Electronic copy available at: http://ssrn.com/abstract=1397685 Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide David Erkens a Mingyi Hung a,* Pedro Matos b September 2010 a University of Southern California, Leventhal School of Accounting, Marshall School of Business, Los Angeles, CA 90089 b University of Southern California, Marshall School of Business, Los Angeles, CA 90089 *Corresponding author. Tel.: 213-740-7377; fax: 213-747-2815. E-mail address: mhung@marshall.usc.edu Acknowledgments: The authors thank the following for their helpful comments: Harry DeAngelo, Mark DeFond, Miguel Ferreira, Jarrad Harford, Victoria Ivashina, Andrew Karolyi, April Klein, Frank Moers, Kevin Murphy, Oguzhan Ozbas, Eddie Riedl, Lemma Senbet, K.R. Subramanyam, and David Yermack. We also thank the workshop and meeting participants at Bruegel, the Chinese University of Hong Kong, FDIC conference, FEA conference, Financial Services Authority, Maastricht University, Organization for Economic Co-operation and Development (OECD), UBC Finance Summer Conference 2009, University of Illinois at Urbana-Champaign, UNC 2010 Global Issues in Accounting Conference, University of Southern California, and Washington University in St. Louis. We gratefully acknowledge the help from Yalman Onaran of Bloomberg and Shisheng Qu from Moody’s KMV. Electronic copy available at: http://ssrn.com/abstract=1397685 Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide Abstract This paper investigates the influence of corporate governance on financial firms’ performance during the 2007-2008 financial crisis. Using a unique dataset of 296 financial firms from 30 countries that were at the center of the crisis, we find that firms with more independent boards and higher institutional ownership experienced worse stock returns during the crisis period. Further exploration suggests that this is because (1) firms with higher institutional ownership took more risk prior to the crisis, which resulted in larger shareholder losses during the crisis period, and (2) firms with more independent boards raised more equity capital during the crisis, which led to a wealth transfer from existing shareholders to debtholders. Overall, our findings cast doubt on whether regulatory changes that increase shareholder activism and monitoring by outside directors will be effective in reducing the consequences of future economic crises. Electronic copy available at: http://ssrn.com/abstract=1397685 1 Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide 1. Introduction An unprecedented large number of financial institutions have collapsed or were bailed out by governments since the onset of the global financial crisis in 2007. 1 The failure of these institutions have resulted in a freeze of global credit markets and required extraordinary government interventions worldwide. While the macroeconomic factors (e.g., loose monetary policies) that are at the roots of the financial crisis affected all firms (Taylor, 2009), some firms were affected much more than others. Recent studies argue that firms’ risk management and financing policies had a significant impact on the degree to which firms were impacted by the financial crisis (Brunnermeier, 2009). Because firms’ risk management and financing policies are ultimately the result of cost-benefit trade-offs made by corporate boards and shareholders (Kashyap et al., 2008), an important implication from these studies is that corporate governance affected firm performance during the crisis period. In this paper, we provide empirical evidence on whether, and how corporate governance influenced the performance of financial firms during the crisis period. We perform our investigation using a unique dataset of 296 of the world’s largest financial firms across 30 countries that were at the center of the crisis. We examine the relation between firm performance and corporate governance by regressing cumulative stock returns during the crisis (from the first quarter of 2007 until the third quarter of 2008) on measures of corporate governance and control variables. We include three corporate governance factors: (1) board independence, (2) institutional ownership, and (3) the presence of large shareholders, measured as of December 2006. In addition, following Mitton (2002), we control for a dummy indicating 1 The list of casualties includes Bear Stearns, Citigroup, Lehman Brothers, Merrill Lynch (in the U.S.), HBOS and RBS (in the U.K.), and Dexia, Fortis, Hypo Real Estate and UBS (in continental Europe). 2 whether a firm is cross-listed on U.S. stock exchanges, leverage, firm size, and dummy variables indicating a firm’s industry and country. 2 Finally, we control for stock return in 2006 because the performance during the crisis period may reflect a reversal of pre-crisis performance (Beltratti and Stulz, 2010). 3 Our analysis finds that firms with more independent boards and greater institutional ownership experienced worse stock returns during the crisis period. A potential explanation for this finding is that boards and shareholders encouraged managers to increase shareholder returns through greater risk-taking prior to the crisis. External monitoring by boards and shareholders may increase risk-taking before the crisis, because managers that have accumulated firm-specific human capital and enjoy private benefits of control tend to seek a lower level of risk than shareholders that do not have those skills and privileges (Laeven and Levine, 2009). We test this explanation by regressing expected default frequency (EDF) and stock return volatility on the governance factors and the same set of control variables. 4 We find mixed support for this explanation. In particular, while we find that firms with greater institutional ownership took more risk before the crisis, we do not find that firms with more independent boards did so. Thus, our findings are inconsistent with independent board members having encouraged managers to take greater risk in their investment policies before the onset of the crisis. 2 We do not control for a dummy variable indicating whether a firm has a Big-N auditor as in Mitton (2002) because only five of our sample firms have non-Big-4 auditors. As reported in Section 4, our result is not sensitive to excluding firms with non-Big-4 auditors or including a dummy variable indicating Big-4 auditor. 3 We do not control for country-level regulatory and macroeconomic variables (as in Beltratti and Stulz, 2010) because this will introduce perfect multicollinearity with our country dummies. By controlling for country dummies in our regression model, our analysis essentially examines how the cross-sectional within-country variation in firm performance is related to within-country variation in corporate governance characteristics. In addition, since our sample consists of all financial institutions including not only banks, but also brokerage and insurance companies, we do not include the bank-specific financial statement variables (such as deposits or loans) used in Beltratti and Stulz (2010). Instead, our model addresses differences in balance sheet characteristics and capital requirements across global financial institutions by controlling for leverage, industry dummies (3-digit SIC), and country dummies. 4 EDF is computed by Moody's KMV CreditMonitor implementation of Merton's (1974) structural model and has been used in prior studies to capture credit risk (Covitz and Downing, 2007). 3 An alternative explanation for the negative relation between stock returns and board independence is that independent directors out of concern for their reputation pressured managers into raising equity capital to ensure capital adequacy and reduce bankruptcy risk, which led to a significant wealth transfer from shareholders to debtholders during the crisis period (Myers, 1977; Kashyap et al., 2008). Consistent with equity capital raisings leading to a wealth transfer from existing shareholders to debtholders we find negative cumulative abnormal stock returns and abnormal decreases in credit default swap (CDS) spreads in the 3-day window around the announcement of equity offerings. 5 To test our alternative explanation for the relation between stock returns and board independence we regress the amount of equity capital raised during the crisis (scaled by total assets) on the corporate governance factors and control variables. Consistent with this alternative explanation, we find that firms with more independent boards raised more equity capital. Moreover, we find that the association between stock returns and board independence becomes insignificant once we exclude firms that raised equity capital during the crisis from our sample. We also explore the relation between firm performance during the crisis and country-level governance, measured as the quality of legal institutions and the extent of laws protecting shareholder rights. We find an insignificant relation between firm performance and the country- level governance variables. This evidence is consistent with firm-level, but not country-level governance mechanisms being important in explaining why some financial firms were much more affected by the financial crisis than others. 5 CDS is an “insurance” contract against the risk of default, in which the buyer makes a series of payments in exchange for the right to receive a payoff in case of default by the referenced entity. The more likely a firm is to default on its debt obligations, the higher a firm’s CDS spread. 4 Finally, we find that our results on the relation between stock returns and corporate governance are robust to several sensitivity tests, including controlling for additional board characteristics (i.e., the existence of a risk committee, the financial expertise of the board, and CEO-chairman duality), controlling for additional ownership characteristics (i.e., percentage of shares held by insiders), using alternative definitions of the crisis period (i.e., July 2007- September 2008 or July 2007-December 2008), and using an alternative measure of stock returns (i.e., abnormal stock returns based on a market model). Our paper contributes to an emerging body of research that attempts to identify the mechanisms that influenced how severely financial firms were impacted by the crisis (Kashyap et al., 2008; Brunnermeier, 2009; Barth and Landsman, 2010), and adds to the current debate on the regulatory reform of financial institutions (Kirkpatrick, 2008; Schapiro, 2009) in several ways. First, concurrent studies on the financial crisis have mostly focused on the macroeconomic factors that are at the roots of the financial crisis (Taylor, 2009), but have not examined why some firms were significantly more affected by the crisis than others. To our knowledge, our study is among the first that examines the role of corporate boards, institutional investors, and large shareholders in the 2007-2008 financial crisis using a global sample. Furthermore, we take a broader view of the role of corporate governance in the financial crisis than other concurrent papers by investigating various aspects of the crisis including risk-taking prior to the crisis and capital raisings during the crisis. Our paper is closely related to a concurrent paper by Beltratti and Stulz (2010), which examines how firm-level and country-level factors (e.g., bank characteristics, governance indices, bank regulation, and macroeconomic factors) relate to bank performance during the crisis. We complement their study by documenting why corporate governance is related to firm- 5 performance during the financial crisis. Specifically, Beltratti and Stulz (2010) find that a shareholder-friendly board (as captured by a RiskMetircs governance index) is negatively associated with firm performance during the crisis, but do not find the source of this association. We find that firms with more independent boards performed worse during the crisis, because independent board members out of concern for their reputation pressured firms into raising equity capital during the crisis, which led to a wealth transfer from shareholders to debtholders. Moreover, Beltratti and Stulz (2010) do not explore the role of institutional investors. We find that firms with higher institutional ownership performed worse during the crisis, because they took more risk before the crisis. Second, we contribute to the large literature on corporate governance (e.g., Bushman and Smith, 2001; Hermalin and Weisbach, 2003) by showing that corporate governance had an important impact on firm performance during the crisis through influencing firms’ risk-taking and financing policies. Hermalin and Weisbach (2003) point out that the absence of a significant relation between board composition (such as board independence) and firm performance is a notable finding in the literature. They suggest that the absence of this relation is consistent with board independence not being important on a day to day basis and propose that board independence should only matter for certain board actions, ‘particularly those that occur infrequently or only in a crisis situation’ (Hermalin and Weisbach 2003, p. 17). Our study adds to this literature by providing evidence consistent with the crisis period being a unique setting in which the actions of board members mattered. 6 6 One common problem for governance studies is that the relation between board characteristics and firm performance may be spurious because they are endogenously determined. We argue that this issue is less likely to be problematic in our setting because the financial crisis is largely an exogenous macroeconomic shock. Moreover, our study also attempts to mitigate this concern by examining how board independence impacted firm actions, and not just firm performance. 6 Finally, our study contributes to the regulatory debate on governance reform by providing a timely and comprehensive investigation of the 2007-2008 financial crisis. Given that the 2007- 2008 crisis is a momentous economic event of great public interest and corporate governance practices are under intense regulatory scrutiny (Kirkpatrick, 2008; Schapiro, 2009), it is important to provide a comprehensive analysis on the role of corporate governance. We find that implications from prior studies on financial crises in emerging markets do not apply to the 2007- 2008 crisis. Specifically, prior studies on the 1997-1998 Asian financial crisis find that greater external monitoring (e.g., non-management blockholdings) is associated with better performance (Johnson et al., 2000; Mitton, 2002), and attribute this finding to worse economic prospects resulting in more expropriation by managers, which highlights the importance of governance reform in this region. In contrast, we find that firms with greater external monitoring (i.e., more independent boards and higher institutional ownership) performed worse, and that this relation is driven by the influence of corporate governance on firms’ risk-management and financing polices. Thus, unlike prior studies on financial crises in emerging markets, our study casts doubt on whether regulatory changes that increase shareholder activism and monitoring by outside directors will be effective in reducing the consequences of future economic crises in developed markets such as the U.S. and most of the EU member countries. An important caveat of our study is that our analysis does not consider the optimal level of risk-taking and equity capital for financial firms, nor does it address whether risk-taking or equity capital raisings provide net benefits to the firms in the long term. Rather, as in prior studies on bank governance such as Laeven and Levin (2009), our goal is to provide an empirical assessment of theoretical predictions concerning the influence of key corporate governance mechanisms on firm performance and managerial actions during the crisis. 7 The remainder of the study proceeds as follows. Section 2 provides the institutional background and motivation of this paper. Section 3 presents the sample and data and Section 4 shows the empirical results. Section 5 presents additional analyses and Section 6 reports sensitivity tests. Section 7 concludes our study. 2. Institutional background and motivation The 2007-2008 financial crisis is commonly viewed as the worst financial crisis since the Great Depression of the 1930s. 7 The crisis not only resulted in the collapse of well-known financial institutions such as Lehman Brothers, but also halted global credit markets and required unprecedented government intervention worldwide. For example, in October 2008, the U.S. government launched the Troubled Asset Relief Program (TARP) to purchase or insure up to $700 billion of assets from financial institutions. In the same month, the British government announced a bank rescue package totaling £500 ($740) billion in loans and guarantees. Motivated by the significance of the 2007-2008 financial crisis, an emerging body of literature has attempted to identify and examine the global roots of the crisis. This literature proposes that a combination of macroeconomic factors such as loose monetary policies and complex securitizations have contributed to the crisis (Taylor, 2009). While these studies are clearly important, they do not paint a complete picture of the crisis. Specifically, these studies do not explain why some financial firms performed much worse during the crisis than others, despite that they were exposed to the same macroeconomic factors. For example, while Citigroup in the U.S. and UBS in Switzerland experienced severe subprime mortgage related losses, JP Morgan Chase and Credit Suisse (also in the U.S. and Switzerland, respectively) 7 See Brunnermeier (2009) and “Worst crisis since ‘30s, with no end yet in sight” (The Wall Street Journal, September 18, 2008). 8 suffered much less damage. 8 Since macroeconomic factors can only partially explain why some firms performed worse than others during the crisis (e.g., U.S. versus Swiss financial firms), it is important to examine how firm-level policies have influenced firm performance during the financial crisis. Two firm-level policies that significantly affected the magnitude of shareholder losses during the crisis have received considerable attention from academics and regulators: (1) risk management before the crisis and (2) equity capital raisings during the crisis. As explained by Brunnermeier (2009), the interplay between banks’ exposure to subprime mortgages and their reliance on short-term borrowing had a significant impact on the performance of financial firms during the crisis period. As the value of risky assets deteriorated during the crisis period, financial institutions could no longer rely on rolling over short-term loans against these assets and were forced to raise capital. Raising equity capital was particularly costly to shareholders during the crisis because it led to a significant wealth transfer from shareholders to debtholders (Myers, 1977; Kashyap et al., 2008). Financial firms’ risk management before the crisis and capital raising activities during the crisis were ultimately the result of corporate boards and shareholders making a cost-benefit trade-off (Kashyap et al., 2008). For example, investing heavily in subprime mortgage related assets and relying on short-term credit lines could have looked very lucrative before the crisis, but exposed firms to considerable risks that led to large losses during the crisis. 9 Similarly, while 8 Based on company reports, by January 2008 the subprime losses for these firms were $18 billion for Citigroup, $13.5 billion for UBS, $1.3 billion for JP Morgan Chase, and $1billion for Credit Suisse (‘JP Morgan’s 1.3 bn sub- prime hit,’ BBC news, January 16, 2008). 9 Citigroup CEO Chuck Prince famously said “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Financial Times, July 9, 2007). [...]... institutional investors pressuring firms into timelier recognition of writedowns during the crisis (Vyas, 2009) In the next section, we further explore explanations for the inverse relation between firm performance and governance factors – that is, the influence of corporate governance on risk-taking before the crisis and equity capital raisings during the crisis. 23 4.2 The influence of corporate governance. .. short-selling bans on the stocks of many financial institutions to curb steep declines of their stock prices (3) In October 2008, changes in the International Financial Reporting Standards (IFRS) allowed financial institutions to avoid recognizing asset writedowns.10,11 10 The International Accounting Standards Board (IASB) issued amendments to the use of fair value accounting on financial instruments in. .. and the coefficient on board independence continues to be insignificant 25 17 crisis period, it does not explain why firms with more independent boards performed worse To provide further insight into the factors that drive the inverse relation between firm performance and board independence, we next explore the influence of corporate governance on equity capital raisings during the crisis 4.3 The Influence... that examining the relation between firm-level corporate governance mechanisms and firm performance is important for understanding the influence of corporate governance on firm performance during the crisis Overall, our study provides insight into why some financial firms were much more affected by the crisis than others Our results are consistent with corporate governance choices and their influence... but also other factors such as the reputational costs of a bankruptcy explaining why independent board members pushed their firms into raising equity capital during the crisis 21 Column (3) of Panel C excludes firms that raised equity capital during the crisis and repeats the analysis in Panel A of Table 2, in which we examine the relation between stock returns and corporate governance If the inverse... within-country variation in corporate governance 19 To mitigate the influence of outliers, we winsorize all continuous variables at the top and bottom 1% of their distributions 13 4 Empirical results 4.1 Firm performance and corporate governance We examine the relation between firm performance and corporate governance during the crisis by estimating models regressing cumulative stock returns during the. .. firms during the 2007-2008 financial crisis Although all firms were affected by the crisis, we find that firms with higher institutional ownership and more independent boards had worse stock returns than other firms during the crisis Further exploration of this finding suggests that this is because (1) firms with higher institutional ownership took more risk prior to the crisis, which resulted in larger... Finance.” Journal of Political Economy 106: 1113-1155 Merton, R 1974 “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” The Journal of Finance 29: 449-470 Mitton, T 2002 “A cross-firm Analysis of the Impact of Corporate Governance on the East Asian Financial Crisis. ” Journal of Financial Economics 64: 215-241 Myers, S.C 1977 “Determinants of Corporate Borrowing.” Journal of Financial. ..raising equity capital helped reduce bankruptcy risk, it was very costly to existing shareholders during the crisis period Consequently, we examine whether board characteristics and ownership structure have affected firm performance during the crisis period by influencing risk-taking before the crisis and equity capital raisings during the crisis In particular, we focus our analysis on board independence,... U.S Financial Institutions during the Financial Crisis of 2007-2008. ” Working paper University of Toronto Weisbach, M 1988 “Outside Directors and CEO Turnover.” Journal of Financial Economics 20: 431-460 30 Figure 1 Magnitudes of writedowns per quarter during the 2007-2008 crisis period This figure plots the magnitudes of writedowns (in US $billion) per quarter for all financial firms covered in Bloomberg . broader view of the role of corporate governance in the financial crisis than other concurrent papers by investigating various aspects of the crisis including risk-taking prior to the crisis and. from Financial Institutions Worldwide Abstract This paper investigates the influence of corporate governance on financial firms’ performance during the 2007-2008 financial crisis. Using. http://ssrn.com/abstract=1397685 1 Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide 1. Introduction An unprecedented large number of financial institutions