Board Independence and Compensation Policies in Large Bank Holding Companies

Financial Management (Financial Management Association), Autumn, 2000 by Chandra S. Mishra, James F. Nielsen

James F. Nielsen [*]

We use a sample of large bank holding companies to empirically examine the association between financial performance and organizational structure. We regress firm accounting performance on measures of board independence, CEO pay-performance sensitivity, the product of board independence and CEO pay-performance sensitivity, and other organizational features and control variables. We find that both CEO pay-performance sensitivity and the relative tenure of independent outside directors have a positive effect on accounting performance. Their interactive effect tends to be negative. Thus, the marginal value of each mechanism for accounting performance declines as the use of the other mechanism increases. These results are robust in a simultaneous equations framework that accounts for endogeneity issues. We also find a positive relation between the percentage of independent outside directors and CEO pay-performance sensitivity.

The board of directors is considered an important internal corporate control mechanism (Fama, 1980, and Fama and Jensen, 1983). Among other things, the directors are responsible for evaluating the chief executive officer (CEO) and other top-executives, determining the level and structure of top-executive compensation, and replacing poorly performing CEOs. Recent studies find that the internal control mechanism, which operates through the board of directors, is generally effective. [1] Because the board of directors is ultimately responsible for determining the compensation package for top executives, the effectiveness of executive compensation in reducing shareholder-manager agency problems can depend on the board composition and on the level of board independence.

Our paper investigates the association between board-independence variables related to independent outside directors, pay-related incentives, and financial performance. We focus on the substitution-monitoring hypothesis, which posits

that the two monitoring variables, board independence, and pay-related incentives, are substitutes. Under this hypothesis, board independence effects should reduce the need to develop compensation contracts that align the interests of managers and shareholders.

We choose the banking industry for three major reasons. [2] First, by focusing on a single industry (Collins, Blackwell, and Sinkey, 1995), we minimize the variability in executive compensation that results purely from industry differences. Industry factors, such as competitive intensity or risk, can account for a large proportion of performance and executive compensation variability in a sample of firms (Smith and Watts, 1992), and might obscure the relation between board independence and executive compensation.

Second, not all firms have the same level of internal monitoring by the board (Lippert and Moore, 1995). Lorsch and Maclver (1989) find that board members exercise more power when firms are facing external threats, and that some of these threats might be the result of a high level of regulatory supervision or surveillance. Moreover, Kosnik (1990) and Johnson, Hoskisson, and Hitt (1993) found that board characteristics might have a greater influence on director involvement during critical times or decisions.

In the last two decades, the banking industry has had to deal with more pressure in both the legislative and economic arenas than any time since the 1930s. By necessity, all banking boards of directors have had to take a more active role in management. Thus, we are able to focus on compensation policies in firms that generally have a high level of internal monitoring by the board. [3]

Third, not all firms experience the same level of agency conflicts or have the same need for board monitoring. Since the 1980s, the deregulation of the financial services industry has opened up investment opportunities for all banks and allowed them to offer nonbanking financial services. Smith and Watts (1992) find that the level of agency conflict can vary across firms' investment opportunity sets: the greater the investment opportunity set, the greater the level of agency conflict. By focusing on the banking industry, we minimize the variability in executive compensation that results from differences in the level of agency conflicts, as a consequence of differences in investment opportunity conditions.

To examine how board independence and compensation policies influence bank performance, we use two separate regression models. The first model uses an ordinary least squares approach to investigate the extent to which various board independence measures interact with CEO pay-performance sensitivity. This analysis controls for firm size, growth opportunities, ownership structure, leadership structure, and market takeover activity. The second model estimates a simultaneous equation system of performance, board independence, and pay-related incentives. In this second model, we use a two-stage least squares (2SLS) method to address potential endogeneity issues.