How does Corporate Governance Affect the Stability of Banks Negatively.docx
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How does Corporate Governance Affect the Stability of Banks Negatively.docx
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HowdoesCorporateGovernanceAffecttheStabilityofBanksNegatively
HowdoesCorporateGovernanceAffecttheStabilityofBanksNegatively?
Du,Yaodong
ELI084A,AcademicSkillsforGraduateStudents
ProfessorCaprario
March30,2014
Abstract
After2008,politicians,lawmakers,economicsandcitizensstarttofocusoncorporationgovernanceofbanksagain.Theyfindthattherearemanyproblemsintheregulationofbanks,andtrytofixthem.However,eventhoughmanyproposalshavebeenproposedbybotheconomicandpoliticalexperts,manyofthemdonotseemtoworkastheypreviouslythought.Inhence,thesesunsolvedproblemwillimpairthestabilityofbanksinturn.Thepaperwillillustratethisinthreeaspects–boardsofdirectors,managementcompensation,andriskmanagement.Theindependenceofdirectorsandboardsizeisdifficulttobedecided;themanagementcompensationpolicieswouldtriggermanagerstotakemoreriskystrategies;andtheriskmanagementlawisstillabsence.Theseaspectswereandareimpairingthestabilityoffinancialindustry,andifwedon’tfixtheseproblems,wewillnevereverjumpoutofthecircleofeconomiccrisis.
Howdoescorporategovernanceaffectthestabilityofbanksnegatively?
The2008financialcrisishascausedmorethan400bankstofailintheUS,andsomegiantinternationalbankswereinvolvedaswell.Forexample,LehmanBrothersHoldingsInc.collapsedwhenthecrisishappened,andAIG,FannieandFreddieweretakenoverbytheUSgovernmentafterthecrisis.Becauseofthenegativeexternalitiesofthebankingindustryfailing,thecorporategovernanceoffinancialinstitutions,whichdrewmuchattentioninthe1997financialcrisis,hasbecomeahottopicagain.Manyexpertsfrombotheconomicandlegalfieldsbelievedthatthecorporate-governancefailurewasamajorcauseofthefinancialcrisis.Moreover,alargenumberofreformplansontheregulationofbankswereproposedbybothpolicymakersandrelatedscholars.However,mostpositionsorplansdoesnotsolvethisproblemwellbecausecorporategovernanceofbanksismorecomplicatedthanthoseofgenericfirmssincebankownsmorecomplicatedmanagerialstructure.Thisarticleconsidersthenegativeeffectscausedbytheflawsofcorporategovernanceonthestabilityofbanksandhowtheregulationofbanksimpingesonthestabilityoffinancialindustry.Eventhoughcorporategovernancehasbeenplacedonaveryimportantposition,andmostvoicesagreetoenhancebankregulationafterthefinancialcrisis,inappropriatecorporategovernancecouldimpairthestabilityofbanks.Thisarticlewillillustratethistopicinthreeaspects:
boardsofdirectors,managerialcompensation,andriskmanagement.
Firstly,boardsofdirectorsplayanimportantroleincorporategovernance.Theproblemofaboardofabankisthepartconcernedmostlyduringthecrisisbecauseaboardofdirectorsisthefundamentalmanagementofacorporate.AccordingtotheDelawareGeneralCorporationLaw,theaffairsandbusinessofacompany“shallbemanagedbyorunderthedirectionofaboardofdirectors”(Bainbridge,2012,p.43).Aboard’sfunctionsincludemanagement,monitoringandservice.Inabank,theroleofmanagingofaboardhasbeenlessemphasizedsincemostbanksaretoobigfordirectorstobemanagedonaday-to-daybasis,andinhence,themanagementdutyismainlyshoulderedbymanagers.Boardsofdirectorsplayaroleofmonitoringandadvisinginmosttimes,andtheywillimplementthemanagementrightsonlywhensomebigdecisions,suchasmergersandacquisitions,needtobemade.Theseparationofmanagementandmonitoringisfavoredbymanycorporates.Forexample,theGreenPaperonCorporateGovernanceinFinancialInstitutions,whichwasafeedbackstatementbytheEuropeanCommissiontotackletheproblemsofbanks’regulation,showedthatthemajorityofrespondentsagreetoseparatetherightsofmanagementandsupervision(Hopt,2013,p.227).AccordingtoHopt(2013),thisprovisioncanefficientlyprevent“groupthinking”or“heardbehavior”(P.227).However,italsogeneratesthetroubleofinformationasymmetry.Theseparationcancauseinformationasymmetrybetweenboardsandexecutivemanagers.Thereasonforthisisthatexecutivemanagersmanagethecorporateonaday-to-daybasisandtheyhavetheadvantageofaccessingtheoriginalinformationofcorporation.Directorshavetoaccesstheseinformationfromthesetopmanagers,sothereisanincentiveformanagementtostrategicallymodifythecorporateinformationandthensubmitittotheboard.Forbankmanagers,itismoresensitiveforthemtochoosesomeriskystrategies,whicharelesspreferredbyboarddirectors,becausemanagers’remunerationsaremostlyrelatedtothebanks’shareprice.Mülbert(2009)saidthatdirectorswithinboardsofbankswouldrealizethedifficultytoobservetheperformanceofmanagersduetothevaguebalancesheetorreport(p.425).Asaresult,directorsarewillingtosupervisethemanagementbehaviorandinhence,hopetocarryouttheirmanagerialdutyagain,whichwouldcauseaseriousconflictbetweentheboardandthemanagement,andfinallydeterioratesthestabilityofbanks.
Furthermore,anotherdifficultiesforboarddirectorsishowtobeindependent.Itisruledbymostcorporationlawsandregulationrules.Forexample,accordingtoBainbridge(2012),thethreemainexchanges–theNYSE,NADAQ,andtheAmericanStockExchange(AMEX)–requiretheirlistingcompanies’majorityboardmemberstobeindependent(p.81).However,itisnoteasytobeindependentfordirectors.Asmentionedintheformerpart,oneobligationofaboardisservice,whichincludesdealingwiththerelationshipwithgovernments,andothercorporates,givingadvicestomanagementandsomeotherrelatedbehaviors,soitisdifficultforandirectortobetotallyindependent,becauseonthecontrary,totallyindependentwouldhurttheinterestofbanks’performance.Nevertheless,ifadirectorisrelatedtoomuchwithmanagementorothergroups,itisalsotendtogenerateeconomyproblemsandinturn,harmthestabilityofbanks.Forexample,someinsiderdealingswouldhappenifdirectorsarerelatedtoomuchinmanagement.That’swhymostlawsputthatdirectorsshallbemajorityindependent.
Moreover,theboardsizeisalsoaproblem.AccordingtoAnginer,Demirguc-Kunt,HuizingaandMa(2008),theboardsizewouldinfluencebanks’capitalizationstrategies.Alargeboardwouldbebettertofulfilltheservicefunction,butlesseffectivetoobservetheperformanceofmanagers.However,smallsizeofboardwouldtendtogenerategroupthinkingandtakechargeofmanagement.
Inconclusion,theboardhasthreemainproblem–informationasymmetry,boardindependence,andboardsize–tofulfillitsfunctions,andinhence,impairthestabilityofbanks.
Secondly,theexecutivecompensationisanotherproblemofcorporategovernanceofbanks.Thecompensationoftopmanagersbecameahot-buttonissueinthe2008financialcrisisbecausepeoplecomplainedabout“corporatefatcatsgettingeverricherwhiletheeconomystruggled”(Bainbridge,2012,p.109).Atthebeginningofthe2008financialcrisis,thesocietydevotedmuchattentiontothequestionthatwhetherthecompensationoftheexecutiveremunerationcontributestothefinancialcrisis.AccordingtoBainbridge(2012),thetopmanagementhadlimitedliability,whichmeanscorporatetopmanagerswereriskfreeindecisionmaking.Moreover,Bainbridgealsopointedthatmanyexecutivemanagersevenhadgoldenparachutesinadditiontooptions,andotherformsofincentive-basedpay.Sincetheseformsofpayarerelatedtotheshareprice,whichisrelativetotheinterestsofbanks,whichisgeneratedbythescaleofloansownedbybanks,thebankskeptlendingmoneyevenwhentheyalreadyknewthecollapseofhousingmarket.AsmeasuredbyCornett,McNutt,andTehranian,theCEOpay-for-performancesensitivityishighlyrelatedtotheperformanceofthefirm.Theperformanceofbanksisalwaysrelatedtothescaleofloans.Ascanbeconcluded,itisobviousthatsuchcompensationwillcauseexecutivemanagerstotakeriskystrategies.Tofixthisproblem,manyproposalswerefloatedduringthecrisis,andDodd-FrankActwasincluded.However,theresultdoesnotseemtobepromising.
Afterthecrisisof2008,Dodd-FrankActwasproposedasaresponseofthegovernment,anditlistedmanyprovisionstoregulateexecutivecompensation.Nevertheless,itisprovednotworkingverywell,andBainbridge(2012)pointedthat,itsprovisionsarequackerybecausetherewasnotenoughempiricalevidenceandtheoreticaljustificationtosupportit(p.15).Forexample,itrequiresaclearpaydisclosure,whichissaidnearlyimpossiblebyBainbridge(2012)because:
Itmeansthatforeveryemployee,thecompanywouldhavetocalculatehisorhersalary,bonus....Thisinformationwouldundoubtedlybeextremelytime-consumingtocollectandanalyze,makingitvirtuallyimpossibleforacompanywiththousandsofemployeestocomplywiththissectionofAct.(p.127)
Moreover,Dodd-Frankrequiresshareholderstovotetoillustratethecompensationofmanagementindetail,whichiscalledsayonpay,buttheeffectivenessisdoubtable.ProfessorJefferyGordonsaidthatsayonpaywouldtransferthepowerfromboardsofdirectorstosomeadvisorycompaniessuchasRiskMetrics,andmakethecompanyinasituationwhichissimilartotheone-fits-allmodelbecauseshareholdersmaylikelytonarrowtherangeofchoicefortheirlackofenoughknowledgebasis(Bainbridge,2012,p.133).
Inconclusion,remunerationoftopmanagersisasignificantprobleminbanks’corporationgovernance,anditstillneedtobefi
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