE 1A AND FIGURE 1B ABOUT HERE] Wih regard o marke power measure, he coefficiens on LN(CV in odd columns show mix signs for differen bank risk measures. Paricularly, he saisically significan posiive coefficien on LN(CV for SYSR indicaes ha banks wih high charer-value are exposed o more sysemaic risk and is consisen wih Saunders and Wilson (2001. However, as hypohesized, he coefficiens on LN(CV and is quadraic erm, [LN(CV] 2, in even columns, are negaive and posiive respecively across all bank risk measures excep for SYSR and boh coefficiens are saisically significan a 5% or beer for all bank risk measures. This illusraes ha, afer conrolling for oher governance and bank characerisics, he naure of relaion beween bank marke power and bank risk is convex (i.e U-shaped. Tha is, bank risk iniially decreases and hen increases wih bank marke power. Thus, our second hypohesis (H2 is well-suppored. This resul is also consisen wih he heoreical predicion of Marinez-Miera and Repullo (2009 regarding he convex naure of relaion beween marke compeiion and bank risk-aking. Solving for he level of CV ha makes he oal effec on CV become negaive for TR, he inflecion poin is This suggess ha he negaive impac of margin effec on bank risk dominaes over he posiive risk-shifing effec for CV of less han 1.19, and vice-versa for CV greaer han Thus, his finding miigaes and reconciles previously empirically documened mix and opposing resuls on he relaion beween charer value and bank risk. The coefficiens on oher bank characerisics variables offer some imporan insighs. For insance, while no direcional predicion was made on OUTSIDEOWN, a saisically significan coefficien on LN(1OUTSIDEOWN for IDIOR, SYSR and IMP/GL sugges ha banks wih greaer ouside direcor shareholding have higher idiosyncraic risk 5 The full effec of he CV for he non-linear specificaion is equal o he coefficien on CV plus wo imes he produc of he coefficiens on squared of CV and a given CV level. The urning poin is calculaed by solving for he unknown CV level ha makes his full effec equal o zero, i.e. δ 5 2*{δ 6 *LN(CV} = 0. 14

16 (IDIOR bu have lower sysemaic (SYSR and credi (IMP/GL risks. The saisically significan negaive coefficiens on LN(TA for TR, IDIOR and ARR are consisen wih our predicion. However, he saisically significan posiive coefficiens on LN(TA for SYSR, 1/Z and IMP/GL, are consisen wih Sever (2006 who shows ha he sysemaic risks of large banks are wo o five imes greaer han hose of small banks. A odds o our expecaion, he saisically significan posiive coefficiens on CAPITAL for ARR and 1/Z indicae ha capial regulaion do no consrain banks from risk-aking. Similarly, he saisically significan coefficiens on DIVER for TR and IMP/GL demonsrae ha diversificaion via nonineres income aciviies could lower banks oal (TR and idiosyncraic (IDIOR risks bu increase heir credi risk. Finally, consisen wih our anicipaion, he coefficiens on previous period MERGER dummy are posiive across all bank risk measures and saisically significan for TR, IDIOR, ARR and IMP/GL. 5. Robusness ess 5.1. Fixed-Effec esimaion Table 5 repors on he fixed-effec panel esimaion of equaion (2 when TR, IDIOR, SYSR, ARR, 1/Z or IMP/GL is he dependen variable. The odd columns (i.e. column 1, 3, 5, 7, 9 and 11 show he FE esimaes of eq.(2 wihou he squared erms of CEOWN and CV while he even columns (i.e. column 2, 4, 6, 8, 10 and 12 demonsrae he FE resuls of eq.(2 wih he squared erms. FE esimaes are robus o endogeneiy in variables from unobserved heerogeneiy. The R-squared of eq.(2 for various risk measures ranges from 1.8% o 28.7%. [INSERT TABLE 5 ABOUT HERE] The inerpreaion of he esimaes relaed o managerial incenives and marke power remains he same as hose in Table 4 excep ha he coefficiens on LN(1CEOWN in odd columns are no longer saisical significan for any of he bank risk measures. However, he coefficiens on LN(1CEOWN and is quadraic erm, [LN(1CEOWN] 2, remain negaive and posiive respecively and saisically significan for all bank risk measures excep for IMP/GL. Similarly, he coefficiens on LN(CV and is squared erm, [LN(CV] 2, also assume negaive and posiive sign respecively for all bank risk measures excep for SYSR and are saisically significan for all bank risks. Thus, even afer conrolling for unobserved heerogeneiy, he FE esimaes also confirm a convex relaion beween bank risk and managerial incenives and bank risk and bank marke power. 15

17 5.2. Two-sep sysem GMM Table 6 below repors he resuls of Arellano and Bover (1995 and Blundell and Bond (1998 sysem GMM esimaion of eq.(2 using differen measures of bank risk. In he sysem GMM, firs-differenced variables are used as insrumens for he equaions in levels and he esimaes are robus o unobserved heerogeneiy, simulaneiy and dynamic endogeneiy (if any. 6 The model fis secion of Table 6 show es saisics for boh firsorder (Π1 and second-order auocorrelaion in second differences (Π2 and Hansen J- saisics of over-idenifying resricions. The residuals in he firs difference should be serially correlaed (Π1 by way of consrucion bu he residuals in he second difference should no be serially correlaed (Π2. Accordingly, in Table 6, we find saisically significan Π1 across all risks and saisically insignifican Π2 for all bank risk measures excep for 1/Z and IMP/GL. Similarly, he Hansen J-saisics of over-idenifying resricions ess he null of insrumen validiy and he saisically insignifican Hansen J-saisics for all he bank measures indicae ha he insrumens are valid in he respecive esimaion. So, we find saisically insignifican Hansen J-saisics for all bank risk excep for SYSR and ARR. Finally, he number of insrumens (i.e. 151 or 170 used in he model is less han he panel (i.e. 212 which makes he Hansen J-saisics more reliable. [INSERT TABLE 6 ABOUT HERE] Compare o pooled-ols esimaes in Table 4, sysem GMM esimaes in Table 6 above presen one noable difference. The posiive and negaive coefficiens on LN(1CEOWN and is squared erm, [LN(1CEOWN] 2, respecively are no longer saisically significan for any of he bank risk measures. However, he coefficiens on LN(CV and [LN(CV] 2 are sill significanly negaive and posiive respecively for all bank risks. Thus, even afer conrolling for unobserved heerogeneiy, simulaneiy and dynamic endogeneiy wih wo-sep he sysem GMM, he esimaes in Table 6 sill suppors ha bank marke power relaes o bank risk in a way consisen wih he expecaion. 6.Conclusion This sudy examines he effec of managerial incenives and marke power on bank risk aking. To ha end, evidence is sough wheher CEO shareholding (a proxy for 6 The sysem GMM esimaes are obained using he Roodman xabond2 module in Saa. Please see Roodman (2006 for deail esimaion procedure of dynamic panel daa using xabond2. 16

18 managerial incenives non-linearly associaed wih bank risk-aking due o he inerplay of he managerial enrenchmen/risk-aversion effec and shareholders asse-subsiuion effec. Similarly, evidence is also sough as o wheher he effec of bank charer value (a proxy for marke power on bank risk-aking is convex (i.e. U-shaped because of he radeoff beween charer value paradigm, margin effec, and shareholder s risk-shifing effec. Using a sample of 212 US BHCs over periods, i.e. 1,534 bank observaions, he resuls show a U-shaped relaion beween bank risk measures and CEO shareholding. This suggess ha bank risk iniially decreases wih CEO shareholding unil i reaches a hreshold and hen a furher increase in CEO shareholding beyond he hreshold poin lower bank risk. CEO shareholding a he hreshold poin for oal risk measures was 3.62% which is higher han he mean CEO shareholding of 4.10%. I indicaes ha bank CEOs incenives were more aligned wih bank shareholding in he pre-crisis period. Hence bank ook excessive risk in he pre-crisis period due o he dominance of he shareholders assesubsiuion effec. This ulimaely leads o he financial crisis. Consisen wih our expecaion, we also find evidence of a convex (i.e. U-shaped relaion beween charer value and bank risk measures. Tha is, a low level of charer value, he naure of relaion beween charer value and bank risk is negaive due o he dominance of charer value paradigm and Marinez-Miera and Repullo s (2009 margin effec. However, a higher level of charer value, bank risk posiively relaed o charer value conveying he dominance of shareholders risk-shifing effec. These findings are robus o various bank risk measures including oal risk, idiosyncraic risk and sysemaic risk as well as differen esimaion mehods. Perhaps one of he imporan policy implicaions of he findings is ha bank CEOs incenives were more aligned wih shareholders incenives in he pre-crisis period and so encouraged banks o assume excessive risk a he cos of ax payers fund. This advocaes he recen various governmens move owards reforming exising execuives pay srucure including Presiden Obama adminisraion. o avoid repeiion of such financial caasrophe and o ensure a sable financial sysem. Similarly, he resul for charer value implies ha marke power (charer value is effecive in resricing bank risk aking a high level of compeiion. Thus, bank regulaors, and policy makers should appreciae he imporance of managerial incenives and marke power while designing appropriae incenives srucure in 17

19 banks and evaluaing he bank enry and exi requiremens in a paricular marke o avoid excessive risk aking. 18

20 References Adams, R.B., Mehran, H., Corporae performance, board srucure and is deerminans in he banking indusry. Working paper, Federal Reserve Bank of New York. Akhigbe, A., Whye, A.M., Changes in marke assessmens of bank risk following he Riegle-Neal ac of Journal of Banking and Finance 27, Anderson, R.C., Fraser, D.R., Corporae conrol, bank risk aking, and he healh of he banking indusry. Journal of Banking and Finance 24, Arellano, M., Bover, O., Anoher look a he insrumenal variables esimaion of error-componens models. Journal of Economerics 68, Barh, J. R., Caprio, G., Levine, R., Banking sysems around he globe: do regulaions and ownership affec performance and sabiliy? In F. S. Mishkin (Ed., Prudenial supervision: Wha works and wha doesn'. Chicago: Universiy of Chicago Press. Barh, J. R., Caprio, G., Levine, R., Bank regulaion and supervision: Wha works bes? Journal of Financial Inermediaion 13, Berle, A.A., Means, G.C., The Modern Corporaion and Privae Propery. Macmillan Publishing Company: New York. Blundell, R., Bond, S., Iniial condiions and momen resricions in dynamic panel daa models. Journal of Economerics 87, Boyd, J.H., De Nicoló, G., The heory of bank risk aking and compeiion revisied. Journal of Finance 60, Boyd, J.H., De Nicoló, G., Jalal, A.A., Bank risk aking and compeiion revisied: New heory and new evidence. Universiy of Minnosoa Carlson School of Managemen Working Paper Series. Boyd, J.H., Graham, S.L., Hew R.S., Bank holding company mergers wih nonbank financial firms: Effecs on he risk of failure. Journal of Banking and Finance 17, Brewer, E. III, Saidenberg, M.R., Franchise value, ownership srucure, and risk a savings insiuions. Federal Reserve Bank of New York Research Paper # Cebenoyan, A. S., Cooperman, E. S., Regiser, C. A., Ownership srucure, charer value, and risk-aking behavior for hrifs. Financial Managemen 28, Chance, D.M., Lane, W.R., A re-examinaion of ineres rae sensiiviy in he common socks of financial insiuions. Journal of Financial Research 3, Chen, C.R., Seiner, T.L., Whye, A.M., Does sock opion-based execuive compensaion induce risk-aking? An analysis of he banking indusry. Journal of Banking and Finance 30,

21 De Nicoló, G., Loukoianova, E., Bank ownership, marke srucure and risk. Inernaional Moneary Fund Working Paper Series # WP/07/215. Demsez, R.S., Saidenberg, M.R., Srahan, P.E., Agency problems and risk aking a banks. Working paper, Federal Reserve Bank of New York. Fahlenbrach, R., Sulz, R., Bank CEO incenives and he credi crisis. Swiss Finance Insiue Research Paper Series # Flannery, M.J., Rangan, K.P., Wha caused he bank capial build-up of he 1990s? Review of Finance 12, Furlong, F. T., Keeley, M. C., Capial regulaion and bank risk-aking: A noe. Journal of Banking & Finance 13, Gala D., Masulis, R.W., The opion pricing model and he risk facor of sock. Journal of Financial Economics 3, Galloway, T. M., Lee, W. B., Roden, D. M., Banks' changing incenives and opporuniies for risk aking. Journal of Banking & Finance 21, Gonzalez, F Bank regulaion and risk-aking incenives: an inernaional comparison of bank risk. Journal of Banking & Finance 29, Goron, G., Rosen, R., Corporae conrol, porfolio choice, and he decline of banking. The Journal of Finance 50, Guay, W.R., The sensiiviy of CEO wealh o equiy risk: an analysis of he magniude and deerminans. Journal of Financial Economics 53, Jensen, M.C., Meckling, W.H., Theory of he firm: managerial behavior, agency coss and ownership srucure. Journal of Financial Economics 3, Jiménez, G., Lopez, J.A., Saurina, J., How does compeiion impac bank risk-aking? Federal Reserve Bank of San Francisco Working Paper Series # Kane, E.J., Unal, H., Change in marke assessmens of deposi-insiuion riskiness. Journal of Financial Services Research 1, Keeley, M.C., Deposi insurance, risk and marke power in banking. The American Economic Review 80, Kim, H.E., Lu, Y., CEO share ownership and firm valuaion. SSRN working paper, viewed 14 February 2010, <hp://ssrn.com/paper= > Kim, D., Sanomero, A. M., Risk in banking and capial regulaion. The Journal of Finance 43, Marinez-Miera, D., Repullo, R., Does compeiion reduce he risk of bank failure? CEMFI Working Paper #

22 May, D.O., Do managerial moives influence firm risk reducion sraegies? The Journal of Finance 50, Meron, R.C., An analyic derivaion of he cos of deposi insurance and loan guaranees. Journal of Banking and Finance 1, Parrino, R., Poeshman, A.M., Weisbach, M.S., Measuring invesmen disorions when risk-averse managers decide wheher o underake risky projecs. Financial Managemen 34, Peersen, M. A., Esimaing sandard errors in finance panel daa ses: comparing approaches. Review of Financial Sudies 22, Roodman, D., How o do xabond2: An inroducion o "difference" and "sysem" GMM in Saa. Working paper, Cener for Global Developmen, Washingon. Saunders, A., Corne, M.M., Financial Insiuions Managemen: A Risk Managemen Approach. McGraw-Hill Companies Inc: New York. Saunders, A., Srock, E., Travlos, N.G., Ownership srucure, deregulaion, and bank risk aking. The Journal of Finance 45, Saunders, A., Wilson, B., The impac of consolidaion and safey-ne suppor on Canadian, US and UK banks: Journal of Banking & Finance 23, Smih, C.W., Sulz, R.M., The deerminans of firms' hedging policies. Journal of Financial and Quaniaive Analysis 20, Sever, R Bank size, credi and he sources of bank marke risk. SSRN working paper, viewed 14 February 2010, <hp://ssrn.com/paper=890658>. Siroh, K. J., Rumble, A., The dark side of diversificaion: The case of US financial holding companies. Journal of Banking and Finance 30, Wooldridge, J. M., Economeric analysis of cross secion and panel daa. Cambridge, Massachuses; London: MIT Press. Wooldridge, J. M., Inroducory economerics: A modern approach (3rd ed.. Mason, OH: Thomson/Souh Wesern. Zhou, X., Undersanding he deerminans of managerial ownership and he link beween ownership and performance: Commen. Journal of Financial Economics 62,

23 Figure1A: Opimum CEO Ownership (% CEO Ownership Toal Risk Inflecion poin = 3.62% 0.8 CEO Ownership(% Figure 1B: Opimum Charer Value Charer value Toal Risk Inflecion poin = Charer value 22

24 Table 1: Definiions of Variables Variables Measures Panel A: Dependen variables (RISK 1. Toal risk (TR The sandard deviaion of he daily bank sock reurns in each year. 2. Idiosyncraic risk (IDIOR The sandard deviaion of he error erms in Eq.(1. 3. Sysemaic risk (SYSR Coefficien of Rm (i.e. 1 in Eq.(1. 4. Asses reurn risk (ARR The sandard deviaion of he daily sock reurns imes he raio of marke value of equiy o marke value of oal asses imes he square-roo of Insolvency risk (Z-score Z = [Average(Reurns Average(Equiy/Toal asses]/sd(equiy/toal asses. 6. Credi risk (IMP/GL Impaired loan as percenage of gross loans where gross loan is he sum of oal loans and loan loss reserve. Panel B: Managerial incenives and marke power variables CEO ownership (CEOWN The percenage of he BHC CEO s shareholdings. Ouside ownership (OUTOWN Charer value (CV Panel C: Conrol variables Bank size (TA The percenage of oal ousanding shares owned by he BHC officers and direcors excluding hose of he CEO. Keeley's Q (Keeley 1990 which is calculaed as he sum of he marke value of equiy plus he book value of liabiliies divided by he book value of oal asses. Toal asses as a he end of each fiscal year. Bank capial (CAPITAL The BHC s oal equiy as a percenage of he oal asses. Diversificaion index (DIVER The diversificaion index is calculaed following Siroh and Rumble (2006 which is 1 (squared of fracion of operaing income from ineres plus squared of fracion of ne operaing income from non-ineres sources such as fees and charges, fiduciary income, rading revenues. Previous M&A (MERGER A dummy for any previous period M&A, i.e. a dummy variable which equals one for BHC ha made an acquisiion in a year, oherwise zero. Year dummies (YEAR Seven individual dummy variables which equals eiher one or zero for each year from 1998 o 2004 wih 1997 being he excluded year. 23