Privatesector P U B L I C P O L I C Y F O R T H E Note No. 198 October 1999 Banking on Governance? Conflicts of interest facing bank owners and supervisors Chad Leechor Banks fail with alarming frequency, resulting in large losses of taxpayer money. A key factor in the high failure rate is the flawed governance mechanism, which exacerbates the risks inherent in banking. Bankers control a lot of other people’s money and have much discretion over the information they disclose. The temptation to engage in excessive risk taking is strong. Tightening banking supervision is seldom the solution. For their part, banking supervisors often face incentives at odds with those of taxpayers. At times they may prefer not to act to minimize taxpayer losses. These twin governance problems are further compounded by the common practice of disclosing banking information only to supervisors, not to markets. This Note explains the conflicts and proposes some solutions. Modern banking has been characterized by fre- in East Asia—reckless. But in banking a debt- quent and widespread bank failures. Even equity ratio of, say, 10 to 1 is considered prudent. advanced countries with sophisticated banking Such leverage intensifies business risks. With frac- practices and supervision have periodically tional reserve requirements, banks may end up experienced large-scale banking distress. In the with no cash on hand to pay depositors. They can United States, for example, in a period of high borrow from other banks or from the authorities, interest rates in the early 1980s, a quarter of the but only within limits. Bankers also face the risk savings and loan institutions failed. In the late of insolvency. If a bank loses a fifth of its asset 1980s the collapse of oil and real estate prices value, it is technically insolvent and may be taken brought another wave of bank failures. over by regulators. Wide swings in business con- ditions can wreak havoc on banks. Depressed Virtually no country is immune to banking crises. cocoa prices, for example, may cause banking dis- According to recent studies, more than 130 coun- tress in Côte d’Ivoire and Ghana, while a fall in tries have suffered major bank failures in the past copper prices may hit Zambia and perhaps Chile. two decades (see for example Caprio and Klingebiel 1999). In many cases the impact on This vulnerability is exacerbated by policy inter- the economy has been devastating. In Argentina, ventions. For example, public deposit guarantee Estonia, and Poland more than half the banks limits depositors’ runs on banks, but also encour- failed in recent banking turmoil. The amount of ages excessive risk taking by bankers (moral public money needed to resuscitate the failed hazard). And it may cause depositors to disregard banks is often staggering (figure 1). the quality of banks. The restrictions on bank branching or on foreign ownership as applied by Banking is an inherently risky business. To begin some countries limit diversification and amplify with, banks have access to unusually high lever- the impact of cyclical and price fluctuations. Pru- age. In nonbank firms a debt-equity ratio of 1 to dential rules of advanced countries also are often 1 is considered high, and a ratio of 4 to 1—as seen problematic. The risk of cross-border interbank The World Bank Group b Finance, Private Sector, and Infrastructur e Network Banking on Governance? FIGURE 1 THE HIGH COST OF BANKING CRISES Ghana, 1982–89 United States, 1984–91 Sweden, 1991–94 Russian Fed., 1998 Norway, 1987–93 probability of losing US$100. Socially, this project Czech Rep., 1989–91 Brazil, 1994–96 is unattractive, with a negative expected value of Philippines, 1983–87 US$1. But if the banker’s maximum loss is only Malaysia, 1997–present Spain, 1977–85 US$10 and the depositors are entitled to only Mexico, 1995–present US$5 of interest, the project has an expected value Japan, 1990s of US$4 to the banker. For some, it would appear Venezuela, 1994–97 Côte d’Ivoire, 1988–91 rational to take the risk. Rep. of Korea, 1997–present Thailand, 1997–present Chile, 1981–83 In developing countries especially, bankers can China, 1990s often reduce their risk exposure because weak Indonesia, 1997–present Argentina, 1980–82 banking rules and poor enforcement enable 0 10 20 30 40 50 60 them to lend large amounts of money to them- Fiscal costs as a percentage of GDP selves or to affiliates (related party lending). Such connected lending allows bankers to take risks Note: Costs for Ghana and Spain are shown as a percentage of GNP. Source: Caprio and Klingebiel 1999. with little or no exposure. This is the banker’s escape—the flip side of a run on banks. lending, for example, is often understated in the A bank’s risk exposure is generally confidential. metric of exposure (risk-weighted assets), lead- Detailed characteristics of individual assets (the ing to a cycle of excessive lending and destabi- borrower’s identity and the status of each loan) lizing credit withdrawals. are costly to monitor and verify. Many banks use historical cost accounting, which obscures their These natural and man-made hazards are known true financial condition. The use of new finan- or predictable. With good governance, a bank cial products, including derivatives and struc- can be prudently managed to avoid the dangers. tured notes, has made risk exposure even more Then why are bank failures so frequent and difficult to assess. Only bank management with widespread? It may have to do with the incen- a good information system and strong banking tives and constraints of the decisionmakers in skills can effectively monitor portfolio quality. banks and supervisory agencies. In addition, bank management has much scope Heads I win, tails you lose for discretion in valuing assets and in making provisions. Through small changes to individual There is a conflict of interest between bankers loans, management can change the aggregate (controlling shareholders and managers) and information it discloses by a wide margin. The other stakeholders—outside investors, deposi- use of independent auditors can help keep man- tors, and taxpayers. It is often quite rational for agers honest, but there are limits. Auditors gen- bankers to take on risks that are not prudent from erally certify financial statements on the basis of the perspective of the other stakeholders. local standards, which may not be consistent Bankers can use devices that reduce their per- with international standards. And auditors face a sonal exposure. They also have an information conflict of interest in their dual role as certified advantage that can be used to conceal the risk public accountants and bank consultants. exposure. In these circumstances bankers are often drawn to inefficient risk taking. Who is watching the umpire? How a banker sees the risk is affected by the com- The bank governance problem is often com- bination of high leverage and limited personal lia- pounded by a conflict of interest between bank- bility. Consider a project that has a 90 percent ing supervisors and depositors or taxpayers. probability of making US$10 and a 10 percent Unlike shareholders, who have an equity expo- sure, banking supervisors have no similar finan- collapse of many public guarantee funds, includ- cial stake in public guarantee funds. Their com- ing the Federal Savings and Loan Insurance pensation cannot be readily tied to performance Corporation in 1989 and state funds (Kane 1992). through the tools of incentive contracts or equity In these cases the supervisors involved had fore- ownership. Nor are banking supervisory agen- knowledge of the trouble, delayed corrective cies subject to the threat of takeover. As a result, actions, and helped in the cover-up. Strategic there is little assurance that banking supervisors behavior by supervisory officials is not confined will use their best efforts in the interest of depos- to any particular country. In the 1990s financial itors and taxpayers. The widespread failures of scandals involving public officials have been public deposit guarantee funds stand in stark uncovered in such countries as France, Mexico, contrast to the well-governed—and profitable— and Russia and in many East Asian countries. business of private sureties, which provide credit guarantee on a commercial basis. Three wishes for the genie When confronted with banking trouble, supervi- Good governance in banking relies on three key sors may find it difficult to proceed if the bank is building blocks: proper incentives, adequate too big to fail or powerful politicians are trying to transparency, and clear accountability. Putting protect the banker. They may be reluctant to dis- these building blocks into place may require close the bad news, especially if the problem unconventional reforms. should have been discovered earlier. And super- visors may often find that friendly relations with Aligning incentives bankers serve their long-term interests better than a strictly arm’s-length relationship. It is crucial that bank insiders have a significant equity stake in the banking business. But uphold- Banking supervisors have much discretion—for ing this role is very difficult. Banks’ accounting example, with regard to the definition of insol- policies need to reflect market risks and borrow- vency or the valuation of assets. A bank that is ers’ credit risks. Bank directors need to be insolvent by accepted accounting standards may accountable. Connected lending and ownership not be by the supervisors’ rules. Supervisors may of banks by commercial interests need to be pro- not recognize changes in the market value of hibited. Also helpful is expanding the scope for assets or do so on a timely basis. And if it serves market insight, for example, through market- their interests, supervisors might delay the nec- based disclosure (see below) and by rolling back essary regulatory action. public deposit insurance. In the business of banking, time is literally Essential, too, is to protect the interests of minor- money. Delayed corrective actions typically ity shareholders, especially among banks that are mean larger losses down the road. Troubled closely held. In particular, the duty of loyalty banks generally respond to losses by taking on should be imposed on banks’ controlling share- more speculative investments in the hope of holders, who also serve as bank directors and making up for them. But this “desperation” risk executives (Leechor 1999). The presence of taking often only magnifies the losses. independent directors and the use of audit com- mittees can also deter insider abuse. These strategic official behaviors are not theo- retical possibilities. Court documents and leg- The interests of the banking supervisors should islative records show that official delay has be aligned with those of the taxpayers. As long allowed many troubled banks to gamble with as public deposit guarantee is provided, the depositors’ money. In the United States, for rewards of the civil servants who manage the example, banking supervisors contributed to the guarantee fund must be linked in some way to Banking on Governance? the underwriting results. But this is not easy. accountable. Banks would have to rely more on Bringing in private sureties as business partners investment merits, including good governance of the public guarantee fund is a possible alter- and creditworthiness, to attract funding. In addi- native. The sureties would take the lead in pric- tion, adequate sanctions against abusive prac- ing and underwriting the risks, with the public tices are essential. For bank insiders, sanctions funds serving as coinsurers. should include unlimited liability, particularly for a breach of disclosure rules. And when fraud is Ensuring transparency involved, criminal sanctions must be an option. Minority shareholders and taxpayers should The coverage and standards of banks’ disclosure have access to judicial remedies against insider generally leave too much scope for discretion. abuse. Banks should be required to disclose not only their financial statements, but also their capital The performance of banking supervisors adequacy ratio, peak exposure concentration, improves when they have clearly defined perfor- lending to related parties, members of the board, mance criteria and a governing body accountable and any conflicts of interest (Nicholl 1996). The to the taxpayers. The supervisors should set tar- disclosure should follow marked-to-market pro- gets for the risk exposure of public funds, explain cedures, which reflect the effects of exchange any deviations from the targets, and provide a rates, interest rates, and commodity prices. And clear plan of corrective actions. They should also Viewpoint is an open bank directors should be required to attest that face significant sanctions for breach of duty, forum intended to their disclosures are not false or misleading. including criminal sanctions for participation in encourage fraud. But such rules are not easy to enforce. dissemination of and debate on ideas, Another problem is that bankers are often Independent and aggressive media can play a crit- innovations, and best required to give essential banking information ical role. In addition, a government ethics office practices for expanding only to the authorities, not to the market. This can help in investigating official misconduct. the private sector. The views published are practice places undue reliance on banking super- those of the authors and visors. In a break from conventional practice, References should not be attributed Chile and New Zealand have started moving to the World Bank or any Caprio, Gerard, Jr., and Daniela Klingebiel. 1999. “Episodes of of its affiliated toward market-based disclosure. Their banks Systemic and Borderline Financial Crises.” World Bank, Financial organizations. Nor do make full public disclosure on a quarterly basis to Sector Policy and Strategy Group, Washington, D.C. any of the conclusions market participants (depositors, their agents, and Kane, E.J. 1992. “The Incentive Incompatibility of Government- represent official policy Sponsored Deposit Insurance Funds.” In J.R. Barth and R.D. of the World Bank or of outside shareholders). This disclosure require- Brumbaugh, eds., The Reform of Federal Deposit Insurance. New its Executive Directors ment gives bankers an incentive to be prudent. York: Harper Business. or the countries they Leechor, Chad. 1999. “Protecting Minority Shareholders in Closely represent. Held Firms.” Viewpoint 190. World Bank, Finance, Private Sector, Banking supervisors should also be more trans- and Infrastructure Network, Washington, D.C. To order additional parent. They should be required to disclose Nicholl, Peter. 1996. “Market-Based Regulation of Banks: A New copies please call regulatory opinions on official forbearance or cor- System of Disclosure and Incentives in New Zealand.” Viewpoint 202 458 1111 or contact 94. World Bank, Finance, Private Sector, and Infrastructure Suzanne Smith, editor, rective actions. Where public deposit guarantee is Network, Washington, D.C. Room F11K 208, used, they should disclose the risk exposure of The World Bank, guarantee funds, along with the standards for 1818 H Street, NW, Chad Leechor (cleechor@worldbank.org), Washington, D.C. 20433, measuring the exposure. And the supervisors Private Sector Development Department, or Internet address should be required to attest that their disclosures Business Environment Unit ssmith7@worldbank.org. are not false or misleading. The series is also available on line (www.worldbank.org/ Clarifying accountability html/fpd/notes/). Printed on recycled Along with better disclosure, competition in the paper. banking business can make bankers more