Corporate Governance and Risk Management: The role of risk management and compensation committees.
Ngoc Bich Tao Marion Hutchinson1 Queensland University of Technology
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Corresponding Author: Queensland University of Technology, School of Accountancy, P.O. Box 2434, Brisbane, Australia Email:
[email protected], Ph: +61 7 3138 2739. Fax +61 7 3138 1812.
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Electronic copy available at: http://ssrn.com/abstract=1979895
Corporate Governance and Risk Management: The role of risk and compensation committees. Abstract This paper examines the role of compensation and risk committees in managing and monitoring the risk behaviour of Australian financial firms in the period leading up to the global financial crisis (2006-2008). This empirical study of 716 observations of financial sector firms demonstrates how the coordination of risk management and compensation committees reduces information asymmetry. First, we show that the compensation committee motivates risk-taking, revealed by the positive association with risk. In contrast, a large risk committee reduces risk-taking. Next, we show that firms experiencing increasing risk benefit from a compensation committee when directors are independent, have professional qualifications, industry and board experience and frequent meetings and a large risk committee. Finally, when a director is a member of both committees there is a positive association between risk and firm performance thus reducing information asymmetry between committees. A director with dual committee membership is able to oversee the association between the firm’s risk exposure and the proportion of risk-taking incentives in compensation packages. The findings have theoretical and practical implications for the current debate on how to improve the governance of financial institutions. Keywords Corporate governance, risk management, compensation committee, risk management committee, firm performance
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Electronic copy available at: http://ssrn.com/abstract=1979895
1. Introduction Recent corporate scandals of financial institutions worldwide have raised considerable concern among investors and regulators. Regardless of whether the global financial crisis resulted from excessive risk-taking (Kashyap, Rajan and Stein, 2008), or is attributable to the increasing levels of risk faced by firms (Raber, 2003), both views identify risk as the major contributor, and highlight the importance of an appropriate corporate governance structure for managing risk. Consequently, the focus of this paper is on identifying factors associated with monitoring risk in the Australian financial sector. The financial sector in Australia is the largest industry sector based on capitalisation. As of June 2011 the 288 companies in the financial sector of Australia have a market capitalisation of AU$455.7billion. The financial sector consists of trading and investment banks, asset managers, insurance companies, real estate investment trusts (REIT) and other providers of financial services. In Australia, employers in all sectors are required to contribute to a compulsory employee superannuation scheme2. This means Australia has the 4th largest pension fund pool in the world, creating enormous opportunities for banks, asset management, financial planning and insurance companies3. Consequently, the governance practices of this sector are important to the economic welfare of Australia.
Agency theory suggests that there are divergent risk preferences of risk-neutral (diversified) shareholders and risk-averse managers which necessitates monitoring by the board (Jensen and Meckling, 1976, Subramaniam, McManus and Zhang, 2009). Consequently, without monitoring, risk-averse managers may reject profitable (but more risky) projects which are attractive to shareholders who prefer the increased return from the higher level of risk.
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Employers are required by law to pay an additional amount based on a proportion of an employee's salaries and wages (currently 9%) into a complying superannuation fund 3 http://www.asx.com.au/documents/research/financial_sector_factsheet.pdf
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Electronic copy available at: http://ssrn.com/abstract=1979895
Excessive managerial risk-taking is not considered problematic for nonfinancial firms because one firm’s failure will not affect a diversified investor’s portfolio in any directional way. Pathan (2009) suggests that bank shareholders prefer excessive risk due to the moral hazard problem of limited liability and the associated convex pay-off (Jensen and Meckling, 1976)4. However, Gordon (2010) suggests that this may not be the case in the financial sector. The failure of a systemically important financial firm increases the likelihood that other financial firms will fail due to the cascading effects from the contraction of the financial sector such as occurred in the Global Financial Crisis. Consequently, monitoring excessive risk-taking by management is particularly important in the financial sector. The risk management committee and the compensation committee are both responsible for monitoring and oversight of firms’ risk-related activities. Thus, a compensation or risk committee that reduces excessive risk taking and the probability of the failure of a systemically important financial firm will benefit diversified shareholders.
This paper investigates the association between the risk management committee (RC) and compensation committee (CC) and the risk and performance level of financial firms. We suggest that certain characteristics of committees (size, composition and function) reflect the committees’ motivation and ability to increase risk-taking that is aligned with shareholders’ interests. The paper therefore predicts a positive association between risk and the structure of the RC and CC. Further, we suggest that firms experiencing increasing levels of risk require a CC and RC that manage and monitor risk so that there is a positive association between risk and performance. The results of the research show that CC characteristics and RC size have an important role in the risk and performance of the firm. Using a principal components
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Pathan (2009) also suggests that poor bank governance is more catastrophic than non-bank firms as bank failure has more significant costs.
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analysis we derive a factor score for the characteristics of the committees and use beta as the measure of risk5.
This paper also investigates the risk and performance relationship when directors occupy positions on both committees (hereafter, “dual membership”). The study finds a positive association between risk and performance when committee members simultaneously serve on the RC and CC. This result demonstrates lower information asymmetry when directors have responsibilities in both committees as they are able to oversee the association between the firm’s risk exposure and the proportion of risk-taking incentives in compensation packages. Subsequently, more informed decisions result in a positive association between risk and performance. Although the result disappears when controlling for endogeneity, dual committee membership remains positively significantly associated with firm performance.
This paper contributes to the literature in several ways. To our knowledge, no other study has empirically tested whether directors’ dual-membership on the RC and CC co-ordinates monitoring the risk level of the firm with monitoring the riskiness of compensation packages. Literature on dual committee membership is limited to theory and minimal analysis (Laux and Laux, 2009; Hoitash and Hoitash 2009). Co-ordination between RC and CC functions reduces information asymmetries which affect firm performance. While some research establishes that board committees improve the performance of the firm (e.g. Klein 1998), there is little research into these committees in Australian companies, in particular their effect on risk and firm performance. Unlike the U.S where establishing an audit, nomination and compensation committee is mandated, there is no mandatory requirement for companies to
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We exclude committee size from the principal components analysis as research finds inconclusive results on the effects of board or committee size.
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establish committees in Australia firms (apart from Listing rule 12.7)6. Instead, corporations can choose not to comply with the recommendations as long as they can justify any noncompliance. Consequently, Australia provides an interesting setting to explore the costs and benefits of board sub-committees.
Further, financial sector firms (banks, diversified financial companies, insurance and realestate investment trusts) have explicitly been excluded from previous research due to the higher level of risk when compared to other firms (Wallace and Kreutzfeldt, 1991) which causes generalisability and transferability problems. In that regard the Australian Prudential Regulation Authority (APRA) has implemented a framework which regulates financial institutions (see Appendix). Prudential Standard APS 510 outlines the skills, knowledge and experience requirements for directors involved in risk management7.
In recent years, many banks and financial institutions have been widely criticised for paying excessive bonuses to some executive directors and senior management at a time when the world is suffering the consequences of a global financial crisis, said to be a result of irresponsible risk-taking by financial institutions (Pathan, 2009). This study contributes to the literature as there is a paucity of research on whether the compensation and risk management practices of the financial sector are associated with the level of risk and related return. Given that the adoption of RC and CC by Australian companies is voluntary, it is not surprising that the influence of these committees has not been fully explored.
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Listing rule 12.7 requires companies included in the All Ordinaries Index to have an audit committee, whereas companies in the top 300 of the index are required to have their audit committee constituted in terms of recommendations provided by the ASX CGC. These recommendations are on the composition, operation and responsibilities of the audit committee. 7 “… the requirement for directors, collectively, to have the necessary skills, knowledge and experience to understand the risks of regulated institution, including its legal and prudential obligations, and to ensure that the regulated institution is managed in an appropriate way taking into account these risks” (APS 510: 3).
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The paper proceeds as follows. In section 2 we review the relevant literature and present a number of hypotheses. Section 3 describes the research methodology. Results are presented in section 4, and the final section provides a summary and conclusion.
2. Background and Hypothesis Development
Financial firms have become large complex organizations involving significant delegation of decision–making and risk-taking responsibility. Consequently, it is difficult to design internal systems that ensure delegated decision making outcomes align principal and agent’s divergent goals (Davis, 1999). Although information asymmetries can be found in all sectors, Andres and Vallelado (2008) suggest that information asymmetries in the financial sector may be stronger due to business complexity and the idiosyncratic nature of the sector. For example, information asymmetry in the banking industry is due to complex transactions including, the difficulty in determining the quality of loans, opaque financial engineering, complicated financial statements, investment risk is easily modified, or perquisites are easier for managers to obtain (Levine, 2004). Within a framework of limited competition, intense regulation, and higher informational asymmetries the board becomes a key mechanism to monitor managers’ behaviour and to give advice on risk management, strategy identification and implementation (Andres and Vallelado, 2008).
According to agency theory, the board of directors is considered a vital element of corporate governance based on the premise that the characteristics of the board members determines the board’s ability to monitor and control managers, provide information and counsel to managers, monitor compliance with applicable laws and regulations, and link the corporation to the external environment (Carter, D’Souza, Simkins, and Simpson, 2010). Subsequently
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the majority of the existing literature focuses on investigating the board’s characteristics such as its composition and size. However, John and Senbet (1998) argue that boards’ internal administrative structure is of more importance in measuring boards’ effectiveness. The board of directors delegates some of its authority to specific committees which are responsible for a particular area in which the committee members specialise. In Australia, the ASX CGC has set guidelines concerning risk management practices within Australian publicly listed companies, laying the responsibility with boards of directors (ASX CGC, 2007). In particular, these guidelines recommend that corporations establish a compensation committee (CC) and a risk management committee (RC) as a means of improving corporate governance, and in particular, risk management.
Board sub-committees are established to assist the board perform its role, particularly with increased responsibilities and pressures placed on the board. Compensation and risk committees are important corporate governance mechanisms that protect shareholders’ interests by providing independent oversight of various board activities (Harrison, 1987). Harrison (1987) suggests that board sub-committee enable directors to devote attention to specific areas of responsibilities, brings legitimacy and accountability to corporations and also improves directors’ participation in board and committee meetings. Research also suggests that separate committees have more influence over corporate performance (Klein, 1998), corporate strategy (Vance, 1983) and reducing agency problems (Davidson, Pilger, & Szakmary, 1998) than the entire board. Consequently, committees are important in firms where agency costs are high, e.g. high risk, leverage, complexity and large size. Furthermore, agency theory suggests that characteristics such as its independence and an independent chairperson are potential factors influencing committee effectiveness (Carson, 2002; Bradbury, 1990). 8
2.1 Risk monitoring in the financial sector: the risk and compensation committee The risk management committee monitors the level of risk the firm is exposed to while keeping in mind the desire to maximise returns. The RC advises the board on the firm’s management of the current risk exposure and future risk strategy (Walker, 2009). The compensation committee oversees remuneration practices which are designed to attract and retain employees. Remuneration practices are also designed to provide incentives for risk adverse managers to assume the level of risk that risk neutral shareholders would tolerate. A major challenge for firms lies in managing risk by designing compensation contracts which lead managers to act in accordance with the risk preferences shareholders and appropriate level of risk for the firm (Murphy, 2000).
Signalling theory is used to address problems of information asymmetry in the market (Certo, 2003). Signalling theory posits that it is generally beneficial for organisations to disclose good corporate governance practices, such as committee formation, to create a favourable image in the market. This in turn minimise any potential firm devaluation by investors’ or to maximise the potential for firm value enhancement. However, Menon and Williams (1994) argue that in many cases committees may be formed to promote the appearance of good corporate governance without serving any useful purpose for the organisation. Consequently, it is the competence (not merely the existence) of the committees which is critical to the success of the firm (Akhigbe and Martin, 2006). Committee directors’ specific knowledge of the complexity of the financial sector enables them to monitor and advise on their area of responsibility.
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Given that the compensation, risk and audit committees are all monitoring committees of the boards, factors determining their governance efficacy are similar. This research examines the governance efficacy of the RC and CC based on four characteristics which were identified by Xie, Davidson and DaDalt (2003) as contributing to audit committee effectiveness8. First, to fulfil their monitoring role, the committees need to be independent of company management. The ASX CGC recommends that the compensation committee should consist of a majority of independent directors (ASX CGC, 2007: 35). This recommendation reflects an agency theory perspective that independent directors are more representatives of shareholders and therefore better contribute to the provision of independent monitoring of management (Fama and Jensen, 1983; Jensen and Meckling, 1976); Pincus, Rusbarsky and Wong, 1989). Therefore, the independence of the RC and CC will be positively associated with firm risk.
Second, the RC and CC need to contain members with expertise in business. Monitoring by the RC and CC requires that the committee members contribute sufficient expertise, judgement and professional scepticism to the monitoring process (Raber, 2003). A further measure of expertise may be the length of service (tenure). We suggest that directors’ ability to monitor risk is related to length of service on the board or in the financial industry. Third, the RC and CC should meet often enough to ensure that relevant issues are considered in a timely and effective manner.
Committees are extensions of the board of directors;
consequently, directors frequently lack time to carry out their duties (Lipton and Lorsch, 1992). More frequent meetings allow potential problems to be identified, discussed and avoided. Therefore, frequent meetings are likely to result in better monitoring of risk. Finally, the size of the compensation and risk committees may arguably have an impact on their monitoring function. 8
Similar to the audit committee, the RC and CC are monitoring committees which specifically handle agency issues (Xie et al., 2003).
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Risk or compensation committee monitoring (measured by committee size, independence, experience and activity) is expected to reduce managers’ risk adverse behaviour. Pathan (2009) suggests that strong board monitoring is positively associated with bank risk taking based on the view that bank shareholders have incentives for more risk and finds that bank board structure (small size and less restrictive) is positively associated with more risk-taking while board independence and shareholder protection is negatively associated with risk. We suggest that the CC and RC make decisions they perceive as representative of shareholder’s interests. Consequently, while acting in isolation, there will be a positive association between CC and RC characteristics and firm risk because research tells us that shareholders prefer more risk (Jensen and Meckling, 1976; Pathan, 2009). However, this does not suggest that shareholders prefer “excessive” risk; this is discussed in the following sections. The preceding discussion leads to the following hypothesis: . H1 :
The composition of the risk or compensation committee is positively associated
with the risk level of financial firms.
2.2 Directors’ dual membership on the RC and CC While Bradbury (1990: 22) argues that audit committees reduce information asymmetry between insiders and outsiders of the firm, Reeb and Upadhyay (2010) suggest that separating directors into specialized committees can create information asymmetries among directors. Similar to the costs of organisational decentralisation, forming board subcommittees can lead to suboptimal decisions by the board as committee members focus on their particular area of responsibility instead of focusing on the overall goal of board decisions. Consequently, the costs of board sub-committees are co-ordination and
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communication problems. It is posited in this study that a potential solution to this problem is to ensure directors mutual involvement in committees that are likely to have some impact on each other. For example, one of the roles of the risk committee is to determine the appropriate level of risk the firm should take while the compensation committee may design remuneration packages with the purpose of increasing managers’ risk taking. Therefore, it seems apparent that these committees should co-ordinate and communicate when making decisions.
Board committees often work independently to achieve their own objectives. However, there are cases where different committees are staffed by a common group of members (Laux and Laux, 2009). In these circumstances, Laux and Laux (2009) suggest an association between the members who serve on both the compensation and audit committee and executives’ pay structure. Specifically, the model developed by Laux and Laux (2009) suggests that separating the functions of the audit and compensation committee members should lead to a higher proportion of pay-for-performance compensation and subsequently increases the monitoring role of the audit committee in the financial reporting process. This is because when compensation committee members also serve on the audit committee, they prefer to reduce CEO incentives to manipulate earnings by lowering incentive pay which in turn leads to lower levels of monitoring. Hoitash and Hoitash (2009) empirically test this hypothesis and find a higher degree of dual committee membership is associated with a lower proportion of CEO incentive compensation.
Similarly, this study considers the co-ordination of monitoring committees (RC and CC) as important. We investigate whether members of the RC and CC coordinate to manage risk and return. In other words, does the CC consider whether the compensation package
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motivates risk-taking which is aligned with the firm’s risk appetite and subsequently is associated with better firm performance? Agency theory predicts that managers who are compensated based on firm performance are more likely to undertake all positive net present value projects without being overly concerned about the associated risks. If the design of the compensation package has the potential to reduce self-serving behaviour, then CC efficacy should also mean higher risk. However, certain compensation policies may encourage excessive managerial risk-taking rather than investing firm resources in a risk-neutral manner (Miller, Wiseman and Gomez-Mejia, 2002).
Although asset pricing theories suggest that no level of risk is excessive for diversified shareholders in non-financial firms because the failure of one firm does not adversely affect their diversified portfolio, Gordon (2011: 5) suggests that shareholders in the financial sector prefer less risk as the failure of a systemically important financial firm will reduce the value of a diversified shareholder’s portfolio from the subsequent increase in the systematic riskbearing premium. In addition, research suggests that instead of looking at risk management from a silo-based perspective, firms that take a holistic view of risk management will improve firm performance (Gordon, Loeb and Tseng, 2009)9. Consequently, communication and co-ordination between the RC and the CC is important for firms in the financial sector and means that directors with multiple committee membership are likely to act more conservatively to avoid excessive risk taking and the threat of firm failure.
Therefore, the compensation committee when setting incentive payment policy must consider whether their policy fits within the firm’s risk appetite. Successful monitoring requires communication with members internally and across committees (Raber, 2003). As directors
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The holistic view of risk management is referred to as enterprise risk management.
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have specific knowledge to serve the committee on which they sit, it is expected that having the same directors on both committees would result in better monitoring in terms of setting appropriate compensation packages and managing excessive risk. The second hypothesis is: H2: Directors’ dual membership on the compensation and the risk committees is negatively associated with risk.
2.2 Risk and firm performance
If the RC and the CC are managing and monitoring risk taking that is in line with shareholders’ risk preferences we would expect to see that a positive association between risk and performance. According to asset pricing models a rational investor should not take on any diversifiable risk (unsystematic risk or idiosyncratic risk), as only non-diversifiable (systematic or market) risk (Beta) is rewarded. A sufficiently diversified portfolio limits the risk exposure to systematic risk only and the level of systematic risk is not affected by the failure of any one firm. Therefore, the return that compensates investors for the risk taken must be linked to its riskiness in a portfolio context - i.e. the beta of the financial sector is the defining factor in rewarding the systematic exposure taken by an investor (Bodie, Kane & Marcus, 2009). Consequently, the failure of a systemically important financial firm will increase the likelihood that other financial firms will fail (Gordon and Muller, 2011) and lowers the expected return in the financial sector (Gordon, 2011). Gordon and Muller (2011) suggest that shareholders in the financial sector internalise, at least partially, the consequences of firm failure (systemic risk) and are more wary of excessive risk-taking. Consequently, at excessive levels of risk there is a negative association between risk and performance because ever increasing levels of risk result in greater uncertainty and risk of default which in turn leads to lower returns.
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In this study of financial firms we suggest that the composition of the RC and the CC will determine their ability to monitor excessive risk so that the level of risk is related to firm performance. Studies of non-financial firms have failed to find any significant relationship (Ellstrand, Daily, Johnson, and Dalton, 1999), find a negative association (Klein, 1998) or a positive association (Young and Buchholtz, 2010) between committee composition and financial performance. Reeb and Upadhyay (2010) in a study of eleven types of committees in non-financial firms find that the finance, corporate governance, public issue/diversity committees are positively associated with performance (Tobin’s Q). Adams and Mehran (2008) find that the number of committees is negatively associated with Tobin’s Q which is consistent with the concept of the costs of co-ordination and communication problems with board sub-committees.
Gordon et al (2009) suggest that a positive association between risk and performance is contingent on the match between risk management and firm-related characteristics. Following this train of thought we posit that in situations of high uncertainty, such as high levels of risk, firms need committees that are competent in managing and monitoring risk. They bring in more resources from outside to increase firms’ governance efficacy. Consequently, the efficacy of the RC and CC in monitoring risk-taking and identifying excessive risk depends on the composition and size of the RC and CC which, in turn, leads to better performance. Committee members are also motivated to do their job well as their value in the human capital market depends primarily on the performance of their companies (Harrison and Harrell, 1993). Hence, committee detection of excessive risk-taking will ultimately lead to lower levels of uncertainty and a positive association between risk and performance. This leads to the second hypothesis.
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H3a: A positive association between risk and performance depends on the composition of the risk and compensation committee.
Further, if dual membership mitigates the communication and co-ordination problems of board sub-committees then we expect to see the goals of the CC and the RC aligned with shareholders’ risk preferences and a positive association between risk and performance. This proposition is related to Gordon’s (2011: 6) suggestion that “even though shareholders may not internalize all of the costs of systemic distress .....their internalized losses are sufficient to justify appropriate measures to control financial firm risk-taking”. Consequently, committees provide monitoring that is necessary to restrain excessive risk-taking but the committees must communicate and co-ordinate to reduce information asymmetry and achieve shareholders’ objectives. This leads to the last hypothesis:
H3b: There is a positive association between risk and performance when there is director dual membership on the compensation and the risk committees.
3. Method 3.1 Sample selection The financial sector in 2008 consists of 265 firms listed on the Australian Securities Exchange (ASX). The sector includes diversified financials, banks, insurance, real estate companies and real estate investment trusts. Financial sector companies are examined in this study because they are operating in a riskier environment compared to other industries (Pathan, 2009) and are often excluded in corporate governance studies. The sample consists of an unbalanced panel data set of 317 ASX listed firms in the financial sector for the years 2006 to 2008 (716 observations) based on the availability of the relevant data. Archival data
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on firms’ corporate governance characteristics (including committee characteristics) is hand collected from the company annual reports from Connect4. Financial variables are provided by Aspect FinAnalysis. Risk measures are obtained from the Centre for Research in Finance (CRIF) risk measurement service of the Australian School of Business, University of New South Wales.
Consistent with prior research we determine the characteristics of firms that establish an RC or CC (e.g. Subramaniam et al., 2009; Yatim, 2010). The sample is then broken down into risk committee and compensation committee subsamples. There are 236 observations (126 firms) with a risk committee, 337 (156 firms) with a compensation committee, and 186 observations (96 firms) with both committees for testing the hypotheses.
3.2 Research Model There are two dependent variables in this study: risk and firm performance.
Our principle
measure of risk is Beta. BETA is the slope coefficient from a simple linear regression of the company equity rate of return on that of the market index, where both are measured as deviations from the risk free rate. Beta is a measure of market risk and is expressed as a coefficient whose average value for the market as a whole is unity. A high beta stock (beta greater than unity) is one that is relatively sensitive to market movements, and a low beta stock (beta less than unity) as relatively insensitive. This measure has been adjusted for thin trading. As an alternative risk measure, we use total risk which is calculated as the standard deviation of firm daily stock returns for each fiscal year STD.DEV. It is measured as the standard deviation of the rate of return on equity for the company and is expressed as a rate of
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return per month computed from the (continuously compounded) equity rates of return for the company’s equity.10
The relationship between risk and firm performance has been widely studied by researchers in business management, economics, accounting and finance. Asset pricing models generally specify that shareholders are compensated for bearing risk by receiving higher returns. Although there are various measures of firm performance used in prior research, this study uses the firms’ earnings per share (EPS) because (1) income-based risk is used in the analysis and EPS also reflects the income of the firm, (2) EPS is likely to be influenced by the firm’s managerial risk taking behaviours which is the emphasis of this study and (3) it is a performance measure that is common amongst all financial firms thus allowing comparability. Prior research has also used this measure for the financial sector (e.g. Luo, 2003). We also used share market returns in robustness tests.
We formally investigate Hypotheses 1 to 3 using random effects generalised least square (GLS) regression estimated with clustered-robust (also referred to as Huber-White) standard errors to control for any serial dependence in the data (Gow, Ormazabal, and Taylor, 2010; Petersen, 2009). The results of the Hausman test determine that a random effect generalised least squares (GLS) regression model is appropriate to test the panel data. Panel data is often cross-sectionally and serially correlated thereby violating the common assumption of independence in regression errors (Gow et al. 2010). Hence, clustered standard errors are unbiased as they account for the residual dependence (Petersen, 2009). According to Petersen’s (2009) simulations, clustered robust standard errors are correct in the presence of
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It is measured over the four-year period ending at the companies’ annual balance date. All measurable monthly returns in the four-year interval are included. Individual monthly returns measure total shareholder returns for the company, including the effects of various capitalization changes such as bonus issues, renounceable and non-renounceable issues, share splits, consolidations, and dividend distributions.
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year effects (if year dummies are included), with no assumed parametric structure for withincluster errors, so that the firm effect can vary both spatially and temporally. We include dummy variables for each period (to absorb the time effect) and then cluster by firm. The definition of the individual independent and control variables are reported in Table 1. The risk and compensation committee models follow. We use CG-i to denote either risk or compensation committee.
BETA =
β0 + β1 CG-i FACTOR + β2 CG-i SIZE + β3 CG-i CEO + β4 LNEPS t-1 + β5 LNASSETS + β6 LEVERAGE + β 7 BDSIZE + β8 YEAR + ε.
(1)
BETA = β0 + β1 DUAL + β2 RCCEO + β3 LNEPS t-1 + β4 LNASSETS + + β5 LEVERAGE + β6 BDSIZE + β7 YEAR + ε.
(2)
LNEPS t+1 = β0 + β1 CG-i FACTOR + β2 CG-i SIZE + β3 BETA+ β4 CG-i FACTOR * BETA + β5 CG-i SIZE * BETA + β6 CG-i CEO + β7 LNEPS t + β 8 LNASSETS + β9 LEVERAGE + β 10 BDSIZE + β11 YEAR + ε.
(3)
LNEPS t+1 = β0 + β1 DUAL + β2 BETA + β3 DUAL * BETA + β4 RCCEO + β5 LNEPS t + β6 LNASSETS + β7 LEVERAGE + β8 BDSIZE + β9 YEAR + ε.
(4)
3.2.1. Independent variables In order to communicate effectively and avoid the problem of diffusion of responsibility, the committee should be relatively small. While the ASX CGC recommends that the compensation committee should have a minimum of three members, there is no such guideline for the risk committee. There are two schools of thought with regard to optimal size. As size increases, so does the incremental cost of poorer communication, diffusion of responsibility and ineffective decision making (Yermack, 1996). Conversely, a larger 19
committee may bring a greater depth of knowledge and diverse skills essential for monitoring risk and compensation practices. Consequently, the size of the committee is likely to be associated with its ability to monitor risk. Consistent with prior research, this study measures committee size as the total number of committee members (Sun, Cahan and Emanuel, 2009; Petra and Dorata, 2008; Hoitash and Hoitash, 2009). We do not predict a direction for the association between committee size and either risk or performance due to inconclusive evidence for either a positive or negative association.
Similar to previous governance research (e.g. Sun et al 2009) we develop a factor score for RC and CC composition using a principal components analysis of five of the six individual measures of committee characteristics. We exclude committee size from the factor analysis due to theoretical and empirical confusion as to whether large or small committees are better monitors. Using a factor score is attractive because it extracts a component that is common to five committee characteristics. The rationale for the committee characteristics as good governance practice is well established in the literature and we expect the factor score to be positively associated with risk and performance. Justification for the components of the factor score follow.
Committee independence is assessed according to compliance with the ASX CGC (2007, p16) definition of an independent director. The information is disclosed either in the corporate governance statement or the director’s report in the company’s annual report. The measure is based on the proportion of independent directors on the committee (Vafeas, 2003a; Anderson and Bizjak, 2003). Consistent with prior research (Xie et al., 2003; Klein, 2002) we measure committee activity using meeting frequency as a proxy.
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Regulators have called for more financial experts on boards following the recent global financial crisis and the increased incidence of accounting scandals (Güner, Malmendier and Tate, 2008). The basic assumption is that directors with a better understanding of financial principals and standards will be better equipped to fulfil their monitoring role of risk avoiding behaviour. The professional expertise of individual committee members is measured by identifying professional qualifications in accounting or finance (e.g. Certified Practising Accountant (CPA), Chartered Accountant (CA) or Chartered Financial Analyst (CFA)). This measure is consistent with that of Petra and Dorata (2008) and Sapp (2008) who examine the relationship between committee expertise and executive compensation.
Long-serving directors are likely to be adept monitoring risk because of their greater experience (e.g., Vafeas, 2003b) and because they have greater firm-specific reputational capital at stake (Fama and Jensen, 1983). Conversely, Bebchuk and Fried (2004) argue that long-serving directors are likely to become entrenched and therefore pursue their own objectives. Directors who have longer tenure on the board (10 years or more) are likely to have greater knowledge and experience in compensation and risk management practices. This measure is consistent with Sun et al. (2009). We also measure committee expertise based on members’ industry experience. Directors with longer tenure in the financial sector would have superior experience in determining an appropriate risk appetite for the company. Therefore, we use the proportion of directors who have 10 or more years of industry experience to measure committee expertise.
Hoitash and Hoitash (2009) measure the interaction between the compensation and audit committee by identifying the number of board members who serve on both committees. This study measures the co-ordination of the compensation and risk committee by creating a
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dummy variable that identifies whether there are directors who have responsibilities on both committees.
3.2.2 Control variables We use prior years, reported earnings per share, as it is likely to have an impact on the current level of either risk or performance (EPSt-1). Firm size is often included as a control variable in previous corporate governance studies (Devers et al., 2008; Miller et al., 2002; Sun et al., 2009, Pathan, 2009) as an increase in firm size is likely to lead to greater monitoring and hence the greater need for corporate control mechanisms such as the compensation and the risk committee. Consistent with previous research (e.g. Pathan, 2009) leverage is also included as a control variable as it is an important determinant of a company’s risk of bankruptcy.
Board size is included in the model as a control variable because there is greater probability that larger boards will establish committees (Subramaniam et al., 2009; Yatim, 2010). CEO membership refers to when the CEO is a member of the CC or RC. Where the CEO is involved in the CC, they can determine their own compensation and it is possible that they will design their compensation to benefit themselves, regardless of the impact on risk or performance. Similarly, the involvement of the CEO in the RC means that the CEO is actively involved in monitoring the level of risk. With greater inside information, the CEO may bring to the committee a level of expertise that reduces the risk level of the firm. On the other hand, the CEO may be motivated to act opportunistically, undertaking such activities as empire building and excessive or unrelated diversification (Baysinger and Hoskisson, 1990) leading to increased levels of risk.
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3.3 Results Table 2 reports the descriptive statistics for the variables related to risk, firm characteristics, firm performance and compensation and risk committees. Of the 716 observations, 47 percent disclose the existence of a CC in their annual reports. It is less common for financial companies to establish a separate RC. Only 3 percent of the sample firms had a stand-alone RC. A small proportion of financial firms, 23 percent, established both compensation and risk committees. Even though the existence of compensation and risk committees is expected to result in improved effectiveness in the overall system of governance (ASX CGC, 2007), financial companies commonly choose not to establish such committees.
The beta coefficient has a mean of 1.3, indicating a high level of market risk facing financial firms in the period 2006-2008. The mean score for the standard deviation of monthly returns (STD.DEV) is 10.6, suggesting a great variability of returns for financial firms. The average size of the CC is 3.2.11 Of the 337 observations, 20.2 percent have a CC consisting solely of independent directors while only 1.26 percent have no independent directors on the CC. Twenty two percent of the sample has at least one director with 10 or more years of board experience and 73 percent of the CC has members with at least 10 years industry service. On average, 28.4 percent of the CC members has either an accounting and/or finance professional qualifications. The average number of CC meetings during 2006-2008 is 2.911.12
In relation to the risk committee characteristics, these committees have an average size of 3.6.13 Members of the RC are primarily independent directors (80 percent). Of the 236 observations, 16.55 percent has an entirely independent RC (i.e. all members are independent 11
There are two CC that have only one member. There are 71 cases (9.96%) where CC have fewer than the ASXCGC recommendation of a minimum of three members. 12 One, two and three CC had no meeting in 2006, 2007 and 2008 respectively. These committees all have more than 2 members. 13 There are 3 RC that have only one member.
23
directors), while less than 1 percent do not have any independent directors on the RC. Nearly 73 percent of RCas have all directors with more than 10 years of industry service and 22 percent have long-serving director on their RC (>=10 years board service). On average, 32 percent of RC members are professionally qualified in accounting and/or finance. The number of RC meetings has a mean of 4.75.14 There is only 3.51 percent of observations reported the presence of the CEO on the RC. Of the 165 observations that have both a RC and a CC, the proportion of board directors who serve on both committees is 23 percent.
The descriptive statistics of the firm characteristics and firm performance variables (EPSt, BSIZE, ASSETS and LEVERAGE) are also presented in Table 2. Financial firms in the sample have a board consisting of between 2 and 13 members with a mean of 5.5.15 The sample contains financial firms of different size and leverage. An average, total assets are $11,005 million and leverage has a mean of 0.547. EPS has a mean of 25.48. Overall, there are no apparent or significant differences in characteristics of financial companies over the period 2006-2008. Interestingly, there is a gradual increase in committee formation over the 3 years.
Table 3 reports the details of the sample by industry over the 3 years. The sample comprises 716 firms: 24 insurance companies (3.4 percent), 43 banks (6 percent), 120 real estate firms (16.8 percent), 146 real estate investment trusts (20.5 percent) and 380 diversified financial companies (53.3 percent).
3.4. GLS Regression results
14
One RC had no meeting in 2006 and another one had no meeting in 2008. These two firms do not belong to the group of 6 firms that have only one member on the RC. 15 Only one board has fewer than the ASXCGC recommendation of at least 3 directors on the board.
24
Consistent with prior research (e.g. Subramaniam et al., 2009) our first test is to determine what type of financial firm has these committees. The results reported in Table 3(b) from the probit regressions show that firms with a RC or a CC are large, with a large board and high risk (beta). This result suggests that firms with more inherent risk set up these committees to monitor and manage risk more closely. Next, we determine whether these firms are successful at managing risk. Leverage is not significantly associated with the existence of the committees while performance (EPS) is positively and significantly associated with the existence of a CC. Insert Table 3 about here The results of testing H1 are reported in Table 4. The results show a positive and significant association between the CC characteristics and risk (B = 0.232; p = 0.009), thus partially supporting H1. We also find a negative association between RC size and beta (B = -0.258; p = 0.030) which suggests small risk committees are positively associated with more risktaking. This result is consistent with Pathan (2009) but does not determine whether the level of risk improves firm performance. Hypothesis 2 posits that directors’ dual membership on the compensation and the risk committee is negatively associated with risk as dual membership is likely to ensure less excessive risk taking due to the communication between the RC and the CC. The result is negative but not significant thus failing to support H2.
The results reported in Table 4 for testing H3a fail to find that a positive association between risk and performance depends on the characteristics of the RC or CC. However, we do find that a positive association between risk and return depends on the dual membership on the RC and CC (B = 0.010; p = 0.029). During testing we discovered that many 2008 firms were delisted in 2009. Consequently, we ran the tests using the 2006 and 2007 observations. The
25
results for dual membership are stronger (B = 0.016; p = 0.000) and the model is wellspecified with an overall R2 of 57 percent and a significant Wald Chi statistic. This result demonstrates that when there are directors with responsibilities in both committees they are able to oversee the association between the risk levels of the firm and the risk-taking incentives of the compensation package. This result also implies that even though separation of committees may help individual committees to focus on their specific tasks, co-operation between the compensation and the risk committee is advantageous for financial firms (in terms of improving firm performance). Thus, the collaboration between these committees lowers information asymmetry and improves monitoring of compensation and risk levels which, in turn, improves firm performance.
The results also show a positive association between risk and performance is associated with CC characteristics and RC size. The conjecture from this result is that financial firms with high systematic risk require a CC with members who are independent of management, have industry and board experience, are professionally qualified and meet frequently to ensure a positive return for shareholders. The threat of future losses due to high risk and uncertainly justifies taking measures that control risk-taking. In addition, the RC should be large enough to monitor excessive systematic risk as there is a positive association between risk and return as RC size increases. Insert Table 4 and 5 about here
3.5 Robustness testing To ensure the validity of the results we run models 1-6 using the standard deviation of returns (SD) measured as the standard deviation of the rate of return on equity for the company and
26
is expressed as a rate of return per month computed from the (continuously compounded) equity rates of return for the company’s equity. Apart from the following, the results remain consistent with the Beta results. The models in general have a stronger explanatory power, the interaction of the RC factor and SD is positive but not significantly related to EPS, CC size is negatively and significantly associated with SD and dual committee membership is not significantly associated with SD.
As mentioned earlier, hypothesis testing is also carried out using the individual characteristics of the RC and CC. The results are consistent with the factor; the individual CC characteristics are significant while the individual RC characteristics are not significant. We also tested for endogeneity by using two tests. The first test is to create instrumental variables using lagged variables and run a 2SLS regression. This method follows Baum, Caglayan and Talavera (2008). The second test is the Durbin-Wu-Hausman test (DWH test) which is used to determine if endogeneity is a problem in the model. The results from the DWH test shows no presence of endogeneity (Chi-sq = 3.31; p = 0.973).
We report the results of the 2SLS regressions in Table 6 where we regress the RC and CC variables on performance. The results are similar to the GLS regression except that the interactions between RC factors and risk and dual and risk on performance are no longer significant. The results show a positive association between dual committee membership and performance; however, a positive association between risk and performance does not depend on dual committee membership. In addition we find that the existence of the CC and RC are positively and significantly associated with firm performance (B = 0.199; p = 0.002 and (B = 0.111; p = 0.035 respectively). However, the interaction between CC or RC existence and risk on performance is not significant (not reported here).
27
Insert Table 6 about here
4. Conclusion This study provides some illumination towards the importance of corporate governance mechanisms as well as the management of risk in Australian financial companies. In the context of agency theory, there are incentives for companies to establish corporate governance controls, such as board committees, due to the inability of shareholders to directly monitor managerial actions (Jensen and Meckling, 1976). This empirical study of Australian firms in the financial sector over the period 2006 to 2008 provides some evidence of the importance of committees in managing risk to improve firm performance.
The
findings from this study demonstrate that it is important to have a compensation committee with members who are independent of management, have industry and board experience, are professionally qualified and meet frequently. More importantly, this study finds when committee members serve on both the risk committee and the compensation committee the firm’s level of risk exposure is monitored more closely so that there is a positive association with risk and performance. This result suggests that coordination and communication problems are alleviated when committee members’ responsibilities transcend tasks. Future research could investigate this finding further by interviewing risk and compensation committee members.
This study is the first to examine the relationship between corporate governance controls (i.e. compensation and risk committee) and risk management in Australian financial companies. Practical implications of the study include the demonstration of the benefits of coordinating monitoring committee functions. Dual committee membership has a positive risk and performance outcome which may mitigate the tendency of some compensation committees to 28
design compensation packages which inadvertently lead to excessive risk taking and poor performance.
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Appendix Prudential Standard APS 510 on Governance The key requirements of this Prudential Standard include:
specific requirements with respect to Board size and composition;
the chairperson of the Board must be an independent director;
a Board Audit Committee must be established;
regulated institutions must have a dedicated internal audit function;
certain provisions dealing with independence requirements for auditors consistent with those in the Corporations Act 2001; and
the Board must have a Remuneration Policy that aligns remuneration and risk management;
a Board Remuneration Committee must be established; and
the Board must have a policy on Board renewal and procedures for assessing Board performance.
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Table1: Definition of variables Variable Measurement Dependent variables Beta The slope coefficient the company’s equity rate of return adjusted for thin trading LNEPSt+1 Reported net profit after tax before abnormal items and less outside equity interests and preference dividends divided by diluted weighted number of shares outstanding during the year plus 1. Committee characteristics used to derive factor score CC/RC IND Ratio of independent directors to total directors on the committee. CC/RCPRO Ratio of directors with professional qualification to total directors on the committee CC/RCSENIORIND Ratio of directors who have more than 10 years industry services to total director on the committee CC/RCSENIORBoD 1 if the committee has member with at least 10 year board service and 0 otherwise CC/RCMEET Number of meetings the committee held in 2008 Explanatory variables CC/RCSIZE Number of directors on the committee. DUAL 1 if there is a member who serves on both the compensation and the risk committee and 0 otherwise. Interaction terms CCFAC*BETA Factor score for compensation committee characteristics * BETA RCFAC*BETA Factor score for risk committee characteristics * BETA CCSIZE * BETA Compensation committee size * BETA RCSIZE *BETA RISK committee size * BETA DUAL*BETA Dual committee membership * BETA Control Variables CCCEO Dummy variable equals 1 if the CEO is also a member of the compensation committee. RCCEO Dummy variable equals 1 if the CEO is also a member of the risk committee. EPSt Reported current earnings per share before abnormal items at year t. LNASSETS The natural log of firms’ total assets in million dollars BDSIZE The total number of directors on board. LEVERAGE The ratio of total liabilities to total assets YEAR Dummy variable for year 2006, 2007, 2008.
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Table 2: Descriptive statistics ALL YEARS (N=718)
2006 (N=221)
2007 (N=248)
2008 (N=248)
VariableContinuous BETA STD.DEV CCSIZE CCIND CCSENIORIND CCSENIORBoD CCPRO CCMEET RCSIZE RCIND RCSENIORIND RCSENIORBoD RCPRO RCMEET EPSt BSIZE ASSETS($million) LEVERAGE VariableDichotomous
Mean
Median
Std.dev
Mean
Median
Std.dev
Mean
Median
Std.dev
Mean
1.274 10.60 3.20 75.13% 73.22% 21.93% 0.284 2.911 3.61 80% 75.10% 13.10% 0.322 4.75 25.480 5.54 11,055 0.547
1.840 8.123 0.937 26% 28.44% 28.74% 0.288 1.997 1.429 24.10% 28.77% 23.81% 0.277 2.496 71.165 2.021 59,583 0.816
1.255 10.325 3.19 77.27% 68.44% 24.10% 0.264 3.19 3.97 79.61% 72.8% 15.4% 0.304 5.38 30.442 5.45 10,191 0.465
1.102 9.709 3.280 75.03% 68.86% 19.38% 0.250 2.85 3.6 78.65% 72.18% 12.48% 0.294 4.44 35.763 5.62 10,603 0.721
1.464 11.722 3.14 73.45% 81.35% 22.65% 0.333 2.74 3.40 81.50% 79.05% 12.16% 0.360 4.63 10.715 5.55 12,272 0.448
Coding
% of sample
Coding
% of sample
Coding
1 1 1 1 1
47 6 33 3.5 23
1 1 1 1 1
0.89 6.9 3 75% 67% 0% 0.25 2 3 81.50% 75% 0% 0.330 4 14.6 5 174 0.46 No. of firms in sample 118 12 82 8 58
2.049 7.801 0.923 24.7% 28.70% 26.15% 0.259 2.074 1.448 25.55% 30.47% 22.02% 0.264 2.389 66.484 2.027 578,168 1.266
% of sample
0.820 7.7 3 75 % 67% 0% 0.25 3 4 75% 74% 0% 0.330 5 13.6 5 159 0.370 No. of firms in sample 98 12 60 6 49
1.915 8.355 0.981 24.02% 25.76% 29.40% 0.274 1.870 1.657 22.44% 26.18% 23.75% 0.243 2.859 58.99 1.945 51,958 0.405
CCEXT CCCEO RCEXT RCCEO DUAL
0.95 8 3 75% 75% 0% 0.333 2 3 93% 81.50% 0% 0.330 4 8.6 5 184 0.410 No. of firms in sample 337 42 236 25 165
Coding
44.3 5.4 27.1 2.7 22.2
1 1 1 1 1
Definitions: see Table 1
35
47.6 4.8 33.1 3.2 23.4
1 1 1 1 1
Median
Std.dev
1.210 8.9 3 75% 100% 0% 0.330 2 3 100% 100% 0% 0.330 4 2.0 5 191 0.40 No. of firms in sample 121 18 94 11 58
1.509 8.131 0.916 28.75% 28.68% 30.58% 0.319 2.011 1.212 24.05% 28.65% 25.45% 0.307 2.286 82.595 2.085 67,360 0.366 % of sample 48.6 7.2 37.8 4.4 23.3
Table 3a: Details of the sample All years Observations % Insurance Bank Real estate REIT Diversified financial Total
2006 Observations
%
24 43 120 147 382 716
3.4 6 16.8 20.5 53.3 100
9 15 37 43 115 219
4.1 6.9 17 19.7 52.3 100
RCEXT
z
CCEXT
z
Constant
-7.474
(-1.30)
-26.004
(-3.70)***
BETA
0.099
(2.48)***
0.071
(2.33)**
STDEV
0.003
(0.35)
0.007
(0.88)
LNEPSt
0.059
(0.53)
3.235
(3.20)***
LNASSETS
0.127
(4.30)***
0.130
(4.30)***
LEVERAGE
0.071
(1.12)
0.104
(1.39)
BSIZE YEAR Pseudo R2
0.169 yes 0.167
(4.70)***
0.168 yes 0.164
(4.80)***
Table 3(b) Probit regression – unbalanced data
Chi 2
151.33****
162.10***
N
716
716
Firms
317
317
2007 Observati ons 7 15 40 51 135 248
%
2008 Observatio ns
%
2.8 6.1 16.2 20.6 54.3 100
8 13 43 53 132 249
3.2 5.2 17.3 21 53.2 100
RCEX and CCEX = a dummy variable 1 if a risk or compensation committee exists; 0 otherwise. *p
