Board of Governors of the Federal Reserve System

February 2014

Corporate Governance and Risk Management at Unprotected Banks: National Banks in the 1890s

Charles W. Calomiris and Mark A. Carlson

Abstract:

Managers' incentives may conflict with those of shareholders or creditors, particularly at leveraged, opaque banks. Bankers may abuse their control rights to give themselves excessive salaries, favored access to credit, or to take excessive risks that benefit themselves at the expense of depositors. Banks must design contracting and governance structures that sufficiently resolve agency problems so that they can attract funding from outside shareholders and depositors. We examine banks from the 1890s, a period when there were no distortions from deposit insurance or government interventions to assist banks. We use national banks' Examination Reports to link differences in managerial ownership to different corporate governance policies, risk, and methods of risk management. Formal corporate governance is lower when manager ownership shares are higher. Managerial rent seeking via salaries and insider lending is greater when managerial ownership is higher, and lower when formal governance controls are employed. Banks with higher managerial ownership target lower default risk. Higher managerial ownership and less-formal governance are associated with a greater reliance on cash rather than capital as a means of limiting risk, which we show is consistent both with higher adverse-selection costs of raising outside equity and with greater moral-hazard with respect to risk shifting.

Keywords: Manager ownership, corporate governance, rent seeking, risk preferences, bank failures, risk shifting, adverse selection

PDF: Full Paper