Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide

https://doi.org/10.1016/j.jcorpfin.2012.01.005Get rights and content

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 add to the literature by examining the corporate governance determinants of financial firms' performance during the 2007–2008 crisis.

Highlights

► Firms with higher institutional ownership performed worse during the crisis. ► Institutional ownership was associated with greater risk-taking before the crisis. ► Firms with more independent boards performed worse during the crisis. ► Board independence was associated with more equity raisings during the crisis. ► Equity capital raisings helped firms survive the crisis.

Introduction

An unprecedented large number of financial institutions collapsed or were bailed out by governments during the global financial crisis of 2007–2008.1 The failure of these institutions resulted in a freeze of global credit markets and required 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 examine in particular the role of independent directors and influential shareholders. 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 stock returns during the crisis on measures of corporate governance and control variables. We capture stock returns during the crisis as buy-and-hold returns from January 2007 to September 2008 or to the date on which the firm was delisted, whichever is earlier. 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, we control for a dummy indicating 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 shows 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 independent directors and institutional shareholders encouraged managers to increase shareholder returns through greater risk-taking prior to the crisis. Shareholders may find it optimal to increase risk because they do not internalize the social costs of financial institution failures and institutional arrangements such as deposit insurance may weaken debtholder discipline. In addition, because of their firm-specific human capital and private benefits of control, managers tend to seek a lower level of risk than shareholders (Laeven and Levine, 2009). Consistent with this view, DeYoung et al. (forthcoming) find that in the years leading up to the financial crisis (2000–2006), banks changed CEO compensation packages to encourage executives to exploit new growth opportunities created by deregulation and the explosion of debt securitization.

We test the risk-taking 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.

An alternative explanation for the negative relation between stock returns and board independence is that independent directors pressured managers into raising equity capital during the crisis to ensure capital adequacy and reduce bankruptcy risk. Capital raisings at depressed stock prices may have led to a significant wealth transfer from shareholders to debtholders during the crisis period (Kashyap et al., 2008, Myers, 1977). Consistent with this wealth transfer, we find negative 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.

While equity capital raisings may have led to poor performance during the crisis, they also may have helped firms survive the crisis and perform better after the crisis. We investigate this issue by performing additional analyses in which we examine whether equity capital raisings had a positive impact on the likelihood that a firm survived the financial crisis and firm performance over the long run. Consistent with equity capital raisings helping firms survive the crisis, we find that firms that raised more equity capital were less likely to be delisted during the crisis than firms matched on pre-capital raising performance. However, inconsistent with equity capital raisings helping firms perform better over the long run, we find that equity capital raising firms perform similarly to the matched firms in the period subsequent to equity capital raisings. One possible explanation is that regulatory interventions such as the Troubled Asset Relief Program (TARP) may have attenuated the positive effect of equity raisings on firm performance in the long run.

Although we focus on firm-level governance mechanisms, we also examine how country-level governance mechanisms, such as the quality of legal institutions and the extent of laws protecting shareholder rights, influenced firm performance during the crisis. 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.

One concern for our analysis is that our corporate governance measures are correlated with some other firm characteristic that is not included in our model, but that has an important influence on financial firms' performance during the crisis period. The exclusion of board size from our analysis may particularly be a concern because firms with more complex operations may have performed worse during the crisis and prior literature suggests that board size is associated with board independence and operating complexity (Adams and Mehran, 2011, Linck et al., 2009). Thus, we repeat our analysis after including various measures of board size (i.e., the natural logarithm of the number of board members, the number of board members, and a piecewise linear specification). We find that our results remain qualitatively similar

In addition, we find that our results are also robust to controlling for other 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 2007–2008 crisis (Brunnermeier, 2009, Kashyap et al., 2008) in primarily two 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-performance during the financial crisis. Specifically, Beltratti and Stulz (2010) find that a shareholder-friendly board (as captured by the RiskMetrics 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 are associated with more equity capital raisings 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

Our study also complements prior studies on the governance determinants of short-term stock return performance during financial crises. Specifically, prior studies on the 1997–1998 Asian financial crisis find that greater external monitoring (e.g., non-management block holdings) is associated with better performance during the crisis (Johnson et al., 2000, Mitton, 2002), and attribute this finding to worse economic prospects resulting in more expropriation by managers. 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, our study suggests that the impact of corporate governance on firm performance during the crisis in developed markets such as the U.S. and most of the EU member countries differs from that in emerging markets.

An important caveat of our study is that our analysis neither considers the optimal level, nor addresses the net benefits, of risk-taking and equity capital raisings for financial firms. Rather, as in prior studies on bank governance such as Laeven and Levine (2009), we provide an empirical assessment of theoretical predictions concerning the influence of key corporate governance mechanisms on short-term firm performance and managerial actions during the crisis. We also caution that our study is not designed to be prescriptive to the debate on the regulatory reform of financial institutions (Kirkpatrick, 2009, Schapiro, 2009). Regulatory reform on corporate governance is a social welfare decision that involves an evaluation of numerous factors and extensive cost–benefit analyses that are beyond the scope of our study. Finally, since we focus on large financial institutions, we caution that our findings may not generalize to smaller financial firms.

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.

Section snippets

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.

Timeline

We conduct our empirical analysis using data from January 2007 to September 2008. We begin our investigation period at the start of 2007 because this is generally regarded as the period when the market first realized the severity of the losses related to subprime mortgages (Ryan, 2008). We end our investigation period in the third quarter of 2008 for three main reasons: (1) The massive government bailouts, such as TARP in the U.S., were initiated from October 2008 onwards. (2) At the end of the

Firm performance and corporate governance

We examine the relation between firm performance and corporate governance during the crisis by estimating models regressing buy-and-hold stock returns during the crisis on our corporate governance variables and control variables. Our variables of interest are the following three corporate governance mechanisms: (1) board independence, (2) institutional ownership, and (3) the presence of large shareholders. Following Mitton (2002), we include a dummy indicating whether a firm is cross-listed on

The effect of equity capital raisings on firm survival and long term performance

While equity capital raisings may have led to poor performance during the crisis, they also may have helped firms survive the crisis and perform better after the crisis. We explore this issue by performing additional analyses in which we examine whether equity capital raisings had a positive impact on the likelihood that a firm survived the financial crisis and firm performance over the long run.

To ensure that our results are not driven by equity capital raising firms having worse performance

Controlling for board size

Endogeneity is a common issue in governance studies that makes interpretation of the results difficult. As pointed out by Hermalin and Weisbach (2003), the relation between board characteristics and firm performance may be spurious because a firm's governance structure and performance are endogenously determined. While this issue is less likely to be problematic in our setting because the financial crisis is largely an exogenous macroeconomic shock, we attempt to mitigate this concern by

Conclusion

In this paper, we provide empirical evidence on how corporate governance influenced the performance of financial 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,

Acknowledgments

The authors thank the following for their helpful comments: Harry DeAngelo, Mark DeFond, Miguel Ferreira, Jarrad Harford, Victoria Ivashina, Andrew Karolyi, April Klein, Luc Laeven, 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

References (36)

  • M. Weisbach

    Outside directors and CEO turnover

    J. Financ. Econ.

    (1988)
  • R. Adams et al.

    Is corporate governance different for bank holding companies?

    FRBNY Econ. Policy Rev.

    (2003)
  • R. Adams et al.

    Corporate performance, board structure and its determinants in the banking industry

    Federal Reserve Bank of New York Staff Reports no. 330

    (2011)
  • J. Baek et al.

    Corporate governance and firm value: evidence from the Korean financial crisis

    J. Financ. Econ.

    (2004)
  • A. Beltratti et al.

    The credit crisis around the globe: why did some banks perform better?

    Working paper

    (2010)
  • J. Bischof et al.

    Relaxation of fair value rules in times of crisis: an analysis of economic benefits and costs of the amendment to IAS 39

    Working paper

    (2010)
  • M. Brunnermeier

    Deciphering the liquidity and credit crunch 2007–2008

    J. Econ. Perspect.

    (2009)
  • D. Covitz et al.

    Liquidity or credit risk? The determinants of very short-term corporate yield spreads

    J. Financ.

    (2007)
  • Cited by (0)

    View full text