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Yadav Gopalan discusses how banks face corporate and regulatory governance pressures. A critical tool of regulatory governance is direct monitoring by bank supervisors.

Image courtesy of interviewee. March 27, 2024

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This video video provides an overview of a study examining governance challenges within the U.S. commercial banking industry, particularly how banks select projects, often with opaque outcomes, such as loans that may later default. It highlights the roles of boards of directors and managers in maximizing bank value while facing regulatory scrutiny.

The paper specifically explores the significance of managerial ratings, known as "M ratings," which assess banks' management quality and influence governance. These ratings are not publicly disclosed but are pivotal in the bank's internal discipline and oversight process. The research finds that M ratings have predictive power regarding future performance indicators, such as non-performing loans and the likelihood of bank failure, especially during financial crises.

The study emphasizes that M ratings can help banks self-regulate by influencing managerial decisions. It suggests that regulatory bodies and boards of directors should incorporate these ratings systematically in their governance practices to improve oversight of bank management. Additionally, the findings may be applicable to less mature banking supervision systems in other economies, guiding them to develop similar rating systems for better bank management and regulation.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

00:00.185 --> 00:01.845
In our study, we have,

00:02.245 --> 00:04.925
a specific setting looking at banks in the commercial

00:04.925 --> 00:06.525
banking industry in the United States.

00:07.265 --> 00:09.405
And, on the one hand, one

00:09.405 --> 00:11.925
of their governance challenges is very similar

00:12.025 --> 00:15.445
to any other company in that boards of directors are going

00:15.445 --> 00:18.965
to delegate project selection to, to managers.

00:19.185 --> 00:20.925
And managers have the discretion

00:20.925 --> 00:23.565
to choose projects at their own will so

00:23.565 --> 00:27.645
that they can maximize firm net present value,

00:27.825 --> 00:29.125
or firm firm value.

00:30.255 --> 00:32.755
Um, the challenge in the banking industry is

00:32.755 --> 00:35.035
that the projects that they select are very opaque,

00:35.145 --> 00:37.595
that they could be the loans that they take,

00:37.905 --> 00:39.875
most primarily, and the quality

00:39.975 --> 00:43.555
of those loans aren't really known at the time origination.

00:44.175 --> 00:47.875
So even if a loan might look like it's high quality at the

00:47.875 --> 00:50.795
time of origination later down the road,

00:51.005 --> 00:52.235
those loans might default.

00:52.385 --> 00:55.395
They might, they might go into non-performing status.

00:56.695 --> 01:00.595
And so the board of directors needs to gauge,

01:00.935 --> 01:02.315
the a tradeoff.

01:02.315 --> 01:05.715
They have a trade-off between pushing the manager,

01:05.715 --> 01:08.475
to compel him or her to maximize the value of the bank.

01:09.095 --> 01:11.555
And they need to also calibrate the likelihood

01:11.555 --> 01:14.955
of regulators intervening because of those loans going bad.

01:15.615 --> 01:19.635
And the intervention of those, regulators is

01:20.395 --> 01:22.875
particularly unique to the banking industry

01:22.875 --> 01:25.355
where you have this external stakeholder that,

01:25.665 --> 01:28.195
that has power to intervene in bank operations.

01:29.195 --> 01:33.935
Now, EM ratings, em ratings are a part of this story

01:33.935 --> 01:35.655
because regulators come in

01:36.355 --> 01:39.695
and, they actually assess different dimensions

01:39.695 --> 01:42.375
of bank performance, including their capital adequacy,

01:42.375 --> 01:44.495
their asset quality, the earnings

01:44.495 --> 01:45.975
liquidity, and market risk.

01:46.115 --> 01:48.615
And a part of that is the managerial quality.

01:49.115 --> 01:52.055
So regulators actually go into the bank, they,

01:52.235 --> 01:54.775
assess the quality of the management relative

01:54.795 --> 01:56.375
to the performance of the bank,

01:56.795 --> 01:59.695
and they assign a score from one to five that is only seen

01:59.695 --> 02:01.935
by the bank manager and the board of directors.

02:01.965 --> 02:03.575
It's not publicly disclosed.

02:04.155 --> 02:06.735
And what we do in the papers decompose the properties

02:06.735 --> 02:08.375
of this rating and examine

02:08.435 --> 02:11.655
how this facilitates governance within the bank itself.

02:11.845 --> 02:16.015
This literature on organizational capital within firms is,

02:16.115 --> 02:17.575
is a fairly old literature.

02:18.355 --> 02:21.095
And, some of the, some of the, I guess,

02:21.095 --> 02:23.855
more classic papers in this literature would be one by

02:24.715 --> 02:28.215
ensure in which they, examine the impact

02:28.215 --> 02:30.455
of managers on firm policies.

02:31.035 --> 02:35.295
The way they do that is by, by employing firm fixed effects

02:35.355 --> 02:38.695
and showing that, okay, when you include firm fixed effects,

02:38.695 --> 02:41.895
that has an incremental explanatory power on

02:41.895 --> 02:43.335
firm, firm performance.

02:43.835 --> 02:45.135
And this was a departure from

02:45.135 --> 02:49.135
how economists classically think about the role of managers.

02:49.725 --> 02:52.935
Classically, we think about managers as being replaceable

02:53.525 --> 02:55.335
cogs into the machinery of a company,

02:55.915 --> 02:58.815
but this literature kind of opened up our eyes and, and

02:58.815 --> 03:02.325
Said that well, managers actually have a specific role

03:02.465 --> 03:06.405
to play, and their styles are distinct from,

03:06.665 --> 03:08.085
the company in and of itself.

03:09.425 --> 03:12.035
There's other papers that have built upon this literature

03:12.145 --> 03:16.715
that include building proxies for managerial quality,

03:17.255 --> 03:22.115
and the demert at all series of papers in accounting kind

03:22.115 --> 03:25.995
of touch upon this, that, when you build upon, when you,

03:25.995 --> 03:29.635
when you build a measure using abnormal performance,

03:29.735 --> 03:34.515
it has some correlation to future performance of, of firms.

03:35.605 --> 03:38.345
Now, I think those are two strands of important literature

03:38.345 --> 03:39.945
that build that, that help our paper.

03:40.565 --> 03:44.505
Um, where we fit in into this literature is by,

03:45.215 --> 03:47.985
looking specifically at the governance challenges

03:48.125 --> 03:49.625
of one particular industry

03:50.165 --> 03:53.705
and showing that, the, the ratings that

03:54.175 --> 03:58.745
that are produced are not, inherent skills

03:59.375 --> 04:00.625
that managers have,

04:00.685 --> 04:02.905
but rather report cards that change

04:02.965 --> 04:04.745
for the same person over time.

04:05.365 --> 04:08.305
And that these report cards help facilitate governance.

04:08.685 --> 04:12.265
So the governance angle of how the manager, the board

04:12.265 --> 04:14.225
of directors, and the regulators interact,

04:14.285 --> 04:16.385
and the role of these ratings in particular

04:17.005 --> 04:19.065
is a unique facet of our paper and,

04:19.205 --> 04:20.985
and something that we hope will contribute

04:20.985 --> 04:23.865
to the literature on understanding how governance works

04:24.405 --> 04:26.945
in highly regulated industries such as banking.

04:27.525 --> 04:30.305
But the United States is fairly unique, relative

04:30.305 --> 04:34.305
to its industrialized peers, in that the US has thousands

04:34.305 --> 04:38.145
of commercial banks ranging from small community banks

04:38.145 --> 04:42.425
that might be just a a few hundred million dollars in size

04:42.605 --> 04:46.385
to the largest internationally active commercial banks such

04:46.385 --> 04:48.745
as JP Morgan, bank of America and Citigroup.

04:48.805 --> 04:51.425
So it spans a wide cross section.

04:52.325 --> 04:54.185
Now, within this framework,

04:54.185 --> 04:56.425
bank supervision plays an integral role

04:56.425 --> 04:58.305
because supervisors

04:58.405 --> 05:01.305
who are stationed at field offices throughout the country

05:02.265 --> 05:04.665
periodically go travel to bank headquarters

05:05.205 --> 05:07.025
and inspect bank operations.

05:07.555 --> 05:11.185
These inspections or examinations are actually secret.

05:11.565 --> 05:15.985
No one can query the timing or the location of these exams,

05:16.005 --> 05:17.945
and they're only known to the board of directors,

05:17.945 --> 05:21.265
the management and the people working at the bank itself.

05:22.005 --> 05:23.145
And as I mentioned earlier,

05:23.205 --> 05:26.305
the regulators have the statutory authority to go in

05:26.445 --> 05:30.265
and inspect and actually change bank operations if they find

05:30.265 --> 05:32.905
that the bank is performing in some deficient manner.

05:33.725 --> 05:36.065
And this happens in a regular interval

05:36.065 --> 05:37.625
between 12 and 18 months.

05:38.465 --> 05:41.645
And through the supervision framework, they produce a series

05:41.665 --> 05:43.485
of qualitative information such

05:43.485 --> 05:45.045
as guidance and recommendations.

05:45.835 --> 05:48.765
They also produce a series of quantitative ratings,

05:48.765 --> 05:51.085
which I highlighted earlier called the camels rating.

05:51.865 --> 05:56.495
Now, the m rating is the, is the M in camels, and that is

05:56.775 --> 05:59.165
Specifically geared towards the managerial quality

05:59.305 --> 06:00.685
of the commercial bank itself.

06:01.385 --> 06:05.205
And so through this repetitive process of examinations

06:05.265 --> 06:07.845
and ratings, it is meant

06:07.875 --> 06:11.165
that the bank might remediate itself if it finds itself

06:11.165 --> 06:13.685
having poor ratings as deemed by the regulator.

06:13.685 --> 06:16.405
At the NIC, the National Information Center is a data

06:16.725 --> 06:18.325
repository that is hosted

06:18.425 --> 06:21.965
by the federal banking regulators in basically

06:21.965 --> 06:23.125
outta Washington dc.

06:23.545 --> 06:27.005
It is a means by which regulators can share information

06:27.135 --> 06:28.925
about a particular bank with each other.

06:29.875 --> 06:34.495
Um, and so after each examination, the, you know,

06:34.495 --> 06:37.015
regulators will basically input all the quantitative

06:37.015 --> 06:39.495
information and it gets stored

06:39.515 --> 06:41.975
and warehoused in this national information center.

06:42.555 --> 06:46.135
And then researchers who have access to this system of data

06:46.715 --> 06:49.135
can go and grab the go, get that data

06:49.275 --> 06:50.295
for what it, what it's worth.

06:50.435 --> 06:54.175
So that is another unique feature of the, of,

06:54.175 --> 06:57.255
of our setting, is that we can observe the ratings

06:57.475 --> 07:00.735
for every commercial bank, whether it be privately held

07:00.795 --> 07:05.655
or publicly traded, going back to at least the early 1990s.

07:06.315 --> 07:10.255
And through that, we can trace out how the m rating evolves

07:10.775 --> 07:13.095
whenever, let's say there's a financial crisis

07:13.195 --> 07:17.845
or a liquidity crunch, or we can also compare the m ratings

07:17.845 --> 07:21.085
after looking at large banks versus small banks.

07:21.905 --> 07:26.725
Um, so it provides us a lens through to, to understand

07:27.035 --> 07:29.925
what is important from the regulatory point of view

07:30.105 --> 07:32.565
of having good management versus bad management.

07:33.065 --> 07:36.765
And also helps us understand whether those m ratings,

07:36.765 --> 07:38.085
whether they be downgraded

07:38.085 --> 07:41.845
or upgraded, have a impact on how

07:42.905 --> 07:44.065
managers are disciplined.

07:44.165 --> 07:46.905
So, so the key results of our paper are as follows.

07:47.035 --> 07:49.625
First, we,

07:50.495 --> 07:54.145
look at the predictive power of the M reading relative

07:54.145 --> 07:56.625
to two important outcome variables,

07:56.635 --> 07:59.185
which is future share of non-performing loans

07:59.285 --> 08:00.505
and the likelihood of failure.

08:01.445 --> 08:04.545
And what we show consistently in our study is that even

08:04.545 --> 08:08.825
after controlling for performance, which is

08:09.545 --> 08:11.425
ROA delinquent loans,

08:12.045 --> 08:15.545
and the quality of the balance sheet, meaning the proportion

08:15.545 --> 08:16.585
of real estate loans

08:16.845 --> 08:21.785
and the proportion of, of, reserves held as,

08:21.925 --> 08:25.225
as a fraction of assets, we find that the EM rating

08:26.045 --> 08:29.025
is very informative about future performance.

08:29.755 --> 08:31.485
What this would suggest that human,

08:31.595 --> 08:33.325
like these human regulators

08:33.625 --> 08:36.405
who have cognitive constraints on their ability

08:36.425 --> 08:38.765
to do their job, have the ability

08:38.825 --> 08:41.365
to produce consistent measures over

08:41.465 --> 08:43.845
and above the information that may be

08:44.205 --> 08:45.485
provided in financial reports.

08:46.785 --> 08:51.085
We also show that during times of crisis,

08:51.585 --> 08:54.965
and times of volatility, that these m ratings

08:55.045 --> 08:58.005
Are incrementally more predictive of future performance,

08:58.515 --> 09:03.165
meaning that there's a higher premium put on human capital

09:03.715 --> 09:06.725
when times are really difficult in the financial sector.

09:08.545 --> 09:13.325
Now, one mechanism that might underpin our results,

09:13.825 --> 09:17.125
is the, is, is governance what you talked about.

09:17.385 --> 09:20.285
Um, so what we found is that

09:21.515 --> 09:25.795
a reason why these m ratings are particularly powerful is

09:25.795 --> 09:28.795
that they help discipline,

09:29.095 --> 09:31.075
the bank manager, right?

09:31.215 --> 09:34.955
So, so when a bank

09:35.595 --> 09:40.155
receives a bad M rating, it is likeer

09:40.305 --> 09:44.075
that manager will, will actually

09:44.685 --> 09:47.315
leave the bank in the next year after the exam.

09:47.495 --> 09:50.635
And that result is fairly robust to an inclusion of

09:51.195 --> 09:53.035
a whole host of control variables

09:53.035 --> 09:54.475
and empirical design choices.

09:55.415 --> 09:59.395
So this tells us that the inclusion of these m ratings

09:59.415 --> 10:01.155
or the, the fact that they exist

10:02.045 --> 10:05.455
help discipline the manager's decision making, which in turn

10:06.105 --> 10:08.135
leads to better future fundamentals

10:08.515 --> 10:11.105
are conclusions kind.

10:11.125 --> 10:15.725
Um, kind of can get speak to three different,

10:15.725 --> 10:20.535
interested parties, one of which is the current regulators.

10:21.035 --> 10:24.895
Um, we think that our results suggest

10:24.895 --> 10:26.055
that m ratings

10:26.395 --> 10:29.135
and, should be incorporated

10:29.965 --> 10:32.375
into the governance structure of commercial banks

10:33.315 --> 10:37.735
on a systematic basis, meaning that,

10:37.995 --> 10:40.215
as part of their own monitoring

10:40.395 --> 10:45.095
and disciplining system, bank regulators can compel boards

10:45.095 --> 10:47.255
of directors to include the EM reading

10:47.435 --> 10:49.095
and compensation practices

10:49.395 --> 10:52.295
and to also use the AM reading when deciding whether

10:52.475 --> 10:56.015
to retain or, let go of,

10:56.315 --> 10:57.535
of managerial talent.

10:57.555 --> 11:00.015
Second is for the boards of directors themselves.

11:00.795 --> 11:02.575
We hope that they can look at our study,

11:03.025 --> 11:06.295
especially those boards of directors in smaller banks

11:06.325 --> 11:10.015
that might not have access to advisors

11:10.275 --> 11:11.415
and external parties

11:11.555 --> 11:14.175
to help guide them on on managerial talent

11:15.175 --> 11:19.725
that they can use the findings of our study to help monitor

11:20.585 --> 11:23.525
the, the performance of managers.

11:23.585 --> 11:26.165
And as I mentioned earlier, this is particularly important

11:26.165 --> 11:27.405
in the banking industry

11:27.435 --> 11:31.605
because the project choices that bank managers make

11:32.185 --> 11:35.205
are fairly opaque and they only materialize in the future.

11:37.035 --> 11:38.615
And I would say the third party

11:38.645 --> 11:42.655
that might find our paper interesting are regulators

11:42.755 --> 11:45.215
and other policy makers in economies

11:45.265 --> 11:49.215
where the bank supervision system may not be as mature

11:49.215 --> 11:50.455
as it is in the United States.

11:51.355 --> 11:52.855
Our hope is that maybe they

11:52.855 --> 11:55.885
Can use our study, develop a system very similar to

11:55.885 --> 11:59.005
what might be in place in the United States, so

11:59.005 --> 12:01.885
that they can in turn use the m rating

12:02.105 --> 12:04.005
or a similar measure that they could develop

12:04.585 --> 12:06.765
to help guide bank managers

12:07.105 --> 12:08.445
and also the boards of directors.

12:08.445 --> 12:10.205
So that manner,

12:10.295 --> 12:13.325
banks can self-discipline themselves instead of having

12:13.325 --> 12:17.205
to rely upon the external force of a, of a bank regulator.

00:00 - In our study, we have, a specific setting looking at banks in the commercial banking industry in the United States. And, on the one hand, one of their governance challenges is very similar to any other company in that boards of directors are going

00:15 - to delegate project selection to, to managers. And managers have the discretion to choose projects at their own will so that they can maximize firm net present value, or firm firm value. the challenge in the banking industry is that the projects that they select are very opaque, that they could be the loans that they take, most primarily, and the quality of those loans aren't really known at the time origination.

00:44 - So even if a loan might look like it's high quality at the time of origination later down the road, those loans might default. They might, they might go into non-performing status. And so the board of directors needs to gauge, the a tradeoff. They have a trade-off between pushing the manager, to compel him or her to maximize the value of the bank. And they need to also calibrate the likelihood of regulators intervening because of those loans going bad.

01:15 - And the intervention of those, regulators is particularly unique to the banking industry where you have this external stakeholder that, that has power to intervene in bank operations. Now, EM ratings, em ratings are a part of this story because regulators come in and, they actually assess different dimensions of bank performance, including their capital adequacy, their asset quality, the earnings liquidity, and market risk.

01:46 - And a part of that is the managerial quality. So regulators actually go into the bank, they, assess the quality of the management relative to the performance of the bank, and they assign a score from one to five that is only seen by the bank manager and the board of directors. It's not publicly disclosed. And what we do in the papers decompose the properties of this rating and examine how this facilitates governance within the bank itself.

02:11 - This literature on organizational capital within firms is, is a fairly old literature. And, some of the, some of the, I guess, more classic papers in this literature would be one by ensure in which they, examine the impact of managers on firm policies. The way they do that is by, by employing firm fixed effects and showing that, okay, when you include firm fixed effects, that has an incremental explanatory power on firm, firm performance.

02:43 - And this was a departure from how economists classically think about the role of managers. Classically, we think about managers as being replaceable cogs into the machinery of a company, but this literature kind of opened up our eyes and, and Said that well, managers actually have a specific role to play, and their styles are distinct from, the company in and of itself. There's other papers that have built upon this literature that include building proxies for managerial quality,

03:17 - and the demert at all series of papers in accounting kind of touch upon this, that, when you build upon, when you, when you build a measure using abnormal performance, it has some correlation to future performance of, of firms. Now, I think those are two strands of important literature that build that, that help our paper. where we fit in into this literature is by, looking specifically at the governance challenges of one particular industry and showing that, the, the ratings that

03:54 - that are produced are not, inherent skills that managers have, but rather report cards that change for the same person over time. And that these report cards help facilitate governance. So the governance angle of how the manager, the board of directors, and the regulators interact, and the role of these ratings in particular is a unique facet of our paper and, and something that we hope will contribute

04:20 - to the literature on understanding how governance works in highly regulated industries such as banking. But the United States is fairly unique, relative to its industrialized peers, in that the US has thousands of commercial banks ranging from small community banks that might be just a a few hundred million dollars in size to the largest internationally active commercial banks such as JP Morgan, bank of America and Citigroup. So it spans a wide cross section. Now, within this framework,

04:54 - bank supervision plays an integral role because supervisors who are stationed at field offices throughout the country periodically go travel to bank headquarters and inspect bank operations. These inspections or examinations are actually secret. No one can query the timing or the location of these exams, and they're only known to the board of directors, the management and the people working at the bank itself. And as I mentioned earlier,

05:23 - the regulators have the statutory authority to go in and inspect and actually change bank operations if they find that the bank is performing in some deficient manner. And this happens in a regular interval between 12 and 18 months. And through the supervision framework, they produce a series of qualitative information such as guidance and recommendations. They also produce a series of quantitative ratings, which I highlighted earlier called the camels rating.

05:51 - Now, the m rating is the, is the M in camels, and that is Specifically geared towards the managerial quality of the commercial bank itself. And so through this repetitive process of examinations and ratings, it is meant that the bank might remediate itself if it finds itself having poor ratings as deemed by the regulator. At the NIC, the National Information Center is a data repository that is hosted by the federal banking regulators in basically

06:21 - outta Washington dc. It is a means by which regulators can share information about a particular bank with each other. and so after each examination, the, you know, regulators will basically input all the quantitative information and it gets stored and warehoused in this national information center. And then researchers who have access to this system of data can go and grab the go, get that data for what it, what it's worth.

06:50 - So that is another unique feature of the, of, of our setting, is that we can observe the ratings for every commercial bank, whether it be privately held or publicly traded, going back to at least the early 1990s. And through that, we can trace out how the m rating evolves whenever, let's say there's a financial crisis or a liquidity crunch, or we can also compare the m ratings after looking at large banks versus small banks. so it provides us a lens through to, to understand what is important from the regulatory point of view

07:30 - of having good management versus bad management. And also helps us understand whether those m ratings, whether they be downgraded or upgraded, have a impact on how managers are disciplined. So, so the key results of our paper are as follows. First, we, look at the predictive power of the M reading relative to two important outcome variables, which is future share of non-performing loans

07:59 - and the likelihood of failure. And what we show consistently in our study is that even after controlling for performance, which is ROA delinquent loans, and the quality of the balance sheet, meaning the proportion of real estate loans and the proportion of, of, reserves held as, as a fraction of assets, we find that the EM rating is very informative about future performance. What this would suggest that human,

08:31 - like these human regulators who have cognitive constraints on their ability to do their job, have the ability to produce consistent measures over and above the information that may be provided in financial reports. We also show that during times of crisis, and times of volatility, that these m ratings Are incrementally more predictive of future performance, meaning that there's a higher premium put on human capital

09:03 - when times are really difficult in the financial sector. Now, one mechanism that might underpin our results, is the, is, is governance what you talked about. so what we found is that a reason why these m ratings are particularly powerful is that they help discipline, the bank manager, right? So, so when a bank receives a bad M rating, it is likeer that manager will, will actually

09:44 - leave the bank in the next year after the exam. And that result is fairly robust to an inclusion of a whole host of control variables and empirical design choices. So this tells us that the inclusion of these m ratings or the, the fact that they exist help discipline the manager's decision making, which in turn leads to better future fundamentals are conclusions kind. kind of can get speak to three different,

10:15 - interested parties, one of which is the current regulators. we think that our results suggest that m ratings and, should be incorporated into the governance structure of commercial banks on a systematic basis, meaning that, as part of their own monitoring and disciplining system, bank regulators can compel boards of directors to include the EM reading and compensation practices

10:49 - and to also use the AM reading when deciding whether to retain or, let go of, of managerial talent. Second is for the boards of directors themselves. We hope that they can look at our study, especially those boards of directors in smaller banks that might not have access to advisors and external parties to help guide them on on managerial talent that they can use the findings of our study to help monitor

11:20 - the, the performance of managers. And as I mentioned earlier, this is particularly important in the banking industry because the project choices that bank managers make are fairly opaque and they only materialize in the future. And I would say the third party that might find our paper interesting are regulators and other policy makers in economies where the bank supervision system may not be as mature as it is in the United States.

11:51 - Our hope is that maybe they Can use our study, develop a system very similar to what might be in place in the United States, so that they can in turn use the m rating or a similar measure that they could develop to help guide bank managers and also the boards of directors. So that manner, banks can self-discipline themselves instead of having to rely upon the external force of a, of a bank regulator.

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