Do supervisory enforcement actions affect board composition?

• Date: 01 January 2021
• Author: Matteo Cotugno,Valeria Stefanelli,Antonio D'Amato,Angela Gallo
• Published date: 01 January 2021
• DOI: http://doi.org/10.1111/corg.12336

ORIGINAL ARTICLE

Do supervisory enforcement actions affect board composition?

Matteo Cotugno

1

| Antonio D'Amato

2

| Angela Gallo

3

| Valeria Stefanelli

4

1

Department of Management, University of

Bologna, Bologna, Italy

2

Department of Economics and Statistics,

University of Salerno, Fisciano, SA, Italy

3

Centre for Banking Research, Cass Business

School, London, UK

4

Department of Economics, University of

Salento, Monteroni, LE, Italy

Correspondence

Antonio D'Amato, Department of Economics

and Statistics, University of Salerno, Via Papa

Giovanni Paolo II, 132, Fisciano, SA 84084,

Italy.

Email: andamato@unisa.it

Abstract

Research Question/Issue: Do enforcement actions impact banks' board composi-

tion? Based on a unique sample of sanctions imposed on Italian banks by the coun-

try's banking supervisory authority from 2009 to 2015, we investigate whether

supervisory enforcement actions affect changes at the board level. Moreover, we

examine whether changes at the board level after a sanction are effective in reducing

the probability of further sanctions in the future.

Research Findings/Insights: The findings reveal that sanctioned banks change their

board composition following a supervisory sanction. We further test whether these

changes improve bank governance and find that, under certain conditions, they may

reduce the probability that the board is sanctioned again. Robustness tests confirm

the results.

Theoretical/Academic Implications: This study provides empirical evidence that sup-

ports the role of supervisory enforcement actions in inducing banks to adopt changes

at the board level. Given that the relationship between supervisory sanctions and

changes in board characteristics is still neglected, we contend that our results may

increase the understanding of the effectiveness of enforcement actions in improving

board characteristics.

Practitioner/Policy Implications: We believe that our results have policy implica-

tions by making a clear and concrete contribution to the ongoing debate on the

revision of the principles for enhancing corporate governance and banking

supervision.

KEYWORDS

Corporate Governance, Enforcement Actions, Board of Directors, Supervisory Authority,

Banking Industry

1|INTRODUCTION

The financial crisis of 2007/2008 pointed out several gaps in bank

governance and risk management (Ladipo & Nestor, 2009; Levrau &

Van den Berghe, 2009). Since then, regulators and supervisory author-

ities have strengthened the protection of bank shareholders' and

stakeholders' interests through stricter corporate governance regula-

tions, particularly with reference to the board of directors (Basel Com-

mittee on Banking Supervision, 2015a, 2015b; European Banking

Authority (EBA), 2011; European Securities and Markets

Authority-European Banking Authority (ESMA-EBA), 2016).

In terms of banking supervision, governance regulations have

been revised to emphasize the importance of the board of directors in

the sound and prudent management of banks (EBA, 2018; ESMA-

EBA, 2016). The board of directors has a key role in bank governance,

as it not only monitors management but also provides guidance and

advice to managers (De Andres & Vallelado, 2008; Grove, Patelli, Vic-

toravich, & Xu, 2011). Specifically, EBA and the Basel Committee on

Received: 1 March 2020 Revised: 20 July 2020 Accepted: 21 July 2020

DOI: 10.1111/corg.12336

22 © 2020 John Wiley & Sons Ltd Corp Govern Int Rev. 2021;29:22–44.wileyonlinelibrary.com/journal/corg

Banking Supervision have placed the board of directors at the top of

the internal governance system. Boards are responsible for the setting

of banks' objectives and level of risk appetite, for bank organization

and direction, and for the organization of the internal control system

(EBA, 2018). Because of the special role played by banks in the econ-

omy and their fundamental differences from nonfinancial corporations

(see de Haan & Vlahu, 2016), failures of banks and of their governance

models are a relevant concern. Thus, stricter supervision has been

implemented by banking authorities to ensure that boards effectively

perform their duties and pursue bank safety. Following the recent

banking crises, the attention of the banking authorities has also been

placed on the level of education of directors and on the need for

banks to provide induction and training processes for newly appointed

boards, which is in line with the fit and proper assessments introduced

by the Capital Requirement Directive IV (CRD IV; EU Directive

2013/36/EU and EU Regulation 575/2013; European Central Bank

(ECB), 2018a).

In their role, supervisors conduct on-site examinations to ensure

that bank operations are consistent with sound banking practices.

When on-site examinations identify unsafe, unsound, or illegal bank-

ing practices, regulators use a variety of supervisory enforcement

actions to require institutions to take corrective measures. These

enforcement actions are intended to accomplish several things,

including bringing about alterations in the practices and behaviors that

caused the misconduct, disciplining the board members of the institu-

tion and avoiding potential losses to the deposit insurance fund.

Whether these actions are effective in promoting the adoption of

sounder and more prudent director behavior is an open question.

Regarding the effectiveness of supervisory activity, the current

literature has focused on the relationship between enforcement

actions and various bank indicators (post-sanction) such as capital,

deposits, risk, and performance. This literature has mostly focused on

the U.S. banks and investigated whether enforcement actions can

reduce bank risk or increase performance (Delis & Staikouras, 2011;

Delis, Staikouras, & Tsoumas, 2017, 2019; Lambert, 2019). Surpris-

ingly, despite the supervisory efforts that target the disciplining of

directors and board-level mechanisms rather than bank risk or perfor-

mance, studies on the relationship between enforcement actions and

changes in bank governance characteristics are still limited. Therefore,

this paper aims to fill this gap in the literature by investigating the

effects of supervisory enforcement actions on the composition of

bank boards. Several dimensions of boards are examined, such as

board turnover, directors' education level, board size, and gender

diversity. A vast body of literature has supported the crucial role of

each of these dimensions in the proper functioning of bank gover-

nance models (see de Haan and Vlahu (2016) for a survey of the liter-

ature). Supervisory actions are imposed on a board and its members

but do not specifically target any of these dimensions. The changes

that banks put into place because of disciplinary actions are thus an

empirical question.

Moreover, unlike previous studies, this analysis is extended to

investigate whether the changes induced by supervisory actions have

an impact on the likelihood of more supervisory actions being

imposed in the future. This extension is relevant to assess the effec-

tiveness of supervision from a regulatory perspective and better cap-

tures whether these changes are relevant to the organizations rather

than merely a formal signal to the supervisory authority that actions

have been taken to improve the governance of the bank.

Based on a unique dataset of the supervisory sanctions imposed

on the directors of a large sample of Italian banks over the period

2009–2015, our results show that sanctioned banks increase board

turnover, reduce board size, and tend to improve the education level

of the board. All of these effects seem to be consistent with banks

reacting to supervisory actions by removing the directors responsible

for the sanction and appointing better-educated directors. By analyz-

ing different types of violations, we find this evidence to hold, in par-

ticular, for credit- and risk management-related sanctions. However,

when testing whether these changes reduce the probability of new

sanctions in the future, we find that only changes in board size have a

significant impact.

Overall, our results contribute to the literature on corporate gov-

ernance and the role of enforcement actions in board functioning in

several respects. First, we investigate whether sanctions imposed by

supervisors are effective in altering board characteristics and behav-

iors and focus on multiple relevant dimensions of board functioning.

Second, we provide evidence of the effectiveness of sanctions as a

disciplinary mechanism, that is, in reducing the likelihood of future

misconduct. This latter point is relevant considering the financial and

reputational costs imposed by supervisory actions on sanctioned

banks and that in some cases in which the financial penalties are

extremely severe have the potential to harm the soundness of the

bank and its financial stability. To the best of our knowledge, both

contributions are novel in the literature. We focus on the Italian bank-

ing system, which is one of the largest in Europe in terms of deposits,

total assets, and number of employees. This banking industry has

recently experienced various cases of bank crises, partly due to board

weaknesses. Therefore, we contend that our results may improve the

understanding of the effectiveness of enforcement actions in enhanc-

ing board mechanisms. Finally, we believe that our results have policy

implications by making a clear and concrete contribution to the ongo-

ing debate on the revision of the principles for enhancing corporate

governance and banking supervision.

The remainder of the paper proceeds as follows. Section 2

describes the literature review and identifies the research questions.

Section 3 offers an overview of the Italian banking system and the

sample, methodology, and variables used in the empirical analysis.

Section 4 analyses the empirical findings. Section 5 reports the

robustness check results, and Section 6 reports the conclusions, limi-

tations, and implications.

2|LITERATURE REVIEW AND RESEARCH

QUESTIONS

As stipulated in banking regulations, supervisory activity occurs on a

regular basis so that bank board behavior is continuously monitored

COTUGNO ET AL.23