- Analysis of corporate governance in the banking sector
- Incorporating a strong board of directors and management team
- Implementation of effective risk management practices
- Formulating an attractive compensation scheme
- Instilling market discipline
- Implementation of effective enforcement
Corporate governance forms part of the most crucial components in the survival of firms in different economic sectors. Different scholars have advanced numerous definitions of corporate governance. According to Swarup (2011), corporate governance refers to structures, mechanisms, and modalities through which a firm’s goals and objectives are set with regard to the firm and shareholders’ interests. The core objective of corporate governance in an organization is to improve the shareholder’s value and attain financial stability. In addition, corporate governance aims at ensuring that there is effective control over a firm’s behavior and performance. Corporate governance also entails the set of systems through which management teams direct and control organizations in an effort to align and improve their economic and social goals. According to the Organisation of Economic Cooperation and Development (OECD), corporate governance also includes the internal mechanisms through which firms are controlled. Alternatively, corporate governance can extend to include the various mechanisms that are implemented to promote corporate fairness, accountability, and transparency.
The need for corporate governance in organizations arises from the existence of separation between a firm’s ownership and control, which results in the creation of an agency relationship between managers and owners. In case a firm incurs a loss, the investors suffer the consequences through the loss of their investment. In addition, managers may not act in the best interest of the investors hence necessitating the need for corporate governance (Swarup 2011). Anand (2007) asserts that one of the many roles of a firm’s board of directors is to ensure that effective corporate governance strategies are in place. In order to entrench good corporate governance within an organization, it is vital to ensure that an effective company hierarchy is in place. Farber (2003) asserts that effective corporate governance ensures that accountability, integrity, transparency, social responsibility, fairness, independence, and trust are entrenched within an organization. This aspect makes corporate governance stand out as a self-regulatory mechanism (Anand 2007). This paper entails a comprehensive analysis of corporate governance in organizations with a specific focus on banks, as one of the global financial institutions.
Analysis of corporate governance in the banking sector
Corporate governance within the banking sector is paramount considering the fact that banks are characterized by a high degree of opaqueness compared to other financial institutions (Anand 2007). In addition, the degree of information asymmetry within banking institutions is relatively high when compared to other financial firms. For example, banks may not disclose the quality of their loan product when advancing to the customers. This insight means that customers cannot be conversant with the characteristic of the loan for a long period. In addition, informational asymmetry also reduces the shareholder’s capacity to extend corporate control (Levine 2004). According to Levine (2004), a significant amount of cost is involved in monitoring the manager, which consequently results in the emergence of the free-rider problem whereby some shareholders depend on other parties to undertake the monitoring role. According to Levine (2004), large creditors within the bank can enhance corporate governance. However, their capacity is dependent on legal systems, which in most cases are inefficient. Large bank creditors may also collude with bank insiders giving them a capacity to benefit while the less informed investors are exploited thus limiting corporate governance.
Banks also have a higher capacity of modifying the degree of risk associated with their assets (Anand 2007). In addition, banks can extend their loan products to individuals whose creditworthiness is low. The basis of such decisions is the manager’s personal interest to increase their compensation in the short run. This aspect arises from the fact that the bank will receive a higher interest income. Countries with efficient financial systems experience a high rate of economic growth (Arun & Turner 2009a). Banks form a significant proportion of the developing countries’ financial systems, which underscores the importance of ensuring effective corporate governance. According to Levine (2004), industrial societies of firms operating in diverse economic sectors in developed countries have realized the need to strengthen corporate governance in an effort to be competitive on a global scale. Examples of these societies include the Vienot Commission of France, Cadbury Commission in the UK and South Africa’s King Committee on Corporate Governance.
According to Arun and Turner (2009a), integration of sound corporate governance is essential in ensuring that banks undertake investment carefully, and this element is enhanced by the fact that banks’ main source of finance to undertake their investment is the depositor’s funds. The risk of failure arising from mismanagement underscores the importance of corporate governance. According to Arun and Turner (2009b, p.109), it is important for governments to intervene in order to control the conduct of the bank’s management team. The need for government intervention has resulted from the high rate of globalization. In addition, a high degree of discretion amongst banks’ management teams can result in a banking crisis, as illustrated by the 2008 global financial crisis that emanated from the failure of the major US banks to reinforce effective control mechanisms. As a result, the banks engaged in excessive risk-taking activities.
According to Vives (2000), banking crises arise from poor bank governance. Levine (2004) asserts that banking crises have the capacity to destabilize governments, cripple economies thus increasing the level of poverty. Numerous cases of bank failure have been documented over the past decades. According to a report by the Federal Deposit Insurance Corporation (FDIC), 2005 and 2006 were the only two years from 1934 to 2007 when the United States did not experience bank failures due to a lack of effective corporate governance.
Considering the contribution of the banking sector to countries’ economic growth, it is paramount for a firm’s management team to institute effective corporate governance. In a bid to achieve this goal, the banking sector should take into account a number of issues. Some of these aspects include strengthening the board of directors and the management team, integrating effective risk management practices, provision of optimal compensation, undertaking market monitoring, and integration of effective enforcement.
Incorporating a strong board of directors and management team
According to Mehran (2011), the board of directors is one of the most effective parties that can strengthen corporate governance in organizations. Consequently, banks should ensure that they have selected an effective board of directors. In the process of selecting the board of directors, it is paramount for the banks to ensure that they select directors from both within and without the organization. Additionally, the size of the board of directors should be relatively small. This assertion arises from the fact that a large board of directors increases the free-rider problem in the organization. Additionally, the representation of outside directors should be more than inside directors, which arises from the fact that outside directors are likely to be more firm in implementing corporate governance strategies compared to inside directors (Mehran 2011).
Banks should ensure that managers and the board of directors have a concrete understanding of the corporation’s mission. This aspect will play an important role in nurturing a culture of integrity. Redefining the formulated mission increases the probability of the banks’ Chief Executive Officer and the Board of Directors adhering to the formulated legal and financial standards. It is paramount for the board of directors to institute an effective control and governance mechanism. In a bid to achieve this goal, banks should be effective in selecting the CEO and board of directors. The selected board of directors should have the capacity to monitor diverse bank operations. Some of the aspects that should be considered in the process of selecting the board of directors and the management team include their personality, performance, and integrity.
Considering the complex nature of the banking industry, coming up with the board of directors and the topmost management team should also take into account the experience of the candidate. Banks should also evaluate the selected candidates’ skills such as strategic, operational, financial, and commercial skills. The decision to incorporate candidates with banking expertise as the board of directors emanates from the fact that banks will be required to make decisions involving risky activities (Mehran 2011). Additionally, bank leaders should be in a position to balance risk-taking activities and organizational performance. In the selection of the board of directors, the involved parties should execute the practice with prudence. For instance, busy executives should not qualify as members of the board of directors. This assertion arises from the fact that such members might not have sufficient time to monitor banks’ operations hence leading to poor performance (Mehran 2011).
Implementation of effective risk management practices
According to Mehran (2011), a crucial link exists between risk and corporate governance. In a bid to improve risk management in their operation, banks’ management teams should incorporate effective risk management practices. Lack of reasons for the profound bank failure that was experienced during the 2007/2008 financial crisis is lack of risk governance by banks (European Commission 2011). Most board members of the US banks did not adhere to sustainable risk management practices. Additionally, the board members did not identify and limit excessive risk-taking activities. Consequently, their banks engaged in the provision of complex and numerous financial products that exposed the banks to risks (European Commission 2011).
In a bid to survive in the dynamic business environment, it is paramount; it is paramount of the board of directors to define the level of risk that is acceptable within the firm. Additionally, a risk monitoring committee should be established and assume the responsibility of overseeing the implementation and operation of the firm’s risk management system and policy (European Commission 2011). According to Mehran (2011), it is paramount for banks to consider the possibility of developing a risk culture within all the departments. One of the ways through which the organization can achieve this goal is by communicating the level of risk that the organization has accepted throughout the organization. An experienced Chief Risk Officer (CRO) should be selected to lead risk management activities (Mehran 2011). The CRO should aid in identification, measurement, and reporting on the risk exposures faced by the firm. Additionally, a reporting relationship between the board of directors and the CRO should be established.
Formulating an attractive compensation scheme
Numerous cases of financial fraud within the banking sector have been occurring over the past years (Idolor 2010). An ineffective compensation scheme is one of the reasons that explain why employees engage in financial fraud. According to Mehran (2011), poor executive compensation practices are one of the reasons that explain why the 2007/2008 financial crisis occurred. To enhance corporate accountability, it is paramount for banks to reform their remuneration schemes. Findings of previous studies conducted on the effect of compensation on executive accountability revealed that banks that have implemented a relatively high compensation scheme were resilient during the 2007 financial crisis (Vaitilingam 2009). This scenario emanated from the fact that the executives were more cautious with regard to risk-taking.
In their quest to maximize profits, banks executives involve themselves in developing risky products. Their motivation emanates from the fact that such products would result in the firm generating higher profits hence culminating in higher financial benefits (Adeyemi 2006). In a bid to promote accountability, it is important for banks’ management teams to consider the possibility of designing a comprehensive compensation policy for the top executives. The compensation policy should align with the associated risk. This aspect will play a critical role in ensuring that the executive does not engage in risky activities.
Instilling market discipline
In the course of their operation, it is paramount for banks to implement effective market discipline. One of the elements that should be implemented relates to nurturing transparency. According to Adeyemi (2006), transparency regarding banks’ operations is an important element in strengthening corporate accountability. Effective disclosure culminates in the development of investor confidence. One of the elements that firms should focus on in their disclosure process is the possibility of risk occurrence. The process of risk disclosure should entail the provision of all the relevant information related to the risk. For example, the top management should ensure that the bank discloses all financial information related to the firm’s operation.
Such information is critical in winning investor confidence. When disclosing the financial information, the firms should illustrate the profitable business lines and those that have a high chance of losses (Reaz & Arun 2006). The information should appear in a meaningful and easy-to-understand manner. Additionally, banks should disclose their scale and scope of operation. The information disclosed through various forms such as the financial statements should be accurate and up-to-date.
Implementation of effective enforcement
The promotion of corporate accountability is a challenging task for firms in different economic sectors. This element arises from the fact that the firm’s employees may derive motivation from diverse areas. For example, the existence of personal interest may stimulate managers to undertake risky activities whose objective is to achieve personal goals rather than the established goals (Organisation for Economic Cooperation and Development 2009). In a bid to deal with this challenge, it is paramount for a firm’s management team to institute and enforce comprehensive codes of conduct. The code of conduct should outline how the employees, members of the management team and the board of directors should act in the process of executing their duties.
The code of conduct should outline the behaviors that the employees, board of directors, and the management team should avoid in the course of their operation. One such behavior is disclosing information that can result in insider trading. In addition to formulating the codes of conduct, the firm’s management team should put effort to ensure that they are implemented to the letter (Organisation for Economic Cooperation and Development 2009). It is also critical for banks’ management team and board of directors to formulate a comprehensive corporate governance framework (Orogun 2009). Some of the issues that should be taken into account include the reporting requirements, areas of authority and responsibility. In a bid to enforce corporate governance effectively, it is important for banks to institute effective standard operating procedures, governance structure, and an internal control mechanism (Organisation for Economic Cooperation and Development 2009).
Organizations in different economic sectors are carrying the responsibility of ensuring that they achieve their social and economic goals. In a bid to achieve this goal, integration of corporate governance is very important due to the separation of firms’ ownership and control. Lack of effective corporate governance can result in the failure of the firm hence affecting various stakeholders such as the investors, society, and financiers negatively. As one of the economic sectors, the banking industry plays an important role in the economic development of various countries. Consequently, their survival and future success are critical. However, there have been numerous cases of bank failures across the world due to ineffective corporate governance. To reinforce corporate governance, banks should consider the possibility of incorporating a strong board of directors and management team, implementing effective risk management practices, formulating an attractive compensation scheme, instilling market discipline, and enforcement of good ethics.
Adeyemi, B 2006, Stemming the tide of poor corporate governance: The Nigerian banking sector experience, Ajayi Crowther University, Oyo.
Anand, S 2007, Essentials of corporate governance, John Wiley & Sons, New York.
Arun, T & Turner, J 2009a, Corporate governance of banks in developing economies: concepts and issues, Institute for Development Policy and Management, Manchester.
Arun, T & Turner, J 2009b, Corporate governance and development: reform, financial systems and legal frameworks, Edward Elgar Publishing, Chicago.
European Commission: High-level expert group on reforming the structure of the EU banking sector 2011. Web.
Farber, D 2003, Restoring trust after fraud: does corporate governance matter, Michigan University, Michigan.
Idolor, E.J 2010, ‘Bank frauds in Nigeria: underlying causes, effects and possible Remedies’, African Journal of Accounting, Economics, Finance and Banking Research, vol.6 no.6, pp. 1-19.
Levine, R 2004, The corporate governance of banks: a concise discussion of concepts and evidence, University of Minnesota, Minnesota.
Mehran, H 2011, Corporate governance and banks: what have we learned from the financial crisis. Web.
Orogun, W 2009, Bank distress in History. Web.
Organization for Economic Cooperation and Development: Policy brief on improving corporate governance of banks in the Middle East and North Africa 2009. Web.
Reaz, M & Arun, T 2006, ‘Corporate governance in developing economies: perspective from the banking sector in Bangladesh’, Journal of Banking Regulation, vol. 7 no.3, pp. 94-105.
Swarup, M 2011, ‘Corporate governance in the banking sector’, International Journal of Management and Business Studies, vol. 1 no. 2, pp. 76-79.
Vaitilingam, R 2009, Recession Britain: News ESRC report on the impact of the recession on people’s jobs, business and daily lives, Economic and Social Research Council, London.
Vives, X 2000, Corporate governance: Does it matter, Cambridge University Press, Cambridge.