In the aftermath of the economic crisis many governments are calling for tighter banking regulations to keep such a debacle from ever happening again. But Harald Hau, Associate Professor of Finance at INSEAD, says better bank governance may actually be a more effective answer to the problem – an insight which emerges from taking a closer look at the German experience.
“While the financial crisis is often characterised as a crisis of the entire financial system, the real failings occurred in the banking system” says Hau. In collaboration with Marcel Thum from the University of Dresden, he decided to approach the crisis by analysing its impact on banks in one country: Germany.
“Germany is interesting to look at because we have a banking system that has two relatively different and separate corporate governance structures,” Hau notes.
German banks are divided between the state-owned Landesbanken and privately-held institutions like Deutsche Bank and Commerzbank. The Landesbanken not only fared far worse in the crisis but have cost German taxpayers billions of Euros in bailouts. The state of North Rhine-Westphalia, for instance, has given one billion euros in loan guarantees to the state’s WestLB. In Saxony, it’s even worse: 2.73 billion euros to Sachsen LB. Roughly speaking, the average loss of publicly-owned banks during the crisis was about three times higher than for the private sector. Why?
The answer, Hau says, is in their governance. Hau and Thum studied the resumés of more than 593 supervisory board members of the 29 largest German banks – half from the private sector and half from the public sector. They found that the boards of state-run institutions were not only political appointees but astonishingly, says Hau, “people that typically lack any financial background that … don’t have any banking experience.”
While all members have approximately the same educational level, “the financial competence is about three times higher (according to an index measure) in privately-owned banks than in state-owned ones,” he says. The study also shows that the more a bank’s supervisory board is stacked with political appointees, the worse it faired in the financial crisis as ‘political boards’ failed to implement decent risk management principles.
Hau also highlights the formidable challenges faced by any outside control: “If you’re an outsider either as a regulator or a supervisory board member it’s very hard to understand what is really going on within a large institution. But a lack of financial literacy makes control completely illusionary.”
Subsequent to this research, Germany passed a new law, which enables bank regulators to remove supervisory board members who don’t meet a certain level of competency. In a first step, the German bank regulator, the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or Bafin) has checked more than 3,000 resumés. Supervisory board members with insufficient financial competence will be asked to take specialised executive courses. Only a refusal might draw sanctions. The new law does not apply retroactively to supervisory board appointments prior to September 1, 2009.
Regulations, however, are not the sole answer: Hau insists that shareholders should also press for better boards. “Given the long history of bank supervision in the developed world, the crisis is a new reminder of the limitations of the regulatory route.”
According to Hau, banks will remain very fragile institutions due to their lack of equity capital. “A good economic policy should limit their importance for the economy as a whole – for example by withdrawing tax benefits of debt financing or even by taxing high leverage.“
The flipside to a reduced role of banks is more reliance on the financial market, which need to develop alternatives to bank finance. Hau concludes: “The financial system of the 21st century will be more stable if it relies less on banks and more on financial markets. But such a development is less likely to occur if bank interest and politics mingle – another reason to get politicians and bureaucrats out of bank boards.”
This article was written by David Turecamo based on an interview for INSEAD Knowledge.