This paper was part of the conference "Beyond Pillar 3 in International Banking Regulation: Disclosure and Market Discipline of Financial Firms," cosponsored by the Federal Reserve Bank of New York and the Jerome A. Chazen Institute of International Business at Columbia Business School, October 2-3, 2003.Bank stocks ; Bank supervision ; Bank capital ; Risk

Philip E. Strahan

English

Research Papers in Economics

FRBNY Economic Policy Review / September 2004 109
1.I n t r o d u c t i o n
articipants at this conference debated the merits of 
market discipline in contributing to a solution to banks’ 
tendency to take too much risk, the so-called moral hazard 
problem of deposit insurance. With government safety nets 
protecting creditors, banks probably do not bear the full 
costs associated with their risk taking, either in ex-ante 
pricing of deposits and other sources of funds or in ex-post 
monitoring. In fact, the policy rationale usually given for 
safety nets is to remove the main mechanism for ex-post 
monitoring: the bank run.
Simon H. Kwan’s contribution broadens this policy debate 
by reminding us that market discipline necessarily comes with 
public ownership of bank securities. By separating ownership 
from control, public ownership of bank equity potentially 
worsens managerial agency problems. His evidence suggests 
that public ownership makes some banks less cost efficient and 
less profitable, but safer than they would be under private 
ownership. Thus, in thinking about the best ownership of 
banks, we ought to consider a trade-off between the market 
discipline benefits of public equity ownership and the potential 
agency costs.
2. Market Discipline from
Public Equity
As described in the proposal to revise the Basel Accord, market 
discipline involves “developing a set of disclosure requirements 
that will allow market participants to assess key information 
about a bank’s risk profile and level of capitalization” (Bank for 
International Settlements 2003).1 Much of the discussion of 
market discipline has focused on whether banks should be 
required to issue publicly traded subordinated debt, and 
whether changes in debt prices will directly influence a bank’s 
behavior.2 But even without direct influence, the information 
impounded in securities prices can provide regulators with a 
signal about bank health that goes beyond what can be learned 
from examinations. Perhaps more important, because the 
market information is available for all to see, these public 
signals may mitigate the problem of regulatory forbearance 
(see, for example, Kane [1989]).
Under most conditions, variations in stock prices generate 
more information about investor beliefs than variations in the 
prices of debt securities.3 Equityholders receive a residual 
claim, making stock prices vary more with changes in 
information about a bank’s future prospects than prices of 
fixed-income debt securities. Moreover, equity securities trade 
more frequently in more liquid secondary markets than do 
debt securities. Thus, changes in stock prices can act as the best 
early-warning signal from the securities markets.
Philip E. Strahan
The views expressed are those of the author and do not necessarily reflect the 
position of the Federal Reserve Bank of New York or the Federal Reserve 
System.
Commentary
Philip E. Strahan is an associate professor of finance at Boston College.
P110 Commentary
3. Agency Problems in Banking
Agency problems occur when managers make decisions that 
place their own welfare above the welfare of outside 
shareholders. Manifestations of the problem can take many 
forms, including consumption of perks (such as corporate 
jets), overinvestment (in the form of empire building), and 
excessive pay. Three control mechanisms—corporate 
governance, capital structure, and the corporate takeover 
market—usually constrain managerial discretion. Governance 
includes direct monitoring by corporate boards and large 
shareholders, and the tying of managerial pay to performance 
with stock-based and option-based compensation and cash 
bonuses linked to accounting returns. A levered capital 
structure helps by imposing a hard constraint on managers. 
Only the regular payment of interest prevents financial distress 
and a loss of control. According to Jensen (1986), debt reduces 
“free cash flow,” thereby limiting the ability of managers to 
consume perks or waste corporate resources with bad 
investments. When all else fails, hostile takeovers can 
sometimes act as a last resort to force out bad managers.
These control mechanisms may not work very well in 
banking. Regulation and deposit insurance not only create 
moral hazard problems, they also blunt the standard market 
mechanisms that work to rein in managerial agency problems. 
While governance mechanisms, at least in principle, ought to 
function as well in banking as in other industries, the other two 
mechanisms almost certainly do not.4 For example, debt does 
not impose a hard constraint on banks. With insurance, 
depositors have no incentive to withdraw funds or otherwise 
trigger financial distress. As long as regulators will allow it, a 
bank can simply raise new deposits to finance its business, 
however bad. Billet, Garfinkel, and O’Neal (1998) show that as 
banks get into trouble, they tend to rely increasingly on insured 
deposits as a funding source. The corporate takeover market in 
banking has also been hampered by regulations. For example, 
only a bank or financial holding company in the United States 
can acquire another bank. The list of potential acquirers was 
restricted even further by state laws prohibiting interstate 
banking until the 1980s. Because these control mechanisms are 
weak, it seems theoretically plausible that agency problems 
would be worse in banking than elsewhere.
We also know from empirical research that managerial 
agency problems have led to misallocation of bank credit (Peek 
and Rosengren 2002); bank inefficiency (for example, Shranz 
[1993] and Jayaratne and Strahan [1998]); and, in dire 
circumstances, such as those experienced during the savings 
and loan crisis, managerial looting, both of shareholders and 
taxpayers (Kroszner and Strahan 1996; Akerlof and Romer 
1993). Moreover, the frequency of hostile takeovers—deals 
designed to get rid of bad managers—has been conspicuous by 
its absence in the banking industry (Prowse 1995).
Kwan’s paper adds to this body of evidence. He documents 
that banks with publicly traded stock (where control is 
separated from ownership) are less efficient and less profitable, 
but safer, than private banks of similar size (where control and 
ownership are presumed to be closely tied because managers 
own all or most of the bank’s equity). Specifically, banks with 
public equity have lower returns on assets due mainly to their 
higher noninterest costs, compared with banks that remain 
private. These differences are driven by the smaller banks. 
For large banks, Kwan finds increases in costs that are not 
statistically significant overall, and that are not even consistent 
in sign over time. His results highlight the following trade-off: 
public equity may increase market discipline by generating 
public information about bank profitability and solvency, but 
it may also increase costs—at least for small banks—by 
separating ownership from control.
For the same reason that it raises costs, public ownership 
may also help offset banks’ tendency to take too much risk. 
Shareholders tend to hold a well-diversified portfolio, so they 
need not worry much about firm-specific risk. Managers hold a 
large and poorly diversified stake in their bank, however, both 
because they have made firm-specific investments in human 
capital and because a large fraction of their financial wealth is 
tied up in the bank’s stock. This portfolio, while improving the 
typical manager’s incentive to increase profits and share prices, 
probably makes the manager more risk averse than shareholders 
would like. Kwan provides some support for this notion. He 
finds that the small public banks hold more capital per dollar of 
assets than do private banks. But he does not find that asset risk 
depends on the ownership of banks, although I would have liked 
to see more work on this dimension. Kwan studies volatility of 
earnings (based on each bank’s time-series standard deviation of 
return on assets) and loan delinquency rates. These measures 
reflect, in large part, ex-post performance. I also would have 
liked to see additional analysis of measures of insolvency risk—
such as a “Z-score” estimate of the probability of insolvency or 
simple balance sheet ratios (for instance, the ratio of loans to 
assets, the ratio of business loans to assets, the ratio of liquid 
assets to total assets)—to test further whether managers of 
publicly held banks choose safer operating policies than do 
managers of private banks ex ante, as theory suggests.
4. Who Should Own Banks?
Public ownership enhances market discipline and increases 
access to liquid securities markets, potentially lowering the cost FRBNY Economic Policy Review / September 2004 111
of equity. Thus, issuing public equity offers two advantages—
more market information for regulators and a lower cost of 
capital for banks—against which to weigh greater agency costs. 
Large banks obviously need more capital in dollar terms than 
do small banks. Moral hazard problems are also worsened for 
large banks by the perception that systemic consequences make 
them too-big-to-fail. Moreover, Kwan offers little evidence 
that large public banks have higher costs than do large private 
banks. So, the benefits of public equity seem easily to outweigh 
agency costs, thus dictating that large banks should be publicly 
held. Small banks, however, should probably remain private. 
The efficiency losses that come with public ownership of small 
banks that Kwan documents are large—noninterest costs are 
about 20 percent higher at the small public banks compared 
with at the small private banks. These agency costs, plus the 
high fixed costs of issuing public securities, probably outweigh 
any “market disciplining” benefits for small banks.
Despite what appear to be large agency costs at the small 
banks, equilibrium seems consistent with “optimal” ownership 
of banks. All of the largest U.S. banks are publicly owned and 
all of the smallest banks are privately owned. Kwan focuses 
only on the marginal banks—those smaller than the largest 
privately held bank and larger than the smallest publicly held 
bank. Among these, he finds important effects of ownership on 
capital structure and cost efficiency only among the small 
banks, and fewer than 10 percent of these small banks are 
publicly owned. (In the two smallest size classes, 496 out of 
5,536 firm-year observations—about 25 banks—are public.)
Much of the debate on market discipline has been over 
whether banks ought to issue subordinated debt. Variations in 
bank stock prices, however, promise to give regulators more 
information than do variations in subordinated debt prices, at 
least as long as bank failure is not imminent. Kwan’s study 
points to agency problems as a cost against which these benefits 
of market discipline should be weighed. If policymakers want 
to enhance market discipline by increasing public ownership of 
smaller banks, more thought should be given to ways to lower 
the agency costs that come with separation of ownership from 
control. A relaxation of constraints on the bank takeover 
market would represent a move in this direction.Endnotes
112 Commentary
1. The two other requirements aimed at reducing the moral hazard 
problems are improved supervision and more accurate risk-based 
capital adequacy standards.
2. Bliss and Flannery (2001) argue that banks do not respond directly 
to changes in the value of their outstanding subordinated debt or 
equity. For evidence that changes in market prices can help inform 
regulators, however, see Flannery (1998).
3. When distress becomes imminent, equity values can reflect the 
option value associated with government protection of the bank. 
In these times, stock prices only reflect upside potential, whereas 
downside risk is borne by the deposit insurer. Variations in the price 
of traded debt securities therefore may sometimes be more helpful to 
regulators than variations in equity prices.
4. Bank supervisors have recently placed greater emphasis on such 
internal controls as bank boards of directors, internal audit functions, 
and other governance mechanisms in preventing losses from fraud or 
mismanagement of the bank.References
FRBNY Economic Policy Review / September 2004 113
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The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York 
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the 
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in 
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

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Commentary on "Risk and return of publicly held versus privately owned banks"

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Commentary on "Risk and return of publicly held versus privately owned banks"

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