Bank institutional setting and risk-taking: the missing role of directors’ education and turnover

Author:Antonio D’Amato, Angela Gallo
DOI:https://doi.org/10.1108/CG-01-2019-0013
Pages:774-805
Publication Date:05 Aug 2019
Bank institutional setting and risk-taking:
the missing role of directorseducation
and turnover
Antonio DAmato and Angela Gallo
Abstract
Purpose This paper aims to analyze the relationshipbetween bank institutional setting and risk-taking
by exploring whether board education and turnover are drivers of the risk propensity of cooperative
banks comparedto joint-stock banks.
Design/methodology/approach Based on a comprehensivedata set of Italian banks over the 2011-
2017 period, this paper examines whether these board characteristics affect the risk propensity of
cooperative and joint-stockbanks. Bank risk is measured by the Z-index, profit volatility and the ratio of
non-performingloans to total gross loans.
Findings The findings show that cooperatives take less risk than joint-stock banks and have lower
board turnover and education. Furthermore, this study finds that while board education mediates the
relationship between the cooperative model and bank risk-taking, there is no evidence for board
turnover. Thus, the lower educational level of cooperative directors contributes to explaining the lower
risk-takingof cooperative banks.
Implications The findings have several implications. In terms of the more general policy debate, the
results point to the need to strengthenthe governance model for both joint-stock and cooperative banks
while supportingthe view that a more ad hoc perspective on the best models and practicesfor each type
of institutional settingwould be preferable. In particular, the study reveals how board education’seffects
on bank risk-takingshould be carefully monitored.
Originality/value Through a mediation framework, this study provides empirical evidence on the
relationship between bank institutional setting (by distinguishing between cooperative and joint-stock
banks) and risk-taking behavior by exploring the underlying mechanisms at the board level, which is
novel in the literature.
Keywords Corporate governance, Cooperative banks, Bank ownership, Board of directors, Bank risk
Paper type Research paper
1. Introduction
In the years before the financial crisis, bank risk came under greater scrutiny by regulators,
reinvigorating the debate among policymakers and academics regarding best practices in
bank risk management and governance. In the banking industry, a crucial rolein managing
the relationship between risk and governance is assigned to the board of directors. As
stated in the corporate governance principles for banks introducedby the Basel Committee
on Banking Supervision (2015), “The board is responsible for overseeing a strong risk
governance framework, including review of key policies and controls, and should be active
when it comes to defining the risk appetite and ensuring alignment thereof within the bank.
It should ensure the efficacy of the risk management, compliance and internal audit
functions”. Since the Basel Committee introduced the prudential capital framework in 1988,
the literature on this topic has grown rapidly and in different directions (Anderson and
Fraser, 2000;Boyd and De Nicol
o, 2005;Jime
´nez et al., 2014;Saunders et al.,1990). More
Antonio D’Amato is based
at the Department of
Economics and Statistics,
University of Salerno,
Salerno, Italy. Angela Gallo
is based at CASS Business
School Banking and
International Finance,
London, UK.
Received 8 January 2019
Revised 11 April 2019
Accepted 15 April 2019
PAGE 774 jCORPORATE GOVERNANCE jVOL. 19 NO. 4 2019, pp. 774-805, ©EmeraldPublishing Limited, ISSN 1472-0701 DOI 10.1108/CG-01-2019-0013
recently, the literature has emphasized the critical role of good corporate governance in
banking and revealed how existing regulatory failures could severely impair the stability of
the financial system. To reduce those loopholes revealed by the 2007-2008 crisis,
regulators at the global level have revised their corporate governance standards in areas
related to the board of directors and management compensation. The responses of banks
to these initiatives have differed. The most divergence in these reactions is evident between
joint-stock banks and cooperative banks. Joint-stock banks and their governance were at
the center of the financial crisis, and they are therefore more willing to comply with new
standards, whereas cooperativebanks argued that they performed better in terms of having
lower volatility and more stable returns, as they took less risk during the crisis than joint-
stock banks did because of their specific corporate governance characteristics (European
Association of Cooperative Banks[EACB], 2015).
While numerous explanations have been invoked for why cooperative banks take less risk,
e.g. business model characteristics and ownership structure, to the best of our knowledge,
no studies to date have directly related this difference to bank governance and specifically
to board characteristics (Chaddad and Cook, 2004;Fonteyne, 2007;Groeneveld and de
Vries, 2009;Hansmann, 2000). By the same token, studies on bank governance and risk-
taking have thus far neglected the implications of different institutional settings. Therefore, it
is relevant from an academic and policy perspective to explore in greater depth the
different roles played by boards of directors in the risk-taking of cooperative banks (Kumar
and Zattoni, 2018). To contribute to fillingthis gap, we add a new dimension to the literature
by enhancing the understanding of how board characteristics differently affect the risk-
taking of these two types of institutionalsettings. In line with more recent studies (Baran and
Forst, 2015;Pevzner et al., 2015), we examine this issue using a mediation framework that
allows us to investigate the interplay between risk-taking our outcome variable and
ownership status via the inclusion of a third variable (mediator variable) related to board
characteristics.
The empirical literature has mainly analyzed the impact of board structure (in terms of size,
gender composition, etc.), directors’ independence and compensation packages on firm/
bank outcomes (De Andres and Vallelado, 2008;Fahlenbrach and Stulz, 2011;Mehran
et al.,2012
;Pathan, 2009;Vallascas et al., 2017); to date, the impact of board education
and turnover remain less studied (Berger et al.,2014;Minton et al.,2014). These two
dimensions, however, play a crucial role in the difference between the governance of joint-
stock banks and cooperative banks because of the institutional setting. Therefore, our
analysis aims to empirically test whether board education and turnover play a role in
explaining the difference between joint-stock and cooperative banks in terms of risk-taking
after controlling for other identified drivers of risk-taking and other governance
characteristics.
To test our hypotheses, we apply a dynamic panel approach to hand-collected data for a
comprehensive sample of 638 Italian banks over the 2011-2017 period. Descriptive
analyses reveal a relatively high number of bank directors with low levels of education
(proxied by the holding of at least a university degree) in the Italian banking industry (only
39 per cent of board members hold a university degree), especially among cooperative
banks (only 23 per cent of cooperative directors hold a university degree). Moreover, we
find that cooperatives take less risk than joint-stock banks and that their boards have lower
turnover and lower education levels. The mediation analyses reveal that board education
mediates the relationship between banks’institutional setting and bank risk, which indicates
that cooperative banks take less risk than joint-stock banks because directors of
cooperatives are less educatedthan directors of joint-stock banks. This finding supports the
view that less-educated directors tend to assume less risk (Beber and Fabbri, 2012), which
leads cooperative banks to be more stable. Notably, our results are valid only for measures
of total risk (Z-index and standard deviation of ROA) but not for our proxy of credit risk.
VOL. 19 NO. 4 2019 jCORPORATE GOVERNANCE jPAGE 775
Extending the analysis, we test an alternative explanation of credit risk-taking determinants,
and we find that small cooperative banks assume lesscredit risk than large ones. This result
suggests that small cooperative banks operating in localized areas have a closer
relationship with their customers, so that directors’ level of education is probably less
relevant than the soft information acquired on the borrowers and the peer monitoring
mechanisms. In contrast, our estimations do not support the hypothesis regarding the
mediating role of board turnover on the relationship between the bank institutional setting
and bank risk.
At the industry level, our investigation aims to add new evidence to the active debate in
Europe regarding how institutional differences should be reflected in ad hoc banking
regulation and corporate governance standards (European Association of Co-operative
Banks, 2015). This debate began soon after the recent financial crisis, as cooperative
banks stressed their ability to master the crisis (higher resilience) much better than other
banking groups. Write-offs by European cooperative banks (cooperative banks represent
20 per cent of the European banking services market) amounted only to 7 per cent of the
write-offs of the whole banking system after the outbreak of the financial crisis. The
cooperative banking industry claimed that this outcome was “due to their prudence in
dealing with risks and the cooperative ownership and governance model that keep them
close to their members and customers” (European Association of Co-operative Banks,
2012).
From an academic perspective, however, this view contrasts with agency theory, which
predicts that the weaknesses associated with cooperative banks’ ownership structure and
the ambiguity of their objectives will lead to poor governance (Borgen, 2004;Hart and
Moore, 1998). Our results contribute to both the academic and industry debates showing
that one of the weaknesses of their model the lower level of education of the directors
helps to explain the lower level of risk of cooperatives and thus their better performance in
the recent financial crisis.
In terms of the more general policy debate, our results overall point to the need to
strengthen the governance model for both joint-stock and cooperative banks while
supporting the view that a more ad hoc perspective of the best models and practices for
each type of institutional setting would be recommended. Regarding the more specific
discussion on the level of expertise and education that should be required to become a
director of a bank board, our evidence points to a positive role of a low education level on
risk-taking. We are not suggesting that less-educated boards are a desirable feature of
banks’ boards. In this respect, our evidence is able to highlight only that the weakness of
the cooperative bank governance model remains an issue even in light of their stronger
resilience during the crisis. The remainder of the paper is organized as follows. Section II
specifies our testable hypotheses and discusses the related literature. Section III describes
our empirical design and related methodological issues, and Sections IV and V discuss our
results and our robustness checks. Section VI discusses policy implications and concludes
the paper.
2. An overview of the Italian banking system
Italy is a bank-oriented systemin which banks are the key providers of loans to non-financial
companies and the main collector of household savings. On the one hand, credit provided
by banks is almost of 166 per cent of Italy’s GDP, which is relatively higher compared to
Germany (127 per cent) and France (157 per cent). On the other hand, Italian banks have
deposits amounting to almost 69 per cent of total liabilities, which is higher than the levels
for French (54 per cent) andGerman banks (62 per cent). Overall, banks account foralmost
85 per cent of Italy’s financial sector, and their total assets represent approximately220 per
cent of Italian GDP.
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