Chapter 20
Corporate Governance and Supervision: From Basel II to Basel III
1. INTRODUCTION: CORPORATE GOVERNANCE AND THE SPECIAL CASE OF BANKS
One of the best known definitions of corporate governance is the one used by the influential Cadbury Committee,1 which described corporate governance as “the system by which companies are directed and controlled.”2 Over time the definition has been refined in various ways by authors who are keen to draw attention to the relationships involved in the process of direction, and crucially to specify for whose benefit the organisation is being controlled. Any definition rooted in economics focuses on the relationship between managers (in practice the board of directors, as controllers) and shareholders (as owners of the business in whose interests it is run). Given that most businesses are not entirely funded by equity, other approaches include lenders alongside shareholders as beneficiaries of the process. A still broader definition, and one which is espoused by the OECD,3 is based on the idea that companies exist for the benefit of a range of stakeholders, so corporate governance is concerned with a set of potentially complex relationships between management, shareholders, lenders, employees, customers, and wider society.
This approach is useful in thinking about the corporate governance of banks because they play a pivotal role in the economy. We need look no further than the recent banking crisis for proof of this. Governments across the globe have rescued banks from failure, not because they wanted to protect the interests of their shareholders but because they wanted to protect depositors and to ensure that funds would be available to borrowers. In other words, governments have bailed out banks in order to safeguard stakeholders. This view that banks are special because of their relationships with a myriad of stakeholders helps to explain why some countries regulating the governance of listed companies (including banks) through corporate governance codes have issued special codes for banks and other types of financial institutions. It also explains why international bodies like the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) take such an active interest in banks’ governance.
In this chapter we will consider some of the common features of corporate governance regulation affecting companies across the globe before going on to look at banks as a special case. The BCBS has published guidance on corporate governance in banks; here we will focus on recent changes in that guidance as it affects risk management, remuneration practices, and transparency in banking structures. As we will see, the recent banking crisis exposed shortcomings in each of these areas, so it is vital that banks improve their governance practices in order to protect themselves and to better serve their stakeholders.
2. REGULATION AND THE CORPORATE GOVERNANCE OF LISTED COMPANIES
If we accept the view that corporate governance is concerned with the relationships between stakeholders, it is clear that it is regulated in a variety of ways, including the laws on securities, bankruptcy, and employment as well as through accounting standards and stock exchange listing requirements. In many jurisdictions, a code of corporate governance4 forms part of those listing requirements. Codes of corporate governance tend to focus on the role and composition of the board of directors, since it is ultimately up to the board to manage relationships between the company’s various stakeholding groups. Most codes are based on the “comply or explain” principle, which means that the company can choose either to comply with the code’s recommendations or to deviate from some or all of them, as long as it explains in its annual report or some other publication why it has chosen an alternative practice. Among the benefits of this approach are that it recognises the impossibility of formulating one set of rules that makes sense for all businesses in all situations, and that it requires companies themselves to draw attention to those practices that deviate from the code. This allows the market, rather than the regulator, to determine the importance of the deviation and, if it is judged serious, to “punish” the company by reducing its share price. While the detailed requirements differ from code to code, most emphasise the importance of sharing power at the top of the organisation, of ensuring that directors can bring independent judgement to the board’s deliberations, and of delegating specific areas of oversight to small subcommittees of the board.
While every board of directors has a variety of tasks to perform, most can be classified under one of two headings: strategy and monitoring. The implementation of strategy must be overseen by someone who works full-time in the company, while oversight of the monitoring function is arguably best done by someone who can bring truly independent judgement to bear on the company’s behaviour. This is why most codes recommend that the chief executive officer (CEO) who runs the company should not chair, that is run, the board, arguing instead that the chair should be a non-executive or independent director. A non-executive director is simply a director who is not employed by the company in question, while to be deemed independent they must pass certain other tests, which vary from country to country but are designed to ensure that the director does not have business or personal links to this company. In countries where the stock market is large, there is a big pool of experienced directors from which to draw when choosing non-executive directors. This makes it viable to write the code in terms of independent directors. In countries where few companies are listed the number of available independent directors is much smaller, so it may be necessary to make recommendations with reference to non-executives, recognising that some of them may have business relationships with the companies on whose boards they sit.
In addition to the requirement that the board chair should be a non-executive or independent director, most codes specify that a minimum percentage of all board members should be either non-executives or independent. This allows the board to form smaller specialist independent subcommittees responsible for the oversight of specific areas of governance. The three subcommittees that are usually recommended are the audit, remuneration, and nomination committees. The audit committee has a wide remit. It is responsible for the oversight of the company’s financial controls, reporting system, and relationship with its auditors. In the absence of a specialist risk committee it should also ensure that the risks taken by the business are compatible with the shareholders’ preferences. The remuneration committee is responsible for formulating a remuneration policy that rewards executive directors for creating shareholder wealth. This involves the design of remuneration packages that build in the right blend of incentives. In doing this, the committee may draw on the expertise of remuneration consultants. It is up to the nomination committee to recognise skills gaps on the board and to seek out new independent directors who can fill those gaps as and when board vacancies occur.
Implicit in the discussion so far is the assumption that companies are overseen by a single board. While this is the case in English-speaking countries, the dual-board system is used extensively in continental Europe and Asia. While the details vary from country to country, in this system a team of executives forms the management board, which as the title suggests is responsible for the strategy and management of the company, overseen by a supervisory board made up of independent directors and in some cases, employees or their representatives. In such a system there is a clear distinction between the CEO who runs the company and sits on the management board and the chair of the supervisory board, and the subcommittees are drawn from the members of the supervisory board to ensure that they operate independently.
Codes of corporate governance apply to all banks that are listed on the stock market. Clearly, bearing in mind recent controversies over the operation of banks, the functions of the audit or risk committee and the remuneration committee are of specific interest in the banking industry. These are influenced by Basel II and in some states by additional codes of conduct applying only to banks. In some countries (Georgia,5 Nigeria,6 Qatar,7 and Singapore,8 for example) the board is urged to set up a risk committee; in The Netherlands it is up to the executive board to specify the bank’s risk appetite for approval by the supervisory board at least once a year. In addition, the Dutch code specifies that executive board members’ remuneration must be consistent with the bank’s risk policy. This emphasis on risk in banking codes is entirely consistent with the advice of the BCBS, as we will see in the next section of this chapter.
3. BASEL PILLAR 2 AND CORPORATE GOVERNANCE IN BANKS
Basel II is based on the BCBS’s Three Pillars of Regulation. The first is concerned with minimum capital requirements, where capital is defined in relation to market risk. The second relates to the supervision of capital adequacy, and the third to market discipline based on reporting by banks. Pillar 2 is based on four key principles, the first of which is of most interest in the context of corporate governance because it relates to banks rather than to their supervisors, as the other three do. This principle states that “banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.”9 Given that this principle refers to risk and strategy, it links directly to the operation of banks’ boards whose governance role extends to risk and capital adequacy. The BCBS has been offering guidance on the enhancement of corporate governance since 1999. That guidance is based on the OECD “Principles of Corporate Governance,” which were first published in 1999 then amended in 2004. The BCBS has followed the OECD’s lead, updating its advice as the OECD principles were updated, but has in addition offered further guidance in the light of the financial crisis of 2007 and beyond.
The OECD principles cover six areas of governance more general than the provisions discussed in Section 2. This reflects the fact that the principles are designed to guide policy makers around the world. Some will be using them to start from scratch in regulating governance, while others will be building on existing legislation. The six principles discuss the basis of an effective governance framework, shareholder rights, the treatment of stakeholders, transparency, and the role of the board. As we have already seen, national corporate governance codes tend to focus on the role of the board, as do the eight principles discussed in BCBS (2006).10 These eight principles had grown to fourteen by the time the BCBS published its 2010 principles.11 They provide rather more detail in three key areas of governance that have assumed greater prominence since the 2007 banking crisis and its aftermath. These are risk management, remuneration practices, and transparency in corporate structures.
3.1 Risk Management
The OECD principles state clearly that risk management is a key responsibility of the board of directors. While legislation usually implies that the entire board has responsibility for the oversight of fundamentally important areas like this, in practice much of the work is devolved to either the audit committee or to a specialist risk committee. The BCBS is concerned that risks are poorly articulated and communicated between different divisions of banks, implying that risks taken at lower levels in the organisation can thwart board policy, yet recent evidence suggests that boards themselves, acting in the interests of shareholders may be responsible for excessive risk taking in banks.
The moral hazard problem facing shareholders is well documented in the corporate finance literature. The risk faced by shareholders increases when companies use debt financing because the risk associated with the assets financed by debt is borne by the shareholders, and in addition interest payments increase costs and so reduce the profit pool from which dividends are paid. This can lead shareholders to advocate risk taking, knowing that when the risks pay off they will reap all the benefits, but when things go wrong the debt holders will share the pain as the company struggles to make interest payments and, in the last resort, becomes insolvent, so that the debt holders are left facing losses.12 This may be a particular problem in banks, given that, as Gualandri and colleagues13 point out, they are often more highly leveraged than other firms. This propensity to take risk is heightened if the company is protected from the worst consequences of such financial distress. Again this is exactly the case in the banking industry where deposit insurance and the too-big-to-fail mentality protect banks from the consequences of poor or overly risky decision making.
Laeven and Levine14 provide evidence based on data from 48 countries that concentrated ownership leads to greater risk taking. While risk taking can be mitigated by strong regulatory oversight of banks, this effect is felt less strongly when ownership is concentrated in the hands of a few large shareholders. Caprio and colleagues15 provide evidence that block holders are important owners of bank shares. In their sample of banks in 44 countries, the “average” country has 75 percent of its banks controlled by a block holder. This means that regulators need to find ways to curb the tendency of shareholders to encourage risk-taking. One possible solution is implied by Pathan.16 He finds that strong boards, those that represent shareholders’ interests, are associated with greater risk taking by American banks. His definition of a strong board is three-fold, based on small board size, the proportion of independent directors, and finally nonrestrictive shareholder rights, which are measured by the absence of both a staggered board17 and of poison pills. While small boards and nonrestrictive shareholder rights lead to more risk taking, when the board has a higher proportion of independent directors the bank takes fewer risks. This may be because these directors take a wider, stakeholder-oriented view of their role, rather than acting solely on behalf of their shareholders.
The tension between independent directors and powerful shareholders appears also in the work of Erkens and colleagues.18 They examined the consequences for institutional shareholders and independent boards for banks’ stock returns in 30 countries during the financial crisis. They found that higher levels of institutional ownership and board independence were associated with lower returns. They hypothesised that this was related to risk taking before the onset of the crisis, but crucially discovered that while greater institutional ownership encouraged risk taking, board independence did not. In fact those banks with independent boards raised equity to boost their capital, which transferred wealth to their debt holders from the existing shareholders, consistent with a stakeholder orientation. These findings are important because empirical evidence on the relationship between board independence and corporate value in nonfinancial institutions is largely inconclusive, casting doubt on the efficacy of independent directors. Here we can see a clear rationale for regulation that encourages board independence in banks so as to alleviate the moral hazard problem.
To make sure that policy and day-to-day decisions are consistent with its strategy the board is advised10 to establish a risk committee, and if the bank is large or has international operations, to appoint a chief risk officer (CRO). The risk committee should be responsible for advising on the bank’s risk appetite both today and in the future. Both the risk management function within the bank and the CRO should have access to the committee, which should also be able to take advice from external experts on matters such as mergers and acquisitions. The principles give no guidance on the composition of the committee, but national codes of corporate governance—those that assume risk management will be undertaken by the audit committee—usually specify that it should be independent. Given the evidence discussed earlier, this would be sound advice in the case of banks where risk should be considered from a stakeholder perspective.
The CRO plays a key role in directing the risk management function and communicating with the risk committee. The principles describe the CRO as an “independent senior executive.” The CRO should be independent in the sense that he or she should not take responsibility for specific lines of business and should not also serve as the CFO, chief auditor, or other officer of the bank. This allows the post holder to step back from operational issues and to consider risk at the level of the bank. The risk management function should model current risks and use stress tests to understand future risks, communicating the results both across the organisation and up to the risk committee. This should increase the awareness of risk among key personnel so that they recognise how their decisions contribute to the risk profile of the bank as a whole. The principles again make specific mention of mergers and acquisitions, stressing the importance of due diligence, which was inadequate in the Royal Bank of Scotland’s acquisition of ABN Amro and contributed to its failure.19
Given the importance of controlling shareholders in the banking industry and the belief that governments will not allow financial institutions to fail, it is not surprising that banks take bigger risks than their stakeholders would approve. The BCBS10 emphasis on risk management through a board-level risk committee and the CRO is a logical response. This response can succeed only if bankers have incentives to reduce risk. Given that high risk goes hand-in-hand with high expected return, and bankers are rewarded for creating returns, there is a danger that risk reduction strategies based on board structures alone will not be effective. For this reason, we turn now to an examination of remuneration in the banking industry.
3.2 Remuneration Practices
Remuneration is probably the most controversial, or at least the most talked-about, area of corporate governance. This applies to the banking sector more than any other, given that following the banking bailouts we, the general public, now see ourselves as owners, not just because we invest in pension funds that hold bank equity, but because we are taxpayers who did not participate in our governments’ decisions to hold shares in major banks. The other distinguishing feature of banking remuneration is that the public is aware of the bonuses paid to bankers who are not board members, while in other sectors it is the pay of company directors that grabs the newspaper headlines.
According to the FSB in 2009,20 flawed compensation practises contributed to the 2007 crisis. It therefore published a set of principles relating to remuneration. In 2010 the BCBS21 reacted by offering guidance to bank supervisors on the implementation of these principles. The principles aim to ensure that the remuneration paid to bank directors (and to other staff who are in a position to change the risk faced by the bank) should reflect that risk as well as the bank’s returns. The suggestion is that this can be achieved by developing a closer relationship between the remuneration and risk committees, changing the balance between bottom-up and top-down payment systems and ensuring that deferrals and clawbacks give the right incentives to those employees who affect risk.
We saw earlier that corporate governance regulation usually requires boards to set up independent remuneration committees to determine the size and composition of executive directors’ remuneration packages. The overarching aim of the system is to design packages that attract, retain, and motivate directors. Attraction and retention depend on offering a salary and other benefits that are comparable with those offered in competing companies. This explains the widespread use of remuneration consultants with knowledge of industry norms. They are able to tell individual companies how their salary levels stand in relation to the industry median, often labelling any payment below the median as uncompetitive and hence unlikely to attract or retain. To avoid being uncompetitive, the company raises its payment levels, contributing to a ratchet effect as others in the industry follow suit. Motivation is achieved by offering short- and long-term bonuses based on profitability or shareholder returns, usually measured in relation to a stock market index or to a group of peer companies.
These variable components of the package are often paid in the form of shares or options, which can be sold or exercised sometime in the future. The use of options is controversial, because they are often designed with a low exercise price—which means that they become profitable when the share price moves up only slightly—so they do not motivate directors to work much harder or smarter than they do now. In addition the value of options depends not just on the absolute value of the underlying share, but also on its volatility. Given that the relationship is positive, the value of options increases with volatility, encouraging directors to take risks. In the past it was argued that managers are inherently more risk-averse than shareholders because they have human capital tied up in their organisations. Options were therefore seen as a means to encourage greater risk taking in line with shareholders’ preferences.22 Such an argument would be highly unpopular today as many people blame excessive risk taking on the use of options in remuneration packages. Interestingly, recent papers suggest that this conclusion is erroneous. Using very different data sets Ayadi and colleagues23 (for Europe) and Fahlenbrach and Stulz24 (for the United States) conclude that option-based remuneration does not encourage greater risk taking in banks. Rather, the use of long-term incentive plans based on performance over a period of time were associated with bank failure in the case of European banks, while American bankers, like their shareholders, experienced a wealth loss during the crisis.
Even if options are not to blame, bankers have taken risks that have backfired on shareholders, so it is not surprising that the FSB aims to ensure that bankers are not rewarded for taking undue risks. It therefore recommends that the remuneration committee should work with the risk committee to make sure that the variable compensation offered takes account of the current and future risks faced by the bank, and does not limit its ability to build its capital base. This is not to deny the importance of variable or performance-related remuneration. In fact the FSB recommends that a substantial part of the total package received by employees who affect the bank’s risk profile should be variable. However, it is also keen that a large proportion of the variable component should be deferred and should be awarded in equity or a related instrument, so as to ensure that recipients are motivated to continue performing strongly in order to reap rewards in the future. Employees working in the compliance and risk-management functions of the bank are the exception to this general principle. To ensure that they operate independently, the FSB recommends that their packages should be determined separately from those in other business areas and that performance should be measured in terms of achieving broad objectives rather than narrowly specified return or risk targets.
In providing guidance on the FSB principles, the BCBS suggests a need to reconsider the balance between the use of top-down and bottom-up systems, both of which are used to determine remuneration in banks. Anyone who reads the newspapers is familiar with the idea that banks declare bonus pools and then share them out between their star performers. This reflects a top-down or award-focussed system. The bank’s performance determines the size of the bonus pool, which is then shared out, often on the basis of short-term performance by individuals. This method ignores the risk assumed by those individuals and any “legacy losses” brought forward and recognised during the period. The alternative is a bottom-up or payment-focussed system based on the individual’s performance rather than the bank’s. This allows the risk assumed by individuals to be taken into account and is therefore more likely to change behaviour.
There is no doubt that shareholders are hungry for change in the way that bankers are paid. During the spring of 2012 significant numbers of shareholders voted against the remuneration packages offered at Barclays, Credit Suisse,25 and UBS.26 One of the issues that sparked controversy at Barclays was the fact that the bonus pool was larger than the dividend payout. Shareholders voted nearly 27 percent of the shares against the remuneration report. While clearly nowhere near a majority, this is a significant “no” vote. The Walker Review27 into corporate governance in the United Kingdom banking industry states that when fewer than 75 percent of votes are cast in favour of the remuneration report, the chair of the remuneration committee should stand for re-election the following year. In the Barclays case, the chair of the committee was due for reelection in 2012. Nearly 21 percent of votes were cast against her, a far higher proportion than those cast against any other director, indicating the strength of feeling of the shareholders.28
Clawbacks of banking remuneration at HSBC,29 Lloyds,30 and UBS31 in February 2012 also sparked media interest. As mentioned earlier, clawbacks are recommended by the BCBS as a way of ensuring that risk features in the design of remuneration packages; they force employees to return some or all of a bonus payment received in the past when additional risks or other unwanted behaviour come to light. In the United States, the Sarbanes-Oxley Act of 2002 permits the clawback of bonuses paid as a result of employee misconduct, such as the deliberate misstatement of earnings. In practice the act is rarely used to recover such payments, partly because only the SEC can bring legal actions under this legislation, and it simply does not have adequate resources to bring every case to trial. The Dodd–Frank Act of 2010 goes some way towards remedying this situation. It requires companies that have to restate their financial results, whether as a result of misconduct or mistake, to clawback “underserved” payments already made to employees. Rather than allowing the clawback of an entire bonus, this legislation requires the repayment of that portion of the bonus that is not justified under the restated figures. Like the Sarbanes-Oxley Act and much of the governance regulation already discussed, this applies to all listed companies, not just to banks. In the United Kingdom, the Walker Review, which applies only to banks and other financial institutions, allows clawbacks in the event of misstatement and misconduct.
The actions of banks in taking back bonuses and of shareholders in voting against remuneration reports are indicative of a new determination to reform compensation practices in banks. The timing suggests that the market has taken heed of the regulators and realised that change is necessary to provide the right incentives to bankers.
3.3 Transparency and Banking Structures
The third area in which there has been considerable change between the publication of the 2006 and 2010 “Principles for Enhancing Corporate Governance” is in the area of complex banking structures. Having previously suggested that poorly constructed remuneration packages encouraged risk taking by bankers, we come now to see how those risks were manifested in the form of structured products and special-purpose entities (SPEs). Structured products allow investors to gain exposure to asset classes that they cannot normally access. Real estate provides a simple example. Buildings are “lumpy,” to use a word beloved of economists. They are large and expensive, making it difficult for most people to incorporate them in their portfolios. Securitisation took away the lumpiness of real estate by creating securities based on underlying buildings so that a whole range of investors could include a single piece of real estate in their portfolios. Securitisation has been practised since the 1980s and is not in itself a problem. The problems we have seen recently arose because of the rise of the so-called shadow banking system, in which banks created SPEs to raise funds and to create more complex structured products, whose risks were not always understood by the holders.
A special-purpose entity is an organisation created by, but legally separate from, the company that forms it. This means that while the bank creating an SPE is regulated by the relevant banking supervisor, the SPE it has formed is not regulated. SPEs are usually created to hold and finance specific assets, taking both the asset and the financing off the balance sheet of the originating company and thereby increasing the bank’s regulatory capital. For example, the SPE could hold the cash flows from credit card receivables or mortgage payments on either residential32 or commercial33 property as assets financed by a bond issue, creating a form of collateralised debt obligation (CDO). If sufficient numbers of people are unable to pay their credit card bills or mortgages, bondholders lose out but the originating company is unaffected because the risk associated with the asset was transferred to the SPE. In a variant on this security, a synthetic CDO is based on credit default swaps (CDSs) rather than on debt contracts. A CDS is a security that makes a payment in the event of a credit event. This type of security is used by banks to insure against a borrower going bankrupt.
Even before the banking crisis, Partnoy and Skeel34 warned that these products could have adverse consequences. They focussed on the relationship between banks and the companies to which they lend, explaining that if the bank insures itself using CDOs, it is hedged against bankruptcy risk and so is less concerned to monitor the borrower and offer advice if it is heading for trouble. In this way the borrower loses a valuable corporate governance mechanism. Barth and Landsman35 argue that the bank itself may be less well governed as investors do not have the incentive to monitor the quality of off-balance sheet loans. Further, as banks create more and more complex structured products, their relationships with other stakeholders become more complicated and the potential for moral hazard increases.
Some banks, faced with the prospect that investors in SPEs would lose money, decided to take the assets held by SPEs back on to their own balance sheets in order to safeguard their reputations.36 Others that had guaranteed credit lines to the SPEs to bolster their credit ratings had no choice but to take their assets back on to their books. This forced them to show the assets at their (now reduced) market value and to recognise the losses associated with those assets under fair-value accounting. This both reduced profitability and created the need to raise regulatory capital by making issues in a depressed market. It also meant that in order to avoid taking on more risk the banks stopped lending to companies and to each other, transferring the crisis to the real economy and reducing liquidity in the banking sector.37
The widespread surprise and incredulity in financial markets as risky assets reappeared on banks’ balance sheets and liquidity dried up indicate the lack of understanding of the size of the shadow banking sector and the complexity of the instruments traded there. This is why BCBS emphasises the danger of opaque corporate structures in its “know-your-structure” and “understand-your-structure” principles.
BCBS9 is clear that it is the board’s responsibility to understand the bank’s structure and in particular the implications for risk of setting up complex structures such as SPEs. Senior management should apply to the board for permission to set up such structures with the understanding that where possible, they should be avoided. Where they are necessary the risks associated with the structures should be understood and each new entity should be subject to internal audit and regular assessment of how its risks impinge on the rest of the organisation. Where complex structures are established on behalf of customers for whom structured products are created, the bank must be aware that their customers’ motivation could lead to inappropriate behaviour that could damage the bank’s reputation. Again it is up to senior management and the board to monitor such situations, ensuring that the structures and products are used for their intended purpose, and that the risks of these activities are managed. In addition the bank must be ready to discuss these arrangements and the policy governing them with its supervisors. This is one aspect of transparency vital to corporate governance. The bank must also make relevant disclosures to other stakeholders so that they can understand both the bank’s structure and its risk appetite.
These exhortations have been supported by accounting standards setters who have changed their reporting requirements to improve the quality of information available to investors and other stakeholders in banks’ annual reports.38 U.S. GAAP and IFRS now have very similar requirements to consolidate SPEs in banks’ financial statements and to provide narrative information on the relationship between the bank and the assets and liabilities of the SPE.
4. CONCLUSION
The traditional focus of the corporate governance literature is the relationship between corporate governance and performance. Researchers hypothesise that improved governance will lead to improvements in profitability and/or market value. We know that risk and expected return move together, but until the banking crisis we gave insufficient consideration to the relationship between governance and risk. As we have seen in this chapter, banks and wider society have learned some hard lessons on this subject since 2007. International authorities now recognise that banks must be governed and regulated from a broadly defined stakeholder perspective. They need strong independent directors who are willing to challenge the interests of shareholders in order to ensure that banks are able to operate for the benefit of their clients and other stakeholders.
In this chapter, we have focussed on three related areas for change in bank governance. The first is a greater emphasis on risk in both board-level discussions and throughout banking operations. This should be facilitated through the establishment of a board-level risk committee, the introduction of the CRO role, and the work of the risk function within the bank. The increased focus on risk will only be effective if employees do not have incentives to increase risk in order to raise return and hence improve their remuneration. For this reason banks have been encouraged and indeed have started to clawback bonuses paid as a result of inappropriate behaviour and to ensure that remuneration packages are constructed so as to be consistent with the bank’s risk appetite. Finally, regulators have challenged boards to fully understand the potentially complex structures of their operations, particularly in respect to the relationships between banks and SPEs, and to see them as “special” in the sense that they should be used sparingly. In addition, accounting standards are changing to enhance the transparency of these arrangements so that stakeholders should in future have a better understanding of the risks taken by banks.
NOTES
1. Financial Reporting Council, “The Financial Aspects of Corporate Governance” (FRC 1992).
2. This wording reflects the fact that the Cadbury Committee’s terms of reference related to the commercial sector, whereas corporate governance is an issue for nonprofit corporations, including such entities as universities. However, this chapter is concerned with the commercial sector.
3. Organisation for Economic Co-operation and Development, “Principles of Corporate Governance” (OECD 2004).
4. As an indication of the importance of codes in regulation, the website of the European Corporate Governance Institute (www.ecgi.org) provides links to the codes operating in more than 80 countries worldwide.
5. Association of Banks of Georgia, “Corporate Governance Code for Banks” (ABG 2009).
6. Central Bank of Nigeria, “Code of Corporate Governance for Banks In Nigeria Post Consolidation” (CBN 2006).
7. Qatar Central Bank, “Corporate Governance Guidelines for Banks and Financial Institutions” (QCB 2008).
8. The Monetary Authority of Singapore, “Guidelines on Corporate Governance for Banks, Financial Holding Companies and Direct Insurers which Are Incorporated in Singapore” (MSA 2010).
9. Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (Bank for International Settlements [BIS] 2006).
10. Basel Committee on Banking Supervision, “Enhancing Corporate Governance for Banking Organisations” (Bank for International Settlements [BIS] 2006).
11. Basel Committee on Banking Supervision, “Principles for Enhancing Corporate Governance” (Bank for International Settlements [BIS] 2010).
12. This is known in the finance literature as the “shareholders’ call option” according to which, if the company is worth less than the amount of debt, the call option is “out of the money” and the shareholders will leave the company to the debt holders. This is one consequence of the shareholders’ limited liability.
13. E. Gualandri, A. Stanziale, and E. Mangore, “Internal Corporate Governance and the Financial Crisis: Lessons for Banks, Regulators and Supervisors.” Paper presented at the IAAER Conference, Venice, 4–5 November, 2011.
14. L. Laeven and R. Levine, “Bank Governance, Regulation and Risk Taking.” Journal of Financial Economics 93 (2009), 259–275.
15. G. Caprio, L. Laeven, and K. Levine, “Governance and Bank Valuation,” Journal of Financial Intermediation 16 (2003), 584–617.
16. S. Pathan, “Strong Boards, CEO Power and Bank Risk-Taking.” Journal of Banking and Finance 33 (2009), 1340–1350.
17. When a board is “staggered” or “classified,” a proportionate number of the directors is eligible for reelection each year. A staggered board may act as an anti-takeover device in that it is hard to get agreement for a deal from a changing board. Given that anti-takeover devices protect incumbent management, they are a sign that shareholders’ rights are restricted.
18. D.H. Erkens, M. Hung, M., and P. Matos, “Corporate Governance in the 2007–2008 Financial Crisis: Evidence From Financial Institutions Worldwide,” Journal of Corporate Finance 18 (2012), 389–411.
19. Financial Services Authority, “The Failure of the Royal Bank of Scotland” (FSA 2011).
20. Financial Stability Board, “FSB Principles for Sound Compensation Practices: Implementation Standards” (FSB 2009).
21. Basel Committee on Banking Supervision, “Compensation Principles and Standards Assessment Methodology” (Bank for International Settlements [BIS] 2010).
22. See for example, C.W. Smith and R.M. Stulz, “The Determinants of Firms’ Hedging Policies” Journal of Financial and Quantitative Analysis 20 (1985), 391–405.
23. R. Ayadi, E. Arbak, and W.P. De Groen, “Executive Compensation and Risk Taking in European Banking, “ in J.R. Barth, C. Lin, and C. Wihlborg, eds., Research Handbook on International Banking and Governance (London: Edward Elgar, 2012).
24. R. Fahlenbrach and R.M. Stulz, “Bank CEO Incentives and the Credit Crisis.” Journal of Financial Economics 99 (2011), 1–26.
25. http://uk.reuters.com/article/2012/04/27/uk-barclays-creditsuisse-agm-idUKBRE83Q0B020120427, accessed June 22, 2012.
26. www.bloomberg.com/news/2012-05-03/ubs-improved-controls-after-trading-loss-chief-ermotti-says.html, accessed June 22, 2012.
27. H.M. Treasury, “A Review of Corporate Governance in UK Banks and Other Financial Industry Entities: Final Recommendations” (2009).
28. Poll results can be downloaded at www.group.barclays.com/about-barclays/investor-relations/annual-general-meetings.
29. This followed the misselling of long-term care bonds to older customers, see www.telegraph.co.uk/finance/newsbysector/banksandfinance/9107147/HSBC-set-to-claw-back-mis-selling-bonuses.html, accessed 19 June 2012.
30. This followed the misselling of payment protection insurance, see www.thisismoney.co.uk/money/news/article-2103654/Lloyds-claw-1m-plus-bonuses-wake-PPI-scandal.html accessed 19 June 2012.
31. This followed a rogue trading scandal; see www.telegraph.co.uk/finance/newsbysector/banksandfinance/7206896/UBS-claws-back-180m-of-bonuses.html, accessed 19 June 2012.
32. In the case of a residential mortgage-backed security or RMBS.
33. In the case of a commercial mortgage-backed security or CMBS.
34. F. Partnoy and D.A. Skeel, “The Promise and Perils of Credit Derivatives.” University of Cincinnati Law Review 75 (2007), 1019–1052.
35. M.E. Barth and W.R. Landsman, “How Did Financial Reporting Contribute to the Financial Crisis?” European Accounting Review 19 (2010), 399–423.
36. P. Andre, A. Cazavan-Jeny, W. Dick, C. Richard, and P. Walton, “Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger.” Accounting in Europe 6 (2009), 3–24.
37. J. Crotty, “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture.’” Cambridge Journal of Economics 33 (2009), 563–580.
38. See Barth and Landsman (2010), note 35.