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Governance of Financial Institutions

Summary and Keywords

Corporate governance is a central issue in business and economics. However, governance in financial institutions is more complicated than in other fields because of the nature of financial services and instruments. Financial organizations are similar to other businesses in terms of their purposes of establishment, but confidence in management and complex risk structures are more important in financial organizations than in other businesses. In financial institutions, there are various areas in which problems arise that are related to corporate governance, including the agency problem and stakeholder protection. The importance of good governance for sound performance of financial institutions was reconfirmed during the 2008 financial crisis, raising the need to understand the agency problems and the efficiency of various corporate governance mechanisms in mitigating them. International organizations, such as the Organisation for Economic Co-operation and Development, the Basel Committee, the International Finance Corporation, and the International Organization of Securities Commissions, have been working with regulators and policy makers to improve corporate governance practices both in nonfinancial and financial institutions. Corporate governance, especially in financial institutions, is essential in guaranteeing a sound financial system, capital markets, and sustainable economic growth. Governance weaknesses at financial institutions can result in the transmission of problems across the finance sector and the economy. Consequently, the effectiveness of governance mechanisms of financial institutions and capital markets after financial crises had significant importance in a period that witnessed an intensive discussion of corporate governance issues with new regulations and the related academic works.

Keywords: corporate governance, financial institutions, OECD corporate governance principles, Basel Committee corporate governance principles, agency theory, stakeholders theory, conflict of interest, financial crisis

Good governance is important in every aspect of the society, including the corporate environment, general society, and the political environment. Good governance levels can improve public faith and confidence in the political environment. When resources are too limited to meet the minimum expectations of the people a good governance level can help to promote the welfare of society. A concern with governance is also prevalent in the corporate world. Good governance is essential for good corporate performance. One view of good corporate performance is that of stewardship; while the management of an organization is concerned with the stewardship of financial resources it would also be concerned with oversight of environmental resources (Aras, 2015a). Claessens and Yurtoglu (2012) review the relationships between corporate governance and economic development and well-being. They found that better-governed corporate frameworks benefit firms through greater access to financing, lower cost of capital, better firm performance, and more favorable treatment of all stakeholders.

Corporate governance has been the subject of a growing amount of research since the beginning of the 21st century following a series of corporate meltdowns, frauds, and other catastrophes that led to the destruction of billions of dollars of shareholder wealth, the loss of thousands of jobs, criminal investigation of dozens of executives, and record-breaking bankruptcy filings (Monks & Minow, 2011). However, since the global financial crisis, central banks, regulatory bodies, supervision agencies, and stock exchanges have started to question the effectiveness of the current corporate governance applied to financial institutions (Aras, 2015a, 2015b). The focus of corporate governance has turned to the evaluation of the efficiency and effectiveness of corporate governance mechanisms in terms of board size, board composition, the separation of CEO and chairperson, and audit quality (Aras & Furtuna, 2015). Financial institutions are widely believed to play an increasingly important role in corporate governance (Carleton, Nelson, & Weisbach, 1998). The crisis became a powerful reminder of the importance of the financial system and good governance. Financial crises are not random events, but are set in motion by the decisions of individuals and institutions operating within a given framework of laws, regulations, and tax codes. According to Hopt (2013), there were inappropriate incentives promoted by compensation practices, deficiencies in board profile and practices, and failures in risk management and internal control. This was exacerbated by complex and opaque bank and bank group structures and by legal and practical difficulties of regulating and supervising cross-border operations of bank groups. These deficiencies did play a certain role in leading to the financial crisis. The scope and the impact of the financial crisis, which is believed to be heavily rooted in the corporate governance inefficiencies of publicly listed companies and financial institutions, boosted changes in regulation and corporate policies (Aluchna & Aras, 2015).

Regulation is a significant influence on institutional structure. The degree of risk taken by financial institutions and the diversity of their investments are affected by how competition and stability in financial systems are traded off and the form in which investor protection is provided (Mayer, 2002). Corporate governance can be considered as creating an organizational environment of trust, ethics, moral values, and confidence among the organization’s stakeholders, including the government and the general public. Corporate governance especially in financial institutions is essential in guaranteeing a sound financial system and stable economy. Governance weaknesses at financial institutions can result in the transmission of problems across the finance sector and the economy as a whole (Basel Committee, 2015).

The Objective of Corporate Governance

The concept of “corporate governance” in today’s context emerged for the first time in 1992 in the Cadbury Committee Report: Financial Aspects of Corporate Governance. This report, known as the Cadbury Report, defines “corporate governance” as “the system by which companies are directed and controlled” (Cadbury, 1992). A more widely used definition claims that corporate governance “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” (Shleifer & Vishny, 1997). Aiming to give a broader definition, the Organisation for Economic Co-operation and Development (OECD) published Principles of Corporate Governance (2004), which defines corporate governance as “a set of relationships between a company’s management, its board, its shareholders and other stakeholders.” With this definition, corporate governance can be considered as an environment of trust, ethics, moral values, and confidence and good governance, which is important in every aspect of the society be it the corporate environment, general society, or the political environment (Aras & Crowther, 2008). The corporate governance framework should promote transparent and fair markets and the efficient allocation of resources. It should be consistent with the rule of law and support effective supervision and enforcement. Effective corporate governance requires a sound legal, regulatory, and institutional framework that market participants can rely on when they establish their private contractual relationships. This corporate governance framework typically comprises elements in legislation, regulation, self-regulatory arrangements, voluntary commitments, and business practices that result from a country’s specific circumstances, history, and tradition. The desirable mix between legislation, regulation, self-regulation, voluntary standards, and so on will therefore vary from country to country (OECD, 2015).

The objective of corporate governance in corporations is to maximize shareholders’ value in the context of the corporate mission by establishing a balance in setting goals and encouraging efficient use of resources. Corporate governance helps businesses and all institutions to meet global challenges while improving organizational competitiveness and safeguarding the interests of all stakeholders. Long-run viability, more efficient resource allocation, and elimination of uncertainties are the other primary benefits of corporate governance (Aras, 2008). Moreover, governance does matter in a company’s performance, market value, and credibility; therefore, implementation of corporate governance principles benefits every corporation. In fact, good governance has significant impact on firm performance and shareholder returns. A number of studies have investigated the relationship between corporate governance mechanisms and performance (see Agrawal & Knoeber, 1996; Anderson & Reeb, 2003; Aras, 2015b; Bhagat & Black, 1999, 2002; Bhagat & Bolton, 2008; Gaur, Bathula, & Singh, 2015; Hermalin & Weisbach, 1991, 2003; La Porta, Lopez de Silanes, & Shleifer, 1999).

Denis (2001) defines governance mechanisms as legal mechanisms, internal and external control mechanisms, and product or service competition. According to that study, the legal requirements and legislations are the main support of governance mechanisms. Internal control mechanisms that involve the board of directors, compensation policies, majority shareholders, and debt of the firms are also mentioned, as are external mechanisms such as independent audit firms. Denis (2001) defines the last component, product or service competition, as a successful management practice that makes the firm successful in the market, bringing profit and prolonging life. Hence, the risk of being unsuccessful in competition prevents the managers from behaving inappropriately. Management can be interpreted as managing a firm for the purpose of creating and maintaining value for shareholders. Corporate governance procedures determine every aspect of the role for management and balance the development of control mechanisms in order to increase shareholder value and stakeholder satisfaction. In other words, the goal of corporate governance is to create balance between economic and social goals of companies, including efficient use of resources, accountability in the use of power, and the social environment. Good corporate governance considers all of the following (Aras, 2015a):

  • Creating sustainable value

  • Increasing shareholder satisfaction

  • Providing efficient and effective management

  • Increasing credibility

  • Obtaining efficient risk management

  • Providing an early warning system against all risk

  • Creating a responsive and accountable corporation

  • Describing the role of firm units

  • Developing control and internal auditing

  • Keeping balance between economic and social benefit

  • Using efficient resources

  • Establishing performance controls

  • Distributing fair responsibility

  • Producing necessary information for stakeholders

  • Maintaining the independence of the board (from management)

  • Ensuring compatible and sustainable performance

  • Attracting new investors, shareholders, and more equity

  • Having higher credibility and lower cost of capital

Governance can be very complicated and requires a long-term plan and results in long-term benefits for institutions to maintain sustainable performance.

Governance in Financial Institutions and Conflicts of Interest

Agency theory, which deals with the conflict of interest between principles and agents, has been a concern since Adam Smith’s 1776 Wealth of Nations. Berle and Means (1932) stated that the most important feature of modern firms is to separate the firm’s owner from its management because conflicts between the two lead to a divergence of interest between managers and owners. Jensen and Meckling (1976) describe this as a relationship of authority. As stated by Lambert (2001), agency theory evaluates the impact of the conflicts of interest between principals and agents for the following reasons:

  • shirking by the agent,

  • the diversion of resources by the agent for private consumption,

  • the differential time horizon of the agent and the principal, and

  • differential risk aversion of the agent and the principal.

The corporate governance aims to solve the agency problem by mechanisms such as board directors, compensation systems, dominance of majority shareholders, and the labor market professionals. The general agency problem can be characterized as a situation in which a principal (or group of principals) seeks to establish incentives for an agent (or group of agents) who takes decisions on behalf of the principal and that affect the principal. The agent is expected to act in ways that contribute to maximizing the principal’s own objectives. The difficulties in establishing such an incentive structure arise from either divergence of the objectives of principals and agents or from the asymmetric information between principals and agents (Vickers & Yarrow, 1988). Jensen and Meckling (1976) described the problem more generally as the conflict of interest between “principals” (shareholders) and their “agents” (managers). According to Baums and Scott (2005), the basic problem is that agents and managers are entrusted by principals and investors to issue authority over their property and capital, which is supposed to be used to advance the interests of the owners rather than creating personal gains for the agents (Aras, 2008).

Jensen and Meckling (1976) developed agency theory in the context of the conflicts of interest between corporate managers and external equity and debt holders. Agency theory starts with the assumption that people act unreservedly in their own narrowly defined self-interest with, if necessary, guile and deceit. The firm is usually seen as a set of contracts between the various parties involved in the production process including the owners, managers, workforce, and creditors among others. Agency theory switches the center of attention from the firm to the set of contracts that defines each firm. It is primarily concerned with the contracts and relationships between principals and agents under conditions of asymmetric information (Aras, 2008). On the other hand, stakeholder theory (Freeman, 1984) in corporate management argues that there is a variety of stakeholders involved in the organization and each deserves some return for involvement. Accordingly, management is the process of balancing these various stakeholders’ interests aligned in the same direction. According to stakeholder theory, corporate value is maximized if the business is operated by its management on behalf of all stakeholders and returns are divided appropriately amongst those stakeholders in a way that is acceptable to all. However, a single, universally accepted mechanism for dividing returns among all stakeholders does not exist, and stakeholder theory is significantly lacking in suggestions in this respect. Nevertheless this theory has considerable traction and is based upon the premise that operating a business in this manner achieves outcomes in the long-run optimization of returns to shareholders. Stakeholder theory is premised on the recognition that corporations are “externality machines” (Greenfield, 2006) and without due consideration of these externalities, shareholder value maximization may come at a very high cost to everyone else. The optimization of returns to stakeholders is achieved in the long run through the optimization of performance for the business and achieving a balanced consideration of all stakeholders’ interests. Consequently, the role of management is to optimize the long-term performance of the business to this end, thereby rewarding all stakeholders appropriately, including themselves as stakeholders in a community of stakeholders.

Agency theory and shareholder theory have been the paradigmatic theories of corporate governance. Agency and stakeholder theories can be regarded as competing normative theories of the operations of a firm; they lead to different operational foci, different conceptions of management’s responsibilities, and different implications for the measurement and reporting of performance. It is significant however that both theories have one feature in common: The management of the firm is believed to be acting on behalf of others, either shareholders or stakeholders in general, and they do so not because of altruism but because they are rewarded appropriately. Therefore, much effort is devoted to the creation of reward schemes that motivate these managers to achieve the desired ends (Aras & Williams, 2017).

The foundations of the conflicts between shareholders and executives are identified by principal-agent theory that result in further works that focus on providing the most efficient structures and governance models for the company (Aluchna, 2015). For financial institutions, the scope of corporate governance goes beyond the shareholders (equity governance) to include debt holders, insurance policy holders, and other creditors (debt governance). From the perspective of the supervision of financial institutions, debt governance is the primary concern in governance. Failures in corporate governance of banks and other financial institutions contributed to the financial crisis. In Hopt’s study (2013), equity governance and debt governance face partly parallel and partly divergent interests of management, shareholders, debtholders, supervisors and other creditors. Management tends to be risk averse for lack of diversification, but may be more risk prone because of equity-based compensation in final outcome. The normal shareholders are interested in the share price and the dividends (rational apathy); and therefore cannot be a counterbalance to the risk-taking of the directors. On the contrary, they will demand more bank profit and higher dividends. These shareholders cannot be expected to take into consideration the interests of debt holders; in reality, they may actually be risk prone in the hope that if the risk materializes they will lose only their share while the real losses will be borne by the debt holders. On the other hand, the debt holders are interested not in the profit of the bank as such but in being paid. They are therefore risk averse, especially to ex-post risk extension. Yet as in the case of shareholders, the interest and incentives of the debtholders differ widely. Supervisors are risk averse and interested in maintaining financial stability and in preventing systemic crises especially. Finally, all of these factors contribute to making the governance of financial institutions unique.

The corporate governance function encompasses the role of financial systems in alleviating agency problems that arise among stakeholders in the firm. The degree to which the financial system influences economic performance in the real sector depends on how effectively it carries out its governance functions as well as capital allocation functions (Tadesse, 2003). Major decisions within the financial institutions are mainly influenced by the board of directors and by external governors such as market participants, regulators, and legislators. These forces are not all equal and their interests do not always align because they do not always want the same outcomes or risk profiles for financial institutions. Just as principal-agent problems exist between the owners and managers of firms, there may also be a disconnect between the interests of society and those of regulators who are designated protectors of the public interest (Levine, 2011).

Good Governance for Resilient and Sustainable Financial Institutions and Capital Markets

Good corporate governance is required in all sectors, but especially in financial institutions. The financial sector plays the central role of intermediating savings and allocation of capital in the economy. Firms in the financial sector are key players in creating market disciplines favoring better standards in the corporate sector. Most of these firms have important fiduciary functions and act as internal or external monitors. In part, conflicts of interest are more common due to the multiplicity of intermediaries and the increasing consolidation in the financial sector across different activities.

After the waves of deregulation and the technology revolution of the 1970s and 1980s, financial institutions and their activities and products underwent a profound change. In banks, there was a veritable explosion of off–balance sheet items triggered by forays into more complex financial products, such as derivatives and securitizations. The boundaries between banks, securities firms, investment banks, and insurance companies blurred, and their products began to straddle the different market segments. Bank books took on market risks arising from their trading activities, including positions in equity, debt, commodities, and foreign exchange. Traditional functions of banking widened and comprised capital markets activities and insurance business, and more complex and opaque structures of banks has emerged. Such structures have been shown to be a major impediment to good corporate governance of banks and led to grave risk management and internal control failures (Hopt, 2013).

Although the capital markets have a vital function in the financial system, in recent times, “the governance of financial institutions” usually referred to the institutions in the banking sector. The governance of capital market institutions did not receive equal interest from academics or from the business sector (Aras & Yobas, 2013). Extant studies analyze the relation between the efficiency of equity markets, bank financing, and corporate governance (Qian & Yeung, 2015, p. 258). At the same time, banks play an important role in examining firm quality and disciplining them through creditor rights enforcement. Qian and Yeung (2015) reckon that the disciplinary roles of equity capital markets and banks are interconnected. Banks as financial intermediaries in capital markets require investor and depositor confidence as a whole.

The OECD Council Meeting at Ministerial Level (2002) noted that the integrity of corporations, financial institutions, and markets is essential to maintain confidence in economic activity and protect the interests of stakeholders. The importance of governance of capital markets is also at the center of World Bank studies. In World Bank research papers, corporate governance is emphasized as a key component of capital market development. It is also stated that good corporate governance reduces emerging market vulnerability to financial crises, reduces transaction costs and cost of capital, and leads to capital market development. The global financial crisis was a stark reminder to the world’s financial community of how important corporate governance is to global financial stability. It illustrated that markets will not always correct themselves, and that the ethical standards central to good corporate governance are not always apparent in the actions of market participants (UNCTAD, 2010, p. 130).

Corporate governance provides sustainable economic development via increasing the performance of companies and their access to outside capital. Governance weaknesses at financial institutions can result in the transmission of problems across the finance sector and the economy as a whole. Good corporate governance has stabilizing and growth effect on the macro economy. According to Mayer (2002), there is a strong relationship between economic growth and financial development. The economic benefit of corporate governance can be based on the protection of investors since it is a crucial determinant of the financial system. The development of financial systems is partly related to the external financing of companies, which plays a key role for investors’ protection in promoting the external financing and growth firms. Creating confidence ensures stability in the management of the financial well-being. Therefore, good governance discipline helps increase confidence and trust in the existing system, which is vital for all stakeholders.

To maximize wealth for their shareholders, financial institutions are inclined to take extreme risks that can increase instability in the financial system. Many negative consequences for the economy, however, could be avoided by improving the quality of the corporate governance practices of financial firms (Zagorchev & Gao, 2015). As asserted by Kirkpatrick (2009), a substantial part of the 2008 financial turmoil can be “attributed to failures and weaknesses in corporate governance arrangements” (p. 2). Zagorchev and Gao (2015) provide evidence suggesting that governance mechanisms are likely to diminish excessive risk taking and positively affect the performance of financial institutions. Moreover, combining firm profitability with specific corporate governance components, including executive directors’ stock ownership, greater board independence, more board committees, and reduced reliance on a staggered board have beneficial effects for financial institutions.

Policy makers try to improve current legislation by enabling better monitoring of financial institutions’ activities. Public policy makers have also started to question the appropriateness of the current corporate governance applied to financial institutions. In particular, the role and the profile of risk management in financial institutions have been put under scrutiny. In many recent policy documents, comprehensive risk management frameworks are outlined in combination with recommended governance structures (e.g., Basel Committee, 2008; FSA, 2008; IIF, 2007). One common recommendation is to “put risk high on the agenda” by creating respective structures. This can involve many different actions. As already claimed by the Sarbanes-Oxley Act in 2002, financial expertise is considered to play an important role. Otherwise, more specific measures involve either the creation of a dedicated risk committee or designating a chief risk officer who oversees all relevant risks within the institution (Aebi, Sabato, & Schmid, 2012, p. 3214).

The new postcrisis global financial architecture may still be under construction, but significant positive characteristics are already emerging. Decision making in the new structures will be more inclusive and democratic. Standards will be more likely to converge in the interests of transparency and disclosure, and greater enforcement cooperation across jurisdictions will leave transgressors with fewer places to hide. The International Organization of Securities Commissions (IOSCO) is optimistic that investors will be better served and sustainable growth will better be supported by markets that recognize good governance in business (UNCTAD, 2010, p. 130).

Effective corporate governance is critical to the proper functioning, safety, efficiency, and overall stability and resilience of capital markets. Based on acknowledged international standards, global capital markets need consistent and harmonized high-quality regulation to identify vulnerabilities that potentially trigger a higher level of market risks and lead to financial instability. To this end, emerging markets regulators, through IOSCO, can play a prominent role in coordinating their activities, benchmark approaches, and practices, while taking into consideration the special characteristics and conditions of each market reality.

Capital markets regulators deal with major issues, such as breaches and instabilities that impact capital markets, that could be prevented through effective corporate governance structures. The promotion of good governance practices should permeate the regulatory activity in its all dimensions, being translated into proper, balanced, and truly effective regulatory requirements, recommendations, and policies that contribute to market resilience (IOSCO, 2016).

Governance of Banks and Financial Crises

The recent financial crisis was a severe wake-up call because it has adversely affected employment, consumer spending, pensions, the finances of national and local governments worldwide, and the global economy. Weaknesses in corporate governance structures within companies and banks were cited as reasons for excessive risk taking, skewed incentive compensation for senior managers, and the predominance of a board culture that values short-term gains over sustained, long-term performance (Claessens & Yurtoglu, 2012). Financial institutions are special in terms of risk management because of the particular challenges faced in ensuring effective risk management and the systemic risks they may pose to the financial system. We all witnessed how regulators missed the potential systemic impact of various classes of financial products, such as subprime mortgages, and in general failed to spot the large systemic risks that had been growing during the previous two decades (G30, 2012). The financial and economic crisis has shown that there are failures in governance and problems with the market system. These have been the main issues depicted as representative of systemic failures of the market system with contagion effect and the lax application of systems of governance and regulation. Thus many people are arguing for improved systems to combat this. Naturally many people have discussed these failures and the consequent problems and will continue to monitor them in the future. The main differences are that recent cycles are driven by the financial markets and the era of globalization means that no country is immune to the effects felt in other countries. The globalization and systemic risk effect should stifle the debate about preventing future occurrences through the introduction of an enhanced regulatory regime. Regulators are bounded by their terms and areas of reference, whereas finance and trade is increasingly without boundaries. So the only form of regulation that would be effective is a global system of regulation (Aras, 2015a).

Focus of corporate governance in financial institutions diverges from the typical value- maximization focus of corporate governance and reflects the unique position of financial institutions vis-à-vis the broader economy. The role of banks as efficient allocators of scarce capital throughout the rest of the economy requires a new definition of an ideal financial institution, as well as new metrics for measuring good governance and strong performance. Although Mehran and Mollineaux (2012) point out that a healthy economy cannot exist without a well-functioning financial system, they also imply that the long-run stability of the financial system is not well understood. Therefore, they focus primarily on banks because problems of corporate governance arise within the banking industry and leads to suggestions for the governance of financial institutions as well as the governance of the financial system as a whole. Zagorchev and Gao (2015) imply that research on the governance of financial institutions is motivated by three specific corporate characteristics:

  1. 1. Financial institutions tend to be more opaque and have greater information asymmetries than nonfinancial companies;

  2. 2. Banks are very different from nonfinancial firms since they are regulated and have deposit insurance due to their importance and opacity;

  3. 3. Financial firms and their managers should have fiduciary duties to both nonshareholders and shareholders.

Therefore, consistent with Laeven (2007) and Mehran, Morrison, and Shapiro (2011), the government is also a stakeholder in banks in that people are highly concerned about and affected by bank failures. This suggests that financial institutions have more stakeholders than nonfinancial companies. Mehran and Mollineaux (2012) stress the importance of information and incentivizing market discipline through disclosure as a critical component of studying and improving the corporate governance of financial institutions. How market discipline will shape behavior and how the information content of prices will be affected depend on who produces the information, what is disclosed, when it is disclosed, and under what economic conditions it is disclosed. Given the homogeneity of banks and bank holding companies and the contagious nature of information, it is important to identify who discloses the information. Even more important is the content of what is disclosed. As asserted by Mehran et al. (2011), two key differences distinguish the governance of banks from that of nonfinancial firms. The first is that banks have many more stakeholders than nonfinancial firms since banks consist of more than 90% debt as opposed to an average of 40% for nonfinancial firms. The second is that the business of banks is opaque and complex and can shift rather quickly. Levine (2004) emphasizes two main reasons for a separate analysis of banks’ corporate governance:

  1. 1. Banks are generally less transparent than nonfinancial companies. For instance, loan quality is not always observed and disclosed for long periods. Banks can change the risk composition to their advantage more quickly and take over the problems by extending loans to clients who cannot fulfill previous debt obligations. Briefly, the first reason for separate analysis for corporate governance in banking is based on accruing information.

  2. 2. Banks are important for the economy and their activities are vital to observing economic policy. Governments have banks and the international standard organizations guarantee heavy involvement in the banking industry, such as Bank for International Settlements, International Monetary Fund, and World Bank implementation. When the bank is owned by the government, the governance character is perceived differently.

It is generally agreed that the latest financial crisis was caused by excess risk taking and increasing systemic risk, and these shortcomings in financial institutions’ corporate governance played a central role in the contagion of effects. The recent crisis is often described as the most serious financial crisis since the Great Depression. It is therefore crucial for bodies such as the OECD Steering Group on Corporate Governance and others to examine the situation in the banking sector and assess the main lessons for corporate governance going forward (UNCTAD, 2010, p. 55). The main irony of the governance failures of 2007–2008 was that many took place in some of the most sophisticated banks operating in some of the most developed governance environments in the world, such as the United States and the United Kingdom. A variety of studies have been carried out to analyze the contribution of weak governance to bank failures and more broadly, to the financial crisis. The majority of their conclusions can be categorized into four broad areas (UNCTAD, 2010):

  • Risk governance

  • Remuneration and alignment of incentive structures

  • Board independence, qualifications, and composition

  • Shareholder engagement

Inadequate risk management and inappropriate pay practices in the financial industry are being placed squarely at the center of the financial crisis. Pay-setting and risk management takes place in the context of a set of corporate governance practices and structures. Hence, the view of the OECD that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements” (Kirkpatrick, 2009, p. 2) is shared by a number of key policy makers.

Monks and Minow (2011) point out that good corporate governance requires a complex system of checks and balances. In essence, corporate governance is the structure that is intended (a) to make sure that the right questions are asked and (b) that checks and balances are in place to make sure that the answers reflect what is best for the creation of long-term, sustainable, renewable value. Two firm-level policies that significantly affected the magnitude of shareholder losses during the crisis have received considerable attention from academics and investors: (1) risk management before the crisis and (2) equity capital raisings during the crisis (Erkens, Hung, & Matos, 2012). Erkens et al. (2012) provide empirical evidence on how corporate governance influenced the performance of financial firms during the latest financial crisis.

A 2010 European Commission report asserted that the financial crisis highlighted poor enforcement of existing rules and regulations on corporate governance and inadequate supervisory control of governance practices in financial institutions. In many cases, supervisors did not monitor whether risk management frameworks and internal organizations were well-adapted to changes to business models and financial innovation. They also failed to ensure appropriate expertise of boards and to apply a “fit and proper” test, focusing essentially on a probity test. Five main areas can be identified where the banks failed to accommodate the Basel Committee’s (2010) governance principles during the 2008 financial crisis (Hopt, 2013):

  • Risk management and internal control failures

  • Deficiencies in the profile and practice of directors and senior management

  • Complex and opaque corporate and bank structures

  • Perverse incentives

  • Failures in disclosure and transparency

These principles, frameworks, and recommendations fell short for several reasons: The 1999 version of Basel Committee’s governance principles put too much emphasis on shareholders; the 2006 revision recognized the need to protect depositors and other creditors but came too late; and well-established principles, such as those on internal control, were not sufficiently applied.

Evolving Corporate Governance Principles for Banks

OECD principles are keystones for corporate governance implementation; however, these principles are not specific to financial institutions. The Basel Committee,1 the International Monetary Fund, the World Bank, and other organizations have published principles for financial institutions and governments developed many codes for both state-owned and private institutions.

The United States, the European Commission, and individual nations conducted their own reviews of local bank failures and put forward laws and recommendations (European Commission, 2010a). These include the Dodd-Frank bill in the United States, the Walker Recommendations in the United Kingdom, and the European Commission’s green paper on the Corporate Governance of Financial Institutions and Remuneration Policies (2010b).

The Basel Committee formulated specific recommendations for bank governance in 1999. These principles were updated in 2006, 2010, and 2015. The 2010 principles sought to reflect key lessons from the global financial crisis that began in 2007 and to enhance how banks govern themselves and how supervisors oversee this governance. The 2010 report overhauled the 2006 report fundamentally. The recommendations provided guidance to establish a new regulatory framework on top of the law, regulations, and codes. They are principle-based rather than rule-based and aim to ensure that implementation by all banks is proportionate to size, complexity, structure, economic significance, and risk profile of the bank or the group. In the Basel Committee’s eight principles for good corporate governance of banks in 2006, the word “risk” does not appear at all, while in its fourteen principles of 2010 it appears in nine of the fourteen principles. In banking, key risks include credit, market, operations, compliance, and reputation, among others. Yet during the financial crisis it became evident that many of these risks had been neglected, underestimated, or not understood or taken into consideration, particularly in the case of systemic risks (see Basel Committee, 2010; Hopt, 2013).

Given the widespread failure of risk management, it is not surprising to see the increased focus on risk oversight and board accountability for risk following the financial crisis—to establish a risk culture and robust risk systems and processes to enable better risk oversight. The Basel Principles of 2015 respond to a need for a holistic approach to risk: risk culture, risk appetite, risk competence, and alignment of compensation with risk. Key revisions specifically support the following (IFC, 2016):

  1. 1. Strengthen the guidance on risk governance, including the risk management roles played by business units, risk management teams, and internal audit and control functions (the three lines of defense) and the importance of a sound risk culture to drive risk management within a bank;

  2. 2. Expand the guidance on the role of the board of directors in overseeing the implementation of effective risk management systems;

  3. 3. Emphasize the importance of the board’s collective competence as well as the obligation on individual board members to dedicate sufficient time to their mandates and to remain current on developments in banking;

  4. 4. Provide guidance for bank supervisors in evaluating the processes used by banks to select board members and senior management; and

  5. 5. Recognize that compensation systems form a key component of the governance and incentive structure through which the board and senior management of a bank convey acceptable risk-taking behavior and reinforce the bank’s operating and risk culture.

Corporate governance of banks in the past focused more on corporate governance structures. Since the financial crisis, the emphasis has turned more to the achievement of better corporate governance through increased board effectiveness. Therefore, greater emphasis is not just on “fit and proper” people (as individual board directors), but the Basel Committee’s 2015 guidelines also wants to see “fit and proper” applied to the entire board to ensure collective competence. The Basel Committee wants the board collectively to have the skills and experience for adequate oversight and to have the time and the competence to challenge management and truly hold management accountable. The focus is on board effectiveness (IFC, 2016).

It is important to note that “collective responsibility” of the board refers to the board’s duty to the company and to all its shareholders. In its decision making, the board must act in good faith and in the best interests of the company. It should perform its duties efficiently and effectively and operate in a financially responsible manner. The decisions of the board are collective decisions and bind the company. The board is especially expected to play an effective role in risk governance. For example, board supervision of a bank is expected to be effective in at least three areas: risk appetite, risk strategy, and risk oversight and culture. The board is therefore expected to “own” the results in these areas (IFC, 2016). The role of a chief risk officer (CRO) has also been made clearer, with internal links between risk officers, compliance officers, and internal auditors in supporting and testing internal controls and the overall company control environment being strengthened. Closer collaboration is expected between the CRO and the board committee overseeing risk. More work is needed by both national authorities and banks to establish effective risk governance frameworks and to enumerate expectations for third-party reviews of the framework. Banks also need to enhance the authority and independence of CROs. National authorities need to strengthen their ability to assess the effectiveness of a bank’s risk governance and its risk culture and should engage more frequently with the board and its risk and audit committees (Basel Committee, 2015).

Conclusion

This article aims to investigate governance mechanism of financial institutions in the light of governance theories and internationally accepted governance principles for financial institutions. Financial institutions play an increasingly important role in corporate governance, and failures in the corporate governance of banks and other financial institutions contributed to the financial crisis. Corporate governance, especially in financial institutions, is essential to guaranteeing a sound financial system and stable economy. However, financial institutions and services have a distinctive nature that requires specific corporate governance principles. After heavy damage was inflicted by the 2008 financial crisis, public policy makers started to question not only the appropriateness of the corporate governance practices in financial institutions but also better implementation of governance principles. Since that time, the Basel Committee on Banking Supervision has regularly improved corporate governance principles for banking.

The Basel Committee’s 2015 guidelines imply that risk management and internal controls are critical for governance of financial institutions, particularly for banks. A better understanding of the important elements of corporate governance such as effective board oversight, rigorous risk management, strong internal controls, compliance, and other related areas will mitigate the risk of a financial crisis similar to 2008. Divergent interests of stakeholders should be managed effectively and the primary objective of corporate governance should be safeguarding stakeholders’ interest in conformity with public interest on a sustainable basis. Similarly, IFC (2016) research also pointed out that significant and widespread changes have occurred in corporate governance of financial institutions in the wake of the financial crisis of 2008. Areas of corporate governance practices that have seen noteworthy changes are control environment and risk, transparency and disclosure, shareholder rights, increased commitment to good corporate governance, and the examination and strengthening of corporate governance codes.

All developments in corporate governance improve the quality of information available to the board, boost the performance of management, and enhance the company’s awareness of attention to risk, all of which should benefit the company and support the achievement of its objectives in the long term. It is highly likely that such developments will continue to regulate the market for the benefit of corporate governance in market development, economic growth, and stability. This is the “new normal” in corporate governance (IFC, 2016). Globally, many financial services firms have drawn lessons from the recent financial crisis. However, even though governance principles are developed, it is still not possible to conclude that governance in leading financial institutions has been fully addressed. Governance is an ongoing process and should not be considered as a fixed set of guidelines and procedures. In order to prevent another crisis, better regulation of financial institutions and greater global coordination among regulators are crucial.

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                                                                                                                        Notes:

                                                                                                                        (1.) The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It usually meets at the Bank for International Settlements in Basel, Switzerland, where its permanent Secretariat is located.