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The role of corporate governance in the 2008 Financial Crisis

Final Report Summary - CG&FC (The role of corporate governance in the 2008 Financial Crisis)

The objective of this project was to study three important aspects of corporate governance closely related to the debate on the causes of the recent financial crisis: i) the association between managerial risk-taking incentives and excessive risk-taking, ii) the effect of corporate risk oversight on firm value, and iii) the role of proxy advisory firms in the corporate governance process.

The research work done during these years can be summarized in two points. On the one hand, some of the results consistent with the notion that top executive compensation has important economic consequences. More specifically, it is found that risk-taking incentives can lead to undesirable behavior, both from a shareholder and from a societal perspective. Specifically, equity portfolios provide managers with incentives to misreport when they make managers less averse to equity risk. Moreover, evidence supports the idea that there are substantial externalities associated with the level of risk-taking incentives in the banking sector, and that the risk-taking incentives of bank managers played an important role in the Financial Crisis.
However, other results of this project also suggest that corporate governance follow economic principles and are consistent with shareholder value maximization. Specifically, it is found that, on average, shareholders benefit from stock option repricings around the financial crisis. However, the results also show that the benefits of this repricings are lower among firms following the restrictive policies of proxy advisors. Moreover, our evidence suggests that a significant number of firms suboptimally changed their compensation programs in anticipation of the first shareholder advisory vote on executive compensation in the US. “Say-on-pay” regulation was introduced in the US in July 2010, under the assumption that executive compensation practices were an important contributing factor to the 2007-2008 Financial Crisis. These compensation changes seem to be consistent with the features known to be favored by proxy advisory firms in an effort to avoid a negative voting recommendation.
I also examine the consequences of corporate governance regulation introduced around the financial crisis during the post-crisis period. I analyze board changes in the periods prior and subsequent to the recent financial crisis and find that, in the post-crisis period, directors are more likely to resign from their riskiest directorships. My results suggest that, after the financial crisis, director risk exposure plays an increasing role on director turnover, and that the post-crisis emphasis on risk management could be causing some firms to lose director talent.
Collectively, the results of the project thus far suggest that compensation practices and other governance mechanisms shape managerial behavior. However, the evidence in the research papers generated in this project also highlight the importance of being aware of the trade-offs and spillovers of corporate governance regulation.
The results of the project inform the ongoing debate on corporate governance, both in academia and among market participants. Specifically, the work developed in this project contributes to our understanding of the economic consequences of corporate governance regulation on issues such as executive compensation, the role of the board on risk oversight, and the role of proxy advisors in the economy. This is important considering the interest on understanding the potential role of corporate governance around the financial crisis.