The Good - or the Bad and the Ugly? Corporate Governance and Risk Taking in Banks

Abstract

This paper analyzes the influence a bank’s corporate governance structure has on its risk taking. To do so, the paper specifically looks at illiquidity and insolvency risk, as measured by a bank’s liquidity creation and its margin between interest income from loans and interest expenses on deposits. The relevance of this question is rooted in banks’ core business models: maturity transformation. By transforming short-term liabilities into long-term assets banks generate profits through the exploitation of the yield curve spread. However, in times of tightening or inverting yield curve spreads the banks’ transformation margins narrow. Management then faces a dilemma: accepting narrowed spreads and lower profits or increasing the volume of maturity transformation. Either option poses a threat to the bank, the former of insolvency, the latter of illiquidity. This paper tries to answer the question of how banks with different owner and manager structures deal with this trade-off. Analyzing a sample of 259 U.S. commercial banks over the period 1998-2010, the paper finds that banks with low separation of ownership and control increase their liquidity risk in times of narrowing or inverted yield curve structures to keep profit levels up through volume effects. In contrast, banks with higher separation of ownership and control opt for less liquidity risk, also in times of regular yield curve spreads, and thereby also accept lower interest rate margins.

Keywords: Insolvency Risk, Liquidity Risk, Yield Curve Spread

JEL Classification: G21, G28, G32, G33