Investment opportunity set, product mix, and the relationship between bank CEO compensation and risk-taking

The product mix changes that have occurred in banking organizations during the 1990s provide a natural experiment for investigating how firms adjust their executive compensation contracts as their mix of businesses changes. Deregulation and new technology have eroded banking organizations’ comparative advantages and have made it easier for nonbank competitors to enter banking organizations’ lending and deposit-taking businesses. In response, banking organizations have shifted their sale mix toward noninterest income by engaging in municipal revenue bond underwriting, commercial paper underwriting, discount brokering, managing and advising open- and close-ended mutual funds, underwriting mortgage-backed securities, selling and underwriting various forms of insurance products, selling annuities, and other investment banking activities via Section 20 subsidiaries. These mix changes could affect firms’ risk and the structure of CEO compensation. The authors find that as the average banking organization tilts its product mix toward fee-based activities and away from traditional activities, equity-based compensation increases. They also find that more risky banks have significantly higher levels of equity-based compensation, as do banks with more investment opportunities. But, more levered banks do not have higher levels of equity-based CEO compensation. Finally, the authors observe that equity-based compensation is more important after the Riegle-Neal Act of 1994.

The “risk-adjusted” price-concentration relationship in banking

Price-concentration studies in banking typically find a significant and negative relationship between consumer deposit rates (i.e., prices) and market concentration. This relationship implies that highly concentrated banking markets are “bad” for depositors. It also provides support for the Structure-Conduct-Performance hypothesis and rejects the Efficient-Structure hypothesis. However, these studies have focused almost exclusively on supply-side control variables and have neglected demand-side variables when estimating the reduced form price-concentration relationship. For example, previous studies have not included in their analysis bank-specific risk variables as measures of cross-sectional derived deposit demand. The authors find that when bank-specific risk variables are included in the analysis the magnitude of the relationship between deposit rates and market concentration decreases by over 50 percent. They offer an explanation for these results based on the correlation between a bank’s risk profile and the structure of the market in which it operates. These results suggest that it may be necessary to reconsider the well-established assumption that higher market concentration necessarily leads to anticompetitive deposit pricing behavior by commercial banks. This finding has direct implications for the antitrust evaluations of bank merger and acquisition proposals by regulatory agencies. And, in a more general sense, these results suggest that any Structure-Conduct-Performance-based study that does not explicitly consider the possibility of very different risk profiles of the firms analyzed may indeed miss a very important set of explanatory variables. And, thus, the results from those studies may be spurious.

Inter-industry contagion and the competitive effects of financial distress announcements: evidence from commercial banks and life insurance companies

Contagion usually refers to the spillover of the effects of shocks from one or more firms to other firms. Most studies of contagion limit their analysis to how shock affect firms in the same industry, or "intra-industry" contagion. The purpose of this paper is to explore and document the likely magnitude of "inter-industry" contagion. In their comprehensive study of intra-industry contagion using many individual industries Lang and Stulz (1992) argue that if contagion is not simply an informational effect it will impose a social cost on our economic system. If this is true for intra-industry contagion, then the same argument must hold for inter-industry contagion as well. We focus on inter-industry contagion effects in this paper because the vast majority of the extant literature about contagion has neglected its important potential cost to shareholders. Most of the studies on contagion attempts to differentiate between a "pure" contagion effect and a signaling or information-based contagion effect. An example of a pure contagion effect would be the negative effects of a bank failure spilling over to other banks regardless of the cause of the bank failure. And, an example of a signaling contagion effect would be if a bank failure is caused by problems whose revelation is correlated across banks, and the correlated banks are impacted negatively. We conduct our investigation of contagion by examining three separate announcements involving adverse information about commercial real estate portfolios. The first announcement is by a large commercial bank (the Bank of New England), the second announcement consists of a series of events--from several large banking organizations and a regulatory agency (the Office of the Comptroller of the Currency), and the third announcement is by a large life insurance company (Travelers). There are two reasons we chose these particular events. First, the events seemed to be very unusual and very significant indicators of future (and present) financial distress. Second, the events shared a common theme of financial distress caused by problems with commercial real estate portfolios. We first establish that the commercial bank announcements negatively impact the equity values of life insurance companies (and vice versa). Next, we demonstrate that the bank regulatory agency announcement negatively impacts the equity values of life insurance companies as well as commercial banks. We then explicitly test if the shareholder wealth effects are linked to a set of specific firm characteristics. Consistent with previous contagion studies, our results provide strong evidence of "intra-industry" contagion related wealth effects. We also find that these contagion effects, to a significant degree, can be explained by firm specific variables. This implies that the intra-industry spillover effects associated with our three events are not of the totally "pure" contagion variety, but have an informational component as well. We also find very strong evidence of significant "inter-industry" contagion-based shareholder wealth effects. Again, these contagion-based wealth effects do not appear to be purely contagion-based. Wealth effects can also be explained by such factors as geographic proximity, asset composition, liability composition, leverage, size, and regulatory expectations.Insurance ; Bank failures ; Stocks

Deregulation and the relationship between bank CEO compensation and risk taking

The deregulation of the banking industry during the 1990s provides a natural (public policy) experiment for investigating how firms adjust their executive compensation contracts as the environment in which they operate becomes relatively more competitive. Using the Riegle-Neal Act of 1994 as a focal point, we investigate how banks changed the equity-based component of bank CEO compensation contracts. We also examine the relationships between equity- based compensation and risk, capital structure, and investment opportunity set. Consistent with theoretical predictions, we find that after deregulation, the equity- based component of bank CEO compensation increases significantly on average for the industry. Additionally, we find that more risky banks have significantly higher levels of equity-based compensation, as do banks with more investment opportunities. But, more levered banks do not have higher levels of equity-based CEO compensation. Finally, we observe that most of these relationships become more powerful in our post- deregulation period.Corporate governance ; Bank supervision

Corporate governance structure and mergers

Few transactions have the potential to generate revelations about the market value of corporate assets and liabilities as mergers and acquisitions (M&A). Corporate governance and control mechanisms such as independent directors, independent blockholders, and managerial share ownership are usually important predictors of the size and distribution of the incremental wealth generated by M&A transactions. The authors add to this literature by investigating these relationships using a sample of banking organization M&A transactions over the period 1990-2004. Unlike research on nonfinancial firms, the impact of independent directors, share ownership of the top five managers, and independent block holders on bank merger purchase premiums in this environment is likely to be measured more consistently because of industry operating standards and regulations. It is also the case that research on banks in this area has not received adequate attention. The authors model controls for risk characteristics of the target banks, the deal characteristics, and the economic environment. Their results are robust. They support the hypothesis that independent directors may provide an important internal governance mechanism for protecting shareholders' interests, especially in large-scale transactions such as mergers and takeovers. The authors also find the results to be consistent with the hypothesis that independent blockholders play an important role in the market for corporate control as does managerial share ownership. But these effects dampen the impact of independent directors on target shareholders' merger prices. Their overall findings would support policies that promote independent outside directors on the board of banking firms in order to provide protection for shareholders and investors at large.Corporate governance ; Bank mergers

SBA guaranteed lending and local economic growth

Increasingly, policymakers look to the small business sector as a potential engine of economic growth. Policies to promote small businesses include tax relief, direct subsidies, and indirect subsidies through government lending programs. Encouraging lending to small business is the primary policy objective of the Small Business Administration's (SBA) loan-guarantee program. Using a panel data set of SBA guaranteed loans, we assess whether SBA guaranteed lending has an observable impact on local economic performance. We find a positive and significant (although economically small) relationship between the relative levels of SBA guaranteed lending in a local market and the future per capita income growth in that market.

Does government intervention in the small-firm credit market help economic performance?

The guaranteed lending programs of the Small Business Administration (SBA) are large and growing rapidly. The SBA’s fiscal year 2008 performance budget calls for $25 billion in guaranteed loans for small businesses—a new record for the agency. Some critics of SBA programs suggest they do not help small businesses or overall economic performance. Other critics suggest that these programs unfairly benefit the financial institutions that participate in SBA’s guaranteed lending programs. While very little serious empirical evidence exists on whether the net economic impact of the SBA’s guaranteed lending programs is positive or negative, a few recent studies provide some insight into the question. In general, they suggest a small positive impact of the SBA’s programs on economic performance. However, the results are very tentative and further research is needed to declare a more definitive position. We provide a general overview of the SBA’s guaranteed lending programs and summarize the results of these studies.Small Business Administration ; Small business - Finance ; Economic development

Are SBA loan guarantees desirable?

Over the last 10 years, the Small Business Administration has been responsible for well over $100 billion in small business credit extensions, more than any single private lender. This Commentary explores the motivations for such a large investment of taxpayer dollars.Small Business Administration ; Loans ; Credit

On SBA-guaranteed lending and economic growth

Increasingly, policymakers are looking to the small business sector as a potential engine of economic growth. Policies to promote small businesses include tax relief, direct subsidies, and indirect subsidies through government lending programs. Encouraging lending to small business is the primary policy objective of the Small Business Administration (SBA) loan-guarantee program. Using a panel data set of SBA-guaranteed loans we assess whether SBA-guaranteed lending has an observable impact on local and regional economic performance.Small Business Administration ; Loans ; Small business