C O M P O S I T I O N , S T R U C T U R E & R I S K - T A K I N G
- a study on Danish bank boards 2003-2008
COPENHAGEN BUSINESS SCHOOL 2010 COPENHAGEN BUSINESS SCHOOL 2010 COPENHAGEN BUSINESS SCHOOL 2010 COPENHAGEN BUSINESS SCHOOL 2010
STINE MARIE SKOV STINE MARIE SKOV STINE MARIE SKOV
STINE MARIE SKOV CAND.MERC(FIR) 270881-xxxx CASPER JUUL KAUFMANN
CASPER JUUL KAUFMANN CASPER JUUL KAUFMANN
CASPER JUUL KAUFMANN CAND.MERC(FSM) 110683-xxxx
SUPERVISOR: PROF., DR.MERC. FINN ØSTRUPFINN ØSTRUP FINN ØSTRUPFINN ØSTRUP
CHARACTERS CHARACTERS CHARACTERS
CHARACTERS:::: 272.481 272.481 272.481 272.481
PAGES:PAGES:PAGES:PAGES: 226226226226
Individual contribution to the thesis at hand:
Casper Juul Kaufmann wrote all even pages Stine Marie Skov wrote all odd pages
E X E C U T I V E S U M M A R Y
The thesis at hand is motivated by the criticism directed at Danish banks’ boards in the wake of the financial crisis and poses the research question: “Have the structure and composition of Danish bank board affected risk-taking in the period from 2003-2008?” To answer this, the thesis constructs ten hypotheses in a deductive, comparative research design: six hypotheses regard the composition of Danish bank boards, four regard the structure. The thesis defines five groups of stakeholders, who are all affected by the bank’s actions: the shareholders, the board of directors, the management of the bank, the depositors and society at large.
The hypotheses emerge from a thorough review of the corporate governance literature field with a special dedication to agency theory, as well as from extensive literature reviews on the theory and empirical research.
The answer to the research question is found through the subsequent data analysis, built on 4.829 manually collected, unique data points. The thesis finds that the structure and composition of Danish bank boards in the period 2003-2008 has indeed affected risk-taking in Danish banks, because:
• Independent directors are found to allow more risk-taking than dependent directors.
• Experienced board members are found to allow less risk-taking than inexperienced (less than five years of board experience)
• Directors with more than three simultaneous directorships are found to allow more risk- taking than directors with three or less directorships
• Directors are found to allow increasingly more risk as their years on the board increases
• Directors with a master’s degree in finance, economics, business economics or accounting are found to allow more risk-taking than those without such an educational background
• The existence of incentive programs (bonuses and stock (option) plans) is found to be positively related to risk-taking
• It is found that if the CEO has been in place longer than the board on average, risk-taking has been increased relative to a situation in which the board has served longer than the CEO.
“Gender” and “board size” are tested as well, but do not yield any results.
The origins of the findings are then discussed at length, leading to a final part that draws up three models; an actuarial model that suggests pricing the banks’ risk insurance correctly, a soft-law model that recommends specific bank governance recommendations and finally, a society model in which a government representative is (re-) introduced to banks’ boards.
1 INTRODUCTORY PART 12
1.1BACKGROUND, JUSTIFICATION AND MOTIVATION 12
1.2RESEARCH OBJECT AND AREA 13
1.3REAL ECONOMIC IMPACTS 13
1.3.1THE HOUSING MARKET BUBBLE AND BUST 14
1.3.2CREDIT AND LIQUIDITY FREEZE 15
1.3.3STOCK MARKET TURBULENCE 16
1.3.4OTHER IMPACTS 17
1.4ACTORS AND ACTIONS 17
1.4.1THE GENERAL POPULATION 17
1.4.2THE REGULATORS 17
1.4.3THE BANKS 18
1.5THE RESEARCH QUESTION 18
1.6AIM AND CONTRIBUTION 19
1.7DELIMITATIONS 19
1.8LIMITATIONS 20
1.9STRUCTURE OF THE THESIS 21
2 METHODOLOGY 22
2.1METHODOLOGICAL REFLECTIONS 22
2.1.1EPISTEMOLOGY 22
2.1.2ONTOLOGY 23
2.2RESEARCH DESIGN 23
2.3DATA 24
2.3.1PRIMARY DATA 24
2.3.2SECONDARY AND OTHER DATA 24
2.3.3DATA QUALITY 24
2.4THEORY 25
2.5PARTIAL CONCLUSION 25
3 THE RESEARCH FIELD 26
3.1THE BANKING INDUSTRY IN DENMARK 26
3.2THE BANKS IN SOCIETY 26
3.3THE STAKEHOLDERS 27
3.3.1THE OWNERS 27
3.3.2THE DEBTHOLDERS 28
3.3.3THE MANAGEMENT 28
3.3.4THE BOARD OF DIRECTORS 28
3.3.5THE SOCIETY 29
3.4RISK 29
3.4.1CREDIT RISK 29
3.4.2MISMATCHING 30
3.4.3FUNDING LIQUIDITY RISK 30
3.5REGULATION AND RISK-MONITORING 30
3.6PARTIAL CONCLUSION 31
4 THEORY 32
4.1CORPORATE GOVERNANCE 32
4.2TRANSACTION COST ECONOMICS 33
4.3AGENCY THEORY 33
4.3.1FUNDAMENTAL AGENCY THEORY 34
4.3.2THE EXTENDED AGENCY PROBLEM 34
4.3.3CONTRACTS 35
4.3.4EX-ANTE INFORMATION ASYMMETRY – HIDDEN CHARACTERISTICS 36
4.3.5EX-POST INFORMATION ASYMMETRY – MORAL HAZARD 37
4.4TYPES OF AGENCY PROBLEMS 37
4.4.1TYPE 1:OWNER VS. MANAGER 37
4.4.2TYPE 2:MINORITY VS.MAJORITY INVESTORS 38
4.4.3TYPE 3:SHAREHOLDERS VS.STAKEHOLDERS 38
4.5DEPOSIT INSURANCE 38
4.6RISK AND RISK PREFERENCES 41
4.6.1THE SHAREHOLDERS 42
4.6.2THE BOARD OF DIRECTORS 42
4.6.3THE MANAGEMENT 42
4.6.4THE DEBTHOLDERS 43
4.6.5THE SOCIETY 43
4.7ALTERNATIVE CEO RISK PREFERENCES 44
4.7.1OTHER MODELS OF CEO RISK PREFERENCES 44
4.8THE BOARD OF DIRECTORS 45
4.8.1THE ROLE OF THE BOARD 46
4.8.2THE OPTIMAL BOARD 47
4.9PARTIAL CONCLUSION 48
5 HYPOTHESES 49
5.1DETERMINING THE TESTABLE PARAMETERS 49
5.2INDIVIDUAL LEVEL 49
5.2.1INDEPENDENCE 50
5.2.2BOARD EXPERIENCE 52
5.2.3GENDER 53
5.2.4MULTIPLE DIRECTORSHIPS 56
5.2.5BOARD TENURE 59
5.2.6FINANCIAL EDUCATION 61
5.3HYPOTHESES - THE BOARD LEVEL 63
5.3.1BOARD SIZE 63
5.3.2INCENTIVE PROGRAMS 64
5.3.3THE CEO’S TENURE VERSUS THE BOARD’S TENURE 67
5.4PARTIAL CONCLUSION 68
6 SAMPLE CONSTRUCTION 69
6.1THE TIMEFRAME 69
6.2THE POPULATION AND SAMPLE 69
6.2.1EXCLUDED BANKS 71
6.3THE BOARD MEMBERS 72
6.4WEIGHING THE INFLUENCE 72
6.5INDIVIDUAL LEVEL VARIABLES 72
6.5.1INDEPENDENCE 72
6.5.2BOARD EXPERIENCE 73
6.5.3GENDER 73
6.5.4MULTIPLE DIRECTORSHIPS 73
6.5.5TENURE 74
6.5.6FINANCIAL EDUCATION 74
6.6BOARD LEVEL VARIABLES 74
6.6.1BOARD SIZE 75
6.6.2INCENTIVES 75
6.6.3THE CEO’S TENURE VS. THE BOARD’S TENURE 75
6.7PARTIAL CONCLUSION 75
7 RISK MEASURES 76
7.1ASSEMBLING RISK IN ONE MEASURE 76
7.2STOCK VOLATILITY 76
7.3ABSOLUTE GROWTH IN LOANS 77
7.4ANNUAL RELATIVE INCREASE IN LOANS 77
7.5GROWTH IN THE LOAN/DEPOSIT RATIO 78
7.6THE ABSOLUTE LEVEL OF LOANS TO DEPOSITS 79
7.7CHOICE OF RISK MEASURE 81
7.8PARTIAL CONCLUSION 82
8 DESCRIPTIVE STATISTICS 83
8.1THE SAMPLE 83
8.2THE RISK MEASURE 83
8.3INDIVIDUAL VARIABLES 84
8.3.1INDEPENDENCE 84
8.3.2BOARD EXPERIENCE 84
8.3.3GENDER 85
8.3.4MULTIPLE DIRECTORSHIPS 85
8.3.5TENURE 87
8.3.6FINANCIAL EDUCATION 87
8.4BOARD LEVEL VARIABLES 88
8.4.1BOARD SIZE 88
8.4.2INCENTIVE PROGRAMS; BONUS AND STOCKS 89
8.4.3CEO VS. BOARD 89
8.5PARTIAL CONCLUSION 90
9 DATA ANALYSIS 91
9.1REGRESSION ANALYSIS 91
9.2MODELS FOR ANALYSIS 91
9.3STATISTICAL RESULTS 93
9.3REFERENCE CATEGORIES 93
9.4.1INDIVIDUAL LEVEL, INCLUDING EMPLOYEE-ELECTED REPRESENTATIVES 94
9.4.2INDIVIDUAL LEVEL, EXCLUDING EMPLOYEE-ELECTED REPRESENTATIVES 94 9.4.3BOARD LEVEL, INCLUDING EMPLOYEE-ELECTED REPRESENTATIVES 94 9.4.4BOARD LEVEL, EXCLUDING EMPLOYEE-ELECTED REPRESENTATIVES 94
9.5RESULTS 95
9.5.1INDIVIDUAL INDEPENDENT VARIABLES 95
9.5.2.INDEPENDENCE 95
9.5.3BOARD EXPERIENCE 95
9.5.4GENDER 96
9.5.5MULTIPLE DIRECTORSHIPS HELD BY THE BOARD MEMBER 96
9.5.6TENURE (TIME SPENT ON THE BOARD) 96
9.5.7FINANCIAL EDUCATION 97
9.6BOARD LEVEL INDEPENDENT VARIABLES 97
9.6.1BOARD SIZE 97
9.6.2STOCK PAYMENT / STOCK OPTIONS 97
9.6.3BONUS SCHEMES 98
9.6.4CEO VS. THE BOARD 98
9.7CORRELATIONS 98
9.7.1MODEL 1A AND 1B. 99
9.7.2MODEL 2A AND 2B 99
9.8FULL MODELS 100
9.9MOST RISK-TAKING DIRECTOR AND BOARD 100
9.10PARTIAL CONCLUSION 101
10 DISCUSSION AND IMPLICATIONS 102
10.1INDEPENDENCE 102
10.1.1DISCUSSION OF THE FINDINGS 102
10.1.2THE SAMPLE 103
10.1.3IMPLICATIONS 104
10.2BOARD EXPERIENCE 105
10.2.1DISCUSSION 105
10.2.2THE SAMPLE 106
10.2.3IMPLICATIONS 106
10.3GENDER 107
10.3.1DISCUSSION 107
10.3.2SAMPLE 107
10.3.3IMPLICATIONS 107
10.4MULTIPLE DIRECTORSHIPS 108
10.4.1DISCUSSION 108
10.4.2THE SAMPLE 108
10.4.3IMPLICATIONS 109
10.5TENURE 109
10.5.1DISCUSSION 109
10.5.2THE SAMPLE 110
10.5.3IMPLICATIONS 110
10.6FINANCIAL EDUCATION 110
10.6.1DISCUSSION 110
10.6.2SAMPLE 111
10.6.3IMPLICATIONS 111
10.7BOARD SIZE 112
10.7.1DISCUSSION 112
10.7.2THE SAMPLE 112
10.7.3IMPLICATIONS 113
10.8INCENTIVE PROGRAMS 113
10.8.1DISCUSSION 113
10.8.2THE SAMPLE 114
10.8.3IMPLICATIONS 114
10.9THE CEO VERSUS THE BOARD 114
10.9.1DISCUSSION 114
10.9.2THE SAMPLE 115
10.9.3IMPLICATIONS 115
10.10PARTIAL CONCLUSION 115
11 RECOMMENDATIONS 118
11.1THE BANK AND ITS ENVIRONMENT 118
11.1.1THE ACTUARIAL MODEL 120
11.1.2THE SOFT LAW MODEL – WITH HARD LAW EXTENSIONS 121
11.1.3THE SOCIETY MODEL 121
11.1.4FINAL RECOMMENDATION 122
11.5PARTIAL CONCLUSION 122
12. CONCLUSIONS 123
13 REFERENCE LIST 125
14 TABLE OF CONTENTS - APPENDICES 133
TABLE OF FIGURES, GRAPHS, TABLES AND CHARTS
FIGURE 1.1 REAL ESTATE PRICE DEVELOPMENT IN DENMARK (1995-2009) ... 14
FIGURE 1.2 ILLUSTRATION OF THE TED SPREAD FROM 1995 TO 2009 ... 15
FIGURE 1.3 ILLUSTRATION OF VARIOUS STOCK MARKET INDICES (2003-2008) ... 16
FIGURE 1.4 OVERVIEW OF THE THESIS STRUCTURE ... 21
FIGURE 4.1 GRAPHICAL DEPICTION OF THE CALL OPTION ON EQUITY ... 39
FIGURE 4.2: GRAPHICAL DEPICTION OF THE DEBTHOLDER’S PUT OPTION ... 41
FIGURE 4.3: GRAPHICAL DEPICTION OF THE RISK PREFERENCES OF THE 5 STAKEHOLDER ... 41
TABLE 5.1 DIVERSITY PARAMETERS ... 54
FIGURE 6.1 SIX LARGEST DANISH RETAIL BANKS IN THE SAMPLE ... 70
FIGURE 6.2 THE MEDIUM-SIZED RETAIL BANKS IN THE SAMPLE ... 70
FIGURE 6.3 THE SMALLEST DANISH RETAIL BANKS INCLUDED IN THE SAMPLE ... 71
TABLE 6.1: EXCLUDED BANKS ... 71
TABLE 7.1: LOAN/DEPOSIT RATIO FOR SELECTED BANKS IN 2007 ... 81
TABLE 8.1 LOAN/DEPOSIT RATIOS FOR THE PERIOD 2003-2008 ... 83
TABLE 8.2 INDEPENDENCE ... 84
TABLE 8.3 BOARD EXPERIENCE ... 84
TABLE 8.4 GENDER ... 85
TABLE 8.5 MULTIPLE DIRECTORSHIP ... 86
TABLE 8.6 TENURE ... 87
TABLE 8.7 FINANCIAL EDUCATION ... 87
TABLE 8.8 BOARD SIZE ... 88
TABLE 8.9 INCENTIVE PROGRAMS ... 89
TABLE 8.10 BOARD VS. CEO ... 89
TABLE 9.1 MODEL STATISTICS ... 93
FIGURE 11.1: THE BANK’S STAKEHOLDERS; IMPACT AND INFLUENCE ... 119
1 INTRODUCTORY PART
The following thesis finds its motivation in the criticism directed at Danish banks and especially Danish banks’ boards of directors in the wake of the economic boom and subsequent bust. In the public debate it is a common perception that Danish bank boards have ratified excessive risk-taking in banks, which leads to the research question of the study at hand: “Have the structure and the composition of Danish bank boards affected risk-taking in the period from 2003-2008?”
Methodologically, the investigation into the research question is conducted deductively through the examination of ten hypotheses. The hypotheses are of course not arbitrary; rather, they are derived from a comprehensive review of the corporate governance research field and from multiple literature reviews on specific subtopics of corporate governance. However, in accordance with deductive methodology, it is not argued at length why the hypotheses in question are chosen as they are. Rather, they are justified by actually leading to significant results in the course of examination.
Agency theory is the most important basis for formulating these hypotheses. Six hypotheses are directed at the individual director’s characteristics and are thus concerned with the composition of boards, while four investigate the board’s characteristics and thereby the structure of boards. The sample used to test these hypotheses is comprised of 67 Danish banks and 749 directors, a data pool of 4.829 unique data points.
Data analysis leads to a number of results and observations, which are interpreted and discussed further. The discussion lays a foundation for recommendations to improve current corporate governance practices. The concluding sections answer the research question by determining that risk-taking and board structure/board composition are in fact related to a certain extent.
1.1 Background, justification and motivation
The thesis at hand is fundamentally motivated by the global financial crisis1 observed in the past years and its research is justified by the real economic impacts this crisis has had (and still has) on large parts of society. This introductory part of the thesis outlines the research object and area and subsequently elaborates on its justification by outlining the real economic
1 For clarification reasons it should be noted that while the term “financial crisis” may represent a rather populist version of
“financial turbulence, financial turmoil, economic contraction, recession” and so forth, it is used in this thesis as a covering term for the abnormal happenings in the financial markets in the later years. Also, ‘financial crisis’ is a well-known term.
impacts the crisis has had and following this, the actors and actions that have been publically discussed as culprits are presented.
1.2 Research object and area
While the culprit of the crisis is still being debated, the real economic effects are clearly visible, as presented in the next paragraph. The public debate points towards financial institutions as those responsible for engendering a crisis at such a scale by lending out too much money. More specifically, the criticism is aimed at the management of the financial institutions (‘management’ in this sense including the board of directors and the executive level within the institutions). At the time of writing, a consensus seems to have formed to the effect that financial institutions in general and banks in particular have engaged in irresponsible, excessive risk-taking. However, the criticism is still imprecise, which impedes the development of corrective measures to prevent similar crises in the future. This motivates researching the management and the management systems of the banks, specifically those in the bank holding the final responsibility – the board of directors. This is the research object of the thesis and therefore, the natural field of research is that of corporate governance.
The criticism aimed at the banks’ boards is a global phenomenon, but in order to reduce potential bias stemming from different political, economical, social, technological and legal business environments, the research sample is concentrated on one area; Denmark. Danish banks provide a relevant sample as it has been argued that the Danish banking industry, once considered a safe, conservative one, has been hit relatively hard by the financial crisis.
Thus, the research object for the thesis is the relevant aspects of the constitution of boards of directors in Danish banks.
1.3 Real economic impacts
Before venturing into describing the institutions criticized in the wake of the crisis, its impacts on various parts of society are outlined. Generally speaking, the impacts of the financial crisis fall into three different, but surely inter-linked, categories. They are identified as the housing market bubble (and bust), the credit and liquidity freeze and the abnormal stock market fluctuations as well as unusual fluctuations in ‘other’ markets. They will each shortly be described and their impact on the real economy will be outlined to justify the treatment of the financial crisis as a researchable problem.
1.3.1 The housing market bubble and bust
Throughout many parts of the world, house prices increased rapidly from about 2002-2003 until reaching peaks in the late part of 2006, in 2007 or in 2008. In the research area of the thesis, Denmark, the house price boom took off around 2003 and peaked in late 20062:
Figure 1.1 Real estate price development in Denmark (1995-2009)
All real-estate price data in figure 1.1 have been retrieved from Realkreditrådet (Realkreditraadet 2010a)
When the boom ended, prices plummeted as depicted in figure 1.1 and (partly) because of the high leverage in home purchases during the boom, numerous home owners now face negative equity on their mortgages (linearly correlated to the size – in % - of the mortgage taken out).
This effectively immobilizes these groups of people in the housing market as they cannot move without converting their negative equity into a loan without collateral. This loan will in some instances end up being more expensive than the payment on the mortgage taken out in the home purchased. This is clearly an efficiency loss in the housing market which risks spilling into the labor market as a second-order effect, as increasing labor force immobility can lead to increasing mismatching in the job market.
On the other hand, those who did not enter the housing market during the boom are affected by much stricter credit policies by the banks if wanting to purchase a home (Børsen 2009b, Direkt 2010, Kjær 2010). This is also an indication of ineffective allocation of resources in the housing market as entry into the housing market in recent years can be said to have been determined as much by timing of entry as by economic ability.
With hindsight, a consensus is forming that some loans should not have been granted – although housing prices are somewhat stabilized at the time of writing, the number of foreclosures on homes is still rising (Realkreditraadet 2010b).
2 Considerable geographical variation exists, but the first markets to stagnate, Copenhagen apartments, did so in the 3rd quarter of 2006
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Q1 1995 Q4 1995 Q3 1996 Q2 1997 Q1 1998 Q4 1998 Q3 1999 Q2 2000 Q1 2001 Q4 2001 Q3 2002 Q2 2003 Q1 2004 Q4 2004 Q3 2005 Q2 2006 Q1 2007 Q4 2007 Q3 2008 Q2 2009
Real-estate prices
Houses Apartments
In summary, the seemingly lax credit policies of mortgage lenders (who finance upwards of 80 % of the home purchase) and the banks (who finance the rest) have been suggested to have led to too many and too expensive home purchases, which could be defined as a housing bubble (Kindleberger 1987).
The behavior of the banks has drawn critical remarks from several sources. For example, the Danish Social Democrat opposition leader writes that “[we] are determined to never again be placed in a situation in which recklessness in the financial sector would present a real threat to our national wealth and welfare”, (Thorning-Smith 2009) (translated for this thesis), a view shared by others (Formsgaard 2008, Lunde 2008)
1.3.2 Credit and liquidity freeze
Another visible pointer towards the suggestion that banks in general had lend out too much money was the credit and liquidity freeze beginning in the Spring of 2007 and culminating with first Bear Stearn’s fire sale in March 2008 to JPMorgan and finally with the bankruptcy of Lehmann Brothers in August 2008 (Wearden, Teather et al. 2008, Brunnermeier 2009).
Interbank-overnight rates climbed as insecurity about the banks’ investment portfolios spread and banks across the board sought to reduce engagements to stock up on equity because the loan portfolios suddenly were deemed of much less quality than originally anticipated.
Figure 1.2 Illustration of the TED Spread from 1995 to 20093
Source: Data in figure 1.2 was retrieved from Yahoo Finance(Yahoo Finance 2010)4
3 The TED spread the difference between the interest rate on three-month Treasury bills and three-month LIBOR, the rate banks charge on loans to each other. The TED spread is an indication of lack of trust in financial markets; its widening was a sign that things were going bad (Krugmann 2008).
2003 2004
2000 2001 2002 2005 2006 2007 2008 2009 450
400 350
50 250
100 200
TED SPREAD
Hence, many small businesses, dependent on running lines of credit, suddenly faced harder conditions when re-negotiating terms and interest rates with their banks (Børsen 2009b, Børsen 2009a). Undoubtedly, some negative-NPV-projects have been avoided by stricter credit policies - which is economically sound - but it must be considered likely that some projects with arguably positive NPV have been turned down due to lack of credit facilities.
This, too, constitutes a real economic impact of the financial crisis and it too can be traced back to the lax lending policies in the years leading up to the crisis.
1.3.3 Stock market turbulence
Stock markets lost substantial amounts of value as the forecasts for future demand and economic activity on the whole changed. Also, with the contraction of credit, leveraged investments decreased significantly once the future projections turned sour (European Commision 2010)
Figure 1.3 Illustration of various stock market indices (2003-2008)
All stock data in figure 1.3 has been retrieved from Euroinvestor in July 2010 for the period 2003-2008(Euroinvestor 2010).
It is not argued that it is an economic problem that stocks lose value per se, nor is it a problem that investors re-calibrate their risk forecasts; these events are part of keeping the markets efficient. It is argued, though, that markets work less efficiently if booms and busts occur and the transition from one to the other is characterized by (irrational) euphoria or panic (Jorion
0,0000 100,0000 200,0000 300,0000 400,0000 500,0000 600,0000
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OMX OMX
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Dow Jones Dow Jones
1.000,0000 1.200,0000 1.400,0000 1.600,0000 1.800,0000 2.000,0000 2.200,0000 2.400,0000 2.600,0000 2.800,0000 3.000,0000
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FTSE FTSE
2007), which can distort the fundamental value (as measured by the share price) of companies temporarily, leaving room for arbitrage, which can only occur in imperfect market conditions.
The impact on the broader parts of the population is found – mainly – in pension funds, whose value increased as markets did and then decreased along with the market, leaving savers with greater uncertainty about their future income stream.
1.3.4 Other impacts
Other impacts include commodities markets (copper, oil, gold), which have shown indications of smaller booms following the withdrawal of investments from the stock markets. These local booms exhibit the features of an investor ‘flight to safety’ in which funds are withdrawn from corporate shares and placed in commodities carrying real, intrinsic value. When commodities become investment objects, those utilizing the commodities for production and consumption face inflated prices and less purchasing power, thus hindering production/consumption with the commodity, because it is crowded out by the investment purchases.(Forbes.com 2008)
Aside from the purely business and private economic impacts, the financial crisis has sparked national economic crises that are in many cases related to high lending and borrowing5(European Commision 2010, Caballero, Farhi et al. 2008).
1.4 Actors and actions
Having now looked at (some of) the effects of the financial crisis, the focus turns to the actors in the events leading up to the crisis and to the actions taken by these actors.
1.4.1 The general population
While not the research focus of the thesis, reactions and perceptions within the general population and the climate surrounding the boom cannot be completely left unmentioned. A general sense of real estate as an eternally superior investment (Skovgaard 2006, Carstensen 2007, Hansen 2007), and unprecedented increases in consumption spending as a result of second mortgages taken out in the hastily rising home equity have arguably led to pressure on banks to finance the outer 20 % of expensive home purchases.
1.4.2 The regulators
In the area on which this thesis is focused, Denmark, it is the Danish Financial Supervisory Authority (“Finanstilsynet”, DFSA) which has been in charge of monitoring the banks’ loans
5 Greece springs to mind as an infamous example.
and their portfolios (Financial Business Act 2003, Financial Business Act 2003, Financial Business Act 2003, Financial Business Act 2003). The deposit insurance in Danish banks as well as the perceived notion of the society as a ‘lender of last resort’ for the banks necessitates a supervisory authority. The DFSA has been criticized for not intervening in the period 2003- 2008, especially for de-facto allowing the banks to build up large and/or undiversified loan portfolios (Børsen 2008, DR 2009, Heering, Jeppesen et al. 2009) which in some cases have been much too large, causing financial distress when the financial crisis commenced.
1.4.3 The banks
Concerning the banking sector, management and governance structures have been condemned for having been too optimistic, too focused on short-term gains and for not having shown caution enough, which has led to the effects outlined above.
There seems to be a consensus that those responsible for the banks’ actions have failed to live up to their responsibilities (Ritzau 2008, Børsen 2010a, Børsen 2009). This means, in effect, the banks’ boards as they are the supreme governing body of the banks (in theory, the shareholders are, but they act through the board of directors, practically as well as legally).
The criticism, however, is partly inconsistent or at least points in many directions; from some sides, the boards have been criticized for not being knowledgeable enough about the relevant bank’s operations to properly monitor the top management’s actions. From other sides the criticism is that bank boards are merely rubberstamping risk-seeking CEOs’ proposals and others again point towards the incentive systems proposed/approved by the boards as the culprit of the financial crisis – in Denmark as well.
1.5 The research question
This thesis seeks to remedy some of the confusion outlined in the paragraphs above. The motivation and justification have centered the attention on the banks and specifically, those holding ultimate responsibility in the banks: the board of directors, which emerges as the object of research interest to the thesis at hand.
It is an assumption of the thesis that no comprehensive study on the Danish bank boards exist.
Rather, many fragmented perspectives (incentive pay, education etc.) have been proposed by academics and public commentators alike.
As the value and consequences of having a board cannot be tested – all banks must have a board, thereby making it an exogenous factor – the attention shifts to the differences between boards; their respective different structures and the composition of each individual board member’s characteristics in the years leading to the onset of the financial crisis, to be precise.
The research question of the thesis is then:
“Have the structure and the composition of
Danish bank boards affected risk-taking in the period from 2003-2008?”
The question is sought answered through an exhaustive examination of the Danish bank boards and each of their directors. Instead of dividing the research questions into sub- questions, the thesis answers its research question through building ten hypotheses and subsequently testing and analyzing these, leading to a frame for the discussion and recommendations.
1.6 Aim and contribution
It is the aim of the thesis to provide the reader with a comprehensive overview of the Danish bank boards in the period of economic boom and subsequent bust (2003-2008), specifically of the characteristics of the boards and of the board members that take significance in risk-taking behavior.
The thesis aims to equip shareholders in Danish banks with a study that can guide the election of board members dependent on the behavior wished on the board, yet it is also the aim to provide the public debate and, in turn, the policy makers with information on which type of bank board structures and which type of bank board director that have taken on or allowed relatively more/less risk in the researched period.
The thesis’ contribution is that it is the first study to undertake such an exhaustive review of the Danish bank boards with respect to the period leading up to (and including some of) the financial crisis.
1.7 Delimitations
The thesis places itself within a large theoretical field as well as in a large subject field: the study of corporate governance applied to the financial crisis could go in almost any direction and could take several theoretical approaches.
This thesis chooses to follow core corporate governance theory by deploying an agency problem perspective to the dynamics observed in Danish banks. Social theories at one end of the spectrum might yield other and differently qualified discoveries, as would at the other end of the spectrum the politological approaches to the governance issues in Danish banks.
Furthermore, it is not the aim of the thesis to test the applicability of the agency theory field;
it is the aim to answer the research question through its hypotheses.
The thesis will not seek to investigate the social dynamics of the relations between shareholders, stakeholders, the board and top management; neither will it embark on socio- psychological dynamic in an intra- nor an inter-organizational perspective. While these factors may indeed be relevant to the general understanding of boards of directors, they are taken as exogenous factors in the thesis at hand.
The environment in which the banks work are also taken as exogenous factors in all parts of the thesis except for that of the final recommendations. That means that for instance Basel-II, the legal foundation for the Danish Financial Supervisory Authorities, whether deposit insurance should exist etc. are not the focus of this paper.
In relation to the specific actions of the Danish bank boards and top managers in Danish banks, it is also a delimitation of the thesis that it is assumed that actors act in good faith.
Thus, criminal acts and other actions in bad faith are not taken into account as endogenous factors.
1.8 Limitations
First of all, the thesis is limited by the fact that by all accounts, not all impacts of financial crisis, (which have motivated the production of thesis), known yet. For example, at the time of writing the concluding remarks on this paper, Amagerbanken was still in considerable financial distress.
Secondly, the research design and the nature of this comparative study carry with them their own limitations. For example, the chosen design is conducive to a (primarily) quantitative analysis, but it is acknowledged that a case study could capture qualitative phenomena not captured in this research design. Furthermore, the data collection is conducted as a desk study, which may limit the scope of the investigation and it is acknowledged that a more qualitative field study may have revealed relevant perspectives not presented in this investigation.
Due to the scale of the research objective, specific limitations are explained when appropriate to increase the intuitive understanding of the respective sections for the reader.
1.9 Structure of the thesis
Figure 1.4 Overview of the thesis structure
Source: own contribution
Figure 1.4 illustrates the overall structure of the thesis. It is divided into six thematic parts.
The parts comprise twelve distinct sections each covering numerous paragraphs. Each of the twelve sections is commenced by a partial introduction where the purpose and the structure of the respective section will be outlined. In order to capture the main pointes each section will be summarized in a partial conclusion.
RESEARCH QUESTION PART OBJECTIVE
Outline the motivation, introduce the research problem and objectives and present the structure and research design
Provide a solid foundation for understanding the research field
Build testable hypotheses
Statistically analyze the hypotheses based on the data collected.
Discussion and implications of the findings and further recommendations
Summarize the findings and present the concluding remarks Hypotheses
Introduction
Analysis Theory
Evaluation
Conclusion Have the
structure and composition of Danish bank boards affected the risk-taking in the period from 2003-2008?
2 METHODOLOGY
The purpose of the following section is to give an accurate account of the basic considerations and assumptions employed in this thesis. First, it is defined what is considered acceptable knowledge within the scope of this thesis through a review of its epistemological and ontological position. Then, the appropriate research design is identified. Next, the general data selection process and its sources are outlined. Finally, the theoretical field is critically reviewed.
2.1 Methodological reflections
“Corporate governance” presents certain challenges as a chosen research area (as described in section 1.2); the field spans the entire social sciences theory/empirical field, ranging from in- depth qualitative social research to econometrical applications of concepts from the natural sciences. Because of the apparent width and depth of the research area, it is necessary to explicitly define the epistemological and the ontological assumptions being made, as this directs a selection process when obtaining primary data and secondary data, when identifying relevant theoretical foundations for the arguments presented, when analyzing the data and when discussing the findings.
2.1.1 Epistemology
It is a basic assumption of this thesis that the outlined research problem can be understood in terms that are measurable and observable, and this is reflected in the research design.
Therefore, this thesis is primarily positivist in its epistemological considerations, as it is the conviction underlying the research approach that what is observed is tangible and quantifiable (Bryman, Bell 2003).
However, as this thesis seeks to provide not only an understanding of the problem, but also suggestions for optimized board structures and board composition (both implied through measurements of optimality in board work (section 4.8.2) and explicitly in the recommendations (section 11), the epistemological stance of the critical realism is appointed as well (Langergaard, Rasmussen et al. 2006).
As an example, a pure positivist stance would regard all actors as (equally) rational (at least ideally), whereas this thesis acknowledges the concept of bounded rationality in human actors in economic transactions, which by definition is neither equally present nor equally constant in the individuals examined in the sample.
In adhering to a critical realist’s stance, it is acknowledged that human differences are real and in principle objective, even though grounds and explanations for these are not. This separates the considerations of this thesis from those of the structuralist’s or the social constructivist’s.
2.1.2 Ontology
Having defined above what the thesis at hand considers acceptable knowledge the ontological perspective should be outlined to establish the understanding of the observed phenomena.
As it is a founding conviction that the research objective – the board of directors – is a separate structure independent of its social actors the ontological stance must adhere to objectivism. More specifically, even though the research objective can only be approached through a specific perspective it is considered to exist independently of the perspective chosen.
2.2 Research Design
The research design chosen in the thesis can be characterized as a comparative design (Bryman, Bell 2003). While the data collection and subsequent analysis may resemble that of the cross-sectional design (ibid), the objective is to determine differences between the observed entities in the sample, not to give conclusive answers on the whole sample’s features. The comparative design provides the opportunity to examine the same variables in different cases (in this case, in boards, board members and CEOs), which is crucial to solve the proposed research question. In terms of the level of research, the investigation is on the individual level when examining CEOs and board member characteristics and on the group level when examining the features and interactions of the board as a whole.
The comparative research design applied in this thesis is sought to be strong in replicability by consciously choosing measurement variables that are relatively easily obtained (see section 6). Also, by being very explicit in the criteria employed, it is believed that the study could be replicated without much alteration by other groups of researchers. The design chosen should also be externally valid as none of the parameters tested are specific to the focal industry and geographic area. It therefore provides a research ground for generalization beyond the context (the sample taken into consideration) (Langergaard, Rasmussen et al. 2006).
However, comparative designs have been criticized for lacking internal validity as the causal links can, in some cases, be hard to determine to a satisfactory extent. This problem is mitigated when variables are non-manipulative, which – to the extent possible – they are sought to be (Bryman, Bell 2003).
The nature of the study, following the research question’s and the design’s structure is that of hypothesis building, hypothesis testing with subsequent data description, data analysis and discussion of the findings in relation to the outlined hypotheses and the theory underlying these. This approach is best described as a deductive approach (ibid). The sample construction has been assigned its own paragraph, in which the specifics of the data selection are outlined, see section 6.
2.3 Data
The thesis at hand bases its findings on extensive data collection to support the testing of the constructed hypotheses. The data was collected in the period from March – July 2010 and comprises approximately 6000 manually collected unique data points. In addition to this, vast financial data on stock volatility, loan/deposit rates and other risk parameters have been collected in pre-assembled form from governmental and industry sources.
To assist the hypothesis building and to structure the data analysis, thorough attention has been paid to previous studies and to existing theories in the field.
2.3.1 Primary data
The primary data for the study is obtained primarily from various data sources: annual reports, online databases/directories and from the general news outlets. The primary data serves as the foundation for the investigation into the boards of Danish banks, as this data is not obtainable from any already-assembled sources. For example, the online directories provide the professional title of a board member, but do not indicate whether this amounts to having ‘experience’ or having a ‘financial education’ or not (see sections 5.2.2 and 5.2.6).
These distinctions rest solely on the data obtained in the course of the research leading to this thesis at hand.
2.3.2 Secondary and other data
The secondary data is obtained primarily in the form of other researchers’ articles. Also, some data is collected from researchers, who do meta-studies on previous research; thus, some data might be ‘tertiary’ in nature. The use of this data is mainly for supporting the risk-parameters (see section 7) or to support the hypothesis building through theory (see all sub-sections in section 5.
2.3.3 Data quality
In the data collection, due consideration has been paid to the reliability and validity of the data sources. The validity of the data is of course only as strong as the validity of the sources.
Thus, some information has been found in sources that are inherently prone to information of questionable quality – such as Linkedin and Facebook profiles. However, all such sources have been cross-checked in case of doubt. For example, a person’s own claims on her/his Linkedin profile have been checked with the bank’s information or with general news. It has been the general principle to exclude data that could not be readily verified throughout the data collection process, a fact which has resulted in the omission of a few board member characteristics. This does not distort the overall data reliability, though, as more than 99.9 % of the data sought after has been found and verified.
2.4 Theory
As described in section 2.1 the corporate governance area is a broad field. At the same time, the theoretical frameworks available to the researcher in corporate governance often stem from other fields and the application of these related theories to the corporate governance field have resulted in many middle range theories emerging from empirical work. Thus, the apparent ‘lack’ of grand theories is – for now – a condition which research in the field circumvents by building middle range theories through empiricism.(Bryman, Bell 2003) The theoretical works used in the thesis are found primarily in the hypothesis building. Multiple findings are cited and referenced throughout the paper.
2.5 Partial conclusion
It was outlined that the thesis is positivist, critically realist and objectivist in its scientific nature. The deployed research design is that of a deductive, comparative design conducted as a desk study. The data consists of primary and secondary data and the theory is drawn from the corporate governance research field, which itself draws on a broad range of social science fields.
3 THE RESEARCH FIELD
The following section on the Danish banking industry serves two purposes: first, it provides the reader with an understanding of the research area and its dynamics. Second, it serves the purpose of elaborating on the relevance of researching the industry by defining the banks’ role in society (as it is seen from this thesis’ perspective) and by defining the stakeholders to the Danish banks – the latter undoubtedly being intertwined with the former.
3.1 The banking industry in Denmark
The Danish banking industry is at the time of writing comprised of 133 banks, which in total have DKK 2.7 trillion. of capital at work6. The industry is relatively concentrated with the six largest banks making up > 80 % of the total capital. The largest bank, Danske Bank, alone accounts for 52 % of the total capital (Finanstilsynet 2010).
In Denmark, three types of banks serving individual consumers exist: retail banks (“banker”), savings banks (“sparekasser”) and cooperative savings banks (“andelskasser”). The legislation on the three types has in the later decades converged and differs only when regarding ownership structure. All retail banks must be incorporated, whereas savings banks can be owned by self-governing foundations. Cooperative banks are owned by the members of the cooperative. Retail banks cover 95 % of the total banking industry, savings banks and cooperative savings banks the remaining 5 %(Finanstilsynet 2010). Due to the similarities between banks and because retail banks make up such large part of the industry, the incorporated ownership structure is the one considered in this thesis. This would justify referring to the owners of the banks considered in the paper at hand as the “shareholders”.
3.2 The banks in society
As outlined in section 1, the banks have drawn massive criticism to themselves as the financial crisis took hold. The instability (allegedly) caused by the banks’ practices has, as described in section 1.3, had ramifications far beyond the bank and its shareholders. This presents a peculiar dilemma: apparently, the bank as a firm looks like other industry companies – it is listed at stock exchanges, has private owners, runs marketing campaigns etc.
– but its actions impact non-shareholding stakeholders to an extent much larger than a regular product company is capable of.
6 Capital-at-work is not to be confused with working capital. It is comprised of the sum of deposits, equity, issued bonds and sub-ordinated loan capital.
These observations are supported by the findings of Ahn and Choi (2009), who observe that banks are “special” economic units due to their distinctive roles in financial intermediation, in the payment system and in liquidity, etc.
The banks’ own interest organization in Denmark supports this view and it expresses this in the following way:
“The banks are a part of daily life in Denmark. The banks’ role is to channel money to the right places for citizens, the businesses and for governmental institutions […]The banks are a part of the Danish national economy and they hold a great importance for the development of the economy.”(Finansrådet 2010) (translated).
Thus, the banks themselves acknowledge that their role is to serve their stakeholders at large and this view will not be contended further. This does not mean, of course, that banks do not run for profit and for maximization of shareholder wealth, but it justifies the existence of a supervisory authority to oversee that the banks do not take risks that endanger the economic health of the society as a whole because of their special status as a financial institution.
3.3 The stakeholders
As the bank fulfills a role larger than that of the ordinary corporation and thereby affects its stakeholders to a greater extent and whose stakeholders on the other hand (through legislation, regulation etc.) impact the bank’s actions, it is deemed imperative to outline the bank’s and the stakeholders’ interrelation.
The bank is seen as having five groups of stakeholders. Throughout the thesis, these will be the angles from which to consider the bank’s actions and the findings of the research. Surely, more groups could be included and considered, but the five groups represent the full environment the banks operate in, each of them containing subgroups of stakeholders. The thesis is considered relevant for all five stakeholder groups and the implications of the research (see sections 10.1-10.9) will address the five stakeholder groups’ views separately when necessary.
3.3.1 The owners
The bank’s owners are its shareholders or owners who own different types of stakes in the bank. Some banks are primarily owned by foundations, some are listed at the Copenhagen OMXC stock exchanges, some are incorporated but not traded etc. The owners will be addressed “the shareholders” in general as previously mentioned, because the main body of literature on ownership and specifically on ownership in banks assumes incorporation. The
main focus of the thesis is on incentives and they do not differ considerably from shareholder to foundation owner – the execution and engagement in the ownership do differ, but it is the incentive structure that is primarily researched and analyzed upon, unless otherwise specifically stated.
3.3.2 The debtholders
The bank’s debtholders are primarily its depositors, secondarily its institutional lenders. The depositors are insured by the Deposit Insurance Fund7, which means deposits in almost the entire research period were guaranteed up to DKK 300,000 – in the last days of 2008 depositors enjoyed unlimited deposit insurance. (Financial Business Act 2003). The dynamics and hazards of deposit insurance are evaluated in section 4.5, but as stakeholders, the depositors are rather passive if they hold deposits smaller than the deposit insurance guarantee, because their deposit is guaranteed and is not dependent on the bank’s risk-taking.
In the paper, the terms “depositors” and “debtholders” are used interchangeably although it is recognized that they are, in fact, not completely identical8.
3.3.3 The management
The term “the management” is directed at the top management of the bank, but it essentially covers all individuals deriving the main part of their human capital investment from being employed at the banks. Since it is assumed that the executive management employs its own incentive system inside the bank (through management style, pay programs etc.) and it thus has every opportunity to align “their” corporation with their incentives, only the management that answers to the board is considered in the thesis unless otherwise stated. To be clear, the terms “the management”, “the CEO”, “the executive management” and similar expressions all refer to those inside the banks who are employed by the board of directors.
3.3.4 The board of directors
The board of directors is hired by the shareholders, elected at the general assembly of the bank. In some banks, the board of directors is not elected directly at the general assembly, but instead, a board of representatives is elected which in turn elects the board of directors. In any case, the general assembly is the institution that the board of directors directly or indirectly answers to(Erhvervs- og Økonomi Ministeriet 2009).
7 In Danish “Indskydergarantifonden”.
8 The incentive conflict between depositors, insurer and shareholders is the one considered in the main body of the banking agency literature and also in this thesis.
3.3.5 The society
Society as a whole is a stakeholder in the bank. The society includes the economic environment, the political environment, the social environment, the customers and trading partners of the bank as well as all parties that are affected in some way or another by the bank’s actions, but who are not officially a part of the bank’s governance system.
3.4 Risk9
In order to measure risk and risk-taking in the banking industry, as set forth in the research question of this thesis, an outline of banking risk must be undertaken. Later, in section 7.7, the specific choice of risk measure is explained; this part covers banking risk as a phenomenon only.
Generally, banking risk falls in two categories: credit risk and mismatching (London External 2009).
3.4.1 Credit risk
Credit risk is the risk that the counterparty to the transaction the bank has engaged in does not fulfill his duties. In plain terms, credit risk is the risk that loans will not be paid back in due time. Proper credit risk management consists of three principles: selection of the borrower, limitation in loan-giving, meaning to differentiate the loan amount and terms based on the creditworthiness of the customer and finally diversification in terms of borrower types so that the bank is less exposed to specific, local economic contractions (ibid).
A related phenomenon observed in the financial crisis in Denmark is the operational stress that heavy growth in loans puts on proper credit assessment; it is argued in the wake of several bank failures that the credit management did not adhere to the three credit management principles, witnessed by e.g. Roskilde Bank’s 45 % exposure to the real-estate market. Furthermore, there are strong indicators that the limitation principle was not adhered to as many (and large) loans were given without collateral and as expedite cases which, ceteris paribus increases operational risk and, subsequently, credit risk (Skipper-Pedersen, Stenbjerre 2008, Venderby 2007).
9 “Risk in banking” is a topic worth a thesis on its own; due to limitations in scale and scope of this thesis, the paragraph on risk will neither venture into a detailed, technical analysis of the different definitions, mechanisms and applications of risk, nor will it seek to investigate the risk management instruments of the banking industry (VaR comes to mind). This paragraph primarily serves as a toolbox to provide the reader with a basic understanding of the risk financial intermediaries are exposed to in their business environment as well as to provide reasoning for this thesis’ choice of risk-taking behavior measurement in section 7.7.
3.4.2 Mismatching
The bank’s balance sheet is somewhat different from other companies’: on its asset side are its outstanding loans and investment activities, on its liabilities side are deposits from depositors, which can be regular checking accounts connected to the customers’ salary payment accounts, as well as loans taken out from other banks and finally, its equity.
A bank’s balance sheet is inherently mismatched; loans usually have long maturities while deposits and interbank funding usually have shorter maturities. The discrepancy in time to maturity is more specifically defined as a bank’s ability to “settle obligations with immediacy” (Drehmann, Nikolaou 2009) and is termed funding liquidity risk (ibid).
3.4.3 Funding liquidity risk
This creates a need for outside funding, for example if an unusual amount of depositors want to withdraw money at the same time – loans are not especially liquid, but many deposits can be withdrawn without notice. Naturally, a bank with many deposits and few loans will not experience a need for intermediary funding, unless in a bank run. However, the larger the loans compared to the size of deposits, the greater the need for the bank to obtain loans itself to cover its own investment (the loans given), which is obtained from a wholesale funding provider. If the bank cannot obtain funding in the interbank market, through alternative sources or through raising capital, its existing capital and, subsequently its solvency, is threatened, because it will not be able to “settle obligations with immediacy” (ibid).
The reasons for not being able to obtain funding can be name-specific (the individual bank cannot obtain funding) or systemic (no banks can obtain funding) (London External 2009)–
the name-specific reasons can be that of the bank’s loan portfolio’s quality, the systemic reasons can be that of insecurity about common traits of all banks’ portfolios (Bechmann, Raaballe 2008) .
3.5 Regulation and risk-monitoring
As the bank’s business model entails risk-taking to some extent and because this risk-taking, as explained in previous paragraphs, can affect large groups of the population, the industry’s risk-taking is regulated by the Danish Financial Supervisory Authority (DFSA)10, acting in accordance with the Basel (I and subsequently II) requirements, which all banks must adhere
10 In Danish “Finanstilsynet”.
to in Denmark11. Moreover, the regulators (DFSA) will also monitor a bank’s risk choice because they have the responsibility to maintain a stable financial system (Merton 1977a).
However, because the banks are regulated, it has been suggested that no need exists for bank- specific soft law in the form of banking governance codes. Therefore, banks are encouraged to follow the general corporate governance recommendations as set forth by the so-called Nørby committee in 2001 (revised numerous times since).(The Danish Commerce and Companies Agency 2005)
3.6 Partial conclusion
It was found that the banking industry in Denmark comprises 133 banks, but is rather concentrated. It was argued that banks strive to maximize profits and shareholder wealth, but that they also serve a role as financial intermediaries. The five stakeholder groups were identified as the owners, the debtholders, the management, the board of directors and the society.
Risk in banking was found to stem from two main sources; credit risk and funding liquidity risk. These risks to the financial institution were outlined as being overseen by the DFSA.
11 The specific requirements of the Basel accords (2006) can be found here: http://www.bis.org/publ/bcbsca.htm
