Corporate Governance and Depository Institutions Failure: The Case of an Emerging Market Economy

This paper studies the relationship that exists between ownership and governance of depository institutions (DI) on one side, and the dominant cause of failure on the other.

The paper states that the extant theory implies that:

• In stock owned DI, where management is well controlled, or interests are aligned with those of shareholders, the dominant cause of failure will be moral hazard between shareholders and debt holders;
• In DI with diffuse ownership with poor management control, or where management's interests are not aligned with those of owners, the dominant cause of failure will be agency costs, manifested in expense preference behavior that leads to failure.

The paper:

• Evaluates the relative importance of both conflicts in explaining the failure of DI with different ownership and governance structures in an emerging market - Columbia;
• Attempts to establish empirically the relative importance of these two conflicts as determinants of insolvency in DI.

The paper discusses:

• Theories of moral hazard and agency costs in DI;
• The role of markets and hierarchies to control principal-agent conflicts;
• The data, the statistical methodology and results;
• Quality of management, an alternative hypothesis explaining failure.

The study concludes that:

• In Columbia, moral hazard is a key factor in explaining bank failure, while agency costs explain insolvencies among financial cooperatives;
• In state owned banks, both moral hazard and agency costs are significant in explaining failure;
• Agency cost variables are more significant in explaining failure than moral hazard variables;
• Agency costs explain the failure of government owned banks.