Bank Boards - Keep a Seat for the Chief Risk Officer (CRO)

Is the presence of a CRO on the board associated with better bank performance?

I have been thinking of this issue, especially after reading Corporate Governance and Performance around the World: What we Know and What We Don't, by Inessa Love of the World Bank (2011).  I will write more about this survey paper later but one of the key points that I took away was the benefit of establishing a Difference in Difference (DID) approach to assessing the linkage between corporate governance and performance.  

DID is a technique in econometrics that attempts to calculate the effect of a explanatory (or independent) variable upon a response (or dependent) variable by comparing observational study data over time for a treatment group versus the control group, and ntends to eliminate selection bias in a study.  Love posits that a change in laws and regulations may provide an opportunity to consider a causal relationship between corporate governance and performance (as opposed to simple correlation of these variables) using a DID approach, as such changes may impact some firms but not others.

I began thinking about this issue and how it may relate to changing regulation of the banking industry, including Dodd Frank (US) and the Walker Review (UK).  For example, Dodd Frank has specifically required US banks of a certain size ($10bio or more) to establish an independent risk committee of the board, chaired by an independent director.  Such a change may alter traditional, pre-crisis bank governance norms where the CRO's role was subordinated by the CEO, or risk metrics were reported to the board via the audit committee or FD.  More on this issue can be found at:
http://www.bankdirector.com/magazine/archives/4th-quarter-2012/what-s-the-risk/.

I was pleased to then find a paper that investigates this issue empirically for North American banks, entitled Risk Management, Corporate Governance, and Bank Performance in the Financial Crisis by Aebi, Sabato, and Schmid (2011).  The researchers here consider the presence of a CRO on the board (or his/her reporting to the board) upon bank performance for a large sample of North American banks.  Performance metrics considered include buy and hold stock returns, ROA, and ROE metrics before and during the crisis periods (2006 and 2007/8).  

Aebit, Sabato and Schmid do find that banks with a CRO on the board (or reporting directly to the board) exhibit better performance.  They also rightly raise the potential that in certain cases, the assessment and treatment of risk may be a lower priority for some CEOs, versus maximising asset, sales, or short-term profits, what they call "managerial empire building".    

This paper and other research I am doing makes me think banks are different in so many ways from traditional corporate entities, notably in terms of corporate governance.  In effect, managerial empire building may align the CEO with shareholders more so in banks than in traditional corporates, especially when the elephant in the room is the regulator/deposit insurance provider.  But if regulators are to become even more obtrusive, then traditional boardroom dynamics will change from a monitoring role to that of risk assessor.  Are bank boards ready and equipped for this responsibility and complexity?  Are they aligned and incentivised to for this higher standard of behaviour?  Or have they always been been effectively on the hook anyway?

I have also been thinking of how to further exploit regulatory change and evaluate the relationship of bank governance and performance.  One means to do this may be to include non US commercial banks and financial institutions within the sample. Another means would be to evaluate the CRO in the boardroom and the impact to more immediate performance statistics as dependent variables, such as loan loss provisions or paying regulatory fines, a growing source of negative profits for banks these days.

More to come...

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