The Capital Purchase Program and Board Appointment

Topic & Objectives

In the aftermath of the financial crisis, one of the main objectives of policymakers around the world has been to increase the capital ratios of financial institutions. While a variety of tools have beenused, acommon problemassociated with the recapitalizations of financial institutions is the negative ex‐ante and ex‐post incentive effects of bailouts. We argue that an instrument has been overlooked that addressed the incentive effects and might be partly responsible for the fast recovery of the financial sector in the US. We study an important feature of the TARP program and in particular the Capital Purchase Program (CPP), namely the ability of the U.S. Treasury to appoint board members in recapitalized institutions.Under the CPP agreements, the Treasury purchases preferred stock, equity warrants, or subordinated debt from a financial institution in exchange for dividend or interest payments. While the bank is not legally obliged to pay dividends or interest, the agreement provides the Treasury with the right to appoint up to two directors if six or more payments are missed. We hypothesize that this feature addresses the ex‐post moral hazard if these appointments are not seen as ceremonial and impact the corporate governance of the bank. It also addresses the ex-ante moral hazard if banks try to avoid having Treasury‐appointed board directors on their boards.

We assembled an original database of banks’ missed payments under  the program as well as information on their board members and CEOs, executive compensation, and balance sheet information to study the impact of the appointment rule. We find that banks try to avoid crossing the six missed payment threshold, as there is a clear discontinuity in the empirical distribution of missed dividend payments to the U.S. Treasury between five and six missed payments. We also developed a simple model that explains this finding by the fact that the appointment of directors reduces the manager’s private payoff. The predictions of the model are then confirmed in an empirical analysis: We find that, on average, for banks that missed one to three payments, the increase in the number of missed payments in the next quarter is about 0.77‐0.8 i. However, banks with four missed payments are more disciplined compared to those, as the number drops to 0.64, and banks close to the threshold are even more disciplined, as it drops further to 0.42. After crossing the threshold, banks revert to the previous level  of 0.77, consistent with the behavior of the model, which here indicates the loss of the private benefit. This effect is more pronounced for healthy banks, which are more free to choose their payouts,  compared to banks which are more restricted in their payouts due to poor performance. To address the question of how these payouts are made, we also investigate the impact of this covenant on capital ratios. We document that banks appear to reduce their capital ratios once they cross the six missed payments threshold and estimate a positive causal effect of the threat of director appointment on capital ratios.

To corroborate the evidence on banks’ management avoiding Treasury director appointments, we use as an exogenous shock the dramatic ouster of Citigroup CEO Vikram Pandit in 2012. The abrupt resignation was imposed by the board and especially by Citi’s chairman, Michael O’Neill, appointed by the Treasury in connection with TARP funding. We find that it induced a sharp exodus of banks from the CPP. This exit was enabled by banks buying out the government's equity stake, which meant that private equity was infused to replace the government's investment. Consequently, this ended up being an effective device to get banks to recapitalize and ensure that the government's investment was limited in duration.

We also investigate the performance of the banks which received Treasury‐appointed board directors. Out of 162 banks that crossed the threshold, 16 banks received a director appointment. Combining a matching approach and difference-in-difference setup, we find that the appointment of board directors increased the performance of banks, as measured by a reduction in non‐performing loans over loans, and an increase in return on equity as well as return on assets. Furthermore, they also improved corporate governance, as earnings management was significantly reduced after the appointments, and reduced executive compensation.

These findings highlight the importance of the director appointment features implemented in the CPP to reduce the bailout‐related moral hazard problems. The insights from our study are relevant for rescue programs for the financial sector in times of crisis, for example, the recent COVID‐19 pandemic.

Key Findings

• The right to appoint up to two directors after missing six dividends affected banks’ decision‐making, as banks tried to avoid crossing this threshold.
• The threat of board director appointments had a positive effect on banks’ capital ratios.
• Board director appointments led to higher performance, better auditing, and lower executive pay.

Policy Implications

• Including covenants in bailout contracts to appoint independent directors after missing dividends on the bailout money reduces the bailout‐related moral hazard. Banks had higher repayment discipline to the government (ex‐post moral hazard), and they tried to avoid crossing the threshold of the appointments (ex‐ante moral hazard).
• If well chosen, these directors can also improve recipient banks’ performance and corporate governance.