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Corporate Governance and Risk Management the Role of Risk

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Corporate Governance and Risk Management the Role of Risk
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  Corporate governance and risk management: The role of riskmanagement and compensation committees Ngoc Bich Tao, Marion Hutchinson ⇑ School of Accountancy, Queensland University of Technology, Australia a r t i c l e i n f o  Article history: Received 24 February 2012Revised 4 February 2013Accepted 6 February 2013Available online 4 April 2013 Keywords: Corporate governanceRisk managementCompensation committeeRisk management committeeFirm performance a b s t r a c t This paper examines the role of compensation and risk committees in managing and mon-itoring the risk behaviour of Australian financial firms in the period leading up to the globalfinancial crisis (2006–2008). This empirical study of 711 observations of financial sectorfirms demonstrates how the coordination of risk management and compensation commit-tees reduces information asymmetry. The study shows that the composition of the risk andcompensation committees is positively associated with risk, which, in turn, is associatedwith firm performance. More importantly, information asymmetry is reduced when adirector is a member of both the risk and compensation committees which moderate thenegative association between risk and firm performance for firms with high risk.   2013 Elsevier Ltd. All rights reserved. 1. Introduction Recent corporate scandals of financial institutions worldwide have raised considerable concern among investors and reg-ulators. Regardless of whether the global financial crisis resulted from excessive risk-taking (Kashyap et al., 2008), or isattributable to the increasing levels of risk faced by firms (Raber, 2003), both views identify risk as the major contributor,and highlight the importance of an appropriate corporate governance structure for managing risk. Consequently, the focusof this paper is on identifying factors associated with monitoringrisk in the Australian financial sector. The financial sector inAustralia is the largest industry sector based on capitalisation. As of June 2011 the 288 companies in the financial sector of Australia have a market capitalisation of AU$455.7 billion. The financial sector consists of trading and investment banks, as-set managers, insurance companies, real estate investment trusts (REIT) and other providers of financial services. In Austra-lia, employers in all sectors are required to contribute to a compulsory employee superannuation scheme. 1 This meansAustralia has the 4th largest pension fund pool in the world, creating enormous opportunities for banks, asset management,financial planning and insurance companies. 2 Consequently, the governance practices of this sector are important to the eco-nomic welfare of Australia. Agency theory suggests that there are divergent risk preferences of risk-neutral (diversified) shareholders and risk-aversemanagers which necessitates monitoring by the board ( Jensen and Meckling, 1976; Subramaniam et al., 2009). Conse- quently, without monitoring, risk-averse managers may reject profitable (but more risky) projects which are attractive toshareholders whoprefer the increased returnfromthe higherlevel of risk. Excessivemanagerial risk-takingis not considered 1815-5669/$ - see front matter    2013 Elsevier Ltd. All rights reserved.http://dx.doi.org/10.1016/j.jcae.2013.03.003 ⇑ Corresponding author. Address: Queensland University of Technology, School of Accountancy, P.O. Box 2434, Brisbane, Australia. Tel.: +61 7 3138 2739;fax: +61 7 3138 1812. E-mail address:  m.hutchinson@qut.edu.au (M. Hutchinson). 1 Employers are required by law to pay an additional amount based on a proportion of an employee’s salaries and wages (currently 9%) into a complyingsuperannuation fund. 2 http://www.asx.com.au/documents/research/financial_sector_factsheet.pdf .  Journal of Contemporary Accounting & Economics 9 (2013) 83–99 Contents lists available at SciVerse ScienceDirect  Journal of ContemporaryAccounting & Economics journal homepage: www.elsevier.com/locate/jcae  problematic for nonfinancial firms because one firm’s failure will not affect a diversified investor’s portfolio in any direc-tional way. Pathan (2009) suggests that bank shareholders prefer excessive risk due to the moral hazard problem of limitedliability and the associated convex pay-off ( Jensen and Meckling, 1976). 3 However, Gordon (2011) suggests that this may notbe the case in the financial sector. The failure of a systemically important financial firm increases the likelihood that other finan-cial firms will fail due to the cascading effects from the contraction of the financial sector such as occurred in the Global Finan-cial Crisis. Consequently, monitoring excessive risk-taking by management is particularly important in the financial sector. Therisk management committee and the compensation committee are both responsible for monitoring and oversight of firms’ risk-related activities. Thus, a compensation or risk committee that reduces excessive risk-taking and the probability of the failure of a systemically important financial firm will benefit diversified shareholders. This paper investigates the association between the risk management committee (RC) and compensation committee (CC)and the risk and performance level of financial firms. We suggest that certain characteristics of committees (size, composi-tion and function) reflect the committees’ motivation and ability to increase risk-taking that is aligned with shareholders’interests. The paper therefore predicts a positive association between risk and the structure of the RC and CC. Further, wesuggest that firms experiencing increasing levels of risk require a RC and CC that manage and monitor risk to ensure a po-sitive association between risk and performance. The results of the research show that RC and CC characteristics have animportant role in the risk level of the firm. Using a principal components analysis we derive a factor score for the character-istics of the committees and use beta as the measure of risk. 4 This paper also investigates the risk and performance relationship when directors occupy positions on both committees(hereafter,‘‘dual membership’’). The study findsa positiveassociationbetweenrisk andperformance whencommittee mem-bers simultaneously serve on the RC and CC. This result demonstrates lower information asymmetry when directors haveresponsibilities in both committees as they are able to oversee the association between the firm’s risk exposure and the pro-portion of risk-taking incentives in compensation packages. Subsequently, more informed decisions result in a positive asso-ciation between risk and performance. The result persists when controlling for endogeneity.This paper contributes to the literature in several ways. To our knowledge, no other study has empirically tested whetherdirectors’dual-membership on the RCand CC co-ordinates monitoringthe risk level of the firmwith monitoringthe riskinessofcompensationpackages.Literatureondualcommitteemembershipislimitedtotheoryandminimalanalysis(Chandaretal.,2012;HoitashandHoitash,2009;LauxandLaux,2009).Co-ordinationbetweenRCandCCfunctionsreducesinformationasym- metries which affect firm performance. While some research establishes that board committees improve the performance of thefirm(e.g.,Klein,1998),thereislittleresearchintothesecommitteesinAustraliancompanies,andinparticulartheireffecton risk and firm performance. Unlike the US where establishing an audit, nomination and compensation committee is man-dated, there is no mandatory requirement for companies to establish committees in Australian firms (apart from Listing rule12.7). 5 Instead,corporationscanchoosenottocomplywiththerecommendationsaslongastheycanjustifyanynon-compliance.Consequently, Australia provides an interesting setting to explore the costs and benefits of board sub-committees. Further, financial sector firms (banks, diversified financial companies, insurance and real-estate investment trusts) haveexplicitly been excluded from previous research due to the higher level of risk when compared to other firms (Wallace andKreutzfeldt, 1991) which causes generalisability and transferability problems. In that regard the Australian Prudential Reg-ulation Authority (APRA, 2009) has implemented a framework which regulates financial institutions (see Appendix A). Pru- dential Standard APS 510 outlines the skills, knowledge and experience requirements for directors involved in riskmanagement. 6 In recent years, many banks and financial institutions have been widely criticised for paying excessive bonuses to someexecutive directors and senior management at a time when the world is suffering the consequences of a global financial cri-sis, said to be a result of irresponsible risk-taking by financial institutions (Pathan, 2009). This study contributes to the lit-erature as there is a paucity of research on whether the compensation and risk management practices of the financial sectorare associated with the level of risk and related return. Given that the adoption of RC and CC by Australian companies is vol-untary, it is not surprising that the influence of these committees has not been fully explored.The paper proceeds as follows. In Section 2 we review the relevant literature and present a number of hypotheses. Sec-tion 3 describes the research methodology and Section 4 provides the results of the analysis. The final section provides asummary and conclusion. 2. Background and hypothesis development Financial firms have become large, complex organisations involving significant delegation of decision-making and risk-taking responsibility. Consequently, it is difficult to design internal systems that ensure delegated decision-makingoutcomes align principal and agent’s divergent goals (Devis, 1999). Although information asymmetries can be found in all 3 Pathan (2009) also suggests that poor bank governance is more catastrophic than non-bank firms as bank failure has more significant costs. 4 We exclude committee size from the principal components analysis as research finds inconclusive results on the effects of board or committee size. 5 Listing rule 12.7 requires companies included in the All Ordinaries Index to have an audit committee, whereas companies in the top 300 of the index arerequired to have their audit committee constituted in terms of recommendations provided by the ASX CGC. These recommendations are on the composition,operation and responsibilities of the audit committee. 6 ‘‘ . . .  the requirement for directors, collectively, to have the necessary skills, knowledge and experience to understand the risks of regulated institution, including itslegal and prudential obligations, and to ensure that the regulated institution is managed in an appropriate way taking into account these risks ’’ (APS 510: 3). 84  N.B. Tao, M. Hutchinson/Journal of Contemporary Accounting & Economics 9 (2013) 83–99  sectors, Andres and Vallelado (2008) suggest that information asymmetries in the financial sector may be stronger due tobusiness complexity and the idiosyncratic nature of the sector. For example, information asymmetry in the banking industryis due to complex transactions including, the difficulty in determining the quality of loans, opaque financial engineering,complicated financial statements, investment risk is easily modified, or perquisites are easier for managers to obtain (Levine,2004). Within a framework of limited competition, intense regulation, and higher informational asymmetries the board be-comes a key mechanism to monitor managers’ behaviour and to give advice on risk management, strategy identification andimplementation (Andres and Vallelado, 2008).According to agency theory, the board of directors is considered a vital element of corporate governance based on thepremise that the characteristics of the board members determines the board’s ability to monitor and control managers, pro-vide information and counsel to managers, monitor compliance with applicable laws and regulations, and link the corpora-tion to the external environment (Carter et al., 2010). Subsequently the majority of the existing literature focuses oninvestigating the board’s characteristics such as its composition and size.However, John and Senbet (1998) argue that a boards’ internal administrative structure is of more importance in measur-ing a boards’ efficacy. The board of directors delegates some of its authority to specific committees which are responsible fora particular area in which the committee members specialise. In Australia, the ASX CGC has set guidelines concerning riskmanagement practices within Australian publicly listed companies, laying the responsibility with boards of directors (ASXCGC, 2007). In particular, these guidelines recommend that corporations establish a compensation committee (CC) and a riskmanagement committee (RC) as a means of improving corporate governance, and in particular, risk management.Board sub-committees are established to assist the board perform its role, particularly with increased responsibilities andpressures placed on the board. Compensation and risk committees are important corporate governance mechanisms thatprotect shareholders’ interests by providing independent oversight of various board activities (Harrison, 1987). Harrison (1987) suggests that a board sub-committee enables directors to devote attention to specific areas of responsibilities, bringslegitimacy and accountability to corporations and also improves directors’ participation in board and committee meetings.Research also suggests that separate committees have more influence over corporate performance (Klein, 1998), corporatestrategy (Vance, 1983) and reducing agency problems (Davidson et al., 1998) than the entire board. Consequently, commit- tees are important in firms where agency costs are high, for example, high risk, leverage, complexity and large size. Further-more, agency theory suggests that characteristics such as its independence and an independent chairperson are potentialfactors influencing committee effectiveness (Bradbury, 1990; Carson, 2002).  2.1. Risk monitoring in the financial sector: the risk and compensation committee The risk management committee monitors the level of risk the firm is exposed to while keeping in mind the desire tomaximise returns. The RC advises the board on the firm’s management of the current risk exposure and future risk strategy(Walker, 2009). The compensation committee oversees remuneration practices which are designed to attract and retainemployees. Remuneration practices are also designed to provide incentives for risk adverse managers to assume the levelof risk that risk neutral shareholders would tolerate. A major challenge for firm risk management is designing compensationcontracts which motivate managers to act in accordance with the risk preferences of shareholders while maintaining anappropriate level of risk for the firm (Murphy, 2000).According to signalling theory (Certo, 2003) organisations disclose good corporate governance practices, such as commit-tee formation, to create a favourable image in the market. This, in turn, minimises any potential firm devaluation by inves-tors or maximises the potential for firm value enhancement. However, Menon and Williams (1994) argue that in many casescommittees may be formed to promote the appearance of good corporate governance without serving any useful purpose forthe organisation. Consequently, it is the competence (not merely the existence) of the committees which is critical to thesuccess of the firm (Akhigbe and Martin, 2006). Committee directors’ specific knowledge of the complexity of the financialsector enables them to monitor and advise on their area of responsibility.Factors determining the governance efficacy of the compensation, risk and audit committees are similar as they are mon-itoring committees of the board. This research examines the governance efficacy of the RC and CC based on four character-istics which were identified by Xie et al. (2003) as contributing to audit committee effectiveness. 7 First, to fulfil theirmonitoring role, the committees need to be independent of company management. The ASX CGC recommends that the com-pensation committee should consist of a majority of independent directors (ASX CGC, 2007, p. 35). This recommendation re-flects an agency theory perspective that independent directors are more representatives of shareholders and therefore bettercontribute to the provision of independent monitoring of management (Fama and Jensen, 1983; Jensen and Meckling, 1976;Pincus et al., 1989). Second, the RC and CC need to contain members with expertise in business. Monitoring by the RC and CC requires that thecommittee members contribute sufficient expertise, judgement and professional scepticism to the monitoring process(Raber, 2003). A further measure of expertise maybe the length of service (tenure).We suggestthat directors’ability to mon-itor risk is related to length of service on the board or in the financial industry. Third, the RC and CC should meet oftenenough to ensure that relevant issues are considered in a timely and effective manner. Committees are extensions of theboard of directors; consequently, directors frequently lack time to carry out their duties (Lipton and Lorsch, 1992). More 7 Similar to the audit committee, the RC and CC are monitoring committees which specifically handle agency issues (Xie et al., 2003). N.B. Tao, M. Hutchinson/Journal of Contemporary Accounting & Economics 9 (2013) 83–99  85  frequent meetings allow potential problems to be identified, discussed and avoided. Therefore, frequent meetings are likelyto result in better monitoring of risk. Finally, the size of the compensation and risk committees may arguably have an impacton their monitoring function.Risk or compensation committee monitoring (measured by committee size, independence, experience and activity) is ex-pected to reduce managers’ risk adverse behaviour. Pathan (2009) suggests that strong board monitoring is positively asso-ciated with bank risk-taking based on the view that bank shareholders have incentives for more risk and finds that smallbank boards are positively associated with more risk-taking. Governance variables (board independence and shareholderprotection) are negatively associated with risk, suggesting that more stringent monitoring reduces bank risk-taking.As the role of the RC is to monitor firm risk levels we expect that an effective RC, as determined by the composition of theRC, will be associated with maintaining risk levels commensurate with the firm’s risk appetite. In other words, we do notexpect a positive association between RC composition and firm risk. In contrast, agency theory infers that the role of theCC is to design compensation contracts that induce risk-averse managers to undertake all risky projects that are represen-tative of shareholders’ interests. Consequently, there will be a positive association between CC characteristics and firm riskbecause research suggests that shareholders prefer more risk ( Jensen and Meckling, 1976; Pathan, 2009). However, this doesnot suggest that shareholders prefer ‘‘excessive’’ risk; this is discussed in the following sections. The preceding discussionleads to the following hypothesis: H 1a .  The composition of the compensation committee is positively associated with the risk level of financial firms. H 1b .  The composition of the risk committee is negatively associated with the risk level of financial firms.  2.2. Directors’ dual membership on the RC and CC  While Bradbury (1990: 22) argues that audit committees reduce information asymmetry between insiders and outsidersof the firm, Reeb and Upadhyay (2010) suggest that separating directors into specialised committees can create informationasymmetries among directors. Similar to the costs of organisational decentralisation, forming board sub-committees canlead to suboptimal decisions by the board as committee members focus on their particular area of responsibility insteadof focusing on the overall goal of board decisions. Consequently, the costs of board sub-committees are co-ordination andcommunication problems. It is posited in this study that a potential solution to this problem is to ensure directors mutualinvolvement in committees that are likely to have some impact on each other. For example, one of the roles of the risk com-mittee is to determine the appropriate level of risk the firm should take while the compensation committee may designremuneration packages with the purpose of increasing managers’ risk-taking. Therefore, it seems apparent that these com-mittees should co-ordinate and communicate when making decisions.Board committees often work independently to achieve their own objectives. However, there are cases where differentcommittees are staffed by a common group of members (Laux and Laux, 2009). In these circumstances, Laux and Laux (2009) suggest an association between the members who serve on both the compensation and audit committee and exec-utives’ pay structure. Specifically, the model developed by Laux and Laux (2009) suggests that separating the functions of theaudit and compensation committee members should lead to a higher proportion of pay-for-performance compensation andsubsequently increases the monitoring role of the audit committee in the financial reporting process. This is because whencompensation committee members also serve on the audit committee, they prefer to reduce CEO incentives to manipulateearnings by loweringincentive pay which in turn leads to lower levels of monitoring. Hoitash and Hoitash (2009) empiricallytest this hypothesis and find a higher degree of dual committee membership is associated with a lower proportion of CEOincentive compensation.Similarly, this study considers the co-ordination of monitoring committees (RC and CC) as important. Agency theory pre-dicts that managers who are compensated based on firm performance are more likely to undertake all positive net presentvalue projects without being overly concerned about the associated risks. If the design of the compensation package has thepotential to reduce self-serving behaviour, then CC efficacy should also mean higher risk. However, certain compensationpolicies may encourage excessive managerial risk-taking rather than investing firm resources in a risk-neutral manner(Miller et al., 2002).Asset pricing theories suggest that no level of risk is excessive for diversified shareholders in non-financial firms becausethe failure of one firm does not adversely affect their diversified portfolio. However, Gordon (2011, p. 5) suggests that share-holders in the financial sector prefer less risk as the failure of a systemically important financial firm will reduce the value of a diversified shareholder’s portfolio from the subsequent increase in the systematic risk-bearing premium. In addition, re-search suggests that instead of looking at risk management from a silo-based perspective, firms that take a holistic viewof risk management will improve firm performance (Gordon et al., 2009). 8 Consequently, communication and co-ordinationbetween the RC and the CC is important for firms in the financial sector and means that directors with multiple committeemembership are likely to act more conservatively to avoid excessive risk-taking and the threat of firm failure. Therefore, when setting the incentive payment policy the compensation committee must consider whether their policyfits within the firm’s risk appetite. Successful monitoring requires communication with members internally and across 8 The holistic view of risk management is referred to as enterprise risk management. 86  N.B. Tao, M. Hutchinson/Journal of Contemporary Accounting & Economics 9 (2013) 83–99
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