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The importance of structural corporate governance factors identified by the New York Stock Exchange’s 2010 Commission on Corporate Governance was reaffirmed here with various empirical and forensic studies. The key, recurring structural factors were all-powerful CEO (the duality factor and related Board independence issues), weak system of management control, focus on short term performance goals (and related executive compensation packages), weak code of ethics, and opaque disclosures. Such weak corporate governance factors were key contributors to both fraudulent financial reporting and excessive risk-taking which facilitated the U.S. financial crisis in 2008. Corporate governance listing requirements by major stock exchanges around the world will help mitigate such problems from recurring in the future.
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
Hugh Grove*, Lisa Victoravich**
The importance of structural corporate governance factors identified by the New York Stock
Exchange’s 2010 Commission on Corporate Governance was reaffirmed here with various empirical
and forensic studies. The key, recurring structural factors were all-powerful CEO (the duality factor
and related Board independence issues), weak system of management control, focus on short term
performance goals (and related executive compensation packages), weak code of ethics, and opaque
disclosures. Such weak corporate governance factors were key contributors to both fraudulent
financial reporting and excessive risk-taking which facilitated the U.S. financial crisis in 2008.
Corporate governance listing requirements by major stock exchanges around the world will help
mitigate such problems from recurring in the future.
Keywords: Corporate Governance, Financial Crisis, Banks, Risk-Taking
* University of Denver, School of Accountancy, Denver, CO 80208-2685, United States
Tel: 303-871-2026 (Phone)
Fax: 303-871-2016 (Fax)
** University of Denver - Daniels College of Business, 2101 S. University Blvd., Denver, CO 80208, United States
At the end of January, 2011, the U.S. Financial Crisis
Inquiry Commission (Commission 2011) wrote in the
report’s conclusions: “the greatest tragedy would be
to accept the refrain that no one could have seen this
coming and thus find nothing could have been done.
If we accept this notion, it will happen again.” The
Commission also concluded that the 2008 financial
crisis was an “avoidable” disaster caused by
widespread failures in government regulation,
corporate mismanagement and heedless risk-taking
by Wall Street. It found that the Securities and
Exchange Commission (SEC) failed to require big
banks to hold more capital to cushion potential losses
and to halt risky practices and that the Federal
Reserve Bank “neglected its mission by failing to
stem the tide of toxic mortgages.”
Citing dramatic breakdowns in corporate
governance including taking on too much risk, the
Commission portrayed incompetence with the
following examples. Citigroup executive conceded
that they paid little attention to mortgage-related
risks. Executives at American International Group
were blind to its $79 billion exposure to credit-default
swaps. Merrill Lynch managers were surprised when
seemingly secure mortgage investments suddenly
suffered huge losses. The banks hid their excessive
leverage with derivatives, off-balance-sheet entities
and other accounting tricks. Their speculations were
aided by a giant “shadow banking system” in which
banks relied heavily on short-term debt. The
Commission concluded: “when the housing and
mortgage markets cratered, the lack of transparency,
the extraordinary debt loads, the short-term loans and
the risky assets all came home to roost” (Chan 2011).
In the aftermath of the U.S. financial crisis of
2008, the New York Stock Exchange (NYSE)
sponsored a Commission on Corporate Governance
which issued the following key corporate governance
principles (2010):
The Board of Directors’ fundamental objective
should be to build long-term sustainable growth
in shareholder value. Thus, policies that promote
excessive risk-taking for short-term stock price
increases, and compensation policies that do not
encourage long-term value creation, are
inconsistent with good corporate practices.
Management has the primary responsibility for
creating a culture of performance with integrity.
Management’s role in corporate governance
includes establishing risk management processes
and proper internal controls, insisting on high
ethical standards, ensuring open internal
communications about potential problems, and
providing accurate information both to the Board
and to shareholders.
Good corporate governance should be integrated
as a core element of a company’s business
strategy and not be simply viewed as a
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
compliance obligation with a “check the box”
mentality for mandates and best practices.
Transparency in disclosures is an essential
element of corporate governance.
Independence and objectivity are necessary
attributes of a Board of Directors. However,
subject to the NYSE’s requirement for a majority
of independent directors, there should be a
sufficient number of non-independent directors
so that there is an appropriate range and mix of
expertise, diversity and knowledge on the Board.
Shareholders have the right, a responsibility and
a long-term economic interest to vote their shares
in a thoughtful manner. Institutional investors
should disclose their corporate governance
guidelines and general voting policies (and any
potential conflicts of interests, such as managing
a company’s retirement plans).
Structural Corporate Governance Issues
Various empirical studies have investigated the
impacts of these structural problems of corporate
governance upon banks’ risk taking (stock market
based measures) and financial performance (return on
assets, non-performing assets, etc.). The following
corporate governance variables have been found to
have a significant, negative impact on risk taking and
financial performance (Allemand et. al. 2011, Grove
et. al. 2011, Victoravich et. al. 2011):
CEO duality (the CEO is also the Chairman of
the Board of Directors)
CEO and Board of Directors entrenchment and
independence (only staggered re-elections of
long-serving Board members versus all Board
members re-elected every year)
Senior Directors (over 70 years of age)
Short-term compensation mix (cash bonuses and
shorter-term stock options (1 to 4 years) versus
longer-term stock options, awards, and restricted
Non-independent and affiliated Directors (larger
percentages of such directors versus independent
Ineffective risk management committees (few or
no meetings or no such risk committees)
Also, high leverage (debt to equity) levels were
associated with high levels of banks’ risk taking and
poor financial performance in these studies. When
implementing the $700 billion bailout of major U.S.
banks, the U.S. Treasury did not replace any existing
bank Board members but added new Directors to
represent taxpayer interests. Many of these original
Directors oversaw the big banks and brokerage firms
when they were taking huge risks during the real
estate boom. A corporate governance specialist
concluded: “these boards had no idea about the risks
these firms were taking on and relied on management
to tell them” (Barr 2008). A senior corporate
governance analyst said: “this financial crisis is a
direct result of the compensation practices at these
Wall Street firms” (Lohr 2008).
Concerning the lack of disclosure transparency
by these banks in not using fair value reporting for
their assets, Arthur Levitt and Lynn Turner, former
SEC chairman and former SEC chief accountant,
respectively, observed (Levitt and Turner 2008):
“There is a direct line from the implosion of
Enron to the fall of Lehman Brothers—and that’s an
inability for investors to get sound financial
information necessary for making sound investment
decisions. The only way we can bring sanity back to
the credit and stock markets is by restoring public
trust. And to do that, we must improve the quality,
accuracy, and relevance of our financial reporting.
This means resisting any calls to repeal the current
mark-to-market standards. And it also means
expanding the requirement to disclose the securities
positions and loan commitments of all financial
institutions. Fair value reporting, when properly
complied with and enforced, will simplify the
information investors need to make informed
decisions, and bring much needed transparency to the
market. By reporting assets at what they are worth,
not what someone wishes they were worth, investors
and regulators can tell how management is
performing. This knowledge in turn is fundamental to
determining whether or not an institution has
sufficient capital and liquidity to justify receiving
loans and capital. We should be pointing fingers at
those at Lehman Brothers, AIG, Fannie Mae, Freddie
Mac, and other institutions which made poor
investment and strategic decisions and took on
dangerous risks.”
Furthermore, at a recent Town Hall discussion,
entitled Does Wall Street Really Run the World?,
Lynn Turner (2011) made the following comments.
“There was greater attention to risk management
when Wall Street firms were partnerships with
individual partner liability twenty years ago versus
today as corporations (similar to the evolution of the
Big Four accounting firms). Wall Street firms
changed from raising money for corporations and
serving as investment brokerage firms to a new
emphasis on trading for its own sake and for their
own shareholders. There was eleven trillion dollar
market cap destruction from the economic crisis of
2008. These firms were not really creating value but
were selling toxic investments such that a Rolling
Stone reporter nicknamed Goldman Sachs the
Vampire Squid. Paul Volcker has commented that the
last real innovation of Wall Street banks was the
ATM thirty years ago, actually by a Nebraska bank.”
Structural Corporate Governance:
Bear Stearns and Lehman Brothers
Corporate governance for risk management and
company oversight was very weak at both Lehman
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
Brothers and Bear Stearns per the following red flags
which were related to the structural corporate
governance factors in the NYSE Commission on
Corporate Governance report (Grove and Yale 2011):
CEO Duality: At Bear Stearns, the CEO, James
Cayne, had also been the Chairmen of the Board
(COB) for the last seven years. At Lehman
Brothers, the CEO, Richard Fuld, had also been
the COB for the last seventeen years.
Board Entrenchment and Independence: At both
banks, there were no staggered board elections as
all members were re-elected annually. However,
both CEOs had been in their jobs for more than a
decade: 26 years for the Bear Stearns CEO and
17 years for the Lehman Brothers CEO. Also,
there were majorities of older and long-serving
Directors as noted below.
Senior Directors: For Bear Stearns and Lehman
Brothers, respectively, the majority of the
Directors were over age 60: 85% and 91%, over
age 70: 23% and 55%, and over age 80: 15% and
18%. Also, 54% of the Bear Stearns Directors
were retired or just “private investors” or in
academia. 91% of the Lehman Brothers Directors
were retired or “private investors.”
Short-term Compensation Mix: Both companies
had large portions of their compensation
packages for their top executives in short-term
cash (bonus) and stock options,
Non-independent, affiliated, and diverse
directors: Long-serving Directors may lose or
reduce their independent perspective. For Bear
Stearns and Lehman Brothers, respectively, the
number of Directors serving since the 1980’s
were 38% and 9% and since the 1990’s were
31% and 55% for totals from the 1980’s and
1990’s of 69% and 64%. Also, there were only
one woman and one minority on Lehman
Brothers’ Board and none on Bear Stearns Board.
Ineffective Risk Management Committee: Bear
Stearns’ risk committee only started in January
2007 just 14 months before JP Morgan Chase
bailed out the company by taking it over in
March 2008. Three of the four members were
age 64 and the other was age 60. Lehman
Brothers’ risk committee had only two meetings
in 2006 and 2007 before it went bankrupt in
2008. The chairman of the risk management
committee was age 80 and a retired Salomon
Brothers investment banker with banking
experience but from a different era. The other
members were age 73 (retired chairman of IBM),
age 77 (“private investor” and retired Broadway
producer), age 60 (retired rear admiral of the
Navy), and age 50 (former CEO of a Spanish
language TV station). What were the
qualifications of these last three members for
serving on this risk management committee?!
Opaque Disclosures: Per the SEC chairman and
SEC chief accountant, there was a direct line
from the implosion of Enron to the fall of
Lehman Brothers which was an inability for
investors to get sound financial information
necessary for making sound investment
decisions. To correct this problem, investors
must resist any calls to repeal the current mark-
to-market standards for financial instruments
while also expanding the requirement to disclose
the securities positions and loan commitments of
all financial institutions. However, there was no
fair value reporting at either bank which would
have provided the information investors needed
to make informed decisions and bring much
needed transparency to the market.
The day-to-day management of corporations is
generally regulated by state law. Because Delaware
generally favors management and directors, many
companies choose to incorporate there. Delaware law
has a highly rigorous standard for finding officers and
directors liable for a company’s mismanagement, “no
matter how stupid or self-serving their decisions”
(Davidoff 2011). Under Delaware law, only if
officers and directors intentionally acted wrongfully
or their conduct was so oblivious that it produced
essentially the same result, would a Delaware court
find them liable.
There may be liability for corporate officers and
directors under federal law. Such liability stems
mainly from securities fraud cases where such
individuals make a misstatement or omission. Such
liability has nothing to do with the management or
oversight of a company but usually are misstatements
about the accounting or financial condition of a
company. Personal liability for officers and directors
in federal cases are only a little less rare than state
cases since the legal standards are high and insurance
often covers such cases. There have been only nine
cases where an officer or director was held personally
and criminally liable for securities fraud in the last
quarter century, the most notable were Enron,
WorldCom, Tyco, and Qwest. In the Enron
shareholder litigation case, there was a $165 million
settlement but the directors personally had to pay
only $13 million as the rest was covered by insurance
(Davidoff 2011).
The following conclusions from a forensic
accounting report on Bear Stearns emphasized poor
corporate governance, especially the lack of key
disclosures and possible liability for Bear Stearns
executives and directors (Yale and Grove 2011):
In my opinion, the evidence suggests that Bear
Stearns inflated the values of its financial instruments
that, in turn, inflated Bear Stearns earnings and
shareholders’ equity from the quarters ending August
31, 2007 through February 29, 2008. The
extraordinary denials on “Black Monday”, March 10,
2008 concealed an important deception apparently
agreed upon by senior Bear Stearns executives who
did not disclose evidence that the Company was
indeed facing the beginnings of a liquidity crisis
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
brought on by doubts about the value of its assets
that, in turn, raised questions about the adequacy of
Bear Stearns’ equity capital.
Even more remarkable was that senior Bear
Stearns executives knew or should have known that
even when the Company conceded to counterparties
in collateral value disputes, Bear Stearns continued to
use its own traders’ higher valuations. In effect, Bear
Stearns was knowingly cooking its books. There are
indications in the SEC memoranda that Bear Stearns
tended to use the traders’ more generous valuations
for profit and loss purposes, even when Bear Stearns
conceded lower valuations to the counterparty for
collateral valuation purposes.
These practices apparently resulted in the
overstatement of income and capital and
inappropriately inflated asset values. Pricing its
massive portfolio of mortgage-related and other
securities was complicated further because market
prices for many of the Company’s assets were not
available because some securities traded infrequently
or were thinly traded at highly distressed prices.
In its 10-Q for the period ending June 30, 2008,
JP Morgan Chase reported that the value of Bear
Stearns’ stockholder equity at May 30, 2008 was
slightly less than $6.1 billion or some $5.8 billion less
than Bear Stearns reported at February 29, 2009
(Sorkin 2011). Apparently, Bear Stearns took massive
write-downs and charges during the two-month
period, although the nature of the charges was not
explained. What was disclosed, however, was that JP
Morgan Chase took an additional $3.5 billion of
charges against Bear Stearns’ trading assets when it
marked them to fair value, further reducing Bear
Stearns’ stockholders’ equity to just $2.6 billion.
Clearly, the loss of value could not have occurred
exclusively in this three-month period between
February 29 and May 30, 2008. The arbitrariness of
such write-downs is illustrated by the current
financial accounting for Greek bonds. Two French
companies, BNP Paribas and CNP Assurances, took
only a 21% write-down on their Greek bond
investments but Commerzbank of Germany wrote
down the same Greek bonds by 51% and all three
firms had the same Big Four audit firm (Turner
The Florida investor’s case against Bear Stearns
was settled for a small fraction of his losses although
the investor’s attorney advised him to continue the
legal battle since there was a solid legal basis to
continue. However, it appeared that the established
legal strategy was again successful here: just
outspend the other, smaller side until it gives up!
Corporate officers and directors often argue that the
potential liability for a company’s operations is
significant and claim that the risks of serving as an
officer or director have become too great. As a result,
they contend, it will become more difficult to recruit
and retain competent officers and directors. “But the
truth is that they have about the same chance of being
held liable for their poor management of a public firm
as they have of being struck by lightning” (Davidoff
Few directors and officers from the financial
crisis have yet been found liable under either state or
federal laws. Angelo Mozilo, Countrywide CEO, did
pay $22.5 million of a $73 million fine, the rest being
covered by insurance. The Lehman Brothers’ CEO
and top executives did owe $90 million in fines that
were covered by insurance. Further, many directors
from Bear Stearns (six), Lehman Brothers (six), and
Enron (seven) continue to serve on other boards. The
old boy network on Wall Street is emphasized here as
is the decline in importance of reputation on Wall
Street. Prior bad conduct simply is not viewed as a
problem. Also, the Dodd-Frank financial reform act
only involves the “too big to fail” entities. If one fails,
the act authorizes the federal government to claw
back just two years of compensation from those held
responsible for the failure. This is a weak penalty for
the failure of a big bank with many billions of assets
(Davidoff 2011).
Concerning executive and director
compensation as a structural corporate governance
problem, the average salary of a CEO at S&P 500
companies was $10.8 million in 2010 up 27.8% over
2009 and the median salary for a CFO was $3
million. Outside directors’ compensation now
averages about $200,000 for Fortune 500 companies.
The upside of serving as an officer or director appears
large while the legal liability downside appears very
limited. Also, 25 major U.S. corporations paid their
CEOs more than they paid to the U.S. government in
federal income taxes in 2010, primarily due to
transfer pricing with offshore tax havens. Many
public U.S. companies spent more on lobbying that
on federal income taxes, such as these 25 companies
which spent over $150 million on lobbying and
campaign contributions in 2010 (Anderson
Risk Management in Corporate
Both financial and non-financial tools for risk
management appeared to work well in the analyses of
Bear Stearns and Lehman Brothers (Dutta et al 2010).
Both companies had similar, very weak financial
positions and weak risk management practices as
discussed subsequently. The Bear Stearns bailout
may have been helped by Wall Street connections,
like Henry Paulsen, the U.S. Treasury Secretary who
was also the former CEO of Goldman Sachs.
However, possibly the federal government later
thought that Lehman Brothers was “too big to save”
since it was twice the size of Bear Stearns. Then, after
the Lehman Brothers bankruptcy ignited the world
financial crisis in 2008, the federal government
reversed its thinking and bailed out the largest 19
U.S. banks in 2009 with over $700 billion in funds
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
since they were now “too big to fail.” This bailout
occurred despite the fact that all these banks had
received unqualified audit opinions on their financial
statements and internal controls in their prior year’s
annual reports before the bailout. No “going
concern,” explanatory paragraph, audit reports were
issued for possible bankruptcies in these banks. Thus,
audit reports appear not to be a tool for assessing the
risk management of such banks.
Risk management at the major U.S. (bailout)
banks was very poor and contributed significantly to
the U.S. financial crisis which started with the
bankruptcy of Lehman Brothers in September 2008.
In March 2010, the SEC started requiring all publicly
traded companies in the U.S. to provide disclosures
that describe the Board’s role in risk oversight. Such
disclosures were required in the annual proxy
statements of these firms. In July 2010, the U.S.
Federal Financial Reform (Dodd-Frank) Act was
signed into law and mandated risk committees for
Boards of financial institutions and other entities that
the U.S. Federal Reserve Bank oversees.
The following interview with Satyajit Das
(2011), an international respected expert on finance
with over 30 years of working experience in the
industry, provided comments on risk management
and corporate governance in the banking industry:
“As banks expanded their mortgage service,
they exhausted the pool of people who they could
reasonably lend to and, then, they moved onto the
others—until they came to people who couldn’t ever
really pay them back. So the trick was to hide or get
rid of the risk of non-payment---it became a case of
NMP (not my problem) or risk transfer. So banks
made loans that they shouldn’t and, then, they
transferred them to people who probably didn’t quite
grasp the risk fully or were incentivised to look the
other way. It was a culture of fraud and self-delusion.
It’s amazing how much money banks can make just
shuffling paper backwards and forwards. Paul
Volcker, the former chairman of the Federal Reserve
Bank, argued: ‘I wish someone would give me one
shred of neutral evidence that financial innovation
has led to economic growth---one shred of evidence.’
Management and directors of financial
institutions cannot really understand what is going
on---it’s simply not practical. They cannot be across
all the products. Non-executives are even further
removed. Upon joining the Salomon Brothers Board,
Henry Kaufman found that most non-executive
directors had little experience or understanding of
banking. They relied on Board reports that were
neither comprehensive nor detailed enough about the
diversity and complexity of the bank’s operations.
They were reliant on the veracity and competency of
senior managers, who in turn were beholden to the
veracity of middle managers, who are themselves
motivated to take risks through a variety of profits
compensation formulas.”
Also, the Board of AIG included several
heavyweight diplomats and admirals, even though
Richard Breeden, former head of the SEC, told a
reporter: “AIG, as far as I know, didn’t own any
aircraft carriers and didn’t have a seat in the United
Nations” Such poor risk management at banks has
recently occurred again as it was reported that UBS
lost over $2 billion through the manipulations of a
UBS rogue trader, just like the Barings Bank rogue
trader which bankrupted that bank in the 1990’s. Un-
hedged trades by the UBS rogue trader had been
going on since the 2008 financial crisis, despite the
clean opinions given by a Big Four auditor on the
internal controls of UBS (Craig et al 2011).
It’s silly to think that everybody in finance is
evil or engaged in fraud. Most people involved are
very smart, diligent, hardworking and passionate
about what they do. It’s groupthink. They have ways
of thinking about the world. They think it’s the right
way so they keep trying it again and again. At least
until there is a horrendous disruption and then they
go: “Oh dear? There’s a problem.” Take Alan
Greenspan. He thought deregulated markets were the
solution. He thought that any problem could be fixed
by flooding the system with money. He was wrong,
but even today he doesn’t really see that his world
view is erroneous. These people are very good at
rationalization and don’t tolerate dissent. As for
responsibility, they are doing what is accepted
practice---they think they are doing the best for their
stakeholders. As long as you follow convention, you
are unlikely to be successfully prosecuted or made
liable. Ultimately that may be the only real purpose of
corporate governance---to ensure that by following a
set of accepted practices, you make yourself and your
organization litigation proof (Davidoff 2011).
In response to an email about this issue of why
Bear Stearns was saved and Lehman Brothers let go
into bankruptcy, Lynn Turner (2011) replied: “Both
were highly risky with very, very arrogant CEOs and
chairmen. Neither had a great board but Bear Stearns
may have had better connections on their board and
in this instance, Lehman Brothers being second was
fatal. Both depended way too much on very short
term financing, including overnight commercial paper
or daily repurchase agreements-a very ill advised and
highly risky strategy for any company let alone one
with very little capital.”
Structural Corporate Governance
Factors: Evidence from U.S. Commercial
In the wake of recent financial crisis, corporate
governance practices in the banking industry have
received heightened attention. Anecdotal evidence
has suggested that corporate governance at banks was
ineffective at preventing detrimental lending
practices, leading to an extremely vulnerable
financial system. The global economic impact of the
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
financial crisis and the alleged role played by
corporate governance have signified the need for
more empirical research on the role of corporate
governance at banks. Empirical questions have arisen
regarding current corporate governance structure in
the banking industry. These questions included
whether corporate governance practices promoted in
the non-regulated and non-financial industries can
also effectively enhance the governance of banking
firms and the role of these corporate governance
mechanisms in shaping bank performance during the
financial crisis period.
Structural corporate governance factors were
analysed in U.S. bank performance during the period
leading up to the financial crisis (Grove et al 2011).
The factor structure by Larcker et al (2007) was
extended to measure multiple dimensions of
corporate governance for 236 public commercial
banks. Findings revealed that structural corporate
governance factors helped explain banks’ financial
performance. Also, strong support was found for a
negative association between higher leverage and
financial performance measures (in terms of return on
assets and excess stock returns) as well as loan
quality (in terms of non-performing assets). Such
findings indicated excessive risk-taking by banks.
The structural corporate governance factor of CEO
duality was also negatively associated with financial
The extent of executive incentive pay was
positively associated with financial performance but
exhibited a negative association with loan quality in
the long-run. There was a concave (increasing then
decreasing) relationship between financial
performance and both board size and average director
age. There was also weak evidence of an association
of anti-takeover devices, board meeting frequency,
and affiliated nature of committees with financial
performance. Agency theory was applied to the
banking industry with the expectation that the
structural corporate governance-performance linkage
might differ, due to the unique regulatory and
business environment. Results extended Larcker et al
(2007), especially regarding the concave relationship
between board size and performance and the role of
leverage. However, given the general lack of support
for agency theory predictions here, alternative
theories may be needed to understand the
performance implications of corporate governance at
banks. Findings were relevant for regulators,
especially concerning the ongoing financial reforms
of capital requirements and executive compensation.
Specifically, there was a consistent negative
association between leverage and performance which
supports the current debate on increasing the
appropriate level of tier I capital for banks.
Such evidence has emphasized how regulation
significantly influences the effectiveness of corporate
governance. Hagendoff et al (2010) argue that there is
a complementary association between regulation and
some governance mechanisms and that they should
be developed in synchrony. Thus, effective regulation
of banks and synchronous effective corporate
governance mechanisms are very important, given the
significant role that these institutions play in the
financial markets. This conclusion is especially
important when negative repercussions, such as the
2008 financial crisis, are experienced from risk-
taking of banks not being properly managed and
regulated, such as high bank leverage without
minimum capital requirements.
Such research has offered important
implications for the ongoing debate about capital
requirements for banks. In June 2011, the Basel
Committee on Bank Supervision announced it would
add an additional capital charge of 1% to 2.5% of
risk-adjusted assets on the largest banks as protection
against huge bank losses that could spark another
financial meltdown. As a consequence, the world’s
systemically important banks must hold as much as
2.5% more capital than the 7% core Tier 1 capital
already required. Such research results, which
consistently show a negative association between
level of debt in a bank’s capital structure and bank
performance, have supported the need for such a
surcharge in capital requirements, which in turn may
alleviate concerns about the potential negative effects
on lending and economic recovery. Indeed, high-
leveraged banks have been shown to under-perform
low-leveraged banks on financial performance and
loan quality indicators.
Further, this research contributed to the debate
on another aspect of structural corporate governance,
namely executive compensation. Regulators,
shareholders, and compensation committees may find
motivation here for a reform of executive
compensation packages, such as requiring long-term
ownership of stock acquired through options or
restricted stock. Using a study of U.S. community
banks, Spong and Sullivan (2007) reported that an
ownership stake for hired managers improved bank
performance and boards of directors were likely to
have a more positive effect on community bank
performance when directors also had a significant
financial interest in such banks. Furthermore, as
suggested by Paul Hodgson, a senior analyst at the
Corporate Library, a governance research group, one
way to reshape executive pay is to employ very long-
term payouts, up to ten years out (Barr, 2008). Lastly,
such research may capture the consequences of the
mismatch between incentive systems and risk
management with a lack of risk adjusted financial
targets in executive compensation (Kirkpatrick,
Structural Corporate Governance Factor
of Bank Executive Compensation
The recent financial crisis has drawn much attention
to the equity incentives used to compensate
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
executives in the banking industry. For example, the
chief executive officer (CEO) of bankrupt
Countrywide Financial, Angelo Mozilo, cashed out
options that he received as a performance incentive
worth $414 million between 2004 and 2008. In light
of this anecdotal evidence, the amount and structure
of executive compensation packages in the banking
industry have been hypothesized by the financial
press as a cause of excessive risk-taking behavior.
Unsurprisingly, subsequent to the bailout period, the
SEC issued new disclosure rules effective for proxies
filed after February 28, 2010 to report employee
compensation policies and practices that create risks
that are reasonably likely to have a material adverse
effect on the company. The rules also changed the
value reported for restricted stock and option rewards.
Directors and shareholders need to understand a
company’s broader compensation policies and
analyze whether these policies appropriately consider
both risk and long-term firm growth.
A few studies have examined the relationship
between executive compensation and bank risk
taking. Houston and James (1995) reported that bank
CEOs received less cash and option compensation
and equity-based incentives which do not promote
risk taking. Chen et al (2006) reported more current,
contradictory findings that banks were progressively
using more option-based compensation and this form
of compensation is linked with risk taking. Ang et al
(2002) also found that bank CEOs were paid more
and have more equity-based pay in their
compensation structure than CEOs in non-banking
firms. DeYoung et al (2010) reported that in response
to deregulation, bank boards designed compensation
to include more stock options aimed at encouraging
CEOs to take on new risky business opportunities.
Another key factor influencing bank risk
individually or when coupled with high levels of
equity incentives was CEO power. For example,
Wachovia’s board of directors asked its CEO, Ken
Thompson, to leave in May, 2008 and subsequently
split his role as the Chairman of the Board (COB) and
the CEO, due to reports that Thompson was running
the company without proper controls (Mildenberg
and Son 2008). Also, he has been blamed for taking
the lead role in the $24 billion acquisition of Golden
West Financial (GWF) which brought aboard rising
loan defaults, due to GWF’s riskier, "pick-a-
payment" mortgage portfolio (Foust 2008). In May of
2008, Washington Mutual announced that their CEO,
Kerry Killinger, would step down from the role of
chairman in order to strengthen corporate governance
and reduce CEO power. He was blamed for leading
the company into $19.7 billion of asset backed,
adjustable rate mortgages and subprime mortgages
which was more than any other lender nationwide
(Task 2008).
Promotion of unethical behaviour by equity-
based compensation may be more present at banks,
given that large banks are often considered to be “too
large to fall” from a regulatory perspective and the
expectation that more government bailout funds will
be received to offset potential bank failure, i.e., the
“moral hazard” problem. This situation may increase
executives’ tendency to engage in risky behaviour
(Kane, 2000). Such risky behaviour may enable bank
executives to increase their short-term compensation
by maximizing short-term performance at the expense
of the bank’s long-term performance. On the other
hand, in the face of longer-term equity incentives, it
makes economic sense for a CEO to focus on long-
term performance since focusing on short-term
performance might be costly with lower stock prices
in the long-term.
This research (Victoravich et al 2011)
investigated whether CEO power affects the
relationship between equity incentives and risk-taking
at banks. CEO power was examined on the basis that
it is a key corporate governance factor which enables
a CEO to pursue his or her own agenda. Previous
literature has shown that CEO power in the form of a
more entrenched CEO can have adverse effects on
management behavior and incentives (Bebchuk
2002). Thus, over-powerful CEOs were expected to
be more able to influence the firm’s decision making
to their own benefit which is likely a function of their
level and type of personal wealth which is tied to
their firm’s stock price performance, i.e., short-term
vs. long-term focus. CEO power was measured with
an index comprised of five underlying variables:
CEO duality (the CEO is also the COB), a staggered
board of directors, the proportion of insiders who sit
on the board, the proportion of affiliated board
members who also sit on the board, and whether the
CEO is the founder. Equity incentives were measured
in terms of equity compensation (stock options and
restricted stock) and CEO wealth (value of
exercisable and un-exercisable options). These
measures were employed to capture incentives related
to both short-term and long-term firm performance.
Risk taking was estimated with both firm specific and
market based measures in terms of total, idiosyncratic
and systemic risk.
This research then empirically tested these
allegations that weak governance in the form of CEO
power and equity incentives (two key structural
corporate governance factors) is related to bank risk
taking during the period when the financial crisis
unravelled. This research examined whether bank risk
was a factor influenced by chief executive officer
(CEO) power, equity incentives, and the interaction
between these factors during 2005 through 2009,
which marked the unravelling of the financial crisis.
Bank specific risk decreased with CEO power and
CEO equity-based incentives (newly granted stock
options and restricted stock and accumulated
exercisable and un-exercisable stock options). These
findings suggested that when CEOs have more
power, they can influence the board’s decision-
making to their benefit in reducing risk. Further,
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
when their personal wealth was more tied to firm
value, they were less likely to take on high risk
projects as these projects could be detrimental to their
personal wealth. However, CEOs with more power
did take on higher levels of firm risk when they had
greater levels of future personal wealth in the form of
un-exercisable options. These results suggested that
powerful CEOs are more likely to take on risk when
their personal wealth is tied to long-term firm value,
as opposed to short-term firm value. However, results
from a supplementary analysis indicated that just cash
compensation (total salary plus bonuses) was linked
to higher bank risk which may be responsible in part
for the risky, short-term practices that led to the
financial crisis. This finding suggested that CEOs
may have been focusing on maxing out current year
bonuses and salary increases by taking on additional
risk. Bonus compensation is more certain due to
comfort associated with predicting earnings and
related metrics, i.e., earnings per share, return on
assets, etc., versus the ability to predict the firms’
stock price.
This study contributed to the literature with a
new perspective on how CEO power and equity
incentives shape managerial risk-taking behavior at
banks in the recent period of the unraveling financial
crisis. The findings contradicted the contention that
equity incentives and an over-powerful CEO lead to
increased risk-taking at banks. This evidence should
be of interest to boards, especially the members of the
compensation and nominating committees, who need
to evaluate the costs and benefits of equity incentives
and the proportion of truly independent directors that
sit on the board. The evidence will also help boards
understand how equity and cash incentives affect
CEO’s decision making related to risk taking.
These findings were also relevant to
compensation committee members at banking firms.
Given the nature of the banking industry and the
ability to maximize short-term profitability by taking
on risky loans and engaging in risky hedging
activities, special attention should be taken when
creating compensation packages of top executives at
banking firms. Compensation of banking executives
should be comprised of long-term equity incentives,
primarily in the form of restricted stock in order to
reduce risk taking. As well, short-term cash based
compensation should be minimized to curb excess
risk taking. This conclusion is especially important,
due to the moral hazard problem present at banks
which is a result of the assurance provided by deposit
insurance and taxpayers’ bailout funds as well as the
complex nature of banking transactions, which
decreases the transparency of executive actions.
The findings were also relevant regarding
executive compensation in the form of restricted
stock and future CEO wealth in the form of un-
exercisable and exercisable stock options deserves
more attention by academic researchers. The
preponderance of the literature on equity incentives
focuses on stock options which is only one part of
executive equity compensation mix. Thus, restricted
stock and accumulated options in the form of both
exercisable and un-exercisable options appeared to
have a more profound impact on risk taking than just
stock options at banking firms.
Corporate Governance Listing
Requirements: Investor Protection From
Fraudulent Financial Reporting
A major lesson from recent financial reporting frauds
and the U.S. 2008 financial crisis was that effective
reform of corporate governance is needed now more
than ever. Thus, corporate governance listing
requirements of major stock exchanges were analyzed
to assess the level of investor protection from such
investment disasters (Grove et al 2009). This issue
was especially critical to emerging stock exchanges,
like in the United Arab Emirates (U.A.E.) and Russia,
where these countries are trying to attract foreign
investors. The corporate governance listing
requirements of the well-established stock exchanges
in the United States (both the New York Stock
Exchange or NYSE and the over-the-counter-stock-
exchange or NASDAQ), United Kingdom (London),
and Singapore, were compared to listing requirements
of the emerging stock exchanges in the U.A.E. and
Russia. The effectiveness of these corporate
governance listing requirements for protecting
investors were assessed by determining how they
address the structural corporate governance factors
identified by the NYSE Corporate Governance
Commission previously listed at the beginning of this
As an example of such listing corporate
governance requirements, the U.A.E. state owned,
Borse Dubai stock exchange’s listing requirements of
2010 have drawn from both (U.S) and U.K. listing
requirements. Since the UAE Borse Dubai stock
exchange’s goal was to become another major stock
exchange by filling the “24/7” continuous, world
trading gap between the U.K. and Singapore, their
listing requirements for corporate governance are
important considerations for many investors. Also,
the Sarbanes-Oxley Act (SOX) requirements in the
U.S. (Felo and Solieri 2003) have been analyzed as
they were written in part to address structural
corporate governance factors. The emerging Russian
or RTS Stock Exchange listing requirements have
focused upon the rules needed for major Russian
companies to be included on its leading or most
exclusive “List A”, as opposed to the less prestigious
“List B” (Derisheva 2007).
Common corporate governance structural
problems have been identified in fraudulent financial
reporting research dating back to the early 1980’s
(Grove et al 1982) and have continued to the present
(Basilico and Grove 2008). These structural factors
appeared to be adequately covered by the various
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
stock exchanges’ listing requirements for corporate
governance as follows: all-powerful CEO, weak
system of management control, focus on short term
performance goals, weak or non-existent code of
ethics, and questionable business strategies with
opaque disclosures. Various behavioral corporate
governance factors did not appear to be adequately
covered by these same listing requirements: senior
management turnover, insider stock sales, CEO
uncomfortable with criticism, independence problems
with external auditors, and independence problems
with investment bankers.
One way to assess the effectiveness of the
corporate governance listing requirements of major
stock exchanges and related SOX regulations was to
look at current trends in financial statement
restatements by publicly-held companies. For
example, approximately ten years after Enron,
WorldCom, Tyco and Qwest, corporate America still
has many accounting errors. 1,172 U.S. companies
filed financial restatements in 2007, down 15% from
2006 which was up 6.5% from 2005. In 2004 and
2003 there were only 600 and 500 such restatements,
respectively. However, the pattern has been changing
as the SOX requirements are fixing U.S. financial
reporting for many investors. For the first time in a
decade, companies of all sizes filed fewer
restatements to correct accounting errors in 2007 than
they did the previous year in 2006. Also, restatements
at large U.S. companies (with market capitalization
over $750 million) dropped from 2005 to 2006 by
26%. Similarly, midsize U.S. companies (with market
capitalization between $75 million to $750 million)
also dropped 13%. However, an increase in
restatements (up 45%) from 2005 to 2006 came from
the small or “microcap” companies (with market
capitalization less than $75 million) which tend to be
less regulated in the U.S. by the SEC and SOX (Glass
Lewis & Co. 2008). The SEC typically has
investigated just large or mid-size companies for
earnings management and fraud in its Accounting and
Auditing Enforcement Releases (AAERs) which have
leveled off at about 50 per year since their peak of 77
in 2003 following the major U.S. financial reporting
Since the advent of SOX requirements in the
U.S., initial public offerings (IPOs) have increased in
the U.K., primarily from Russian and Chinese
companies, while IPOs have decreased in the U.S. A
possibly related event was that fraudulent financial
reporting has increased in the U.K. while recently
decreasing in the U.S. Also, many new Chinese
companies have avoided the IPO process in the U.S.
by doing reverse mergers with existing U.S. publicly-
traded companies. Also, a growing body of economic
research has shown that the cost of equity capital
varies with the regulatory and disclosure
environment. When a foreign company has cross-
listed on a U.S. exchange, it has incurred a significant
reduction in its cost of capital and also has been given
a valuation premium (often 30 per cent or more) over
non-cross-listed companies from its home country.
Conversely, when a foreign company has cross-listed
on the London Stock Exchange, there has been no
valuation premium nor has a reduction in the cost of
capital occurred. These patterns have continued for
over 15 years. The obvious explanation was that
stricter enforcement in the U.S. has caused investors
to view cross-listed company’s financial results with
greater trust and assign a higher valuation, i.e.
deterrence works. Also, criminal enforcement of
securities offences has been virtually unknown in the
U.K. and civil insider trading cases have remained
rare. Given the hidden costs of insider trading, the
time may have come for the U.K. to do more
enforcement (Coffee 2008).
In 2005, National Ratings of Corporate
Governance were established by the Russian Institute
of Directors for 150 Russian companies, i.e. the
majority of companies whose securities were traded
on the Russian stock exchange. For the first half of
2004, only one company received a Class A rating for
a high level of corporate governance while most
companies (116) received a medium level of risk with
a Class B rating for a positive level of corporate
governance. However, the corporate governance of
these companies has been improving. At the end of
January 2005, a second set of ratings was done. The
number of companies receiving a Class A rating
increased to five and the number of companies
receiving a Class B also increased versus companies
with Class C or D ratings (low or unsatisfactory
levels of corporate governance, respectively).
In 2007, the Asian Corporate Governance
Association produced its fourth survey of corporate
governance in Asia in collaboration with an Asian
brokerage firm. 582 listed companies in eleven
Asian-Pacific markets were rated on a corporate
governance scale of one to 100 and, then,
summarized by countries’ stock exchanges using this
scale. The derivatives trading scandal at China
Aviation Oil, the Chinese state-owned jet fuel
importer, and accounting frauds at several smaller
Singapore-listed companies reduced that city-state’s
score, placing it a level with Hong Kong as the
ongoing number one and two rated stock exchanges.
India was third and China was ninth. These surveys
have raised awareness of good corporate governance
practices in this region. For example, many Singapore
companies have improved corporate governance
practices, especially in promoting greater
independence of boards and better communication
with shareholders. Also, regional financial reporting
and disclosures have improved while the
independence of audit committees and political
influence on regulatory action are still problematic.
These corporate governance improvements have
helped offset the reluctance of equity investors to
invest in listed companies in the region. Also, private
equity investors have helped to improve corporate
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
governance in listed companies since they had the
patience and skill to work closely with management
in order to improve their investment exit strategies.
The corporate governance listing requirements
of major stock exchanges in the world have enhanced
investor protection against common corporate
governance factors that facilitated fraudulent
financial reporting and the financial crisis in the U.S.
Investors have appeared to be protected by the
corporate governance listing requirements of each
major stock exchange concerning the structural
factors cited in the report of the NYSE Corporate
Governance Commission as follows: all-powerful
CEO (duality factor and lack of Board independence),
weak system of management control, focus on short-
term performance goals, weak code of ethics, and
opaque disclosures. Conversely, investors have
appeared to be unprotected by behavioural factors
related to corporate governance as follows: CEO
uncomfortable with criticism, senior management
turnover, insider stock sales, independence problems
with external auditors and independence problems
with investment bankers (Grove et al 2009).
Using a benchmarking approach where best
practices of corporate governance were taken from
various entities, the U.A.E. approach drew from both
U.S. and the U.K. listing requirements in constructing
its own listing requirements for structural corporate
governance problems. A similar approach could be
used here as specific listing requirements or statutory
laws in various countries could be used as
benchmarks by other countries to strengthen investor
protection. Accordingly, excerpts from major stock
exchanges’ listing requirements for corporate
governance and related SOX requirements were
elaborated as guidelines to protect against each of the
unprotected behavioural corporate governance factors
as follows.
Concerning the factor, CEO uncomfortable with
criticism, the London Stock Exchange listing
requirements could be used to bolster investor
protection. Rule E1 stated that institutional investors
should enter into a dialogue with companies based on
the mutual understanding of objectives and Rule E2
stated that institutional investors should avoid a box-
ticking approach to assessing a company’s corporate
governance. Thus, if institutional investors asked
tough questions of a company’s management,
particularly the CEO, then, he/she should be more
comfortable with criticism and additional tough
questions from financial analysts, hedge fund
managers, and other investors in conference calls and
other meetings with investors. Also, assistance may
come from the U.A.E. Article 12.2b which stated that
shareholder rights shall include the opportunity to
efficiently participate and vote at General Assembly
meetings and the right to discuss the matters listed on
the agenda and to ask questions of the Directors and
external auditor, who shall answer them to the extent
that shall not be in any prejudice of the Company’s
interest. More independent Board of Directors, as
required by all the stock exchanges, should help in
this area as well.
Concerning the factor, senior management
turnover, a statutory requirement, similar to the SOX
requirement on insider trading, could be used here to
increase investor protection. Senior management
turnover would have to be disclosed on a company’s
website within two days and reported to the SEC in
the same time. Another aid would be the NYSE and
NASDAQ requirements strengthening a company’s
nominating committee with all independent directors.
Also, a version of the U.A.E. requirement for
directors could be applied here. ARTICLE 3.4 stated
that a director shall stay in office until he is
succeeded, or he resigns, or he is dismissed via a
Board of Directors’ decision.
Concerning the factor, insider stock sales,
various SOX requirements could be used by all the
stock exchanges to enhance investor protection. SOX
Section 403 required executive stock trades be
reported electronically within two days and also
posted on the company’s website. SOX Section 304
required forfeiture of bonuses and profits from equity
sales by the CEO and CFO when firms restate
financial statements from material non-compliance
with financial reporting requirements as a result of
misconduct. Also, a Russian stock exchange
requirement could be used here. RULE 8 stated that
an issuer’s Board of Directors shall pass a document
on the use of confidential information about the
issuer’s activities, securities issued by this company,
and transactions, which involve the above securities,
since its disclosures can considerably influence the
market price of the issuer’s securities. Also, U.A.E.
ARTICLE 14 (Appendix, Section 2) stated that the
required Governance Report shall state the
transactions of the Directors and their Relatives in the
Company’s securities during the period of the Report.
Concerning the factor, independence problems
with external auditors, various SOX sections could be
used by all the stock exchanges to help protect
investors. SOX Section 508 required that lead audit
partners be rotated off an audit engagement every five
years and no audit team member be hired by a
company during the one year preceding an audit. An
Italian law was much stronger in requiring that the
entire lead audit firm, not just the lead audit partner,
be rotated off an audit engagement every five years.
SOX Section 508 also prohibited audit firms from
designing and implementing financial information
systems, providing internal audit services, and
providing valuation and appraisal services to audit
clients. SOX Section 802 required that external
auditors retain audit working papers for at least seven
years. All the non-U.S. stock exchanges have rules
establishing audit committees that need to review the
independence of external auditors. For example, the
Singapore Stock Exchange RULE 11 stated that the
Board should establish an Audit Committee,
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
consisting of three non-executive, independent
directors, and having written terms of reference
which clearly set out its authority and duties,
including the review of independence and objectivity
of external auditors. However, none of these stock
exchanges’ listing requirements, including the U.S.
ones, specifically defined auditor independence like
the SOX Section 508 or required auditor working
paper retention like Section 802.
Concerning the last factor, independence
problems with investment bankers, SOX Section 501
enabled the SEC to create rules governing research
analyst conflicts of interest and the SEC has been
acting with a professional financial analysts’ group
(FINRA) to establish and enforce the independence
of financial analysts. However, none of these major
stock exchanges have any corporate governance rules
in this area to help protect investors. One suggestion
would be similar to the SOX Section 508 prohibiting
auditors from performing non-audit services other
than tax. A similar rule here would prohibit
investment banking firms from providing investment
research recommendations on client companies, like
the FINRA Rule 2711. Thus, all these “sell-side”
financial analysts who work for the investment
banking firms would be prohibited from providing
such research and from going on road shows to
promote client security offerings. In essence, the
investment research on these client companies would
be performed by the “buy-side” financial analysts
who do independent research primarily for
institutional investors, similar to the New York
Attorney General’s settlement with the largest
investment banks in the U.S.
Thus, there is potential of corporate governance
listing requirements for both structural and
behavioural factors from various stock exchanges
around the world for preventing fraudulent financial
reporting and, thus, for protecting investors.
Managers, board members, internal and external
auditors, and government regulators should apply
these corporate governance listing requirements and
related recommendations to help reduce financial
reporting fraud and excessive risk-taking from the
financial crisis in the U.S.
A related strategy to help detect and prevent
financial reporting fraud and financial crisis
investment disasters was to strengthen risk
management guidelines for companies, as
summarized by Hilb (2004): The task of the board
and top management is to define an integrated,
future-oriented risk management concept. It should
be integrated with the existing planning and
leadership processes but not constrain entrepreneurial
freedom. Such a risk management concept should
give management the assurance to cope with daily
risk and it should keep the responsibility for directing
and controlling within the board. Boards should
report annually to owners about their risk assessment
and decision-making processes. At the board level,
risk management deals with the process of early
detection, prevention, and management of dangers, as
well as identification and effective realization of
entrepreneurial opportunities. Thus, there must be the
conscious exploration of risks where opportunities
can be realized and in the prevention or reduction of
risk, where the anticipated risk outweighs the
expected gains. Risk management deals primarily
with higher assurance in planning and a higher
probability that company objectives are achieved.
These corporate governance factors should be
controlled for improved risk management and
individual high-risk areas need to be monitored
closely. For example, the SEC has reported that over
50% of the financial reporting frauds and earnings
management cases that it detected involved revenue
recognition practices. As another example, such risk
management guidelines could be summarized for
investors in the Governance Report required by the
corporate governance listing requirements of the
U.A.E. stock exchange (ARTICLE 14): The
Governance Report is an annual report of Corporate
Governance practices signed by the Chairman of the
Board of Directors and submitted to the Stock
Exchange Authority on an annual basis or on request
during the accounting period covered by the Report.
The Governance Report shall be inclusive of all such
information as set out in the required Authority
approved form, including in particular: 1)
requirements, principles, and application methods as
necessary for Corporate Governance, 2) violations as
committed during the financial year together with the
reasons and the method to remedy and avoid the same
in the future, and 3) composition of the Board of
Directors, according to the categories and terms of
office of its members, determining the remunerations
of General Manager, Executive Manager or CEO as
appointed by the Board of Directors. This
Governance Report required by the U.A.E. Authority
has six approved sections: governance practices,
transactions of directors in securities, composition of
the Board of Directors, external auditor’s fees, audit
committee, and general information. The governance
practices section could be expanded to require a
summary of how a company’s risk management
strategy dealt with these structural and behavioural
factors of corporate governance, concerning
violations and corrective actions to protect investors.
The importance of the structural corporate
governance factors identified by the New York Stock
Exchange’s 2010 Commission on Corporate
Governance was reaffirmed here with various
empirical and forensic studies. The key, recurring
structural factors were all-powerful CEO (the duality
factor and related Board independence issues), weak
system of management control, focus on short term
performance goals (and related executive
Journal of Governance and Regulation / Volume 1, Issue 1, 2012
compensation packages), weak code of ethics, and
opaque disclosures. Such weak corporate governance
factors were key contributors to both fraudulent
financial reporting and excessive risk-taking which
facilitated the U.S. financial crisis in 2008. Corporate
governance listing requirements by major stock
exchanges around the world will help mitigate such
problems from recurring in the future.
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... This incident resulted in the deep drop of the stock prices and the bankruptcy of several prominent financial institutions in the US (Tarraf, 2011). Grove and Victoravich (2012) mentioned that several financial institutions, such as Citigroup, American International Group, and Merrill Lynch, were not aware of the credit risks associated with the massive amount of mortgage loans that existed in the market at that time. US Financial Crisis Inquiry Commission reported that "when the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans and the risky assets all came home to roost" (Grove & Vistoravich, 2012). ...
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Objective-This study aims to know the impact of corporate governance mechanisms on the non-performing loan of a bank. This study also aims to analyze which corporate governance aspects are significant to the banks' non-performing loans in Indonesia. Another objective of this study is to examine whether the relationship between corporate governance and non-performing loan depends on bank ownership. This study's corporate governance variables are the board size, board independence, and bank ownership category. This study focuses on the non-performing loan of the banks in Indonesia. Methodology-This study will examine 26 banks in Indonesia listed on the Indonesian Stock Exchange (IDX). It includes both foreign-owned (foreign bank) and domestic banks. The length of the period of observation is seven years, from 2012 to 2018. Panel data of these banks are analyzed using the fixed-effect regression. Findings-The regression result shows that board size and bank ownership category have no significant impact on the non-performing loan, while the board independence impacts non-performing loans negatively. Novelty-This study contributes to the academic literature, specifically on the issue of corporate governance in the banking sector. This study's result and findings could be used as the reference for other studies and further research on the corporate governance issue. This study will also expand the literature about corporate governance in the Indonesian banking sector since there are still a limited number of studies that discussed this specific matter.
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Corporate governance has gone through three decades of profound changes in terms of new regulations, new practices, and environmental conditions. Many countries drafted guidelines for best corporate governance practices following Cadbury report (Cadbury, 1992). These practices were mainly related to the board of directors (composition and functioning), internal controls, and internal audit. The Enron scandal followed by the collapse of Arthur Andersen, one of the big five audit firms, and the enactment of the “Public Company Accounting Reform and Investor Protection Act” (Sarbanes-Oxley law) in 2002 were other milestones in the evolution of corporate governance. This law brought about significant changes related to public company accounting oversight, auditor independence, financial disclosure, and corporate responsibility. The financial crisis in 2008 started in the United States and has shaken the world economy. This crisis was due to weak corporate governance that led to fraudulent financial reporting and excessive risk-taking. Grove and Victoravich (2012) consider CEO duality, lack of board independence, weak management control systems, short-termism, weak codes of ethics, and opaque disclosures among the main drivers of this crisis. The COVID-19 has consistently shown that firms with better corporate governance and corporate social responsibility practices were the most resilient entities during the first quarter of the pandemic (Ramelli & Wagner, 2020). All these topics are addressed in this collection of high-quality research papers of this year’s first issue of Corporate Board: Role, Duties, and Composition.
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The COVID-19 global pandemic has created unique and far-reaching impacts on corporations. Given the essential oversight role of boards of directors, it becomes critical for them to develop strategies as their companies respond to the challenges and risks under these unprecedented circumstances. This paper applies corporate governance principles and action plans for boards to help their companies survive this crisis and build sound business prospects both in the short run and long run. For immediate company survival, this paper encourages boards of directors to focus on short-term liquidity and employ five principles for COVID cash management as proposed in Gifford (2020), including detailed forecasting, setting spending priorities, initiating early communication, shortening reporting cycles, and planning for low cashpoints. Since liquidity does not equate to solvency for company survival, boards of directors also need to focus on long-term solvency by monitoring the new normal of business strategies, including the high likelihood of insolvency among small businesses and mixed solvency situations among large corporation. In addition, this paper identifies the key opportunities for the boards of directors to exploit and strengthen corporate governance during this pandemic period, including advocating a COVID disaster recovery plan with best practices, developing an emergency response checklist, establishing efficient disaster responses, and bolstering monitoring mechanisms for employees, operations, finances, customers, and supply chains (Butcher, 2020). The major sections of this paper are current COVID reflections, a case study of the Hertz Corporation, future COVID reflections, business strategies for the new normal, COVID cash management principles, COVID threats to corporate governance, COVID opportunities for corporate governance, and conclusions
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The latest issue (volume 16, issue 2) of the journal Corporate Board: Role, Duties and Composition is exploring the topics of board director benchmarking information, board gender and risk-taking, board structure and firm performance, corporate veil and innovation governance. Overall, the articles in the present issue are dealing with timely topics and their results call for further research as, in some cases, they are challenging traditional corporate governance theories.
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Money laundering can boost corruption, worsen poverty, and bankrupt vulnerable financial institutions. In view of this, a study was conducted amongst the banks in West Africa, in cash-based economies, with the objective to ascertain the level of their Financial Action Task Force implementation. The study found that the implementation of the Financial Action Task Force recommendations in these countries was at different stages due to these countries being cash-based economies. The majority of these countries have anti-money laundering legislation but lack the capability to monitor and counter money laundering activities. This may be ascribed to a lack of adequate resources, expertise, investigations and prosecution capabilities. Some amendments to the Financial Action Task Force recommendations are proposed to incorporate cash-based economies in order to effectively combat money laundering.
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International and U.S. banks should benefit from studying Countrywide Financial Corporation's business practices leading up to the 2008 financial crisis in order to develop lessons learned for improved risk management and corporate governance by both boards of directors and management. Especially for U.S. banks, the 2010 Dodd-Frank Act now requires all U.S. banks supervised by the Federal Reserve Bank to have risk management committees with at least one "risk management expert" on the committee. However, the $6.2 billion "London whale" loss at JPMorgan Chase in 2012 has motivated large institutional shareholders of JPMorgan Chase common stock to demand the removal of three risk management board members. It was hard to determine the "risk management expert" among the four committee members: a JPMorgan Chase director since 1991, the head of Honeywell International, a former KPMG executive, or the president of the American Museum of National History. Internationally, the proportion of bank boards that have risk committees was significantly higher in Europe in 2005 (26.6%) than in the United States (9.6%) (Allemand et al 2013). When a board decides to create a risk committee, it shows greater awareness of the importance of risk management and control (Hermanson 2003). When risks are complex and when the regulatory environment is strong, the creation of a risk committee becomes necessary and a risk management committee can help to make the profile risk of a bank more intelligible to the board. The presence of such a committee should lead to a lower risk (Brown, Steen and Foreman 2009). However, Countrywide had a risk management committee. Although it was repeatedly warned of investment risks by senior Countrywide executives, it ignored such risk warnings. Similarly, a weak system of management control was found to be a key, recurring structural factor in corporate governance implications from the 2008 financial crisis (Grove et al 2012). The following excerpts from the forensic accounting report on Countrywide are used to develop six key risk management lessons that should have been learned by any bank risk management committee for improved corporate governance. This forensic accounting report for Countrywide Financial Services was prepared by Gordon Yale, a practicing forensic accountant in Denver, Colorado. This forensic investigation of Countrywide was performed at the request of the Attorney General of the State of Florida who used the resulting forensic report in litigation against Countrywide's Chief Executive Officer, Angelo Mozilo. A Florida court threw the Mozilo case out because Mr. Mozilo was not a resident of the state. Before an appeal by the Florida Attorney General was decided, the Mozilo case was dropped because Bank of America, which had acquired Countrywide as it neared financial collapse in 2008, settled a larger action with eleven states, including Florida, for approximately $8.4 billion. In doing so, Bank of America avoided prosecution for Countrywide's alleged fraudulent conduct - inducing customers into taking out subprime mortgages and other risky, high-cost loans. The State of Florida's share of that settlement was nearly $1 billion. This forensic report was used to develop key risk management lessons learned from Countrywide which was the largest generator of these risky, "no-doc" (no significant applicant qualifications) subprime mortgages and other high-cost loans which helped precipitate the 2008 financial crisis.
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In mid-March, 2008, with substantial government support, JP Morgan Chase agreed to acquire Bear Stearns for $10 per share. Because Bear's shares traded at $170 a year earlier, the market cap destruction of 94% was devastating to the once venerable investment bank and its investors. The Financial Crisis Inquiry Commission had also cited as failure the inconsistent treatment by the federal government in helping to bail out Bear Stearns in March, 2008 but letting Lehman Brothers go into bankruptcy in September, 2008. This paper investigates such inconsistencies by comparing and assessing the risk management and corporate governance practices of Bear Stearns and Lehman Brothers in their March-September, 2008.
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In March 2008, the US government bailed out a failing Bear Stearns by arranging a sale to JP Morgan Chase, with US government guarantees for many Bear Stearns' toxic assets that came with the acquisition. In September 2008, the US government failed to bail out a failing Lehman Brothers, which then went into bankruptcy. Soon thereafter, the US government established a bailout program for many other failing financial institutions. This paper uses financial risk and fraud models to attempt to answer the question as to why Bear Stearns was bailed out, but Lehman Brothers was not. Based on the analysis, was the right or wrong firm bailed out? In summary, these financial risk and fraud models show potential for developing effective risk management monitoring and stronger corporate governance in order to enhance relationships between management, financial reporting, and the stability of the economic system in crisis and post-crisis conditions.
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This paper analyzes the corporate governance listing requirements of major global stock exchanges to assess the level of investor protection from investment disasters, such as corporate fraudulent financial reporting (e.g. Enron, Lehman Brothers, Satyam, and Parmalat) and the 2008 financial crisis which destroyed over $1 trillion in market capitalization of U.S. companies. This investor protection issue is especially critical for emerging stock exchanges that are trying to attract foreign investors, such as in the United Arab Emirates (UAE) and Russia. This issue is assessed by comparing the corporate governance listing requirements of the well-established stock exchanges in the United States (both the New York Stock Exchange or NYSE and the over-the-counter-stock-exchange or NASDAQ), United Kingdom (London), and Singapore to the listing requirements of the emerging stock exchanges in the UAE and Russia. The effectiveness of these corporate governance listing requirements in protecting investors is assessed by determining how they address ten common corporate governance factors which represent lessons learned from recent fraudulent financial reporting scandals. These ten factors have been divided into two groups of five. The first five common factors were the same ones found in a 2010 Commission on Corporate Governance report, sponsored by the New York Stock Exchange, to investigate the 2008 financial crisis. This paper has called them “structural” factors and labelled the other five common factors as “behavioral” factors. The global listing requirement comparisons reveal that investors seem to be quite well protected from the five “structural” factors but not the five “behavioral” factors. The paper concludes with listing requirement suggestions to protect investors from these five “behavioral” factors. Investor protection from all ten factors is still needed as recent U.S. and global surveys have indicated that financial reporting manipulations are ongoing.
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To auditors, investors, fund managers, short sellers, and other external users, fraud and bankruptcy models may serve as important tools in analyzing the financial information presented by companies. Along with the earnings management ratios, quality of earnings and quality of revenue (Schilit 2003), more elaborate models and metrics (Altman 1968 and 2005, Dechow, Sloan and Sweeney 1996, Sloan 1996, Beneish 1999, and Dechow, Ge, Larson, and Sloan 2007, and Robinson 2007) may serve as a veritable arsenal of techniques for detecting financial problems within companies. When used together as a group, these models may also act as good leading indicators or predictors of future stock price performance. Furthermore, Security and Exchange Commission (SEC) letters to companies questioning their financial reporting may serve as a good screening tool for applying these models since such letters may alert auditors, investors, and other external users to potential financial reporting problems within a company. When companies file their annual 10-K reports, SEC personnel evaluate the financial data and try to determine if there are any potential improprieties or unusual methods being used. If there are, they will send a comment letter to the company outlining the dispute. As of May 12 th , 2005, the SEC began publicly releasing comment letters which were issued after August 1 st , 2004. They are now available through the SEC's Edgar Database. The comment letters are sent by individual SEC staff members as part of a review and do not constitute a position taken by the SEC. These letters are only meant to outline reporting concerns, in contrast to Accounting and * The authors are, respectively, Professor of Accounting, Professor of Finance, and alumni of the University of Denver.
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Prior research studies have examined the detection of fraudulent financial reporting using either financial ratios or nonfinancial factors relating to corporate governance. Are both types of factors relevant for such fraud detection? In this paper, we consider both types of factors, using experiences of fraudulent financial reporting companies as a learning opportunity for management, government regulators, investors, and auditors to develop early warning systems or red flags for fraudulent financial reporting.
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Manuscript Type: Empirical Research Question/Issue: Does corporate governance explain US bank performance during the period leading up to the financial crisis? We adopt the factor structure by Larcker, Richardson, and Tuna (2007) to measure multiple dimensions of corporate governance for 236 public commercial banks. Research Findings/Insights: Findings reveal corporate governance factors explain financial performance better than loan quality. We find strong support for a negative association between leverage and both financial performance and loan quality. CEO duality is negatively associated with financial performance. The extent of executive incentive pay is positively associated with financial performance but exhibits a negative association with loan quality in the long-run. We find a concave relationship between financial performance and both board size and average director age. We provide weak evidence of an association of anti-takeover devices, board meeting frequency, and affiliated nature of committees with financial performance. Theoretical/Academic Implications: We apply agency theory to the banking industry and expect that the governance-performance linkage might differ due to the unique regulatory and business environment. Results extend Larcker et al. (2007), especially regarding the concave relationship between board size and performance, and the role of leverage. Given the lack of support for our agency theory predictions, we suggest that alternative theories are needed to understand the performance implications of corporate governance at banks. Practitioner/Policy Implications: We offer contributions to regulators, especially for ongoing financial reforms of capital requirements and executive compensation. Specifically, we show a consistent negative association between leverage and performance, which supports the current debate on Tier I capital limits for banks.
This Article argues that once undistorted shareholder choice is ensured-which can be done by making it necessary for hostile bidders to win a vote of shareholder support-boards should not have veto power over takeover bids. The Article considers all of the arguments that have been offered for board veto-including ones based on analogies to other corporate decisions, directors' superior information, bargaining by management, pressures on managers to focus on the short-run, inferences from IPO charters, interests of long-term shareholders, aggregate shareholder wealth and protection of stakeholders. Examining these arguments both at the level of theory and in light of all available empirical evidence, the Article concludes that none of them individually, nor all of them taken together, warrants a board veto. Finally, the Article discusses the implications that the analysis has for judicial review of defensive tactics.
The turmoil that struck financial institutions in 2007 has, by the end of 2011, significantly deteriorated the fundamentals of the global economy, eroding trust in sustainability of the markets, solvency of banks and even the credibility of sovereign states and monetary unions. Whether this is the most serious financial crisis since the Great Depression only history will tell, but it is clear by now that the damage to the global economy has been extraordinary. This chapter looks into some of the corporate governance lessons that could prevent this from happening again and presents the main findings and conclusions of the OECD Corporate Governance Committee as reflected in several OECD publications as well as in G.Kirkpatrick (2010).Corporate governance rules and practices of many of the financial institutions that collapsed have often been blamed to be partly responsible for the crisis. The failures of risk management systems and incentive schemes that encouraged and rewarded high levels of risk taking are key factors in this context. Since reviewing and guiding risk policy is a key function of the board, these deficiencies point to ineffective board oversight. And since boards are accountable to shareholders, they also have been put under the spotlight, as many of them seemed to have no interest in expressing their views on the functioning of companies as long as returns were within targets.Corporate governance failures are surely not the cause of the crisis, but they did not prevent and may have even facilitated some of the risky and misguided corporate practices that had such severe effects once the downturn started. Importantly, much of what we have learnt from the demise of some of these financial institutions can serve as an important lesson for non-financial corporations in general. Some of the key lessons from the corporate governance perspective are described in this article.This paper is structured as follows. In the first section we describe the macro-economic as well as the corporate governance dimension of the financial crisis, particularly the way remuneration practices, risk management procedures, limited board oversight as well as shareholder passivism contributed to the poor performance of some major banks. The second section explains how existing corporate governance principles and national corporate governance codes have been re-evaluated against this background, and some of the recent developments are presented. We finish offering some general conclusions.
WASHINGTON — The 2008 financial crisis was an "avoidable" disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the conclusions of a federal inquiry. The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.
This article provides an overview of research we have done on how different aspects of corporate governance influence bank performance. We use a random sample of state-chartered community banks in the Midwest and gather detailed information from bank examination reports on the ownership structure of these banks, the policymaking and operational responsibilities of their managers, and the wealth of key bank insiders. The sample banks have a wide range of management, ownership and board structures, thus providing a comprehensive look at various parts of the bank governance framework and the financial incentives that influence managers and owners. Among such incentives are the ownership of bank stock and the importance of this ownership to the overall financial wealth of prominent decision makers within each bank. We find that an ownership stake for hired managers can help improve bank performance, consistent with a reduction in principal-agent problems posited by financial theory. We also find that boards of directors are likely to have a more positive effect on community bank performance when directors have a significant financial interest in the bank. Finally, we find that the wealth and the financial positions of managers and directors significantly influence their own attitudes toward taking risk and their bank's risk-return trade-offs.
The empirical research examining the association between typical measures of corporate governance and various accounting and economic outcomes has not produced a consistent set of results. We believe that these mixed results are partially attributable to the difficulty in generating reliable and valid measures for the complex construct that is termed corporate governance. Using a sample of 2,106 firms and 39 structural measures of corporate governance (e.g., board characteristics, stock ownership, institutional ownership, activist stock ownership, existence of debt-holders, mix of executive compensation, and anti-takeover variables), our exploratory principal component analysis suggests that there are 14 dimensions to corporate governance. We find that these indices have a mixed association with abnormal accruals, little relation to accounting restatements, but some ability to explain future operating performance and future excess stock returns.
Manuscript Type: EmpiricalResearch Question/Issue: The specific monitoring effect of boards of directors versus industry regulation is unclear. In this paper, we examine how the interaction between bank-level monitoring and regulatory regimes influences the announcement period returns of acquiring banks in the US and twelve European economies.Research Findings/Insights: We study three board monitoring mechanisms – independence, CEO-chair duality, and diversity – and analyze their effectiveness in preventing underperforming merger strategies under bank regulators of varying strictness. Only under strict banking regulation regimes, do board independence and diversity improve acquisition performance. In less strict regulatory environments, corporate governance is virtually irrelevant in improving the performance outcomes of merger activities.Theoretical/Academic Implications: Our results indicate a complementary role between monitoring by boards and bank regulation. This study is the first to report evidence consistent with complementarity by investigating the effectiveness (rather than the prevalence) of governance arrangements across regulatory regimes.Practitioner/Policy Implications: Our work offers insights to policymakers charged with improving the quality of decision-making at financial institutions. Attempts to improve the ability of bank boards to critically assess managerial initiatives are most likely to be successful if internal governance is accompanied by strict industry regulation.