Tuesday, 16 April - 3 PM - Seminar Room (DEM)

Abstract

The global financial crisis of 2007 – 2008 is commonly attributed to excessive risk-taking caused at least in part by corporate governance weaknesses in the financial system. The failure of existing controls to prevent unwarranted risk-taking prompted regulators to impose personal sanctions on board members for breaches of the banking legislation. Yet, there is little evidence on the effectiveness of such reforms. This paper aims to fill this gap by examining the effects of increasing directors’ personal liability on the risk-taking of private financial institutions. We utilize a 2015 regulatory reform in Sweden that imposed a penalty of up to five million euro on directors of financial institutions for regulatory violations, thus effectively increasing their personal liability. We find evidence of lower earnings and cash-flow volatility, higher distance to default, lower probability of experiencing a big loss, and higher probability of a credit rating upgrade following the reform, suggesting that more director liability equates to less risk-taking. Such effects could be driven by the incumbent directors becoming more vigilant or the new directors joining after the reform. Path analysis indicates that the reduction in risk-taking is predominantly driven by incumbent directors becoming more prudent, whereas the new director types explain the observed changes in risk-taking to a lesser extent. Notably, the increase of female members on the boards of affected firms contributes to lower risk-taking, while the lower percentage of experienced board members increases risk. Overall, our findings indicate that director liability provisions affect the risk-taking in private financial institutions.