Corporate governance of banks has some particular features making it different from non-financial governance. Banks often work with high debt ratios and their assets are generally less transparent than assets of traditional non-financial companies. The first factor creates incentives, and the second creates opportunities for taking part in high-risk projects or outright funneling of assets from the banks. As a result, risks shift from shareholders to debtholders, including depositors, especially if a bank comes close to failure. The closer failure is, the more interested shareholders are in risky projects with modest chances of success.
The case of Financial Corporation Otkritie, which pursued quite an aggressive acquisition strategy but was eventually rescued by the Bank of Russia, provides a good example of both the risk-shifting problem (its acquisitions were a bet on improving market conditions) and the “too-big-to-fail” problem (the acquisitions could be regarded as a part of its owners’ rapid expansion strategy).
Some risks can be eliminated or mitigated through bank regulation: for instance, through capital requirement adjustment. Nonetheless, corporate governance plays an important complementary role. For example, independent and competent directors can balance the interests of shareholders and debtholders in banks. High standards of corporate governance can also help restore access of private banks to international capital markets.
We have analysed corporate governance in the 30 largest Russian banks (by total assets in 2012), focusing on three key aspects: ownership structure, boards of directors and CEOs from 2007 to 2017.
In Russia’s banking sector, the risk-shifting problem is exacerbated by the widespread ‘blockholder model’. All domestic private banks are controlled by one large shareholder or a small group of individuals, who are often heavily involved in governance.
At the same time, minority shareholders have limited control. The three largest shareholders together hold on average about 84% of shares of the 30 largest Russian banks. It is natural for state-owned and foreign banks to have a single large shareholder (the government or a foreign bank holding), but in private banks, the largest three shareholders together hold on average 69% of shares, which is much more than in mainland Europe, for instance. Research shows that on average, banks with high ownership concentration tend to take more risks, especially in countries with generally lower levels of investor protection.
Distinctive features of boards of directors and CEOs
Upon the introduction of the Corporate Governance Code (CGC) by the Bank of Russia in 2014, recommending inclusion of independent members in boards of directors, the share of independent directors has increased in private banks but fallen in state-owned ones. Since not all financial entities report on independent directors and the criteria they use to define whether a board member is independent are not always clear, we have introduced our own definition of outside directors. We consider an outsider to be any individual that has not occupied a top management position in the banks, its holding or subsidiary companies, nor has been a advisor or a large shareholder of the bank (with a stake larger than 5%) during the past five years. Surprisingly, in 2007–2017, the share of outsiders decreased from 47% to 37% on average, while in state-owned banks the drop was even more significant. In other words, at the end of this period, almost 2/3 of board members were affiliated with banks or bank groups through work contracts or capital shares, i.e. were not independent.
The blockholder model is compatible with the insider model of governance, under which the role of independent and outside directors is limited, while insiders, who are tightly affiliated with the bank one way or another (former top managers, employees of holding or subsidiary companies, large shareholders, etc.) prevail in governing bodies. In many private banks, boards are populated by insiders, i.e. large shareholders themselves or their appointed current and former top managers. The prevalence of insiders is perhaps even more troublesome for state-owned banks: although some decisions may be based on instructions from controlling state agencies, the large proportion of insiders on their boards may lead to serious agency problems when managers are not effectively monitored.
Lengthy tenures may impair a board’s monitoring function. The CGC assumes that a board member is no longer independent if they have served for more than seven years on a board. Currently, the average tenure for the largest Russian banks is about 5 years, having nearly doubled in 2007–2017. This is true for all bank types and is particularly evident in state-owned banks where the average tenure increased from 3 to 5 years in 2012-2017.
The analysis of monetary compensation received by board members shows that the median board remuneration in real terms increased between 2007 and 2012 and amounted to 3.1 million rubles per year in 2012. However, board compensation fell by 66% (in real terms) by the end of 2017. This drop is mainly driven by the decrease in board compensation in domestic private banks. In our view, this downfall probably reflects a reduced role of the board of directors, especially in banks where the dominating shareholder communicates directly with top management. In contrast, state-owned banks saw moderate growth of the board compensation, which exceeded that of foreign and domestic private banks in 2017. At the same time, we see a substantial increase in average age, tenure, and executive compensation (i.e. chairpersons and CEOs) in these state-owned banks with growing board compensation. This can mean that insiders fend executives off from the influence of the key shareholder, the state.
How to improve corporate governance
Greater transparency of governing bodies should become a major focus of corporate governance improvement: it is crucial that banks disclose information on board committees, the professional background of executives, and importantly, about board independence. Today, this information is often fragmented, although banks, for instance, are obliged to publish IFRS-compliant accounting statements and must adhere to even higher requirements on disclosure of beneficial ownership than non-financial companies.
Even after the introduction of CGC, most banks are neither required to comply with it, nor obliged to explain reasons for noncompliance. The CGC “comply or explain” requirement, including disclosure about independent directors installed, applies only to listed firms. Extension of these requirements to all banks will help investors, including depositors, know more about composition of the boards of directors and executive compensation, enhancing their understanding of banks’ incentives.
In the past, Russian banks took excessive risks (for instance, by extending risky loans, often to related parties, or attracting funds at high deposit rates). This could be addressed by assigning to bank managers fiduciary duties to act in the interests of both shareholders and debtholders and strengthening the role of independent directors with a similar mandate. Finally, limiting the dominance of insiders in state-owned banks should strengthen the monitoring function of the board.