Strong Governance and Lower Tobin’s Q

cones safetyCorporate governance has been a flash point for institutional investors for some time – at least since the collapse of Enron and WorldCom, where earnings statements proved to conceal more than they revealed. That marked the culmination of a go-go investing era where new words were invented to obscure income statement fundamentals — that is, if high-flying companies had any earnings at all.

But how successful have corporate governance measures proven in their first test, the financial crisis of 2008? That’s tough to judge because it was not so much creative accounting as that old familiar, leverage that brought the high low. In any event, the results seem mixed at least for banks, say Emilia Peni and Sami Vähämaa, researchers at the University of Vaasa, Department of Accounting and Finance, in their paper “Did Good Coporate Governance Improve Bank Performance During The Financial Crisis.”

“Consistent with the literature on non-financial firms,” research they look at suggests “that strong corporate governance has positive effects on the financial performance and stock market valuation of banks. More generally, the prior studies indicate that the same corporate governance attributes that affect non-financial firms are also relevant in bank governance.”

But what about during a financial crisis? Here, the evidence is less clear. For example, prior research indicates that lower-leveraged banks did better than those with higher leverage. Regulation, however, played little role. Other studies suggest that banks with shareholder-friendly boards fared not so well. Compensation differences seem to have had no discernible impact. Finally, and more equivocally, better-governed banks also tended to take more risks – not something to be rewarded when investors are hastily pulling back on risk.

Using a sample of 67 large banks in the U.S., with $8 trillion in assets (though size varies greatly), Peni and Vähämaa “posit that banks with stronger corporate governance mechanisms had (i) higher profitability, (iii) higher market valuations, and (iii) less negative stock returns amidst the crisis.”

They found three things. First, “banks with stronger corporate governance mechanisms had significantly higher profitability in 2008. This finding suggests that good governance may have moderated the adverse influence of the financial crisis on financial performance.”

But the banks did not sustain higher valuations. Instead, they fell below or close to Tobin’s Q in 2008. Here, Tobin’s Q is calculated as the sum of the market value of equity and the book value of liabilities, minus the book value of the assets. They noted “our results indicate that strong corporate governance practices may have had negative effects on stock market valuations of banks during the crisis, as banks with stronger governance are found to be associated with lower Tobin’s Qs and stock returns amidst the crisis.” Indeed, during the crisis, valuations fell the bigger the bank, even though the bigger the bank the lower its loan ratio and the higher its profitability (or the lower its loss).

Still, the third hypothesis seems to have been borne out, after separating the period into three: pre, mid and post-crisis. “We also find that banks with stronger corporate governance mechanisms provided substantially higher stock returns in the immediate aftermath of the crisis from March 2009 onwards, indicating that good governance may have mitigated the adverse effects of the financial crisis on bank credibility among stock market participants.”

In a crisis, it seems, past governance is not necessarily a predictor of near-future performance.