Article review

Corporate Governance of Financial Institutions

Mafaz Ahmad Khan

57-E BBA(Afternoon) 8th Semester IBA (Punjab University)

Financial Institution Ma'am Labiba Sheikh

IBA-(Punjab University)

April 25, 2013

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The Financial Crunch of 2008 has filled the air of the globe with much apprehension regarding the financial system of countries. Much research has been conducted as to the factors contributing to the crisis and most of the evidence points towards factors related to financial institutions as the major contributors. In a nutshell high borrowing with less or no monitoring has been attributed to the crisis. This article takes a panoramic view of the financial system of the U.S in order to suggest remedies for the destruction caused by the crunch and also improve the financial system. The reasons have been segregated into three broader aspects namely governance of financial institutions, information disclosure by financial institutions and the role of market participants and government in bringing about a development in the financial system. The article takes its start from drawing a picture of a good financial institution. Here, the author has briefly described all the solutions of problems faced by the system. For instance, it says the principal-agent problems between the management can be resolved by making them as responsible as possible for value maximization of business association. Although it is often observed that the empirical results are mingled but such value maximization is crucial for resolving the problems facing poorly managed firms. Similarly equity-based compensation as well as market for corporate governance plays an important role in enhancing the management and aligning interests of stakeholders. The article then goes on to explain corporate governance as a vital tool for success of financial institutions just like non-financial ones. It says that for the governance of financial institutions, it is important for the body to possess both skills and willingness to do so which comes from The Board of directors who are the key players in giving directions to these

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institutions about day-to-day operations and are also responsible for good practical behavior. They make important decisions for the firm, monitor its progress, and consider the strengths and weaknesses. In addition to the formation of BOD and bank boards, corporate governance also plays a crucial role in communication and interaction with other participants of the market. It also brings about an element of independence in the banking system. Shareholders should, on the other hand scrutinize the directors of the bank as to further improve their independence if they are to safeguard their ROIs. The article then describes the external market forces involved in a financial system and how they can be established in order to develop strong system overall.It points out one major cause for the problems faced by the financial market as the failure of governments. Recent research highlights the role of information played in managing financial institutions and the systemic risks involved. However there is a need of conducting more research in this area to resolve the complications and yield high quality information for financial markets. In addition to this it is also important for the market to be disciplined and organized. In order to maintain discipline and disclosure in market, the regulators have the choice between two methods. They can either spread the information outside of markets using obligatory disclosure by banks or they can motivate the people involved to disclose transparent information by incentivizing this act through bonuses etc. It would not be any wrong to conclude that the lack of transparency in banking systems points towards corruption present in the administration. The policies that tend to motivate production of information are considered to be more productive and beneficial for the

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development of financial institutions. Besides, other areas regarding governance of financial institutions that should also be given enough attention include capital structure, agency problem, failure of banks, information disclosure and corporate boards. All these areas have been dwelled upon in the article using examples and evidences. The article then jumps on to the financial market in general and points out the underlying issues therein. It says current financial markets experience problems such as imperfect information and moral hazards. In case the functioning of banking system is prevented by a sudden shock, the economy experiences far more severe consequences and distress. The recovery time of these shocks is smaller for financial firms and longer for non-financial firms and households. Moreover, the article contains a separate section regarding the linkage between financial institutions and market discipline and the role of information there. It explains how closely both information and market discipline are connected. The bottom-line is the more the authoritative market participants are in gathering information, the more disciplined would be the market. The job of regulators is to give a number of incentives to banks, their managerial staff, and market participants; and stake holders so that they work more honestly and effectively. For this purpose they introduce different schemes and programs. In the end the author gives some suggestions to resolve fiscal issues concerning financial institutions and for their better governance. Maintenance of a high equity capital has been highlighted here. The author after discussing some improvements leaves space for the supervisory bodies to carry further research around the three lenses of corporate governance, disclosure requirements & information flow in the financial market.