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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Development of emerging countries is often enabled through non-conventional finance. Indeed, the prohibition of interest and some other impediments require understanding conventional finance and Islamic finance, which both seek to be ethical and socially responsible. Thus, comparing and understanding the features of Islamic banking and conventional banking, in a globalized economy, is fundamental.
This book explains the features of both conventional and Islamic banking within the current international context. It also provides a comparative view of banking governance, performance and risk-taking of both finance systems.
It will be of particular use to practitioners and researchers, as well as to organizations and companies who are interested in conventional and Islamic banking.
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Seitenzahl: 395
Veröffentlichungsjahr: 2016
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Table of Contents
Cover
Title
Copyright
Preface
Introduction
PART 1: From Corporate Governance to Banking Governance
1 Corporate Governance: A Brief Literature Review
1.1. The features of corporate governance
1.2. Fundamental theories of corporate governance
1.3. Corporate governance and ethics
1.4. Corporate governance and psychological biases
2 Banking Governance
2.1. Banking
2.2. Central banks
2.3. Special features of banks
2.4. Special features of banking governance
3 Islamic Banking Governance
3.1. Specific products of Islamic banking
3.2. Financial transactions of Islamic banks with the bank’s participation
3.3. Financial transactions of Islamic banks without the bank’s participation
3.4. Overview of Islamic banking
3.5. The Islamic development bank
3.6. Features of Islamic banking governance
4 Mechanisms of Corporate Governance, Banking Governance and Islamic Banking Governance
4.1. Mechanisms of corporate governance
4.2. Mechanisms of banking governance
4.3. Mechanisms of Islamic banking governance
PART 2: Banking Performance
5 Performance Measurement
5.1. Performance measurement: definitions
5.2. Performance measurement tools
6 Corporate Governance and Performance
6.1. Ownership structure and performance
6.2. Board structure and performance
6.3. Incentive pay and performance
6.4. Legal protection and performance
6.5. Audit committee and performance
PART 3: Bank Risk-Taking
7 Banking Governance and Performance
7.1 Board composition in banking
7.2. Ownership structure
7.3. Incentive pay
7.4. Regulation and supervision
7.5. BCBS
8 Banking Risk Analysis
8.1. Risk exposure for conventional banks
8.2. Risk exposure for Islamic banks
9 Banking Risk Management
9.1. Traditional risk management techniques
9.2. International risk management tools
9.3. Market risk management
9.4. Credit risk management
9.5. Management of operational risk
9.6. Board responsibilities in risk management
9.7. Manager responsibilities in risk management
9.8. Islamic banking risk management
10 Corporate Governance and Risk-Taking
10.1. Board of supervisors and risk-taking
10.2. Regulation: supervision and risk-taking
10.3. Ownership and risk-taking
10.4. Audit committee and risk-taking
10.5. Incentive pay and risk-taking
Conclusion
Bibliography
Glossary
Index
End User License Agreement
List of Tables
2 Banking Governance
Table 2.1.
Largest 30 conventional banks [SNL 15]
Table 2.2.
Comparative analysis between U.S. and EU resolution regimes
Table 3.1.
Principles of the most common Islamic financial products
Table 3.2.
Differences following Levy [LEV 12]
3 Islamic Banking Governance
Table 3.3.
Theoretical Islamic bank balance sheet based on maturity profile
Table 3.4.
Theoretical Islamic bank balance sheet based on functionality
Table 3.5.
Principles of balance sheet: conventional versus Islamic bank [KOP 08]
4 Mechanisms of Corporate Governance, Banking Governance and Islamic Banking Governance
Table 4.1.
Structure of an Islamic bank’s balance sheet under the FAS and IFRS standards
5 Performance Measurement
Table 5.1.
The relationship between cash flow based performance measures (source: [PLE 12])
List of Illustrations
1 Corporate Governance: A Brief Literature Review
Figure 1.1.
The agency model
Figure 1.2.
The stewardship model
Figure 1.3.
The stakeholder model [DON 95]
3 Islamic Banking Governance
Figure 3.1.
Total Sukuk issuance (Source: S&P [2015])
Figure 3.2.
Geographical distribution of issuance in 2014 (source: S&P 2015). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
Figure 3.3.
International participation banking assets (source: Central banks, EY analysis [EY 16]). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
Figure 3.4.
Regional market contributions (source: Central banks, EY analysis [EY 16]). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
Figure 3.5.
Participation industry footprint (source: EY analysis [EY 16]). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
Figure 3.6.
Quantitative development landscape (source: Thomson Reuters, 2016). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
Figure 3.7.
Market share changes (source: EY analysis [EY 16])
Figure 3.8.
Asset growth (source: EY analysis [EY 16]). For a color version of this figure, see www.iste.co.uk/benbouheni/banking.zip
4 Mechanisms of Corporate Governance, Banking Governance and Islamic Banking Governance
Figure 4.1.
Organizational chart of a typical corporation (source: [BER 14])
Figure 4.2.
Corporate governance structure: conventional banks versus Islamic banks (source [GRA 06])
5 Performance Measurement
Figure 5.1.
Profitability and shareholders’ equity in focus:
Figure 5.2.
ROE of Islamic banks from 2009 to 2014 [BAN 15]
Figure 5.3.
Annual asset growth rates (AAGR) from 2009 to 2014 (source: [BAN 15])
Figure 5.4.
ROA of Islamic banks from 2009 to 2014 (source: [BAN 15])
8 Banking Risk Analysis
Figure 8.1.
Risks are identified and often mitigated (source: [EY 16])
9 Banking Risk Management
Figure 9.1.
The “three-pillar” approach (source: [HEF 05])
10 Corporate Governance and Risk-Taking
Figure 10.1.
Islamic banks and regulations (source: EY analysis [EY 16])
Landmarks
Cover
Table of Contents
Begin Reading
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Series EditorChantal Ammi
Banking Governance, Performance and Risk-Taking
Conventional Banks Vs Islamic Banks
Faten Ben Bouheni
Chantal Ammi
Aldo Levy
First published 2016 in Great Britain and the United States by ISTE Ltd and John Wiley & Sons, Inc.
Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licenses issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned address:
ISTE Ltd
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John Wiley & Sons, Inc.
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© ISTE Ltd 2016
The rights of Faten Ben Bouheni, Chantal Ammi and Aldo Levy to be identified as the authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
Library of Congress Control Number: 2016944314
British Library Cataloguing-in-Publication Data
A CIP record for this book is available from the British Library
ISBN 978-1-78630-082-9
Preface
The global financial crisis and sovereign debt have a close relationship with the governance, performance and risk taking of banks. Therefore, to reduce financial turmoil, mechanisms of banking governance must be reviewed in order to increase performance and reduce risk-taking.
In this book, we review and compare banking corporate governance, performance and risk-taking by conventional banks and Islamic banks. We note that Islamic banks may use the same governance mechanisms as a conventional bank in addition to the Shariah Supervisory Boards (SSB), the Shariah review unit, the Islamic International Rating Agency (IIRA) and the Islamic Financial Services Board (IFSB) as the main mechanisms of monitoring the Islamic banking system. However, unlike conventional systems, Islamic banking is based on the active participation of public policy institutions, regulatory and supervisory authorities and Shariah authorities, which ensures consistency with Islamic law (Shariah) principles and guided by Islamic economics. It is worth recalling that banking governance affects performance and risk-taking. Therefore, performance measurement is an assessment of an organization’s performance, including the measures of productivity, effectiveness, quality and timeliness. Hence, traditional methods (e.g. ratio analysis, income statement analysis, market value added, cash flow statement, variance analysis, standard costing, etc.) and modern methods, mainly economic value added, are bestowed.
Performance is the outcome of many interlinking factors where corporate governance is the only one possible element within the whole set of performance drivers. Good banking governance has long been considered a crucial role for stakeholders in the business environment. Moreover, risk-taking has been widely debated in the financial literature. Further to financial scandals, managerial risk-taking has been specifically emphasized. Indeed, it is worth pointing out the different banking risk exposure – market risk, liquidity risk, credit risk and operational risk. We conclude that all banks are exposed to the same risks. In addition, Islamic banks are exposed to Shariah risk or operational risk, which is related to the structure and functioning of Shariah boards at the institutional and systemic level. Regarding risk management, many tools are used to reduce risk-taking (e.g. asset–liability management, financial derivatives, Basle principles, risk adjusted return on capital, market value at risk (VAR), Monte Carlo method, beta method, minimizing credit risk, assessing the default risk and the credit VAR). For operational risk management, quantitative and qualitative methods are proposed. Moreover, the IFSB has issued many guiding principles and technical note for the Islamic financial services industry in order to reduce risk-taking.
We conclude that there are similar determinants of performance and risk-taking for both conventional banks and Islamic banks. This similarity is due to the fact that all banks operate in the same institutional environment, they are exposed to same risks – except operational issues generated by Shariah SupervisionBoards (SSB) – and they use the same tools in managing their assets and liabilities. However, there are significant differences between conventional and Islamic banks governance because the latter provide Shariah compliant finance and have Shariah Supervision Boards (SSB) as a key feature of their banking governance.
Faten BEN BOUHENIChantal AMMIAldo LEVYJune 2016
Introduction
International scandals and recent financial and economic crises, especially the European sovereign debt crisis, have led to renewed interest in corporate governance, in particular banking governance. As such, in recent years banking governance has become one of the most debated subjects [BEN 10, BEN 13a]. As a fundamental economic concept, corporate governance has come to the attention of media and of academics [BEN 15, LEV 15]. Corporate governance is a set of mechanisms that affect how a corporation is operated. It deals with goals and welfare of all the stakeholders, including shareholders, management, board of directors and the economy as a whole. Adams et al. [ADA 10] argue that the firm is confronted by a myriad of governance-related problems and that its governance structure emerges as its best response to those problems. Hence, given the heterogeneity of governance issues faced by firms, it is unlikely that a unique governance policy is in the best interest.
In contrast to the failures in the conventional banking sector, Islamic banks did not announce substantial write-offs during the financial crisis but have been rather resilient [CHA 09, CHA 10, GRE 10]. While conventional banks have faced significant difficulties, Islamic banks seem to have fared better during the global financial crisis [MOL 15]. We must note that Islamic finance represents only 1% of global finance [LEV 16].
In this book, we review the theoretical and empirical research of banking corporate governance and its main mechanisms, especially in comparative banking governance between conventional banks and Islamic banks, and thus present the different tools used in banking performance and risk-taking. We highlight banks because they are the engine of the economy and their bankruptcy disrupts the whole economic system. These strong externalities on the economy make the corporate governance of banks a fundamental issue. Well-governed banks will be more efficient in their functions than those governed poorly [LEV 04].
Seeing the phenomenal growth of Islamic finance and the supply of Islamic financial products and services around the world by many banks, including well-known institutions, may be crucial to understand the features of Islamic banking and Islamic banking governance. Not only the good governance of banks is important; the question arises as to whether they are different from other corporations. Banks appear with new questions to the corporate governance problem due to their specific characteristics and their regulated condition.
Recently, Mollah and Zaman [MOL 15] examined whether Shariah supervision helps Islamic banks perform better and create shareholder value during the period 2005–2011. In particular, they focused on exploring the effect of (1) Shariah boards, (2) board structure and (3) CEO power on the performance of Islamic banks vis-à-vis conventional banks. Their analysis of bank performance and governance shows that boards of Islamic banks are more independent compared with their conventional counterparts and that conventional banks recruit more internal CEOs than Islamic banks. The small boards in Islamic banks and Shariah boards seem to be profit driven, but independent directors are associated with a decline in the performance of Islamic banks. They find different results between Islamic and conventional banks. Therefore, they conclude that the “multilayer” corporate governance model instituted in Islamic banks helps them to perform better than conventional banks, but this is due to inbuilt Shariah mechanisms in Islamic banking. Despite concerns about their independence and limited monitoring ability, they find that Shariah boards play a significant role in protecting shareholder interest and affect the performance of Islamic banks. They also find that board structure and CEO power are also an important influence on the performance of Islamic banks.
Our reflection can be briefly summarized around the following questions:
1) why has corporate governance become more important?
2) what is special about the banking governance of Islamic banks?
3) what are the different measures of banking performance?
4) what is the impact of banking governance on performance?
5) how can we analyze and manage banking risks?
6) what is the impact of banking governance on risk-taking?
Corporate governance relates to the manner in which the business of the bank is governed, including setting corporate objectives and the bank’s risk profile, aligning corporate activities and behaviors with the expectation that the management will operate in a safe and sound manner, running day-to-day operations within an established risk profile, while protecting the interests of depositors and other stakeholders. It is defined by a set of relationships between the bank’s management, its board, its shareholders and other stakeholders1. La Porta et al. [LA 00] pointed out that corporate governance has an important influence on the development of financial markets and corporate values, and that, as a whole, financial markets are developed in order to protect the rights of investors. They find that firms in countries that provided better protection to shareholders, on average, had a higher Tobin’s Q. However, Johnson et al. [JON 00] indicate that corporate governance mechanisms could explain the depreciation of the currency and the extent of the decline in the stock market more than macroeconomic factors during the Asian financial crisis. They also found that those countries that provided better protection to minority shareholders suffered less severely than those that only provided weak protection to minority shareholders during the Asian financial crisis. Claessens et al. [CLA 02], using a sample of nine countries in Asia, showed that corporate value would be greater in firms with higher cash flow rights held by controlling shareholders.
Mitton [MIT 02], by using the five countries, the most affected by the Asian financial crisis as his sample (Indonesia, South Korea, Malaysia, the Philippines and Thailand), noted that firms with better corporate governance had smaller declines in their stock prices during the financial crisis. The major findings of Mitton [MIT 02] also state that the stock price would perform better when the firm had a higher quality of information disclosure or a greater concentration of external shareholdings, where a higher quality of information disclosure meant that the firm had an American depositary receipts offering, or that its financial statements had been audited by a Big-Six accounting firm. Mitton [MIT 02] also find that the decline in the stock price was smaller for firms whose activities were concentrated than for diversified firms. In addition, Lemmon and Lins [LEM 03] indicate that the stock price decline during a financial crisis was greater when a firm’s controlling shareholders had greater control rights and smaller cash flow rights. Joh [JOH 00] indicates that corporate profitability would be lower if the firm had lower ownership concentration, or if there was a high disparity between control rights and ownership rights, which suggests that corporate governance impacts accounting performance.
Using data for a sample of South Korean firms during the Asian financial crisis, Baek et al. [BAE 04] find that corporate governance had an influence on the decline of stock prices. They indicated that the decline in a firm’s stock price during a financial crisis was smaller when that firm’s unaffiliated foreign investors accounted for a larger shareholding within the firm or a better quality of information disclosure, and that the decline in the stock price during this period was larger when the controlling family in the firm had a larger shareholding or when the voting rights of the controlling shareholders were greater than their cash flow rights. Moreover, Klapper and Love [KLA 04] pointed out that better corporate governance helps improve operating performance and raises the firm’s market value, and so corporate governance is more valuable when the minority shareholders are not protected enough by the legal environment.
Beltratti and Stulz [BEL 12] and Fahlenbrach and Stulz [FAH 11] analyze the influence of corporate governance on bank performance during the credit crisis: by analyzing the influence of CEO incentives and share ownership on bank performance Fahlenbrach and Stulz [FAH 11] find no evidence for a better performance of banks in which the incentives provided by the CEO’s pay package are stronger. In fact, their evidence points to banks providing stronger incentives to CEOs performing worse in the crisis. A possible explanation for this finding is that CEOs may have focused on the interests of shareholders in the build-up to the crisis and took actions that they believed the market would welcome. However, these actions were costly to their banks and their shareholders when the results turned out to be poor. Moreover, their results indicate that bank CEOs did not reduce their stock holdings in anticipation of the crisis and CEOs did not hedge their holdings. Hence, their results suggest that bank CEOs did not anticipate the crisis and thus the resulting poor performance of the banks as they suffered huge losses themselves. Beltratti and Stulz [BEL 12] investigated the relationship between corporate governance and bank performance during the credit crisis in an international sample of 98 banks. Most importantly, they find that banks with more shareholder-friendly boards as measured by the “corporate governance quotient” obtained from Risk Metrics performed worse during the crisis, which indicates that the generally shared understanding of “good governance” does not necessarily have to be in the best interest of shareholders. They argue that “banks that were pushed by their boards to maximize shareholder wealth before the crisis took risks that were understood to create shareholder wealth, but were costly ex-post because of outcomes that were not expected when the risks were taken”.
Moreover, Erkens et al. [ERK 10] investigated the relationship between corporate governance and performance of financial firms during the credit crisis of 2007/2008 using an international sample of 296 financial firms from 30 countries. Consistent with Beltratti and Stulz [BEL 12], they find that firms with more independent boards and higher institutional ownership experienced worse stock returns during the crisis. They argue that firms with higher institutional ownership took more risks prior to the crisis, which resulted in larger shareholder losses during the crisis period. Moreover, firms with more independent boards raised more equity capital during the crisis, which led to a wealth transfer from existing shareholders to debt holders. Minton et al. [MIN 10] investigated how risk-taking and U.S. banks’ performance in the crisis relate to board independence and financial expertise of the board. Their results show that the financial expertise of the board is positively related to risk taking and bank performance before the crisis but is negatively related to bank performance in the crisis. Finally, Cornett et al. [COR 11] investigate the relation between various corporate governance mechanisms and bank performance in the crisis in a sample of approximately 300 publicly traded U.S. banks. In contrast to Erkens et al. [ERK 10], Beltratti and Stulz [BEL 12] and Fahlenbrach and Stulz [FAH 11], they find better corporate governance, for example a more independent board, a higher pay-for-performance sensitivity and an increase in insider ownership to be positively related to the banks’ crisis performance.
This book is organized as follows:
–
Part 1: From Corporate Governance to Banking Governance
: in this part, we review the academic literature trying to understand the special features of the corporate governance, the banking governance and the Islamic banking governance, and the different mechanisms of corporate governance;
–
Part 2: Banking Performance
: this part is divided into three chapters, the first chapter deals with the different performance measurement tools, which vary among traditional and modern methods, the second chapter is about the relationship between corporate governance and performance and the third chapter presents banking governance and performance;
–
Part 3: Banking Risk-Taking
: this part is divided into three chapters; in the first two chapters, the banking risk analysis and management are discussed, and in the last chapter, we expose the relationship between corporate governance and risk taking by banks.
1
See, for instance, [VAN 08].
PART 1From Corporate Governance to Banking Governance
In this first part we review the academic literature in trying to understand the special features of the corporate governance, the banking governance and the Islamic banking governance and the different mechanisms of corporate governance. We touch on research points of many characteristics, such as nature of activities, regulation, supervision, capital structure, risk and ownership, that would make banks unique and thereby influence their corporate governance.
This part is composed of four sections. Section 1.1 broadly defines corporate governance and their features. Section 1.2 explains the special characteristics of banks and banking governance. Section 1.3. deals with Islamic banking governance and their singularity compared to conventional banks. Section 1.4 focuses on the different mechanisms of corporate governance, banking governance and Islamic banking governance.
1Corporate Governance: A Brief Literature Review
1.1. The features of corporate governance
1.1.1. Definitions of corporate governance
Corporate governance in the academic literature seems to have been first used by Eells [EEL 60] to denote “the structure and functioning of the corporate polity”. The most quoted definition of corporate governance is the one given by Shleifer and Vishny [SHL 97]: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. Corporate governance deals with the agency problem: the separation of management and finance, the fundamental question of corporate governance is how to assure financiers that they get a return on their financial investment”.
In their survey, Shleifer and Vishny [SHL 97] account for different governance models, especially those of the United States, UK, Germany and Japan. They conclude that the United States and the United Kingdom have a governance system characterized by a strong legal protection of investors and a lack of large investors, except when ownership is concentrated temporarily during the takeover process. However, in continental Europe as well as in Japan, the system is characterized by a weak legal protection of minorities and the presence of large investors.
According to Braendle and Kostyuk [BRA 07], the term “corporate governance” is susceptible to both narrow and broad definitions, related to the two perspectives of shareholder and stakeholder orientation. It therefore revolves around the debate on whether management should run the corporation solely in the interests of shareholders (shareholder perspective) or whether it should take account of other constituencies (stakeholder perspective).
Narrowly defined corporate governance concerns the relationships between corporate managers, the board of directors and shareholders, but it might as well encompass the relationship of the corporation to stakeholders and society. More broadly defined, corporate governance can encompass the combination of laws, regulations, listing rules and practices that enable the corporation to attract capital, perform efficiently, generate profit and meet both, legal obligations and general societal expectations.
Lipton and Lorsch [LIP 92] give a definition in favor of a shareholder perspective as follows: the approach of corporate governance that social, moral and political questions are proper concerns of corporate governance is fundamentally misconceived. If we expand corporate governance to encompass society, as a whole it benefits neither corporations nor society, because management is ill-equipped to deal with questions of general public interest.
Hess [HES 96] mentioned that “corporate governance is the process of control and administration of the company’s capital and human resources in the interest of the owners of a company”. In the same sense, Sternberg [STE 98] considered that “corporate governance describes ways of ensuring that corporate actions, assets and agents are directed at achieving the corporate objectives established by the corporation’s shareholders”.
The OECD1 principles of corporate governance (2004, 20152) tried to give a very broad definition, as it should serve as a basis for all OECD countries:
“Corporate governance defines a set of relationships between a company’s management, its board, its shareholders and other stakeholders”. An even broader definition is to define a governance system as “the complex set of constraints that shape the ex post bargaining over the quasi rents generated by the firm” [ZIN 98].
This definition focuses on the division of claims and can be somewhat expanded to define corporate governance as “the complex set of constraints that determine the quasi-rents (profits) generated by the firm in the course of relationships and shape the ex-post bargaining over them”. This definition refers to both the determination of value added by firms and the allocation of it among stakeholders that have relationships with the firm. It can be referred to a set of rules and principles, as well as to institutions.
Du Plessis et al. [DU 05] define corporate governance as: “The process of controlling management and of balancing the interests of all internal stakeholders and other parties (external stakeholders, governments and local communities, etc.) who can be affected by the corporation’s conduct in order to ensure responsible behavior by corporations and to achieve the maximum level of efficiency and profitability for a corporation”. Under a definition more specific to corporate governance, the focus would be on how outside investors protect themselves against expropriation by the insiders (large investors). This would include minorities’ protection and the strength of creditor rights, as reflected in collateral and bankruptcy laws, and their enforcement. It could also include such issues as requirements on the composition and the rights of the executive directors and the ability to pursue class-action suits [CLA 12].
Although there are a myriad of definitions on corporate governance and they vary between narrow and broad perspectives, governance may be defined as a set of internal and external mechanisms working together to obtain an efficient and an optimal alignment of all parties’ interests, and getting a win–win relationship. In a subjective conception of the term corporate governance, “banking governance is defined as a set of internal and external mechanisms, which aims optimal harmonization between shareholders, directors and stakeholders. It is based on the safe cooperation between management and control in order to obtain a win–win relationship in which interests are aligned and goals are achieved”.
1.1.2. Nature of the agency problem
The problem of corporate governance is rooted in the Berle–Means [BER 32] paradigm of the separation of shareholders’ ownership and management’s control in the modern corporation. The agency problem occurs when the principal (shareholders) lacks the necessary power or information to monitor and control the agent (managers) and when the compensation of the principal and the agent is not aligned. The separation of ownership and control results in information asymmetry, thus potentially leading to two types of agency problems: (1) one agency problem is between outside investors and managers (“principal-agent” agency problem) and (2) the other one is between controlling shareholders and minority shareholders (“principal–principal” agency problem) [JEN 76]. Moreover, La Porta et al.’s [LA 99] research of corporate governance patterns in 27 countries concludes that “the principal agency problem in large corporations around the world is that of restricting expropriation of minority shareholders by the controlling shareholders”.
Shleifer and Veshny [SHL 97] consider that contracts between financiers and manager are the source of the first agency problem because they lead to management discretion. Then, the existence of large investors, which causes expropriation of minorities, is the second source of the agency problem. Hence, to mitigate the conflict between all the parties (managers and shareholders, large and minority shareholders), the literature offers several solutions, such as monitoring by the board of directors, incentive contracts and protection of minorities.
1.1.3. Origins of the agency problem
1.1.3.1. Contracts
The substratum of the agency problem is the separation of management and finance, or ownership and control. A manager raises funds from investors either to put them to productive use or to cash out his holdings in the firm. The financiers need the manager’s specialized human capital to generate returns on their funds [SHL 97].
As Hart [HAR 89] observes, every business organization, including the corporation, “represents nothing more than a particular ‘standard form’ contract”. The very justification for having different types of business organizations is to permit investors, entrepreneurs and other participants in the corporate enterprise to select the organizational design they prefer from a menu of standard-form contracts.
So there is a contract signed between owners (financiers) and managers that specifies what the manager does with the funds, and how the returns are divided between him and the financiers. The problem is that the manager is motivated to raise as much funds as he can, and so tries hard to accommodate the financiers by developing a complete contract. And the manager and the financier have to allocate residual control rights not fully foreseen by the contract [GRO 86, HAR 90].
The effect of this is that managers end up with significant control rights (discretion) over how to allocate investors’ funds. To begin, they can expropriate them, which Shleifer and Vishny [SHI 97] refer to as management discretion.
A vast amount of literature explains how managers use their effective control rights to pursue projects that benefit them rather than investors3. Grossman and Hart [GRO 88] describe these benefits as the private benefits of control.
Moreover, managers can expropriate shareholders by entrenching themselves and staying on the job even if they are no longer competent or qualified to run the firm [SHL 89]. As argued in [JEN 83], poor managers who resist being replaced might be the costliest manifestation of the agency problem.
1.1.3.2. Large investors
When control rights are concentrated in the hands of a small number of investors, this can lead to the expropriation of minorities. In their survey, Shleifer and Vishny [SHL 97] discussed the forms of concentrating ownership, and how they address the agency problem. Hence, they subdivided large investors as follows:
– Large shareholders:
Their control rights give them the power to put pressure on the management, or in some cases to oust the management through a proxy fight or a takeover [SHL 86b].
In the United States, large share holdings, and especially majority ownership, are relatively uncommon probably because of legal restrictions on high ownership and exercise of control by banks, mutual funds, insurance companies and other institutions [ROE 94]. Even in the United States, however, ownership is not completely dispersed, and concentrated holdings by families and wealthy investors are more common than is often believed4.
In Germany, large commercial banks often control over a quarter of the votes in major companies through proxy voting arrangements, and also have smaller but significant cash stakes as direct shareholders or creditors5. In addition, one study estimates that about 80% of the large German companies have an over 25% non-bank large shareholder [GOR 98]. In smaller German companies, the principle is family control through majority ownership or pyramids, in which the owner controls 51% of a company, which in turn controls 51% of its subsidiaries and so on [FRA 94]. In France, cross-ownership and the so-called core investors are common [OEC 95].
In Britain and the United States, two of the countries where large shareholders are less common, a particular mechanism for consolidating ownership has emerged, namely the hostile takeover [JEN 83, FRA 90].
– Large creditors:
Like the large shareholders, they have large investments and want to see the returns on their investments materialize. The effectiveness of large creditors, such as the effectiveness of large shareholders, depends on the legal rights they have. In Germany and Japan, the powers of the banks vis-à-vis companies are very significant because banks vote on significant blocks of shares, sit on boards of directors, play a dominant role in lending and operate in a legal environment favorable to creditors. In other countries, especially where procedures for turning control over to the banks are not well established, bank governance is likely to be less effective.
1.1.4. Solutions
1.1.4.1. Incentive contracts
The agency problem arises when contracts are incomplete and managers possess more expertise than shareholders, such that managers typically end up with the residual rights of control, giving them enormous latitude for self-interested behavior. So the better solution is the “incentive contract” to align his interests with those of investors. In this way, incentive contracts can induce the manager to act in investors’ interest without encouraging blackmail [SHL 97].
Incentive contracts can take a variety of forms, including share ownership, stock options or a threat of dismissal if income is low [JEN 76, FAM 80]. The optimal incentive contract is determined by the manager’s risk aversion, the importance of his/her decisions and his/her ability to pay for the cash flow ownership up front6.
1.1.4.2. Monitoring by board of directors
The board of directors is presumed to carry out the monitoring function on behalf of shareholders, because the shareholders themselves would find it difficult to exercise control due to wide dispersion of ownership of common stocks. Therefore, the board’s effectiveness in its monitoring function is determined by its independence, size and composition. The bulk of the literature is empirical, which takes as given the current structure of board governance and studies its impact on firm performance [JOH 98].
However, monitoring by the board of directors is not the best option for minimizing the agency problem, because the agency problem, sometimes, can come from the directors themselves.
Adams [ADA 01] focuses on the conflict between the monitoring and advisory functions of the board of directors: the board’s monitoring role can restrict its ability to extract information from management that is needed for its advisory role. Thus, the model gives insight into the possible benefits of instituting a dual-board system, as in Germany.
The literature has mainly focused on issues relating to board composition, board size and the selection of directors. However, issues relating to the functioning of the board, their dependence from what and from who and how board meetings can be structured to ensure more effective monitoring of management, are equally important. This is a particularly fruitful area for future research.
1.1.4.3. Minority protection
The minority shareholder problem maintains that both the controlling shareholders [SHL 88, GAD 06] and managers [JEN 86, LAN 89, PEA 03] have the power to extract private benefits at the cost of minority shareholders. However, legal regimes, if such exist, may give minority shareholders enough power to extract cash dividends [LA 00].
Corporate and other law gives outside investors, including shareholders, certain powers to protect their investments against expropriation by insiders. For shareholders, these powers range from the right to receive the same per share dividend as the insiders, to the right to vote on important matters, including the election of directors, and to the right to sue the company for damages. The very fact that legal protection exists probably explains why becoming a minority shareholder is a viable investment strategy, as opposed to just being an outright gift of money to strangers who are under few, if any, obligations to give it back [LA 00]. The extent of legal protection of outside investors differs enormously across countries and according to La Porta et al. [LA 98] in common law countries compared to civil law countries, there is better minority protection.
Djankov et al. [DJA 08] discuss and reject two extreme approaches to resolve the principal–principal agency problem. First, they argue that the exclusive reliance on market forces will not solve the problem because, in the absence of regulations, and thus of risks, the temptation for controlling shareholders to engage in opportunistic behavior is too high. Second, because certain related-party transactions, such as propping, may benefit a firm and all its shareholders, governments or regulators cannot legally restrict all of them. Hence, most countries adopt a middle of the road approach, enacting laws that do offer minority shareholders any rights to monitor controlling shareholders and that provide governance mechanisms that restrict private control rights. Accordingly, in countries with better legal protection, investors believe that they are more likely to receive their fair share of their investment’s profits as controlling shareholders are less likely to divert corporate resources away.
1.1.4.4. General actions
Becht et al. [BEC 02] proposed five main ways to mitigate shareholders’ collective action problems:
1) election of a board of directors representing shareholders’ interests, to which the chief executive officer (CEO) is accountable;
2) when the need arises, a takeover or proxy fight launched by a corporate raider who temporarily concentrates voting power (and/or ownership) in his/her hands to resolve a crisis, reach an important decision or remove an inefficient manager;
3) active and continuous monitoring by a large blockholder, who could be a wealthy investor or a financial intermediary, such as a bank, a holding company or a pension fund;
4) alignment of managerial interests with investors through executive compensation contracts;
5) clearly defined fiduciary duties for CEOs and the threat of class-action suits that either blocks corporate decisions that go against investors’ interests, or seek compensation for past actions that have harmed their interests.
They explained that there is potential difficulty with the first three approaches, which is the old problem of who monitors the monitor and the risk of collusion between management (the agent) and the delegated monitor (director, raider, blockholder). It might appear that corporate raiders, who concentrate ownership directly in their hands, are not susceptible to this delegated monitoring problem. This is only partially true since the raiders themselves have to raise funds to finance the takeover. Typically, firms that are taken over through a hostile bid end up being substantially more highly levered. They may have resolved the shareholder collective action problem, but at the cost of significantly increasing the expected cost of financial distress.
1.2. Fundamental theories of corporate governance
1.2.1. Transaction cost theory
Transaction cost theory was first initiated in Coase’s [COA 37] paper and later theoretical described and exposed by Williamson [WIL 96]. Transaction cost theory was an interdisciplinary alliance of law, economics and organizations. This theory attempts to view the firm as an organization comprising people with different views and objectives. The underlying assumption of transaction theory is that firms have become so large they in effect substitute for the market in determining the allocation of resources. In other words, the organization and structure of a firm can determine price and production. The unit of analysis in transaction cost theory is the transaction. Therefore, the combination of people with transaction suggests that transaction cost theory managers are opportunists and arrange firms’ transactions to their interests [WIL 96].
The essential element of transaction costs, that property rights must be protected, is found in most fields of economics and throughout the discipline’s history. Adam Smith, in discussing foreign trade, endowments, corporate ownership structure and non-profit organizations, repeatedly exploits concepts of costly information and the ability of individuals to exploit others’ ignorance to their own advantage [WES 90].
In his study about “the transaction costs”, Allen [ALL 99] mentioned that in macroeconomics the notion of costly information lead to the rational expectations revolution and subsequent real business cycle models based on search and the disincentives found in unemployment insurance programs. Public choice models are founded on the premise that individuals can use the state as a mechanism to transfer wealth to themselves. In game theory, the prisoner’s dilemma and other non-cooperative games are essentially transaction cost problems. And other fields like industrial organization, international trade, development and labor, all contain ideas that hinge on the protection of property rights.
This connection between transaction costs and property rights is summarized in the Coase theorem, which is defined as:
In the absence of transaction costs, the allocation of resources is independent of the distribution of property rights.
There are many attacks and defenses of the Coase theorem, none of which are dealt with here7. The point is that for all property right approaches to transaction costs, the two concepts of property rights and transaction costs are fundamentally interlinked. The neoclassical literature on transaction costs begins in the early 1950s; this literature defines transaction costs more narrowly and models them more explicitly. The definition of transaction costs found in the neoclassical approaches is as follows:
“In general, transaction costs are ubiquitous in market economies and can arise from the transfer of any property right because parties to exchanges must find one another, communicate and exchange information. There may be a necessity to inspect and measure goods to be transferred, draw up contracts, consult with lawyers or other experts and transfer title. Depending upon who provides these services, transaction costs can take one of two forms, inputs or resources – including time – by a buyer and/or a seller or a margin between the buying and selling price of a commodity in a given market” [STA 95].
1.2.2. Agency theory
The phenomena of corporate governance are linked directly to the agency theory, or agency relationships, which focuses on the relationship and goal incongruence between managers and stockholders [JEN 86, JEN 76]. Managers are considered as shareholder agents. There are potential conflicts of interest between the management, ownerships and shareholders due to the delegation of decision-making authority from shareholders to managers. Shareholders and ownerships cannot perfectly and costlessly, monitor the managers, but they are in a position to monitor and acquire the available information possessed by managers otherwise risk information asymmetry.
Agency theory was exposited by Alchian and Demsetz [ALC 72] and further developed by Jensen and Meckling [JEN 76]. Agency theory is defined as “the relationship between the principals, such as shareholders and agents, and the company executives and managers”. In this theory, shareholders, who are the owners or principals of the company, hire agents. Principals delegate the running of business to the directors or managers, who are the shareholder’s agents [CLA 04].
Daily et al. [DAI 03] argued that two factors could influence the prominence of agency theory. First, that the theory is conceptual and simple, reducing the corporation to two participants of managers and shareholders. Second, agency theory suggests that employees or managers in organizations can be self-interested. Agency theory shareholders expect the agents to act and make decisions in the principal’s interest. On the contrary, the agent may not necessarily make decisions in the best interests of the principals. Such a problem was first highlighted by Adam Smith in the 18th Century and subsequently explored by Ross [ROS 73] and the first detailed description of agency theory was presented by Jensen and Meckling [JEN 76]. Indeed, the notion of problems arising from the separation of ownership and control in agency theory has been confirmed by Davis et al. [DAV 97].
In agency theory, the agent may succumb to self-interest, opportunistic behavior and thus fall short of congruence between the aspirations of the principal and the agent’s pursuits. Even the understanding of risk defers in its approach. Although with such setbacks, agency theory was introduced simply as a separation of ownership and control [BHI 08]. Holmstrom and Milgrom [HOL 94] argued that instead of providing fluctuating incentive payments, the agents should only focus on projects that have a high return and have a fixed wage without any incentive component. Although this will provide a fair assessment, it does not eradicate or even minimize corporate misconduct. Here, the positivist approach is used where the agents are controlled by principal-made rules, with the aim of maximizing shareholder value, hence a more individualistic view is applied [CLA 04]. Indeed, agency theory can be employed to explore the relationship between the ownership and management structure.
