The Basel Committee on Banking Supervision has circulated a consultative document on corporate governance principles for banks in October 2014, issued for comments by 9th January 2015. This is an enhanced version of earlier paper issued in 2010 in response to credit crisis.
The main objective of corporate governance to enhance long-term shareholders’ value through right oversight mechanism. However, the implementation of corporate governance has always been a challenge, considering the opacity and complexity of the governance structure of the banks, along with the growing challenges in regulatory interface. The corporate governance in banks is unlike that in non-financial intuitions, as the bank can alter the risk compositions of the assets more than non-financial institutions. Further, the operations of the banks are more complex than that of non-financial institutions, generally. Studies on financial crisis showed evidence of relationship between default and influence of corporate governance structure on risk taking.
The governance objective of the bank to maximise shareholders’ wealth by taking good risk only. So there has a growing need to differentiate between good risk and bad risk, where corporate governance plays a crucial role. Risk appetite statement (RAS) is a board level document. It defines what risks a bank should take as the banks intend to avoid or mitigate bad risks. Risk appetite assesses the level of additional risk for additional opportunities. Good Corporate governance essentially means the bank understands and keeps right amount of good risks. Credit crisis is a natural experiment for risk in the governance.
The lesson learnt is good governance essentially means less bank failure. There are many talks around involvement of shareholders in governance process. However it is evidenced that more involved CEO led to better governance as his/her survival is dependent on the success of the bank. There are several discussion going around on independence of risk managers An elevated Chief Risk Officer (CRO) is crucial for good corporate governance. Higher that status of Chief Risk Officer lesser the risks for the bank. There is also a need to put in place of an entranced process rather than just policy. The process needs to ensure that the risk manager reports independent of the business lines that he/she is monitoring. Other important areas are risk quantification and risk organisation. Differentiation between good risk and bad risk, and risk aggregation across different risks bank wide, need to be ensured. Risk organisation structure should be optimal for the bank with visibility of right decision making process. Risk organisation is bank-specific as it differs from bank to bank. Shareholding patterns also have an impact.
The lower-level managers with considerable shareholdings and direct influences on the bank’s daily operations may take on more risk for moral hazard problem. Independence of board directors and quality of independent director is crucial for corporate governance. Especially for the independent director enjoys a higher public visibility and is subject to reputation risk for default of the bank. This ensures more involvement of the independent director. No evidence is found on the relationship between board size and performance of the bank.
The board should be well qualified to challenge the management of the bank on risk governance. However, a reputed financial institution, in question during credit crisis, had a board containing a former CEO, a top fund manager, and a previous member of the Bank of England’s governing body. Despite of these, the financial institution could not perform well in credit crisis. Another point is risk culture. Risk culture is needed to be built in the process accessible to everybody in the organisation.
The effectiveness of corporate governance is also reflected in market discipline. Disclosures assume importance to all as many of the banks are too complex in structure to understand, which raises “too-complex-to-fail” problem. Regarding compensation, the bank’s board should measure the effect of compensation on the bank’s solvency which necessitates building right metrics. During the financial crisis, it was found that compensation with higher-risk taking incentives worked against the right governance. The excess risk taking by CEO may be controlled by linking CEO’s compensation to the bank's CDS spread.
A peer review conducted by Financial Stability Board (FSB) in 2014 says that banks have made good progress in improving corporate governance. However, many issues to needs to be raised and resolved. So, let us wait to see the comments to be received from the banks on the BCBS paper on the corporate governance in banks under consultation.
Comments