Institutional Ownership of Bank Shares

U.S. bank regulations weaken the incentives for market-based monitoring of bank CEOs, and bank assets are difficult for outside investors to value. Therefore, we analyzed factors that might influence institutional holdings of bank shares. Our primary expectation was that alignment of the economic interests of bank CEOs with those of bank shareholders would be particularly important in determining which banks attract institutional investment funds. Our results suggest that the sensitivity of a bank CEO's compensation to shareholder wealth does have a positive influence on the proportion of a bank's shares held by institutional investors. Additional evidence suggests that bank size is positively related to institutional ownership whereas capital adequacy and stock variance are negatively related to institutional ownership. In general, the evidence implies that when a company's quality is difficult for outside investors to determine, portfolio managers consider the economic incentives of company managers. Professional money managers face unique challenges when selecting U.S. bank stocks to include in their portfolios. The existing finance literature suggests that bank assets are relatively difficult for outside investors to value. Additionally, U.S. bank regulations have historically weakened incentives for market-based monitoring of bank CEOs. In general, although some high-profile instances of U.S. institutional shareholder activism have occurred, notably by the California Public Employee's Retirement System, institutional investors are generally considered to be passive. When a bank stock is underperforming, most money managers would rather sell the shares than incur the costs of becoming involved in the bank's corporate governance.Faced with severe information asymmetries (i.e., situations in which company insiders have better information about the quality of company assets than do company outsiders) and weak incentives to influence CEOs, what variables do portfolio managers consider when investing in bank shares? To identify the factors that might affect money managers' decisions to hold individual bank shares, we gathered information on the following bank-specific characteristics: sensitivity of the CEO's total compensation to share performance, bank size, bank capital adequacy, variance of the bank stock's return, the proportion of directors who are outsiders, share ownership by outside directors, ownership of shares by blockholders affiliated with management (such as employee stock ownership plans), the market-to-book ratio, board size, whether the CEO is also the board chair, and whether the bank is a money center bank. We regressed the percentage of bank shares held by institutional investors on these bank-specific characteristics.The factor of primary interest to us was sensitivity of the CEO's compensation to share performance. Our thesis was that professional money managers will invest more heavily in banks in which the CEO's compensation package is sensitive to changes in bank shareholder wealth (i.e., pay–performance sensitivity). Such a compensation structure should demonstrate to portfolio managers the bank CEO's commitment to maximizing shareholder wealth and the CEO's confidence in the quality of the bank's assets. Our measure of CEO pay–performance sensitivity was the estimated dollar change in the CEO's wealth caused by a $1,000 change in the total market value of bank equity.We found that the sensitivity of bank CEO pay to share performance is positively related to the institutional ownership of banks. Bank capital adequacy, however, was found to be negatively related to the proportion of bank shares held by institutions. Several writers in the finance literature have argued that the interests of bank managers and bank shareholders are more likely to be closely aligned when bank leverage is high. Accordingly, the evidence concerning CEO compensation structure and capital adequacy is consistent with professional money managers investing more heavily in banks with low manager–shareholder conflict.Additional evidence suggests that the institutional ownership of banks is negatively related to bank stock return volatility and positively related to bank size. Return volatility is commonly considered a measure of idiosyncratic (stand-alone) risk, but the measure can also be interpreted as a measure of information asymmetry. Company size is a measure of stock liquidity, which is valued by institutional investors. Company size should also lower information asymmetry, however, because of the greater analyst following, regulatory scrutiny, and media attention large companies attract. Consequently, the evidence regarding volatility, size, and institutional holdings suggests that portfolio managers prefer the less risky bank stocks, liquid bank stocks, and/or the stocks of banks with relatively minor information asymmetry.In general, the evidence from this study implies that when company quality is difficult for outside investors to determine and when incentives for outside shareholders to monitor managers are weak, portfolio managers consider whether the economic interests of company managers are aligned with the economic interests of shareholders.