Corporate Governance and Bank Risk‐taking

• Author: Abhishek Srivastav,Jens Hagendorff
• Date: 01 May 2016
• Published date: 01 May 2016
• DOI: http://doi.org/10.1111/corg.12133

Corporate Governance and Bank Risk-taking

Abhishek Srivastav*and Jens Hagendorff

ABSTRACT

Manuscript type: Review

ResearchQuestion/Issue: Bank governancehas become the focus of a flurry of recentresearch and heated policydebates. How-

ever,the literature presents seemingly conflictingevidence on the implications of governance for bank risk-taking. The purpose

of this paper is to review prior work and propose directions for future research on the role of governance on bank stability.

Research Findings/Insights: We highlight a numberof key governance devices and how these shape bank risk-taking: the ef-

fectiveness of bank boards, the structure of CEO compensation, and the risk management systems and practices employed by

banks.

Theoretical/Academic Implications: Prior work primarily views bank governance as a mechanism to protect the interests of

bank shareholders only. However, given that taxpayer-funded guarantees protect a substantial share of banks’liabilities and

that banks are highly leveraged, shareholder-focused governance may well subordinate the interests of other stakeholders

and exacerbate risk-taking concerns in the banking industry. Our review highlights the need for internal governance mecha-

nisms to mitigate such behavior by reflecting the needs of shareholders, creditors, and the taxpayer.

Practitioner/Pol icy Implications: Our review argues thatthe relationship between governance and risk is central froma finan-

cial stability perspective. Future research on issues highlighted in the review offer a footing for reforming bank governance to

constrain potentially undesirable risk-taking by banks.

Keywords: Corporate Governance, Banks, Board of Directors, CEO Pay, Risk Management

INTRODUCTION

There has been considerable academic and regulatory

interest in how to mitigate bank risk-taking behavior in

recent years. Undue risk-taking by banks jeopardizes the

safety and soundness of individual institutions as well as the

stability of the entire financial sector when contagion causes

risks to spill over to other financial institutions.

A case in point is the financialcrisis that started in 2008. It is

by now a widely held viewthat the vulnerability of the bank-

ing sector during the crisis was at least in part caused by a

build-up of excessive risk by some banks before the crisis

(Brunnermeier, 2009; DeYoung, Peng, & Yan, 2013). Further,

there is significant discussion over the extent to which gover-

nance failureshave contributed to the riskexposures of banks.

In particular, there are questions over whether bank boards

were unable to effectively monitor and control bank risk,

whether executive pay was excessivelystructured to promote

risk-taking, and whether banks’risk management systems

were adequate (Bebchuk & Spamann, 2009; Kashyap, Rajan

& Stein, 2008; Kirkpatrick, 2009).

1

The purpose of this paper

is to focus on these issues by reviewing existing research on

bank governance and risk with a view to formulate empirical

questions for future research.

Our review is set against the background of recent regula-

tory reforms that have placed great emphasis on reforming

governance in order to control bank risk-taking (Basel Com-

mittee on Banking Supervision, 2014; Federal Reserve, Office

of the Comptroller of the Currency, Office of Thrift Supervi-

sion, Federal Deposit Insurance Corporation, 2010; Liikanen

Report, 2012). To date, policymakers and regulators have fo-

cused on specific governance shortcomings. In the UK, the

WalkerReview (Walker, 2009) focused on makingrecommen-

dations on board arrangements and the qualifications of

board members as wellas on the compensation arrangements

of UK banks and financial firms. Similarly, the Netherlands

has had a Banking Code in place since 2010 that contains

guidelines on the make-up of bank boards, including the

qualification and training of board members and their remu-

neration. Additionally, compensation guidelines for CEOs

and other senior executives at large banks have raised the

need for pay instruments to align managerial interests with

ensuring bank stability (Federal Reserve et al., 2010).

However, Kashyap et al. (2008) argue that existing reforms

tend to address only specific governance shortcomings, such

as those related to pay or board composition, but do not

address more fundamental governance flaws. Equally, Becht,

Bolton, and Röell (2011) note that ongoing reforms tend to

follow pre-crisistraditions, whereby governance mechanisms

*Address for correspondence: Abhishek Srivastav, University of Leeds, Maurice

Keyworth Building, Leeds LS2 9JT, UK. Tel: +44 (0)11 3343 6321; E-mail: A.

Srivastav@leeds.ac.uk

© 2015 JohnWiley & Sons Ltd

doi:10.1111/corg.12133

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Corporate Governance: An International Review, 2016, 24(3): 334–345