Banks and Corporate Governance in the USA - Research Proposal Example

Banks and Corporate Governance in the USA With the highly dynamic and integrated global economy, there have been numerous and varied initiatives to create and establish global standards by which businesses and enterprise could regulate its own functioning. Internal regulation is important especially when an organization spans countries, jurisdictions and different legal, economic and social environments. Corporate governance is one of such efforts. The Organization for Economic Cooperation and Development (OECD) (2010) defined corporate governance as the system by which business corporations are directed and controlled, involving the set of relationships between a company’s management, its board, its shareholders, and other stakeholders.1 The OECD stressed that corporate governance also provides the structure through which the objectives of the company are set, and the means of attainments of those objectives and monitoring performance are determined. In another explanation, Peng (2007) summarized the concept as one that deals with how effectively owners of companies supervise management in order to protect the shareholder’s interests and assure returns of investment.2 In a way, corporate governance serves as a tool for stakeholders to be more active in the governance of companies. According to Koch (2007), it should empower shareholders to dismiss management if they are not satisfied with the performance.3 The principle at work with the OECD definition is that the corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.4 Today, the conceptual work, wrote Mulherin (2004), that underpins the research on corporate governance spans fields such as corporate finance, industrial organization, and the theory of the firm and that much of the underlying framework comes from agency theory and transaction cost economics.5 Background Corporate governance has been rarely used, much less mentioned, prior to the 1990s. But today because of the need to introduce shareholder value, the pressure from the shareholders themselves, and the requirement of regulatory laws as well as the stock exchange in countries such as the US, corporate governance has become a byword. Also, corporate governance was catapulted to the center of international development agenda in the aftermath of the East Asian financial crisis of the late 1990s as well as the emergence of increased privatization and financial market liberalization. There is also the contribution of the high-profile corporate failures, frauds and scandals, such as Enron, WorldCom and Royal Ahold, that prompted the World Bank and the world governments to increasingly attend to the corporate behavior, management and policies. Since then, corporate governance has progressively expanded and certainly is gaining its momentum. In October 1998, the World Bank introduced the initial raft of measures to improve corporate governance across the globe. This initiative involved expert and technical assistance, knowledge sharing, and loans tied to governance reform.6 The then UK Chancellor Gordon Brown suggested that the Bank adopt the OECD governance principle and subsequently made similar calls on the members of the Commonwealth. The OECD corporate governance framework typically comprises elements of legislation, regulation, self-regulatory arrangements, voluntary commitments and business practices that are the result of a country’s specific circumstances, history and tradition.7 Brown’s advocacy led to the founding of the Global Corporate Governance Forum under a Memorandum of Understanding signed by the World Bank President James Wolfensohn and OECD Secretary General Donald Johnston in June 1999, wherein cooperation was established in regard to promoting the OECD principles on the international stage.8 Today, the World Bank’s corporate governance activities focus on: the rights of shareholders; the equitable treatment of shareholders; the treatment of stakeholders; disclosure and transparency; and, the duties of board members.9 It is clear from these activities that the Bank’s approach is anchored mostly on the OECD Principles. It was the Bank of International Settlements or BIS that developed the guidelines on corporate governance for banks in 1999. The BIS has also released a number of highly authoritative papers, most of which pertain more or less directly to the establishment of sound corporate governance and the regulatory supervision thereof at banks.10 In addition to this, a special feature of the Commonwealth of Nations programme has been a focus on the banking sector, working through the member-countries’ central banks. This particular initiative was supported at a special meeting of a number of Commonwealth Central Bank Governors in May 2000, as a result of which a Commonwealth working group was established, a comprehensive check list and guidelines for the financial sector published, and a number of country action plan prepared.11 Corporate Governance Structure As a system by which companies are controlled, corporate governance mandates a highly structured hierarchy that is characterized by checks and balances, accountability, division of responsibilities, among other important variables. A common structure mandates that the Board of Directors is responsible for the governance of their companies; the shareholders role in governance is to appoint who will constitute the Board as well as the Auditors and to satisfy themselves that an appropriate structure is in place. According to Sharma: The responsibilities of the Board include setting up the company’s strategic arms, providing leadership to put them into effect, supervising the management of the business and reporting to shareholders on their own stewardship.12 Sharma also stressed that the corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the Board, managers, shareholders and other stakeholders, and spell out the rules and procedures for making decisions in corporate affairs.13 The work of Gower and Davies (2003), specifically in their popular corporate law book, Principles of Modern Company Law, identified the company constitution as being the key source of governance arrangements, including the division of powers between shareholders and the board as well as the composition, structure and operation of the board.14 Best practices and models of corporate governance is not always the same across all sectors and across countries. For instance, the Association of Investment Companies (AIC) has issued a guidance document, the Code of Practice, (which eventually supplemented the UK Combined Code, discussed elsewhere in this paper) - a principles-based and flexible approach that distinguished investment companies from other sectors such as the banking industry. Consequently, such distinction created a need for a different approach to corporate governance specifically tailored according to the industry’s requirements. The corporate governance structure is influenced, according to the Code of Practice, by two important factors: First is that the customers and shareholders of an investment company are the same; and, that investment companies do not usually have employees, hence, the functions of CEO, Company Secretary, investment management team, administration and accounting functions are generally fulfilled by third party fund managers or other delegates.15 (Turner, p43) The variation of the corporate governance principle within the OECD as applied in different countries is wide. On the one hand, some countries take the view that principles-based laws, supported by detailed best practice guidelines, is the preferred framework for governance issues; while on the other hand, there are countries stating that there is no need for a set of principles because of the introduction or the existing law and regulation that already cover it.16 The Anglo-Saxon model, which is predominantly enforced in the UK, Ireland, and also represented in the USA and Australia, focuses on the stock market as the central element of the system of governance.17 Corporate Governance in UK The UK-based companies looked primarily to the Turnbull Guidance on internal control and, while the work done on internal control frameworks by the international Treadway Commission and the US Public Company Accounting Oversight Board (PCAOB) are more directly relevant to the US-listed companies. The Turnbull Guidance explicitly requires boards, on an ongoing basis, to identify, assess, and deal with significant risks in all areas, including information and communication processes.18 The Turnbull Report has been the key source of corporate governance for directors of UK listed companies.19 The most recent version of the Turnbull guidance was published in October 2005, and applies to listed companies in the UK for financial years beginning on or after January 1, 2006. In regard to the specific policy/standard of corporate governance in the UK, the Cadbury Report is credited to have spawned the so-called UK Combined Code. The Cadbury Report was setup by the Financial Reporting Council (FRC), the London Stock Exchange and the accountancy profession in 1991 for the purposes of: 1) addressing financial aspects of corporate governance; and, 2) to show the financial community that some of the major parties involved in the financial markets were greatly concerned about unexpected failures and cases of fraud in the UK.20 In the context of corporate governance, the Cadbury Report was pivotal because of four primary principles it promoted. These are: 1. A clear vision of responsibilities at the head of a company to ensure a balance of power and authority, such that no one individual has unfettered powers of decision. 2. Every board should include non-executive directors of sufficient caliber and number for their views to carry significant weight in decisions. 3. Institutional investors should take a positive interest in the composition of board of directors, with particular reference to avoiding unrestrained concentration of decision making. 4. The Board structure should clearly recognize the importance and significance of the financial function.21 The Cadbury Report recommended the formulation of a Code of Best Practice to be designed as a tool to achieve high standards of corporate behaviour.22 It is basically aimed at all listed companies with compliance to be ensured by the London Stock Exchange, making acceptance of the Code one of its listing requirements. The Code has undergone several amendments since its introduction, including the integration of the previous Turnbull Report in the Code’s re-issue in July 2003. The most recent update was done by the Financial Reporting Council (FRC) in 2008. These series of developments were undertaken in order to examine the progress in the implementation of the code. In 2005, the review was overseen by a group including representatives of listed companies, investors and other stakeholders.23 The updated objectives of the UK Combined Code today include: high quality corporate reporting; high quality auditing; high quality actuarial practice; high standards of corporate governance; the integrity, competence and transparency of the accountancy and actuarial professions; and, our effectiveness as a unified independent regulator.24 Corporate Governance in the Banking Sector Corporate governance in the banking industry is particularly important today because of the fact that the banks are like the bloodstream of the economy. If the industry is stable and healthy then it enables the economy to be strong. On the other hand, once banks are permeated with bad practices driven by poor or the absence of corporate governance, the economy will suffer. The Commonwealth Secretariat also identified two other reasons why corporate governance is pivotal in the modern landscape. The first of these is that in many developing countries, the equity markets are small and do not play a strong role in the national capital markets, as many companies rely more on the debt finance from their banks; in this context there are no institutional investors to perform the powerful role of encouraging corporate governance in companies which they have done in OECD countries but this function can be fulfilled to some extent by the banks for their corporate customers. The other reason is points to the supply chain of the banking system as a potential and powerful promoter of corporate governance throughout the economy. The idea is that Central Banks can exert moral suasion and influence over the commercial banks and set requirements for all licensed commercial banks in accordance with the previously mentioned standards set by the BIS.25 It is expected that this would achieve a domino effect as commercial banks can in turn recommend good corporate governance practices to their corporate clients (including the majority of private and family-owned companies which are not publicly listed and subject to the stock exchange regulations) in order to reduce their risk and probably gain improved borrowing rates. In this regard, the Secretariat maintained: The importance of the “banking supply chain” is increasing with the application of corporate governance criteria for credit risk analysis by a number of ratings agencies, such as Deutsche Bank and Standard & Poor’s, and local ratings agencies in developing countries. If the ratings agencies are checking corporate governance, the banks must do so also.26 The World Bank is also particularly focusing its corporate governance efforts on the banking sector because of its role in developing economies especially in cases wherein the stock market is undeveloped. Monks and Minow (2008) explained that the world body is very aware of the importance of corporate governance as a mechanism for decreasing corruption, arguing that “the resulting international debate has shown that underlying principles of fairness, transparency, accountability, and responsibility reflect minimum standards necessary to provide legitimacy to the corporate sector, reduce financial crisis vulnerability, and broaden and deepen access to capital.”27 Another factor that strengthens the need for corporate governance in the banking industry is the emergence of large and complex baking organizations. This is brought about by the onset of merger and acquisition movements that have occurred in recent years, which resulted to the few but very large and multinational organizations that control a substantial proportion of industry assets. According to Gup (2007), the diverse activities banks through holding company affiliates and through subsidiaries, cut across many legal jurisdictions and traditional regulatory responsibilities.28 The significance of this development is that corporate governance has increased in importance and in scope. Framework in the Banking Sector Considering how the activities, principles and models pertaining to corporate governance have been established, it is easy to understand how it helps bank administration/governance function effectively. According to Fernando (2009), bank supervisory experience underscores the necessity of having appropriate levels of accountability and checks and balances within each bank, which is sound corporate governance make the work of the Board, the CEO, supervisors and managers infinitely easier and that it can also contribute to a collaborative working relationship between these people.29 Furthermore, the recent sound practices that has been released by the Basel Committee underscore the need for banks to set strategies for their operations and establish accountability for executing these strategies and that transparency of information related to existing conditions, decisions and actions, in the context of sound governance, is integrally related to accountability in that it gives market participants as well as the shareholders sufficient information with which to assess and examine the performance and management of a bank.30 At this point, it is important to underscore again that there is no universal corporate governance standard or rules. The recommendations outlined by the World and the OECD allows for flexibility and variations as they recognize the differences in the cases and circumstances of various countries around the world. Nonetheless, there is an emphasis on the standard principles that are expected to be universally applied - transparency, accountability, fairness and responsibility. This is applied in detail by Fernando when he outlined seven best corporate governance practices for banks and these are: 1. The establishment of strategic objectives and a set of corporate values that are communicated throughout the business organization. 2. Setting and enforcing clear lines of responsibility and accountability throughout the organization. 3. Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns (In a number of countries, bank boards as recommended by several committees on corporate governance have found it beneficial to establish certain specialised committees that include a risk management committee, an audit committee, a compensation committee and a nomination committee). 4. Ensuring that there is appropriate oversight by senior management. 5. Effectively utilizing the work conducted by internal and external auditors in recognition of the important control function they provide. 6. Ensuring that compensation approaches are consistent with the bank’s ethical values, objectives, strategy and control environment. 7. Conducting corporate governance in a transparent manner.31 Is Corporate Governance for Banks Effective? The debate in regard to the beneficial effect of corporate governance on banks has generated conflicting arguments and hypotheses, especially in terms of the link between ownership, control and bank performance. Van Frederikslust, Ang and Sudarsanam (2008), maintained that the model of the governed bank suggests that tightly-held, insider-controlled organization outperforms the managed, diffusely-held firm.32 However, the authors also stated that the considering the costs of having large shareholders, ownership concentration or increased monitoring through the owners may be beneficial only up to a certain extent. Nonetheless, there are available evidences that point to the benefits of corporate governance on banks. A case in point is the Deutsche Bank. The organization developed and implemented its own corporate governance principles back in March 2001. This was after intense pressure from the shareholder, the media and the requirement in its listing on the New York stock exchange. The bank has experienced positive changes that are also reflected in an experiment by Lens, an American investment institution that experimented with the link between corporate governance and corporate performance. Solomon (2007) provided a detail account of this case: [Lens] invested in companies with acknowledged weak corporate governance structures. Using extensive shareholder activism, the investee companies have been forced to improve corporate governance, which has resulted in substantial increases in share valuation. This has led to excess returns to portfolio investment, well above the market indices.33 Some of the companies involved in this experiment included Sears and Eastman Kodak. In the said experiment, Lens used a strategy of investing in a company’s shares, then negotiating and effecting change within the company. In the discussion of the actual efficacy of corporate governance in the banking industry, one could examine what happens in its absence. This is demonstrated in the experiences of most East Asian countries in the 1990s. Due to the absence or weak corporate governance, many companies were encouraged to make reckless investments based on heavy debt financing, while banks and financial institutions were discouraged from properly monitoring the soundness of borrowers and managing the risk in their loan portfolios. These developments led to the sudden rise of financial leverage, rendered many East Asian corporations vulnerable to both internal and external shocks in a globalizing financial market.34 Criticisms In the discourse of corporate governance today, there is an issue that persists particularly advocated by critics: whether this concept is relevant at all – whether it could be effective enough to realize its mandate within the organization. The body of literature, in addressing this issue, simply regress a performance measure, such as accounting returns, on a governance variable like management, performance or insider ownership. However, there are studies that reveal how directors feel averse to corporate governance. As previously mentioned, there are those who view corporate governance as time-consuming, wasteful exercise. In the UK, there are directors who believe the current governance reform and regulations in place negatively affects the competitiveness of UK companies. A recent survey, conducted by KPMG and Lintstock, has revealed these concerns, reporting that companies were fairly unanimous in their view that their expenditure on corporate governance compliance was not adding much value for shareholders because it slows down business processes such as in the stage of decision making.35 The World Bank (1999) also identified a flaw in corporate governance, arguing that investors are not exercising their governance roles effectively and also several new owners are exercising control for personal gains and against the interests of minority shareholders.36 Finally, there are also those who argue that competition and rivalry in the banking sector have increased. This trend, wrote Krahnen and Schmidt (2004), is perceived to undermine the banks’ established practice of acting cooperatively in governance matters.37 Here, conflicts are expected to emerge among the competing banks and that insolvency cases indicate that the model behaviour is no longer valid, and with it a key element of the governance system may be about to vanish. Solomon, however, noted that criticisms of corporate governance reform arise mainly from the people whose behaviour is most likely to be altered as a result of the various initiatives, rather than those parties who will benefit from the reforms and that the criticisms relate more to the pain of change than to a genuine belief that good corporate governance does not engender wealth creation.38 This argument, however, does not mean that corporate governance is perfect. As stated, corporate governance across the globe are varied but their one similarity, besides the application of the universal governance principles, is that they all come with their respective flaws. According to Inkpen and Ramaswamy (2006), outside the major developed economies, there is absolutely more room needed for improvement in corporate governance systems. For example, they cited the need for adequate legal protection for investors and the minority shareholders who wield minor influences.39 Again, it is important to underscore that corporate governance framework varies from country to country and so are the flaws and the amount or the degree of improvement and reforms needed. What is essential here is that the corporate governance standards, such as the UK Combined Code, are flexible and have been easily subjected to amendments according to the needs of the changing business landscape. Conclusion Corporate governance has unarguably contributed to the stability, positive performance and profitability of enterprises and financial institutions. In addition, it also functions as a mechanism to effect change in the environment wherein the organization operates. In reviewing the principles that govern this initiative to establish a global standard of regulation, one finds that the objectives, processes, regulations, rules and principles, among other related variables behind it are necessary especially when it comes to the banking industry. There are many reasons for this. As mentioned by this paper, the banks are the lifeblood of an economy; its stability is pivotal in the success of its host country. It has also the capability to effect change, by influencing its customers to adopt corporate governance in their own organizations. One must remember that banks affect the behaviour of firms through lending or collecting fund based on evaluation of a business performance. Furthermore, the modern economic landscape, which is characterized by globalization and liberalized trade, require strong corporate governance in order to protect the interest of the investors and other involved parties. It must be highlighted at this point that the banking industry has a special function in ensuring the stability and integrity of the global financial system. Banks today are large and complex organizations that are deeply entrenched in the global economic system as they operate across countries and offer a number of financial services other than just commercial banking. If one of the world’s major bank is to collapse, its repercussions would be felt by bank regulators and governments the world over. Gup stressed this point, maintaining that banks are different to non-financial corporations due to their public purpose and the position of trust that they hold in the community.40 The risks in the decision-making involved in the banking industry, including its repercussions, are avoided because of corporate governance that ensures that decision-making is not entrusted to only few people, that authority is allocated equitably, that there is an existence of checks and balances, that there is transparency in all of the business processes, and so forth. Indeed, there are many flaws that call for improvement and reform. Nonetheless, they do not outweigh the benefits that banks could acquire by adopting and implementing the corporate governance principles. References Calder, A. (2005). IT Governance: Guidelines for Directors. Cambs, UK: IT Governance Publishing, Ltd. Commonwealth Secretariat. (2004). Commonwealth Public Administration Reform 2004. Norwich: The Stationery Office. Davies, P. and Davies, A. (2003). Principles of Modern Company Law. London: Sweet & Maxwell. Diekman, P.A.M. (2008). Protecting financial market integrity: roles and Responsibilities of Auditors. Kluwer. Du Plessis, J., Grosfeld, B., Lutterman, C., Saenger, I. and Sandrock, O. (2007). German corporate governance in international and European context. Berlin: Springer. Fernando, A.C. (2009). Corporate Governance: Principles, Policies and Practices. New Delhi: Pearson Education India. Gup, B. (2007). Corporate Governance in Banking. Edward Elgar Publishing. Inkpen, A. and Ramaswamy, K. (2006). Global strategy: creating and sustaining advantage across borders. Oxford: Oxford University Press. Koch, E. (2007). Challenges at the Bank for International Settlements: an economist's (re)view. Berlin: Springer. Krahnen, J. P. and Schmidt, R. (2004). The German financial system. Oxford: Oxford University Press. Mallin, C. (2007). Corporate Governance. Oxford: Oxford University Press. Monks, R. and Minnow, N. (2008). Corporate Governance. San Francisco: John Wiley and Sons. Mulherin, J. H. (2004). Mergers and Corporate Governance. Edward Elgar Publishing. OECD. (2001). Corporate governance in Asia: a comparative perspective. London: OECD Publishing. OECD. (2004). Corporate Governance: A Survey of OECD Countries. London: OECD Publishing. OECD. (2004). OECD principles of corporate governance. London: OECD. OECD. (2009). OECD Reviews of Regulatory Reform Regulatory Impact Analysis: A Tool for Policy Coherence. London: OECD Publishing. OECD. (2010). "Corporate Governance." US Mission to the OECD. 22 Jun 2010 Peng, Y. (2007). The Chinese banking industry: lessons from history for today's challenges. London: Routledge. “Report of the Committee on the Financial Aspects of Corporate Governance (Cadbury Report).” (1992) Committee on the Financial Aspects of Corporate Governance. Seker, Y. (2007). What Effects Does Corporate Governance Have on the Banking Sector? Case Study of the Deutsche Bank. Norderstedt: GRIN Verlag. Sharma, M. (2005). Studies In Money, Finance And Banking. Atlantic Publishers and Distributors. Solomon, J. (2007). Corporate governance and accountability. San Francisco: John Wiley and Sons. Turner, C. (2009). Corporate Governance: A Practical Guide for Accountants. Oxford: Butterworth-Heinemann. Van Frederikslust, R., Ang, J. and Sudarsanam, P.S. (2008). Corporate governance and corporate finance: a European perspective. London: Routledge. Waring, K. and Pierce, C. (2004). The handbook of international corporate governance: a definitive guide. London: Kogan Page. World Bank. (1999). Czech Republic: capital market review. Washington D.C.: The World Bank. Publications. Read More