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

• Pages: 774-805
• DOI: https://doi.org/10.1108/CG-01-2019-0013
• Published date: 11 June 2019
• Date: 11 June 2019
• Author: Antonio D’Amato,Angela Gallo
• Subject Matter: Strategy

Bank institutional setting and risk-taking:

the missing role of directors’education

and turnover

Antonio D’Amato 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

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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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