Bank Corporate Governance, Beyond the Global Banking Crisis

• Author: Jean Dermine
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/fmii.12012
• Date: 01 December 2013

Bank Corporate Governance, Beyond the Global

Banking Crisis

BYJEAN DERMINE

Following up on the publication of the Walker Report (2009) in the United Kingdom,

international organizations such as the Basel Committee (2010), the OECD (2010), and the

European Union (2010) have proposed guidelines to improve bank corporate governance

and, more specifically,risk governance. These international reports vary widely on what the

prime objective of bank corporate governance should be, with one group recommending a

shareholder-based approach, and the other a stakeholder-based one. Moreover,the focus of

these reports is exclusively on risk avoidance, with little guidance as to howan acceptable

level of risk should be defined.Drawing on insights from economics and finance, this paper

is intended to contribute to the debate on bank corporate governance.

Our four main conclusions are as follows. Firstly,the debate on bank governance should

concern not only the boards but also the governance of banking supervision with clearly

identified accountability principles. Secondly,since biases for short-term profit maximiza-

tion are numerous in banking, boards of banks should focus on long-term value creation.

Thirdly, board members and banking supervisors should pay special attention to cognitive

biases in risk identification and measurement. Fourthly, a value-based approach to risk

taking must take into account the probability of stress scenarios and the associated costs of

financial distress. Mitigation of these costs should be addressed explicitly in the design of

bank strategy.

Keywords: Banking, bank corporate governance, banking regulation.

JEL Classification: G18, G21, G28, G32.

I. INTRODUCTION

Following up on the banking crisis and the Walker Report (2009) published in the

United Kingdom, international organizations such as the Basel Committee (2010),

the OECD (2010), and the European Union (2010) have proposed guidelines to

improve banks’ corporate governance and, more specifically, risk governance –

all with a common objective: never again!

These international reports vary widely on what the prime objective of bank

corporate governance should be, with one group recommending a shareholder-

based approach and the other a stakeholder-based one. Moreover, the focus of

these reports is exclusively on risk avoidance,with little guidance as to how boards

should define an acceptable level of risk. In this paper,we contribute to the debate

on bank corporate governance, drawing insights from economics and finance.

The paper is divided into five sections. In Section 1, we remind readers of

the significance of the banking crisis, both in terms of private and public costs.

Some ‘high level corporate governance principles’ are identified in Section 2, and

Corresponding author: Jean Dermine, INSEAD Europe Campus, Boulevard de Constance, 77305 Fontainebleau

Cedex, France, Tel:+33 1 60 72 41 33, jean.dermine@insead.edu

C2013 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

260 Jean Dermine

Table 1: Bank Size and Public Bailout Cost (Dermine and Schoenmaker,

2010)

Countries with Countries with

large banks with Bailout cost small banks with Upfront Government

Equity/GDP >4% (% of GDP) Equity/GDP <4% Financing (% of GDP)

Aust ria 5.3% France 1.5%

Belgium 4.7% Germany 3.7%

Denmark 5.93% Italy 1.3%

Ireland 5.3% USA 6.3%

Spain 4.6% Greece 5.4%

Netherlands 6.2%

Sweden 5.8%

Switzerland 1.1%

United Kingdom 19.8%

Source: IMF (2009), IMF (World Economic Outlook), Thomson One Bankers Analytics.

Public bailout costs refers to Upfront Government Financing. It includes capital injection,

purchase of assets and lending by treasury and central bank support provided with treasury

backing. For Denmark, the source is Wall Street Journal (2/7/09).

a discussion of the merits of the shareholder- and stakeholder-based approaches

follow. In the next three sections we discuss more applied issues: problems with

the identification of risk, issues in measurement of performance and design of

compensation schemes, and the identification of criteria to guide the board when

defining an acceptable level of risk. This is followed by four conclusions related

to the need for governance of financial supervision, a focus on long-term value

creation, attention to cognitive biases in risk identification and measurement, and

a value-based approach to risk taking.

II. THE FINANCIAL CRISIS AND THE CALL FOR BETTER BANK

CORPORATE GOVERNANCE

The state-led resolution of the 2007–2009 financial crisis has proven to be

costly. For the OECD as a whole, the gross government debt-to-GDP ratio has

increased by more than 20 percentage points from 2008 to 2011. To this fig-

ure, one needs to add the lost output and social costs for which the global

recession is to blame. In the fourth quarter of 2011, OECD-average youth un-

employment represented 18% of the labor force aged 15–24, an increase of 5%

over four years. And in Spain, youth unemployment had reached 49.6% (OECD,

2012).

In the OECD, countries that host both large and small banks can be affected

(Dermine and Schoenmaker, 2010). As documented in Table1 for the time period

2007–2009, the United Kingdom which hosts large banks relative to GDP (such

as Royal Bank of Scotland), has seen up-front government financing of 20%