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9 8 0 3
Large Shareholders and Market
Discipline in a Regulated Industry:
A Clinical Study of Mellon Bank
by Joseph G. Haubrich and
James B. Thomson
FEDERAL RESERVE BANK
OF CLEVELAND
Working Paper 9803
LARGE SHAREHOLDERS AND MARKET DISCIPLINE IN A REGULATED
INDUSTRY: A CLINICAL STUDY OF MELLON BANK
by Joseph G. Haubrich and James B. Thomson
Joseph G. Haubrich is a consultant and economist at the
Federal Reserve Bank of Cleveland, and James B. Thomson
is a vice president and director of the Financial Services
Research Group here. The authors thank Sandy Sterk and
John Hueter for excellent research assistance.
Working papers of the Federal Reserve Bank of Cleveland
are preliminary materials circulated to stimulate discussion
and critical comment. The views stated herein are those of
the author and are not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.
Federal Reserve Bank of Cleveland working papers are
distributed for the purpose of promoting discussion of
research in progress. These papers may not have been
subject to the formal editorial review accorded official
Federal Reserve Bank of Cleveland publications.
Working papers are now available electronically through
the Cleveland Fed’s home page on the World Wide Web:
http://www.clev.frb.org.
February 1998
Abstract
The change in control at Mellon Bank in 1987 sheds a unique light on several aspects of
corporate control, because Mellon was one of only a few banks with a large shareholder.
We find that the large shareholder did not monitor the firm extensively before it
experienced performance difficulties, but was able to enforce a management change when
problems arose. Contrary to some theoretical models, the shareholder did not have to
acquire a majority stake to effect the change. Mellon’s rapid recovery relative to peer
banks’ reveals the inability of regulatory intervention to substitute fully for market-based
forms of corporate control.
Large Shareholders and Market Discipline in a Regulated Industry:
A Clinical Study of Mellon Bank
Joseph G. Haubrich
Research Department
Federal Reserve Bank of Cleveland
James B. Thomson
Financial Services Research Group
Federal Reserve Bank of Cleveland
Abstract
The change in control at Mellon bank in 1987 sheds a unique light on several aspects
of corporate control, as Mellon was one of few banks with a large shareholder. The bank
underwent a management change earlier than most peer banks; contrary to some theoretical
models, this happened without the large shareholder acquiring a majority stake to e ect
the change. Mellon's rapid recovery relative to peer banks reveals the inability of regulatory
intervention to fully substitute for market based forms of corporate control.
June 30, 1998
JEL codes: G30, G21 Keywords: Corporate control, large shareholders, regulations.
Preliminary. We thank Sandy Sterk and John Hueter for excellent research assistance,
and Mark Sniderman and Andrew Watts for helpful comments. Views Expressed here
do not represent the ocial position of the Federal Reserve Bank of Cleveland or of the
Federal Reserve system.
Corresponding author. Joseph G. Haubrich, Research Dept., Federal Reserve Bank of
Cleveland, P.O. box 6387, Cleveland, OH 44101-1387, (216) 579-2802, Fax (216) 579-3050,
jhaubrich@clev.frb.org.
1. Introduction
Students of corporate control had the chance to observe an unusual and instructive
case in the spring of 1987. In April, after the bank's rst loss in its 118 year existence, the
CEO, in the words of the 1988 Proxy statement, \retired as a director and as Chairman
and Chief Executive Ocer of the Corporation." Press reports suggested that this was at
the request of its dominant shareholder, the Mellon family. In June, Frank V. Cahouet,
a turnaround specialist, then president of Fannie Mae became CEO.1 In July Mellon also
installed a new president and and a new chief nancial ocer.
The Mellon succession provides an opportunity to study how large shareholders matter
for corporate control. Among the 30 largest banks in the U.S., Mellon had one of the highest
concentrations of ownership. In 1980, the 18% held by the Mellon family interests (CDE,
1980) exceeds the concentration of the top 5 holders of 21 of the top 30 banks. Large
shareholders' control e orts should be particularly apparent in banking, where regulation
inhibits other forms of corporate control. Restrictions on branching, market concentration,
and ownership make takeovers, particularly hostile ones, dicult. For large banks, the
implicit Too Big To Let Fail (TBTLF) doctrine makes their closure unlikely.2
The Mellon case sheds light on what large shareholders do and how they do it. Can
large shareholders and bank examiners substitute for an active takeover market? How do
large shareholders in uence the rm: do they use outright takeovers, monitoring, or stock
speculation?
From January to December of 1993, Frank Cahouet was a director of the Pittsburg
branch of the Federal Reserve Bank of Cleveland.
2 The closing of bank constitutes ocial recognition of its economic insolvency. TBTLF,
rst ocially acknowledged in 1984 by then Comptroller of the Currency C. T. Conover in
response to Congressional questioning, represents a policy of not ocially recognizing the
economic failure of a large depository institution. (See U. S. Congress, House Committee
on Banking, Finance and Urban A airs) For a discussion of regulatory closure rules see
Thomson (1992).
1
1
In this paper we examine those questions from the viewpoint of a clinical study of
Mellon Bank. After rst outlining the regulatory and market structure of the industry,
we present a short chronology of the events around the CEO turnover point and compare
the structure and performance of Mellon with a peer group of large banks. The setting
of a regulated industry sets up a natural experiment about di erent methods of corporate
control. Making a clinical study even more valuable, the regulatory setting provides an
unusually rich set of data, down to weekly reports on variables such as loan loss reserves.
We conclude that because of its large shareholder, Mellon Bank experienced an early
management change and an early turnaround relative to its peer group. This provides three
important lessons for corporate nance. It provides evidence consistent with the Gorton
and Rosen (1995) theory (following Jensen [1989]) that corporate control problems, leading
to managerial entrenchment, lay behind the poor performance of large banks in the 1980s.
Secondly, the large shareholder exerted in uence not by monitoring, nor by speculating,
but by forcing a management change along the lines suggested by Shleifer and Vishny
(1986), even though owning considerably less than 50% of the rm. Most importantly,
the early recovery of Mellon shows that regulation is a poor substitute for market based
forms of corporate control. This is troubling in light of Prowse's (1995, 1996) work which
nds regulatory intervention is the prime source of corporate control in banking. In this
case, the market based form|shareholder concentration|leads to an earlier and faster
recovery.
2. Regulatory and Market Structure
The banking market has several distinct features from the standpoint of corporate
control. A variety of regulations make hostile takeovers dicult. As partial compensation,
banks have a novel form of corporate control: regulatory intervention.
2
The National Banking Acts and the Bank Holding Company Act, with its 1970 amendment prohibit any corporation other than a commercial bank or a bank holding company
from acquiring a commercial bank. Some states have even stronger restrictions.3 This
not only prevents commercial rms from owning a bank, but severely restricts nancial
rms as well. Any company owning a bank may only engage in activities \closely related"
to banking (as de ned by the Federal Reserve Board). These laws also geographically restricted bank mergers, as the 1956 Douglas amendment (of Cobb{Douglas fame) prohibited
a holding company from acquiring banks outside its home state unless state regulations
allow interstate banking. 4 In 1987, they generally didn't.
Any legally permissible mergers require prior approval from some combination of state
regulators, the Oce of the Comptroller (OCC), FDIC, and the Federal Reserve Board.
All mergers were then further subject to a review by the Justice Department for anti{
trust implications. Approval of a merger or acquisition could take up to six months,
compromising the ability of a bank to make a successful uninvited bid for a competitor.
These regulations restricted the demand for takeovers by reducing the class of possible
acquiring rms. The rules placed a regulatory tax on takeovers as well. The combination
made hostile takeovers particularly rare. Prowse (1995) nds only four cases of hostile
takeovers (1.7 percent) in his sample of 234 bank holding companies over 1987{92. This
contrasts with 8.8 percent in Mork, Shleifer, and Vishny's (1989) sample of manufacturing
rms. Hence, regulatory and market structure for banks limits takeovers as a control
mechanism.
De facto 100 percent guarantees of bank deposits provided by federal deposit insurance
and bank closure policies (especially TBTLF) e ectively removed creditors as a discipline
3
4
Brickley and James (1987) provide more detail on state merger laws.
See Kane (1996) for a discussion of interstate branching restrictions.
3
on management (see Kane 1985) and hence, as a source of corporate control. Deposit
insurance reduces the incentives for creditors to withdraw their funds or to fully price
changes in the bank's risk into deposit rates (see Thomson 1987). Moreover, unlike creditors of non-bank corporations, depositors and other non-deposit creditors of banks, do not
have bankruptcy protection in that they cannot pursue legal action to close a depository
institution.
Legislation, though making banks relatively immune to market sources of discipline
such as hostile takeovers or creditors introduced a new, non-market form: regulation. Bank
regulators at the state and federal level may undertake a variety of interventions if a bank's
behavior deviates from certain norms. At a relatively informal level, bank ocials must
provide assurances that the problems will be addressed. These assurances may take the
form of verbal promises, board resolutions, or letters and memoranda of understanding. At
a more formal level, regulators can use written agreements, issue cease and desist orders,
and in more extreme cases undertake suspension, prohibition, removal, and even assess civil
penalties. Ultimately, they may seize any depository institution deemed to be operating in
an unsafe and unsound manner. In a recent extreme example, the Federal Reserve ordered
Daiwa Bank to cease all operations in the United States. (See Spong 1990, for more details
on regulatory interventions.)
One intriguing aspect of the problem is the possible complementarity between regulation and market forms of corporate control. For example, in October of 1985, the Federal
Reserve announced (Board of Governors, 1985) a revised policy of bank supervision that
required examiners to present their ndings directly to the board of directors, potentially
increasing the information ow.
3. Large Shareholders and Corporate Control
4
Economists have long pondered control of the large corporation. Adam Smith thought
the separation of ownership and control made managers \negligent and profuse" (Smith,
1976, Book V, Chapter I, part III, article 1.) Alfred Marshall thought small shareholders
\powerless" and looked to large shareholders to \exercise an e ective and wise control over
the general management of the business." (Marshall, 1920, Book IV, chapter XII, section
9, p. 253). Early in this century Thorstien Veblen, Adolf Berle and Gardiner Means
continued the analysis.
More recently, Demsetz and Lehn (1985) noted that the concentration of corporate
ownership is in fact endogenous. They documented that rms in which managerial behavior
was important and also dicult to monitor tended to have concentrated shareholders.
Large shareholdings arise as part of the value maximizing process for the rm.
Shleifer and Vishny (1986) looked more directly at the role of the large shareholder.
In their model, a large shareholder could replace inecient management by making a cash
tender o er for the rm. Since the large shareholder already owns a substantial fraction of
the rm, he or she can pay a premium to obtain control, install new management, and reap
the bene t of a higher share price. The large shareholder increases eciency because he
has the potential to obtain control, de ned by Shleifer and Vishny as 50 percent. Bolton
and von Thadden (1995) have a similar model in which a large shareholder can reorganize
the rm.
Brickley and James (1987) use the concentration of ownership in the banking industry to test the substitution hypothesis: that concentrated ownership substitutes for other
forms of corporate control, such as takeovers or outside directors. While their results are in
general ambiguous, they do nd a signi cant, negative relationship between ownership concentration and the number of outside directors, in states that prohibited holding company
5
acquisition of banks. Agrawal and Knoeber (1996), in a sample of large U.S. rms nd
substitutability among a broad array of control mechanisms: large shareholders, outside
directors, debt policy, and the takeover market.
Admati, P eiderer, and Zechner (1994) explored the trade{o between the monitoring
bene ts of large shareholdings and loss of portfolio diversi cation that results. Since small
shareholders can free{ride on the large shareholder, generally the market produces too
little monitoring and too little diversi cation (risk-sharing). Depending on the structure
of the nancial markets, however, the existence of a large shareholder may lead to excessive
monitoring or the optimal amount of diversi cation.
Admati, P eiderer, and Zechner (1994) also provide a convincing rationale for the
continued existence of large shareholders despite the gains to diversi cation. If a large
shareholder buys more shares, she has an incentive to monitor more, but the market
expects this and she only gains on the shares she already owns. If she sells, she loses on
the shares she owns because of the lower monitoring. This means that while it may be
dicult for an individual to become a large shareholder, she thereafter has strong incentives
to remain so. This seems particularly relevant in the case of founding families, such as the
Mellons.
Kahn and Winton (1995) consider another advantage of large shareholding: the owners can pro t by speculating from the knowledge they get as insiders. In their model, large
shareholders must decide between gathering information for trading and monitoring the
rm to improve its performance. They argue for a version of the substitution hypothesis.
An active, liquid, equity market may substitute for the monitoring of concentrated shareholdings by allowing takeovers. It also encourages information production by outsiders,
who have a greater chance of pro ting from the information.
6
These papers provide many insights into the role of large shareholders, but there
remains a certain mist that we hope our study begins to dispel. In what ways does a
\large" shareholder \monitor" a rm? How does a large shareholder \reorganize" the rm?
Mellon provides a speci c example. The Mellon family did it by changing management,
even though they controlled less than 50 percent of the stock; their holdings were closer
to 15 percent.
4. A Brief Chronology
At the end of 1986, Mellon Bank Corporation, the parent holding company of Mellon
Bank, was the 12th largest Bank Holding Company in America, with total assets of 34.5
billion dollars and an income of 183 million dollars. The company reported a return on
assets (ROA) of 0.5 percent and a return on equity of (ROE) of 9.9 percent. In its annual
report, Mellon noted that these numbers fell short of their long term goals of 0.8 percent
ROA and 16 percent ROE.
The Mellon family remained the dominant shareholder, in 1980 owning 18 percent of
the stock, (CDE 1980) though this number had dropped to 15.5 percent in 1986.5 The
Mellon family holdings were divided among four groups. Paul Mellon and Associates held
the largest block, 2.5 million shares. The Andrew W. Mellon Foundation held half a million
shares, Seward Prosser Mellon held two hundred thousand shares, and Nathan Pearson,
an advisor to Paul Mellon, held one hundred and forty thousand (CDE, 1980).
The Mellon Family in uence was represented on the board by directors with direct
ties to the Mellon family. Of the 28 directors listed in the 1986 Annual Report, three
list aliations to Mellon family holdings: Seward Prosser Mellon, listed as President of
The CDE lists the corporation as owning 23.73 percent of its own stock. Much of this
was trusts owned by the Mellon family.
5
7
Richard K. Mellon and Sons, Andrew W. Mathieson, listed as Executive Vice President
of the same, and Nathan W. Pearson, listed as Financial Advisor to Paul Mellon Family
Interests.
Even in 1986 there was concern about the performance of Mellon bank. Early on, in
March, the New York Times reported on \The Mellon Bank's Fall From Grace" (Bennet,
1986). Concern centered on poor lending decisions, a dicult acquisition of Girard Bank
in Philadephia, and possible management problems. The 1986 annual report remarked
(p.4) that \the Corporation's 1986 nancial results did not meet expectations..."
Expanding rapidly after 1981, Mellon took on large numbers of oil, real estate, and
foreign loans. Ex post of course, these sectors o ered sub{optimal performance. The
purchase of Girard Bank in 1983, caused further problems. Girard's return on assets fell
and the bank su ered a loss in 1985 (Call Reports). It seems this attempt to expand after
the relaxation of Pennsylvania intra-state branching laws in 1982 fell short of success.
Some evidence points to these problems as indicative of management problems, not
just poor decisions. In addition to rumblings in the nancial press (McGowan,1987), at
least one quantitative measure indicated problems, in that 1986 operating costs exceeded
net income.
The extent of board involvement in the face of these problems is unclear. After Mellon
posted a loss in the rst quarter of 1987, the board claimed it had not been kept informed
by the management, to the extent of being \shocked and surprised" (Mitchell, 1987) at the
size of the loss. The board, however, met four times in 1985 and only ve in 1986, whereas
in previous years they had met almost every month (Mellon proxy statements 1982{88).
The executive committee, which oversees the corporation between board meetings, did not
meet at all in 1986.
8
The frequency of board involvement is particularly notable in discussing the role of
large shareholders, given the theoretical emphasis on monitoring bene ts. Although we
postpone detailed comparison with other banks until the next section, the performance
of Mellon bank in the middle 1980s does not make a strong prima facie case for the
monitoring activities of concentrated ownership. It remains possible, of course, that large
shareholders exerted an unobserved in uence.
The e ects of concentrated ownership seemed more apparent in the management
change following the rst quarter loss of 1987. Certainly the board acted swiftly; future
CEO Cahouet later said \The board decided they wanted make a change in management.
The didn't talk about it: they did it." (Andrews, 1988, p. 70) The board then appointed
two directors with close Mellon ties to key positions. Nathan Pearson, since 1948 a nancial advisor to Paul Mellon, became Chairman and Andrew W. Mathieson became head
of the search committee (1988 Proxy Statement). Analyst Douglas Stone, of Prudential{
Bache Securities put it as (Ansberry, 1987), \I think for anyone who had doubts as to who
controls the bank, it's pretty obvious now that the Mellon family runs the show."
From this point on the board also seemed to indicate a greater appetite for oversight.
Cahouet said that he wanted \an involved board" (Andrews, 1988), and he got the job.
In fact, the Pittsburgh Business Times & Journal (Stou er, 1987) worried that the board
was getting too involved, and \might place too tight a rein on Cahouet."
5. Comparison with other Banks
Clearly, Mellon Bank faced problems in the mid 1980s. At the same time, those
problems were not clearly worse than those facing other large banks. Mellon's 844 million
dollar loss in 1987 ranked sixth that year, with two banks losing over a billion dollars
(Zimmerman, 1988). This poses a question confronting the large shareholder hypothesis.
9
Perhaps a very poor year made a management change inevitable, whatever the ownership
structure. In this section we look at a variety of bank performance measures, hoping to
sort out how di erent Mellon looks both in decline and recovery. Ideally, Mellon would
look quite similar to comparable banks before the management change, showing a superior
performance afterwards.
Charts 1-4 report annual measures of bank performance for Mellon bank and two
peer groups, money center banks and large regional banks, taken from the consolidated
Financial Statement for Bank Holding companies, Y-9C.6
Charts 1 and 2 report the return on assets and return on equity for Mellon and the two
peer groups. Panel A shows Mellon and the quarterly high, low and mean return for money
center banks. Panel B repeats for large regional banks. From 1983 to 1986, Mellon blends
in quite nicely with the other banks. All groups show sharp earnings declines (actual losses
for Mellon and the Money Center peer group) in 1987. This poor earnings performance
in 1987, which was concentrated in the second quarter, was largely a consequence of large
loan loss provisions made against LDC debt portfolios (see Musumeci and Sinkey, 1990).
Mellon's results for 1987 were even more dramatic because it also reserved heavily against
its domestic loan portfolio. Mellon shows a further loss in the 1988 resulting from its second
quarter write{down assoicated with the Grant Street good-bank bad-bank transaction,
seen by many as a major step on the road to Mellon's recovery. In part because it moved
aggressively to write-down its bad assets in 1987 and again in 1988, Mellon outperforms
the money center peer group by 1989 and both and regional peer groups by 1991. The
con uence of the ROA and ROE charts is gratifying, in that the ROA measures how
The division into money center and regional banks is based on the Annual Salomon
Brothers review of bank performance. We have standardized the groups, because the exact
banks in each group change over time. So does the name of the report.
6
10
pro tably the rm is employing its total assets; because banks are highly leveraged, though,
it gives a poor idea of how pro table the owners nd the rm.
Charts 3 and 4 look at the cost side of the picture. Chart 3 plots nonperforming
assets (as a percent of total assets), loans on which the borrower is at least 90 days behind
on interest payments. This chart must be treated with some care, as Mellon traditionally
classi ed loans as nonperforming after only 60 days. (It is not clear, however, that fewer
of these loans had to be written o entirely.) For Mellon, the large spike in nonperforming
assets in 1987 provides con rmation that the sharp earnings decline in 1987 was due to
aggressive moves by Mellon to put its credit problems behind it. While its nonperforming
assets remain above the regional bank peer group for the remainder of the period, Mellon's
asset quality recovers rapidly with respect to the money center peer group. Once again
Mellon recovers rapidly relative to the money centers, less dramatically with regard to the
regionals.
Chart 4 looks at noninterest expense as a percentage of assets. This chart tells an
interesting story, if only in contrast to the strong emphasis on eciency and cost cutting
that one hears so often in the nancial press. Mellon's noninterest expenses as a fraction
of assets dipped after 1987, but remained at and increasingly above, the level of both other
groups of banks.
It is possible to make an even ner breakdown by looking at weekly data. Mellon and
other large banks are part of the \Weekly Reporting Bank" sample. We compare Mellon
to subsets of the thirty largest weekly reporting banks in charts 5 and 6.
Chart 5 measures asset liquidity, looking at the proportion of cash, government securities, and net Fed Funds in a bank's portfolio. By itself, liquidity is neither good nor
bad, but shifts can indicate changes in strategy, and extreme values can signal problems
11
of di erent sorts. For example, liquidity problems are a signi cant factor in bank failures
and closure decisions (see Thomson, 1992). The chart plots the liquidity ratio weekly
for Mellon, the 10 largest weekly reporting banks, and the next ten largest in panel A,
and in panel B plots the 29 largest weekly reporting banks (excluding Mellon) and those
banks that survive the entire sample. Mellon stands out as being relatively illiquid, with
occasional spikes due to large transactions on their securities portfolio. By 1988 they have
shifted and become more liquid than the average.
Chart 6 plots loan loss reserve on a weekly basis. This penultimate chart encapsulates
much of the story we have narrated so far. Until 1987, Mellon blends in with the other large
banks. Even the dramatic increase in loan loss reserves seen in 1987 follow the pattern
of the industry|not strange, as many banks lost money on Texas real estate and loans
to Mexico, Brazil, and Argentina. After the corporate control change, Mellon begins to
di er. It takes a further big reserve in late 1987, and then shows a big decrease re ecting
loan charge{o s associated with the formation of the Grant Street Bank in 1988. By 1990
the loan loss reserve is low relative to its peer groups.
A more comprehensive summary measure is provided by the stock returns. Chart 7
plots the cummulative returns of the Mellon stock and stock for both the money center and
regional peer groups. The excess return is calculated from a market model, regressing the
returns on the CRSP equally weighted index. Mellon does better than average through late
1986. Returns then fall below both peer groups, but by October of 1987 the cumulative
returns have rebounded, only to start falling again. The recovery started in September
of 1988, and by the spring of 1989 Mellon returns are on track with its peers. Mellon's
tracking of these groups should not be surprising because the peer groups are dominated
by banks indenti ed as TBTLF (see O'Hara and Shaw, 1990). The cummulative returns
12
clearly indicate the rapid recovery of Mellon.
Were Mellon's returns low enough to force a top management change without the
existence of a large shareholder? The evidence suggests not, adding Mellon as a con rming
instance of the work of Denis, Denis and Sarin (1997) who nd that large shareholders make
top management turnover more senistive to poor performance. Warner, Watts, and Wruck
(1988) nd that poor performance often takes two years to result in a top management
change: Mellon's CEO was replaced less than a month after Mellon announced its rst
quarterly loss. Even for poorly performing rms, CEO resignation was by no means certain.
Warner, Watts, and Wruck nd that for the worst decile of rms, with returns of -0.52,
the turnover rate was 0.139. Weisbach (1988), found a turnover rate of 0.061 for the worst
decile, with a return relative to the market of -0.331. Mellon's return against the market for
1987 was -0.67. While it is never possible to prove a counterfactual, the evidence suggests
that the large shareholder was important in this turnover.
6. Conclusions
We suggest that the turnaround of Mellon was due to internal sources of corporate
control and not to external forces. Mellon's experience was not typical for banks; Prowse
(1995, 1996) found that the main source of corporate control for bank holding companies
is regulatory intervention. Moreover, Prowse nds that bank boards of directors are a
less e ective corporate control device than those for non- nancial rms studied by Morck,
Shleifer, and Vishny (1989). Therefore, what was di erent about Mellon that explains its
turnaround?
Mellon Bank had a large shareholder: the Mellon family. The pattern of events seems
to match best with theories implying discrete intervention by the dominant shareholder.
Once losses occurred, the large shareholder assumed greater importance, apparently forcing
13
a management change, assuming interim command, and heading the search committee.
After the change, the board also seemed to take a more involved stance.
The story of Mellon is consistent with a coherent view of large shareholders and
ownership concentration. The impact of the laarge shareholder was less about monitoring
and more about an ability to force a management change without ocially controlling the
rm. The action resulted in an early turnaround for Mellon Bank. Though the dicult
question is apportioning the credit for the management change between the dominant
shareholders and an ordinary board facing more than ordinary losses, the evidence suggests
Mellon's large shareholder mattered.
14
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