Vol 2 (2005) - Issue 4

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Corporate Governance Challenges Affecting Financial Stability

In the wake of recent corporate scandals and the restructuring attempts of countries throughout the world to rebuild their economies from recent financial crises, much international attention has been given to understanding the causes and dynamics of financial crises. Yet there is an increasing recognition around the globe of the critical importance of good corporate governance frameworks in safeguarding financial stability. The present paper contributes to that debate by describing the role of corporate governance arrangements in encouraging sound risk management practices and in enhancing the financial system so as to be able to resist financial disturbances. Initially, the paper summarizes the corporate governance challenges that affect financial stability, such as connected lending, quality and adequacy of accounting rules, and the role of gatekeepers. Subsequently, it sets out the deficiencies in corporate governance arrangements in the banking and financial sector that also contribute to financial instability. Finally, the paper elaborates on the main ingredients for effective corporate governance in the financial sector. The ultimate objective of the paper is to note the destabilizing impact of weak corporate governance structures on the soundness of the financial system and place corporate governance improvements as building components in the restructuring process of an economy.

Introduction

Concerns about banking crises have increased significantly in recent years with several authors stressing that the frequency and the size of financial crashes during the last quarter-century is unprecedented and have been estimated to be much worse than was experienced prior to 1950. While there is an extensive literature outlining the main factors that can cause financial instability, there is little reference to the corporate governance-related reasons that contribute to financial instability among these financial institutions. The aim of the present paper is to highlight these corporate governance challenges and draw the attention of policy makers to the destabilizing effects of weak corporate governance structures in financial institutions, mainly focusing on the banking sector.
Before analyzing in more depth the issue of the corporate governance challenges in financial stability and explaining our theoretical argument that financial instability may derive from poor corporate governance within financial institutions, it is important to touch upon the importance of banking and financial institutions and highlight their special nature and complexity. The starting point is that banks are crucial to a country’s economy, since they are regarded as the intermediaries of the financial system, placed right in its heart, and therefore their sound operation is a central determinant of the stability of the financial system as a whole. Hence financial institutions must operate in a prudent, fixed and transparent fashion in order to minimize the possibility of failures and systemic risks.
Significantly, financial and credit institutions are not like other ordinary firms: they have special attributes, which considerably intensify the conventional view of corporate governance problems. The unique problems and risks that financial and credit institutions pose are centered on their capital structure; their opaqueness; the existence of the deposit insurance scheme and the lender of last resort; the fact that they operate in a regulated market; and other loyalty problems, like fraud and self-dealing practices. The aforementioned elements constitute the basic attributes for credit and financial institutions to be viewed differently from other corporate entities. In this context, there are additional financial risks associated with the unique importance and operation of banks, like contagion and financial instability, that any banking-oriented corporate governance framework should deal with.