Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.Corporate governance and bank risk in Asean countries.
INTRODUCTION
Introduction
The determinants of corporate governance in the banking sector and their impact on bank risk-taking behavior have been extensively discussed, yet empirical studies in this area remain limited This thesis examines the bank risk governance structure, which pertains to corporate governance in relation to risk management and its oversight of risk-taking behaviors It evaluates the effectiveness of this governance structure and its influence on bank risk-taking and risk management effectiveness Following the 2008 financial crisis, significant reforms in corporate governance related to risk governance have heightened concerns about the efficacy of existing mechanisms Consequently, there is an increasing interest among researchers in bank risk governance, as the complexity and diversification of banks continue to grow.
The study investigates how bank risk governance structures adapt based on three key factors: the banks' scope of operation, the trade-offs between monitoring costs and benefits, and the negotiation power of CEOs Utilizing multivariate regression analysis on six critical variables—audit committee size, independence, presence of financial experts, meeting frequency, existence of a risk committee, and external audit quality—yields supportive results, which remain consistent across various estimation methods.
In relation to bank risk-taking, the study finds that risk governance structure affects bank risk-taking behavior in different ways Most risk governance variables
1 The term “risk governance” was broadly used in the literature We discuss more this term in Section 2.2
Risk management is a crucial concept in banking literature, particularly in its association with bank risk-taking and the influence of corporate governance Key factors such as audit committee independence, financial expertise, meeting frequency, a stand-alone risk committee, and external audit quality are negatively correlated with bank risk-taking, while larger audit committee sizes show a positive correlation Overall, effective risk governance can mitigate risk-taking behaviors, with findings remaining consistent across different estimation methods and periods, including pre- and post-2008 financial crisis analyses The study highlights that the effectiveness of audit committees, external audits, and risk governance in overseeing risk-taking remained stable after the crisis, with enhanced effectiveness noted in countries with high institutional quality Furthermore, the research emphasizes the importance of risk governance structures, excluding audit committee size, in improving bank risk management and performance.
This chapter offers a comprehensive overview of the thesis, beginning with the background and motivation in Section 1.2, which lays the groundwork for identifying the research objectives and three key research questions discussed in Section 1.3 Section 4 summarizes the research methods utilized to meet these objectives, while Section 1.5 outlines the limits and scope of the research Section 1.6 evaluates the contributions of the thesis based on the established objectives, and Section 1.7 details the structure of the remaining chapters.
Background and Motivation
1.2.1 Corporate governance and bank risk in ASEAN
The financial systems in ASEAN countries are gaining increased attention due to their dynamic economic environment, positioning them to potentially become one of the top five financial regions globally However, with greater financial openness, adverse shocks to the banking sector in these nations could lead to contagion effects across the region.
The financial crises of 1997–1998 and 2008 exposed significant weaknesses in bank risk governance, which were identified as key factors in the failures of financial institutions (Aebi et al., 2012; Erkens et al., 2012; Hopt, 2013) These weaknesses stemmed from a lack of understanding of risk-taking activities and insufficient attention from boards towards risk management functions (FSB, 2013; OECD, 2015) In response to the 2008 crisis, international bodies like the Basel Committee on Banking Supervision (BCBS), Financial Stability Board (FSB), Organization for Economic Cooperation and Development (OECD), and International Monetary Fund (IMF) developed guidelines aimed at improving bank risk governance and corporate governance practices (FSB, 2013; BCBS, 2015; OECD, 2015; IMF, 2009) Despite their shared objective of enhancing bank risk governance effectiveness, these guidelines exhibit inconsistencies, such as the BCBS (2015) recommendation for audit committees to have an independent chair who is not the chair of the board or any other committee.
The Financial Stability Board (FSB) emphasizes the importance of having members with expertise in audit practices, financial reporting, and accounting, as well as advocating for their independence Additionally, the FSB recommends that banks establish a separate risk committee, distinct from the audit committee, while the Basel Committee on Banking Supervision (BCBS) maintains that the audit committee should still have a role in risk oversight These conflicting guidelines pose challenges for banks globally in developing effective risk governance frameworks.
In the aftermath of the 2008 financial crisis, ASEAN banks adopted varying risk governance practices, with some countries establishing or updating guidelines aligned with international standards For instance, Singapore and Malaysia introduced "Risk Governance" guidelines in 2013, while Indonesia's Bank Indonesia released Circular Letter No.13/24/DPNP in 2012, detailing risk governance measures Similarly, the Bank of Thailand also contributed to these governance enhancements.
The Handbook for Directors of Financial Institutions published by Thailand's regulator outlines the critical role of boards in enhancing risk governance, while the Banko Sentral ng Pilipinas introduced risk governance guidance through Circular 971 in August 2017 Vietnam's corporate governance code, based on G20/OECD principles, applies to both financial and non-financial firms, highlighting the diversity in risk governance frameworks across ASEAN countries For instance, a risk committee is mandatory in Malaysia, Thailand, Indonesia, Vietnam, Singapore, and the Philippines, but not in some other nations Additionally, the Indonesian regulator mandates that audit committees include at least two independent members, whereas Thailand and Malaysia require a minimum of three, underscoring the varied risk governance structures among banks in the region.
Meanwhile, some researchers still consider international guidelines to be general and incapable of guiding banks in ensuring effective corporate governance (Helleiner,
Continuous improvement in risk management and strengthened governance are essential for preventing future financial crises, as highlighted by Walker (2011) In response to international standards, many countries, including those in ASEAN, are revising their guidelines to enhance bank risk management and stability While these guidelines serve as a foundation for risk governance across various banks, the implementation varies significantly from one institution to another As nations, particularly in ASEAN, strive to create more efficient and stable banking environments, understanding the determinants of banks' risk governance structures becomes increasingly important.
Risk management practices within ASEAN vary significantly among regulators, leading to inconsistent application by banks and potentially ineffective risk management National supervisors typically impose minimum reserve requirements, with countries like Vietnam, Laos, and Cambodia using these as primary tools for liquidity risk management, while others adopt more comprehensive approaches Reporting periods for liquidity risk management also differ; for instance, Singapore and Indonesia mandate monthly reporting, whereas the Philippines requires annual reports, and Laos and Cambodia leave the reporting frequency to individual banks Overall, ASEAN countries have yet to establish a cohesive strategy to enhance the efficiency of bank risk management.
Bank risk-taking behavior and risk management are critical areas of focus in ASEAN countries, particularly following the 2008 financial crisis, which had varying impacts across the region Thailand experienced the most significant negative growth, while Cambodia faced near-zero growth in 2009; in contrast, Vietnam, Indonesia, and Laos maintained high growth rates This raises questions about the role of corporate governance in determining the risks and stability of the ASEAN banking system, warranting further investigation Additionally, research by Nguyen and Vo (2020) highlights that from 2007 to 2014, most ASEAN banking systems underwent significant reforms aimed at consolidation and regulatory strengthening, thereby influencing the corporate governance of banks Consequently, assessing the effectiveness of bank corporate governance in these countries is essential.
From 2010 to 2019, Figure 1.1 illustrates the average risks faced by banks across various countries, highlighting insolvency risk (Zscore), credit risk (NPLS), operational risk (DROA), and the effectiveness of risk governance (RGEI) The data indicates that while credit and operational risks have generally decreased in ASEAN countries, insolvency risk has shown little improvement Additionally, the restructuring strategies aimed at enhancing corporate governance and monitoring risk-taking may inadvertently harm these banks due to the inherent risk-return relationship, underscoring the need for a more balanced approach to risk management.
Starting from 2010 due to data limitations, this study examines the influence of corporate governance on risk-taking and risk management effectiveness in the ASEAN region The analysis reveals that countries like Myanmar, Laos, and Cambodia exhibit higher insolvency risks, while Thailand, the Philippines, and Malaysia face significant credit risks, and Indonesia, Cambodia, and Thailand show elevated operational risks This suggests that the level of risk is not solely dependent on a country's financial development In contrast, Brunei, Cambodia, and Vietnam demonstrate superior risk governance effectiveness Preliminary findings indicate that variations in banking regulations and corporate governance policies across ASEAN countries contribute to differing levels of risk and risk management effectiveness Consequently, understanding corporate governance and bank risk in this region is crucial for banks to develop appropriate policies aimed at fostering a stable financial system.
Figure 1.1: Average risk and risk governance effectiveness of banks by year
Figure 1.2: Average risk and risk governance effectiveness of banks by country
1.2.2 Background of literature on corporate governance and bank risk
The separation of ownership and control in corporate firms leads to a conflict of interest known as the "Agency Problem," where managers (agents) may prioritize personal gain over shareholder (principal) interests A "complete contract" between owners and managers could effectively address this issue, but challenges such as uncertainty, information asymmetry, and cost considerations often hinder its implementation.
& Jensen, 1983a; Grossman & Hart, 1983; Furfine, 2001; and Macey & O'hara,
Corporate governance is essential for addressing issues of incomplete contracts and agency problems in both modern corporations and commercial banks (2003) It serves as a mechanism to mitigate moral hazard arising from asymmetric information (Bushman et al., 2004) Macey and O'Hara (2003) distinguish between internal and external corporate governance, both of which significantly impact the banking sector Effective corporate governance structures, sought by regulators and shareholders, aim to reduce asymmetric information, improve bank performance, and ensure stability (Grossman, 1992; Hellmann et al., 2000; Zhang et al., 2016).
Research on internal corporate governance structures reveals significant dimensions, particularly how governance correlates with firm characteristics Previous studies have predominantly concentrated on specific facets of corporate governance, with Boone et al (2007) exploring the connection between firm attributes and governance outcomes.
A "complete contract" ensures that all parties involved disclose relevant information before and after signing, thereby securing the agreement between shareholders and managers Research indicates that as firms grow and diversify, both board size and independence tend to increase; larger boards balance monitoring costs with benefits, while greater independence reduces managerial influence An analysis of nearly 7,000 firms by Linck et al (2008a) reveals that board structure is influenced by firm size and the costs and benefits associated with directors' monitoring and advisory roles Additionally, Klein (2002b) identifies a positive correlation between audit committee independence and a firm's growth potential Vafeas (2000) highlights that the composition of compensation committees is significantly affected by the type of director, their tenure, and the number of other directorships they hold These studies suggest that corporate governance structures must align with a firm's unique characteristics While much of the research has focused on non-financial firms, Pathan and Faff (2013) emphasize the importance of examining bank holding companies, revealing that the costs and benefits of board monitoring can elucidate the structure of bank boards.
A 2018 study highlights the significant relationship between the structure of both the board of directors and the Sharia supervisory board in Islamic banks and their scope of operation, suggesting that corporate governance is linked to bank characteristics and environmental activities However, existing research has predominantly focused on the board of directors, overlooking other critical elements of risk governance such as the audit committee and risk committee, which are increasingly vital in bank management As a result, there is a lack of evidence regarding the alignment of banks' risk governance with their specific characteristics This study aims to address this gap by examining the determinants of risk governance in the banking sector, emphasizing the importance of understanding whether risk governance structures align with bank characteristics to avoid missteps in establishing uniform risk governance standards.
Research Objectives and Questions
Banks, like any other business, face a range of operational risks This thesis aims to explore the governance of risk and its impact on risk-taking and risk management practices within banks in ASEAN countries.
The primary goals of this study are illustrated in Figure 1.3, highlighting the three main objectives of the thesis The following section will delve into a comprehensive overview of these aims and objectives.
This study aims to explore how a bank's risk governance structure is shaped by its operational scope, the balance between monitoring costs and benefits, and the negotiation power of the CEO, while accounting for other specific bank factors The research evaluates six key characteristics of bank risk governance: the size and independence of the audit committee, the presence of financial and accounting experts within it, the frequency of audit committee meetings, the existence of a risk committee, and the quality of external audits.
Figure 1.4: General objectives of the thesis
- Stand-alone risk committee existence
Effective internal corporate governance in banks safeguards not only shareholder interests but also protects related parties, including depositors and taxpayers Due to moral hazard issues, shareholders may encourage managers to engage in excessive risk-taking, which can jeopardize the welfare of these stakeholders and threaten the stability of banking operations.
The 2008 financial crisis highlighted the critical importance of board oversight in managing bank risk, prompting policymakers to implement regulations that require boards and their committees to actively monitor risk-taking activities of managers This study aims to explore how the structure and effectiveness of risk governance influence banks' risk-taking behavior, emphasizing the need for enhanced corporate governance mechanisms that address the overall risk profile rather than specific risk types By examining insolvency, credit risk, and operational risk, the research seeks to understand how variations in risk governance can impact these distinct areas of risk exposure in banks.
Our third research objective focuses on examining how the risk governance structure and its effectiveness influence the overall effectiveness of bank risk management According to the trade-off principle of risk and return, higher risk-taking can yield greater returns if aligned with the risk attitudes of decision-makers or stakeholders However, regulators generally advocate for enhanced risk governance mechanisms to improve risk management processes Ultimately, the primary aim of any changes in risk governance is to boost the effectiveness of bank risk management, as these mechanisms play a crucial role in overseeing risk management and assessment activities, thereby impacting risk management decisions.
To meet the objectives discussed above, this thesis will try to answer the following research questions corresponding to three research objectives, respectively:
RQ1: Is the risk governance structure associated with bank’s scope of operation, trade-offs between monitoring costs and benefits, and the CEOs’ negotiation power?
RQ2: Do the bank risk governance structure and its effectiveness affect bank risk-taking?
RQ3: Do the bank risk governance structure and its effectiveness affect bank risk management effectiveness?
Data and Research Design
We compiled a panel dataset from Bank Scope (Orbis Bank Focus) that includes ASEAN commercial banks from 2002 to 2019, specifically focusing on Myanmar, Vietnam, Brunei, Cambodia, Laos, Thailand, Indonesia, Singapore, Malaysia, and the Philippines, while excluding Islamic banks due to significant differences in business orientation and efficiency as noted by Askari et al (2010) Comprehensive data on corporate governance structures was manually gathered from bank annual reports and stock exchange websites, while macroeconomic variables were sourced from the World Bank database The resulting dataset is unbalanced, encompassing 104 banks and a total of 1,207 bank-year observations, influenced by missing data.
This research employs both qualitative and quantitative methodologies, utilizing qualitative methods to synthesize theories and review prior studies The quantitative approach involves developing a structured analysis process to address the research questions We formulate and refine research hypotheses based on theoretical frameworks and existing empirical evidence, subsequently applying empirical models to test these hypotheses For the first research question (RQ1), we evaluate the relevant hypotheses using fixed effect/random effect models, logit, and two-stage least squares estimation techniques, which will be elaborated upon in Section 3.3, Chapter 3.
To address the hypotheses linked to the second research question (RQ2), we utilized the system-GMM estimation method for empirical model estimation This analysis was conducted for various timeframes, including a comprehensive assessment of all data and separate evaluations for the periods preceding and following the 2008 financial crisis Detailed information regarding the specific model and estimation method can be found in Section 3.4 of Chapter 3.
In addressing the third research question (RQ3), we utilize the system GMM estimation method to evaluate how the governance structure and effectiveness of banks influence their risk management effectiveness, as detailed in Section 3.5.
Scope of Research
- Scope of time: The study uses data from 2002 to 2019.
- Scope of space: The study examines commercial banks (excluding Islamic and investment banks) in ASEAN countries (Vietnam, Indonesia, Malaysia, Philippines, Lao, Cambodia, Singapore, Myanmar, Malaysia, and Thailand).
This thesis examines the critical intersection of bank risk and corporate governance, specifically focusing on risk governance related to oversight of risk-taking and management within the banking sector It emphasizes three primary types of risk that are crucial to banks: insolvency risk, credit risk, and operational risk.
Contribution of the Thesis
Academically, the thesis adds to the literature on corporate governance and bank risk in several ways:
This study is the first to explore the determinants of bank risk governance structures, a topic largely overlooked in existing literature, which predominantly focuses on non-financial firms and their board structures (Hermalin & Weisbach, 1988; Boone et al., 2007; Linck et al., 2008a) The consensus in the literature highlights the crucial role of the board of directors (BOD) in overall firm management; however, other aspects of internal governance also significantly influence specific management activities As the banking sector's importance to the economy grows, there is an increasing interest among researchers in both BOD and risk governance.
As far as it can be ascertained, no study to date has examined the association of the
This study explores the determinants of risk governance structures in the banking sector, focusing on the balance between monitoring costs and benefits, as well as the negotiation power of CEOs By analyzing these factors, the research enhances existing literature on banking risk governance.
This study enhances the existing literature on bank risk governance by analyzing both individual risk governance characteristics and the overall effectiveness of risk governance in relation to bank risk-taking While previous research primarily focused on the Board of Directors and its committee structure, this study also investigates the impact of risk governance before and after the 2008 financial crisis to identify any changes in its role during these periods.
2008 financial crisis becomes more important when the pressure on oversight risk management of the BOD and its committees is increasing
This study uniquely explores the impact of institutional quality on the relationship between risk governance effectiveness and bank risk-taking, utilizing a diverse sample of banks from countries with varying levels of development and institutional quality Unlike previous research that primarily focused on large banks and financial firms, this investigation aims to contribute to the understanding of corporate governance tailored to the specific institutional contexts of different countries.
Most studies emphasize the importance of risk governance in regulating the risk-taking behavior of banks, but they often overlook the significance of effective risk management While risk governance can limit risky activities, as noted in existing literature (Pathan, 2009; Aebi et al., 2012), it does not necessarily improve the effectiveness of risk management, which is characterized by a high-risk, high-return relationship This study uniquely explores the impact of the risk governance structure on the overall effectiveness of bank risk management.
This study highlights the importance of understanding the relationship between the scope of bank operations, the trade-offs between monitoring costs and benefits, and the CEO's negotiation power in shaping effective bank risk governance structures By providing empirical evidence on how these governance structures influence risk-taking and risk management effectiveness, regulators can assess the need for a uniform risk governance framework across banks The findings suggest that banks should develop tailored policies to enhance their corporate governance based on the institutional quality in their countries Furthermore, regulators are encouraged to establish specific standards and guidelines to help commercial banks improve their risk control measures.
Structure of the Thesis
Chapter 1: Introduction—An introduction is provided, including an introduction to the thesis, presenting the author’s research motivation and thereby defining the research gap Corresponding to the research gap, the author gives the main research objectives and the corresponding research questions The rest of the thesis is structured by the author as follows:
Chapter 2: Theory and Literature Review—This section presents an overview of theories and empirical studies related to risk governance, risk-taking, and risk management effectiveness This discussion highlights the research gaps more by reviewing the literature and research background to assist in developing hypotheses related to the research questions.
Chapter 3-Research methodology: This chapter presents the empirical research procedure and research design used to test the hypotheses in Chapter 2 The first step is to describe research data, data sources, and sample selection Then the author presents regression models and corresponding estimation methods It also provides a critical evaluation of the variables used as proxies for risk governance structure and bank risk-taking, as well as for bank risk management effectiveness.
Chapter 4: Empirical Results and Discussion—This chapter presents the estimation results from the models presented in Chapter 3 On the basis of the regression results, we compare them with initial hypotheses from which to consider the answers to the related research questions.
Chapter 5: Conclusion—This chapter summarizes the entire thesis It revisits the three research questions and summarizes the methodology, hypotheses, and results related to each of the research questions It emphasizes again the findings from the different models by linking their significance It also discusses again the thesis contributions and the policy implications based on research results Finally, it ends with a discussion on the limitations of the research and some suggestions for future studies.
THEORY AND LITERATURE REVIEW
Introduction
This chapter offers a comprehensive review of the academic literature pertinent to the research questions outlined in Chapter 1 Its aim is to summarize significant studies and enhance the understanding of the foundational research that informs the related hypotheses To achieve this goal, the chapter is organized into four key sections.
Section 2.2 of the article delves into risk and risk governance within the banking sector, addressing key concepts such as bank risk, risk-taking, and risk management, while providing foundational knowledge pertinent to the research objectives and questions In Section 2.3, the focus shifts to a theoretical overview and empirical studies concerning the first research question (RQ1): "Is risk governance structure associated with a bank’s scope of operation, trade-offs between monitoring cost and benefit, and CEO’s negotiation power?" This section outlines three primary theories related to governance structure and reviews relevant literature, leading to the formulation of a hypothesis for RQ1.
Section 2.4 provides a theoretical and empirical examination of the second research question (RQ2): "Do the bank risk governance structure and its effectiveness affect bank risk-taking?" It discusses three key theories—Moral Hazard Theory, Agency Theory, and Stakeholder Theory—that elucidate the connection between risk governance structure, its effectiveness, and bank risk-taking Additionally, Institutional Theory is highlighted to explain the anticipated relationship between risk governance effectiveness, risk-taking, and institutional quality This section also includes a review of relevant literature pertaining to these theories, ultimately leading to the formulation of specific hypotheses related to RQ2.
Section 2.5 presents the theory as well as the empirical studies relating to the third research question (RQ3): “Do the bank risk governance structure and its effectiveness affect bank risk management effectiveness?” From this discussion, the final hypothesis will be formulated to address RQ3 Finally, we present a list of hypotheses corresponding to three research questions in Section 2.6 to summarize this chapter.
Bank Risk and Risk Governance Structure
This section explores bank risk and its governance structure, beginning with an overview of the various risks encountered in banking operations It specifically highlights three primary types of risk relevant to this thesis Additionally, it outlines the risk governance framework, which encompasses the Board of Directors (BOD), audit committees, external audits, and dedicated risk committees within the banking industry.
2.2.1.1 Risk and different types of risk within the banking sector
In business, risk represents the inherent randomness in the earnings generation process, which can be managed through a producer's core competencies, leading to a voluntary acceptance of risk, known as 'businessman's risk.' Conversely, some risks are unavoidable, such as those arising from force majeure events Risk is fundamentally the uncertainty surrounding future events and outcomes influenced by various decisions While banks face core and ancillary business risks similar to other firms, their risk exposure is particularly significant due to their critical role in the economy.
Firm risks are divided into two main categories: market risk (systematic/un- diversifiable risk) and financial risk (unsystematic/diversifiable risk) (Santomero,
In the banking sector, risks are typically categorized into five main types: credit, market, liquidity, operational, and insolvency risks (Aljughaiman & Salama, 2019; Li et al., 2013) The Global Association of Risk Professionals (GARP) further refines this classification by identifying six distinct risk categories, which include credit risk, market risk, portfolio concentration risk, liquidity risk, operational risk, and business environment risk.
This section will introduce the three types of risk focused on in this thesis.
Insolvency risk, also referred to as default risk, is the potential for a bank to lack sufficient capital to absorb losses from various risks, ultimately leading to bank default This risk is critical for the stability of the banking system, as higher insolvency risk correlates with lower financial stability According to Boyd and Graham (1986), assessing insolvency risk is vital for understanding both individual bank risk and overall financial stability Weak management of insolvency risk has led to the failure of several banks, making it a significant concern in the banking sector This study emphasizes the importance of insolvency risk management in ensuring the health and stability of banks.
(2017) argue that managing insolvency risk is critical in financial institutions, as failing to manage it is costly at the micro- and macroeconomic levels.
- Credit Risk: Credit risk can be defined as the probability of parties failing to pay back a financial contractual obligation Crouhy et al (2006) define credit risk as
Credit risk refers to the potential loss resulting from changes in the factors affecting an asset's credit quality, particularly when borrowers or counterparties do not fulfill their contractual obligations This risk manifests when borrowers default on loan payments, including principal or interest, which can happen with mortgages, credit cards, and fixed income securities Additionally, defaults may arise in derivatives and guarantees, highlighting the broad scope of credit risk across various financial instruments.
This study emphasizes the significance of credit risk as a critical concern for financial institutions According to Richard et al (2008), credit risk is one of the foremost risks faced by the banking sector Previous research indicates that inadequate credit risk management is a leading cause of bank failures, particularly highlighted during the 2008 financial crisis (Barnhill Jr et al., 2002; Hennie, 2003).
Operational risk refers to the potential for loss due to failures in internal processes, systems, or personnel, encompassing issues such as fraud, asset damage, business interruptions, and legal challenges (BCBS, 2011) The management of operational risk varies based on a bank's size and complexity, with more intricate banking operations requiring a robust operational risk management framework.
In 2012, it was emphasized that banks must independently manage their operational risk to effectively identify, monitor, assess, control, and mitigate these risks Operational risk is crucial for banks, as they strive not only for profit but also for stability in their operations.
Bank risk-taking refers to the behavior of commercial banks in relation to their willingness to engage in risky activities, often influenced by managerial decisions This issue has gained significant attention within the financial sector, especially following the 2008 financial crisis Numerous studies have sought to quantify various types of risks as indicators of risk-taking behavior, including total risk, idiosyncratic risk, and systematic risk, along with credit, market, liquidity, insolvency, and operational risks.
The risk management process in financial institutions involves identifying key risks, assessing their likelihood, and implementing mechanisms to monitor and control these risks (Pyle, 1999) This process includes critical components such as risk identification, assessment, estimation, and measurement, making it more complex in the financial sector due to unique risk types Effective risk management transcends mere procedural steps, evolving into a vital business strategy that encompasses compliance, financial, operational, and strategic risks, all aligned with the organization's risk appetite (Randeva et al., 2014) According to Al‐Tamimi and Al‐Mazrooei (2007), bank risk management entails monitoring and controlling transactions through policies that effectively identify and mitigate risks Financial institutions must adhere to regulatory requirements while establishing robust risk management systems to ensure effective risk monitoring and mitigation (Talwar, 2011).
Regulatory requirements highlight the critical role of risk management in banking According to the Basel Committee on Banking Supervision (BCBS, 2011), effective risk management encompasses four key components: (1) identifying various risks such as market risk, operational risk, and credit risk, and (2) assessing these risks through the use of risk models.
Timely monitoring and measurement of risks, along with effective risk control by senior managers, are crucial components of risk management in banking This process not only mitigates potential risks but also enhances the efficiency of risk-taking In response to the 2008 financial crisis, regulators worldwide have strengthened their risk management requirements and guidelines to ensure greater financial stability.
Risk management in banks is increasingly linked to corporate governance, as the latter encompasses various risk-related decisions Consequently, inadequate corporate governance may lead to ineffective risk management practices According to Clark & Urwin (2008), there are five key decision-making processes that can impact the quality of risk management: strategic, structural, operational, tactical, and monitoring and oversight decisions.
The risk–return trade-off is a fundamental concept in finance, emphasizing that corporations should aim to maximize returns while managing risk effectively (Aljughaiman & Salama, 2019; Sun & Liu, 2014) While the primary goal is often viewed as maximizing returns, it is crucial to frame this objective as achieving optimal returns for a specified level of risk Poor risk management can lead to severe financial repercussions, particularly evident in the banking sector, which plays a vital role in the financial system The 2008 financial crisis highlighted the consequences of inadequate risk management and corporate governance, with banks facing criticism for taking excessive risks (Kirkpatrick, 2009) Furthermore, the interconnectedness of financial institutions meant that the failure of one could jeopardize others, increasing the likelihood of widespread collapse (Tao & Hutchinson, 2013) In response to the 2007 crisis, there has been a growing emphasis on the necessity for robust risk management frameworks (Aebi et al., 2012).
In response to the US sub-prime crisis, regulators and authorized organizations have implemented measures to enhance the governance and risk management frameworks of financial institutions This initiative aims to ensure that boards of directors and senior management are better equipped to address potential shortcomings and safeguard against future financial instability (Van Greuning & Iqbal, 2007).
2.2.2 Corporate governance and bank risk governance
Bank Risk-Taking Theory and Evidence
This section reviews literature on bank risk-taking and governance structures, leading to the formulation of hypotheses H4 to H6 in response to the research question: “Do the bank risk governance structure and its effectiveness affect bank risk-taking?” It explores whether risk governance serves as a crucial monitoring criterion for bank managers' risk-taking decisions Section 2.4.1 delves into the academic theories surrounding bank shareholders' incentives for excessive risk, while Section 2.4.2 focuses on managerial incentives in risk-taking choices Section 2.4.3 addresses stakeholder and regulatory requirements concerning bank risk-taking, and Section 2.4.4 discusses internal corporate governance effectiveness across varying institutional quality environments Finally, based on these insights, Section 2.4.5 will present the proposed hypotheses H4 and H6.
The moral hazard theory posits that bank shareholders encourage managers to pursue high-risk investments, as noted by Galai and Masulis (1976), who argue that shareholders essentially hold call options on the firm's value, incentivizing them to increase asset risk if interest rates do not reflect this risk Merton (1977) further illustrates that shareholders can benefit from a "put option" on the bank’s asset value, leading to a scenario where risk-insensitive deposit insurance premiums provide a subsidy that grows with leverage and risk This dynamic exacerbates the moral hazard problem, particularly in commercial banks, where dispersed creditors, especially depositors, lack the means to control shareholders' risk-taking due to high information asymmetry (Dewatripont & Tirole, 1994a, b) Consequently, shareholders are more likely to engage in risky projects that serve their interests, often at the expense of taxpayers and deposit insurance funds.
Ownership structure significantly influences firm risk, particularly in the context of moral hazard theory Banks with low ownership concentration face heightened moral hazard issues, as diversified shareholders may encourage managers to take excessive risks after securing funds from depositors (Esty, 1998; Galai & Masulis, 1976) Additionally, foreign-owned banks tend to be riskier than domestic ones, as they can better disperse risks and often prioritize higher risk-taking (Lassoued et al., 2016) Studies indicate that foreign banks enhance competition, improve financial services, and access international capital markets, leading to a greater risk appetite among foreign shareholders (Levine, 1996) Evidence shows that foreign-owned banks engage in riskier behavior compared to state-owned banks in various regions, including Asia and Latin America (Levine, 1998; Yeyati & Micco, 2007) Furthermore, state-owned banks may pursue social objectives, financing unprofitable projects, which can lead to a higher acceptance of risk and challenges in mitigating government intervention (Clarke et al., 2005; Shleifer & Vishny, 1997).
Based on moral hazard theory, governance mechanisms are essential for managing bank risk, with regulators playing a crucial role in ensuring that shareholders do not engage in excessive risk-taking To mitigate the moral hazard associated with deposit insurance, regulators implement regulations aimed at preventing systemic risks and protecting minority investors who lack the ability to monitor bank management effectively A key objective of bank regulation is to minimize taxpayer costs in the event of bank defaults, thereby aligning the interests of bank shareholders with those of deposit guarantors and insurers.
According to De Nicolo (2005), banking policy can be categorized into two approaches: one mandates that bank shareholders maintain significant equity stakes involuntarily through capital regulation, while the other encourages voluntary large stakes via bank competition or charter value strategies.
Bank capital regulations impose mandatory capital requirements to restrict financial leverage, forming the foundation of the Basel Capital Accord utilized by international regulators Despite this framework, the effectiveness of capital regulation in managing bank risk remains a contentious issue Furlong and Keeley (1989) suggest that higher capital standards lead to reduced bank portfolio risk, as the marginal value of deposit insurance diminishes with increased leverage Conversely, Gennotte and Pyle (1991) contend that capital standards may encourage greater risk-taking among banks, highlighting the complexity of the relationship between capital requirements and risk management.
10 Considered as an external corporate governance, see Macey and O’hara (2003)
Research indicates that the relationship between bank capital ratios and risk-taking is complex, with studies revealing a U-shaped correlation While some scholars, such as Koehn and Santomero (1980) and Kim and Santomero (1988), suggest that higher capital ratios may lead risk-averse bankers to increase their portfolio risk to offset utility losses from reduced leverage, other analyses highlight the challenges banks face in raising equity to meet capital standards Consequently, banks may resort to taking on greater risks when equity financing becomes prohibitively expensive (Blum, 1999; Jeitschko & Jeung, 2004, 2005).
Banking competition serves as a regulatory strategy that can inadvertently create monopoly rents for bank shareholders by imposing entry and exit barriers within the financial system In a concentrated market with diminished competition, banks can achieve monopoly profits, thereby enhancing their "charter value." This increased charter value often outweighs the costs associated with bankruptcy for shareholders Research has indicated a negative correlation between charter value and bank risk, highlighting the complex dynamics of market concentration and financial stability.
Market discipline serves as a crucial external mechanism for managing bank risk, emphasizing its role in promoting safe and sustainable banking practices It involves the collective actions of investors reacting to negative changes in a bank's condition, particularly within the corporate control market However, research by Prowse (1997) and Goyal (2005) indicates that government prudential regulations may have diminished the effectiveness of market discipline in the banking sector.
Section 2.4.1 addresses bank shareholders' preferences for increased risk, influenced by mispriced deposit insurance premiums and information asymmetry, as explained by moral hazard theory It also reviews prior research on external corporate governance aimed at regulating bank shareholders' and managers' risk appetites through capital requirements and market discipline to mitigate moral hazard issues This discussion assumes no agency conflicts exist between shareholders and managers or between regulators and managers The subsequent section, 2.4.2, will explore the agency problem between shareholders and bank managers, along with internal governance mechanisms designed to resolve these conflicts Finally, Section 2.4.3 will examine the expectations of stakeholders and regulators regarding bank risk-taking.
As discussed in Section 1.2, the separation of ownership from corporate governance creates an agency problem between shareholders and managers (Berle
Agency theory highlights the separation of decision-making power between managers and shareholders, which can lead to managers acting contrary to shareholder interests This article will explore the motivations and benefits for managers in relation to bank risk-taking, while also addressing the contrasting perspectives on risk preferences between bank shareholders, who may favor higher risk, and bank managers, who often prefer to minimize risk.
Agency theory posits that individuals act to maximize their own expected benefits, leading to conflicts of interest between managers, shareholders, and stakeholders (Mccullers et al., 1982) Macus (2008) highlights the challenge of mitigating such behavior due to information asymmetry, where management possesses greater access to firm information than shareholders This dynamic creates a conflict in banking, as shareholders often pressure managers to pursue high-risk strategies However, unlike shareholders with diversified investments, managers' wealth is largely tied to their companies, prompting them to favor overly cautious decisions to safeguard their interests (Aggarwal & Samwick, 2003; Amihud & Lev, 1981; Amihud et al., 1983; Demsetz).
& Lehn, 1985; Smith & Stulz, 1985; Sullivan & Spong, 2007).
Some studies indicate that bank managers might favor risky assets due to various incentives For instance, a bank manager may opt for a less demanding role, leading to more careless loan evaluations and an increased probability of risky loan decisions Additionally, research by Shleifer and Vishny demonstrates that managers may prioritize personal gains over shareholder value, choosing to invest in high-risk projects despite their potential negative impact on overall profitability.
In 1986, it was suggested that managers might pursue risky projects with negative NPVs due to bonuses tied to firm growth Gorton and Rosen (1995) contended that the moral hazard issue was not the primary driver of heightened bank risk in the 1980s They posited that ineffective managers could elevate bank risk to secure substantial returns, which they deemed crucial for job retention Ultimately, Gorton and Rosen emphasized that corporate control issues are more significant than moral hazard in understanding the rise in risk during that period.
Shareholders and bank managers often have differing incentives regarding risk-taking, primarily because bank managers are compensated through fixed salaries rather than equity or stock options (Houston & James, 1995) This fixed salary structure leads managers to adopt a risk-averse approach, unlike owner-controlled banks where the moral hazard problem can be exploited for potential gains Managers must balance the interests of shareholders with regulatory compliance and the needs of depositors, which limits their incentive to engage in risky behavior Consequently, while shareholders may benefit from risk-taking, managers face the threat of job loss and diminished human capital if the bank fails (Cornett & Saunders, 2003) To align the interests of shareholders and managers, it has been suggested that providing managers with more equity in the company could encourage them to embrace greater risk (Jensen & Meckling, 1976; Morck et al., 1988; Shleifer & Vishny, 1997).
Bank Risk Management Theory and Evidence
This study explores the impact of advanced risk governance structures on the effectiveness of risk management in banks, particularly in relation to the high risk–high return dynamic By examining how risk governance mechanisms influence management's risk-taking decisions, we aim to determine whether an effective risk governance framework enhances a bank's ability to manage risks In this section, we will delve into option theory (Section 2.5.1) and present a new hypothesis (H7) concerning the relationship between bank risk governance structures and their effectiveness in improving risk management (RQ3) in Section 2.5.2.
Option theory posits that managers are incentivized with stock options to align their objectives with the firm's interests The value of these options rises with the fluctuations in the firm's asset value, leading to greater option value in more volatile firms This creates a motivation for managers to increase firm risk to pursue higher profits and elevate the company's market share value As a result, the correlation between firm performance and risk levels remains ambiguous.
Bank managers may pursue risky projects to align with shareholder interests without fully considering potential returns, leading to high-risk, low-return investments Conversely, an overly cautious approach may arise from a board of directors (BOD) that limits risk-taking, preventing managers from engaging in high-risk, high-return opportunities Supporting this, Sun and Liu (2014) highlight that an audit committee focused on risk management can enhance a bank’s risk management effectiveness Additionally, Aljughaiman and Salama (2019) demonstrate that certain characteristics of Chief Risk Officers (CROs) and risk committees positively correlate with high-risk, high-return outcomes in banking, emphasizing the importance of an effective risk governance structure While numerous studies indicate that risk governance can limit risk-taking behavior, there is a lack of research exploring how the structure and effectiveness of risk governance impact overall risk management effectiveness in achieving high-risk, high-return relationships.
In options theory, it is essential to recognize that a bank's risk management effectiveness is influenced by its financial performance, rather than merely the levels of risk-taking A low-risk strategy does not inherently signify good practice (Aljughaiman & Salama, 2019) Effective risk management implies that risk-taking should correlate positively with a firm's returns, highlighting the critical trade-off between risk and return.
Effective risk governance can diminish management's inclination to engage in risky decisions, thereby reducing the likelihood of irrational choices Consequently, we hypothesize that improved risk governance will enhance overall risk management effectiveness This leads us to establish our hypotheses related to Research Question 3 (RQ3).
H7: Risk governance mechanisms are positively associated with the risk- performance relationship.
Chapter Summary
This chapter examines the literature and theories surrounding bank risk governance structures and their impact on risk-taking and management effectiveness The insights gained from this review informed the development of hypotheses addressing the research questions outlined in Section 1.3 of Chapter 1.
We summarize the literature in Fig 2.2 and three research questions along with their respective hypotheses in Table 2.1
Table 2.1: Research Questions and Related Hypotheses
RQ1: Is the risk governance structure associated with bank’s scope of operation, trade-offs between monitoring costs and benefits, and the CEOs’ negotiation power?
H1: “Scope of operation” is positively associated with risk governance structure
H2: Monitoring benefit is positively and monitoring cost is negatively associated with risk governance structure.
H3: CEO’s negotiation power is negatively associated with risk governance structure
RQ2: Do the bank risk governance structure and its effectiveness affect bank risk-taking?
H4A: Audit committee size is positively associated with bank risk-taking.
H4B: Audit committee independence is negatively associated with bank risk- taking
H4C: Proportion of accounting and financial experts in audit committees is negatively associated with bank risk-taking.
H4D: Audit committees meeting frequency is negatively associated with bank risk-taking.
H4E: Stand-alone risk committee existence is negatively associated with bank risk-taking
H4F: External audit quality is negatively associated with bank risk-taking.
H5: Risk governance effectiveness is negatively associated with bank risk- taking.
H6: Institutional quality is positively associated with the relationship between risk governance structure and bank risk-taking.
RQ3: Do the bank risk governance structure and its effectiveness affect bank risk management effectiveness?
H7: Risk governance mechanisms are significantly positively associated with the risk-performance relationship.
The next chapter, Chapter 3, will discuss the methodologies used to test the above hypotheses by introducing data, empirical models, and estimation techniques.