What You Need to Know About Corporate Governance for Your Financial Institution

Nicholas J Price
Corporate governance evolved out of the need for a system of checks and balances between owners and managers of corporations. The structure of corporate governance extends to the board directors, managers, shareholders and other stakeholders, and defines their relationships with one another. Corporate governance principles outline how a corporation sets its goals, how they attain their goals, and set some benchmarks for how to monitor the strategic planning process.

The financial crisis of 2008 brought to light many questions about whether the corporate governance practices that have been evolving since the 1930s are appropriate for the banking and financial industries.

Two Key Elements of Corporate Governance

Best practices for corporate governance principles outline the existence and roles of all parties within the corporation. Primarily, corporate governance practices focus on the owners who want to see the maximum profits, and the managers, many of which place their potential for earning incentives a bit ahead of their desire to fulfill the plans and decisions of the boards of directors.

Inarguably, two key elements form the basis for corporate governance. First, corporations have long-term relationships between owners and managers. Our recent history in the corporate world showed us that managers are often misguided in their motivations. As such, many of them have a history of creative communication so that their actions appear genuine. The first of the two key elements is that there need to be checks and balances to prevent managers from serving their own interests ahead of those of shareholders.

Second, corporations must openly disclose their financial reports and other information, making it public to regulatory authorities and shareholders.

The financial crisis created an industry-wide aura of suspicion and mistrust of managers and the way they get compensated.

Post-Financial Crisis Scrutiny of Corporate Governance Practices and Board Oversight

The scandals of major corporations left experts throughout the industry scratching their heads and wondering, 'Where did it all go wrong?' and 'Why didn't we see it coming?'

The government was fairly quick with attempts to rectify the situation to protect shareholders with passage of the Sarbanes-Oxley Act. Regulations and requirements for banks and other financial institutions tightened up severely after the financial crisis, causing big changes to how regulatory bodies require banks and financial institutions to operate.

The crisis was so unexpected and so unprecedented that it quickly became clear that our economy can't function without an accountable, trustworthy financial system.

The downfall of major corporations made us realize that the financial industry operates under that same corporate governance principles as non-financial institutions and that perhaps this was a misstep. The crisis also reminded us that our financial corporations need to be innovative and safe.

Corporate Governance for Financial Institutions Is Different

The design of corporate governance was intended to be one-size-fits-all for corporations, so that everyone plays by the same rules. New conversations are trending in the financial sector about how traditional corporate governance principles and practices don't work well for financial institutions because they are uniquely different from other types of corporations. Banks have to pay more attention to risk than other types of corporations.

People's risk profiles are as different as the people you meet. Some have a preference for aggressive risk in financial investing and others prefer to invest in safer, slower-growth funds. Banks and other financial institutions have a higher responsibility to reduce risk for their shareowners, which means they can't invest as aggressively as their non-financial corporate peers.

How Do We Define a Strong Financial Institution?

Many reports have surfaced since 2008 that attempt to define what a strong financial institution looks like and how it operates. The Federal Reserve Bank of New York issued a report in 2012 that details the components of a strong financial system:
  1. It assists the movement of goods and services
  2. It supervises and disciplines borrowers
  3. It identifies viable investments
  4. It manages risk and uncertainty
  5. It aggregates society's savings for investment
The report makes another crucial point. Banks and financial institutions are private sector firms, but they impact the public interest and the economy at large, which makes them intrinsically different than non-financial corporations.

Factors That Shape Financial Corporations

Three main factors shape banks and other financial corporations. First, they have to comply with a framework of laws and taxes. Second, their leadership consists of internal governing roles like risk officers and board directors. Finally, the external governing factors are financial regulatory bodies, legislators and market participants.

The three forces don't bear equal weight, and they are not aligned with the same risk profile or outcome.

These factors place more pressure on boards of directors than ever before. The financial crisis also placed stronger pressure on boards of directors of non-financial corporations, but not as heavily as boards of banks and financial institutions.

Changing Expectations for Board Directors of Financial Institutions

Another striking revelation that came out during the aftermath of the 2008 crisis was the scrutiny over boards of directors of financial institutions. Regulators continue to put pressure on board directors to guide their financial institutions toward prudent behavior that truly reflects the best interests of their shareholders and protects them. Regulatory bodies have made some changes that require stronger monitoring and oversight by boards.

It's not unexpected or unrealistic for regulatory bodies to hold those expectations, although, in reality, boards of directors only have a fiduciary duty to their shareholders, which puts them on equal footing with the fiduciary duties of non-financial corporations. Boards of directors are not required to take the interests of other stakeholders into account, but they are feeling pressure from regulatory bodies to do so anyway.

The real and expected pressures from the fallout of the crisis are causing boards of directors to put in much more time than they have in the past. One of the new ideas that industry experts are talking about is whether board directorships of financial institutions should be full-time positions and compensated as such.

The Future of Corporate Governance for Banks and Financial Institutions

The research reports and white papers that have come out since 2008 bring up many valid points about whether corporate governance works for financial corporations as it has evolved to its current state. These reports are creating more questions than answers.

Do financial institutions need a different corporate governance structure than other corporations? If so, what would that look like? What should the main components of it be? How is it the same or different from traditional corporate governance rules?

What's certain is that something needs to change. There's a fair chance that the industry will create a new corporate governance structure for banks and financial institutions that will be uniquely different than anything that we've seen before. It also stands to reason that a new structure will evolve as it stands the test of time and experience.

The only other certainty is that banks and financial institutions will need to be a visible force that offers strong and careful input as the financial world progresses.
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Nicholas J. Price
Nicholas J. Price is a former Manager at Diligent. He has worked extensively in the governance space, particularly on the key governance technologies that can support leadership with the visibility, data and operating capabilities for more effective decision-making.