Corporate Governance in Financial Institutions

Introduction

Compared to the typical corporate governance of other financial institutions, banks are unique, and so is their internal control. This statement is supported by empirical data, much of which was acquired after the financial crisis.¹ Banks that adhered to traditional, shareholder-focused strong corporate governance performed worse than banks with boards that were less susceptible to shareholder influence.² The legislation and regulations governing bank supervision are deeply ingrained concerning the unique management of financial institutions and other organizations.³ Most lately, the function of non-bank companies has been the subject of heated debate.⁴ The two dominant regimes in the United States and Europe, notably Germany, are shareholder and stakeholder governance.⁵ However, in terms of bank supervision and regulation, this distinction has been replaced by stakeholder governance and, more specifically, creditor or debtholder governance. The meaning of this for research and reform is still unclear and controversial.

The fundamental regulatory problems with bank corporate governance are numerous. A one- or two-tier board’s makeup and qualifications constitute a significant issue. The overall objective is to improve qualified and independent control, but the idea of allocating a special seat on the board to creditors ignores the realities of worker co-determination. Giving bank regulators a permanent place on the board would put them in the position of having to monitor themselves, which would lead to major conflicts of interest. There are several significant concerns related to bank governance, such as the liabilities and responsibilities of bank directors, particularly concerning risk and compliance, as well as the compensation given to bank directors, senior managers, and key function holders. There are already advantageous claw-back measures in place in several nations, whether they were instituted by banks themselves or were mandated by legislation. Overall, the paper aims to explore the methods and duties of board composition, corporate governance leadership and influence, and efficient and productive management as these are the main discussion points in the identified topic.

Board Composition Methods

The discussion on boards’ efficacy has centered on the board’s creation. A more concentrated focus on the competencies existing on the board, the accumulated intelligence, skills, and experience, has taken the place of the solitary focus on independence and limited fit-and-proper before the crisis.⁶ Diversity, particularly in terms of gender, has also emerged as essential.⁷ The majority of banks use matrices to control their profile actively. However, there are still different viewpoints on what constitutes a good board.

Some boards want their members to have as wide a range of abilities and diversity as feasible. They sometimes group professionals and experts who excel in certain specialized fields but occasionally cannot see the real situation.⁸ Other banks could fundamentally favor all-rounders with leadership experience, forgoing specialized knowledge such as cybersecurity threats and other risk management skills in favor of more extensive leadership experience.⁹ The two strategies may and frequently do complement one another, but there is always conflict in the periphery.

There are established models for board-level paperwork, and chairpersons meticulously schedule member encounters with management and the CEO. In the meantime, they keep a distance between themselves and management and refrain from meddling in those procedures.¹⁰ In best practice boards, presenters are frequently invited from two to three levels below the executive committee, allowing for a broader understanding of the bank’s depth. Even though it has become rather typical to get written regular CEO briefings via the board portal, almost everyone would prefer to hear from the CEO at the opening of the board meeting. Several institutions have extended this approach to include CEO and CFO reports, but these reports must be concise.¹¹ Last but not least, most boards now accept all significant bank disclosures, including numerous documents filed, and are developing strong frameworks for them.

In the full method, the CEO obtains all authority apart from the board’s reserved powers, which they subsequently transfer to other people. In this paradigm, executive committees are not given any formal authority.¹² Executive councils guide the CEO or other managers in their role as chair, notwithstanding the specific nature of their duties.¹³ This is a straightforward strategy where accountability and responsibility are both obvious. The drawbacks include the potential for the CEO’s considerable influence to be abused and some uncertainty regarding board decisions.

A distinct authority structure must always accompany the complete approach to implement the strategy successfully. In job descriptions, specific explanations of each person’s duties and powers will not do. Partial strategies involve the board delegating certain executive powers to non-CEO executives, sometimes in conjunction with stated collaborative power for the executive committee.¹⁴ This is an excerpt from the two-tier board book, where the CEO serves as primus inter pares and the spokesman of the management board.¹⁵ It will be effective if it becomes ingrained in the institution’s culture and reinforced by a board mandate that is substantially broader to track and evaluate the performance of specific executive committee members.

Board Composition’s Duties

The bank’s corporate strategy, financial stability, important hiring choices, internal organization, governance structure, and risk management procedures are all ultimately within the board’s control. The board may assign part of its duties—but not its responsibilities—to board committees where necessary.¹⁶ The bank’s organizational structure should be decided upon and approved by the board. This will make it possible for the board and upper management to fulfill their duties and to make decisions effectively and with good governance. This involves concisely outlining the main duties and powers of the board, top management, and individuals in charge of the control and risk management tasks. According to the relevant national legislation and regulatory requirements, the board members must uphold their duty of care and duty of loyalty to the bank.¹⁷ The board should ensure that related party transactions, including internal team transactions, are assessed for risk.¹⁸ Additionally, they should be subject to the proper restrictions, for example, by mandating that such exchanges be conducted on arm’s length terms along with bank assets that are not misused or misapplied.

The board must consider the legal interests of shareholders, depositors, and other important stakeholders while carrying out these duties. Additionally, it should guarantee that the bank and its regulators have a productive working relationship.¹⁹ A business culture that reinforces proper standards for moral and ethical behavior is crucial to successful governance.²⁰ Certain standards are particularly important regarding a bank’s risk awareness, risk-taking behavior, risk management, and the bank’s risk culture.

The board should establish and uphold company values so that almost all business should be conducted legally and ethically. It should monitor senior management’s and other employees’ adherence to these values to foster a sound corporate culture.²¹ Working to promote risk awareness inside a strong risk culture, communicating the board’s expectations that it does not endorse massive risks and that all employees are accountable for assisting the bank in operating within the known risk appetite and risk limits. Confirm that the necessary steps have indeed been or are being chosen to be taken to interact throughout the financial institution with the corporate values, professionalism, codes of conduct it sets, and supporting policies.

Coordinating the board’s expectations that the bank continues operating within the recognized risk appetite and limits. A bank should outline acceptable and prohibited behaviors in its code of conduct, ethical code, or analogous policy.²² It has to forbid unlawful conduct, including inaccurate financial reporting and malfeasance, and economic crime, such as fraud, breaking of penalties, money laundering, anti-competitive tactics, bribery, corruption, or violating consumer rights.²³ Banks’ corporate governance guidelines imply that it should be made clear that personnel must behave ethically in addition to abiding by laws, regulations, and corporate rules. However, the board should carry out its duties with competence, due care, and diligence.

The bank’s corporate principles should recognize the escalation of issues to higher levels in the organization and the crucial need for prompt and open communication. Employees with valid concerns about unethical, unlawful, or dubious behaviors should be encouraged to voice them privately without fear of retaliation.²⁴ This can be supported by a clearly articulated policy and sufficient procedures and processes that comply with national law and allow workers to express legitimate fears and observations of any infractions privately.²⁵ This involves informing the bank’s supervisor of any pertinent issues.

The mechanism for the whistleblowing policy should be within the board’s control, and top management should be held accountable for resolving credible complaints. The board must monitor and authorize how and whom valid content issues shall be explored and discussed by an objective and independent external or internal body, senior management, and the board itself.²⁶ The board must ensure that employees who express issues are protected from unfavorable treatment or retaliation.

Leadership in Corporate Governance

The board and leadership should be open and honest about their corporate governance framework and procedures, paying special attention to the board’s make-up, the selection of directors, management succession plans, remuneration, and other matters of concern to shareholders. The board and top management should also actively engage in shareholder outreach and uphold the best standards for transparency.²⁷ Serious mistakes or errors in the bank’s disclosure standards may lead to legal and regulatory infractions and heavy regulatory fines.²⁸ The bank’s board of directors and management should see improved openness and communication to win the public’s trust, increase the bank’s worth, and maybe open up access to capital and financing markets.

The board is essential to the bank’s efficient governance since it is answerable to stakeholders like shareholders, authorities, and others. The board is in charge of supervising management, offering organizational leadership, and setting fundamental business principles.²⁹ It should develop a business and risk governance structure to enable supervision and aid in determining the bank’s strategic vision, risk attitude, and risk appetite.³⁰ There is also a responsibility for senior management’s development, recruitment, succession planning, and payment procedures.

The board’s functions and obligations should be crystal apparent to it. It should be equipped with all the essential procedures, committee structures, communication and reporting methods, and abilities to conduct effective supervision. A genuine challenge to management should come from the board, which should be prepared and ready to act independently.³¹ The bank’s risk management processes, financial reporting, and adherence to legal and regulatory requirements should all be subject to independent evaluations for quality, accuracy, and effectiveness.³² Independent assurances are crucial to the board’s ability to supervise the management effectively and are often carried out by the bank’s audit department. The board’s involvement in bank governance differs from management’s involvement. The board is in charge of the bank’s general direction and supervision, but it is not in charge of day-to-day management.³³ The board should supervise the management and hold them responsible for achieving strategic goals within the bank’s risk tolerance.

Efficient and Productive Management

Effective supervision should be facilitated by board composition. The optimal board is well-diversified and comprises people with various skills following the bank’s size, direction, risk tolerance, and complexity.³⁴ Although the credentials of each director will differ, they should together offer the knowledge, perspective, and experience required for efficient bank management. Directors who comprehend the organizational complexity and hazards inherent in the bank’s operations should be included as the directors of larger, more complicated institutions.³⁵ Each director should contribute their specific area of expertise to the board’s monitoring of risk and compliance duties. The management should be prepared and equipped to use independent judgment when evaluating management’s suggestions and choices.³⁶ In order to fulfill its obligations, the board should also be appropriately committed and engaged. The board should ensure a balance between within and outside directors to encourage director independence.

Inside directors work for banks as officials or in other capacities. Outside directors are not staff members of the bank. Directors are considered independent if they have no close familial ties to the institution or its management and no significant commercial or professional links apart from stock holdings and directorship.³⁷ Independent directors provide their experiences from their specialized areas. Since independent directors supervise bank operations and assess management suggestions, these experiences offer perspective and objectivity.³⁸ This mix of internal and external directors encourages impartial scrutiny. Excessive managerial influence may prevent a board from successfully carrying out its legal and oversight duties.

A director should generally be ready and competent to exercise independent judgment and make a convincing case against management’s judgments and suggestions. It is crucial to possess a fundamental understanding of the banking sector, the financial regulatory framework, and the laws and ordinances that underpin bank operations.³⁹ It is necessary to possess a business background, understanding, and experience to help with bank monitoring. They agree to uphold fiduciary duties and responsibilities, which include a strong commitment to prioritizing the bank’s interests over individual ones and avoiding conflicts of interest.⁴⁰ There is also a need to be steadfastly committed to attending committee and board meetings on time, prepared, and familiar with the communities the bank serves.

The board should design a procedure to find, evaluate, and choose director candidates to fill open board positions. The procedure may need to be written depending on the size and complexity of the bank.⁴¹ Certain boards employ a nomination committee, and considering the bank’s operation and the risks associated with that business, the board or selecting committee should assess whether the director applicant has the appropriate expertise, skills, and experience. If the bank, for instance, intends to offer new, altered, or enlarged goods and services, the criteria for required knowledge, abilities, and expertise may change over time.⁴² Depending on specific demands, some boards set extra requirements. The director applicant should be prepared and ready to supervise senior management aggressively and, if required, confront and demand changes.⁴³ Inside directors should not have undue influence when choosing board members, either.

The prospective board member should demonstrate honesty in personal and professional transactions, have a solid reputation and be prepared to put the bank’s objectives ahead of any competing self-interest. Any connections or conflicts the board candidate or their linked interests could have with the bank or its associates should be disclosed.⁴⁴ The board should consider whether a prospective candidate is suitable if they have major interest conflicts that would force them to refrain from voting on certain topics or transactions.⁴⁵ Potential board members should have their backgrounds checked, and current directors should check theirs regularly. A diverse board of directors is another crucial component of a successful organization.⁴⁶ The board needs to aggressively look for individuals from a broad pool, including women and people of color, and applicants with expertise in internal controls and risk management.

Influence of a Corporate Governance

The board of directors is a crucial governance structure that can reduce the agency issue between shareholders and management. Although there is not a perfect board size for every company, corporate value, firm policy decisions, and risk-taking tend to be influenced by board size.⁴⁷ The influence of board size on a company’s success is extensively reported in the literature, but not much research specifically looks at the relationship between board size and a company’s willingness to take risks.

Bank corporate governance is very different from corporate governance in general. Debtors are included in the scope of governance for banks in addition to shareholders, such as equity and debt governance. The main governance issue from the standpoint of bank supervision is debt governance.⁴⁸ The interests of the administration, shareholders, current liabilities, and supervisors are mostly similar and largely distinct regarding equity and debt governance. Deficiencies in bank corporate governance caused the financial crisis.⁴⁹ Reforming corporate law is not as effective for improving bank governance as boosting supervisory legislation requirements.

The judgment process and the efficacy of the board are influenced by board size, and these factors, in turn, impact risk-taking. As a result, the final judgments of bigger groups represent more concessions. According to several earlier research on collective decisions in sociology and economic psychology,⁵⁰ they are less radical than those of smaller units. Therefore, it is likely that larger boards are connected with less variation in corporate performance since they tend to make fewer extreme judgments. Since it takes more discussion and compromises to gain a consensus on a larger board, a larger board moderates the extremeness of board decisions.⁵¹ Therefore, because it is more challenging to reach a consensus in a big group, riskier initiatives are now more likely to be rejected.

Conclusion

In general, assessing the board of directors’ function in financial statements demonstrates how important each choice and action is for a firm. A financial statement is a product of labor done during a specific period, on the one hand. On the other side, the same document also contains a plan for individuals’ upcoming accomplishments and actions. The board of directors supervises and analyses the personnel through the company’s balance statements and cash flows while guiding and supporting them. The financial reporting process is difficult for the employees and the board of directors. However, if everyone involved knows their roles and has received adequate training, their collaboration should help produce positive outcomes and advantages.

Bibliography

Basel Committee on Banking Supervision. “Corporate Governance Principles for Banks.” Bank for International Settlements. (2015).

Bruner, Christopher M. “Corporate Governance Reform in Post-Crisis Financial Firms: Two Fundamental Tensions.” Arizona Law Review 60, no. 4 (2018): 959-986.

Ellul, Andrew. “The Role of Risk Management in Corporate Governance.” Research paper, Kelley School of Business, 2015.

Hopt, Klaus J. “Corporate Governance of Banks After the Financial Crisis.” In Financial Regulation and Supervision, A Post-Crisis Analysis, edited by Eddy Wymeersch, Klaus J. Hopt, and Guido Ferrarini, 337-367. New York: Oxford University Press, 2011.

—. “Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy.” European Business Organization Law Review 22, no. 1 (2021): 13-37.

Fernandes, Catarina, Jorge Farinha, Francisco Vitorino Martins, and Cesario Mateus. “The Impact of Board Characteristics and CEO Power on Banks’ Risk-Taking: Stable Versus Crisis Periods.” Journal of Banking Regulation 22, no.4 (2021): 319-341.

Nestor, Slipton and Tsilipira, Konstantina. “Views from the Steering Room: A Comparative Perspective on Bank Board Practices.” Nestor Advisors (November 2019): 1-51.

Office of the Comptroller of the Currency. “Corporate and Risk Governance.” Comptroller’s Handbook. (2019).

Footnotes

1. Klaus J. Hopt, “Corporate Governance of Banks After the Financial Crisis,” in Financial Regulation and Supervision, A Post-Crisis Analysis, ed. Eddy Wymeersch, Klaus J. Hopt, and Guido Ferrarini (New York: Oxford University Press, 2011), 340.
2. Christopher M. Bruner, “Corporate Governance Reform in Post-Crisis Financial Firms: Two Fundamental Tensions,” Arizona Law Review 60, no. 4 (2018): 962.
3. Klaus J. Hopt, “Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy.” European Business Organization Law Review 22, no. 1 (2021): 15.
4. Bruner, “Corporate Governance Reform,” 964.
5. Hopt, “Corporate Governance of Banks and Financial Institutions,” 16.
6. Hopt, “Corporate Governance of Banks and Financial Institutions,” 15.
7. Office of the Comptroller of the Currency, “Corporate and Risk Governance” (Comptroller’s Handbook, 2019), 8.
8. Hopt, “Corporate Governance of Banks and Financial Institutions,” 12.
9. See note 8 above.
10. Slipton Nestor and Konstantina Tsilipira, “Views from the Steering Room: A Comparative Perspective on Bank Board Practices” (Nestor Advisors, November 2019), 8.
11. See note 10 above.
12. Hopt, “Corporate Governance of Banks After the Financial Crisis,” 345.
13. See note 12 above.
14. Nestor and Tsilipira, “Views from the Steering Room”, 8.
15. See note 14 above.
16. Basel Committee on Banking Supervision, “Corporate Governance Principles for Banks” (Bank for International Settlements, 2015), 9.
17. See note 16 above.
18. Office of the Comptroller of the Currency, “Corporate and Risk Governance,” 17.
19. Andrew Ellul, “The Role of Risk Management in Corporate Governance” (Research paper, Kelley School of Business, 2015). 21.
20. Basel Committee on Banking Supervision, “Corporate Governance Principles,” 9.
21. See note 20 above.
22. See note 20 above.
23. See note 20 above.
24. Nestor and Tsilipira, “Views from the Steering Room”, 11
25. Office of the Comptroller of the Currency, “Corporate and Risk Governance,” 17.
26. Ellul, “The Role of Risk Management,” 28.
27. Hopt, “Corporate Governance of Banks After the Financial Crisis,” 342.
28. Office of the Comptroller of the Currency, “Corporate and Risk Governance,” 6.
29. Bruner, “Corporate Governance Reform,” 964.
30. Catarina Fernandes et al., “The Impact of Board Characteristics and CEO Power on Banks’ Risk-Taking: Stable Versus Crisis Periods,” Journal of Banking Regulation 22, no. 4 (2021): 338.
31. See note 30 above.
32. Nestor and Tsilipira, “Views from the Steering Room”, 43.
33. Office of the Comptroller of the Currency, “Corporate and Risk Governance”, 7.
34. Ellul, “The Role of Risk Management,” 4.
35. Nestor and Tsilipira, “Views from the Steering Room”, 11.
36. Bruner, “Corporate Governance Reform,” 974.
37. Hopt, “Corporate Governance of Banks and Financial Institutions,” 5.
38. See note 37 above.
39. Nestor and Tsilipira, “Views from the Steering Room”, 14.
40. Bruner, “Corporate Governance Reform,” 972.
41. Hopt, “Corporate Governance of Banks After the Financial Crisis,” 345.
42. See note 41 above.
43. Hopt, “Corporate Governance of Banks and Financial Institutions,” 6.
44. Fernandes et al., “The Impact of Board Characteristics,” 338.
45. Ellul, “The Role of Risk Management,” 10.
46. Office of the Comptroller of the Currency, “Corporate and Risk Governance,” 8.
47. Nestor and Tsilipira, “Views from the Steering Room”, 10.
48. Hopt, “Corporate Governance of Banks After the Financial Crisis,” 360.
49. See note 48 above.
50. Fernandes et al., “The Impact of Board Characteristics,” 322.
51. Hopt, “Corporate Governance of Banks and Financial Institutions,” 14.