An examination of the relationship between board characteristics and capital adequacy risk taking at bank holding companies.

Author:Merle, Jill Ann
Position::Abstract
 
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INTRODUCTION

While there has been a large amount of research done in the area of corporate governance and the impact of certain board characteristics on firm performance, research related to board characteristics and firm risk taking is very limited. With the 2008 crisis in the financial services sector, a question can be raised as to whether boards of banks that took on greater risk had common characteristics. If significant relationships were found, this would result in recommendations as to board composition based on desired risk levels for the bank. The research would lead to an awareness of the risk propensity of a given board of directors based on their characteristics. Board members could be selected with consideration as to their influence on the characteristics that have a relationship to the risk taking of the board. Significant relationships between board characteristics and bank risk taking would also help investors to evaluate the potential risk in a given stock based on characteristics of the board of directors.

BANK RISK

Bank risk and the regulation of financial firms are matters of importance due to the desire to maintain stability in the financial system. The term "too big to fail" is often used in regards to financial institutions. A financial firm should be protected from failure due to the systemic risk of the failure (Bullard, Neely, Wheelock, 2009). "Systemic risk refers to the possibility that a triggering event such as the failure of an individual firm will seriously impair other firms or markets and harm the broader economy" (Bullard et.al., 2009). To protect individuals from the impact of bank failure, the government safety net provided to depositors in the form of deposit insurance is generally accompanied by regulations for all firms, regardless of size, that constrain banking firms' activities and corporate organizational form. Federal deposit insurance and capital requirements placed on banks removes the market oversight and, therefore encourages excessive risk taking (Bullard et.al. 2009). Shrieves and Dahl (1992) and Keeley (1990) also discuss the excessive risk-taking by bankers as a result of deposit insurance. Merton (1977) shows that banks maximize the value of deposit insurance to themselves by maximizing their risk. Merton (1977) derives a formula for the cost of FDIC insurance to the government based on the loan guarantees acting as European put options. Option pricing theory is used to show that maximizing the value of stockholders' equity would occur with the maximization of the option value of deposit insurance through increasing leverage and portfolio asset risk (Merton, 1977). Deposit insurance can be viewed as a put option on the value of a bank's assets at a strike price equal to the promised maturity value of its debt. Under a fixed-rate insurance system, banks could transfer wealth from the insurer to stockholders and, without regulation, will maximize the value of the put by increasing asset risk and/or minimizing capital relative to assets. Shrieves and Dahl (1992) claim that the need for bank capital regulation is based to a large degree on the presence of incentives for banks to take advantage of the deposit insurance subsidy for stockholders by taking risks that may expose banks to a high chance of failure. The reason for government regulation of financial firms stems from the belief that bank depositors cannot effectively protect themselves (Dewatripont & Tirole, 1994). The first reason for this belief is that depositors cannot effectively see or control bank risks because of information costs and coordination problems (Flannery, 1998). The time it would take for a depositor to acquire the information to evaluate the risk of an individual bank would not be worth the marginal benefit that depositor would gain from that information. A second reason for government regulation of banking stems from the fact that bank loans are customized privately negotiated agreements that, even with increased availability of price information and trading activity, still often lack transparency and liquidity to depositors (Flannery, 1998). Government regulation may be an attempt to correct the markets failure to assess the true value of the loan portfolios due to asymmetric information. Market and government supervision are alternative methods for governing any type of corporation. Most national governments have instituted nonmarket regulatory mechanisms for bank firms based on the fact that the markets fail to adequately discipline banks.

CAPITAL ADEQUACY RISK

Various capital...

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