Bank failure prediction: corporate governance and financial indicators

Abstract

AbstractThis paper reiterates the importance of corporate governance in banks. Failure prediction studies have mainly relied on using financial ratios as predictors. The most suitable financial predictors for banks are financial ratios following the CAMEL rating system. Also, corporate governance has been proven to be an important aspect of banks, especially after the financial crisis. Given its importance, the novelty of this paper is to test the ability of corporate governance to increase the accuracy and extend the time-horizon of bank failure prediction in the US market. Using discriminant analysis, we predict the failure of banks insured by the Federal Deposit Insurance Corporation from 2010 to 2018. Using financial and non-financial predictors, we find that combining CAMEL ratios with corporate governance variables not only increases the accuracy of prediction but also extends the time horizon to three years before failure. We also show that bank earnings is a more significant predictor than capital structure and asset quality. The results further reveal that CEO compensation, voting rights and institutional ownership are significant predictors. These results are robust when using logit regression and out-of-sample examination. This study shows that corporate governance plays a key role in the success or failure of banks. The regulatory implication of this paper is that more attention needs to be directed to corporate governance and earnings aspects of banks rather than focusing on capital structure.