Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy (2022)

Posted by Klaus J. Hopt (Max Planck Institute), on

Thursday, June 3, 2021

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Banks, Basel, EU, Europe, Financial institutions, Financial regulation, Hedge funds, International governance, Shareholder primacy, Stakeholders
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Klaus J. Hopt is former director at the Max Planck Institute for Comparative and International Private Law, Hamburg, Germany. This post is based on his recent paper, forthcoming in the European Business Organization Law Review.

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Corporate governance was first developed as a concept and field of research for private listed corporations. The idea of developing corporate governance standards spread quickly to other sectors, in particular to banks, insurance companies and other financial institutions. Yet after the financial crisis it turned out that not only banks are special, but so is the corporate governance of banks and other financial institutions as compared with the general corporate governance of non-banks. The corporate governance of banks and other financial institutions has gained much attention after the financial crisis. From 270 economic and legal submissions from 2012 to 2016 in the ECGI Working Paper Series of the European Corporate Governance Institute (ECGI), roughly half address corporate governance questions, and more than a quarter of these look at the regulation and corporate governance of banks (in the broad sense). Empirical evidence confirms this. Banks practicing good corporate governance in the traditional, shareholder-oriented style fared less well than banks having less shareholder-prone boards and less shareholder influence. Apparently bank boards charted a course more aligned with the preferences of shareholders, who—if sufficiently diversified in their holdings—embrace risk more readily than, for instance, a bank’s creditors. Banks that were controlled by shareholders saw higher profits before the crisis as compared to banks that were controlled by directors. Enterprises in which institutional investors held stocks correspondingly fared worse. Banks with independent boards were run more poorly. At least for banks, director independence can carry negative effects whereas expertise and experience are of much greater value, at least when obvious conflicts of interest are avoided.

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The special governance of banks and other financial institutions is firmly embedded in bank supervisory law and regulation. Starting with the recommendations of the Basel Committee on Banking Supervision (revised version in July 2015), many other supervisory institutions have followed the lead with their own principles and guidelines for good governance of banks. In the European Union, this has led to legislation on bank governance under the so-called CRD IV (Capital Requirements Directive), which has been transformed into the law of the Member States. Yet the legal literature dealing with this transformation is mostly doctrinal and concerned with the national bank supervisory law. But there are also more functional legal as well as economic contributions, these addressing primarily, but not exclusively, systemically important financial institutions. The latter are under a special regime that needs separate treatment.

Most recently there has been intense discussion on the purpose of (non-bank) corporations. Shareholder governance and stakeholder governance have been and still are the two different prevailing regimes, the first in the United States (despite some critique most recently) and the second in Europe, particularly in Germany. Yet for banks this difference has given way to stakeholder and, more particularly, creditor or debtholder governance, certainly in bank supervision and regulation. Yet the implications of this for research and reform are still uncertain and controversial. For banks, self-regulation, if at all, must give way to co-regulation or cooperative regulation between the banks and the state. Mandatory transparency is indispensable. For banks this transparency has the additional function of informing the regulators and supervisors in order to facilitate their task of creditor and debtholder protection and more generally the protection of the economy. Particular qualification and independence problems arise for state-owned banks.

The regulatory core issues for the corporate governance of banks are manifold. A key problem is the composition and qualification of the (one tier or two tier) board. The legislative task is to enhance independent as well as qualified control. Yet the proposal of giving creditors a special seat in the board may be disruptive, and in Germany at least, it disregards the reality of labor codetermination at parity. Giving bank supervisors a permanent seat in the board would create serious conflicts of interest since they would have to supervise themselves. There are many other important special issues of bank governance, for example the duties and liabilities of bank directors in particular as far as risk and compliance are concerned, but also the remuneration paid to bank directors and senior managers or key function holders. Claw-back provisions, either imposed by law or introduced by banks themselves, exist already in certain countries and are beneficial, but here more could be done.

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As always much depends on enforcement. This corresponds to an increased orientation in literature and research not merely on substantive company and banking law questions, but also on problems related to procedural law and insolvency law insofar as corporations are concerned. In the area of banking law, one even speaks of a shift from banking contract law to bank supervisory law and bank regulation. Yet based on the above-mentioned empirical findings, this simply does not correspond to more enforcement by shareholders (specifically by large shareholders, institutional investors and hedge funds all of which are currently at the center of the corporate governance discussion). But also a conclusion to impose legal obligations on the creditors—in the place of investors—would be inadequate since that would mean merely shifting the problem from one group of stakeholders onto another. Small creditors like small investors have a rational disinterest, particularly when they are protected by deposit guarantees. Bond creditors as well have only a limited potential and interest in influencing and monitoring the corporate governance of issuers. It follows that rather a mix of civil, penal and administrative sanctions, possibly coupled with private enforcement, may have advantages.

The corporate governance of banks is an ongoing task for supervisors, regulators and legislators, but also one for the banks themselves. In banking, ethics is indispensable, and the tone from the top matters. For all of these issues, more economic, legal and interdisciplinary research on corporate governance in banks and financial institutions is needed, and it could also help pave the way forward. In addition to this, there might also be a role for banks’ own codes of conduct—whether internal or applicable for the entire sector—as is shown, for instance, by the Dutch Banking Code and as is highly recommended by institutions such as the Basel Committee, the European Banking Authority, the European Central Bank and the Financial Stability Board. Internationally, there are successful experiences with the implementation of soft law by the National Contact Points (NCP) under the OECD proposals on corporate social responsibility that could offer orientation to the banking sector too. In the end, however, it inevitably boils down to the ethical standards prevailing among companies and business leaders, who must set the tone from the top. This applies generally to the corporate governance of companies, and it is especially true in respect of banks and financial institutions. Some have rightly observed that a European bank corporation law is gradually developing in its own right, and these authors ask what effect the European banking union will have on the governance of credit institutions. Corporate governance of banks may even pave the way to a self-contained law covering financial intermediaries and their corporate governance.

The complete paper is available for download here.

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FAQs

Why is it necessary that corporate governance is more important in banking companies than in others? ›

In that context, good Corporate Governance is essentially important for banks, because such institutions (a) deal with funds raised from the public; (b) are likely to encounter greater risks including frauds and failure; and (c) if such frauds or failures occur in such institutions, it may pose issues relating to ...

What are principles of corporate governance? ›

The basic principles of corporate governance are accountability, transparency, fairness, responsibility, and risk management.

Why is corporate governance important? ›

Strong and effective corporate governance helps to cultivate a company culture of integrity, leading to positive performance and a sustainable business overall. Essentially, it exists to increase the accountability of all individuals and teams within your company, working to avoid mistakes before they can even occur.

What are the corporate governance aspects relating to banks in India? ›

The corporate governance mechanism as followed by Reserve Bank of India is based on three categories for governing the banks. They are: (i) Disclosure and transparency, (ii) Off-site surveillance, (iii) Prompt Corrective Action.

What are the objectives of corporate governance in banks? ›

The primary objective of corporate governance should be safeguarding stakeholders' interest in conformity with public interest on a sustainable basis. Among stakeholders, particularly with respect to retail banks, shareholders' interest would be secondary to depositors' interest. establish control functions.

How does corporate governance work in banking and financial institutions? ›

Banks practicing good corporate governance in the traditional, shareholder-oriented style fared less well than banks having less shareholder-prone boards and less shareholder influence. The special governance of banks and other financial institutions is firmly embedded in bank supervisory law and regulation.

What are the 7 principles of corporate governance? ›

Seven Characteristics of Corporate Governance
  • Discipline. Corporate discipline is a commitment by a company's senior management to adhere to behavior that is universally recognized and accepted to be correct and proper. ...
  • Transparency. ...
  • Independence. ...
  • Accountability. ...
  • Responsibility. ...
  • Fairness. ...
  • Social responsibility.
6 Mar 2007

What are the 4 P's of corporate governance? ›

People, process, performance, and purpose are the four Ps of good corporate governance.

What are the 8 principles of corporate governance? ›

The 8 P's of corporate governance are:
  • Property;
  • Principles;
  • Purpose;
  • Roles;
  • Power;
  • Practice;
  • People;
  • Permanence.
10 Mar 2020

How can banks improve corporate governance? ›

There are four important forms of oversight that should be included in the organisational structure of any bank in order to ensure the appropriate checks and balances: (1) oversight by the board of directors or supervisory board; (2) oversight by individuals not involved in the day-to-day running of the Page 4 various ...

What are the problems of corporate governance in banking system? ›

These problems include mismanagement, financial impropriety, poor investment decisions and the growing distance between members and their co-operative society. The purpose and objectives of co-operatives provide the framework for co-operative corporate governance.

What institutions are necessary for successful corporate governance? ›

We have about ten such institutions: markets, boards, compensation, gate-keeping professionals, coalescing share-holders (via takeovers and otherwise), information distribution, lawsuits, capital structure, and bankruptcy. Markets are often the most important institution of corporate governance.

What are the factors affecting corporate governance? ›

There are five main factors affecting corporate governance that are crucial to any organisation's corporate governance success.
  • The Corporate Governance Code. ...
  • Behaviour and culture.
  • Skills, experience, integrity.
  • A clear understanding of what the NED role entails.
  • A reminder of the directors' statutory duties.
6 Apr 2018

What are the tools of corporate governance? ›

6 governance tools every board member should be using
  • A governance calendar.
  • Role descriptions.
  • A scheme of delegation.
  • A code of conduct.
  • Board away day.
  • A register of interests.

What is corporate governance in bank management? ›

Corporate governance is the set of processes, customs, policies, laws, and institutions affecting. the way a corporation is directed, administered or controlled. Corporate governance also includes. the relationships among the many stakeholders involved and the goals for which the corporation.

What is the role of financial institutions in corporate management? ›

Financial institutions help small and medium-scale enterprises set up themselves in their initial business days. They provide long-term as well as short-term funds to these companies. The long-term fund helps them form capital, and short-term funds fulfill their day-to-day working capital needs.

Do we have corporate governance in banks? ›

Corporate governance is the system by which companies are directed and controlled. The corporate governance of banks differs from the corporate governance of ordinary companies.

What are the six pillars of corporate governance? ›

The pillars of successful corporate governance are: accountability, fairness, transparency, assurance, leadership and stakeholder management.

What are the six principles of corporate governance? ›

The Principles cover six key areas of corporate governance – ensuring the basis for an effective corporate governance framework; the rights of shareholders; the equitable treatment of shareholders; the role of stakeholders in corporate governance; disclosure and transparency; and the responsibilities of the board (see ...

What are 6 characteristics of a good corporate governance system? ›

Good governance has nine major characteristics:
  • Participation.
  • Consensus oriented.
  • Accountability.
  • Transparency.
  • Responsive.
  • Effective and efficient.
  • Equitable and inclusive.
  • Follows the rule of law.
15 Aug 2018

What are the three main components of corporate governance? ›

The three main components of corporate governance are transparency, accountability, and security.

What are the types of governance? ›

Types
  • Governance as process.
  • Public governance.
  • Private governance.
  • Global governance.
  • Governance Analytical Framework.
  • Nonprofit governance.
  • Corporate governance.
  • Project governance.

How many types of corporate governance are there? ›

There are three types of governance structures including, internal and external mechanisms and independent audits. Internal mechanisms establish reporting lines and performance measures that help monitor an organization's activities to ensure the business stays on track.

What are the models of corporate governance? ›

There are three main models of leadership on which the corporate governance theory is based: the Anglo-Saxon, the Continental and the Japanese model.
  • THE ANGLO-SAXON MODEL – BASED ON ENTERPRENEURSHIP AND.
  • PRIVATE PROPERTY.

Why do banks need a good corporate governance policy? ›

Effective governance frameworks help maintain profitability, competitiveness, and resiliency through changing economic and market conditions by incorporating objectives, policies, and risk limits that are appropriate to the size, complexity, and risk profile of the institution.

What is corporate governance in banking sector? ›

“Corporate governance relates to the internal means by which corporations are operated and controlled.” OECD. “Corporate governance is the system by which companies are directed and controlled.” Cadbury Report, 1992.

What is governance in banking? ›

By governance we mean broadly the oversight that comes from banks' own shareholders and other stakeholders of the way in which they are run. The problem of bank governance stems from the way in which banks are financed and regulated, from the externalities bank failures produce, and from the nature of their assets.

What is the role of effective corporate governance in improving performance? ›

Good corporate governance is expected to increase firm performance. The main objective of the implementation of good corporate governance is to optimize value for shareholders and stakeholders in the long run. This research tries to prove that corporate governance that is performed well can improve firm performance.

How can banks improve corporate governance? ›

There are four important forms of oversight that should be included in the organisational structure of any bank in order to ensure the appropriate checks and balances: (1) oversight by the board of directors or supervisory board; (2) oversight by individuals not involved in the day-to-day running of the Page 4 various ...

Do we have corporate governance in banks? ›

Corporate governance is the system by which companies are directed and controlled. The corporate governance of banks differs from the corporate governance of ordinary companies.

What institutions are necessary for successful corporate governance? ›

We have about ten such institutions: markets, boards, compensation, gate-keeping professionals, coalescing share-holders (via takeovers and otherwise), information distribution, lawsuits, capital structure, and bankruptcy. Markets are often the most important institution of corporate governance.

What are the four pillars of corporate governance? ›

The 4 Principles of Corporate Governance
  • Accountability. Being able to explain every action you make in your business is vital in building confidence among your stakeholders and shareholders. ...
  • Transparency. Transparency, like accountability, engenders confidence. ...
  • Fairness. ...
  • Responsibility.

What is corporate governance PDF? ›

Corporate Governance is a system of structuring, operating and controlling a company with the following specific aims:— (i) Fulfilling long-term strategic goals of owners; (ii) Taking care of the interests of employees; (iii) A consideration for the environment and local community; (iv) Maintaining excellent relations ...

Why corporate governance is significantly important for banking sector in India? ›

Corporate governance also enhances the long term shareholder value by the process of accountability of managers and by enhances the firm's performance. It also eliminate the conflict of ownership and control by separately defines the interest of shareholders and managers.

What are the 8 characteristics of good governance? ›

Citing from the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP), the concept of good governance has eight principles.
  • Participation. ...
  • Rule of law. ...
  • Transparency. ...
  • Responsiveness. ...
  • Consensus oriented. ...
  • Equity and inclusiveness. ...
  • Effectiveness and efficiency. ...
  • Accountability.
18 Nov 2021

Why is bank governance different? ›

But banks also have specific governance issues. The very nature of the banking business weakens the traditional corporate governance institutions of board and shareholder oversight. Banks have the ability to take on risk very quickly, in a way that is not immediately visible to directors or outside investors.

What do you mean by governance? ›

Governance encompasses the system by which an organisation is controlled and operates, and the mechanisms by which it, and its people, are held to account. Ethics, risk management, compliance and administration are all elements of governance.

What are the 7 principles of corporate governance? ›

Seven Characteristics of Corporate Governance
  • Discipline. Corporate discipline is a commitment by a company's senior management to adhere to behavior that is universally recognized and accepted to be correct and proper. ...
  • Transparency. ...
  • Independence. ...
  • Accountability. ...
  • Responsibility. ...
  • Fairness. ...
  • Social responsibility.
6 Mar 2007

What are the 8 principles of corporate governance? ›

The 8 P's of corporate governance are:
  • Property;
  • Principles;
  • Purpose;
  • Roles;
  • Power;
  • Practice;
  • People;
  • Permanence.
10 Mar 2020

What are examples of good corporate governance? ›

Examples of good corporate governance practices include:
  • Calculation of the company's carbon footprint;
  • Respect for human rights in the company;
  • Transparency of executive salaries;
  • Implementation of a code of conduct for employees.
23 Aug 2021

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