Corporate governance issues as contributors to the financial crisis

Hausarbeit, 2017

9 Seiten


Table of contents

1 Introduction

2 Fundamentals of corporate governance

3 Corporate governance issues as contributors to the financial crisis

4 Evaluation of the corporate governance structures after the financial crisis

6 References

1 Introduction

In this paper, issues of corporate governance as contributors to the recent financial crisis will be examined. In that context, the subsequent changes in governance will be evaluated regarding their real risk-reducing impact or rather their potentially adverse consequences for the current financial environment. In order to prepare a sound discussion, there will be at first a definition of corporate governance and an overview of relating theories.

2 Fundamentals of corporate governance

Corporate governance as a term was widely unknown until the 1970s in the US and until the 1990s in the other parts of the corporate world, getting a subject of broader public interest at first in the early 2000s with the management scandals of Enron and Worldcom. Before that, manager’s misbehavior on such a large scale was uncommon (Cheffins 2015). It can be described as a complex set of rules and constraints which control decision-making in firms, executed by the board of directors and senior management. The main purposes are the aligning of these decisions with the objectives and interests of shareholders and other stakeholders (e.g. government, employees, clients, debtholders) as well as ensuring safe operations and compliance with applicable laws and regulations. Therefore, relationships between all parties are defined and the means of reaching the mentioned objectives are provided, combined with a sound incentive environment of pursuing them. Furthermore, a well-structured corporate governance framework formulates duties for the board and management and monitors them in an effective way. Besides the strategic focus like implementing company-wide risk-management procedures there are also processes from lower and operating areas involved (e.g. sound day-to-day-business). If we particularly regard the banking industry, the protection of the rights of the stakeholder group “depositors” has a high priority, as recommended by the Basel Committee (Mülbert 2009). In the light of the recent financial crisis, ‘the task of governance is therefore to balance the ostensible benefits of finance (wealth production via efficient intermediation) with the security and smooth operation of the economy itself.’ (Glenn 2014, p. 229) It can be said, that the stronger a company’s corporate governance is, the better it is positioned in the equity market, because investors can earn higher confidence, that their long-term goals will be fulfilled properly. As a side effect, the socio-economic surrounding can be enhanced by firms that act in the described way (University of London 2016).

For a working governance framework, there exist internal and external control mechanisms accompanied by a number of considerable theories. A classic internal mechanism is ownership concentration: If an institutional investor holds a larger block of shares, he can insist on proper management behavior, because he has the power to sell his equity stake with adverse consequences for the misbehaving management. Shareholders with very large ownership shares usually get a seat in the board of directors, which itself functions as the second internal governance mechanism as its main function is the nomination and supervising of the company’s senior management. A critical aspect for an effective corporate governance is a high number of independent directors, who are not related to or involved in the operating business what constitutes unbiased decisions in favor of the mentioned objectives (Hitt el al. 2007). This thought is linked with the agency theory, which states that non-owning managers tend to value their own interests higher than those of shareholders. Subsequently, independent boards are preferred to ensure that the monitoring of management takes place on behalf of shareholder’s interests (Lynall et al. 2003). On top of that, compensation of managers is indirectly controlled through the board by electing the remuneration committee. This third internal mechanism is characterized by a focus on long-term incentives, which should ensure a long-range aligning of interests by disadvantaging risky short-term management behavior (Hitt el al. 2007). On the other hand, followers of the institutional theory argue, that CEO compensation is mostly dependent on social norms, which could lead to a lower efficiency, if other institutional payment structures with excessive salaries are used as a comparable basis.

Besides the supervising and controlling function of boards there is the role of providing resources to management, which should help to let arise a leadership culture in line with a proper corporate governance. Examples are management advice and counsel, legitimacy and networking with stakeholders. Social networking is crucial for generating resources like industry-specific knowledge – and on top of that it is the basis for board composition, because a famous CEO can be able to attract interesting board members with valuable resources and networks as well (Lynall et al. 2003).

The internal aspects are replaced by external mechanisms mainly if they are not as effective as proposed in theory. The so-called market of corporate control forces managers to show a sound behavior, because if they underperform due to a problematic governance, their firm becomes relatively undervalued and thus a target for hostile acquisitions, likely leading to a dismissal of executives (Hitt el al. 2007). “The mere threat of a change in control can provide management with incentives to keep firm value high, so that the value gap is not large enough to warrant an attack from the outside.” (Denis/McConnel 2003, p. 4) It is in fact questionable, if an underperforming executive recognizes corporate governance issues as the main turnaround driver of corporate earnings. It will be discussed later on, to what extent all these control mechanisms were effective during the financial crisis.

3 Corporate governance issues as contributors to the financial crisis

If we regard the fundamentals of chapter 2 and compare them with the perceived reality of reckless greed during the financial crisis, we should upon first glance be convinced that there hadn’t been any crisis, if the banking industry would have adopted the described procedures and the control mechanisms were working. It exists the opinion, that the crisis is caused only by poor board supervising, insufficient shareholder monitoring and inappropriate remuneration (Erkens et al. 2009). But what if the governance in terms of the important interest-aligning was actually intact and shareholders as a whole were subject to the same short-term incentives (OECD 2009) as the responsible bankers - generating quick and extraordinary returns without regarding long-term consequences?

We defined a high grade of institutional ownership and independent boards as sound governance factors because of a better influence on decisions and lower agency costs. That may be true, but a crucial drawback is, that with less dependent boards there is less identification with the long-term company objectives. On top of that, board independence reduces specific knowledge of the firm which can make it harder for the external board members to monitor specific risks. In this state of affairs, we can observe higher pressure for short-term results, because the institutional investor is holding a call option on the company’s assets and profits seem to be more important than a proper corporate governance, e.g. implementing a sophisticated risk management system (Erkens et al. 2009). Moreover, before the crisis, risk management wasn’t seen as an essential part of strategy, neither by management nor board members (OECD 2009).

Subsequently, senior management in banks was likely to follow the institutional pressure and took higher risk, fearing that the investor could sell his stake, leading to lower compensation or a takeover and replacement. This dilemma goes in line with a higher CEO turnover and pre-crisis returns for firms with large institutional ownership, and a higher risk aversion for manager-owned companies. There is also evidence that a more bonus-related compensation, as part of the mentioned pressure, led to higher risk before and greater losses during the crisis (Erkens et al. 2009). “The highly incentivised remuneration structures, together with a fair amount of greed on the part of bankers were seen as a major or even the single most important cause of the financial turbulence.” (Mülbert 2009, p. 419) A popular example is the evolving of the “originate-and-distribute” model, where banks increased their lending, structured mortgages with bad quality into safe-looking collateralized debt obligations, bought by many types of investors and other banks as well. Everybody involved made profits, leading to high bonus payments, while the risk departments, not to speak of the responsible directors, were not able to assess the danger of these instruments (Smith et al. 2012).

We can see from these findings, that monitoring as well as internal and external control as corporate governance mechanisms took place, but they went into the wrong direction and encouraged higher risk more than sound behavior. Only after the crisis started, the external monitoring evolves the tremendous advantage of disciplining the executives much faster than the regulators could do (Erkens et al. 2009).

To prevent that faulty use of shareholder governance mechanisms, the board function of stakeholder-protection would have come into play. Unfortunately, this wasn’t conducted properly because of major incentive problems: Partial deposit insurance and implicit state guarantees lead generally to lower monitoring efforts for debtholders and depositors, because the “too big to fail problem” gives the appearance that all claims on the bank are state-backed, leading to a complete distortion of incentives for all acting parties (Mülbert 2009). It goes in line with the moral hazard problem for the risk-takers in banks, who know that they will be bailed out anyway. Both aspects could result in lower control effort of directors. In addition, there was no risk-based compensation for non-deposit liabilities leading to a “free liability insurance system, with little or no protection of taxpayers against the changing risk exposures in the financial structure”. (Smith et al. 2012, p. 354f.) The resulting lower returns on bank debt can be regarded as a lack of external control, because every institute, regardless of its balance sheet, pays nearly the same yield. This situation was enforced by a weak market of corporate control, especially in Europe, which was expressed by a low M&A activity of larger banks, partly justified by opaque balance sheets compared to other industries (Mülbert 2009).

In that surrounding of missing market discipline, weak risk management, high institutional pressure and short-term incentives, the systemwide risk was clearly increased and the foundation for the devastating financial crisis was laid. As we could see, corporate governance structures were partly responsible for that outcome.

4 Evaluation of the corporate governance structures after the financial crisis

After the end of the financial crisis of 2007-2009, which was the greatest market turmoil since the 1930s, several new regulations were implemented, some of them to improve corporate governance. In the US, the Dodd-Frank Act of 2010 aims to end the “too big to fail” situation of large banks by creating liquidation plans that protect taxpayers. If that works as planned, the market of corporate control should penalize banks with bad asset portfolios at a hopefully earlier stage by demanding higher yields. Beyond this, there is the clear restricting of proprietary trading for banks, which should reduce the incentive of short-term profits at the expense of long-term goals (Smith et al. 2012).

In the same year, the Basel III framework was set in place, requiring higher levels and better quality of capital. Basically, higher capital leads to higher losses for shareholders during a failure, so that risk-taking should be limited, if interests are at least partly aligned (Repullo 2002). But on the other hand, the complexity increased dramatically: A larger bank has to conduct several million calculations for default probabilities and capital requirements. Additionally, the Dodd-Frank-Act provides for an estimated number of 30,000 pages of regulation in the coming years (Halden 2012). “Complex rules may cause people to manage to the rules, for fear of falling foul of them. They may induce people to act defensively, focusing on the small print at the expense of the bigger picture.” (Ibid., p. 7) Too defensive behavior of banks cannot be in the interest of regulators, as it endangers the profitability and thus the long-term survivorship of banks. Thus, a comprehensible approach of regulation would be preferable.

At the G20 summit of 2009 a set of recommendations was addressed to the regulators, containing mostly compensation procedures -as a key aspect of corporate governance- with the aim of aligning them with the level of risk and making them transparent via public disclosures. Furthermore, variable remuneration should be based more on the success and capital adequacy of the whole company and not on a single business unit. A stronger regulatory and board oversight as well as limitations and clawback provisions on bonusses were endorsed. In the same year, the European Commission set these recommendations into laws, sanctioning these institutes who fail to comply with stricter capital requirements. In Germany, corporate governance was ruled directly by law in 2009: Bad company performance can have immediate consequences for management compensation, even backdated. Further, long-term incentives are set by minimum holding periods of stock options of four years and more independence is ensured by a two-year waiting period for managers, who switch to the board (United Nations 2010).


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Corporate governance issues as contributors to the financial crisis
School of Oriental and African Studies, University of London  (CeFIMS)
ISBN (eBook)
ISBN (Buch)
433 KB
corporate governance, financial crisis
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Arno Hetzel (Autor:in), 2017, Corporate governance issues as contributors to the financial crisis, München, GRIN Verlag,


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