Board structure and corporate risk taking in the UK financial sector

https://doi.org/10.1016/j.irfa.2017.02.001Get rights and content

Highlights

  • We examine the relationship between board structure and risk taking in UK financial sector.

  • Our sample includes banks, insurance, real estate and financial services companies.

  • We show how board size, independence and CEO/chairperson duality affect risk taking.

  • We find that presence of independent directors and powerful CEOs reduces firms' risk taking.

  • The findings however, do not show any significant effect of board size on firms' risk taking.

Abstract

This paper examines the relationship between board structure and corporate risk taking in the UK financial sector. We show how the board size, board independence and combining the role of CEO and chairperson in boards may affect corporate risk taking in financial firms. Our sample is based on a panel dataset of all publicly listed firms in the UK financial sector, which includes banks, insurance, real estate and financial services companies over a ten year period (2003  2012). After controlling for the effects of endogeneity through the application of the dynamic panel generalized method of moments estimator, the findings of this study suggest that the presence of non-executive directors and powerful CEOs in corporate boards reduces corporate risk taking practices in financial firms. The negative relationship can be explained within the agency theory context, where managers are regarded as more risk averse because of the reputational and employment risk. An increased power concentration is therefore expected to enhance the risk aversion behaviour of directors. The findings however, do not show any significant effect of board size on corporate risk taking in financial firms. As this study covers recommendations of the UK Corporate Governance Code on the role of corporate boards in managing firms' risk, the empirical evidence could be useful for corporate governance regulation and policy making.

Introduction

The recent financial crisis of 2007–2009 has revealed several weaknesses in corporate governance mechanisms in different countries. The crisis initially started in the financial sector in the US, UK and other developed economies and led to substantial losses in financial institutions worldwide in a few months' time. In response to the severe effects of the crisis, in 2008, the US government interfered to insure more than $700 billion of the financial institutions' assets whereas the UK government announced a £500 billion rescue package (Erkens, Hung, & Matos, 2012). The UK rescue package led the government to bail out many high profile financial institutions, such as; Northern Rock, Bradford and Bingley, Alliance and Leicester, HBOS and Royal Bank of Scotland, among others (Akbar, Rehman, & Ormrod, 2013). For instance, Northern Rock was initially supported by an emergency loan from the Bank of England, and by February 2008 it had gone into state ownership (Hall, 2008).

Internal corporate governance mechanisms are generally responsible for crafting and implementing strategic decisions in most organisations. In the aftermath of the crisis, there has been consensus in the literature with regards to the inadequate performance of the board of directors which has been regarded as one of the main reasons for the crisis (e.g., Andres & Andres and Vallelado, 2008, Boyd et al., 2011, Erkens et al., 2012, Hardwick et al., 2011, Ingley and van der Walt, 2008). The board of directors has also been blamed for not protecting the shareholders' rights and for focusing on the short term rather than the long-term objectives of their organisations (Erkens et al., 2012). Improving the quality of risk management mechanisms and disclosure by firms has therefore remained on the agendas of regulators in different countries. Similarly, Ntim, Lindop, and Thomas (2013) document that stakeholders' and regulators' efforts in relation to improving risk reporting and management practices produced positive impact on the quality of risk disclosure and risk management in their sample organisations.

As the capital structure of financial institutions is characterised by high leverage, their executives are often motivated to take more risk (Smith & Jensen, 2000). Executives in the financial sector were also accused of taking excessive risk which has been regarded as one of the major causes of the financial crisis (Kirkpatrick, 2009). Similarly, due to the asset substitution effect, there is an increased tendency for excessive risk taking in highly leveraged firms (Sepe, 2012). As the debt equity ratio increases, low-risk investments are substituted with high-risk ones which capture all the possible upside potential (Magnan and Markarian, 2011, Sepe, 2012). High remuneration and incentives to managers also intensified the risk taking attitude of executives which contributed to development of the recent financial crisis (Kirkpatrick, 2009).

Consequently, most corporate governance codes around the world emphasise on the importance of the board of directors in managing the risk of firms. In the UK, the Corporate Governance Code (2010) strongly focuses on board of directors and risk when describing good corporate governance. Section (A.1) in the code states that “…the board's role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed” (UK Corporate Governance Code, 2010, p. 9). In addition, more information on firms' risk management practices and their long-term horizon has also been added to the revised UK Corporate Governance Code (2010). The revised code has given consideration to the long term horizon and future success of firms as the main focus of the board of directors, and has mentioned the term long term horizon of firms several times in its content.

Given the importance of the board of directors in firms' operations, examining the relationship between board structure1 and corporate risk taking is an important issue at the present time. In particular, considering the immense importance of the financial sector in the global economy, the relationship between board structure and corporate risk taking practices in this sector requires a detailed investigation. Furthermore, the operating systems and the way revenue is generated in this sector is different, due to which this sector is more exposed to risk than other sectors. In addition, due to several unique characteristics of financial firms, such as; different operating mechanisms (Macey & O'Hara, 2003); the presence of more opaqueness and greater information asymmetry (Andres & Andres and Vallelado, 2008, Caprio and Levine, 2002) and, greater leverage (Nam, 2004), their corporate governance practices are different from firms in the non-financial sector (see also, Srivastav & Hagendorff, 2016). Arun and Turner (2004) also indicate that the role of the board of directors is more complicated and challenging in the financial sector.

Financial institutions have deposits from people and other channels that together with debtholders and shareholders are overseen by the board of directors (Macey and O'Hara, 2003, Prowse, 1997). Thus, the involvement of more parties leads to more complex agency problems than those which are normally observable in non-financial firms (Andres & Andres & Vallelado, 2008). Furthermore, Pathan (2009) argues that because of the important role that financial institutions play in the stability of the economy, the board of directors as a control governance mechanism is more important in the financial sector than the non-financial sectors. It is also evident that due to the credit and financial relationships, failure of one financial institution could lead to several failures in other institutions (Gordon and Muller, 2011, Staikouras et al., 2007). However, despite all this evidence, most of the published research in this area is based on non-financial sectors with only a limited number of papers covering the relationship between board structure and corporate risk taking in financial firms.

This study therefore aims to examine the relationship between corporate board structure and risk taking behaviour in UK financial institutions. In particular, we show how the board size, board independence and combining the role of CEO and chairperson in boards may affect corporate risk taking in financial firms. The focus on these three structural variables is motivated by the mixed and inconclusive evidence on how these variables are related to the corporate outcomes. In this regard, Adams, Hermalin, and Weisbach (2010) argue that the endogenous nature of the board structure variables leads to several problems in the estimation methods which interfere in measuring the actual effect of governance practices. In particular, board size and independence are the main variables that might be endogenously determined in such relationships (Wintoki, Linck, & Netter, 2012). We therefore control for all three types of endogeneity in our study through the application of dynamic panel generalized method of moments estimator. We also consider the important role of the risk committees with respect to the decisions related to risk taking by the board of directors.

We contribute to the literature on board structure and firms' risk management in three different ways. First, to the best of our knowledge, this is the first study in the UK that examines the relationship between board structure and corporate risk taking in the financial sector. Despite the fact that the financial sector is heavily regulated, this sector was severely hit by the recent financial crisis which led to substantial losses which also has long term implications for other sectors. In the UK, a new regulatory framework for the financial sector was introduced on 1 April 2013. In addition, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) were introduced to work hand in hand with the Bank of England to ensure the financial stability of financial institutions. In particular, the Prudential Regulation Authority has introduced a new risk assessment framework, which aims to protect financial institutions from failing. It is therefore likely that close and intense government monitoring will moderate the role of the board of directors in determining corporate risk taking.

Second, prior studies have extensively examined the relationship between board structure and corporate performance (e.g., Coles et al., 2008, Eisenberg et al., 1998, Guest, 2009, Yermack, 1996). However, with regards to corporate risk taking existing evidence is very limited and mainly based on the US data (Cheng, 2008, Kim and Buchanan, 2008, Pathan, 2009). We argue that due to institutional differences and several other differences between the two countries the corporate risk taking behaviour of the board of directors' in the UK financial firms might differ from the US. Furthermore, although the corporate governance structures are similar in both countries, the UK has been characterised as weaker than the US in monitoring and disciplining of company directors. This can provide company directors with opportunities to place their own interests over and above the interests of shareholders that would result in higher agency costs in UK companies. We therefore argue that these differences are important in exploring the role of board composition on corporate risk taking in the UK.

Third, there is evidence in the existing literature which indicates that corporate board structure is endogenously determined and that findings of most published studies are affected by endogeneity (e.g., Hermalin and Weisbach, 1988, Hermalin and Weisbach, 1991, Hermalin and Weisbach, 1998, Hermalin and Weisbach, 2003). This study therefore addresses the endogeneity issue by following Wintoki et al. (2012) and applies the dynamic panel generalized method of moments estimator (system-GMM) as the method of estimation. We argue that traditional estimation methods such as ordinary least squares (OLS) or fixed effects are unable to control the endogeneity problems whereas through the application of system-GMM we control for three types of endogeneity i.e., unobserved heterogeneity, simultaneity and dynamic endogeneity, and present more consistent results. In addition, we test the robustness of our results by considering the effects of the presence of a risk committee in corporate boards in the sample firms. This analysis is based on the assumption that the presence of a risk committee on corporate boards would affect the risk taking behaviour of financial firms.

Using a panel dataset based on FTSE All-Share Index Financial Firms over a ten year period 2003–2012 (2760 firm year observations), this study finds the evidence suggesting that board structure is associated with corporate risk taking in the UK financial sector. A negative and significant relationship is found between the presence of independent non-executive directors on boards and corporate risk taking behaviour. This finding is consistent with the monitoring hypothesis; as limited availability of information to non-executive directors impedes effective assessment of firms' operations relevant for decision-making (Boone et al., 2007, Linck et al., 2008, Raheja, 2005). We show that CEO power (i.e., combining the two positions of CEO and chairperson) lowers firm risk which is consistent with the existing literature in this area (Kim and Buchanan, 2008, Pathan, 2009). This negative relationship can be explained within the agency theory context, where managers are regarded as more risk averse because of the reputational and employment risk (Amihud and Lev, 1981, Eisenhardt, 1989, Jensen and Meckling, 1976). Therefore, with more power concentration, it is expected that it would increase the directors' risk aversion behaviour. We however, did not find any significant relationship between board size and corporate risk-taking in financial firms. The results also show a significant relationship between the presence of risk committees on boards and all the risk measures used in this study. This finding specifies the important role of risk committees, and supports the regulation about the inclusion of risk committees on the boards of financial firms.

The rest of this paper is organized as follows. In section 2 we briefly discuss previous literature and outline the research hypotheses. Section 3 presents details of the data collection process, variable measurements and estimation methods. Section 4 provides details of the empirical results and related discussions. Finally, section 5 concludes this paper by presenting a summary of the overall findings, main contributions and implications of the study. This section also acknowledges the research limitations and outlines avenues for future research.

Section snippets

Literature review and development of hypotheses

Under the framework of the agency relationships it has been argued that due to reputational and employment risks managers are risk averse (Fama, 1980, Jensen and Meckling, 1976). However, managerial incentives, particularly those tied to corporate performance, might encourage managers to take more risk (Baysinger and Hoskisson, 1990, Jensen and Murphy, 1990). Hence, in order to align the interests of managers to those of shareholders different incentives are offered to managers for increasing

Data sample

This study covers all UK public firms in the financial sector listed on FTSE All-Share Index over a ten year period (2003–2012), and includes banks, insurance, real estate, and financial services companies. The start of the period of analysis is inclusive of the 2003 revision of the Combined Code of Corporate Governance which not only addresses most of the aspects from the previous governance codes but also includes a change with respect to the board independence of UK firms. The revised

Results and discussion

Table 2 presents descriptive statistics of the dependent, independent and control variables used in the empirical analysis. The average Z-score (Idiosyncratic Risk) in the UK financial institutions is 0.12 (0.05), the average board size is around 7 directors, whereas the proportion of non-executives on boards is about 70%. In addition, the CEO/Chairperson duality percentage shows a high level of compliance in separating the CEO position from the chairperson where only 5.3% of the sample firms

Conclusion and implications

The board of directors is considered to be the main internal governance mechanism in modern corporations. This study examines the link between board structure and corporate risk taking in the UK financial sector. It is important to note that most of the previously published studies in this area use only banks in their sample (see for example, Pathan, 2009), however, for conducting more robust analyses we include all financial institutions in our sample. The outcome of our analyses shows board

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