Corporate governance is virtually another term for accountability. It shows to what extent a company’s management is accountable to its shareholders and other providers of finance and whether it has the appropriate structures to underpin that accountability.
Other stakeholders include financial market authorities and, in the case of financial institutions, banking, supervisory authorities and depositors.
The main justification for the existence of accountability is that satisfying stakeholders is dependent on producing the maximum economic efficiency. Proper mechanisms of corporate governance can provide shareholders and depositors in financial institutions with adequate returns on their investments.
Moreover, their existence satisfies the financial market supervisory authorities that the degree of corporate harmony is consistent with the orderly operation of the macro-economy. If such mechanisms did not exist or did not function properly outside investors would not lend to firms or buy their equity securities. Overall economic performance would suffer from lost business opportunities and corporate financial problems would spread to other economic sectors.
Financial institutions have certain characteristics that justify attention to their corporate governance:
* Financial firms are often “opaque” in nature and this gives rise to significant information asymmetries. This in turn makes it difficult to assess management performance.
* The current deregulated nature of the financial environment has meant that the nature of the activities of employees and managers in financial firms has moved from traditional activities, such as transaction processing, toward decision-making activities. This has created greater potential for risk and results not expected or desired by shareholders and other stakeholders.
* Governance is an activity in which communal benefits resulting from private actions lead to inherent free-rider problems. Meanwhile, regulatory and supervisory arrangements in the finance industry play a dominant role. Limitations on takeovers, ownership concentration, prudent supervision and investor protection can weaken product market discipline and this, in turn, can lead to the weakening of the private sector’s incentive to undertake other typical governance functions.
* Financial firms hold equity stakes, provide credit and, consequently, monitor performance, which enables them to have a strong impact on the governance of other institutions. Thus problems in the governance of financial firms eventually reflect upon the governance of non-financial firms.
* Financial innovations have a potentiality for weakening traditional governance processes. For example, the entitlement of equity investors to returns and control rights (votes) can now be analyzed into separate entitlements to capital gain, to a ‘standard’ dividend, to ‘excess’ dividends and to voting rights.
Governance by shareholders: Stakeholders include credit providers, investors (Inc. collective investments) and governments. The mechanisms used by this group can be classified under the headings of design compensation schemes, monitoring processes and capital market (takeover) discipline.
An important source of monitoring arises from competitors when they all contribute to an industry guarantee fund, which is available to regulators for making good losses of a failed institution. Cross institution monitoring can prevent excessive risk-taking by some institutions that would require increased contributions.
However, problems do arise with this system. Withdrawing investment limits can create liquidity problems and hasten the demise of an institution. Action in the public arena can provoke crisis. However, a case can be made for regulatory bodies to act as recipients of such information and to be in a position to act upon it.
Internal control: Financial firms are large complex organizations involving delegation of responsibility for decision-making and risk-taking. Even if the goals of top management are aligned with those of external stakeholders, the design of internal systems to ensure that delegated decision-making is in line with these goals is a complex matter. There are five categories of possible internal control breakdown.
* Lack of adequate management oversight and accountability and failure to develop a strong control culture within the bank.
* Inadequate assessment of the risk of certain banking activities, both on- and off-balance sheet.
* Absence or failure of key control activities, such as segregation of duties, approvals, verification, reconciliation and reviews of operating performance.
* Inadequate communication of information between levels of management within the bank, especially in the upward communication of problems.
* Inadequate or ineffective audit programs and other monitoring activities.
Role of financial firms: As providers or arrangers of finance, financial firms and markets have an important role to play in the corporate governance of business enterprises.
One major area of concern is how alternative financial system designs contribute to corporate governance. There are two main systems, bank-based systems such as those used in Germany and Japan, and capital market-based systems as used in the USA. They can be described as a closed-relationship system versus a “public arms- length” system and each gives rise to different types of finance and monitoring incentives, all of which are relevant.
The ‘public arms-length” system faces a severe case of the “free- rider” problem in regard to monitoring activities. Even where individual stakeholders expend resources on monitoring, such stock market- based systems provide deep liquidity and therefore facilitate action by exit. In contrast, action by voice has adverse immediate wealth consequences for the stakeholder if done publicly, while the ability to exert influence privately is problematic.
In contrast, in a closed relationship system, the individual stakeholder has an incentive (by virtue of a significant stake) and an ability (by virtue of the significant financing role) to exert influence by voice rather than exit. However, the different objectives of the stakeholders in the two systems, reflecting different payoff structures associated with the form of financing, may affect the type of influence exerted.