By selecting, financing, and monitoring firms, banks influence capital allocation, economic activity, and risk (Allen and Gale, 2000, and Levine, 2006). Many governments, however, fear that a bank’s private governance arrangements, including its ownership and management structure, will not produce a desirable allocation of capital, and therefore enact regulations to shape bank behavior (Benston and Kaufman, 1996; Barth et al., 2006). Yet, no previous empirical research studies how a bank’s ownership structure combines with a wide array of national laws and regulations to shape bank risk taking.
In this paper, we evaluate the impact of ownership structure, franchise value, investor protection laws, and bank regulations on the risk taking behavior of banks around the world; thus, we simultaneously examine an individual bank’s private governance structure and the policy environment in which it operates. In contrast, past work examines subsets of these factors. For example, Demirgüç-Kunt and Detragiache’s (2002) cross-country study of deposit insurance and banking crises does not control for regulations designed to limit bank risk taking or for bank-level governance traits. In turn, Saunders et al. (1990) and Demsetz et al. (1997) show how ownership structure, franchise value, and other bank-level characteristics influence bank risk taking in the United States. They cannot, however, test whether numerous laws and regulations shape bank risk taking, and it is unclear whether their results generalize to banks in other countries with different policies. By collecting new data on bank ownership and managerial structure and merging it with data on bank regulations and investor protection laws, we examine how a bank’s private governance arrangements combine with national policies to influence risk taking.
Theory advertises the advantages of simultaneously examining bank-level governance and national policies. Banks are a complex nexus of agency problems and conflicting interests that interact to influence risk taking. As in any limited liability firm, stockholders have incentives to increase bank risk after collecting funds from bondholders and depositors (Galai and Masulis, 1976; Esty, 1998). Furthermore, if bank creditors believe the government insures their investments, they will monitor bank behavior less rigorously, intensifying the ability and incentives of stockholders to increase risk (Merton, 1977; Keeley, 1990).
Traditional agency problems between bank managers and stockholders also influence bank risk taking (Jensen and Meckling, 1976). If managers have accumulated bank-specific human capital, enjoy private benefits of control, and have a large proportion of their non-human wealth linked to the bank, they will tend to allocate assets in an excessively safe rather than a value maximizing manner (Demsetz and Lehn, 1985; Kane, 1985; Saunders et al., 1990).
The ability of managers to adjust bank risk for their own benefit, however, depends on investor protection laws and the ownership structure of the bank (Shleifer and Wolfenzon, 2002; John et al., 2005). For instance, ineffective investor protection laws tend to tip the balance of governance power toward bank insiders, including managers. In contrast, large shareholders have greater incentives and power to limit managerial discretion than small shareholders even in the absence of effective investor protection laws (Shleifer and Vishny, 1986; Caprio et al., 2005). From this perspective, an owner with large voting and cash-flow rights will have the financial motivation and authority to prevent managers from taking excessively safe investments.
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Corporate Governance, Regulation, and Bank Risk Taking
