Economic Policy Review Executive Summary

Is Corporate Governance Different for Bank Holding Companies?

Recapping an article from the April 2003 issue
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of the Economic Policy Review, Volume 9, Number 1 View full article PDF

20 pages / 212 kb

Authors: René Adams and Hamid Mehran

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Index of executive summaries

Overview
Adams and Mehran study an aspect of corporate governance—the governance of financial institutions—that has received relatively little attention in the academic literature. By comparing a range of variables, or characteristics, shown by bank holding companies (BHCs) and manufacturing firms, they shed light on how governance structures differ between firms in regulated and unregulated industries.

The authors identify important differences in the characteristics, which they attribute to the investment patterns of the two types of firms and to the presence of regulation in the banking industry. The differences observed also augment those found by other studies comparing manufacturing firms with insurance industry firms or with public utilities firms. Accordingly, Adams and Mehran's results support the argument that governance structures are industry-specific and suggest that governance reforms, to be effective, should account for industry differences.

Background
The recent series of corporate scandals has prompted regulators, creditors, shareholders, and academics to focus more closely on the corporate decision-making process and propose changes in governance structures aimed at enhancing accountability and efficiency. To the extent that the proposals are based on academic research, they generally draw upon a large body of studies on the governance of firms in unregulated, nonfinancial industries. Financial institutions, however, are very different from firms in unregulated industries, such as manufacturing firms. It is therefore important to consider whether proposals and reforms can also be effective in enhancing the governance of financial institutions.

A central theory in the governance literature argues that board structure, ownership structure, and compensation structure are determined by one another as well as by a range of variables, such as risk, real and financial assets, cash flow, firm size, and regulation. These variables can also influence a firm's conduct and performance. Although numerous studies have examined these potentially complex governance relationships in unregulated firms, relatively few have focused on institutions in a regulated environment.

Argument and Methodology
Adams and Mehran incorporate this environment into their study of corporate governance characteristics. They describe the differences and similarities in the characteristics of regulated bank holding companies and unregulated manufacturing firms, and consider the effect of regulation on banking firm behavior. Because many typical external governance mechanisms, such as the threat of hostile takeovers, are absent from the banking industry, the authors concentrate on internal governance structures and shareholder block ownership.

The study sample consists of thirty-five bank holding companies over the 1986-96 period. For these institutions, Adams and Mehran construct governance variables (or proxies) identified by researchers and practitioners in law, economics, organization, and management as key variables correlated with governance practices. They compare the variables with similar ones for manufacturing firms compiled in other studies.

Findings
Adams and Mehran mine a host of findings from their comparison of bank holding companies and manufacturing firms (tablePDF1page / 25 kb). For example, they find that BHCs have larger boards of directors and a slightly larger share of outside directors. These differences very likely result from BHC size and organizational structure, the regulatory framework, and constraints on the ability of BHCs to engage in hostile acquisitions. From these results, the authors caution that conclusions about board size or board composition are potentially misleading when they omit the effect of industry differences.

The study also finds that BHC boards have more committees and meet slightly more frequently than do the boards of manufacturing firms (tablePDF1 page / 25 kb). Adams and Mehran acknowledge that it is difficult to speculate on the costs and benefits of having more committees. However, they suggest that because regulations on the number of meetings may influence a BHC's choice of directors, regulations can potentially affect the quality of individuals willing to serve on the board.

BHC boards are also found to rely less on long-term incentive-based compensation for CEOs. Furthermore, CEO ownership, measured by direct equity holdings, is smaller in BHCs in both percentage and market value terms. Adams and Mehran observe that because compensation packages and ownership result from a contracting process that takes into account industry structure as well as regulation, the CEO compensation structures of BHCs and manufacturing firms are not expected to become similar in the near future.

Finally, the study finds that fewer institutions hold shares of BHCs relative to shares of manufacturing firms, and that institutions hold a smaller percentage of BHC equity (tablePDF1page/24kb). An important issue raised by this result, according to the authors, is whether institutions that do hold BHC stock are active in governance. Adams and Mehran admit that this is a hard issue to address because there are few documented cases of institutions taking a reactive or proactive role in the governance of banking firms. The authors speculate that institutional investors may prefer to resolve governance issues privately to avoid public announcements, or may rely on regulators to resolve the governance problems of banking firms.


Disclaimer

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.