Evolution of Corporate Governance in the Banking Sector - Term Paper Example

Running Header: Corporate Governance Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Table of Contents Table of Contents 2 1.0 Introduction 3 2.0 Evolution of Corporate Governance in the Banking Sector 3 2.1 Family governance and Economic Enfranchisement 3 2.2 Separation of Powers and Managerial Governance 4 2.3 Governance and Representation 5 3.0 Governance Problems in the Banking Industry 6 3.1 Opaqueness 6 3.2 Complexity 7 3.3 Number of shareholders 7 4.0 Approaches to reform governance in the Banking Sector 8 4.1 Interest rate controls 8 4.2 Strengthening the traditional disclosure regulation 9 4.3 Increasing monitoring by institutional investors 9 5.0 Present Day Good Policy and Practice in Corporate Governance 10 5.1 Setting principle of corporate Governance 10 5.2 Establishing efficient corporate governance structure 10 5.3 Setting up up-to-date information technology systems to ensure quality management 11 6.0 Conclusion 11 References 13 1.0 Introduction Corporate governance emerged due to the increasing need to protect the interests of investors. It involves concern for the manner in which the powers of a corporation are exercised in order to protect assets and resources of the organization. Corporate governance aims at maintaining and upholding shareholders value and at the same time to satisfy their needs. According to Plessis, Hargovan and Bagaric (2010, p. 4), corporate governance generally refers to organizational and legal framework as well as processes and principles within which corporations are governed. In Particular, corporate governance is concerned with accountability, powers and relationships of those who are involved in directing and controlling a company. This ensures that investors are protected against exploitation and misuse of their resources. This research paper is going demonstrate how corporate governance may contribute to higher standards of accountability and business performance in the finance sector. 2.0 Evolution of Corporate Governance in the Banking Sector Mallin, Mullineux and Wihlborg (2006, p. 1) note that evolution of corporate governance in the banking sector is based on changes with relationship between control and ownership. Corporate governance is seen to have evolved in three major periods. Each period had its own model of reference in relation to corporate governance 2.1 Family governance and Economic Enfranchisement According to Gomez and Korine(2005, p. 743) the first period of evolution in relation to corporate governance in the banking sector was characterized by dominance of the founding family and this period stretched from the industrial revolution to 1920s. In this period, individuals were given authority to own banks provided they could afford them hence it marked incorporation of limited liability companies. In return, this led to the emergence of shareowner power. Individuals who owned banks acquired full sovereignty over them and this meant that they were free to buy, sell and create shares of ownership. At this time corporate governance was focused on democratic procedures, that is economic enfranchisement. Dermine (2006, p. 7) notes that the economic enfranchisement period empowered public and gave them the right to own and control banks. However, the fact that banks were fully controlled by owners meant that their decisions did not incorporate external stakeholders. Therefore, external shareholders failed to gain financially from the banks. 2.2 Separation of Powers and Managerial Governance Banks were acquiring greater finances in order to expand and continue growing. The expansion made them to become more complex hence the need for broader and specialized management skills. The growth in size of corporations led to the development of new financial challenges and this called for need of professional management. According to Gomez and Korine (2005, p. 744), the expansion led to need for more funds in order to finance operations of the banks. Dermine (2006, p. 7) emphasizes that at this period banks required more financial resources hence family owners were forced to look for other investors. Therefore, family members were forced to relinquish control of banks to individuals who had professional skills. This marked the separation of ownership and managerial control. Corporate governance at this period was focused at integrating separation of powers by identifying democratic procedures that would ensure harmonious relationships between owners and managers. Owners had the responsibility of providing capital while managers were left to control banks Mallin, Mullineux and Wihlborg (2006, p.4) note that at this period governance laws were enacted and codes of conduct were written so as to safeguard finances that were provided by investors. Furthermore, laws relating to financial disclosures were passed. Banks were required to publish their annual statements with an aim of protecting investors as well as to comply with securities industry. Furthermore, banks were required to elect a board of directors and at the same time to hold annual shareholders meeting in order to ensure greater accountability in management of finances that were provided by owners, depositors and lenders. The board was given the mandate to hire and fire managers and this was intended to oversee and control powers of managers in utilizing the financial resources of stakeholders. 2.3 Governance and Representation The increase in technological innovations as well as globalization and deregulation created a big challenge to managerial governance. In addition, increase in equity based retirement financing and development in employee share options led to the emergence of mass shareholders who adversely diluted ownership of banks and this made managerial governance to become unsuitable (Gomez and Korine 2005, p. 745). Furthermore, institutional investors and lenders continuously sought for more information about the organizations. Moreover, the society gained increased interest in the affairs of the banks. This led to the need for various stakeholders to be involved in affairs of the banks. 3.0 Governance Problems in the Banking Industry 3.1 Opaqueness Banking activities are opaque and this makes it difficult for the stakeholders to assess operations of the banks. According to Caprio and Lavine (2007, p. 16), activities of banks are not readily observable and they remain hidden for an extensive period of time. Banks have continuously altered the risk composition associated with their assets. In addition, banks have been able to hide their financial problems by increasing loans to their clients who cannot be able to service their previous debt obligations. This makes it difficult to assess performance of banking. Mehran, Morrison and Shapiro (2011, p. 4) state that banks have constantly used the opaqueness that is associated with credit rating in order to speed up the process of lending and securitization. Mallin, Mullineux and Wihlborg (2006, p.8) note that agencies used to rate bonds disagree by a large extent over ratings on bonds which are issued by banks as compared to bonds issued by non-financial organizations. Lack of information in relation to how banks rate their bonds further indicates the opaqueness that exists in this industry. Therefore, banks have continuously manipulated their financial statements thereby misleading their stakeholders. According to Caprio and Lavine (2007, p. 18), the opaqueness in banking sector has serious implications for both debt and equity financers hence this can adversely affect strategic development of the industry. Lack of adequate information relating to banks make it difficult for the stakeholders to monitor the performance of their investment. This provides an opportunity for managers to create a number of compensation packages at the expense of investors and customers hence affecting growth of banks. 3.2 Complexity Banking operations are complex hence more difficult to monitor as compared to other non-financial organizations. Mehran, Morrison and Shapiro (2011) note that the complex nature of banks affects the way management interacts with the board as well as the regulators. According to Mallin, Mullieux and Wihlborg (2006, p. 8), the board has constantly failed to effectively represent the shareholders due to lack of understanding on how bank operates. Board members find it difficult to identify and implement best practices in banks due to lack of sufficient understanding of bank’s operations. In addition, lack of provisions relating to composition of the board in order to cope with complex nature of banks makes it easier for managers to misuse their authority. This in turn affects growth of banks hence creating a barrier to their ability to achieve their strategic objectives. 3.3 Number of shareholders Banks have more stakeholders as compared to other financial institutions. According to Mchran, Morrison and Shapiro (2011, p. 3), 90% of funds held by banks is composed of debt and this makes banks to have a large number of stakeholders. Thus, beyond shareholders, bank stakeholders include debt holders who have deposits in the bank and also the holders of debt which has been subordinated. However, despite the large number of stakeholders, board is only concerned with representing views of shareholders. The interests of shareholders have continuously diverged from those held by other stakeholders especially when they are faced with risk (Mallin, Mullineaux & Wihlborg 2006, p. 8). When faced with volatility of returns, shareholders have resorted to short term goals in order to safeguard their investments. On the other hand, debt holders have resorted to long term prospects so as to try to minimize the effects of volatility in interest rates. This has made shareholders to declare high dividends hence place banks at a risk of collapsing. Therefore, shareholders are unwilling to reduce risk faced by a bank even if it’s their obligations. This has made banks to go to insolvency and thus creating a negative consequence on the financial system as well as making the depositors to suffer excessive losses. Banks have a tendency of under pricing deposits held by their customers with an aim of maximizing returns made to their shareholders (Mchran, Morrisson and Shapiro 2011, p. 4). They also utilize cheap deposits provided by their customers in order to offer expensive loans to the lenders. The high returns derived from these loans are not passed to the depositors hence this makes the banks to offer low interest to their customers making it impossible for them to undertake investment activities. According to Dermine (2011, p. 5), underpriced deposit make bankers to view many investment opportunities to be unrealistic. On the other hand, banks have been able to utilize their customers’ deposits in expanding themselves hence achieving their strategic objectives. 4.0 Approaches to reform governance in the Banking Sector 4.1 Interest rate controls According to Kulshreshtha (2008, p. 559), many countries have adopted measures aimed at controlling interest rates. This was done with an aim of offering customers with market friendly debts hence strengthen their financial status. Controlling interest rates in the banking industry is advantageous as it enables banks to attract more customers and thus generate more revenues. In addition, low interest rates improve the relationship between customers and banks and this is important in enhancing the image of the sector. A positive image plays a critical role in assisting banks to excel in their activities. 4.2 Strengthening the traditional disclosure regulation Cioffi (2010, p. 557) states that reforms on the traditional disclosure practices assist in strengthening financial reporting standards in banks and this is important in protecting both internal and external shareholders. Reforms are focused on expanding disclosure requirements and setting strict rules in relation to financial reporting. According to Caprio and Lavine (2006, p. 17), reforms present an opportunity to incorporate current trends in financial reporting as well as disclosures to be made and this further assists in safeguarding banks stakeholders. Strengthening disclosure regulations improves corporate governance by making sure that banks present reliable information to investors hence assisting them to make their investment decisions. Moreover, the regulations encourage managers to adopt better corporate governance practices as well as to assess their performance to stakeholders. Additionally, strong disclosure regulations help in ensuring that stakeholders funds are safeguarded from misuse and thereby improving the management accountability. 4.3 Increasing monitoring by institutional investors Large Institutional investors have emerged as important actors and can be used to monitor corporate governance in banking institutions. According to Dermine (2011, p. 10), individual investors in the banking industry are unlikely to spend time and resources in exercising control owing to free riding hence this makes them to rely on institutional investors who have long term interest in affairs of the banks. Moreover, institutional investors have the ability to pressurize management with an aim of forcing them to exercise corporate governance. Cioffi (2010, p. 544) notes that institutional investors can communications easily among themselves and with management in order to encourage banks to practice corporate governance. The use of institutional investors in monitoring banks has modified behavior of managers making them to adopt fair management practices. Additionally, investors have enhanced transparency in bank’s financial statements by prohibiting managers from making selective disclosures. Furthermore, institutional investors have been able to come up with more rules aimed at strengthening corporate governance in banks. 5.0 Present Day Good Policy and Practice in Corporate Governance 5.1 Setting principle of corporate Governance According to Dermine (2011, p. 10), banks are currently setting guiding principles which state the standards for corporate governance. These principles act as a means of guaranteeing stakeholders about the minimum corporate governance that are applied by banks. Moreover, principles set responsibility of various individuals in bank in order to achieve corporate objective goals. Additionally, the guidelines require the banks to provide annual report in relation to corporate governance. According to United Nations (2011, p. 1), principles of good practice instill a culture based on excellent corporate governance practices hence this ensures long-term sustainability. 5.2 Establishing efficient corporate governance structure According to Mchran, Morrison and Shapiro (2011, p. 6), currently banks have highly qualified board members who have in depth knowledge and experience in relation to operations of banks. Many banks did not have board members who had the necessary financial expertise and this made it difficult for them to efficiently execute their corporate governance responsibilities. The experience that current board members have enables them to exercise efficient supervisory functions and this assists in enhancing corporate governance. Additionally, the skills help them to come up with better policies and strategies for enhancing corporate governance. Therefore, skilled and experienced board members are able to develop techniques that ensure long term sustainability of corporate governance in banks. 5.3 Setting up up-to-date information technology systems to ensure quality management Currently banks are utilizing information technology in order to assist them in monitoring actions of managers. According to Kulshreshtha(2008, p.560), information technology plays a key role in helping banks to achieve their corporate governance goals. Information systems assist board of directors in auditing the management as well as in identifying the risks that may prevent managers to achieve corporate governance objectives. This in turn ensures quality management practices hence good corporate governance. Up to date information technology systems motivate managers to comply with corporate governance. Additionally, systems are able to continuously measure the performance of managers in relation to corporate governance. Therefore, information systems strengthen process of monitoring managers hence this leads to creation of sustainable corporate governance. 6.0 Conclusion In conclusion, corporate governance in banking sector evolved over three stages which include; family dominance, managerial governance and representation. On the other hand, banks face corporate governance issues relating to opaqueness and complexity of their operations and this has prevented them from achieving their strategic objectives. Furthermore, interest rate controls, increasing monitoring by institutional shareholders and strengthening the reporting standards are some of the measures that have been adopted in order to reform governance in banking sector. Finally, current trends in relation to good practice in corporate governance include; setting principles of good practice in banks and using information systems so as to ensure quality management practices. References Caprio, G & Levine, R 2007, ‘Corporate Governance in Finance’, In the 2002 World Bank Conference, pp. 1-46. Cioffi, J 2010, ‘Corporate Governance: Foundations in Finance’, German Law Journal, vol. 7, no. 6, pp. 533-562. Dermine, J 2006, ‘Bank Corporate Governance’, In Faculty & Research Working Papers, pp. 1- 33. Gomez, P & Korine, H 2005, ‘Democracy and Evolution of Corporate Governance’, Journal of Corporate Governance, vol. 13, no. 6, pp. 739-752. Kulshreshtha, P 2011, ‘Banking Sector Governance: The World Bank Framework’, International Journal of Management, vol. 21, no. 5, pp. 556- 567. Mchran, H, Morrison, A & Shapiro, J 2011, ‘Corporate Governance and Banks: What Have we Learned from the Financial Crisis’, In Federal Reserve Bank of New York, pp. 1-44. Mallin, C, Mullineux, A & Wihlborg, C 2006, ‘Financial Sector and Corporate Governance’, Center for Economics and Financial Institutions, vol.3, no.1, pp. 1-19. Plessis, J, Hargovan, A & Bagaric, M 2010, Principles of Corporate Governance, Cambridge University Press, Melbourne United Nations 2010, Corporate Governance Disclosures, United Nations, Geneva. Read More