Review of the literature on risk management

This chapter reviews the literature on the risk management and corporate governance in the banking sector. Part of the literature also attempts to provide a relationship between the independence and financial knowledge of the board of directors and audit committee, and risk management practices by referring to both empirical and analytical research.
2.1 Risk Management in the banking sector
When discussing the challenges faced by financial institutions in managing risk, it is important to have a consistent definition of the term ‘risk’. Risk can be defined as the volatility of a corporation’s market value. Risk management involves the protection of a firm’s assets and profits. Moreover, not only does it provide profitability but also other advantages like being in line with obedience function toward the rule, increasing the firms’ reputation and opportunity to attract more customers in building their portfolio of fund resources. Cebenoyan and Strahan (2004) suggest that “[…] the benefits of advances in risk management in banking may be greater credit availability, rather than reduced risk in the banking system” (p.19). This means that banks will have a greater opportunity to increase their productive assets and profit. Only those banks that have efficient risk management system will survive in the market in the long run. They can follow a four-step routine to reduce their risk exposures and achieve their risk management objectives, as shown below.
Figure 1-Steps for implementing risk management
To properly manage risks, banks must firstly identify and classify the sources from which risk may arise at both transaction and portfolio levels. Risks inherent in lending activities include market risk, liquidity risk, credit risk and operational risk. Market risk is the risk resulting from adverse movements in the level of market prices of equities, currencies, interest rate instruments and commodities. Banks are always facing the risk of losses in on and off-balance-sheet positions arising from undesirable market movements. Banks are inherently vulnerable to liquidity risk due to their fundamental role of transforming of short-term deposits into long-term loans. The FSA has defined liquidity risk as: “The risk that a firm, though solvent, either does not have sufficient financial resources available to enable it to meet its obligations as they fall due, or can secure them only at an excessive cost.”

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Another risk that banks face is credit risk. It is the risk that can be incurred if the counterparty fails to meet its obligations in a timely manner. Loans are the most palpable source of credit risk in many of the banking systems; however, other sources of this risk originate through other activities of banks such as acceptances, trade financing, interbank transactions, financial futures, foreign exchange transactions, swaps, equities, options, bonds, and in the extension of commitments and guarantees, and the settlement of transactions. Operational risk, as its name suggests, is a risk arising from execution of a company’s business functions. The Basel Committee has defined operational risk as: “the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events”, such as the failure of computer systems or error and fraud on the part of staff.
Apart from those risks mentioned above, the Federal Reserve System has also recognised two other risks: legal risk and reputational risk. Legal risk is the risk of loss caused by sanctions or penalties originating from court disputes due to breach of contract and legal obligation. Another legal risk relates to regulatory risk, i.e., the risk of loss resulting from sanctions and penalties pronounced by a regulatory body. Reputational risk may be defined as the risk of loss caused by a negative impact on the market positioning of the bank. It can be seen as the ‘blowing up’ of an initial loss, arising from credit, market, liquidity or operational risks. However, banks hardly pay attention to these categories of risks.
Once identified, the risks should be evaluated to determine their impact on the company’s profitability and capital. This entails measuring them by using various techniques ranging from simple to sophisticated ones. For example, market risk can be measured by using Value at Risk. This stage also calls for estimating three dimensions of each exposure: the potential frequency of losses that exposures have produced or may produce, the potential impact on the organisation if a loss should occur and the potential variation in losses that will occur during the exposure period. Accurate and timely measurement of risk is necessary because with these types of data the risk manager can determine which exposes are most serious and which deserve the most immediate attention.
After measuring risk, bank managers should establish and communicate risk limits through policies, standards, and procedures that define responsibility and authority. These limits should serve as a means to control the risks associated with the banking institution’s activities. There is a variety of mitigating tools that banks may employ to minimise the loss exposures. These tools may be diversification, securitization and even derivative such as withdrawal option, Bermudan-style return put option, return swap, return swaption and liquidity option.
The final step involves appraising the operation of the program regularly to be sure that it is achieving planned results. It helps the managers to evaluate the wisdom of their decision-making. To efficiently monitor risk, all material risk exposures should be identified and measured again. To facilitate this procedure, banks should put in place an effective management information system (MIS) that will provide directors and senior managers with timely reports on the operating performance, financial condition and risk exposure of the firm. If corrective action is indicated at this stage, the first three steps should be repeated.
2.1 Corporate Governance in the banking sector
Corporate governance is a term that is now universally invoked wherever business and finance are discussed. Its purpose is to coordinate a conflict of interest among all parties’ relationship within the company and to develop a system that can reduce or eliminate the agency problems arising from the separation of ownership and control (OECD, 1997). Agency problem occurs when the agents of an organization (e.g. management) use their power to satisfy their own interests rather than those of the principals (e.g. shareholders). It may also refer to simple disagreement between agents and principals. For example, the board of directors may disagree with shareholders on how to best invest the company’s assets, especially when the board of directors wishes to invest in securities that would favour their interests.
Not merely does the term corporate governance carries different interpretations, its analysis also involves diverse disciplines and approaches. One of the most quoted definitions of corporate governance is the one given by Shleifer and Vishny (1997): “corporate governance deals with the ways in which suppliers of finance to corporations assures themselves of getting a return on their investment”. The Cadbury Report, however, defined corporate governance as “the system by which companies are directed and controlled” (para 2.5). Additionally, it recognised that a system of good governance allows the board of directors to be “free to drive their companies forward, but exercise that freedom within a framework of effective accountability” (para 1.1). The Hampel Report, whilst accepting the Cadbury definition of corporate governance, also noted that “the single overriding objective of companies is the preservation and the greatest practical enhancement over time of their shareholders’ investment” (para 1.16). In a similar vein, Charkham (1994) identified two basic principles of corporate governance:
That management must be able to drive the enterprise forward free from undue constraint caused by government interference, fear of litigation, or fear of displacement.
That this freedom- to use managerial power or patronage- must be exercised with a framework of effective accountability. Nominal accountability is not enough.
In the banking sector, however, corporate governance differs greatly with other economic sectors in terms of broader extent of claimants the banks assets and funds. In manufacturing corporations, the issue is to maximise the shareholders’ value but in banking, the risk involved for depositors assumes greater importance due to the fact that almost every bit of banks’ investment are financed by the depositors’ funds. If it goes bankrupt, it will be depositors’ savings that the bank will lose. Indeed, Macey and O’Hara (2001) states that “a broader view of corporate governance should be adopted in the case of banking institutions, arguing that because of the peculiar contractual form of banking, corporate governance mechanisms for banks should encapsulate depositors as well as shareholders”. Arun and Turner (2003) also support this argument. Furthermore, the involvement of government in the banking sector is discernibly higher compared to other economic sectors due to the larger interests of the public (Caprio and Levine, 2002; Levine, 2004).
Rational depositors require some form of guarantee before depositing their wealth in banks. Yet, it is relatively difficult for banks to provide these guarantees to them because communicating the value of a bank’s loan portfolio is quite impossible and very costly to reveal. As a consequence of this asymmetric information problem, bank managers can have an incentive to invest in riskier assets than they promised they would ex ante. To assure depositors that they will not expropriate them, banks could make investments in brand-name or reputational capital (Klein, 1974; Gorton, 1994; Demetz et al, 1996; Bhattacharya et al, 1998), but these schemes give depositors little confidence, especially when contracts have a finite nature and discount rates are sufficiently high (Hickson and Turner, 2003). The opaqueness of banks also makes it very costly for depositors to constrain managerial discretion through debt covenants (Capiro and Levine, 2002, p.2).
As such, government interventions provide the lacking assurance to economic agents in the form of deposit insurance. Nevertheless, although the government provides deposit insurance, bank managers still have an incentive to opportunistically increase their risk-taking, but now it is mainly at the government’s expense. Apart from supporting the argument that a broader approach to corporate governance should be adapted to banking institutions, Arun and Turner (2003) also argue that government intervention do restrain the behaviour of bank management.
The Bank for International Settlements (BIS) has defined the governance in banks as “the methods and approaches used to manage banks through the board of directors and senior management which determine how to put the bank’s objectives, operation and protect the interests of shareholders and stakeholders with a commitment to act in accordance with existing laws and regulations and to achieve the protection of the interests of depositors”. The Table 1 below shows the general principles concerning corporate governance issued by the Basel Committee specifically for bank boards and senior management.
Principle 1
Board members should be qualified for their positions, have a clear understanding of their role in corporate governance and be able to exercise sound judgment about the affairs of the bank.
Principle 2
The board of directors should approve and oversee the bank’s strategic objectives and corporate values that are communicated throughout the banking organisation.
Principle 3
The board of directors should set and enforce clear lines of responsibility and accountability throughout the organisation.
Principle 4
The board should ensure that there is appropriate oversight by senior management consistent with board policy.
Principle 5
The board and senior management should effectively utilise the work conducted by the internal audit function, external auditors, and internal control functions.
Principle 6
The board should ensure that compensation policies and practices are consistent with the bank’s corporate culture, long-term objectives and strategy, and control environment.
Principle 7
The bank should be governed in a transparent manner.
Principle 8
The board and senior management should understand the bank’s operational structure, including where the bank operates in jurisdictions, or through structures, that impede transparency (i.e. “know-your-structure”).
Table 1- Principles of corporate governance for bank boards and senior management
2.2 Corporate Governance Mechanism
According to agency theory, the corporate governance mechanisms reduce the agency problem between investors and management (Jensen and Meckling, 1976; Gillan, 2006). Traditionally, these mechanisms can be classified as internal and external. Llewellyn and Sinha, (2000) states that “internal corporate governance is about mechanism for the accountability, monitoring, and control of a firm’s management with respect to the use of resources and risk taking”. Its main mechanisms are the board of directors, the ownership structure of the firm and the internal control system (Gillan, 2006). Whereas, external corporate governance controls encompass the controls external stakeholders exercise over the organisation and its primary external mechanisms are the takeover market and the legal/regulatory system.
However for the purpose of this paper, we will mainly focus on some internal corporate governance mechanism such as the board of directors, more precisely on its independence and financial knowledge. Corporate governance best practices have also stressed in particular the key role played by the audit committee in reviewing a firm’s internal control system. Internal control systems contribute to the protection of shareholders’ interests by providing reasonable assurance on the reliability of financial reporting, effectiveness of operations and compliance with laws and regulations (COSO, 1994; 2004). As such, we will also draw some attention on the audit committee.
2.3 The board’s independence
The popular media as well as corporate governance experts have characterised boards largely as rubber stamps for management. They are the link between the shareholders of the firm and the managers entrusted with undertaking the day-to-day operations of the organisation (Monks and Minow, 1995; Forbes and Milliken, 1999). As stated in principle 4 above, bank boards should properly supervise the work of managers. Which type of directors can perform better this duty than independent director? In fact, such directors can bring additional experience as well as clarity of thought to deliberations independent of views of management. Moreover, since their careers are not tied to the firm’s CEO, outside directors are believed to be more powerful in keeping efficiently the firm’s top management (Fama, 1980; Fama and Jensen, 1983) and so could be associated with better performance.
Some papers do support this theory. Baysinger and Butler (1985), being among the first studies, find that the relative independence of boards has a positive effect on the firms’ average return on equity by comparing 266 major US businesses over a ten-years period. Kesner (1987); Weisbach (1988); Rosenstein and Wyatt (1990); Peace and Zahra (1992); Ezzamel and Watson (1993); MacAvoy and Millstein (1999); Brown and Caylor (2004) and Ho (2005) also show that shareholder returns are enhanced by having a greater proportion of outside directors on the board. Research by Brickley, Coles, and Terry (1994) shows significantly higher returns to firms announcing poison pill  when outside directors dominate the board. Other studies supporting the benefit of the board’s independence are Dechow and Sloan (1996); Beasely (1996) and Klein (2002) who state that as outside membership on the board increases the likelihood of financial statement fraud decreases. There is also Black et al. (2006) who reports that firms with 50% outside directors have approximately 40% higher share price by studying 515 Korean firms. And more recently, Staikouras C. K., Staikouras P. K. and Agoraki M. K. (2006) find that the percentage of independent directors is positively related with performance measured by Tobin’s Q on a sample of European banks.
On the other hand, others find no convincing evidence that the level of outside directors on the board do add value to corporate performance. For instance, Fosberg (1989) finds that firms whose board is composed of a majority of outside directors do not have a higher performance as measured by the firm’s ROE or sales. Similarly, Hermalin and Weisbach (1991) find that non-executive directors have no impact on corporate performance in their sample of 142 NYSE firms. Pearce (1983) also find no relationship, as too Changanti et al. (1985) in their study of board composition and bankruptcy. The lack of relation between these two components has also been confirmed by Klein (1998), Bhagat and Black (2002) and Hayes, Mehran and Scott (2004). Other scholars refuting the effectiveness of outside directors on the board are Subrahmanyam et al. (1997) and Harford (2000) for the acquisition transactions, Core et al. (1999) for CEO compensation and Agrawal and Chadha (2005) for earnings restatements.
It is normally the board of directors which overviews and approves the risk management policies. But, few papers have tried to link its independence to the firm’s risk management practices and hedging. By analysing a sample of bank holding companies, Whidbee and Wohar (1999) find that the likelihood of using derivatives seem to increase with the presence of external directors on the board but only when insiders hold a large proportion of the firm’s shares. Borokhovich et al. (2004) demonstrate that firms most active in hedging risk, especially when making use of interest rate derivatives usage, are those whose boards are dominated by external directors. Conversely, Dionne and Triki (2004); Mardsen and Prevost (2005) point out that outside directors has no impact on the firm’s risk management policy.
Given the mixed empirical findings, it is quite difficult to assert whether the board independence contribute to corporate performance and the effectiveness of risk management. Although Fields and Keys (2003) assert that there is overwhelming support for independent directors providing superior monitoring and advisory functions to the firm, a unique and clear sign concerning the effect of the board’s independence on any decision including the risk management one could not be predicted.
2.4 The financial knowledge of the board
To adequately perform their supervision role, the board of directors must have financial knowledge  . Indeed, when board members are generalists and lack the technical financial knowledge to understand the complicated reports presented to them, they could vote for motions that increase the risks facing of the firm to a large extent. The company may collapse in this way and therefore hinder the shareholders’ interest. Because of the banks’ dominant position in the economy; they should possess some financial expertise directors on its board so as to make better decisions that will not lead the firm to go bankrupt. However, given its importance, the research on the value of the board’s financial knowledge is quite scarce. At times, reports recognising the benefits of the board’s independence also recommend financial literacy/expertise for directors in monitoring the firm’s performance.
In fact, Booth and Deli (1999) and Guner, Malmendier and Tate (2004) suggest that commercial bankers on boards provide the financial skill needed to enable the business to contract more debt. Thus, this states that financial directors do add value to the firm. There is also Agrawal and Chadha (2005) who discover that there is lower earnings restatement in firms whose boards have accounting or financially knowledgeable independent directors. However, Rosenstein and Wyatt (1990) provide evidence that “positive abnormal returns associated with the addition of an outsider to the board are higher when the latter is an officer of a financial firm”. Later on, Lee, Rosenstein and Wyatt (1999) do come to the same conclusion. However, they were unable to make any statistically difference among the reaction of the three categories of financial directors they consider: commercial bankers, insurance company officers and investment bankers.
To the best of our knowledge, researches on the board’s financial knowledge have only been related with the firm’s performance and not specifically on its impact on risk management practices. As mentioned earlier in this study, the board of directors is usually responsible for the firm’s risk management policies. In other words, risk management is at the core of any board members charter. Financially knowledgeable directors will obviously make better decisions on risk management practices since they will have the technical background to understand the sophisticated tools involved in risk management transactions. As such, firms whose boards are composed of financially knowledgeable directors engage more actively in risk management.
2.5 The audit committee
The audit committee is intended to provide a link between the board and the auditor independent of the company’s management, which is responsible for the accounting system (IOD, 1995). The chief objectives of an audit committee are to improve the quality of financial reporting, to reduce the potential authority for the non-executive director, to improve the channel of communication with the external auditor and, perhaps most importantly, to review the adequacy of the company’s financial control systems. Tricker (1984) defines audit committee as being an important vehicle for ensuring the supervision and accountability at board level. As such, audit committees are very important in banking to safeguard the shareholders’ interest as well as the public trust.
Just as for the board of directors, independence is also considered important for an audit committee because outside directors can exercise their voice and be seen to make a valuable contribution since they are free of any influence arising from the firm’s CEO. Thus, the reported empirical evidence supports this argument. Klein (2002) shows that independent audit committees reduce the likelihood of earnings management, thus improving transparency. In addition, Abbott, Park and Parker (2002) argue that firms with audit committees comprising entirely of independent directors are less likely to have fraudulent or misleading reporting. Ho (2005) states that there is a strong positive link between independent audit committee and corporate competitiveness and also with return on equity after analyzing the international companies from 1997to 1999. Brown and Caylor (2004) do provide evidence that audit committees comprising of independent directors are positively related to dividend but not to operating performance.
On the other hand, some authors find a negative relationship or simply no relation at all between independent audit committee and the firm’s performance. Hayes, Mehran and Scott (2004) prove that the firm’s performance measured by the market to book ratio is not affected by the proportion of outside directors sitting on the audit committee. Agrawal and Chadha (2005) do come to the same conclusion by indicating that independent audit committee members are unrelated to earnings restatement. There are also Beasley (1996) who finds no apparent correlation between audit committees’ composition and financial statement fraud, and Klein (1998) who reports no relation between share prices and the audit committee’s composition. Yet, Carcello and Neal (2000) report a negative relationship between the probability of receiving a going-concern report and the proportion of outsiders on the audit committee.
In addition to independence, the accounting and financial expertise of members of the audit committee has also received widespread attention from the media and regulators  . An audit committee with such characteristics is expected to provide effective monitoring as it possesses the skills needed to understand what is going on in the organisation. Interestingly, Agrawal and Chadha (2005) show that firms whose audit committees have an outside director with accounting background or financial knowledge are less likely to report earnings restatement while Abbott, Parker and Peters (2002) discover that the absence of a financially competent director on the audit committee is highly associated with an increased in financial misstatement and financial fraud. Xie, Davidson, and DaDalt (2003) find that the presence of investment bankers on the audit committee decreases discretionary accruals in a firm. Davidson et al. (2004) and Defond, Hann and Hu (2004) show that the market has a positive reaction following the announcement of directors with accounting /auditing experience on audit committees’ board.
The audit committee is also responsible for evaluating the risk exposures and the measures taken to monitor and control these exposures. To our knowledge no paper has tried to link audit committee’s composition with risk management practices. Because of the mixed and conflicting argument on independence, it is quite difficult for us to attest whether audit committee’s independence encourage more corporate hedging. Furthermore, risk evaluation and risk management tools are quite difficult to use and thus understanding them requires a good grasp of mathematics and statistics. As such, we expect firms whose audit committees’ members are qualified as accounting/financial expert to engage more actively in risk management practices.
Besides independence and accounting/financial knowledge, the Cadbury Report has insisted that all listed companies should have an audit committee comprising of at least three members. This is to urge firms to devote significant director resources to their audit committees so that audit committees monitor the firm’s management more efficiently. However, several studies support the idea that larger boards can be dysfunctional since they may be plagued with free rider, communication problem and monitoring problems  . Therefore, as long as the increase in the audit committee’s size does not pose these types of problems, firms complying with this requirement are expected to report a higher hedging ratio.
Often, corporations, especially financial ones, create another committee named risk monitoring committees. This type of committee is often responsible of the risk monitoring of the firm. However, this does not imply that audit committee is no longer responsible for evaluating and managing risks. It must still discuss and evaluate risk management processes. In other words, the audit committee is there to review risk management processes proposed by the risk management committee. As such, we assume that the same characteristics as the audit committee should be applied to this type of committee to fulfil their duties well.