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

Incentives of managers may conflict with those of shareholders or creditors, particular at highly leveraged and opaque institutions such as banks. Bankers may abuse their control rights to pay excessive salaries, give themselves favoured access to credit, or take excessive risks at the expense of depositors. Banks must design contracting and governance structures that sufficiently resolve agency problems so that they can attract funding from minority shareholders and depositors. Examining how banks resolve those conflicts in today’s banking environment is complicated by government regulation of capital structure and corporate governance practices, and by protections, such as deposit insurance, too-big-to-fail policies, and a lender of last resort, which can distort incentives. To investigate the endogenous emergence of corporate governance mechanisms that limit rent seeking and credibly manage risk, we look at banks from the 1890s, a period when there was no deposit insurance, no lender of last resort, and virtually no government interventions to save banks. We use national banks’ Examination Reports, a detailed resource containing information about ownership, governance, tools for managing risk and levels of risk. We link differences in ownership structure (especially the extent of managerial ownership) to differences in corporate governance policies, risk outcomes, and banks’ approaches to risk management.

Use of formal corporate governance controls is lower when manager ownership shares are higher. This reflects substitution between ownership and formalized oversight in controlling managerial incentives toward risk. On the one hand, we find that managerial rent seeking via higher salaries and greater insider lending is greater when managerial ownership is higher and lower when formal governance controls are employed. On the other hand, banks with higher managerial ownership tend to target lower default risk, which is consistent with greater risk aversion by managers when managerial stakes are high. We also find that 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 is consistent both with higher adverse-selection costs of raising outside equity and with greater moral-hazard with respect to risk shifting.

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