Better Governance of Financial Institutions

The following post comes to us from Klaus J. Hopt, a professor and director (emeritus) at the Max-Planck-Institute for Comparative and International Private Law, in Hamburg and was advisor inter alia for the European Commission, the German legislator and the Ministries of Finance and of Justice.

Banks are special, so is corporate governance of banks. It differs considerably from general corporate governance. Specific corporate governance needs exist also for insurance companies and other financial institutions. This article, Better Governance of Financial Institutions, analyzes the economic, legal and comparative research on governance of financial institutions and covers the reforms by the European Commission, the European Banking Authority, CDR IV and Solvency II up to the end of 2012. External corporate governance, in particular by the market of corporate control (takeovers), is more important for firms than for banks, at least under continental European practice.

For financial institutions, the scope of corporate governance goes beyond the shareholders (equity governance) to include debtholders, insurance policy holders and other creditors (debt governance). Some include the state as stakeholder, but the role of the state is better understood as setting the rules of the game in a regulated industry. From the perspective of supervision debt governance is the primary governance concern. Equity governance and debt governance face partly parallel and partly divergent interests of management, shareholders, debtholders and other creditors, and supervisors. Economic theory and practice show that management tends to be risk-averse for lack of diversification but may be more risk-prone because of equity-based compensation in end games and under similar circumstances. Shareholders are risk-prone and interested in corporate governance. Debtholders are risk-averse and interested in debt governance. Supervisors are risk-averse and interested in maintaining financial stability and in particular in preventing systemic crises.

This is confirmed by recent empirical research on the financial crisis. Beltratti and Stulz found that banks with more shareholder-friendly boards performed significantly worse. The findings of other studies lead into the same direction: that shareholder structure has an influence on risk taking. Monitoring by major stockholders is relevant also for banks. Banks with higher institutional ownership did worse. Whether failures in the governance of banks were a major cause of the financial crisis is highly controversial. The fact is that there were wrong incentives inspired by compensation practices, deficiencies in board profile and practices (especially but not exclusively in state-owned banks), and failures in risk management and internal control. This was exacerbated by complex and opaque bank and bank group structures and by the legal and practical difficulties of regulating and supervising cross-border operations of bank groups. While these deficiencies did play a certain role, there were many other and more important causes that led to the financial crisis. Systemic risk is not avoided by governance measures. Deposit insurance and bail-out have an ambiguous role. Both encourage undue risk-taking and free-riding, but they are indispensible for depositor protection and mastering systemic crises. This trade-off requires careful balancing.

Prominent reform proposals include clearer separation of the management and control function, possibly by a two-tier board as for Swiss and Belgian banks or a similar separation within the one-tier board; establishment of a separate risk committee of the board or an independent chief risk officer (CRO); dealing with the problem of complex or opaque structures and organization; and group-wide corporate governance in single entities as well as in the group. Appropriate supervisory law requirements are needed for the internal procedures of banks and other financial institutions, specifically for risk management, internal control and compliance, and internal and external auditing. Supervisory fit and proper tests for the board, the management, key function holders and major shareholders are useful. So are appropriate incentives and the elimination of negative incentives, in particular as far as compensation is concerned. Measures that enhance long-term orientation and shareholders’ say on pay are rightly on the reform agenda. Qualification and experience of board members is more important than independence, though having a number of independent directors is useful. This has been demonstrated particularly in the failures of state-owned banks. These and other requirements of the regulation and supervision of banks and other financial institutions concerning better governance are demanding and even severe, but necessary for regulated industries such as financial institutions.

While the financial crisis showed clearly that more regulation, supervision and enforcement were unavoidable, there are now signs of overregulation. Also here it must be remembered: The market knows better than the state, provided that the state sets the appropriate rules of the game. Furthermore there is growing concern that the severe requirements of bank regulation and bank supervision will spill over to the corporate governance of the firm. This can be seen in relation to risk-prevention standards, requirements on the profile and practices of the board and compensation. In the end, everything depends on the people. Therefore supervisory law requirements need to address foremost the profile and practices of the bank board. Professionalization, continuous formation, and external evaluation are important desiderata to be monitored and enforced by bank supervision.

The full article is available for download here.

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