Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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One response to “Governance of banks

  1. student July 9, 2009 at 5:33 pm

    “… top management of UK banks were people of exceptional ability”

    should be

    “… top management of UK banks were people of exceptional greed”

    It is a fact that finance profession attracts mostly greedy people, motivated by prospects of making money at any cost and not by their desire to do good or create something useful. If they are bright (a lot are but definitely not exceptional) impact due to their greed is amplified.

    My question is does finance require brighter people than say manufacturing. Answer is clearly no. Do they add more value than people in other sector – again no. So why exorbitant pay scales? Banking, like power, should be a utility function not really a value creation function like engineering or research.

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