Analysis of Banking Sector in the UK - Example

Corporate governance in the U.K. banking sector of the Table of Contents Governance of banking institutions 3 Corporate governance reform in the U.K banks 4 Basel Committee actions regarding risk management 4 Walkers report 2009 5 Size composition and qualification 5 Board functioning and evaluation 6 Institutional shareholders roles 6 Governance of risks 6 Remuneration 7 Turner Review 2009 7 Capital adequacy, liquidity and accounting 8 Institutional and geographic coverage regulations 8 Deposit insurance 8 Credit rating agencies 9 Remuneration and FSA supervision 9 Firm risk management and governance 9 Establishing independent risk committee 9 Advantages and disadvantages of risk committee 10 References 12 Governance of banking institutions The governance systems existing in banks have played a contributing role towards the financial crisis. Failure of financial firms in meeting needs of the economy has caused a downfall in the financial sector. Lack of efficiency in the governance system has been identified as one of the causes behind failure of the banking system, which had ultimately triggered the financial crisis. The organization for Economic Co-operation and Development (OECD) has come up with an action plan for improving the governance system of banks. The U.K. government has also commissioned the development of a regulatory framework for improving performance of the financial service sector. A broad development of the banking sector is regarded necessary for improving the economic condition. The changes are necessitated mainly in the area of corporate governance (Grant, 2009). The U.K. government has decided to revise the fund, which is allocated to banks under the Troubled Asset Relief Program. The developments issued in these areas indicate that the reforms in regulatory framework and policy making structure are essential. In order to bring about changes in the corporate governance framework of the banking sector, it becomes essential to conduct research upon the current state of financial services existing in the economy. The study conducted regarding corporate governance prevalent in the banking sector has identified that mergers, acquisitions and ownership structures also have a broad implication upon the manner in which banks function. Banks and financial institutions across the world have different structures and follow dissimilar regulatory principles, thereby inducing the problem of conducting exhaustive research related to bank governance across multiple nations. Experts have mainly considered concentrating upon publicly traded banks as more data regarding their operations are available. Publicly traded banks hold a majority of the assets in the banking sector. Hence, their actions have a larger impact upon the economy (Barth, et al., 2005). The empirical evidences, which were studied and analyzed during the course of this paper, have revealed that banks and non-banking financial institutions incorporate similar regulatory framework. Very few researchers have devoted themselves towards analyzing that banks must have regulatory frameworks, which are different from that of the non-financial firms. Experts have mainly concentrated upon areas such as, ownership structure, size of the board and pay systems. Little effort has been given towards assessing the impact of bank governance on the economic conditions (Adams, 2010). Corporate governance reform in the U.K banks The critical reasons behind failure of the banking system during the crisis period may be cited as the over dependency on inappropriate models of business, management and control processes as well as defective decisions regarding mergers and acquisitions before and during the crisis. The boards of different banks in the U.K are seen to have similar roles and responsibilities towards their stakeholders, which further generates the requirement to analyze better ways in which few banks delegate their functions compared to that of others. In respect of the constitution and role of the board in improving efficiency of performance, the main questions to be addressed are: whether or not to extend the statutory statements of responsibility, whether two tier structures of the board are a feasible option and whether to maintain separate responsibilities assigned to the executive and non-executive directors. Additionally, the banks must also consider whether or not to continue relying upon the non-executive director’s wisdom and contribution towards corporate governance. It has also been claimed that forced breakup of the global banks in terms of board members would help to mitigate difficulties involved in corporate governance (Beaumier & DeLoach, 2011). Most listed banks of the U.K. have a larger board of directors than the FTSE 100. The banks in the U.K have an average board size of 15 to 16 members, whereas the average board size of FTSE 100 is 11 to 10. This fact has raised the debate whether or not the average number of members constituting the board has a role to play in performing effectively. The general belief amongst experts is that a larger board is less manageable. In practice, it is seen that the decision relating to board members depends on circumstances such as, scope of the business, nature and organizational structure (Barth, et al., 2005). Basel Committee actions regarding risk management The Basel Committee on Banking Supervision had identified that it is important to understand, study and improve corporate governance systems existing in the financial sector. The banking business is highly complex and therefore, it is essential to have concrete corporate governance policies that not only fosters growth, but also helps maintaining a balance in the risk existing in the economy. Basel Committee had analyzed the corporate governance systems existing in 69 commercial banks across 6 developed nations in order to understand problems and complexities of corporate governance pertaining to the banks and financial institutions. It was observed that the boards, which had a balance between internal and external members, are able to create more value and perform efficiently compared to those that did not follow similar structure (Beaumier & DeLoach, 2011). The committee also developed the understanding that governance systems existing in banks do not vary highly from that of the non-financial ones. Studies conducted upon the banking systems indicate that maintaining transparency of information and providing timely information are few of the main challenges faced by the banking sector. Complexities may arise out of aspects such as, inadequate perception regarding quality of the loans and financial mechanism for reducing or diffusing risks that are not engineered in a proper manner. Risks also exist in the form of investment risks, which cannot be managed or hedged away easily. The committee had also realised that the manners in which banks and financial firms manage their debt and loan related policies have a significant impact upon overall risks existing in the economy. Banks must realize monetary condition of the economy and accordingly regulate the loan and credit policies. Such policies must be monitored by the financial regulators and should only be imposed on their consent (Andres & Vallelado, 2008). Walkers report 2009 Sir David Walkers’ report on corporate governance existing in the banking sector published in 2009 states some of the key governance requirements therein. These have been discussed as follows (Walker, 2009). Size composition and qualification Walker states that non-executive directors must have sufficient understanding and knowledge regarding the banking rules and framework of operations. In order to be able to contribute towards efficient performance of the board, having high knowledge and skills is essential. Banks must provide adequate support to the non-executive directors as and when required. The U.K. Financial Services Authority must monitor balance of the board members. The monitoring must be done on the basis of experience, management and behavioural qualities of the board members. Walker had also suggested that non-executive directors should spend a minimum of 30 to 36 days as sitting members of the board. As a result, the non-executive directors are not excluded as they represent other firms sitting on the banks board. The time commitments must be made clear to the shareholders on their request (Walker, 2009). Board functioning and evaluation The Walkers report suggests that non-executive directors must have adequate competencies to challenge strategies of the board. The Chairmen of the board must spend a large portion of their time in analyzing operations and strategies undertaken by the entity. The position of chairmanship must be subjected to election on an annual basis. The responsibilities of the senior independent directors and the chairmen are to be clearly specified. These roles have been mentioned in the recommendations published earlier. Walker has further identified that the board members must involve in regular induction and business awareness programs. Board members must also be adaptable to the situation of elections being held on an annual basis (Brancato, et al., 2006). Institutional shareholders roles Boards must acquire timely information regarding changes made in the share register. They must also consider understanding reasons behind the changes made and accordingly state their views. Additionally, the Financial Reporting Council must specifically follow the best practices and principles. The Council must also encourage establishing such practices within the banks’ corporate governance set up. A firm’s compliance levels with the Stewardship Code require to be monitored explicitly. Banks must adhere to the process of clearly disclosing details regarding assets, liabilities and investments on their websites, which would in turn facilitate information dissemination to different interest groups. The websites must also present information relating to commitment followed by the institutions in respect of the codes of conduct (Walker, 2009). Governance of risks The report states that the FTSE 100 listed companies, which are banks and life insurance firms, must establish a broad risk committee. The risk committee must be separate from the audit committee. The risk committee must have a chief risk officer who would report to the committee and as well as the chief executive officer. The risk committee must be chaired by a non-executive director. The non-executive director must be given the responsibility of appraisal related to strategic decisions and other practices (Webb, 2009). Remuneration The report emphasizes upon the development of a remuneration committee, which will govern the principles and policies relating to remuneration adopted by the banks and financial institutions. The policies of remuneration regarding high-end employees must be specifically regulated. The report states that banks must clearly specify the number of employees who earn more than the median range of income and belong to the executive board (Walker, 2009). Walkers report mainly aims to examine effectiveness of risk management at the board level. The report recognizes that efficiency at the board level becomes essential for improving the overall corporate governance. The report provides recommendations regarding the policies of remuneration and managing incentives. The report also states that experience and knowledge of the board members play a vital role in delegating corporate governance policies. Walker has also mentioned in his report that shareholders must be encouraged to participate in the decisions making process and monitoring of business activities. There must also be adequate transparency in the policies followed for managing risks, auditing the financial statements and nomination procedures. The report has been developed as an effort to align the practices followed for regulating banking governance standards with that followed internationally (Adams & Mehran, 2003). Turner Review 2009 The Turner report was developed as an effort towards managing the financial crisis faced by Britain and other nations of the world. The report contains 28 recommendations. Experts are of the belief that if these recommendations are followed, it is possible to radically alter the landscape of banking. The review emphasizes upon the aspect that banks are required to keep sufficient amount of capitals so as to avoid encountering risk. As a result, credit rating agencies have to supervise the activities of banks more closely. The report also identifies that irresponsible pay scales must be removed from the corporate policies. The report states that a new European regulator of banks must be established in order to regulate the banks’ activities (Kallamu, Saat & Senik, 2013). Few of the guidelines that have been laid down by the review are discussed below. Capital adequacy, liquidity and accounting The review report states that overall capital requirements established for the banking sector must be raised. The review is of the suggestion that if the minimum requirements of capital are raised, then the regulatory policies are automatically minimized. The report indicates that the minimum requirements must be higher than that specified in the existing Basel rules. Financial regulatory authorities must take immediate action towards implementation of the Basel II regime related to capital development. The review report also states that banks and regulatory authorities must recognize liquidity related regulations and supervision as equally important aspects as the capital regulations. Regulatory authorities must consider developing a funding ratio, which ensures sustainable funds in the balance sheet (Aebi, Sabato & Schmid, 2012). Institutional and geographic coverage regulations The review mentions that institutional and regulatory framework must follow the policy of economic sustainability, rather than merely complying with legal requirements. In order to analyze overall risks existing in the economy, regulatory authorities must acquire information related to activities of the unregulated financial institutions. Regulatory authorities must also be given the power to revise and implement rules relating to liquidity and capital, as and when required, so as to manage the current economic scenario (Minton, Taillard & Williamson, 2011). Deposit insurance Regulatory frameworks must make sure that interests of the retail deposit insurance firms are protected at all times and especially against bank failures. There must be clear communication in respect of the extent of financial cover provided by insurance contracts (Aebi, Sabato & Schmid, 2012). Credit rating agencies The review report states that all credit rating agencies must be subjected to supervision and registration in order to ensure proper governance and manage conflicts. The regulations must be developed in a manner such that they are applicable only for securities that can be rated consistently. Rating agencies must also inform investors about the criteria used for rating. The rating must reflect the risk arising out of credit and not those associated with liquidity or market prices (Minton, Taillard & Williamson, 2011). Remuneration and FSA supervision Remuneration and incentive policies must be established in a manner such that they are aligned with the risk management needs. The financial services authority must consider increasing the amount of resources invested in the high impact organizations, especially the large sized banks. The authority must monitor the strategies formulated in respect of risks, instead of focusing on systems and procedures broadly. FSA must also divert attention towards analysis of the information, which is related to the key risks. The review report suggests that the FSA have to intensify the manner in which the balance sheet analysis for banks is conducted and the accounting judgments, which are developed thereafter (Minton, Taillard & Williamson, 2011). Firm risk management and governance The review report suggests that guidelines that are laid down in respect of corporate governance and risk management in firms must be followed extensively. The skill and time invested by the non-executive directors of large and complex banks in order to perform complex duties must be revised from time to time (Mulbert, 2009). Establishing independent risk committee Public companies are seen to devote themselves towards the development of risk committees. As per the regulatory framework established by the U.K. government, it is essential for the banking and financial institutions to remain transparent in respect of the information related to risks arising out of the stock market activities. Companies are required implementing risk monitoring and reporting systems, which fulfil needs of all the interest groups. Banks must consider reviewing these systems on a regular basis so as to avoid development of director’s liability. Banks risks and operational efficiencies are studied by analyzing the financial reports. Hence, stringent policies must be established in respect of preparation of the financial statements (Mulbert, 2009). One of the major changes, which experts have identified, is that companies must disclose all relevant information and weaknesses relating to the internal control systems reporting functions. It is also essential that the principal executive officer and the chief finance officer of the companies certify effectiveness of the corporate policies and internal control systems. These aspects must be reviewed and verified while rating the banks and financial institutions. Enterprise risk management integrated framework must be followed in order to monitor the internal control systems. The risk committee will be responsible for meeting all above mentioned requirements so as to effectively manage the enterprise wide risks. The risk committee must have at least one expert who is equipped with very high knowledge regarding assessing, identifying and managing risk exposures in the large complex firms (Polo, 2007). One of the significant roles to be performed by the risk committee is that of assisting the board members in exercising their duties. The committee will also help the board of directors to take important decisions regarding risk management. Risk management may be perceived differently by separate firms. Some firms consider that risk management is mainly about adopting measures against informed risks and subsequently minimizing loss. For other firms, undertaking risk is about managing assets and securities in a manner such that it increases value of the same. However, the risk undertaken under such circumstances must be such that it does not cause losses. Therefore, the ways adopted by an organization to manage risks is related to the goals set. In most cases, the risk management committee, which is established independently by banks, oversee the operational risks and forecasts catastrophic risks that may arise in future. The committee also implements various practices of risk management across different departments and management levels of the firm (PWC, 2012). Advantages and disadvantages of risk committee Establishing a risk committee, which is separate from the audit committee, may or may not suit the needs of all banking and financial firms. Setting up a standalone committee for risk management may help a company to convey the message to investors and employees that risk management is conducted very seriously therein. Establishing a committee dedicated solely towards the purpose of risk management may help the board members to develop deeper insight regarding risk related issues (Leeladhar, 2004). Developing a risk committee may require assigning few of the board members to serve and manage the activities conducted, which may not be feasible for all banking firms, especially for those with fewer members. Also, setting up a committee may cause an organization to incur greater amount of expenses in respect of paying for the members who devote time and effort towards risk management. Experts have also identified that developing a risk committee may cause duplication of several duties (Partiga & McAvoy, 2010). References Adams, R. & Mehran, H. (2003). Is corporate governance different for bank holding companies. Economic Policy Review, 9(1), 123-142. Adams, R. B. (2010). Governance of Banking Institutions, in Corporate Governance: A Synthesis of Theory, Research, and Practice. New Jersey: John Wiley and sons. Aebi, V., Sabato, G. & Schmid, M. (2012). Risk management, corporate governance, and bank performance in the financial crisis. Journal of Banking & Finance, 36(12), 3213-3226. Andres, P. D., & Vallelado, E. (2008). Corporate governance in banking: The role of the board of directors. Journal of banking & finance, 32(12), 2570-2580. Barth, J., Hartarska, V., Nolle, D. & Phumiwasana, T. (2005). A cross-country analysis of bank performance: the role of external governance. Social Science Electronic Publishing, 1(1), 1-45. Beaumier, C. & DeLoach, J. (2011). 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