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87© Retail Banking Academy, 2014

RETAIL BANKINGACADEMY

305.Governance and Ethics

Course Code 305 - Governance and Ethics

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Course Code 305Governance and Ethics

Introduction

The year 2012 witnessed a series of banking scandals that may be traced back to lapses in corporate governance and ethical violations. We briefly examine some of the most egregious examples.

The Libor rate-fixing scandal has led to the creation of a UK House of Commons Parliamentary Commission on Banking Standards that is expected to report on “lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for government policy.” (www.parliament.uk).

The JP Morgan Value-at-Risk fiasco is apparently partly blamed on loose risk management governance as reflected in Jamie Dimon’s testimony to the US Senate Committee on Banking, Housing and Urban Affairs on 13 July 2012. The chairman and CEO stated, “personnel in key control roles in CIO were in transition and risk control functions were generally ineffective in challenging the judgment of CIO’s trading personnel. Risk committee structures and processes in CIO were not as formal or robust as they should have been.”

The HSBC money laundering problems in the US and Mexico have led to questions about corporate governance. “When you have failings of control of this scale, it raises questions about corporate governance and risk control,” one large institutional fund manager told the Sunday Telegraph. “This is a big issue for the bank.” (Daily Telegraph, 21 July 2012). “Reacting to the bank’s overseas dramas HSBC Australia’s CEO Paulo Maia has told the Sydney Morning Herald that he would be introducing top global governance standards on his watch.”

The Standard Chartered Bank/Iran scandal prompted the bank to make significant changes to its board of directors. “The board is believed to have decided that the bank needs a more international non-executive profile to reflect its global presence and is keen to recruit business leaders from Asia and the Americas to fill the gap. “As many as three current board members may make way shortly as they are close to no longer being deemed independent. Corporate governance guidelines suggest that after 10 years board members should move on or the bank should explain why they have not.” (Daily Telegraph, 17 August 2012)

These examples demonstrate that one or more of the central cornerstones of corporate governance – executive compensation, boards, risk management, and market discipline – have been abrogated. These violations come at a steep cost.


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As we develop these four key themes of corporate governance and ethics in this module, it is important to note that banks are different from non-financial firms. Banks are more complex with a lot more stakeholders (shareholders, debt holders, regulators, depositors and importantly, taxpayers). They are also opaque in that it is extremely difficult to figure out, unambiguously, the extent of risk-taking on the bank’s balance sheet. Indeed, the total risk on a bank’s balance sheet may change even if no new positions are undertaken. For example, the estimated credit risk of an existing exposure may migrate to higher levels since the likelihood of default typically increases during a downturn, leading to a lower recovery rate. This complexity and opacity of banking balance sheets makes corporate governance more difficult in banks as compared to non-financial firms.

Finally, it may seem strange that corporate governance should be in place just to serve the interests of shareholders – the so-called American model. Indeed, traditional corporate finance promotes shareholder wealth maximisation as the predominant objective of a firm and proposes corporate governance instruments – such as employee stock options awards – to align the interests of shareholders and managers. But a typical bank balance sheet is highly levered, implying that shareholder equity is low, in the range of less than 10 percent, compared to other suppliers of capital – notably depositors and lenders of subordinated debt. Basel III has even permitted a leverage ratio of no more than 33. Hence, excessive risk-taking to maximise shareholder wealth may be at the expense of other stakeholders who supply the lion’s share of a bank’s liabilities. Ultimately, society bears the consequences of excessive risk-taking. Indeed stock option awards may hasten an alliance of managers and shareholders to serve each others’ interests at the expense of all other stakeholders.

This module considers the fundamental principles of modern corporate governance in banking and ends with an appendix on corporate governance in Islamic banks.

Corporate governance has taken on increasing significance* since the recent financial crisis, as many researchers have found that, among the reasons for the crisis, a breakdown of corporate governance is a significant cause. Specifically, the failure of corporate governance in financial institutions (and banking, in particular) is probably correlated with the financial failure of these firms. It seems that corporate governance in banking was shallow, even cosmetic. Where were the boards of directors? What about the independent directors? They were supposed to be less influenced by senior management. It seems that the guardians of stakeholders’ interests were asleep or incompetent. Worse still, even senior management did not seem to know what they were doing, and delegated control to the architects of exotic instruments, the risks of which were unknown to even the architects themselves.

Where were the independent directors? Were they allowed to be truly independent? Or were independent directors not up to the job? Did they truly understand the fundamental principles of banking?

Actually, research has produced some unexpected findings regarding independent directors. For example, Adams (2009)† finds that US banks with more independent directors on the board of directors were more likely to receive Troubled Asset Relief Program (TARP) money.

Similarly, Fahlenbrach and Stulz‡ (2009) find that US bank CEOs with more equity incentives suffered enormous wealth losses during the 2008 financial crisis and that their firms performed worse than others.

* Indeed, Morey et al (2009), in the Journal of Banking and Finance, found that approximately 53 percent of academic papers on corporate governance were published since the Enron crisis in 2001. Curiously, only 47 percent of academic papers on the subject were published during the entire period from 1969 through 2001.† Adams (2009) in Governance and the Financial Crisis suggests that too much independence can result in boards with not enough expertise to understand the business activities of complex financial products and transactions. Hence, the hypothesis: is effective board governance based on independence or functional expertise?‡ Fahlenbrach and Rene Stulz, “Bank CEO Incentives and the Credit Crisis”, Dice Center Working Paper 1009- 13, Ohio State University (2009).


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More surprisingly, Beltratti and Stulz (2009),* using conventional indicators of good governance, find that banks with more shareholder-friendly boards performed relatively worse than banks in countries with stricter capital-requirement regulations and with more independent supervisors. How about companies with good governance structures in place? Erkens, Hung, and Matos (2010),† using a dataset of 296 financial firms from 30 countries that were at centre of the crisis, find “that firms with more independent boards and higher institutional ownership experienced worse stock losses during the crisis period”.

Was it that boards had a too small percentage of independent directors? Maybe they were outvoted by the other directors. But it is likely that this was not the case. In their recent article, Ferreira‡ et al reported that right before the beginning of the crisis in 2007, the average board independence in the world’s largest banks was roughly 67 percent, meaning that two out of three bank directors were formally independent.

This module deals with advanced issues in the study of corporate governance in banking. What is meant by corporate governance? Why is it important in the modern corporation? We begin with a formal definition of corporate governance provided in the literature. We then consider the relationship between governance structures and ethics. In particular, we consider the potential link between the organisational structure of a retail bank and ethical behaviour.

Corporate governance may be defined as a set of criteria that governs the actions of boards of directors and senior management with respect to stakeholder and societal obligations and which provides oversight on potential conflicts. In short, “corporate governance is the system by which companies are directed and controlled”. (Cadbury Report, 1992). As stated by BCBS, effective corporate governance practices are essential to achieving and maintaining public trust and confidence in the banking system.

Similarly, “corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders… also the structure through which objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.” - Preamble to the OECD Principles of Corporate Governance, 2004

The Basel Committee on Banking Supervision defined corporate governance (in 1999) as: “The manner in which the business and affairs of individual financial institutions are governed by their boards of directors and senior management.”

In 2006, the Basel Committee Principles on Corporate Governance published principles that focused on the Board and Senior Management.§ We discuss these principles and their implications for the management of retail banks in Chapter 3. Suffice it to state at this time that the Basel Committee conceded that the financial crisis requires further elaboration of its 2006 statement. On 16 March 2010, the Committee released a statement containing the following excerpt:

“Drawing on the lessons learned during the crisis, the Committee’s document, Principles for Enhancing Corporate Governance, sets out practices for banking organisations. The key areas where the principles have been strengthened include: (1) the role of the board; (2) the qualifications and composition of the board; (3) the importance of an independent risk management function; including a chief risk officer or equivalent; (4) risks should be identified, assessed and monitored on an ongoing firm-wide and individual entity basis; (5) the board’s oversight of compensation systems; and (6) the board and senior management’s understanding of the bank’s operating structure and risks.”

* Beltratti and Stultz, Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation (2009).† Erkens, Hung and Matos, Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide, CELS 2009 4th Annual Conference on Empirical Legal Studies Paper (2010).‡ Ferreira et al: “Boards of Banks”, London School of Economics Financial Markets Group (2010).§ The Committee of European Banking Supervisors (CEBS) issued 21 principles of corporate governance as part of Pillar 2 to European financial institutions. While Basel focused on the board and senior management, CEBS provided guidance on internal control functions – risk management, compliance and internal audit.


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The historical development of corporate governance principles by BCBS is reflected in the diagram below:

305.1: Basel Principles

There is an obvious presumption in the Basel Committee’s principles for enhanced corporate governance in banking and that is: there is a link between the breakdown of corporate governance and bank financial performance. Indeed, Cheng (2008)* claims that the relation between the characteristics of corporate boards and firm performance is a key issue in the corporate governance field. We will explore this hypothesis in this module.

It is worthwhile to note that different jurisdictions follow models of governance that have meaningful differences. We consider these in turn.

The various approaches to corporate governance depend on the answer to the question: which stakeholder’s interests should be served in the agency relationships? The American model is best described by an excerpt from Easterbrook and Fischel (1983):† “The shareholders receive most of the marginal gains and incur most of the marginal costs. They therefore have the right incentives to exercise discretion.”

Hence, in the American model, corporate governance instruments are for the sole purpose of maximising shareholder value. This is not just a legal principle but also a moral one. Shareholders have a direct ownership of the corporation and are entitled to the residual value as an extension of their right to private property. This may be seen from the perspective of the famous assertion that “the corporation exists for the benefit of shareholders.” (Goodpaster, 1991).‡ In this market- oriented model, the role of corporate governance is to create incentives and implement control mechanisms that serve to align the interests of shareholders with managerial behaviour. Since the focus is on shareholder value creation, the stock market may be viewed as a final arbiter of whether managers are over-indulging in wasteful spending and pursuing self interest.

The German model of governance is founded on ‘insider participation’ that includes ‘worker councils’ that have co-determination rights and boards also include employee membership.§

There is a dual board of directors in Germany and some other European countries where the supervisory (i.e., non-executive) board, comprising various stakeholders, elects, advises and supervises the management (i.e. executive) board.

* S. Cheng, “Board size and the variability of corporate performance”. Journal of Financial Economics, 87, 157-176 (2008).† Frank H, Easterbrook, and Daniel R Fischel. “Voting in Corporate Law”. Journal of Law and Economics 26: 395-427 (1983).‡ Goodpaster, K E “Business Ethics and Stakeholder Analysis”. Business Ethics Quarterly 3 (1): 62-75 (1991). § G. Jackson, M Hopner, and A Kurdlebusch. “Corporate Governance and Employees in Germany: Changing Linkages, Complementarities and Tensions”. Discussion Paper. RIETI (2004).


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The focus is to enhance the interest of all stakeholders.

With this introduction, the rest of this module is organised as follows:

Chapter 1: The Underlying Theories of Corporate Governance

Chapter 2: Corporate Governance Instruments

Chapter 3: Bank Operational Structure, Risk and Ethics

This module concludes with a summary and multiple choice questions.

We begin with the main point that the demand for corporate governance arises from the agency problem between principals and agents in the modern corporation.


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Chapter 1:Underlying Theories of Corporate Governance

There are two generally accepted theories of corporate governance: the agency theory and the stewardship theory. The agency theory derives a negative view of managers relative to other stakeholders that is based on the principal agent problem. This problem arises because of the separation of control (managers) and ownership (shareholders) and hence managers can take actions to further their own personal objectives at the expense of shareholders and other stakeholders. The agency theory has interesting ethical implications such as managers becoming self-serving. The stewardship theory is based on the notion that senior management values collaboration with all stakeholders and hence acts to promote the interests of all stakeholders.

305.2: Principles underlying CG in banking

We now consider both theories of corporate governance and their implications for ethical violations.

Agency Theory

The principal-agent relationship in the modern corporation has its theoretical development in


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the studies by Spence and Zeckhauser* (1971) and Ross† (1973). These contractual relationships create a separation of ownership and control and this may create important governance issues. This was the main point of Berle and Means‡ (1932). They observed that top corporate executives, “while in office, have almost complete discretion in management”. (page 139). Take the case of a public corporation where shareholders may have some difficulty monitoring and enforcing the contractual obligations of the agent. The main reason for this is that shareholders may be unaware of the day-to-day operations of the firm; may not be fully cognisant of the risk that managers may be incurring; and, in general, may have limited information about the future prospects of the firm.

These examples reflect a manifestation of asymmetric information between shareholders and managers, with shareholders, as a group, being less informed.

Of course, when the manager is the sole equity owner of a firm, there is no separation of ownership and control and thus no agency problem exists between the manager and the owner since the two parties are one and the same. Their interests coincide. In contrast, when residual claims to equity are diffused among many outside investors as in the case of most publicly traded corporations, (i.e., there are a large number of retail investors) the separation of ownership and control leads to potential divergence between the interests of owners and managers.

For clarification, we define agency theory as a study of the principal-agent relationship that results from the separation of ownership and control. Closely related is the study of agency problems defined as the study of the problems derived from agency theory.

These are problems that arise from information asymmetry – monitoring by the principal of the agent’s actions and the divergence of the utility functions (i.e. tolerance for risk) of the agent and principal. As pointed by Macey and O’Hara (2001), “agency problems occur when the principal (shareholders) lacks the necessary power or information to monitor and control the agent (managers) and when the compensation of the principal and the agent are not aligned.”

Clearly the agency relationship creates agency problems. The first is the so-called principal-agent problem that creates a monitoring or verification problem for the shareholders – they cannot fully monitor the contract they have with the managers. As Ross (1973, page 138) states, “the difficulty arises in monitoring the act the agent chooses.”

Accordingly, we present a description of agency theory and its underlying assumptions so as to place corporate governance in its relevant context.

The fundamental tenet of agency theory, as stated above, is that the interests of the principal and agent may diverge. To limit this divergence, the principal can create incentive contracts that align the interests of the principal and agent. The principal may also incur monitoring costs to limit opportunism on the part of the agent.§ On the other side, it may be that the agent has to pay bonding costs to convince the principal that the former will not take actions to harm the interests of the latter, and therefore win the right to manage the resources of the principal. This is common in the asset-management business where asset managers (agents) incur bonding costs to win mandates. The monitoring costs by principals and the bonding costs by agents are examples of agency costs.

Agency theory deals with solutions that minimise agency costs that arise from the agency relationship. The solution-mechanisms suggested by the literature include governance instruments (i.e., boards of directors), market mechanisms (e.g., block shareholders, long-term debt holders; deposit insurance) and regulation.

* Spence and Zeckhauser, “Insurance, Information and Individual Action, American Economic Review (Proceedings), 61, 380-387 (1971)† Ross, “The Economic Theory of Agency: The Principal’s Problem. American Economic Review, 63: 134-139 (1973)‡ Berle and Means, The Modern Corporation and Private Property, New York, Commerce Clearing House (1932)§ In the module entitled Business Ethics we discussed the moral issues that arise from ‘opportunism’


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Before we investigate the effectiveness of each of these proposed solutions for minimising agency costs, we discuss the question: why are banks different from non-financial firms when it comes to agency theory?

Traditional agency theory is based on three assumptions.* These are as follows:

a. Capital markets are competitive (in particular, unregulated).

b. The principal-agent relationship is underlined by information asymmetry between the principal and agent. But this will depend on whether shareholders are institutional (i.e. pension funds, insurance companies, hedge funds, other banks). These investors are likely to incur less information asymmetry and hence experience less agency costs.

c. An optimal debt-to-equity ratio exists somewhere between 0 and 100 percent. This is a statement of the Miller and Modigliani theorems on capital structure. The existence of an optimal level of debt-to-equity ratio (hereafter, leverage ratio) is rationalised as follows: If capital markets are perfect, except that corporate taxes exist, based on the fact that interest payments on debt are tax-deductible, the optimal level of debt should be 100 percent. But if higher levels of debt create financial distress costs (arising from financial leverage), there is trade-off between interest – tax deductibility of debt and the present value of distress costs. This determines the existence of an optimal level of leverage.

But banks operate in a different environment and agency issues are more complex. This implies that corporate governance is even more difficult.

Let us examine the agency issues in banking.

First of all, banks operate in regulated markets. Unlike non-financial firms, Basel III regulates capital and sets standards for liquidity and leverage.

Furthermore, there are several agency relationships in banks. Similar to non-financial firms, there is an agency relationship between managers and equity holders and between equity holders and bond holders. But in banks, there is also an agency relationship between depositors and managers as well as between managers and regulators. This set of agency relationships, which are not necessarily operating in parallel but have cross-effects on each other, makes for additional complexity in banks.

For example, bond holders prefer low risk (i.e., stable) cash flows since they are more concerned about getting repaid in full and on time. Equity holders prefer some level of risk since they are concerned about risk-adjusted returns. Regulators are concerned about systemic stability and impose limits on risk-taking that may not be aligned with shareholders’ objectives. These are examples of conflicting objectives (agency issues) in banks.

Finally, banks are highly leveraged, with most of the funds loaned coming from depositors and bondholders. Indeed, the ratio of debt to equity for banks is invariably greater than 100 percent. It is not uncommon for banks to finance their assets with about 90 percent debt. Basel III has limited the asset/equity multiple to no more than 33 to 1.

There are other issues as well. While shareholders in the non-financial institutions also have an information-asymmetric relationship with managers, the degree of asymmetry is higher for banks.† Banks are deemed to be more opaque. It is quite difficult for principals to assess the risk-structure of a bank’s balance sheet. Loan quality can easily be hidden or distorted by extending the term of the loan to customers.

Indeed, there is evidence that debt-rating agencies disagree more about the quality of bank * See Ciancanelli and Gonzalez: Corporate Finance in Banking: A Conceptual Approach, European Financial Management Association Conference, Athens (2000).† Furfine, “Banks as Monitors of Other Banks: Evidence from the Overnight Federal Funds Market”, Journal of Business 74, 33-57 (2001).


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bonds compared to other non-financial companies.* Consequently, Macey and O’Hara (2001) argue that a broader view of corporate governance should be adopted in the case of banking institutions.

Open Question #1

Do you agree that the agency theory of corporate governance is based on the notion that there is ample opportunity for managers to be self-serving?

The Stewardship Theory

The second underlying theory of corporate governance is based on the notion that managers act as stewards of the varied interests of all stakeholders. The assumption is that senior management is guided not by self-serving and short-term financial gains at the expense of other stakeholders but by personal and professional reputation. Stewards are motivated by organisational success and so collaboration is valued. Senior managers, in terms of Hofstede’s culture model, are guided by the collective view of the bank.

We note that the definition proposed by Davis, Schoorman and Donaldson (1997)† views stewards as protecting the interests of shareholders rather than all stakeholders. They state that ‘stewards protect and maximise shareholders’ wealth through firm performance.’ This module combines their definition with stakeholder theory where the latter was proposed by Freeman (1994)‡ and embodied in, for example, Kaplan and Norton’s balanced scorecard.

* D. Morgan, “Rating Banks: Risk and uncertainty in an opaque industry”, American Economic Review, 92, 874-88 (2002).† J.H. Davis, F.D. Schoorman and L. Donaldson, “Toward a stewardship theory of management”, Academy of Management Journal, 31: 488-511 (1997).‡ R. E. Freeman, “The politics of stakeholder theory”, Business Ethics Quarterly, 4(4) 409–421 (1994).


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Chapter 2:Corporate Governance Instruments

Chapter 1 discusses the agency theory of corporate governance in banking and shows that there is an opportunity for management to pursue private and self-serving objectives at the expense of other stakeholders. In addition, it may be more difficult for other stakeholders to differentiate short-term managerial actions from long-term actions for value creation. While corporate governance instruments such as the design of executive compensation are intended to reduce agency costs, the bank board of directors is given a predominant role in monitoring the actions of senior management.

We now consider the effectiveness of some common corporate governance instruments.

The board of directors*

There is an extensive academic and professional literature on the optimal design of board of directors in relation to sound corporate governance. Four key factors for enhancing bank board effectiveness have been identified. These are:

a) board of directors’ skills, knowledge and independence;b) board of directors’ busyness;c) size of the board andd) term limits for directors.

We consider each of these factors:

a) Board of directors’ skills, knowledge and independence

BCBS (Section A, Principle 2 of ‘Principles for Enhancing Corporate Governance’, hereafter BCBS [2010]) states that ‘board members should be and remain qualified…relevant to each of the material financial activities the bank intends to pursue’. To facilitate this education process, it is recommended that ‘the board should ensure that board members have access to programmes for

* There are generally two types of board structures: the one-tier board system, typical of the US, Spain and many other countries, and the two-tier system that is typical of Germany and the Netherlands. A one-tier board consists of both non-executive directors (outside) and executive directors (inside), who are the top executives of the bank. A two-tier board comprises a supervisory board of non-executive directors to which a board of executive directors report.


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initial and ongoing education on relevant issues. In addition, the board should dedicate sufficient time, budget and other resources for this purpose.’* It is interesting to note that research findings from the recent financial crisis identified directors’ lack of banking expertise as one of the main causes of corporate governance failures for banks.

For example, Kirkpatrick (2009)†, referring to board directors, posed an interesting question: Are they up to the task? He states that “in the wake of the financial crisis many boards of financial enterprises have been quite active, with a number of CEOs at problem banks being replaced. Tellingly, both Citibank and UBS have also announced boardroom departures to make way for new directors with finance and investment expertise.” He further contends, “even though board competence is difficult to judge by outsiders, it is often asserted that current directors lack banking and financial experience”.

Related to the skill and experience of directors is whether they are independent‡. Highly experienced directors with appropriate banking experience may still have a personal relationship with senior management that render them ineffective in their corporate governance role.

But being independent may not be enough. For example, Ferreira et al (2011)§ reported that right before the beginning of the crisis in 2007, the average board independence in the world’s largest banks was roughly 67 percent, meaning that two out of three bank directors were formally independent. Yet this very high proportion of independent directors was not sufficient to prevent corporate governance failures.

The answer seems to be that directors should possess both attributes.

So the recommendation is as follows:

The board of directors should comprise a significant proportion of directors who are independent and have material expertise and experience in retail banking.

We now consider the second factor for board effectiveness. The relevant question is whether the mere fact of holding multiple outside board seats compromises a director’s ability to effectively perform his/her monitoring duties for a particular bank. We introduce two competing hypotheses – busyness versus experience.

b) Board busyness and experience hypotheses

The Board Busyness Hypothesis states that board members with multiple directorships are over-committed (i.e., over-boarding) and this is likely to diminish their role as monitors for any one bank. This is similar to the concept of ‘interlocking’ where at least two banks share one or more of the directors on the board. The argument against director busyness is a lack of time to be fully committed to bank business and, importantly, a doubt concerning whether information sharing with multiple boards may inadvertently occur. This brings into focus the possibility of even an inadvertent violation of confidentiality of bank business.

There is also evidence that “individuals with multiple board seats (or “busy” directors) exhibit a higher tendency to be absent from board meetings”¶, which further reduces their role as effective corporate governance instruments. In relation to the busyness hypothesis, Richard Leblanc,Professor of Law and Corporate Governance at York University in Canada, claims that directors who are on more than two boards are less effective as monitoring instruments.

* It is noteworthy that the Office of Superintendent of Financial Institutions (OSFI: the national regulator of Canada) recently announced it was going to interview directors and evaluate their Curriculum Vitae.† G. Kirkpatrick, “The Corporate Governance Lessons from the Financial Crisis”, Financial Market Trends, OECD, (2009).‡ Independent or unrelated directors may be defined as those who are not current or former employees or officers of the firm or its subsidiaries, their associates or their family members.§ Ferreira et al, “Boards of Banks”, LSE Financial Markets Group, (2010).¶ P. Jiraporn et al, “Too busy to show up? An analysis of directors’ absences” Quarterly Journal of Economics and Finance, Vol.40, Issue 3, (2009).


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Open Question #2Do you agree that busy directors are likely to be relatively high quality directors and this is more important in relation to their effectiveness than their potential lack of time?

On the other hand, the Experience Hypothesis proposes that directors who are on multiple boards are in fact assets since they bring experience, expertise and networking benefits to the bank. Simply put, there are benefits in terms of networking and knowledge transfer from being on multiple boards. There is support for this hypothesis by Ferris et al (2003)* amongst others. This hypothesis is also in line with the open question above where there is a trade-off between time (busyness) and quality (experience and expertise).

CommentThe busyness versus experience hypotheses debate continues but most experts recommend that multiple directorships be limited so as to encourage director focus on board matters.

The third factor of board effectiveness is board size.

c) The size of the board

It is worth noting that BCBS (2010) underlines the predominant role of the board of directors and senior management for the safety and soundness of banks. In doing so, BCBS places emphasis on the configuration of bank boards with an adequate number of directors “capable of exercising independent judgment of the views of management, political interests or inappropriate outside interests”.

So what is a recommended “adequate number of directors”?

There is evidence that board size may have an effect on the financial performance of banks. But the nature of this relationship is unsettled. The theoretical argument is as follows:

Smaller boards are preferred because these are likely to focus more on important issues facing the organisation rather than just comply with the CEO recommendations. On the other hand, boards with larger size may encourage free-riding and groupthink so that due diligence and risk management may suffer.

From this argument, one can conclude that there is an optimal number of board directors that arises from a trade-off. This trade-off is described as follows:

There is increasing benefit in terms of financial performance to having a bank board with a smaller number of directors, but this benefit may decline due to problems of coordination and control as board size increases.

A graphical depiction of this trade-off is as follows:

* S.P. Ferris, M. Jagannathan, and A C Pritchard, “Too busy to mind the business? Monitoring by directors with multiple board appointments”, Journal of Finance, Vol. 58, Issue 3, p. 1087, (2003)


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There is a trade-o� between e�ective debate

in the decision-making process that gives rise to

free-riding, loa�ng and group think as board size increases

Measure of Financial Performance (ROE)

Optimal Number of Directors Board Size

305.3: Board size trade-off

This inverted U-shaped relationship is supported by several research studies. For example, the cost of director free-riding has been identified in a recent study of Nigerian banks* so that increasing the board size excessively leads to a decline in financial performance. Similarly, Dogan and Yildiz (2013)†, in a study of Turkish banks, find that larger board size has a negative effect on the bank’s return on equity (ROE). Finally, Andres and Vallelado (2008)‡, in a study of sixty-nine commercial banks operating in Canada, US, UK, Spain, France and Italy over the period 1995-2005, found that the inclusion of more directors leads to higher financial performance but then declines after a certain limit, which they found to be 19 directors. This describes an inverted U-shaped graph as shown above.

So what is the recommended size of a board of directors?

Lipton and Lorsch (1992)§ recommend an optimal board size of eight to nine directors with a maximum of 10 directors while Leblanc (2013)¶ asserts that the board of directors should normally range between 7–11 members. His argument is that the ‘size of the board should be commensurate with size and complexity of the company, but also should facilitate decision making. Excessively large boards incents free riding and disincents dialogue and decision making during and at the meeting, thus rewarding decisions before the meeting or in an executive committee’.

While these authors recommend a relative precise range for board size, Leblanc’s argument is probably the best advice:

The size of the board should be commensurate with the size and complexity of the banking business.

Here are two lessons for sound corporate finance in banks:

* O. Uwuigbe and A. Fakile, “The Effects of Board Size on Financial Performance of Banks: A Study of Listed Banks in Nigeria”, International Journal of Economics and Finance, Vol.4, No.2, (2012).† M. Dogan and F. Yildiz, “The Impact of the Board of Directors’ Size on the Bank’s Performance: Evidence from Turkey”, European Journal of Business and Management, Vol. 5 No.6, (2013).‡ P. Andres and E. Vallelado,”Corporate governance in banking: the role of the board of directors”, Journal of Banking and Finance, 32: 2570-2580, (2008).§ M. Lipton and W. Lorsch, “A modest proposal for improved corporate governance”, Business Lawyer, 48: 59-77, (1992).¶ R. Leblanc, “Forty proposals to strengthen: The public company Board of Director’s role in value creation; management accountability to the Board; and Board accountability to shareholders”, International Journal of Disclosure and Governance, 10, 295–310, (2013).


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Lesson: A large board of directors reduces the value of the bank because of free-rider problems*.

Lesson: Outside directors may be more effective monitors of management because they are in theory less beholden to management and may also bring a different perspective to bear on problems the management faces†.

*†We now consider the fourth factor for bank board effectiveness – term limits.

d) Term limits for directors

What should be the tenure of a director of a bank board? A related question is: do directors become less effective over time (entrenchment hypothesis)?

The theoretical argument for a term limit for directors is that the longer the tenure on the board, the more a director becomes entrenched in his/her position and is likely to be more closely aligned with management and so lose his/her independence. This is the implication of the entrenchment hypothesis: the independence of outside directors may be compromised when they serve for longer tenure periods together with the same CEO. For this reason, countries around the world have imposed term limits in the range of nine to twelve years.

Here are some examples:

• UK, India, Hong Kong, South Africa, Singapore, Malaysia all have term limits of 9-10 years in various forms (e.g., subject to test of independence). An example of this test of independence in Hong Kong requires companies appointing an independent director beyond a recommended nine-year limit to hold a separate vote for the director using a special resolution.

• In France, directors no longer qualify as independent if they have been on the board for more than 12 years. This is probably the strongest statement about term limits for board directors.

• Spain recommends a 12-year limit for independent directors while, in the UK, boards should annually explain their reasons for determining that directors are still independent if they have served more than nine years on the board.

• The European Union recommends terms no longer than 12 years.

The general conclusion is that bank board directors’ tenure should be limited since there is a risk that their independence may give way to closer ties with management. The recommended range is 9-12 years.

We now extend the discussion to another important corporate governance instrument: senior management.

Senior Management

BCBS (2010) defines senior management as a core group of individuals who are responsible and should be held accountable for overseeing the day-to-day management of the bank. Their role on corporate governance is spelled out in Principles 5, 6 and 7 of Section B of BCBS (2010). This role is summarised as follows:

* Hamid Mehran, Alan Morrison, and Joel Shapiro. “Corporate governance and banks: What have we learned from the financial crisis?” Federal Reserve Bank of New York Staff, Reports No. 502), (2011).† Renée B. Adams and Hamid Mehran, “Bank board structure and performance: Evidence for large bank holding companies”, Journal of Financial Intermediation, 21, 243-267, (2012).


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Senior management should ensure that the bank’s activities are consistent with the business strategy, risk profile, and policies approved by the board.

One immediate question is: what are the required competencies for senior management of a retail bank to carry out its corporate governance obligations?

Similar to directors of the board, senior management must have necessary experience and required expertise in retail banking as well as personal and professional integrity. Simply out, senior managers must be leaders in retail banking as espoused in module 301. In their conduct of their corporate governance obligations, they must lead the bank so as to promote accountability and transparency and thereby reduce agency costs while encouraging the stewardship approach of governance.

In summary, the corporate governance obligations of senior management are as follows:

• Align with the board of directors to set the ‘tone at the top’ by being exemplary (i.e., walk the talk);

• Create an ethical corporate culture; and

• Ensure that management’s actions are aligned with the board’s directives.

One of the most important ways to ensure that senior management fulfil their corporate governance obligations is through appropriate executive compensation plans.

Executive Compensation Plans While Basel (2010) gives the board overall responsibility for the design and operation of the compensation system of the entire bank, it normally delegates a large part of this responsibility to senior management. However, the board does review and approve compensation for senior management. Principle 11 of Section D of Basel (2010) specifies four components of a compensation plan that are aligned with sound corporate governance in banks. These are as follows:

Aligned with Prudent Risk Taking

Alignment refers to the design of compensation contracts that do not encourage risk taking by management that violates the limits imposed in the bank’s risk appetite statement. This may be the case when incentives arising from compensation plans encourage management to be self-serving with a short-term focus rather than inspire long-term value creation. The design of the variable component of executive compensation can have unintended consequences in terms of corporate governance and ethics.

Take the case of stock options. There is a branch of studies in corporate finance that has studied the incentive effects of stock-option grants. This is quite an interesting component of compensation contracts. The idea is that as the market value of equity rises, stock option grants will move towards being in-the-money – that is, become more valuable if they are cashed straight away. This way, managers share in value-creation activities they initiate. Importantly, by having their compensation tied to the movement of share prices, the objectives of shareholders and senior management are aligned and this tends to mitigate the negative effects of the agency problem outlined in Chapter 1.

But there could be unintended negative corporate governance effects. Managers may be encouraged to take actions to increase risk to generate higher stock prices in the short run. But this is akin to gambling and can create harmful effects for the bank. For example, there is evidence* that when senior management is granted stock options as part of their variable compensation, they are less likely to be prudent and engage in less hedging of interest rate and

* J. Supanvanij and J. Strauss, “The effects of management compensation on firm hedging: Does SFAS 133 matter?” Journal of Multinational Financial Management, Vol.16 Issue 5, (2006).


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currency risk – clearly in violation of its corporate governance obligations to be prudent in risk-taking.

In summary:

“Performance-based pay should be conditioned on a wide range of internal and external metrics, not just stock price.” (US Treasury Secretary Principles, June 2009)

Symmetric wih Risk Outcomes

This means that compensations systems in the bank should set the size of the bonus pool in relation to some measure of the overall performance of the bank. Hence bonuses should be reduced or not paid should the bank or division fail to meet the benchmark level of performance. This is meaning of being ‘symmetric in risk outcomes’.

Sensitive to Risk Time Horizons

As stated above, performance-pay should be linked to prudent risk-taking. But risky outcomes may not be fully revealed in a short period of time. This being the case, variable compensation payments should be deferred for multiple years to permit a full realisation of risky outcomes.

May be Subject to Malus / Clawback

Deferred compensation may be subject to clawbacks or malus conditions. Clawbacks are when paid-out compensation is reclaimed because of gross negligence, malfeasance, restatement of financial statements and so on. But reclaiming money already paid out can be difficult and may even conflict with local labour laws.

Malus conditions may be in place during the deferral period and they may result in a reduced amount (even zero) of deferred payments. Malus may take effect if it turns out that the actual employee performance is significantly lower than the benchmark performance on which the original compensation award was determined. Malus may be preferred over clawback. This is because adjusting deferred payouts before they are paid is easier than having to claw back payments already made.

We now discuss another aspect of corporate governance – risk management. While module 307 deals with risk and capital management, in this section we consider issues related to risk governance as part the corporate governance obligations of the board and senior management.

Risk ManagementAccording to BCBS (2010), the risk management function typically involves:

“identifying key risks to the bank;

measuring exposures to those risks;

monitoring risk exposures and determining the corresponding capital needs (i.e. capital planning) on an ongoing basis;

taking steps to control or mitigate risk exposures; and

reporting to senior management and the board on all the items noted in this paragraph.”

What are the main elements of effective risk governance in banks?

An answer is provided by Mongiardino and Plath (2010)* who outlined best practices for effective risk governance. These best practices stipulate that the board should appoint a dedicated risk

* A. Mongiardino, and C. Plath, “Risk governance at large banks: Have any lessons been learned?”, Journal of Risk Management in Financial Institutions 3, 116-123 (2010).


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committee comprising a majority of independent directors and that the CRO should be part of the bank’s executive board. Unfortunately, Hau and Thum* (2009) find that most risk committees of bank boards did not have enough independent and financially knowledgeable members to implement this set of best practices.

In this process, the independence of the Chief Risk Officer (CRO) is paramount and even if the CRO reports to the CEO or other senior management, the CRO should have unimpeded access to the board of directors and its risk committee. There is evidence that this imperative by BCBS is not without merit. In fact, Aebi et al (2012)† find that banks in which the CRO reports directly to the board of directors performed significantly better in the credit crisis. Specifically they state that “most importantly, our results indicate that banks in which the CRO has a direct reporting line to the board of directors and not to the CEO (or other corporate entities) exhibit significantly higher (i.e., less negative) stock returns, ROA, and ROE during the crisis”. They attribute this finding to an assertion that the CEO and CRO may have conflicting interests and, if one reports to the other, the risk agenda may not receive the appropriate attention. This finding is in line with BCBS (2010), which recommends that “the CRO should have sufficient stature, authority and seniority within the organisation”.

On an operational level, the bank’s risk management function includes an assessment of the risks of new products, significant changes to existing products, the introduction of new lines of business and entry into new markets. “Finally, the bank’s risk exposures and strategy should be communicated throughout the bank with sufficient frequency. Effective communication, both horizontally across the organisation and vertically up the management chain, facilitates effective decision-making that fosters safe and sound banking and helps prevent decisions that may result in amplifying risk exposures.” ‡

This chapter concludes with two topics in corporate governance which have relevance, especially for banks. These are: a) the Corporate Governance Implications of Deposit Insurance; and b) the Corporate Governance Effects of Regulation and Supervision.

a) The Corporate Governance Implications of Deposit Insurance

Retail banks raise the largest proportion of funding from depositors. In addition, there is a large volume of deposits that are relatively small in monetary value. The economics of deposit insurance typically demonstrate that depositors have an asymmetric-information relationship with managers and that this agency relationship could lead to banks runs and macroeconomic instability. This justification of deposit insurance is the hallmark of the Diamond and Dybvig model, since depositors supply liquid funds and managers invest in largely illiquid assets such as long-term loans and mortgages, after meeting fractional banking reserve ratios. Deposit insurance now available in numerous countries provides macroeconomic stability and depositor safety. This is the traditional argument in favour of deposit insurance.

But what are the corporate governance implications of deposit insurance? Does the availability of deposit insurance encourage excessive risk-taking by bank managers?

It is likely that the provision of deposit insurance would reduce the urgency for depositors tomonitor the risk-taking activities of managers. This creates a moral hazard where the existence ofdeposit insurance encourages managers into excessive risk-taking. The costs of such actions willbe borne by the deposit insurance authority and potentially by the tax-payer. Several research findings have demonstrated that the existence of deposit insurance creates passive depositors who are likely to become weak corporate governance instruments. This potential moral hazard problem may lead to excessive risk-taking by managers and thereby complicate the agency relationship between managers and shareholders. This is an example of how different agency

* Harald Hau and Marcel Thum, “Subprime crisis and board (in-)competence: Private vs. public banks in Germany”, Economic Policy, 24 (60), 701–751, (2009).† Vincent Aebi, Gabriele Sabato, and Markus Schmid, “Risk management, corporate governance, and bank performance in the financial crisis”, Journal of Banking and Finance, 37 (2): 433–47, 2012.‡ BCBS (2010)


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relationships in banking may be correlated. These inter-linkages make it more challenging to design good governance structures.

To this point we see that senior management compensation contracts have an important effect on excessive risk-taking, and that this may be compounded by the provision of deposit insurance.

We now consider the second issue.

b) The Corporate Governance Effects of Regulation and Supervision.

The economics of regulation is based on the notion that banks and other financial institutions may engage in excessive risk-taking that can only be discerned after the negative consequences are observed. As opposed to other non-financial firms in the economy, a bank that actually suffers financial distress, or even the rumour of such a condition, can lead to loss of confidence by depositors. This may lead to a bank run, which can cause the bank to fail in its obligations to other financial institutions. The bank may find itself de-risking and de-leveraging its balance sheet, and so be unwillingly to lend to the real economy. This possibility places a significant role on boards of directors in balancing the competing interests of all stakeholders – from shareholders on the one hand, and depositors and other lenders on the other. To compound this problem and as pointed out above, the provision of deposit insurance would probably reduce the propensity of depositors to monitor the risk-taking activities of the bank. Capital regulation may be rationalised as a way of reducing the moral hazard induced by excessive risk-taking by managers of banks.

But does bank regulation substitute for other forms of corporate governance instruments? In fact, Booth et al* (2002) find that in regulated industries such as banking, the interrelations among internal governance mechanisms are not as strong as in industrial firms. They interpret this as evidence that regulation serves as a substitute for internal monitoring mechanisms. But this view is not supported by research. For example, Becher and Frye† (2008) find evidence to support the view that regulation and other internal bank governance instruments are complementary and are not substitutes.

A current view is that regulation is intended to reduce the likelihood of excessive risk-taking by bank managers and lower the risk of systemic failures. But as we have emphasised throughout this module, there are several agency relationships in the banking sector and hence numerous opportunities for agency costs. We have already discussed the agency relationship between managers and shareholders as well as depositors and managers. The agency relationship between managers and regulators is discussed in detail in Bruche and Liobet‡ (2011). They contend that the regulator is at a disadvantage vis-à-vis the bank management and cannot tell if the bank is part of the ‘walking wounded’ or ‘living dead’. The so-called zombie bank can hide non-performing loans by simply extending them. This places a greater onus on boards of directors to effectively monitor management with respect to balance sheet transparency. One reason for the bank boards to become more vigilant is that Basel III has given banks considerable discretion in measuring and monitoring sources of risks through the application of internal models.

We note that the bank board of directors has a role in assuring that Basel III principles of increased and higher quality capital as well as leverage and liquidity standards are met. But Hellwig§ (2010) offered a pessimistic view about the success of capital compliance and suggests that risk is immeasurable. He maintained that the “notion of measuring risks is itself quite an illusion and that in practice the risk-calibration approach provides banks with too much scope for manipulating their models so as to ‘economise’ on equity capital by not recognising risks”.

* James R , Booth, Marcia Millon Cornett, and Hassan Tehranian, “Boards of Directors, Ownership, and Regulation”, Journal of Banking and Finance 26, 1973-1996 (2002).† Becher and Frye, Does Regulation Substitute or Complement Governance?, University of Central Florida (2008).‡ M. Bruche and G. Liobet, “Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans”, LSE Discussion Paper No. 675, (March 2011).§ M Hellwig, “Capital Regulation after the Crisis: Business as Usual?”, Max Planck Institute for Research on Collective Goods, (2010).


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Surely, without regulation there is not an a priori reason for managers to take into account the social cost of tail risk-taking.

Hellwig continues, “Regulation and supervision are there to reduce this governance problem. When the model-based approach to capital regulation was introduced, however, the regulatory community was so impressed with the sophistication of recently developed risk assessment and risk management techniques of banks, that they lost sight of the fact that the sophistication of risk modelling does not eliminate the governance problem which results from the discrepancy between the private interests of the bank’s managers and the public interest in financial stability.”

In summary:

Sophisticated internal modelling of risk is not a solution to governance problems in banking. Regulation and supervision are required.

We have already seen that from a governance perspective, the board of directors provide oversight while senior management are responsible for internal control.

What is the corporate governance role of bank supervisors?

Simply put, Basel (2010) views bank supervisors as promoting and assessing good governance practices in banks. To achieve this important objective, there are several principles for guidance. These are as follows:

• Supervisors should provide guidance to banks on expectations for sound corporate governance and should regularly evaluate the bank’s governance policies and practices as well the efficacy of its implementation. It is interesting to note that an important element of supervisory oversight of bank safety and soundness is an understanding of how corporate governance affects a bank’s risk profile. Accordingly, supervisors should expect banks to implement organisational structures that include appropriate checks and balances. We consider the role of bank structures in corporate governance in the next chapter.

• Supervisors are encouraged to meet with board directors, senior management and control functions as part of the on-going supervisory process. This consultation process serves to help supervisors in ‘getting to know your bank’ and avoid a one-size fits all approach to supervision.

• Supervisors should require effective and timely remedial action by a bank to address material deficiencies in its corporate governance policies and practices. Of course the nature of the remedial action is proportional to the type of corporate governance deficiency that threatens the safety and soundness of the bank or relevant financial system.

The following summarises the main entities of bank corporate governance.


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Bank Corporate Governance

Board Oversight

(monitoring and advising)

Senior Management Internal Control

Risk Management

Independent CRO

Supervisors Promote Good Governance

305.4: Main entities of bank corporate governance

In the next chapter, we consider the role of organisational structure in risk governance as well as its implication for ethics.


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Chapter 3:Bank Operational Structure, Risk and Ethics

This chapter considers the relationship between the bank’s operational structure and the risks it poses for corporate governance. As we indicated in Chapter 2, senior management, as part of its corporate governance obligations, is responsible for the creation of an ethical culture in the bank. We also examine the link between bank structure and ethics by consideration of organisational and cultural silos.

Bank operational structure and risks

Know Your Structure

The term ‘operational structure’ refers to how the bank’s activities are formally grouped so as to effectively implement the bank’s strategy. While there is research to show that the appropriate design of a bank’s operational structure should match external factors (e.g., regulation and supervision) with its internal factors (e.g., people, processes and products), this implies it may not be possible to create an ideal structure for all banks.* However, if customer centricity is the main focus of a bank’s strategy to achieve long-run value creation, then there may be a preferred operational structure that is appropriate for retail banking – that is, one which is decentralised and less hierarchical with board and management involvement to reduce the formation of silos.

This is because decentralisation has the potential for the creation of silo behaviour. As retail banks increase their product offerings and seek to efficiently manage a portfolio of channels to face ever greater competition, information flows across the organisation become crucial. In fact, horizontal coordination across business units becomes especially important. In the design of its operational structure senior management must be fully aware of the potential for organisational silos† that may impede information flows necessary for optimal customer experience. In fact Basel (2010) states that “organisational silos can impede effective sharing of information across a bank and can result in decisions being made in isolation from the rest of the bank. Overcoming information-sharing obstacles posed by silo structures may require the board and senior management to review or rethink established practices in order to encourage greater communication.”

* J. Galbraith, Designing complex organizations (Reading, MA: Addison-Wesley Publishing Co, 1973)† Organisational silos can be characterised by business lines, legal entities, and/or geographic units being run in isolation from each other, with limited information shared and, in some cases, competition across entities.


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Lesson While strategy determines the direction the bank wants to take, the operational structure provides the location where decision-making power resides. Importantly, the free flow of information across business units is critical to create positive customer experience – the most important rationale for the bank’s operational structure.

It is not enough for the board of directors and senior management to know the operational structure of the bank. It is also important to understand the structure.

Understand your structure

This means that the board and senior management should identify, assess and mitigate sources of risk to the bank that are likely to emanate from its operational structure. For example a matrix structure may be quite complex and thereby conceal sources of operational risk to the bank. While a matrix structure provides more flexibility in the sharing of skills and competences across business units, ambiguity in employee reporting can be frustrating. Furthermore, there is likely less clarity and more complexity in such a structure – attributes of operational structure that Basel (2010) suggests can lead to corporate governance failures. On the other hand, while a functional structure creates homogeneous business units, there is risk that such units may pursue their own objectives at the expense of the bank’s strategic goals. Worse, business units in isolation lack an end-to-end view of retail banking operations and the requirement for horizontal coordination.

There is evidence to support the argument that functional operational structures can create risks to the bank. For example Mudambi and Navarra* (2004) demonstrated how managers in a functional structure can have objectives that diverge from the bank’s strategic goals. Furthermore, De Motta† (2003) shows that with greater power to make decisions, managers in business units can make costly decisions that are not immediately observed by senior management.

Finally, Roy‡ (2008) makes a key point about risk management and capital allocation issues related to a functional structure. He states that “in a functional structure the impact of risk capital for exercising behavioral influence over risk-taking decisions at the unit level (e.g., the branch) may be limited because the managers involved in decision making may not get a clear line of sight of business drivers and results.”

Lesson The board of directors and senior management must understand the bank’s operational structure and the risks to sound corporate governance.

Bank Operational Structure and Ethics In Chapter 1, the link between agency theory of corporate governance and possible unethical behaviour of managers is established. We now continue this discussion to a potential relationship between the bank’s organisational structure and ethics.

In fact there are several academic articles that address the relationship between a bank’s organisational structure and business ethics. The rationale for this alleged link is aptly described as follows:

“An organisation’s structure is important to the study of business ethics because the various roles and job descriptions that comprise that structure may create opportunities for unethical behavior.”

* R. Mudambi and P. Navarra, “Is knowledge power? Knowledge flows, subsidiary power, and rent-seeking within MNCs”, Journal of International Business Studies 35 (5):385–406 (2004).† Adolfo de Motta, “Managerial Incentives and Internal Capital Markets”, Journal of Finance, v. LVIII, no. 3, pp. 1193-1220, (June 2003).‡ Anjan Roy, “Organisation Structure and Risk Taking in Banking”, Risk Management 10:2, 122-134 (2008).


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Indeed, James* (2000) advised that “managers should focus on developing organisational structures that do not undermine the ethical sensitivities and attitudes of workers and that reinforce ethical behavior.” Further, a paper by Brickley, Smith and Zimmerman† (2009) proposes that the relationship between organisational structure and ethics is a leadership challenge and states that “a key question for top management is whether the incentives established by the firm’s organisational architecture reinforce or undermine the code of conduct”. In this sense, ensuring consistency in organisational design is an important leadership function - one that is critical to encouraging ethical behaviour as well as the pursuit of shareholder value. In support of this statement, they state that effective corporate leadership involves more than developing a good strategic plan and setting high ethical standards. It also means coming up with an organisational design that encourages the company’s managers and employees to carry out its business plan and maintain its high ethical standards.

What is the theoretical link between organisational structure and ethics?

Recently, a group of retail banking professionals who are also members of the board of the Retail Banking Academy were questioned about the problems of a silo organisational structure and how to resolve this problem and mitigate inter-group conflicts andethical violations. Their responses were similar to that of Dick Harryvan, former CEO, ING Direct, as stated below:

“A lot of today’s problems came about through commission structures and the sometimes horrendously high rewards to distributors of these products, where again I think the danger is that it gets salesmen acting more in their own interest than the client’s interest. The more complex the product, the less the clients understand what they are paying. So a lot of things get blended in. As my old boss used to say, financial services companies are great at making products so complex that you need an intermediary to de-complexify it for the client. Of course in the meantime, they get potentially high remuneration which is not to the client’s benefit in terms of returns or value for money.

Open Question #3“Silos are the result of organisational culture and not just organisational structure.”

Do you agree?

The questions and typical answers in the survey are presented below:

* H S, James, Jr “Reinforcing ethical decision making through organisational structure”, Journal of Business Ethics, 28(1), 43-58 (2000)† Journal of Applied Corporate Finance, Volume 21, Number 2, pages 58-66


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Survey Questions and Typical Answers

Question 1

How would you define a silo organisation structure?

Response

A silo organisation is one where people are focused only on their own department/activities. An end-to-end overview of the business/process is missing. Measures taken to optimise own department/activities may therefore be suboptimal for the whole. Importantly people are focused on tasks and not overall company objectives. The client view is therefore often missing because there is not a more holistic view of the business or of how a client experiences the services/processes.

Question 2

In your experience, how does a silo structure create inter-group conflict and other suboptimal behaviour?

Response

Lack of interaction/personal relationships across departments/silos result in focus on own department and suboptimal solutions and less innovation because more holistic and diverse perspectives are missing. Misunderstanding of different silo motives and lack of alignment to a common goal creates friction and suboptimal solutions.

Question 3

How would you best structure a retail bank to eliminate, as much as possible, a silo structure and thereby minimise inter-group conflicts?

Response

Ensure a customer focus whereby end-to-end review of processes is key and wherever possible make one manager/unit responsible for full process performance. The excuse that poor performance is due to other departments’ poor performance should be eliminated where possible through unity of control.

Question 4

How might compensation contracts create silo behaviour?

Response

If variable pay is based on key performance indicators that are not aligned over the departments or are not focused on the overall performance of the company, it will cause staff to focus on their own department activities. This stimulates silo-type behaviour.

So after seeing the harm that silo behaviour can cause for long-term value creation in a retail bank, the immediate question is:

What type of organisational structure is likely to reduce the formation of silos?

For simplicity, let us consider organisational structure as binomial – centralised and decentralised.In the former, decision-making power is located at the highest levels of the organisation and there is a rigid system of compliance. In the latter, decisions are made at lower levels but consistent with the overall vision and business strategy.

So which is preferred for a retail bank?

First, a centralised structure is likely to establish a code of ethics with well-defined penalties for


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violations. The consequence is that employees will find it necessary to just comply with the code for fear of negative consequences. Arguably, a centralised structure is likely to enforce ethical principles. But a view of ethics as being compliance-directed is unlikely to lead to optimal customer service. Customer service relies mostly on employee engagement and not just on observing the letter of the code.

Second, a decentralised structure is consistent with increased flexibility at lower levels of the bank. Paradoxically, the resultant localisation of decision-making power may lead to the creation of self-interest and silos.

So we have a surprising conclusion:

A centralised organisational structure may actually have a lower degree of ethical violations. Insuch organisations, compliance is enforced by way of fear of punishment. A decentralised organisational structure may have a higher degree of ethical violations. In such organisations, the locus of decision-making power is at lower levels and the risk for silo formation is higher.

Since we propose that a values-based ethical culture is preferred over one that is compliance-based, it is imperative to implement policies to reduce the risk of silo formation in a decentralised organisational structure.

LessonIt is likely that silo thinking is not the result of the bank’s operational structure but of a weak ethical bank culture. It is the creation of a values-based environment that fosters the stewardship approach to corporate governance which is preferred.

We now propose some practical solutions to reduce the likelihood of the formations of silos.

Policies to Reduce the Likelihood of Silo Formation

a) First Policy

Banks must make it a priority to reduce a silo mentality that may exist in the minds of employees. ‘Silo mentality’ refers to a mindset of employees that propagates a point of view determined by their own specialisation.

This mindset makes it impossible for these bank specialists to view the full set of operations with the various interconnections and cross-functional relations that typically exist in a retail bank. They are unable to determine the risks that their actions may cause in another functional area of the bank. Such a mindset may exist in a matrix or functional operational structure since it is the outcome of the specialist over-estimating his/her own value in the bank. They are imprisoned in the walls of their own limited although highly specialised knowledge.

It is imperative that all retail banking employees be appropriately qualified in retail banking theory and practice. As a member of a profession, they should take ongoing development courses and seminars to be familiar with new ideas and best practices to serve the client better. To eliminate the silo mentality in the bank, it is imperative to eliminate the silo mentality in bank staff through a holistic and accredited training programme.

b) Second Policy

Senior management should design compensation contracts that are based on financial outcomes and measures of customer satisfaction for ALL employees. For those employees who are not in direct contact with outside customers, they should be evaluated on the basis of their service to


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internal customers. Let us consider this problem as experienced by Ian Lindsey*:

“At Flemings we had a fairly flat management structure. We described Flemings as a group of cottage industries (or fiefdoms) which operated under the Fleming brand. The MDs of the individual businesses were well aware of the overall objectives of the group but nevertheless it was difficult to achieve inter-divisional cooperation.

“Remuneration was by way of salary plus a discretionary bonus. The bonus was truly discretionary;nobody, other than the chairman, knew how individual bonuses were decided upon yet there was still an absence of inter-divisional cooperation. I headed the retail banking division and wanted to launch a private banking service which would have involved other divisions but disagreements over allocation of costs and revenues, marketing and sales strategies meant that, while Flemings had all the component parts to launch an exclusive private banking service, it never did. I believe the failure to agree over the division of costs and revenues of joint divisional ventures, was in part because divisional heads believed their individual bonus was linked directly to divisional results even though they were discretionary.

“I mentioned the flat management structure; it would be best described as a spider’s web. We hadretail banking operations in several countries; the chairman would quite often send the retail bankingmanaging director from one country to another to ‘familarise’ himself with the other operation.Upon one’s return to the UK, the chairman would question that individual about the trip and so obtainideas on how to improve the operations. Obviously there was always resentment/fear when hostingsuch visits. However the flat spider web-like management structure was quite effective in achievingmore optimal performance.”

This chapter makes two key points in relation to corporate governance in banks:

• The board of directors and senior management must ‘know your structure’ and ‘understand your structure’ so as to identify, assess and mitigate potential risks that emanate from the structure;

• Cultural silos are more important than organisational silos in creating unethical practices in banks.

SummaryThis chapter dealt with corporate governance in retail banking. Chapter 1 presented the underling theories of corporate governance – the agency theory and the stewardship theory which includes the stakeholder theory. The agency theory is based on the principal-agent problem where the separation of ownership (shareholders) and control (management) creates conflicts of interest leading to a loss of shareholder value. It also has implications for ethics in that the agency theory is an explanation for the occurrence of self-serving behaviour of managers at the expense of other stakeholders. The stewardship theory is based on the assumption that managers value collaboration and seek to advance the long-term interests of all stakeholders. This theory also has implications for business ethics since it is more aligned with the Kantian moral philosophy of having the right motives.

Chapter 2 considers the role of important corporate governance instruments in monitoring the actions of senior management especially in light of agency theory. It presents four factors for an effective board of directors in relation to oversight of senior management. These are:

a) board of directors’ skills, knowledge and independence;b) board of directors’ busyness;c) board size; andd) term limits of directors.

* Member of the RBA Awarding Body in a private communication.


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The role of senior management in sound corporate governance in banking is also considered. The key role is summarised as follows: senior management should ensure that the bank’s activities are consistent with the business strategy, risk profile, and policies approved by the board. In addition, the corporate governance obligations of senior management are as follows:

• Align with the board of directors to set the tone at the top by being exemplary;• Create an ethical corporate culture; and • Ensure that management’s action align with the board’s directives.

The importance of the design of executive compensation (an important responsibility of the board of directors) is considered and four factors are recommended. Executive compensation should be:

• Aligned with prudent risk taking;• Symmetric with risk outcomes;• Sensitive to risk time horizons; and • Subject to Malus/Clawback.

We also considered the role of risk management in corporate governance in banking. This is spelled out in Basel (2010) as follows: the risk management function typically involves:

“identifying key risks to the bank; measuring exposures to those risks; monitoring risk exposures and determining the corresponding capital needs (i.e., capital planning) on an ongoing basis;taking steps to control or mitigate risk exposures; and reporting to senior management and the board on all the items noted in this paragraph.”

Importantly, the role of the Chief Risk Officer is emphasised in terms of authority and independence.

Finally, we considered the role of deposit insurance in influencing the monitoring effectiveness of depositors. In addition, the role of supervisors and the effects of regulation are discussed.

Chapter 3 presented a link between the operational structure of a retail bank and the risks that may emanate from it. The key responsibilities of the board and senior management to ‘know your structure’ and ‘understand your structure’ are discussed and a key point is highlighted: while strategy determines the direction the bank wants to take, the operational structure provides the location where decision-making power resides. Importantly, the free flow of information across business units is critical to create positive customer experience – the most important rationale for the bank’s operational structure.

This chapter concludes with a discussion of the potential link between silos and ethical behaviour of bank employees. The final conclusion in this regard is that cultural silos are more difficult to deal with compared to organisational silos. Two policies to mitigate this problem are discussed.


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Multiple Choice Questions

1.Which theory of corporate governance implies the possibility of opportunistic behaviour by senior management at the expense of other stakeholders?

a) Stakeholder theoryb) Agency theory c) Teleology d) Deontology

2. “In relation to bank board directors, there are benefits in terms of networking and knowledge transfer from being on multiple boards.” This statement reflects which one of the following hypotheses?

a) Over-boarding hypothesisb) Busyness hypothesisc) Experience hypothesisd) Agency hypothesis

3. Consider the following statements:

a) The entrenchment hypothesis states that the independence of outside directors may be compromised when they serve for longer tenure periods together with the same CEO.b) Countries around the world have imposed term limits for board directors in the range of nine to twelve years. c) The independence of directors is enhanced if they are adequately skilled and knowledgeable in business practices.

Which of the following comprises the most number of correct statement(s) only?I: a) and b) only II: a) and c) only III: a), b) and c)IV: b) and c) only

4. Which one of the following is not one of the recommended attributes of a compensation system for sound corporate governance?a) Align with prudent risk taking b) Sensitive to risk time horizonc) Symmetric risk outcomesd) Comprises a significant proportion of variable rewards

5. Conditions imposed by a bank board which enable it to modify the terms of a deferred compensation plan during the deferral period is called:a) Clawbackb) Malusc) Non-paymentd) Deferral


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6. The graphical relationship between the financial performance of a bank and board size is U-shaped. This shape represents a trade-off between which two of the following statements?

a) Smaller boards are preferred because these are likely to focus more on important issues facing the organisation rather than just comply with the CEO recommendationsb) Board size is related to the size and complexity of the banking businessc) Larger boards are likely to encourage free-riding and groupthink so that due diligence and risk management may suffer

Which option comprises the correct two statements that describe the trade-off?

I: a) and b)II: a) and c)III: b) and c)

7. Which of the following is not consistent with effective risk management?

a) The chief risk officer (CRO) should have unimpeded access to the board and its risk committeeb) The senior management of the bank should approve and oversee the banks’ risk appetite frameworkc) Best practices in risk management require that the dedicated risk committee of the board comprise a majority of independent directorsd) The bank’s risk exposures and strategy should be communicated throughout the bank with sufficient frequency.

8. Which of the following statements is incorrect?

a) A matrix structure can be relatively complex and conceal sources of operational risk.b) A matrix structure provides more flexibility in the sharing of skills and competences across business units.c) A matrix structure can create ambiguity in employee reporting, leading to frustration.d) A matrix structure has all the attributes of an operational structure that lead to sound corporate governance.

9. Which theory of corporate governance puts a value on collaboration with all stakeholders?

a) Agency theory b) Stewardship theoryc) Entrenchment theoryd) Shareholder theory

10. Which operational structure will likely lead to the creation of organisational silos in a bank?

a) Matrix structure b) Hierarchy structurec) Functional structured) Centralised structure

Answers:

1 2 3 4 5 6 7 8 9 10

b c III d b II b d b c


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Appendix: Corporate Governance in Islamic Banks

Islamic banking is based on fundamental principles of profit-sharing partnerships where lending is intended to finance productive direct investments. Specifically, Islamic banking is based on four fundamental principles:

• absence of interest-based transactions (riba);

• avoidance of speculation (gharar) i.e., contractual uncertainty.*

• payment of an Islamic tax (i.e., zakat); and,

• involvement in only Sharia-compliant products/services.†

A typical Islamic bank balance sheet is as follows:

Assets Liabilities

Cash balances Demand deposits (amanah)

Financing assets (murabahah, salaam, ijarah, istisnah)

Investment accounts (mudarabah)

Investment assets (mudarabah, musharakah) Special investment accounts (mudarabah, musharaka)

Fee-based services (joalah, kifalah,…) Reserves

Non-banking assets (property) Equity capital

The Islamic bank balance sheet reflects the ‘two-window theoretical model’ - one for demand deposits and the other for investment or special investment accounts, which are not true liabilities as in conventional banks. Therefore, such profit-sharing investment deposits are not liabilities. Investors’ capital is not guaranteed, and they incur losses if the bank does.

Based on these fundamental principles of Islamic economics, Islamic banks should be less exposed to asset-liability mismatch, and therefore to equity duration risk, than their conventional counterparts. This comparative advantage is manifested in the ‘pass-through’ nature of Islamic banks, which act as agents for investors-depositors and pass all profits and losses through to them. But this places a greater onus on individual account holders to be more vigilant about the risk-taking activities in an Islamic bank compared to their conventional counterparts who receive a fixed interest on their deposits that may be covered by a national deposit insurance plan. In a nutshell, it is likely that individual account holders are effective corporate governance instruments in Islamic banking.

Furthermore, avoiding contractual uncertainty (gharar) is one way to manage one source of risk in Islamic banks. This is because prohibition of gharar forces parties to avoid contracts with a high degree of informational asymmetry and with extreme payoffs. Recall that, in the Business Ethics (Retail Banking I ) module, a high degree of information asymmetry between manager and owner of funds can lead to manager opportunism - an extreme form of self-serving behaviour. The prohibition of speculation puts investment banking at odds with Islamic banking and increases the likelihood that parties to a contract will be more responsible and accountable.

* This is one reason why Tier 2 Capital in Islamic banks is quite rare. Indeed, Tier 1 Capital + Tier 2 Capital = Tier 1 Capital in Islamic banks† Lewis (2005) states that these specific principles of Islamic economics as well the over-arching influence of the Sharia provide the foundations for corporate governance and ethics in Islamic banking


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In addition, given the over-arching requirement of the Sharia, it is most important that Sharia- compliance boards comprise directors who are well-informed on Islamic economics; possess a high degree of professional banking expertise and experience coupled with high ethical standing; and understand the implications of Sharia on the conduct of Islamic banking.

While, as we have demonstrated in this module, modern corporate governance in conventional banking is based on a complex web of agency relationships aiming to reduce the costs of agency conflicts, in Islamic banking, the underlying principle is stewardship. After all, one can think of a mudharabah contract whereby the bank acts a steward or trustee for the funds entrusted to it by individual account holders. This is similar to a contractual relationship in the conventional investment funds sector.

Stewardship theory stipulates that the (bank) executive is intrinsically motivated to do a good job and be a steward of customers’ entrusted funds. This is similar to a fiduciary duty. Furthermore, the most likely reason for a variation in the manager’s performance (i.e., performance which is below expectations) is due not to a lack of motivation but because of a constraining bank organisational structure. This is interesting in the context of the components of intellectual capital discussed in the People Management (Retail Banking II) module. This is a case where organisational capital constrains human capital from delivering optimal results.
