The interaction between corporate governance and liquidity of the bank

Banks have a special role in providing liquidity to investors. They offer short term or demand deposits to meet the liquidity needs of depositors and deploy these funds in relatively illiquid (but high earning) loans. These short maturing liabilities are seen as a monitoring device available with depositors because if not satisfied with bank performance, they could refuse to renew their deposits. With a view to maintain public confidence in the banking system, governments in different countries have provided deposit insurance to retail depositors. This has helped greatly in providing a stable basis for bank operations. However, the same arrangements create a moral hazard problem for banks because bank owner/ managers can be tempted to take more risks. Such measures to assuage depositors should therefore be accompanied by measures, which would ensure that the process of asset choice and management are not excessively risky.

Liquidity is important not just from the perspective of investors’ preference and their risk appetite, but also in terms of external governance mechanisms. Effectiveness of the market for corporate control depends on liquidity but there is a tradeoff between liquidity and different governance mechanisms. Widely dispersed ownership would improve liquidity and attract a wider class of investors. However, such wide ownership would reduce the incentives to monitor client performance; voting by feet may become more tempting. In such a scenario share prices become a tool for management performance and useful to devise management compensation packages.

On the other hand, if there are large holders, liquidity would be low but there would be incentives for these large lenders/ investors to monitor their clients, in which case, the market for corporate control would be more effective. When share ownership is dispersed, liquidity would be higher but management may tend to hold effective control.

Risk management is an important parameter that affects the performance of a financial institution. Regulators’ aim is to encourage regulated entities to make correct risk assessments, take adequate risk sharing/mitigation measures and to hold adequate capital to bear the risk. But how much risk an institution should bear is a prerogative of the management or board of directors. Risk tolerance will also influence profitability levels and volatility therein, which makes it akin to a business decision. The acceptable risk profile will determine business quality in terms of products, sectors and clients. Acceptable risk levels will not be static; they would change in response to the changing business environment. Different constituents in a financial institution could have a different view on the levels of risk lenders should accept. Borrowers themselves would like it if lenders accept higher risks while depositors would prefer low risks.

Setting risk tolerance limits in a dynamic context and ensuring that business proposals accepted are in conformity with the acceptable risk profile is crucially important in maintaining good governance in financial institutions. This task involves not just senior management but nearly all employees. Selection of employees with suitable skills, providing a performance linked compensation package and a professional work environment are necessary to recruit and retain talent. While compensation of senior executives has been considered as an important aspect of corporate governance, human resource policies pursued by companies are considered a prerogative of managerial responsibilities. However, given the importance of skills in financial institutions, particularly in asset management, the crucial importance of HR policies needs recognition. These would operate as governance mechanism.

Resources:

• 1.    Liu Lawrence, ‘Corporate Governance for Financial Institutions'

• 2.    Jalan Bimal, 'Corporate Governance and Financial System: Some Issues'

• 3.    Масeу J R and O'Hara M, 'The Corporate Governance of Banks'

"Экономика и социум" №5(24) 2016