Does Bank Institutional Setting Affect Board Effectiveness? Evidence from Cooperative and Joint‐Stock Banks

• Date: 01 March 2017
• Published date: 01 March 2017
• DOI: http://doi.org/10.1111/corg.12185
• Author: Antonio D'Amato,Angela Gallo

Does Bank Institutional Setting Affect Board

Effectiveness? Evidence from Cooperative and

Joint-Stock Banks

Antonio D’Amato*and Angela Gallo

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Do cooperative banks suffer from board def‌iciencies less frequently and severely than joint-stock

banks? To answer this question, we analyze banks operating in Italy during the period 2006–2012 to examine whether the

governing bodiesof cooperative banks are lesseffective in carrying out theirduties than those of joint-stock banks. Def‌iciencies

in the governing body are measured by sanctions imposed by the supervisory authority.

Research Findings/Insights: Findings revealed that the boards of directors of cooperative banks were sanctioned more often

than board of directors of joint-stock banks. Furthermore, board turnover mediates the relationship between the cooperative

status and board def‌iciencies.

Theoretical/Academic Implications: This study provides empirical evidence in support of the weakness of corporate gover-

nance in cooperative banks. Methodologically, our approach is novel in that we adopt a measure of board

effectiveness/def‌iciency based on an independent third-party perspective (supervisory authority) that is not biased by the

different objective function of the two types of banks.

Practitioner/Pol icy Implications: The f‌indings have several policy and managerialimplications. We contribute to the ongoing

debate on the proposal for f‌lexibleregulation of corporate governance for cooperative banks and emphasize that policy-makers

and regulators should rethink the corporate governance structures of cooperative banks. In particular, the study reveals how

board turnover should be carefully monitored to reduce board def‌iciencies at the bank level.

Keywords: Corporate Governance, Board Effectiveness, Institutional Setting, Banking Industry, Enforcement Actions

INTRODUCTION

The recent f‌inancial crisishas emphasized the criticalrole of

good corporategovernance in banking, and revealedhow

existing regulatory failures could severely impairthe stability

of the f‌inancial system (Beatty & Liao, 2014). In both the US

and Europe, the boards of several key f‌inancial institutions

were found to have been unable to either effectively monitor

risk-management systems and executive salaries (the United

States and United Kingdom) or guard against conf‌licts of in-

terest (Spain and Germany). In response to the crisis, since

2009, the Organization for Economic Co-operation and

Development (OECD), the Financial Stability Board (FSB),

and the Basel Committee on Banking Supervision (BCBS)

have revisedtheir standards for corporategovernance in areas

such as risk management, board structures, compensation,

and the role of supervisors. The EU Commission and the

European Banking Authority (EBA) have developed new

laws and sub-laws to implement these new standards for the

European Union (Capital Requirements Regulation [CRR]

and Capital Requirements Directive [CRD] IV). The most re-

cent initiative is by the BCBS with the publication in October

2014 of a consultation paper aiming to revise the document

“Principles for enhancing corporate governance”(BCBS,

2015). The response of banks to these initiatives has been dif-

ferent. Joint-stock banks andtheir governance were at the cen-

ter of the f‌inancialcrisis, and they are thereforemore willing to

comply with new standards to restore the conf‌idence of the

market, whereas cooperative banks questioned whether the

new principles were suff‌iciently f‌lexible to respond to the

diversity of their business (lower risks, lower volatility, and

more stable returns) as well as their higher resilience during

the crisis (European Association of Co-operative Banks

[EACB], 2015).

In particular, in January 2015, the EACB published notes

on the recent BCBS consultation paper and argued that

cooperative banks performed better during the crisis than

did joint-stock banks because of their specif‌iccorporate

governance characteristics. However, this argument

challenges the traditional view supported by the theoretical

*Addressfor correspondence: AntonioD’Amato, Department of Economics& Statistics,

University of Salerno, Via Papa Giovanni Paolo II, 132, 84084 Fisciano (SA), Italy. Tel.

+39.089963107;E-mail: andamato@unisa.it

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12185

78

Corporate Governance: An International Review, 2017, 25(2): 78–99

literature based on agency theory that cooperative banks

may suffer structurally more from weak corporate gover-

nance than do joint-stock banks, causing substantial board

ineffectiveness (Alexopoulos, Catturani, & Goglio, 2013;

Cuevas & Fischer, 2006; Llewellyn, 2005, 2006; Shaw, 2006).

To contribute to the debate outlined above, this study

focuses on the board of directors, which plays a key role in

current regulation, as the top of the internal governance

system of the banks (EBA, 2011). In particular, the purpose

of this work is to investigate whether and to what extent the

institutional setting affects the effectiveness of the boards of

cooperatives compared to those of joint-stock banks.

To investigate this issue empirically, we take into account

that cooperative and joint-stock banks differ in their

objectives, in their ownership structure, and in the rights that

are granted to their owners. As in cooperative f‌irms,

members/owners of cooperative banks are also their

customers. Membership is not transferable, and is redeemable

at a nominal value. Moreover, cooperative banks are charac-

terized by the one-member one-vote per capita regardless of

the subscribed capital. Consequently, members cannot accu-

mulate votes by purchasing shares on the market. As for the

bank objective, prof‌it maximization is not the sole business

objective ofcooperative banks as in joint-stockbanks, but they

pursue the maximization of members’value by offering

products and services along with the distribution of prof‌its

(Fontayne, 2007).

Given that prof‌itability is not the mainobjective of coopera-

tive banks, to avoid biased results, we deviate from the litera-

ture on corporate governance that focuses predominantly on

f‌inancial performance as a proxy of the effectiveness of gover-

nance. We argue that this comparison should focus on the

bank’s internal governance system, a limited but crucial com-

ponent of bank governance that is not affected bybank objec-

tives and/or key bank stakeholders. As a consequence, we

evaluate the board effectiveness of cooperative vs. joint-stock

banks using a supervisory authority as an independent

third-party perspective. This authority has the power to im-

pose sanctions on the board of directors for misconduct, and

we use these sanctions as a proxy for board def‌iciencies. Al-

though the objectives of cooperative banks differ from those

of joint-stock banks, the supervisory authority has the same

objective when supervising both types of banks and their di-

rectors: to detect misconduct at the bank level and ensure

the f‌inancial stability of the banking system. Moreover, this

proxy of board def‌iciency renders our analyses less likely to

be affected by endogeneity as the sanctions are the result of

regular controls of the supervisory authority, which do not

depend on bank behavior.

Based on a unique dataset of the supervisory sanctions im-

posed on the directors for a largesample of Italian banks over

the period 2006–2012, our results show that cooperative

boards are more def‌icient than boards of joint-stock banks.

In particular, regression results show that cooperative boards

have on average a higher probability of being sanctioned, in-

curring more violations and, especially for small banks,incur-

ring more severe penalties. Notably, we also f‌ind that

compared with joint-stock banks, cooperative boards are

more likely to be def‌icient in credit management.

These results are in line with agency theory and less sup-

portive of the current debate on the strength of cooperative

bank boards, but they conf‌irm the specialness of cooperative

governance mechanisms. In practice, our results suggest that

particular attention should be paid to board turnover as we

f‌ind that turnover mediates the relationship between board

def‌iciency and cooperative status, suchthat cooperative board

members are at greater risk of becoming powerful and

entrenched. Theresults are robust to differentdependent var-

iables, model specif‌ications and time periods (pre- and post-

crisis).

In this work, we contribute to the literature on corporate

governance and the role of institutional settings in board

functioning. To the best of our knowledge, the empirical

evidence on the relationship between bank institutional

setting and the effectiveness of corporate governance is

limited if not absent. Our contribution is twofold. First, we

adopt a third-party perspective, which allows the construc-

tion of new measure(s) of board def‌iciency. Second, we de-

velop our empirical analyses based on methodologies from

the corporate fraud literature and apply them to bank corpo-

rate governance. To the best of our knowledge, both contri-

butions are novel in the literature. Italy has one of the

largest cooperative banking systems, and it is worth noting

that Italian banks have recently made progress in improving

their corporate governance as a result of the implementation

of European Directives, specif‌icprovisionsintroducedbythe

Bank of Italy (BoI), and industry codes of conduct. Our

results may improve our understanding of the major weak-

nesses of existing board regulations. Finally, we believe that

our results can have policy implications by making a clear

and concrete contribution to the ongoing debate on the revi-

sion of the principles for enhancing corporate governance

and partially supporting cooperative banks.

The paper is structured as follows. In the next section, we

present the theoretical background of our study. Then, we re-

view the literature to develop our research hypotheses. Next,

we present the sample and the methodology used to test the

hypotheses. Then, we present and discuss the results and the

robustness checks. Finally, we discuss the implications of our

f‌indings and our conclusion.

THEORETICAL BACKGROUND AND

HYPOTHESES DEVELOPMENT

Theoretical Approach

In the agency perspective, the boardof directors has a key role

in monitoring the managers to prevent them from pursuing

their own interests over those of the owners (Fama & Jensen,

1983). In the banking sector,the role of the board is even more

critical than in other industries. Banking business is complex

and therefore nontransparent to a wide audience of stake-

holders (shareholders, creditors, debtors, regulators, etc.).

Llewellyn (2007) shows that f‌inancial f‌irms:

•are characterizedby complex and nontransparent manage-

ment, primarily due to the characteristics of f‌inancial

products (Levine, 2004);

•are relationship- rather than transaction-based businesses

involving long-term contracts. This characteristic makes it

more diff‌icult for the customers to control relationship

dynamics and the decision to get out;

79BANK INSTITUTIONAL SETTING AND BOARD EFFECTIVENESS

© 2016 JohnWiley & Sons Ltd Volume 25 Number 2 March 2017