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Board Structure, Ownership, and Financial Distress in Banking Firms. International
Board Structure, Ownership, and Financial Distress in Banking Firms. International
8 (1999) 281–292
Abstract
This investigation pursues a new direction in the analysis of financial distress in banking
firms. The research was inspired by recent research on corporate governance and the need to
understand the internal processes behind the financial decisions that result in bank failures.
The analysis examined the relationship between the ownership and structure of the board of
directors and the internal control mechanism that influences the survival of the firm. The
following aspects of ownership and governance are investigated: ownership by directors and
officers, ownership by the CEO, number of directors, percentage of inside directors, and CEO
duality. The influence of board structure and ownership on the probability of financial distress
was explored with a sample of approximately 300 banking firms. The empirical tests indicated
a lower probability of financial distress when one person is both the CEO and chairman of
the board, but the other factors did not have a significant effect. 1999 Elsevier Science
Inc. All rights reserved.
JEL classification: G21; G28
Keywords: Corporate governance; Internal control system; Financial distress; Banks
1. Introduction
The emergence of the banking industry from the most serious financial crisis since
the 1930s has resulted in a strengthened deposit insurance fund and a relaxation of
regulatory concern for bank failures. The large amounts of risky credit card debt
recently incurred by banks, however, underscore the point that financial distress in
banking is always an issue (Federal Deposit Insurance Corporation, 1997).
1059-0560/99/$ – see front matter 1999 Elsevier Science Inc. All rights reserved.
PII: S 10 59 -05 60 (9 9)00 026 - X
282W.G.
W.G.Simpson,
Simpson,A.E.
A.E.Gleason
Gleason/ International
/ InternationalReview
Reviewof of
Economics
Economics
and
and
Finance
Finance
8 (1999)
8 (1999)
281– 282
281–292
Financial distress in banking remains a significant issue for owners, managers, and
the public. The incentives for risk-shifting from equity owners to depositors exist in
banking similar to the agency problems caused by the conflict between owners and
debt-holders in other corporations. John, John, and Senbet (1991) argue that risk-
shifting incentives in depository financial institutions arise from the existence of limited
liability for owners and the associated convexity of the levered equity pay-off produced
by the limited liability. The incentives for risk-shifting will exist in spite of risk-adjusted
deposit insurance premiums according to John, John, and Senbet (1991). As a result,
banks with managers closely aligned with the owners would seek risk that is shifted
to depositors and the public insurance fund.
An analysis of bank failures prepared by the Office of the Comptroller of the
Currency (OCC) identified the major immediate cause of many bank failures as
poor asset quality that eventually impaired the bank’s capital position (Office of the
Comptroller of the Currency, 1988). The OCC investigation further concluded that
the primary reason banks encounter asset quality and capital problems is the failure
of the board of directors and management. According to the OCC, the ultimate
causes of bank failures are an uninformed or inattentive board of directors and/or
management, overly aggressive activity by the board and/or management, problems
involving the
chief executive officer, and other problems related to board oversight and management
deficiencies. Failure of the board to monitor the activities of management and staff
resulted in poorly followed loan policies, inadequate compliance with internal policies
and banking laws, inadequate problem loan identification, and ineffective asset/liability
management, according to the OCC.
Jensen (1993) argues that the board of directors is crucial to effective internal
control systems: “The problems with corporate internal control systems start with the
board of directors. The board, at the apex of the internal control system, has the final
responsibility for the functioning of the firm. Most importantly, it sets the rules of
the game for the CEO” (p. 862). The ultimate consequence of a dysfunctional
corporate internal control system is the failure of the firm.
A rich and important body of research that addresses the prediction of financial
distress in commercial banks and the classification of banks based on financial stability
has evolved (Demirguc-Kunt, 1989). The present investigation pursues a new direction
in the analysis of bank survival inspired by the research on corporate governance and
the need to understand the processes behind the financial decisions that result in bank
failures.1 The purpose of this analysis is to examine the relationship between the board
structure and ownership of a commercial banking firm and the occurrence of financial
distress in that firm. A set of testable hypotheses was developed from the model
governance structure in Jensen (1993). The hypotheses were tested empirically by
regressing measures of the board structure and ownership of a group of approximately
300 banking firms on an indicator of the probability of financial distress.
3. Hypotheses
3.1. Hypothesis I: Management and board member equity ownership
Jensen (1993) suggests that many problems occur because neither managers nor
directors normally own a substantial proportion of the firm’s equity, which decreases
the incentives of directors and officers to pursue the shareholders’ interests. Saunders,
Strock, and Travlos (1990) provide evidence that banks controlled by stockholders
have incentives to take higher risk than banks controlled by managers. If stockholders
prefer more risk than non-owner managers and stock ownership aligns managers and
directors with owners, then the probability of financial distress in a bank would be
higher when managers and directors own a higher proportion of the equity.
HA: Banks with higher proportions of equity ownership by directors and managers
have higher probabilities of experiencing financial distress, ceteris paribus.
4. Statistical methodology
4.1. Sample design and data sources
The sample consisted of those banking firms listed in the SNL Quarterly Bank
Digest (SNL Securities, 1993), which also had proxy statements available for 1989.
The sample included only banking firms that were publicly traded because these were
the only firms with publicly available ownership data. The SNL Quarterly Bank Digest
provides data on most publicly traded banking firms and includes approximately 375
firms. Only firms that did not have complete financial data or a proxy statement were
omitted.
The following ownership and board structure measures were taken from 1989 proxy
statements:
1. the percentage equity ownership of all officers and directors as a group,
2. the number of directors on the board,
3. the percentage of insiders on the board,
4. the combination of the CEO and the chairman of the board into one position,
and
5. the percentage equity ownership of the CEO.
A surrogate for financial distress and the control variables were taken from the SNL
Quarterly Bank Digest for the end of the year 1993. This procedure produced a sample
of 287 banking firms with complete information.
The time structure of the regression equations reflects the proposition that the
effect of ownership and board structure will not be observed immediately in bank
performance but will take three to five years to present. The measures of ownership
and board structure were taken as of the end of the first quarter 1989 because the
proxy information was prepared at that time. The ownership and board structure in
place at the beginning of 1989 was expected to influence the probability of financial
distress at the end of 1993, approximately five years later. The regression equations
are cross-sectional with one lagged independent variable, the measure of ownership
or board structure.
4.2. Tests of hypotheses
The hypothesized relationships were tested with the following ordered logistic
equation:
logit (p2 1 p3 1 p4) 5 a 1 b0GOVi 1 g9xi 1 ei
where
p1 5 Prob(Yi 5 1 | GOVi, xi),
p2 5 Prob(Yi 5 2 | GOVi, xi),
p3 5 Prob(Yi 5 3 | GOVi, xi),
p4 5 Prob(Yi 5 4 | GOVi, xi),
Yi 5 a variable representing the SNL rating of the ith banking firm (1 5
no risk of financial distress, 2 5 little risk of financial distress, 3 5
some
risk of financial distress, and 4 5 strong risk of financial distress),
GOVi 5 an indicator of ownership or board structure for the ith banking firm,
xi 5 a vector of control variables that will impact the probability that Yi 5
n,
b0 5 a parameter to be estimated,
g9 5 a vector of parameters to be estimated,
a 5 an intercept term, and
ei 5 the error term.
The term logit(p2 1 p3 1 p4) represents cumulative probabilities and the model
predicts the probability of more financial distress with changes in the relevant effects
variables. The logit term on the left hand side of the equation equals log{(p2 1 p3
1 p4)/(1 2 p2 2 p3 2 p4)}, which is the log of the ratio of the cumulative
probabilities that a particular banking firm will have a high level of risk to the
cumulative probabilities that the firm will have no risk of financial distress.
The estimation procedure assumed a common slope parameter associated with the
relevant effects variables and used maximum likelihood regression.2 The relevant
effects vector xi is composed of the variables described in Table 1.
The coefficient of primary interest is b0. The hypothesized relationships between
ownership and board structure and the probability of financial distress in terms of
the regression coefficients are:
H0: H A:
I. Management and board equity ownership b0 < 0 b0 .
II. Board size b0 > 0 0b0 ,
III. Insiders on the board b0 > 0 0b0 ,
IV. CEO duality b 0 < 0 b00 .
V. CEO equity ownership b 0 < 0 b00 .
0
Table 1
Variable definitions and descriptive statistics
Definition of the variable Mean Minimum Maximum SD Sign
Y 5 SNL Safety Rating 1.321 1.000 4.000 0.777
GOV1i 5 common shares 0.164 0.001 0.694 0.141 1
owned by directors and
officers/total common shares
GOV2i 5 number of directors 14.596 4.000 37.000 5.786 2
GOV3i 5 number of insiders on 0.176 0.000 0.800 0.102 2
board/total board members
GOV4i 5 1 if CEO and COB 0.568 0.000 1.000 0.496 1
same person, 0 otherwise
GOV5i 5 common shares 0.0359 0.000 0.621 0.0685 1
owned by the CEO/total
common shares
X1i 5 book value total assets $1.714 bil $70.6 mil $187.6 bil $5.2 bil 2
X2i 5 nonperforming assets/ 0.0190 0.0011 0.2010 0.0235 1
total assets
X3i 5 market value per share/ 1.465 218.750 3.629 1.304 2
book value per share
X4i 5 book value of total 0.082 0.013 0.145 0.018 2
equity capital/total assets
Sign, the hypothesized sign of the regression coefficient in the estimated equations.
SD, Standard Deviation of the variable.
5. Empirical results
5.1. Tests of hypotheses
The maximum likelihood estimates of the ordered logistic regression parameters
reported in Table 2 reveal that the null hypothesis was rejected for Hypothesis IV
but could not be rejected in the other relationships. The parameter estimate indicates
that CEO duality (i.e., when the same person is both the CEO and chairman of the
board) has a significant effect on the future probability of financial distress in a banking
firm. The regression coefficient b0 for Hypothesis IV is positive which indicates that
banking firms where the same person is both the CEO and chairman of the board
have a lower probability of financial distress five years later. This result is consistent
with the theory that a dual CEO-chairman of the board is more likely to have the
ability to pursue his/her personal interests and is less likely to be aligned with the
interests of shareholders who prefer greater risk taking by the firm.
The regression estimates give no indication that ownership is an important influence
on the probability of financial distress in the future. The combined equity ownership
of directors and officers and the individual equity ownership of the CEO did not have
an effect. The percentage of insiders on the board and the number of directors on
the board does not appear to impact future financial distress.4
The relative magnitudes of the standardized regression coefficients suggest that the
governance variables are less important influences on risk than the control variables
representing bank size, the riskiness of the loan portfolio, and the banking firm’s use
of financial leverage.
5.2. Explanatory power of the equations.
The signs of all significant regression coefficients were correct and all of the control
variables were highly significant except the market value to book value ratio. The 22
30145
W.G. W.G.
Simpson,
Simpson,
A.E. A.E.
Gleason
Gleason
/ International
/ International
Review
Review
of Economics
of Economics
and Finance
and Finance
8 (1999) 281–30145
8 (1999) 281–
292
Table 2
Maximum likelihood estimates of the ordered logistic equation parameters
Parameters Hypothesis I Hypothesis II Hypothesis III Hypothesis IV Hypothesis V
a (constant) 17.7050 19.6892 18.7043 21.2958 18.7223
(0.00) (0.00) (0.00) (0.00) (0.00)
b0 (GOV1i 2 management 0.0141
and board equity owner- [0.1094]
ship) (0.37)
b0 (GOV2i 2 board size) 0.0575
[0.1831]
(0.19)
b0 (GOV3i 2 insiders on 0.0207
the board) [0.1160]
(0.38)
b0 (GOV4i 2 CEO duality 1.4010
[0.3833]
(0.01)
b0 (GOV5i 2 CEO owner- 0.0400
ship of equity) [0.1512]
(0.19)
b1 (X1i 2 book value 20.8544 21.0168 20.9196 21.1083 20.9062
total assets) [20.7777] [20.9254] [20.8370] [21.0088] [20.8248]
(0.00) (0.00) (0.00) (0.00) (0.00)
b2 (X2i 2 nonperforming 0.9193 0.9215 0.9338 0.9852 0.9219
assets/total assets) [1.1785] [1.8184] [1.1971] [1.2631] [1.1819]
(0.00) (0.00) (0.00) (0.00) (0.00)
b3 (X3i 2 market value per 0.3415 0.3308 0.2899 0.2331 0.3016
share/book value per [0.2454] [0.2377] [0.2084] [0.1676] [0.2167]
share) (0.39) (0.41) (0.56) (0.67) (0.55)
b4 (X4i 2 book value of 21.3247 21.3551 21.3392 21.3992 21.3418
total equity capital/ [21.2145] [21.2424] [21.2278] [21.2828] [21.2302]
total assets) (0.00) (0.00) (0.00) (0.00) (0.00)
Standardized regression coefficients are in brackets. Probabilities for a Wald Chi-square test are in
parentheses.
that assumed a common slope parameter for each explanatory variable was reasonable,
that is, the null hypothesis of common slope parameters could not be rejected at a
normal level of confidence.
6. Conclusion
This investigation indicates that the combination of the CEO and chairman of the
board into one position may influence the internal control system of a banking firm
in such a way as to reduce the probability of financial distress in the firm. The result
that a single powerful manager will reduce the probability of financial distress is
consistent with theory and previous empirical evidence. A manager with significant
control over both operations and the board would not be as susceptible to the influence
of outside directors, and other monitors, that would cause the interests of management
to be more closely aligned with shareholders. A dual CEO–chairman of the board
would be capable of pursuing his/her own interests, which could mean taking less risk
to protect unique human capital.
These results have obvious implications for the regulation of banking firms because
shareholder dominated banks would be more likely to engage in risk-shifting to
depositors and ultimately the FDIC fund. In other words, banks with a combined
CEO-chairman of the board are less likely to require FDIC assistance. Furthermore,
regulatory efforts to influence risk taking by controlling other aspects of basic board
30147
W.G. W.G.
Simpson,
Simpson,
A.E. A.E.
Gleason
Gleason
/ International
/ International
Review
Review
of Economics
of Economics
and Finance
and Finance
8 (1999)
8 (1999)
281–292
281–291
292
structure and ownership would not be effective. The evidence of this analysis and the
previous evidence of Saunders, Strock, and Travlos (1990) suggest that the nature of
the internal control mechanism is an important issue for bank regulation.
The fact that other basic indicators of the internal control system were not found
to be significant suggests that the impact of board structure and ownership on banking
firm behavior may be too complex to be captured by simple structural characteristics.
The results of this investigation cannot be seen as the final answer to the question of
how internal control systems function in banking firms, but only a first step. Future
research should strive to penetrate inside the black box of the internal control system
for banking firms to better understand the complex dynamics of corporate decisions.
Acknowledgments
We are grateful to Carl Chen, editor, and an anonymous referee for their patience
and many helpful comments. The authors bear full responsibility for any remaining
errors or omissions.
Notes
1. Brickley and James (1987) empirically tested the proposition that board structure
is related to the effectiveness of the outside market for takeovers in the banking
industry. Saunders, Strock, and Travlos (1990) investigated the relationship be-
tween risk taking in banking firms and their ownership structure. Baysinger and
Butler (1985) found that board independence had a small impact on the future
relative financial performance of a sample of industrial firms. Changanti, Maha-
jan, and Sharma (1985) found that the number of directors on the board is
inversely related to failure in a sample of retail firms but no relationship existed
with other measures of governance structure (e.g., percentage of outside directors
and chairman-CEO duality).
2. The SAS System was used to compute the ordered logit equations. A proportional
odds model was considered to be appropriate. Refer to Peterson and Harrell
(1990) and Greene (1997) for a discussion of ordered logit regressions.
3. The measure of the probability of financial distress in banking firms developed
by Thomson (1992) was an adjusted capital ratio he called NCAPTA. NCAPTA
was calculated for each of the firms in this sample and the correlation coefficient
between the SNL Safety Rating and NCAPTA was 0.84. The SNL Safety Rating
was used because it is partially based on the market value of equity while
NCAPTA considers only the book value of equity. Sinkey (1978) proposed a
measure similar to NCAPTA.
4. Changanti, Mahajan, and Sharma (1985) did not find a significant relationship
between the number of insiders on the board or CEO duality and failure in
retailing firms. They did find that the number of directors was related to failure.
5. The reported R-square is a generalization of the normal coefficient of determina-
tion from ordinary least squares regressions (Magee, 1990). Nagelkerke (1991)
developed the adjustment to the generalized R-square. Green (1997) indicates
there is no exact counterpart to the standard regression R-square in the general-
ized regression model and points out the limitations of the generalized coefficients
of determination.
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