Who Disciplines Bank Managers?

If you owned a commercial bank and it started creating losses, you would probably want to replace the bank’s managers, right? In fact, you would probably like to replace them before the bank starts generating losses. And if your bank’s managers knew in advance that they would get fired if they don’t ensure the bank’s financial soundness, they would work to ensure that the bank is financially sound, correct? Well, it is not that simple.

Yes, when banks dip into the red, their managers do lose jobs. Indeed, losses incurred by U.S. banks during the recent financial crisis coincided with forced departures of their executives. In addition to highly-publicized executive turnovers in major financial institutions, such as Citigroup and Merrill Lynch, there have also been many turnovers at smaller and less widely known banks such as Douglass National Bank and Riverside Bank. The reasons for the turnovers are not always clear, although various explanations can be found. For example, when Riverside Bank CEO John Moran was fired in June 2008, one of the board members was quoted as saying “John is a great banker, unfortunately he'd never been through the tough times of banking right now. … He's not as seasoned as what we need in today's banking climate.”

So, perhaps this is a form of market discipline that is at play – to some extent at least. Some executives do get fired, and there seem to be reasons for them to go. However, the experience of the recent global banking crisis makes clear that market discipline leaves much to be desired. It is therefore important to answer the following two questions: (i) How do these forced exits actually come about? and (ii) What is their impact on the bank’s performance?

In a paper recently published in the Review of Finance, Klaus Schaeck, Andrea Maechler, Stephani Stolz, and I are trying to address these two questions, using a novel, hand-collected dataset on turnovers in small and medium-sized U.S banks between 1990 and 2007. 

Why look at small and medium sized banks? The banks in our sample tend to be relatively small in terms of asset size (the average total asset size in our sample is USD 330 million). So why bother? Well, examining these banks provides two main advantages. First, examining small and medium-sized banks allows us to study market discipline in a ‘laboratory setting’ of sorts. Existing studies of market discipline tend to focus on large, publicly listed banks, many of which are considered ‘too big to fail’. In other words, their size may make the traditional disciplining devices less effective. In contrast, small and medium-sized banks are unlikely to be subject to implicit support guarantees. Analyzing such banks enables us to study the effects of disciplining mechanisms in a setting where banks have little expectation of being bailed out. Second, small and medium-sized banks matter collectively. In the U.S., the nearly 8,000 ‘community’ banks represent 96 percent of all banks. More importantly, they are major providers of credit, especially for small and medium-sized businesses (DeYoung, Hunter, and Udell, 2004; Independent Community Bankers of America, 2007). So, understanding what makes them ‘tick’ is important.

On the first question (i.e., how the forced exits of bank directors actually come about), we find that executive dismissals are robustly associated with higher risk taking and with losses. This finding is illustrated here in Figure 1: risky banks--those with low ‘z-scores’--are more likely to end up with losses and they are also more likely to see their executives replaced. (For example, the 25 percent of banks that have the lowest z-scores in our sample account for 64 percent of the loss-making banks and 46 percent of the executive turnovers.) This is consistent with predictions from standard economic models of executive turnovers, in which shareholders monitor and discipline their executives. Our results are robust to alternative samples and alternative definitions of who is a bank executive. They also remain qualitatively unchanged when we adjust for differences in ownership structure among banks and for corporate control activity (mergers and acquisitions). An important element of our study is that we also examine whether the executive firings can be explained by pressure from debt holders or regulatory actions, but we do not find evidence that these would have statistically significant impacts on the firings.

On the second question (i.e., the impact of the bank executive’s firing on the bank’s subsequent performance), our results do not support the influencing dimension of market discipline, a finding that is consistent with most of the market discipline literature (e.g., with Bliss and Flannery, 2002). We analyze the risk, performance, and losses in ’turnover banks’ (those that have gone through the firing of an executive in recent years), and do not find their performance significantly better than ’control banks’ (similar banks that have not recently gone through an executive turnover). If anything, we find weak results that the ‘turnover banks’ operate at higher levels of risk, experience higher losses, and have lower profitability than those in the control groups. In other words, we find no convincing evidence that turnovers constitute an effective disciplinary mechanism. These findings cast some doubt on the ability of market discipline to influence bank performance.

The recent financial crisis has demonstrated important shortcomings in the effectiveness of disciplining mechanisms in large financial institutions. This may have reflected too-big-to-fail policies, and may be different for small and medium-sized banks. But our evidence suggests that even for small and medium sized banks, market discipline left something to be desired. Our research thus seems to cast an unflattering light on the idea of relying on market discipline in small and medium-sized banks, except through their shareholders. But even then, it is not clear that shareholders’ actions necessarily improve bank soundness.

Our study’s findings inform the ongoing policy debate on how to improve regulation. Although one of the three pillars of the Basel II capital standard is the ‘market discipline pillar’, the financial crisis has demonstrated that the channels through which this discipline works (or is supposed to work) are not yet well understood. Currently, it is not clear if and how banks, especially non-listed institutions, are disciplined by debt holders, shareholders, and regulators. Our research sheds light into the role and relative importance of these stakeholders.

What are the possible policy implications? Market discipline clearly leaves something to be desired. But it would be a mistake to think that sole reliance on tight regulation and supervision is a solution. What one needs is for regulation and market discipline to complement each other. Our findings highlight the importance of a good understanding of the factors that undermine the efficacy of disciplining forces. 

References:

Bliss, Robert, and Mark J. Flannery, 2002, Market discipline in the governance of U.S. bank holding companies: monitoring vs. influence. European Finance Review 6, 361-395.

DeYoung, Robert, William C. Hunter, and Gregory F. Udell, 2004, The past, present and probable future for community banks, Journal of Financial Services Research 25, 85-133.

Independent Community Bankers of America, 2007, Community bank payments survey result.

Schaeck, Klaus, Martin Cihak, Andrea Maechler, and Stephanie Stolz, 2011, “Who disciplines bank managers?”, Review of Finance. doi: 10.1093/rof/rfr010