Corporate Governance in Banking: A Conceptual Framework

Penny Ciancanelli
E-mail: p.ciancanelli@strath.ac.uk
And
Jose Antonio Reyes Gonzalez
E-mail: areyes@eh.quik.co.uk


Department of Accounting and Finance
Strathclyde University
Glasgow, G4 0LN

Tel: (44) (0) 141 548-3896
Fax: (44) (0) 141 548-3547










This paper can be downloaded from the
Social Science Research Network Electronic Paper Collection:
http://papers.ssrn.com/paper.taf?abstract_id=253714







Paper submitted for presentation at the European Financial Management Association Conference,
Athens, June, 2000 The authors would appreciate that the copyright of this conference paper be
respected and that no part of it is cited without the permission of the authors. The paper was
presented by Jose A. Reyes-Gonzalez. Correspondance should be directed to Penny Ciancanelli.

2




Corporate Governance in Banking: A Conceptual framework


Abstract

In the wake of far reaching financial system reforms, almost three fourths of the
member countries of the IMF experienced significant episodes of systemic crisis and
associated bank failures. Notably absent in the ensuing debates on the correlation
between financial system reforms and systemic crisis was discussion of corporate
governance in the affected banks and the role it may have played in the provoking
financial crisis.

Consideration of corporate governance in banks is, however, apparently easier said
than done. While there is a great deal of empirical research on corporate governance,
very little of it concerns the behaviour of owners and managers of banks; all of it
assumes that banks conform to the concept of the firm used in Agency Theory.

The aim of this paper is to demonstrate the limitations of that assumption and to
propose an alternative conceptual framework more suitable to its analysis. We argue
that commercial banks are distinguished by a more complex structure of information
asymmetry arising from the presence of regulation. We show how regulation limits the
power of markets to discipline the bank, its owners and its managers and argue that
regulation must be seen as an external force, which alters the parameters of
governance in banks.

Key words: Corporate Governance, Banks, Regulation, Agency Theory.


3
Introduction
Between 1980 to 1997, over 130 countries, comprising almost three fourths of the
member countries of the International Monetary Fund (IMF) have experienced
important problems with their banks. (Lindgren, Garcia, Saal, 1996) The fact that
these crises occurred after implementation of far reaching reforms of the financial
system revived long standing debates in Economics and Finance on role of bank
regulation. (Mishkin, 1992; McKinnon, 1993) Notably absent in the debate, however,
is consideration of the corporate governance of banks and the role it might play in
systemic crisis.
1


Consideration of corporate governance in banks is, however, apparently easier said
than done. While there is a great deal of empirical research on corporate governance,
very little of it concerns the behaviour of owners and managers of banks. In addition,
there is no clear theoretical path between governance as a microeconomic concept
and regulation as a macroeconomic concept. There is, therefore, little guidance as to
the conceptual framework that is suitable to understanding governance in banks.

This lack of guidance creates a strong theoretical motive for research on these
issues. By defining a conceptual framework appropriate to governance in banks, it is
possible to contribute to the further development of the microeconomics of banking.
Specifically we seek to widen the scope of financial management research so that
governance is understood as an integral part of the microeconomic foundations of
what is called systemic risk in the banking literature.
2
(OECD, 1995; Davis, 1995;
Lindgren, Garcia and Saal, 1996)

This paper has two aims. The first in to demonstrate the limitations of current
approaches to the governance in banks. The second aim is to offer a more robust

1
By commercial banks, we mean private sector corporations that intermediate between depositors
and borrowers. It is outside the scope of this paper to consider the effect of changes in the financial
services industry on the varied ways in which regulators have sought to define a bank.

2
The chief features of systemic risk are well known: Runs (unexpected withdrawal of deposits),
unexpected and rapid reversals by securities holders, excessive volatility in the foreign currency
market and generalised symptoms of panic amongst financial asset holders. (Sundarajan and
Balino,1991) The desire to prevent such episodes is the main rationale for national regulation and the
fear of contagion through global systems of intermediation is the main rationale for international efforts
at regulation.

4
conceptual framework. We do this by analysing the underlying assumptions of the
standard theoretical framework adopted in corporate governance studies and
demonstrate two complementary arguments. Firstly, we show that the assumptions of
Agency Theory make it unsuitable for analysing governance in commercial banks
because regulations intended to prevent systemic risk (e.g. secure the integrity of the
banking system) limit the disciplinary power of market forces.

Secondly, we demonstrate that the agency problem in commercial banks is
structurally different from that found in other publicly listed firms. Regulation, a
transcendental feature of banking, alters the parameters of the agency relationship by
introducing a third party--the regulator. This creates additional information
asymmetries and associated agency problems. This implies that any moral hazard
to which regulation gives rise may be an empirically more robust parameter of poor
governance than is the conflict of interest between the owners and managers of
commercial banks. Indeed, it can be argued that liberalisation of banking regulation
has amplified moral hazard because, on the one hand, the reforms have given banks
the freedom to take greater commercial risks and, on the other hand, the regulator
shares this risk through his remaining commitment to act as a lender of last resort.

This paper has three main sections. In the first section, we critically evaluate the
standard framework of corporate governance and its suitability for banks. We argue
that the use of Agency Theory implies the adoption of assumptions that obscure the
unique governance dilemmas confronting bank owners, managers and regulators.

In the second section, we propose a new conceptual framework for analysing
corporate governance in banking firms. We are particularly concerned to integrate an
analysis of the specific impact of regulation on both the nature of the market and the
nature of the principal-agent relationship in bank firms.
In the third and concluding section, we elaborate the idea of a governance gap. We
argue that the regulatory structure now in place provides bank owners with incentives
to take risks that are greater than those deemed prudent by regulation. (Franke,
2000) The main manifestation of this gap is the correlation between deregulation of
banking systems and rapid increase of non-performing loans. We are suggesting that

5
this pattern has its origins in a gap between the expected and actual incentives
created by regulation.

Section 1. Banks and the Concept of the Firm
Awareness that commercial banks are somehow different from other corporations
may explain why there has been very little research--either empirical or theoretical--on
their corporate governance. Previous research on corporate governance is limited
mainly to empirical research using data on US banks. This research assumes that
banks conform to the concept of the firm used in Agency Theory. That is, it assumes
that moral hazard in banks is the same as that identified for any company in which
control and ownership are separated.

One strand of this literature (Saunders, Strock and Travlos, 1990; Allen and
Cebenoyan, 1991; Gorton and Rosen, 1995) is concerned specifically with
managerial conduct. (Cf. Diamond, 1984; Glassman and Rhoades, 1980 and
Edwards, 1977) The other strand considers the different elements of the corporate
governance mechanism in banks. (Prowse, 1995; Houston and James, 1995; and
Crawford, Ezzell and Miles, 1995) In both strands, banks are treated as if they were
the same as any other firm.

It is possible that the wide publicity given to financial system reforms throughout the
world have created the impression that banks have been completely deregulated.
This is not the case, however. While most governments have adopted financial
deregulation
3

as a central element of the reform of national financial systems,
4

banks
and banking continue to be regulated. Deregulation has been about changes in the
rules of the game rather than the abandonment of rules altogether. No country has
adopted a complete laissez-faire approach to their financial systems. (Vittas, 1992)
The important implication for financial management studies is that the regulator and

3

As early as the middle of the 1980s, some prescient observers pointed out the crisis potential of
such rapid and far-reaching financial deregulation. (Diaz-Alejandro, 1985)

4

Three kinds of financial system are identified: stated directed and enterprises financed mainly by
bank loans, bank directed and enterprises financed mainly by bank loan, and market directed and
enterprises financed by debt and equity securities. (Arbor 1995)

6
regulation are a transcendental feature of bank management everywhere in the world
today.

From a theoretical perspective, previous research is even more limited. The
application of Agency Theory to banks assumes that banks operate in the same type
of competitive markets and are structured managerially by the same forces as all
other firms. This assumption is completely at odds with that found in the banking
literature. Specialists in banking studies (whether economists or political scientists)
regard banks as different and distinct from ordinary firms, either because that is the
empirical state of affairs (e.g. they are regulated) or because their specific
characteristics require regulation. (Ogus, 1994; Goodhart, Harmann, Llewellyn, Rojas-
Suarez and Weisbrod, 1998) In either case the fact of (or need for) regulation makes
it untenable to assume competitive markets.

In order to illustrate the lack of fit between standard agency models and the firm
known as a bank, it will be useful to review its assumptions and compare those to the
characteristics of banks. Agency Theory makes at least three assumptions:
Normal or competitive markets
The nexus of information asymmetry is the principal-agent relationship
between owners and managers
Optimal capital structure requires limited gearing (The Modigliani and Miller
Theorems)

In contrast, one finds that commercial banks function
In regulated or administered markets
The agency problem is more complex
Capital structure is highly geared reflecting the banks function as an
intermediary. Owners rarely provide more than 10% of funds loaned; bond
holders and depositors provide the rest
For governance, the more complex agency problem is of particular importance. In
addition to information asymmetry between owners and managers, there are at least
three additional loci of asymmetric information in banks:
Between depositors, the bank and the regulator
Between owner, managers and the regulator
Between borrowers, managers and the regulator


7
The importance of these additional loci of information asymmetry suggest that the
nature of the firm called a bank is qualitatively different from the nature of the firm
implied by Agency Theory.
5


However, even though we consider Agency Theory to be of limited use in the analysis
of bank governance, the agency problem remains an important conceptual tool.
6
As
we noted above, the existence of a more complex structure of information asymmetry
is a distinctive feature of commercial banks. The question that remains is how might
this difference matter.

In order to develop our answer to this question, we need to discuss four theoretical
issues in some detail. First, what is the nature of the market in which the firm called a
bank acts? Second, what is the dynamic relationship between the market and the
firm? Third, in theoretical terms, how might regulation affect the market and the firm?
Fourth, what is the object of regulation, the firm or the market?

The nature of the market in which the bank operates
The foundational work on markets and firms is that of Coase. (Coase 1937) He was
the first to go into the black box called the firm and draw attention to the fact that the
entrepreneur and his employees (factor) were integrated in firms by means of
contracts. Jensen and Meckling appear to have supplemented the Coasian
framework with the concept of asymmetric information in order to formulate the
agency problem in a prescriptive way, e.g. with the idea that contracts could be written
in such a way as to overcome the implicit information asymmetry between the factors
integrated in the firm.


5

We have identified four sources of moral hazard: Type 1, is the same as that discussed in Agency
Theory and is the conventional two person 'game' involving the owner (as the principal) and the
manager (his agent). Type 2, is that discussed in theories of bank regulation. The depositor is the
principal; the bank is the agent. The regulator insures the depositor in order to limit systemic risk.
Types 3 and 4 are the moral hazards linked to governance.

6

There seems to be some confusion in the literature as to the difference between Agency Theory and
the agency problem. In our discussion, we distinguish between the two on the basis of the
assumptions required when using them, particularly those regarding the market.

8
Their original formulation of the agency problem is quite abstract and concerned with
the general problem of control in the Coasian firm. We argue that the while the
general notion of agency problem or agency relationship are sufficiently abstract, the
particular concepts of the market and the firm, which underpin its use in finance
research, are ill suited to the study of banks and therefore of corporate governance in
the firm called a bank.

The concept of the market in the Coasian firm assumes perfect competition.
However, perfect competition is not a workable concept for explaining the specific
features of bank markets. (Campbell, 1994; Hodgson, 1993) We argue that the
existence of banking regulation affects the nature of the markets in which the firm
called a bank operates. Therefore the specific constraints in bank markets will have
to be the building blocks of both prescriptive (normative) models of best practice in
corporate governance in banks and empirical analyses (behavioural models) of the
origins of control loss (weak corporate governance) in contemporary banks.

The dynamic relationship between the market and the firm called bank
In the theory of the firm derived from Coase, the dynamics of the relationship between
the market and the firm are not considered. Indeed, there are serious questions as to
whether one can say that the concept of the firm in Coasian based theories
constitutes a coherent theory of the firm as such. The firm is treated as if it is
independent of the market and the market is treated as if it is independent of the firm.
However, from a systems perspective, the market and the firm are not independent of
each other. The firm, in order to operate, must contract with other firms for its inputs.
Therefore, it is possible to say that the market is the result of a sort of contracting
between firms. Contracts with other firms are not the only ones that firms are required
to make. They are also required to enter into contracts with regulatory authorities,
such as local government, health and safety authorities, officials, and so forth. Thus, if
the firm is a nexus of contracts between factors, the market is a nexus of contracts
between firms and between firms and regulators.

The treatment of the firm as separate from the market may be an artifact of the partial
equilibrium framework used by Coase. (Putterman, 1986) In general, financial
management models derived from Coase also treat the firm as separate from the
market and the evolutionary models of the modern corporation rarely make an

9
appearance. (Cf. Chandler, 1977) Furthermore, there appears to be a strong
assumption that firms are the only logical alternative to markets as a means to
allocate the factors of production. This is, of course, not true. The firm emerges as
the single alternative to the market only if one abstracts from the historical facts of
their joint evolution. However, if one considers the variety of organisational designs
which have developed historically, one is aware of the existence of a third type of firm:
The regulated firm operating in a regulated market. Even Coase (1937) himself noted
the effect that regulations such as tax would have for his argument, writing:

"such a regulation would bring into existence firms which otherwise would
have no raison dtre" (p. 45)

In other words, regulation affects the efficiency calculus between markets and firms.

Alternatively, if we are to abstract from history and accept that planning within firms or
market price are alternative resource allocation mechanisms, what logic compels us
to exclude the government as having powers to regulate allocation? Equally what
reasons are there to exclude regulation from any source (including agreements
amongst the firms themselves) as a logical third alternative mode of allocation to that
of the price mechanism (the market) and the firm?

Of course, for purposes of modelling relations within the firm, it may be sensible to
make ceteris paribus assumptions (e.g. treat the market as a parameter). However,
a coherent theory of the firm must take into account how the behaviour within firms
interacts with that in other firms to constitute market processes through the relays of
feedback and spill over effects. Indeed, the lack of such a system perspective on the
market makes it possible to argue that financial management has no theory of the firm
as such. On this point, Jensen and Meckling (1976) have written:

"While the literature of economics is replete with references to the theory of
the firm, the material generally subsumed under that heading is not a theory
of the firm but actually a theory of markets in which firms are important
actors." (p. 211)


10
Regulation and the Agency Problem
Coase himself did offer a very brief consideration of regulation in the development of
his general theory. He noted that governments and other regulatory bodies often
treated the same transactions differently depending on whether they occurred in
markets or a firm. (Coase, 1937, p. 45) Few working within the Coasian tradition
have attended to the potential implications of this observation. Of particular
importance is its implication for the agency problem. If we accept that governments
and other regulators behave in this way, the possibility exists that regulation creates a
specific context for the writing of contracts between the firm and the regulator, and
between the principal and the agent within the firm.

We argue that bank regulations have quite specific effects on both the market and the
firm. The power of markets to discipline the bank is limited through regulations on
entry, mergers, take-overs, administrative rules and so forth. Obviously, these
market regulations also affect bank management decision-making. In addition,
bank firms often face direct regulation, including statutory supervision, limitations on
the scope of the business and fiduciary criteria for top managers. The latter implies
that the labour market in middle level and top level managers is constrained. In some
firms and jurisdictions, the mobility of middle level and top managers is also
constrained.

The Object of Regulation: The Market or the Firm?
What is the object of regulation? The market or the firm? Could regulation constrain
markets and at the same time offer scope for opportunism by the owners and
managers of the firm called a bank?
In general, the literature on bank regulation emphasises the stated purpose of
regulation as that of maintaining the integrity of the market system. To a great extent
this is a legacy of the strong spill over effects of the financial markets crash of 1929.
The spectre of debt deflation crises triggered by events in the financial sector
continues to preoccupy bank regulators. (Vittas, 1992; Hausmann and Rojas-Suarez,
1996; Rojas-Suarez, 1997)

Attention is firmly focused on the management of exogenous shocks to the system
through lender of last resort support from the government. However, lender of last

11
resort operations are inevitably indiscriminate; they bail out all banks, regardless of
their previous conduct. In general terms, they shift the cost of risk to all the
stakeholders in the system. We argue that crises may derive from poor corporate
governance within the sector; in other words, bank governance is an important
endogenous source of system weakness.

Excessive risk taking by the firm called bank has important implications for the market
system because of economic agents common membership in a network of
interdependent funds flows and the banks monopoly of the payments system.
7
This
creates the potential for rapid transmission of governance failures in one bank to the
banking sector and thereby to the rest of the economic system. We argue that studies
of regulation and the regulators themselves devote less attention to corporate
governance as an endogenous source of systemic risk than it devotes to exogenous
or market sources of systemic risk.

Section 2. Regulation and Corporate Governance
It is clear that developing models of corporate governance in banking requires that we
understand how regulation affects the principals delegation of decision making
authority

(Jensen and Smith, 1984) and what effects this has on the behaviour of their
delegated agents. (Freixas and Rochet, 1997)
We suggest that regulation has at least four effects. Firstly, the existence of regulation
implies the existence of an external force, independent of the market, which affects
both the owner and the manager. Secondly, because the market, in which banking
firms act is regulated, one can argue that the regulations aimed at the market
implicitly create an external governance force on the firm. Thirdly, the existence of
both the regulator and regulations implies the market forces will discipline both
managers and owners in a different way than that in unregulated firms. Fourth, in
order to prevent systemic risk, such as lender of last resort, the current banking
regulation means that a second and external party is sharing the banks risk.

7
While outside the scope of this paper it may be useful to briefly address the claim that financial
innovation have altered this. Financial innovation affects the extent and complexity of the credit
linkages in an economic system. They do not, however, replace the fundamental requirement for an
end-point. At the end of any chain of credit is the terminal transaction in which the debt is satisfied by
the payment of cash and the wealth claim of the creditor is realised. Banks continue to have the
monopoly over the transmission of these essential moments of the realisation of asset values and
ownership claims in the economic system.

12

Regulation as an additional external governance force
In the conventional literature on corporate governance, the market is the only external
governance force with the power to discipline the agent. The existence of regulation
means there is an additional, external force with the power to discipline the agent.
This force is quite different from the market. It acts in both the macro economic
sphere (at the level of the banking sector) and in the microeconomic sphere (at the
level of the individual banks). This implies that the power of regulation has different
origins and different parameters, and therefore different effects to those produced by
markets. Moreover, there is little ambiguity regarding the empirical references for
regulation. Banking regulations everywhere are framed in law and have a precise,
determinate institutional existence. Specific powers are granted while others are not.
This has two implications.

First, the effects of regulation are open to empirical verification; there are definite
instruments, means, actions, prescriptions and all of these are subject to tests of any
set of behavioural hypotheses. Research can identify those behaviours that have their
origins in the fact of regulation and cannot be assigned to generalised processes of
market competition.

Second, bank regulation reveals the existence of interests separate and distinct from
the private interests of the firm. As a governance force, regulation is intended to
serve the public interest, particularly the interest of the consumers of the banking
services. Moreover, regulation itself is enforced by an agent of the public interest--the
regulator. This agent does not have a contractual relationship with either the
principals firm or with the banking organisations as an interest distinct from the
principals. For this reason, the relation between the regulator, the firm and its owners
is usually modeled as a political relationship.
8



8

The hypothesis of regulatory capture of industries is widely used in political science and certain
strands of industrial relations theory. It may very well be the case that bank regulators are
substantively subordinated to the banking industry. However, our argument has a different focus. We
are saying that, at a formal institutional level, the regulator is acting as the agent of the public interest
and therefore, with respect to any given bank, is in a super-ordinate position.

13
Given the above, the external forces affecting corporate governance in banks include
not only distinctive market forces but also regulation. The fact of regulation means
that governance in banks must be concerned with not only the interests of owners and
shareholders but with something called the public interest as well. Additionally,
regulation and its agent, the regulator, have a different relationship to the firm than
either the market, bank management or bank owners. This relationship is not limited
to or defined by financial contracts and is not subordinate to but arguably super
ordinate to the firm.

Regulated markets.
Regulation creates constraints on market processes, limiting their nature and scope
and subjects all firms to the threat of administrative action by the regulator. In
standard corporate governance models it is claimed that the market has super
ordinate powers over the firm because it is a staging ground for significant threats to
managerial control (e.g. new entrants to the market, mergers, acquisitions, and take
overs). The market in managerial labour is another staging ground for threats against
managers misbehaviour. The existence of specific controls on mergers, risk taking
and on employees as fiduciaries all limit the disciplinary power of markets.

Of course, the disposition of regulatory power will rarely occur without reference to
and consideration of issues, structures, processes and concerns articulated by both
the market and by individual firms. Nevertheless, it is accepted that the public interest
is supposed to be the overriding consideration in the deliberations of the regulator.
(Visentini, 1997).
At the most general level, regulation is associated with the resolution of market failure
in provision of the public good of financial stability. Whether specific regulations fulfil
this function or not, their existence necessarily alters the parameters of competition
between regulated firms. In other words, the characteristic limitations (restrictions)
imposed are not concerned with market structure per se (e.g. barriers to entry or
market monopoly power) as a means to ensure competition. Instead, the constraints
imposed by bank regulators in many countries attempt the opposite.

Regulators seek to constrain price and other forms of competition. They seek to
restrain new entries, prevent mergers, acquisitions, take overs, and, in general,

14
promote only those mergers and acquisitions that assist in reducing system risk. In
addition, regulations often establish minimum qualifications, require character
references and other evidence of probity for persons considered for management
positions within a bank.

Hence, following up on the claim of Visentini (1997) that the banking and financial
markets take on the characteristics of administered markets (p. 175), one could
argue that regulations are intended to restore a welfare rather than a competitive
equilibrium.

Regulation as representing the public interest.
In the conventional view of the firm found in financial management theory, attention is
mainly focused on identifying what we will characterise as those interests internal to
the organisation. These include such things as the maximisation of wealth as the
principals primary (if only) interest. To fulfil that interest the agent has a well-specified
objective function: the maximisation of shareholder wealth. The manager is expected
to act and take decisions on behalf of the owners interest. The implication is that any
system or method of corporate governance ought to take as their objective
safeguarding the interests of the principal, which means maximising shareholder
wealth.

However, as we have seen, in the banking firm, there exists another interest--that of
the regulator acting as an agent for the public interest. This interest exists outside of
the organisation and is not necessarily associated, in an immediate and direct way, to
maximisation of bank profits. The mere existence of this outside interest will have a
profound effect on the construction of interests internal to the firm. Thus, because the
public interest plays a crucial role in banking, pursuit of interests internal to the firm
requires individual banks to attend to interests external to the firm. This implies a
wider range of potential conflict of interests than is found in a non-bank corporation

In bank corporations, the agent should respond not only to the owners interest, but
also to the public interest expressed by regulation through administrative rules, codes,
ordinances, and even financial prescriptions. In order to assure and to protect the
public interest, regulation imposes a form of external governance on the agent. Thus,

15
the agent is monitored by the regulator, to prevent misconduct. If the manager does
not act in conformance with the regulations, he or she can be disciplined through extra
market administrative action including the possibility of being excluded from
employment in the sector altogether.

The above implies that the banks manager must function in light of two distinct sets of
interests. One is the private interests internal to the firm; the other is the interests
external to the firm. From the perspective of governance, the agent will seek to
ensure that behaviour beneficial to the firms interest does not compromise the public
interest.

Sharing the banks risk.
A centrepiece in analyses of the agency problem is the proposition that the owners
interest may be affected by the self-regarding actions of the agent. In banks, the main
action the principal delegates to the agent are lending decisions. The owner or
owners is or are thought to bear the risks taken. This fact, together with the
delegation of the firms management to a second party, creates the rationale of the
so-called agency problem. Thus, as the contingent claimant on the organisation
resources, shareholders bear any business risk that the firm faces in its everyday of
operations.

It is often assumed that on average owners/investors are risk averse. (Fabozzi,
Modigliani and Ferri, 1994) Thus, investors seek to minimise risk for a given level of
return. Therefore, one of the main objectives of corporate governance is taken to be
the creation of decision structures which prevent the agent from engaging in activities
which expose the investor to a higher level of risk than that desired by the
shareholders. Therefore, proper governance is deemed to require systems that
prevent this problem, such that the agent finds it difficult to take higher risks than
desired by owners.

In banks, the framework of action, motivation and behaviour is quite different.
Because current banking regulation is concerned first and foremost with the existence
of systemic risk, regulation applies those policy instruments deemed effective in
limiting systemic risk. Of those instruments, the lender of last resort and systems of

16
deposit insurance are the ones deemed to be the best means to prevent contagion,
bank runs and other threats to system integrity. From a governance perspective,
however, the presence of these policy instruments dramatically changes the
relationship between the agent and the principal in banks and the conceptual
framework required to understand it.

First of all, these standard policies of system risk limitation imply that bank owners are
in a risk sharing relationship with an external authority. The business risk, that in
ordinary firms would be borne totally by the shareholders, is now only partially
assumed by them.

Of course, in ordinary firms, creditors and other commercial entities take some risk
with any firm they do business with. However, because the firm called a bank is in a
risk sharing relationship, it is possible that it is willing to assume much higher levels of
risk than unregulated firms. Indeed and perversely, excessive risk taking in lending is
the most rational course of action by bank firms precisely because it is, in a sense, a
one way bet. If the risk taken leads to a very high return, the bank pockets excess
profits. If the risks taken result in a bankruptcy that is perceived to be threat to the
system, the owners are bailed out. It has been documented in the bank literature of
various countries that some banks are too big too fail and regardless of the risky
lending behaviour engaged in, they are inevitably bailed out because not to do so
would threaten the banking system. (Miskin, 1992; Vittas, 1992; Goodhart, Harmann,
Llewellyn, Rojas-Suarez and Weisbrod, 1998)

In principle, there appears to be no upper limit to the risk the regulator is willing to
bear, the question that arises from a governance perspective is would investors
(principals) in banks have an incentive to encourage excessive risk taking by their
agents? Banking regulations normally include some attention to risk taking by bank
managers. However, they usually do not impose such limits on owners. Therefore, if
the shareholders are able to engage in riskier behaviour than considered desirable by
the regulator, governance in banking might need to focus on the owner rather than the
manager.


17
The view that bank owners may be more problematic for the regulator than the
managers may seem arguable. However, we argue that regulation, in addition to
establishing risk sharing between the government and the owners, also and at the
same time gives them additional freedom of action. This is because regulation limits
competition and therefore owners are protected against the discipline of the market.
In contrast, the agent may actually have less freedom than managers of other types of
firms since they are often directly scrutinised by the regulator.

To summarise our argument thus far, we are saying that a theory of corporate
governance in banking requires consideration of the following issues:
Regulation as an external governance force separate and distinct from the
market
Regulation of the market itself as a distinct and separate dimension of
decision making within banks
Regulation as constituting the presence of an additional interest external to and
separate from the firms interest
Regulation as constituting an external party that is in a risk sharing relationship
with the individual bank firm

Theories of corporate governance in banking which ignores regulation will
misunderstand the agency problems specific to banks. This may lead to
prescriptions that amplify rather than reduce risk. In other words, if one accepts that
regulation affects the banking sector in an important way, one must also accept the
fact that this has important implications for the structure and dynamics of the principal
agent relationship in banks. Moreover, if the structure and dynamics of the principal-
agent relationship are different, we cannot assume that the lessons derived by
Agency Theory research on non-regulated firms are relevant or useful. Certainly, they
cannot be applied in a mechanical way.

Section 3. The Governance Gap in Bank Regulation
In this section we explore in greater detail how governance at the firm level is in a
dynamic feedback relation with regulation at the system level. In our view, a
governance gap has been created by the deregulation of financial systems without
considering their implications for the management of banks. Episodes of difficulty in

18
the banking sector correlate strongly with the reforms and evidence an increase in
systemic risk. The reason for increased systematic risk is that liberalisation lifts
important constraints on the allocation decisions of bank managers and leaves to the
collective decisions of the market the price or level of interest rate to be charged.
Absent robust structures of corporate governance in bank firms, existing regulations
make it difficult to prevent rational owners from taking excessive risks with depositors
money.

The extent of the banking problems emerging in the wake of the financial reforms has
differed from place to place: In some cases it has affected the entire national banking
system, in others it has been restricted to the major banks only.
9

In Japan, the worlds
second largest economy, serious trouble in the banking sector continues without much
respite after nearly six years of concerted government efforts. More recent
manifestations of structural weaknesses are found in Asia and Southeast Asia. South
Korea and Indonesia have experienced profound and destabilising shocks to the
entire array of economic and political institutions.
10


Because of the pervasive importance of the banking system to the operations of
national economies, these failures have attracted a great deal of attention from policy
makers and public policy researchers. Of specific concern to them are the fiscal
consequences of lender of last resort interventions. Thus, the fiscal cost to the
Mexican government for rescuing commercial banks is estimated to have now
reached $100 bns or 20% of GDP; in Japans case, it is thought that the cost to the
government has now reached $300 bns.
11


The OECD (1995) has classified the purposes of regulatory policies into three main
categories:

9

There is a degree of judgement in these classifications. However, following Sundarajan and Balino
(1991), crisis refers to cases of runs, other substantial portfolio shifts, collapses of financial firms
requiring general government intervention. They classify evidence of generalised weakness of the
banking system as a significant problem.

10

Rojas-Suarez (997) has pointed out that the Latin American region offers numerous examples of
deficiencies in regulatory and supervisory procedures that, she argues, causes the newly liberalised
financial institutions to operate under a system of distorted incentives.

11

The Economist, November 6th-12th 1999.


19
To meet government objectives on resources allocation
To provide instruments of monetary control
To correct market failures
12


The past decades reform of financial systems involved the elimination of most
regulations in the first two categories. Having liberalised credit allocation and
eliminated ceilings on the rate of interest, regulators turned their attention to the issue
of market failure. (Caprio, Atiyas, and Hanson, 1994)
13

The issue of market failure is
linked to systemic risk and the monitoring of the behaviour of financial intermediaries,
especially banks. According to the OECD, systemic risk refers to potential threats to
stability of the financial system as a whole arising from risk taking by individual
financial actors. (1995, p. 11) The discussions of these issues are mainly concerned
with the protection of the consumers of banking services.

However, from a governance perspective, management of systemic risk involves
three main types of policy instruments including:
Prudential supervision such as minimum capital standards
14

Lender of last resort and deposit insurance
Policies that limit competition

We discuss each of these in turn, focusing on issues related to bank governance
issues.

Prudential Supervision
The deregulation of credit allocation implied the need for regulatory expertise in
assessing the overall risk exposure of individual banks. However, as the crises
revealed, the regulators often lacked the expertise required for prudential supervision
of risky lending practices. The near universal adoption of the Basle capital adequacy
framework reflected an official consensus as to the minimum of owners capital that
ought to be at risk in lending. Losses from risky lending practices were to have been

12

This refers to market failure seen to arise from very rapid internationalisation and increased
competition between financial institutions. (Swary and Topf 1992)

13
In some developing countries, privatisation was a matter of transferring the ownership of public
assets rather than to improve banking performance through market forces. (Reyes 1994)
14

The most relevant international event in this regard was the so-called Basle Agreement on the
measurement of bank capital and agreement to minimum thresholds. (1988)

20
absorbed by additional owners capital. However, because of the agency problems
discussed earlier (strong information asymmetries between the regulator, the bank
and the weaker commitment of investors) owners were able to shift costs onto
regulators and few banks increased the capital asset ratio in line with the riskiness of
their lending decisions.

Lender of Last Resort and Deposit Insurance
The lender of last resort is an important regulatory power normally assigned to the
Central Bank. Deposit insurance is often compulsory and is under the control of either
the Central Bank or a non-governmental regulatory institution. Both the lender of last
resort and deposit insurance are intended to function as the joint and several means
available to the regulator to prevent runs and to manage severe liquidity problems.

It is widely recognised that however effective these instruments may be in fulfilling their
stated purpose, they present certain characteristic problems. We are arguing that
these characteristic problems are intimately connected to the quality of corporate
governance in banking.

In the case of the lender of last resort function, the danger is the possibility regulators
may confuse generalised liquidity problems with an insolvency problem provoked by
weak financial controls at the firm level or deficient overall corporate governance in
the banks that make up the banking industry in the country. This seems to have been
the case in Finland, (1991-1992), Norway (1988-1992), Sweden (1991-1993).

The failures to prevent and then carefully identify the origins of the crisis have meant
that the costs of the crisis have been shifted arbitrarily to the public purse. In the case
of Sweden, for example, the fiscal cost was over 3 percent of the GDP (OECD,
1995). In Venezuela (1994) the cost of restructuring the banking system was 13
percent of the GDP (Hausman and Rojas-Suarez, 1996) and in Mexico is expected
that the fiscal cost of rescuing the commercial banks could be around 20 percent of
the GDP (Lopez, 1999).

It is also well understood that there are hazards associated with deposit insurance. Its
existence reduces the incentive for both bank management and depositors to attend

21
to the overall risk exposure created by lending decisions. The perverse results of
deposit insurance schemes are evidenced by, for example, the costs of public rescue
operations in the US; these are estimated at 3.2% of GDP for the period 1980-1992.

Restrictions on competition
Restriction on competition is accomplished through regulations directed at new
entrants to the sector and regulations which limit the behaviour of existing members of
the sector, including constraints on mergers, acquisitions and take overs.

Regulation of ownership has several purposes: To prevent the creation of structural
sources of hazard, such as, lenders and borrowers being controlled by a common
owner or corporate group; To prevent excessive market concentration and other
sources of conflict of interest between the financial sector and the rest of the
economy. Restriction on ownership may or may not be associated with economy
wide antitrust regulation. Whatever its form or source, it is must be accepted that
limitations on ownership constitute intervention in the operations of markets that
Agency Theory assumes are available to discipline managers.

Policy instruments devoted mainly to systemic risk impose a certain degree of
restrictiveness on market forces. Therefore, one of the most important aspects of the
effectiveness of the standard framework of regulation is the creation of barriers to
competition in the banking sector. This has far reaching consequences for
governance in banks, especially for the agency problem within banks.

However, up to now, financial deregulation has concentrated more on the ability of
banks to conduct business at market clearing prices than on the nature of the market
itself. We argue that from a governance perspective, this constitutes a strong gap in
control. On the one hand, banks can conduct business at market clearing prices, and,
on the other hand, they do not face the discipline of a competitive market.
Additionally, regulators do not appear to realise that corporate governance in banks
as an endogenous source of systemic risk.

The most important evidence for this argument lies in two often overlooked features of
many of the commercial banks implicated in recent crises--the owners of the banks

22
were often its top managers and accounting information on non performing loans was
limited or non-existent. This may help to explain why systemic crises were triggered
in countries as different as Sweden and Mexico. The common factor appears to have
been a governance gap created when the banks were deregulated without attention
to the need to craft new governance structures suitable to the new conditions.

Concluding Comments
We have argued that financial regulations have structural consequences at two levels:
on the sector as a whole and on the individual firms that compose the sector. In other
words, regulation creates a unique type of firm whose specific characteristics have
only recently begun to attract the attention of financial management scholars. (Freixas
and Rochet, 1997)

Because regulation imposes constraints on market forces and because the regulator
acts on behalf of the public to share risk with the owners, corporate governance of
banks must be seen to be different from that of the average or typical firm. Thus, in
banks, it is to be expected that (I) the problem of governance will be more complex (ii)
the relationship between the agent and the principal is unique in being mediated by
an external force and (iii) the owners may be considered as the single most important
source of moral hazard. Therefore, in general, we argue that a conceptual framework
for corporate governance needs to include (as a management control issue) the
extent to which operating practices in banks amplify systemic risk and generate
crises and to analyse the ability of the new rules of the regulation game to contain
them.

The views of Fama (1980) on differences in the commitment of owners and
managers to the firm as an organised entity are relevant at this point. Fama argues
that the corporate form and developed financial markets makes owners less
committed to a specific firm than its managers will be. Fama writes:

"...the risk bearers in the modern corporation also have markets for their
services--capital markets--which allow them to shift among teams with
relatively low transaction costs and to hedge against the failing of any given
team by diversifying their holdings across teams." (p. 137)


23
Thus, investment capital is likely to be more mobile than the managers of a firm.
Fama (1980) writes:

"If there is a part of the team that has a special interest in its (the firm's)
viability, it is not obviously the risk bearers". (p. 137)

If one accepts this as valid in general terms, the implications for banks is that the
commitment of investors in banks may be even weaker than that found in other firms.
This is because the owners of banks share risk with the regulator. Thus, bank owners
have less incentive to monitor excessive risk; indeed, they have an incentive to take
risks greater than those deemed prudent by the regulator. The governance gap
created by deregulation places them in the unique position of sharing the costs of risk
but not the profits earned in taking it.
Indeed, if any owner has a directive or executive power in the bank, such a bank might
be even riskier than other banks since they would be in the position to override the
stronger commitment of the managers to the continued existence of the organisation
as such. Indeed, the fact of the regulation of the banking labour market may be
expected to reinforce the commitment of the manager making it higher in banks than
in other firms. However, if corporate governance proposals to align the interests of
the principal and the agent result in actions (e.g. profit related bonuses, stock options
and so forth) which make the bank manager a bearer of risk as well, her or his
superior commitment to the firm called a bank could be reduced thereby increasing
the moral hazard problems.

Our analysis implies that owner managed banks are potentially the greatest
endogenous source of systemic risk. Such banks are in a position to engage in the
riskiest of actions knowing full well that they may keep the rewards without bearing the
full cost of the risks taken. This may explain why owner managed banks were key
actors in the recent crises in Eastern Europe, Latin America, Southeast Asia and
Asia.

The reforms undertaken in many countries altered the parameters of control in
banking firms in ways that appears to have amplified moral hazard and in certain
cases to have created fertile soil for opportunistic behaviour by both the principal and
the agent. Governance structures that may have been suitable in the prior regulation

24
regimes were evidently an unexpected source of systemic risk in the reformed
regulation regimes.

It is accepted that each country has a specific sort of corporate governance and
diverse methods of corporate control as result of its history, economic and business
culture. (Ciancanelli and Reyes, 1999; Ciancanelli and Scher, 1999; Prowse, 1994)
15

Therefore, it follows that there is not one best type of corporate governance. At the
same time, one can say that all corporations, whatever the particular forces that
constrain their behaviour, act in light of both internal and external rules. The latter
emanate mainly from the legal system, regulation and codes of conduct. (Cadbury,
1998) Of these the government and regulatory bodies are deemed to play a
transcendental role in corporate governance. (Charkham, 1995)

The observed forms of corporate governance of banks emerge in the course of their
operations as entities having to respect the private interest of owners, on the one
hand, and the public interest in the overall stability of the system, on the other hand.
(Visentini, 1997) Thus, if one accepts that the banking regulatory framework is one of
the most important external forces in shaping the behaviour of banks, a theory of
corporate governance needs to address the integration of both internal and external
forces in order to attain an optimal balance of public and private interests. 16






15
In U.K., as result of the Cadbury Committee (1992), corporate governance entered the national
debate regarding the relationship between the public and private interests.
16
In the case of U.K. checks and balances upon the power of the CEO have been legislated following
up on the recommendations of the Cadbury Committee, an independent investigator into the issues
set up by the national government.

25
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