An investigation into the Impact of Corporate Governance on Financial Performance
This particular study was aimed at investigating the Impact of Corporate Governance on Financial Performance. The study utilized the Case study of Barclays Bank, in order to examining the implications of corporate governance on the financial performance of financial service organizations, especially during the recent financial crisis. The findings of the study revealed that good corporate governance provides a positive influence on the financial performance of organizations, specifically financial service organizations. Recommendations of how good corporate governance can governance influences organizational financial performance were presented one of the most essential was having an effective board of governors . The study concludes that corporate governance can indeed enhance financial performance within the banking sector.
The success of this study has been dependant on the contributions of many people, especially those who spared their time to share their thoughtful criticisms as well as suggestions to improve this study. Special thanks to my supervisor Mrs. Ron Cambridge whose enthusiasm, creativity, constructive guidance, and her commitment to excellence has made this paper work successfully.
This section introduces the concept of corporate and provides a background on the impact of corporate governance on financial performance. It also provides a brief profile of Barclays bank which will be used as a case study for the purpose of this research. The statement of the problem, research objectives, research questions, significance, scope and delimitation of the study.
1.1 Background of the study
Corporate governance has in the recent years gained a great deal of attention due to the increased number of corporate scandals that have led to the collapse of huge corporations such as World.com and Enron. Although a precise conclusion about the definition of corporate governance has not been arrived at, corporate governance can be described as a system through which organizations are controlled and directed. in broder terms, corporate governance means the process by which firms are directed, controlled and held accountable. It encompases authority, direction, stewardship, leadership, accountability and control excersised in organizations. As Smith (2010, p. 3) explains, corporate governance helps in defining a firm and its general environment and political and social environments in which it operates. Corporate governance is linked to organizational financial performance. The way resources are managed and controlled are organized affects an organization’s competitiveness and performance in the long run. It determines the conditions for enhancing investor’s confidence and goodwill and access to capital markets.
In order to ensure that there is no conflict of interest between the various stakeholders, organizations have to establish processes, laws and rules which are to influence the way in which a company is regulated, operated and controlled (Prasad ,2006). Corporate governance entails the relationship that exits between the management of the a firm and the various stakeolhers, as guided by the various rules and regulations as well as organizational goals and objectives. The key players are borad of directors, management and shareholders. Other stakeholder include customers, employees, suppliers, regulators, bankers and other lenders, the environment and the community.
Over the years it has been noted that capitalism and the free market economy created an avenue for many business organizations to expand. Many investors became owners or shareholders and they developed massive enterprises. However governance was a problem in many organizations and many of these companies collapsed. Today many public and private corporations have adopted the representative type of government. The stakeholders of the company select the directors, who take up the role of managing the operations of the organization. The directors, who are collectively referred to as the board of directors then delegate the responsibility of managing the actual operations of the organization to the Chief executive officer (CEO). The role of the CEO is to be accountable to the board of directors and also to the shareholders of the company. This approach of control and direction forms the foundation of corporate governance. To maintain between investors and organizational managers, a very high level of trust must exist between them. As Brownbridge (2007) explains, the borad of directors acts as a conduict between managers and investors.
The foundation of trust among directors, managers and investors is usually built on four major pillars of corporate governance, namely,. accountability, transparency, responsibility and fairness. These pillars form the foundation for six main principles of corporate governance developed by OECD which are recognized globally (Brownbridge, 2007). These principles are:
- Ensuring that an organization has laid out an effective corporate governance framework
- Ensuring that the established corporate governance framework protects the rights of shareholders
- To ensure that all shareholders, irrespective of size of contribution, are treated equitably
- To ensure that all stakeholders (including investors, employees, supplirers, customers and society co-operate in creating wealth and jobs and in enhancing financial stability of a firm
- To ensure that all material matters relating to to a firm’s financial performance, governance and ownership are disclosed accurately and in timely manner
- To ensure that the established corporate governance framework enhances effective guidance of a firm by the board, ensures accountability of the board to shareholders and other stakeholders and allows for effective monitoring of the management of a firm.
Brownbridge (2007) explains that the more widely the above principles are applied, the more efficetively and equitably are resources allocated within an organization. Precisly, the purpose of a corporate governance framework is to encourage efficient use and allocation opf resources and to ensure accountability of stewardship if these resources. Eficient use and allocation of resources is associated with good performance. Thus, the emergence of corporate governance has frequently been perceived as a relevant strategy of salvaging the collapse of businesses. It is however essential to take note of the fact that in despite the existence of corporate governance, organizations have still faced the challenge of poor financial performance and fraudulent financial reporting which has further resulted to their collapse. Thus, improvements in management and control of resources within firms is essential if worldwide efforts to halt corruption and other kinds of malpractices are to achieve the desired results. It is therefore vital for organizations to comply corporate governance principles established by appropriate legal, professional and ethical framework
1.3 Problem Statement
Various studies have shown that there is a strong relationship between corporate governance and firm’s financial performance. Acording to Smith (2010, p. 21), a well functioning corporate governance system enables an organization to generate confidence and goodwill among investors. it is widely highlighted that good governance enables a firm to attract investors and makes it easier for such a firm to raise sufficient capital or funds necessary for astrong performance. Smith (2010, p. 21) highlights that a good governance system steers a firm to become efficient and to realize higher returns to capital. Frederikslust et al (2008, p. 75) argues that such a system helps to improve firm’s wealth, to increase employment orportunities and provides many other benefits to shareholders. Accountability, transparency and probity of financial corporations makes shareholders to accept them as legitimate, responsible, caring and honest wealthcreating organs (Frederikslust et al, 2008, p. 75). This helps to enhance image, reputation and market standing of a corporation. Frederikslust et al (2008, p. 75) also notes that good governance within commercial corporations helps to attract local and foreign investors and customers and to assure them that their funds or investment are well managed and secure. As such, Frederikslust et al (2008, p. 75) points out that good governance among financial corporations helps to attract sufficient funding and hence shield itself from financial distress. Most importantly, such a firm is able to record successful financial performance over time.
Frederikslust et al (2008, p. 75) noted that on the contrary, poor governance in financial corporations makes them vulnerable to financial distress in the future. Precisely, a poor governance system in financial organizations is associated with poor overall performance, non-conducive micro- and macroeconomic crises and risky financial patterns. Such a governance leads to loss of confidence and goodwill among investors which leads to insufficient funding. Thus, Frederikslust et al (2008, p. 75) concludes that good governance is vital to a commercial organization’s financial performance. Other studies have given contrasting results. Gompers et al (as cited in Smith, 2010, p. 28) found that there is no significant relationship between corporate governance and a firm’s financial performance. In a study involving small and midsize enterprises, Eisenberg et al (as cited in Smith, 2010, p. 28) found a negative correlation between firm’s board size and profitability. Mak and Yuanto (as cited in Smith, 2010, p. 28) found similar results to Eisenberg et al in a study in a study of listed firms in Malaysia and Singapore.
Despite the mixed results, corporate governance principles have become much more important recently for all stakeholders of commercial organizations (iluding investors, customers, potential investors workers and governments). As such, corporate governance has been receiving high priority in the agenda of commercial institutions. Despite this, there are limited studies showing clear-cut relationship that exists between corporate governance and financial performance in financial institutions. Thus, the presence of mixed results and lack of adequate literature on the impact of corporate governance on financial performance in financial organizations calls for further research. Therefore, this paper seeks to fill this gap by investigating this issue in the context of Barclays bank.
1.4 Aims/Objectives of the Study
The main aim of this study is to investigate the impact of corporate governance in financial institutions. From this main objective, specific objectives were derived as follows:
- To assess the impact of board size on financial performance of Barclays bank
- To asses the relationship between direstors’ independence on financial performance of Barclays bank
- To establish the relationship between consecutive remuneration and financial performance of Barclays bank
- To establish the impact of audit quality on financial performance of Barclays bank
- To establish the relationship between communication, trust and disclosure and financial performance of Barclays bank
- To determine the influence of CEO duality on financial performance of Barclays bank
- To establish the impact of board committees composition on financial performance of Barclays bank
1.5 Research Quastions
- What is the the effect of borad size on financial performance of Barclays bank?
- How does independence of directors influence financial performance of Barclays bank
- How does directors’ remuneration affect financial performance of Barclays bank?
- What is the impact of audit quality on financial performance of Barclays bank?
- How do communication, trust and disclosure influence financial performance of Barclays bank?
- What is the impact of CEO duality on financial performance of Barclays bank?
- What is the impact of borad commetees composition of financial performance of Barclays bank?
The main purpose of this study is to investigate the impact of corporate governance on financial performance of financial organizations. Although researchers and academicians have found mixed results regarding the relationship between corporate governance and financial performance in various sectors, most of them have stressed that there exists positive relationship between them. The results of this study are particularly useful to corporate leaders, especially in financial institutions, who wish to establish the importance of corporate governance system in financial performance in their organizations. The results are of key importance to Barclays bank as they will be highly applicable in the process of making governance policies and decisions within the firm. Through these results, Barclays leaders will have a better understanding of the impact of their past, current and future governance practices. Thus, the study may steer Barclay’s leaders to improve governance practices in areas with great impact on financial performance of the organization.
Additionally, this study plays a crucial role, in theory and practice, as it endeavors to be part of the contribution the theory of corporate governance. It will enrich the literature review of future studies and researchers will therefore find the study resourceful when covering other areas that were not exploited by this study. The report will act as a source of reference and stimulate interest among academicians and thereby encourage further research on the relationship between corporate governance and financial performance in financial institutions. Finally, this research is important to governments and other authorities who wish to understand the importance of corporate governance in organizations and hence use the findings as basis for strengthening corporate governance frameworks.
This research comprises of five chapters. The first chapter frames the area of interest and also outlines the problem to be investigated. The chaper gives a background of the study, examines the concept of corporate governance, gives a brief profikle of Baclays bank, presents objectives of the study and research questions, explains the significance of the study and highlights limitations of the study. The second chapter reviews existing literature on the impact of corporate governance on financial performance. The third chapter examines the research’s methodological approach the strategies employed for collection of data. The fourth chapter presents the findings of the study in relation to the question raised in the first chapter. Descriptive analysis of both primary and secondary data is conducted in the same chapter. The fifth chapter gives the summary of the research, conclusion and recommendation.
2.0 LITERATURE REVIEW
This chapter reviews past literature related to the topic of study. Precisely, it summarizes literature that has given focus to corporate governance and its impact on financial performance. In order to understand this better, the chaper reviews through of the main threories that form the foundation of corporate governance, namely, agency theory, shareholders theory and stakeholders theory. Finally the section presents a conceptual framework which describes both corporate overnance and financial variables that are going to be adopted in this study.
2.2 Theoretical Review
2.2.1 Agency Theory
Corporate governance is based on Agency theory which explains how best the relationship between principals and agents can be tapped to form governance that can help an organization to realize its goals. Some entrepreneurs accumulate a lot of capital but they do not have enough time or requisite expertise to run their own expertises (Organisation for Economic Co-operation and Development, 2011, p. 261). At the same time, there are managers who have excess of ideas to use that capital effectively. The owners of capital (principals) hand over their enterprises to managers (agents) for control. In this relationship, principals (or shareholders) have a duty to safeguard their investment by selecting and putting in place the most suitable governors (directors) to ensure that effective governance system is implemented. The Agents are then given the responsibility for managing and controlling the enterprise in the most efficient way.
As Organisation for Economic Co-operation and Development (2011, p. 262) explains, all corporations are exposed to agency problems which may ruin their performance if not effectively dealt with. The board of directors’ major role is to develop action plans to develop with these problems in to ensure that the interests of the principals are safeguarded. A corporation’s board of directors is also accountable to non-shareholder stakeholders that have an interest to see that a corporation is well governed such as customers, partners, suppliers, employees and the surrounding community (Organisation for Economic Co-operation and Development, 2011, p. 261). Therefore, the board of directors of Kingfisher PLC is expected to discharge its duties in line with these requirements in order to maximize shareholders’ wealth and to protect the interests of non-shareholder stakeholders.
Coles, et al (2001) argue that without establishing an effective mechanism of monitoring the firm there is an impending risk whereby the management of the firm can maximize their own interests as oppose to the interests of the shareholders. Coles et al (2001) highlight that the agency problem arises when the agents or the management use the authority given to them by the owners shareholders, to maximize their own gains. Brown and Caylor (2006) argue that when the corporate governance of a firm is properly aligned, such a system should be able to satisfy the interests of both parties and in addition improve both the shorter and long-term performance of the organization.
Within the banking sector, the agency problems are quite unusually. Colley, (2005) highlights that; the areas of conflict frequently involve two or more parties concurrently. Shareholders in banks usually invest capital in an equal proportion or more to the amount that is needed by regulators that is about 12%. This requirement usually increases the incentive of the shareholders in order to capitalize their utilities through exploiting the funds of other supplies. Most of the supplies in the banking sector are investors who only posses small portions of investment in the bank, as a result the investors in the banking sector have no adequate power to control and monitor the operations of the owners and the management. In such a scenario corporate control and control by external market fails to control the actions of the owners of the bank and the managers (Colley, 2005).
Empirical date in the research provides a suggestion or implication that the impact of corporate governance on financial performance is usually reflected by the measure of the variables of governance and financial performance (Larcker, et al (2005). For instance in a scenario where the number of board members is small, the directors are independent and the directors and officers have a significant amount of shares in the firm , such firms are usually linked to a higher financial performance . As indicated by the agency theory, core stakeholders of the firm are likely to effectively monitor the actions of every shareholder holder in order to ensure that their wealth is maximized effectively (Larcker, et al (2005).
Stiles and Taylor (1993) highlight that an efficient framework for corporate governance is one can be able to minimize the agency problem and also the agency cost. These two problems are frequently linked to the separation of control and ownership. According to Stiles and Taylor (1993) there are three effective mechanisms that can be used in that the corporate governance system can overcome the agency problem. One of the methods is by encouraging the management to directly align their interests with the interests of the shareholders, for instance the stock options, compensations plans and the monitoring of the boards directly. Another strategy entails strengthening of the rights of the shareholders in order for them to have a greater capability to monitor the management and have greater incentive. Monks and Minow (2004) argue that this particular approach improves the rights held by investors through the use of legal protection. Another strategy is the adoption of indirect methods of corporate control like those provided by the capital markets, the corporate controls market and the managerial labour markets.
2.2.2 Stakeholders Theory
Stakeholder theory is a theory of firm management that addresses morals annd values that should be upheld in managing a firm. It describes the importance of all stakeholders to an orgaization’s success and the need for management to serve their interests. Stakeholder theory recognizes the fact that organizational managers have a fudiciary duty to to put the needs of shareholders or stockholders first and to maximize value for their investments. However, this theory recognizes that other stakeholders of a firm, including employees, customers, suppliers, creditors, governmentbodies, trade unions, trade associations, political bodies and communities, are equally important to an organization.
As Freeman (1984, p. 25) pointed out, organizational stakeholder is “any group or individual who can affect or is affected by the achievement of a firm’s objectives.” Thus, the management should not only be responsive to shareholders, but to all individuals or groups who qualify to as stakeholders. Given that the main objective of corporate governance is to maximize wealth, this implies that all stakeholders are vital to an organization since they play part in enhancing the success. Freeman (1984, p. 26) noted that most debates on corporate governance focus on corporate managers, directors and shareholders as the key players and thus, ignore the importance of other stakeholders. According to Freeman (1984, p. 26), shareholders are often reluctant to exercise all of their rights and responsibilities of ownership especially in lasge public firms but other stakeholders, especially workers, are often aggressive in excersising their rights and responsibilities.
Communities are interested in the governance of financial institutions as key stakeholders as they derive benefits from being customers, employees, lenders and beneficiaries of corporate social responsibilities of these institutions. Employees are interested in the governance of a financial institution as they would like to have an assurance that the institution will sustain itself and hence secure their jobs. Customers are interested in the governance of such institutions since they will have an assurance that their savings are secure and that they are able to access affordable products and services. In the same vein, governments are interested in the governance to get assurance that the public is not exploited by fraudsters and to ensurance that the public will derive value for their investments.
2.2.3 Shareholders Theory
Sharehoder theory is described by two shareholder-oriented governance models: the the finance or the principal-agent model and the myopic market model. The principal-agent or finance model assumes that the principal aim of firms is to maximize wealth. According to the model, the problems of corporate governance arise due to wromg deeds by agents who advance their own interests in a principal-agent relationship. In other words, agency problems occur when agents fail to give regard to the objectives of the principals (Blair, 1995, p. 11). In addition, the separation of control and ownership increases thepowers of agents or managers and gives them leeway to observe their own objectives and to serve their oown interests at the expense of principals or investors. There are two problems that arise in the relationship between agents and principals. First, it is difficult for the principal to verify the actual activities that the agent is doing or to verify that the agent is behaving in the desired, appropriate manner. Secondly, the agent and the principal may have differing perceptions regarding risks and thus, they may prefer different actions (Blair, 1995, p. 12). These problems lead to costs known as ‘agency costs’ which occur as the principles try to make followup to ensure that agents observe their interests. To solve these problems, the principal-agent model proposes that the principal and agent should determine the most efficient contract between themselves that will ensure that agents observe the interests of principals. The principal-agent model insists that market regulators are the most efficient mechanisms and denies their failure. At the same time, this model acknowledges the failure of organizational internal control (Blair, 1995, p. 12).
Like the principal-agent model, the myopic market model acknowledges that corporate managers should always serve the interests of shareholders. However, it criticizes corporate governance due to its competitive myopia (Agumba, 2008, p. 73). According to the model, corporate governance system encourages managers to focus more on short-term returns by sacrificing long-term benefits and competitiveness of a firm. The myopic market view contends that financial markets force managers to focus on short-term gains, which contradicts the key objective of maximizing shareholder’s wealth in the long-term. The model suggests that corporate governance should create a platform in which managers and shareholders share long-term performance horizons. Corporate governance should create an envioronment which increases loyalty and reduces the ease of exit. The model proposes for “a corporate governance framework that encourages ‘relationship investing’ in order to lock financial institutions long-term positions, restrictions on the takeover process and on voting rights for short-term shareholders, and the empowerment of other groups such as employees and suppliers that have long-term relationships with the firm” (Agumba, 2008, p. 73).
2.3 The relationship between corporate governance and financial performance
Brown and Caylor (2009) highlight that a lot of empirical research reveals that there is a significant and positive relationship between the financial performance of a firm and its corporate governance. Apart from this empirical research, surveys have also been undertaken to analyze the existing relationship between the concept of corporate governance and financial performance. The Association of British insurers conducted a study in 2008, with the objective of evaluating the question of whether good corporate governance does improve the financial performance of listed companies. The study involved the examination of 654 companies in a period of three years 2004 and 2007. Brown and Caylor (2009) reveal that the findings of the study were actually positive. The records indicated that companies that had adopted good corporate governance attained returns that were 18% higher that those with poor corporate governance. The findings of the study further revealed that organizations that had a breach of the best practices of corporate governance, experienced a 1% reduction in their annual ROA; industrial adjustments.
Erkens et al (2012) evaluated the impact of corporate governance of the financial performance of organizations during the financial crisis of 2007-2008.The study involved the use of a unique dataset of a total of 296 financial firms that exist in 30 countries. The countries were at the core of the financial downturn. Erkens et al (2012) highlight that their findings indicated that organizations that had boards that were more independent and an institutional ownership that is high had poor stock returns, during the crisis. Another finding from the study was that organizations that a larger institutional ownership took an increased amount of risk before the crisis which led to losses to the shareholders. Also the study revealed that organizations that had a more independent board had an increased equity capital which resulted to a transfer of wealth from the shareholders to the firm’s debt holders. Erkens et al (2012) highlight that the overall finding of the study was that corporate governance was evidently a great determinate of financial performance during the crisis.
Other researches have echoed the above findings and proved that firms with higher corporate governance have higher Tobin’s q or market value and perform better (Beiner et al., 2004, p. 65; Schmidt and Zimmermann, 2004, p. 112). Bauer and Guenster (2003, p. 1) found that firms with good corporate governance systems delivered 2.1 percent higher returns compoared to firms with poor corporate governance systems. A study conducted by Schilling (2003, p. 367) involving 242 companies listed in FTSE Eurotop 300 index indicated that firms with better corporate governance performance had a higher Tobin’s q. These findings were supported by another study conducted by Black et al (2003) that involved 526 Korean firms. In addition, a research conducted by Klapper and Love (2002) across 14 firms in developing countries showed that better corporate governance correlated with bettwe market valuation and overall performance.
Shleifer and Vishny (2009) highlight that good corporate governance systems assure shareholders that they will get adequate returns on their investments. Without good corporategovernance mechanisms, investors may not be attracted to fund a firm or to purchase a firm’s equity securities. Such a firm is likely to miss good business opportunities and is also likely to suffer from financial problems. Previous evidence has shown that corporate governance has a positive correlation with a firm’s economic performance. For instance, a study carried out by Rajan and Zingales (2008) in various industries indicated that companies with better corporate governance attracted funding from governments and investors and had better financial measures compared to firms with poor governance. Therefore, effective corporate governance system (measured through strong protection of the rights of stakeholders, better accounting standards and stronger rule of law) is crucial to the financial performance of a firm. Gemmill and Thomas (2004) and Drobetz et al. (2003) echoed the above findings as they found in their respective studies that good corporate governance influences financial performance of a firm. These studies concluded that effective corporate governance leads to lower cost of capital. Gemmill and Thomas (2004) found that effective governance reduces exposure of a firm to risks and hance, it leads to lower cost of capital.
Various studies have adopted different methods and alternative perspectives in order to explain how the relationship that exists between corporate governance and the financial performance of a firm. Gompers et al (2003) found an important correlation that exists between various measures of financial performance and the rights of shareholders. The study involved creating an index through the use of variables that are governance related and those that are related to financial performance. The findings of the study revealed that the index of governance is greatly connected with the stock returns. Chung et al (2003) also performed a study to evaluate the cross-sectional relationship that exists between the market value of a firm and its R&D and capital expenditures. The findings of the study indicated that the market valuations of the investments of the firm were greatly dependant on the composition of the board, but not specifically on the institutional holdings of the firm. Another study was also conducted by Larcker et al, (2005) in order develop 14 constructs of governance through the analysis of principle components. The study revealed that the 14 constructs of governance are greatly connected to the future performance of the firm.
Other researches have focused on the impact of information disclosure on firm’s performance. Coombs and Watson (2001) noted that greater disclosure helps to attract stock market liquidity and subsequently, lowers the cost of capital. The scholars argued further that the commitement of firm’s manages to increase disclosure levels helps to reduce information assymentry between themselves and investors and lowers the cost of capital. Redcued cost of capital implies an increase in a firm’s valuation. The main diea behind information disclosure is that it minimizes information asymmetry between shareholders and managers and thereby lowering uncertainties. As well, information disclosure helps to reduce cases of fraud within organizations. Reduced uncertainties and cases of fraud helps toincrease a firm’s valuation.
Other studies have shown that investors are ready to pay a premium for effective corporate governance. Monks and Minow (2004) found that shareholders are willing to pay a premium of 10-12 percent for good governance. At the same time, a significant percentage of investers are often willing to withdraw their funding in cases of poor corporate governance. Monks and Minow (2004) explained that poor corporate governance translates into higher agency costs. When the market realizes it and estimates these costs, stock market returns declines. On the other hand, good governance translates into lower angency costs. According to Monks and Minow (2004), this signal is usually not properly incorporated in market prices.
Coles, et al (2001) argues that although the various studies that have been conducted have revealed that there is a positive relationship between corporate governance and the financial performance of a firm. Coles, et al (2001) assert that corporate governance is not the only significant factor that influences financial performance. A firm may have an effective corporate governance system however its financial performance may be poor. Chung et al (2004) propose that effective corporate governance has to work coherently with other variables that influence successful performance. Chung, et al(2004) highlight that corporate governance is likely to positively influence the financial performance of the firm if a supportive and enabling environment is provided. Such kind of an environment may develop both at the industrial level. In addition such an enabling environment should be developed at difference scales, which are from the level of the individual company to the industry level, to the government level and also at the international level. Goergen (2012) further highlights that an enabling environment where corporate governance can positively influences the performance of a firm can be a robust one if it is well supported.
Although the issue on whether directors should be affiliates or employees of an organization or outsiders has been researched extensively, no clear-cut conclusion has been reached. On one hand, it has been argued that inside directors are well versed with a firm’s operations and they are relatively more effective when monitoring management activities. On the other hand, outsiders are perceived to make independent decisions which give priority to the interests of shareholders and focus more on maximizing value for shareholder’s investments. Faccio and Lasfer (2010) argues that a corporation’s board shouldinclude both insiders and outsiders but outsiders should be more in order to enhance independence. Although scholars such as Faccio and Lasfer (2010) indicate that an optimal mix shold be selected to enhance effectiveness of corporation’s board, there is little theory on the determinants of an optimal mix.
Existing discussions concerning the principles of corporate governance have been presented in three major reports that have been published from the 1990’s (Monks and Minow,2004).In the year 1992 the Cadbury Report was released, in the year 1998 and recently in the year 2004 the principles of Corporate governance (OECD), was released. In the year 2002, the Sarbanes-Oxley Act was passed in the United States. The U.K also recently established the U.K corporate governance code, 2010, which contains principles and provisions that companies are supposed to comply with. According to Monks and Minow (2004) satisfactory engagement between investors and the board of a company is a crucial element in financial performance and also in corporate governance.
Brown and Caylor (2009) highlight that the major pillars of corporate governance in financial service industry include trust, disclosure and financial transparency. Prasad, (2006) highlights the OECD and Cudbury reports and other regulations and reports provide the general values under which firms are required to operate in order to facilitate good corporate governance. Some of the essential areas highlighted by the reports include the respect of shareholders rights, the board should be of an appropriate size and have commitment and independence, ethical behavior and integrity should be held when making decisions in the organization and lastly transparency and disclosure, which requires the firm to uphold integrity when undertaking financial reporting and also the board should openly provide information to stakeholders in order to enhance accountability(Prasad, 2006). In all these sources, it is highlighted that good corporate governance system is key to organizational successful performance.
Conceptual Framework for Corporate Governance and Financial Performance
There are various variables that assist in understanding how corporate governance and financial performance relate within the financial service sector. These key variables are highlighted by a conceptual framework as indicated by Figure 1 below;
Figure 1: Conceptual Framework for Corporate Governance & Financial Performance
Variables for corporate governance
Corporate governance in listed companies in the UK is currently guided by corporate governance code that has been developed over the last two decades. Prior to 1992, the corporate governance of UK companies was regulated by customs and practice. According to Mullerat and Brennan (2010, p. 51), company law together with some stock requirements laid down only basic rules concerning boards of directors, financial reporting and audit. The Cadbury review was established in 1991 in response to a series of financial scandals. The Cadbury Report which was released in 1992 began the process of greater codification of corporate governance norms and as Mallin (2007, p. 22) points out, the report was the first to set out recommendations regarding structure of boards of directors and company’s accounting systems in the UK.
Following on from the Cadbury Report, there have been a number of subsequent reviews to the corporate code made by committees led by Sir Richard Greenbury (1995), Sir Ronnie Hampel (1998), Nigel Turnbull (1999), Sir Derek Higgs and Sir Robert Smith (2003), and Sir David Walker (2009) (Bain & Barker, 2010, p. 267; Blowfield & Murray, 2008, p. 216; Brown & Snyder, 2012, p. 299). The reviews covered various aspects of corporate governance including board size, independence of directors, executive remuneration, non-executive directors, role of audit committees, desired composition of board committees, importance of duality of chief executive officer and also significance of communication, transparency, trust and disclosure. The recommendations made in all these reviews are incorporated in the UK Corporate Governance Code 2010. The standards laid out in this code are not legally enforceable and thus, it is a voluntary code for the directors of UK companies. However, companies with a premium listing on the London Stock Exchange (LSE) such as Barclay bank are required to apply the code on a ‘comply and explain’ basis. This code has relevance to Barclays bank UK and in many instances, it has been a source of deterrence to financial irregularities in the company. Being the main parameters that are used to determine adherence to corporate governance principles in the UK, the aforementioned aspects highlighted in the UK Corporate Governance Code 2010 will be used as proxies for corporate governance in this study.
Independence of the members of the board of directors
Based on the fact that the board of directors is the main essential device in supervising the management, it is essential for the board of directors to be independent. Abdullah (2004) highlights that the independence of the members of the board of directors is one of the most significant aspects in effective corporate governance. The independency of the board implies that the non executive directors have the mandate to control the behaviour of the management in addition they are required to protect the interests of the shareholders. In most cases a board of directors that is independent consists of individuals who do not have any sort of material interest with the organization apart from the aspect of their role in directorship. In addition the independence of the board is also characterized by a board that undertakes its operations without any sort of interference from both the internal and external stakeholders. In the context of Barclays Banks the board of directors increased the level of scrutiny on security documentation, day to day credit controls, impairment measurements and fraud controls. The findings attained by the board of directors were later submitted to non-executive directors for further scrutiny. The involvement of the non-executive directors in the scrutiny process implies that good corporate governance existed in the bank. The non executive directors had the mandate to control the behaviour of the management. This therefore spearheaded the stable financial performance of the bank during the financial crisis.
Size of the Board
The composition is also an essential element in corporate governance. Naciri (2008) highlights that there is a worldwide agreement concerning the most favorable size an organizations board of directors. A big number of board members is basically a challenge when it comes to utilizing them efficiently or developing any sort of effective individual participation. In addition a large composition of board members also implies an addition costs for the firm in terms of paying for their compensation packages. Naciri (2008) highlights that; the average composition of the board is about 9 members. However many boards are composed of 3 to31 members. There are other analysts who propose that the most ideal or appropriate size is about seven.
In the context of Barclays bank, the bank reduced the composition of its board members, in addition no new directors were appointed in the same year.
The role of the audit committee is to work in collaboration other auditors in order to certain that the financial books of an organization are correct and that they do not possess any conflict of interest that many have an implication on other stakeholders. The main duty of an audit committee is to strengthen the quality of financial information and maintain investor confidence regarding the financial markets and the quality of financial reporting. The degree of the quality of financial information will largely depend on how well the audit committees are reducing creative accounting practices or fraud. Provision of strong and reliable financial information enables investors to easily identify any manipulation of the books of accounts. Therefore, the audit committee has a responsibility of directly improving the quality of information by overseeing the process of financial reporting. They also have an indirect responsibility of supervising internal management and external auditing. The responsibility of Audit committee to improve information quality and strengthening of controls normally causes investors to have a lot of confidence on matters relating to quality of financial reporting and corporate governance (Wearing & Wearing, 2005).
In the context of Barclays Banks the role of the audit committee is to strengthen the quality of financial information and maintain investor confidence was an indication of good corporate governance in the bank. For instance the Barclay’s banks audit committee held approximately ten meetings in 2008. The areas of focus in the various meetings involved how to solve the disruptions that have occurred in the financial service sector and the credits market.
The meetings and the frequent reviews of the financial information of the organization were useful in enhancing the stable performance of the bank during the financial crisis.
Transparency, Trust and Disclosure
Transparency, Trust and Disclosure are integral components of corporate governance. These aspects are useful in creating pressure for progressive financial performance (Colley, 2005).
In order improve the power of the board of directors to monitor as well as oversee the management of the institution, the institution should not practice CEO duality. As highlighted by Jensen (1993), if the CEO is left to hold the post of the board chairman there is a higher probability that it will result in a lack of autonomy and a conflict of interest between the board directors and the institution’s CEO.
It is contended that if the institution practice CEO duality, there is a higher probability that the CEO will have a significant influence as far as the board agenda and control of information flow is concerned (Jensen, 1993).This is likely to hamper the board of directors’ ability to carry out their duties effectively since the CEOs ability to influence the board agenda and information flow is projected to be much stronger when he is the CEO and the board chairman as well.
The institution ought therefore to adopt the non-dual structure as this will greatly push the institution towards grasping various opportunities as well as meeting the obligations to the shareholders and other institution’s stakeholders. In addition, a dual structure of leadership should not be adopted as it provides an indication of lack of separation of decision management and decision controls.
Variables for financial performance
The variables for financial performance that are linked to financial service organizations are usually reviewed on grounds of performance dimensions which include asset quality, capital adequacy ,liquidity and earnings.
Methodology simply refers to the manner in which we approach and execute functions or activities. In doing research, it can be described as a way and manner in which a study is conducted and includes all the methods used to carry out research within the social and natural sciences (Creswell, 2003). It encompasses the entire process of doing research which involves planning, conducting the research, disseminating the findings and drawing conclusions. It is a process that helps to achieve a complete and correct set of information requirements from those involved in the study. This chapter explains the methodology that is going to be used by the researcher for the purpose of this study. The selected methodology is based on assessment of the optimal strategy for responding to the research questions of this study.
3.1 Case Study
How Barclays Banks Corporate Governance impacted on the Banks Financial Performance during the Financial Crisis – Corporate governance report- 2008
In the wake of the threatening financial crisis, Barclays Bank U.K adopted a robust corporate governance approach that assisted the banks financial performance during the crisis. As the economic downturn begun to evolve in 2008, the board committee members of the Bank gave a directive that the key controls of the firm should be reviewed in order to enhance effective risk management. The committee therefore increased the level of scrutiny on security documentation, day to day credit controls, impairment measurements and fraud controls. The findings attained by the board of directors were later submitted to non-executive directors for further scrutiny (Barclays Bank, Corporate Governance Report, 2008).
Also in the same year the audit committee was provided with additional reports and presentations concerning the impact of the new Lehman Brothers acquisition, together with an original risk assessment of the acquisition of this particular business in North America. In addition the committee was handed a report concerning the impact of the new acquisition of the financial reporting of the bank during this particular year. The committee also took up the role of challenging the management to ascertain that the function of the internal audit is effectively resourced in order to cope with the challenges that may arise due to the financial down turn.
The committee was also provided with regular updates of core regulatory frameworks for corporate governance such as; sanctions compliance, Sarbanes –Oxley and Basel 11.
Barclay’s banks audit committee held approximately ten meetings in 2008. The areas of focus in the various meetings involved how to solve the disruptions that have occurred in the financial service sector and the credits market. In the initial years of 2008, the banks audit committee conducted a separate meeting on valuation of difficult financial instruments and derivatives. The meeting also involved the reviewing of the methodology used valuation. The valuation methodologies include; trading desk evaluation, benchmarking, independent price testing, risk and finance (Barclays Bank, Corporate Governance Report, 2008).
The Audit committee spent a considerable amount of time in reviewing the disclosures made by the bank. The reviews were made across the asset backed securities, exposures to credit markets and the positions of leveraged credit. As an aspect of the approval of all statements, the audit committee also reviewed the value of the exposures to the credit market which also involved the reviewing the categories of key assets, exposure movements (paydowns/sales) and underlying collateral by rating and vintage.
The Audit committee was also provided with management statements which were specific presentations from the Chief Operations Officer. The valuations were further discussed with the Finance director of the group, external auditors and Risk Director. The committee was given reassurance from various control functions such as Finance, external auditors and Risk department that there was no variation in the selling prices of assets and the underlying marks. The committees become contented with the fact the models and the markets were adequately robust and will enable relevant and reliable valuations to be established (Barclays Bank, Corporate Governance Report, 2008).
Review of Board Members
During the year 2008, the composition of the board was reviewed. Following various deliberations, a recommendation was made to the board by the Committee for Sir Michael Rake to take over from sir Stephen Russell as the Board’s Audit Committee chairman from March 2009. Also in 2008 the Board did not appoint any new directors other than No new Directors other than Patience Wheatcroft and Sir Michael Rake, were to be part of the Board beginning 1st January 2008.
Engagement of Shareholders
Barclays bank had a comprehensive programme for investor relations. The program entitled regular access to the senior management of the bank in order for them to directly interact and discuss various issues about their investments (Barclays Bank, Corporate Governance Report, 2008).
For the year ended 31st December 2008
|Cash and balances with central banks
Existing for sale investments
Loans and advances to banks
Loans and advances to customers
|Deposits from banks
Debt securities in issue
|Net interest income||11,469||9,610||9,143|
The committee made a review of the activities that were undertaken in the year 2008, which was also a year merged with the economic downturn. The committee then concluded that it did discharge its responsibility as required. In addition the committee admitted that it complied with the terms of reference of the corporate governance. In addition although the bank was also faced with the effects of the economic crisis the difference that exist between the income generated by assets that earn interest and the amount of interests paid on liabilities (Net Interest Income), was higher than the previous two year 2007 and the year that followed 2009 (Barclays Bank, Corporate Governance Repor
4.0 Analysis of the Case Study
The adoption of poor corporate governance in the banking sector has progressively been recognized as one of the grounds for the financial crisis that has just passed. From the evidence gathered in the last financial crisis, both non-listed financial service organizations and those that are listed, have acknowledged the fact that good corporate governance is a significance aspect in the performance of banks. Colley (2005) highlights that; corporate governance concerns the development of credibility. In addition it also entails enhancing accountability and transparency as well upholding an efficient channel of disclosure that can foster good financial performance. It’s basically all about sustaining confidence and building trust among the interest groups that exist in the organization.
Barclays Bank is an example of how good corporate governance was able to assist the bank during the crisis. As indicated by the case of Barclays Bank the adoption corporate governance practices lead to a stable financial performance of the bank even during the crisis. Some of the areas of effective corporate governance include;
4.1 Effective risk governance
One of the core areas of corporate governance by the bank was the aspect of risk management. As the crisis begun, the Barclays Bank committee member’s gave a directive that the key controls of the firm should be reviewed in order to enhance effective risk management.
Effective risk governance is basically one of the reasons why the bank was able to stabilize its performance during the crisis. Julio and Bessis (2011) highlight that one main lesson from the financial down turn is that comprehensive and sound risk governance was an important aspect. Julio and Bessis (2011) further highlights that senior management working in the Banking Industry are usually exposed to the various risk such as credit risk , operational , market and strategic risk.
In the context of Barclays Bank, the senior management and Board members had a well integrated view of risk management. In addition the senior management and Board members of the Bank had a clear plan concerning how they were to work on risk management. Furthermore risk analysis was well undertaken and the areas of concern were outlined , these therefore resulted to the effective approaches to risk management and also adoption of the right models in order to enhance financial stability during the crisis.
In the context of Barclays Bank the management of the bank developed a framework of corporate governance whereby the trust, transparency and effective disclosure was undertaken by the management. For instance the board of directors of Barclays Banks increased the level of scrutiny on security documentation, day to day credit controls, impairment measurements and fraud controls. The findings attained by the board of directors were later submitted to non-executive directors for further scrutiny. Such an initiative is an indication of transparency, creation of trust and effective disclosure by the Bank.
5.0 Recommendations on how Corporate Governance can be used to Improve Financial Performance
Development of an Effective Board of Directors
A number of boards within the financial service industry have more often than not proved to be ineffective. According to Mallette & Fowler (1992), a major reason for this ineffectiveness can be argued based on the hegemony theory that contends that the boards of directors are often unable to fulfill their overseeing roles and that of protecting the interests of their shareholders. This view contends that the management of financial institutions dictates the boards of directors, as a result, leaving them to operate merely as ceremonial rubber stamps. Walker (2009) identifies that boards created by CEOs who chose and hire directors are often ineffective since the directors chosen go along with him/her hence a shortage of competent directors.
Therefore, according to Mallette & Fowler (1992), what needs to be done to improve the effectiveness of the board of directors is to appoint outside directors on the corporate boards who will determine the board’s monitoring as well as the oversight duties. Outside directors are believed to be effective due to their ability to advice, solidify business and personal relationships, in addition to sending out an indication that the institution is flourishing rather than their ability to monitor. Mallette & Fowler (1992) also notes that outside directors are able to come up with independent judgments regarding the performance of the institution owing to the dominant role by the CEOs in selecting the outside directors.
Development of Training Programs for Non-Executive Directors
A number of non-executive directors are often argued to be ineffective due to lack of skills necessary to contribute to the institution’s performance. As highlighted by (Jensen, 1993), special skills, for instance knowledge of accounting and law are very crucial. It is therefore important that financial service organizations develop various training programmes for the
Non-Executive Directors so that they are able to improve as well as advance their corporate governance practices. This training will make them contribute positively to the performance of the financial organizations as they will now possess a good understanding of the business.
The above study provides backing to the idea that corporate governance can indeed enhance financial performance within the banking sector. Corporate governance is majorly about developing credibility , ensuring accountability and transparency as well as preserving an efficient system of disclosure that can enhance good corporate performance . It concerns how trust is developed and how all the interests groups within the organization can build and also sustain the trust. The case of Barclays banks gives an clear indication of the fact that owners and managers of banks who depict the intention and effort to implementing good corporate governance will definitely attain positive results in their financial performance. The outcome of the existence of effective corporate governance therefore positively influences the financial performance of the banking sector. Indeed the outcome of the analysis of the financial performance of Barclays Bank during the crisis provides a strong link to the notion that corporate governance, positively influences the financial performance of a firm.
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